Naughty, naughty, banks

Yet again we\’ve got this story of how horrible the banks are being in the way they price their mortgages.

However, banks and building societies have been accused of cynically manipulating the rates on offer to deprive new borrowers from benefiting from recent base rate cuts. The rates on offer are now comparable to the uncompetitive standard variable rates offered by lenders.

Lloyds TSB yesterday released its new products and borrowers must now pay up to 2.09 per cent more than the Bank of England base rate for a mortgage.

Before last week\’s cut in the base rate, Lloyds was charging home owners 1.09 per cent above the official rate.

Abbey and Alliance & Leicester have also increased profit margins and now charge up to 2.04 per cent above the base rate.

Mortgage experts say that until a month ago, the best deals allowed borrowers to pay just 0.5 percentage points more than the base rate, the average is now 2.34 percentage points above base rate. This means on a £150,000 tracker mortgage a home owner would pay an extra £170 on their monthly repayments.


Base rate is not what determines the price of a mortgage (obviously). It\’s LIBOR.

No, not because the banks borrow the money at LIBOR in order to lend it on to the house buyer. That particular business model of borrowing short in the wholesale markets to lend long on housing is a little less popular after Northern Rock imploded.

No, it\’s because the banks can lend the money out at LIBOR, without having to deal with people wanting piddly amounts like £150,000, without having to worry about loan to value ratios, loan to incomes and all the rest. They can, if they\’ve got a few hundred million on their books, lend it out to another bank at LIBOR (I\’m leaving alone the point that they don\’t very much want to do this at present….that\’s another matter entirely). Indeed, that\’s actually what LIBOR is, an average of the rates at which banks are prepared to do this (it is, after all, the "offer rate").

Whatever happens to base rates, whatever the BoE say, or our Chancellor and the rest, LIBOR is thus the rate at which the banks can lend the money wholesale and at low risk (umm, relatively, which takes us back to the credit crunch which isn\’t what I want to talk about). So, if they are then going to lend the money retail (ie, with higher costs) and greater risk that will be the starting point for how they calculate the rate at which they will do so.

The price they pay to borrow money is irrelevant. What matters is the alternative price they can get for lending the money to someone else. That old economist\’s standby, the opportunity cost of their lending.

To take banks out of it for a moment. If I\’ve got a truck load of zirconium tubing from an old nuclear power plant (a position I have actually been in, several times in fact)  then the price I charge the buyer doesn\’t depend upon what I paid for it. Sure, I\’d like that price to be higher than what I paid for it, but that isn\’t what determines the price I am able to get. The price I am able to charge depends upon what someone is willing to pay for it….and crucially, that price is driven up by what all the possible buyers of Zr tubing are willing to pay for it. The winning buyer\’s offer is driven up by what the alternative buyers are willing to offer.

And money\’s no different in this regard. The price the buyer has to pay is not determined by the cost of supplying the money. It\’s determined by what the alternative users of the money are willing to offer. Which, in a crude (and not accurate in detail but good enough in a broad brush sense) manner, is what LIBOR is.


7 thoughts on “Naughty, naughty, banks”

  1. One quibble and one question.

    [Quibble] “Lloyds TSB yesterday released its new products and borrowers must now pay up to 2.09 per cent more than the Bank of England base rate for a mortgage.”

    No it isn’t. It’s 2.09 percentage points. [/Quibble]

    Question is: why isn’t LIBOR moving? As the cost of money falls (due to BoE rate drop), margins rise and there is volume/share to be grabbed by offering below your competitors.

    I can appreciate that the risk premium has risen, but for LIBOR not to move at all in response to a 150 pp cut in costs seems peverse.

  2. That is a much better explanation. You have to bring opportunity costs into it for it to make sense.

    Re C and K’s point, that’s the beauty of it. The LIBOR minus BoE spread used to be teeny tiny, it had drifted up to about 100 bps (reflecting higher risk; conveniently in line with lender-of-last-resort rate of BoE base plus 1%) and since last week the spread is AFAIAA 1.5%.

    Seeing as the spread is a measure of how little banks trust each other, this suggests that they trust each other even less than before.

    Nice going, Nulabour!

  3. It doesn’t mean someone on a variable rate tarcker pays more, it means they don’t pay less. Over the last 3 years around 70% of all new mortgages have been “fixed”, while the rest have been tarckers – ususally base rate. You will probably find that the real reason for the 150bp cut was to avoid sticker shock for those coming off fixed rate. As I look, a 10year swap can be had for 4.3% so it should still be profitable to offer similar rates to even the best fixes of 2005

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