This time last year some British banks, including leading building society Nationwide, put a freeze on further tracker rate cuts even if the Bank of England (BoE) continued to lower the base rate. As the gap between the low BoE rates and the prevailing interbank rates widened, banks were losing more and more money on existing tracker loans as they had to pay more to fund them than they were receiving in interest payments. This was a great deal for customers, as their payments kept reducing, but it was a bad deal for the banks, which were still paying a lot for funding, regardless of central bank action. To stop the pain, Nationwide used a get-out clause in its mortgage contracts to allow it to stop reduction once the BoE rate fell below 2%.
Irish tracker customers were spared this fate at the time as no lender in the Irish market included such clauses in their loan agreements. Consequently, anyone lucky or savvy enough to have got on a tracker rate in the good times received the full benefit of 3.25% in reductions from October 2008 to May 2009. This shaved hundreds of euro off the average mortgage at a time of massive contraction in the economy and provided some level of comfort as incomes and unemployment fell.
But Irish trackers are not airtight. They may not have the threshold clauses common in UK mortgages, but clauses relating to funding costs are widespread. Though they vary from lender to lender, all invoke the right to end a tracker's link to the European Central Bank rate and move it to some other reference rate, usually to one of the Euribor interbank rates or a rate priced off the Euribor.
Rate hike on standard variables
None of the lenders have indicated any moves in this direction, but mortgage brokers and other market sources expect that to change eventually, as the cost of money for Irish banks remains stubbornly high.
Both Irish Life & Permanent and Bank of Ireland have raised money under the new government guarantee, the Eligible Liabilities Guarantee (ELG), and while investor demand has been encouraging, the price was relatively high at 1.45% above the benchmark for BoI and 1.65% above for IL&P. This puts the funding cost north of 5%. A borrower on an ECB+1% tracker is only paying 2%, by contrast.
Obviously banks cannot keep this up forever. That is why they are moving first to raise their rates on standard variable mortgages. IL&P put theirs up 0.5% last summer and will be raising them by the same amount again in February. EBS chief executive Fergus Murphy said late last year the EBS would be changing its rates in 2010 also. According to estimates by Irish Mortgage Brokers, on average, standard variable mortgages will cost 1% more by the end of this year and 0.5% more on top of that by the end of 2011.
The logic that applies to standard variables applies to trackers too, only there is less flexibility on trackers. So will the banks try their luck on their lossmaking loans? Already, several lenders have begun revoking trackers on customers who seek to renegotiate loans due to arrears or other payment problems, since breaching the terms and conditions renders the bank's price commitment null.
IL&P's terms and conditions state that the bank can substitute another reference rate if "an event occurs which fundamentally affects the use of the ECB rate as a reference rate". According to a spokesman, current market conditions do not meet this standard.
"We have been asked this frequently and our consistent answer has been that we do not see it as relevant under the current circumstances," the spokesman said. "[The clause] is designed for an extreme situation in which the ECB ceases to operate or is replaced by something else."
EBS said only a small number of mortgages operated with such a rate clause, but that it was too strict to invoke right now. "For the vast majority of our book we don't have any clause in the tracker contract. They are linked to ECB only," said Dara Deering, director of membership business at EBS. "However, we have a small number of cases where there is a clause giving us the option to change the base rate to one-month Euribor if there was a wide gap between the two. Today, the one-month Euribor rate is less than the ECB rate so this does not give us any flexibility."
Tracker get-out clause
KBC, the Belgian bank formerly known as IIB, employs wording which would appear to allow a lot more room for manoeuvre, though. Its tracker get-out clause permits a switch in the reference rate when the Euribor moves 0.25% higher than the widely-quoted ECB rate – however, the bank defines Euribor in its documentation as "the rate at which the lender [KBC] is offered funds of like amount on the Euro Interbank Market". Given that each institution is quoted different rates depending on its perceived creditworthiness, KBC could potentially reset its trackers far above prevailing norms if it was being forced to pay a lot for its funding, as all Irish banks are.
But could any bank get away with such a move in a market which is highly sensitive to price movements given how much taxpayer money has been used to prop up the banks already? "It's hard to imagine anyone trying it," said Dolmen stockbrokers head of research Oliver Gilvarry. "There would be uproar. I don't know if it would be worth it."
But Karl Deeter, operations manager at Irish Mortgage Brokers, believes it will happen just gradually enough to keep it from being noticed: "I think somebody will exercise their get-out clause on trackers eventually, perhaps starting with the smallest group – say the 1.8%+ trackers. They'll offer them a comparable variable to keep the outcry down and base the decision on the ongoing contract for certain LTVs or otherwise."
This approach would at least give the customer a deal while giving the bank some flexibility in future pricing – which could pay off for either side. But once the seal is broken, less favourable arrangements become conceivable.
NIB's loan losses
One of the banks hit hardest by the difference between central bank rates and market rates is National Irish Bank (NIB).
NIB was very active in the switcher market before the crisis and had a strategy of cherrypicking the best customers from other lenders, especially those with low loan-to-value ratios (LTVs). These were borrowers whose loans got relatively smaller as house prices went up during the bubble.
NIB enticed such customers with market-leading rates for low LTV tracker mortgages. Its best rate – withdrawn in 2008 – was 0.5% above the ECB rate for loans at less than 50% of the house value. Rates graduated upwards in proportion to the LTV, so a 60% loan was charged at 0.6% above ECB and so on.
But these prices were predicated on cheap funding, which disappeared, and rising house prices, which have reversed. Now NIB is stuck with loans that once were ideal but now are totally uneconomical under current market conditions.