Just what are Swap and LIBOR Rates?

Hi all, I’ve had a few queries about the markets, as lots of customers are coming in wondering why mortgage rates and fees are still high despite the drop in Bank Rate to 2%.

Well firstly, rates have thankfully dropped a lot this last month following the Bank rate cut, and the best buys show that we are now getting sub 4% trackers and fixed rates filtering through. However, the lowest rates continue to be subsidised with high arrangement fees, and you will have to keep doing the maths to help them work out what arrangement would suit them best over the few years they intend to keep the mortgage.

We do tend to band about the terms LIBOR and swap rates, but you may not know the difference between the two, and most importantly, how they affect the new mortgage rates for your clients.

The rather simplified explanation of LIBOR is as follows: It’s the London Inter Bank Offer Rate, which means that, as banks lend to each other every day for short amounts of time, such as overnight, one month or three months, they tot up what rates they agreed to lend at, and we see an average of the rates for those transactions every evening. The 3 month LIBOR is the one that gives the best impression of what sort of price the lenders are paying wholesale for their short term cash, as this is the funding they will use to make trackers.

If Bank rate has fallen, the lenders believe they can replace their money a bit cheaper, and also now, as they gain more confidence in each other and believe it to be less risky handing over a load of money, (as the recipient bank is less likely to go bankrupt in the next 3 months!) they agree to lend each other money at a lower rate. We see this as the LIBOR falling day after day.

If you are a lender, and you’re getting your money at LIBOR, you can, broadly speaking, add a bit of a margin, and lend it out. For the sake of consumer understanding though you represent the price as a margin over Bank rate, such as BR + 1.99, and this, to be fair, is what has caused a lot of confusion for consumers. Lenders simply don’t get their funding at Bank rate, they get it a LIBOR, but they have always listed their mortgage prices over Bank rate. Even if they did want to advertise their new mortgage prices as a margin over LIBOR, it would be a right pain changing the pay rate every night, you’d have to have daily interest (some still don’t) not to mention the horrific cost of altering the KFI quoting machines, and the responsibility of explaining to clients exactly how variable their rate could be.

Yesterday the 3 month LIBOR was 2.64%. This means lenders would need to offer new deals at Bank rate + 0.64 as a minimum just to break even. However, lenders have been instructed by the government, and for their own security, to stash vast amounts of income in their own ìTier 1î capital piggy banks to give themselves a genuine asset base. They are also getting ready for a grotty year of losses as their borrowers default and money is lost carrying out repossessions and write offs. This means they have to price an extra percent or so extra in fees and rate to get more cash in. Far from ‘not passing on Bank rate cuts’ they simply haven’t had enough of a fall in their overheads to pass on.

Swap rates work differently and are a way for lenders to secure a constant flow of wholesale money at a set price for a longer term, say two years or five years. Interest rate Swaps are slightly more complicated as they are a ‘derivative’, but the short, short version works like this: If I (lender A) reckon the cost of cash I can get in at LIBOR is going to average out at about 3.5% over the next two years, but another lender believes that LIBOR will in fact fall and fall, and they would have only got an average of say, 2.5% for lending the cash over the two years, I might agree with another lender to borrow money at a fixed interest rate of for two years of 3%. I’m going to be paying them a fixed rate of 3% for that money regardless. I can lend it out to my consumers as two year fixed mortgage deals of 4%, and make a nice little 1% profit (this is why fixed mortgage rates always have a specific dd/mm/yyyy end date by the way: it’s because the funding for them does). At the same time, I will lend lender B money on the fluctuating rates of LIBOR. I will be secretly hoping that LIBOR in fact stays higher than 3%, and I’ve, therefore, got my long term supply of cash cheaper than if I had tried to get it from the LIBOR market, whilst this other bank will have been paying me that higher LIBOR during that time too. The other lender (lender B) is getting my 3% income without fail for 2 years.

In real life, the lenders normally agree to swap the fixed interest loan and the LIBOR interest loan with each other, then instead of actually paying each other monthly, just settle up at the end of 2 years.

One of these lenders is indeed likely to lose out ultimately- and it’s a gamble to know who will be right until after the two years, but because the fixed rate of wholesale cash is there for me long term, I was able to offer fixed rate mortgages to attract all the borrowers who wanted to know what they would be paying every month, or didn’t want to take the risk of their mortgage going up.

The average rate the lenders agreed their swaps at yesterday (06/01/09) was 2.61%. From this we might also be able to glean than lenders might think that in two years time the LIBOR markets will have averaged out to broadly the same as they are today (the 2.69%); it may also have been influenced by a belief that Bank rate will fall again this week, but lift slightly again towards the end of this year.

Both LIBOR and swap rates are falling now, showing that lenders do have more faith in each other and their ongoing funding sources, and pretty soon, they will have stashed all the cash they need to in their Tier 1 capital piggy banks, and paid back a lot of their government debt (where applicable). Their interest rates won’t necessarily need to be so high, they will have some freedom to take slightly more risk on loans to value, and some rather competitive deals could appear. At the same time, the first time buyers saving deposits will have got a tidy sum together, and, the UK will have the added issue of being wildly short of property as new build development has all but ground to a halt: falling short on house building targets bay about 100,000 homes a year, meaning demand could be strong. All things being well, this could indicate a very sharp upturn in house price values, it’s just a matter of when.