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Warning over 'profit destructive' home loan

As Australia considers introducing ’rate tracker’ mortgages, one industry veteran has highlighted how the popular home loans left British banks high and dry when the GFC hit.

Earlier this month, the House of Representatives Standing Committee on Economics asked the CEOs of the big four banks whether tracker mortgages, which are used in overseas markets such as in the UK, could be applied in this market.

The concept of pegging mortgage rates to the cash rate has been suggested by the committee in the past, as they could ”protect customers from interest rate fluctuations that are not genuinely caused by changes to the bank’s cost of funds”, and ”offer customers greater transparency and reassurance by behaving as customers expect variable rate mortgages to behave”.

The suggestion is timely, as there have been criticisms by some that the banks’ tardiness in passing on interest rate cuts is making them millions of dollars in profits.

However, former NAB and Barclays executive Steve Weston has said that there are significant risks involved in rate trackers, as British lenders and brokers both warned about the dangers of tracker loans during The Adviser’s recent UK Study Tour.

According to Mr Weston, tracker mortgages had become hugely popular in the UK by 2005, accounting for approximately 60 per cent of new home loans. Prior to that period, the market had been dominated by fixed rates.

”Just prior to the financial crisis, some banks had [rate trackers] priced as low as 20 basis points above the Bank of England rate due to intense price competition,” Mr Weston told Mortgage Business.

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”When the financial crisis hit, liquidity dried up and banks struggled to raise funding through wholesale markets. As a result, retail deposit rates increased. In fact, deposit rates rose to levels higher than the rates being charged on most tracker loans.”

Trackers ’profit destructive’ for lenders

At the time, wholesale funding was typically locked in for periods of five years, which was the expected life of the mortgage during the period. But the sharp spike in deposit rates and the difficulty for home buyers to obtain finance radically changed the behaviour of rate tracker mortgage customers, according to Mr Weston.

”Suddenly the banks found themselves in a situation where borrowers weren’t paying their mortgages off in five years; it was far more attractive to deposit their money into a savings account and get a better rate. And customers weren’t moving homes as regularly because it had become difficult to obtain finance for a new home loan.”

The Bank of England rate fell from 5 per cent to 0.5 per cent between April 2008 and May 2009, where it remained until recently. Those with a rate tracker home loan could have been paying as little as 70 basis points on their mortgage. However, with banks paying upwards of 2 per cent on deposits and wholesale funding, the tracker loans quickly became ”profit destructive” for lenders, said Mr Weston.

He added there are still UK banks that have up to 25 per cent of their mortgage book locked in life time rate trackers, eight years after the start of the GFC.

”The risk of tracker mortgages is that we have another liquidity event where you see the funding costs rise rapidly but the lender can’t reprice the mortgage because they’ve committed to the customer to move the rate only when the RBA does,” he said.

”Banks would be forced to absorb the losses.”

Major banks oppose tracker mortgages

Westpac boss Brian Hartzer stood opposed to the introduction of rate tracker mortgages at the banking inquiry this month, arguing that tracker mortgages could be risky for banks during times of economic hardship.

Saying that they were ”fraught, from a risk point of view”, Mr Hartzer argued that although they would be ”fine when everything is fine”, he said that ”when things are not fine, they can be a real problem”.

Mr Hartzer explained: ”When your cost of funds spike dramatically and yet you’re unable to reprice your loan book, that’s a serious for problem for the bank.”

He gave the example of how tracker mortgages partially contributed to the Northern Rock collapse in the UK during the financial crisis.

According to the chief executive, the premium involved in ”managing all the risks inherent in [tracker mortgages] … make that product really unattractive for a customer”.

”We think customers who want certainty are much better served by a fixed rate loan,” he added.

[Related: Banking review pushes for tracker mortgages]

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