The Central Bank of Ireland published a paper on Friday entitled Fixed Rate mortgages – generating risk or building resilience. The paper noted a rapid shift in traditional variable rate mortgages towards fixed rate mortgages in Ireland and other countries.
Fixation periods appear to be slowly lengthening. The paper notes that whilst fixed rate mortgages can increase household resilience, this is likely to increase the cost of the mortgage. Pricing risk is shifted from households to the banks who must then diversify away the risk through funding markets or through market hedges and the pricing risk depends on numerous jurisdiction specific regulatory and institutional factors.
At present, the majority of Irish mortgages have fixations below 5 years. The paper notes that if growth in short term fixations continues in Ireland, the market will slowly look more like the UK market, where most mortgages are issued on “teaser” rates, bearing in mind that variable rates in Ireland are generally at higher levels than most fixed rates.
The paper notes that the current point in the cycle and flat swaps curve makes longer-term fixations relatively attractive for banks and customers, suggesting that the key issue with longer term fixed rate mortgages is pricing risk.
The Central Bank notes that while the average wholesale funding maturity has increased to 8.66 years in 2018, banks are still 80% funded by variable rate deposits. There are also no government backed securitisiers or insurance providers in Ireland. Combined with the lack of a liquid market for long-term fixed rate securities, the paper suggests it may be difficult to obtain sufficient funds to support a large long-term fixed-rate mortgage book.
The paper goes on to add that if fixed-rate mortgage books continue to grow, banks will need to engage in risk hedging strategies and set margins and capital buffers high enough to insure them against any residual risk. These additional costs will likely result in households paying higher mortgage rates, reflecting the benefits they obtain from being insured against bank funding cost risk. Margins are likely to increase even more if households are able to refinance at low cost, as banks will need to compensate for the additional refinancing risk.
According to Goodbody Stockbrokers, "The paper provides useful insights into the Irish mortgage market, noting that the length of fixation is closer to the UK model than the European model. The paper suggests that the current funding structure for Irish banks may make it difficult to support a large fixed rate mortgage book."
They added, "Whilst the Financial Stability Note doesn’t dictate Central Bank policy per se, the paper seems to be suggesting that unless the Irish mortgage model can develop a cheaper longer-term funding model, banks will need to engage in risk hedging strategies and set margins and capital high enough to compensate for the additional refinancing risks. These costs will likely result in households paying higher mortgage rates."