Interest Rate Risk in the Pricing of Banks' Mortgage Lending

Abstract

Residential mortgage rates in Hong Kong have fallen to a historic low level since late 2004, largely because of severe competition and the prevailing exceptionally low funding cost of the banks. Because of the abundance of liquidity in the banking system, HIBOR is at an abnormally deep discount to LIBOR of about 200 bps. Under the Currency Board arrangements, HIBOR tracks LIBOR closely in the long run. The average HIBOR-LIBOR differential for the past 16 years is near zero. However, with US interest rates rising, and given the long repayment period of mortgages, there are risks of a reduction on the interest rate margin for mortgage loans made under the prevailing monetary conditions. Such risks could arise from a narrowing of the average spread between Hong Kong's best lending rate and the cost of funds during the tightening phase of US interest rates, and a shift of the risk premium of Hong Kong dollar over the US dollar to a more normal level. For simplicity, loans are classified into three groups for analytical purposes to assess these risks: HIBOR-financed loans, time deposits-financed loans and loans financed by an average mix of time, demand and savings deposits. Currently, banks are generally pricing mortgage loans at BLR -2.75% and providing cash rebates of 1% of loan amounts, with a gross mortgage margin of 130 bps for HIBOR-financed lending and 163 to 167 bps for deposits-financed loans. Simulations derived under different scenarios of interest rate upswings and risk premium reversals indicate that such a margin reduction on loans priced on the currently very low funding cost could be tangible. When HIBOR converges with LIBOR, and assuming US interest rates to increase by 120 bps in the next 12 months as expected by the market, the gross margin of mortgage loans would be reduced because of the lead-lag relationship among the rises in the various interest rates including BLR, and their different responses to the shocks. Taking account of the deposit-acquiring cost (30 bps), operating cost (30 bps) and credit cost (10 bps), the mortgages which are financed by time deposits or with a mix of customers' deposits are expected to maintain a positive, albeit thinner, margin. The expected tightening of the mortgage spread is likely to exert pressures on the earnings of the banking industry. How the margin of mortgage portfolio and earnings of individual banks may be affected depends much on the structure of their own funding sources and actual operating and credit costs. Note that many of the banks involved in the mortgage market have a sizeable retail deposit base.