We believe in constantly adding value through our unique content to homeowners in Singapore by providing that “cutting edge” perspective on how to choose the best mortgage loan that you will never find elsewhere. Starting this week we will do a 3-part series on the topic – “What The Banks Don’t Tell You”, starting with this first article about the differing funding strategies of banks. So stay tuned to this blog.
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At MortgageWise we have been advocating going for longer 4 or 5 year fixed rate mortgage for almost the entire 2015, even if those packages do not come with any legal subsidy for refinancing. It always amazes me how people tend to be easily seduced by lower rates dangled by the banks for either floating rate packages or shorter-term fixed rate like 2-year fixed. Is that a really good idea?
To understand this, let us take a look at the funding strategy of a bank handled mostly by its Treasury department. Now let me first qualify this. We do not proclaim to be experts in this area and in fact we love to hear from you if you happen to know in the Treasury operations of banks or handle cost of funds. What we do know is that no matter whether it’s a $50m or a $500m tranche of funds for a foreign vs a local bank, the mortgage business unit (within the consumer bank divison) gets its funding from the Treasury. Think of it like internal business units which all need to account for profitability in whatever they do, in other words the idea of transfer pricing. Treasury department manages cost of funds for the entire bank across all business divisions be it consumer or corporate, secured or unsecured lending, etc. It employs different strategies in doing so be it sourcing for the funds directly from its retail or corporate deposits, or from the money market, and it involves complex hedging tools beyond our understanding. It then transfers that cost of funds by adding a mark-up as profit before it lends out to mortgage division who in turn does its own pricing to end consumers. In the case of fixed rate promotion, a local bank’s mortgage divison may acquire a tranche of $500m (higher volume for local banks) from Treasury to do a 3-year fixed rate promotion and once that quota of loan volume is approved the promotion ends. We do not know the precise nature of the transfer pricing but we do know the margins are much thinner for such fixed rate tranches, as opposed to floating rate where there is no such need to “lock-in” the cost of funds. The product team within the mortgage division will be tasked to price in the spreads, come out with the final fixed rate to borrowers and track the take-up.
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By understanding all that, what can we learn and how can we benefit? We have mentioned earlier the margins are thinner for such fixed rate tranches and we believe it costs a lot more for Treasury to lock in fixed rate tranches for longer periods (whether from retail deposits or money market) as the risks is higher when you need to hedge over a longer period. For that reason we observed that many banks are not inclined to offer fixed rate beyond 2 years especially local banks.
We suspect there is one big difference between foreign and local banks when it comes to funding strategy. Understand that local banks, because of their huge deposit base in Singapore, tend to be net lenders in the money market – they lend out more than they borrow. The reverse is true for foreign banks who depend more on the interbank market for funds to grow their assets (or loans). If a foreign bank locks in a tranche of funds to run fixed rate promotion for 5 years, yes it pays higher interest or hedging costs to acquire the funds from the market, which will lead to a higher interest rate for end borrowers but the way I see it the bank’s exposure is capped. The spread is already fixed for 5 years. Hene foreign banks will have less inertia to do longer term fixed rate as long as the final rate is deemed to be still competitive. In the case of local banks who are net lenders in the interbank market, their main source of funds come from deposits. It is unlikely they will be able to justify a $500m tranche of funds to run a 5-year fixed rate promotion and remain profitable as they are unable to “lock in” such cost of funds back-to-back on deposits funding per se, unlike foreign banks. Yes in the past you do have at least one local bank offering 5-year fixed rate during a low interest rate environment that continues to stay low. That has all changed now.
If you as a homeowner are of the view that interest is bound to rise, how can you then lock in fixed rate for the longest period? If you are somehow able to access the interbank market and make an offer to acquire the funds directly, you would gladly pay a slight premium to “hedge” your cost of funds over a longer fixed period like 4 to 5 years. Most of us are unable to. And since local banks are not willing to run fixed rate beyond 2 or 3 years now due to their funding strategies as explained above, the best way for one to take advantage of the differing cost structure between local and foreign banks is to access such longer term hedge through the latter.
To summarize, what the banks don’t tell you about cost of funds is this – they prefer you take shorter term fixed ratein an environment when interest is set to rise. So now you know the reason why we started advocating the contrarion approach since beginning of 2015.
At MortgageWise, we seek to provide thought leadership in the area of mortgage planning in Singapore, taking deep dive into developments and news on mortgages & helping clients track interest rate movements. We do not just go for one-time business with clients but rather choose to build long trusting relationships by giving truly independent advice to the extent of losing the deal. We strive to become the first-choice mortgage partner for homeowners and the creditable distributor of mortgage products for banks and financial institutions in Singapore.