Subject: Mortgage repayment penalties
The Office of Fair
Trading's recommendations do not reflect fair practice and are
against the interests of consumers. The OFT's actions as a result
of complaints by disingenious borrowers will mean a higher cost
of mortgages for all. Somebody will have to pay for the sharp
practice by some borrowers. It will not be the banks. It will
be other borrowers.
Warren Edwardes
is author of "Key Financial Instruments:
understanding and innovating in the world of derivatives" Jan. 2000, Commissioned
by Financial Times Prentice Hall ISBN 0273 63300 7
London 
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15 October 1999
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Warren Edwardes discussed fixed rate mortgage penalties on BBC Radio 5."Banks that provide fixed rate mortgages have to protect themselves against interest rate movements. Using derivatives such as swaps they effectively borrow at a fixed rate in the money market. When a customer walks away from his or her fixed rate commitment, the bank cannot renege on its part of a deal.
So consider a customer with a £60,000, 15% mortgage with 7 years remaining. Imagine rates fall to 5%. The customer gains 10% per annum or £4,200 per year for 10 years. This is a grand total of £42,000 ignoring compound interest. If the customer gains the bank loses and should expect to pay an appropriate penalty.
However, the banks are not entirely justified in their method of calculating such penalties. If interest rates rise and the customer repays a mortgage, the bank makes a windfall profit - but it does not pass this on to the borrower."
23 October 1999 Stephen Byers, the UK Department of Trade and Industry Minister, held a summit on 29th October 1999 with chairmen of British mortgage banks to discuss lending practices and terms. Many bank chairmen declined the invitation. According to The Times of 23rd October 1999 ("Bank chairmen snub the Byers summit") a bank source said "inviting the chairmen of the country's mortgage lenders indicated a profound misunderstanding of how mortgage lenders work ... chairmen would not be conversant with the finer details of specific products."
I totally agree with the unnamed "bank source". But it is disgraceful that it is wrong to assume that bank chairmen understand what happens in the banks under their charge. But the quoted proud statement perhaps suggests something worse. Obtaining a broad understanding of relatively simple products such as fixed rate mortgages and their embedded derivatives and talking to a briefing is apparently beyond the capability of these glorious amateurs. Or is the case that all of this technical stuff is deemed to be beneath the dignity of some senior bankers and best left to the jolly good chaps like Nick Leeson on the dealing desks. It is no wonder that bank after bank loses a small fortune on derivatives trading. A telling comment by a senior Barings executive when Leeson disappeared was "one of our barrow-boys has gone missing".
16th February 2000 The UK's Office of Fair Trading has issued two recent press releases and a report on the subject of early repayment penalties.
(1) - Nat West reduces redemption charges PN 39/99 28 October 1999
(2) - Mortgage Redemption Fees, Economic Research Paper 18, November 1999
(3) - Test for Excessive Redemption Charges PN 43c/99 18 November 1999
(2) states: "Hence a redemption fee must be charged to recover the value of the option implicitly sold to fixed rate mortgage holders. To be a "fair" charge we would expect this redemption fee to equal the value of the option implicitly sold plus a modest fee to recover the incremental costs incurred in administering the redemption."
.............................................................
The redemption fee should be based on actual replacement costs at the time of replacement. The above only applies if ALL borrowers pay the fee whether they cancel or not, whether rates rise or fall or even whether they are expected to rise or fall.
The OFT rightly states that there is an implied option built into a fixed rate mortgage. This is only an option because borrowers can compare the benefits of switching lender with the mortgage early repayment penalty and choose the most favourable strategy. There is no option granted explicitly. Banks do not buy options when they lend at fixed rate, The lock in their liability costs by buying fixed-floating interest rate swaps - thus synthetically borrowing at fixed rates.
Consider again the following scenario:
a £60,000 borrowing
15% fixed rate mortgage
with 7 years remaining
market rates fall to 5% for a period of 7 yearsA valuation of the embedded option must approach the subject as follows:
(a)
"What is the value to the borrower,
of the borrower's ability to walk away
at the time the borrower considers walking away
from a fixed rate mortgage of £60,000,
at a fixed rate of 15%,
for 7 years remaining
when open market rates for a 7 year mortgage are 5%?"OR
(b)
"What would be the cost to the borrower (insurance premium payable) in the open market
of the borrower's ability (option) to INVEST
£60,000,
at a fixed rate of 15%,
for 7 years
when open market rates for a 7 year mortgage are 5%The answer to both these questions is:
If the customer walks away, the customer gains 10% per annum or £4,200 per year for 10 years. This is a grand total of £42,000 ignoring compound interest.
Consider (a) and replace the crucial phrase
"at the time the borrower considers walking away"
with
"at the time the borrower borrows the funds"
What would the value be?
The scenario would be:
a £60,000 borrowing
15% fixed rate mortgage
with 10 years remainingThe answer to the question is now:
NIL (ignoring administration costs) - open market rates for a 10 year mortgage are also 15%. No financial value in switching on the day of taking out the mortgage.
One could change the OFT's statement
"To be a "fair" charge we would expect this redemption fee to equal the value of the option implicitly sold plus a modest fee to recover the incremental costs incurred in administering the redemption."
slightly but fundamentally:
"To be a "fair" charge we would expect this redemption fee to equal the value of the option implicitly sold VALUED AT THE TIME AND EVENT OF THE REDEMPTION plus a modest fee to recover the incremental costs incurred in administering the redemption."
Note that ALL borrowers do not pay the insurance fee - only those that cancel the mortgage and they do so only when the insurance is of value.
Consider the fully comprehensive car insurance market. Would such a market work if the only drivers who paid the insurance premiums were those that had just written off their cars?
If the cost of comprehensive insurance on a GBP 20,000 car was GBP 1,000, the replacement cost would also be GBP 1,000. (The scenario under the fixed rate mortgage) on the day the mortgage is taken out.)
Now the insurance becomes really valuable if the car meets with an accident and becomes a total write-off. The replacement cost of such insurance would now be GBP 20,000 - the current value of the insurance in the knowledge that the car was a write off. One would get short shrift if one tried to pay GBP 1,000 after the accident. (This is similar to offering to pay a modest early mortgage redemption fee or an interest rate insurance premium after interest rates have fallen and knowing the value of the benefit to the borrower of walking away.)
Conclusion
It is grossly unfair for a buyer of insurance (in this case interest rate insurance) to pay for the insurance only when and if s/he wishes to claim. This is no more and no less than officially encouraged sharp practice and can be compared with someone losing a video camera on holiday and then and only then paying for insurance; or upgrading to fully comprehensive insurance from third-party after the car's windscreen develops a crack. Just as fraud in the travel and car insurance market has led to an increase in premiums, such use of unfair practice legislation will inevitably lead to an increase in mortgage interest rates for the majority of borrowers who are content to keep within their contractual terms. Interest rate insurance will have to be bought by lenders to allow EVERY borrower to walk away from his or her commitments under fixed rate mortgages.
The Office of Fair Trading's recommendations do not reflect fair practice and are against the interests of consumers. The OFT's actions as a result of complaints by disingenious borrowers will mean a higher cost of mortgages for all. Somebody will have to pay for the sharp practice by some borrowers. It will not be the banks. It will be other borrowers.
But the real mystery in this story is why NatWest and the mortgage industry generally have not clearly explained the rationale for replacement cost early repayment penalties. I can think of only two possible explanations.
- they caved in to pressure from the Office of Fair Trading and set the costs off against their Public Relations budget.
- and this is a really frightening scenario: they didn't understand the methodology themselves.
The OFT report Mortgage Redemption Fees, is backed up by some very modern mathematical methodology. But I have not studied it. It is a truism that even if the most rigorous technical analysis systems are used to solve a problem, if the wrong problem is solved then the answer will also be wrong.
Post script
I personally had a substantial 5 year fixed rate mortgage taken in 1991 at 13%. Rates fell pretty sharply. But I did not go whingeing to the Consumers Association or the Office of Fair Trading. I did not redeem the mortgage. I simply repaid all but £100 of the mortgage! I believe that this loophole has generally been closed. My actions were perfectly legal and within the letter of the mortgage contract. But I would not claim that my actions were "fair".
Arguably, many retail banks have a justified reputation for indulging in sharp practice. And consumers' bodies may feel that any victory over them is worth having. But unfair and unjustified actions will only bring such bodies into disrepute and diminish the value of their otherwise splendid work.
related articles
"APRs - misleading, misused or just plain misunderstood", 8 Apr. 1995, The Times, London
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