By Paul Lewis
Presenter, Radio 4's Money Box
Match-making banks looking to minimise interest-rate risk
Like many other products, a mortgage has to be manufactured. In the case of home loans, the factory is a City of London dealing room.
One company which does the deals that set the rate we pay on fixed-rate mortgages is ICAP.
Radio 4's Money Box went to the firm's offices in Broadgate in the City of London, where dealers match banks offering, and looking for, mortgage products
Trading floor fever
Each broker is surrounded by three large screens but the deals are actually done by a noisy process known as "open outcry".
Old technology backs up new
The dealers stand up, gesticulate and shout the prices of competing offers until a match is made.
Once a deal is done, it is written on a whiteboard by a trainee broker with a marker pen.
The desk we are interested in is the one where banks "swap" interest rates.
The brokers are match-making lenders who want to convert the fixed-rate mortgage loans they make to us into a variable rate loan from another bank.
Those other banks want to sell variable rate loans in exchange for a regular fixed-rate payment.
ICAP's global turnover across all its desks in 50 countries is $2.3 trillion (£1.4 trillion), every working day.
These deals protect the banks from risk.
Three out of four home loans taken out recently were at a fixed rate. The rate of interest on those products is guaranteed to stay the same whatever happens to the bank rate or to the rates the banks charge each other.
But lenders run a big risk in lending us money at a fixed rate. If interest rates rise they will have to pay out more to savers. And if rates rise a lot then they could be paying out more to savers than the fixed rate they are charging on home loans.
Deals are done by 'open outcry'
The same is true if they go to the newly re-opened international money markets where they can borrow money at a variable rate.
So they go to brokers like ICAP to find other banks who are prepared to swap the fixed interest payments they will get for a regular variable payment linked to current interest rates.
The matching of these contrasting needs is known as the swap market. And the price they negotiate around is a rate of interest called the "swap rate".
The swap rate figures are updated throughout the day on the screens in front of the brokers.
The numbers reflect the rate the market expects for average interest rates over various periods from one to 60 years.
And the two-year rate - which sets the benchmark for the cost of fixed-rate funds over two years - was 1.87% on 17 September 2009, when Money Box visited the broker.
INTEREST RATE ESTIMATES
Average over 2 years: 1.8700%
Average over 5 years: 3.3250%
Average over 10 years; 3.9725%
Average over 30 years: 4.0700%
Source: ICAP, 17 September 2009
"This 'swap rate' of 1.87% - you can regard it as the market expectation of average floating [variable] rates over the next two years, " said ICAP economist Don Smith.
"These rates are at a historic low. Other things being equal you should expect that to result in lower fixed rates."
But research by the information group MoneyFacts has found quite the opposite.
It shows many fixed-rate deals are rising.
Earlier this week, the swap rate was 1.83% but the average two-year fixed rate was 5.12%. And the gap between them of 3.29% has never been larger.
Keeping money in the bank
Ray Boulger, technical manager at mortgage brokers John Charcol, told Money Box there are complex factors at work:
"In any market the price you pay depends on supply and demand and there is not enough supply," he said.
Paul Lewis is shown current swap rates by economist Don Smith
"Gross margins are much higher than they were in the past. You could say that is taking advantage.
"But the cost of funds is not as simple as looking at the swap rate."
He also said that new international rules mean that banks have to have much more capital in their vaults in case anything goes wrong.
And that makes loans of 90% of the cost of a home much more expensive.
"Lenders have to set aside about eight to 10 times the capital to support a 90% mortgage than they do to support a 60% mortgage."
The expense of fixed rates means his company is now advising people to take variable-rate mortgages.
"In June we were recommending fixed rates," he said. "But since then the market has changed.
"In June swap rates went up but fixed rates went up by more.
"And comments by [Bank of England Governor] Mervyn King and the Monetary Policy Committee make it clear that interest rates are going to stay low for longer. So we are now recommending tracker rates or discounted rates."
A day's dealing ends
Around half past four in the afternoon, calls to the dealing floor get less frequent and the shouting has stopped.
Most brokers are more interested in the screen showing the international cricket than the one updating their financial information.
Another £1.4 trillion has been swapped, hedged, converted, and de-risked.
And another day ends in the City.
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