Opinion: How banks always win with break fees

By Roger J Kerr When market swap interest rates were plunging to record historical lows in February and March this year thousands of home mortgage borrowers naively concluded that they could walk away from their contracted fixed rate mortgages with two and three years to run and re-fix at the much lower market rates. The Sunday newspapers were full of comparisons of how the banks all applied slightly different rules when it came to calculating break costs for borrowers who wanted to terminate fixed rate mortgages early. Some banks calculated the break cost on the interest rate differential between the original fixed rate mortgage interest rates and the rate the bank could invest the funds for the balance of the term at the retail deposit rates for that term. Other banks more correctly used their own mortgage lending rate the bank could re-lend the funds for the remaining term. Hence the different break costs between ANZ, BNZ, Westpac, ASB and Kiwibank. What was surprising was that there was no industry standard for calculating and charging break costs. In the wholesale markets if a corporate borrower wishes to terminate a swap early they know that the bank will quote the market swap rates for the remaining term and the discounted cashflow calculations will produce a cash gain or loss, depending on whether the current market is above or below the original fixed paying swap. In the case of home mortgage borrowers, the banks all point to the legal documentation the borrowers signed at the outset as an adequate defence of their calculation method. There is certainly no consistency of calculation, no consistency of the market rates the reinvestment interest rates are based on or even any half-decent transparent disclosure of what happens if a borrower wants to terminate early. Consider the situation of a home mortgage borrower who was savvy enough to be on the ball to fix for five years when five-year market swap rates hit a low of just above 4.00% in February/March. Many such borrowers fixed mortgages for five years at rates between 6.00% and 6.30%. The five year mortgage lending rates are now 8.30% as swap rates have increased sharply to nearly 6.00%. If such a borrower had to now terminate that fixed rate mortgage early, for whatever reason, with four and a half years to run, do you think the bank would pay the borrower the difference between 6.30% and 8.30%. No way Jose! The bank's rules are that they pocket the windfall gains and the borrower is just right out of luck. The bank can now re-lend those funds at the much higher 8.30% mortgage lending rates. The bank would have hedged its five year mortgage book in February/March at the prevailing 5-year swap rates at that time i.e. 4.00%. The bank can re-lend the funds at 8.30% and pocket a massive 4.30% margin over the remaining four and half years left to run. Unlike the fair rules of engagement in respect to marked-to-market gains and losses in the wholesale swaps markets, in the retail lending market the banks charge the customers the losses, however with a smile on their faces pocket the customer's gains for themselves. Now you know how banks make most of their profits "“ heads I win, tails you lose! It is time the Banking Ombudsman, the Consumers Institute, the Bankers Association, the Securities Commission, The Reserve Bank, the Mortgage Brokers Association, the MED, INFINZ or someone designed a standard calculation method of "Wholesale swap rate in, wholesale swap rate out" for mortgage borrowers who break contracts early. All banks should apply the exact same calculations of the difference between the wholesale swap rate at the time the mortgage rate was fixed and the wholesale swap rate on the early termination date. In this way all arguments and unfair/inequitable practices will end. The retail banks in New Zealand need to restore their reputations, adopting this "Kerr Standard" for early break costs/gains for all mortgage customers would be a good start. "”"”"”"”"”- * Roger J Kerr runs Asia Pacific Risk Management. He specialises in fixed interest securities and is a commentator on economics and markets. More commentary and useful information on fixed interest investing can be found at rogeradvice.com