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Leland Sun

The flatness of the yield curve for longer dated products will make Hong Kong banks even more reluctant to offer them

In July last year, I urged potential homeowners to lock in to a fixed-rate mortgage for as long as possible because the United States Federal Reserve had started raising interest rates a month earlier.

Let  me review the path of interest rates over the past 14 months in Hong Kong and the US.

Since Hong Kong operates under a fixed exchange rate mechanism, interest rate trends here are largely dependent on interest rate movements in the US.

The  Federal Reserve has raised short-term interest rates 10 times over the past 14 months and lifted the federal funds rate from 1 per cent to 3.5 per cent. At the same time, US banks have increased the prime rate from 4 per cent to 6.5 per cent. Banks in Hong Kong have increased the prime rate from 5 per cent to 6.75 per cent.

The absolute level of Hong Kong mortgage rates has doubled over the past year from 2.25 per cent to 4.5 per cent. Therefore, if a Hong Kong borrower was able to secure a two-year fixed rate mortgage at a rate of 3.35 per cent in July last year, the borrower would have been insulated from the increasing monthly mortgage payments as prime increased.

The current mortgage rate results not only from higher absolute interest rates, but also from a narrowing of the prime/Hibor spread by 1.65 per cent (from 4.75 per cent to 3.10 per cent). This spread reduction has forced banks to increase the floating rate mortgage margin by about 0.5 per cent (prime -2.75 per cent to prime -2.25 per cent) in order to maintain a sufficient net interest margin to cover  operational costs.

The combination of this rising mortgage margin and the prime rate rising by 1.75 per cent has  increased the typical mortgage rate by approximately 2.25 per cent. The fixed mortgage rate (using the two-year swap rate as a benchmark) has increased by only 1.5 per cent.

With the absolute level of floating mortgage rates narrowing to fixed rates, several banks in Hong Kong have recently relaunched their 70 per cent loan-to-value 'fixed-rate' mortgages or, in reality, floating rate mortgages with a short fixed-rate period (usually up to two years), for both the primary and secondary market.

The latest offerings are an attempt to attract borrowers into opting for short-term fixed rates at a slight premium (0.33 per cent) to the standard prime rate indexed mortgage as compared with last year, when borrowers were reluctant to lock in at a much wider premium (1.05 per cent).

A borrower considering a fixed-rate mortgage should evaluate not just the initial fixed rate, but also the floating interest rate reset margin.

In some fixed-rate mortgage products, banks have increased the floating rate margin to offset the lower upfront teaser rate offered to entice borrowers.

Since most borrowers have missed a large part of the upward interest rate cycle, fixed-rate mortgages are less attractive today.

Additionally, the Hong Kong prime rate is still higher than its US counterpart and banks here  may find it unnecessary to raise rates next week, even if the Federal Reserve is inclined to do so. That is because the banking system continues to be flooded with excess liquidity.

As  funding costs have increased substantially, the flatness of the yield curve for longer dated fixed-rate mortgages means banks will understandably be even more reluctant to offer them.

Since many banks have not developed the ability to manage the prepayment risk inherent in fixed-rate mortgages and have limited access to the local debt markets to effectively match their mortgage assets, I would not expect more fixed-rate products - especially with longer fixed-rate periods  - to be offered any time soon.

Should the yield curve invert (defined as short-term interest rates higher than longer-term interest rates) over the next few months, it will be even more difficult for Hong Kong banks to adequately match their asset/liability risk for fixed-rate mortgages.

Leland Sun is the chief executive of Pan Asian Mortgage



Fixed-rate mortgages are looking less attractive