January 20, 2021 by Dymphna

Why banks will pay you to borrow

The secret is that rates could go a lot lower yet.

I noted in my wrap last week that there’s a good chance that rates will go lower from here.

In fact, in the next few years, we could even see rates go negative.

That is, the banks will pay you to borrow money.

I know this sounds pretty wacky, and before Covid hit, I never thought it would have been possible.

But let me talk you through what’s changed and how negative mortgage rates might become a reality… potentially in the next few years.

So the key to understanding this is understanding what banks actually do.

The high-school version is they get money from depositors (who they pay interest to), and they then lend it out to borrowers.

This isn’t wrong, but it’s only part of the picture.

Mostly, the banks borrow money from domestic and international capital markets. They borrow money like you and I borrow money, and they have to pay interest just like we pay interest.

They then lend that money on to borrowers.

The difference they get between what you pay them, and what they pay the markets, is what they make as profit.

In that sense you can think about banks as merchants of money. They “buy” money at a particular price, and then “sell” money on at a premium, keeping the margin as profit.

Ok. That all make sense?

Now, what’s changed is that banks are able to get money at a much cheaper price these days.

Much, MUCH cheaper.

And who are they getting this cheap money from?

The RBA.

After Covid hit, the RBA introduced what they call the “Term Funding Facility” or TFF.

Basically, the RBA prints money (yep, just makes it up), and then lends it to the banks at a very discounted rate, so long as the banks then lend it on to customers.

That discounted rate started at 0.25%, which is where the official cash rate was, but then the RBA generously lowered the rate to just 0.1%.

Think about that for a sec. The banks are getting money for the ridiculously low price of just 0.1% fixed for three years. Crazy.

Of course, the banks gave up borrowing money from the money market and paying chump rates, and moved most of their funding over to the TFF.

Take a look at bond issuance. Bond issuance at the major banks flatlined after Covid.

So the banks stopped borrowing from the more expensive wholesale money markets and started leaning more heavily on the RBA’s TFF.

And this is why the banks have been able to offer such cheap mortgage rates – especially the matched fixed rates – to borrowers.

Now, how do we get from here to negative rates?

Well, as I said, the RBA is just making all of this up. They get to make up the rate they charge the banks (currently 0.1%), and they (very literally) get to make up the money they’re lending to them.

So it’s all up to the RBA.

So what if the RBA decides that rather than 0.1%, they say the TFF rate is going to be -0.5%, or -1.5%?

That is, what if they say to the banks, we’ll pay you to take this money off us, so long as you lend it on to borrowers?

The banks would then have the ability to pay you to take the money off them (i.e a negative mortgage rate), and as long as the RBA is paying them more than the banks are paying you, they’re making a profit.

And that’s how negative mortgage rates might happen. The infrastructure is already in place and it’s already functioning.

And the reality is we’re already seeing the first wave of nations cross the river over to negative rates.  

The European Central Bank started with 0.1% funding for banks in 2014. By 2016 the rate was -0.4%. And now it’s -1.0%.

Yes, the central bank will pay commercial banks up to 1% if they can just find someone (anyone!!!) they can lend to.

In fact, banks in Denmark have already started offering homeowners 20-year loans at a fixed interest rate of zero:

Customers at the Danish home-finance unit of Nordea Bank Abp can, as of Tuesday, get the mortgages, which will carry a lower coupon than benchmark US 10-year Treasuries. At least two other banks have since said they’ll do the same…

Back in 2012, policy makers drove their main rate below zero to defend the krone’s peg to the euro. Since then, Danish homeowners have enjoyed continuous slides in borrowing costs.

The once unthinkable notion of borrowing for two decades without paying interest comes as central bankers across the globe shy away from rate hikes.

This is what our future could look like.

Maybe rates won’t go negative. Maybe you’ll never get paid to take out a mortgage.

But we need to let go of the idea that mortgage rates have hit a ‘floor’.

The reality is there is no theoretical floor for interest rates. They could keep falling forever.

(Probs not, but you get my point).

Interest rate cuts are still a possibility, and still a potential driver of house prices this year.

Welcome to the brave new world.