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Rate-rise cloud hangs over ‘teaser’ mortgages

(Published by South China Morning Post, 07 Apr 2010)

To the pleasant surprise of many, global economies are recovering at a much faster rate than that predicted by the professional pundits.

Evidence of this came in Hong Kong last week when the president and chief executive of the Federal Reserve Bank of Chicago, Charles Evans, revealed that the Fed was likely to raise short-term interest rates without necessarily waiting for a significant improvement in the unemployment rate as it expected the number of unemployed to remain high for an extended period.

The implications for Hong Kong mortgagors will be quite significant.

Since January last year, banks have been enticing prospective mortgagors to accept residential mortgages using the Hong Kong interbank offered rate (Hibor) as the mortgage rate index, given that the spread between Hibor and the prime rate has remained at its widest level since late 2004.

In the past 15 months, more than 50 per cent of new mortgage originations (HK$135 billion) have been based on the Hibor index, which represents about 20 per cent of outstanding mortgages in the banking industry’s mortgage loan book. Although these Hibor-indexed mortgages provide a prime-indexed cap, banks are likely to have approved these applications based on the current Hibor mortgage rate of 0.80 per cent (one-month Hibor plus 65/70 basis points).

In many ways, banks in Hong Kong have fallen into a similar trap to United States’ mortgage lenders by offering an extremely low teaser or introductory mortgage rate to entice borrowers – and approving these loans based on existing interest rates, while not taking into account longer-term risks, or what the Hong Kong Monetary Authority refers to as risk assessment through the cycle.

For example, take two mortgagors, each buying a HK$3 million property in 2009 with a 22-year-maturity mortgage and opting for the teaser, Hibor-based loan. The first buyer has the ability to make the 30 per cent down payment (70 per cent loan-to-value ratio), while the second buyer can make only a 10 per cent down payment (90 per cent LTV).

As the table shows, an increase in short-term interest rates to 3 per cent, the interest rate level prior to the global financial crisis, would have a significant and potentially negative impact on Hong Kong borrowers as the percentage of their monthly income needed to service their mortgage would increase to between 51 per cent and 66 per cent (debt-to-income ratio) – well above the HKMA guidelines.

As Hong Kong uses a fixed exchange rate system to the US dollar, interest rates must increase in tandem with the US.

Hong Kong borrowers have shown great resilience in meeting mortgage loan payments, even during the financial crisis when property values fell by nearly 70 per cent from their 1997 peak. However, the successful marketing by banks of teaser-rate, Hibor-indexed mortgages will place tremendous pressure on borrowers to continue to meet increasing mortgage payments.

On the positive side, Hibor-based mortgages do provide some degree of temporary comfort to banks, given that 20 per cent of their mortgage loan book no longer has the prime/Hibor basis risk. However, this positive impact may be short lived as borrowers undoubtedly will choose to switch their mortgages to prime-indexed cap rates when the Fed begins raising short-term rates later this year or early next year.

In the US, the lure of low initial mortgage rates as marketed by unscrupulous financial institutions and intermediaries as mainly Option ARMs (adjustable-rate mortgages), is just beginning to show its negative impact on borrowers.

The number of Option ARMs that will have their mortgage rates heavily reset upwards over the next three years are not an insignificant percentage and in due course will demonstrate the US borrowers’ ability to keep up their mortgage payments based on the adjusted rate levels. In Hong Kong, the full impact of higher monthly payments will not be realised until the Fed begins lifting interest rates.

However, evidence from the global mortgage markets suggests that the highest correlation to mortgage delinquencies and defaults results from the inability of borrowers to make their monthly mortgage payments, rather than their unwillingness to pay.

Hopefully, Hong Kong borrowers’ will not fall into the same trap as their US counterparts.

Leland L.Sun

Leland L.Sun
Director and Founder of Pan Asian