Mortgage rates on variable mortgages could be a lot lower. Is that the fault of the banks? Not really.

That might be surprising to hear from us, but in general, how institutions behave has a lot to do with the pressures, incentives and regulations they are facing, although (sub) culture also plays some role (read our previous entries on misbehaviour of top bank management).

In The Netherlands, it just emerges that the margins on variable rate mortgages have doubled in the last five months, even on those mortgages for which there are state guarantees, so that banks do not face any risks on these.

One could react by exclaiming “scandalous!” (or stronger versions we’ll leave to your imagination). We’re not doing that. Banks are not welfare institutions, and they are faced with very weak balance sheets and increasing risks of default on loans due to a weakening economy.

So it’s not surprising that they do everything possible to repair their balance sheets and reduce risk exposure, although one could wish they had started doing so five years ago..

There are a couple of ways that would force banks to behave.

1) The obvious way would be market forces. Competition, in textbook theory, would punish the high borrowing cost bank, and reward the banks offering the lowest mortgage rates.

The curious thing is that this does not seem to work, as there are significant rate differentials that any economist is at pains to explain (at least within the usual ‘rational economic man’ framework that they tipically employ.

It’s even more curious because mortgages are the biggest ticket items of many, if not most households, even observers not totally sold on that ‘rational economic man’ framework typically used by economist would expect consumers to actually compare rates and conditions when going for a mortgage.

One partial explanation could be that banks are milking their existing mortgages, and once having gone for a mortgage, consumers stop comparing, combined with the hassle and cost of refinancing.

One possible solution would be to enact regulation making refinancing less costly.

2) Speaking about regulation, that would be another solution. We’re not fans of regulation for regulation’s sake, but one has to realize that most markets do not work without it, and it can be an effective way to correct for market failures. But one also has to realize that regulation can get it wrong.

One reasonable (albeit ad-hoc) example also comes from The Netherlands, where the state is guaranteeing 80% of the losses of sub-prime mortgages on the books of ING bank (that is, it’s US subsidiary ING Direct).

Such a partial insurance has advantages (pointed out by the extremely clever Dutch economist Sweder van Wijnbergen):

• It’s cheaper than buying the toxic assets or injecting capital, but achieves the same in shoring up the bank balance sheet enough to restore the all important confidence (to the share price, but more importantly to the bank itself, so that other banks will lend it again in the inter-bank market)
• The partial character provides incentives for the bank to still try and make the best of these assets

But there are still lose ends:

• The taxpayer incurs risk, but no reward
• The improvement in the balance sheet is not necessarily accompanied by an increase in lending.

3) The latter two points would be dealt with by nationalization, which, although also having disadvantages (no perfect solutions in these imperfect times, alas), is still our most favoured option, although it should be temporarily, like they did in Sweden a decade and a half ago.