In 2022-Q1, we have seen significant increases in swap rates and consequently in Dutch mortgage rates. The increasing inflation and the intervention of central banks to curb it, inverted the decreasing trend of mortgage rates observed over the previous years. This article provides an overview of recent market developments in the Dutch mortgage market and the impact the increasing interest rates might have on the housing market, borrowers and institutional investors.

Following mostly a decreasing trend for the last 8 years, swap rates, a leading indicator for mortgage rates, have inverted over the last 12 months. While this increase seemed minor when it started back in 2021 Q1, recent data shows that over the past weeks, swap rates have climbed to levels not seen for years due to market expectations around rising interest rates, fueled by economic uncertainty. The increase in swap rates put mortgage spreads under pressure, especially during 2022 Q1. After a few years of decreasing mortgage interest rates, home buyers are facing increasing rates again. In this article, we take a closer look at the recent mortgage rate developments and the impact that it could have on investors and the housing market.

What are interest rate swaps?

An interest rate swap is an agreement between two counterparties to exchange one stream of future interest payments for another, over a set period and based on a specified principal amount. In most cases, interest rate swaps include the exchange of a fixed interest rate for a floating rate [1].

As it is shown in Figure 1, swap rates across different tenors have been increasing over the last months. Therefore, the cost of hedging the interest rate risk has been increasing for mortgage lenders. Given the relatively low spread levels in the market, these additional costs are passed to the borrowers in the form of higher mortgage rates. An interesting development is that recent swap rate curves show a downward sloping trend for certain tenors, which means that some of the longer tenors have lower rates compared to the shorter ones. For example, the 30-year tenor has a lower cost than the 10-year tenor. This development is opposite to the typical trend, in which hedging for longer periods is more expensive.

Why are swap rates increasing?

Swap rates are based on market assumptions surrounding what interest rates will be over the term of the swap contract. Since the beginning of 2021, inflation has risen in many countries worldwide. In May 2022, the annual inflation was recorded at historically high levels in major economies:

• US: 8.6% in May-22, the largest annual increase since December 1981 and after climbing to 8.5% in Mar-22
• Germany: 7.9% in May-22
• UK: 7.9% as of May-22 [2]

As we can see from Figure 2, inflation is on the rise in many major economies with food and energy prices hitting record highs. This rise has been caused in large part by high consumer demand after the pandemic and supply chain disruption and exacerbated by the Russian invasion of Ukraine which drove up commodity prices over recent months [3].

As a response to the increasing inflation, Central banks around the world are pushing for higher interest rates. On June 15th, the Federal Reserve announced the largest rate increase since 1994, taking the most aggressive step yet to curb the highest rates of inflation in 40 years [4]. Just a couple of days before the Fed’s announcement, the European Central Bank had announced that it will raise interest rates by 0.25% in July [5]. In the meantime, ECB executives implied that ECB might increase the rates by 0.50% in September [6].

Spread developments

Mortgage spreads, the difference between mortgage market rates and swap rates, have been following a decreasing trend since 2014. The decreasing trend was temporarily interrupted during 2019 Q3 when the average QoQ increase in spreads was approximately 22 bps. The moves in spreads resulted from small decreases (8bps) in mortgage rates and significant decreases in swap rates (30 bps) on average.

During 2020 Q2, when the pandemic started, mortgage spreads increased by an average of 35 bps. That was caused by the decrease in swap rates, which was driven in part by an unprecedented set of measures to mitigate the tightening of financial conditions across the euro area, and the increase in mortgage rates. Soon after, mortgage spreads returned to the pre-pandemic levels and fell even more the following months to reach to the lowest point of the last years in February of 2022. This decrease can be explained by the increase in risk-free interest rates and at the same time the strong performance of Dutch mortgages and increased market competition.

During the first two months of the year, swap rates increased more than mortgage rates in the same period, which led to a further decline in spreads. However, the mortgage rate increases in March, outweighed the increase in swaps, leading to a QoQ increase in spreads.

Impact of rising rates on the mortgage market

Given the rise in interest rates, it’s very likely that existing homeowners will try to refinance a property and lock in rates before they increase further. According to HDN, In the Netherlands in the first quarter of 2022, banks processed over 191,000 mortgage applications for remortgages--an increase of 37% since Q1 2021. Due to the rise in interest rates, the number of remortgage applications grew by 75.4% in Q1 2022 from the year before [7].

At the same time, Kadaster, the Dutch Land Registry, registered almost 16,000 property transactions in April, which is approximately 16% less than the year before. In addition, during the first four months of 2022, 60,000 residential property transactions were registered compared to almost 85,500 a year earlier, marking a drop of 30%. In addition, house prices rose by 19.7% in April 2022 YoY, which is lower compared to 20.2% YoY recorded in February 2022. These developments highlight the fact that rising interest rates have dampened house price growth [8].

Impact on homeowners

One of the most imminent effects of increased interest rates is that it directly affects the borrowing cost and borrowing capacity. For those homeowners who recently took out a mortgage (before the rates went up) and have a long-fixed rate period, there will be no effect in the short-term. However, there is a significant chunk of mortgages approaching the end of their fixed rate period, which means that their interest rates will be reset soon.

Based on the latest data sourced from the European Data Warehouse (March 2022), which consists of almost €85 billion of Dutch residential mortgage, almost €7.2 billion of mortgages are expected to reset the coming months, 20% of which are expected, based on the current market rates to be impacted negatively (higher interest rate).

Impact on investors

In the Dutch mortgage market, banks were the main providers of mortgages over the past decades. However, their dominance is challenged by institutional investors – insurers, pension funds and investment funds. To be more specific, since 2014, banks’ mortgage portfolios grew by €12 billion whereas those of institutional investors grew by €82 billion [9]. For this category of investors, the market value of their mortgage portfolios is very important for financial reporting. Thus, in this section we look at how the market value has performed over the last years and especially during 2022 Q1 with the increasing mortgage rates.

To capture the effect of interest rate changes on the value of a mortgage portfolio, LoanClear created a market weighted valuation index of mortgages originated from 2015 onwards. As we can see in Figure 7, the Dutch mortgage valuation index followed an increasing trend since 2015 until 2016 Q2. After that point, it remained stable until it started increasing again in 2019 Q1. The increasing trend was temporarily interrupted in 2020 Q2 and then it returned to the pre-pandemic level. This upward trend was primarily caused by primary mortgage rates, on which the discount rate is based, moving down. The interest rate increases during 2022 Q1= had a negative impact on the valuation, which dropped by almost 8 percentage points. The majority of which is driven by the change in the discount rates. With the looming interest rates increases that have been announced by ECB, it is possible that the downward trend continues in the next months. The decreasing values though does not necessarily mean that the coverage ratios of the investors are going down since liabilities are also decreasing and hedging against interest rate movements might be in place.

Conclusion

After many years of decreasing interest rates, the mortgage market is facing again increased rates. Inflation, skyrocketed over the last months and as a result, it triggered significant changes in the monetary policy of central banks.

In this article, we analyzed the recent developments in the Dutch mortgage market. House price increases started to cool down after an almost non-stop increase since 2015. Borrowers who are close to the end of their fixed rate period are very likely to face increased monthly payment and institutional investors already see the value of their portfolios declining. Considering the signals for continued interest rate hikes and war-related uncertainties, we anticipate further decreases in Dutch mortgage valuations.

References

[1] PIMCO: Interest rate swaps

[2] OECD Data

[3] Wolrd Economic Forum

[4] The New York Times

[5] European Central Bank

[6] Reuters

[7] Hypotheken Data Netwerk (HDN)

[8] Centraal Bureau voor de Statistiek, Kadaster

[9] DNB

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