A new standard
in the Dutch mortgage market
During the past few years, the Dutch mortgage market has changed. Although their name suggests otherwise, fixed rate mortgages are nowadays anything but fixed. Fixed rate mortgages used to maintain a fixed coupon until the next interest reset date, but now coupons are adjusted based on the Loan to Value (LtV) of the mortgage. This new market standard in the Dutch mortgage market has introduced an additional layer of complexity in mortgage valuations and in the calculation of net interest income and duration, for example.
The fixed coupon of a mortgage is composed of the risk-free interest rate as well as several spread components. One of those components is the credit spread. The credit spread is determined based on the risk profile of the mortgage via an LtV bucket structure.
New versus old market standard
Over the lifetime of a mortgage the risk profile, and hence the credit spread, usually improves. This is mainly due to (p)repayments. Under the old market standard, this decrease was not reflected in a decrease of the fixed coupon of a mortgage until the next interest reset date. This resulted in an increase in the profit margin over the lifetime of a mortgage. Under the new standard, the decrease in the credit spread is reflected by a decrease in the fixed coupon of a mortgage. This results in a more stable profit margin over the lifetime of a mortgage.
Implications of the new market standard
Nowadays, almost all investigated mortgage providers adjust the coupon based on the LtV of the mortgage. More than half of the providers automatically adjust the coupon after (p)repayments, while the other providers do so after a request. Therefore, adjusting the coupon during the interest fixed period can be considered the new market standard.
It was the Dutch Authority for the Financial Markets (AFM) that pushed forward the new market standard. The AFM argues that banks should act in the best interest of their clients by passing on to them the benefit of a decrease in credit risk. The new market standard is mainly in the advantage of consumers who (p)repay their mortgage during the interest fixed period. Due to the (p)repayment, the LtV decreases. When the new LtV falls to a lower credit risk category, the new standard prescribes a downward adjustment of the client rate. Of course, this downward adjustment of the client rate is unfavourable for mortgage providers because it results in a decrease in interest income. Next to this, mortgage providers face some other challenges resulting from the new standard. A number of these challenges are related to mortgage valuations.
The challenges in mortgage valuations can be illustrated by comparing two mortgages with the same characteristics, one under the old terms and conditions and one under the new terms and conditions. The fixed coupon of the mortgage under the old terms and conditions remains constant until the interest reset date, while the coupon of the mortgage under the new terms and conditions will decrease depending on the LtV. As both mortgages have the same characteristics, the mortgage under the old terms and conditions is worth more from the perspective of the mortgage provider because it will give a higher interest income against the same risk. Nevertheless, a newly issued mortgage with the new terms and conditions, valued today, is valued at par. The same holds for a mortgage with the old terms and conditions that was issued and valued a few years ago. This may initially seem counterintuitive. The result will be explained in the following paragraph.
An important starting point for mortgage valuations is that newly issued mortgages, with characteristics that are comparable to the market standard, are valued at par (see table 1 below). A newly issued mortgage with the new terms and conditions valued under the old standard has characteristics that are worse than the market standard. Therefore, this mortgage will be valued at a discount from par. Alternatively, a newly issued mortgage with the old terms and conditions valued under the new standard has characteristics that are better than the market. This mortgage will be valued at a premium from par. This means that the value of a mortgage is not only determined by the expected interest income but also by the prevailing market standard.
Discount spread calibration
From a more technical point of view, the counterintuitive result in valuations can also be explained by the discount factor. To get to the value of a mortgage, the expected cash flows are discounted by an appropriate discount factor, which is determined by calibrating a discount spread. The discount spread can be decomposed in several spreads, one of which is the profit margin. Under the old market standard, the profit margin increases over time, while the profit margin under the new market standard is more stable. Therefore, the discount spread under the new standard would be lower (on average) than the discount spread under the old market standard. As a result, when valuing a mortgage with the new terms and conditions (and with lower expected cash flows) with a discount spread calibrated under the new standard (with a lower discount spread), there is an offset in the valuation results that again leads to a valuation at par.
The new standard implies that valuation models need to be enhanced by incorporating the decrease in interest payments as well as a change in discount spread calibration. The question is whether the enhanced approach for mortgage valuation results in significantly different measures for fair value because of the offsetting effect of the lower interest payments and lower discount spread. In other words: does this offset suggest that we can compute the net present value of a mortgage under the new standard by using the valuation methodology under the previous standard?
To examine this question, we conducted an impact analysis on a stylized mortgage portfolio. We created a model that calculates the net present value under both standards: with and without adjusting the client rate in the expected cash flow schedule and in the discount spread calibration. To test for different market circumstances, we stressed interest rates by 300bp to reflect a situation where mortgages are valued far below or far above par. The analysis shows that the maximum relative difference in net present value is 30bp. This difference is observed when stressing interest rates with minus 300bp. This means that the offsetting effect between the expected cash flow schedule and the discount spread does not fully eliminate the impact on the value, especially when mortgages are valued far above par.
For other metrics, the impact can be much bigger. This is particularly the case for metrics where discounting does not play a role, such as the net interest income. These metrics do not have the advantage of an offset between discount rates and expected cash flows. Furthermore, also durations and key rate durations will be affected.
The new standard in the Dutch mortgage market will have implications for mortgage valuations, but the impact is expected to be particularly significant for other metrics such as net interest income, duration and key rate duration. With the AFM pushing mortgage providers towards automatic adjustment of the coupon, risk management departments and finance departments should prepare for the implications of this change.