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"But I don't need long dated funding"

11 October 2016
Richard Kemmish

On the one hand, bonds need to be longer dated to avoid the dreaded negative yield. On the other hand, ‘my mortgages are too short to warrant lots of ten year funding’.
OK, so we can issue new bonds with a negative yield now. That has been proven. But it does result in a book seriously skewed away from real money investors and towards banks and central banks, with the potentially negative implications of that. And it still feels weird. Still difficult to explain how you can ask someone to pay to lend you money. 

Maybe we should consider the other side: my mortgages don’t warrant high duration funding.

In the context of an on-going programme and a revolving pool of assets this argument doesn’t make a lot of sense to me. Covered bonds are not about funding this specific pool of assets, they are about funding a bank via the assets that happen to be available to it over the course of the bond’s life.

Five year average life mortgages funded by a ten year bond are only really a problem if you are going to stop writing new mortgages sometime in the next ten years. That could be because you’ve decided that writing mortgages isn’t very profitable any more. It has happened, although usually not in the bank’s home market. Generally though a bank makes this decision it sells the entire mortgage bank, liabilities and all, to another institution. So the need for stable long term funding remains in place. 
 The alternative way to stop writing mortgages is to go bankrupt, which does rather expose you to asset-liability mismatches. The possibility of these mismatches could ex ante make it more costly to issue longer dated covered bonds that would create a maturity mismatch (via the workings of the rating agency models). But, to pick just one example, when Northern Rock failed it was clear that the de facto average life of its assets was less than that of its funding. The problem was not a credit problem, it was a cost of carry one, that is, lots of cash sitting around waiting for the long dated funding to mature.

I think that when issuers say that they don’t want long funding for their mortgages for ALM reasons what they usually mean is that they don’t want to abandon the ‘maturity transformation’ role of the banking system. They still want funding to on average be shorter than assets as this is the most traditional source of banking profits.

Except that it has gone away now. To pick one indicator at random the spread between 3 month euribor and 10 year bunds is, at time of writing, 24 basis points. Five years ago it was 200 basis points. There is basically no money to be made by creating a maturity mismatch.

Surely then the availability of absolute low long rates, and that’s contribution to funding stability  should  trump traditional thinking about appropriate maturity profiles?

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