News David McWilliams

Sunday 21 September 2014

Why a cut in interest rates will push up mortgage costs for first-time home buyers

Published 21/05/2014 | 02:30

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European Central Bank (ECB) president Mario Draghi
European Central Bank (ECB) president Mario Draghi

What better city for a football lover to be in this week than Madrid? I have always loved Spanish football commentary. Even though I haven't a word of Spanish, I love the rapid-fire speech, the dramatic rolling Rs, the intensity and pace of the commentators and of course, the demented celebrations when a goal is scored.

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As the locals here in Madrid gear up for the Champions League final between Real and Atletico on Saturday, the only talk is of the game, its significance and how it sets up Spanish football for the World Cup where they are defending Champions.

Spain has an extraordinary record having won the Euros in 2008 and 2012 and the World Cup in 2010. The national team is not the force it was in 2010, but no one in Europe can deny the dominance of Spain over the past decade.

However, Spain's purple patch in football has been mirrored by a catastrophe in its economy.

Almost since the day Iker Casillas lifted the European Cup in June 2008, Spain itself has remained firmly in the red. The economy has been in freefall.

Like Ireland, Spaniards were conned into thinking they could get rich buying and selling Spain to each other with other people's money. The subsequent bust was spectacular and is still being felt in debilitating levels of unemployment and indebtedness.

As any economic textbook would tell you, when countries go through this type of contraction, prices fall. When people get used to prices falling they expect it to continue and this leads to a deflationary spiral. The very act of cutting prices prompts people to think that prices are going to fall even more next month or next year, so they hold off spending.

Deflation – which means that the price of your product is falling – is a disaster when you have lots of debt because it means that although your debt repayments stay the same you have less money. The less money you have, the less likely you are to spend and the spiral takes hold where deflation leads to less spending and lower prices. Bank lending falls and people try to pay back debt.

Those with savings save more, not less, because they are delaying spending. As such, deflation is much more difficult to deal with than its nemesis inflation.

The cure for deflation is inflation. Both Ireland and Spain need inflation right now.

Now here's where things get interesting, because whereas both Ireland and Spain need inflation now, the fact that Spain needs it matters to Germany.

Why is this? It is because in Europe, size matters. A problem in a small place like Ireland isn't a problem to anyone else but the Irish. However, a problem in a big country like Spain is everyone's problem. This is why deflation in Spain – and Italy – prompted the ECB to say that it would cut interest rates again to prevent deflation taking hold in the southern periphery.

So what might the ECB do and how will it affect us in Ireland?

The ECB, which used to be a Germanic fiefdom has suffered what might be termed an Italian coup d'etat, under the Italian Mario Draghi (below). He will cut rates next month to help Spain and his native Italy; how this affects Ireland will not be high on anyone's agenda in Europe but affect us it will.

The ECB is likely to cut the base lending rate from 0.25pc to zero and possibly cut the deposit rate, the rate that banks get for depositing money at the ECB from 0pc to -0.15bps. This means saving money will cost you.

Now what will this do in Ireland and how will it affect the property market, which everyone is talking about now? When this move comes in June, the headlines will say that interest rates for borrowers will fall. They will fall for some, but not all.

Here is where the existence of tracker mortgages changes the game and, counter-intuitively, the fall in ECB rates will mean that interest rates to first-time buyers might go up, not down! How could this be?

It is because banks make money by lending. So they need to lend more than they take in as deposits. This is why they charge more money for a loan than they pay out for a deposit. The difference is their profit. But with trackers they can't charge more money on the loans because these loans are linked to the ECB base rate. So this means the banks have to charge higher margins on other new loans to compensate for the "subsidy" they are paying out on the trackers. This means that new first-time buyers could end up paying actually more interest – above 5pc – on new loans even though the official rate of interest is zero!

How will his affect the housing market? It means that the "cash buyer" is in an even stronger position to elbow out the first-time buyer because the cash buyer will have at least a 5pc cushion to bid above the first-time buyer with a mortgage. This means that the dynamic of recent months, where first-time buyers are being priced out of the market, will continue.

The fascinating and worrying thing about this story is just how little control we in Ireland have over our destiny. Deflation here in Spain is dictating conditions in Ireland far more than events in Ireland are dictating conditions in Ireland. Do you find that bizarre? I do. It is something to consider when voting this week. Every time you vote for "more Europe", you are voting for less and less influence over your own life. And there was me thinking that our forefathers fought for democracy to have more, not less control over their own affairs!

www.davidmcwilliams.ie

Irish Independent

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