Volatile Liquidity Costs as Part of the Interest Margin

Since the end of 2021, liquidity costs have risen sharply. They can now, for example, exceed the pure credit margin in fund financings. For instance, in March and early April, we observed cases where banks quoted an 80 BP (1 basis point (BP) = 0.01%) margin but 100 BP in liquidity costs for ten-year financings, resulting in a total interest margin (the difference between the interest rate and the swap rate, which includes both credit margin and liquidity costs) of 180 BP. During the same period, other institutions accepted significantly lower liquidity surcharges, some well below 50 BP. This resulted in total interest margins between 80 and 180 BP, despite consistently competitive credit margins. In conjunction with volatile swap rates, total interest rates ranged from 3.74% to 4.65% – a difference that, especially for longer maturities, easily amounted to several hundred thousand EUR in nominal credit costs and can even determine whether an acquisition is economically viable. We present a simple indicator for the increase in liquidity costs for mortgage loans in the box at the end of the text. However, for practical purposes, it is particularly interesting how individual institutions calculate these costs. The significant differences can be observed in four exemplary financings that were tendered via the credX platform:

• Acquisition financing for new residential construction, > EUR 30 million debt volume for 10 years, interest margin 100 BP, LTV 80%, interest rate fixing upon signing term sheet
• Portfolio financing for retail acquisition, > EUR 100 million debt for 10 years, LTV approx. 45%, credit margin 80 BP and liquidity costs 100 BP, thus interest margin 180 BP, interest rate fixing only possible shortly before disbursement
• Acquisition financing for new retail construction, < EUR 10 million debt volume for 5 years, LTV approx. 50%, interest margin 81 BP, reserved upon submission of term sheet
• Existing property financing for care facilities, < EUR 10 million for 7 years, LTV approx. 50%, 111 BP interest margin, fixing upon acceptance of term sheet

For borrowers, this unusual situation presents several specific considerations:

• Compared to the years before 2022, loans have become much more expensive, not only due to significantly increased funding costs but also due to liquidity costs.
• The frequently practiced comparison of “interest margins,” i.e., the difference between funding costs (usually determined via the swap curve) and the offered nominal interest rate, is not suitable for assessing the development of the actual bank margin. The impression that many banks have expanded their margins is likely mostly due to this simplified view.
• The liquidity costs an institution applies are often more significant for the terms than the level of the credit margin – especially since for financings with low credit margins, such as fund financings with moderate leverage, there is often little room left for interest rate reductions.
• If a bank fixes the credit margin but not the funding costs and liquidity costs, the total interest rate can currently fluctuate by more than 50 BP within a few weeks.

Borrowers are therefore increasingly interested in identifying institutions that apply low liquidity costs and are potentially willing to fix the interest margin or even the specific total interest rate early (upon signing the term sheet or even submitting the indication). However, there is no reliable way to ascertain this through publicly accessible criteria. While it is true that mortgage banks tend to operate in a more capital market-oriented manner and quickly pass on fluctuations in money and capital markets, all institutions are already legally obliged to realistically account for liquidity costs in their calculations. The surcharge results from several components that are not externally discernible:

• The chosen covered interest rate curve for the covered portion (typically 60% of the loan-to-value ratio)
• The chosen uncovered interest rate curve for the remainder
• Surcharges to reflect the risk of implicit options affecting the loan’s cash flow (e.g., early drawdown of funds or repayments)
• Costs of liquidity reserve formation
• Costs to meet the Net Stable Funding Ratio or to adequately price risks related to meeting the ratio

The varying liquidity surcharges are therefore dependent on a multitude of settings, the specific liquidity sources available, the balance sheet structure, the institution’s rating, and business policy decisions. The surcharges are provided to client advisors in the calculation systems on a daily basis. Depending on business policy, those responsible for business can then make greater or lesser adjustments to suit the specific case. In our experience, the only effective way is to precisely solicit the relevant institutions within a structured tender process and to specifically address liquidity costs and underlying funding costs when evaluating the indications. An indicator of the direction and, to a limited extent, the magnitude of changes in liquidity costs is provided by the spread between the Pfandbrief curve and the swap curve, which is shown in the following graph: