Hi all,
I live in the UAE and variables rate mortgages here are based on a short term interest rate (3 month Eibor-which is calculated by the central banks).
I am just wondering what is the rationale for someone to be willing to lend money for the long term linked to a short term interest rates. First you are always borrowing at 3 months Eibor plus a margin, so one thought is that this margin is compensating for the fact that they are lending for the long term, however why not base it on some long term rate + a margin… Is it because the banks themselves fund the mortgages in the short term interbank market…
Thanks,
linking to short term rates makes asset-liability matching much easier. you don’t get a long duration to make money between the seams but you don’t have to worry about shocks quite as much. this is probably ideal, if not necessary, in petroeconomies like the UAE where short-term rates and unemployment can go in the same direction, unlike superdeveloped countries.
imagine being a bank in the UAE and FDI goes wildly negative, the central bank raises rates to defend the currency so short-term rates go from 3% to 10% and unemployment goes from 4% to 15%. attaching mortgages to short-term rates versus a 15-, 30- or even 5-yr is likely the difference between living and dying as a bank. at least in much of the west where longer terms are normal, ST rates typically go down when unemployment goes up, temporarily boosting NIMs while people are defaulting, and keeping the books a little more balanced.