The UK mortgage market has never been more competitive. A quick flick through the personal finance section of the Sunday newspapers confirms that the battle for borrowers’ business is being fought out with interest rates as the primary weapon. There are currently some extremely low rate deals available with no overhanging redemption penalties and with rates more than 50 basis points under the bank base rate.
These deals are great news from the homebuyer’s perspective, but less so from the point of view of mortgage lenders. Why? Because, quite simply, these deals do not make them any money. The profitability models used by lenders to justify such deals assume borrowers do not move their mortgage after the fixed or discounted rate period, but this is usually not the case.
Buying market share
So why do lenders continue to market such deals and continuously battle to offer even lower rates? The answer is growth. Lenders need to grow and these types of price-driven mortgage products buy market share. And all the evidence shows that, as a tactic, it does achieve its objective of attracting more business.
In 2002 both gross and net lending reached record levels in the UK. Gross lending totalled nearly £219bn over the year, of which £79bn was new lending. The Council of Mortgage Lenders (CML) reported that 38% of all loans by value were remortgages (up from 25% only three years ago), with fixed rates accounting for 29% of all loans being fixed rates and discounted deals 33%. Consequently, homeowners have been quick to realise the benefits of remortgaging, both to release additional cheap rate funds and to reduce monthly outgoings by locking into a cheaper deal.
Put simply, the industry is operating in an era where ‘churning’ is increasingly becoming the norm and most lenders, who are unable to oppose this trend, have thrown in the gauntlet and joined in the game. In a report published last month jointly by the CML and PA Consulting Group, the replacement ratio for UK lenders ‘ which is the proportion of a lender’s mortgage book which has to be replaced by new business before any growth can take place ‘ has increased from 15% to 29% in the last three years.
So a lender needs to replace approximately one-third of its mortgage book each year before it has taken even one step forward in terms of growth. This is a huge burden to work under and it is obvious that, sooner or later, some lenders are going to falter under the pressure.
Interestingly, the same report continues to point out that, despite lenders being aware of the problem and acknowledging ‘staying as they are’ or churning is not a long-term option, they continue to do it because they do not see any alternatives. Three-quarters ‘ 75% ‘ of lenders confirmed they are primarily focused on new business acquisition, with only 25% saying they have ‘an equal focus on new business and customer retention.’
The problem becomes even more acute for smaller building societies, because they do not have the ability to take on the big lenders in a pricing war for new business. Therefore they face a growing crisis when it comes to increasing the size of their asset base, year in year out.
But does it matter if a few smaller societies disappear from the mortgage market? Yes, it does, because what makes the UK mortgage market so healthy is competition. It would not be in the interests of borrowers for mortgage lending to be further dominated by a small number of ‘super-lenders.’ The wide variety of lenders in the UK means choice and competitive deals for homeowners, regardless of whether they are full-status, niche or non-conforming borrowers.
Some societies have become aware of other ways in which they can increase the size of their mortgage asset base, which do not depend on marketing cut-throat rate deals on mortgages. An example of this is ‘through lending,’ which is a technique pioneered in the UK by GMAC RFC during the past few years.
In a through lending arrangement one lender (for example, a building society) agrees with another lender (a specialist, non-conforming lender) to generate mortgage assets on its behalf to pre-agreed terms, which includes both underwriting criteria and product pricing. When an agreed volume of business has been generated, the assets are transferred to the society, which can choose to either administer the new loan book itself, or outsource the administration to the organisation which generated the loans in the first place.
Like all good ideas, the concept of through lending is a simple one. Building societies can acquire additional mortgage assets of a known quality and profit signature without needing to invest in systems, infrastructure, staff and training, or the time and effort required to build a suitable distribution base. Many societies also say, strategically, they do not want to acquire the expertise to become players in specialist niche markets.
GMAC RFC has developed several deals of this type with leading high street lenders. For smaller regional societies, however, the problem they face when contemplating such an arrangement, is the size of the portfolio they wish to acquire. GMAC’s deals have typically been for £100m or more. For smaller societies, deals of this size may be prohibitively large as their needs may only be for an additional £10m or £20m of mortgage assets. And the costs involved in constructing such a deal for a relatively small volume of loans can kill the concept before it even gets off the ground.
Another solution to this problem for regional societies has been the recent creation of a ‘mutual co-operative.’ The setting up of The Mutual Co-operative will allow societies to work in the same way as through lending, but on a smaller scale. In isolation, a £20m through lending deal is not viable, but a £100m deal is. However, if five £20m deals can be pooled together, the economics start to make sense for all involved.
The lender behind the co-operative, Mortgages plc, has a well-established distribution network which is capable of generating large volumes of profitable mortgage assets. By inviting regional societies to co-operate as part of a pooled deal, everyone benefits. The societies see their asset base grow, the lender is able to process larger volumes of business and brokers have a wider range of products to market to their clients.
Keeping the competition alive
As far as products are concerned, it is expected that the mortgage loans will primarily be made up of ‘niche’ and near-prime mortgages. These deals are profitable from day one and are in high demand in the market at the moment.
Such deals pose no issues for either intermediaries or their clients, as they enable lenders to continue to develop new, competitive products that will be attractive to borrowers. Through lending arrangements do not change the underlying terms of a mortgage, so borrowers have nothing to concern themselves about. And when the loans come to the end of their terms the lender has the opportunity to market its prevailing range of products to their borrower. It is a win-win situation for everyone involved.
For smaller regional building societies the pressure is inevitably on to try and compete head-to-head with lenders for new business, but unfortunately it is a battle they are destined to ultimately lose. But by adopting a growth strategy which includes through lending arrangements such as those described above, smaller societies can focus their marketing effort, not on trying to acquire business at any price, but on developing and marketing added-value products and services which truly differentiate them from their big brothers.
At the end of the day, surely mutuality as a concept is all about running a business for the benefit of its members? Through lending and link-ups can play a part in enabling smaller societies to grow in a controlled manner which is not simply about slugging it out for market share in the best buy tables. It is in the interest of the market as a whole for smaller lenders to prosper alongside the large lenders, because it ensures the mortgage market remains fit and healthy.
Remortgage churning is forcing lenders to replace one-third of their mortgage book each year just to break even.
Many smaller builder societies are turning to through lending to grow their mortgage assets.
The Mutual Co-op will see smaller building societies offering their own niche and near-prime mortgages.