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Outside edge

By the time you read this, we will have heard the result of the Bank of England&#39s August interest rate deliberations and the betting is on no change. Indeed, I believe the base rate may be in for another relatively long period of stability. This will inevitably lead to a wringing of hands among personal finance journalists as they will not be able to recycle one of their longest repeat pieces.

The press&#39s constant criticism of how banks and building societies respond to interest rate movements fails to recognise that these are commercial organisations and the opportunity of changes in supply prices to either shift margins or make windfall gains is simply good business practice. Exactly the same happens in the oil market and, indeed, in most commodity markets.

In some ways, we should be grateful for the windfall gains as they enable lenders to operate at lower standard margins because they receive this occasional boost to profitability. Indeed, many lenders take into account the expected frequency of such gains when resetting their rates following base rate shifts. This has been evident in the time taken to announce new rates in response to two recent unexpected cuts in base rate. The beauty of it is that they can profit whichever way the rate moves.

Despite the best efforts of the press, the customer is unlikely to remortgage if the lender delays passing on an increase for six weeks. There are far greater incentives to move than this and the lenders are aware of it.

Clearly, those who abuse the system will suffer ultimately, particularly in the intermediary market, yet I see little market share won by the early movers such as The One Account or Direct Line attributable to their faster response. A number of the early movers have Liboror base rate-linked products, in any event.

The increasing reliance on wholesale funding does itself put pressures on lenders to respond more quickly in an upward interest rate move and I expect this trend to continue as securitisation of all mortgage classes advances. It all depends on when the average interest reset on their securitised book happens in relation to the timing of the base rate shift.

In some ways, the more relevant concern is the margin shifts that are occurring. The major mortgage lenders&#39 results demonstrate that they are increasing their net interest margin quite effectively on the back of pricing shifts following moves in the base rate. We are as an industry in relatively uncharted waters here as we have probably never such a low interest rate environment combined with a fiercely competitive price-led market for both mortgages and deposits.

Traditionally, as interest rates decrease, lenders look to make more margin on the mortgage book as their ability to drop deposit rates and lower their average funding costs declines. With depositors now receiving trivial returns, the moral pressure not to lower mortgage rates and maintain deposit rates is very strong. However, lenders cannot afford this stance, simply because of competitive new business pressures. This has several deeply worrying consequences.

First and foremost are the diminishing returns that pensioners, particularly, receive on their savings. Of more long-term concern is that it is clear that the ever-cheapening cost of mortgages is now maintaining, if not positively fuelling, ongoing consumer spending rather than impacting on the housing market. I sense that this, rather than any risk of a crash in house prices, is causing the Treasury and the Bank of England concern and so it should. With an increasing trend toward interest-only mortgages, even a small hike in interest rates could lead to a dramatic percentage increase in borrowing costs and trigger a massive consumer slowdown.

The solution for the intermediary is to strongly recommend products that revert to a base rate-tracking structure. There has been a notable trend in this direction in the last year, particularly among exclusives marketed by the bigger intermediaries. Sadly, a number of these only track for around five years before reverting to a normal variable. There is an added downside that the headline rate is less attractive since the lender&#39s earn-out is at a lower margin. Why should any of this matter while the market remains competitive and the opportunity to remortgage appears as soon as the fixed or discount period ends?

Mark Chilton is an independent mortgage consultant

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