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Profit of gloom

Market volume gro-wth in retail mortgages in the UK has masked

falling lender profit margins on mortgage advances.

We estimate that the net present value to a lender of an average

retail mortgage advance in the UK halved from £700 to £350

between 1997 and 2002.

This reflects the fact that market development was more than offset

by greater compet-ition. Bigger mortgages, falling loan to value,

falling repossession rates and growth in higher margin non-conforming

segments have been more than offset by interest margin erosion,

increased remortgaging, inc-reased price discounting and a shift from

branches to less profitable broker and direct distribution channels.

We anticipate that len-ders&#39 profit margins have further to fall and

that volume growth will slow. Annual gross advances will drop from

the 2002 peak to a more sustainable level. Unless lenders achieve

step-changes in their cost structures, we estimate that the total

pre-tax profits available in the market will be reduced from

£4.5bn to £4bn by 2005.

These changes will be driven by four main factors:

Uncertain macroeconomic climate and housing market

Fears of a UK recession are growing and interest rate trends remain

uncertain due to the “two-speed” UK econ-omy. A slowing of the

housing market and/or economy will reduce lending volumes and

increase credit losses at a time when many balance sheets are exposed

to high debt-to-income loans.

Annual property repossession rates are at a low point. If

repossession rates were to return to 1991 levels by 2005 (a worstcase

scenario, given differences in interest rate and macroeconomic

conditions), about 90,000 properties would be repossessed in the

course of 2005 compared with 18,280 in 2001 and 49,410 in 1995.

High remortgaging levels

Remortgaging volumes peaked at £84m in 2002. Increased

remortgaging reduces average mortgage value (as the expected duration

of lender revenue streams falls), adds to market instability (as

mortgage stock is moved from one lender to another) and pressurises

weak lenders (those unable to compete efficiently on price or select

loyal customers). The remortgaging boom has been driven by lender

price discounting, aggressive marketing of remortgage products, a

growing role for third-party mortgage brokers and greater consumer

price sensitivity.

Remortgaging levels are likely to remain high in the medium term and,

with the chance of new regulations limiting early prepayment

penalties, remortgaging may increase further.

Increasing price competition

Price competition in the UK market takes two main forms – rate

discounts and the levels of standard variable and fixed rates. As

market growth slows and len-ders fight to maintain or grow market

share, price competition will intensify. In the worst case, net

interest margins could fall to the break-even point for new advances.

However, a more realistic scenario is that new advances will remain

profitable for an “average” lender but will become break-even or

unprofitable for more inefficient lenders.

New regulation

Mortgage lenders are facing new regulatory challenges, particularly

new FSA req-uirements and the New Basle Capital Accord. A likely

impact of the new FSA requirements will be to shift value from

lenders to consumers through more consumer-friendly sales.

Basle will reward lend-ers with advanced risk management systems by

reducing the current 4 per cent regulatory capital weighting for

mortgage assets. This is likely to reduce prices as the capital costs

for compliant lenders fall and further pressurise small or

unsophisticated lenders not able to achieve compliance.

What can lenders do?

In an environment of inc-reasing prepayment risk and increasing

credit risk, the ability to identify low-risk customers, quantify

risk and price for risk will be vital to maintain profit margins. In

addition, as profit margins fall, managers will need to demonstrate

tighter cost control and greater investment selectivity.

Winning lenders will take one of four forms:

Large, sophisticated mortgage lenders – using scale, brand and

sophistication to win/maintain market share without threatening


Diversified high-street banks – the ultimate retailers in the

mortgage market, selling their own and increasingly other people&#39s

mortgage products to a valuable customer base as part of a broad

retail product offering and brand.

Leading non-conforming specialists – using sophistication in risk

management, pricing and mortgage trading to exploit a profitable but

highrisk market segment and making use of third-party mortgage broker


Well funded market innovators – using a clearly differentiated sales

platform and/or product offering with strong funding support to win

market share.

Losing lenders will take one of two forms:

Over-ambitious lenders “built on sand”. Lenders that buy (or have

bought) market share without sufficient risk management and pricing

discipline and maintain a “buy and hold” balance sheet approach will

be exposed if market conditions deteriorate. The stability of their

mortgage stock will fall (due to increasing remortgaging), credit

provisions will grow (exacerbated by inadequate risk management

systems) and these effects will not be offset by interest margins

(due to poor pricing decisions). Profits will be eroded and solvency

may be threatened.

Small lenders that lack scale and management sophistication. These

len-ders have survived due to attractive market conditions, have few

real competitive advantages and are likely to be acquisition

casualties in a market downturn.

As the market slows, lenders face much greater challenges. For some

len-ders, the the challenge is effective implementation. For others,

the optimal strategy is blurred by the amb-ition that demands buying

market share at any price and the realism that suggests caution.


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