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' 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
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.
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's
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
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.