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Rates of change

We are living in the age of the mortgage wars. Media coverage of the mortgage business has come out of the ghetto of the business pages on to the front pages of the nation&#39s tabloids.

Cheltenham & Gloucester and Alliance & Leicester are the latest lenders to join the ranks of the rate cutters since battle commenced last month.

The reason for this outbreak of hostilities is the big issue facing traditional lenders – the front book/back book divide. Existing borrowers on uncompetitive standard variable rates have been used to subsidise new customers. Now lenders have decided this proposition is no longer sustainable.

Competition has intensified with new entrants to the market. Remortgaging is more common, too. According to figures from the Council of Mortgage Lenders, in the last quarter of 2000, 30 per cent of new mortgage lending was remortgaging. This compares with a figure of 21 per cent in the last quarter of 1999.

Another reason for volatility in the mortgage market is increased awareness. Customers are better informed than ever before. Personal finance supplements enhance the lifestyle sections of our Sunday papers – I swear these sections get bigger every week.

So, lenders are facing a double whammy. The profitable back books are diminishing as increasing numbers of better informed borrowers take their custom elsewhere. But the front book with loss-leading rates has real persistency problems. The rate tarts are less loyal and lenders are struggling to retain new borrowers for long enough to recover initial incentives.

Newer lenders have anticipated these problems by having no real front book/back book divide. The traditional lenders have now realised that they will have to bring their books together.

A word of warning – beware the smoke and mirrors. While it is true that traditional lenders are adapting to highly competitive conditions in the mortgage market, do not believe all the spin. Some lenders are developing the habit of announcing cuts which may not come into effect for weeks afterwards. They see no reason to pass on these benefits to customers immediately.

A number of lenders are guilty, too, of pandering to the laziness of their apathetic customers. Too many borrowers are unaware that their standard variable rate will remain unchanged unless they get on their bike and inform their lender that they would also like to benefit from the cut. Never mind the lenders which continue to calculate interest on an annual basis.

Of course, we are talking about the mortgage business. Lenders are not suddenly becoming philanthropic. While traditional lenders are adapting to a new environment, they are not doing so too quickly.

But what does this mean for the short term? A likely recession in the US could lead to more interest rate cuts. The minutes from the last meeting of the Bank of England&#39s monetary policy committee show concern about the effects of a possible US slowdown.

The money markets are pricing in two 25-basis-point cuts, with a strong likelihood that the first of those will occur in April. With a likely interest rate cut next month, mortgage rates seem set to move in line.

However, it would be dangerous for IFAs to assume that base rates and standard variable rate movements will continue to mirror each other. At some point in the not too distant future, there has to be a natural floor below which standard variable rates will not fall. After all, mortgage banks have the needs of savers to consider. So do not expect standard variable rates to push significantly below 6 per cent.

Nonetheless, in the long term, competitive pressures are not going to lessen. Gazing into the future, some trends can be identified.

I believe we will see the gradual demise of discounts and fixed rates out of line with the money markets. The death throes of such products may take a while to be seen but they will happen because such offers are unsustainable.

What propositions should IFAs be looking for? Given that the importance of short-term incentives must diminish, the key will be the importance of selecting a lender which has the ability to offer a competitive and sustainable standard variable rate over the long term.

Lenders with certain key strengths will be in the strongest position to offer this proposition. Mutuals will have an advantage through the ability to pass on savings to their customers, not to their shareholders. To maintain a competitive variable rate, however, lenders will need economies of scale as well as slick and efficient processing capability to minimise costs. So we should see the telephone banks and other centralised lenders continue to benefit from the advantage of lower costs.

Beyond this, the ability to differentiate between competitors offering the same standard variable rates will enable particular lenders to stand out from the crowd. Added value will be king. As customers become better informed, they will seek to benefit from additional features such as daily interest and the mechanism to overpay or take a payment holiday without penalty.

Ongoing flexibility and long-term competitive rates will take over from short-term incentives as key features, allowing more customers to use their mortgage as part of their wider financial planning.

The interest rate war does represent a fundamental change although it may take some time for the end game described above to be reached.

The lenders most likely to succeed in the end game will be assisted by the advantages of mutuality, economies of scale, efficient processing ability and innovative product design geared to ongoing benefits to customers.

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