It is still only three months since the storm in global credit markets blew up over concerns about exposure to American non-conforming lending, leaving Northern Rock struggling in its wake.
A small elapse of time, but long enough to observe some short-term consequences and to make predictions as to how events will play out in the UK mortgage market in 2008.
An immediate effect of the credit crunch has been that the London Inter-Bank Offered Rate (LIBOR) has moved up. Unlike the Base Rate, which is set directly by the Bank of England, LIBOR rates are set by the demand and supply of money as banks lend to each other on a daily basis. It has therefore become more expensive for the centralised lenders to raise wholesale funds to create new mortgages for their customers.
We have already seen the disappearance of a couple of centralised lender brands – the London Mortgage Company and Victoria Mortgage Funding.
In addition, GMAC-RFC, which had a top 10 market share, is scaling back its UK operation. Across the mortgage market, lenders have either tightened their lending criteria or simply pulled loans, particularly those focused on the non-conforming area. The number of residential mortgage products available has fallen by 40 per cent in the past three months.
Impact
What impact might this have on the lender-borrower relationship? In the past few years, the balance of power has been slanted towards the borrower rather than the mortgage lender. The borrower has been ‘managing’ the mortgage lender or, more precisely, using an intermediary to manage the mortgage lender.
According to CACI estimates, between 65 per cent and 70 per cent of new mortgages are now arranged by introducers, rather than coming through lenders’ high-street branches. Time-pressured and faced with a bewildering array of short-lived mortgage offers, borrowers have simply asked brokers to narrow down the field and to help them choose a mortgage that fits their wallet.
Borrowers have also taken advantage of historically low interest rates, to lock themselves into attractive deals. In the first seven months of 2007, three-quarters of new mortgages were arranged on a fixed rate basis. Two-year fixed rate deals were the most popular, followed by three-year fixes.
There has been a double whammy for lenders. Consumers have learned to keep their household expenses down by going back to a broker once one short-term fixed rate deal ends to remortgage onto another fixed rate. At the same time, consumer power and regulatory interest from the Financial Services Authority (FSA) have made it more difficult for lenders to tie customers in or to impose exit charges by another name to discourage mortgage switching.
Particularly telling
The accompanying chart, made up of anonymised data from CACI’s Mortgage Market Database, is particularly telling. It shows, for each of the top 10 lenders, the retention rates as at October 2007 for introduced mortgages arranged over the past seven years.
By looking at the left hand side of the chart, it can be seen that none of the top 10 lenders has managed to retain more than 30 per cent of the mortgages that were introduced to them in 2000. In the worst case, the retention rate is just over 10 per cent.
Look along the chart to the year 2004 and it can be observed that, typically, lenders have managed to retain around 40 to 45 per cent of the business written in that year. To turn this figure on its head, around 60 per cent of mortgages introduced to lenders by intermediaries are switched away within three years. In short, six out of 10 mortgages arranged by brokers don’t make it much beyond their third anniversary.
Market predictions
So, in a harsher lending climate, will these market dynamics be maintained or will a new pattern emerge? Here are CACI’s predictions for 2008.
We believe 2008 will be the year of the traditional balance sheet lender. In the new environment, lenders that attract funds from retail deposits to fund their lending are going to be at a distinct advantage versus lenders that are heavily reliant on wholesale markets for their funds. Similarly, lenders that hold mortgages on their balance sheets will be in a better position than lenders that aim to sell on the bulk of their loans.
Lenders will continue to tighten their lending criteria. They will be increasingly selective about who they take on as borrowers. The accent will be on quality of lending. More attention will be paid to affordability and, so as to keep a close monitor on new borrowers, lenders with extensive branch networks may attempt to grow the proportion of new business that is arranged via their branches. Self-certification of income will come under the spotlight.
If you are prime borrower with a good credit history and a low prospective loan-to-value (LTV), then people will compete for your business. If you have a poor credit history and are looking to borrow money at a high LTV then you are going to have to pay more for the privilege.
Risk will be properly priced once more – and non-conforming borrowers will be the ones who pay. Overall, there’s going to be a shift of power from borrower back to the lender.
Mortgages will not become any cheaper. As we’ve seen, the cost of wholesale money to lenders has gone up and lenders are going to have to compete for retail funds, so savers can expect some good rates. Lenders will also take the opportunity to rebuild their margins.
In some quarters, there appears to be a belief that borrowers will soon find relief from a sustained reduction in Base Rate. Realistically, this must be in doubt. Because of inflationary pressures – and we’ve seen a substantial increase in the price of oil – the ability of central banks to keep cutting Base Rates to bail out overextended borrowers is limited.
Looking at the year ahead
So in 2008, new mortgage activity is going to slow up. Gross residential mortgage lending can be expected either to plateau or to fall slightly.
House prices will not move uniformly. National house price indices will become of less relevance. Prices will diverge in different parts of the country. Increasingly, the focus will be on localised markets. In some localities, demand will continue to support prices. In others, for example Manchester, oversupply of property, in particular one or two-bedroom flats, may lead prices to fall as amateur buy-to-let investors exit the market en masse. Repossessions will increase, but skewed towards the non-conforming market which, by our calculations, represents around 7 per cent of the total market.
Northern Rock’s share of new lending will be redistributed among the other lenders, but lenders, in particular those with shareholders, will not chase market share at the expense of profitability. Indeed, the chief executive of HBOS recently said that, in future, HBOS is going to take month-by-month decisions about the ‘trade-off between volume and margins’. In this environment, while their share of net lending is currently below 20 per cent, building societies should thrive.
On the horizon
On the horizon, in first quarter of 2008 the financial services regulator will publish the results of the second stage review of the effectiveness of its mortgage regime. We can also expect to see further development of the FSA’s ‘Treating Customers Fairly’ initiative.
The results of Chancellor Alistair Darling’s review of covered bonds will be published in the March 2008 Budget. The government seems determined to encourage a consumer appetite for long-term fixed rate mortgages but, as with healthy school dinners, there is little evidence so far that the public wants them, although maybe this will change. If long-term fixes were ever to become the norm, there would be an obvious impact on mortgage introducers’ cash flows.
Finally, much depends on consumer confidence and whether employment holds up. Although high-street retail sales rose by 4.9 per cent in September compared with a year ago, consumers at some stage will have to start moderating their spending. At least 320,00 households will be coming off fixed rate mortgages between January and August 2008 and either re-fixing at a higher rate or finding themselves lodged medium-term on a standard variable rate.
Either way, there will be less money about and consumers will be more cautious about entering into long-term financial commitments, such as mortgages.
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