CML news & views

In two days’ time, we are planning to publish our mortgage and housing market forecasts for this year and next. Many may expect them to predict a period of only modest recovery, which could extend for some years beyond 2010 – and they will be right.

We have stability in the mortgage market but at the risk of stagnation. So, could market prospects be boosted by the recently announced re-structuring of nationalised and part-nationalised banks?

Last week’s Treasury announcement of the planned changes in the Lloyds Banking Group and the Royal Bank of Scotland (RBS) outlined three key priorities, putting an increase in lending in the economy alongside financial stability and delivering value for money for the taxpayer. We agree.

Trying to increase the volume of lending – to businesses, individuals and customers seeking mortgages – is a key objective, although it has proved to be a challenging one in practice. Too often, the government has failed to acknowledge the constraints under which lenders are operating – and the often conflicting demands that are being made of them. But we expect the pent-up demand that exists in the market to help ensure that mortgage lending commitments are met.

Competition and diversity

In announcing plans to split up the Lloyds Banking Group, RBS and Northern Rock, the chancellor, Alistair Darling, told MPs that one of his goals was to “increase diversity and competition in the banking sector – giving customers more choice and better service.”

There was no mention of mortgage pricing. But if new entrants price properly for risk, they will not be able to undercut substantially existing lenders that are active in the market.

So, how likely is it that the recent announcements will help bring about an increase in mortgage lending? It is too soon to say. Lenders entering the market will not be handicapped by potential losses from past business, but they will still need to compete for access to funds for new lending. 

The jury is still out on whether – and to what extent – they will be able to increase overall funding in the market and meet pent-up consumer demand at realistic prices.

New arrangements

When he made his announcement about the Lloyds Banking Group and RBS, the chancellor said he had been looking at participation by the two firms in the government’s asset protection scheme and working with the European Commission to meet rules for state aid. As a result, both firms needed to “make divestments of significant parts of their businesses over the next four years,” he said.

Lloyds Banking Group will therefore sell Cheltenham & Gloucester, Intelligent Finance, the TSB brand, Lloyds TSB Scotland and some Lloyds TSB branches in England and Wales, the chancellor said. Overall, it will be required to sell 600 branches over the next four years.

Meanwhile, RBS will dispose of its insurance businesses – including Direct Line and Churchill – as well as its commodity trading arm and card payment processing operation, divesting more than 300 branches over a similar period.

In a separate announcement a week earlier, the state-owned Northern Rock also unveiled plans to re-structure, creating two separate companies. The first is to be a new savings and mortgage bank, licensed as a deposit-taker by the Financial Services Authority (FSA) and offering new saving products and mortgage lending. It will hold and service all savings and some mortgage accounts.

Meanwhile, most of the rest of the Northern Rock mortgage book – around 90% of which is fully performing and not in arrears, the chancellor said – will be retained in a separate asset management company. This second company will not offer new mortgages or take deposits, but will continue to be regulated by the FSA as a mortgage provider.

The chancellor said that what was being hived off in total from the three companies amounted to “about 10% of the retail banking market in the UK.” This would “potentially create three new banks on our high street in the space of five years.” None of the assets would be sold to existing big players in the industry, he said. “This will increase diversity and competition in the banking sector – giving customers more choice and better service.”

The current market

In the current market, there is only a relatively small number of active lenders. Our data on the largest mortgage lenders in 2008 confirmed that lending has become much more heavily concentrated in the hands of a small group of large firms. 

The six largest firms advanced almost 80% of gross lending in 2008; the year before, those same firms accounted for two-thirds of lending. The trend has continued this year, with new lending now even more concentrated in the hands of the largest lenders.

Nationwide Building Society is one of the top six lenders, but the other five are all banks, and two of them are partly government-owned. Generally, the building society sector has been shrinking, with re-structuring under way – and this process may accelerate if the FSA persists with plans for separate regulatory controls for societies alongside wider reforms emerging from the ongoing mortgage market review. 

Specialist lenders, meanwhile, have been worst affected by the chronic funding shortage, and many are now inactive because of their inability to access funds. 

Funding constraints 

Although the small number of recent wholesale funding deals by some large institutions is a welcome development, this market remains largely closed for most lenders. Until investors are encouraged back to provide additional funding, it will be difficult for lending activity to expand.

The funding shortage has effectively led to mortgage rationing over the last two years, with a sharp decline in the number and range of products available in the market. One result is that borrowers now have to put down larger deposits, and this is a particular problem for many first-time buyers, as we have highlighted recently. Currently, this group is required to find average deposits of 25%. 

Other issues

In summary, we now have a lending industry in which:

• Some lenders and intermediaries have already left the market, perhaps never to return, given that levels of activity will be lower in future.
• A growing number of borrowers are – or will be – excluded from entering or transacting in the market. Among this group will be first-time buyers without deposits, customers whose credit rating has worsened because of the recession, and self-certified borrowers who are at risk of being denied access to the market by a change in FSA rules.
• Lenders, as a whole, do not have enough funding for mortgages to help promote the economic activity that will help lift the UK out of recession.
• A mortgage market in which there is a thriving range of different types of lending institution – banks, building societies and specialist lenders – has largely disappeared.  A key challenge is to reverse this trend.
• The development of innovative products capable of delivering real consumer benefits is being constrained. This has removed a traditional advantage for UK customers compared to borrowers in other countries, namely, widespread access to a variety of products tailored to their needs at different stages in life.
• Mortgage costs have risen, and will remain higher than before the credit crunch. And with higher taxes coming through from 2010 onwards, and higher interest rates in due course, consumers’ capacity to borrow will be further constrained.
• There is a risk of regulatory intervention through the FSA’s mortgage market review that does not address these problems, ‘shuts the stable door’ after the market has corrected itself and does not focus on the real detriment for borrowers with multiple debts.

Conclusion

In such a market, what will be the effect of the recent re-structuring announcements? Can they help deliver greater diversity and competition and promote choice and better service, as the chancellor predicted?

Clearly, the proposed changes to the three banks do create potential opportunities for new entrants, perhaps from overseas following the recent move by the Bank of China. 

We may therefore see a welcome increase in the number of active lenders in the UK mortgage market. But current market conditions are unlikely to precipitate a rush to enter the market, so the opportunities may only be fully realised in the medium or longer term. 

Could the break-up of existing institutions promote greater diversity in the market? The sale of assets might attract interest from the mutual sector, but the reality is that the most likely new entrants are well-capitalised banks from overseas or from other retail businesses – only a handful of names come to mind. It is difficult to see how the recent announcements could create any new opportunities for existing specialist lenders. 

A key question is whether future disposals are driven by competitive bidding, or will be more akin to “fire sales.” As taxpayers, we all have an interest in ensuring early repayment of government support at a profit, and this will be a key measure of success.

Clearly, new entrants over time would increase competition from the small number of active lenders we have today. Any such moves would be a step in the right direction. But we are unlikely to see a return to the highly competitive mortgage market we saw before the credit crunch. 

Any widening of choice in the current market is likely to deliver the greatest benefit to prime, low-risk borrowers. And while a steady increase in the number of active lenders may occur over a period, it is unlikely to lead to the launch of a new range of innovative products.

Ultimately, the re-structuring could play a part in what is likely to be a slow improvement in the availability of mortgage funding. But it will not, in itself, restore a properly functioning wholesale mortgage funding market. 

Perhaps the key to understanding the likely impact of the re-structuring is to look at the government’s own predicted timetable. It expects the changes to be implemented over four years, and certainly not immediately. 

So, while the break-up of assets may contribute to a slow and steady increase in competition and choice, it is unlikely to alter our general view, reinforced in our forthcoming forecasts, that the volume of mortgage lending – and market conditions more generally – will only improve slowly over a prolonged period.