solution

Case Study

Centralized mortgage lending – a salutary story

The latter part of the 1980s in the UK witnessed the rapid birth, and almost equally rapid nadir, of what were termed centralized mortgage lenders. Names such as The Mortgage Corporation, National Homeloans and Mortgage Express came from a standing start to take of the order of 25 per cent of new mortgage business by 1990. Their success was based upon a combination of opportune timing and the unresponsive nature of traditional sources of mortgages, most notably the building societies.
In terms of good timing, the centralized lenders were able to take advantage of a period of time during which the cost of funds on the wholesale money market was cheaper than retail-sourced funds. Building society mortgages were largely funded by retail-sourced funds – indeed, there were strict limits on the percentage of their mortgage funds that could be sourced on the wholesale money market. Being centralized lenders, they had no branch infrastructure costs to carry and were able to administer new mortgage applications efficiently from one central administration centre. This gave them additional cost advantages which, together with lower funding costs, gave them a clear pricing advantage over their traditional rivals.
Three other factors worked together with their pricing advantage to give the centralized lenders a tremendously strong competitive edge. First, they were able to process new mortgage applications very fast (often within 24 hours, compared with the 4–6 weeks that was typical for building societies at the time). Speed is of the essence for the typical homebuyer as, once a desirable new home has been found, there can often be a race to cement a deal with the seller of the property. Secondly, the centralized lenders appreciated the importance of intermediaries, such as estate agents, mortgage brokers and insurance company sales agents, in placing new mortgage business. In the late 1980s, in the order of 60 per cent of new mortgages were placed with lenders via intermediaries. This resulted in a very low cost of new business acquisition compared with the branch costs of the traditional lenders. Recognizing the role of intermediaries, the centralized lenders focused their own new customer acquisition activities upon them. Thus, high volumes of new business were generated at low cost, and in a short period of time the newcomers were challenging the supremacy of a well-established incumbent industry. Thirdly, the centralized lenders brought product as well as service innovation to the mortgage business. They were able to use their treasury skills to provide new forms of interest rate management, such as fixed rate and ‘cap-and-collar’ loans.
They began to use securitization as a means of putting their loan books off balance sheet and thereby enhancing the return-on-capital to their shareholders. They introduced so-called deferred rate mortgages, most notably the 3:2:1 scheme, whereby the interest rate payable in the first year of the mortgage was a full 3 per cent less than the standard variable rate (SVR), reducing to a 2 per cent discount in the second year and 1 per cent in the third year. The ‘6 per cent’ deferred interest arrived at in this way was to be added to the outstanding loan at the end of Year 3, and the new, higher amount would be repaid at the prevailing SVR from Year 4 onwards.
The meteoric rise of the centralized lenders was also assisted by three factors external to their control. First, the house-purchase market in the UK experienced a sustained boom from 1985 onwards. Secondly, interest rates were falling steadily towards the end of that decade. Thirdly, in 1999 the Thatcher government gave advance warning that it was going to remove a tax-break known as ‘multiple MIRAS’. This had the effect of lighting the blue touch paper on a firework – the housing marketing rocketed property values to stratospheric levels.
Just as propitious timing had brought about the dramatic growth of centralized lending, so too did a set of negative economic factors result in its almost equally dramatic demise. During the course of 1990 interest rates began to rise – indeed, in little over a year the base rate doubled from 7.5 per cent to 15 per cent. Unsurprisingly, the housing market went from boom to bust within just a few short months. The centralized lenders’ price-edge evaporated, causing already declining sales to fall even faster. The rapid rise in interest rates caused hardship for borrowers, and mortgage payment defaults began to grow. At the same time, falling property prices rapidly eroded the margins of security of the lenders. To make matters even worse, many borrowers on deferred-rate mortgage schemes were among the defaulters. This meant that the interest outstanding grew rapidly and added to the losses that would be incurred as security margins disappeared. It should be borne in mind that the centralized lenders’ ‘asset’ base of mortgages was accumulated when property prices were at or near their historical peak, and that loan-to-value ratios were typically 90 per cent. In other words, the lenders had a margin of security of just 10 per cent, while between 1990 and 1992 the average property value fell by the order of 30 per cent. The outcome was that the new lenders withdrew from the market by ceasing to accept new business in order to limit further potential losses for their shareholders. All operational focus was upon damage limitation by acting quickly to gain access to whatever security remained in the valuations of properties in default. Repossessions rose sharply, and so did the financial losses of the centralized lenders.
Inevitably, it was the more ‘successful’ companies which had built the largest books of business that suffered most, and the majority of the high-profile lenders went out of business. Some of the smaller ones managed to survive, and have carried on at the margins of the mainstream business.