The battle to sell mortgages hots up

Banks are desperate to win your home loan. Sales gimmicks are now commonplace

West Bromwich Building Society's decision to hand out free cars with their mortgages left some experts wondering yesterday whether the mortgage market has flipped from being highly competitive to just plainly mad for those lenders fighting to increase their slice of the £783bn sector.

West Bromwich Building Society's decision to hand out free cars with their mortgages left some experts wondering yesterday whether the mortgage market has flipped from being highly competitive to just plainly mad for those lenders fighting to increase their slice of the £783bn sector.

In fact, a closer inspection of the small print of West Bromwich's "Brum Brum" offer suggests it will not be great value for most customers. But it is nonetheless a function of the enormous pressure lenders are under to lure the increasingly value-conscious borrowers with promises not only of competitive rates, but also a range of extra perks ranging from "cash back" to DIY vouchers.

The impact such competition has on the lenders' bottom line is clear to see. Abbey, Britain's sixth biggest lender, last week became the latest bank to warn that it had been forced to drop the price of many of its existing mortgages, with a result that profits from its core retail banking division would be "weaker" in the coming months.

Britain's mortgage market is one of the most competitive in the world, and the sector produces some of the most meagre profit margins compared with other industries. One senior banking source said: "Supermarkets make profits of 5 per cent and consumers still praise them. On mortgages, banks' profits margins are less than 1 per cent and falling."

On the face of it, the mortgage market does not seem to be a particularly attractive place to be. The consumer lobby has pressurised banks in the past few years to drop the hidden charges and redemption penalties which used to make the line of business such a profitable one.

And banks themselves - under pressure from competitors - have chosen to cannibalise their profitability in a bid to retain old customers as well as gaining new ones by slashing the price of their existing book of mortgages as well as new deals.

As a result, while in the past banks have made substantial sums from customers who pay their "standard variable rate", which is usually significantly higher than the Bank of England's base rate, these days, customers in that category have dwindled.

Ray Boulger, a senior technical manager at the mortgage adviser Charcoal, said: "Only one third of borrowers are on the SVR now. And even that does not give the full picture because it includes people on a much lower than average mortgage size and so are unlikely to move on. Overall, the proportion of the total lending book in the UK on the SVR is only 15 to 20 per cent."

Given the razor-sharp nature of profit margins on mortgages, it might seem particularly alarming that most City pundits believe interest rates are about to increase, raising the possibility that borrowers will not be able to repay their loans and leaving banks with lots of bad debts on their books.

While most lenders eschew the belief that the housing market is heading for a crash, the general picture that times are hard in the tough world of mortgage pricing is one that they are quite happy to see propagated. This is especially in the light of the volley of criticism from politicians and consumer groups this year about the record profits almost all of Britain's major banks reported.

The reality is somewhat different, with most analysts pointing to the fact that financial services, including mortgages, remain one of Britain's most profitable sectors.

Robin Down, an analyst at Morgan Stanley, said: "On a three to five-year view, I would expect to see continued downward pressure on mortgage margins. But that is a function of where the banks have started - this is a sector which makes a 21 per cent return on equity."

In fact, many aspects of the mortgage market remain highly attractive for banks.

James Leal, an analyst at Teather & Greenwood, said: "The market may be incredibly competitive, but it is also very profitable. That is because it provides opportunities for cross-selling products directly linked to mortgages like payment protection insurance. And there are other opportunities to cross sell because the relationship with a mortgage customer is deeper than with someone who has walked into a branch to change a ten pound note into two fives."

Banks can also afford to cut mortgage margins to the bone because the line of business is predictable and produces far fewer bad debts than lending on credit cards and other unsecured loans (see table). As a result, regulation around credit control is relatively light, making mortgages a very cost-effective business to be in.

"Banks' return on equity is very high, and much of that is from mortgage lending. That is because Basle regulations require a lower capital weighting on mortgages," Mr Leal added.

The risk of a rise in interest rates leading to a cascade of bad debts for banks has also been over-stated. Despite the fact that house prices have rocketed in the past 10 years, the average loan is worth only 50 per cent of the value of the property. Mortgage repayments as a proportion of average earnings also remains very low compared with the early 1990s - the last time that house prices crashed.

One analyst said: "Banks have got twice of the value of the loan secured in the property. If there were to be another drop in house prices, it would have to be a pretty serious crash before the banks started to lose money."

An environment of rising interest rates also provides opportunities for banks to boost their margins across their books of lending and saving products. Banks often use a process known as "rate gapping" when interest rates change, moving their mortgage books into line with the change in base rates, but delaying before they change their savings rates, earning profits while they delay.

The prospect of an increase in the base rate has also contributed to a general easing in the ongoing war on pricing between rival lenders, with a number taking advantage of the impending rise to increase the cost of their new loans.

While Abbey said last Thursday that it had had to slice the price of its existing mortgage book, it had good news on new mortgages, saying it was raising the price of them.

"A rising interest environment alleviates some of the structural pressure. Abbey has put its prices up, so has Woolwich [part of Barlcays]. Deals are now about 80 basis points above the base rate, which is an increase on two or three months ago," said Mr Down.

Gary Hockey-Morley, head of mortgages at Abbey, said the banks have partly learned from their own mistakes, especially in their chase of business in the remortgage market, which has exploded in the past few years.

"Rates have increased in the past quarter, after banks looked at their pricing models. There have been a lot of people becoming serial remortgagers, chasing one deal after another, which is not what you want if you are a bank," Mr Hockey-Morley said.

Instead Abbey, which is struggling to boost its profitability, contends that it can take on the mortgage giants on the basis of superior service and flexibility rather than headline rates. Whether customers can be persuaded that that is what they want, remains to be seen.