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The new mortgage order – beginners guide to lending

By AMI's Chief Executive Robert Sinclair, published in Moneyfacts, July 2023

Background

The recent challenges brought about by rampant inflation, causing interest rates to be rapidly escalated in the UK and some other economies is bringing pain to the UK housing and mortgage market.  What we are seeing are remedies used in the 1980’s when 70% of people owned their own homes, with 80% of people on variable rate mortgages.  In 2023 only 62% own their own home with 80 % on fixed rates. This means that the interest rate remedy will take longer to work and will impact in a random way those who are unlucky to be coming to the end of their fixed rate deal.

In the low interest rate environment from 2008 to 2022, only experts needed to understand lender funding models, hedging strategies and pipeline management processes.  Since we entered a higher inflation environment, with volatile interest rates and sudden product withdrawals, these topics have become important for everyone to understand.

Mortgage funding is not just about raising deposits to lend out to borrowers, which is how traditional building societies worked until the mid-1980s. Then, borrowers waited in a ‘mortgage queue’ until the society accumulated sufficient funds from savers to lend out as mortgages. Modern lending works differently with more sources of funding.

In essence, lenders make profit by ‘borrowing’ from savers and investors and lending to other customers in the form of mortgages and loans. The lender charges the borrowers interest, passes some of this to its savers and keeps the rest to cover its costs and return value to shareholders or members.

Without alternative funding, lenders could run into cashflow difficulties, as they can’t control the timing of inflows and outflows so that everything remains in sync. They need to protect themselves from volatile interest rates. If lenders get their funding models wrong, they risk making significant losses – or in the worst-case scenario, becoming insolvent.

The rate type conundrum

Variable rate mortgages are relatively easy to fund.  Assuming a lender’s funding costs are Base Rate +1%, if the lender charges its mortgage borrowers Base Rate +2%, it can keep the 1% difference for itself. If the Base Rate rises, the lender can increase the rate offered to savers and raise the variable rate charged to borrowers to maintain its margin. It needs to increase the rate to savers to maintain a required level of deposits to fund its loans.

Fixed rates are different.  If Base Rate is 0.5%, and initial funding costs are 1.5% (Base Rate +1%), the lender still makes a 1% profit charging a fixed-rate borrower 2.5% – at first.   But if Base Rate increases to 1%, the lenders’ margin is halved to 0.5%. If Base Rate goes to 1.5%, the profit is wiped out, as funding costs (Base Rate +1%, or 2.5%) are now equal to the income from the fixed-rate borrower. If Base Rate goes up again, the lender makes a loss on the loans that it has made as it is having to pay more to keep its deposits.

Making it work

This is where swaps come in. The lender can ‘hedge’ to take the risk out of their fixed rate mortgage lending by buying a set amount or ‘tranche’ of money from a counterparty in the financial market, fixed at a particular ‘swap’ rate for a specified period of time.

The ‘swap rate’ is the fixed interest rate that the counterparty demands in exchange (as a ‘swap’) for the uncertainty of having to pay the short-term floating or variable rate of interest for the money over the time period.

Both parties are effectively placing a bet – the lender thinks rates will go up, the counterparty thinks they will go down. If variable rates rise above the swap rate, the counterparty loses their ‘bet’ and has to pay the lender the difference. If rates fall, the reverse applies. This helps insulate lenders against rising rates when offering fixed-rate mortgage deals.

It is therefore the prevailing rate in the “Swaps” market that dictates the pricing of fixed rate mortgages rather than any direct relationship with Bank of England Base Rate or the cost of funding deposits.

This is made more complex based on when the lender chooses to “buy the swap”.  This may be an estimate based on mortgage applications received that will convert to completed loans.  Others will base this on value of offers made, others may wait until loans complete. Some might use fixed term deposits to “naturally hedge” the risk.

Rising swap rates put lenders in a difficult position. Once the funding runs out for fixed-rate deals at a particular price, the lender has to pull the deal or sell the product at a loss, compromising the financial health of the business. This is why we have seen some lenders pulling products with very little notice.

The management conundrum

The issue facing lenders is that the minute a deadline is announced, applications flood in, creating a dilemma, balancing giving as much notice as possible with avoiding a surge of demand they do not have the operational or financial capacity to meet.

A lender might be receiving a manageable quantity of applications, but if a ‘cheaper’ provider withdraws suddenly, they then become lender of choice for the market and are inundated. That lender may then need to withdraw more quickly than they had planned or wanted.

Of course, this situation is incredibly challenging for brokers and consumers. To be told a product is on the shelf, only to have it abruptly vanish causes wasted time, expense and a great deal of stress and uncertainty for all involved.

Even if a product is repriced immediately, it might not then be affordable for the customer or allow them to borrow enough. If it is affordable, the worry continues that it could be pulled yet again, causing further anxiety for the broker and consumer.

There are no easy answers to this problem, and the solutions will require a compromise between lenders and brokers and most importantly one that works in the best interests of consumers.

Some have suggested that a 24-hour product withdrawal notice period became mandatory.   This could be problematic. Some lenders could simply not absorb high-volume applications if they were unable to withdraw products – so could not risk putting themselves in that position in the first place. It could lead to the disappearance of some fixed-rate deals altogether, the need to build in extra margin to all products or to take products off sale earlier. Ultimately the consumer would lose out.

In practice, lenders should always try to give as much notice as possible, but it is unlikely there could ever be a ‘one size fits all’ approach.

The Impacts

Product withdrawal deadlines outside of core business hours affect work-life balance and create stress and uncertainty. Setting application closing times in the evening on the one hand is being supportive, but it brings with it choices, stress and often disappointment.

Lenders must consider operational changes that could have a positive effect on ensuring sensible product withdrawal timeframes, such as internal committees meeting earlier in the day and/or more frequently. Committing to notice periods within core hours may not be feasible right away if IT systems or internal processes need to be modified. But as interest rate volatility looks set to continue, the mortgage industry needs to consider new ways of working to adapt to the new normal.

Honest communication and engagement is key. With every decision there are trade-offs, and open dialogue about the decisions being taken, the discounted alternatives, and the reasons behind these decisions can make all the difference in supporting brokers to explain what is happening to their clients.

This ties in with the Consumer Duty requirement to put consumers in a position to make ‘informed decisions’. Broker firms reviewing their product panels may wish to keep track of lender notice periods and communications to see which deliver more certainty and stability for clients, and feed this into their recommendations accordingly. Clients with a higher risk appetite may be prepared to tolerate the risk of an unexpected or short-notice product withdrawal if it means the potential for a better deal.

The Future?

Ultimately, lenders do not want short notice product pulls. Service, profitability and relationships suffer and so there is little incentive to remove products at short notice other than to mitigate potential harm. Lenders do not take product withdrawal decisions lightly and understand the grief such a decision can cause to both brokers and consumers.

That is why it is important for the industry to work collaboratively.  We are in a new world and we will not go back to the interest rates we saw. Advisers are going to have to explain to consumer what this new normal is going to be and help them budget and plan for the longer term increased costs of housing.

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