Blind led by the greedy, is verdict on home loans

The Miles Report: Development of long-term mortgages in UK held back by short-sighted consumers and cross-subsidies from lenders
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The Great British consumer casts a long shadow over the 124-page report into the housing market compiled by Professor David Miles and his team at the Treasury.

The Great British consumer casts a long shadow over the 124-page report into the housing market compiled by Professor David Miles and his team at the Treasury.

He or she is too focused on short-term gain, can't understand the risks involved in taking out a mortgage, suffers from financial illiteracy and ultimately can't resist a bargain.

However, in an exhaustive investigation into the puzzle of why Britain lacks much demand for, or supply of, longer-term mortgages, Professor Miles shares the blame around.

Lenders are accused of cross-subsidising between old and new customers, financial advisers are criticised for the way they are paid, and the legal and financial system gets it in the neck for not facilitating the growth of a market in longer-term mortgages.

His report throws a harsh glare on to the murky world of Britain's mortgage market, where more than nine out of 10 loans are on variable interest rates or are fixed for less than five years. But the Imperial College economics professor stopped short - at least for now - of saying he had identified a "market failure", a finding that could have triggered a regulatory inquiry.

At a Treasury briefing to unveil his report, Professor Miles said: "There is no evidence of classical anti-competitive behaviour, but I am concerned that some features of the market are not working as well as they should and in the interests of all borrowers."

Gordon Brown, the Chancellor, commissioned Professor Miles in April to look at why the take-up of long-term mortgages was so low in Britain compared with other countries.

The report was seen as a sop to the pro-euro lobby, because the short-termist structure of Britain's mortgage market is seen as an obstacle to entry into the single currency.

But his investigation has resulted in a wide-ranging analysis of the failings - and successes - of the market and of the behaviour of the millions of people involved in it.

The headline-grabbing finding of the report is the degree to which loyal customers on the standard variable rate subsidise "loss leader" deals for new customers.

Professor Miles found that the standard variable rate in October was 1.8 percentage points above the money market rate - 5.4 versus 3.6 per cent.Borrowers who took a typical discounted variable deal - where the lender effectively offers a short-term price cut - were paying as much as 2.5 percentage points below the most competitive 25-year deal available.

"We have a system of pricing here that discounts deals offered to new lenders at rates at which it is hard to see how lenders make profits and there's a degree of cross-subsidisation," he said.

"If you were comparing a 10- or 15-year deal with a discounted deal the rates will look extremely expensive.

"This means that longer-term fixed-rate mortgages appear expensive when compared with discounted mortgages."

However he had some sympathy with the mortgage industry which he said was "trapped" in a pricing structure that meant it had to make a loss on short-term deals. "I don't think this is a great situation but it is not a sign of a lack of competition or a cartel," he said. "The market is highly competitive."

The mortgage industry had not expected Professor Miles to come up with any hard proposals in his interim report, and took his comments in its stride.

Michael Coogan, the director general of the Council of Mortgage Lenders, said the issue of cross-subsidy "posed a significant challenge" for Government and lenders alike. "We look forward to working with Professor Miles on this to develop helpful recommendations for his final report," he said.

Cheshire Building Society, whose 25-year fixed rate mortgage - believed to be Britain's only one - has 500 customers, naturally said it supported the Miles review.

"Among customers who have taken the deal a main motivation is to be secure in the knowledge that although [base] rates may rise, they payments will not," said a spokesman.

Turning his attention to the consumer, Professor Miles said that ultimately the average homebuyer had a "poor understanding of risk and therefore pays little attention to the insurance which longer-term fixed-rate mortgages can provide against unexpected interest rate rises".

He said it was "not wildly implausible" that base rates could double over the next five years.

"There's a great deal of evidence that households in the UK attach a great deal of weight to the cost up-front and many people perceive the costs of the mortgage as the level of the first monthly repayment," he said.

Less than one in 10 UK borrowers has a fixed rate for more than five years and none for more than 10, whereas in the United States 80 per cent have a rate fixed for at least a decade.

While a mortgage is probably the largest - and the riskiest - financial transaction most people will make, Professor Miles is plainly concerned about the level of financial literacy in the UK. He said half of the poorest tenth of households had a mortgage while only a quarter of households with annual income below £6,500 was financially literate. The financially illiterate, according to a Financial Services Consumer Panel, are defined as those who find it "difficult to understand financial leaflets and materials".

This paled into insignificance compared with the knowledge needed to make an intelligent decision about a mortgage. "Understanding about standard deviation or the operation of the yield curve is not something that comes easily to many people," Professor Miles joked. "Silly people do need help, but a pricing structure that works in favour of the astute [favours] those who are richer, who have bigger mortgages and who read newspapers' personal financial supplements."

He indicated he had financial intermediaries in his sights, pointing out there was a financial incentive for advisers to sell products that had the prospect of a resale in the future.

However, Ben Thompson, director of Clear Cut Mortgages, said advisers were well-placed to advise customers on tricky issues such as fluctuations in rates. "Consumers can make substantial savings by choosing short-term fixes in the current market," he said.

While Professor Miles was assiduous in not being drawn on concrete proposals, his report highlights a number of obstacles to opening up the market. At the moment he said most mortgages were funded from lenders' savings deposits, which removed the interest rate risk as both rates rose and fell at the same time. In order to offer longer-term deals, lenders had to be able to offset the risk that base rates might vary wildly over that time, or they could end up facing open-ended losses.

He said the development of a larger market in fixed-rate, longer-term mortgages depended on the efficiency with which mortgage lenders were able to raise funds. This, in turn, depended on a number of factors - such as insufficient liquidity and the inability of lenders to predict the risk that people might pay off the mortgage early, before they had turned a profit - some of which would prove temporary.

Professor Miles said other factors - the impact of accountancy rules, capital adequacy and restrictions on building societies - were less likely to be transitory. "All these are affected by policy decisions," he said, indicating that he may recommend changes to the law in his April report.

Rob Thomas, general manager of the European Mortgage Finance Project, which seeks to create a US-style secondary finance market in Europe, said this would be a key issue. "We are keen that these issues are addressed in a fundamental way, which means we don't want to see tinkering but real change," he said. "There are substantial issues of short-termism in the market and he has recognised that."


'Understanding about standard deviation or the operation of the yield curve is not something that comes easily to many people'

- Professor David Miles