Please don't call it market failure, says Professor David Miles, but the UK mortgage market is not working as well as it should for most borrowers. In a Treasury commissioned report on the mortgage market, Professor Miles puts UK lenders on notice that he has identified flaws in the system and intends to recommend policy solutions in time for next year's Budget. But what are these flaws, and is Professor Miles correct in thinking that the market will be improved by addressing them? I'm not sure he's right on either count.
Nobody commissioned to write a report on a perceived failing in the system is going to come to the conclusion that there is nothing wrong with it at all. Yet Professor Miles struggles to find obvious fault with a market which, by his own admission, is highly competitive, extraordinarily innovative and has succeeded in hugely expanding home ownership in Britain.
In order to understand the difficulty with this report, you have to go back to the reasons why it was commissioned. The Professor Miles study was born out of the five euro tests, which found that the housing market was a key structural difference between the UK and the core eurozone economies. That in turn would make it difficult for Britain to live with Continental interest rates without changes to the way housing is financed. This is because British mortgages are overwhelmingly variable rate or short-term fixes, in contrast to the Continent, where long-term fixed rate deals predominate.
The effect is to make UK housing and through it consumer demand much more sensitive to short term interest rate movements than in the eurozone. Never mind that this has proved a boon to the UK economy over the past four years. By putting more money into householders' pockets, cuts in short-term interest rates have kept consumption buoyant through one of the worst business downturns in living memory. Never mind also that far from making the UK economy more cyclical and volatile, our reliance on variable rates has actually made it less so by supporting consumption during a period of depressed external demand. Monetary policy has had far less "piston" on the Continent, because it has failed to improve disposable incomes in quite the same manner.
Yet despite the fact that the British love affair with variable rate mortgages has saved the economy from recession this past few years, it is none the less somehow thought of as a bad thing. Professor Miles takes the view that it is "clearly desirable in its own right" that Britons reduce their dependence on variable rate mortgages, and that this would be the case whether or not we join the euro. Again, I am not sure he is right about this.
So why is it that borrowers in Britain find long-term, fixed-rate deals so unattractive? Is this a case of the market failing to respond to demand at advantageous enough prices, or of the demand simply not being there. Professor Miles concludes that it's a bit of both. Borrowers are much more price sensitive than risk sensitive, so they concentrate their buying on attractively priced short-term deals without regard for the longer term risk to their pockets from rising interest rates.
Professor Miles reckons the fault lies in large part with the mortgage lenders, which tend to cross subsidise customer acquisition from inert existing members. As the report puts it, the structure of mortgage pricing means that for new borrowers, variable-rate products and short-term, fixed-rate mortgages look cheaper than long-term, fixed-rate deals. In many cases, such attractively priced short-term deals are available at below the cost of funds and are only feasible for most lenders because existing customers pay in excess of funding costs. To use the jargon, the front book is being subsidised by the back book. Once captured, customers will then be milked for all they are worth by the big bad lender.
Only of course they don't have to be and in growing numbers they are not. Remortgaging has become a boom business reserved not just for the financially savvy. Mortgage promiscuity is these days practiced by almost everyone. As a consequence, the average length of a mortgage has nearly halved in recent years from 7 years to 4. Furthermore, lenders have begun to realise that attempting to poach each other's customers is a zero sum game and have taken steps to narrow the effective differential between back and front book rates. Nationwide claims to have eliminated it entirely, with growing benefits in terms of customer loyalty and in attracting long-term mortgage business from elsewhere.
Professor Miles highlights an interesting phenomenon, but let's not pretend there is anything inherently wrong with discounting in pursuit of customer acquisition. All businesses do it, and in any case Professor Miles is about five years behind the times in thinking it still a fault in the system.
Long-term, fixed-rate mortgages are not the panacea this report suggests. In Germany they are extraordinarily inflexible, with very heavy penalties for early redemption and a tendency to exclude the poorer elements of society. The system in the United States is self evidently better, but in order to get round the problem of early redemption, the borrower is forced to pay relatively high fees running to thousands of pounds to secure the mortgage in the first place. The system also only works because of an implicit government guarantee of the long-term funding required to support it. Worse, it is only available to the obviously creditworthy. Those with no equity to offer, or with a poor credit history, are forced to pay whatever the sub-prime lenders demand.
Even if Britain were to join the euro, which as we all know is now rather unlikely for the foreseeable future, it seems to me better that the economy should suffer the short term inflationary boom that an immediate reduction in rates to European levels would prompt, than that we should attempt to transplant an alien mortgage system, whose advantages are far from obvious, on to our own.
I don't want to apologise for the big mortgage lenders, but they already produce more competitively priced mortgages than are generally available on the Continent. If you believe that macro-economic policy has got inflation beat, there is in any case no reason to believe short-term interest rates are going to rise very far from their present level. Few believe base rate will be higher than 4.5 per cent by the end of next year, which is only 75 basis points more than it is now.
The other half of the Government's investigation into the intricacies of the housing market, Kate Barker's report into supposed failings in the supply of housing, is published with the pre-Budget report today. Planning constraints are a big part of the mischief, as are the big private sector housebuilders, who gain more by restricting supply than satisfying demand. Yet the biggest failing is the virtual cessation from the early 1980s onwards of social house building, or what used to be called council houses. Only the Government can do something about that. The same is true of an often overlooked aspect of Britain's house price bubble - the fact that it is highly tax advantageous to invest in housing. Investment in a primary home is free of capital gains tax, making it as tax efficient to plough savings into your house as into your pension, perhaps more so given that money invested in a pension is restricted to purchase of an annuity. The effect has been a growing distortion of the savings and investment market in Britain, with an ever larger proportion of capital being sunk into unproductive bricks and mortar, and a dwindling proportion into productive industry.
A Chancellor, as shot through with the work ethic as this one, would surely be minded to tackle this, the most important anomaly in Britain's soaraway housing market, if he could. There's not much wrong with the UK mortgage system. There is on the other hand a great deal wrong with the tax advantages of housing over other forms of investment. Yet to change it significantly by making housing subject to capital gains tax would be political suicide. Even further to adjust stamp duty is dangerous territory for this home loving nation.Reuse content