Manley’s Maxim: “Logic is a systematic method of arriving at the wrong conclusion with confidence”

From the Lender’s Perspective

A lender is in business to make money; even a mutual building society must operate so that it at least does not lose money.  All lenders borrow from either the retail market (eg people making deposits) or the wholesale markets (eg Institutions buying portfolios).  Some lenders use both channels. The retail market is less sensitive to interest rates but is expensive to manage, whereas the wholesale market is relatively efficient to those who understand it.

Wholesale lenders are themselves highly geared.  By carefully enhancing the credit rating of their wholesale products, they can make do with capital as little as 2% in some cases – that is rather like borrowing on an LTV of 98%.

Securitisation
Securitisation is an increasingly common way of raising cost effective finance for a wide range of different assets that were previously difficult to finance. It was originally developed in the USA, the idea came to the UK market in the 1980s. The process, the parties involved and the documentation, as well as pricing, can appear mysterious to the uninitiated. 

The securitisation process is effectively the bundling together of a group of individual mortgages such that they may be treated, for funding purposes, as a single entity and made available to prospective investors in mortgage debt.

Mortgage debt is seen as a relatively attractive and safe investment by many institutions, such as pension funds.  Securitisation allows lenders to raise money in the money markets, then lend it on to residential property purchasers and finally sell the resulting tranche of mortgages on to other institutions in bulk.  This is also known as "off balance sheet lending" since the debt does not form part of the lender’s assets.  This process does not affect the terms and conditions of the individual borrowers in any way, and most people are quite unaware that their mortgage cash may have actual started off in someone else’s pension fund.

Sales channels
Most lenders sell through two main channels: direct, via branches, telephone sales or web sites, and indirect through mortgage intermediary introducers such as brokers and estate agents.  These days it is common to pay intermediaries a commission for completed business, since brokers can no longer rely on commission from endowment policy sales as an income source.  They are expected to market and sell the lender’s products and rightly expect a commercial reward for doing it successfully.

The Internet shows great promise for the financial services business in general, not just as a sales channel, but as a highly efficient process that can be easily automated and integrated with a lenders back-office systems. 

The Internet is a worry to some intermediaries, as they fear many prospects who would otherwise use them, can now more easily go direct to lenders on the web.  But the truly independent brokers such as John Charcol can themselves operate successfully on the web and add value to their services, since the choice to most people is still bewildering – apart for my readers thus far, naturally.  An on-line broker can more easily locate the optimum product to suit their clients and this area will certainly grow.

Interest Margin
Whichever way lenders obtain funds, they all need to lend at a higher interest rate than they borrow – called the margin – to cover their marketing and administration expenses for both borrowers and their own investors, and still leave a profit. 

Lenders have to include the costs of processing new applications, valuing the property and investigating the credit worthiness of the applicant.  Some of these costs are recovered directly from the borrower through valuation or administration fees, which can themselves be added to their loan.  Once the case completes, on-going administration is required to collect the monthly payments and manage such activities as producing statements, dealing with rate changes, redemptions and arrears and so on.  There must also be a reserve for possible losses and the administrative costs of funding the operation.

Some lenders also obtain additional income from other sales activities, typically commissions earned on household insurance policies, payment protection insurance and indemnity guarantee insurance.  All the net costs and supplementary income streams must be considered in order to decide just what the overall margin must be.  Individual mortgage products can then be designed and marketed in the best way to suit the brand of the lender, their sales channels and their speciality.

Designing the products
Most lenders would consider a model rather like the loan comparator spreadsheet to ensure that their offerings achieved the right return.  The initial expenses to a lender will differ to that of the borrower so the lending IRR will not be the same as the borrower’s IRR.  For example, the borrower may pay for the house valuation and the legal fees, which will increase their IRR, whereas the lender does not pay for these fees.  On other hand, the lender has to pay a processing cost, which is not directly paid by the borrower.

The mortgage market is very competitive. There is an oversupply of funds at the moment, which has trimmed margins on standard mortgage products right to the bone. Consequently, lenders devise all sorts of methods to attract business, even launching loss-making products in the hope that the margins can be relaxed in the future when no one is looking. The spreadsheet entitled “Mortgage Product Design” is for lenders and other professionals to use to help ensure their designs make the appropriate margin. Borrowers might also like to have a peek, as it will help them better understand the lender’s position.