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					BUY NOW, PAY LATER: THE IMPACT OF COMPETITION IN THE UK
MORTGAGE MARKET
In choosing between different sorts of mortgages, UK households tend to attach a great
deal of weight to the level of monthly repayments upfront. Consideration of where interest
rates might move in the future – and what this might imply for the affordability of variable
rate mortgages – seems to play a far smaller role than might be expected.

Writing in the Economic Journal, Professor David Miles examines the impact of
competition on the type of mortgage most households choose. He notes that when
comparing the UK mortgage market with those of other developed economies, two striking
facts stand out:

     First, the stock of mortgage debt in the UK is large, both absolutely and relative to the
     size of the economy.

     Second, an unusually high proportion of that mortgage debt is at interest rates that
     are either variable, or will shortly become variable. UK households take on more
     uncertainty about the levels of their mortgage payments than in almost any other
     country in the world.

In itself, the fact that UK households face a higher degree of uncertainty about the nominal
profile of mortgage payments than elsewhere does not show that there are failures in the
structure of the UK mortgage market. But because of the size of the UK mortgage market, it
does prompt a series of fundamental economic questions:

     Are UK households taking account of the risk and return characteristics of various
     types of mortgage contracts in making choices?

     What are the incentives of lenders and financial advisers in the UK mortgage market?

     Are there problems in the capital markets preventing the emergence of fixed rate
     mortgages that might better suit the true preferences of many households?

     What might the contribution of the dominance of variable rate mortgages have been
     to the unusually (though not uniquely) high degree of variability in house prices in the
     UK?

Miles analyses the choices made by households and considers whether there might be
market failures that prevent the structure of mortgage debt better reflecting the underlying
preferences of households.

Analysis of optimal decision-making suggests that mortgages with interest rates fixed for
substantially longer than two or three years might be expected to be attractive to a
substantial proportion of households that make decisions in an informed, forward-looking
way and where the prices of mortgages are transparent and sustainable. First-time buyers
– whose loan-to-income ratios are high and whose future income is often very uncertain –
would be expected to value the risk reduction of fixing the interest rate for several years. So
it is surprising that so few such mortgages are sold.

Miles explains that the pricing structure of mortgages plays to a tendency to focus on initial
cost rather than on the possibility of future interest rate movements. The pricing strategies
used by many lenders have generated very low initial costs for variable rate mortgages and
created cross-subsidisation across borrowers.
But the existence of cross-subsidisation is not a symptom of a lack of competition in the UK
mortgage market. Quite the contrary. A lender that stopped offering discounted products
would risk losing market share to many other lenders. Because the market for new lending
is so competitive – with financial intermediaries and mortgage brokers ensuring that new
borrowers know what the lowest rates are – the cost to any one lender of deviating from the
dominant pricing model is significant.

Miles find that explanations often put forward for the preponderance of variable rate
mortgages – explanations based on credit restrictions, inflation volatility and self-reinforcing
tendencies in the market – are not very satisfactory. The tendency for advisers not to focus
on risks of interest rate movements is likely to be a more important factor.

ENDS


Notes for editors: ‘Incentives, Information and Efficiency in the UK Mortgage Market’ by
David Miles of Morgan Stanley and Imperial College London is published in the March 2005
Economic Journal.

For further information: contact RES Media Consultant Romesh Vaitilingam on 0117-983-
9770 or 07768-661095 (email: romesh@compuserve.com); or David Miles via email:
David.miles@morganstanley.com

				
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posted:11/4/2008
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