The Future of the UK Mortgage Market: The Impact of ... · 2. Then to forecast sales of current account mortgage products using market diffusion modelling techniques. These forecasts

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0© the f u t u r e foundation

The Future of the UK Mortgage Market: TheImpact of Generation Flex

Summary of Key Findings

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The Future of the UK Mortgage Market : The Impact of Generation Flex

In May 2000, Virgin One asked the Future Foundation to develop a comprehensive picture of how the UKmortgage market is likely to develop – and to understand the impact of the new generation of current accountmortgages (the so-called ‘Generation Flex’ products) on this market.

The results paint a picture of a mortgage market that is about to change radically – with significant growth overthe next 3-5 years. A detailed research report is attached – the key findings are summarised below.

Key Research Findings

• The UK mortgage market is forecast to grow from £500bn of outstanding mortgage debt at the end of1999 to around £900bn outstanding at the end of 2010 (Graph 1 overleaf).

• The majority of the growth in net and gross mortgage lending is expected to occur by 2005 – when thechange in shape of the UK population will be the leading factor in rapidly slowing this growth (Graph2 overleaf).

• Current account mortgages look set to account for around 20% of net mortgage lending until 2003 –based on a central forecast drawing on the experiences of the more developed Australian and NewZealand mortgage markets. The upper forecast suggests a market potential of 25% of net lending(Graph 3 overleaf).

• It is predicted that current account mortgages will have outstanding mortgage balances of around £50billion by 2005 – around 6% of the total outstanding mortgage debt. This is from an estimated marketsize of £1.5 billion at the end of 1999.

• The annual growth in current account mortgages over the next ten years is expected to average asmuch as 40% - with sales likely to more than double each year in the early years, with growth easingthereafter.

• The prediction that we are at the onset of a period of rapid growth for this new generation of mortgagesis supported by the most recent consumer research amongst homeowners with a mortgage or thoseexpecting to buy a home within the next six months :

� nearly 40% of this base are now aware of current account mortgages

� nearly 50% of this base will actively consider current account mortgages when they get a newmortgage – with the younger audience showing even greater interest (63% for 18-34 year olds)

� nearly 50% of this base are searching for simpler ways to organise their finances

� nearly 90% of this base said that early mortgage repayment to save money was important to themwhen considering a current account mortgage. The next most important benefit (with 87% ofrespondents) was identified as knowing exactly where you stand with your finances.

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Key Illustrations from the Report

Graph 1 – Forecast growth in the overall UK mortgage market from 1999 to 2010

Graph 2 – Forecast Gross and Net Mortgage Lending in the UK from 1999 to 2010

Graph 3 – Forecast for current account mortgage sales as a percentage of net mortgage advances

Background Information

0100200300400500600700800900

1000

1999

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Outstandingmortgage balances

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1999 2000 2001 2002 2003

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CAM sales as apercentage of netsales - mid forecast

CAM sales as apercentage of netsales - upper forecast

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Annual grossmortgage advancesAnnual net mortgageadvances

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About the Future Foundation

Established in September 1996, the Future Foundation are a future focused, commercial think-tank – advisingcompanies on how to plan for the future in meeting developing customer needs and also on how to contributevalue to the wider environment in which they operate.

Terry Athaide, who performed this mortgage market research, is an economist with twelve years’ consultingexperience. He has worked for clients across four continents on a range of economic and market forecastingissues. Terry has two degrees in Economics and is a Fellow of the Royal Economic society and a Member of theInstitute of Management Consultants.

He specialises in economic forecasting and providing quantitative solutions to market forecasting issues. He is anAssociate of the Future Foundation, Director of the Foresight First economics consultancy and Economic Advisorto the Volkswagen group. He previously worked at the Henley Centre for Forecasting.

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Launched in April 1998, the Virgin One account is the UK’s most successful current account mortgage – withover 30,000 customers and a mortgage book of £2 billion. Customers can access their accounts by telephone,through the internet and at any branch of The Royal Bank of Scotland.

If you have any questions regarding this research please contact :

Scott MowbrayMarketing ManagerVirgin One

Telephone : 01603 707140Mobile : 07720 426958Fax : 01603 707591

ContentsPage

Executive summary 1

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1 Introduction 2

2 The UK mortgage market – recent history 3

3 The total mortgage market forecasts 8

4 The market drivers 14

5 The Australian market 19

6 The current account market forecasts 24

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Executive summary

In May 2000 Virgin One asked the Future Foundation to produce forecasts of the development of theUnited Kingdom mortgage market with particular emphasis on the current account mortgage product.This report presents the Future Foundation’s findings.

The task of forecasting was approached in two stages; forecasting the total mortgage market usingeconometric techniques; and forecasting the current account mortgage market using market diffusiontechniques. The latter carries more inherent uncertainty, particularly as the current account mortgagemarket is still in its nascent stage.

The recent history of the UK mortgage market can be characterised by periods of rapid market growthfollowed by sharp downturns. There have been economic, regulatory and supply side changes that haveaccentuated this pattern during the last thirty years.

The key drivers of the outstanding mortgage balance (mortgage credit) were identified as realhousehold disposable incomes, mortgage interest tax relief, mortgage rates and demographic (age-related) change. The gross and net advances markets are driven by these same factors, except grossdomestic product replaced RHDI as the measure of affluence, and house price inflation featured. In thenet advances market, the regulatory change that made it easier for banks to compete was a significantfactor.

The total mortgage market will slow in growth over the next decade. Demographic factors and the lossof mortgage interest tax relief will combine to offset the benefit of sustained economic growth over thisperiod. Growth will average 5.3% to 2010 for the outstanding balance and will remain positivethroughout. Growth in gross advances will manage 6.6% on average, but will be more volatile. For netadvances, growth will be more volatile still, and negative in some years, averaging 3.3%.

The Australian market for current account mortgages is the most developed and has the most openlyavailable information store. While early sales of current account mortgages were promising, the shareof the total mortgage market fell disappointingly in its early years. This is attributed to ineffectivemarketing and communications work on the part of the industry. This apparently changed when thebanks offered current account mortgages in 1994. Sales increased rapidly and market share accelerated.

Using the Australian sales data, innovative and adoptive consumer behaviours have been modelled asthe example of how the UK market diffusion might follow. The rates of both innovation and adoptionwere very high from the mid-1990s, suggesting immediate recognition of the product benefits acrossthe potential market.

Taking the latest Australian and New Zealand market sales of current account mortgages as(conservative) benchmarks for the UK market potential, and the Australian pattern of market diffusion,a range of market share forecasts have been produced. The validity of this procedure clearly depends onsome explicit assumptions. These share forecasts have been combined with the outstanding balanceforecasts for the UK to produce a range of current account market forecasts.

The UK current account mortgage market is expected to see very rapid growth over the next two years,as the product benefits are quickly recognised by market innovators who will be responsible for earlysales. Rapid adoption should see sales increase from 1999’s £1.5bn to £46bn (forecast range midpoint)in 2005 and £60bn (forecast range midpoint) in 2010.

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1 Introduction

In May 2000 Virgin One asked the Future Foundation to produce forecasts of the development of theUnited Kingdom mortgage market with particular emphasis on the current account mortgage segment.This report presents the Future Foundation’s findings.

The forecasts are of generic demand for the total mortgage market (outstanding balances or totalmortgage credit, gross and net advances) and current account products. Brand specific forecasts liebeyond the scope of the study.

The approach taken to the forecasting had two stages:-

1. First to forecast the total mortgage market in terms of the outstanding balance (total mortgagecredit), gross and net advances. Econometric modelling techniques were used to quantify the causalrelationships between the drivers of market demand and mortgage spend. These quantifiedrelationships were then used to forecast mortgage spend according to explicit assumptions of thefuture values of the market drivers;

2. Then to forecast sales of current account mortgage products using market diffusion modellingtechniques. These forecasts have been based on the existing data on the nascent UK market but alsohave also used sales data from the more mature current account mortgage markets in Australia andNew Zealand.

The two stages incorporate different degrees of forecasting certainty. The econometric forecasting workis dependent on a consistently recorded market history of several decades and reliably collated statisticson the economic, demographic, regulatory and market environments. The current account mortgagesales forecasts are based on the relatively small quantity of available statistics for the UK market andparameters of market development calculated from statistics of other national markets. The degree ofcertainty to be associated with the current account mortgage forecasts should therefore be less than thatfor the total mortgage market forecasts. The current account mortgage forecasts are detailed as a rangeto reflect this uncertainty.

Moreover, the longer the forecast horizon, the less is the certainty that should be associated with anyforecast. The total market models are driven by assumed values (themselves forecasts) of economic andmarket drivers. Given the difficulty inherent in forecasting the development of the economy even in theshort term, the market drivers are assumed to change uniformly between 2005 and 2010, based on theforecast average of the period 2000 to 2005. This eliminates the need for incorporating the economiccycle so far into the future.

All data used in the modelling process, the results of the qualitative research into the UK market forcurrent account mortgages and a technical description of the forecasting techniques used are containedin the report Appendix.

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2 The UK mortgage market – recent history

The mortgage marketThe UK mortgage market has undergone dramatic change during the last ten years. The range ofmortgage products available to consumers has grown exponentially, many of the major mortgagelenders have changed legal status and with it strategic direction, and a number of the major lendershave merged while others have emerged with low cost on-line products. Despite this apparentevolution, the UK market still lags behind many other national markets in terms of the sophistication ofits products and its customer service philosophy.

Mortgages have become increasingly important to households. The chart shows, in indexed form, thedevelopment of nominal gross domestic product (the broadest measure of economic activity) andmortgage credit, or the outstanding balance of mortgage debt. The chart shows that the two grew atvery similar rates during the 1970s, and that mortgage credit growth accelerated very sharply at the startof the 1980s before easing during the early 1990s. The implication is that households have beenspending an increasing proportion of their incomes on mortgages, a fact corroborated by the standardmortgage debt to earnings ratios.

The post-war experience of the UK mortgage market has been dominated by a small number of majorbuilding societies and a great number of smaller, regionally focused building societies. The first pricingpeak shown in the chart below reflects the very favourable tax treatment of mortgage loans until 1974(all mortgage interest payments qualified for tax relief at the borrower’s marginal rate) and the average13% retail price inflation of the period. The second price surge followed another burst of retail priceinflation, in excess of 18% annually during the mid-1970s and the collapse of the Social Contract wageagreement that led to spiralling earnings settlements across industry.

A change in mortgage regulation –the abolition of the supplementary special deposits scheme, or‘corset’ – saw the high street banks enter the market in the early 1980s. This coincided with theintroduction of the Mortgage Interest Relief At Source (MIRAS) tax incentive to home ownership, theloosening of government monetary policy during a period of rapid economic growth that increasedhousehold disposable incomes, and the widespread sale of council homes to sitting tenants. As a

Mortgage credit has grown much fast er than G

0

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4,000

4,500

70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99Source National Statistics, CML, Future Foundation

Mortgage credit

GDP

Indexed nominally, 1970=100

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consequence, the proportion of owner-occupied households in the UK increased from just over 57% tojust over 67% during the course of the 1980s.

The mortgage market experience of the 1990s marked something of a contrast to that of the previousdecade. Interest rates increased sharply in 1989 and 1990 when the inflation rate approached 10% andgovernment policy was for sterling to ‘shadow’ the deutschmark before formal membership of theExchange Rate Mechanism. These higher interest rates pre-empted the recession of 1991. Risingunemployment, for the first time among white-collar workers, and poor earnings growth severelydeflated confidence in the housing market. Prices fell and negative equity became commonplace.Negative equity persisted for years for many households who had bought during the latter years of the1980s. The housing stock had also increased, itself stimulated by the previous house price inflation.

During the last two years, though, the UK mortgage market has expanded at rates last seen during thepeak of the market boom of the late 1980s. Gross advances increased by 28.0% in 1999 while netadvances grew by 50.2%. Overall mortgage credit increased by 8.2%.

The outstanding balanceMortgage lending in the UK has grown faster than the economy in general in every year since 1928,except for during the Second World War and a brief spell of particularly high inflation in the 1970s.Mortgages have consistently been one of the highest priorities for UK consumers.

The value of the mortgage market accelerated sharply during the 1970s and 1980s as rising levels ofhome ownership coincided with high rates of earnings inflation and consequent mortgage borrowing.The stock of mortgage credit (the balances outstanding) saw annual growth of below 15% in just twoyears of this twenty year period. The chart below shows the value of the outstanding mortgage balancein nominal (cash) terms since 1970 with the corresponding annual percentage changes.

The chart demonstrates the economic uncertainty of the early 1970s, a period characterised by sluggisheconomic growth and, in 1973, the oil price shock that saw inflation and interest rates rise abruptly. Thelate 1970s and early 1980s saw steadily accelerating market growth, helped by high inflation rates andthe introduction of Mortgage Interest Relief At Source to encourage wider home ownership. The

House price inf la tion, 1971-199 9

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71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99Source CML, Future Foundation

Nominal house p rices

House prices adjusted for retail price inflation

Annual % change

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financial market deregulation of the early to mid-1980s, culminating in the Financial Services Act1986, saw increasing volumes of funds released into the domestic mortgage market. The wave ofaccelerating mortgage balances peaked in 1988 when the MIRAS tax incentive was restricted to housepurchases rather than individual buyers, so encouraging couples to buy before this tax incentive wasremoved.

The impact of the interest rates increases in 1989 and 1990 is clear; so is that of the 1991 recession andthe draining market confidence in the years that followed.

The retail price inflation rate fell sharply (and with it earnings inflation) to just 1.6% in 1993, reducingthe acceleration in the growth of the outstanding balance. The economy saw steady but moderateeconomic growth in the mid-1990s, although the unemployment rate did not start to fall consistentlyuntil 1997. Since then we have seen record numbers of people in jobs, unemployment fall to its lowestlevel since 1975 and earnings growth pull ahead of the price inflation rate. The mortgage market hasresponded with surging growth.

Mortgage lendingThe history of gross and net mortgage lending follows the broad story of the stock of mortgage credit,as Table 2.1 shows. Gross and net lending activity saw enormous growth during the 1970s and 1980s.Annual gross and net advances increased by annual averages of 17.2% and 19.4% respectively duringthe 1970s, effectively doubling the value of the market every four years. Similar rates of increases wereachieved during the 1980s, although this time gross advances saw better growth than net advances.

However, when the effects of retail price inflation are taken into account, these growth performancesseem a little less impressive. The gross and net advances history is also expressed in constant (1995)prices. We see that the real annual growth in gross advances in the 1970s was just 4.1% on average,rising sharply to 11.6% in the 1980s. The growth in real net advances was better in the 1980s than inthe 1970s whereas the opposite held true for nominal market growth. The real growth figures show thedevastating effect of the housing market weakness of the early 1990s and the comparative marketstrength of the last four years.

The outs tanding balances o f mor tgages in t he 1970-1999

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70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99

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Annual % change

Outstanding balances

Source CML, Future Foundation

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Table 2.1 Mortgage lending in the UK, 1970-1999Gross

advancesNet

advancesGross

advancesNet

advances£ millions, current prices £ millions, 1995 prices

1970 2,355 1,250 19,482 10,341

1980 11,484 7,368 29,210 18,741

1990 69,823 33,287 87,339 41,638

1995 57,285 15,165 57,285 15,165

1996 71,660 19,106 69,946 18,649

1997 77,227 23,834 73,092 22,558

1998 89,360 25,225 81,730 23,071

1999 114,365 37,882 102,995 34,116

Average annual % change

1971-1980 17.2 19.4 4.1 6.1

1981-1990 19.8 16.3 11.6 8.3

1991-1995 -3.9 -14.5 -8.1 -18.3

1996 25.1 26.0 22.1 23.0

1997 7.8 24.7 4.5 21.0

1998 15.7 5.8 11.8 2.3

1999 28.0 50.2 26.0 47.9

Source CML, The Future Foundation

Table 2.2 compares the real growth in mortgage advances since 1970 compared with the growth inoverall household spending and household spending on other durable goods. (Durable goods are itemsthat households consume gradually over a period of time rather than instantly, like food or fuel. Theseitems tend to be more expensive, often require purchase credit, and are generally taken to be plannedpurchases.) The table shows that real spending on gross and net advances increased more quickly thanoverall household spending and spending on other durable goods during every period except the early1990s.

Gross and net mortgage advances, 19 70-19

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70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99

£, billions

Gross advances

Net advances


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Table 2.2 Mortgage lending and consumer spending in the UK, 1970-1999

Grossadvances

Netadvances

Totalhouseholdspending Vehicles

Majorappliances Clothing

£ millions, 1995 prices

1970 19,482 10,341 237,739 8,620 NA 11,032

1980 29,210 18,741 297,256 12,933 2,611 15,524

1990 87,339 41,638 415,788 22,424 4,651 23,044

1995 57,285 15,165 438,453 20,749 4,631 28,347

1996 69,946 18,649 454,686 22,673 4,975 29,773

1997 73,092 22,558 472,701 24,680 5,813 31,076

1998 81,730 23,071 487,479 25,953 6,360 31,734

1999 102,995 34,116 506,742 26,397 6,920 33,504

Average annual % change

1971-1980 4.1 6.1 2.3 4.1 NA 3.5

1981-1990 11.6 8.3 3.4 5.7 5.9 4.0

1991-1995 -8.1 -18.3 1.1 -1.5 -0.1 4.2

1996 22.1 23.0 3.7 9.3 7.4 5.0

1997 4.5 21.0 4.0 8.9 16.8 4.4

1998 11.8 2.3 3.1 5.2 9.4 2.1

1999 26.0 47.9 4.0 1.7 8.8 5.6

Source CML, ONS, the Future Foundation

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3 The total mortgage market forecastsThis section describes the approach to and techniques used in forecasting the total UK mortgagemarket. A more technical description of the techniques used is provided in the Appendix.

ApproachEconometric modelling techniques have been used to forecast mortgage credit (the outstandingbalance) and gross and net advances. The mortgage market satisfies the broad criteria for theapplication of these techniques:-

� The mortgage market is fairly mature, despite the rapid movements in spend over the last fewdecades;

� It seems reasonable to assume that the potential mortgage spend is conditioned by economic,market, demographic and regulatory factors, all of which lend themselves to quantification;

� It seems reasonable to assume that the relationships between these factors and mortgage debt arelikely to hold into the medium term future;

� The supply side changes have been well documented, allowing their effects to be incorporated intothe market models.

The approach has been to explain the market history in terms of the drivers of sales, and then to use thisexplanation to predict how the market will develop over the next decade, again in terms of those marketdrivers.

Econometric modellingEconometric modelling is the use of statistical analysis to explain the pattern of development of aneconomic or marketing variable in terms of one or more causal factors. The modelling process is to:-

1. identify the causal factor(s) driving the changes in the level of the variable according to strictstatistical tests;

2. quantify the discrete relationship(s) between the causal factor(s) and the variable in question;

3. test the stability of the relationship(s) over the sample period;

4. use these relationships to forecast the variable in question by making explicit assumptions of thefuture values of the causal factor(s).

A key feature of this forecasting process is that the quantified relationships between each of the factorsand the variable in question, in this case mortgage spending, are calculated as an average over thesample period. This is to eliminate any bias created by any temporary outlying data that might not fullyrepresent the market. Furthermore the forecasts are naturally highly dependent on the assumed futurevalues of the forecast variables. Accordingly, these assumptions are explained in Section 4 below.

The model structuresThe model structures were designed to capture the effects of the key market drivers over the sampleperiod, 1970 to 1999. These drivers were assumed to represent the economic, demographic, market andregulatory environments. The potential drivers tested in the modelling process are listed in Table 3.1.

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Table 3.1 The potential market drivers tested for inclusionEconomic Demographic Market Regulatory

Gross domestic product Total population Mortgage rates Mortgage interest tax relief

Household disposable income Adult population House prices (CML/DETR) Abolition of double-MIRAS

Wealth levels 25-35 year olds House prices (Nationwide BS) ‘Corset’ abolition

Interest rates 25-59/64 year olds The housing stock

Household spending

Savings levels

Gross household incomes

Consumer credit levels

Share prices

Employment levels

Unemployment levels


A critical quality of the modelling process has been the similar paths of development taken by a numberof the drivers tested. For example, the history of the housing stock, as represented by figures providedby the DETR, showed very similar proportional movements annually to the number of people in the 25-35 year old age group, here representing the demographic of first time property buyers. (The two seriesshowed a 97% correlation coefficient, a measure of coincident proportional movement. Perfectcoincidence has a measure of unity, no coincidence a zero measure.) The impact on the modellingprocess is important. When two series show such coincidence, the modelling techniques have difficultyseparating out their respective signals to market behaviour.

The market drivers that met the modelling criteria for inclusion (as listed in the Appendix with thosethat were not) are shown against each of the market measures in Table 3.2 below, with indications ofboth the direction and scale of impact.

Table 3.2 The model drivers included in the forecasting models

Market driver Outstanding balance Gross advances Net advancesReal household disposable income ++

Gross domestic product ++ ++Mortgage interest tax relief + + +

Mortgage rates - -Population aged 25-35 - - -

Population aged 25-59/64 +++House prices - -

‘Corset’ abolition +Source CML, The Future Foundation

Real household disposable income and gross domestic product captured the effect of the economy onthe market. The impact of mortgage interest tax relief was consistent in scale across the models, as werechanges in mortgage rates. The 25-35 year population age group was used as a proxy for the potentialfirst time buyers, and curiously was negatively correlated with all three markets. This age groupexpanded only moderately during the 1980s and most rapidly during the early 1990s when the market

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drew back. Our interpretation is that, as more young adults have pursued higher education and taken onmore personal debt, the prospect of home ownership has lost some its appeal. Furthermore, it is this agegroup that might have first considered home ownership when house prices fell in the early 1990s andhave been discouraged to enter the market more than other age groups. (We have been able to useabsolute levels of population groups instead of proportional levels because the movement in the level ofthe total population is so slow.)

House prices had consistently negative relationships with the gross and net advances markets, with aone year lag in impact. In fact it was the rate of house price change (inflation) that was consistentlynegatively correlated with gross and net advances. It seems that households have been less inclined totake on mortgage debt after the periods of high house price inflation, but have been more inclined to doso after periods of low house price inflation. Finally, the abolition of the supplementary special depositsscheme, or ‘corset’, in 1980 made it easier for banks to compete with the building societies in themortgage market. This significant supply side change intensified competition thereafter and had aconsistently positive relationship with net mortgage advances. This would suggest that this changeresulted in more price-based competition that added additional value to the market.

Table 3.3 The total mortgage market forecasts

Outstanding balance Gross advances Net advances£ billions

1970 13.3 2.4 1.3

1980 52.4 11.5 7.4

1990 294.1 69.8 33.3

1999 493.8 114.4 37.9

2000 527 148 49

2001 564 170 58

2002 614 187 61

2003 671 219 60

2004 712 238 55

2005 750 255 53

2010 876 232 54

Annual % change, annual average

1970-1979 16.5 18.3 6.6

1980-1989 19.0 18.9 18.0

1990-1999 6.7 6.6 1.1

2000 6.7 30.2 43.4

2001 7.1 15.1 20.3

2002 8.9 9.6 4.4

2003 9.3 17.4 -1.2

2004 6.1 8.7 -8.3

2005 5.3 7.2 -3.7

2006-2010 3.2 -1.8 0.6


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Forecasts of the mortgage outstanding balanceAs the chart below shows, the model formulation captures the level, trends and turning points of theoutstanding balance market history well. The rapid acceleration in spend in the early and mid-1980s hasbeen successfully tracked as well as the deceleration of the early 1990s. This reflects the interplay ofthe demographic drivers working with the favourable regulatory and economic drivers to lift marketgrowth in the late 1980s to levels that proved unsustainable. The model also faithfully picks up theresurgence in market growth of the last few years, as economic growth and still rising numbers in the25 to retirement age group have more than compensated for the gradual withdrawal of mortgageinterest tax relief that has acted to increase effective mortgage costs.

House prices did not feature in the model as there was no consistent relationship between theoutstanding balance and house prices. We interpret this result as implying that the outstanding balanceis most related to affluence increases and population changes, with house prices determining the choiceof house purchase rather than the amount borrowed. House prices could also offer a mixed signal to themarket; rising prices might deter some people from entering the market, or might represent an asset of

The outstanding balance - model

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Model fit

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The outstanding balance forec

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Source Future Foundation

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rising value in which to invest. Market pricing has been more successfully captured by the mortgagerate, the price of borrowing funds/holding a mortgage.

The forecast of the outstanding mortgage balance shows that the recent strong market growth shouldcontinue for the next few years. Good consistent economic growth will deliver similar increases indisposable incomes, although the growth in the adult population aged 25 to retirement age will continueto slow, reducing the impact of this source of market growth.

Forecasts of the gross advances marketThe history of gross mortgage advances differs from that of the outstanding balance in that the cyclicalswings are far more pronounced. As the model fit chart shows, both the market acceleration of the1970s and the rapid growth of the mid-1980s that trebled gross advances in the space of three years isreproduced. The model captures this market fluctuation together with the market decline of the early1990s and the recent strong recovery.

Like the outstanding balances model, mortgage interest tax relief, mortgage rates and the 25-35 year oldpopulation cohort featured in the model, with similar roles in determining market activity. However the25 to retirement age cohort did not feature, probably because the general mortgaged population do notregularly change mortgage provider or products. Gross domestic product features strongly in explaininglong term growth rather than disposable incomes. GDP represents not only growing consumer affluencebut also frequently acts as a signal to consumers of trends in economic well being, serving as a proxyfor confidence. Finally house price inflation figures in the gross advances model with a negative effecton market spend lagged by one year. It seems that accelerating house price inflation deters additional(gross) borrowing in the following year.

The growth of the past few years should continue in the gross advances market, although this effectshould start to recede in about three years. The combination of the recent house price inflation, therapidly slowing growth in the 25 to retirement age group and loss of MIRAS should offset the effect ofgrowing consumer affluence by this time. The forecast is for slowing market growth with theprobability of consistent negative growth in the latter half of the decade. To give an indication of whatthis implies in volume terms, if average gross advances increase with our expectation for house prices,

Gross advances - model f

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71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99

Actualvalues

Model fit

£ billions


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then the number of loans in 2005 will be around 40% above 1999’s level falling to somewhere around10% below 1999’s level in 2010.

Forecasts of the net advances market1

The market history for net advances is even more volatile than the gross advances market. The growthduring the 1970s is more pronounced; so too is the lending peak in the 1980s and the market weaknessin the first half of the 1990s. This was the hardest market to model by far, and this is reflected in themodel test statistics. While the model does not quite reproduce the peak of net lending in the late 1980s,it does faithfully capture most of the market trends before and after this point. Since the net lendingpeak was such an unusual confluence of market determinants that are extremely unlikely to coincideagain, this does not undermine the overall predictive power of the model.

The structure of the net advances model is similar to that of the gross advances market. Again, GDPacts as an affluence and confidence measure, mortgage interest tax relief and the 25-35 age group figureprominently. House price inflation has a negative effect again, lagged by one year. Significantly, the

The gross advances forec

-40%

-20%

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80 82 84 86 88 90 92 94 96 9820

00 2 4 6 8 10-150

-50

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350Annual % change

£ billions


Net advances - model f

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71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99

ActualvaluesModel fit

£ billions


Virgin One


market changes following the abolition of the supplementary special deposits scheme, or ‘corset’feature in this model

The sharp house price inflation of the last two years should start to have their effect on the net advancesmarket. Like the gross advances, the loss of MIRAS and the rapidly declining growth in the 25-59/64age group will act to drain the market growth from the economy. Growth in net advances is expected toturn negative in 2003, to return to positive growth at the end of the decade.

1 The forecasts of the net advances model do not equate to the annual differences in the outstandingbalance. The models driving the forecasts are independently specified, so it is unlikely that they wouldneatly tally in this way.

The net advances foreca

-40%

-20%

0%

20%

40%

60%

80 82 84 86 88 90 92 94 96 9820

00 2 4 6 8 10-30

-20

-10

0

10

20

30

40

50

60

70Annual % change

£ billions


Virgin One


4 The market driversThis section describes the paths of the market drivers used to produce the total market forecasts. Theirnumerical values are presented in the Appendix.

The population aged 25 to 59/64This age group has been defined to cover the part of the population who would be eligible for and likelyto engage in mortgage borrowing – that is, above 25 years of age and pre-retirement. As the chartshows, this age group fell gradually during the 1970s before the surge in the birth rate from the mid-1950s to the mid-1960s – the ‘baby boomers’ lifted its level dramatically, from 26 million in 1983 tothe current 30 million level. This age group will start to level off equally dramatically over the nextdecade at 31 million

The population aged 25-35This age group is included in the modelling to cover the key source of mortgage debt growth, first timebuyers. The growth of this age group was highest in the early 1970s and from 1987 to 1994. Critically,the numbers in this age group have started to fall during since 1997 and should continue to decline untilthe end of the decade

Real household disposable incomeRHDI is total household income less income taxes, local taxes and social security contributions,adjusted for inflation. It measures the spending power in consumer markets. It moves with theeconomic cycle, but varies occasionally with earnings and personal taxation changes. The increases inemployment, and the more stable economic growth since the early 1990s, have led to relativelyconsistent growth in RHDI. This pattern of development is expected to continue into the medium term.

The demographic movements in million197 0-201 0

25

26

27

28

29

30

31

32

70 72 74 76 78 80 82 84 86 88 90 92 94 96 9820

00 2 4 6 8 106

7

8

9

10

Source Government Actuarial, Future Foundation

Aged 25-35, RHS

Aged 25-59/64, LHS

Virgin One


Gross domestic productGDP is the broadest measure of economic activity and is the aggregate measure of output or income.The history of the UK economy has until the early 1990s can be characterised by periods of rapidgrowth in output, followed by recession. The recessions of the early 1970s, 1980s and 1991 are shownin the chart. This pattern appears to have been broken since 1992, with eight successive years ofconsistent, moderate economic growth. This is expected to continue into the medium term, with theGovernment and Opposition parties committed to the current policy priorities of low inflation andeconomic stability.

The mortgage interest rateThe average mortgage interest rate data since 1980 has been provided by the Council of MortgageLenders. This data was not collated before 1980. For the period 1970 to 1979 this series has been

Growt h in GDP and RHDI, 1 97 0-2 01 0

-4

-2

0

2

4

6

8

10

71 73 75 77 79 81 83 85 87 89 91 93 95 97 991 3 5 7 9

% change

GDP

RHDI

Source National Statistics, Future Foundation

The mor tgage interest rate, 19 70-20

0

5

10

15

20

70 72 74 76 78 80 82 84 86 88 90 92 94 96 98

2000 2 4 6 8 10


%

Virgin One


approximated using the relationship between the average mortgage interest rate and base interest rate inthe 1980s applied to the base rate data for the 1970s, which has been provided by the Bank of England.

The chart shows the mortgage interest rate peaks of the recession in the mid-1970s, early 1980s and theearly 1990s during sterling’s membership of the Exchange Rate Mechanism. Interest rates are expectedto hold their current levels for the next few years and then to fall on the UK’s entry to the singleEuropean currency, probably in 2004/5. Mortgage rates are expected to follow this general pattern.

Mortgage interest tax reliefThe impact of mortgage interest tax relief on the mortgage market has been enormous. The chart showshow this tax perk was exploited by increasing numbers of mortgage holders, peaking at an annual £7.7billion (2.6% of the outstanding balance) in 1990. The tax relief has been phased out in successive stateBudgets and was abolished in March this year. The forecast has been provided by the Inland Revenue.All future mortgage interest tax relief will be minimal compared to recent levels.

House pricesHouse price inflation in the UK has been extremely volatile. Price inflation peaked at 40% in the early1970s, 30% in the late 1970s and 25% in the late 1980s. The current level of 16% is modest incomparison, but earnings and retail price inflation are now much lower compared to these previousperiods. The forecast is for house price inflation to moderate into the medium term to a sustainable6.5%. This is based on the implicit assumption that the previous imbalances of demand and supplyconditions in the housing market do not recur over the forecast horizon. That is, the housing stockcontinues to gently increase and that the general pricing environment in the UK remains docilecompared to the experience of the 1970s and 1980s.

Mortgage interest tax relief, 19 70-201

0

1

2

3

4

5

6

7

8

9

70 72 74 76 78 80 82 84 86 88 90 92 94 96 9820

00 2 4 6 8 10

£ billions

Source Inland Revenue

Virgin One


House price inf lat ion foreca

-10

0

10

20

30

40

71 73 75 77 79 81 83 85 87 89 91 93 95 97 99 1 3 5 7 9

Source National Statistics, Future Foundation

% change

Virgin One


5 The Australian market

This section describes the history of the current account mortgage market in Australia and the marketmodelling work to quantify the innovative and adoptive consumer behaviour there.

The launch in AustraliaThe current account or all-in-one mortgage is a relatively new concept to the UK mortgage market.Naturally there is a great deal of uncertainty in predicting the market potential for this product. As therehave been no obvious parallel products in this or other financial service markets, we have looked toother national markets for examples of how this innovation might develop market share.

The most developed national market for current account mortgages is Australia. Current accountmortgages were launched by Citibank in 1988/89 with the ‘Mortgage Power’ product which combineda cheque account with credit/debit cards and mortgages. The aim of the product was to exploit the trendtoward home ownership in Australia of the previous decade.

Table 5.1 Home ownership levels in England, Australia, New Zealand and CanadaEngland Australia New Zealand

% of households that were owner-occupiers

1975/76 55.7 67.9 69.7

1980/81 57.7 68.2 71.2

1985/86 63.2 70.4 73.5

1990/91 67.4 68.8 73.5

1995/96 67.6 69.0 70.5

Source Alan Holmans, Housing Finance, February 2000

The chart below shows the quarterly sales (outstanding balance) of current account mortgages since thestart of 1990 in nominal and real terms, adjusted to account for the effects of inflation. The chart showsa several years of stagnant sales of around A$30 billion before the period of accelerating growth from1994.

Quart erly sales o f current accounmort gages in Australia, 19 90-20 0

0

10,000

20,000

30,000

40,000

50,000

60,000

70,000

80,000

1990.1 1991.1 1992.1 1993.1 1994.1 1995.1 1996.1 1997.1 1998.1 1999.1 2000.1

Current prices

1990 prices

A$, millions

Source Reserve Bank of Australia, Future Foundation

Virgin One


At March this year the outstanding balance had increased to A$75 billion. It would seem that the periodof rapid product adoption normally associated with product innovations took place four or five yearsafter its launch. Outstanding balances fell during the second year after launch; showed several years ofgrowth well below overall market average; and then rapidly accelerated. The market share of currentaccount products of all home loans is illustrated below.

This sales history does not represent the usual pattern of market diffusion. This would be an ‘S’ shapedcurve suggesting initially accelerating sales growth (from a small base) as the product concept isaccepted by innovators, and subsequent stronger sales growth as the concept gains broader appeal.

One possible explanation of the early failure of the current account mortgage product in gaining marketshare was the unfortunate timing of the product’s launch. Australia endured a deep recession in theearly 1990s. Economic growth was negative in 1991, but perhaps more importantly for the mortgagemarket, interest rates had risen sharply in 1989, with unemployment to follow in subsequent years.Under these circumstances, the appeal of more established mortgage products, especially the fixed rateoption, might have increased.

The share o f current account mort gagest he t otal mort gage market

0%

2%

4%

6%

8%

10%

12%

14%

16%

1990.1 1991.1 1992.1 1993.1 1994.1 1995.1 1996.1 1997.1 1998.1 1999.1 2000.1Source Reserve Bank of Australia, Future Foundation

The impact o f the 1 99 1 recession ohouseholds in Aust ralia

0

5

10

15

20

1987 1988 1989 1990 1991 1992 1993 1994 1995Source World Bank, Future Foundation

Base interest rate

Unemployment rate

%

Virgin One


The declining market share of current account mortgages in the early 1990s is also at least partlyattributable to poor marketing and confusing advertising. The product’s market share started to increasesharply in 1995 when the banks entered the market with better use of the media in selling the productbenefits.

Learning from the Australian experienceDespite its intriguing history, the Australian experience provides the best example of market diffusionof current account mortgages. Of course the Australian market differs from the British market in anumber of ways:-

� the overall market is much smaller – the population of Australia is 18.5 million compared to theUK’s 56 million;

� the tax treatments of mortgage repayments and property inheritance vary;

� the Australian market is more developed in the range of products available and customer serviceorientation;

� the Australian mortgage industry is less concentrated than Britain’s; the British mortgage market isdominated by the largest four lenders (although this is changing), while the Australian market ismore widely spread with more regional dominance among players.

Even so, levels of home ownership are very similar as Table 5.1 above shows, and the British market isenjoying a period of very rapid product innovation, rising consumer awareness and intensifyingcompetition.

Following the work of Bass (1969) and Mahajan, Muller and Bass (1990) the Australian currentaccount market data has been analysed and modelled to quantify the rate of product diffusion. Thiswould form the basis of our assumptions for the rate of diffusion in the UK. The aim has been to isolateand quantify two specific measures of diffusion:-

1. the innovation effect (external influence): these are the market innovators (and perhaps some earlyadopters) who would recognise the product benefits immediately and buy. They are not influencedby the numbers of people who have already bought;

2. the imitation effect (internal influence): these are people who are influenced by the numbers ofprevious buyers and increase relative to the number of innovators.

The parameters estimated by the modelling process of these diffusion measures vary according to thesample period used. The entire period produces an ‘U’ shaped diffusion curve, accounting for the sharelosses in the early years after launch. This has the effect of distorting the innovative effect, actuallymaking it negative.

Virgin One


When the modelling process is applied to the market data for the second half of the 1990s, when theindustry’s marketing effort had improved the product’s market performance, the customary ‘S’ shapedcurve emerged. The market shows signs of levelling off in the last year, with the rate of gain of marketshare slowing compared to 1997 and 1998.

New ZealandThe current account mortgage market in New Zealand has existed for at least five years. Unfortunatelythere has not been sufficient data collated for us to draw any firm conclusions about its rate ofdevelopment or its suitability as an example for the UK market to follow. The source of mortgage data,the Reserve Bank of New Zealand, has only been collecting mortgage product data since 1994.

The adop tion of current account mortgagesAustralia, 199 0-2000

0

2

4

6

8

10

12

14

16

1990.1 1991.1 1992.1 1993.1 1994.1 1995.1 1996.1 1997.1 1998.1 1999.1 2000.1

Market share, %

Actual values

Model fit


The adop tion of current accoun t mortgagesAustralia, 1995-200 0

4

5

6

7

8

9

10

1995.1 1996.1 1997.1 1998.1 1999.1 2000.1

Model fit

Actual values


Market share, %

Virgin One


The Reserve Bank has advised us that it is collecting data on current account mortgages but “the series,particularly as a history, is not yet sufficiently stable to release publicly.” The Reserve Bank does note,though, that current account mortgage products comprise 10% of the floating rate mortgage productssegment, which currently accounts for 41% of the total market in value terms.

Table 5.2 The shares of mortgage products in New Zealand 1994-1997Fixed Rate Floating rate

%

1994 7 93

1995 19 81

1996 38 62

1997 50 50

1998 54 56

1999 59 41

Source Reserve Bank of New Zealand

The Reserve bank’s figures show a substantial shift into fixed rate products. However, many of thefloating rate products are becoming more flexible, with early and top up payment options, but again, nofigures are available.

Virgin One


6 The current account mortgage market forecasts

This section sets out the current account market forecasts, the assumptions underlying them and theprocess of adopting the Australian market experience.

The current account product history in the UKThe current account product is a very recent innovation for the UK mortgage market. First Activelaunched at the start of 1998. Kleinwort Benson and Virgin One launched products later that spring. Atthe end of 1999 there was an estimated £1.5 billion of outstanding current account mortgage debt(about 0.3% of the total market), although there is no information on the number of account holders.Further product launches are expected this year.

Adopting from the Australian experienceSince there is so little data on the nascent UK current account mortgage market, we are forced to lookat other national markets for indicators of likely demand for this product. Australia has the mostdeveloped and comprehensively documented market history on which to draw. In doing so, we aremaking some critical assumptions:-

� that it is generally reasonable to transpose the Australian experience, in terms of product innovationand adoption, onto the UK market. (The main differences between the national markets were listedin the previous section.);

� more specifically, that culturally the UK market is as ready for this product innovation as Australiawas in 1994. That is, that UK consumers are as equally likely to understand and value the productbenefits as their Australian counterparts were in the mid-1990s when the product marketing hadbeen refined;

� that the current account mortgage product is and will continue to be launched with promotionalspend proportional to that given to the Australian re-launch.

One key difference is that the UK products are being launched during a period of sustained economicgrowth and relatively benign interest rates while the mortgage market is expanding very quickly.Housing transactions growth has averaged 13%1 during the year to March 2000 and house priceinflation 12%2.

The UK current account mortgage market forecastsIn addition to the general assumptions listed above, the forecast listed below are based on the followingfurther assumptions:-

� that the total market potential in the UK for current account mortgages ranges between 4% and10% of the total mortgage market (balances outstanding). This is based on the New Zealand andAustralian experience, two relatively mature national markets compared to the UK;

� that the propensities for consumer innovation and imitation (see Section 5) in the UK mortgagemarket are the same as those in the Australian market;

� that the market stasis that limited current account product growth during the first half of the 1990swas attributable to temporary marketing and economic factors that are unlikely to occur in the UKmarket into the medium term.

Virgin One


The forecasts under the two market potential points of 4% and 10% are listed below with an arithmeticmid-point, the central forecast. The first assumption listed above – that the total market potential rangesbetween the penetration rates in Australia and New Zealand – are supported by recent quantitativemarket research. The key results of this research are presented in the Appendix. It is worth noting herethough that, despite still being a relatively new product in the UK, 38% of homeowners with amortgage or those who plan to buy a home with a mortgage in the next six months have heard ofcurrent account mortgages. Furthermore, 48% of this base would be interested in current accountmortgages if they were going to get a new mortgage or re-mortgage.

Table 6.1 The current account mortgage forecastsCurrent account

mortgage, 4% marketpotential assumption

Current accountmortgage, 10% marketpotential assumption

The outstandingbalance forecast £bn

Marketshare (%)

Marketforecast £bn

Mid-point marketforecast

Marketshare (%)

Marketforecast £bn

1999 494 0.3 1.5 1.5 0.3 1.5

2000 527 1.0 5 8. 2.1 11

2001 564 1.9 11 18 4.4 25

2002 614 2.5 15 26 6.1 38

2003 671 3.0 20 34 7.3 49

2004 712 3.3 23 41 8.1 58

2005 750 3.5 26 46 8.7 65

2006 798 3.7 29 51 9.1 73

2007 824 3.8 31 54 9.4 77

2008 845 3.8 32 57 9.6 81

2009 861 3.9 34 59 9.7 84

2010 876 3.9 34 60 9.8 86

% change

2000 6.7 251 546 644

2001 7.1 102.0 117.1 124.2

2002 8.9 45.7 48.7 50.0

2003 9.3 28.9 30.1 30.6

2004 6.1 17.5 18.1 18.3

2005 5.3 12.4 12.7 12.9

2006 6.3 10.9 11.1 11.2

2007 3.3 6.3 6.4 6.4

2008 2.6 4.6 4.7 4.7

2009 1.9 3.2 3.3 3.3

2010 1.7 2.6 2.7 2.7

Source The Future Foundation

The table shows that, like the Australian market in the mid-1990s, the UK current account mortgagemarket is expected to see rapid early growth as innovators adopt the product quickly and adapters soonfollow. The growth is ‘front-loaded’ with very rapid expansion expected in the first half of the decade,

Virgin One


slowing to near total market speed by the end of the forecast horizon. The forecast range is achieved bythe growth in the early years, reflecting the importance of innovator consumers to recognise the productbenefits, as they did in Australia in 1995. The mid-point forecast suggests that the average annualgrowth rate of current account mortgages will be 52%, although most of this growth will occur in thefirst few years.

1 According to National Statistics2 Nationwide Building Society

Documents

The Future of the UK Mortgage Market: The Impact of ... · 2. Then to forecast sales of current account mortgage products using market diffusion modelling techniques. These forecasts