Braced for merger-mania

Activity in the specialist mortgage market is getting more ferocious by the day. First, Deutsche Bank raided HBOS subsidiary The Mortgage Business in September and made off with the Fab Four, otherwise known as Bill Dudgeon, Mark Bergin, David Parry and Paul Graham.

Then in October HBOS lost another high-profile gang, the Famous Five of Michael Bolton, Alan Cleary, John Nixon, Rob Williams and Mark Smith, snaffled by London-based private equity firm The Oakwood Group.

A host of US investment banks are rumoured to be hungrily eyeing the higher margins in the UK specialist lending sector.

Financial giant Morgan Stanley is currently sizing up packager Advantage Home Loans, with a deal expected in the next few months.

And US mortgage giant Countrywide Financial Corp has moved closer to setting up its own UK sub-prime lender by purchasing the remaining 30% stake in mortgage processor Global Home Loans. Further developments are breaking on an almost daily basis, usually on the Mortgage Strategy website, with the most recent being news that Florida-based Bayview Financial is launching in the UK.

Most pundits predict a frenzy of start-ups and acquisitions in 2006. These are exciting times, but what will it mean for brokers and borrowers?

Sadly, the men at the heart of all this activity, the Fab Four and the Famous Five, are contractually barred from talking to journalists about their plans. Bill Dudgeon, ex-managing director at TMB, doesn’t officially join Deutsche Bank until January. He is still carrying out staff appraisals at HBOS but is willing to offer some general comment on the market. The juicy stuff will come next year. “US banks still believe there are margins to be made in the UK, particularly on the specialist side. It fits their securitisation model nicely and this country’s is also a buoyant and growing market,” he says.

The bedding in of Financial Services Authority regulation has also helped. “The checks and balances give them a bit more security when entering a market. This is one more thing the investment bank risk director can tick off,” he says.

How all this activity affects brokers depends on the business models the Anew entrants adopt. Publicly, Dudgeon offers questions rather than answers. “Will they use packagers? Will they go for whole of market? Will they set up jazzy websites? So far, it’s unclear, but there are plenty of things they could do to make life easier for brokers.”

The $64,000 question, he says, is whether more will follow. “The market has slowed since the boom years of 2003 and 2004 but it is still buoyant. And there’s plenty of room for innovation.”

Michael Bolton is keeping an even lower profile but Mike Culhane, chief executive of London-based equity firm The Oakwood Group, is happy to explain the thinking behind his move into the specialist sector.

He says the 10-year prime market was largely driven by churning and has now run its course. This spells bad news for mainstream lenders.

“High street lenders stimulated the market in three ways: by pricing remortgages the same as house purchase deals, by paying brokers commission on remortgages and by making two-year deals the most attractive on the market. But the level of churn is now so great they are struggling to make money from their books,” Bolton says.

Statutory regulation could make life even tougher, with the FSA stipulating in MCOB that lenders must price for risk. “Currently, a first-time buyer wanting, say, a 97% LTV pays a similar rate to somebody on their third or fourth house borrowing just 60%. Similarly, remortgage customers are more risky because many are trying to get out of debt, but they still get the pick of the deals. Banks daren’t price for risk because some new entrant with no back book will snap up all those customers,” Culhane says.

Regulation hasn’t raised the barriers to entry as many predicted – quite the reverse. “The regulatory system has been in place for over a year, giving the market certainty and stability which is what investors like,” he says.

Mortgage processors such as Homeloan Management and Global Home Loans have also lowered entry barriers. “Entrants can keep start-up costs to a minimum by outsourcing many processes. This gives them an advantage over retail banks which operate expensive branch networks and pay for costly TV and newspaper advertisements. “Up to 65% of the UK mortgage market goes through intermediaries, which makes it an attractive proposition,” he says.

Culhane sums up the attractions: “Barriers to entry are low. Returns can be lucrative. Traditional high street players don’t know what to do. Why wouldn’t investment banks be interested?”

Investment banks have the added incentive of making profits from securitisation. “Until this year equities have struggled. Investors are sitting on piles of cash, and securitisation bond issues offer excellent returns,” Culhane says.

So how can the retail banks fight back? One option is to ape their competitors either by poaching staff from specialist lenders or by acquiring a lender. “This makes independent players such as Kensington Mortgages, Paragon Mortgages and Mortgage Express attractive targets for traditional players. If, say, Barclays wants a presence in the UK specialist mortgage market, it will probably end up buying one of these outfits,” he says.

Brokers should welcome all this activity because it will help them resist growing competition from the high street banks.

“Santander, which bought Abbey, has a tremendous cross-selling operation in Spain, where its average customer has seven different financial products, and wants to bring that to the UK,” Culhane says. “It plays Mr Nice Guy to brokers now but why on earth would you pass one of your clients to a predatory cross-selling bank? If you sell an Abbey mortgage now you are effectively handing over your client for good. Nationwide is another lender that is working hard at retention.”

Investment banks, by comparison, aren’t interested in selling buildings or contents insurance, only returns on assets. That should make them much more appealing to brokers, he says.

Publicly at least, established lenders are playing down the threat to their position. Paul Fincham, spokesman for HBOS, says the group is nicely positioned to fight off the challenge of new entrants. “Our multi-brand, multi-channel strategy with Halifax, IF, Bank of Scotland, BM Solutions and TMB means we are better placed to meet this challenge than many mainstream operators.”

Sean Webb, chief commercial officer at GE Home Lending, warns that large companies can’t just stroll into the arena and expect immediate success. “Acquisitions can’t succeed just on the size and strength of the acquiring brand but must also capitalise on the market experience of the acquired company and the development of its products and services,” he says.

Steve Haggarty, managing director at HML, says there are two apparently conflicting views of the mortgage market. “Traditional lenders say the market is tough. There is over-capacity with too many lenders chasing too few borrowers and margins are getting thinner. Distribution and origination rule. If they weren’t in the market, many of the big lenders wouldn’t be looking to enter. Yet at the same time, the entire investment banking industry seems to be targeting the UK.”

Investment banks have good reasons to take an interest. “They are attracted by the stability and maturity of the mortgage market, which neatly balances the more cyclical elements of their business,” he says.

Tougher international capital adequacy standards, drawn up by the Basle committee, have also spurred them into action because secured first mortgage assets are reasonably capital efficient, Haggarty says. There is also an element of ‘me-tooism’. “Merrill Lynch has made a success of Mortgages PLC. Lehman Brothers has done well with Southern Pacific and Preferred. Other investment banks clearly think that if they are in it for the long haul, we should be there as well,” he says.

This is great news for HML. “Entrants may handle design, pricing and marketing themselves, but won’t want the upfront costs of acquiring premises, commissioning IT, and so on, and will probably want to deal with a servicer such as ourselves. They can lock right into our model and only pay for what they use. We carry the risks,” he says.

This might be great for pure outsourcing services but it’s bad news for established lenders. “They might have to look at their business models, and also outsource, which could lead to a virtuous circle as far as our business is concerned,” Haggarty says.

Confidentiality agreements prevent him from naming names but he says the company’s sales pipeline is the healthiest it has ever been. “We are looking at 12-15 new entrants coming into the market in 2006. People are getting prepared, they are getting funding in place and understanding distribution.”

The next battleground will be all market share. “Michael Bolton and Bill Dudgeon have a record in origination, drumming up business and getting the volumes. That is what the entrants are looking for – somebody to raise their profile in the market,” he adds.

Despite the frenzy of activity, Haggarty predicts the impact on product development will be negligible. “I’ve been in this industry for 33 years and there is nothing new to see. Stuff just gets repackaged and given different names. We were servicing flexible mortgages for Klein- wort Benson in 1989, for example. Everything is cyclical,” he says.

Peter Gladdy, director of Mortgages Direct, agrees that this is part of a cyclical business pattern that has occurred every 10 years, but is optimistic that it will lead to improved products. “The increase in activity is welcome as it will lead to more innovative deals and better service for customers. But the challenge is to hold onto the recent surge of investment and take it into the next 10 years.”

You don’t have to be a major US investment bank to see rich pickings in the specialist sector. The past two years have seen a host of arrivals including Beacon Homeloans, Victoria and Unity Homeloans.

Bob Sturges, spokesman for Money Partners, says as an expanding market with attractive margins, the specialist sector is flavour of the month. “Regulation has also helped by resolving the image issues that the specialist sector has suffered in the past,” he offers.

It is also a growing market. “The specialist sector is worth around 35bn a year and Datamonitor suggests this could grow to 60bn by 2008. But that may still not be large enough to sustain the existing and new players. Entrants will have to be aggressive on pricing, product design, marketing and PR to make their presence felt and I predict all this activity will eventually lead to consolidation,” he says.

Entrants will have to work hard to impress brokers. “These days, you can’t take for granted your old business relationships. You need access to technology and sourcing systems, KFIs, regulation and compliance support, and product design and distribution. We all invest a lot more in these relationships and new lenders must work hard to give brokers what they want,” Sturges says.

Ray Boulger, senior technical director at John Charcol, agrees the current spate of mergers and acquisitions could lead to consolidation but points out that the mortgage market has sustained a surprising number of lenders. “If you asked me five years ago whether the number of building societies would shrink I would have said yes, but amazingly few have been swallowed up. The number of lenders is now rising rather than falling. But how long can it last?”

November saw yet another entrant, Salt, the specialist lending division of Derbyshire. Salt aims to offer light and medium adverse and self-cert mortgages via the intermediary market through a controlled distribution network of six packagers.

Marketing director Mark Blackwell believes there is scope for smaller players to carve a niche in the specialist sector. What they need is a clear proposition and Salt will be concentrating on service. “We aren’t going head-to-head with the bigger names and why should we? We are not trying to be mass market but will focus on building relationships with selected packagers and intermediaries who are disappointed with the quality of service from existing lenders.”

Like many brokers Simon Tyler, managing director of Chase de Vere Mortgage Management, welcomes the increased competition, which should lead to innovation and competitively priced products. “But it could also lead to consolidation as not everybody can maintain market share if new lenders come into play. That makes it cheaper for big lenders to grow by acquiring instead of chasing new business.”

Simon Jones, director of Savills Private Finance, says 2006 is shaping up to be a thrilling year. “We can expect more poaching, more acquisitions and more investment bank interest. I’m hoping the entrants will bring innovation to the specialist market.” l

Specialist sector faces a turbulent year
Colin Sanders is chief executive of Money Partners
In its relatively short history, one characteristic has marked the specialist lending sector out from its more pedestrian mainstream cousin – its capacity for generating and embracing rapid and continuous change. From product innovation through to the ever-evolving nature of lender-broker relationships, it has moved onward and upward.

So, a year on from Mortgage Day, will there be a period of consolidation or one of dramatic twists and turns?

It would be a brave punter who put their money on the former scenario. It is much more likely that 2006 will be the most competitive year yet. This will probably be the case for the entire mortgage industry, but its effects will be more keenly felt amongst the specialists.

The evidence supporting this is plain enough. Growth will continue but at a slower rate than at any time in the past decade. In the meantime, there will be more providers offering more products in competition for market share. Also, consumers will continue becoming more financially aware and correspondingly more demanding in their product selection. Add to all this the certainty that several specialist lenders will launch in 2006 and the scene is set.

We have had a foretaste of what is to come with the emergence of a raft of lenders in 2005. These include Money Partners, Beacon and Victoria. More recently, a regional building society launched its own sub-prime brand.

Each has set about carving out market presence and share by offering intermediaries an attractive proposition that blends product and process appeal with service excellence. Each would argue they have achieved this. Regardless, the effect has been to raise the temperature across the sector.

But expect it to get even hotter next year when the Class of 2006 launches onto the scene. It is likely to comprise the ex-HBOS specialists together with a clutch of cash-rich investment banks and possibly our old friends at Countrywide, the US giant long-rumoured to be poised to enter.

The question is whether the market in its present condition can support this fresh burst of lender testosterone.

As things stand there are three possible outcomes. First, the market grows beyond expectations to allow all to share in its bounty. Second, lenders accept reduced levels of volume and asset growth. Third, all hell breaks loose and there are clear winners and losers.

My money is on a combination of the second and third scenarios. I think the effect will be exacerbated if the economy dips and lenders are unable to deliver the results to support their business models. And even if I’ve not called it quite right, it really would be a bold punter who gambled on a quiet 2006.

Mergers can create problems among staff
Mark Witcomb is divisional sales manager for financial services at Venatus Business Intelligence

The financial services sector has always been rife with mergers and acquisitions and the mortgage industry is no exception. With the UK mortgage market still attracting attention from overseas investment organisations, and the need for smaller companies to join forces to become more powerful organisations, the next year will be interesting.

When companies merge there have to be commercial benefits such as size, geographic coverage or distribution.

But one benefit often overlooked concerns the most powerful asset of any organisation – the people employed within it. The question is, how does the merged company ensure it retains the best people and find ways to elevate the right employees within the structure?

When commercial change happens, it affects employees in different ways. Broadly, there are two personal viewpoints possible when it comes to a merger. Some people see it as a negative move that will lead to departments merging and eventually job losses, while others see it as an opportunity to be part of a growing business that will become stronger following a reorganisation.

Companies must take care as, when mergers happen, communication within staff ranks can be limited and this can lead to confusion. Inevitably some employees will consider their options – stay or leave.

Further to this, as and when a merger or acquisition becomes common knowledge, employees in both firms can become a focus for outside recruitment organisations playing on their fears or doubts about what the future may bring.

Companies adopt various tactics to try to retain and select the right individuals for key positions. These can involve ‘golden handcuff’ offers to stay for a certain time period or even requesting employees to re-apply for their own jobs.

But the best way for an organisation to avoid staff problems or uncertainties is to be open about the strategy of the merger, what the expected changes are and why they will be of commercial benefit.

If staff selection is necessary it should be carried out using the correct process. Involving an outside firm can be a good way of keeping selection unbiased, and provide a legally defensible system.

One benefit of this approach includes companies being able to identify individuals who are not best placed in their current roles but could be elevated to more senior positions. It will also communicate to the market that the new organisation is doing things in a proper manner and therefore enhance its attraction among existing and prospective employees.