A risk-based pricing systems model of the UK residential mortgage market

Allison Orr and Gwilym Pryce

ERES from European Real Estate Society (ERES)

Abstract: The UK residential mortgage market has developed into a sophisticated market with a complex pricing structure, an array of products designed to cater for subsets of perceived borrower needs and aggressive pricing. Studies on the pricing structure of mortgages in the mid-2000s confirmed suspicions that lenders were using existing standard variable rate mortgage holders to cross subsidise new borrowers. This allowed lenders to drop their mortgage rates to levels too low to enable them to earn a return sufficiently high enough to compensate them for the risks carried on these loans [Miles, 2004]. The preferential treatment of newer customers raises the issue of fairness in the UK mortgage market as does traditional credit rationing methods used to differentiate and exclude high risk borrowers. Arguably, home loans should be accessible to all households and pricing, as specified by the efficient pricing hypothesis, should be based on the risks and costs attached to the loans, not simply determined by borrowers being new or existing customers [White, 2004]. The principle underpinning risk-based pricing is that the rate charged on a mortgage should reflect the probability of default and expected loss in the event of default. Under such a pricing structure lenders should legitimately be charging different mortgage rates depending on the risk characteristics of the borrower. Yet, mixed, and often confusing and contradictory, evidence exists relating to the use of risk-pricing of mortgages in the UK and the potential implications for lenders. In this paper we seek to address this gap in our knowledge and contribute to the debate over the behaviour of lenders and the operation of the residential mortgage market. This will be undertaken by developing a risk-pricing systems model to enable the estimation of the relationship between interest rates charged by UK lending institutions on individual loans using UK mortgage survey data. References Miles, D. (2004) The UK Mortgage Market: Taking a longer view. Final Report and Recommendation, HM Treasury, London. Pryce, G. (2003) Worst of the good and best of the bad. Adverse selection consequence of risk pricing, Journal of Property Investment and Finance, 21(6), 450-472. White, A. M. (2004) Risk-based mortgage pricing: present and future, Housing Policy Debates, 15(3), 503-531.

JEL-codes: R3 (search for similar items in EconPapers)
Date: 2012-01-01
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