Merrill predicts last days of the building society

JOHN WILLCOCK

Financial Correspondent

Aggressive price-cutting in the mortgage market will mean cheap mortgages for the next two years, - and could force building societies into the red, with most either selling out to banks or converting to banks themselves.

That was the forecast today from the investment bank, Merrill Lynch, which says that competition has hotted up since its previous report on building societies last December. Operations like Royal Bank of Scotland's Direct Line, which sells mortgages by phone, are putting the squeeze on building societies.

Merrill claims that "the upshot of this is that most building societies cannot continue to be profitable and will cease to exist in any meaningful way over the next few years (either giving up their mutual status or being taken over by other financial institutions)."

The latest forecast from David Miles and Ian McEwan, analysts at Merrill, predicts that the housing market will be flat over the next 2 years. Following that, they expect a housing boom with an estimated 20 per cent per annum growth.

Their previous predicition that mortgage margins for societies would halve from 2 per cent to 1 per cent over five years has now been shortened to just two years. New direct-lending institutions with extremely low cost bases have become the price leaders, they say.

A society which made most of its income from mortgage interest, with a fairly typical cost/income ratio of 50 per cent would be reduced to around break-even.

"Societies which can compete on cost grounds will nonetheless feel pressure to abandon mutuality as members come to view reserves as something to which they have ownership claims."

Merrill's comments come as National & Provincial is preparing to meet Abbey National for talks on Monday. The meeting follow's Abbey's public announcement earlier this week that it would be prepared to pay "a substantial premium over net asset value" for N&P.

If Abbey is successful it may tempt other banks to follow, says Mr McEwan, with Royal Bank of Scotland in the lead.

Merrill's note has outraged building society figures. Alistair Lyons, chief executive of N&P, said yesterday: "It is an extreme extrapolation of a scenario until it's no longer relevant."

"Mortgage margins are being driven down. But they are being driven down by the societies, not the banks. We have far lower cost/income ratios than the banks, usually 40 per cent against their 60 per cent."

John Wriglesworth, a senior manager with Bradford & Bingley, dismissed Merrill's forecast that the mortgage market would recover after two years as "just garbage."

He also said that societies are in a far stronger position than the banks: "We are quids in, and the banks are quids out. This is just scare-mongering, trying to capitalise on the spirit of the day."

Bbecause of the ageing population and continuing negative equity for homeowners, the mortgage market would remain flat for the next five years.

"Margins for societies will come down but this overlooks how far they went up. Margins have risen in every year since 1983, with the exception of 1994. We can afford to lower our margins, for two reasons.

"Firstly, interest rates are rising, which means we can make a much higher return on our free reserves.

Secondly, our bad debts are plummeting. The society sector's bad debts rose by 200 times from 1987 to 1992. They won't come down so far again. But it puts us in a very strong position for a price war."