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The industry has been dodging LTV caps for a while, but the MPC’s Charles Bean has loaded the gun again, so one has to question for how long it can remain safe from this bullet
Ever since the credit crunch hit and the realisation dawned that lending over the value of a property probably wasn’t the wisest move, there have been repeated suggestions that LTVs should be capped. Each time though, the industry has dodged a bullet as the suggestions have remained just that - ideas on the table that have never come to fruition.
But the sector can only have so many near misses, and with the spotlight once again on LTV limits, one has to question whether this particular bullet could finally hit its target. The latest suggestion comes from Monetary Policy Committee member and deputy governor of the Bank of England Charles Bean. At the recent Federal Reserve Bank of Kansas City’s annual conference, Bean delivered a speech on monetary policy after the fall.
He claimed varying margin requirements might be a more appropriate instrument for dealing with vulnerabilities building up in the capital markets more generally.
“Finally, there is the option of introducing direct constraints on the terms or availability of credit, for instance, imposing maximum LTV ratios in the mortgage market,” he says.
“The best approach seems likely to involve a portfolio of instruments. And while experience of the use of these tools might be limited, it is not entirely a tabula rasa. In particular, a number of developing and emerging economies have experience in applying some of these instruments, while there are also lessons to be drawn from the past experience of some advanced economies too.”
This is the latest in a long line of occasions when LTVs have been the topic du jour. In March 2009 the Turner Review suggested that 100% LTV mortgages could be banned and claimed the prospect of mortgage caps was open to debate.
The sector braced itself but in October of that year, when the Mortgage Market Review was published, it seemed there was nothing to fear. LTV caps were not to be introduced.
Writing in Mortgage Strategy just after the publication of the MMR, Lesley Titcomb, then director of small firms at the Financial Services Authority, said the regulator had recognised this would not rectify the ills of the market.
“Earlier in the year there was speculation that we could intro-duce LTV and loan-to-income limits,” she wrote. “We think these will not solve the problems we are looking to fix and will restrict access to many who can afford a mortgage.”
But the issue was not laid to rest permanently and in the same article Titcomb warned that a high LTV cap could still be employed.
“We are not ruling them out as they may have value as a macroprudential tool - a means to control overall levels of borrowing,” continued Titcomb.
“We will look further at restricting loans that show a mix of high-risk characteristics as a high loan-to-income ratio on interest-only loans to borrowers with impaired credit.”
It was a close one, but the market survived it. The next near miss came with a new government. With the Conservative/Liberal Democrat coalition in power the sector awaited chancellor George Osborne’s plans for the market at his Mansion House speech in June.
The day before the speech rumours abounded that the govern-ment was set to impose caps on LTVs, with tales that a leaked copy of the speech showed suggestions to cap LTVs.
An article in the Telegraph on June 15 stated that “the precise details of the controls the Bank is to be given will be detailed fully at a later date. However, they are likely to include restrictions on the LTV ratios offered to customers. For instance, families could be prevented from taking out a mortgage for anything more than 75% of the value of their home.”
But on June 16 when the speech was delivered there was no mention of caps and the industry collectively breathed a sigh of relief.
Now, with the issue being brought to light yet again, there are fears it might not be so lucky. With Norway and Sweden both imposing LTV caps earlier this year, is the UK about to follow suit? “The talk of caps being placed on maximum LTVs for mortgages comes as a surprise, having already been considered in the MMR,” says David Hollingworth, head of communications at London & Country.
“The MMR ruled out the need for specific caps to be placed on lending in terms of the LTV or maximum income multiples, so the deputy governor’s speech will only serve to reopen what appeared to be closed debate.”
Hollingworth says this is mentioned as one of a number possible initiatives and he believes that imposing direct curbs and limit-ations on product design is the least desirable route if we want an inno-vative mortgage market in the future.
“Of course lenders have made a shift towards lower LTV lending but this ongoing discussion signals that, one way or another, there will be measures to ensure there’s no speedy return to a market of excesses,” he adds.
“That is unlikely to come as a big surprise but certainly indicates that home buyers will still face the challenge of raising substantial deposits for some time to come.”
Iain Laing, chief credit officer at Santander, says there are practical issues surrounding this idea.
“It is not as simple as enforcing, for example, a speed limit,” he says. “Speed is something that can be measured simply and objectively. The value of a particular house or the income of an individual are not easily and unambiguously measured. Market controls of this nature are likely to have unpleasant consequences.”
Alan Cleary, managing director of Precise Mortgages, is particularly concerned about the effect a cap could have on first-time buyers.
“Limits on LTVs are a blunt instrument and would have undesired consequences for the housing market,” he says.
“First-time buyers are an endangered species as a result of lenders’ lack of appetite for high LTV loans. Without first-time buyers the market will eventually come to a halt.”
Cleary says it should also be noted that while limiting LTVs is common practice in some countries the availability of granular credit data in the UK means lenders can trade off some of the risk of higher LTV loans with credit.
“There are better ways of creating sustainable capital markets and my reading of Bean’s comments is that he was voicing his ideas rather than stating a Bank policy view,” he adds.
Danny Lovey, proprietor of The Mortgage Practitioner, reiterates Hollingworth’s comments regarding the lack of high LTVs available anyway. Indeed, of the 2,373 mortgage products available today just 166 are at 90% LTV - a paltry 7%.
“We effectively have a limit on LTVs as any first-time buyer will know,” he says. “The capital cost required by lenders to lend at high LTVs is now in place under Basle II which makes it expensive to lend at that level.”
Basle II is an international business standard that requires financial institutions to maintain enough cash reserves to cover risks incurred by lending.
Paul Broadhead, head of mortgage policy at the Building Societies Association, says Basle II and other initiatives render a cap on LTVs pointless.
“We’ve already got a raft of proposals coming out with Basle II and capital buffers,” he says. “You certainly wouldn’t need to limit LTV even in a macro-economic sense. You’d stop expansion at the top of the market but you’d exclude creditworthy buyers, so you’d stop any growth at all as the lifeblood of the housing market would be sucked out.”
Broadhead says in terms of managing risk LTVs, are just one part of risk assessment and the most important things are the ability of borrowers to repay their mortgage.
Fahim Antoniades, group director of Mortgage Centre IFA, believes the root of the problem is being ignored.
“Closer scrutiny is needed on the link between higher LTVs and the problem in the capital markets, which as far as I remember stemmed from indiscriminate securitisation,” he says.
“It seems to me that if capital is securitised properly it does not matter whether you lend at 95% LTV or 75% LTV.
“Sometimes statistical patterns can emerge which seemingly point to a cause and effect but we have to be able to study this properly and establish the link between high LTVs and vulnera-bilities in the capital markets, otherwise we could be in danger of stating that eating paella is the cause of getting a tan.”
Rob Roberts, head of mortgages services at Lift-Financial, agrees with this.
“Limiting LTVs is the wrong approach,” he says. “The answer isn’t in limiting options, it is in making certain that lenders that have the high LTV options are underwriting them properly and setting their risk parameters accordingly. They should be looking at a proven income with a long-term history in a field of employment, stability in personal profile and an excellent credit record. If the underwriting is appropriate, there is no reason not to allow it.”
Roberts adds that lenders should price high LTV products accordingly given the higher risk and the increase in processing requirements.
“A free market economy should be allowed to be just that,” adds Roberts. “Of course there needs to be regulation around what should be available. If you want to limit LTVs then limit them to 100%. To stifle innovation and ingenuity would be to strangle the life out of the property and mortgage markets.”
Bean’s comments have once again opened up the debate on the role of the Bank and the government when it comes to controlling the market.
“Innovation is the key to recovery and the role of the regulator is to ensure that the processes are in place to back up innovative ideas, not to stop them being developed,” says Roberts.
Mark Blackwell, managing director if xit2, says Bean’s comments are the sort of intervention you would least expect at the dawn of a new regulatory regime led by a traditionally laissez faire Tory government.
“Next we will see the reintroduction of consumer credit restrictions of years ago that meant receipts had to be produced for every pound of a further advance applied for,” he says.
Blackwell says the role of central banks and administrators is to ensure no systemic risk to money supply and that the financial system remains robust with the application of strategic intervention and pragmatic regulation.
“The lending community surely doesn’t want a member of the government to sit in at every lender’s credit and risk committee meeting making sure LTVs are dampened down,” he adds.
LTV caps would stop expansion at the top of the market, exclude creditworthy buyers and suck the lifeblood of the industry
Dev Malle, group sales director at Personal Touch Financial Services, says a cap on LTVs would not be progressive.
“The financial services industry and in particular the mortgage industry has been developing sophisticated risk models for a number of years,” he says. “It would be a backward step to apply a blunt criteria tool in isolation and throw the baby out with the bath water.
“LTV bands can be varied in scorecard models by lenders based on the risk for that particular borrower. That is preferable to a one size fits all approach.”
Paul Hunt, managing director of Phoebus Software, says that although an LTV cap would be a blunt method of controlling lenders and lending, in principle it could work.
“But in practice, it would have little effect on the market,” he adds. “For a start, if this were put in place, any lender with an ounce of commercial sense would find a way around it. You’d start to see lenders providing an unsecured loan with the mortgage for instance - or taking other security against a top-up loan.
“Once lenders had the funding, they would start working around a cap with ease.”
Hunt says a far better option to control lenders might be to make the loan originator responsible for any borrower shortfall, if the originator could have reasonably predicted it.
A Bank source says no decision has been made and Bean was simply suggesting one measure that could be taken.
But after so many false dawns can the mortgage industry really be hopeful this time? One has to question how many bullets it can dodge.
The best approach to the uk’s monetary policy is likely to involve a portfolio of tools
An edited extract from Charles Bean’s speech - Monetary Policy After The Fall - at the Federal Reserve Bank of Kansas City Annual Conference on August 28
“There are multiple dimensions to macro-prudential policy. On the one hand, it encompasses actions to make the banking system more robust to shocks, recognising the interconnectedness of financial institutions. This interconnectedness was somewhat neglected in the run-up to the crisis, when it was assumed that if banks were individually safe, then the system would be too. The presence of network externalities meant this was far from being the case.
A key ingredient here is increasing not only the quantity of capital available to absorb losses but also its quality, as some capital instruments have turned out to be ineffective loss absorbers unless the bank is liquidated. Instruments that bail in creditors before that point is reached, such as contingent convertible bonds, therefore hold some attraction. That is particularly important for institutions deemed too large or too systemically important to fail.
In addition, structural reforms can improve the robustness of the financial system. These issues are the object of discussion within the Financial Stability Board and the Basle Committee and firm proposals, together with a transition timetable, are due shortly. While this territory is beyond the scope of this paper, it is worth noting that effective measures to improve the robustness of the financial system, by reducing the likelihood and severity of future crises, also reduce the need for monetary policy.
On the other hand, there is also a potential role for macro-prudential policy to cool credit/asset-price booms that appear to be getting out of hand. Most discussion of such instruments has so far revolved around the introduction of a pro-cyclical capital buffer.
Banks would be required to build up extra capital/reserves during a credit/asset-price boom, which can then be run down in the event of a bust. This should reduce the incentive for banks to leverage up in a boom, as well as making the financial system more robust in a bust. Other instruments could, however, be deployed to this end. For instance, credit/asset-price booms are usually characterised by an excessive shift into riskier forms of lending. In that case, an instrument more directly targeted at the microeconomic distortion would be to increase the risk-weights attached to such lending when computing banks’ required capital.
And, as we have seen in the present crisis, much of the action may take place outside the regulated banking system in the wider credit markets. In that case, varying margin requirements might be a more appropriate instrument for dealing with vulnerabilities building up in the capital markets more generally.
Finally, there is the option of introducing direct constraints on the terms or availability of credit, for instance imposing maximum loan-to value ratios in the mortgage market.
The best approach seems likely to involve a portfolio of instruments. And while experience of these tools may be limited, it is not entirely a tabula rasa. In particular, a number of developing and emerging economies have experience in applying some of these instruments, while there are also lessons to be drawn from the past experience of some advanced economies too.”
An LTV cap is a blunt instrument
Fionnuala Earley senior economic adviser Royal Bank of Scotland
Charles Bean’s speech raised the issue of maximum LTV requirements as a way to manage booms and busts in credit markets and asset prices. The idea is not new, here or abroad. Such measures are already in use in Scandinavia, Austria, Poland and to a limited extent in Germany. They are also being used in Asia to settle frothy housing markets with some success.
The idea of an LTV cap in the UK was raised in the March 2009 Turner Review and examined more closely by the FSA in its October 2009 Mortgage Market Review.
To revisit the debate, the rationale for an LTV cap is to protect borrowers from the consequences of imprudent borrowing, protect banks from the consequences of imprudent lending and constrain over rapid credit growth and excessive property price increases.
A cap should put a brake on lending and take some steam out of the market before it builds up too strong a head.
But a cap is a blunt instrument. It will tend to disadvantage new entrants to the housing market who cannot rely on, for instance, family sources of money for initial deposits. This potentially has deeper social consequences in terms of the equality of access to property ownership.
Limiting access to funds without taking account of individual circumstances seems overly severe
Also, high LTV loans may be more prudent for borrowers and lenders than raising funds via more expensive channels such as credit card debt or unsecured loans. It is also not clear that all borrowers at higher LTVs are a risk and limiting access to funds without taking account of individual circumstances seems overly severe.
The FSA concluded that the potential benefit of banning the sale of loans above a certain LTV was not overwhelming in the UK. Its research suggested that high LTV lending was not a key trend in the expansion of mortgage credit in the latest cycle.
During the last credit boom the proportion of 90%-plus lending was significantly lower than in the 1980s or 1990s. The FSA was also cautious about concluding that high LTV lending is the best way to protect lenders’ and borrowers’ solvency. There was more evidence that the type of lending, for example, self-cert, was a better indicator of default.
An LTV cap was only one of a number of macro-prudential measures Bean mentioned. The others relate to capital provisions which make it more expensive for banks to make riskier loans in a booming market and so reduce their incentive to do so.
It seems clear that he believes the best approach would be a portfolio of measures to suit the particular circumstances, in which case an LTV cap might only come into play if other, more flexible, tools were ineffective.
