FSA caught napping by interest-only
FSA research into the interest-only fiasco centres on how lenders are taking steps to address the problems when the regulator should be answering why it was asleep on the job
The Financial Services Authority, which has described interest-only mortgages as a ”ticking time bomb,” has tightened up relevant regulatory requirements in the final rules of the Mortgage Market Review which it published in October.
It also revealed that it intends to publish the findings of further analysis of interest-only borrowing in the first quarter of 2013.
Conveniently, this further research will be focusing on how many borrowers may be unable to repay their capital and on the steps lenders are taking to address the issue, as opposed to establishing how the fiasco actually arose.
Because a huge amount of the blame should be shouldered by the FSA itself which ultimately, when it comes to interest-only, was asleep on the job.
Yes, it is certainly true that lenders have been guilty of reprehensible practices well before the sales of mortgages became FSA regulated in 2004.
During the early-to-mid 1990s they stopped insisting that endowments or other repayment vehicles were assigned to them and at around the turn of the century they even started including options on application forms to have interest-only mortgages without stating a specific repayment vehicle.
Not surprisingly, according to the FSA’s own research, 77 per cent of all interest-only mortgages in the second quarter of 2012 had no reported repayment strategy.
But the regulator should have made defusing this time bomb one of its key priorities the moment its remit was widened to include mortgage sales, and this should have involved going considerably further than the recently unveiled MMR measures – which seem to have more to do with paying lip service than with safeguarding consumers.
With effect from 26 April 2014 interest-only mortgages can only be offered to those who show they have a credible repayment strategy, and relying on rising house-prices or inheritances are considered too speculative to qualify. Lenders are also required to check that the repayment strategy is still in place once during the mortgage term.
But the key point is that at all times the actual responsibility for repaying the capital remains with the borrower, and any borrower determined to take foolish risks will almost certainly be able to do so.
The meekness of the recent intended measures contrast wildly with rules imposed in other areas of financial services.
Take pensions income drawdown, for example, where there is a similar need to protect the more naïve or reckless consumers against their own potential folly.
Unless you can demonstrate an existing pension income of at least £20,000 a year your income withdrawals are currently capped at a miserly rate even slightly lower than that of a single life annuity, and the income level must be reviewed at least every three years.
If someone fails to repay the capital on their mortgage it could leave them without a home in the same way that if someone withdraws too much from their pension pot it could leave them without a worthwhile pension.
Yet one set of rules is about as lax as those that allowed the Titanic to set sail without adequate lifeboats while the other has suffered from the type of overzealousness and inconvenience that characterises so much current health and safety legislation.
It doesn’t take a genius to work out that the difference in approach probably results from the ability of pensions to slot conveniently into the category of investment business whereas interest-only mortgages fall awkwardly between different regulatory stools.
Many mortgage intermediaries are not authorised to deal in investment business and mortgage lenders are increasingly laying off those staff who are actually authorised.
Furthermore, receiving suitable investment advice isn’t necessarily always the key to repaying the capital with an interest-only mortgage. It can, for example, be quite possible to do so from the sale of other properties, from downsizing or – although the MMR refuses to acknowledge the fact – from an expected inheritance. It is hard to see why relying on an inheritance that one’s own flesh and blood has stated is a cast-iron certainty should be considered more risky than relying on stock markets to deliver!
The FSA showed far more ruthlessness towards another product type that spanned different sets of its rules. In 2004 it prohibited income protection contracts that eventually converted to long-term care plans from being sold by those not qualified to advise on long-term care, resulting in all relevant providers withdrawing from the market.
Bright Grey and Scottish Provident managing director Roger Edward recalls trying to point out to the FSA that income protection sales may take place 30 or 40 years before long-term care was ever needed and that the IFA who sold the policy may well have retired, meaning that the policyholder would need new advice anyway.
But he describes trying to put over his eminently logical argument as having been like “banging my head against a brick wall.”
So why didn’t our regulator show similar stubbornness in insisting in 2004 that anyone wanting to go down the interest only route had to have their repayment vehicle monitored regularly either by an IFA or by a suitably authorised department at their lenders?
One assumes it was because it didn’t have the nerve to rock the boat by radically reducing the supply of a product that was selling like hot cakes at the time. The convertible protection product, on the other hand, was a recent innovation that had yet to catch on.
If compulsory investment monitoring had been introduced in 2004 providers would have probably pulled the plug on interest-only mortgages even more quickly than they have done recently – many providers have significantly tightened their lending criteria during the last three years and recent months have even seen The Co-operative Bank and Nationwide withdraw altogether for new borrowers.
If the administrative hassle involved with assigning repayment vehicles or even just asking for details of their existence proved uneconomic then so would the task of regular internal monitoring of investment performance or of having to liaise with a third party that does so! Indeed, the recent tightening of lending criteria seems directly attributable to now groundless fears created by the regulator itself during its original MMR discussion paper in 2009.
Ray Boulger, senior technical manager at John Charcol, points out that the original 2009 MMR
proposal was that lenders would have to recheck repayment strategy at outset and monitor it several times during the mortgage term, but that this has been subsequently watered down to having to check it at outset and only once further during the mortgage term.
He says “The original proposals would have placed a huge responsibility on lenders and this also created fears that they could be sued by clients who complained their investments weren’t on course, although the final MMR wording has made it clear they can’t be held liable in this respect.
Banks and building societies are talking absolute rubbish when they say there is no demand for interest-only mortgages because they have been tightening up the criteria so much during recent years that most people can’t meet them.”
Interestingly, Nationwide spokesperson Steve Blore does acknowledge that regulatory fears played some part in his company’s withdrawal.
“Lack of demand was by far the most important factor, and it was a commercial decision taken before the MMR was published,” he says.
“But we could see there could potentially be an issue if there was a burden on the lender to check that repayment vehicles were suitable as we would in effect have to create a team to do it.”
However, there could perhaps now be some mileage in restricting new interest-only mortgages to more sophisticated borrowers able to demonstrate that they don’t need the security of regulation.
This would certainly have been harder to implement during the heart of the mortgage boom in 2004 but would seem well worth considering now that new interest-only mortgages have – according to the CML– decreased to less than 10 per cent of all new residential mortgages this year and to only 2 per cent for first-time buyers.
Anyone currently wishing to opt out of receiving mortgage advice by virtue of being a high net worth investor must currently have a minimum net annual income of £300,00 or minimum net assets of £3m.
But allowing more financially aware fairly affluent borrowers an ability to opt out of regulatory protection based on a combination of considerably lower financial limits and an ability to demonstrate significant relevant knowledge might encourage lenders to relax their criteria.
“Most of our clients are in control of their finances and are taking interest-only mortgages out of choice rather than necessity,” says AFP Partnership senior partner Mark Banfield.
“But they are being locked out by lenders taking a one-size-fits-all approach and are lumbered with their current lender’s standard variable rate because they can’t move on an interest-only basis.
“So lenders are ignoring the profitable centre of the market.”
The Government is prepared to place those who indulge in buy-to-let beyond the scope of regulation, and many of them have no claims to being considered high net worth individuals.
So perhaps the FSA should be showing a little more faith in the comfortably-off who are financially astute enough to realise that having an interest-only mortgage can have advantages when income is irregular or can simply make far more sense than renting? Doing so could maybe help atone –however slightly – for its previous regulatory nap in this area.