Grave concerns
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There are fears that interest-only will struggle for survival if the MMR proposals become law, with the CML leading the charge against them. But some in the industry believe it’s right to restrict the product
Could the Mortgage Market Review be the end of interest-only? The Council of Mortgage Lenders and many in the industry are worried that the Financial Services Authority has effectively buried self-cert and seems to be starting to dig the grave of interest-only.
The second MMR consultation paper in July called for two major changes to be made to interest-only. First, lenders had to assess affordability on a capital and interest basis, even where the loan was going to be taken out on an interest-only basis.
Second, the regulator argued that interest-only should only be used where a valid repayment vehicle is in place. And a valid repayment vehicle in the regulator’s eyes would definitely not include relying on future house price inflation and downsizing to a smaller property.
Lenders would also have to check that the repayment vehicle was valid at the outset and, unless the product was guaranteed, monitor the existence and adequacy of the repayment method by regular inspections throughout the life of the mortgage.
It’s the latter stipulation - checking up on how the repayment vehicle is performing - that seems to be the main element that will cause interest-only to be laid to rest if it makes it to the final MMR policy document.
Lenders will be faced with the cost and complexity of annually monitoring repayment vehicles. Perhaps more important, they will also face the regulatory risk of becoming responsible for the performance of the repayment method. For lenders looking to reduce costs and already weighed down by regulation this could be a toxic combination.
Interest-only can be traced back to the 1970s, but it came into its own in the late 1980s and 1990s, mainly as a result of the tax efficiencies associated with mortgage interest tax relief at source.
But the CML says that following the withdrawal of MIRAS and the increase in complaints around endowment policies in the early 2000s, interest-only deals have been stable.
It estimates the number of mortgages with an interest-only component to be 3.25 million worth £470bn - about 28% of the number and 32% of the value of all outstanding mortgages.
By the CML’s own admission, as house prices surged and affordability was stretched in 2006 and 2007, interest-only accounted for 34% of all new lending at the peak of Q4 2007.
By contrast, the number of such mortgages in Q2 2010 has dropped to just 17%. Several lenders including Lloyds Banking Group, Skipton Building Society and Platform have restrictions on interest-only to make it harder for borrowers to access such deals.
In addition to the £500,000 cap on interest-only mortgages Lloyds group imposed in May 2010, only last week it announced it would randomly sample cases from brokers to ensure repayment vehicles were in place (see box overleaf).
Lloyds group seems to be leading the way with interest-only restrictions - it placed the £500,000 cap two months before the second MMR paper came out - and it will be interesting to see how many lenders put similar measures in place.
But not everyone is unsympathetic to what the FSA is attempting to do. The regulator admitted as much in the last MMR consultation paper when it said that in their responses to the first MMR paper some had called on it to go further with the restrictions it was looking to place on interest-only.
There are those that see the 17% interest-only lending figure as a positive sign. Speaking to Mortgage Strategy TV two weeks ago, Tony Ward, chief executive of Home Funding, argued that the FSA was taking the right course to re-establish the boundaries.
“Interest-only loans should have been niche products,” he says. “They were in the 1980s and 1990s but were misused by large lenders. I’m not surprised the FSA has made it clear that interest-only should not be used in the same way going forward.”
Charles Haresnape, group mortgage services director at Connells, agrees with Ward that the scope of interest-only should be drastically reduced.
“I’m not saying it should be regulated out of existence, I’m saying it should be rare and that much lower numbers of cases should justify interest-only,” he says.
He argues that the CML’s own data proves this point. With interest-only accounting for 34% of all lending at the peak of the market, Haresnape says this was a sign affordability was stretched and that many borrowers could not afford the capital and interest repayments as house prices rocketed.
“The CML’s evidence seems to suggest that when affordability gets stretched the proportion of interest-only goes up,” he says. “My question is what happens when affordability gets stretched again, as it inevitably will at some point? Does that mean interest-only will increase again? I don’t think that’s the right way to do interest-only - it should be for occasions when it can be justified.”
You don’t have to look far for examples of interest-only loans with a questionable justification. There are plenty of borrowers who have effectively been mis-sold an interest-only mortgage, especially among those above retirement age.
Kevin Friend, strategic partnerships director at Mortgages. co.uk, says he’s seen numerous examples of people in this age bracket being sold interest-only mortgages. He gives the example of a 70 year old borrower who was given a £430,000 mortgage on an interest-only non-verified basis, with the term of the mortgage taking the borrower to the age of 96. He had a £4,000 monthly income that was derived primarily from dabbling in investments. Friend says that when the borrower got into trouble his lender refused to accommodate him, forcing him to sell land he owned and when that failed to solve the problem, the lender gave him further advances that he used to pay off the mortgage.
“Interest-only was totally abused,” he says. ” It is without doubt the area that should be of most concern and is probably the largest reason behind irresponsible lending.”
Despite this, he doesn’t agree with the FSA’s stance towards interest-only and sides with the CML’s attitude towards the product.
“The FSA isn’t looking at this in a logical way,” he says. “It is looking at it from the position of a ’one size fits all’ solution, which isn’t the answer. Interest-only mortgages need to be looked at but I don’t think the FSA has drilled down into the detail or understands what sits behind it. It was irresponsible lending where lenders failed to look at borrowers’ ability to pay at the time or in the future.”
Ray Boulger, senior technical manager at John Charcol, argues that with restrictions already in place we are starting to see anomalies on lenders’ application forms where selling the property or remortgaging at a later point is not deemed a suitable repayment plan. If the MMR is looking to make the market transparent, he argues it’s already failing.
“Most people now are required by lenders to commit mortgage fraud,” he says. “If they’re a first-time buyer or relatively young they will actually expect to repay that mortgage or certainly most of it either on the sale of the property or through refinancing.
“But in many cases lenders will not accept that as the way the mortgage is going to be repaid and insist on some other method.”
While there may be some sense in this, he says that if lenders expect borrowers to be honest on application forms, to then disregard their repayment plan - selling up or refinancing at the end of the initial rate period - seems perverse.
“I would accept that if you were taking out a mortgage at 50 years of age, then interest-only may not be sensible,” he says. “But when you’re 25 or 30 it may be sensible.”
John Cupis, managing director of PMS, argues that what the mortgage industry is facing with the proposed changes to interest-only is the first attempt to impose product regulation on the market.
“FSA chairman Lord Adair Turner said in May 2009 at that first mortgage conference that one of the hazards of product regulation is that you push one button over here and another button comes up over there,” he says.
“And that might be regarding the impact on the housing market or lending criteria. This is the first attempt to interfere with product regulation and we’ve already had a significant backlash. A blanket ban of interest-only would be a mistake and would give lenders and customers a significantly reduced number of options in terms of how to repay a mortgage.”
But aside from the outright mis-selling of interest-only to pensioners, why does the FSA have such a problem with it?
The CML argues that the number of interest-only borrowers who face a shortfall at the end of their term is low.
“Generally, if they do, the lender will seek to extend the term of their mortgage and, if possible, move the borrower on to capital repayment terms,” the trade body said in its response to the MMR’s recommendations on interest-only.
It adds that it is rare for lenders to repossess the property and that they are not seeing significant losses from interest-only customers. In other words, the majority of customers’ repayment vehicles work. Even the FSA concedes in the MMR that there may be circumstances where the sale of property is a realistic option for those with a large family house who plan to downsize when their children leave home. It just says it is unlikely to be a realistic option for everyone.
But the main thrust of the CML’s response has been that the costs and complications that lenders would be lumbered with would cause them to run for the hills. The MMR says unless the repayment method can be guaranteed lenders should monitor the repayment method with regular inspections throughout the life of the loan.
“This could happen through checking on the continued existence of the repayment method, perhaps on an annual basis, with the adequacy of the method checked, say, every five years,” the FSA says in its responsible lending document. “This would ensure that repayment problems are identified as soon as possible.”
It’s the regular annual inspections that has got lenders hot under the collar. The CML has been pretty blunt in its response. It argues that the consultation paper was likely to see the majority of lenders withdrawing from interest-only for owner-occupiers.
“Compliance costs in checking the existence of repayment methods annually will be passed on to customers, significantly impacting on the price differential between interest-only and capital repayment,” the CML says in its response.
“The regulatory risks of taking a judgement on the adequacy of the repayment method will be considered by lenders to be too great.”
Instead it says lenders should have a policy on what are plausible repayment methods for specific consumer groups. That way certain repayment methods - such as selling the property - would be appropriate or highlight vehicles that are high risk such as volatile or complex investments. Lenders would have to validate the repayment vehicle at point-of-sale by getting documentary evidence that it exists. But pivotally they would not be responsible for its performance.
And rather than an annual check-up, the CML says it should only be necessary to pro-actively seek to revalidate the existence of the repayment method once more in the mortgage term.
“This should be at a point where lenders can, in agreement with the borrower, move them on to capital repayment or take other remedial action,” the CML adds. “Our view is that this review should take place approximately seven years before maturity where the original term was for 20 years or more and the borrower has not made proactive contact with lender and is still on interest-only.”
This would be quite a climbdown from what the FSA is recommending and would presumably ensure lenders stay in this market. If the final MMR proposals come out in their current form many in the market are certain it could have serious ramifications for not just the mortgage market but house prices as well.
Interest-only loans should have been niche products. They were in the 1980s and 1990s but were misused by large lenders
“There are a lot of situations where interest-only is the sensible solution and if the FSA proposals go ahead in their current form a lot of borrowers will be disadvantaged as they won’t be able to get the most appropriate mortgage for their needs,” says Boulger.
“What the FSA is doing is meant to help consumers but it seems to be taking the view that if it eliminates 100% of risk then we’ll avoid being criticised in the future. But it’s ignoring the fact that if it removes 100% risk it eliminates most mortgages being sold.”
This is a concern shared by many in the market. The CML published a report last week that revealed some 50% of all mortgages taken out in the last five years would not have been available if the last consultation paper was implemented in its current form. With the housing market on life support, the simple argument is that if you restrict access to finance further, prices will inevitably tumble.
“Interest-only is a great payment method for thousands of borrowers,” says Friend. “If it was no longer available it would leave a massive gap in the market and would probably cause the downturn of an already fragile housing market.”
Cupis says it comes down to providers being able to make rational and logical decisions on who they lend to.
“A lender’s job is to assess risk - that is its core competence,” he says. “If a lender doesn’t feel comfortable in assessing an interest-only loan then it won’t lend on it. But if it does it for some reason and can prove it’s a good decision and can demonstrate that to the customer, the regulator and the intermediary, let it get on with it.”
There is no getting away from the fact that some abuse of interest-only occurred in the run-up to the credit crunch. But unless the government’s plan is to reduce house prices to such an extent that affordability is more in line with average earnings - great for first-time buyers but disastrous for the rest of the country and the government- then axing interest-only would reduce the chances of many of them ever getting a foot on the housing ladder.
The industry’s ultimate concern is that if the FSA brings in measures that put interest-only six feet under, it is digging the grave of the housing market.
Interest-only can be useful
ANDREW BADDELEY-CHAPPELL
HEAD OF MORTGAGE STRATEGY AND POLICY
NATIONWIDE BUILDING SOCIETY
The interest-only market has come under increased scrutiny recently, which has highlighted the issue of how far regulation should protect consumers from themselves, without suffocating a restricted market.
The FSA had previously parked this in the ’too difficult’ box but has now been spurred into action by feedback from the original discussion paper last year.
There are two polarised views of mortgages. The first is that the purpose of a mortgage is to ensure you can own a property outright in which you can then live when you retire. To ensure this is the case you require a repayment mortgage whose term ends before retirement.
The second is that a mortgage is a source of low cost finance and property is many customers’ most valuable asset. The mortgage acts as a valuable source of funding for a range of activities, in particular if the capital does not need to be paid off over the mortgage term. This flexibility means the certainty of outright ownership cannot be guaranteed through the mortgage.
In practice most customers fall between these two positions. They aim to repay the mortgage in full but are willing to use it for wider purposes than just home ownership. It therefore follows that interest-only mortgages are not in themselves bad or high risk, and they can provide a useful solution to borrowers who require lower mortgage payments for a short period of time, such as first-time buyers, or those who have an established means to pay off the capital.
In a world of grey, black and white will regulation be able to draw an appropriate balance?
So in a world of grey, can black and white regulation draw an appropriate balance? Or, as FSA chairman Lord Adair Turner has noted, will the price paid by those customers who are deprived the opportunity to make sensible informed decisions be too high?
I suspect the combination of an intrusive and intensive regime, a transfer of responsibility from customers to lenders, and a general expectation that the market will be judged with the benefit of hindsight, as well as the standards of tomorrow, will mean most lenders think twice before taking the risk.
If lenders continue to lend on an interest-only basis it is likely to be in niches, where the risk of a poor customer outcome is largely eliminated.
Lenders are likely to shy away from lending that requires regular review assessment and valuation of repayment vehicles.
Customers will not be permitted an alternative approach, however much they may like to do so.
For some vulnerable customers this will avoid the temptation of money-now, pay-later. But an indisputably larger group will lose the valuable freedom to manage their finances in a way that reflects their own appetite for risk and their plans for the future.
Robust advice is the right route
ROBERT SINCLAIR
DIRECTOR ASSOCIATION OF MORTGAGE INTERMEDIARIES
The Association of Mortgage Intermediaries believes the future for interest-only is brighter than many think.
Despite the fright taken by some lenders that appear to have approved more than their fair share of this product, it is clear many good brokers have solid evidence of a repayment method, although this may not be as detailed as a full repayment plan or a comprehensive repayment vehicle.
While the Financial Services Authority has been asking questions and consulting, some lenders have already adapted their position on interest-only due to changing market conditions and their perceptions of risk, by altering their criteria and restricting access to certain customer groups. This appears to be much more about their own risk appetite and what might happen later on customer complaints than pressure by the FSA.
But through all the work on the Mortgage Market Review and to re-establish a fully functioning mortgage market it must be remembered that the credit crunch was driven by the closure of capital markets and the inappropriate risk assessment of securitised mortgages. It was the bad use of these mechanisms that led to the bank bailouts.
If the FSA conducted a proper root cause analysis it would have different solutions to those proposed
If the FSA conducted a proper root cause analysis it would have led it to that answer and therefore different solutions to those currently proposed. Its apparent aversion to a type of borrowing that has served many consumers well might be misplaced. It is also to be hoped that we will not see the implementation of some of the more interventionist suggestions.
When such products are delivered on an advised basis and with a robust assessment of appropriateness for the customer, there is a relevant place and use for interest-only mortgages. Suitable advice is the key to ensuring that the method by which the consumer takes out a mortgage is appropriate for their circumstances.
We believe the majority of consumers will still opt for a capital repayment mortgage. For those who consider an interest-only mortgage, allowing them to only be sold on an advised basis would provide consumers with the enhanced service and protection they require.
It would also ensure that an approved person is accountable for assessing the suitability of interest-only mortgages for borrowers’ circumstances. This is not an affordability issue on day one or subsequently.
It is the appropriate use of a funding route which, with appropriate risk assessment, should leave individuals no worse off. We must ensure we do not sacrifice a good choice for many on the altar of perfection.
It is the broker community that is best placed to deliver these good outcomes for consumers and we must deliver this message repeatedly to the FSA and others.
We must create a framework for interest-only to be a responsible choice
PETER CURRAN
HEAD OF INTERMEDIARIES
LLOYDS BANKING GROUP
Back in May we announced that we had conducted a strategic review into interest-only lending. We were the first major lender to review our approach to interest-only lending in this way, which prompted the inevitable why? First and foremost, we want to be able to continue to provide borrowers with an interest-only option. In the right situation, it absolutely has its place.
But it’s not always going to be right and, given its increasing popularity, it was the right time for us to take a look at our approach.
That’s not to say that we were experiencing any problems with borrowers unable to pay - but we had to be sure things would continue that way.
We welcome that this is also being addressed as an industry issue by the FSA in the Mortgage Market Review. Despite concern that the regulator is looking at this market, we should all be mindful that many lenders have already taken steps to address the concerns that were raised in the early consultation stages.
One issue we needed to address was the sentiment that interest-only mortgages would be considered as a cheaper alternative to repayment mortgages, with little consequence paid to the significance of the choice. Maintaining a suitable repayment vehicle is a real responsibility and should not be taken lightly.
Another key issue consideration was a review of which repayment vehicles are acceptable. Few people would disagree that borrowers should not be able to rely on the sale of their home to repay the capital. Similarly, the sale of a business or inheritance cannot provide any certainty of what they’ll be worth at a given time in the future.
We are introducing a sampling process whereby random cases will be selected after the offer stage and brokers will be asked for a copy of supporting documentation for the repayment vehicle stated on the application. This is the responsible thing to do - for the lender, the intermediary and the borrower.
As a process, it’s nothing new. We conduct random sampling for other elements of the application so, given its importance, it makes sense for us to adopt the same approach for repayment vehicles.
With a commitment to responsible lending, we still believe that there’s a place for interest-only in the market. But as an industry we have to take action and continue to make sure the right framework is in place for interest-only to be a responsible option in the right circumstances.
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