There has been significant growth in the number of lenders offering secured lending to people with credit problems including those who have been bankrupt, have County Court judgements against them and for purposes such as debt consolidation.
As consumer credit debt tops an eye watering 1.2 trillion it’s no wonder that the big lenders in the UK and some from abroad have been falling over themselves to get a slice of the growing sub-prime cake.
But brokers should show caution. This article examines the evolution of the sub-prime market and the implications for those who are active in it. From a broker’s perspective, get your sub-prime business wrong and the consequences could be serious.
Several factors caused a growth in demand for sub-prime mortgages in the mid-1990s. These included mainstream lenders automating their credit scoring procedures, more people with debt repayment problems, more marginal borrowers seeking loans for home ownership and, in the late 1990s, soaring levels of borrowing for consolidation of debts as interest rates rose. Since the early 1990s a range of factors have created circumstances in which both the demand for and the supply of sub-prime lending has flourished.
After the 1990s recession, more people had suffered some episode that had harmed their credit rating, whether from repossession, falling into arrears with housing or utility payments, having had a CCJ or being made bankrupt.
Reflecting broader labour market changes, more people had contract or flexible terms of employment, and income that was variable or hard to confirm.
Mainstream lenders who had also suffered during the housing recession reacted by exercising extreme prudence in their lending, particularly using mechanised and centralised credit scoring mechanisms to select only low-risk borrowers.
The sub-prime sector started to evolve in the mid-1990s with the entry of specialist lenders. They saw a niche for taking a more individualised approach to underwriting and pricing the risks involved. Luckily a buoyant property market has covered up deficiencies in risk pricing models. Prices have more than doubled in the past decade, so let’s not heap too much praise on sub-prime lending actuaries.
A higher proportion of borrowers in the sub-prime sector are in arrears than in the mainstream sector, as might be expected (around 15% in 2005). There is also evidence that sub-prime lenders move towards possession more quickly once arrears start to accumulate on first and, especially, second mortgages.
There is now a raft of specialist sub-prime to sub-prime lenders who are mopping up heavy adverse clients – High Street Home Loans, Blemain, Preferred and Swift to name but a few.
Competition seems like good news for sub-prime clients and brokers. There have been several new entrants in the UK sub-prime mortgage market. Deutsche Bank has entered the fray, as has edeus headed by the ubiquitous Michael Bolton. Others lenders of note include Mortgages PLC which is backed by Merrill Lynch. It is making inroads with innovative products, keen pricing, technology and sales support.
Advantage (now owned by Morgan Stanley) has entered the ring too. GE Capital, GMAC-RFC, BM Solutions, Money Partners, Platform… the list goes on. None of these organisations are here to dabble. They want serious market share and that means sacrificing margin to get to the top of sourcing system best buy tables.
When lenders compress margins, other things can suffer, such as commission payments. At the near prime end of sub-prime there is little difference between rates offered by high street lenders and commissions paid. If there is a sustained price war – and the signs are one is underway – only lenders and brokers with healthy balance sheets will survive.
That could mean the end for a number of niche players. Its like the corner shop taking on Tesco. There will be casualties and collateral damage. As a broker, that niche sub-prime len- der you recommend may not be around forever.
Clearly sub-prime lenders fill a market gap. They allow entry to owner-occupation for those who are able to repay but fail high street criteria. They allegedly offer credit repair to borrowers who, if they maintain repayments can re-enter the mainstream market.
There is an important qualification to make here. Sub-prime lenders in the main will not actively credit repair their clients. It would be nice to assume that your sub-prime client who has suffered the ignominy of higher interest rates would automatically get a rate reduction if they paid their sub-prime mortgage for two years.
That’s not how it works. Sub-prime lenders securitise their lending portfolios and that means investors who buy these juicy mortgage-backed bonds expect a decent rate of return. Managing these cleansed clients to a better rate would put them at loggerheads with investors so customers miss out. Brokers and IFAs need to remain vigilant and manage their cleansed clients back to prime rates with high street lenders or face the wrath of the FSA which is taking an ever closer look at this market segment. More on that later.
Record levels of consumer debt has mean that debt consolidation has become popular. Consolidating can provide a fresh start for someone whose borrowing has become unmanageable. Sub-prime borrowers are higher risk overall and face higher interest rates and charges than mainstream borrowers. They also face higher charges. Risk and reward is a fundamental business principle There is evidence that sub-prime lenders are relatively quick to pursue repossession and impose high charges to borrowers in arrears.
Repossessions in 2006 doubled in number compared with 2005 – a worrying trend and one which would gain real momentum if property prices headed south.
This can lead to a downward spiral for borrowers through repeated remortgaging from lenders at increasingly higher rates and worse terms due to increasingly poor credit records. This is an area of significance to mortgage brokers and IFAs, and one that could come back and bite the unwary.
Now for the FSA perspective. Its initial review of sub-prime lending is no doubt the first of many more detailed ones as it begins to understand the complexities of the market. In its initial review the FSA was concerned many firms could not show that they had gathered sufficient information in certain areas to demonstrate the suitability of a sub-prime product. All information gathered for the purpose of assessing suitability needs to be recorded.
The FSA has sounded the warning bell, reminding brokers that they must have regard to all relevant facts about a customer of which they should reasonably be aware when selling a sub-prime product as well as those that a customer has disclosed. Sounds ominously legal to me.
It also says firms must determine what is relevant when dealing with each customer, but in particular brokers must understand and document a customer’s credit history including an awareness of their debt position, details of existing mortgage arrangements and income and expenditure information to assess affordability.
To show suitability firms can use a fact-find document to evidence that all requirements have been discussed and considered with the customer, completing a checklist as a means of showing that additional considerations have been reviewed.
It’s only a matter of time before the FSA starts to enforce its Treating Customers Fairly principles. Those in the sub-prime sector can pay significantly more for borrowing than in the mainstream sector. While this might appear unfair in that it is the vulnerable who pay the most, the question is whether such borrowers pay more than is warranted by the extra risk they present.
Some pundits express concern that people may be tempted to borrow more than they can afford. Spiralling levels of consumer debt back this up.
There is no doubt the FSA will soon start to monitor what is being done to credit repair sub-prime clients. Leave a cleansed client on higher sub-prime rates longer than is necessary at your peril. TCF principles are there for all to observe, and the FSA – as it proved recently with some hefty fines – does have teeth. This is not a pleasant thought.
The sub-prime market is set for a period of competition and consolidation. Factor in the FSA and its principles-based management and it’s clear that you can’t just play at sub-prime lending.
Unless you have critical mass and sub-prime is a significant proportion of your business mix tread carefully because there is no doubt the FSA will claim more scalps. It might even be a good idea to refer this business to a specialist sub-prime mortgage broker and sleep easy.
Thomas Reeh is chief executive officer of Blackandwhite.co.uk