The idea behind sub-prime lending is simple. As the prime lending industry develops in any country it will define the customers who do not fit the existing underwriting criteria as sub-prime or non-conforming. Sub-prime lenders offer mortgages to these borrowers who are deemed too risky by prime lenders.A higher rate of interest is then charged to cover the extra risk. The percentage of the market which is defined as sub-prime depends on demography, culture, regulation and macro-economic conditions. So, it is clear sub-prime mortgages have enormous potential worldwide. Every country that has, or will have, a recognisable mortgage lending industry could in time develop a sub-prime sector. The US has the most mature sub-prime market in the world but other countries are following in its footsteps. Sub-prime is already an important part of the mortgage markets in the UK and Australia and will in time be a feature of markets the world over. Prior to the emergence of the sub-prime sectors in the US, the UK and Australia, each country had an established prime mortgage market and a largely deregulated financial sector, combined with a culture of home ownership and a stable macro- economic environment. As such, they provided ideal developing grounds for sub-prime. Using these markets as examples it is possible to trace a developmental pattern for sub-prime markets around the world. Initially, a few small scale operations enter the market – Kensington is the obvious example in the UK. These companies are able to tap into the previously ignored borrower base outside prime lending criteria. Marketing products through brokers, the first entrants tend to design high rate products aimed at more heavily adverse customers as they try to differentiate themselves from the prime players. With little competition in the early stages, potential rewards to lenders are significant. High profits attract a greater number of companies which in turn leads to margin compression as price competition increases. From the examples of the US, UK and Australia it is clear competition stimulates greater product diversification as companies try to attract a broader range of borrowers and exploit niche markets – such as buy-to-let and self-cert – to sustain growth and profitability. This process goes hand in hand with a growing understanding of, and ability to price, risk. Interest-only mortgages and discounted products emerge at this stage. The sub-prime market is likely to grow considerably during this period Tas both the range of products available and the public awareness of these products increase significantly. The next stage of development is marked by more sophistication. The use of technology increases as credit scoring begins to play a part in the increasingly sophisticated approach to risk, and technology allows further improvements in efficiency and service. Technology also allows lenders to focus on their distribution strategies. Sub-prime markets rely heavily on intermediaries as a source of originations. Direct marketing is expensive and only a small proportion of the population will require sub-prime mortgages. Improving the efficiencies and rewards for packager and broker distribution through online lending platforms is a great competitive advantage and drives overall market growth. Another area of development is funding. Many early entrants to sub-prime lending are non-deposit taking specialist lenders. These firms will typically use warehouse lines from major banks to finance their business. This leads to a need to refinance regularly according to the terms of the warehousing agreement. Initially this can be problematic as the volumes generated are insufficient to make securitisation cost-effective. One option is small-scale whole loan sales which involves a lender selling a pool of loans to another institution. Future Mortgages, the first seller of whole loans in the UK, was a case in point. As companies grow, the volumes of assets generated are sufficient to make securitisation viable. Then companies may develop a mixed strategy of sales and securitisation. The UK and Australia can be thought of as second tier markets with Australia lagging slightly behind the UK. The sub-prime sectors in both countries comprise an important element of the mortgage market. But they have not reached the level of maturity seen in the US. The UK market developed in the early 1990s as a result of de-regulation and the prevalence of credit impaired borrowers. It has followed the life cycle set out here, with considerable growth after the turn of the millennium. It now accounts for around 14% of the national market compared with 20% in the US. Australia lags, with 6% of the market taken by the sub-prime lenders. Improved technology and more sophisticated funding options have been developing in the past few years. Players in the UK are starting to reach the stage at which competition and macro-economic conditions are squeezing margins and market share. This is driving a need for efficiency gains as lenders fight to maximise both volumes and profit. Some lenders have launched online decisioning systems and others are sure to follow. As the use of technology trends ever upwards there are likely to be interesting developments in the mortgage software area. Neither the UK nor Australia has a state-owned Fannie Mae equivalent purchasing loans, nor a FICO credit scoring system so there is limited drive for a technology standard to develop. Instead, companies build or buy tailor-made software, seeking competitive advantage where they can. But uniformity is a major goal of some software. For example, the logical end point for sourcing software is a sourcing engine that covers all products. Once such software exists, brokers will not require an alternative. As the technology becomes more sophisticated so the funding mechanisms will become more efficient. Both whole loan sales and, to a lesser extent, securitisation are quite labour intensive activities at present. As the lenders and servicers in the UK and Australia become more technologically advanced, the movement of loan data and performance statistics will become much easier. As this happens the secondary market for mortgage loans will become more liquid, allowing a greater range of financing options for new-start and established lenders. Sub-prime mortgages have great potential in other sizable, well developed mortgage markets around the world. Many European countries have significantly deregulated their financial markets, opening themselves up to a more sophisticated mortgage market. The Dutch market has already shown some signs of developing risk-based pricing. The market in Spain, which has previously had an unsophisticated range of products, is developing rapidly. More flexible products are becoming available such as interest-only and self-cert deals, and products with optional payment holidays. Germany too has big potential as the culture of renting property long-term gives way to a trend toward home ownership and years of economic problems give rise to a significant sub-prime population. The emerging markets of Eastern Europe must develop coherent prime mortgage sectors before sub-prime can take hold but the prospects for growth are considerable in the long term. Outside Europe, mortgage markets in countries such as in Malaysia are developing quickly. They are often aided by governments enthusiastic for greater home ownership and fostered by investors hungry for residential mortgage backed securities. It’s only a matter of time before a recognisable sub-prime element emerges. The development of the sub-prime element here and abroad should be welcomed as a way to open up home ownership to those denied it in the past. The sub-prime market will develop wherever there is demand from borrowers that prime lenders are unable or unwilling to satisfy. There will always be differences in law, culture and demography across sub-prime markets, but the principles behind successful sub-prime lending remain the same. The companies that combine efficient funding with accurate risk pricing and product design, not forgetting high levels of service, will succeed in sub-prime markets anywhere in the world. Mike Culhane is chief executive of The Oakwood Group
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