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Welcome to sub-prime, but beware

New entrants in the sub-prime sector must understand the complexities involved, but the increased competition should be welcomed by brokers and customers, says John Webster

I worked in the prime market in a previous life, so when I was first approached to join Preferred I asked a friend working in sub-prime what the sector was like. He told me it was just another product range. Of course I now know that isn’t true. It didn’t take long to ascertain that sub-prime is a completely different animal from prime, with a completely different culture.

Barely a week goes by without the announcement of another new entrant to the sector. Most recently, it was revealed that Derbyshire Home Loans – part of the Derbyshire – and West Bromwich are launching into the marketplace, and the rumours about Deutsche Bank’s plans to follow suit intensified when it recruited Bill Dudgeon and three of his colleagues from The Mortgage Business.

And it’s not only mainstream lenders that are looking to diversify. Beacon launched a sub-prime lender in August and it is possible that other packagers will do the same.

There is no denying that sub-prime lending is attracting increasing interest. So what’s the big attraction?

To a prime lender, the increased margins available on sub-prime business must be appealing. But there is an obvious and straightforward reason for these margins – the risks are greater. If new lenders don’t fully understand the risk pricing model before launching their products it will be a dangerous and expensive endeavour for them.

Arrears in this sector are higher than in mainstream lending and the costs of collection might well dent the profit margin that seemed so attractive in the first place. It is essential that lenders looking to enter the sector do their homework.

They must understand a variety of factors including the risk pricing relationship, the multi-faceted nature of sub-prime product design, the importance of developing excellent relationships with intermediaries who distribute sub-prime mortgages, the possible complications that come from lending to individuals with County Court judgements and arrears, and the different systems required to service and manage sub-prime business.

The same is true for any packager who decides to follow Beacon into the lending arena. The directors at Beacon – including Mark Abbott and Brian Pitt – have considerable experience in sub-prime lending but other packagers might not have the same lending knowledge and skills available. A packager will obviously be able to draw on its experience of the sub-prime market when embarking on such an endeavour but should not underestimate the nature and extent of the challenges involved in becoming a lender.

The nature of sub-prime lending is complex and the necessary skills and understanding can only be learnt over time. A good sub-prime lender should foster a harmonious balance between its sales and credit teams despite the potential for conflict between the two.

A lender would be foolish to consider entering the market without first researching all these ingredients. It could be detrimental to customers if the realities of sub-prime were to result in an unprepared entrant having to make drastic revisions to its products soon after their launch or even, ultimately, withdraw from the market.

A Mortgage Strategy poll in July asked intermediaries whether they thought the sub-prime market was overcrowded. A total of 26% of respondents said it was and that there was no room for new players, while 74% recognised that more competition could lead to more competitive products for themselves and their clients. This is an important issue as the market might be getting crowded, rather than overcrowded. And it is becoming increasingly competitive as every lender strives to retain or improve its position in the market.

Offering lower prices and rates means falling margins so it is crucial that lenders gain competitive advantage. It’s a tough market but this has led to increased product innovation and lower rates and charges.

This all seems to be proving profitable for intermediaries, with a MarketView survey published in July revealing that 63% of sub-prime brokers saw an increase in business that month compared with 33% of brokers in the general market.

Increased competition is a good thing for customers as it will bring better products at cheaper prices. A few years ago, an individual with adverse credit would have had limited options but now specialist lenders cater for several levels of adverse and there are plenty of sub-prime products available. And now near prime rates are moving ever closer to those offered by mainstream lenders.

It will be interesting to see how the sub-prime sector evolves in response to the increase in competition. Will there be even more development of different levels of sub-prime? Will more lenders in the sector shape their business strategies according to the cost savings they can reap through technological advances, rather than the needs of customers?

There is speculation that the approach of some sub-prime lenders to the market is beginning to replicate the high street practices that led to the birth of the sub-prime sector in the first place.

Ultimately, we should not lose sight of the customer’s needs and that is why new lenders must make sure they fully comprehend the complexities of the sub-prime sector before jumping in – and why existing lenders and intermediaries should welcome the competition.


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