Over the past few years, lenders have depended on short-term pricing models as they have concentrated on customer acquisition. But this has meant they have also suffered from diminishing margins. Now, they are reviewing their options and any changes in strategy will affect pricing models. So to what extent will the market change in the near to medium term?
Recent events in the US sub-prime mortgage market and factors such as the rise in UK base rates, regulatory interest in fee structures and the Treating Customers Fairly initiative, the Basle II provisions as well as the onward march of technology might have left some people wondering what pricing in the specialist mortgage market will look like in the coming months.
The biggest recent supply side changes to affect the market have come from regulation, the continuing high level of competition and the growth of the securitisation market. And the increasing demand by investors for quality residential mortgage-backed securities means there is still an appetite for better margin lending lower down the credit curve.
Sub-prime mortgages have be-come popular investment vehicles, carrying high enough returns to offset any perceived risks. Their attractiveness in the UK – especially to US investment banks and hedge funds – has only been enhanced by difficulties in the US market.
The flight to quality away from the tarnished US sub-prime securitisation market means more demand for securitisation in the UK. As long as we avoid cross-contamination from the US there will be a demand for sub-prime loans and the investment opportunities they provide. But will we escape contagion?
The trend in mortgage-backed securities in the UK shows upward pressure on pricing, particularly where these are mixed origination sub-prime loans. In-vestors are showing some early signs of caution, so watch this space.
On the regulatory front, the Financial Services Authority introduced regulation at a cost that has been borne by brokers, lenders and the public. That cost continues to make itself felt. What’s more, the increased focus on charges such as exit fees and early repayment charges means margins are being squeezed in areas previously felt to be impregnable. And there is more to come.
The imminent implementation of Basle II and the ad-vanced, internal ratings-based approach to capital means lenders will use their own models to calculate the capital they require. This will allow many to return capital either to shareholders or reinvest it in pricing and product development.
These supply side pressures and opportunities have given rise to a plethora of new lenders and also raised questions about the viability of present business models. The debate about the validity of trail commissions has again become high profile, and some lenders have changed their business models. Our model incorporates elements of profit-sharing to deliver long-term value to our distributors and also to align interests between brokers and lenders. This is a new feature in this market and is intended to benefit brokers, lenders and customers.
On one level, it has never been so attractive to set up a new lender or lending brand. The attraction of a clean start means lenders can minimise overheads, make the most of technological advances and reinvent the way mortgages are priced and brought to market. This means loans can be priced competitively and small gains in market share can be made quickly, given the right business model, reputation and connections.
The use of technology to provide decisions in principle, underwrite and even audit for securitisation means there is room for cost reduction without compromising responsible lending standards. But the effect on established players has prompted some loosening of credit criteria in an attempt to protect market positions without compromising margins.
The push for technological solutions highlights the desire of lenders to cut costs, but it’s important that lower costs don’t result in higher risks.
Finally, macro-economic influences are helping fuel the demand for sub-prime loans. Base rates may not have peaked at 5.5%. The Monetary Policy Committee was careful not to cite strength in fuel, food and furniture prices as the reason for April’s inflation surge. Instead, it pointed to increased company pricing power as the justification for its bearish outlook.
Higher interest rates mean more remortgaging as well as more people slipping into difficulties and need-ing specialist solutions. Until len-ders decide they want no more of this business, rising rates will fuel de-mand for sub-prime loans.
It’s tempting to say that in the short to medium term, the specialist broker’s lot will not be a bad one. Regulation means overheads are higher, but there is less competition. The demand side pull for specialist lending combined with the supply side push means proc fees are continuing to rise.
Of course, TCF remains high on the agenda but regulatory adherence amounts to little more than good business practice. In the longer term, the call from some in the industry to adopt trail commissions tells you all you need to know about the high level of proc fees. Unsustainable in the long term they may be, but not in the short term.
The combination of growing borrower and investor demand for sub-prime business is a heady cocktail for the specialist market. It should reassure brokers that lenders will remain keen to be in this arena and therefore price competitively for some time yet.
With proc fees north of 1% in many cases, this is good news for brokers who manage their clients well. Lenders will need to maintain a careful balance between responsible lending and survival. Desperate to remove cost and protect margins, many are finding it difficult to meet targets – mutuals, in particular. Margins may be narrowing but that is simply a fact of life when playing this game.
Until there are fewer lenders, that equation can’t change, so if present conditions continue, sub-prime will be fruitful for some time to come.