John Heron, director of mortgages at Paragon, explains how the firm dealt with the fallout of its exit from the buy-to-let sector and why, despite the market turmoil, this is the right time for a comeback
Back in 2008 the buy-to-let market was battered, bruised and struggling to survive. But before the credit crunch hit the sector had been booming. The rise in property porn television meant everyone wanted to try their hand at being a landlord.
Credit was easy to come by, house prices were constantly increas-ing and it seemed impossible not to make a profit. Then the bubble burst. The liquidity crisis developed into a credit crunch and the dream of buying a home almost disappeared, never mind owning homes to rent out.
In February 2008 the sector was rocked further when Paragon, one of the biggest names in buy-to-let, ceased new lending – the strongest sign that the sector was on its knees.
But two and a half years later it’s a different market again. Latest data from the Council of Mortgage Lenders on buy-to-let lending shows it’s on the up. With a 12% rise in Q3 2010, the sector has been heralded as like the Greek god Atlas holding the rest of the industry on its back.
Aside from the increase in lending, another reason why people are so upbeat about the sector is that after its self-enforced exile Paragon has returned to lending. In September 2010 it announced it would offer buy-to-let mortgages again after securing a £200m revolving warehouse deal with Australian Macquarie Bank.
John Heron, director of mortgages at Paragon Group, says the decision to pull out of the market in 2008 was carefully considered.
“We are a business that has always securitised mortgages,” he says. “We were the first organisation to securitise mortgages in 1987 and
we’re certainly one of the most prolific issuers of mortgage-backed securities.
“We picked up straight away that something was wrong in the market in August 2007.”
Heron says that in just a few weeks it became clear that the sector wasn’t going to recover quickly so the management decided that ceasing lending was the best option. But it had to be done correctly.
“What’s critical in maintaining your integrity and ability to return to the market is the way you run your obligations down,” he says. “If you crash in a blaze of glory and leave your customers and intermediaries high and dry they don’t forget that in a hurry.”
Instead Paragon planned an orderly rundown of new lending that took place over December 2007 and January and February 2008.
“By February, when we made our last loan, we’d fulfilled every outstanding obligation,” he says. “I think the intermediary market appreciated that we’d gone to extraordinarily lengths to control it.”
Key to this was communication and Heron says he and his team made sure brokers were up to speed with what was happening.
“It was clear by Christmas 2007 that these were extraordinary events,” he adds. “Because Paragon was a business that had been securitising for so long, the fact those markets were closed and looked as though they were going to remain closed for an extended period, we knew it was a radical situation.”
It became apparent that the business would have to be positioned for a different environment, specifically a financial crisis.
“To some extent we’d been doing that for years,” he says. “Our approach was to be cautious and build the business robustly so it could survive a downturn.”
Heron says the lender had a reputation for being a picky underwriter and being fastidious over its assessment of property.
“I think sometimes it irked the intermediary market,” he adds. “We asked an awful lot of questions about the landlords we would lend to and maintained our own team of surveyors and would have to see every property we would lend on.
“As a result of that, when times got difficult the portfolio of mort-gages was robust. Our arrears rates were low, as were our losses.”
Of course, this isn’t to say none of Paragon’s customers suffered in the credit crunch. Heron admits that some have been under press-ure, but says Paragon’s three-month arrears are below the average for prime owner-occupied business.
“We’ve seen few repossessions,” he says. “Where we have seen arrears we’ve been able to work things out with landlords in the majority of cases. At the heart of our lending has been a quality letting property.”
Many buy-to-let lenders suffered as the market collapsed. Mortgage Express, for example, was one of the biggest names in the buy-to-let arena that collapsed as a result of parent company Bradford & Bingley’s downfall.
Heron says buy-to-let went wrong for lenders that did not control who they were lending to and the property they were lending on.
“This is how some of our former competitors found themselves involved in city centre new-builds and with too many fraudulent cases,” he says. “The controls were not tight enough.”
In the 21 months since Paragon closed its doors it has focussed on looking after and retaining existing customers.
“That has been made easier by the environment,” he says. “The interest rates our customers are paying are low – 1.5% to 2% over Libor – and that’s attractive compared with the market generally.”
Of course, what has also helped it retain borrowers is their inability to remortgage elsewhere.
“It’s not easy for customers to move around even if they could find a well-priced deal,” says Heron. “So retaining customers has been less of a challenge than it might have been.”
Credit control has also been a high priority.
“We focussed on building and maintaining an enlightened arrears management area, which operates in two ways,” he says. “One is we do everything we possibly can when working with a landlord who is experiencing difficulties.”
There are several ways Paragon can assist including directing its senior managers and surveyors to look at things that are not work-ing in the landlord’s business.
“The majority of times that works well,” he says. “Where it doesn’t we use a receiver rent which allows us to appoint an inde-pendent individual to step into the shoes of the landlord and operate the property as if they were the landlord. And that process has many benefits over a repossession.”
Unsurprisingly, he says repossessions are always traumatic and tend to be destructive of value.
“You’re taking people out of a property and putting it on the market usually at below market value,” he says.
A receiver of rent collects rent on behalf of a lender when the landlord defaults on the mortgage.
“Longer term, assuming the landlord recovers their financial position, you can return the control of the property to the landlord and they get back a property that’s been maintained,” adds Heron.
Like many finance firms, Paragon has also concentrated on building ancillary services.
“They’ve been interesting and varied,” he says. “In the private rented sector we’ve established a tenant assessment service and that works withletting agents to undertake credit risk assessments of potential tenants. That’s been interesting.”
Paragon has also been providing landlords with Energy Perform-ance Certificates and has built up its general insurance service.
“Beyond that we’ve been dealing with the trading of mortgage assets, buying in mortgage and personal loan assets from other lenders,” adds Heron. “We also have a third party loan management service working with a number of clients where we manage the loan book on their behalf.”
But with funding back in place Paragon is now able to get back to performing its primary function – lending.
“We never made any secret of our ambition to return to new lending,” says Heron. “That was our intention from February 2008. But it was critical that the return was sustainable.”
He says it could not take the chance of taking the first funding facility that came along in case that proved inadequate and the lender was forced to withdraw again.
“We have maintained an ongoing dialogue with a wide range of banks and we had been looking around for the right relationship,” he says. “The facility with Macquarie has worked out well. While it may not be as large as we would like, it’s adequate for our current operations. We will continue to talk to a number of other banks.”
The funding allows Paragon to build the critical mass in new lending that’s necessary to get to the point where it can securitise the mortgages.
One would think this is a good time for new investors to enter the market, given the CML’s latest figures, but while lending is up many lenders have tightened their criteria.
“In some ways it’s been an encouraging year for buy-to-let because we’ve seen a number of lenders expand their operations,” says Heron.
“Clearly the market has been dominated by The Mortgage Works and BM Solutions but they haven’t stood still.”
Of the £8.5bn in buy-to-let lending that was done last year – a far cry from the £44.6bn at the height of the market – the bulk of that came from BM Solutions and TMW.
This year though the market has seen a number of new lenders coming into the market at the same time as old lenders such as Paragon have returned.
“Aldermore has been interesting offering both professional and amateur products,” says Heron. “We’ve also seen some of the reg-ional building societies get active such as Norwich and Peter-borough, Principality, Manchester Building Society and a number of interesting offerings from them, and of course we are back in the market.”
Unfortunately for would-be investors, the increase in lenders in the market has not made obtaining a mortgage easier.
“There is clearly greater diversity and some competition among lenders,” says Heron. “Nevertheless because of the impact of the credit crisis lending criteria is tight across all those lenders and margins are relatively wide.”
Platform announced this month that it would not allow borr-owers to switch to a buy-to-let deal and will no longer accept app-lications from self-employed professional property developers and landlords. Also, the maximum number of buy-to-lets individuals can have with any lender, including Platform, will be restricted to five.
In September Lloyds Banking Group limited buy-to-let property portfolios to a maximum of three properties or £2m worth of lending – whichever is exceeded first. Platform’s maximum property expos-ure is three properties or £1m.
“This is partly driven by Basle III requirements on all financial institutions to hold more capital,” says Heron. “If businesses are being asked to hold more capital there is a lower level of funding available for any proposition.”
He adds that the margins on that money are going to be wider because businesses have to get a return on their capital.
“These issue – tighter lending criteria and wide margins – will only improve slowly and will impact on demand in the short term,” he says. “A fairly commonly held view in the industry is that the sort of lending we saw in 2007 – £44bn – is not normal.”
A normal market, according to Heron, is around £20bn to £25bn, something we’re a long way short of. He says 2010’s figure will not be radically different to 2009.
“For the buy-to-let market to expand we need to see more lenders and more competition, and we’ll only see that if funding markets improve,” he says. “Our return is part of the evidence of improve-ment but it’s got some way to go yet.”
Yet while the buy-to-let sector is trying to find its feet again it seems it may be faced with added pressure as a result of the Spending Review, not to mention the changing structure of society. Housing allowance will be restricted to a maximum of £400 a week which could have a serious effect on the private rental sector, especially in high cost areas such as London.
“We have a rapidly changing topography in housing,” says Heron. “We have seen home ownership reduce over the past seven years. We are dealing with a social rental sector that can’t keep pace with demand and will struggle, given the reduction in public spending. We can’t increase the level of properties available in social renting so private renting has to take the strain.”
Heron says that while the private rental sector is capable of carrying this burden the government must ensure it doesn’t dis-incentivise landlords.
“If you’ve created a situation with a shrinking owner-occupied sector and a social renting sector you cannot expand you then demotivate landlords,” he adds. “We’d have the makings of a serious housing crisis.”
Simplifying the many regulations for landlords could help. The National Landlords Association claims that there are now some 50 acts of Parliament and more than 70 sets of regulations governing the private rented sector.
“There are the well known central measures like for houses in multiple occupation but there are all sorts of health and safety measures too,” he says. “We should make it more straightforward for landlords to run their business and not put road blocks in their way because it’s so important that they expand the supply of housing available to tenants.”
With the Financial Services Authority still talking about regulating the buy-to-let market this bureaucracy may increase. At the recent Mortgage Business Expo in London, Guy Garrard, head of business development at Tiuta, asked delegates if they thought buy-to-let would be regulated in 2011. The majority believed it would.
Heron says better explanations are needed of the regulation that could be imposed.
“The debate about regulating buy-to-let has been frustrating because it’s been badly informed,” he says. “It’s one of those things people talk about with little knowledge and without an under-standing of how the sector is structured or who the landlords are.”
The role of professional landlords, he says, is particularly misinformed.
“There are around 1.2 million landlords in the UK,” he says. “But if you look at the distribution of property, 11% of those landlords own 75% of the properties so the role of professionals is crucial.”
Paragon has spoken to the FSA and the Treasury, and the priority is to make sure both understand the market before committing to regulation that may or may not work.
“The FSA’s view is that there were a number of features around buy-to-let lending by certain market participants that have bad outcomes,” he adds. “That may have been centred around city centre flats, buying off-plan and property investment clubs.”
Heron says the regulator’s primary concern was not about the type of mortgage but about the risk the investor was taking.
“It wasn’t about whether the landlord has a two-year fix or an interest-only mortgage,” he adds. “I don’t think they voiced any concern about the
choice of mortgage. It worried about individuals making decisions that might go wrong.”
It is this Heron takes issue with. He argues that if someone buys one, 10 or even 100 properties, they are engaged in the business of being a landlord and it is difficult for the state to intervene in that transaction.
“How does the FSA control that transaction because lenders don’t,” he adds. “Lenders operate a role in financing buy-to-let for those who need finance. The issue is what is it that you regulate and what are the appropriate limits of regulation?”
He says if an individual wanted to buy a retail unit it would be classed as a business decision but because buy-to-let property is a residential there’s a debate about whether it should be regulated.
“At the heart of buy-to-let is a commercial process,” he adds. “It’s a business rather than a consumer transaction.”
While the regulation debate rages on Heron is optimistic about what’s in store for the sector next year.
“It’s going to be a stable time – a time of expansion, regeneration and growth,” he says. “I think it’s going to be an exciting year – one about innovation, lending and growth.”
Obviously the market wants to know what Paragon has planned for next year but Heron is tight-lipped.
“I can’t really tell you that, can I?” he laughs.”We do have plans. It’s early days for us. We’ve been lending just over a month now but we are pleased with the response of the market. It’s great to have had such a good reception.”
Innovation, lending and growth are words that have been notable by their absence of late so Heron’s optimism is sure to be welcomed by the industry. And if the CML’s latest figures are anything to go by he may just be right.
1977-1980 University of Warwick, BA in history and politics
1980-1983 Graduate trainee at Nationwide Building Society
1983-1986 Assistant manager at Leamington Spa Building Society
1986-1990 Regional manager at National Home Loans
1990-1997 Marketing director at National Home Loans
1997-2003 Managing director at Paragon Mortgages
2003-present Director of mortgages at Paragon Group
Hobbies: Skiing, playing the guitar, music in general, film and photography
Favourite film: In Bruges was the last film I watched – brutal, bleak and funny
Favourite book: Don’t have one. The last book I read was Matterhorn by Karl Marlantes – stunningly good – and I am now reading TheAmerican by Martin Booth
Mortgage: An offset