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Just tinkering

The FSA will not make any decisions on the mortgage industry for six months but fine tuning of LTVs and income multiples is certainly on the agenda.

Call it a reprieve or a stay of execution but for the next six months at least the mortgage market has escaped any severe interference.

In the run-up to the publication of the report into the economic crisis by Lord Adair Turner, chairman of the Financial Services Authority, the mortgage market waited with bated breath. Would this spell the end of specialist lending? Were first-time buyers going to be frozen out of the market for good with 100% LTVs banned indefinitely? Would a restriction on income ratios change the mortgage and housing sectors forever?

As it happens the mortgage sector was left hanging as the report revealed that no decisions would be made until Q3 of 2009.

But you’d be a fool to think that’s the end of it. The FSA will be tinkering with the mortgage sector, there’s no doubt about that. The report confirmed the paper, to be published in September, will consider the merits of limiting LTV and income multiples along with other options for mortgage market reform.

The report identified the role high LTV products have played in the economic crisis, stating that “the rapid extension of mortgage credit was a key factor in the origins of the financial crisis in the US, the UK and several other countries. In the UK high initial LTV and loan to incomes played an important role.”

It also revealed the number of mortgage products allowing over 100% LTV almost doubled from 3.9% in 2005 to 7.4% in 2007. It adds that the actual riskiness of these high LTV products, like Northern Rock’s 125% Together mortgage, increased as rapidly rising property prices raised the probability of a subsequent price collapse.

“Both some customers and some providers relied imprudently on the assumption that there would always be a supply of new remortgage offers to allow refinancing when initial low interest periods ended. Some providers assumed that initial LTVs would fall rapidly over the contract to reduce their risks,” the report claims.

Recent FSA figures showing rising arrears seem to support the theory that the crunch has caught borrowers, relying too heavily on the abundance of products on offer before the crisis, off guard.

Figures released last week show that mortgage arrears have increased by 31% in the last year. Repossessions jumped by more than 68% over the same period.

The regulator says 46,750 homes were repossessed in 2008, up from 27,900 in 2007. By the end of 2008 some 377,000 mortgages were in arrears by at least 1.5% of the loan balance, meaning borrowers had missed at least three mortgage payments.

Clearly there has been a weakness in the FSA’s previous way of regulating the UK financial services industry. Turner and FSA chief executive Hector Sants admitted in their recent Treasury Select Committee appearance that philosophically speaking, previous regulation of UK financial services firms had been flawed.

As such, in its latest review the FSA admits that it was previously reluctant to “accept the idea that it should reg-ulate products in either retail or wholesale markets”.

It says that until now it had worked on the basis that while firms must be subject to prudential regulation to ensure financial soundness, direct product regulation was not necessary. Its reasoning was that well managed firms would not develop excessively risky products because well informed customers will only choose products which serve their needs.

The regulator, says the report, has always believed that regulating products would stifle innovation. But this view may no longer be appropriate.

The review claims there are three justifications for mortgage product regulation:

– Protecting customers against the consequences of imprudent borrowing;

– Protecting bank solvency against the consequences of imprudent lending;

– Constraining over rapid credit growth and excessive property price increases, which increase the amplitude of economic booms and busts.

It goes on to look at the negative repercussions of implementing a maximum LTV. These include the fact that lower LTVs or income multiples will disadvantage entrants to the housing market who cannot rely on alternative sources of money, such as financial help from their family.

The review states the growth in available credit seen in the years before the credit crunch was viewed in the UK and the US as “driving a democratisation of home ownership”.

Also, high LTV mortgages are viewed as preferable to obtaining the same amount of money though com-bining a mortgage with credit card debt or unsecured loans.

Unsurprisingly, the majority of the mort-gage sector can identify the downside risks to the regulation of products.

“If the FSA and government go down the route of mortgage control to try to head off future asset bubbles, they are likely to entrench and worsen future housing under-supply that is rooted in the constraint of land supply,” says Stewart Baseley, executive chairman of the House Builders Federation.

“House price booms are caused by an imbalance between supply and demand and the long-term solution to escalating prices is to ensure there are enough homes to meet demand – not to impose regulation that takes no account of personal circumstance or risk that could discriminate against people perfectly able to realise their ambitions of home ownership.

“We are cleaning the car window when the petrol tank has a hole in it,” says Baseley.

Fahim Antoniades, director at Quantum Mortgage Brokers agrees. “Capping lenders’ lending ability to 3 x salary, as has been suggested, is crossing the boundary between regulation and dictation. I sincerely hope that common sense will prevail and that we don’t have to bear the brunt of a knee-jerk imposition of unworkable rules.”

Simon Webster, managing director of Facts & Figures Chartered Financial Planners, also agrees that capping incomes is a bad move. “Over the past few years many people took mortgages at 5% or 6% fixed rates. When they come out of these fixed rates they will be on standard variable rate, which is far lower than they were able to pay before. Those on trackers are already hugely better off. So where is the consumer detriment they are supposed to be trying to protect?

“By all means cap LTV at 100%. But if 3 x income is sensible at a 10% or 12% mortgage rate then 4 x or 5 x income is commensurate with a 5% or 6% interest rate and no one seriously expects rates to go above this level for the next 10 years,” he says. “Besides, given the current climate, who is seriously going to try to borrow silly amounts of money in the first place?”

Many industry players say if the paper that’s set to be published in September imposes limits on LTV and income multiples, as has been hinted, then this would be a backwards step for brokers, following years of forward thinking and innovation.

“It’s inevitable that this looks like a sledgehammer to crack a nut,” says Bill Warren, managing director of Bill Warren Compliance. “To limit LTVs and return to the historic approach of limiting income multiples will take the UK mortgage and housing market backwards by several decades. The stronger application of affordability and suitability rules is both commercially (assuming the government and FSA want to retain a healthy mortgage market) and ethically a more mature approach. 

“Lenders applying the rules and not chasing volumes and margins could return the mortgage market to some sanity. Simple actions such as returning to a policy of providing Mortgage Indemnity Guarantees, as has recently been mooted by the Association of Mortgage Intermediaries, would help the risk and funding barriers diminish.”

Sally Laker, managing director of Mortgage Intelligence, says the FSA limiting income multiples would be a backwards step as lenders have moved to an affordability model which generally is fair and works well. “It could also have dire implications for the remortgage market with borrowers needing more than 3 x income being stuck with their existing lender and at their mercy in terms of interest rate. The current banking crisis is a result of wholesale funding issues not irresponsible retail lending so yet again we face a situation whereby we could end up throwing the baby out with the bathwater,” she says.

As yet there are no definite plans and the review says September’s paper will “assess the strength of the arguments for and against” and “analyse the extent to which customer defaults and bank losses are correlated to either high initial LTV or Loan to Incomes”.

It will also assess the merits of direct product regulation compared with other potential policy levers, for example “tighter regulation of mortgage selling and in particular greater focus on suitability requirements” or “more aggressive use of differentiated capital requirements against mortgages of different LTV or LTI”.

Notably the review says the paper will also determine whether the FSA’s remit should be extended to cover second-charge and buy-to-let mortgages. This suggestion, at least, was greeted with support.

“The FSA should regulate secured loans. I have always thought it bizarre that secured loans are more or less in the same market as remortgages but are not FSA regulated,” says Tim Wheeldon, joint managing director of secured loan master broker Fluent Money.

“A lot of people in the secured loan market are afraid of FSA regulation, but it creates a level playing field and would be good for the industry and consumers.

“The current regulation from the Office of Fair Trading is pretty basic. A lot of secured loan brokers were regulated by the FSA to sell payment protection insurance, but brokers don’t sell a lot of that any more. That said, the FSA has to do a lot of work in the first-charge mortgage market, so if it does decide to regulate secured loans I cannot see it happening very quickly.”

But Wheeldon questions the timing of the move. “Why would the FSA chose to regulate secured loans now, prime lenders are not known for getting involved in secured loans. The market for secured loans is almost non-existent at the moment, so there would be little point regulating it now. I would prefer to see the FSA focussing on getting the wholesale markets up and running again. It needs to get the markets going again before it thinks about regulation.”

A statement from the National Association for Commercial Finance Brokers says: “A buy-to-let trans-action has been considered as a commercial activity and the NACFB has provided a Code of Practice for brokers operating in this sector. A number of our members will deal with limited companies who may have many hundreds of buy-to-let properties in their portfolio who are very different from an unsophist-icated borrower who may have just the single property. It will be very difficult to bring in regulation where one size fits all.”

Of course cavalier mortgage products are not solely to blame. On a wider scale financial innovation – most notably, securitisation – is at fault claims the review. The “demand for yield uplift, stimulated by micro-imbalances, has been met by a wave of financial innovation, focussed on the origination, packaging, trading and distribution of securitised credit instruments.” This “financial innovation” was intended to satisfy the demand for “yield uplift”, otherwise known as high returns.

According to the review as securitisation grew in prominence over the past two decades it was praised for reducing banking system risks and cutting the total costs of credit intermediation. So rather than a regional bank in the US holding a dangerously undiversified holding of credit exposures in its own region, securitisation allowed loans to be packaged up and sold to a diversified set of end investors.

But, as the mortgage industry is all too aware, this wasn’t actually the case. When the credit bubble burst it emerged that toxic debt was not safely out of the way in the hand of end investors but smack bang in the middle of banks’ and lending institutions’ books.

Market discipline has also been called into question. The review questions the extent to which we can rely on market discipline rather than regulatory action to constrain risks. It says that in the past it was argued that market discipline could play a key role in incentivising banks to constrain capital and liquidity risks.

The Basle II capital adequacy framework includes the assumption that improved disclosure would play a significant role alongside regulation in encouraging firms to act appropriately.

Its aim was to encourage market discipline by developing a set of disclosure requirements that would allow market participants to assess key pieces of information on a firm’s capital, risk exposures and risk assessment processes.

But the review goes on to say that certain events in the past five years demonstrate the failings of market discipline.

In particular there was a problem that bank share prices failed to indicate the risks those firms were taking were actually increasing. In other words the disclosure offered by banks of their debts at the time did little to prepare us for what was to come.

Turner also claims that a fundamental review of the market risk capital regime should be launched and a counter-cyclical capital adequacy regime introduced, with capital buffers which increase in economic upswings and decrease in recessions.

Credit ratings agencies also come into the spotlight, not surprisingly given their role in the crisis.

It suggests that agencies should be subject to registration and supervision to ensure good governance and management of conflicts of interest and that in future credit ratings should only be applied to securities for which a consistent rating is possible.

And the Bank of England and International Monetary Fund are not off the hook either.

The Bank and the FSA should be “extensively and collaboratively” involved in a macro-prudential analysis of markets says the review. Macro-prudential analysis looks at the health of the underlying financial institutions in the system and performs stress tests and scenario analysis to help determine the system’s sensitivity to economic shocks. It also wants the bodies to be jointly involved in the identification of policy measures.

The IMF it says must also have the resources and robust independence to do high quality macro-prudential analysis.

There was a mixed response from the mortgage industry. “While a general programme of measures to ensure that banks are dissuaded from risky lending policies, putting more cash aside for a rainy day and tighter regulatory controls seem to be a no-brainer, the question of how to keep mortgage lending itself in check has remained open to consultation,” says Andrew Montlake, communications director at Coreco Group.

“The danger of offering a one size fits all approach with regards to a cap on income multiples is that it potentially creates more of an issue than it actually solves.” He says “3 x income multiples means that not only will many be unable to purchase property at all, thus further alienating first-time buyers the government is so desperate to get back into the market, but also the fact that a simple multiple calculation does not actually mean that a loan is more affordable to certain people.”

Montlake says many lenders work on an affordability basis which is much more scientific and means those who can easily afford a bigger loan can obtain one, while those with more outgoings and commitments are not stretched further.

“I welcome the consultation process and hope that it will represent a sensible, industry wide commitment to ensuring that customers get the best advice,” he says.

Martin Weale, director of the National Institute of Economic and Social Research, says other factors, outside of regulation, need to be tackled. “It is a mistake to think that the sources of the current crisis can be resolved merely by regulating the banks. The fundamental factors which make over-expansion of balance sheets possible need to be addressed.

“Some of these issues will no doubt be covered in future work from the FSA. But we look forward to the Treasury analysing and addressing these problems with the thoroughness that Lord Turner has shown,” he says.

While it may appear at first that the mortgage sector got off lightly with the Turner Review it seems we’ve simply been given longer to stew, waiting for what many now see as the inevitable. Mortgage lending, it would seem, may never be the same again.

Mortgage caps are a bad idea

Ray Boulger
Senior Technical Manager
John Charcol

The Financial Services Authority will publish a paper in September considering reforms of the mortgage market, including the option of regulating LTVs and income multiples. As a consequence any definitive action almost certainly won’t happen this year and probably not until after the election.

The Turner Report says regulation on retail products, particularly mortgages, would be “premature”, but he emphasised that there needs to be debate on the issue.  

In his recent Mansion House speech the governor of the Bank of England Mervyn King made the same point. “Whatever exuberance – rational or irrational – existed has been destroyed by the crisis. So we have time to reflect before we decide on the shape of a new regulatory system,” he said.

There is a lot of common sense in this report, but also dangers in some of the issues flagged up for discussion, in particular the possibility of regulating mortgage products and imposing caps on LTVs and/or income multiples.

But the fact that the report has already identified some of the negatives of going down these routes is helpful. For example it warns that with a cap on LTVs, useful tools such as consolidation will be in jeopardy. It also points out that by limiting income multiples the “democratisation of home ownership” will be adversely affected. It also recognises that “a high LTV would be preferable to a borrower making up the deposit with some form of unsecured lending”.

Some of the report’s conclusions are based on a worrying failure to understand all the dynamics of the mortgage market. Turner comments that the trend in Loan to Income ratios has risen rapidly since 2000 and that this “in part reflected the fact that borrowers required rising loan multiples to afford higher house prices”.

While this is true there is no recognition that the other main reason is that borrowers and lenders were progressively becoming more comfortable with higher LTI mortgages as they recognised that interest rates were unlikely to shoot back up to double figures. Likewise the report quotes Poland as an example of a country with regulatory LTV restrictions, the implication being that its mortgage regulation is one step ahead of the UK’s.

What it doesn’t mention is the huge regulatory failure in that country that allowed many borrowers to be sucked into euro-denominated mortgages because of the lower interest euro rate, and as a result exposed them to huge losses as the zloty fell 22% against the euro.

Once the FSA consultative document has been issued it will be up to the mortgage industry to respond robustly to convince the FSA that product regulation and mortgage caps, of either income multiple or LTV, are a thoroughly bad idea and will reduce consumer choice.

The start of a long journey

Peter Williams
Executive Director
Intermediary Mortgage Lenders Association

A quick read suggests the Turner Review is an impressive tour de force by Lord Adair Turner. The 126-page report sets out what went wrong, what changes to banking and supervisory regulations are needed, the wider issues raised and who the recommendations are directed at and over what timescale given the global economic crisis.

From a mortgage market perspective there is much of significance in the report. The recommendation to adjust the treatment of the probability of default would help smooth capital requirements and there is a proposal to limit gross leverage to constrain balance sheet growth along with the creation of an economic cycle reserve and more scrutiny of liquidity.

Lord Turner also recommends the FSA should continue to move to enhanced supervision with a focus on business models, strategies and risks rather than on systems and processes with an increased analysis of sectors and firm performance. Remuneration policy would be part of this.

He specifically rejects forcing a separation of utility banking from investment banking, preferring instead to cover that through capital and liquidity requirements.

The upshot of the 28 firm recommendations is probably that lenders will be required to hold more capital and to operate more conservatively. This suggests that the costs of operations increase while the scope is narrowed.

The report then moves on to address ‘open questions for debate’. Should there be product regulation on loan to value or loan to income? The report points to the upward drift in average LTVs and more dramatically LTIs and notes there are several countries where these are controlled.

These questions will be explored via an FSA review of the mortgage market which will also explore the merits of direct product regulation alongside tighter regulation on mortgage selling or onerous capital weightings.

These are hugely significant ideas and give us some sense of the direction of regulatory thinking in response to the credit crisis. Clearly there are lessons to be learned and policies to be introduced.

The challenge now will be to balance out the need for this and at the same time to ensure we continue to have a competitive and innovative UK mortgage market. The whole industry must engage in this debate.

Certainly IMLA will play its part reflecting its focus on the intermediary market in general and its particular interest in the spectrum of the non-prime market.

Part of our task will be to reflect on the wider needs of the UK’s home buying public and how we secure the mortgage market they need.

It is a time for reflection and careful consideration and the Turner report has offered an important start. IMLA welcomes it but it is only the start of a very long journey.


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