Aggressive lenders nearly killed the sub-prime market in the US 10 years ago by cutting margins and increasing proc fees. Could the same thing happen in the UK?The sub-prime mortgage market in the UK continues to grow unabated. Lenders are reporting record levels of business and are now offering a kaleidoscope of product options across their ranges. This is excellent news for consumers with impaired credit histories who can now gain access to deals with headline rates that have a distinctly prime look about them. But what happened in the sub-prime mortgage market in America in the early 1990s, in similar economic conditions, may give some lenders cause for consternation. To put things into context, here is an overview of how the mortgage market in the US has operated since the late 1960s. It has some distinct differences to that in the UK. The existence in the US of a government sanctioned secondary mortgage market is the most obvious of these. In simple terms the secondary market works in the following way. Prospective home owners apply for mortgages through primary lenders such as banks in the same way as over here. The loan is granted and funds released provided the lender’s criteria are met. Once the loan is originated, lenders have a choice. They can either hold the loan in their own portfolios or sell them to the secondary mortgage market, replenishing their funds and enabling them to make further loans. For the loan to be saleable in this way it must be within the secondary lender’s underwriting parameters and loan limits. The large secondary lenders such as the famous Fannie Mae and Freddie Mac effectively create off-the-shelf products which consumer-facing financial institutions can brand and offer as their own. The secondary lenders then pool these mortgages and sell them as securities to Wall Street investors. In 2004 approximately 66% of all new mortgage loans in the US were bought by secondary market investors. It’s estimated that the liquidity this system creates drives down mortgage rates by as much as half a percentage point. It also serves to create transparency in pricing not present in the UK market since these secondary mortgage providers are entirely visible to the consumer. The conventional mortgage in the US is the 30-year fixed rate with no redemption penalties. This is unique to the US, so much so that it is often referred to as the American mortgage. This type of lending is considered beneficial to the US economy as a whole. During a recession interest rates typically decline and borrowers can refinance without penalties to take advantage of lower interest rates, increasing their disposable income and consumption ability. When interest rates rise borrowers are sheltered from the adverse effects of higher rates and mortgage payment shocks, reducing the likelihood of payment defaults. Home ownership is right at the heart of the American Dream. An American home owner receives tax relief from the government on mortgage interest at the same rate as Income Tax. In the US, this is typically about 30%. This effectively means for the same amount of money the average American can buy a far larger property than he can afford to rent. The US government was keen to ensure that as many people as possible had access to mortgage lending and in 1974 The Home Mortgage Disclosure Act was enacted by Congress. This regulation was sparked by concerns that financial institutions were failing in their responsibilities to provide adequate home financing in specific urban areas. This was a practice known as red lining, whereby whole communities were systematically ignored by local finance providers. The regulation requires lenders to collate and disclose data regarding the demographics of their borrowers, allowing the public to determine discriminatory lending practices. It was against this backdrop that the US sub-prime market was born and by the mid-1980s it became firmly established, some 10 years ahead of the emergence of such a sector in the UK. The transparency afforded by the secondary market gave sub-prime lenders a model on which to base their own lending criteria and pricing and the previously excluded communities a ready-made demand for their products. Initially mortgage books performed comparably with their prime counterparts. Against two to three-year loss models portfolio performance was far better than anybody had forecast, making each securitisation extremely lucrative. This inevitably attracted new lenders into the market place, increasing competition. Margins and pricing were squeezed, fees were reduced and lenders even started to give up their third year redemption penalties. Sound familiar? Then the bubble burst. And house prices stopped going up. At the same time the default rate started to soar. The previous performance of their lending books had given lenders the false belief that their lending policy was spot on and complacency was rife. In reality, borrowers were getting themselves out of trouble by refinancing, eating into the equity in their homes to avoid payment shocks at the end of initial discount periods. These payment shocks were in themselves relatively new phenomena given America’s penchant for long-term fixed rates. Brokers and lenders were quite happy to assist borrowers to this end and churning, or ‘loan flipping’ as it’s called in the US, proliferated. Once the equity ran out, the performance of sub-prime mortgage books collapsed. This was obviously bad for the lenders but was also bad for the borrowers as lending spreads rose and choice fell. Does the current ‘me too but cheaper’ attitude of some sub-prime lenders who should know better bode ill for borrowers in the adverse sector? More to the point, is the Financial Services Authority keeping its eye on this ball?
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