Sub-prime is dead. Long live specialist lending.
It could almost be a cry from a battlefield but these are the sentiments of one of the country's top sub-prime lender chief executives.
The last 12 months have seen the specialist lending sector go from strength to strength with record levels of business written and, presumably, record profits made. At the same time, product innovation has continued with correspondent lending, among others, firmly making its mark.
“The sub-prime market as we know it will be dead in five years time as a standalone industry,” says the chief executive. “What we are seeing is a market beginning to emerge that is moving to a total servicing operation. A market based not around sub-prime but around risk-based pricing. The traditional 'one in four' market has gone [one in four borrowers traditionally being refused credit from mainstream lenders]. This market will soon be based on price alone and within five years it will only be the balance sheet lenders that will be able to survive.”
So who is this chief exec so proud to boast of traditional sub-prime's demise? He would, of course, rather not say. At least not for the moment, but the argument he puts forward is interesting.
He says there is, and has been for some time, a situation quietly developing that will put an end to today's sub-prime lending sector forever. That's not to say that the market is going to get smaller. Far from it. If anything the sub-prime, or rather specialist, arena is going to get bigger. “You only have to look at the recent comments made by Sir Edward George to realise that to be the case,” he says.
“The house price rise increase is just not sustainable. The faster the rise now, the sharper will be the shock when it comes to an end.”
Gina Collman, head of corporate communications at GMAC-RFC, says the mortgage industry has reached a crossroads where the question now is: what is sub-prime?
“Traditionally, anything that didn't conform to the norm was classed as sub-prime,” she says, going on to cite the example of self-cert.
“The question used to be whether it was self-cert or whether it was sub-prime,” she says. “You can have both but some brokers would have immediately classed self-cert as sub-prime and that has now changed.”
Our nameless chief exec backs Collman and even goes a step further.
“What we are witnessing is the growth in the number of balance sheet lenders who are active in the sub-prime market and I think that it will only be a matter of time before we see these players come out as the true dominant force in sub-prime lending,” he says.
So who are these balance sheet lenders?
“It's lenders that have access to vast sums of capital. Lenders like GMAC-RFC, GE Capital and Citi Corporation. All have the balance sheets to operate to a full service industry. And it's these lenders that are going to be able to offer products across the full lending spectrum from prime to sub-prime.”
But Stuart Aitken, director of credit at Southern Pacific Mortgage Limited, says SPML is also in this league.
“We're backed by a world class financial institution, Lehman Brothers, and already offer a prime flexible product with more prime products planned in 2003. This trend is not for the future – it's happening now.”
The CEO-with-no-name argues that what it comes down to is a return on assets, which seems to be ever-decreasing. The margin average used to be 3%. So, if you do not have the balance sheet to lend against, he says it would be reasonable to suggest that returns are going to be down.
And his views are somewhat backed up by Bob Sturges, communications manager at sub-prime lender igroup.
“Evolution is a word we have become used to seeing as a way of describing developments in the sub-prime market,” he says. “And it's apt because the sector has evolved from what was essentially an unregulated single product market catering to adverse-credit customers into the sophisticated and complex, multi-niche product sector of today, i.e. the specialist lending sector.”
Sturges says that to be a successful large-volume lender in this market specialist lenders will have to offer the full range of niche products demanded by today's consumers – from buy-to-let to self-certification and credit repair.
“They must also maintain suitable support infrastructures capable of providing first class levels of service,” he adds. “Alternatively, they should have access to appropriate outsourced facilities if this better suits their operational strategies. To do all this requires expertise, experience and investment – especially as we gear up for the demands of a new regulatory regime in 2004.”
And it's on this basis that Sturges believes it's reasonable to assume that the specialist lending sector of the foreseeable future will be dominated by the bigger niche lenders currently on the scene.
“Many of these – including igroup – are already owned by large international organisations and are well-placed to maximise the market opportunities available either through their own efforts or by calling on the substantial resources offered by their parents, whether financial, operational or reputational,” he says.
Although Sturges concedes some of the smaller independent specialist lenders remain competitive, he says that in the long-term it's hard to see how they will cope.
“There are several independent specialist lenders that are well respected and currently enjoying successful levels of trading, but it's difficult to see how they can survive as independents if they wish to compete on level terms.”
But Richard Hurst, communications manager at Future Mortgages, says he doesn't necessarily see the market degenerating into a price war.
“It's not necessarily about what you can sell, but what you can process,” he says. “The investment you would need in processing would have to be massive. Could these lenders – which, de facto, includes ourselves – price off a global balance sheet? Possibly, but how are you going to manage the flow? You might find some of the larger companies expanding on the customers that they want but I don't think that you will ever see them wanting to dominate – you don't necessarily want 10,000 applicants per month.”
However, Sturges also says that securitisation is another issue to take on board too.
“Regarding on-balance sheet lending vs securitisation, both work well for different types of lenders. However, securitisation is susceptible to the whims of the capital markets,” he says.
“And while these are generally supportive at the present time, this might not always be the case. Lenders able to rely on a guaranteed source of funds are therefore able to plan ahead with a greater degree of certainty.”
So what of the smaller lending factions of the sub-prime community?
“There's simply no future for those earning margins of less than 3%,” says our anonymous exec. “What you are seeing is assets being depressed.”
If this chief executive is to be believed, and he normally is, then despite competition on the balance sheet, smaller lenders in this niche sector still have two of the most valuable weapons in any lender's armoury – speed and franchise.
“Some of the lenders in this sector often get clouded in issues of little importance, especially the building societies. Take Britannia, for example. They can get completely clouded in the issue of mutuality when what they should be looking at is the ability to make money.”
He cites Bristol & West as the prime example of a medium-sized building society done good.
“They used to worry about the mutual argument all of the time,” he says. “But once they realised the cost savings and benefits that could be made from demutualisation and what could be made financially, minds soon began to change.”
SPML's Aitken, on the other hand, feels that the real issue lies elsewhere.
“The mutuality debate is a side issue here. Profitability depends on expertise within the specialist lending market. For non-standard lending, i.e. wherever products are designed to balance risk and reward, skill and experience will give lenders the edge. It is those lenders who have the skills and experience in decision-making and arrears collection who will make sure any specialist market works – whether they are small, large, mutual or not.”
And igroup's Sturges agrees with Aitken. “Many of the major specialist lenders are subsidiaries of UK banks, mortgage banks or building societies,” he says.
“Most are well established in their own right and have secure distribution lines offering competitive and attractive products. Being part of larger UK-based retail finance organisations, they can rely on their parent businesses for support. And so long as economic conditions remain favourable, there is every reason to expect them to continue to do well.”
Sturges argues that in this regard they are no different to the lenders owned by the large international organisations.
But our still-anonymous chief exec maintains that the reason smaller sub-prime lenders can compete at the moment is that they can take important decisions fast.
“Look at Future Mortgages, for example. Future works because a small team is at work behind all the strategic decisions. It's the same for lenders like Preferred and SPML. Their strategy against the non-balance sheet lenders should be to exploit the value of the franchise, the value of their branding.”
Understandably, SPML disputes this categorisation as a smaller lender. With completions of over £1bn on target and £1.5bn forecast for 2003, it believes it is already playing in the premier league.
And it's also a point that Aitken says proves branding is not that much of an issue.
“Branding is all about a consistent set of values and messages and not really affected by sources of funding or size of organisation. For example, SPML has done very little by way of corporate advertising to promote its brand, yet the brand has become synonymous with high service levels by word of mouth and personal experience.”
Another issue of importance the incognito chief exec says is cost ratios and he believes the problem lies with the surge in equity that homeowners have enjoyed over the last year.
“The problem with the economic cycle at the moment is that everyone's being bailed out by the equity market. Loans that are in arrears can be remortgaged away because of the increase in equity value. But then in a downturn that again is going to cause even more problems.
“If it costs you less per asset to process loans then it's an irrefutable law of economics – you can't compete in the market place.”
There seems to be an almost general agreement that the number and frequency of arrears in this market is beginning to rise.
Though Aitken says SPML has seen no evidence from its own lending or their experience in the market that arrears are rising.
“This should be expected in a low interest environment when sub-prime borrowers can get excellent fixed and discount rates,” he says.
But when the frequency rate goes up, so does the severity – the rate at which lenders repossess properties. And when this happens lenders will get 'hosed down', as when the market falls they can't get the return on their investment.
But SPML's Aitken does not agree that all lenders will suffer the same amount of arrears in a downturn.
“The best non-conforming lenders will already have good collections management systems in place. We have a pro-active system of immediate personal contact with borrowers when a payment is missed, with counselling services on hand to keep the assets performing well and arrears at a minimum. Lenders who don't already have an effective collections management process will not be able to start from scratch effectively, should a sudden economic recession occur.”
igroup's Sturges says all lenders would be impacted by a downturn in the economy with consequences for delinquency and repossession levels.
“Equally, we would be affected in the event we failed to observe the highest standards of professionalism and propriety in our dealings with customers,” he adds. “Either eventuality would attract adverse publicity which, coupled with an impaired business performance, would inevitably cause concern at headquarters.”
However, whether this would be greater in the HQ of a British-owned company as opposed to an overseas one is a matter for speculation.
“Suffice it to say,” says Sturges, “we all need to make sure we continue to grow our businesses in a way that delivers the numbers whilst maintaining values and standards.
“The good news is that the economy looks set to remain fair with continuing high demand for specialist mortgage products. We therefore feel that the majority of established lenders – whether subsidiaries of UK or foreign-based companies – will continue to do well.”
So is the housing market going to crash? The problem in the 1970s lay with oil prices, in the 1980s it was high interest rates coupled with the loss of MIRAS that caused all the problems. So what about 2003?
One answer could well be unemployment. Although pundits seem divided on this issue, the theory is that widespread redundancies in the City of London – largely due to the decline in investment banking – could soon filter out to the regions and have an effect on the rest of the economy. The impact of this in London can already be seen at a macro level. Hackney cabs seem to be in endless supply where once they could be notoriously difficult to get hold of. Applications for gym memberships are on the decline – mailshots and special deals for potential new members are on the rise.
Of course, a downturn in the market will have benefits for the sub-prime market, notably in sorting the wheat from the chaff in terms of the lenders that could survive such a crash.
Whether the sub-prime label will still be around in the future remains to be seen but there is little doubt that there will be a definite need for specialist lenders catering to those with specialist needs – whether that's for borrowers who will fail traditional credit scoring methods or those that require a little extra help, albeit for self-cert purposes or for products such as Right to Buy.
Downturn aside, Collman does agree that the market is shifting. GMAC's own product range offers somewhere in the region of 3,200 different permutations for which products can be tailored to individual circumstance.
“We are moving into a pricing environment,” she says. “Rates are the keenest that they have been for 30 years – even LIBOR [London Inter Bank Offer Rate] is hanging around at 4%.”
Although GMAC does offer such an array of products it has not gone to market without attracting some criticism. After all, 3,200 products is enough for even the wiliest of brokers to contend with, not least sourcing systems that find the maze almost impenetrable.
But Collman defends this complexity by choosing a select distribution model. “We introduced this concept through the packager market place,” she says. “As we deal with a select number of packagers, it was easier for them to be educated. It may look complicated at first but it's a simple grid calculation – and for those introducers using it, it has become a simple method.”
There are other ways to get products to market and Collman believes that whatever way the market shifts there will always be the opportunity for lenders to produce standard off-the-shelf products – after all, not everyone will always want to use the services of an intermediary.
“I think that there'll always be the opportunity for standard off-the-shelf products as not everyone will use a financial adviser,” she says.
“There's always going to be the opportunity for products that the public are familiar with.”
“It's an evolutionary process,” she adds. “A mortgage is normally the biggest single purchase decision that anyone is going to market. As the market begins to evolve and more and more lenders begin to price for risk, the process will perpetuate and will eventually become the norm.”
But SPML's Aitken says pricing for risk is already the norm.
“That's what mainstream lenders do, when they screen out all their perceived risky applicants by credit scoring systems. The really interesting thing here is how do you quantify and classify risk?” he asks.
“Certain levels of arrears and CCJs etc have become standard measures of risk against which lenders can match applicants with variously-priced products. But if they increase dramatically, lenders may have to have a far wider range of products to cater for all from the slightly non-conforming through to those who have been really badly hit by recessionary factors. We expect greater pricing for risk and a blurring at the edges as the market matures and risk pricing develops.”
Sturges says that the UK's low interest rate environment looks set to continue for the foreseeable future and argues that as such the opportunity for specialist lenders to compete purely on price has and will diminish.
“It is therefore incumbent upon each of us to find alternative ways to distinguish our products from the mass,” he says. “Service will play a key part in this. So long as the basic product offerings are in place, the lender that offers an efficient, consistent and reliable service will always be attractive to introducer partners. But this requires time and effort, and the winners will be those lenders able to adopt and adapt quickly new ideas and new technology.”
Sturges, however, believes that most specialist lenders will continue to price for risk to reflect the nature of their product portfolio.
“At igroup,” he says, “our GEM mortgage range is positioned to offer products at an appropriate price across different risk categories: the higher the risk, the higher the rate.
“However, as the pure sub-prime population shrinks – principally as a result of a healthy economy – we continue to attract more business at the lower-risk end of the spectrum. This puts us in competition with other specialist and, increasingly, mainstream lenders. And it is here that service standards and product innovation will make the difference, not just price.”
The emergence of this growing grey area of lending was highlighted last year, with research from Datamonitor showing that although the number of people systematically refused credit from mainstream lenders was decreasing, business at traditional sub-prime lending institutions was booming.
At the time the data was written, pre-9/11, the research highlighted improved economic conditions, fewer county court judgements and a lower level of mortgage arrears had brought more than three-quarters of a million individuals out from what was commonly seen as the 'credit underclass' to the mainstream. But 7.9 million people – one in five of the working population – remained 'non-standard', representing £16bn of business.
There's little doubt that this £16bn, if not more, has been captured by the market players this year.
But perhaps for the moment the final thought should go to David Johnson, former managing director of igroup and now joint managing director of Brentwood-based Commercial First Mortgages.
“You can understand why the balance sheet lenders will stand the test of time,” he says. “The securitisation markets are notoriously volatile and imagine what impact another Gulf War will have on oil prices and the market in general. Margins are being relentlessly squeezed and the future for lenders now surely has to be distribution. It will be the key to their survival.”
SPML first in Europe to achieve S&P's 'Above Average' servicer rating
SPML recently broke new ground in the mortgage lending industry by being the first lender in Europe to be awarded an 'Above Average' servicer evaluation rating by Standard & Poor's. This is the second highest evaluation awarded by the company.
SPML operations director Angela Davies says: “We felt it was important for SPML to obtain a servicer evaluation rating for a number of reasons. Our service to packagers and brokers is already acknowledged to be among the best in the sector. However, we are now completing at least three securitisations a year, so we needed an independently-assessed external measure to help us achieve top overall ratings for these bonds.
“We are also increasingly providing a third-party administration service to other lenders especially those who have bought tranches of non-conforming loans to generate margin, and who need an experienced non-conforming loan servicer to administer the loans. Here, again, the S&P rating provides an objective measure of our service standards for prospective customers.”
Standard & Poor's assessment covered a comprehensive range of SPML's business activities, including financial position, collections management, technology, administration, internal controls, staff and training.
What do packagers think about the future of the specialist lending market?
John Mawdesley, managing director, The Mortgage Partnership. Has the UK's sub-prime market reached the end of the beginning? Trailblazer in the market, Kensington, had proved the case by 1997/98 while another early entrant, CMC, almost destroyed it. In the mid-1990s, these first entrants were very quickly followed by other start-up operations.
Distribution as ever was key, with success coming through the third-party market, the low entry cost choice for all new lenders, and given a new twist by concentrating on packagers. Two exceptions, Money Store and Future, initially saw things differently – the former quickly abandoned its plans to sell direct to the consumer while Future, until recently, built its business without packager relationships. (It is interesting that, as the market matures, Kensington has bought a B2C operation).
Until recently it has been quite hard to differentiate between sub-prime lenders – product innovation has been the standard formula with deeply discounted LIBOR margins and the introduction of fixed deals all underpinned by hefty reversion rates. Each lender in its turn has suffered by failings in service and underwriting standards but the initial marriage of convenience between sub-prime lenders and packagers, which many thought would end in a messy divorce, has now blossomed into a tighter relationship of correspondent and branded lending deals.
The sub-prime market has no apparent leader. This, combined with minimal entry barriers, has meant a number of mainstream entrants such as Birmingham Midshires and Bristol & West. Although these new entrants have a trick or two to learn, they have been attracted by the higher margins and the benefits of perceived incremental business. The Britannia's move with the merger of Platform and Verso brings a new twist that appears to want to mirror the operations of Birmingham Midshires and GMAC.
This market is still in an exciting growth period, with new mainstream players putting pressure on the established names with product and distribution innovation. I believe we will see more 'new' players by acquisition coming to the market who will be tempted to squeeze the margins in an effort to buy volume. This will put serious pressure on the undercapitalised who will need to have all their wits about them to survive. Over the next few years, as the market matures, lenders will need to become more sophisticated and will find it increasingly difficult to ignore the allure of customer retention programmes enticing mature sub-prime customers into mainstream products.
How long can the sub-prime sector afford to ignore this simple and cost-effective cross-sell? How long can sub-prime specialists ignore the overtures from the mainstream? The next year or two will be very interesting.
Wayne Smethurst, senior partner, The Finance Centre. The sub-prime industry this year has seen correspondent lending facilities now available to a wider audience. These new lenders on their own would not have had such an impact on the industry if they had not evolved from packagers. Now there are fewer truly independent packagers in the sub-prime market because, if you take on the correspondent facility of one lender, the natural progression is that most of your business will be directed to that facility.
Introducers are much better informed than they were 12 months ago, in part due to specialist publications such as Mortgage Strategy. They will not tolerate being offered the products of one lender in preference to another purely because of the packager's correspondent facility, especially when they are faced with losing the client to a competitor as a result. This situation is quickly being recognised by introducers as these 'packagers' become Trojan horses for their correspondent lenders. The end result will be packagers concentrating on their lending facilities and eventually discarding their agencies with other lenders as these then become their direct competitors.
At the other end of the scale, some lenders have not been offering particularly attractive or competitive products and have not been receiving volume business from packagers. To compensate they have offered 'packaging' facilities to anyone who can provide a regular but small amount of business and are prepared to do that extra work to earn more commission.
This in itself creates a tendency for that small introducer/packager to direct their business to these lenders. What follows is a vicious circle of poor advice for the customer and poor service from the lender because of the sheer number of different sources with their varied levels of experience.
Next year will see packagers below a certain size encouraged, if not forced, to redirect their business via a large packager or network, particularly with the prospect of FSA regulation looming ever closer.
Mel Fordham, managing director, Olympian Financial. The sub-prime market has certainly evolved over the last 12 months with more and more mainstream lenders entering the market. However, specialist players continue to emerge with ever-more innovative product offerings.
Brentwood-based Commercial First looks set to become a big player in the market, offering non-conforming commercial lending. This launch brings a new dimension to the market and a funding solution for many businesses or entrepreneurs who have had some difficulties or who have little or no accounting information to support their borrowing requirements.
The ongoing success of igroup proves that we should never underestimate our established sub-prime players. The company has recently pushed its lending through the £300m a month barrier – indicative of the levels of growth that the market has accomplished.
Continued growth in the sub-prime sector indicates that innovative products, simplified underwriting and a willingness to accept complicated and unique borrower situations pays dividends and certainly pays die recognition to borrower requirements.
These are all factors that the mainstream lenders will need to recognise if they are going to make any kind of impact in the market.
Looking ahead to the future of the specialist lending market
Keith Robinson, managing director, National Guarantee. The last 12 months have been very exciting for the sub-prime market. The volumes of business have been exceptionally strong. However, the biggest development has been the outsourcing by lenders of the whole sales process from point-of-sale through to the certificate of title stage. This has been an innovation for the market and has brought many benefits to intermediary lenders and consumers. Intermediaries can now control the process and ensure a fast turnaround for their clients – and lenders can reduce the cost of administration.
I believe the increasing use of the internet as a sales channel and as a vehicle for lenders to bring on online decision technology will be the most important development area over the next year. The internet offers a unique platform for consumers to gather information, it provides a new sales channel for intermediaries and allows lenders to automate the application process by providing online decisions for their intermediaries and packagers.
Richard Hall, managing director, Best Advice Mortgage Centre. This year has seen a major development in the flexibility offered by sub-prime lenders to borrowers. It is becoming recognised that many borrowers are in unusual circumstances which the non-conforming sector can cater for. This has resulted in higher LTVs now available from sub-prime lenders as they recognise the needs of consumers.
One development that is likely to affect the market is the entrance of mainstream lenders into the sector. They will need to learn a different set of skills to be successful, focusing on their underwriting and credit scoring processes to make sure that the individual needs of sub-prime borrowers are catered for. In the coming year established sub-prime players will need to concentrate on innovation, flexibility and customer retention to ensure they stay ahead. This year will also see more IFAs entering the sub-prime market and becoming involved in a market they have traditionally shied away from as they search for other avenues of business.
Technology will bring more added-value
Alan Hill, managing director, First Mortgage Options. The sub-prime market has matured significantly over the past year or so and is today an accepted part of any mortgage intermediary's armoury. With the ability to address clients with credit history problems, the majority of intermediaries are now faced with what must seem like a never-ending number of lenders with a myriad of products to choose from. It must be daunting to use a quotation system that highlights so many lenders prepared to lend. Sub-prime lenders' criteria aren't much easier to understand than, say, a prime lender – and that's where a specialist dedicated sub-prime helpdesk is essential.
The coming year promises a huge explosion of e-commerce capabilities, allowing data capture at the point of sale but this will not leave the sub-prime market behind. Indeed, some of the more established prime lenders will be envious of the new kids on the block. This technology boom in the sub-prime arena will be aided by continued experienced sales support and helpdesks that can match a borrower to a lender. This is what we call a value-added service and it will always be essential.