The UK press has rightly devoted extensive column inches to covering the company failures and rapidly rising loan default rates afflicting the US sub-prime market. And reasonably enough, journalists have also been shining a spotlight on UK firms and asking the question – are UK sub-prime lenders headed for a US-style meltdown?
I have witnessed the birth, near collapse and rebirth of the US sub-prime sector – I moved to the UK before the current round of troubles hit – so I would have to answer no. In my opinion, there is little reason to expect this particular malaise to extend across the pond and afflict sub-prime lending in the UK.
I base this answer on a number of things. First, a series of features have compounded financial problems for many lenders stateside that are unique to the US sub-prime market.
Buy-backs are a case in point. Unlike the UK, where most participants in the sub-prime market sell a relatively small proportion of the loans produced to investment banks or to other intermediaries, many of the big US players sell billions of dollars worth of production each quarter.
But the buyers of these loans historically demand a contractual obligation that the sellers will buy back the loans under certain circumstances.
The most critical buy-back right is the early payment default provision which gives buyers the right to demand a buy-back of a loan if it goes into default within 60 to 90 days of purchase.
Although sub-prime loans inevitably have higher default rates than loans to borrowers with strong credit, a default within the first three months is a good indicator of problems with a lender’s underwriting.
The disparate nature of the US market has further fanned the flames. Regions where there are rising interest rates and weak job and income growth have pushed more US sub-prime borrowers towards default. Importantly, this has also made it difficult for some lenders to maintain production volumes without loosening their underwriting standards. Cue a spike in mortgage defaults.
Lenders have consequently been hit by increased EPD claims. These claims deplete their cash reserves resulting in some US sub-prime lenders having to rein in lending or shut up shop completely. The surviving players have consequently cut back on the availability of mortgage credit to sub-prime borrowers by tightening their underwriting criteria and scrutinising loans more closely. The UK is largely protected because this major contributor to the downward US spiral is not prevalent here.
Another feature of the US sub-prime market that is not widely replicated in the UK is the reallocation of credit risk in underlying mortgages to alternative vehicles in the capital markets – in this case hedge funds and the structured funding vehicles known as collateralised bond obligations.
This has been accompanied by an explosion in the market for credit derivatives based on sub-prime mortgage credit risk. Ordinarily, this greater efficiency in the capital markets should be a good thing for lenders because it allows them to avoid exposure to a downturn in the economy that might increase mortgage defaults and losses.
It was precisely that risk that caused such severe problems for US sub-prime lenders in the crisis of the late 1990s. As we saw, the impact of the extra liquidity was to magnify price movements in the mortgage market. This inflicted additional losses on lenders that were holding sizeable inventories of loans that moved from being profitable to unprofitable overnight. These lenders therefore, faced big margin calls from warehouse lenders which were in many cases the same Wall Street investment banks making EPD claims.
Over here, the bulk of sub-prime lenders still retain significant portions of risk in their loan books. The market for the riskiest mortgage slices does not have the breadth or liquidity seen in the US, nor is there a big market in sub-prime-linked mortgage credit derivatives.
What this means in practice is that, were the underlying conditions in the market to worsen, lenders would have more time to adapt and adjust their product strategies and pricing.
Does that mean there is nothing to fear over here? Unfortunately, life isn’t that simple. The UK sub-prime market is still vulnerable to a rise in unemployment or a fall in the property market.
But it’s not all gloom as the US experience has taught some valuable lessons – less-ons which, if lenders take heed, could ensure that even in bad times the industry in the UK has a soft landing and steers clear of the crises seen in the US.
I believe that lenders need to prioritise measures to ensure their ability to effectively service loans after they are originated are as robust as possible – especially those measures that prevent and cure delinquencies and mitigate losses once borrowers have gone into arrears.
If macroeconomic factors start to bite in the UK and pressure on borrowers mounts, those lenders with strong servicing operations and good records will be better positioned to retain investor confidence and have continued access to capital.
Pivotal to taking the sting out of any potential downturn is maintaining disciplined underwriting practices. Lenders must maintain firm control over the credit evaluation process and resist pressure to compete by loosening underwriting standards to succeed.
Ultimately, the winners in this scenario will be borrowers shunned by the high street as this will ensure they retain access to flexible and creative mortgage and remortgage solutions.