Non-conforming gap across the pond

The UK non-conforming market is approaching its 10th anniversary. It has a lot to celebrate – exceptional growth in mortgage volumes, the ongoing development of new products, and a strong reputation among intermediaries and customers. The unprecedented growth is remarkable, but its development owes a lot to its US roots.

The future of the UK non-conforming market looks bright. A recent report from Datamonitor has estimated that the non-conforming mortgage market will reach £19.5bn by 2006. This reflects a compound annual growth rate of 6.3% between 2002 and 2006. Supporting these predictions, our own Non-Conforming Mortgage Report found that 85% of IFAs and mortgage brokers predict that the market will continue to grow annually by £4bn, a continuation of the level of business growth experienced in 2001-2002, when the UK market grew from £11bn to £15bn.

Across the pond, the US market is significantly more established, having existed for over 35 years. The volume of US non-conforming mortgage completions was estimated at $186bn (£118.5bn) in 2001, having grown from $41bn in 1996 – a net increase of 354%. This growth was fuelled by an environment where a staggering 50% of the US population in 2001 – more than five million households – were non-conforming.

The UK&#39s non-conforming sector evolved from an initial rush of US companies establishing start-ups in the mid-1990s. Many of these have since returned to the US as a result of economic and regulatory challenges within the US non-conforming industry in the latter end of the decade. But some such as Preferred have remained and successfully grown from these American roots.

Today, the UK market has a different structure compared to that of the US. It is amazing that the UK market is still made up of so few companies – less than a dozen key players – while at the same period of the sector&#39s development in the US market there were hundreds of non-conforming lenders. A subtle difference perhaps, but it is certainly an important one when you are looking to divide up your customer base.

The US industry has evolved significantly since its early days in the 1970s. I draw particular attention to developments over the last five years, during which we have seen considerable consolidation of the US industry. The market is now made up of a handful of large companies such as Citifinancial, a subsidiary of CitiGroup, Household and Countrywide Mortgages – one of the largest lenders in the US.

Although the UK market has yet to experience widespread consolidation, the entrance of mainstream lenders into the non-conforming market will have an effect as mainstream margins and customer networks face continued competitive pressures. When analysing the UK and US markets, there are many more differences than just market structure and size. I have highlighted some key differences:

• Decision process The depth and breadth of credit reporting in the US provides lenders with a wealth of robust credit information, both negative and positive, on individuals, going back seven years. Consequently, industry professionals rely heavily on customer credit scoring to make decisions. Such sophisticated credit scoring systems have yet to be developed in the UK non-conforming sector. The information on which to base decisions is primarily made up of negative items, for example, County Court judgements, which do not always give an accurate picture of a borrower&#39s creditworthiness. To counter this deficiency, at Preferred we assess risks on a case-by-case basis, making decisions but evaluating a number of borrower attributes, while placing heavy emphasis on affordability and with our fundamental underwriting decision based on experienced judgement.

• Credit reporting The Fair Isaac Credit Score is particularly prevalent and takes precedence over other information lenders may have on a customer. The FICO incorporates the customer&#39s payment history, length of credit history, new credit information, types of credit used and amounts owed to deliver a holistic view of the individual. This in-depth information is made available through the three major credit-reporting agencies, offering US lenders a choice of separate or combined reports.

The system works in the US because the gathering of credit information is a two-way street. There is a requirement for lenders to provide credit agencies with regular customer information that is used in compiling these credit reports and which the lenders use to make decisions on applicants. In return, monthly updates on all mortgage loans on the lender&#39s books are sent to the credit bureau, which uses this data in its credit report.

• Property valuation In the US property valuation is known as the Fanny Mae Appraisal or FNMA. This industry standard provides infor-mation on all aspects of the property – important for both homebuyers as part of the purchasing decision, and lenders when approving a loan. Moreover, the information provided is substantially expansive in comparison with the typical UK property valuation.

• Talent pool One of the key differences between the UK and US is the availability of qualified non-conforming industry talent. In the US there is an abundance of professionals with specialist knowledge of the non-conforming market, mainly because of the age and size of the sector. Of particular interest is the way the sophisticated nature of US credit reporting and scoring has led to the homogenisation of the industry. This has led to a fundamental gap in the US market. While in the UK we are more akin to taking experienced judgemental risks, the US market has gravitated to an extreme towards a borrower&#39s credit score. Decisions in the UK are made on a number of factors including the value of the property, affordability and, most importantly, the judgement and wisdom of experience captured over the years.

However, because of credit scoring and the homogenisation of the market, this human element has effectively been removed from the US arena. Customers who would qualify based on overall attributes beyond the scorecard results are being shut out of the market and the talent pool has also eroded as the historical level of experienced underwriting is no longer required. The US industry has gone full circle, which has opened up a significant albeit unfortunate gap in the market for traditional non-conforming lending.

Next week I will look at other differences between the UK and US markets, paying particular attention to regulation.

Points of divergence

The seven key differences between the US and UK non-conforming markets:

• Decision process

• Credit reporting

• Property valuation

• Talent pool

• Product offering

• Technology

• Government incentives

• Regulation