There seems to be much comment in the market following Lloyds Banking Group’s decision to bring in changes to interest-only mortgage criteria after Santander cut its interest-only LTV from 75% to 50%.
Last week, Accord announced the withdrawal of their 75% and 85% LTV products following an uplift in interest-only applications blamed partly on the recent decisions taken by Santander and Lloyds. Leeds is the latest lender to announce cuts in criteria.
It’s worth remembering that these products came out of the growing market for endowment and pension backed mortgages in the 1980s and early 1990s.
The mortgages were heavily marketed and distributed through IFAs who were also selling the investment product.
From a lender’s perspective, they were happy because there was a known repayment vehicle, and in the case of endowments, these were assigned as security.
However, as it wasn’t possible to assign a pension, lenders inevitably moved away from assigning endowments in the interests of speed and easy processing and by the mid 1990s no lenders were assigning endowments.
Somewhere along the line some lenders also dropped the need to investigate whether a repayment vehicle existed at all and then interest-only really took off. If you were a lender that tried to investigate the viability of repayment plans then you were deemed too picky by intermediaries and so followed suit or lost market share.
Today we have thousands of interest-only borrowers who have a loan but no way to repay it. The situation has been compounded by the underperformance of low cost endowments.
And, where there was a settlement by the insurer in lieu of damages the proceeds would have been paid directly to the borrower rather than being credited to the mortgage account. They will have been spent long ago. The interest-only time bomb is a significant issue, which still needs resolving.
FSA takes action
The FSA are trying to prevent this situation from happening again.
Interest-only loans aren’t being outlawed going forward but the principles of ensuring sensible repayment plans are in place are being re-established.
From a broker perspective it has been argued that the FSA and lenders are over-reacting with tightening of rules and cuts in criteria but I think this overlooks the whole picture.
In fact there are two main reasons for the lenders slide towards a more prudent approach to this product and their recent tightening of criteria.
Firstly, lenders will be required to assess affordability on interest-only mortgages on a capital and interest repayment basis unless there is evidence that the borrower has a robust vehicle in place to provide for repayment.
Lenders will be required to obtain evidence of the repayment vehicle prior to completion of the loan and will be expected to check on the performance or continued existence of the vehicle during the life of the loan.
The lender’s policy for interest-only mortgages will be required to be set at board level.
Lenders fear future sanction
Beneath that though is the fear that lenders will be challenged retrospectively on these decisions which could lead to regulatory and reputational sanction. In short, the interest-only product is now seen to carry more risk.
Secondly, and this is significant, despite more positive noises in the market, funding and capital remains in relatively short supply.
Any one of the major lenders could lend multiples of their current volumes if they wanted to and they are having to regulate business volumes in a variety of ways.
Additionally, higher LTV mortgages require multiples of the capital that, for example a sub-80% LTV mortgage would. Capital is scarce and with Basel III just 10 months away it’s getting scarcer. Is it any wonder then that one of the ways lenders have chosen to manage their risk, capital and funding issues is to cut the criteria back by invoking a lower LTV on these higher risk products? Essentially they are requiring the borrower to put in the capital rather than do it themselves.
Interest-only lending has its place but is an undeniably higher risk product for lenders and one that should rightly remain as a niche rather than mainstream product. That’s how it started; the market just lost sight of that.
On the positive side, there is a great opportunity for a new niche player here who is prepared to understand and manage the risks properly.