Monday 4 December
Howard Davies
Chairman, Financial Services Authority

I last spoke to the CML at your annual lunch on 25 February. I noted that there were signs that credit standards were reducing, and that affordability might be becoming an issue. I said that while loan to income ratios were still relatively low by the standards of the last housing boom, it should not be forgotten that consumers have more non-mortgage debt than they had a decade ago. And I drew attention to the fact that a growing proportion of loans by major lenders were at loan to valuation rates of 95% or over. All this was based on a detailed survey we had conducted of lenders representing just over half the market, in 1999, based largely on end 1998 figures.

I concluded that it was vital for mortgage lenders to look hard at their credit methodologies and to remember the hard-learned lessons of the last downturn in house prices.

How has the market developed since February? Are the worrying trends we identified then still observable? Or have we seen signs of a more cautious approach by lenders?

The short answer is that the picture is rather mixed. We have assembled some new data for the first three-quarters of this year, and looked at the way lending practices have changed since the end of 1998. Although the data come from a slightly different sample of lenders, they still represent around half of UK residential mortgage lending.

What we have found is that there has been a continued upward trend in average income multiples since last year’s survey. That upper trend is reflected in the CML’s own trend figures which show that average income multiples are now at or above the level at the height of the last housing boom in the third quarter of 1989. For first time buyers the average income multiply is now 2.29 times, compared to 2.2 in 1989, for example.

Of course the level of interest rates is considerably lower now than it was then, and with monetary policy now in the safe hands of the Bank of England, there is good reason to hope that we shall not see the kind of high interest rate peaks that characterised the 70s, 80s and early 90s. But, as I pointed out earlier this year, while higher income multiples are perhaps manageable at low long-term interest rates, unsecured borrowing commitments by the same borrowers have also been rising. So we continue to stress the importance of affordability models which review overall income and expenditure of the borrower, and the potential impact of changes in interest rates, to support the underwriting process.

And one particularly worrying trend is the continuing rise in loans at high income multiples, by which I mean above 3 for a single borrower or 2½ for joint borrowers. The proportion of loans in this category has increased sharply, and represented as much as a third of new lending in recent quarters.

You will all be aware that the Government have recently begun to take an interest in the whole issue of over indebtedness and responsible lending, through the DTI’s Debt Taskforce. That reinforces the need, we think, for lenders to monitor their trend in lending by income multiple. And we have been surprised to find that not all lenders do so as a matter of course. Of course income multiples are not perfect predictors of default but, they do provide an indication of the degree of income stretch in new lending and thus the sensitivity to increase in interest rates.

Both of these trends continue to worry us, therefore. But there is light as well as shade in this picture of the landscape. And we are encouraged to see that the overall level of higher loan to valuation lending has moved down since our last review with the proportion of loans at over 75% of valuation having fallen back quite markedly.

But it remains important for lenders to be careful in the case of high loan to valuation loans, particularly those over 95%. That is particularly relevant now, given the substantial rise in house prices over the last 2 years.

And the picture in London justifies especially close attention.

It may be true that the over excitement that was evident in parts of the housing market at the beginning of the year has now dissipated somewhat. We have even seen talk of some price reductions in the last few months. But it is striking that the gap between average London house prices and average prices in the rest of the country is now as large in percentage terms as it was in its peak in the late 1980s. On the Halifax index the ratio of London to average home prices peaked at 1.75 at the beginning of 1988 and was again at that level in the third quarter of this year, having fallen to 1.22 in 1993. Indeed the last peak in this ratio was followed by 5 to 6 years in which London prices under performed the rest of the market by around 30%.

I am not in the prediction business, and it may be that the London premium will remain at this historically high level, or that house prices elsewhere in the country will trend upwards more quickly. But clearly one cannot exclude the possibility of a fall in London house prices, which could put very high LTV loans into the danger zone.

In short, the concerns we expressed in February remain present, and we continue to counsel prudence.

Of course there are over important changes underway in the mortgage market, too. You may well be most pre-occupied by the pressure on margins, certainly in new business, but also increasingly in the back book, too. That margin pressure does have a read across to the prudential side, quite clearly, since as the overall business becomes somewhat less profitable, the economics will become ever more sensitive to default rates.

But from a consumer perspective the consequence is that the market has become more competitive and more responsive. The industry has become much sharper in its pricing, much more rapid in its processing, much more imaginative in its product design and much more flexible in its marketing. All these are very positive trends and I acknowledge all the hard work put in by the staff of mortgage lenders to make them happen.

But, unfortunately, as a regulator I must take an interest in the sins of the past as well as the promises for the future.

And one of our major preoccupations over the last year has been the problem of endowment mortgages, and how to cope with an awkward inheritance of poor selling practices in the past.

Unfortunately, the endowment mortgage story has become one in which it is difficult to get across a balanced perspective, where reasoned argument is drowned out by noise in the system. We are criticised on one side for stirring up discontent by requiring endowment providers to issue re-projections to policyholders. And on the other side we are lambasted by those who would like us to order a full scale, drains up, review of every endowment sale in the last 12 years. That is something we have declined to do, on what I believe to be sound cost benefit grounds, sound in the consumer interest, I should say, not the firms’.

But that is to say what we have decided not to do. Because equity returns have been strong through the last decade, consumers on average have done pretty well with an endowment product compared to the alternative of a repayment mortgage.

That is not, however, the case for everyone, by any means. Some consumers have undoubtedly suffered loss from poor advice given. Some, too many, consumers were given to believe that their policies were guaranteed to pay off the mortgage, and now find that that is far from the case. Others were sold badly flawed products, flawed on any reasonable assumptions, and often incorporating unjustifiably high charging rates.

Against that background we have put together a careful, and we believe proportionate response to the problem.

First, we have insisted that consumers should get, and continue to get on a regular basis, clear and consistent information about the position of their mortgage endowment and their options for the future. I find it frankly pretty astonishing that product providers were aware that many endowments were not on track to pay off the mortgage, yet had no plans to tell policyholders that uncomfortable news, leaving them to face an unpleasant surprise at the end of the term, perhaps at a time when they are not in a position to do much about it, except sell the house. I regard this as extremely poor customer service and I am pleased that the ABI, on behalf of the life insurance industry, has now accepted that argument, and have agreed that policyholders should receive re-projections as a matter of course in future.

So in January all holders of endowment mortgages were sent an FSA fact sheet which explained the general position, and from April onwards individual re-projections letters have been sent out. Some 7 million have gone out so far and the full process, which will involve around 11 million letters to 6 million households is on track for completion by June of next year. Independent research carried out for the Financial Services Consumer Panel, published a week or so ago, has confirmed the effectiveness of this communication programme. More than 90% of consumers sampled find the re-projection information clear. Around 70% of policyholders with red or amber letters, indicating a material risk of shortfall, have taken or are planning to take action in response. And most of those who are not doing so have a valid reason for not acting now.

Second we have put out advice to consumers who consider that they do have good grounds for a complaint. We have issued for consultation new regulatory guidance to firms to ensure that they handle complaints and calculate redress in a consistent and fair way. By the end of October firms had received some 51,000 complaints and around 4,000 complaints had found their way to the Ombudsman. That may seem small against a background of 7 million re-projection letters sent out, but it means a big jump in the Ombudsman’s workload, nonetheless. These numbers of complaints will certainly rise and a major effort will be needed on the part of firms to ensure that consumers’ complaints are properly dealt with. At this stage, however, the volume is less than 1% of the re-projections issued.

Thirdly, we are continuing to look at whether some firms have chunks of past business – particularly endowments based on unrealistic assumptions for growth or expenses – where the unsuitability of advice given is likely to have led to significant consumer detriment on a large scale. We are in discussion with a number of firms about classes of past business where it may be necessary to order a pro-active review to put matters right for a substantial number of policyholders. This looks as though it may cover hundreds of thousands of policies, rather than millions, and we will make further announcements in that area as soon as we can.

The disciplinary announcement we made on Friday of last week, following our investigation of mortgage endowment problems at Royal Scottish Assurance, where a redress programme estimated to cost around £50 million is now underway, should leave no one in any doubt about the seriousness of our intent to deliver appropriate compensation and to impose appropriate sanctions where that is justified. Formal investigations into a number of other firms are moving ahead now. Where we find that firms have been mis-selling we will take disciplinary action and require redress to be paid.

Fourth, to ensure that current and future selling practices are acceptable we are now reviewing the selling practices of some 30 major firms, which account for 3 quarters of the current market. Through detailed on-site inspections we are looking at the quality of advice currently being given. Firms must properly match the risks of an endowment the needs and personal circumstances of a consumer. Once again, we will take disciplinary action against firms and, if appropriate against registered individuals too, where our work identifies continuing failings.

In all of this our aim has been, and remains to deliver a reasoned and proportionate response to the endowment problem and to make sure that the industry delivers sound professional advice to support decisions that are among the most important people make on their finances. At the FSA we have been disappointed, as we have assumed responsibility for the regulatory system, to find that so much clean up work in relation to past sales has been necessary. We would prefer to be looking to the future. But there are people out there who need our help, and they will get it.

There are lessons for the regulator, too, in this sorry story. Not least they lie in the fact that supervision methods which focus principally on individual firms did not pick up on the poor selling practices as quickly as they should have done. It took some crosscutting thematic work, looking at how a cross-section of the whole industry was selling this particular product, to uncover some uncomfortable facts. So a key aim of our new regulatory strategy will be to direct our work at high-risk areas highlighted by good market intelligence. We aim to ensure that we can nip problems in the bud in future. And we are making substantial changes to our organisation and staffing to achieve that effect. We shall be making some major announcements on that front at a conference next Monday.

At the same time, we are gearing up to take on our new responsibilities in the mortgage market. Since the Government’s announcement, earlier this year, that we would regulate mortgage lenders both from a prudential and a disclosure perspective, we have been working on the detail of the new régime.

The Treasury have now launched a consultation on the definition of a mortgage which will come into our régime. The aim is to focus on those types of secured lending most likely to be long-term and/or associated with house purchase.

And, within the scope the Treasury have set out, we are approaching our task with a number of key thoughts in mind.

First, the market is – as I have said – very innovative at present and as long as consumers are equipped to take informed decisions, and understand the opportunities they have for shopping around, innovation and competition will work to their advantage.

Second, it is clear that consumers do behave differently when taking on a mortgage from the way they act when they think about making long-term investments. Their primary focus, unsurprisingly, is on the house and not the mortgage. They are often in a rush, keen to ensure that they can get the finance to secure the home they have set their sights on. That’s particularly true when prices are rising. The result is that they may not think hard enough about the deal on offer, or spend enough time shopping around. It is also the case that a wider range of consumers, including those who are less financially sophisticated, take on mortgages than take on personal pensions or life insurance policies. It follows that the information package we develop needs to help consumers (many of whose minds are on other things) to make informed decisions. This is a tall order.

Third. We know that meeting this challenge is as much about the timing of information delivery and its presentation as it is about factual content. That is a lesson we have learned from an analysis of the effectiveness, and otherwise, of disclosure régimes in the past.

Lastly, we recognise that many consumers will continue to need or to want advice. So there can be a very important rôle for self regulation through the mortgage code, if the industry as a whole is prepared to make and sustain the commitment required to render that code effective. That is a matter for you, and not for the FSA. Though of course we are very interested in the decisions you reach.

At present, we are awaiting considered responses from consumers, and from the industry itself, to the proposals both the Treasury and we have put forward. Subject to those responses we shall get ahead which putting together the detail of the régime, for eventual implementation in early 2002, given a fair wind.

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