Risks in the mortgage market: A regulator's view
Speech by Clive Briault, Managing Director, Retail Markets, FSA
Council of Mortgage Lenders Annual Lunch
20 April 2007
Good afternoon, and thank you Michael for your kind invitation to speak today.
I want to begin by thanking Michael and the CML for their cooperation with us over the past year on a wide range of issues, including:
- the development and successful application of a system to help lenders to identify and report fraudulent loan applications handled through mortgage intermediaries;
- assisting and supporting our work on Treating Customers Fairly;
- working together on the Statement of Good Practice for Mortgage Exit Administration Fees;
- providing major inputs to our Mortgage Effectiveness Review, to our thematic work on equity release and on early repayment charges, and to the development of a comparative table for payment protection insurance; and
- strong support for our financial capability initiatives.
You would probably be happier if I stopped there and let you enjoy your lunch, but I also want to speak to you today about how I see the UK mortgage market two and a half years after we began regulating it. I will cover five specific issues:
- the importance of stress testing your risks;
- the risks we see in the sub-prime sector;
- mortgage exit fees;
- our move to more principles-based and more outcome-focused regulation; and
- our review of the effectiveness of mortgage regulation and the possibility of an EU mortgages Directive.
The world we live in
We have lived for more than ten years in benign times. Indeed, the Governor of the Bank of England has described this period as 'nice'. My English teacher warned against using such a vague adjective - but Mervyn King has heeded this advice: in this case NICE means Non-Inflationary Consistently Expansionary. This is rather a mouthful even before lunch, but it is a good description nonetheless.
These conditions of low inflation, low unemployment, consistent growth and low interest rates have helped the mortgage industry to flourish. Gross mortgage lending was up 20% in 2006 to around £345 billion, bringing the outstanding stock of mortgage lending to above £1 trillion at the end of 2006. This has attracted new lenders to enter the market at what seems like an ever increasing rate. We have seen more than twenty new mortgage lenders enter the market since October 2004.
Although I expect that these benign conditions will continue over the next year, I am not an economic forecaster. I do my best to avoid appearing on the front page of the Daily Mail as the latest commentator to predict that house prices will fall. There are enough of them already. But I do worry about the downside, and its potential impact on both the firms we regulate and on consumers. Recent favourable economic conditions have enabled and encouraged many consumers to take on additional debt, much of it secured against property, but many of them will be unprepared and ill-equipped for a weaker economic environment.
We have at present historically high levels of personal debt relative to income. Total household debt, which stood at about 70% of income 20 years ago, is now more than twice that, mostly secured against property. However, in a world of low interest rates, the ratio of interest payments to disposable income is much more manageable. Currently the ratio of interest payments to income stands at around 20%, well below its peak of around 30% in 1990. But we are now seeing this ratio creeping up, which in turn increases the vulnerability of both borrowers and of those who have lent to them. A one percentage point increase in interest rates has a much larger impact when interest rates are around 5% than when they were above 10%.
This vulnerability is beginning to show though in other data. We have already seen increases in individual insolvencies: personal bankruptcies and IVAs have risen five-fold since 1998; and even prime mortgage arrears, which came down markedly over the last decade, are beginning to rise.
Stress testing
It is important that all mortgage lenders undertake regular stress testing of their credit risks against shifts in external conditions, including movements in house prices, interest rates, and unemployment. And where lenders have significant exposures against sub-prime, buy-to-let and other specialist sectors of the market then they should take account of potential changes in economic conditions specific to these sectors.
For those lenders taking advantage of the advanced approaches under the Capital Requirements Directive, we will be looking very carefully at the assumptions you are making in determining how much capital you should be holding against the potential credit losses that may arise. In particular, we will be looking at stress testing results. We expect to see realistic and robust scenarios that demonstrate the impact - on arrears, provisions, profits and capital - of a much less benign economic environment. And it is important that lenders firms do look at the impact on profits as well as on capital that could arise from poor performance – it may not help to have adequate capital to cover the impairment charges if your funders lose confidence in your business because of significant reported losses.
In calibrating these scenarios, there are some extremely relevant pointers as to what can go wrong: not just in the history of the last UK housing boom and bust at the end of the 1980s/early 1990s, but also in the fall-out that we are currently witnessing in the US sub-prime mortgage market - which may cost lenders in excess of $150 billion. Reference points issued by us for assessing downturn Loss Given Defaults suggest that when lenders are calculating their Loss Given Defaults on mortgage portfolios they should allow for a 20% reduction in house prices, and a further 20% reduction from forced sale after a property has been repossessed; and should allow for 35% of loans in default to end up in repossession.
Risks in the sub-prime sector
The sub-prime sector is a rapidly growing part of the mortgage market, estimated at 8% or more of total mortgage lending. And the number of lenders active in the sub-prime market has grown, with the entrance of both new lenders and lenders already operating in the prime end of the market. The principle of risk and reward applies, of course, so lenders would no doubt seek to reassure me that their pricing models allow for the fact that sub-prime mortgage arrears are currently running, even in these relatively benign economic circumstances, at up to 20 times the rate of arrears on prime mortgages.
I accept that the UK sub-prime market is not the same as in the US. Loan to value ratios have been less aggressive in the UK, and in the UK we have less of an issue with the low start adjustable rate mortgages with interest roll-up that seem to be causing particular problems in the US. However, we cannot completely ignore the parallels with our own market. For example, lenders are in some cases taking on substantial risks through a combination of high loan to value ratios and high income ratios, in part because borrowers are using additional borrowing against property as a means not only of debt consolidation but also of increasing their debt at regular intervals by taking as much advantage as possible of rising house prices. Continued house price appreciation may therefore be masking some severe difficulties in some sectors of the housing market.
Placing a one way bet on rising house prices as a mechanism guaranteed to bail out both borrowers and lenders is not a sensible course of action - even a slowdown in house price rises could expose a number of seriously over-indebted borrowers.
We have seen existing prime lenders diversify their lending into the sub-prime market. I say "diversify", although in this case portfolio theory is unlikely to apply since the "diversification" is likely to increase rather than decrease risk. If you diversify away from prime mortgage lending into almost any other asset class, your credit risk is likely to increase. The risks are particularly high where firms have no initial knowledge or experience in this specialised end of the market and are attracted mainly by the potentially wider margins available. We have seen cases where lenders have undertaken little or no analysis of the risks that go with those margins, and where it was far from clear to us how the senior management or the board of the firm could have taken a fully informed decision to enter the sub-prime market.
The high level of sub-prime arrears also raises some important questions about the extent to which lenders have taken affordability into account when undertaking this lending. Our rules require both lenders and advisers to make an assessment of a borrower's ability to afford the mortgage, so high default rates should be prompting lenders to review their affordability models and to understand the root cause of high arrears.
Our focus on assessing affordability has three key aspects:
- to look at net income – that is, income after tax and having deducted expenditures such as borrowing costs, maintenance, dependant relatives and similar regular calls on available income;
- to consider whether the borrower can afford the payments, not just at the start of the mortgage but also when rates change, such as after an early discount period; and
- to consider whether the borrower can repay, or has a plan to be able to pay, the capital amount.
Although many of the findings from our study last year of the Quality of Mortgage Advice Processes were generally positive for lenders, we did find that while advice-giving lenders had robust processes in place for the assessment of affordability, these were not always followed and applied consistently. Indeed, much of our supervisory and thematic work to date has pointed to firms' assessment of affordability being a key area of concern in the mortgage market. So this will continue to be a focus of our thematic work over the next year. We want lenders and advisers to apply appropriate lending criteria, including taking account of affordability; we want consumers to have a better understanding of the risks they may be exposed to when they take on debt; and when advice is offered, we want it to be suitable to the consumer's needs.
Similarly, the sub-prime mortgage sector is an area we are currently looking at and on which we will continue to concentrate. We have been looking at lenders' policies in this sector, and reviewing lenders' and brokers' case files to see how these policies are being applied in practice. We have also been looking at intermediaries' sales processes more generally in the sub-prime market. We will be reporting our findings in June.
Mortgage Exit Administration Fees
The need for firms to act fairly is central to an efficient retail financial services market and to the strengthening of consumers' confidence in it. Following discussions with the CML, we released a Statement of Good Practice on Mortgage Exit Administration Fees in January. The main purpose of the Statement was to address the issue of recent increases to these fees, and to indicate to lenders how they should draft exit fee and variation terms and how they should apply these terms fairly in practice.
The Statement contained measures, agreed with the CML, to stop borrowers from being surprised by unexpected increases in these fees. We gave lenders until the end of February to decide how they would treat existing customers when they come to exit their mortgage. Over 95% of lenders have now confirmed that existing customers will be charged a fee which is equal to or lower than the original fee that applied when the customer took out the mortgage. And we will require the remaining lenders to justify the decisions that they have taken.
We expect lenders to treat past customers who complain about the level of the mortgage exit administration fee they were charged in the same way as they treat comparable current customers; and by the end of July to review their fees and terms and conditions for future customers. Consumers should know when they sign up for a mortgage what fee they will pay on exit, or should be given a clear idea of how the fee might be increased fairly.
We have seen many examples of significant deficiencies in firms' standard form consumer contracts. We see this as an example of how there remains much further to go in meeting the Treating Customer Fairly agenda. I find it odd, for example, that no-one in so many firms spotted and questioned the unfairness – a legal as well as more general unfairness – of raising these exit administration fees. Or if they did spot this, who overruled them, and why?
Consumer groups – and the press – are becoming ever more exercised in opposing what they consider to be unfair terms. We see warnings in national newspapers for customers to look out for increases in interest rates and other fees by lenders in order to recover the cost of reducing and repaying exit administration fees. We are not a price regulator – we do not impose limits on rates or fees, or prevent lenders from varying fees, provided the variation term or mechanism is fair, transparent and legal. But senior management need to make sure that this is indeed the case. We do not want this to turn into a game of regulatory Bat-A-Rat where we hit one unfair fee, only for another to pop up elsewhere. Otherwise there would be a real risk of reputational damage to the industry.
Moving to a More Principles-Based and Outcome-Focused Approach
You will no doubt have heard a lot about our move to a more principles-based approach. Why are we doing this?
We want to see a stronger focus by firms on the outcomes that really matter – better outcomes for consumers, for investors and for markets; and therefore better outcomes against our four statutory objectives. A more principles-based and outcome-focused approach should encourage senior management to focus more on the Principles and the outcomes we want them to deliver; and should enable these outcomes to be delivered more effectively.
We want senior management to develop a greater understanding of how the Principles and our other high-level requirements should apply in practice; to drive and embed change throughout their firms; and to measure that this is delivering the right outcomes. A more principles-based approach also provides senior management with greater flexibility in how they run their business while meeting our requirements, and in particular greater scope to compete and innovate while doing so; or indeed to compete by exceeding our minimum requirements.
For consumers we are working, in partnership with many others, to improve levels of financial capability. We want consumers to be capable and confident in dealing with the financial services industry. And we are looking for ways to encourage consumers to engage more actively when dealing with financial services products and services, since it is in their own best interests to do so.
This is absolutely not about any lowering of our standards, or passing standard-setting to the industry. We are not changing our Principles and other high level requirements. Our Principles are themselves rules. They articulate the outcomes we require firms to deliver. Examples include that firms must conduct their affairs with integrity, that firms must pay due regard to the interests of their customers and treat them fairly, and that firms must maintain adequate financial resources. And this does not mean that we will confine ourselves entirely to high-level conversations with firms in order to establish that these standards are being met. There remains a role for more detailed testing, not least to determine whether the aspirations and intentions of senior management are indeed being translated into the right outcomes in the customer-facing operations of their firm.
To some extent this has to be an "act of faith" on our part. But the potential prize is considerable. If we can shift towards a greater focus on regulatory outcomes, a greater involvement by the senior management of firms in delivering these outcomes, and the embedding of this senior management drive throughout the business of the firm, then the potential for real change is massive – for consumers, investors and markets. And this should emerge not just through the behaviour of each individual firm but also through more dynamic and competitive markets that help to deliver our statutory objectives.
Treating Customers Fairly
Our Treating Customers Fairly initiative is at the forefront of our more principles-based and more outcome-focused approach. We are challenging firms to treat their customers fairly throughout the product life-cycle.
We have recently completed a general assessment of progress by the industry - including mortgage firms - against our end-March deadline for all firms to be at least implementing Treating Customers Fairly in a substantial part of their business, and will report back on this early next month.
We have also been focusing on the respective responsibilities of providers and distributors. What does this mean for mortgage lenders?
First, when designing a new product, lenders should consider which types of consumer the product is likely to be suitable for, and equally importantly which types of consumer it is not likely to be suitable for. There are a number of mortgage products that may be suitable for only a limited number of consumers, such as high income ratio and high loan to value products, equity release products and sub-prime mortgages.
Second, lenders should select appropriate distribution channels, consistent with their products being bought by the types of consumer for which they were intended.
Third, lenders should provide appropriate information to both distributors and consumers. They should communicate to their distributors both the advantages and the risks of their products, and make clear which types of consumer the product is likely to be suitable for. And lenders must communicate clearly the nature of the product to consumers, including significant features outside the headline price so that consumers can make informed decisions. Firms need also to consider the low levels of consumer understanding of financial products, including mortgages. The development of increasingly complex products underlines the importance of lenders providing information which is clear, fair and not misleading.
Fourth, we expect lenders to monitor that products are ending up with the right type of customer. I stress that we are not talking here about 'policing' individual distributors, but we do expect lenders to monitor product sales at a high level and to take action where they see that products are finding their way to customers who are not part of the target market.
And finally, we expect product providers to deliver an effective post sale service. We expect firms to ensure that their contact with customers, and any information they provide, continues to deliver fair treatment.
Mortgage Effectiveness Review
As well as looking at how mortgage firms are coping with regulation, we are also considering whether the mortgage regime we brought in two and a half years ago is delivering the intended outcomes for consumers.
We are considering this in two stages. In the first stage we focused on the mortgage process up to the point of sale, looking particularly at disclosure and advice. Our findings led us to conclude that the market is moving in the right direction, which is good news. The prime mortgage market remains competitive; and consumers find our disclosure documents helpful and are using them to shop around.
As we announced earlier this month, in the second stage we will focus on areas where the potential for consumer detriment is higher and for that reason we will be looking at the sub-prime market; lifetime mortgages; how lenders treat borrowers in arrears; and the suitability of advice on sub-prime and specialist mortgages.
We are also seeking to identify – with the help of our stakeholders – whether there are any areas of the Mortgage Conduct of Business Sourcebook that we could simplify, re-focus, and move further towards a more principles-based approach.
We are in no rush to rewrite our rulebook if there is no convincing argument to do so. The areas we looked at in the first stage of our effectiveness review – in particular disclosure – seem to be achieving good outcomes, at least across the prime mortgage market. Feedback from the industry shows little appetite for rule changes. And there will shortly be an EU White Paper on Mortgages. If the EU decides to introduce a Directive, the implications for the UK's mortgage regime could be far-reaching, so it is right to wait and see the direction the European Commission is moving in before taking any final decisions on our rulebook.
Europe
With the Commission’s White Paper looming, I will close by summarising our views on the issues raised. I am pleased to say your views and ours are very much in line.
We are encouraged by the better regulation approach being adopted by the Commission and we support the view that there are benefits to be gained from open, competitive, diverse and efficient mortgage markets.
However, our view remains that the Commission has not made the case for legislation to harmonise consumer protection in the mortgage sector across Member States. There is no evidence to suggest that the absence of common standards across Europe in the information and advice provided to consumers is a significant barrier to market integration, and any attempt to introduce a 'one size fits all' approach risks undermining the benefits of existing rules tailored to national markets.
We believe that the value of an integrated European market will come not from consumers shopping for mortgages across borders but by making it easier for lenders to enter new markets. European action should therefore tackle structural barriers that constrain lenders from operating across borders. These include the efficiency of mortgage funding arrangements; cross-border access to consumer credit data, while maintaining key data protection safeguards; developing common valuation standards that can be widely used and understood by valuers and lending institutions; raising confidence in repossession procedures, while maintaining consumer safeguards; and encouraging the development of open access to online land registry information systems.
These structural barriers should be the priority of the Commission's work, and in our view market-led initiatives in some of these areas have a key role to play in delivering markets that are competitive and efficient across the European Union.
Conclusion
I have outlined a number of concerns about the mortgage market from a regulator's perspective, and what we are doing about them. In most cases, however, the necessary action rests with the industry, be it in:
- stress-testing your business against the impact of tougher economic conditions;
- taking account of affordability in making lending decisions and when giving advice;
- setting fair and transparent charges; and
- treating your customers fairly.
The UK mortgage market is an exciting and innovative sector. But there will be more challenging times ahead for all of us. We need to be prepared to rise to these challenges so that together we can make a real difference to the mortgage sector and to UK consumers. We look forward to working closely with the industry towards this end.