What Lies Beneath

What lies beneath?

There has been significant growth in the number of lenders offering secured lending to people with credit problems, including those who have been bankrupt, have County Court Judgments logged against them, and for purposes such as debt consolidation. As consumer credit debt tops an eye-watering £1.2 trillion in the UK, it is no wonder that the major lenders in the UK and some significant players from abroad have been falling over themselves to get a slice of the growing sub-prime cake in the UK.

But for the IFA there is need for caution. The evolution of the UK sub-prime market needs to be examined and the implications for those who are active in it examined.
From an IFA's perspective, get sub-prime business wrong and the consequences could be serious.

Several factors caused a growth in demand for sub-prime mortgages in the mid-1990s. These include: mainstream lenders automating credit-scoring procedures; more people with previous debt repayment problems; more marginal borrowers seeking loans for home-ownership and, in the late 1990s, soaring levels of borrowing for consolidation of debts as interest rates rose. Since the early 1990s, a range of factors has created circumstances in which both the demand for, and the supply of, sub-prime lending has flourished.

Following the 1990s recession, more people suffered some episode that had harmed their credit rating whether from house repossession, falling into arrears with housing or utility payments, which were pursued more aggressively by privatised companies, having had a CCJ or being made bankrupt. Reflecting broader labour market changes, more people had flexible contracts or terms of employment and income that was variable or hard to confirm.
Mainstream lenders, which had suffered during the housing market recession, reacted by exercising extreme prudence in lending, particularly using mechanised and centralised credit-scoring mechanisms to select only low-risk borrowers.

Individualised

The UK sub-prime sector started to evolve from the mid-1990s with the entry of specialist lenders. These saw a niche for lenders building on a more individualised approach to underwriting and pricing the risks involved in lending to sub-prime borrowers. Luckily a buoyant property market has covered up any deficiencies in the risk pricing models. House prices have more than doubled in the past decade, so it is not advisable to heap too much praise on the sub-prime lending actuaries.

A greater proportion of borrowers in the sub-prime sector are in arrears than those in the mainstream sector, as might be expected, around 10 per cent to 15 per cent in 2004.
There is also evidence that sub-prime lenders move towards possession more quickly once arrears start to accumulate, on both first and, especially, second mortgages. Now there is a new raft of specialist sub-prime to sub-prime lenders which are mopping up the heavy adverse clients. Competition would on the face of it seem like good news for sub-prime clients and intermediaries active in this segment. This year there are expected to be six new entrants in the UK sub-prime mortgage market.

Deutsche Bank has already entered the fray, Oakwood Financial Services enters later this year, headed by the ubiquitous Michael Bolton, formerly of BM Solutions/HBoS. Others of note, include Mortgages Plc which is backed by Merrill Lynch, and is making real inroads with its innovative products, keen pricing, technology and extensive teams of field sales support. GE Capital, GMAC, BM Solutions, Money Partners, Platform the list goes on. These organisations want serious market share and that means sacrificing margin to get to the top of sourcing system best-buy tables.

When lenders compress margins, other things can suffer, such as commission payments. At the near-prime end of sub-prime there is now little difference between rates offered by high street lenders and commissions paid.

If there is a sustained price war, and the signs are it is under way, only those with big balance sheets will survive. That could mean the end for a number of small niche players. It is like the corner shop taking on Tesco there will be casualties and collateral damage. A favoured niche sub-prime lender may not be around forever.

Clearly sub-prime lenders fill a market gap. They allow entry to owner-occupation for those who are able to repay, but fail high street criteria. They allegedly offer credit repair to borrowers who, if they maintain repayments can re-enter the mainstream market. There is an important qualification to make here. Sub-prime lenders in the main will not proactively credit repair clients.

Assumptions

It would be nice to assume that a sub-prime client who has diligently suffered the ignominy of higher interest rates would automatically get a rate reduction if he paid his sub-prime mortgage for two years without missing a beat. But that is not how it works. Sub-prime lenders securitise their lending portfolios and that means investors who buy these juicy mortgage-backed bonds expect a decent rate of return.

Proactively managing these cleansed clients to a better rate would put them at loggerheads with their investors, so it is the customer who misses out. Brokers and IFAs need to remain vigilant and pro-actively manage their cleansed clients back to prime rates with high street lenders or face the wrath of the FSA which is taking an ever closer look at this market segment.

Record levels of consumer debt mean that debt consolidation has become increasingly popular. Consolidating can allegedly provide a "fresh start" for a client whose borrowing has become unmanageable. Sub-prime borrowers are higher risk overall, and face higher interest rates and charges than mainstream borrowers. They also face higher charges.
There is evidence that sub-prime lenders are relatively quick to pursue repossession and impose relatively high charges to borrowers in arrears. Repossessions have doubled in number from last year. A worrying trend, and one which would gain real momentum if property prices headed southward.

This can lead to a downward spiral for borrowers, through repeated re-mortgaging from lenders at increasingly higher rates and worse terms due to increasingly poor credit records.

This is an area of significant importance to intermediaries and one that could come back and bite the unwary.

The FSA's initial review of sub-prime lending is no doubt the first of many more detailed investigations as it begins to understand the complexities of the market. In its initial review the FSA was concerned many firms could not demonstrate that they had gathered sufficient information in certain areas to demonstrate suitability of a sub-prime product.
All information gathered for the purpose of assessing suitability needs to be recorded. The FSA has sounded the warning bell, reminding brokers that they need to have regard for all relevant facts about a customer of which they should reasonably be aware when selling a sub-prime mortgage product as well as those facts that a customer has disclosed himself.
It also added that firms must determine what is relevant when dealing with each customer, but in particular brokers must understand and document:

- the customer's credit history, including an awareness of his debt position details;

- any existing mortgage arrangements and

- income and expenditure information to assess affordability.

To demonstrate suitability firms can use a factfind document to show that all requirements have been discussed and considered with the customer. Completing a checklist can demonstrate additional considerations have been reviewed with the customer.

Enforcement

It is only a matter of time before the FSA starts to enforce its treating customers fairly principles. Those in the sub-prime sector can pay significantly more for borrowing than those in the mainstream sector.

While this might initially appear to be unfair in that it is the more financially vulnerable who pay the most, the question is really whether such borrowers pay more than is warranted by the extra risk they present.

Money advisers, in particular, express concern that people may be tempted to borrow more than they can really afford. Spiralling levels of consumer debt back this up.
There is no doubt the FSA will start to monitor what is being done to proactively credit-repair a sub-prime client. Leave a cleansed client on higher sub-prime rates longer than is necessary at your own peril. The TCF principles are there for all to observe, and the FSA does have teeth.

The sub-prime market is set for a period of extended competition and consolidation. Factor in the ever- increasing presence of the FSA and its principle-based management and it is clear that you cannot play at sub-prime lending. Unless a company has critical mass and sub-prime is a significant proportion of the business mix, it should tread carefully because there is no doubt that the FSA will claim scalps.