Although changes in regulation are due, once the Mortgage Market Review has been completed, it could take some time before anything actually happens. Paul Hunt of Phoebus Software discusses how this will impact on lenders and software suppliers
Feeling good about regulation is like looking on the bright side of any catastrophe. When you quit looking on the bright side, the catastrophe is still there. The situation is certainly fairly bad at the moment, with the world waking up to the fact that the old regulatory regime didn’t deliver. President Barack Obama has spoken of his plan to revamp financial regulation in an attempt to protect borrowers from "confusing and high risk mortgages". Obama is advocating vanilla mortgages - simple, long-term loans without complicated features.
But the wretched, rickety regulatory regime that the British mortgage industry is operating under won’t be stabilising any time soon. The big calendar event of 2010, the election, will have a massive impact on new regulations - to all intents and purposes that will guarantee no new regulations will be issued until late 2010. The knock on effect will mean any changes we see in 2010 won’t be effective until 2011. Consultation papers will only extend this out further. This is dangerous. There is a risk that the market could continue to stagnate until the new regulations are understood. Furthermore, will the Financial Services Authority deem it appropriate to look retrospectively where it is clear the market rules are changing? More uncertainty.
So changes like those laid out in the Mortgage Market Review will continue to hang over the mortgage industry like a cloud for some time. Although the discussion period ended on 30 January, the feedback statement won’t be with us until March, after which time detailed proposals for change will be issued. The proposals could include a number of changes, such as the banning of self-certification mortgages, making it harder for the self-employed to get finance. Other proposals include stricter affordability assessments, while buy-to-let mortgages and second-charge lending may also be regulated.
The Mortgage Market Review looks as if it will completely remove consumers' responsibility for their own financial decisions. Which seems odd, because the current financial catastrophe doesn’t owe too much to mistakes made by British consumers. When it came to mortgage credit at the beginning of the 21st century, it was American industry experts who fundamentally lost their way. The consequences were disastrous not just for borrowers and financial institutions in the
Many mortgage brokers and originators sold mortgages directly to securitisers. They therefore had no economic risk when considering the loan applications of even very risky borrowers. Without any money at risk in case of loss, brokers and originators had every incentive to apply the weakest underwriting standards that would produce the most mortgages that could be sold. And unlike banks, most mortgage brokers in the
That produced, on a global scale, the worst underwritten mortgages in history.
Policy recommendations
How do we fix the system to stop this from happening again while still providing adequate mortgage credit to borrowers? A number of policy recommendations that have been put forward provide credible responses to problems in the mortgage markets that were at the heart of the financial crisis. Among the most important are stronger capital requirements for mortgage-backed securities and collateralised debt obligations, reform of credit rating agencies, and enhanced consumer protection regulation for mortgage products.
All of these would help, but I believe that we need to do more to address directly the core underwriting problems that led to so much misery. And we need to do so in a way that applies equally to all mortgage lenders that operate in a given market. This point is critical: any new mortgage regulation that is adopted must apply to all providers to prevent the kind of competitive inequity and pressure on regulated lenders that eroded safe and sound lending practices in the past.
Mortgage Market Review
The Mortgage Market Review doesn’t address this. Sadly, the FSA won’t be able to fix our industry’s problems by underestimating the ability of the vast majority of people to make responsible decisions for themselves. And this is exactly what the Mortgage Market Review is doing. Lending must be responsible, but consumers benefit from and appreciate lenders and intermediaries that treat them as adults. There is a real danger that FSA will create a regime in which consumers feel they need to take no responsibility for their own financial decisions and consider borrowing to be risk free. The government should re-examine the Mortgage Market Review proposals, which concentrate on the 5 per cent of the market who exhibit less favourable characteristics.
But I’m not suggesting the market doesn’t need a review. We do because lenders with high-risk strategies forgot the basics of pricing for risk, effective credit underwriting, and controlling the application process. Fortunately, those lenders are now largely out of business – although the remaining lenders (who lent responsibly) now have to deal with the regulatory consequences.
Underwriting standards
So, instead of focusing all our regulatory efforts on treating consumers like children, regulators might focus on the need to establish certain minimum underwriting standards for all residential mortgages. These would not be "best practices" or even suggested practices that regulators bless as appropriately prudent. Instead, they would be the true minimums that we believe must be observed to keep lenders from risking too much loss to both themselves and their customers. These standards would not dictate every underwriting feature of a mortgage product; instead, they would focus on core practices of sound underwriting on which there is the broadest consensus.
The problem is a lot of the regulation currently on the table is not clearly defined. Take the proposed changes to underwriting the full affordability of a loan, for instance. How is this going to be achieved? What will the rules be? How much will be down to lender interpretation? These are questions that need answering. Working the margins of any affordability model can be used to gain competitive advantage. If we aren’t careful, we could end up with dodgy lending by stealth. Is the FSA going to try and prescribe what parameters are applied?
Affordability models
Lenders need to establish their affordability models. These should be broadly similar, shouldn’t they? But will lenders define affordability to support higher lending volumes or lending quality? Tweaking the model parameters will, potentially, move a lender into or out of competition with its peers. It’s a question of quality versus quantity. Will the FSA regulate affordability model parameters too?
The question of how to achieve full access to the affordability of the loan is hugely important as it has the potential to affect both lender and software.
There are yet more unanswered questions surrounding self-certification. What does the regulator even mean by self-cert? How are they going to define it? Will there be any circumstance where it will be accepted? How will part time income / casual work / benefits in kind fit into the equation?
And why should lenders invest in more underwriters? Why should they invest in new systems for that matter? If they rent new systems, even on flexible payment terms, the cost of implementation will inevitably end up increasing the cost of mortgages. So the borrower will suffer. They’ll end up paying more as lenders pass on the costs through higher application fees.
These new standards will clearly be a burden to lenders in the short term. But they won’t want to neglect their business as they go about adapting to them. They will want to break their stride as briefly as possible to adapt to meeting these new standards. Lenders may well find themselves blocked by systems that were designed to operate in the less complex world of volume origination - rather than the more exacting one of quality. What does the FSA want them to prove? Will it insist on quarterly reporting to show how income was evidenced and what affordability ratio was used?
Remortgage market
There may be enormous repercussions for the remortgage market. It could disappear. As lenders tie in borrowers for longer to ensure a good return, remortgaging will go up in smoke.
Pre-Mortgage Market Review borrowers may be excluded from the remortgage market and the standard life of a mortgage will increase. Profitability will start going up with increased margins, longer terms and higher application fees. Products may become standard across the market with all lenders offering the same sized loan based on income. Business models will have to change. Customer retention will become more important than it has been for years and there will be a greater focus on value-added cross-selling.
Buy-to-let
Buy-to-let could be regulated like any other mortgage where the investor is classed as casual. This will be hugely complicated for lenders and their systems. How does any individual prove they are a ‘casual’ BTL investor? Market data will not be available.
More questions arrive from the term “Political Risk”. The biggest worry concerns how it is to be defined. Will there be sufficient detail to ensure lenders know what is required? If they simply have to try to interpret the message they won’t always get it right. Then they’ll get fined when the interpretation doesn’t match up to that of the FSA. It’s unfair on lenders. And it’s grossly irresponsible. Furthermore, will it end up being over regulated? There will be no competition as competitive edge will be difficult to secure.
Lenders won’t know to whom they can lend. How can lenders prove income, as it will be their responsibility? And how will the smaller players justify spending the money on systems? Nobody has told them how much they can lend.
Software suppliers
Regulation will also have an impact on software suppliers like us. In the short term, it may not be huge. Initially lenders will use underwriters to do manual calculations. That’s bad news for the consumer because the inevitable consequence is more man-made errors. The affordability concept will be more difficult to carry out manually. But in the medium term, systems will need to incorporate the changes. Lenders’ software will need to ensure lenders are able to demonstrate prudent lending and to certify a consistent approach by all underwriters.
The problem with regulators is that the kind of man who wants the regulator to adopt and enforce his ideas is always the kind of man whose ideas are idiotic. Personally, I like a lot of the people involved in regulation when I meet them. Indeed, there are some I would trust with anything - anything, that is, except the regulation of the financial service industry.
Paul Hunt is managing director of Phoebus Software
Date: 1st, February, 2010
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