Events are combining to put ever-greater pressure on mortgage intermediaries, and it will only get worse in 2004. Mortgage advisers are going to have to learn more about lenders’ operations so they are able to explain just why some products will be suitable and others will not, or borrowers will go online for advice.
It is understood that all mortgage advisers must be now be qualified and within two years giving mortgage advice will be an activity that is subject to statutory regulation. Therefore, if we stand back from the fine detail and try to get a broader view, the picture that emerges is quite simple. Mortgage advisers are now in the process of being expected to add value to the transaction, and not just facilitate the process. This will be possible because advisers will need to know enough about the mortgage choices under consideration to help their clients to make more informed decisions.
Making a choice
This is not too much of an over-simplification. All the components of a mortgage decision depend on choices. Which lender? Which product? How much to borrow? Who will lend the money? Even those mortgage intermediaries who are making ‘non-advised’ sales will be expected to give information to borrowers so they can answer these questions. If customers know all the answers already, they would not consult an intermediary but would apply to the lender direct. This means most mortgage intermediaries will have to raise their knowledge levels to meet this challenge.
Supplying the answers to these questions is relatively straightforward when it comes to mainstream applicants thanks to the many excellent mortgage sourcing database services that now exist. Such comparative product databases should be more than able to cope with the limited number of variables in mainstream products. For example, interest rates and all associated special offers such as discounts, fixes and caps fees; length of loan term, income multiples, and loan to values (LTVs). In general, these last two elements define the type of limited credit risks mainstream lenders are prepared to take ‘ and those products that allow higher LTVs and income multiples will rarely carry special offers on pricing.
However, when it comes to niche and non-conforming mortgage products, the scenario is radically different. The same product variables exist in non-conforming lending, but they are only part of the picture. In this sector, which is geared up to accommodate the needs of borrowers who simply do not fit into the limited range of mainstream ‘pigeon holes,’ the major elements of product design are to do with increased risk.
A balancing act
More importantly ‘ from the point of view of understanding how to explain these products to potential customers ‘ product design in this market sector is a balancing act between credit risks on one side, and the level of interest charged to cover that risk on the other.
Taking the example of self-certification mortgages, even before the traditional factors such as arrears and county court judgements (CCJs) are considered, it is easy to see why they are riskier than mainstream lending. An applicant who does not provide documentary proof of income represents an increased level of risk. Once this extra element comes into a mortgage product’s design, the risk/reward balancing act is still a fairly straightforward matter, as there is only one extra risk element to add to the existing list. So advisers looking for a self-employed product can still look across a range of mortgages from different lenders, and give information on suitable products according to the circumstances and needs of each individual applicant.
However, when it comes to the next layer of credit risk elements ‘ arrears, CCJs, IVA and bankruptcy ‘ which indicate a borrower’s past problems with managing their credit arrangements successfully, the risk-reward balancing act reaches a far higher level of complexity.
Here, the focus has moved right away from comparing nuances on different lenders’ products and onto the prospective borrower and their circumstances. It is easy to see the adviser not only needs to have a good knowledge of comparative products from the various lenders ‘ but also a good understanding of the risk banding that each lender operates internally.
The factor that complicates matters is that each lender operates its own rules about risk ‘ so no two lenders will have exactly the same bandings. This is because ‘ similar to the credit scoring systems operated by the majority of mainstream lenders ‘ each non-conforming lender bases its product bandings on its own particular experience of how loans within the scheme perform. In other words, product groupings are based on how well the borrowers within each scheme have kept up payments in the past. If performance is good, then interest rates are at the lower end of the scale. If performance is poor, then products will carry a relatively higher loading on whatever base rate is being used, normally the London Interbank Offered Rate (Libor).
As with credit scoring, lenders keep a constant watch on loan performance and adjust product criteria to take account of it. If certain schemes start to look over priced, then the criteria can be widened, for example, higher LTVs, or lower levels of documentation. Conversely, if schemes are proving to be under priced, then criteria will need to be tightened by lowering the maximum loan size, or the amount of arrears or CCJs. Alternatively, of course, the scheme might simply be re-priced.
At the lower end of impaired credit, applicants may be allowed to self-certify income and have up to £3,000 worth of CCJs, as long as their LTV requirement is no higher than 65%, and they can provide a reference or statement from their existing lender or landlord showing 12 months’ payments made and due. Whereas at the other end of the scale, a borrower may be allowed an LTV of up to 80%, self-certified income, unlimited arrears and CCJs, and no provision of documentary proof of regular rent/mortgage payments ‘ but the loading above Libor will be 5%. For those wanting a 90% LTV, on the other hand, a 4% margin above Libor may be charged, but documentary proof of income may be required, together with proof of 12 months regular rent/mortgage payments, and a maximum amount of arrears of two missed in the last 12 months.
Keeping it low
Confusing? Not really. Stated simply, the aim where the risk of default is higher is to reduce the potential for those defaults turning ultimately into a loss on the sale of a repossessed property, by keeping the LTV relatively low. The higher the combined risk of default and loss, the higher the margin is above the relevant base rate. In addition, when adverse credit factors are combined with self-certification and/or buy to let, the lender will expect the addition risk to be covered by a relatively higher price. At the moment, loans in the niche and non-conforming sector are nearly all subject to an underwriting process ‘ as their complexity warrants. But with increased market knowledge and experience of loan performance, it will become possible for lenders to start constructing credit-scoring systems that streamline the underwriting process yet still treat each borrower as an individual.
To date, borrowers may not have been forthcoming in asking for explanations about product pricing on non-conforming and niche mortgages ‘ so there has been no need for advisers to gain a working knowledge of product structure and pricing. However, regulatory changes will bring about a greater demand for this sort of information. After all, borrowers cannot fail to notice the changes ‘ and if mortgages are worth regulating, then this is bound to prompt applicants to take a greater interest in their terms and conditions before they commit. Advisers in the non-conforming sector who want to prosper in the post-regulatory climate are advised to be ready to answer much more searching questions from customers in future.