Who would have believed a few years ago that initial payment rates on non-conforming products would be lower than 5%, with rates almost mirroring those charged on the high street?
To understand how and why this has happened, we need to look at how the recent past has influenced today’s market and then look at how the risks are currently priced.
Until the mid-1990s, if a non-conforming customer wanted a loan, they would probably pay whatever the lender could get away with. This was due to lack of competition, but also because there was no sense of what the correct price should be. This resulted in ‘back-street’ lenders charging extortionate interest rates and fees to the borrower.
This is undoubtedly where many of the problems regarding the perception of intermediaries and lenders that specialise in non-conforming lending stem from. Despite many lenders in this sector having reputable owners ‘ Platform Home Loans are owned by Britannia Building Society and Future Mortgages by Citibank ‘ some people still feel there is something ‘dodgy’ or ethically wrong in offering mortgages ‘ or any other credit for that matter ‘ to people who have experienced credit problems in the past. Although this attitude is changing and there have been many more high street brands entering the market, it is still not uncommon to meet intermediaries who visibly turn their noses up at the thought of writing this type of business.
The key to lending in the non-conforming sector is how the risk is priced and currently there are two main methods used. These are:-
l The bucket principle. This is where customers are placed into categories based on the perceived level of aggregate risk. This enables the lender to promote a simple and transparent pricing structure.
l Menu pricing. The price is calculated based on an incremental price for each of the applicants risk circumstances such as level of arrears/ county court judgements (CCJs), purchase versus remortgage, LTV and so on.
Both methods have their merits, although menu pricing has proved to be more difficult to understand ‘ especially for intermediaries providing advice. However, it does mean every loan has its price which, in turn, means no application is ever rejected.
Making it work
All this sounds great, but does lending to non-conforming customers in theory work? The simple answer is yes.
Margins for non-conforming mortgages range between 2.5% to 4.75% over London Inter Bank Offer Rate (Libor) and unsecured credit and car loan APRs are about 30%. Compare these margins to current ‘high street’ examples:
High street mortgage rates are often below the cost of obtaining the funds in the first place. This has resulted from the fierce competition that has developed with major lenders fighting for market share.
Credit card balance transfers usually offered at 0% for a certain period of time and interest free credit is offered by many stores when purchasing large and costly goods.
Therefore, you can see why many well-established high street names are now entering the non-conforming market in one way or the other.
Recipe for success
So what makes a good non-conforming lender? To be successful in this market lenders need to consider the following six components before implementing any strategy. These are:-
l Distribution: Lenders must check on a prospective and retrospective basis the quality of their distribution. This is not just from a credit risk perspective, but also from a cost perspective. A recent report published by the Council of Mortgage Lenders (CML), The Changing Structure of the UK Mortgage Market, showed that telephone-based lending has the lowest associated cost with branch-based lending costing double. Intermediary lending, including the cost of procuration fees, has a cost of around 91% of branch-based lending.
The report also notes that intermediary lending may be less profitable in the early years following set-up, due to the importance of up-front incentives in this market. The lender must also be constantly aware of the competition and be prepared not to follow competitors who enter certain sectors of non-conforming that do not fit their business plan.
l Underwriting: Whether processing several thousand deals a year or several hundred thousand, every application must be treated individually. In the low volume scenario, this may mean looking at every deal although and in the high volume scenario, it means constant re-analysis of the scorecard to fine-tune it to get the ‘right’ customers.
l Data: Lenders must constantly analyse all available data to understand which customers pay and which do not. Data must be used to fine tune decision-making processes to get the right balance of margin between risk and loss.
l Arrears management: It is vital to have focused and proactive collection techniques, with skilled collectors who understand the remedies available to cure late payers.
l Regulation: All lenders must consider legal requirements such as unfair terms. Also, with regulation by the FSA a couple of years away, it is impor- tant for lenders to monitor comments and news pieces in the trade press, especially as the current debates ‘ such as packager regulation and correspondent lending ‘ all concern the non-conforming sector.
l Pricing and risk: In the end it all boils down to pricing and risk. However, get it wrong by pricing too cheaply or taking too much risk and there will be problems which can lead to servicing issues (too much business too quickly) and high arrears (poor quality at wrong price).
There are many examples of lenders coming to market and getting it wrong, many by focusing on one sector of the non-conforming market, which turned out to be the wrong sector for them. These failures are most commonly due to the wrong pricing and risk approach. Covering a wide cross section of the non-conforming market, lenders are less at risk from over exposure in certain sectors than those that focus on one area.
On the horizon
The non-conforming sector has seen rapid growth in recent years and looks set to continue. But how can we confident of such strong growth?
Firstly, consumer debt is increasing. Unsecured lending is now over £80bn (the highest ever) ‘ roughly £3,000 per working person in the UK
Working/employment patterns are also changing. Around 10% of the UK workforce is self-employed (nearly three million people) and 16% of self-employed people have had some sort of mortgage payment problem.
Then there is the fact that credit scoring by lenders is still on the increase ‘ 12% of employed people have had a mortgage payment problem and refusal of credit is common place.
And all this is happening against a back drop of social instability ‘ one in three marriages end in divorce and 787,000 people have been unemployed in the UK for six months or less.
In 2002 and beyond, more institutions will enter the non-conforming market, through both start-ups and purchases of existing non-conforming lenders. The success of these largely depends on whether they can get many, or all of the components right ‘ some, but not all, will.
It is likely that some non-conforming lenders may look to experiment and try to develop products that have been tried and tested in the high street.
Do not be surprised if you see cashbacks, no overhanging redemption penalties, incentives such as free valuations and interest rates based on base rate rather than Libor.
However, it should be remembered that non-conforming is different to high street lending and whatever variations lenders may come up with, they must be properly priced otherwise the business will fail.
Paul Hunt is marketing manager at Platform Home Loans
More high street names are expected to enter the market ‘ either as start ups or by acquisition of specialist lenders.
All non-conforming loans should be underwritten on an individual basis.
Lenders that cater for a wide range of non-conforming borrowers are likely to perform better as risk is spread across the portfolio.