It would seem logical to look at the impaired credit market with a few facts and figures. However, this is not as easy as it may at first appear. This is because we have a jargon problem in our industry. Figures are quoted freely for the value of sectors such as the sub-prime market and they range from as low as £5bn to an impressive £16bn. In addition, the newly named complex prime sector is apparently worth £32bn, but there are few robust and verified amounts.
Furthermore, the make-up of borrowers who fit into this market remains uncertain. Research analysts Datamonitor estimate that by 2006, there will be about seven million people in the UK who qualify for a non-standard loan. This should equate to just under 30% of the UK working population, or almost one in three ‘ meaning there should be a significant jump in terms of potential gross lending.
However, it is this difficulty in finding accurate figures to express the market’s success that has moulded the development of the impaired credit market.
One of the most interesting developments in the market is the segmentation and subsequent naming of the various customer groups. You will have heard the expressions ‘sub-prime’, ‘non-conforming’, ‘non-standard’, ‘adverse credit’, ‘impaired credit’, ‘niche’, ‘specialist’ and ‘complex prime’, but what do they mean and are they, as some would claim, all the same thing?
In areas such as the self-employed, there are huge differences in classification and terminology. The self-employed account for over 13% of the UK working population. So should lending to these borrowers be considered niche? Loans for this group have peculiarities that sit outside traditional lending that could classify them as specialist or non-conforming. It would be inappropriate to automatically label them as sub-prime or adverse credit.
It is often quite the opposite, as those managing their own business are often more proficient and appreciative of the financial needs of both their companies and personal situations. However, there still remains some confusion in the industry about how this sector should be classified.
One of the key development phases for the sub-prime market has been the launch of alternative product offerings from traditional high street lenders.
Despite a shaky start, the growth in the sub-prime market has been significant and robust. The inclusion of high street lenders into the market is something of a turnaround from their humble beginnings, when lenders were falling over themselves to decry loaded rates and loose criteria. How quickly things changed as mainstream lenders saw more customers fall into the sub-prime sector ‘ and even more critically ‘ as falling interest rates squeezed the margins on traditional home loans.
A way in
There were two routes the high street lenders took in tapping into this market. The first was the creation ‘ or acquisition ‘ of a subsidiary company and consequent brand. This provided two noticeable advantages. First, if the pricing or lending policy began to attract any negative press or brand values, the parent company could distance itself from these issues. The average customer on the street was often not aware of any parental ownership and so traditional values could be maintained.
The second advantage was that the credit and risk policies on the new mortgage book could be separated from mainstream loans. Unlike the average product range which contains various types and prices to create a blend of mortgage sales, by separating the sub-prime company, the credit and risk position of the parent company suffered no dilution. The disadvantage with this method was simply the resource required to build or buy a new point of sale and processing entity.
The second route that lenders took was to set up new internal divisions to specifically deal with these alternative loans. One of the advantages for the company was that many policies, procedures and even processing systems could be adapted for the new range. However, the downside for this was that the underwriting and processing was often not sufficiently altered to adapt to the peculiarities of the sub-prime market. A good example would be the reliance on ‘tick-box’ underwriting and credit scoring.
Although brokers have captured a huge part of the impaired credit and non-conforming market, there needs to be constant pressure to protect and ring-fence this business. A huge section of the market goes through packagers, which in itself raises some interesting and important issues regarding regulation.
The packaging debate
There is a certain amount of debate over whether packagers should be included in the new regulation. The sticking point seems to be over the issues of advice and when it is given in the sales process. If the packager is operating outside of an organisation as simply a processing and transactional resource, then there seems little point in adding a new regulatory burden into the process.
However, for those brokers or organisations that package themselves and also give advice to the client, then regulation, such as is applied to all other advisers, seems appropriate. Our belief is that the packaging market will not only survive, but thrive if each individual organisation sets out its stall in either the advice or the processing camp.
Gone are the heady days of a PAYE borrower with an impeccable credit history walking into your office to take out a 25-year variable rate loan to buy their one and only house.
We are now experiencing a raft of innovations in terms of products, expertise in underwriting and experience in credit and risk options.
As a result, products are structured around criteria limits that group the number and amount of county court judgements, or divide pricing or time limits for arrears or bankruptcy. However, although these benefit the end borrower, they introduce a myriad of complications in promoting and communicating products.
Another clear indication of the growth of the market is that just five years ago, the many sourcing systems did not even recognise product and criteria variations for the non-conforming market. Some might say many are still some way behind the market, but to be fair, the technology to support intricate calculations based on criteria as well as pricing is challenging to say the least.
The diagram on page 18 indicates that the first level of consideration when deciding which sector a case should fall into relates to the product type such as fixed, discount or capped and even the innovations in flexible and current account mortgages.
Underneath this section, the market splits into niche sectors.
These niche sectors include buy to let, right to buy, self-build, semi-commercial, self-cert, equity release, high loan to value (LTV), let to buy, self-employed, expatriate and 100% LTV loans.
Some of these niches can be significant in terms of numbers involved and business volumes, but they are niche nonetheless.
What is new is the section that appears when credit problems need to be applied to these niche markets ‘ referred to in the diagram as sub-niche. There is certainly an expectation that just as prime begat sub-prime, so individual sectors will require an additional level of classification.
We, like many other lenders, have found that the further you drop down the lending options into sub-niche markets, the greater the reliance on experience and expertise for pricing and processing. Quite simply ‘ credit scoring does not work and any lenders still relying on it will have a tough time over the coming year.
So what does the future hold? There will certainly be some rationalisation among lenders over the next year, a direct result of the cannibalisation of lending boundaries. With so many players in the market offering loss-leading products in an attempt to gain market share not all can be guaranteed survival.
The most significant change in the impaired credit market will come when the honeymoon period is over and rates begin to rise.
Since the entry of high street lenders into the impaired credit market, rates have fallen and bottomed out to the current level of 4%. It is when rising rates induce arrears and further credit problems that we will sort the men from the boys.
Richard Hurst is communications manager at Future Mortgages
It is estimated that by 2006, 30% of the UK working population will require a sub-prime loan.
Sub-prime lending continues to be segmented by different terminology and a new class ‘ sub-niche ‘ is set to emerge.
When rates begin to increase it is predicted that some lenders will back out of the sub-prime market.