Sub-prime mortgages have changed almost out of recognition since first appearing in the UK in the mid-1990s. There have been a number of reports claiming that it has come of age, as underwriting practices become more sophisticated and mainstream lenders begin to get involved, but there is still a long way to go before it can truly be described as the finished article.
In the last two years, there have been a number of new entrants to the sub-prime arena and there are now strong rumours of several other mainstream lenders seriously looking at this sector of the market.
With margins in the mainstream market now unprofitably low and in many instances non-existent, and margins in niche lending such as self-certification and buy to let quickly going the same way, it is not surprising many lenders see sub-prime as one of the last bastions of profitable lending. But although, on the face of it, margins look enticing, what every lender looking in from the outside has to bear in mind is that margins are primarily a reflection of the risk from lending to borrowers with a less than perfect credit record. Get the pricing and credit mix wrong and what started out as a positive margin can quickly turn into a major loss.
It is the fear of the unknown that has led some lenders to enter the market by gingerly ‘dipping a toe into the sub-prime water’ in areas in which they are relatively comfortable. This may sound like a reasonable strategy, but if you are coming from a mainly mainstream background, these areas tend to be limited.
Although at first glance some of the products offered by these lenders looked appealing in terms of rate and the level of adverse credit allowed, it is the small print and actual underwriting that has caused problems for many brokers and packagers. In particular, rules such as ‘none in the last year,’ ‘account to be up to date at the time of application,’ as standard policy, rather than product specific, have led to such comments as ‘the best products available that no-one can use.’
This attempted ‘cherry picking’ of sub-prime by some lenders, is a perfectly legitimate strategy, as factors such as ‘time since’ are one of the major determinants of risk. For brokers, the issue is how many of the cases submitted are likely to get through. Quite simply, brokers and packagers active in the sub-prime sector often do not fully understand the extent of a client’s problems, let alone the exact dates they occurred.
Without access to credit data, most submissions are assumptive, based on the information available at the time. Invariably, the situation tends to differ slightly from that originally stated when a lender actually views the case. Where the credit is worse than anticipated, lenders with a restrictive sub-prime credit policy are often not able to then offer a customer an alternative product. The result is, the broker or packager has to try and place the case elsewhere, resulting in wasted time and effort.
This unfamiliarity with, and in many instances fear of getting caught out by, sub-prime has influenced more recent entrants to the market to use either existing specialist subsidiaries or to buy an existing established sub-prime player. This approach recognises the key to success in sub-prime is understanding and pricing for risk as well as all the associated factors in undertaking and maintaining a sub-prime book. Good sub-prime underwriting is essential to establish confidence in brokers and packagers. Underwriting must follow not only the stated policy but also the spirit of that policy. With thousands of possible circumstances, most of which are unique to an individual, not every circumstance can be catered for in a credit manual.
As a result of experience and partly due to the new entrants into the market, the number of sub-prime lenders in the UK who now cater for most adverse situations has increased. Consequently, viewed from the outside, some of the lending, particularly at the adverse end of the market, would appear to be risky in terms of likely defaults. Although the risk to the lender is obviously much greater, this risk is mitigated by a combination of the reward of a higher interest rate, active arrears management, limiting the maximum percentage advance and previous experience in dealing with this type of case.
To the outsider, it would appear some sub-prime lenders will take on almost any case, but this is not true. Sub-prime has been around for a number of years and many lenders are now backed by experienced underwriters and serious financial backing. What drives almost all sub-prime lenders in their lending decision, and therefore their credit policy, is the simple question: is the person we are lending to likely to pay? This is also coupled with an examination of any potential shortfall in the unfortunate event of repossession. As a result of this, there are some areas and cases that even sub-prime lenders will not touch. For example, unlimited arrears cases may look risky (as indeed they are), but it is how the arrears occurred and the applicant’s history which is of paramount importance. As a result, remortgages from other sub-prime lenders are viewed with caution and most lenders in this sector require evidence of the last few mortgage payments before proceeding.
While lenders try to avoid lending to repeat offenders or serial non-payers, individuals who appear to have difficult circumstances are often viewed compassionately. For example, people who have been the subject of repossession and/or bankruptcy are often considered to be an acceptable risk. The reason comes down to the individual circumstances that led to this situation. A failed business will often lead to bankruptcy and, as a result, the loss of the house. Accordingly, most lenders will lend to satisfied bankrupts with repossessions being judged on the merits of the individual case.
An immature market
Having said this, and despite a growing number of entrants to the market, given its very short history (in relative terms), the sub-prime market should still be regarded as immature. This lack of maturity can be demonstrated by some of the products still being promoted in the sub-prime sector, products that have, by and large, disappeared from the mainstream. For example, the practice of offering a customer a huge day one discount for a relatively short period of time, reverting to a much higher back-end pay rate, with the customer still subject to redemption charges. The headline rate looks great, the reversionary rate less so.
In the mainstream market, brokers have steered away from these products on the basis that they generally do not best serve clients’ interests. Some sub-prime lenders argue brokers have a choice whether to use the heavily discounted schemes available. The problem is that sub-prime customers are, by their nature, more vulnerable and, given payment problems in the past, are less likely to adapt and cope with wildly fluctuating mortgage payments. Potentially vulnerable customers may buy a product based on the front rate, either ignoring or not fully comprehending the longer-term payments required.
It is still fairly common to find sub-prime products out there with a day one pay rate similar to mainstream rates, which revert (normally after a year or less in many instances) to a rate often some 50% or more higher. These products may look great on a mortgage sourcing system, but dramatically increasing a customer’s pay rate within a year, when they have already demonstrated they have had past payment problems, is hardly the best way to get them back on their feet and keep them there.
Some people have expressed surprise that new lenders are looking to enter a sector which must be suffering from diminishing returns. The argument is, given the current booming economic conditions, the pool of sub-prime borrowers must be shrinking and hence the market sector diminishing. Figures from the County Courts do indeed show the number of CCJs registered is falling and arrears/repossessions statistics from the CML show a similar pattern. However, the statistics must be judged in the context of the social, economic and lending situation that exists, rather than in isolation. The booming availability and reliance on credit by the UK population, changing employment patterns, and increasingly sophisticated credit systems by lenders could easily lead to a growth of non-conforming borrowers of which sub-prime will continue to be a major part.
The positive news for the consumer is that as more lenders come into this sector, as they inevitably will, greater competition will bring greater innovation in products and, of course, lower prices. Sub-prime in the UK is entering a new era.
Peter Stimson is head of product development at GMAC Residential Funding
The established sub-prime players now cater for most adverse circumstances.
Without access to credit data, most applications are assumptive, based on the information available at the time.
Beware of products with a cheap day one discount and a high reversion rate.