The innovation race

Over the past five years, the non-conforming sector has developed into a sophisticated market, offering a broad range of products and services. As such, some mainstream lenders have now entered the market as they have begun to realise that by widening their product range there are considerable benefits.

The growing market for non-conforming products has been fuelled by the increasing number of people who have seen the nature of their employment change or who have experienced problems which has resulted in difficulty in obtaining credit. According to a Data Monitor report, in 2002 alone approximately 7.8 million people were refused credit from traditional mortgage lenders.

One of the results of this demand for non-conforming products has been the number of mainstream players who have entered the market with different degrees of success. From a non-conforming lender’s point of view, fair pricing is essential to ensure competitive rates, but it is important to ensure that the added underwriting risk is taken into consideration. It therefore makes good commercial sense to cover this additional risk with a premium, as is done with self-certification products.

A fair and transparent pricing policy can be set in several ways; one of which is to link to the London Interbank Offered Rate (Libor), which is based on rates at which banks borrow funds from each other. This provides the most transparent form of pricing policy as the rate cannot be changed once the borrower has put their signature to the mortgage documentation. The non-conforming lenders that offer Libor rates are currently Preferred Mortgages, SPML, Future, Platform and GMAC RFC. By using Libor these lenders ensure the benefit of a fair ‘indexed’ rate throughout the life of the mortgage. Libor tracks market rates which means that rate changes are passed onto the borrower. Although setting rates linked to Libor has many benefits it is important to remember that it is Libor’s transparency that is most important. However, it should be noted that rate indexing can be achieved in other ways such as with a base rate tracker, again, a transparent rate with many benefits for borrowers.

With interest rates at record lows borrowers are able to take out some of the lowest mortgage rate deals for 50 years and Libor linking ensures that this is the case. Some may be surprised to learn that some non-conforming rates now start from around 4.5%. Also from the mortgage intermediaries viewpoint, Libor enables advisers to explain the benefits with confidence, knowing they are not going to be in a difficult position with their client in cases where full rate decreases have not been passed on

Product innovation

One of the keys to a successful market is innovation and, in the mortgage market, this is delivered through new products and process. There have been a number of product innovations in the non-conforming market to date, but there are three which are really worth highlighting. The shared ownership product is one such example. It is a niche product, where the market identified an opportunity which led to the development and roll-out of the product. Nevertheless, the social housing debate continues, with key workers, such as nurses, suffering from the lack of affordable housing particularly in Central London. Shared ownership products allow these people in the lower end earning bracket to join the housing market and take their first step on the property ladder.

Secondly, over the last year, a key innovation within the non-conforming marketing place has been correspondent lending. When looking at the development of correspondent lending in the UK, many have talked of the success of correspondent lending in the US, but there are a number of differences between the two countries. The US is a well-developed market, and there are a number of differences between the UK and its US counterparts:

For example, a correspondent could approach funding line providers directly. The size of funding line would be dependent on expected annual turnover, and that funding line would typically be a 30 to 60-day facility. With a 30 to 60-day restriction, the correspondent lender would therefore only complete mortgages they were sure they could sell. This allows the sophisticated correspondent to benefit from having a pre-agreed sales price (based on loan attributes) from the ultimate buyer.

Another dynamic in the US correspondent model is the majority of the correspondents needed to be able to service the completed mortgage. Typically this would mean the collection of at least the first monthly payment.

With the US model, if the correspondent makes an underwriting mistake at the mortgage processing stage, for example it does not actually fit the criteria of any of the lenders, they might be saddled with a loan that they cannot sell at the pre-agreed price and therefore might be forced to sell the loan at a discount.

Around 50% of the US non-conforming market is made up of correspondent lending, a clear indication of the benefits of this approach to the selling and marketing of non-conforming mortgages.

The UK model does not require correspondent lenders to have access to their own funding line. However, some UK correspondents would have to sign a lengthy legal agreement, which outlined the parameters of the loan pool in relation to the correspondent lender’s commitment. They would be allowed to design their own products ‘ within certain criteria. This is an essential benefit of the UK approach to correspondent lending. In effect, the US model has been successfully hybridised to fit UK conditions.

The third innovation in the market is the move towards electronic trading. Many non-conforming lenders are convinced that there will be an increasing amount of business transacted electronically over the next 12 to18 months. E-trading can be defined in many ways. While, it could just mean obtaining information online, it could also include running the whole transactional process.

However, the current inability to provide a system that has ‘water tight’ e-signatures seems to be holding this development back. Many have the view that with coming regulation, brokers and intermediaries will need to move forward and progress their technology, in order to improve service to borrowers and increase their competitive edge. Technology will drive the industry, and especially the non-conforming sector, whether intermediary or lender over the next five years.

Underwriting

There have recently been a number of new entrants to the non-conforming market. Many of these new entrants are prime lenders using prime market underwriting techniques, but it is clear that they have had varying degrees of success. Conversely, the success of the non-conforming market has been built on using highly developed skills ‘ in both underwriting and marketing terms ‘ to provide flexible and competitive solutions that the customer needs. Good and thorough underwriting ensures responsible lending. Each case should be considered individually rather than using credit rating or scoring processes. Matters such as the levels of current credit and the ability to repay have to be taken into account. Therefore, some lenders not experienced in the non-conforming market need to review their current processes ‘ for instance, the need to move away from using credit scoring to make the final decision. Non-conforming lenders have skills and experience, which has been established by an entrepreneurial/bespoke approach to lending. Price, and even more so innovative niche products, such as shared ownership, are equally important alongside specialised distribution techniques. A clear commitment to the intermediary market and vision of where the lender is in the market place is essential for success.

l See page 34 for a more detailed analysis of the difference and similarities in the UK and US markets.

key points