BBA Retail Banking Scotland Seminar, 21 November 2011Seminar notes: Understanding mortgage regulationSlide 1: Title PageSlide 2: Levels of regulationGiven that badly underwritten mortgages were one of the key underlying issues which drove the creditcrunch, it is perhaps not unsurprising that the focus of the regulator has come round to look at thisarea. But, while there has been some breathing space to allow market correction in the mortgageindustry, either by accident or design, it is surprising that the focus of regulators at a global, Europeanand UK domestic level seems to be converging. 2012 will be a key year for mortgage regulation, andmy talk today will aim to bring you up to date with the three different strands of regulation:Global, European and UK - with some thoughts on what might be in the FSA’s delayed consultationpaper on the mortgage market review – MMR2Slide 3: GlobalSo, looking at a “global” level first – let’s do a bit of scene setting.I’m no Robert Peston, but from a global perspective there are a few common threads that are drivingthe regulators:The ramping up of capital holding requirements for banks and other financial institutions in the wakeof the credit crunch has had a major impact on the shape of the mortgage industry. The banks are,understandably, hoarding capital to shore up their balance sheets. And we have seen the quantitativeeasing steps taken by the UK government not resulting in the increase in funds available for lending.Capital holding requirements have constricted the amount and types of mortgage available in themarket, and we have seen perhaps the biggest impact here on FTBs, with the average age andtypical deposit rising, with knock on effects for the housing market. There are some signs of 95% LTVmortgages becoming available again, but slowly and in small numbers.We have also seen the return of a lack of liquidity in the inter-bank market, largely on the back ofsovereign debt issues in the Eurozone. Bill Jamieson, writing about the current crisis in this morning’sScotsman, describes the freezing up of the economy and markets.“Sovereign debt strains are moving from the periphery to the core. There is a clear sense that thiscrisis is now coming to a head, with an outcome that could see world stock markets plunging to theirlows of March 2009 and below”.Talk in the US of the US Federal Reserve spearheading the formation of a Global Liquidity Fund toavert a global financial meltdown.Lack of liquidity will again have a serious impact on the availability of mortgage finance.At the same time, bankers’ pay and bonuses are back in the spotlight, but let’s leave that topic foranother dayPressure on capital and liquidity go hand in hand with increased costs, particularly for “higher risk”lending. Even though the central banks are keeping their base rates at historic lows, mortgagelenders have to pass these increased costs on to their customers through higher SVRs and higherfixed rates.Slide 4: Global – mortgage specificLooking now at mortgages in a bit more detail, at a global level the reins have been taken up by theFinancial Stability Board (FSB).
2[Pick up bullets from the slide]And, in March this year the FSB published a mortgage underwriting thematic. This thematic has ledto the formulation of a high level framework of draft principles, which we’ll come to in a moment. Butan important feature of the FSB’s evidence gathering and policy formulation is a recognition andconclusion that international standardisation is not the answer. This is largely down to the differencesin national real estate markets, and culture and socio-economic policies. Imposing a prescriptiveapproach that does not meet these different national characteristics would only result in significantcost, while potentially denying access to mortgage funding for many borrowers.Slide 5: Global – mortgage specificSo, turning to look at this high level framework, we begin to see some familiar threads comingthrough, with income verification being at the top of the list. An analysis of income and expenditureand an assessment of a customer’s ability to service and fully repay the mortgage are not far behind.However, and crucially, the FSB are proposing to give countries flexibility about whether to useprescriptive standards (such as maximum LTV ratios), or regulatory incentives (such as lower capitalholding requirements for less risky loans) to ensure underwriting quality. The FSA has said that theyare firmly in the latter camp, particularly as regards LTV and LTI ratios, and perhaps that gives ussome pointers as to how MMR2 is likely to look.A consultation on the high level framework was published in late October, and is open for commentuntil 9 December. The FSB hope to finalise and adopt these standards early in 2012. this timetablemeans that the principles, with the flexibility they embody, have been drawn up at a time whenEuropean policy makers may well end up with a more prescriptive approach to regulation.Slide 6: EuropeanSo looking now at a European level, we have seen the emergence of a new regulatory structure, witha more active regulatory and supervisory role being taken by Europe. Perhaps this paints a bit of thebackground to what we have been seeing in the last couple of months, with political change in Greeceand Italy having been driven through by economic pressures.[pick up bullets from slide]Slide 7: European – mortgage specificTurning now to look specifically at mortgages, we currently have a draft directive on credit agreementsrelated to residential property (CARRP) making its way through the European machine. (or shouldthat be “swimming” through?)Its aims are as set out on the slide[pick up bullets from slide]However, all the evidence points to mortgage customers continuing to shop locally, with their needsbeing met by products tailored to the local market.[a good example of this is the recent flurry of opinions on the attractiveness of otherwise of long termfixed rates – we’re talking 30 year rates and longer. The way mortgages are funded in the UK, thereality is that the headline rate for these would be unattractive, and lenders would need to hedgeagainst early repayment with hefty ERCs. These features are not a reality in some other countries.We also have the evidence from the recent past have shown a preference for “short” term fixed ratesof 2 to 5 years with not much taste for longer term fixes.
3Slide 8: What the Directive coversSo what does the draft Directive cover? And we’ll come back to some of the issues that these bulletsthrow up in a moment.Well at first glance the first version of the draft Directive appeared to have been lifted straight from theConsumer Credit Directive, with “mortgage” substituted for “credit”.[pick up bullets from slide]Bullet 4 – of cetral importance to the draft Directive is the importance of lenders robustly assessingaffordability – so back to one of the FSB’s high level principles.Slide 9: Scope of the DirectiveLooking now at some of the key issues and concerns with the draft Directive:Firstly scope – what is in and what is out. Well, most “mortgages” are in, apart from equity releaseloans. However, as drafted, the Directive will also catch Buy to Let loans, bridging loans, high networth borrowers and credit union lending.The Buy to Let market in the UK is quite different from most other member states, and this is quiteoften down to local rules on who can own property and who can lease property. While the UK hasbeen lobbying hard to have BTLs excluded from scope, other member states are just not getting it.The FSA is very much of the view that it is more proportionate to let member states deal with the likesof bridging loans and high net worth borrowers at a national level.Slide 10: Key concerns: pre-contractual infoAnother key concern is the imposition of the ESIS as standard across Europe (the SECCI from theconsumer credit directive anyone?). And this is something they are not going to back down on.[pick up bullets from slide]We’ve still to see from the FSA whether MMR2 will include tweaks to the KFI. However, the FSA ison record saying that their research following the early MMR consultation papers indicated thatdetailed disclosure does not always result in customers taking in information, or making betterpurchasing decisions.Slide 11: Key concerns – advertising and disclosureThe next concern centres around the advertising and disclosure requirements within the draftDirective. The risk again is information overload – with customers being deluged with information. Itmay drive lenders to bland “information-less” adverts: “we’re the Nationwide and we do mortgages” –so no “rate led” advertising.Again, a specific example to be included in the advertising – thought to be unworkable. Smacks of“representative example” in the consumer credit directive.Slide 12: Key concerns: obligation to deny creditI don’t have too much to say about the next key concern – the obligation to deny credit. But theconcern here is that an overly prescriptive approach will potentially exclude a chunk of customers whomay initially have difficulty in proving they can repay over the lifetime of the mortgage (and for whom,say, an initial 5 year interest only period might be appropriate to get them going).
4Do lenders or borrower for that matter have a crystal ball?Can you really expect a mortgage adviser in branch sitting explaining why the algorithms built intotheir online decision making process have rejected the customer? Lenders are unlikely to want to putit all on paper either – they guard their credit scoring mechanisms jealously to maintain theircompetitive edge.Slide 13: Key concerns – giving adviceThe draft Directive’s articles on giving advice are at odds with how advice on mortgages hasdeveloped in the UK. The implication from the draft Directive is that only firms who look at “whole ofmarket” can give advice.However, the FSA has stated that it recognises the benefit of lenders being allowed to advise only ontheir own products. Similarly, it is recognised that customers do benefit from intermediaries onlyadvising on a limited number of products.Slide 14: Other issuesSome other issues are highlighted in this slide. Just to pick out a couple:Bullet 3 – FSA is clear that the host regulator should be supervising the activities of any passportingfirm to ensure a level playing field.And then the last bullet, the “Delegated Acts” issue, which potentially allows the Commission to re-write parts of the Directive without proper consultation.Slide 15: How the Directive is consideredThis is a bit of an explanation of the mechanics of how the draft Directive is being considered. Not toomuch to say here, but we should look at the ECON and IMCO reports in a bit more detail.Slide 16: ECON ReportThe ECON report was a wide ranging one, and sought to bring in a raft of additional areas, some ofwhich are simply unworkable:[pick out bullets from side]cooling off period of 14 days – simply may not suit consumers who often wait until the last minutebefore getting their mortgage arranged.Slide 17: ECON amendmentsThe ECON report has now been debated in the EU Parliament, and a number of these ECONproposals have been struck out.[pick out bullets from side]Slide 18: IMCO reportThe IMCO report has been much more supportive of the mortgage industry and its views[pick out bullets from side]
5Slide 19: UK mortgage industry lobbyingAnd so how has the UK mortgage industry has been seeking to influence the progress of the draftDirective?Well, in a number of ways[pick out bullets from side]The FSA claim to have been influential in a number of changes in policy, using the evidence it hasgathered in the aftermath of the early MMR consultation papers as a position of some strength.Slide 20: Where are we on the UK issues?Well this is an ongoing process, though nearing the end. Where are we on the issues of mostconcern to the UK mortgage industry?[pick out bullets from side]I’ve given a steer, largely thanks to Jackie Bennett of the CML, who has been closely involved indiscussions in Europe.Still a moving target.Slide 21: Possible timetable for the DirectiveHere is the possible or likely timetable. However, there is lots going on in Europe at the moment, sothere may well be slippage.Member states get two years to implement the Directive once it has been published in the officialjournal. What the consumer credit directive has shown is that it is vitally important for “legal certainty”to be reached as soon as possible so that the industry can have as long as possible to adjust theirsystems, documentation, processes, and then train their staff, and of course this all costs money.In the UK this might be a slightly easier process, as the primary regulatory sourcebook is MCOB andFSMA which sits behind it. It is relatively easy for the FSA to make changes to MCOB to meet EUrequirements, without necessarily having to wait for primary or secondary legislation to be passed.Slide 22: Interaction with the MMRAnd how will all of this fit with the FSA’s MMR?Well, it is clear that the FSA has taken its time digesting the feedback on their earlier consultations,and have said on a number of occasions that they are not rushing in change, and that any newregulations will be held over as long as possible to avoid negatively impacting market recovery,whenever that might be. However, the pace of change might be forced by the new Directive to theextent that it differs from MCOB.Slide 23: DomesticAnd finally then, turning briefly to the domestic picture. Emil will speak on the new regulatorystructure later this afternoon, so I won’t steal his thunder. Suffice to say that the new FPC are likely tohave power to impose macro-prudential levers on the industry where it wishes to steer the industry ina particular direction – for example through the use of LTV or LTI caps.
6Slide 24: FSA’s Mortgage Market ReviewSo, as we wait for MMR2, let’s look back at what the FSA stated as the principal intended outcomesof MMR.[pick out from slide]Slide 25: Mortgage market review proposalsAnd the main consultation paper contained some threads that we are familiar with from earlier:Income verificationAssessment of income v expenditureThe was a major storm over the affordability criteria, such as a proposed ban on interest onlymortgages, and with affordability being measured over a 25 year term. However, there is someevidence that the FSA is softening its views on this, though it remains to be seen what is in MMR2.And there have been lots of calls for joined up thinking with the government’s housing policy,[including Eric’s own sermon from the mount at last year’s seminar]. The housing minister, GreggShapps, has been making the right sort of noises on this, with hopefully a positive impact on thecontent of MMR2.Slide 26: Lord Turner, Chairman FSA - 23 June 2011This led to recognition from the chairman of the FSA, Adair Turner, that perhaps you don’t need ahammer to crack a nut. A recognition that MMR needs to be proportionate and that we need aninformed debate.Slide 27: Future timetable for MMRWhen??Slide 28: DomesticAnd other challenges that firms are having to face at the same time. Certainly an interesting time tobe a mortgage lender.[pick out bullets]Any questions?John Lunn, Partner, Morton Fraser LLPjohn.email@example.com 247 1066