Speech by Lesley Titcomb, Director of Small Firms and Contact Centre, FSA
Keynote address to the European Mortgage Federation’s annual conference
19 November 2009
Around the world the financial crisis has required interventions of unprecedented scale. The support of governments and central banks has been crucial and will remain a significant factor for the foreseeable future. The causes of the financial crisis can be traced back to fundamental issues with the development of the global financial system and macroeconomic imbalances.
But mortgage lending, and in particular the past quality of it, has found itself under the spotlight. The loss of market confidence in 2007 was a result of growing problems with US mortgage-backed securities. What the risis has not revealed is evidence of misselling and irresponsible lending in European mortgage markets on anything like the scale seen in the US. This only highlights that mortgage markets, at the retail level at least, remain largely national. The differences between these national markets are many.
While the retail market may remain decidedly national, funding is clearly global and so the effects of the crisis have been widely felt. Mortgage lenders across many countries had come to rely more on wholesale funding sources, which dried up overnight. With the securitisation and covered bond markets closed, and other forms of funding scarce, gross lending has fallen across Europe.
Given how closely mortgage and housing markets are intertwined, it is not surprising to see a similar story here, albeit with a few exceptions. But also interesting are the differences in some of the figures. While the decline in lending has been sizeable in countries like the UK and Ireland, in others it has been much less so. The same is true for house prices. Again this only goes to illustrate how national markets differ, which in turn means that EU Member States responding to the crisis will have different issues to address.
Addressing the problems
What is noticeable, however, is the degree of common cause on addressing the fundamental problems. The funding issues have been truly global and the challenge is being addressed at the international level. There is much to be done, for example, through the Basel Committee work on significantly strengthening the global capital regime. We are active contributors to this work, as well as taking a series of steps nationally to reform our prudential policy framework.
The EU has also grasped the nettle, recognising the need to improve on existing safeguards and introduce new controls. A key element will be clearly implementing in the EU the new standards agreed by the Basel Committee. The regulation of credit rating agencies aims to increase confidence and deliver ratings qualitatively better than under current standards. Of course, this is no substitute for firms doing their own due diligence on potential purchases, and so we support the principle of new requirements on investor due diligence and originator transparency.
Then there are the European proposals to constrain risk transfer arising from past developments in the securitisation markets. Changing it so that banks and other regulated financial institutions can only buy into securitisations where the originator retains a significant piece of the net economic interest should help correct a past failing.
It is not surprising that these policy developments are focused on wholesale and prudential matters; this is where the market is most international in character. The differences I previously mentioned in retail markets mean that the majority of consumer-facing actions are being taken at the national level. So, for example, the Dutch authorities are looking at strengthening affordability measures. Meanwhile several countries have been grappling with how best to address the potential for consumer detriment as a result of their markets featuring large volumes of foreign currency denominated lending.
For a number of others, thinking has been prompted by the need to implement the Consumer Credit Directive (or CCD). This, of course, only applies to unsecured credit and the risks and features of mortgages are very different. But understandably, countries that have not previously had specific mortgage rules will look at the CCD to see if there aren’t at least a few aspects that make some sense when applied to their mortgage market.
The UK, on the other hand, is one of those countries that already has in place specific mortgage regulation. This is far more extensive than the CCD, so the Directive hasn’t been the prompt for us to look again at our regulatory approach.
But we have, as many of you will know, been undertaking a fundamental review of the UK mortgage market, the causal drivers for poor outcomes and the most appropriate regulatory response to these. The result is our recently published Mortgage Market Review Discussion Paper. This marks a very significant shift in our strategic direction. The review is not a response to current market conditions. Rather, it looks across the economic cycle, the good times and the bad, with two broad aims in mind. The first of these is a mortgage market that is sustainable for all participants – consumers, lenders, intermediaries and investors. Secondly, we want to see a flexible mortgage market that works better for consumers.
Many consumers have benefited from a UK market that in large part has been competitive and has evolved to meet a range of borrowing needs. The vast majority of these consumers are continuing to meet their mortgage payments and see no increasing risk of losing their home. But the market has gone wrong for some and where it has it is a cause of major economic distress. Such cases highlight that UK regulation has been ineffective in constraining particularly risky lending, or unaffordable borrowing. We need to put this right and the Mortgage Market Review says how we plan to go about this.
As you would expect, our review focuses on the UK market and the issues we see there. Just as we wouldn’t claim to be experts on other national mortgage markets, the review should not be seen as a response to matters that have arisen in other countries. So if you were to ask me what elements of our Mortgage Market Review might best translate to other markets, my answer wouldn’t be to highlight any particular policy conclusion of ours. Rather, I would stress the value of carrying out an evidence-based analytical review of the causes of detriment. As well as providing a clear base for national policy development, such reviews can help refresh the knowledge of a wide set of stakeholders. After all, market conditions have changed greatly since several of the Commission’s studies in support of their White Paper agenda.
While our focus has been the UK market, in thinking about how we might best achieve our objectives we have consciously sought out policy approaches from around the world. The issues may be different in each market, but the options available to regulators are not infinite, so it makes great sense for us to look at others’ experience in using various policy tools. We’ve learned a great deal from doing this, and in turn we hope our analysis will be of interest beyond the UK.
Take, for example, the question of banning sales of products above a set loan-to-value (LTV) or loan-to-income (LTI) ratio. Earlier in the year The Turner Review said we would specifically consider the case for using such tools in the mortgage market. We’ve looked at a number of countries who either ban high LTV mortgages or who make use of income affordability measures such as an LTI multiple or a maximum debt servicing ratio. Typically LTV ratios are used to limit credit growth, stabilise a volatile property market or enhance financial stability, while income multiples tend to be used to prevent borrowers defaulting.
The use of such measures makes instinctive sense. But having now analysed the performance of tens of thousands of UK mortgages, we don’t have overwhelming evidence for banning high LTV or LTI lending. While the UK saw a very rapid growth in mortgage credit, the fundamental driver for this was not a growth in high LTV lending. In fact, the average LTV for house purchase has been falling since 1997. Similarly, while the data suggests that higher LTVs can lead to higher default rates, the same analysis finds that other mortgage characteristics are stronger indicators of payment problems ahead. In particular, much more powerful predictors of default are if the borrower self-certifies their income or is credit impaired.
There is a much clearer link between high LTI lending and the UK’s rapid growth in mortgage credit. From the early 80s to the peak of the market in 2007, LTIs rose from less than twice the average income to more than three times. A high LTI might be thought to describe the kind of financial stretch that would increase the borrower’s chance of defaulting. But our analysis shows the LTI not to be a strong predictor of arrears, less reliable in fact than the LTV.
None of this means that we don’t think high LTV or LTI lending has contributed to issues in the UK market. What we are saying though is that from the available evidence neither form of lending has been a causal driver for the problems we’ve seen. Given this, our current view is that it would be overly blunt to simply cap lending at high LTV or LTI ratios. There are many consumers with such loans for whom affordability has never been an issue.
We think though that there may well be scope for a more targeted approach, curtailing lending where there are multiple risk factors. We are looking to see if there are toxic combinations of borrowing that put a consumer at greater risk. This means poring over the characteristics of loans that go into default to find out if, for example, there is a clear trend where a consumer with past credit impairment and an unstable income borrows at a high LTV. If we find that there are toxic combinations, we feel that prohibiting these would address the detriment from imprudent borrowing or lending much more directly, and proportionately, then simply preventing any lending above a set threshold. That said, there might be a case for such a threshold in support of a wider macro-prudential objective, and we would want to revisit this if future arrears data suggests a stronger link with the affordability of the loan.
A rigorous assessment of affordability is central to what our Mortgage Market Review is looking to achieve. Like many other regulators, we had previously assumed that prudential self-interest would focus a lender’s mind on the question of affordability. We went beyond this when regulating, to explicitly require a firm to assess affordability from the consumer’s perspective, but we kept the requirement at a high-level because of the assumption that lenders already had their own reasons for wanting to lend only to those who could repay.
We now think that assumption is flawed. Developments in financial instruments have allowed some firms to sell off any risk resulting from originating poor quality business. More fundamentally, from a UK perspective at least, in a housing market showing strong and consistent year-on-year growth, lenders have less regard to individual affordability. Put plainly, increases in the asset value minimise the chance of any loss given default. So, we plan changes that will make it much more explicit that lenders bear ultimate responsibility for assessing affordability.
Placing the onus on lenders is an important principle for us. Unlike the great majority of Member States we have a mortgage market where intermediaries play a leading role. For many years intermediaries have been responsible for the majority of mortgages sold. This means, of course, that intermediaries must offer a professional service, but the bottom line is that they are not product designers and they do not make the decision to lend. So it makes sense, we think, to focus particular regulatory scrutiny on those that do – lenders.
One way of doing this, which the Mortgage Market Review flags, is through product regulation. We see this embracing a wide range of policy options. For example, it could mean prohibiting a particular product type or facility. The most obvious example for us is self-certification of income, which I appreciate has not been a common product feature in other markets. We’re proposing that in future lenders should verify all income. Another example, and a different form of product regulation, would be the work I mentioned earlier on toxic loan combinations.
In each case, product regulation allows us to address a specific risk. We don’t though see a role for ourselves as the designers of ‘plain vanilla’ mortgages. Even were you to create standardised mortgage products that were simple to understand, it’s difficult to see how they could ensure that the disparate borrowing needs of consumers are well met. To our way of thinking, interventions that significantly constrain sensible and sustainable product flexibility and diversity would be a poor outcome for the future.
The current poor outcomes for some UK mortgage borrowers have been a key driver for our review. The most extreme example of this is the loss of the home. Our concerns about the fair treatment of UK borrowers in payment difficulties have been well-publicised, and this continues to be an area to which we attach particular importance. Repossession must be the last resort for any lender and they should look at the full range of forbearance options they can use. Nor should lenders look at borrowers in arrears as an additional income stream. But we recognise that repossession has to remain a possibility, for example, where realistically the borrower is never going to be able to repay. In such circumstances the consumer’s own interest might not be best served by remaining in an unaffordable property while missed payments and arrears charges eat into any remaining equity.
Consumer protection and Commission intervention
The financial crisis is causing all policymakers to reassess their approach and reflect on the adequacy of consumer protection measures. We are no different in this regard, nor is the Commission. In the past, the Commission’s focus has been to remove obstacles to the internal market and improve the efficiency and the competitiveness of EU residential mortgage markets. Commissioner McCreevy continues to position the development of a more integrated market as the overriding driver for any action at EU level, but the desire to restore consumer confidence is inevitably leading to greater scrutiny of consumer protection measures.
The Commission set out its vision in its spring communication. In speaking of ‘delivering responsible and reliable markets for the future and restoring consumer confidence’ the Commission said it would come forward with measures at EU level on responsible lending and borrowing. Included within this was a call for a reliable framework on credit intermediation.
Concrete measures have been delayed until the new Commissioner is appointed, but policy development continues. The White Paper on mortgage credit kick-started a major work programme on measures that might support greater market integration. This includes a cost benefit analysis of possible policy options, as well as further research into areas such as credit intermediaries and non-banks. Much of this work is now completed or coming to a close. But as greater priority becomes attached to restoring consumer confidence, some re-focusing of the work programme is inevitable.
The clearest sign of this was the consultation on responsible lending and borrowing launched earlier in the year, and the public hearing that followed in September. The Commission continues to analyse the responses, which on this hot topic will surely be many in number. But what was clear from the public hearing, and it’s a view we strongly support, is that any consideration of responsible lending and borrowing needs to reflect the work already underway in response to the crisis. Changes in the wider prudential framework aim to significantly alter lending behaviours, as will actions planned or already taken by national governments or regulators. And it’s right to also recognise that the industry has taken its own steps, such as consolidating existing lending practices into the EMF Responsible Lending Standards for Home Loans.
This changing landscape presents a challenge for any policymaker. They must take account of the changing regulatory environment, understand the interaction between the various policy initiatives and identify where any intervention will genuinely add value.
As we know, the Commission has long been thinking about mortgage market interventions. This culminated previously in the 2007 White Paper, in which the Commission acknowledged that mortgage markets will remain principally national in character. The White Paper recognised that consumers predominantly shop locally for mortgage credit and that the majority will continue to do so for the foreseeable future.
The consequence for the Commission was the conclusion that any integration would be supply-driven, through establishment by lenders in the Member State of the consumer. But a lot has happened since the publication of the White Paper in 2007. The funding crisis means that firms have turned away from plans to enter new markets, and high-profile failures, such as those of Icelandic banks, are likely to further diminish consumer appetite for dealing with a firm that is not local.
Incidentally, we would agree with Commission’s conclusion on integration being supply-driven. We’ve been looking at UK consumer appetite for cross-border shopping in financial services. Our research highlights that while increasing numbers of consumers in the UK are looking outside their domestic market for low-cost, low-risk items, the appetite for shopping across borders for financial services is very limited. In fact, the evidence suggests that the vast majority of UK consumers are unlikely to take advantage of a more open market in financial services even if that market can be created.
Interestingly, the research found mortgages to be one of the products in theory most open to consumers switching to an overseas provider on the basis of a more competitive interest rate. UK mortgage borrowers have shown themselves to be very conscious of headline rates, sometimes to the exclusion of regard to wider product risks and features, so this finding is not surprising. But what was telling was that even these consumers needed there to be a significant price differential before they would consider buying cross-border. Given the global nature of the market for wholesale funding of mortgages it’s unlikely that lenders in other countries would be able to offer the price differential required to persuade consumers to switch. It’s also important to bear in mind that the research assumed that a level playing field exists in all other aspects of European mortgage markets. As we know, that is not the case.
Returning then to the possible grounds for European intervention in retail markets, current conditions are unlikely to foster greater integration. So this brings us back to possible consumer protection objectives for intervention. Over the past year, the Commission have been carrying out consumer testing of the standardised product disclosure that is currently voluntary. The aim is to assess how to improve the usefulness and relevance of the European Standardised Information Sheet for home loans (ESIS).
In the past, disclosure has been the cornerstone of the FSA mortgage regime. But as part of the Mortgage Market Review, we have been re-examining its role. Our expectations for disclosure were that it would enable consumers to shop around and compare the services and products on offer from different firms. We also hoped it would help consumers make better informed choices. These are very similar objectives to those that the Commission has.
We now have five years’ experience with a prescriptive disclosure regime introduced at considerable cost to firms – costs inevitably reflected in product pricing. Our research shows that consumers rarely use standardised product disclosure to inform their decision-making. Consumers typically value disclosure as a record of their purchase – but a record doesn’t require standardisation of format and content. We think such evidence is an important aid to understanding the likely effectiveness and proportionality of disclosure as a regulatory tool.
There is now wide recognition of the importance of understanding consumer behaviour in developing effective policy. Not only do UK mortgage consumers not use standardised product information as intended, but the evidence collected for our Mortgage Market Review challenges our previous assumption that consumers were rational market participants. In practice, the misbuying we have seen in the UK mortgage market provides clear evidence that some consumers fail to properly engage or act in a way that would protect their own best interests.
This bears out a point made in The Turner Review regarding the limits on consumer behaviour. We think it is particularly important to recognise the behavioural limitations in the mortgage market where borrowers are too often motivated by an immediate want or need. In many cases the mortgage is simply the means by which the consumer can get the desired home, car or holiday. Consumers focus much more strongly on the end result. Understanding this limitation on rational market behaviour is leading us to take a much more interventionist approach. Through the Mortgage Market Review and our subsequent policy development, we believe we can put in place effective and proportionate measures to address issues seen in the UK market. We are committed to so doing.
Conclusion
In conclusion, we are all – the Commission, firms and regulators – aiming for the same thing. We want markets that are responsible and reliable in future, and we want to restore consumer confidence and choice.
This makes it understandable that the Commission is considering what action it might take on responsible lending and borrowing. But it is a time of great change to the regulatory landscape. It is vital that any policy thinking takes full account of the various initiatives going on internationally, at a European level and nationally. Indeed, I would go further. Given the extent of existing interventions, there are good grounds for assessing the effectiveness of these initiatives before deciding on what further action, if any, to take. This will provide the strongest evidence base for demonstrating the added value of further intervention.
If the completion dates were six months earlier…it would have been a completely different story 
