MMR Notes 26.10.2010

Talk on the FSA’s Mortgage Market Review Consultation Paper 10/16
First slide - introduction
Good afternoon ladies and gentlemen. I’m here to talk to you this afternoon principally about the
FSA’s Mortgage Market Review consultation paper, CP 10/16, and in particular the FSA’s proposals
around affordability assessments and interest only mortgages, but as you can see from my first slide, I
will also be looking at the European dimension and then do a bit of crystal ball gazing to see how
mortgages might be sold in the future after MMR.
New slide - MMR - setting the context
If I could firstly set the context to the Mortgage Market Review. As you may know, the FSA were
conducting thematic reviews in the mortgage market as far back as 2005, with reviews looking at
responsible lending practices in the areas of sub-prime, interest only, self certified mortgages and
lending into retirement. These thematic reviews were addressing concerns which were already
rearing their heads in 2005, and were showing up weaknesses in responsible lending practices and in
lenders’ assessments of their customers’ ability to afford a mortgage – checks which in some cases
were non-existent.
From late 2007 onwards, the credit crunch brought wider prudential issues to the fore. The evidence
was becoming clear that the existing regulatory framework was not preventing risky lending and
unaffordable borrowing. Now I have no intention to rehearse the credit crunch with you, but I’d like
just to pull out two strands for the purposes of today’s talk:
Firstly, at the peak of the boom, lenders were feeling insulated from the worst risks associated with
loans being made, because they were able to pass risks on to others e.g. by securitisation and the
effects of a red hot remortgage market, with customers here today, gone tomorrow. This manifested
itself in relaxed lending criteria, increased risk taking and increased competition, much of it from non-
deposit taking lenders and those relying to a large extent on wholesale money markets for funding.
Secondly, a boom in house prices, giving ready access to credit for all, including the credit impaired
and other at risk groups. With interest rates at historically low levels, and with extended forbearance
by lenders, this has masked a chunk of the market which is vulnerable to the effects of unaffordable
lending. If you then add in the current poor state of the housing market, the recent comprehensive
spending review, and unemployment on the rise, the FSA are now taking a far more robust and
interventionist approach to regulating firms and markets, and are prepared to take steps to shape the
market to deliver “appropriate outcomes”. So while much in the Consultation Paper was there to open
a discussion, we should expect this context to very much shape the outcome of the review.
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New slide – MMR - aims
And so the CP sets out the changes which the FSA believe are needed
“to deliver a more responsible approach to lending in the future, to ensure a sustainable market and
one that works better for consumers”
and their aim
“to have a mortgage market that is sustainable for all participants and to have a flexible market that
works better for consumers”
And as we shall see in a moment, the FSA believe that the mortgage market should be underpinned
by a robust and effective assessment of individual affordability, which they believe will:
• address potential causes of mortgage business failure
• contribute to the fight against financial crime, and
• ensure that individual borrowing decisions are responsible and affordable, thereby limiting
harm
However, I believe that lenders have already moved on to address many of these issues, whether it
be by addressing the issues highlighted in the OFT’s irresponsible lending guidance, tighter lending
criteria (which granted have been brought about by market conditions), or voluntary forbearance on
arrears. The risk is that tighter market regulation by the FSA will act to further limit access to
mortgage markets at a time when the housing market is at its most fragile. Some research has shown
that the proposals set out in the MMR will have a major impact on the availability of mortgage finance,
particularly those proposals relating to interest only mortgages – and we’ll be returning to look at
those types of mortgage in a moment. That impact may potentially far outweighs the risks which the
FSA’s review sets out to address.
New slide– overview of FSA MMR proposals
The next slide sets out an overview of the FSA’s proposals as contained in the consultation paper:
• affordability assessments
• interest only mortgages
• product regulation
• arrears charges
• responsible borrowing – educating the consumer
• non-deposit taking lenders
and I’d like to take a closer look at the first two of these.

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New slide - affordability assessments - 1
So affordability assessments, I’ve set out on this slide the main aims of the FSA’s proposals on
affordability:
“lenders should assess consumers’ ability to repay for all mortgage applications through an
assessment of their income and expenditure, and lend only where the mortgage is assessed as
being affordable in light of their free disposable income”
and
“a mortgage is affordable if its level and terms allow the consumer to meet current and future
obligations in full, without recourse to further debt relief or rescheduling, avoiding accumulation of
arrears, while allowing an acceptable level of consumption”
I think we would all probably agree that it makes sense not to provide a mortgage to someone who
cannot afford to maintain the monthly payments. The issue centres around the definition of
“affordability” and the subjectivity of that test. The FSA’s approach is set to introduce some
measurable objectivity into that test of affordability, and that is where the contention starts to arise.
Finding a common set of parameters to apply across the spectrum of income groups is a difficult
hurdle, and the potential to disenfranchise sections of the public from the ability to own their own
home is a real issue. While one part of government policy is to speed the return of the golden age of
home ownership, another part is set to remove the means to do so by regulation of mortgage policy.
At a very practical level, this is all about the FSA strengthening its existing requirements in MCOB on
affordability to make them more explicit. Currently lenders have considerable flexibility in how they
assess affordability, and as I highlighted when setting the context, some firms have been using
inadequate means, such as an over availability of self certification of income, or have over-relied on
house prices (desk top valuations). One statistic which appears mind boggling with hindsight is that in
2007 and 2008 approximately 50% of all mortgage applications were processed without income
verification.
So in practical terms the proposals mean that firms would have to verify income for all applications
with evidence coming from an independent and reliable source, and with human beings doing the
checking. Lenders are not prevented from using statistical data or their own expenditure models, but
these must be robust and be capable of justification. The assessment should produce a figure
representing a customer’s free disposable income and from that lenders should be able to extrapolate
a “maximum borrowing capacity” using certain standard assumptions which we’ll look at in a moment.

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It is immediately clear what some of the consequences of the affordability proposals will be, and I’ve
detailed the main ones on the slide.
The issues for self employed customer are not new, that is finding the evidence to verify income, but
they might find that they have to wait a bit longer until they have an income history before they come
within the income verification limits.
But there are potentially issues for us all if the rules are too rigid. There has been talk for example of
a “killer clause” which would mean that if your expenditure is more that your total disposable income
in any one month out of a 25 year period then your mortgage is not affordable. Clearly some of us will
not be able to go on holiday or have Christmas again!!
The CML have published some of their research to illustrate the extent of the potential ramifications of
the FSA’s proposals. They looked at borrowers who would have been affected by the FSA’s
proposals during a period between 2005 and Q1 of 2009 across a range of customer types, from
borrowers with impaired credit history (where almost 80% of customers would not have qualified for
the mortgage they received), through FTBs, home movers, remortgagers, and right to buy (at about
30%). Of particular interest is the fact that, across the board the CML reckoned that 51% of
customers would have been impacted, accounting for something not far short of 4 million mortgages –
a huge number.
They research also looked at certain categories of borrower types who would have been affected by
the proposals, and whether those borrowers who now have mortgages have mortgages which are
performing, are in arrears or have gone to possession. The research illustrated the relatively low
numbers of arrears and possessions cases as a proportion of the total number of affected borrowers,
and serves to counter one of the FSA’s key planks to their proposals which is that they are seeking to
reduce overall numbers.
I spoke earlier about measures of objectivity being introduced to the subjective test of affordability.
This slide details some of the main measures proposed:
• the assessment must have regard to committed expenditure, including on an actual basis for
credit commitments such as loans and credit cards
• it should include some element of contingency expenditure, including some measure for “life
events” such as marriage, divorce, children, unemployment, retirement - though that in itself
reintroduces some subjective elements.

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• Lenders must use a capital and interest basis, even where the product type is interest only.
We’ll look at this in a moment. But just to give you a flavour of what this means, a mortgage
of £100,000 over a 25 year term at an interest rate of 5% would cost you around £590 per
month on a repayment basis, but only £417 on an interest only basis (about 79% of the cost).
• Lenders must use a 25 year term – sounds OK, but some customers may want a longer term
to help with affordability in the short term, switching to a shorter term after say 5 years.
• Stress test against interest rate increases. FSA proposal is to publish a guideline margin on a
quarterly basis. To be based on forward swap rates. Designed to be a minimum, rather than
the actual margin to be used, so lenders encouraged to build in larger buffers.
• And lastly, to make it even harder for credit impaired borrowers by applying a stricter
affordability test – the CP has suggested a buffer of 20% being applied to the calculation of
free disposable income.
Clearly there is a lot in there for lenders to grapple with.
New slide - interest only mortgages - 1
If we could turn now to look at interest only mortgages, the CP includes a number of discussion points
that lenders were asked to look at and comment on by the end of September. The responses will
help inform the FSA’s policy approach going forward, and they may need to consult further on this
moving into 2011.
The FSA’s concerns centre very much round the apparent lack of repayment vehicles specified in a
high percentage of interest only mortgages, and potentially a ticking timebomb waiting to go off in 20
or so years’ time when all of the interest only mortgages sold in the peak between 2003 and 2008
start maturing.
The FSA view this very much as an affordability issue, and state that customers should only be given
a mortgage on an interest only basis if they have a valid and realistic repayment vehicle in place.
Definition of repayment vehicle:
“A realistic plan to repay the capital that does not involve relying on house price inflation or an
unrealistic intention to downsize at the end of the term”

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Looking at the meat of the proposals the FSA outlined for discussion, these have possibly provoked
the greatest amount of controversy:
• Lenders to monitor the existence of the RV annually
• They are to check the “adequacy” of the RV every 5 years
• ban “sale of property” as an acceptable RV, as they do not view this as realistic option for all
customers considering the state of the housing market
• propose special limited life IOMs for FTBs – suggest 5 year maximum term, with customer
reverting to a repayment basis.
The argument for the first two bullets is that these would identify repayment problems as early as
possible. But what would the remedial action be? Conversion to a repayment mortgage, and possibly
increasing the term to make it affordable – at the same time riding a coach and horses through the
mortgage contract.
I have detailed here the responses from the CML and BSA which, as you might expect, are at the
opposite end of the scale from the FSA’s proposals. I think central to their reaction is the apparent
lack of any onus on the customer to make sure that they have an adequate and suitable repayment
vehicle in place. And this is a point which has been made about the FSA’s proposals across the
board, in that they appear to have taken all responsibility away from the customer and lumped it all on
the lenders. The risk is then that if a customer gets a mortgage, they will then assume that the lender
will be to blame if it all goes pear shaped, because the lender is doing all the checking and so it must
be OK.
The CML and BSA do accept that lenders should validate the RV during the application process and
then check its existence (N.B. not its adequacy) once during the term. For example, the CML has
suggested that if the term is over 20 years then the check should be made 7 years before maturity, or
if less than 20 years, then at 2/3rds of the term. At this point in time there should still be time to put a
repayment vehicle in place, though this may involve switching all or part to a repayment basis and
extending the term.
They have also questioned the FSA’s approach to banning the sale of the property as a valid RV.
Their research points to the fact that very few properties are repossessed at the end of the mortgage
term because the owners no longer wish to or cannot sell because of market conditions. Remember
that these are borrowers who may well have had no arrears history in 25 years. It is far more likely

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that the mortgage term would be extended and the mortgage switched to a repayment or part
repayment basis.
And remember that the annual mortgage statements already contain reminders to customers to check
the adequacy of their RV.
New slide – other FSA proposals in MMR
If I could draw my look at the Mortgage Market Review to a close by touching briefly on the other main
proposals set out by the FSA in the consultation paper.
• product regulation – the FSA has concluded that they do not intend to regulate mortgage
products directly, such as imposing maximum LTVs or LTI. Instead, as we have seen their
focus is on an assessment of affordability.
• arrears charges – the FSA want lenders to fairly and adequately assess the underlying costs
when setting arrears charges, and in particular firms must not be seen to be adding a margin
or picking up costs incurred by other parts of their businesses.
• responsible borrowing – educating the consumer. This is possibly the one place where the
FSA acknowledge that the consumers have a role to play in all of this, and their focus is to
raise knowledge and understanding. They have a number of new information packs on their
money made clear website, and there is new work being undertaken by the Consumer
Finance Education Body with initiatives focussing on high risk groups.
• non-deposit taking lenders – a proposal to introduce a prudential regime for these lenders
which will be closer to the FSA’s prudential sourcebook for banks and building societies.
There is a fear however that this might lead to an exclusion of these mortgage providers from
the market, and an embedding of the market in the hands of a small number of lenders
(currently something like 90% of all mortgages are provided by 6 lenders/lending groups) –
lack of competition driving prices upwards.
New slide - implementation issues
Lastly on MMR, if I could touch briefly on implementation issues.
The MMR consultation paper is open for responses until 16 November 2010, and so there is still a
window of opportunity to make representations.
There is the prospect of further consultation papers later this year and into 2011. These are likely to
cover distribution and advice in relation to mortgages and, it is hoped, more on interest only
mortgages. The scope of the CPs might also be extended to cover second charge lending and buy to
lets if the responsibility for these loans is transferred to the FSA, as is likely.

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The MMR consultation paper makes it clear that final implementation dates for their proposals will
depend on how quickly the market recovers. Nothing in the CP to suggest what they might take to be
clear evidence of a recovery in the mortgage market and all the signs are that that might be some way
off in the future. And you may have read in today’s press of new figures released by the BBA showing
that net lending, stripping out redemptions and repayments, was just £1.6 billion in September, well
down on the £2.5 billion in August and the lowest figure since October 2000.
And lastly, the FSA do not see possible European policy intervention as a reason for delaying their
policy proposals to address UK market detriment, but they say that they will keep the European
dimension in mind.
New slide - European dimension
Well that takes us neatly into a brief look at the European dimension.
What we are currently looking at is a European Working Paper issued in July this year entitled
“responsible mortgage lending and borrowing”. This follows on a White Paper on the integration of
EU mortgage credit markets from December 2007, and various studies, expert groups and
stakeholder representations since then. The focus has shifted from market integration across the EU
to a focus on business conduct. The stated aim of the working paper is
“to help minimise consumer detriment, improve customer mobility, facilitate cross-border activity and
create a level playing field throughout the EU”
What is encouraging is a greater acknowledgement in the working paper that some of the
responsibility for the lending/borrowing decision does rest with the customer.
new slide - European dimension 2
I don’t plan to spend a huge amount of time on this as serious doubts remain that the Commission
has not made a case for market intervention at an EU level.
If I can pick out one or two points from the next couple of slides
On conduct of business issues, any of you in the room who have been grappling with the Consumer
Credit Directive will be feeling a bit of a sense of déjà vu when it comes to standardising pre-contract
information, adequate explanations and the assessment of credit worthiness, and standardising
information in advertisements, and it actually looks as if the Commission have just dusted off one of
the CCD working papers and changed the title to “mortgages”.

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new slide - European dimension 2
Indeed, when it comes to APR, they have even acknowledged that they want the APR calculation for
mortgages to be as close as possible to that used in the CCD.
The word from the Commission is that there is a possible EU Directive on responsible mortgage
lending and borrowing in early 2011, but I understand there is a fair amount of lobbying already going
on. It remains to be seen what direct impact that might have on the UK mortgage market, as the EU
are unlikely to look to gold plate conduct of business rules from the off.
New slide – selling mortgages under MMR
And so finally, we come to my views on what the mortgage market might look like in a post MMR
world. I’ll leave you to read through the bullets on the slide.
Perhaps there is a real opportunity for lenders to gain and retain their customers’ loyalty. What
purchasers will clearly need to know with some certainty is how much they can borrow, making certain
assumptions about the value of the property they want to buy. Customers need to be in a position to
know that they can verify their income to their lenders’ satisfaction, and what their borrowing power
might be from the outcome of an affordability assessment, and all of this at a much earlier stage in the
process. Lawyers acting for purchasers need to know that their clients can get a mortgage, and we
may well see a growth in the “subject to mortgage” offer as a market response.
And my final point – in the absence of adequate transitional measures, we may all find that our ability
to remortgage away from our current lenders to a better deal is seriously limited. “Mortgage
prisoners” – with customers locked into mortgages potentially at increasing SVRs, with the option to
switch to a better deal no longer available.
Lack of interest only mortgages, and a requirement to assess affordability on a 25 year term on a
repayment basis will undoubtedly exclude a section of lower paid workers who will not meet new
affordability criteria, while those same people are facing rising rentals in the social housing sector, and
a lack of good quality affordable housing in the private rental sector. And if you were reading the
newspapers this morning, you will have seen the Institute of Fiscal Studies forecasting that the
poorest fifth of Scots will be hit hardest by the UK government’s proposed budget cuts.
Thank you for listening
Ends
John A Lunn, Partner, 26 October 2010

MMR Notes 26.10.2010

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MMR Notes 26.10.2010