The FSA must seek to ensure that borrowers take out mortgages that are sustainable, but avoid introducing rules that exclude them unnecessarily from access to mortgages, and therefore to home-ownership. And lenders need to make sure mortgages are affordable, which is why income verification has become a central issue of the review.

The FSA has not been helped by a debate about income verification that has often generated more heat than light. Some commentators have taken an inflexible approach, arguing for the need to verify income in every case – in a similar vein to those that have argued for strict loan-to-value or loan-to-income limits.

Perhaps this is partly a kneejerk reaction to the problems of the past, and is based on an assumption that income verification avoids later financial difficulties or economic stress. But we do not believe that the evidence supports this contention. 

Past problems

In our response to the mortgage market review, published last week, we acknowledged that the FSA’s analysis of past problems in the mortgage market was broadly correct. Historically, self-certified mortgages offered by some lenders were open to abuse. The term ‘liar loans’ was invented because the lax behaviour of a few firms increased the scope for mortgage fraud. 

Some lenders also ‘fast tracked’ loans through their systems inappropriately, marketing the fact that income checks may not be made and offering them to higher risk customers, for whom they may not have been sustainable.

Many of these products and credit assessment techniques have now been corrected, as a commercial response to an increase in losses and fraud. Self-certified mortgages have disappeared for the moment in response to public criticism, and firms have tightened their approach to electronic underwriting. Borrowers, too, are taking a more responsible approach to the way in which they apply for – and use – credit.

The market has therefore corrected itself, and a shortage of funding and tighter credit assessment mean that there will be no return to past excesses in the foreseeable future. That is re-assuring, and provides some useful breathing space for the FSA. The regulator now has time to make sure it is clear about the real causes of consumer detriment, to test its proposed reforms carefully to make sure they address it, and to deliver the right balance of costs and benefits for lenders and borrowers.

The challenge for the regulator

We think that, contrary to the FSA’s discussion paper proposals, the regulator should make a clear distinction between self-certified mortgages and fast-tracking in its approach to regulation. 

Self-certified loans are mortgage products where the borrower is asked to declare his income but the lender does not check it with the employer or with company accounts (typically, there are electronic checks of credit behaviour and experience instead). 

Fast-tracking, on the other hand, is a process that lenders may use to streamline mortgage applications for some (lower risk) borrowers. The problem was that, with both self-cert and fast tracking, competition caused industry standards to drop, increasing the risks for businesses and the scope for unaffordable borrowing

So, in its review document, the FSA argues that the distinction between the two was blurred by those lenders that actively marketed fast-tracking to brokers and consumers, while at the same time relaxing underwriting criteria. We agree. We accept that the FSA needs to be assured that the fast tracking of lower risk mortgage applications is distinct from the self-cert product, and that any risks with streamlined processing have been anticipated. Instead, however, the FSA proposes a product ban and universal income verification – imposing regulatory costs with no comparable benefits to consumers.

Payment problems

The FSA also refers to an analyst’s report that rates of arrears on fast-tracked loans have been higher than on mortgages where income has been verified. To test this, we have undertaken our own survey of 11 firms, covering 51% of the market, details of which were published in our recent response to the review. 

The arrears rate for fast-track loans was, in fact, 35% lower than the portfolio of verified loans from the reporting sample.

Those findings are what we would expect. They conform with the industry’s view that fast tracking is an underwriting decision to process quickly and efficiently mortgages where the risk is lower than average, and the need for a “paper chase” is removed. Although our survey was limited in size, it confirmed that income non-verified lending is an umbrella term covering two very different types of activity, which merit different treatment. This must not be forgotten when making a final decision on the right approach to regulating self-cert mortgages and the fast tracking process in the future.

Managing the risk

Building on our many months of consultation with lenders, and the work we have undertaken in reviewing their lending policies, we sought in our recent submission to develop a high level, industry-wide understanding of when the fast-tracking of mortgage applications might be considered appropriate for the future. 

In suggesting this, our goal is to try to ensure that lenders have enough flexibility to be able to innovate – and the capacity to remove costs and complexity from the mortgage process where it is appropriate and sensible to do so – while providing re-assurance to the FSA that the abuses of the past will not re-emerge. In our view, a practical working definition of the circumstances in which it may be appropriate to fast track a loan could include: 

• a credit score limit for borrowers, excluding those that have experienced payment problems in the past;
• a loan-to-value limit of 75%;
• the exclusion of applications from buyers with no or little experience of mortgages;
• the exclusion of buyers whose income is complex;
• the exclusion of self-employed borrowers; and
• an acceptable degree of random sampling of fast-tracked applications, with the lender verifying the income stated by the lender.

We also sought to develop a similar understanding about the circumstances in which self-cert mortgages may be acceptable. Given the higher level of arrears associated with self-cert, and the scale and consequences of past abuse, we accept that the case for maintaining these products is weaker. However, examples where borrowers may be capable of sustaining a mortgage commitment but could find it difficult to prove their income include:

• those self-employed who have recently launched a business but have yet to submit formal accounts;
• self-employed customers whose income varies considerably;
• self-employed customers who can produce audited accounts in which they have sought to maximise tax efficiencies;
• sole traders and partners;
• self-employed contractors; and
• borrowers with complicated – and perhaps numerous – income streams.

The future debate

We accept the need for a broader debate about how this could work. We do believe, however, that an outright ban on some products – or an obligation to verify income in every case, whatever the risk – would have harmful long-term consequences and can be avoided.   

On its own, the FSA’s proposed ban on self-cert mortgages will not guarantee that lending is either responsible or sustainable – this has more to do with risk-based pricing, effective credit underwriting, the availability of plentiful and stable funding and a benign economy.

Incomes change over time, and borrowers who have an acceptable level of earnings verified at the outset may encounter difficulty in future. Income verification based on paper documents can also be manipulated and is not immune to fraud. Increasingly, lenders rely on electronic verification using their own records, credit reference data and other sources like the Inland Revenue. We do not believe that this should be constrained unnecessarily by FSA rules.

Conclusion

We agree with much of the FSA’s analysis of the cause of past problems. The regulator cites “major economic distress” experienced by some borrowers as its rationale for intervention. But there are numerous causes of such distress, including borrowers who have over-extended themselves using multiple sources of credit, changes in personal circumstances, badly timed investment in property, irrational borrowing and irresponsible lending. 

Many of these causes of distress have little to do with income verification. We therefore believe that further analysis, supported by industry knowledge, is needed before changing the requirements for verifying income or introducing product bans.

The FSA’s review should deliver regulatory reform that helps revive the mortgage market. But there are many potential pitfalls for the FSA, and for lenders and borrowers. And there is a significant risk that regulatory change in current market conditions could undermine competition and choice for consumers, without enhancing stability. The FSA is therefore right to issue a discussion paper, rather than pressing ahead with specific proposals for immediate change.

We believe that, apart from its recently launched consultation on arrears and possessions (which we support in principle), the FSA should make no further changes to the regulation of mortgages this year. There is no short term risk if the regulator takes more time to reflect or analyse market data. The current process of structural market adjustment should therefore be allowed to continue – alongside progress towards global prudential reform and improvements in the economic backdrop. 

A clearer understanding of the real causes of consumer detriment is needed. And before pressing ahead with further changes, the FSA will also need to apply rigorous cost-benefit analysis – informed by market data – to its proposed reforms.