"With all the news around property price increases, the outlook for the mortgage industry would appear to be bright. The recession is now over and the longer-term economic outlook appears rosy. However, as we emerge from a prolonged property slump it is worth a fresh view on not only what went wrong pre-2008 but also how the market has changed since this period. Whilst a lot of the lessons of the ‘noughties’ appear to have been taken on board, we don’t believe it is simply enough to look back to past mistakes; we also need to look forward and review some of the new emerging risks, which may have a profound impact on lending in the coming years.
Inflation: The pros and cons
Historically, one of the biggest issues the UK has faced is inflation. High inflation has a lot of negative issues associated with it: it impacts productivity and competitiveness, discourages savers, and can lead to increased wage/price spirals. However, it does have one ‘positive’ particularly with regards to risk: it reduces relative debt.
In simplistic terms, if inflation is at 10 per cent and goods, services, property and wages are increasing at the same level, a 95 per cent loan-to-value will in the course of three years reduce to less than 70 per cent. For those of you who remember the house price crash of the early 1990s (post MIRAS) the reason it was so short and there was ultimately such a strong bounce back was inflation approaching 20 per cent. Great news if you are a risk manager!
A new economic reality
Inflation however, is now no longer viewed as the main issue facing the UK in at least the medium term. Whilst we now have positive economic growth, there is still a lot of spare capacity in the UK economy and ‘stagflation’ (stagnation, low inflation) is viewed by many as a far greater threat.
With wage rises (averaging currently less than 1 per cent) still falling behind very low inflation (at now under 2 per cent), there is no reason to assume that the property rises we have seen in some parts of the UK will continue for much longer.
Arguably the current rises, particularly in London and the South East, are a supply/demand rebalancing post-2008 and once this has settled down, property inflation will come back to a level linked to broad affordability. This is even more likely to occur given the recent Mortgage Market Review changes and a determination by the Bank of England to ensure that property prices aren't fuelled by increased borrowing.
The message is clear. The old economic reality is being replaced by a new economic reality and this means that from a risk perspective, you can no longer count on inflation to at least solve part of the longer-term risk equation.
The current risk and lending dilemma Stagflation presents a particular problem for mortgage lenders. Not only does it mean that asset appreciation is uncertain, it also means capital requirements (which have increased several fold for higher LTV loans in recent years) remain higher for longer. This makes higher LTV lending (anything above 75 per cent but especially 85 per cent +) very costly and therefore unattractive.
There is also the question of default and losses.
All things being equal, (based on some analysis I undertook a few years ago in a previous life), a 95 per cent loan is seven times more likely to default than a 75 per cent LTV loan. This situation is dramatically exacerbated if a property isn't appreciating or, more worryingly, is depreciating.
In short, consumer equity or more crudely, ‘skin in the game’ really matters.Given all of the above, it is hardly surprising that lenders have been reluctant to offer high LTV loans and it has taken direct ‘encouragement’ from the government to get the market moving here - much of which is arguably counter to the message they have been giving banks to manage risks more carefully.
The past is a foreign country: they do things differently there The risk approach banks have historically used (and by this I do mean risk as opposed to fraud prevention) has focused on three key strands: loan-to-value, consumer willingness to pay (credit history); and consumer ability to repay (affordability). Of the three, affordability is perhaps the most over-hyped risk in that from experience, unless a lender has clearly lent a consumer an unaffordable amount, it has a relatively low impact.
There is, however, a fourth factor now clearly coming into play in this new environment and that is individual property risk. Surely I hear you say, the banks look at this already? What about the mortgage valuation? Well, the answer to this is a partial yes, but I am referring to a fundamental revision of the way banks assess the security of a property.
If you look at the current process, the banks instruct a qualified surveyor who in nearly all cases does a good job of assessing current condition, value and providing property specific data. Based on this and the other risk factors a bank will make a lending decision. However, the lending decision is invariably a largely ‘point in time decision’ for a loan, which is typically 25 years in length.
With no real certainty around asset appreciation, it is my view that assessing a property should preferably look at a wider range of factors to ensure that the property itself has a good long-term outlook. This means assessing things such as socio-economic conditions, environmental information such as flood and subsidence data, past sales history and historical price appreciation, local area demand now and in the future, and other long-term trend data. In other words, a robust holistic view of the property and environment in which it sits.
Some properties are more equal than others
As we are now firmly in the digital age, there exists a huge amount of data on UK properties, both at a macro and individual level. As well as historical sales and marketing data, there also exists huge amounts of environmental data ranging from typical concerns such as flood to more current issues like fracking. There is also the influence property type and location has on an asset’s long-term value.
This isn't a London and the South East versus the rest of the country argument. Property disparity is easily evidenced across all UK locations where certain properties and specific locations have performed Significantly better than others that may be close by. The UK has a very heterogeneousness property mix and this, together with the physical and built environment, makes property a very mixed long-term outlook and a very specific risk.
‘Buy land, they’re not making it anymore’
Property used to be seen as a one way bet. The events of 2008 and the inflationary outlook should start to change this view. This also shouldn't be just a concern to lenders but also to property purchasers.
Landmark recently undertook a survey which showed that while 80 per cent of homeowners said they would not buy a house that was at risk of flood, only 42 per cent of people actually investigated flood risk before purchasing their home. The survey also found that 55 per cent of buyers expect their legal representative to inspect a property’s flood risk automatically as part of the conveyancing process. The phrase, ‘too little, too late’ springs to mind.
A conjoined approach
One problem with property and environmental data is how to use it in a meaningful assessment. Often data is looked at in an individual, ‘binary’ way. For example, is there a flood risk, yes or no?
Whilst it can be argued that events such as flooding or subsidence may be considered ‘low probability’ events, by analysing this level of data upfront together with other specific property and environmental data, it is possible to provide each property with a ‘risk score’. In much the same way that a lender evaluates an individual’s credit worthiness using a credit score, the data that exists around asset risk can equally be transformed into a property risk score.
Higher LTV lending
Currently LTV limits are non-specific. If a property is deemed in an acceptable condition and the current value is in line with the market, there is generally no discrimination in terms of LTV based on property or location.
However, if, by using the data available as a whole on the property, it should be possible to determine which properties represent a lower long-term risk and therefore allow LTV limits to become more flexible and based on specific rather than general risk. A holistic property risk approach would allow both lenders and consumers to be more informed as to the longer-term risks. It would also assist lenders in managing longer-term capital requirements by focusing the front end of a bank’s operations either towards properties with a better longer-term outlook or to accurately assess the level of long-term capital likely to be required
By doing so, lenders (and also insurers) will have greater peace of mind and security if environmental and property related information is automatically fed into the process – perhaps as part of the mortgage valuation
process.
Electronic desktop reports could be fed directly into the existing process and could include everything from flooding reports and contaminated land studies, through to bespoke data extracts that trigger enhanced due-diligence workflow.
