UK mortgage reforms: a roadmap for Australia?

By Martin North, cross-posted from the Digital Finance Analytics Blog:

The UK has been transforming the way mortgages are sold, with some significant changes coming in on 26th April 2014. We discuss the changes and consider how they compare with current Australian regulation.

The review, which was a response to the GFC, started in 2009 with a discussion paper, which led to a policy statement and rules in 2012. It has been party influenced by the European Commission proposals for a directive on mortgage credit.

“Consumers will be better informed as lenders will have to provide them with a standardised information sheet so they know the risks but can also shop around for the best product at the best price to suit their needs. It ensures that vulnerable consumers are protected by reducing the risk of over-indebtedness and default. Creditors will be encouraged to apply reasonable forbearance when confronted with consumers in serious payment difficulties.”

The reforms are wide-ranging, covering how mortgages are sold, consumer disclosure and protection, non-standard mortgages and prudential regulation.

The Financial Conduct Authority (the UK Regulator) (FCA), says:

“It had become clear by the height of the market in 2007, that, while the mortgage market had worked well for many people, it had been a cause of severe hardship for others. The regulatory framework in place at the time had proved to be ineffective in constraining particularly high-risk lending and borrowing. The MMR package of reforms is aimed at ensuring the continued access to mortgages for the great majority of customers who can afford it, while preventing a return to the poor practices that we saw in the past.”

There are a number of significant changes which will impact both lenders and intermediaries (brokers). For Lenders the main changes are:

• Lenders will be fully responsible for assessing whether the customer can afford the loan, and they will have to verify the customer’s income. They can still choose to use intermediaries in this process, but lenders will remain responsible.
• Lenders will still be allowed to grant interest-only loans, but only where there is a credible strategy for repaying the capital.
• There are transitional provisions in the MMR that allow lenders to provide a new mortgage or deal to customers with existing loans who may not meet the new MMR requirements for the loan. The borrowing will not be able to exceed the amount of their current loan, unless funding is required for essential repairs. The decision on whether or not to lend in these cases will remain with the lender.

For Brokers the main changes are:

• The removal of the requirement on intermediaries to assess affordability.
• The removal of the non-advised sales process.
• Most interactive sales (e.g. face to face or telephone) to be advised.
• An ‘execution only’ sales process for non-interactive sales (internet and postal).
• Every seller required to hold a relevant mortgage qualification.
• It will no longer be compulsory to provide customers with an Initial Disclosure Document (but firms can continue to do this if they want to). Instead, certain key messages about a firm’s service must be given to customers.
• The Key Facts Illustration will not have to be given every time the firm provides the customer with information about a product that is specific to them. Instead, it will only be required where a firm recommends a product or products, where the customer asks for a KFI, or where the customer has indicated what product they want in an execution-only sale.

The stunning change is that lenders cannot pass responsibility off to a broker. They are full responsible for assessing whether the customer can afford the loan. This is going to require significant additional analysis, according to industry analysts. To illustrate the point they use a number of case studies. Here is one:

“Mr and Mrs James received advice when they recently re-mortgaged. Mrs James is a housewife with no income. Mr James, currently aged 45, is a teacher and a member of a final salary pension scheme with a normal retirement age of 60. They were recommended a capital and interest mortgage over 20 years, taking Mr James five years past his expected retirement age.Before recommending the term the adviser obtained confirmation that Mr James intended to retire at 60. The adviser considered reducing the term to 15 years to finish prior to retirement but Mr James was not happy with the increased mortgage payments.Knowing the mortgage was to run into retirement the adviser conducted two assessments of affordability and recorded both on file:

• The first looked at affordability prior to retirement using Mr James’s current full-time teacher’s salary. The adviser demonstrated the mortgage was affordable at the current standard variable rate.
• The second looked at affordability in retirement. Mr James provided details of his expected pension income and when asked about likely changes to expenditure he confirmed this would probably remain unchanged.
• Using this information the adviser demonstrated the mortgage was affordable in retirement, again using the current standard variable rate.

The adviser explained why he recommended a term of 20 years and that this meant paying the mortgage with reduced income in retirement for five years. The adviser confirmed he checked the payments were affordable in retirement, using the information supplied, but warned Mr James this was based on current interest rates which might increase in the future.

Firms should also consider the following points: Better understanding of retirement issues – not all customers will retire at 65. Many occupational pension schemes allow members to retire earlier with good benefits. Firms should go beyond simply asking the question about a customer’s intended age of retirement and assess affordability using their expected position in retirement. Relevant documentary evidence – if customers are unsure what their retirement income will be, firms should seek documentary evidence, such as annual pension statements from their occupational scheme. Review practices and procedures – firms could review their fact find for example to include prompts to remind advisers to consider retirement where appropriate and to help demonstrate how customers are able to afford a mortgage in retirement.”

This is a more rigorous requirement than currently exists in Australia, where the obligation of lenders and brokers is to ensure the loan is “not unsuitable”. In fact banks are using the HIA-CBA Housing Affordability Index which compares the level of monthly mortgage repayments on a median-priced property purchased now with average weekly earnings. The index does so at current interest rates, which of course are very low at the moment. The data driving it though relates to property in the CBA portfolio only.

The other measure which is used is the Henderson Poverty Index or Household Expenditure Measure (which uses ABS data). Here are some recent examples from the two indices which are used in mortgage calculators.

Monthly living expenses for single adults

Monthly living expenses for couples

The application process will ask potential borrowers to list current living commitments. Lenders will compare this with the tables, and use the higher figure to assess affordability. This is discussed in detail here.

The point I want to make is that the Australian assessment is a pale reflection of the proposals being introduced in the UK. I believe we should be moving to tighter affordability assessments in Australia, and that ASIC should revise the “not unsuitable” guidelines to more closely match the UK proposals.

The UK proposal to put the final responsibility on the lender is to be welcomed, as it removes some of the complexity in the relationship between the customer, lender and broker. We should do the same.

At the same time, I would also follow the UK changes to Brokers commissions, as we discussed here. Brokers are now either identified as tied, or all of market advisors, and they cannot receive commissions because of the conflict involved. These are “Advised” transactions. Instead they need to charge a fee paid by the prospective borrower. Typically this is several hundred pounds. The exception to this is from referrer sites who provide general advice only, or execution only, they can charge lenders a referrer fee.

There is substantial opportunity for further reform in the Australian mortgage industry and given the current state of the market, I think this is overdue.