Key Takeaways

• We have found that the main driver behind recent growth in U.K. mortgages is rising house prices--not increased mortgage creation. We estimate that since 2013 outstanding mortgage debt has risen by 15%, but the number of mortgage loans by only 4%.
• Although the number of first-time buyers has increased in recent years, high house prices mean deposit requirements are often high. More people are entering home ownership later in life. Therefore, in the future homeowners having mortgage debt later in life will likely become the norm rather than exception.
• In an environment of weakening house prices, we believe lenders, to continue to grow, will seek to innovate to serve older homeowners who generally have large amounts of housing equity and incomes, and younger borrowers who currently have difficulty accessing housing credit owing to low deposits or limited affordability.
• We also foresee scenarios where underwriting standards stretch to accommodate borrowers with relatively weak affordability who would otherwise be excluded from the mortgage market.

Our Findings

Although the number of mortgages is increasing, its contribution to the growth in the value of mortgage debt is outstripped by house price growth. From 2013 to 2018, we estimate the number of mortgages increased by 4.0%, but the value of mortgage debt increased by approximately 15.0% (see chart 1). We also observe that people are commencing home ownership later in life, and that since 2008 in England the number of homeowners aged 25-34 has fallen by 13 percentage points to 38% from 51% (see chart 2). This trend in part reflects the difficulty first-time buyers have faced entering the housing market owing to a combination of high home prices and more stringent lending standards.

Chart 1

Chart 2

Stagnating House Prices Are A Call for Innovation

In an environment of stagnating house prices, we expect lenders will try to find ways to stimulate mortgage growth. One the one hand, they will need to innovate to facilitate lending to younger borrowers who cannot currently afford down payments and, on the other hand, to unlock housing equity held by people in or approaching retirement.

Product Innovation

The following are products that are either being currently originated or are being developed.

Savings deposit guarantee mortgages

Loans of this type in many ways resemble a standard first-buyer mortgage. The novel feature is that, in addition to a standard mortgage loan, a party other than the borrowers or owner-occupiers, most typically parents of the borrowers, place cash in a savings account with the mortgage lender, which offers security to the lender in the event of borrower default and that would lower loss severity. In effect, it operates like a loan-level reserve fund.

Credit considerations.  It is possible that such products may lower default and delinquency risk if the parents of the borrower are notified by the lender of any delinquency at an early stage and are in a position to assist in curing delinquency (making good on all overdue payments, including any late charges or fees), which may ultimately protect against potential loss of their deposit.

For a pledged deposit of this nature, the securitization issuer would require security over the cash; there may be conditions in the terms of the account that make this difficult. In addition, cash would need to be covered by suitable mitigating action if the deposit-taking bank is downgraded below certain rating levels. This in and of itself and the associated potential setoff may make a securitization exit for such loans difficult.

Long-term fixed rates

The U.K. Financial Conduct Authority's underwriting requirements stipulate that for a fixed rate of five years or less, a stressed interest rate needs to be used when assessing affordability (MCOB 11.6.18). Where the fixed rate is longer than five years, then the fixed rate itself can be used. On the premise that a 10-year fixed-rate loan has a rate lower than a stressed rate, more leverage can be obtained. Therefore, all things being equal, long-term fixed-rate mortgages will have higher loan-to-value (LTV) ratios.

Credit considerations.  Long-term fixed-rate mortgages will likely have lower prepayment rates than the more usual two- to three-year fixed-rate products because redemption penalties are likely to be higher for longer and act as a disincentive to prepay. This means that past prepayment data for a lender may not be representative. For similar reasons, we would expect that such loans would also be portable, that is, the loan can be moved to a new property. This brings additional operational risk into securitizations to the extent portable loans are not bought out of a securitization. The move to longer-term fixed rates may themselves reduce remortgaging and contribute to future lower mortgage volumes, as borrowers will remortgage less frequently.

Piggyback second charges

A piggyback second charge is a loan that has been originated at the same time as a first charge, leveraging the same underwriting process. For example, the affordability assessment, valuation process, and legal process is performed once and used as an input into making the decision to lend on both the first- and second-charge mortgage at the same time. Both loans would generally be originated on the same day. It could also be the case that the first- and second-lien lenders are not the same entity or are even related at any corporate level. But, rather, the lenders have an agreement to share the costs of origination.

The attractiveness of such an arrangement is that costs are shared and may lead to lower pricing for the borrower.

Credit considerations.  Given tightened regulation for second liens, from a credit perspective the risks will likely mirror those of standard first- and second-lien loans. However, from an operational perspective, it will be important to understand whether it is the first- or second-lien holder that owns and is responsible for the underwriting decision.

Income stretch products

Given the regulatory supervision of mortgages and mortgage lenders in the U.K., there are few areas of latitude that lenders have in underwriting decisions. Two of those areas are, firstly, what can be considered as income when assessing affordability and, specifically, how variable components of income are assessed. For example, how much credit is given to bonus payments and commission? The second element is the robustness of the lender's policy regarding minimum trading periods for a self-employed applicant.

An additional way that income can be stretched is lengthening the term of a repayment mortgage to lower the monthly payment.

Credit considerations.  If a lender uses several tactics simultaneously to aid the affordability assessment, significant risk layering may arise.

Shared equity and private-sector equivalents of Help to Buy

The U.K. government's Help to Buy equity loan is a version of a shared equity product where a mortgage lender takes the first-lien position, typically up to 75% LTV, the government takes a position between 75% and 95% LTV, with the borrower putting down a 5% deposit. In the Help to Buy scheme, no interest is due on the government loan in the first five years and the government shares both upside and downside risk in house price movements.

The limitations of Help to Buy are the absolute size of the loan and its use to purchase new-build properties. The scheme is scheduled to end in 2023. Private-sector versions of Help to Buy will find it difficult to compete with the five-year interest-free period the official scheme offers. So, initial versions of this product will likely seek to offer something that is not available under Help to Buy, for example, larger loan sizes to properties that are not new builds.

Credit considerations.  Specific credit considerations of such products relate to how losses incurred when a borrower opts to sell the property at a loss, when not in default, are managed by the transaction. While such a scenario would only arise when house prices are declining and would involve the borrower losing the deposit, in case of severe declines in house prices such behavior may be tactically the best option for some borrowers.

Guarantor mortgages

A guarantor mortgage is a mortgage loan where a party other than the main obligors or owner-occupiers of a mortgage loan, typically the parents, are responsible for any losses on the mortgage in the event of a loss on the sale of the property following default.

Credit considerations.  What is being guaranteed can differ significantly from lender to lender. In some situations the guarantor would be obliged to make any delinquent monthly payments, in other cases it is only the loss on the sale of the property.

From a credit perspective, we would anticipate, given a deficiency in the status of the owner-occupier or main obligors, default and delinquency performance for such mortgages to be worse than the average for prime mortgages. The question arises as to what degree the guarantee prevents default or loss. We would anticipate the lending criteria used to assess the guarantor, the relationship between the main obligors and the guarantors, and the information flow--especially notification of early delinquency to the guarantor--to bolster the effectiveness of guarantees.

Multiple borrower mortgages

We define a multiborrower mortgage as a loan where the incomes of more than two people are taken into account when assessing affordability--often up to four. The obvious advantage from a purchaser's perspective is that with more incomes, more deposits, and more people sharing transaction costs, home ownership becomes accessible where it otherwise may not have been.

Credit considerations.  The performance of such loans would depend on the same factors that would drive performance in a more typical loan where the incomes of two people are taken into account. For example, unemployment or underemployment, illness, and relationship breakdown.

As more people support the lending decision, the risks of such events affecting a borrower are considered higher. It could be argued that with more borrowers, there is a higher chance of borrowers being able to shoulder the burden of events such as unemployment. The degree to which this is the case in reality would depend on the origination standards used.

Retirement interest only (RIO)

A RIO loan is to a borrower in or approaching retirement where only interest is paid and no capital, and so the mortgage lender is exposed to mortality as well as default risk.

Credit considerations.  The credit considerations of such mortgages are explained in detail in "Help The Aged: The Changing Landscape For U.K. Borrowers In Retirement Creates Risks And Opportunities For Lenders," published on June 1, 2018. The article explains that the lending policies of RIO loans will drive the degree to which the transaction is exposed to both credit and morality risk. For originations with a high maximum age, mortality and morbidity risk will be material.

Mixed use and small scale commercial collateral

The definitions of mixed use and small scale commercial are not standardized. Generally, we observe loan balances and property values that are in line with or marginally higher than observed in purely residential transactions.

Mixed use would generally have elements of residential and commercial, for example, a shop above a flat. The nature of commercial can vary significantly, for example, bed and breakfast establishments to small industrial units.

Credit considerations.  Given the esoteric nature of the assets, risks will differ from property to property. However, the liquidity of the market for such assets in a stressed period may be limited.

Holiday buy to let (HBTL)

HBTL is, as the name suggests, buy to let (BTL) for short-term holiday lets rather than longer-term tenancies. Accordingly, stability of rental streams is linked to the "want" of going on holiday rather than "need" for shelter, and therefore default risk is likely to be different than standard BTL.

Credit considerations.  Compared with standard BTL, HBTL is operationally more complex to manage, with a higher likelihood of void periods, and more to manage in terms of cleaning and handovers. Currently, lenders offering this product are protecting themselves against this risk with generally lower LTV ratios and higher pricing.