Mortgage Market Review: 'Common sense' reform?

Updated December 2011

The Financial Services Authority (FSA) finally published its long awaited and highly publicised Mortgage Market Review: Proposed package of reforms (MMR) on 19 December 2011. The proposals are designed to "cut off the tail of poor lending" but are they a sweeping package of onerous reforms or more of a damp squib?

The MMR has received mixed reviews in the press, with one paper claiming that "thousands of credit-worthy people will be frozen out by new mortgage rules […] it is feared." The FSA argues, however, that the proposals will have very little impact in current economic conditions and the "tail" which will be cut off upon growth in the market will prevent another collapse.

Background

The MMR pulls together the FSA's previous consultation papers on arrears-handling practices (January 2010), responsible lending (July 2010) and distribution and disclosure (November 2010). It also contains new proposals on interest-only mortgages, non-deposit taking lenders and niche mortgage markets along with the draft rules to be introduced to the Mortgage: Conduct of Business Sourcebook (MCOB).

Whilst it may cause a few raised eyebrows amongst underwriters, the FSA has set out three principles, around which its proposals are based, of good mortgage underwriting:

1. Mortgages and loans should only be advanced where there is a reasonable expectation that the customer can repay without relying on uncertain future house price rises.

2. An affordability assessment should be carried out, which must allow for the possibility that interest rates might rise in the future; and

3. Interest-only mortgages should be assessed on a repayment basis unless there is a believable strategy for repaying out of capital resources that do not rely on the assumption that house prices will rise.

The FSA does acknowledge that, in its view, all lenders are applying these principles and lending prudently in the current economic climate.

It is concerned, however, that "as money returns to the market, firms will come under increasing pressure to consider riskier lending and will focus more on market share than maintaining lender standards."

The proposals

In order to achieve its two stated objectives, a sustainable market and a market which works better for consumers, the FSA wants to prevent consumers taking on mortgages which are clearly unaffordable or where there is a risk of them becoming so (e.g. where there is a rise in interest rates). Lenders will have to take into account whilst applying the principles of good underwriting, three elements:

1. Affordability assessment

Lenders must obtain "reliable evidence" to verify the borrower's income stated on the mortgage application form. Accordingly, self-certified mortgages and "fast-track" mortgages would no longer be permitted.

Having verified the borrower's income, lenders will have to make an affordability assessment based upon disposable income. Whilst acknowledging that its previous proposals were overly prescriptive, the FSA requires that as a minimum, a lender must take account of:

• The committed expenditure of the borrower, such as credit and other contractual commitments that will continue after the mortgage is entered into; and
• The basic essential expenditure of the borrower's household.

Additionally, it will become a requirement to assess a borrower's ability to pay where the term of a loan is to be extended.

The FSA has decided not to proceed with its previous proposals of limiting the term over which affordability is to be assessed to 25 years and building an extra 'buffer' into affordability assessments for credit-impaired consumers.

In relation to consumers planning on borrowing into retirement, the FSA has conceded that it is sufficient for lenders, when dealing with younger borrowers, to seek confirmation of a pension provision. Lenders will, however, be expected to carry out a more thorough assessment for borrowers closer to retirement.

2. Interest rate stress test

Underwriters will have to take into account the impact of market expectations of future interest rate rises on affordability. Although the FSA has stated that it will not set an interest rate for this mandatory stress test, it intends to specifically prohibit lenders making their own forecasts as to the movement of interest rates. Lenders will have to justify their stress tests, taking into account a period of five years into the future, by reference to an independent published source of market expectations.

The FSA appears to have dismissed the valid argument that any prudent underwriter will take into account the impact of a rise in interest rates, along with a number of other factors, on a borrower's ability to pay to protect it's own interest. No convincing explanation is given for reliance on independent market forecasters such as the Bank of England which, like everyone else, has a far from perfect record.

3. Interest-only proposals

Affordability, under the proposals, should be assessed on a capital and interest basis unless there is a clearly understood and believable alternative source of capital repayment. Even in a situation where a credible alternative means of capital repayment exists, a lender must also take into account the actual (current) costs of that strategy and not simply an estimate.

Whilst there is a legitimate case for preventing the use of interest-only mortgages by customers who cannot afford a repayment one, this proposed step will mean that lenders will have to be wary of "advising" clients on the merits of their capital repayment strategy. Generally speaking, lenders do not have the expertise to assess whether the investment vehicle(s) used by the borrower will produce a sufficient return to pay off the capital remaining at the end of the mortgage term. The proposed measures could lead to borrowers relying on the lenders' checks to verify that repayment strategy is sufficient, which should not be the case.

Lenders will also be required to keep a record setting out the reasons for lending on an interest-only basis. They will have to seek evidence of the repayment strategy at the application stage and develop a clear interest-only policy against which to assess interest-only applications, signed off at board level. The policy must set out the repayment strategies accepted by the lender and the controls in place around that strategy. This policy must be monitored and audited on a regular basis.

Distribution and disclosure

The FSA is proposing to remove the current prescriptive rules requiring intermediaries to assess affordability and replace them with a general requirement for them to ensure that the consumer meets the lender's known eligibility criteria. This move amounts to a formalisation of the FSA's intention for ultimate responsibility to lie with the underwriter.

The FSA is also taking away the requirement for the Initial Disclosure Document and a consumer will only need to be supplied with one Key Facts document before the sale of a mortgage under the proposed rules.

Arrears procedures

Under a proposed new rule, lenders will be prevented from taking more than two direct debits in a month from a customer in arrears. This rule appears somewhat superfluous as it would be surprising if any lenders were attempting to do this.

In addition, and rather significantly for many lenders, the existing rule allowing lenders to remove customers in arrears from concessionary interest rates will be replaced with a rule allowing removal from concessionary rates only where there is a material breach unrelated to a payment shortfall.

The questionable rationale for removing this right is that to remove a concessionary rate risks putting a borrower who is in arrears into a worse financial position and exposing them to the uncertainty of variable rates.

The FSA's own consultation, however, revealed that these terms, whilst common, were only exercised in extreme circumstances and that some lenders did not exercise them at all because they believed that to do so would be unfair. It appears overly prescriptive, in light of good market practice, to take away this right altogether and it will mean that many lenders will be forced to amend their mortgage terms and conditions.

As the FSA does not mention terms permitting a lender to transfer borrowers in arrears who are on an interest-only mortgage to a capital and interest mortgage, it appears that this will remain as a right.

The sales process

As a result of responses to the consultation on responsible lending, the FSA is removing the non-advised sales process for interactive sales. The FSA considers that where there is any form of interaction with a consumer, a firm should assess whether the mortgage is appropriate to the needs and circumstances of that consumer. This appears a sensible step, bearing in mind that purchasing a mortgage is, for many people, the most important investment they will ever make.

Non-interactive sales, for example pure online or some postal sales, will remain non-advised, however certain vulnerable consumers must always receive advice. Once a consumer has received advice, they will be able to reject it and purchase a product on an execution-only basis should they want to.

Under the new rules, all mortgage intermediaries will need to obtain a standardised mortgage qualification. The FSA will allow 30 months for intermediaries to pass all the necessary modules but this will not start until it has conducted a review of the exam syllabus. It could be some time before we see the effect of this change.

Conclusion

The first consultation paper published by the FSA, back in January 2010, received lots of attention because many of the suggested amendments were overly prescriptive and restrictive. Since that time, the mortgage market has, to a large extent, corrected itself. The FSA is concerned, however, that when markets pick up again, we will see a return of "dangerous" lending practices.

The proposals are open to consultation until the 30 March 2012 and the FSA has indicated that it will not be implementing any changes until the summer of 2013. The full implications of the MMR will not become clear until all the details have been agreed but it is a relief that it is not as onerous as it might otherwise have been.

This publication is intended for general guidance and represents our understanding of the relevant law and practice as at December 2011. Specific advice should be sought for specific cases; we cannot be held responsible for any action (or decision not to take action) made in reliance upon the content of this publication.

TLT LLP is a limited liability partnership registered in England & Wales number OC 308658 whose registered office is at One Redcliff Street, Bristol BS1 6TP England. A list of members (all of whom are solicitors or lawyers) can be inspected by visiting the People section of this website. TLT LLP is authorised and regulated by the Solicitors Regulation Authority under number 406297.

Back to publications