The FSA's regulatory philosophy has been based on the assumptions that: (i) firms must be subject to prudential regulation to ensure financial soundness; (ii) they must be subject to conduct of business regulation, including the regulation of selling approaches, to ensure that customers are treated fairly and are well informed; but (iii) that product regulation is not required because well managed firms will not develop products which are excessively risky, and because well informed customers will only choose products which serve their needs. The regulation of selling approaches has included the requirement that products sold should be ‘suitable’ to the individual customer’s requirements, but the FSA has not considered it within its remit to prohibit specific products or product design features.
The regulatory philosophy has been that product regulation would stifle innovation, which in a competitive market has beneficial effects, and that the regulator is less well placed than the market to judge whether products deliver customer value.
Within the Turner Report the analysis of fundamental theoretical issues – market efficiency and market rationality, challenges these assumptions, and one implication is that regulators may need to regulate products, in both retail and wholesale markets.
Retail product regulation may encompass maximum loan-to-value ratios or loan-to-income ratios. In the retail market the introduction of product regulations limiting mortgage loan-to-value (LTV) or loan-to-income (LTI) ratios merits consideration, the report says.
Trends in initial LTVs were less dramatic than sometimes supposed, with only a slight increase in the % of new loans with an LTV greater than 90%. But the proportion of mortgage products allowing more than 100% initial LTV almost doubled (from 3.9% to 7.4%) between 2005 and 2007and the riskiness of high initial LTV mortgages increased since rapidly rising property prices increased the probability of a subsequent price collapse. Both some customers and some providers relied imprudently on the assumption that ever rising house prices would reduce the risks otherwise inherent in high LTVs. Some customers assumed that there would always be a supply of new remortgage offers to allow refinancing when initial low interest rate periods ended; and some providers assumed that initial LTVs would fall rapidly over the contract to reduce their risks. The loan-to-value will change over time as borrowers repay their mortgage, take out further advances and/or as the value of the property changes.
The trend in LTI ratios was more clearly upward, with the average income multiple rising rapidly after 2000, and with the % of loans which had initial LTI over 3.5 growing from 20 to 30% between 2005 and 2007. These rising LTIs in part reflected the fact that borrowers required rising loan multiples to afford higher house prices.
The UK has not imposed either legal restrictions or non-statutory restraints through guidance on mortgage LTV’s or LTIs since the general dismantling of credit quantity restrictions in the 1970s. But limitations on LTV or LTI are in place in for instance Hong Kong, the Netherlands, Greece, Austria and Poland: and several other countries (e.g. Denmark and Germany) make maximum LTV ratios a condition of eligibility for covered bond programmes.
There are three potential rationales for mortgage product regulation:
• protecting customers against the consequences of imprudent borrowing;
• protecting bank solvency against the consequences of imprudent lending: Hong Kong’s rules on maximum LTVs are for instance widely credited with enabling it to weather a major property price slump between 1998 to 2002 with only minimal impact on bank capital; and
• constraining over rapid credit growth and excessive property price increases, which increase the amplitude of economic booms and busts.
Equally it is important to note important arguments against such restrictions:
• Requirements for lower initial mortgage LTVs or LTIs, will tend to disadvantage new entrants to the housing market who cannot rely on, for instance, family sources of money to pay initial deposits. In both the UK and the US, rapid growth in mortgage credit was seen as driving a democratisation of home ownership.
• And it can be preferable for people to have high LTV mortgages, than to achieve the same total leverage more expensively by, for instance, combining a reasonably high LTV mortgage with extensive use of credit card debt or unsecured loans.
The FSA’s paper on regulating the mortgage market will assess the strength of the arguments for and against. It will analyse the extent to which customer defaults and bank losses are correlated to either high initial LTV or LTI, and will draw lessons from international experience. It will also assess the merits of direct product regulation compared with other potential policy levers such as (i) tighter regulation of mortgage selling and in particular greater focus on suitability requirements or (ii) more aggressive use of differentiated capital requirements against mortgages of different LTV or LTI .
The paper will also consider whether more effective regulation of the mortgage market, through either tighter conduct rules or direct product regulation, would require the extension of the FSA’s remit to cover second charge mortgages and buy-to-let mortgages.
