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Bland Unsight

FSR June 2017: affordability recommendation

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There was an adjustment to the Financial Policy Committee recommendations to lenders on affordability testing in the most recent Financial Stability Report.

The discussion is in Box 5, from where the following two excerpts are drawn:

Quote

The new Recommendation states that lenders should test affordability by considering a 3 percentage point increase in their current reversion rate (for many lenders this is the standard variable rate, or ‘SVR’), while the previous Recommendation stated that lenders should consider a 3 percentage point increase in Bank Rate. So far, lenders have been using a range of approaches to calculate the stressed interest rate at which they test affordability — so there has been a lack of consistency across the market. Because the previous Recommendation was expressed as a 3 percentage point change in Bank Rate, it was open to different interpretations by lenders. For example, lenders could make different assumptions about whether the appropriate rate to use was the one at origination or the reversion rate. Indeed, there has been significant variation across lenders on the stressed mortgage rate used to assess affordability compared to their current SVRs. Around half of the mortgages extended in 2016 Q4 were tested using a stressed interest rate of SVR plus 2.75–3.25 percentage points. About 30% of mortgages were tested at a lower rate, and about 20% at a higher rate.

 

Quote

Although the new Recommendation will require some lenders to increase the stressed interest rate at which they test affordability, the aggregate impact on current mortgage lending is expected to be small. The amendment reinforces the insurance role of the FPC’s measures.

  • In 2016 Q4, the average stressed rate (weighted by the volume of new lending) was just over 6.8%. Bank staff estimate that with the new Recommendation it would have been just over 7%.(1)
  • Bank staff’s central estimate is that, had the new Recommendation been in place in 2016, it would have reduced mortgage approvals by less than 0.5% relative to the previous Recommendation, with a slightly larger impact on smaller lenders than on the major lenders.
  • The aggregate impact on actual lending is estimated to be small because, even if a lender increases its stressed interest rate, borrowers whose mortgage payments (calculated at the stressed rate) are low relative to their incomes will still pass the test.

For context here's how the lenders' quoted SVRs have moved over the last twenty years or so with the base rate (monthly average thereof in fact) for comparison.

5958e07533813_SVRsandbaseratetoMay2017.png.90ccf4fc92f55c45cda98933da0131b8.png

 

I think there's something fun here. Very low rates on 2-year fixed rate mortgages walk and talk a bit like loss leaders and the bank will make a bit of money on them but more money when deals expire and move to the reversion rate and borrowers either can't (or for whatever other reason don't) refinance onto a new competitively priced deal.

Therefore, my surmise is that the banks have an incentive to keep the SVR/reversion rate as high as possible.

By anchoring affordability checks to the SVR/reversion rate + 3% (i.e. 300 bps) you've probably got a reasonably robust way of ensuring that it's a little harder for banks to game the affordability checks (because gaming them by dropping their reversion rate hits the bottom line).

The other thing is that such high stress testing rates (high relative to the pay rate) seriously limits the extent to which the system is weakened by the absence of a cap on mortgage term when assessing affordability. As discussed previously the longest possible mortgage term you can have on a repayment mortgage is an infinite term and what you have at that point is an interest only mortgage. A bit of dicking around with a spreadsheet (or some algebra, if you prefer that kind of thing) will show you that if you are borrowing at high multiples of income and stress testing at 7%+ then very soon the pure interest cost on the mortgage principal becomes such a large share of your after tax income that you're going to be failing affordability checks.

One of the arguments that is often rolled out to contest even the possibility of an significant drop in house prices is the idea that any minor correction will call forth an army of buyers. I'm still dubious about that. The combination of the FCA's Mortgage Market Review implementation (h/t Ah-so for making sure I correctly link MMR to the FCA) and the the FPC's recommendations on affordability stress rates mean that prices have to drop a long way from here in order to find a big chunk of effective demand armed only with earnings and mortgages (and not also backed by two BOMAD loans and a Help to Buy equity loans, for example).

When you combine that with the removal of interest-only self-certification mortgages I can't see why we won't be going back to 2003 prices at least if the marginal buyer becomes mortgaged first-time buyers. Given the falls involved in getting to that point, it would not be unreasonable to imagine that prices might correct further before knife-catching looks like the best option. It's certainly difficult to square current prices with the restrictions on lending that are already in place and that would suggest that whatever is driving current prices, it is not a stable flow of working households borrowing against their earnings.

Edited by Bland Unsight

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It's BTL buying several properties basing (sub prime) borrowing on rents. that's the mechanism. FTB have not been setting the new highs.

we will have to wait quite a while to see how many BTL are forced sellers with the tax changes, no-one really knows the full extent as even mortgage lenders never thought to carry out any due diligence when throwing money at allready hugely leveraged morons 

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Was this also covering the comment that some lenders were forecasting that they would not pass on all of the rate rises to SVR's ? 

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6 hours ago, Bland Unsight said:

There was an adjustment to the Financial Policy Committee recommendations to lenders on affordability testing in the most recent Financial Stability Report.

The discussion is in Box 5, from where the following two excerpts are drawn:

 

For context here's how the lenders' quoted SVRs have moved over the last twenty years or so with the base rate (monthly average thereof in fact) for comparison.

5958e07533813_SVRsandbaseratetoMay2017.png.90ccf4fc92f55c45cda98933da0131b8.png

 

I think there's something fun here. Very low rates on 2-year fixed rate mortgages walk and talk a bit like loss leaders and the bank will make a bit of money on them but more money when deals expire and move to the reversion rate and borrowers either can't (or for whatever other reason don't) refinance onto a new competitively priced deal.

Therefore, my surmise is that the banks have an incentive to keep the SVR/reversion rate as high as possible.

By anchoring affordability checks to the SVR/reversion rate + 3% (i.e. 300 bps) you've probably got a reasonably robust way of ensuring that it's a little harder for banks to game the affordability checks (because gaming them by dropping their reversion rate hits the bottom line).

The other thing is that such high stress testing rates (high relative to the pay rate) seriously limits the extent to which the system is weakened by the absence of a cap on mortgage term when assessing affordability. As discussed previously the longest possible mortgage term you can have on a repayment mortgage is an infinite term and what you have at that point is an interest only mortgage. A bit of dicking around with a spreadsheet (or some algebra, if you prefer that kind of thing) will show you that if you are borrowing at high multiples of income and stress testing at 7%+ then very soon the pure interest cost on the mortgage principal becomes such a large share of your after tax income that you're going to be failing affordability checks.

One of the arguments that is often rolled out to contest even the possibility of an significant drop in house prices is the idea that any minor correction will call forth an army of buyers. I'm still dubious about that. The combination of the FCA's Mortgage Market Review implementation (h/t Ah-so for making sure I correctly link MMR to the FCA) and the the FPC's recommendations on affordability stress rates mean that prices have to drop a long way from here in order to find a big chunk of effective demand armed only with earnings and mortgages (and not also backed by two BOMAD loans and a Help to Buy equity loans, for example).

When you combine that with the removal of interest-only self-certification mortgages I can't see why we won't be going back to 2003 prices at least if the marginal buyer becomes mortgaged first-time buyers. Given the falls involved in getting to that point, it would not be unreasonable to imagine that prices might correct further before knife-catching looks like the best option. It's certainly difficult to square current prices with the restrictions on lending that are already in place and that would suggest that whatever is driving current prices, it is not a stable flow of working households borrowing against their earnings.

To what extent can we, if at all, quantify people with cash sitting to pile back in with greater cash equity?

Fascinating analysis. Well done.

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