The Financial Stability Board (FSB), the international regulatory task force set up following the recent global financial crisis with the aim of developing and promoting effective regulatory policies in the interest of improved financial security, has just published its Principles for Sound Residential Mortgage Underwriting Practices.
Whilst the principles are, by design, high-level, they provide further authoritative ammunition in support of arguments of contributory negligence in claims pursued by lenders against their professional advisors. Such cases have seen a significant increase in the wake of the 2007 global crisis as lenders seek to recoup their losses.
Paratus AMC Limited v Countrywide Surveyors Limited (December 2011)
The High Court decision in Paratus was the first UK case to deal with contributory negligence of lenders in the current recession and should be familiar to all defendant firms and their Professional Indemnity insurers. In that case, the Court held that the lender’s conduct justified a reduction of 60% of any damages due to the lender as a result of the lender’s contributory negligence during the mortgage application and approval process. The shortcomings in that case related to lack of proper assessment of loan affordability and failure to investigate discrepancies in the information provided in the loan application.
The FSB Principles
The Principles provide useful guidance as to the nature and extent of the measures which a responsible lender should take when underwriting secured residential lending. The Principles, which cover five key areas, are seen by the FSB as a minimum acceptable loan underwriting standard. Set out below are the key recommendations relevant to assessing lender vulnerability in professional negligence cases; they can be applied equally to past as to current and future lending.
- Effective verification of prospective borrower’s income and other financial information
- Lenders should verify and document each applicant’s current employment status, relevant income history and other financial information (eg credit score, credit registers) submitted for mortgage qualification.
- Lenders should be concerned not only with a borrower’s “ability to repay” but also their “propensity to repay”.
- Sufficient income history should be obtained and variability in income (eg overtime or bonuses which are not guaranteed to continue in future years) should be identified and factored into any decision.
- For borrowers who are self-employed or entrepreneurs and those with seasonal incomes, lenders should require more extensive financial history or third party verification.
- Lenders should make and maintain a proper record of the documentation obtained.
- Reasonable debt service coverage
- A fundamental component of loan underwriting; lenders must make an accurate assessment of the borrower’s ability to repay the mortgage, both immediately and in the foreseeable future.
- Lenders should establish, review and maintain appropriate processes to assess the borrower’s ability to repay the loan including appropriate consideration of existing debt levels, interest rate fluctuations, introductory loan rates and discounting of temporarily high income levels.
- The assessment of ability to repay should not be based on an assumption of appreciation in value of the property or a significant increase in the borrower’s repayment capability.
- Appropriate loan-to-value (LTV) ratios
- Lenders should adopt prudent LTV ratios with appropriate levels of deposit from the borrower’s own resources.
- A better consideration of the “real value” of the available equity should be made, to include a robust and prudent approach to property valuations.
- Effective collateral management
- Lenders should ensure sound valuation processes, standards and methods by their surveyors.
- Lenders should ensure that valuations are realistic and sustainable.
- The scope and extent of the valuation report should be commensurate with the property value and the inherent risks.
- Prudent use of mortgage insurance
- Where mortgage indemnity insurance is used, lenders should not rely upon this as a substitute for sound underwriting practices.
The standard of loan underwriting in the period up to 2008 was, in many cases, exceptionally poor. Although the FSB Principles post-date the lending involved, they provide authoritative guidance on the minimum standard to be expected of a reasonable lender whenever that lending takes place. As demonstrated by the decision in Paratus, a lender’s failure to implement and apply reasonably prudent measures during the mortgage application process can lead to substantial reductions in any damages recoverable. It may well be useful to refer to the FSB Principles to reduce exposure to existing lender claims where these principles were breached.