The FSA has published a speech by Adair Turner (Chairman, FSA) entitled The mortgage market: Issues for debate.
At the start of his speech Lord Turner briefly discusses the financial crisis and why the agenda for regulatory reform includes options related to the residential mortgage market. He adds that the Turner Review raised the issue of whether consideration should be given, for instance, on the limits on maximum loan-to-value (LTV) or loan-to-income (LTI) ratios.
However, Lord Turner stresses that his Review “made clear that the FSA was not at this stage making firm recommendations, but rather posing questions for consideration, which we will address in a Discussion Paper to be published in September, a Discussion Paper which we hope will stimulate a wide-ranging debate.”
In his speech Lord Turner sets out some of the issues concerning the mortgage market that need to be considered in the debate.
Lord Turner notes that many respondents to the Turner Review believe that it is obvious that constraints have to be placed on the mortgage market and query why the issue is even being debated.
However, Lord Turner refers to data drawn from the Council of Mortgage Lender’s database and the FSA’s Product Sales Database. Lord Turner states that these databases show “that the percentage of new mortgages extended with LTV ratios of over 95% was in the mid teens in the 1970s, soared to over 40% in the 1980s and early 1990s, and then fell significantly in the fifteen years running up to the crisis - which seems to completely contradict the story of irresponsible lending expansion.”
He adds that “if these were the only figures we had available and we knew nothing else about what happened, we would be telling ourselves a story of how borrowers and lenders, burnt by the 1990s recession, had learned their lessons and became more prudent.”
In light of this data Lord Turner states that there needs to be a period of careful analysis before any conclusion can be reached. However, he does state that “part of the story seems to be a major change in the balance between different types of mortgage borrower, and a major divergence between what’s been happening to initial LTV ratios and initial LTIs.”
Lord Turner concludes that this development has created significant risk on the basis that the flip side of low interest rates, low consumer price inflation and lower normal earnings growth, is that the burden of mortgage debts is rapidly eroded by earnings growth over time. He states that with “higher LTIs today than in the 1990s, it might be concluded that mortgage debt affordability is more vulnerable to today's economic downturn than it was in the early 1990s, despite lower average LTVs.”
However, Lord Turner states that this might be a hasty conclusion. He says that in one key respect “this recession is likely to be much more favourable to high-income leverage borrowers than that of the early 1990s. Between 1988 and 1990, mortgage interest rates rose from about 9% to 14% and stayed there until autumn 1992. That rise produced a very large increase in the percentage of income devoted to mortgage interest, well above present levels and therefore, alongside rising unemployment, played a crucial role in driving the dramatic rise in arrears and repossessions between 1988 and 1992. In this recession, conversely, interest rates have collapsed.”
Lord Turner states that it is “therefore at least possible that overall arrears and defaults from owner-occupier mortgages may be no worse or even somewhat less bad in this recession than in the early 1990s, even if the fall in GDP is equally large or indeed larger, and even if the peak to trough house price fall is more severe.”
Lord Turner states that the appropriate regulatory response could have at least three different objectives. These are:
- To protect individual customers against the consequences of over-risky borrowing. The FSA already regulates the selling process for first mortgages and has a principle of suitability. The question is whether the FSA should decide that there are some products (for instance, loans above a certain LTV or LTI) which are so unlikely to be suitable for any customer that they should simply be banned and/or whether the FSA can and should tighten its regulation of the selling processes, with more restrictive and aggressively enforced definitions of suitability.
- The FSA’s aim could be to protect the banking system from losses, given the large economic harm that occurs when the banking system suffers large losses. The FSA has already made it clear that it will be far more willing in the future to make judgments about sustainable business models, rather than relying on the wisdom of markets to discipline and control excessive risk taking. But it would only make sense for the FSA to pursue this objective via the regulation of allowable product characteristics, if it believes that a particular product category such as residential mortgages is so particularly important as a source of risk that it requires a specific approach. That case is not yet clear.
- The FSA could propose mortgage regulation as a means to reduce the amplitude of economic cycles, if it believes that high absolute leverage (asset or income-related) tends to produce greater house price volatility and as a result greater volatility of consumer expenditure.
Lord Turner also argues that careful consideration should be given about the relative merits of alternative policy instruments, and in particular the choice between product specific regulation, sales regulation and firm level regulation. He makes 3 points:
- A key choice in any product regulation could be between LTV and LTI limits.
- The FSA also needs to explicitly compare the merits of product level regulation, with firm regulation. The FSA needs to look at the appropriate capital treatment of mortgages of different LTIs and LTV ratios.
- It may be that policy intervention should focus on specific selling approaches and specific institutional risk, rather than on product regulation or in addition to it.
View FSA speech - The mortgage market: Issues for debate, 12 May 2009