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Never say never again. You think subprime lending has learned its lesson from the noughties banking crisis? Maybe, and maybe not, says Michael Wilson

  • By Sue Whitbread

 

What’s the one thing we all know about the 2008 financial crisis? Correct, it started when a bunch of major banks got caught holding portfolios of subprime mortgage debt that their managers had parcelled up into so-called bonds for the banks’ diversified delectation. And no, they probably wouldn’t have done such a risky thing if the international credit rating agencies hadn’t given them dodgy Triple A assessments that made them look like the safe high-yielding bets that they really weren’t.

But that’s ancient history now. So what happened next? There’s no need to tax your memory too badly, because the mental scars are probably still there. A handful of American banks, most notably Lehman Bros, went under in short order during September 2008, and the whole counterparty system would have gone into a paranoid death-spiral if the Federal Reserve hadn’t turned super-hero and forced credit into the system. Nor was it just a transatlantic panic: in Britain, in France, even in Switzerland, the devastated share prices and the state-organised buyouts became our daily fare.

This time it’s different?

Nine years after Lehman Bros, that still seems like a lot of hurricane damage to have happened because one smallish butterfly had flapped its wings on the other side of the Atlantic. But there we are. A decade of loose lending, much it under “irrational exuberance” Al Greenspan at the Fed, had set up an ambitious over-reliance on the expectation that even the poorest borrowers would be able to pay without default just as long as the growth wagon kept on rolling. And the rest, as they say, is history….

Except that perhaps it isn’t. If you think the 2008 debt crisis started in September 2008, then think again, because the first subprime collapses had been happening almost 18 months earlier – and even then, the commentators had already been discussing the threat of subprime apocalypse for many months.

That 18-20 month lead time is the bit that bothers me. Market perception lags are still as common as ever they were. And the credit trade is no slouch at thinking up new ways to bamboozle the gullible into backing stuff for which they really ought to have developed a terminal allergy. So please forgive me if I seem to be crying wolf here. Every so often, the wolf really does turn up and eat everybody.

Just call it non-prime, and watch

So what’s my point? Simply, that the idea of sub-prime lending is now regaining traction in a market that ought surely to have known better? I’m going to focus on three fast-growing market sectors which have set up deceptively high-risk scenarios. What you make of them is up to you. But in their various ways, the new “non-prime” models seem pretty much as subby as the old ones, give or take a change of name.

Yes, I’m looking at the big three: non-prime mortgage lending, high-margin consumer lending, and PCP car loans, which have left the business-only sector to become Britain’s overwhelmingly dominant form of car-buying. As with the sub-prime saga of 2007, the borrowers in all these scenarios carry quite a lot of risk but the lenders carry much, much more.

But will we get 18 months’ notice, like we did in 2007? That’s what focuses my mind. You see, I’m looking at an autumn in the USA that has sunk quite a lot of low earners’ prospects, sometimes quite literally; and at our very own doorstep lender Provident Financial, which has been wiping the smile off Neil Woodford’s face. And then, by a complete coincidence, at the sliding resale prices in the used car market, especially for diesel, and which seems likely to leave quite a lot of “guaranteed” end-of-term valuations under water.

And I’m asking myself: “Is there a story going on here? I do hope not, but if so, where will it go? And have the regulators done enough to head off the risk?

Safeguards in place

Up to a point, I’m pretty sure that they have. At the macro level, most of the developed world has done enough to beef up the core security of banking institutions by tightening up the definitions relating to reserves: it isn’t likely that banks could have listed “Triple A” subprime bonds as part of their Tier 1 capital, the way they could a decade ago.

And at the consumer level, the FCA’s continuing action against payday lenders such as Wonga has made considerable strides: the 2015 caps on charges, the reining in of cowboy enforcement techniques and the limitations on debt rollovers have all done serious damage to the profitability of these lenders: Wonga in particular declared a £35 million loss in 2014, and its APRs are now back down to a mere 1,500% or thereabouts, compared with 5,853% previously.

Improvident Financial

So how did it happen that Provident Financial, a Bradford-based doorstep lender with APR rates of around 800% even on its ‘improved’ online loans, was still hanging onto 800,000 UK customers right up to the time of its shocking August announcement that the £60 million profit it had been forecasting for its consumer credit division had somehow turned into a £120m projected loss? What sort of a corporate culture would have kept that prospect dark in what was, after all, a FTSE-100 company?

Questions, questions. If anything, Provident Financial had actually been among the gentler subprime lenders, charging a typical £43 interest for a £100 loan that ran for 13 weeks. Its distribution pattern, consisting essentially of 4,500 mainly local and part-time agents, had merely taken up the slack after the 2008 crisis, which had left millions of people with credit problems desperate for loans that they could no longer get from the now-frightened banks. And its typical loan balance was only around £500, after all.

And what was wrong with that, many would have asked? Even the FCA agrees that credit for the disadvantaged is a legitimate right, and that if it’s used in the right way it can help families to balance their budgets and smooth out any unexpected costs. The huge APRs charged are counterbalanced by very high default rates (plus hefty legal and recovery charges), which will explain why so many doorstep lenders are making low profits or indeed losses.

To which, Provident Financial would have agreed that its own downfall had been largely caused by its dismissal of its 4,500 part-time operatives in favour of 2,500 full-times. To you and me, that might have seemed a logical step if it meant that the sale process became less housewife-amateurish and more FCA-compliant. But alas, it appears that it also killed the modus operandi on the doorstep: debt recovery rates plummeted from 90% to just 57%. (Ouch.) And that in turn sent the company’s share price down by 70%. In a day…

Does all this spell the end of doorstep lending? Judging by the competitors muscling into Provident Financial’s territory, it seems the answer is no. A bigger worry would be if Provident’s Vanquis Bank came under a run of pressure from panicky investors. It does, after all, have half a billion pounds out on loan.

PCP car loans

And so to the Personal Contract Plans (PCPs) which now account for as much as 80% of UK car purchase finance, with an estimated £58 billion out on loan (source: Bank of England.) If you’re familiar with the mechanics of the deal, you’ll know that your upfront deposit allows you a surprisingly attractive ’rental’ in a situation where the eventual residual value of the car is fixed by the lender. In practice you’re paying for somebody else’s guesstimate of the depreciation rate, and your payment rate won’t change even if they’ve got it wrong.

And if they have? Well, it’s not your problem, is it?  The real pressure is on the banks which have lent out £24 billion of that £58 billion, and the car manufacturers who are exposed to the other £34 billion. For the banks, we can say that that £24 billion would equate to around 9% of their Tier 1 capital.

So what’s the problem? Well, for one thing, as we know, the dieselgate scandal has raised calls for entire classes of cars to be phased out (or simply crushed), a factor which appears to be hurting resale values among diesel vehicles. And for another, there’s a growing trend in the United States toward repackaging the trickier “subprime” car loans as bonds for the investment industry to buy. Does that ring any bells with you? And if so, are you bothered that delinquency rates are now nudging 6%?

No need to panic just yet, the Bank of England says. It would take a 30% collapse in UK residual values to wipe out car finance profits – and anyway, America’s car finance is vastly bigger than our own. Annual finance issuance is in excess of $90 billion, having risen by 17% in 2015 alone, and around $100 billion of the accumulated total has been repackaged into bonds, of which about a third is rated “subprime”. (Says Fitch.)

The problem appears to be that US car residuals are now falling away quite fast after two years in which secondhand values had held up well. And that will do two things. First, it’ll reduce the ‘capital stock’ of the finance companies, and secondly it’ll persuade lower-income car buyers to default because they know they can replace their cars for less than whet the loan companies say they’re worth. Are we ready for that scenario?

Subprime mortgages

And so to the big one, as far as the newspapers are concerned, even though the economists are not so sure. Quietly, very quietly, subprime mortgages are creeping back into the marketplaces of both Britain and the United States. The horror has returned. Except, of course, that this time around it’s squeaking rather than roaring.

In the States, so-called “non-prime” lending is now running at around $3 billion a year, which sounds a lot compared with $1 billion over the previous 18 months but is actually microscopic compared to the $1.6 trillion annual volumes of homebuyer debt. What has changed, however, is that the legislative environment itself seems likely to shift.

In America, at least, the mortgage market has been dominated in recent years by the Dodd-Frank banking rules which reined in the post-crisis institutions and gave them a good talking to about loose credit. What’s changed is that President Donald Trump has now set his face against Dodd-Frank and may try to dismantle all or part of it.

And now, after a summer of stagnant growth and autumn hurricane wipe-outs, what do you suppose an embattled Prez is likely to do? Tighten lending criteria for the hard-pressed working man with little money, or relax them?

And in Britain?

Fortunately it couldn’t happen here, could it? The Mortgage Market Review put an end to unaffordable mortgage arrangements, didn’t it? And the tightening of lending criteria has made it all but impossible for customers with troubled credit scores to get onto the housing ladder, for better or worse?

That’s what you think. Quietly, almost surreptitiously, “impaired credit” mortgages are coming back into the game – it’s just that you don’t see them advertised by the big players. Instead, alternative banks and pseudo-banks such as Masthaven or Pepper Homeloans or Magellan or Bluestone or Kensington Mortgages (honestly) are offering carefully risk-graded home loans to people who’ve had anything from a missed phone contract payment to a County Court Judgment.

And if you’re expecting that the interest rates will be crippling, you may be in for a surprise. Pepper Homeloans says that its two year fixes go as low as 2.28% for buyers “who marginally fail a credit score”; Kensington says that its clients may pay only 1% more than the average buyer, or perhaps 1%. (Although I don’t have any details of the arrangement fees, which may not be modest.) And at the upper end of the risk scale, Magellan will apparently talk to even last-year bankrupts, albeit at rates of perhaps 8% over three years.

And that, you might say, is the financial services industry working in its most efficient way for the benefit of our whole society. It’s not for me to question the financial risk and return assessments at the far outer edges of the credit system. All that I really want to know is that those risks can be contained if they go belly up, without a spread of contagion like the last time around.

But a reality check, please. The parameters of debt are changing all the time, and the spirit of human ingenuity knows no limits where the rules are concerned. If you’re expecting to see direct descendants of the monsters that sent us down in 2008, remember the wise words of Mark Twain:

History doesn’t repeat itself. But it rhymes.”