The 15th September marked the 10th anniversary of the collapse of Lehman Brothers, the largest bankruptcy filing in history. It marked the point at which failures in the US mortgage markets developed into a full-blown international banking crisis. Arguably, this event has come to define the Financial Crisis, the effects of which are still being felt (see recent articles on the UK’s Productivity Malaise and the UK’s Employment Crunch).
How did the collapse happen?
During the early to mid-00’s lower interest rates, high mortgage approvals rates and securitisation created a “real-estate bubble” in the US. Securitisation facilitated by investment banks enabled mortgage lenders to fund more mortgages, including UK lenders. It provided a mechanism by which mortgages could be incorporated into financial products in such away that credit rating agencies could assign these products a disproportionately favourable risk rating i.e. triple-A. The assigned ratings obscured the higher credit risk inherent in the underlying mortgages. The “Triple-A” rated financial products were sold to investment firms. These sophisticated players would have been expected to preform sufficient due diligence to understand, monitor and even model the products in which they were investing.
Lax lending criteria lead to individuals being over extended and increased property speculation. Demand for prime, sub-prime and buy-to-rent mortgages increased as did property prices. In an effort to slow the economy and forestall inflation interest rates were raised during 2004 to 2006. As short-term discounts on adjustable rate mortgages came to an end, many borrowers could not meet the payments at the higher rates. Foreclosures increased. House prices which peaked in 2006, fell sharply. Reductions in household spending, and then business investment, followed leading to job losses through the economy which exacerbated the problem. The bubble burst.
The conduct risk faced by mortgage providers from the sale of inappropriate mortgage products to customers was passed via investment banks to investment firms through failures in processes and systems and by staff. Operational risk had become endemic within the banking system. When the credit event finally manifested in the real-estate market the systemic operational risk failure meant banks no longer trusted each other with respect to their credit risk exposure. The liquidity on which the financial markets are so dependent dried up and faced with a systemic run on the banks governments were forced to step in.
What was the impact on the UK debt selling and purchasing model?
Post Lehman’s, the UK’s Financial Conduct Authority (FCA) was born. Subsequent regulatory changes have since been focused on the best interests of the customer throughout their “life” with the account holder. Such moves to ensure the consumer was protected from future financial market downturns proved politically popular.
The regulatory response also extended to post charge off debt which by definition contains a high proportion of customers that are financially vulnerable and require proper and fair assessment of their circumstances. This further increasing the conduct and operational risks associated with managing these portfolios.
The extended operational requirements and responsibilities in managing the conduct risk throughout the life of the customers account, which typically extend towards a decade of management, mean many UK lenders increasingly look towards the debt sale model. Debt sale allows the seller to transfer the conduct risk associated with long term customer management to the purchaser, as the new account holder. The trend in the UK continues to move towards a sale model and the signs are that contingency debt as was, will not exist in the future.
At the pre-purchase point, the current SCOR rules that control access to bureaux data, restrict purchasers from pricing debt portfolios using credit data. This limits an assessment on the customer’s affordability and potential liquidation performance. However, at post purchase the purchaser becomes responsible for the portfolio’s conduct risk. The apparent misalignment of these two regulatory requirements skews debt purchase towards the established purchasers. It is only these businesses that can match customers to their existing stocks to properly assess the sale book, and therefore price more accurately than challenger purchasers. Also, the regulatory environment supports the sellers using their existing dominant purchasers for their sales, since these entities provide a known conduct risk to the sellers.
Challenger purchasers have little or no historical performance data from which to derive pricing, especially for portfolios of a different sector or product to what they have worked previously. Paying too much for a portfolio could be disastrous for the seller, the purchaser and the customers, if the customers journey is deemed to be unsupportive or challenged too firmly, by a purchaser keen to break even on their investment.
It could also be argued that the conduct risk and “protecting the customer” mantra hasn’t been consistently adopted across the UK. Many customers empowered with their new Income and Expenditure requirements are paying over increasingly longer periods. This extends their time as a customer under management, with little challenge from some purchasers keen to demonstrate their “low conduct risk” approach to the sellers.
Is the current model sustainable?
There is a risk that the debt purchase market will become dominated by larger purchasers which could be detrimental to sellers and their customers. A lack of competition can also lead to market instability.
Are customers being protected? A potential risk could be that the customers currently paying very little towards their debt over say, a 10-year period are unaware that the debt will still show on their credit reports for six years after the debt has been repaid. Customers currently in their early twenties might not be eligible for main stream mortgages until their late thirties, where as an insolvency could arguably see these customers repair their credit ratings in a shorter period of time. Will the political environment drive more change around purchasers “mis-selling” repayment plans, or not properly communicating all facts to the consumer at the time of the payment plan set-up in the future? Time will tell!
John Willoughby, Director, elanev Limited