Simon Whittaker is finance director at Mortgages for Business
In the latest of a string of government crackdowns affecting the buy-to-let mortgage market, the Prudential Regulation Authority (PRA) published a consultation paper (CP11/16) in March proposing stricter underwriting standards in a bid to prevent the market from overheating.
The consultation paper follows a review by the PRA of underwriting standards in the buy-to-let sector. The review covered 31 firms (circa 92% of the market) and highlighted concerns about lenders’ growth plans and how they intend to meet them.
The paper subsequently sets out “to prevent a marked loosening in buy-to-let underwriting standards and to curtail inappropriate lending and the potential for excessive credit losses.” Laudable objectives certainly and I do not propose to regurgitate analysis of the proposals that has been performed by others – instead I want to concentrate on a few key elements of the proposals.
In order to strengthen standards, the PRA insists that a minimum level of stress testing should be put in place to ensure loans remain affordable if and when rates rise.
When assessing the affordability of a potential buy-to-let mortgage, firms should take account of likely future interest rate rises over a minimum period of five years, the PRA says. The exception to this would be a fixed-rate buy-to-let mortgage contract that is valid over a five-year period.
Furthermore, the PRA expects firms to observe:
• Market expectations
• A minimum increase of two percentage points in buy-to-let mortgage interest rates
• Any prevailing Financial Policy Committee (FPC) recommendation and/or direction on the appropriate interest rate stress tests for buy-to-let lending
It also states that lenders should assume a minimum interest rate of 5.5% during the first five years of a mortgage contract.
Crucially the implication of the consultation paper is that these new stress tests will not be applied to remortgages where there is no additional borrowing. This would be good news for existing borrowers who might otherwise find their remortgage options significantly restricted by the proposals; however, it is not clear how lenders will operate this…
So let’s consider the impact of these proposals on the buy-to-let mortgage market as it currently stands. There are currently just over 1,000 buy-to-let mortgage products available and of these 25% are fixed rate products with a fixed rate term of five years or more – and almost all of these meet the proposed guidelines. Of the remaining 75% (short term fixes and tracker/discount products), 40% would meet the minimum test at 5.5% and a further 14% are stressed at 5.24% or higher meaning that that only a relatively small adjustment to the stress test would be required to meet the 5.5% hurdle. This leaves around 21% that would need significant adjustment in the stress test to meet the 5.5% hurdle – not a major disruption to the range of products currently available.
However this ignores the requirement to allow for “a minimum increase of two percentage points in buy-to-let mortgage interest rates”. If two percentage points were to be added to Bank Rate, LIBOR and lenders’ standard variable rates then virtually all of the stress tests currently used, other than those relating to five year (and over) fixed rate mortgages, would fail to meet the PRA requirements.
The only way that such an assumption could be accommodated without changing dramatically the current level of mortgage made available to new borrowers would be to reduce the (virtually standard) 125% coverage requirement. The extra 25% of cover above 100% is designed to cover a variety of factors including:
• Letting costs
• Interest rate fluctuations
But this level of cover served the industry very well in the last financial crisis. To the extent that lenders had problems with their books of buy-to-let mortgages, this was due to inadequate underwriting of the borrower and/or of the quality of the security property.
The only factors that could lead to a rise of two percentage points in interest rates would be a buoyant economy and/or increases in inflation. These are the very factors that would lead to increases in rents – but the PRA does not permit any allowance to be made for future rent rises in the stress tests. We believe therefore that this proposal needs more careful analysis before it is put into place.
Furthermore there is a very vague requirement for lenders to consider “any tax associated with the property” in assessing affordability. Is this a veiled reference to the intended non-deductibility of finance costs in personal tax computations that will come in in 2020/21? If so I could understand an increase in the stress test for higher rate tax payers to around 160% – but this would not be applied to limited companies or to people who are likely to continue to be basic rate tax payers after the proposals come into force. Once again clarity and rigorous analysis of the proposals are required.
‘Portfolio landlords’ (defined as landlords who have “four or more mortgaged buy-to-let properties across all lenders in aggregate”) also come under review in the proposals. The paper states there is evidence of an increase in arrears rates relating to landlords who have portfolios of four or more mortgage properties. As such the PRA expects “that firms conducting lending to portfolio landlords do so according to a specialist underwriting process that accounts for the complex nature of the borrower and their portfolio of properties.”
I would be intrigued to see the evidence for this assertion and whether in fact this “evidence” fails to strip out the effect of lax standards of underwriting that existed 10 years ago that I have referred to already. I suspect that if the analysis were to be performed rigorously it would be found that responsible portfolio landlords have a lower risk profile than single property landlords.
Should the proposals be passed, the PRA estimates a 10-20% decrease in the number of cumulative new approvals for buy-to-let mortgages by Q3 2018.
Finally, in an announcement that has not attracted so much attention, the PRA is proposing to “enhance the transparency and consistency of the PRA’s regulatory approach” by “clarifying” that buy-to-let lending is not eligible for a 24% “supporting factor” in relation to related capital requirements. Boring technical stuff maybe – but it could have a significant effect on the cost of buy-to-let mortgages so let me explain.
Lenders are required to hold a certain level of capital related to the value and nature of their lending in order to cover off the potential of borrower default. Having determined the calculation of the desirable level of such reserves, regulators (and politicians) concluded that this required level of reserves might curtail lending to SMEs and thus slow down the economic recovery. It was therefore decided to reduce this capital requirement by a random amount of 24% – and in the way that the rules were drafted all forms of buy-to-let lending were eligible for this reduction in capital requirements.
If this “supporting factor” is removed then lenders will need to increase the level of capital for their buy-to-let lending – and this will increase the cost of buy-to-let mortgages. It is difficult to assess precisely how much this will affect the cost of buy-to-let mortgages – but it could be as much as 0.25% p.a.
The Consultation Paper CP11/16 closes on Wednesday, 29 June 2016.