U.S. News

U.K. Mortgage Standards Safer than U.S. but Slipping


U.K. lenders have been more conservative so far than their U.S. counterparts in providing mortgages to those with less than perfect credit histories, though standards are on the slide.

The U.K. subprime mortgage market is newer and smaller than its equivalent across the Atlantic, which means it has had less opportunity to come unstuck.

Subprime loans account for around 8% of U.K. mortgage lending, according to the FSA, versus 20% of U.S. lending in 2006.

Both Citigroup and S&P estimate the U.K.'s outstanding "nonconforming" mortgage bonds -- a broader definition that includes borrowers with poor credit histories and those who do not meet lending criteria for other reasons -- at about $70 billion, compared with $565 billion of U.S. subprime bonds.

"It is not as evolved as in the United States," said one U.K.-based credit analyst, before qualifying his remark. "Perhaps I should say the U.S. is worse, and this market has not been as bad."

In the United States, the subprime market ballooned after interest rates began to rise in 2004 and mortgage refinancing dropped off, while mortgage bonds were still in strong demand in the capital markets.

Lenders looked for ways to keep up volumes and so relaxed lending criteria and turned to riskier products such as negative amortization loans, with initial repayments so low they do not even cover interest, so the outstanding amount grows.

Another risky product was piggyback arrangements to finance down payments, which accounted for 29% of all U.S. subprime lending in 2006, according to Standard & Poor's.

The U.K. nonconforming mortgage market got its start only in the mid-1990s, when borrowers who had defaulted due to a recession and collapse in house prices in the early 1990s sought to re-enter the market, said Andrew South, a director at Standard & Poor's.

The Primrose Path

Like their U.S. counterparts, however, U.K. lenders have recently been tempted to loosen their criteria.

A growing number of lenders have been entering the adverse credit market, pushing down margins, according to a report by the Council of Mortgage Lenders, which estimated the number at more than 30 in November.

"There has been a huge increase this year, with normal, mainstream mortgage lenders getting into it," said Katie Tucker, a mortgage specialist at broker John Charcol.

That means the consumer with a poor credit history has more options for finding a loan, because each lender has its own risk model -- one may allow court judgments but refuse a borrower who has missed payments, while another is unfazed by missed payments but rejects anyone hit by a court judgment, she explained.

Even so, products such as piggyback loans that finance 100% of a house purchase are not yet part of the U.K. scene. A few lenders will finance as much as 95%, Tucker said.

Overall market figures show the U.K. still has higher standards. More than 70% of U.S. subprime mortgages in 2006 were for more than 80% of purchase prices, compared with 54% of U.K. nonconforming loans, according to S&P.

"The reason that U.K. subprime mortgages haven't been a problem is mostly structural, although partly cyclical also," said Neal Shah, co-head of the mortgage-backed securities team at Moody's.

Since 2004, U.S. interest rates have risen to 5.25% from 1%. When U.S. house prices slowed and declined in some parts of the country, defaults jumped.

"You haven't had house price declines in the U.K., and while interest rates are going up here, it is more of a recent trend," Shah said.

U.K. benchmark rates have risen by a smaller amount from a higher base, to 5.75% from 4.5%, in the past year.

Not Big on CDOs

Another difference is how mortgages have been packaged.

In the U.S. last year, more than 90% of low-rated subprime-mortgage backed bonds went into collateralized debt obligations (CDOs), a device to make assets more appealing to investors by slicing the risk into tranches.

Investors in the riskiest tranches, which pay the highest yield, must take all the losses in the portfolio up to a fixed amount, before investors in the next tranche see any loss, and so on. This boosts yields at the risky end of the portfolio and reduces risk at the safer end.

In the U.K., nonconforming mortgage-backed bonds have had such minimal losses so far that most have been snapped up directly by insurance companies and other money managers, said David Covey, an ABS analyst at Lehman Brothers. Until the past few months, that demand has kept spreads low and made them less attractive as underlying assets for CDOs.

While the U.S. has a number of pure subprime CDOs, there are none in the U.K.

The U.K. nonconforming bonds that have gone into CDOs thus far make up only a modest part of any CDO portfolio, which should help limit the impact from a collapse in U.S. subprime CDOs.