If your image of sub-prime is of penal interest rates and unsavoury collection methods, think again. The sector is on its way to respectability and boosting banking profits. Nick Kochan reports

Mortgage banks everywhere hear the news: ex-bankrupt businesspeople, struggling divorcees, freelancers and the self-employed are your best customers not your worst. Stop trying to lend at low margin to accountants, lawyers and civil servants who are reliable but earn the bank peanuts. Instead, find the customers who used to be turned away; by using modern techniques, in credit scoring and securitisation, they can be transformed into profitable business. The word profitable is key here because, whereas a traditional UK lender usually gets 170 basis points above the cost of funding for a straight mortgage, a non-traditional lender can charge up to 500bps.

Welcome to the world of sub-prime – or B and C lending, as it is more elegantly known in the US. The business is mature in the US, developing fast in the UK and likely to spread to the rest of Europe and other countries as the social trends that created the market start to evolve throughout the world. These trends are the decline in the nuclear family, the shift of many workers from long-term stable employment to contract and freelance working, and increased economic volatility with its impact on small businesses. This has created a huge class of people with poor credit histories due to bad luck rather than bad character and people with non-conforming credit histories that confound the standard scoring systems. Many have substantial, if irregular, incomes but cannot get a mortgage.

A gap in the market

Graeme Johnston, a partner at PricewaterhouseCoopers in London, says: "Supply teachers [in Britain] have reliable and bankable income, even though they have a week-by-week contract rather than permanent work, yet Abbey National or Halifax would struggle to lend to them. The sub-prime lender would say this is a no-brainer."

This glaring gap in the market has been spotted by entrepreneurial financiers and, in the past five years, they have made money at the expense of mainstream banking names. Now the big names are realising what they have missed and are trying to recapture the business.

The sub-prime market in the UK has been estimated by Datastream to be worth £6bn ($8.4bn) and likely to reach £10bn in five years. It includes some virtually unknown companies, such as Kensington, igroup and Paragon. Yet these are barely blushing violets: independently quoted Kensington Group, which pioneered the market in 1995, has loans on its books valued at £2bn, while igroup has loans of £1.7bn.

The meteoric expansion of the sector has attracted the interest of a number of US institutions. These see not only the prospect of immediate profit, but also the opportunity to gain a foothold in an industry that observers say is following a path, set by the US itself, towards more aggressive consumer selling. Citigroup acquired Future Mortgages last month and GE Capital acquired igroup for £200m in June.

In the UK, the Halifax has invested heavily in its Birmingham Midshires offshoot, which aims to put £250m worth of sub-prime loans on its books by the end of 2002, while mortgage lender Bristol & West quietly has widened its lending criteria to pull in those it would once have excluded as too risky. According to igroup's chief operating officer Colin Sander, the key US trend now being pursued in the UK is the growing rate at which borrowers remortgage - the so-called "churn rate". The average UK churn-rate of four to seven years will move in line with US rates which are closer to two to three years. (It is not unusual for a US borrower to refinance every year to take advantage of a new deal.) The European churn rate is also likely to increase but more slowly. This growing UK trend suits the independents, which have more market-driven and flexible styles than the mainstream lenders, which are typically more bureaucratic. In this process of making mortgages more like commodities, parts of the mortgage package, such as redemption penalties, are also being squeezed, hitting a traditional source of income for the mainstream lender. "We would be not be surprised if the UK followed the US. Redemption penalties will get more competitive," says Mr Sander. Kensington has said it has removed redemption charges for borrowers of more than three years' standing.

Another aspect of North American mortgage lending set to reach the UK is that of setting interest rates according to repayment performance. One Canadian mortgage lender demands a top interest rate of 10% from borrowers for the first year, but the rate is reduced to levels that match conventional lending if the borrower performs well. The system not only rewards good payment records but also ensures good borrowers do not migrate to blue-chip firms.

Latecomers' strategies

As the UK moves in line with the US, mainstream lenders are being forced to adopt more aggressive marketing and pricing strategies in a market they once dominated with ease.

That was before the UK housing recession in the early 1990s decimated loanbooks, cost £1bn in bad loans and sent the industry scurrying for cover. The result was the imposition of overly systematic and inflexible lending criteria excluding many viable borrowers who were experiencing temporary difficulties. Fleet-footed independents moved in and had a five-year window to exploit the lending gap. Now the mainstream is belatedly bidding for brand loyalty in a sub-sector largely lost to them.

The new entrants face a steep learning curve, says John Maltby, chief executive of Kensington. The specialists have been accumulating underwriting expertise for more than five years, so the newcomers are bound to stumble, he says. "Somebody coming into the market is actually at a disadvantage because they have not got five years history of what works and what does not. So they will make the same mistakes we made three years ago. It is a barrier to entry. It is not just the skill or the experience of people but it is the corporate knowledge that we have gained and gathered. They are going to have to work hard to catch up. For them to replicate the specialist nature of all parts of the business is a major investment. Are they going to put a mortgage adviser and a non-conforming mortgage underwriter in every branch?"

Specialist approach

Detailed and individual underwriting is at the core of the specialist approach to the less reliable borrower. Mr Maltby, whose firm employs 21 underwriters, says: "We are a specialist lender, rather than taking a broad-brush approach across a market, we recognise that everyone's circumstances are different. We will look into the underlying reasons for that event. For example, if somebody has a county court judgment (CCJ) [relating to past financial difficulties], it could be that at some point there has been a redundancy and they may not have been able to pay for the car. The skill of our underwriters is to take a close look at the event."

Nick Lord, an analyst at Schroder Salomon Smith Barney, says: "The big guys who are the newcomers have not been in the market for 10 years; they will end up picking the wrong type of business and they will not price it right." A points system - similar to that employed by the mainstream - determines independents' willingness to lend to a borrower with a poor credit history. For example, igroup has a points system that takes account of the number of CCJs and monthly arrears on past mortgage payments. But, according to igroup's Mr Sander, it differs from the mainstream lender in giving flexibility to the lending officer. "We take a much more subjective view than prime lenders.

"Depending on the amount of equity in the property, or the longevity of the business, we draw a line within one of the six risk grades. The underwriters may make a subjective decision to over-ride the points system. When a business goes under, there may be a string of CCJs which may not be anybody's fault. We have to know that things have changed, why it is different today. That is the subjective bit; you cannot always prove that to the level demanded by the building society. The mainstream lender would not have the mandate to go outside the box," he says.

The borrower pays first in terms of the upfront price and second in terms of penalties exacted for failure to comply. Upfront rates for sub-prime mortgages are determined by underwriters using the credit history points system, but for the better sub-prime borrowers, with one negative point, for example, the rates start around the same price as the more expensive prime mortgage.

Kensington says its lowest price of 6.99% undercuts the basic price of some prime mortgages. The majority of its borrowers pay closer to 10%, the top end of its range.

Bristol & West sub-prime borrowers pay no more than 7.75%, an indication for some observers that this mainstream house is extremely selective about the quality of the sub-prime borrowers it will accept.

The industry suffers from a bad image related to past cases of penal rates and tough collection methods, which the new participants are keen to dispel. As one lender says: "We carry a lot of baggage." The industry's worst nightmare almost happened in the mid-1990s when City Mortgage Corporation, an earlier incarnation of today's igroup, was threatened with an investigation by the Office of Fair Trading for alleged usurious lending. The company smartened up its act once it was acquired by the US company Ocwen and survived. Today it is one of the stars of the UK sub-prime show.

Approach to customer

The industry's smooth-talking operators do not mince their words when discussing arrears or the back-end of the operation. Kensington says it has 15% of its loan book in arrears and it takes a tough line with non-payers. "We are specialists at collection, so if the borrower is one month down, we are very proactive. We will call them and find out why." The firm even offers to take a payment on a debit card from debtors who would normally claim a cheque was in the post. It claims that only 0.8% of its securities are repossessed and it loses about 20bps in terms of write-offs. Such levels are achieved by taking a conservative view of residual values on the underlying security.

Bristol & West, one of the more innovative and upfront of the High Street participants, gives the best example of the softly-softly approach to sub-prime lending. It supplies pre-completion counsellors to people taking out adverse credit mortgages. The counsellors phone potential borrowers before they sign up and run through the new outgoings. Borrowers are told they can contact a counsellor if they are concerned about making a late payment. The scheme has been "incredibly successful" and the bank says its admittedly young portfolio is only 1% in arrears.

US influences in this specialist part of the lending market are evident in the financing of the independents' loan books as well as in their retail and marketing techniques. Kensington and igroup were early participants in the UK's asset-backed securities market. They were later joined by Paragon. Kensington alone has completed 12 securitisations worth a total of £2bn since its creation in 1995. A total of 89% of the company's bonds are rated triple A, and Standard & Poor's has upgraded its early issues from A to AA and BB to BBB.

Observers say part of the appeal of sub-prime lending to the ratings agencies is their willingness to take a conservative stance to collateral, so the company will put in collateral of £52.5m to cover mortgages of £50m. This gives the rating agencies the comfort that the first 5% of losses and defaults are already covered.

These structures may be conservative but they have enabled the sub-prime operators to make wide margins on cost of funding. Mr Johnston at PwC says the major sub-prime players make 400-500bps over the cost of funding, as opposed to 170bps by a High Street lender for a prime mortgage.

Competition hots up The arrival of mainstream US entrants, with their massive balance sheets and cashflows could yet make life tougher for those that remain completely independent. So igroup, which formerly played in the asset-backed market, is largely withdrawing from the market and will use the balance sheet of its new parent group, GE Capital.

An igroup executive says: "GE Capital will be our banker and it would carry us on its balance sheet. It is very profitable for us to be able to use its balance sheet with minimal costs. It puts us in a strong position against competitors and against the High Street building societies.

"Securitisation is quite a costly way of getting deals. You are under pressure to make sure warehouse lines are replenished by securitising. You are under constant pressure."

The company also cites the expense and time required to supply information to the rating agencies.

The economic recovery that followed the recession of the early 1990s has played into the hands of the sub-prime market, and a few independents have burgeoned. The next recession, with its inevitable crop of bankruptcies, frauds, defaults and repossessions, will prove the industry's severest test. It will test the mettle and commitment of the High Street names and independent operators that now boast of a market that seems to have come from nowhere and to be going ever upwards.

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