Capital Markets

Bricks and Slaughter

Lenders in America and Britain retrench, but for how long?
Economist StaffNovember 9, 2007

A touch-up job for the decorators or months of work for the builders? Like homeowners contemplating renovation, mortgage lenders on both sides of the Atlantic must work out what to do now that two of the industry’s supporting joists—funding from the wholesale markets and growth in riskier loans—have cracked.

American lenders face the more difficult task. The “implode-o-meter”, a sardonic website tracking the damage done by America’s housing slump, puts the number of lenders to have hit serious trouble since last year at 182. Larger firms are suffering too. On November 6th IndyMac Bancorp became the latest big American mortgage lender to report a loss in the third quarter. In Britain, where things are less apocalyptic despite the Northern Rock debacle in September, signs of strain are nonetheless evident in high household debt-service ratios, a record gap between earnings and property prices for first-time buyers and falling mortgage approvals.

Most institutions are becoming more cautious. Lots of lenders relaxed their underwriting criteria when times were good, betting that rising house prices would always ensure a return even if borrowers defaulted. Mark Greene, chief executive of Fair Isaac, a research firm which compiles America’s most widely used credit scores, reports that lenders’ risk appetites have shrunk. As well as making greater use of such scores to assess borrowers, they are tightening their lending criteria (by demanding larger downpayments, say) and also being more diligent in their tracking of loans after they have been written. New-found caution extends to less risky borrowers as well: according to the Federal Reserve, more than 40% of American banks have tightened standards on prime mortgages since July.

A more prudent approach to funding also now holds sway. That means greater emphasis on retail deposits, where liquidity concerns are less acute, rather than wholesale markets. Doing more to attract deposits may have other benefits, such as opening up cross-selling opportunities, tightening underwriting controls and retaining customers for longer. Countrywide, America’s largest mortgage lender, is busily opening banking centres as it seeks to reduce its reliance on capital markets.

Amid the pain, there are some slivers of comfort. The bigger lenders can expect to pick up some of the slack caused by the disappearance of smaller rivals. Nici Audhlam-Gardiner, head of mortgages at Abbey, Britain’s second-largest mortgage lender, says that brokers who previously steered business to now-defunct or struggling players are now turning her way. Consumers may also value the perceived stability of bigger institutions.

The credit crunch has also opened the way to the repricing of loans. Some of this reflects upward pressure on lenders’ own costs, as funding has become more expensive, but there is room for a little bit of cream on top. “A fair bit of supply has left the market and the remainder has more pricing power,” says Nick Hill of Standard & Poor’s, a rating agency.

The longer-term impact of the credit crunch on lenders’ business models is harder to predict (and depends in part on the severity of the housing-market slowdown). Some think that the strategy of chasing volume growth through lower prices has had its day. The boss of HBOS, Britain’s biggest mortgage lender, has signalled that the bank will no longer focus on market share as its main measure of success. Chris Samson of Deloitte Touche Tohmatsu, a consultancy, says that several lenders are actively looking at premium products that enable people to manage payments more flexibly over the lifetime of a loan and to release money against housing equity more easily.

Others are less convinced that mortgage lenders can stand out through product innovation. “It’s difficult to invent a product without 90 other lenders reproducing it pretty quickly,” says Bob Pannell of the Council of Mortgage Lenders, a British trade body. Mortgage brokers remain powerful in America and Britain, which tends to work against loyalty to any particular lender. And price is still critically important to borrowers. A survey of British consumers conducted by YouGov for Deloitte after the bank run at Northern Rock found that people paying or considering a mortgage still rank the cheapest rate as much the most important factor in their choice of lender.

If so, things may end up coming, if not full-circle, then close to it. Craig Focardi of Tower Group, a research firm, thinks that a shift in American lending capacity from subprime borrowers to the prime market spells more intense price competition. Appetite for the most risky lending has genuinely shrivelled, not least because the threat of litigation against predatory lenders hangs in the air. “Truly marginal borrowers are not going to have the same opportunities,” says Jeff Nielsen of Navigant Consulting, which specialises in helping firms facing upheaval. But as lenders search for ways to fatten their margins, “near-prime” lending will look attractive to many. It is not just the ranks of people with patchy but not poor credit histories that have swelled as a result of the credit crunch; so too have the amounts of data that can help lenders to spot the signs of financial stress in future. For now, “back to basics” is the mantra among mortgage lenders. But when they start to focus on profits rather than survival, the siren call of risk will sound again.