Indemnity scheme: a step towards solving key problems
Published: 30 November 2011 | Author: Bernard Clarke
It has long been recognised by most housing market commentators that the UK is suffering an imbalance of supply and demand. Construction of new homes may total around 120,000 this year, compared with a target of around 240,000 that most commentators regard as necessary if the UK is to keep pace with anticipated need.
It should therefore be no surprise that we welcomed the announcement of support in the government’s housing strategy for a mortgage indemnity scheme to encourage increased sales of newly-built property.
In conjunction with the Home Builders Federation (HBF), we had already been working on the details of a similar scheme for some time. But the announcement earlier this month of an element of government backing will increase the scale of the scheme, ensure that more builders will join it and maximise its contribution to the government’s agenda for growth.
From a lender’s perspective, the principal outcome should be that more mortgages are available at 95% of a new property’s value, enabling those with only modest deposits to buy a home. From a builder’s perspective, the real measure of the scheme’s success will be the extent to which the construction industry is able to respond by building more new homes. Overall, the proposal has the potential to deliver a welcome boost to confidence in the housing market.
Measuring the scheme’s success
In announcing the scheme as part of its wider housing strategy, the government said it could support "up to 100,000 prospective buyers who are currently frozen out of the housing market because of the need for large deposits."
The housing minister, Grant Shapps, has, however, mentioned no target for the number of mortgages advanced under the scheme. It would be difficult to determine exactly how many new mortgages are taken out as a result of the scheme, as it is possible some of the loans would have been advanced anyway, though perhaps on different terms.
The government accepts that lenders must decide whether to participate in the scheme, and it wants to uphold lending standards. It will therefore leave it to lenders to determine individual mortgage applications. Applicants are likely to be those whose incomes would allow them to take out mortgages without undue stress on their finances but who cannot find the high deposits typically required on newly-built property at present.
The government has also said that it will evaluate the impact of the scheme after two years, and assess whether there has been a positive and appropriate effect on the demand and supply of new properties. We believe that these are the primary criteria for judging the success of the scheme.
It is only over an extended period that it will be possible to assess the full impact on housing supply. At the same time, it is important to understand that it is impossible to solve all the problems created by a shortage of housing in just two years. Significantly, however, the scheme also has the potential to deliver benefits over a much longer timescale, particularly while initial deposits remain high and create delays for people aspiring to buy.
Some commentators have speculated about the impact of the scheme on the price of newly-built property. We have already begun work with members wanting to participate in the scheme to address some of the issues, including how to protect lenders against the potential for prices in the newly-built housing sector to be skewed.
For the scheme to succeed, it will be essential for lenders to have confidence in the valuation process. Builders would therefore not be able to offer financial incentives to buyers, as the effect of this would be to erode the minimum deposit of 5% that purchasers need to put down under the scheme. In the weeks ahead, we will be working with the Royal Institution of Chartered Surveyors to ensure that its guidance to valuers is clear and robust, and that it addresses lenders’ concerns.
Another key factor in determining success will be how the scheme is viewed by the regulator. We are optimistic that the Financial Services Authority (FSA) will take a positive view of guarantees provided by the government and builders, and that capital relief will be available to lenders of all sizes wanting to participate. A favourable approach by the FSA would enable lenders to make mortgages at 95% loan-to-value ratio more readily available.
How would it work?
Under the scheme, buyers of a newly-built property would pay a 5% deposit, with the lender determining their eligibility for a 95% mortgage to complete the purchase. As part of that process, lenders would apply their normal standards in deciding whether mortgage repayments are affordable and the property provides adequate security for the loan. Lending quality would therefore not be compromised, and all the FSA rules and usual lender practices would apply to the mortgage decision.
If the borrower is unable to keep up with the mortgage payments and the property is taken into possession, any money owed to the lender would be recovered first from the borrower’s equity stake. As with any other mortgage, the deposit paid by the borrower therefore provides the first level of protection from losses.
With mortgages advanced under the proposed scheme, however, the lender has additional protection for up to 95% of further potential losses, first from a fund created by the payment by the developer of 3.5% of the purchase price, and thereafter by a guarantee from the government of a further 5.5% of the price.
Potentially, all parties could incur costs to draw on the scheme. All parties therefore have a clear incentive for it not to be drawn on in practice.
Another important consideration in keeping any potential losses in check is that borrowers will only be able to take out capital repayment mortgages under the scheme. From the outset, therefore, borrowers will be continuing to build their equity stake, further reinforcing protection for themselves, the lender, the builder and the government. We have estimated that, assuming flat property prices and a notional interest rate of 5%, a buyer paying a 5% deposit would have more than 20% of equity in the property after five years.
The borrower’s liability
It will be crucial for borrowers to understand that their liability is exactly the same as under any other mortgage agreement, and that funds from the builder or the government do not indemnify home-buyers. This is, to all intents and purposes, a conventional mortgage. The guarantees in the scheme should enable borrowers to get a mortgage for a higher proportion of the value of the property than would otherwise have been the case. But they will still be required to re-pay in full any shortfall if the lender is forced to take possession of the property and sell it.
When the builder pays into the scheme 3.5% of the purchase price, its funds are transferred to the lender (or its bank if it is not a deposit-taker). The lender will pay interest on the balance, returning any unused funds after seven years. Importantly, the scheme allows lenders and builders to create separate "silos" of funds protecting properties built by the same developer and mortgaged with the same lender, but not covering properties built by different firms or mortgaged with other lenders.
Any lender or developer may participate in the scheme, and mortgages may be advanced on houses or flats. But there is no compulsion to join, nor to lend on particular properties, and both lenders and developers will be free to decide which counter-parties they are prepared to work with. The scheme will be available for the purchase of owner-occupied property, but not buy-to-let investment, and there could be caps on the maximum value of property and income of the buyer.
Potential benefits of the scheme
For creditworthy borrowers buying suitable properties, the scheme can help close the gap between the mortgage they would normally have been able to obtain and the amount needed to buy a newly-built property. The scheme therefore has the potential to help in a variety of ways:
- It can provide a much-needed boost to the UK economy. By enabling more new homes to be sold, it will encourage developers to build, thereby supporting jobs in the construction sector and creating demand for goods and services that further support employment.
- Home-buyers are helped not only by access to mortgages at higher loan-to-value ratios than might otherwise be available, but also by the contribution that increased construction rates may make to rectifying the imbalance between housing supply and demand.
- Developers are assisted by a larger pool of potential customers to buy new homes.
- Lenders are helped by measures that mitigate the risks and also potentially the costs of advancing higher loan-to-value mortgages.
Everyone should be clear, however, that there are limits to the market problems the scheme is capable of addressing. It will not, for example, increase the flow of funds available to lenders. Conditions in funding markets are likely to remain challenging. But the funding shortage has reinforced a strong preference for risk-averse lending, which has sharply restricted the availability of mortgages at higher loan-to-value (LTV) ratios. The new scheme may, however, make higher LTV mortgages more readily available.
A number of lenders have already announced that they will participate in the scheme, along with almost 30 builders – providing more than 60% of new homes in the UK – who have said they will take part. The scheme will only operate in England but we hope that similar initiatives will also be introduced under devolved powers in Scotland, Wales and Northern Ireland, providing benefits there for home-buyers, builders and the wider economy.
It is important to understand, however, that wherever a scheme operates, it does not force consumers to buy, or lenders to lend. Lenders will be free to decide for themselves if they want to participate, and will continue to assess carefully individual mortgage applications, based on the borrower’s ability to pay, individual circumstances and the security provided by the property. Borrowers, meanwhile, will need to make their own careful assessment of their ability to meet their commitments, and must be encouraged to act responsibly.
A long-tern shortage of housing in the UK is the root cause of many of the problems experienced today in all tenures. The housing shortage has pushed up costs for buyers and for those renting privately, and contributed to an inadequate provision of social housing.
On balance, therefore, the government’s indemnity scheme appears to be a step in the right direction. It has the potential to contribute to a solution to the fundamental problem of a shortage of property, by enabling builders to sell more homes and encouraging them to construct more housing. We therefore welcome it, and will continue to work with members, the government, builders and others to try to ensure that it delivers the best possible outcome.