Road Traffic Accident Versus mortgage Mis-selling
I was in Court recently, helping two pensioners take on the might of a European Bank. We had a strong case and the Respondent’s barrister was struggling and, as a result, started comparing the situation in hand to a Road Traffic Accident.
The barrister’s instinct to compare were correct, in that both the “Road Traffic Management” and “Consumer Mortgages” are similar in that they both operate in a heavily regulated environment. There are clear rules and everything is well sign posted or at least most of the time.
Now, for the record, the barrister did stop as he realised he was digging his own case grave with an unrehearsed story line. However, it got me thinking that he was on to something. Is there a difference between being hit by a car and being mis-sold a mortgage. Both result in injury, both involve real people and both can have life changing implications that are not always obvious at the time of injury.
In a Road Traffic Accident, when people are hurt, the first responder, the ambulance service focus on the injured parties. The next responder, the police, secure the area, manage traffic flow to avoid further accidents, and try to work out what happened. Was it an unfortunate accident, did anyone break the rules, speeding, running a red light, weather conditions, visibility, drug taking, etc. etc.
When a consumer defaults on a mortgage, the first responder to the scene is the bank who sold the mortgage. There is no second responder, no police.
The bank does not investigate the cause of the accident, why the default arose, they just want their money back, and as soon as possible. Usually a default is caused by a change in the borrower’s circumstances such as job loss or illness, but sometimes a default arises because the loan was unsuitable from the start; a mis-sold mortgage. Consumer mortgage mis-selling was summed up well by the UK’s financial services regulator:
“if your circumstances have not changed and you struggle to pay your mortgage, it is likely that the mortgage was not suitable for you”.
Every “Interest Only” home mortgage that I have witnessed, defaults at the end of the term. The borrowers, usually in their sixties, receive a letter stating the full amount is now due and failure to pay will result in default.
Who in their right mind would sell Unsuitable Products?
Now, why would a bank want to offer you an unsuitable product. You could ask the same of an infamous second hand car salesperson, withholding some facts. To fully appreciate how such an issue can arise in a bank, you only have to look at the US property crash of 2007 (reference “The Big Short”), where salesmen offered consumers cheap money without a care in the world, knowing that the mortgage will be sold to another bank or pension fund within a very short period, and that ultimate buyer has no sight of the underwriting. [Underwriting is the process of assessing the product to ensure it meets both the customers’ and the bank’s risk appetite and that the return is adequate for that risk]
By the way, the salespersons and their overseers have pocketed their commissions and bonuses when they sold the mortgage and certainly within a year of the drawdown.
The underwriting is always carried out by a group separate to the mortgage sales force and that segregation is a fundamental control in banking.
Why was the Irish Consumer Mortgage Market so attractive to European Banks given its size
Ireland in the mid noughties, became an attractive venue for foreign banks, as the Celtic Tiger roared. The introduction of low interest rates, thanks to EU membership, Foreign Direct Investment leading to increased number of well paid jobs, young educated English speaking population, all looking for homes and mortgages. All this despite our relative tiny market size, made the numbers stack up back at head office.
Bankers and their Capital
Why is the consumer mortgage market so attractive? The answer lies in capital, which is the banker’s own money at risk. Bankers borrow most of what they need to fund their loans by using other people’s money – deposits, international loans, securitisations, etc. but they do need to put up some of their own capital. How much capital is required against a loan is dictated by the prevailing regulatory rules and strict international standards apply. If the bank in question has few historic losses on consumer mortgages, then the approved models, that calculate the capital, will produce lower capital requirements.
Up to 2009, there was a European tradition of not defaulting on your home loan so the models required banks to put up very little capital compared to their commercial lending activity.
An Example of Why Consumer Mortgages are so Attractive
A bank advances €100m commercial loan, the banker’s capital requirement might be €10m. If, after borrowing costs, net interest is 3% or €3m, Return on Capital is 30% (€3m/€10m).
If the same bank advances €100m in consumer mortgages, it’s regulatory capital models might produce a capital requirement of €4m. The gross margin is the same at €3m, however, the Return on Capital goes to 75%. I’m ignoring all the fixed costs, etc. but you get the maths, same income levels but return goes from 30% to 75% on capital invested.
The Irish consumer mortgage market became very competitive as more and more foreign banks arrived, driving down the cost to consumers. They chased market share and deals for the Irish consumer became cheaper and easier to obtain. The local banks joined the madness, as their traditional market share was obliterated. The building societies were also flexing their muscles and competing with the banks, now run by individuals with ambition to challenge the old model.
All this competitiveness culminated in a mortgage product not anticipated by regulators or the Consumer Credit Act (CCA) 1995. For example, the CCA addresses Endowment Mortgages, which are Interest Only loans with an insurance policy and that policy provides sufficient funds at the end of the term to clear the mortgage. The Endowment Policies have had their own mis-selling issues, however, they did have a repayment of capital vehicle. It is clear from the rules in place that no one anticipated a home loan that did not actually pay off any capital. The banks, lazily, used the same documentation for their Endowment Loans (without the Endowment) and Buy-to -Let loans to offer this Interest Only product. If the CCA or regulators had anticipated such a product, then the following associated warnings might read as follows:
|WARNING: This in an interest only loan and the entire amount borrowed will be outstanding when you are close to retirement. We have ignored the regulatory rules in place which require us to establish how you might repay the capital sum in 20 years-time but we don’t care as that’s a very long time away.|
|WARNING: This in an interest only loan and is effectively a rental arrangement, as we will rely on you to sell your home at the end of the term unless you have come up with some great plan all on your own. By the way, banks are not permitted to own consumer property and this is a great solution for us to avoid those rules while enhancing profits.|
As competition for market share increased, other banking best practices were ignored and might have required the following warnings:
|WARNING: The repayments on this mortgage go beyond your retirement date and neither the bank nor you have any idea how those payments will be met when your income naturally falls.|
|WARNING: We have not evidenced your income and relied upon aspirational statements from your accountant or yourself.|
Was anyone watching? Was there a policeman?
The Irish regulator at the time had concerns and relayed its actions in its annual reports:
Central Bank Annual Report 2002: “detailed analysis carried out on home mortgage lending policy and practice identified some areas where mortgage lenders could improve their lending assessment and a set of characteristics of prudent home mortgage loan assessment was circulated to the mortgage lenders in February and July 2001.”
Central Bank Annual Report 2002: “the Governor has written to all mortgage-lending institutions to stress the need for the highest lending standards to be applied.”
Central Bank Annual Report 2003: “A directive was issued to credit institutions to improve their internal controls in the area of: (1) client income verification and…”.
The regulator was so concerned that they eventually published the detailed document entitled “Consumer Protection Code 2006”, for financial services companies. In the previous year, the regulator recognised the need to protect consumers and noted in the report Consumer Protection Code Regulatory Impact Analysis of December 2005:
“Consumers are far less well informed about financial products than the providers of those products. In fact, many potential buyers of retail financial products may not even know what it is that they do not know. In the absence of complete information necessary to make informed choices, competition alone will not produce optimal outcomes for consumers”.
The Consumer Protection Code, published in August 2006, encapsulated what had already been communicated directly to banks with respect to mortgages and it continued with the principles set out in the Code of Practice for Credit Institutions, 2001. Those principles set out the standards expected from a bank that it:
“acts honestly, fairly and professionally in the best interests of its customers and the integrity of the market; acts with due skill, care and diligence in the best interests of its customers; does not recklessly, negligently or deliberately mislead a customer as to the real or perceived advantages or disadvantages of any product or service;”
The 2006 Code specifically covered items previous communicated directly to the banks such as “Suitability”, “Know your Customer” and “evidencing of income” in detail and requested credit institutions to comply with “the letter and spirit of this Code”
Consumer Mortgages had its own section in Consumer Protection Code 2006
“Where a mortgage is offered to a consumer for the purpose of consolidating other loans…………………must provide the consumer with a written indicative comparison of the total cost of continuing with the existing facilities and the total cost of the consolidated facility on offer.”
“Before a mortgage can be drawn down…………………. and other supporting documentation evidencing the consumer’s identity and ability to repay.
Where the rules ignored?
It’s safe to say that a lot of these rules, controls and guidance were ignored as time progressed as banks fought for market share in the run up to the 2008 crash. In 2016, US private equity firm Lone Star warned buyers of bonds, containing €564 million of loans issued by Irish Nationwide, that it cannot stand over original commitments tied to the home loans in their statement:
“No assurance can be given that the lending criteria of [the provider] in respect of the mortgage loans were applied at the time of origination of the mortgage loans………..” according to a bond prospectus for a vehicle called European Residential Loan Securitisation 2016-1 DAC, a Lone Star affiliate used to sell the mortgage-backed securities.
In other words, the issuer of the bonds cannot confirm that loans were granted in line with the mortgage provider’s lending criteria, that each loan has the correct documents attached, and that the lender carried out sufficient borrower background checks.
Financial products are usually “mis-sold” in order to make an individual complete a purchase that does not properly suit their needs, and the product or service was recklessly misrepresented.
If you feel you are a victim of mortgage mis-selling prior to 2009, please complete the questionnaire on our website at https://misselling.ie at the APPLY tab, for a free review of your mortgage.