The Low Down on Lo–Doc
Over the past three years, lo-doc lending has emerged as a force in the Australian and New Zealand residential mortgage market. While still a small percentage of the market, based on worldwide trends Bluestone estimates that around 15% of all new lending will be done in a lo-doc format within the next two to three years, with the non-bank sector writing proportionally more of the market.
Friday, July 2nd 2004, 12:38PM
Lo-doc products can be defined broadly as loans delivered by lending institutions (traditionally from prime lenders) to predominantly self-employed borrowers, requiring a reduced set of documentation as evidence of serviceability (the ability of a borrower to make regular payments on their loan).
Compared to standard mortgage products, many lo-doc products have a lower loan to value ratio (LVR) and the maximum size is limited to mitigate some of the additional risk arising from this reduced evidence. Importantly, most also require mortgage insurance. By contrast, non-conforming products are typically delivered by specialist lenders, who focus on lending to riskier borrower segments using a risk-adjusted pricing model.
Most specialist lenders do not use mortgage insurance, and many will take self-employed borrowers with some adverse credit issues to a higher loan balance, and often a higher LVR. The incremental risk is carried by a mix of strategies including charging an additional risk margin which is available to cover losses, tighter security criteria (reducing potential market value declines), and more robust arrears and enforcement processes.
Documentation requirements in lo-doc products range from ‘virtually fully-verified’ where a full set of documentation is required (with the exception of tax returns) to ‘No-doc’ or ‘Asset-lend’ products, where virtually no serviceability information is required.
Due to the positive obligation under the Credit Contracts and Consumer Finance Act 2003 it is expected that lenders will certainly be required to satisfy themselves as to serviceability.
Most lo-doc products attract a premium to standard variable rates, some as high as 1% p.a. but most in the 0.4 - 0.75% p.a. range. Herein lies the first of several attributes which are likely to impact on the longer term performance of lo-doc pools - any borrower paying a premium rate who can refinance to an alternative lower rate product is likely to do so at their earliest convenience. Thus the average life of lo-doc products is likely to be materially lower than traditional prime pools, as strong borrowers refinance into prime pools as soon as possible. Borrowers who are relatively weaker, perhaps taking a lo-doc product because they badly wanted to purchase a property, but wouldn't pass traditional servicing tests, are likely to remain in these pools creating a long and relatively more delinquent tail with attendant servicing costs.
A shorter average life depresses the present value of a loan written by a lo-doc lender, a fact not apparent untila lo-doc portfolio has run its course. By this stage it is obviously too late to re-price the product, and fixed costs associated with writing the new business might not have been defrayed.
Thus the apparent attractiveness of higher margins may be illusory in a shorter average life pool with more expensive servicing overheads. It is possible that this reduced term may stress the lo-doc lenders with thinner balance sheets, particularly if they are battling higher costs associated with arrears management.
The primary risk in any mortgage pool typically falls to credit losses however, which in many lo-doc programmes is carried by mortgage insurers.
Herein lies a second major risk identified in overseas markets - will the insurers be able to pay in a consistent and timely manner honouring their obligations, if a number of lo-doc pools deteriorate markedly?
Despite positive assurances made at a time of historically low mortgage insurance losses, the risk lies in a downturn when insurers may be somewhat more embattled. At its simplest, the markets may perceive a risk that a mortgage insurer may not pay under a policy if they can demonstrate that the borrower lied to them in their application, particularly regarding their ability to service their debt.
And yet, if a borrower could easily demonstrate their serviceability, surely they would go to a traditional lender for a mortgage and save themselves the premium charged on a lo-doc product. Almost by definition, a lo-doc borrower is going to struggle to demonstrate that the income they declared in their application is real, giving an insurer a tempting out - ‘why should we pay on the loss arising from this lo-doc loan when the borrower lied to us regarding serviceability?’
Bluestone’s approach to lending to the self-employed is intended to avoid a number of these pitfalls. Credit risk is not carried by a mortgage insurer, removing a third party in the credit chain. Income is both certified by the self-employed applicant, and checked by reference to the position of the borrower’s asset and liability statement (personal balance sheet) and stated income relative to business type. Evidence of asset accumulation in line with disposable income is considered a plus, as are other regular commitments being met comfortably. GST numbers are collected for all self-employed applicants, which together with bank statements confirm that they are operating a bona-fide business and not outside the tax net.
This article was supplied by Bluestone
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