Democratising-Mortgage-Lending.pdf

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DEMOCRATISING

MORTGAGE LENDINGHow peer-to-peer will redistribute the prots of buy-to-let

DECEMBER 2014


2/242 OF 24 www.landbay.co.uk

DEMOCRATISING MORTGAGE LENDING: HOW PEER-TO-PEER WILL REDISTRIBUTE THE PROFITS OF BUY-TO-LET

CONTENTS

Foreword [3]

Executive summary [4]

SECTION 1 [5-15]LOW RISK LENDING OPPORTUNITIES

1:1 [5-7] Property as security

1:2 [8] Security of income generating property

1:3 [9] Landlord covenant or commitment to pay

1:4 [10-15] Positive outlook for tenant demand

SECTION 2 [16-21] A SECURED PEER-TO-PEER LENDING MODEL

2:1 [16] General peer-to-peer model

2:2 [17] Peer-to-peer buy-to-let lending model

2:3 [18-19] Landbays approach to risk assessment

2:4 [20-21] Stress testing

SECTION 3 [22]CONCLUSION




Long-term impacts o pro ound changeare always underestimated, even as short-term expectations overshoot. I believe that

peer-to-peer is one o these phenomena atruly signicant development or nance,economics and ultimately society.

However, the revolution o peer-to-peernance has only so ar reached a ractiono the population, and so by denition hasbarely started. Developing new savings andinvestment products that make space ora traditionally prudent taste or nancial

caution will be vital in opening up peer-to-peer nance to everyone.

But new products alone will not be enough to reach this ull potential. Finance oall kinds will increasingly rely on an open and transparent sharing o in ormation.When the whole population can be included in the world o inance, a well-in ormedpopulation will be essential.

Enlightened competition is the uture.

For that reason we commissioned this independent report. And or that same reason wedecided to provide the Wriglesworth Consultancy with Landbays own internal stress tests.

o my knowledge, these are the rst ever published stress tests or any peer-to-peer lendersloan book, and I hope a use ul gesture in the direction the nancial world must travel.

Foreword by John Goodall

John Goodall, cofounder and CEO of Landbay December 2014




Peer-to-peer lending has started to capture the popular imagination. But or consumersconsidering placing their money with a peer-to-peer provider there is a con using arrayo options and rates on offer. As with other investments, the key to understanding whereto lend is understanding the risks.

Peer-to-peer rms offering personal loans or loans to small businesses will generally paya higher rate to lenders but with higher risk. For more cautious investors, wanting to testthe market, lending to buy-to-let landlords offers a low risk alternative.

Lending to buy-to-let benets rom our layers o protection: the realisable value othe property; the sustainable rental income; the landlord borrower commitment topay, which is a claim on their wider nancial resources; and the robust outlook or the

sector. Yet data rom the PRA shows that variable rate buy-to-let borrowers pay 1% or1/3 more in interest on average than owner-occupied borrowers. We believe that currentbuy-to-let lending is no riskier than lending to owner-occupiers, suggesting traditionalproviders are ailing to serve buy-to-let borrowers properly.

Landbay is the rst peer-to-peer provider to ocus exclusively on the buy-to-let sector.o illustrate the robustness o its port olio o buy-to-let loans we have stress tested it

under a range o scenarios. Under the severe scenario o the bank rate going to 5.75%,house prices alling by 23% and rent arrears reducing landlord rental income by 6%,

the average loan-to-value (L V) rises to 87% and income coverage alls to 104%. Teseare reassuring results that suggest that Landbays port olio should withstand severecircumstances well.

Landbays approach to assessing loan applications may provide it with a sustainableadvantage in the marketplace. While mainstream lenders making thousands o loanstend to grant these loans based on a series o rules, smaller lenders are better positionedto seek a broad picture o the borrowers overall nancial position, allowing them to pickthe sa er borrowers.

DEMOCRATISINGMORTGAGE LENDING:HOW PEER-TO-PEER WILL REDISTRIBUTETHE PROFITS OF BUY-TO-LET

Executive summary




SECTION 1 LOW RISK LENDINGOPPORTUNITIESBUY-TO-LETS FOUR LAYERSOF PROTECTION

1:1 - Property as security

CHART 1 UK GDP growth and inflation

Historically UK residential property has been the sa est orm o collateral or lenders o all varieties. Fortunately we can track its price per ormance on a regional basis as ar back as1973, when the Nationwide Building Society started publishing this data.

Over the our decades since 1973 the UK has suffered our major recessions (in the mid 1970s,early 1980s, early 1990s and the 2008-9 period) and seen the economic environment changeout o all recognition. Tis has thrown up a wide range o different challenges rom the highination o the 1970s, to the high unemployment o the 1980s and 1990s, the nancial turmoilo 2008-9 and the alling real wages o recent years.

Source: ONS

% c

a n g e o n a y e a r e a r

i e r

-5.0%

0%

10.0%

15.0%

20.0%

5.0%

25.0%

1 9 7 1

1 9 7 3

1 9 7 5

1 9 7 7

1 9 7 9

1 9 8 1

1 9 8 3

1 9 8 5

1 9 8 7

1 9 8 9

1 9 9 1

1 9 9 3

1 9 9 5

1 9 9 7

1 9 9 9

2 0 0 1

2 0 0 3

2 0 0 5

2 0 0 7

2 0 0 9

2 0 1 1

2 0 1 3

RPI ination GDP growth




Q1 1976-Q2 1981

Q1 1982-Q2 1989

Q1 1996-Q3 2007

Q1 2009-Q3 2014

NORTH 94% 117.9% 210.0% 8.0%

YORKS & HUMBER 104.7% 151.7% 236.4% 14.0%

NORTH WEST 119.6% 132.8% 221.8% 12.4%

EASTMIDLANDS

107.8% 188.2% 234.5% 24.2%

WEST

MIDLANDS

123.3% 174.8% 206.9% 20.5%

EAST ANGLIA 118.4% 231.9% 253.3% 35.2%

OUTER SOUTH EAST 116.8% 224.0% 259.8% 36.0%

OUTER METRO. 112.3% 216.9% 265.1% 42.4%

LONDON 112.1% 211.0% 327.4% 65.3%

SOUTH WEST 113.9% 202.0% 260.3% 24.9%

WALES 96.2% 143.8% 241.2% 16.2%

SCOTLAND 92.3% 80.5% 186.7% 8.6%

N. IRELAND 91.9% 26.1% 447.9% -13.5%

UK 109.2% 157.5% 258.5% 26.1%

Against the background o this changing economic environment house prices have beenremarkably robust, rising by over 1,800% between 1973 and 2014. Examining the data in detailwe would make the ollowing observations:

House prices are relatively stable, showing much lower price volatility than other assetssuch as commercial property or equities.

Housing is a good hedge against in lation, rising in value during periods whenin lation is high.

Yet housing can also per orm well in a low ination environment as we have seen inrecent years, as low interest rates have reduced the cost o servicing a typical mortgage.

House price changes tend to be serially correlated, meaning that you observe a run ohouse price gains ollowed by a run o alls rather than the more random pattern that isgenerally observed in most other asset markets such as equities or bonds.

able 1 illustrates this nal bullet point, showing how UK regional house prices haveper ormed during the our upswings ollowing the our recessions mentioned above. Teseupswings tend to be quite long all lasted at least 5 years and in the longest upswing, houseprices rose continuously or over a decade rom the start o 1996 to the third quarter o 2007.

Source: Nationwide Building Society

TABLE 1 Upswings in house prices




Te ipside o these long upswings are the downturns in house prices that have coincidedwith economic recessions. able 2 shows the maximum alls in regional house prices in thelast our market downturns. When ination was high, in the recessions o the mid 1970s andearly 1980s, house price alls were modest or non-existent, illustrating just how much housingbenets rom being a hedge against ination.

With lower rates o ination in the early 1990s and late 2000s, nominal house price alls were aeature o the market. But or a lender lending up to 72% loan-to-value, even taking the

peak-to-trough regional house price alls o the last two recessions would not give rise tonegative equity in the majority o regions.

O course individual properties can experience larger price changes due to a range o actorsincluding localised market distress or the deteriorated condition o the individual property.Lenders need to manage these issues by, or example, preventing loan port olios rombecoming too geographically concentrated.

Mid 1970s Early 1980s Early 1990s Late 2000s

NORTH NO FALL NO FALL -14.2% -16.5%

YORKS & HUMBER NO FALL NO FALL -28.4% -18.5%

NORTH WEST NO FALL -3.0% -12.5% -17.9%

EAST MIDLANDS NO FALL NO FALL -25.1% -19.3%

WEST MIDLANDS -8.0% -3.3% -16.6% -17.5%

EAST ANGLIA NO FALL -2.7% -35.8% -21.7%

OUTER SOUTH EAST NO FALL NO FALL -35.9% -20.0%OUTER METRO. NO FALL NO FALL -30.9% -19.1%

LONDON NO FALL NO FALL -31.8% -20.1%

SOUTH WEST NO FALL NO FALL -28.1% -18.1%

WALES NO FALL -2.2% -17.1% -20.0%

SCOTLAND NO FALL NO FALL -6.7% -15.7%

N. IRELAND NO FALL -8.8% -4.9% -54.3%

UK NO FALL NO FALL -20.2% -18.7%

Source: Nationwide Building Society

TABLE 2 Peak to trough decline in house pr ices




1:2 - Security of income generating propertyWhile the market value of a buy-to-let property provides security for a loan, it is actually therental income stream that it generates that really underpins the safety of the lenders position.As long as the rental income can comfortably service the mortgage payments, the lender canbe quite condent that they are ultimately unlikely to face a loss.

While house prices have been relatively stable compared to other assets such as equities, rentshave been even more stable, as Chart 2 reveals. Tis is a major source of comfort for buy-to-let lenders because it demonstrates that the landlords cash ow generally remains dependablethrough different economic conditions. Using the official government private rental series,the largest recorded fall in rents of the past two decades was the 0.5% fall recorded in the late2000s recession between mid 2009 and mid 2010.

Lenders need to ensure that rental income is sufficient to meet maintenance costs andunexpected expenses. So it is normal or lenders to insist on an income coverage ratio (ratio orents to mortgage payments) o at least 125%. Landbay stipulates a minimum rental income o125% o the mortgage payment, rising to 135% or rst time landlords and 140% or houses inmultiple occupation (HMOs).

Te importance o rental income is also illustrated by a comparison o buy-to-let lending withproperty development nance. Development nance allows developers to build or convert

properties which can be rented or sold once completed. But during development there willbe no stream o income and any development project, whether large or small, runs the risko cost or time over-runs and the risk o disappointment on uture sale or rental value. Notsurprisingly, lenders require a higher return to compensate or the higher risk o nancingproperty development.

CHART 2

Average quarterly rents

Source: ONS and LSL Properties Services

A

v e r a g e q u a r t e r l y r e n

t

1,000

2,400

2,200

2,000

1,800

1,600

1,400

1,200

1 9 9 6

Q 4

1 9 9 7

Q 2

1 9 9 7

Q 4

1 9 9 8

Q 2

1 9 9 8

Q 4

1 9 9 9

Q 2

1 9 9 9

Q 4

2 0 0 0

Q 2

2 0 0 0

Q 4

2 0 0 1

Q 2

2 0 0 1

Q 4

2 0 0 2

Q 2

2 0 0 2

Q 4

2 0 0 3

Q 2

2 0 0 3

Q 4

2 0 0 4

Q 2

2 0 0 4

Q 4

2 0 0 5

Q 2

2 0 0 5

Q 4

2 0 0 6

Q 2

2 0 0 6

Q 4

2 0 0 7

Q 2

2 0 0 7

Q 4

2 0 0 8

Q 2

2 0 0 8

Q 4

2 0 0 9

Q 2

2 0 0 9

Q 4

2 0 1 0

Q 2

2 0 1 0

Q 4

2 0 1 1

Q 2

2 0 1 1

Q 4

2 0 1 2

Q 2

2 0 1 2

Q 4

2 0 1 3

Q 2

2 0 1 3

Q 4




1:3.1- The financial strength of landlords

1:3 - Landlord covenant or commitment to payTe lenders third layer o protection is the so-called borrower covenant. An assessment othe strength o the borrower covenant looks beyond the single property on which the loan issecured to assess the soundness o the borrowers total nancial position.

In part this is to understand the borrowers wider nancial situation do they have incomerom a salary o other rented properties? How strong is their overall balance sheet. In part it is

to assess the borrowers attitude to debt. Is the borrower likely to prioritise loan paymentsover other expenditure?

Te value o the security and rental income enter the borrower assessment in a airlymechanical way; all lenders including Landbay apply a maximum L V and a minimuminterest coverage ratio. But there is much more scope or lenders to do things differently whenit comes to assessing the strength o the borrowers personal commitment to pay. For example,Landbay seeks a broad overview o the borrowers wider nancial position but many larger

lenders are ocused more narrowly on the property being mortgaged. Some lenders insist ona certain level o employment income, indicating that they are targeting so-called amateurlandlords who are managing the business in their spare time.

Many traditional lenders set limits on the number o properties their borrowers can mortgage.By doing so, these lenders are deliberately ocusing their attention on the amateur landlordin pre erence to larger pro essional landlords with numerous properties. Tis may seemsurprising given that the pro essional landlord with a port olio o properties is likely to be armore experienced with a better understanding o the markets they operate in.

When it comes to the borrower covenant, the buy-to-let market has a potential advantage overlending to owner-occupiers. Te typical buy-to-let borrower is mature (in their 40s or 50s),is more nancially stable and has higher net assets than the typical owner-occupier borrower.Ofen the buy-to-let borrower will have a substantial amount o equity in the property inwhich they reside.

For lenders, such landlords should represent a lower risk than a rst time buyer in their

twenties, with no track record o managing a mortgage and a limited nancial cushion shouldanything go wrong. Even the typical second or third time homeowner is unlikely to be assolid a lending proposition, as most homeowners depend on a single source o income to paytheir mortgage - their salary. Having a port olio o rented properties provides the landlordwith more diversity o income and, in extremis, should provide more options or dealing withnancial stresses as rented properties can always be sold to meet commitments.




1:4 - Positive outlook for tenant demandBy its nature, the assessment o a lending proposition needs to be orward looking. Te lenderneeds to be condent that the borrower will meet their obligations into the uture. Historicalexperience provides a good grounding or understanding the dynamics o the UK housing andrental markets. And the current nancial circumstances and past track record o the borrowershould be a good guide to their uture creditworthiness. But history is not always aper ect guide to the uture.

It is important there ore to understand the actors that are likely to shape the market in thecoming years and decades. For buy-to-let lenders, tenant demand is a key variable. We cangauge the possible uture demand or rented property by re erence to uture demographicprojections.

able 3 shows the official government orecast or the UKs population. It shows that in the 25years between 2012 and 2037 the UK is expected to see an increase o just under 10 million in

its resident population. Tis increase o nearly 400,000 a year is substantially higher than therate o growth seen in previous decades, suggesting that demand or accommodation will beexpanding at an unusually ast rate relative to the existing stock o property.

Te UK has traditionally had a weak supply response the output o new houses has struggledto rise adequately in response to higher demand. And this effect has become more pronouncedin recent years, with house building alling way short o the level required to keep pace withthe growth in household numbers. Tis has created a cumulative worsening o the housingshortage, the result o which has been higher house prices, making it more difficult or peopleto buy, which in turn has raised tenant demand, putting upward pressure on rents.

TABLE 3 Population projections (millions)

2012 2017 2022 2027 2032 2037

England 53.5 55.4 57.3 59.1 60.7 62.2

Wales 3.1 3.1 3.2 3.2 3.3 3.3

Scotland 5.3 5.4 5.5 5.6 5.7 5.8

Northern Ireland 1.8 1.9 1.9 2.0 2.0 2.0

United Kingdom 63.7 65.8 67.9 69.9 71.7 73.3

Source: ONS




U K

o u s i n g c o m p e

t i o n s

-00

50,000

100,000

150,000

200,000

250,000

1 9 8 0

1 9 8 1

1 9 8 2

1 9 8 3

1 9 8 4

1 9 8 5

1 9 8 6

1 9 8 7

1 9 8 8

1 9 8 9

1 9 9 0

1 9 9 1

1 9 9 2

1 9 9 3

1 9 9 4

1 9 9 5

1 9 9 6

1 9 9 7

1 9 9 8

1 9 9 9

2 0 0 0

2 0 0 1

2 0 0 2

2 0 0 3

2 0 0 4

2 0 0 5

2 0 0 6

2 0 0 7

2 0 0 8

2 0 0 9

2 0 1 0

2 0 1 1

2 0 1 2

2 0 1 3

Public sector completions Private sector completions

1:5 - Superior arrears performance against mainstream lending

So, buy-to-let benets rom important inherent protections, but how does it per orm relativeto other loan types? Chart 4 shows three month plus arrears or buy-to-let and owner-occupied lending in the UK since 1999. In 12 out o these 15 years, arrears were lower inthe buy-to-let market, which is a remarkable per ormance or a class o lending that onlycommenced in 1996.

Te three years when three month plus buy-to-let arrears exceeded those o the mainstreammortgage market coincided with the nancial crisis and recession (2008-10). Closerexamination o this per ormance reveals that it was very concentrated geographically, byproperty type and by lender.

As Chart 3 shows, there has been only a modest number o social housing completions inrecent years around 30,000 a year. At the same time, the rate o owner-occupation has been

alling since 2002, when it stood at 70%, to an estimated 62% today. Tis has happened asyoung people have ound it increasingly difficult to access owner-occupation due to a highhouse price to earnings ratio. In addition, since the nancial crisis, tighter mortgage lendingcriteria and higher deposit requirements.

Te above actors have been supporting the growth o the private rented sector, which hasexpanded rom 9% o households in 2000 to around 20% today, and point to urther growthin rental demand. Tis higher demand in turn suggests that there will be upward pressureon rents and downward pressure on rental voids over an extended period. Tis represents areassuring background or lenders to the private rented sector.

CHART 3 UK Housing Completions

Source: Department of Communities and Local Government




Indeed, aggregate buy-to-let arrears numbers mask a wide range o per ormance romindividual lenders. In the nancial crisis a small number o lenders had a disproportionateshare o the sectors arrears. One o the largest contributors was Brad ord & Bingley, whowere very active in the buy-to-let market through their Mortgage Express brand, using anautomated underwriting process (see Section 2.2 or a uller explanation).

By contrast Paragon Mortgages, who operate a manual approach to underwriting loans,reported three months plus mortgage arrears o 0.3% in March 2014. During the nancial

crisis Paragon Mortgages arrears were consistently below the industry average not only orbuy-to-let but also or owner-occupied lending. We believe its approach to assessing loans wasa large part o the explanation or this exemplary record on arrears.

CHART 4 Three month plus mortgage arrears

Source: Council of Mortgage Lenders

% o

f m o r t g a g e s m o r e

t h a n

3 m o n t

h s

i n a r r e a r s

0.00%

0.50%

1.00%

1.50%

2.50%

2.00%

3.00%

3.50%

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

Buy-to-let Owner-occupiers




-00

20,000

40,000

60,000

100,000

80,000

120,000

120,000

2009

Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3

2010 2011 2012 2013 2014

2 month plus tenant arrears 3 month plus buy-to-let landlord arrears

We can also compare buy-to-let mortgage arrears with tenant rent arrears. Chart 5 compares 2month plus rent arrears with 3 month plus buy-to-let mortgage arrears. Despite the differencein length o arrears between the two series they do allow or a comparison o the trend and theextent to which landlords can absorb tenant arrears. Chart 5 paints quite a positive picture:buy-to-let mortgage arrears have been alling consistently since 2009 despite rising rent arrearsup until 2012, showing that landlords were able to absorb higher rent arrears. But since 2012rent arrears have also been trending down.

Tere is no comparable industry data on arrears or consumer or personal loans or loans tobusinesses. Tis in itsel could be considered something o a drawback or individuals thinkingo lending to these classes o borrower because it makes it difficult to gauge what a normallevel o arrears is or these loans or how cyclical the arrears per ormance is. Indeed, it isprobably more important to understand arrears per ormance or these other classes o lending.Tis is because where loans to either individuals or businesses are not secured on valuableassets such as property, the chances o recovering what is owed in the event o de ault is likelyto be much lower.

Despite the lack o published data, anecdotal evidence shows that arrears and losses are

typically much higher both or unsecured consumer loans and or loans to small businesses,and this is reected in the higher rates o interest charged in these markets.

CHART 5 Landlord mortgage and tenant rent arrears

Source: Council of Mortgage Lenders and LSL Property Services




1:5.1- The management of buy-to-let arrears

1:5.2 - Credit losses

1:6 - Buy-to-let versus owner-occupied mortgage rates

Te management o arrears is usually conducted using quite a different ramework in theprivate rented sector. While repossession is the standard avenue when an owner-occupiedborrower de aults, buy-to-let lenders will typically appoint a receiver o rent to run a propertyor even the whole port olio o a landlord who has allen into arrears. A receiver o rent can

take control o the property at the request o a lender when the borrower has ailed to meettheir obligations, ensuring that the property is properly run and that mortgage payments areprioritised out o any ree cash ow that exists.

A receiver o rent has the power to decide on the ultimate course o action: sell the property,continue to rent it out or return it to the landlords control. Tis exibility allows the receiverto choose the option that is most likely to maximise value or the landlord and the lender.For example, in a market where sales are weak but rental demand is strong, properties canbe retained and rented, avoiding the need or sale at a reduced price. On past evidence, thereseems little doubt that the receiver o rent allows or more efficient management o arrearsin the buy-to-let sector.

While there is comprehensive industry data on mortgage arrears, un ortunately there is noequivalent data on mortgage credit losses either or buy-to-let or owner-occupied lending. Butbuy-to-let lenders that use a receiver o rent can substantially reduce arrears and in many casesreturn properties to the landlords control. Lenders report that this has substantially curtailedcredit losses in recent years.

In contrast, in the owner-occupied market there is considerable pressure rom the regulatoror lenders to show orbearance to borrowers in arrears. Tis can give the borrower time

to recover their nancial position but equally it can allow a borrower in serious nancialdifficulty to remain in the property or an extended period ultimately leading to a worsenancial outcome or both the homeowner and the lender.

Data rom the Prudential Regulatory Authority (PRA) shows the average mortgage ratecharged to regulated (owner-occupied) and unregulated (buy-to-let) borrowers. Chart 6shows the distribution o interest rates above Bank o England base rate or the latest quarteravailable. It shows that while 55% o new variable rate owner-occupied loans were at less than3% above bank rate, the same was true o only 17% o buy-to-let loans. Over recent quartersthe average variable rate charged to buy-to-let was 4.0% against 3.0% or owner-occupiers,one third more.




Tis data is revealing because in view o the superior average arrears per ormance o buy-to-letover the past 15 years, the additional layer o protection provided by the rental income stream,

a robust outlook or rented property and lower maximum L Vs, it is hard to argue that buy-to-letis higher risk than owner-occupied lending. Tis suggests that the traditional lenders thatstill dominate the mortgage market are not providing buy-to-let borrowers with appropriatemortgage pricing.

CHART 6 Interest rate paid above bank rate (variable rate loans)

Source: Prudential Regulation Authority

0%

10%

30%

40%

50%

70%

20%

60%

Less than 2% above 2 < 3 % above 3 < 4 % above 4% or more above

Regulated Un-regulated (Buy-to-let)




Peer-to-peer lending is rapidly gaining acceptance in the marketplace with over 1 billion nowlent. As public and media interest has grown, the peer-to-peer business model has become alittle better understood. It has sometimes been described as the democratisation o nance bringing savers and borrowers together without the need or a complex and expensive bank satin the middle.

However, the detail o how peer-to-peer providers manage this coupling o savers andborrowers and how they manage the risks involved is not well understood. Most people havea reasonable comprehension o credit risk i the borrower cannot pay and any security ailsto cover the short all there will be a loss. Tis loss can potentially all on the lender althoughmost peer-to-peer providers have a protection und that can absorb initial losses.

But peer-to-peer lenders also ace a range o other issues that would be amiliar to any bankexecutive. Tere is operational risk, market risk, renancing risk, liquidity risk and interestrate risk. For example, operational risk relates to the robustness o systems supporting thebusiness and customer ullment. Peer-to-peer providers need to have robust systems toensure a smooth experience or both lenders and borrowers.

Lenders on the plat orm have liquidity risk in the sense that they are entering into a xed termloan agreement with a borrower. I they want to get their unds back early then they are relianton someone else depositing unds on the plat orm in order to take over their loan.

SECTION 2 A SECURED PEER-TO-PEERLENDING MODEL

2:1 - General peer-to-peer model




Te majority o peer-to-peer lenders that have been established to date have ocused onproviding either unsecured personal loans or loans to small businesses. By comparison withthese alternatives, using the peer-to-peer model to lend exclusively against residential property

or rent should offer consumers a sa e and transparent lending opportunity and a goodroute into the nascent peer-to-peer market. Te extra security offered by lending secured onresidential property is something that ordinary customers can understand, andappreciate the benets o .

But even within a ramework o secured lending there are degrees o risk. Te lender has tochoose the size o cushion that is built in via the minimum deposit and rental income coverdemanded o the borrower and perhaps more importantly it has to develop a culture that seesrisk control has central to the business o lending.

Te Landbay model is designed to bolster the sa ety that comes rom secured lending with

conservative lending limits. Mortgages are limited to an L V o 72% and an incomecoverage ratio o at least 125% is required.

Landbay loans are ring enced or the benet o the lenders. Tis can be contrasted with thesituation in most banks and building societies, where loans are usually available to meet thebanks general obligations, even when the bank is engaged in other much riskier lending,although o course bank deposits are protected by the Financial Services CompensationScheme up to 85,000. Te Landbay Protection Fund adds a urther level o sa ety.

In keeping with most other peer-to-peer lenders, Landbay provides a discretionary und,which is currently receiving 0.25% o loan balances. Tese unds are ring enced or the beneto Landbay lenders. Te Protection Fund can be used to make up any uture short all thatcould occur in the income rom the loan port olio. O course, it is not a guarantee o paymentbut it acts as a buffer in a similar way to bank capital which provides a buffer between the

unds that savers have provided and the amount lent out to borrowers.

2:2 - Peer-to-peer buy-to-let lending model

2:2.1 - Protection Fund




Landbays approach can be contrasted with that o the mainstream mortgage lenders that usemainly automated underwriting systems. Automated loan underwriting in broad terms relieson a series o lending rules. I the applicant passes each rule they are approved and i they ailon any they will be rejected.

In addition, automated underwriting does not lend itsel easily to the collection o too widea range o in ormation on the borrower because this adds complexity to what is meant to bea straight orward binary decision making process. So it is normal or a mainstream lender to

assess a buy-to-let applicant without a detailed overview o the value o other properties theyown relative to the amount owed on them, or an overview o the cash ow they generateon other properties.

Larger lenders may consider it necessary to use a series o rules in their loan assessmentprocess so that each member o a large loan underwriting department can quickly assesswhether a loan should be approved. But each additional rule has the potential to reject somehigh quality borrowers while potentially accepting some poorer quality ones.

For example, one rule commonly used by mainstream lenders is that the property must belet on a single tenancy agreement. Mortgage applicants renting rooms out separately willautomatically be declined regardless o the L V, income coverage ratio or their level oexperience. So a mainstream lender lending up to 80% L V, would reject an application onan L V o 20% and accept an application on a neighbouring property at 80% L V where the

ormer was rented by the room and the latter on a single tenancy.

A range o actors come together to make an efficient and sa e lender. But what can really marka lender apart is its approach to assessing a loan application or so-called loan underwriting.Success ul loan assessment is a crucial element in ensuring the robustness o any lendingoperation, be it bank, building society or peer-to-peer lender.

When assessing mortgage applications, Landbay has a very clear philosophy:

1. Gather a broad picture o the mortgage applicant and pay close attention to the qualityo the borrower.

2. Cash ow is paramount and house prices are the backstop.

As stated above, Landbay uses the basic criteria such as maximum L V and a minimumincome coverage ratio that are key risk measures used across the buy-to-let lending industry.

But it is Landbays desire to understand the ull picture o the borrowers nancial positionthat could differentiate it in the longer term.

Landbays ocus on the importance o cash ow also marks it apart rom many other peer-to-peer lenders who are lending on residential property. Many o these lend on developmentopportunities, where developers invest to convert or upgrade a property. Because developerstypically receive no income while they are converting or renovating a building, they aceadditional risk, as does their lender. Landbay avoids this market, ocusing instead onready-to-rent property.

2:3 - Landbays approach to risk assessment

2:3.1 - Automated loan assessment




ypically rst time or amateur landlords are much more likely to stick to the moststraight orward option o renting a whole property. More experienced landlords are morelikely to rent properties by the room and will do so where they can see it generates a betterreturn. So while the rule barring renting by the room was imposed to reduce risk, it can havethe opposite effect, skewing the characteristics o the population o borrowers being accepted

or loans or the worse.

Other examples o mainstream lenders rules excluding some success ul experienced landlordsinclude the rule against lending to limited companies and lending on properties rented tohousing benet recipients (which some pro essional landlords specialise in). Indeed, manymainstream lenders impose a cap on the number o properties a landlord can mortgage withthem. Tis deters experienced landlords with large port olios, again skewing the loan booktowards the amateur landlord.

Te undesirable results o an automated approach to loan assessment can be seen in theevents that ollowed the nancial crisis. Buy-to-let arrears and subsequent losses or some

lenders rose alarmingly in certain specic locations mainly new blocks o ats in provincialcity centres. Te landlords borrowing on these properties met the criteria o the mainstreamlenders. However, on closer examination these landlords were mainly amateurs who had beenenticed into an over-exuberant market with little consideration or the sustainability o eitherprices or rents.

Te lenders in question also do not appear to have carried out a robust assessment o thepotential rental demand when lending on new developments in areas where the overall supplyo new ats was known to increase sharply. Instead, these lenders relied on their rules basedloan assessment system to weed out risk and deliver quality loans.

Automated underwriting may have also in some cases allowed higher levels o raud to slipthrough. Larger buy-to-let lenders like Mortgage Express were hit by some organised raudthat led to substantial losses. In contrast, experienced manual loan underwriters can be quitegood at spotting suspicious looking applications, picking up clues that would most likely bemissed by an automated approach.


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2:4.1 - Scenarios

Mild

Sharp

Severe

Te most likely scenario over the next two years is a gradual increase in interest ratescoupled with house price growth slowing to around 2-4% pa. Rent levels are expected to grow

at a similar pace underpinned by the ongoing increase in demand or rental properties againsta backdrop o limited supply.

However, under the mild scenario we have assumed that bank rate increases to 2% and houseprices correct by 10%. We expect a 2% hit to landlords rental income rom rising arrears ascompanies tighten budgets, leading to a rise in unemployment and subdued wage growth.Under this scenario we see rent levels hardening slightly as ination picks up and rental supplyremains restricted. Based on this outlook the average L V remains below 75% with incomecoverage com ortably above Landbays minimum at 139%.

A sharper correction would result rom higher ination or aster economic growth, resultingin interest rates moving quickly to the new normal o 3.5%. In this scenario mortgageaffordability becomes stretched pushing house prices down 17%, similar to the all in 2008.We assume that rent arrears reduces landlords rental income by 4% and we assume that rentalprices rise by 2%, a conservative assumption against the backdrop o higher ination and acontinued shortage o rented property.

Under these assumptions, Landbays port olio L V moves to 80%, and income coverage

remains close to the criteria minimum at 120%.

Under the most severe scenario, the bank rate reaches pre-2008 levels at 5.75%, triggeringlarger house price alls o 23% as mortgage affordability reduces sharply and arrears andrepossessions jump. Rent arrears reduce landlord income by 6% as unemployment rises. Butthis scenario is likely to be associated with signicantly higher ination. Tis ought toprovide an offsetting rise in rental prices, although again we have conservativelyassumed that rents only rise by 2%.

Tis severe scenario drives the average L V to 87%. Whilst income coverage alls belowLandbays minimum criteria, it remains above 100% thus at least covering loan repayments.Under this scenario the borrower covenant is likely to play a particularly important role aslandlords with broader nancial resources will nd it much easier to weather these conditions.In this severe scenario, the expected reduction in the rate o new house building will urtherexacerbate the supply/demand imbalance, suggesting that rental price growth could be pushedhigher in the subsequent recovery.




With the many problems that banks have aced in recent years, and the poor value or moneythey have ofen provided their borrowing and savings customers it is hardly surprising thatconsumers are looking or better value alternatives. It is equally unsurprising that, in thisenvironment, the peer-to-peer lending model has started to capture the popular imagination.

But consumers understanding o the peer-to-peer model still lacks depth. For example, whilemost consumers looking to lend through peer-to-peer sites understand the principle thathigher reward goes hand-in-hand with higher risk, ew are amiliar with the specic risksthat different peer-to-peer sites entail.

For savers who want to take a cautious approach, lending secured on rented residentialproperty offers obvious advantages as it occupies the very low risk end o the peer-to-peerlending spectrum. Tis orm o lending offers a series o layers o protection the security othe property itsel , the rental cash ow, the claim on the landlord and the robust outlook

or rental demand.

2013 arrears data or buy-to-let lending conrms its soundness with 1.08% o buy-to-letproperties in arrears o 3 months or more compared with 1.78% or owner-occupiers, itselhistorically one o the sa est orms o lending. In contrast, industry arrears data is not evenavailable or other lending segments such as personal loans and lending to SMEs. So or the

cautious saver looking or a reasonable return, peer-to-peer and buy-to-let may well makethe per ect partners.

SECTION 3 CONCLUSION


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Tis material is or in ormational purposes only. It is not intended as investment advice and theWriglesworth Consultancy are not soliciting any action based on it. Te material is based on

in ormation that the Wriglesworth Consultancy consider reliable, but we do not represent that it isaccurate or complete and it should not be relied upon as such.

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For further information contact:

Rob Tomas , Director o Research, Te Wriglesworth Consultancy,[email protected] / 020 7427 1414

John Goodall , CEO, Landbay, [email protected] / 020 7960 6550

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