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Emerald Group Publishing Limited
Copyright © 2007, Emerald Group Publishing Limited
Here, are some headlines: “Pensioner runs up £30,000 debt” – on 20 different credit cards, whilst living in a rented mobile home on the basic state pension. Another confesses, “I'm £80,000 in debt on 12 credit cards.” In 2006, the FSA found that too many small mortgage lenders and brokers misled customers about their fees and charges, and the media also highlighted interest-only mortgages as a source of risk. This turned out not to be the case, when the FSA completed its investigations in 2005. The level of repossessions is a recurring theme, especially when interest rates look set to rise – harking back to the collapse of the housing market in the early 1990s. In January this year, the Royal Institute of Chartered Surveyors, estimated that 50 families a day would lose their homes during the year. The senior economist at the Institute said that couples needed nearly 82 percent of their joint take-home pay to fund the upfront costs of buying a home and that by comparison with ten years ago home loan repayments counted for about 13.5 percent of a couple's take-home pay and now accounts for 23 percent. All truly alarming.
The next question posed by the media, politicians and the regulatory authorities is: who is to blame? The banks, obviously and credit card companies with their high rates of interest and tempting offers, playing on people's wish to buy goods and services. Their activities must be curbed and the politicians must legislate with a new Consumer Credit Act in 2006, which updates the 1974 Act and applies to consumer credit or hire purchase arrangements up to £25,000 and sets out the information a consumer must have, the nature of advertising and consumer rights if goods are faulty or a rebate if loans are repaid early. At one point, politicians seemed to suggest, that in order to protect the public, people should only have one credit card each! They were reacting to the kind of headlines mentioned above.
It is always worth looking more closely at the figures involved and the basis of the argument. One of the leading mortgage lenders in the UK, GMAC RFC, examined the way in which mortgage statistics are worked out: they are often based on comparing average house prices to an average single person's income, an entirely out-dated concept and even where they compare a couple's income to average house prices, they still give a false impression. On this basis, the cost of an average house in 2005 rose to six times the average salary. Averages are as ever entirely misleading. The issue is really one of affordability and it is argued that, taking initial mortgage interest as a percentage of gross and net income at the time of application shows that in 1980, borrowers were paying 26 percent of their net income but by 2005, it was 21 percent. That is still high, of course, and policy-makers and lenders it is a concern, but that is not the issue here.
The issue is the assessment of affordability, which is more difficult to assess, but is vital if mortgage lenders are to lend responsibly. This requires much more sophisticated underwriting techniques, which are way beyond simple multiples of the incomes the borrowers claim to have, and applied appropriately and a focus on understanding the prospective borrower's attitude to credit and their ability to understand and manage debt. A responsible approach to lending will check the availability and have access to credit bureau data; use credit profiling and scoring; use affordability measures and electronic identification, and has greatly reduced the possibility of paper fraud. The use of such techniques, GMAC RFC means that its serious arrears (six month plus) were 0.39 percent v. the Council of Mortgage Lenders average of 0.43 percent for the first half of 2006. A rigorous application of affordability assessments, which also take account of possible future interest rate rises, and the willingness to refuse to offer a mortgage, if the prospective borrower cannot meet the criteria. That is one of the best safeguards consumers can have and one which does not make access to credit too restrictive. It is one which by providing advice enables the consumer to reach a rational and independent decision, if the concept of affordability is open to discussions between the prospective lender and borrower.
Unsecured credit raises even more problems, certainly in the eyes of the media and politicians, who love to decry credit cards, but use them all the time. Those who remember the days before credit cards appreciate the freedom, including the freedom from embarrassment that they provide. Interest rates on credit cards are high, but it is unsecured credit and apart from the credit limit on the card, the providers of such credit are taking on much more risk than lending secured on property, a physical asset. These comments are not intended to support excessively high interest rates or hidden charges, but just to point out that the lenders are taking on much higher levels of risk and there has to be an element of proper pricing of the risk involved. What is vital for the stability of the banking system as a whole is that lenders should price and manage risk effectively and that they should have sufficient capital reserves to cushion any shocks to any particular bank. It is so long since it has been necessary to rescue a bank in the UK (Johnson Matthey was the last one in the 1984) that the importance of pricing and providing for credit risk is overlooked by all but the banking supervisors.
The Government, the Bank of England and the Financial Services Authority have been working together to help to prevent people from falling into debt. During 2005, the proportion of balances more than three months in arrears increased to 8.5 percent in September of that year from 7.4 percent nine months earlier. It should be noted, however, that this does not necessarily mean that the individual has fallen into unmanageable debt, since they may wish to pay off a large expenditure over a few months. Levels of personal insolvency rose in the first quarter of 2006, an increase of 73.4 percent on the same period in 2005. But it should be noted that the Government introduced new solvency legislation, which has made it simpler and much less disadvantageous to declare oneself insolvent. Calls to debt advice agencies rose during 2006 and no doubt have continued to rise.
Various strategies have been adopted: increasing financial capability and awareness and clarity of literature; sharing information between credit institutions; improved responsible lending guidance in the Banking Code; action by Government agencies to ensure that people receive benefits on time and to improve advice and support services for those who have fallen into debt. Credit unions get a mention, but much more should be done to encourage credit unions as these are often the most effective way of extending credit to lower income individuals and families. These are all perfectly sensible initiatives, although the objective of improving financial capability will prove as elusive here as in other endeavours, with too little attention as ever being paid to providing all pupils with the basic tools required throughout the rest of life-understanding percentages, interest and compound interest and how to work them out. It is to be hoped that maths teachers now relate basic arithmetic to the exciting topic of money-how to spend it and how to save it and how to keep simple monthly accounts and budget for a month's salary, but that might be too much to hope for!
What has been lost in all these initiatives and the public discussion of debt is the individual's responsibility. It is hard to believe that people who rack up thousands of pounds on their credit cards do not know, even if they refuse to acknowledge it to themselves, that that is what they are doing. That public debate must not encourage people to think that if they build up such debts that it is someone else's fault-the banks, the offers of credit cards that pour through all our letter boxes or the failure of the financial institutions or the regulators to explain that if you borrow money, there comes a point at which you must pay it back and that will cost more than it did to buy the goods and services in the first place. The only time when it is really possible to blame anyone else but one's self is when the same government and governmental agencies which exhorts the public not to fall into debt, causes it by failing to pay people their dues on time. That is not generally the case, so the message of individual responsibility must have a part to play.