One way to better assess the health of the mortgage market

Across the financial services industry, understanding a sector’s vital signs – in sickness and in health – is vital. Electronification and greater regulatory scrutiny have driven a data revolution in public markets but also in one of the world’s largest private asset classes: residential mortgages. While the data we have for the residential mortgage market is more detailed and comprehensive than ever, it is not as publicly available as its public market equivalents, despite a market that was valued at over €77 billion in Ireland^[1] , €519 billion in Spain^[2], and £1.65 trillion in the UK this year^[3].

Given the market’s enormous size, both in terms of value and the impact it has on individuals’ daily lives, transparency is key. The challenge is that gaining a window into the market’s inner workings is easier said than done. Different to public bond markets, for example, mortgages are typically more illiquid and repaid monthly. Secondly, while institutional finance borrowers will often signal if they cannot meet a payment, individuals under financial stress are not guaranteed to notify lenders if they are struggling. The conundrum for lenders and managers is how to use the data available to measure the health of the mortgage market more effectively.

Foresight vs. Hindsight

There are several closely watched indicators that relate directly to the health of the mortgage market. Mortgage approvals often point to levels of mortgage demand, while arrears have long been the yardstick for measuring mortgage stress. Although useful, arrears data provides a diagnosis of a problem after it has taken root.

For lenders and investment managers, having the foresight to tackle a problem in its early stages is a major advantage. Harvesting and analysing data from multiple sources is key to delivering deeper credit intelligence. This means using arrears data but also looking at other indicators, including direct debit rejections (DDRs). To understand how the measures can be used together, it is important to unpack their constituent parts:

• Arrears: Arrears are missed or incomplete payments – in the UK, the FCA defines arrears as a shortfall equal to two or more monthly repayments or when outstanding payments exceed 1.5% of the outstanding loan balance. The accuracy of arrears data is typically good, as lenders report information on their portfolios to the FCA via Mortgage Lending and Administration Return (MLARs) or industry bodies.
  
  In other countries such as Ireland, lenders are subject to the Central Bank’s Code of Conduct on Mortgage Arrears (CCMA) and the Financial Reporting (FINREP) framework, a broader regulatory framework for financial institutions in the EU. Increases in arrears are therefore a useful indicator of when a large group of households is falling significantly behind their repayments.
  
  

• DDRs: Direct debit rejections occur when a payment fails to clear at source. A DDR typically indicates that there is something wrong with a payment and often means that adequate funds have not been transferred to meet a loan or mortgage payment. DDRs can have several triggers – increases in monthly repayments, for example, or a change in circumstance that may mean an individual has insufficient funds to make the payment, but also technical or administrative errors. 
  
  DDRs on their own are not necessarily an indication of arrears risk, but they often serve as an early indicator of borrower trouble, both on an individual and portfolio level. A significant uptick in DDRs across a portfolio can be indicative of a wider trend. Equally, a fall in DDRs could indicate an improved or improving position within a group of borrowers.

Arrears and DDR data used together can provide a deeper level of analysis that can ultimately reveal potential risks before they happen, while also providing a way to track growing or reducing risk in times of economic change.  While neither measure is perfect, combined they can paint a more holistic picture of the state of the mortgage market and help investors better monitor portfolios.

One final point – data transparency is important not only for loan and investment managers assessing risk in their portfolios, but also for borrowers as it can help lenders identify and address early signs of stress. For example, at Pepper Advantage, a DDR automatically gets flagged as a potential risk. If it seems like the challenge is persisting, we will contact the borrower to see if there are things we can do to help.

Factoring DDRs into managers' and lenders’ calculations is therefore critical in assessing the type and level of mortgage market risk at specific points in time. As managers and lenders continue to steer their ships in quickly changing conditions, DDRs are a light on the dashboard that should not be ignored.