One of the first things I was taught when I entered finance was the “Five C’s of Banking”; Character, Capacity, Capital, Conditions and Collateral. The first four points determine a borrower’s likelihood of paying. The final point focuses on whether the lender’s security will be sufficient in the event that any or all of the first four checks fail.
The hierarchy of the Five C’s underlies the historic principles of lending: Ensuring the borrower is likely to pay, can afford to pay, will continue to pay and in an enforcement situation will not create a loss. Finance pre-GFC saw wholesale abandonment of these fundamental principles. Credit criteria were eased, exceptions were the norm and loans were written that would make an old time banker turn in his grave.
Was it all bad? No – it afforded credit to applicants who were outside the parameters of traditional lenders, and gave capital to Australia’s biggest economic generator: small business. However, Lenders in the US were certainly reckless. The high-LVR ninja loans will surely confound economic historians as they ponder the logic of no recourse lending to those without income or a financial stake in the transaction. Australian lenders remained prudent by comparison and although writing loans in record numbers, generally maintained overall sensible parameters. Nonetheless, the Australian low doc and non-conforming industry has been tainted by the cavalier behaviour of our overseas counterpart.
The political fallout from the GFC spawned the National Consumer Protection Act 2009, which was greeted with hysteria, panic and an exodus of industry participants. Now with the dust settling and the hyperbole easing, this much is clear: The NCCP doesn’t kill off low-doc lending. The NCCP doesn’t kill off non-conforming lending. The NCCP simply reminds us as finance professionals that the Five C’s need to be addressed.
Character: The borrower’s likelihood of meeting future obligations
While also incorporating credit history, ‘Likelihood of meeting future obligations’ ties in closely with a cornerstone of the NCCP, that a lender must make reasonable enquiries about the borrower, their requirements and objectives: A loan which is not in the borrower’s best interests and does not meet their long term objectives is unlikely to be one they feel compelled to pay.
Capacity: The ability to generate the cash flow to repay from normal operations
This is where the NCCP really bites the dubious lender. Under the NCCP, lenders must make reasonable enquiries to ensure a borrower can repay the loan without substantial hardship, while taking reasonable steps to verify that financial information. Some thought that this aspect of the NCCP would spell the end of low-doc and non-conforming lenders. It hasn’t. Rather, lenders have simply needed to explore what combination of evidence constitutes reasonable enquiry and that evidence is reliable and verifiable.
Capital: Equity the owner has put into the transaction
The NCCP doesn’t specifically mention equity positions of applicants etc, however the emphasis placed on meeting the borrower’s objectives has put the brakes on maximum-LVR lending for the sake of it. Cash-outs are generally limited to verifiable purposes. Further, there’s no doubt that post-GFC LVR’s have reduced as lenders have moved to ensure borrowers have old-fashioned “hurt money” in the deal.
Conditions: The market the applicant operates in is stable, or will not threaten the business
The NCCP broadly covers this point when asking lenders to consider ‘suitability’. The borrower’s objectives must be considered in a broader context. For example, property market projections have resulted in a dearth of development finance.
Collateral: The security pledged by the borrower
An unfortunate feature of lending is that a borrower’s best-laid plans do not always materialise and security needs to be realised from time-to-time. The focus of the NCCP is to ensure the credit assessment is sufficient to minimise events of default and mortgagee sales. With the requirement for IDR/EDR processes the security is further protected and lenders need to ensure their policies and assessments align with the NCCP requirements.
The 5 C’s tell us that the NCCP shouldn’t be considered scary and won’t kill off legitimate products or opportunity. Low-doc and non-conforming lending is still alive and well, and most lenders were already operating in an NCCP compliant manner. The NCCP simply ensures that lenders and brokers follow some old banking standards to ensure the interests of vulnerable borrowers are protected. And there’s nothing new about that.
Michael Watson is operations and marketing manager of non-conforming lender MKM Capital.