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Last Updated: Tuesday, 4 December 2007, 17:55 GMT
Lenders 'must prepare for worst'
Mortgage application form
The FSA is also to look at how those in mortgage arrears are treated
UK mortgage lenders have to prepare for the "very real prospect" of the global credit crunch getting much worse.

The Financial Services Authority (FSA), said a tougher global financial situation could affect the whole UK mortgage market, boosting defaults.

Access to cash could become more difficult - a problem that caused the run on Northern Rock earlier this year.

Lenders needed contingency plans to guard against the "worst outcomes", the City watchdog said.

The FSA also told lenders that despite the liquidity and credit risks it was important that lenders maintained their focus on treating customers fairly, including their treatment of customers in arrears.

Changing world

Already there were signs that the market might be changing, the FSA said.

The watchdog warned that arrears and repossessions have increased significantly, albeit from a very low base and concentrated in specific sectors of the market.

"There is a very real prospect that conditions will worsen further into next year, in terms of both liquidity and credit risks," Clive Briault, the FSA's retail managing director, told the Council of Mortgage Lenders' annual conference.

He said that firms should be assessing their funding and liquidity positions, and testing whether or not their business models could withstand severe market problems and volatility.

Arrears and repossessions have increased significantly, albeit from a very low base
Clive Briault, FSA

They should also review and assess their medium and longer-term strategies and the options open to them, as well as considering contingency plans against the worst outcomes.

"We want there to be a competitive and thriving mortgage market in the UK which clearly meets the needs of consumers," he continued.

Lenders should have tested business plans that take account of the changing world, with viable funding models, he said.

Mr Briault added that firms needed boards and senior management that understood and knew how to operate in the best interests of their customers in a variety of market conditions.

Difficult refinancing

The FSA estimates that more than 1.4 million borrowers on fixed-rate, short-term mortgages are due to come off their favourable terms next year, which were fixed when the Bank of England's main interest rate was lower.

Many of them will either have to pay higher interest rates as a result, or will go back to the market to find new deals.

Should they not find them, the resulting higher repayments could see them rein in consumer spending sharply. In some of the worst cases, this may even lead to a repossession of the property that has fallen into arrears.

Mr Briault explained that many of the borrowers were on relatively high loan-to-value ratios or income multiples and would find it difficult, if not impossible, to refinance their mortgage on favourable terms.

At the bottom end of market, the so-called sub-prime sector that focused on people with poor or non-existent credit histories, many borrowers "may not have access to the market at any price".

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