The Paragon Group of Companies PLC

MANAGEMENT REPORT

BUSINESS REVIEW

OPERATING SEGMENTS

The Group's investments in loans and the amounts invested in the year for each division are summarised below:

Paragon Mortgages

Paragon Mortgages is one of the longest established lending brands in the buy-to-let mortgage market. Alongside its sister brand, Mortgage Trust, Paragon Mortgages maintains a significant presence for the Group in this sector of the UK mortgage market that continues to show strong growth. Trading activity in the year was very strong, with the segment contributing £94.0 million to underlying Group profit (2014: £80.5 million), an increase of 16.8%. The strong pipeline of new business, and the continued success of new business operations indicate good potential for further growth.

Total loan assets of the Paragon Mortgages segment at 30 September 2015 were £9,221.7 million, 4.3% higher than the £8,842.9 million a year earlier, of which £8,999.1 million were buy-to-let mortgage assets (30 September 2014: £8,575.6 million).

Buy-to-let

A wide range of social, demographic, political and economic factors continue to drive strong growth in private renting, alongside general issues of affordability in the owner occupied sector. Significant amongst these over the year have been the impact of the FCA's Mortgage Market Review ('MMR'), high levels of migration to the UK and the continuing challenge of improving the supply of housing in the UK in the face of population growth and the rate of household formation. This strong and sustained increase in rental demand has led, in turn, to strong demand for buy-to-let finance. The Group has been able to capitalise upon this to a greater extent this year because of the progress made with the Group's strategy of diversification of funding sources, with Paragon Bank making a significant contribution to the Group's performance in buy-to-let lending over the year for the first time. Total advances grew as a result to £1,326.6 million, an increase of 102.0% over the previous year (2014: £656.6 million) with £350.0 million of this advanced by Paragon Bank, as described further below.

Over the year the Group has expanded its operations to match the enhanced funding capability. This in turn has allowed it to compete more effectively across a wider range of products for landlord customers, illustrated by the expansion of buy-to-let lending to Scotland, funded by retail deposits. As a result the Group saw strong growth in application volumes from January 2015 which in turn has driven a significant increase in completions since the half-year. The pipeline of new business was maintained at high levels across the second half of the year resulting in a pipeline of new business (live cases between application and completion), of £713.7 million at the period end, £309.5 million of which was in Paragon Bank. This total was 72.1% greater than the pipeline of £414.8 million at the end of September 2014 and supports continued high levels of new lending into the next financial year. The credit quality of the new lending business written in the year has remained excellent.

The introduction in the MMR of tougher regulatory requirements for owner-occupier mortgages in the spring of 2014 coincided with the onset of a period of weaker activity in the housing market. However, there has been strong growth in housing transactions reported by the Council of Mortgage Lenders ('CML') since January 2015, with these peaking at 121,000 in July 2015, the highest level seen since the financial crisis. An improved outlook for the economy combined with a decisive outcome in the General Election to drive up consumer confidence, which has resulted in mortgage approvals also reaching a post-crisis high of 136,000 in July with the level of activity in the owner-occupied market boosted by government intervention including the Help-to-Buy scheme. Despite this improved level of activity, house price growth has remained stable with Nationwide assessing the annual rate of growth at 3.8% at the end of September and Halifax reporting 8.6%.

The private rented sector has continued to grow strongly. Data in the annual Survey of English Housing for 2013-14, published in February 2015 by the Department of Communities and Local Government indicated that the private rented sector, comprising 19% of households in England, is now larger than the social rented sector and remains the only growing form of tenure. In broad terms we continue to see a weakening of demand for owner-occupied housing, a static social rented sector and a private rented market that is expanding to fill the gap.

Strong tenant demand continued to drive demand for buy-to-let mortgages with CML data for the year ended September 2015 showing £35.2 billion of lending compared to £25.8 billion for the previous year. Whilst growth is strong, in real terms this is a continuation of the recovery rather than a 'boom' in buy-to-let, illustrated by the fact that buy-to-let lending in 2014 was little different to the levels seen ten years ago.

The policy environment for the private rented sector has become more challenging following recent Government announcements. In the summer budget the Chancellor of the Exchequer announced changes to the tax regime for rented property that will result in landlords only being able to claim relief on finance costs at the basic rate of tax, currently 20%, along with the cessation of the 'wear and tear' allowance. An extended lead-in period has, however, been allowed, giving landlords time to adjust their strategies. Research to date by the industry has indicated that the changes will have a muted impact on the motivation for landlords to invest although some reduction in the rate of growth is anticipated and some landlords are expected to look to increase rents to compensate for their increase in costs. We also expect a number of larger scale landlords to transfer their properties into a corporate structure, an area of the market in which the Group has considerable experience and where there is less competitor capability.

The Group's outstanding buy-to-let balances are analysed below:

At 30 September 2015 the Group's buy-to-let portfolio stood at £9,363.2 million, 9.0% higher than the £8,592.1 million reported a year earlier. The annualised redemption rate on the overall buy-to-let book, although higher than the 4.1% reported for 2014, still remains low at 5.8%, despite the increasing numbers of post credit crisis accounts included in the portfolio. The annualised redemption rate on these loans, at 12.1% (2014: 9.2%), is, as expected, approaching the levels seen before the credit crisis as the book matures. The annualised redemption rate on pre-crisis lending, at 4.4% is little changed from the 4.0% seen in the year ended 30 September 2014. This performance indicates that the Group's landlord customers continue to display a long-term commitment to property investment.

The Group's approach to underwriting remains robust with a focus on the credit quality and financial capability of our customers underpinned by a detailed and thorough assessment of the value and suitability of the property as a security. This approach continues to deliver market leading credit performance across historic and current lending.

New loans continue to be of a high quality, with a good affordability profile, low average loan-to-value ratios and strong customer credit profiles. The credit performance of the portfolio over the year continued to be exemplary, with the percentage of loans more than three months in arrears (note 9) standing at 0.19% as at 30 September 2015 (30 September 2014: 0.25%) and remaining considerably better than the CML's comparable market average of 0.67% at that date (30 September 2014: 0.85%).

Security values have also benefitted from the effect of increased house prices. The Nationwide House Price Index showed appreciation in residential property values of 3.8% over the year (2014: 9.4%), while the indexed loan-to-value ratio of the buy-to-let portfolio at 30 September 2015, at 69.7%, was broadly similar to its level a year earlier of 71.7%. The increase in average prices, however, is part of a more volatile picture, which has been particularly marked at the local and regional level. The Group maintains a specialist team of in-house surveyors to maximise its understanding of particular markets, both from a valuation and lettings standpoint.

The number of properties with an appointed receiver of rent reduced by 13.3% to 1,062 at 30 September 2015 (30 September 2014: 1,225), and 96.9% of the properties available for letting in the receiver of rent portfolio were let at that date (30 September 2014: 97.2%).

Other assets

The Paragon Mortgages operating segment also includes income generated from legacy loan books, including owner-occupied mortgages, car loans, secured consumer loans and unsecured consumer loans. Save for the management of these books in run-off, there has been little activity in recent years in these areas. These assets form a small part of the segment's results, when compared to buy-to-let assets and performed in line with our expectations. Their values are shown below.

Although the Group has returned to lending in the car finance and secured loan markets, this new lending is through Paragon Bank and is reported under that segment.

Idem Capital

Idem Capital is one of the UK's principal consumer debt buyers and is a servicer of loans for third parties and for co-investment partners. The division's portfolios performed strongly in the year to 30 September 2015 and, with the benefit of new investments made during the year and a firm control of costs, Idem Capital's underlying profit contribution increased by 2.5% to £49.3 million (30 September 2014: £48.1 million).

Activity in the UK debt purchase market remained at a high level during the year, with UK based financial institutions continuing to dispose of both paying and non-paying consumer loans, either as business-as-usual sales or through deleveraging processes. These financial institutions have continued to actively manage and reduce the size of their purchaser panels in recent years, for operational efficiency and to facilitate compliance with regulatory obligations. Idem Capital has maintained its position as an active panel member for the major UK based debt sellers and has participated in several transactions during the course of the financial year.

Idem Capital's investments are summarised below.

The value of Idem Capital's investments totalled £451.0 million at the year-end (30 September 2014: £426.5 million). Of the total carrying value, including co-investments, 51.9% related to loans secured on property (2014: 63.2%).

At 30 September 2015, the 120 month gross estimated remaining collections ('ERC') for the Company's portfolio stood at £677.7 million (30 September 2014: £682.2 million). ERC is a common measure of scale in the debt purchase industry reflecting likely future cash flows from the acquired assets over the next ten years, which will reduce over time as balances are collected. At 30 September 2015 cumulative cash receipts totalled 107.2% of the values predicted at the point the loans were acquired (30 September 2014: 105.3%).

During the year, the Idem Capital division acquired and assumed servicing of a further 107,800 accounts in three principal transactions. After taking into account portfolio run-off, acquired accounts under management increased by 44.7% and total accounts under management (including third-party serviced assets) increased by 14.3%.

The numbers of loan assets managed by Idem Capital and the wider Group are shown below.

Following the year end, Idem Capital successfully concluded a transaction to raise external finance for its existing unencumbered unsecured portfolio and to refinance an existing facility on more favourable terms, the division's third external funding transaction. This is discussed further in the funding review below.

Idem Capital utilises the Group's highly developed loan servicing and collection capability which is used for its own purchases and for co-invested and third party assets. The Group has invested heavily in its compliance infrastructure in recent years and is well placed to deliver the operational standards required by the UK regulatory authorities and by portfolio vendors.

Paragon Bank

Paragon Bank provides the Group with diversification of both income streams and funding sources. It saw strong development in the year and after the year end its profile was significantly enhanced by the acquisition of Five Arrows Leasing Group, adding capability in asset finance and related businesses to the Group's offerings.

The initial costs of developing the Bank's business and product offerings, together with the fixed costs necessitated by the regulatory environment in which it operates, resulted in an underlying loss for the year in this segment of £8.6 million (2014: £6.4 million). This was higher than expected due to the cost of carrying a higher level of retail deposits against the growing loan pipeline. Following the Five Arrows Leasing Group acquisition, the Bank is expected to report a profit in 2016.

Paragon Bank funds its new lending advances and pipeline though savings deposits. The Bank's funding position at 30 September 2015 is summarised below.

The Group provided capital of £33.0 million to Paragon Bank during the period (2014: £48.9 million) and its policy is to provide the Bank with sufficient capital to cover its planned requirements over each twelve month period.

During the previous year ended 30 September 2014 Paragon Bank launched car finance, secured personal loan, buy-to-let mortgage and savings products, all of which it has continued to develop through the year. The car finance and secured personal finance businesses are relatively new operations and during the year have focussed on establishing distribution. Buy-to-let loans are generated through existing Group channels and as a result volume growth has been strongest in this area. Further information on each of these businesses is given below. Paragon Bank's loan assets at 30 September 2015 are analysed as follows.

Investment in these product lines during the year is expected to produce further organic growth in future periods.

In November 2015 the Bank also launched a short term property development finance product, supported by specialist employees, to broaden the Group's offering to property investors. It continues to investigate further product developments, where these match its risk appetite. In addition to organic product development, it intends to work with the Idem Capital team to identify potential asset purchases that fit with its risk appetite and business model, thereby broadening the scope of both parts of the Group.

Buy-to-let

During September 2014 Paragon Bank commenced offering buy-to-let mortgages, using the Group's existing systems and distribution channels, with distinct and complementary products to those offered by Paragon Mortgages. The Bank's first full year of buy-to-let lending has been very successful, with £350.0 million of advances made (2014: £0.5 million), and a healthy pipeline of business of £309.5 million ready to complete in the new financial year (2014: £45.3 million). Most of this business has been written on 2-year fixed rate products, with an average loan size of just under £200,000, an average loan-to-value ratio ('LTV') of less than 75% and interest coverage ratio of over 140%. There have been no arrears on the business written so far by the Bank. The buy-to-let market is discussed in more detail under 'Paragon Mortgages' above.

Having established itself as a credible provider of good quality buy-to-let products, the Bank will seek further opportunities to lend to good quality applicants on good quality properties with a demonstrable ability to achieve a strong and sustainable rent.

Car finance

The UK car market has continued to grow during the year ended 30 September 2015. During September 2015 463,000 new cars were registered (2014: 426,000) which was the highest number ever recorded for a month, representing the 43rd consecutive month of growth. Calendar year-to-date registrations were 2,097,000 which is a 7.1% increase on the comparable period in 2014 (2014: 1,958,000).

The UK car finance market has also experienced considerable growth, with total finance for the year ended September 2015 reported by the Finance and Leasing Association ('FLA') up 13.2% at £36.1 billion (2014: £31.9 billion), with similar percentage increases witnessed for new and used car funding at £23.7 billion and £12.4 billion respectively (2014: £20.8 billion and £11.1 billion).

The new regulatory authorisation regime introduced by the Financial Conduct Authority ('FCA'), based upon its Consumer Credit Sourcebook ('CONC') is now well progressed with the first application period for firms closing on 1 April 2016. The new regime has been widely adopted in the car market and the new requirements implemented, however, challenges still remain in respect of individual interpretations, particularly those relating to commission arrangements and affordability, both of which are being further reviewed by the FCA in early 2016.

Paragon Car Finance has continued to make good progress during the year and has considerably expanded both its product range and distribution network. Business volumes continue to rise on a monthly basis with the extant book delivering better than expected performance, with total advances of £43.9 million in the year (2014: £5.3 million). None of the Bank's car finance accounts were more than two months in arrears at 30 September 2015 (2014: none).

Personal finance

The second charge mortgage market has experienced significant growth over the year with new business volumes in September 2015 showing a year on year increase by value of 22% to £67 million (September 2014: £55 million) according to FLA data. In contrast, the number of new second charge mortgages fell by 6.8% to 1,577 over the same period (September 2014: 1,692). The average second charge mortgage advance in September was therefore £42,500, a year-on-year increase of 30.8% (September 2014: £32,500).

During the year, Paragon Personal Finance has established relationships with over 60 brokers enabling the business to gain a firm foothold with an estimated monthly market share now approaching 5%. Advances in the year were £15.2 million (2014: £nil) with a pipeline of new business of £4.4 million (2014: £nil). None of the Bank's second charge mortgage accounts were in arrears at 30 September 2015.

Second charge mortgages will become regulated under the FCA's MCOB regime in March 2016 and lenders, brokers and trade bodies are heavily involved in ongoing preparation for the new regulatory environment. Paragon Personal Finance itself is well advanced in terms of systems, procedures and employee training and considers itself well placed to make further market gains over the next twelve months.

Asset finance

The Group acquired Five Arrows Leasing Group Limited, through Paragon Bank, on 3 November 2015, after the year end. This represents a significant strategic broadening of the Bank's scope into the SME asset finance market.

Five Arrows Leasing Group was formed in 1988 and has been owned by Rothschild & Co since 1996.  It offers a range of asset finance products, through its subsidiary brands, to UK SMEs, including equipment, vehicle and construction equipment finance and is also a provider of lease servicing. 

The Group has identified the SME market as presenting an attractive opportunity to deliver growth, addressing a different market to its existing offerings, whilst using elements of the same skill base. The FLA reports total market for asset finance for businesses at 30 September 2015 covered £66.3 billion of outstanding balances, with £28.4 billion of advances in the year then ended, and is forecast to grow in coming years. The market is addressed by a range of companies, many with specialist offerings.

The Five Arrows Leasing Group team is highly regarded, has a strong credit ethos and will have a good cultural fit within the wider Paragon business. The product suite of the business currently addresses several distinct segments of the SME market, including some specialised niches, and has several growth opportunities. Five Arrows Leasing Group will form the basis for further SME finance development within Paragon Bank, organically or by further acquisitions. It will be re-branded in the near future to reflect its change in ownership.

Savings

The UK savings market continues to grow strongly, with household savings balances reported by the Bank of England increasing by over £40 billion in the year to 30 September 2015. This strong supply has helped to maintain relatively low savings rates, which only increased marginally in fixed term bond segments over the year.

Retail deposits at 30 September 2015 had reached £708.7 million (30 September 2014: £60.1 million) even though the Bank's savings product range remains reflective of its stage of development, with a focus on attracting term funding to manage interest rate risk and often limiting product availability for short periods of time. Accounts are offered through the internet and include fixed and variable rate savings products. Our straightforward approach and consistently competitive products have been recognised in the industry and by our customers.

Paragon Bank was named as Best New Savings Provider at the fifth annual Moneynet Awards in February 2015 and nominated as a finalist for the Best Online Savings Provider award by Moneyfacts for the second consecutive year in October 2015.

In customer feedback 91% of those opening a savings account with the Bank between August and September 2015 rated the overall savings process as 'good' or 'very good', while 84% stated that they would 'probably' or 'definitely' take a second product with Paragon Bank.

RISK

Following a review in 2014, the Group's risk governance framework is now based upon a formal three lines of defence model which is being embedded in all areas. Credit, Asset and Liability and Operational Risk and Compliance committees, formed of executive management, report to the Board Risk and Compliance Committee, the membership of which comprises the Chairman and the independent non-executive directors of the Group.

In the last year we have also consolidated a number of established risk functions into an independent second line Risk and Compliance division headed by a Chief Risk Officer. 

The Group's governance structure provides an effective basis for the management of risk within which:

·    The first line of defence, comprising executive directors, managers and employees, holds primary responsibility for designing, operating and monitoring risk management and control processes

·    The second line of defence is provided by the Risk and Compliance division, the Board Risk and Compliance Committee and its supporting sub-committees

·    The third line of defence is provided by Group Internal Audit function and the Board Audit Committee which are responsible for reviewing the effectiveness of the first and second lines of defence

REGULATION

In March 2015 the Mortgage Credit Directive Order introduced legislation to move second charge mortgages from the FCA's consumer credit regime to its residential mortgage regime and to implement a new regulatory regime, to be overseen by the FCA, in relation to consumer buy-to-let mortgage contracts. Both these new regimes are to take effect in March 2016.

The Group is putting in place the necessary processes and procedures to comply with both regimes from March 2016 and we do not believe that they will have a material impact on the operation of any of our businesses.

During the period the Financial Policy Committee of the Bank of England ('FPC') was granted powers to regulate owner occupied mortgage lending. The FPC has also requested the power to regulate buy-to-let mortgage lending by reference to loan-to-value, debt to income and interest coverage ratios. HM Government is currently consulting on this request. The Group will keep this exercise under review to determine what impact it might have on its business model.

All relevant Group companies hold the requisite interim permissions from the FCA under the new consumer credit regime and have applied, or will apply, for full authorisations under the consumer credit, second charge mortgage and consumer buy-to-let mortgage contract regimes.

Paragon Bank is authorised by the Prudential Regulation Authority ('PRA') and regulated by the PRA and the FCA. The Group is subject to consolidated supervision by the PRA. The current and projected rate of regulatory change, driven by domestic and European policy, is significant, as further aspects of the Basel III supervisory regime are rolled out and the Basel Committee on Banking Supervision consults on further changes. The governance and control structure within Paragon Bank and the wider Group has been established and developed to ensure that the impact of new requirements on the business are clearly understood and planned for. Regular reports on key regulatory developments are therefore received at both executive and board risk committees.