2 Economic regulation
Introduction
9. In order to protect taxpayers' investment
in the sector, and to ensure that public investment is safeguarded
and used for the purpose intended—the provision of social
housing—and that unreasonable burdens are not imposed on
public funds, registered providers must be financially viable
and well governed. The taxpayer has invested £43.8 billion
in the current social housing stock of just the 400 largest providers
(which represents about 35% of the value of their housing properties).[24]
A failure of a provider would not only risk the loss to the taxpayer
of the value of this historic subsidy, but also have a significant
impact on the provider's tenants. The Regulator explained that:
If there were a series of failures of providers,
they would have dire consequences for the tenants of those providers.
If lenders ever get to the point where they have to enforce their
security, it ceases to be social housing. The protection that
tenants have then relies on their tenancy agreements and not on
the protection of their being within a regulated sector. We [the
Regulation Committee] are very, very concerned about that.[25]
Ujima is, to date, the only housing association to
become insolvent (in 2008),[26]
although Cosmopolitan Housing Association came close to insolvency
in 2012, with reported shortcomings in recognising and managing
its financial risks.[27]
Cosmopolitan was eventually rescued by a takeover by Sanctuary
Group, a process supported and facilitated by the Regulator.[28]
Current pressures
10. The Regulator explained that providers' financial
viability was currently being challenged in three ways. First,
with lower grant levels, new social housing for rent was developed
with higher levels of debt than previously, which meant higher
total interest payments. Second, some £40 billion of bank
debt to the sector was "underwater", i.e. the cost of
providing the funding was more than the banks received in return.
This meant that banks were more likely to seek re-pricing opportunities
and so make existing debt more expensive.[29]
Finally, welfare reform might increase the proportion of rent
overdue and therefore the amount providers would need to spend
on debt collection and potentially evictions and court costs,
as well as affecting their cash flow and costs of short term borrowing
to provide working capital.[30]
In this
report we have not set out to examine the basis for, or quantify,
the risks identified by the Regulator as facing the sector. But
it must be part of the Regulator's job to be alert to the risks
and the perception of risks which could affect the financial viability
of social housing providers. From the evidence we received we
are satisfied that he is.
11. A signal that providers of social housing
are working in a more challenging climate was Moody's downgrade
of all but one of the rated English housing associations in May
this year. Moody's explained that this was driven by a downward
"reassessment of likelihood of extraordinary support from
the UK government [...] in light of ongoing developments in the
sector" and "reflects challenges for the Regulator [...]
to step in and protect entities and their creditors in extreme
situations", as demonstrated by the Cosmopolitan experience.[31]
When we asked the Regulator about this downgrade, he cited an
earlier downgrade to housing associations' credit ratings in February
2013, emphasising the general economic climate, rather than regulatory
challenges, as the reason for Moody's decision:
Moody's has basically downgraded most of the providers
in the sector on two occasions in the last six months. The first
one-notch downgrade was at the same time as UK sovereign debt
lost its AAA rating and was a direct consequence of that. At that
point, they put the sector on negative watch, primarily driven
by their perception of the level of Government support for the
sector [...] They eventually settled on a further one-notch downgrade
for the majority of associations that they rated, but that was
done with the removal of the negative watch [...] They moved to
a position that brings them broadly in line with the other main
rating agency, Standard & Poor's, and provides stability for
the sector going forward.[32]
12. When Moody's announced the downgrade on 17
May 2013 its summary said that its:
revision in the support assessment reflects challenges
for the regulator [...] to step in and protect entities and their
creditors in extreme situations. Many of the same issues were
highlighted in facilitating the long-term viability of Cosmopolitan
Housing Group, ensured in a merger with Sanctuary Group . This
episode served to illustrate the difficulties in ensuring a satisfactory
outcome when a housing association encounters financial distress.
The recent discussion document issued by the regulator on proposals
to adjust the regulatory framework leads Moody's to be more cautious
in its assessment of the likelihood of timely government action.[33]
13. We share the assessment of Places for People
that the "failure of Cosmopolitan sent shockwaves through
the sector, resulting in Moody's casting doubt on the effectiveness
of the regulator and effecting a subsequent downgrade of Moody's
credit rating". It voiced concerns from the sector "that
the regulator would struggle with multiple rescues, should such
a scenario present itself".[34]
We note that the Regulator has commissioned a "lessons learned
exercise from the [...] case to ensure our approach to managing
failures in individual providers is as robust as it can be".[35]
Recent press reports indicated, however, that DCLG had "blocked
the commissioning of a review into the near collapse of Cosmopolitan
Housing Group [...] on the grounds it is too expensive" at
a cost believed to be more than £10,000.[36]
14. We note that Moody's, in
downgrading its ratings for all but one of the English housing
associations in May 2013, cited the Cosmopolitan episode as showing
the difficulties in ensuring a satisfactory outcome when a housing
association encountered financial distress and the challenges
the Regulator would face if it had to step in and protect entities
and their creditors in extreme situations. We welcome the Regulator's
intention to review lessons from the Cosmopolitan episode and
ask for a copy of the review when it is completed. We are therefore
concerned by press reports that DCLG has blocked the commissioning
of a review. In responding to our report we ask the Government
to explain whether it has blocked the review and, if it has, why
and how it assessed the consequences of its decision for the independence
of the Regulator and the regulation of the social housing sector.
The Regulator's ratings
15. The new Regulatory Framework for social housing
in England came into operation on 1 April 2012. It sets out the
parameters under which the Regulator carries out his regulatory
responsibilities. It requires the Regulator to "carry out
annual engagement with larger providers to enable it to achieve
a minimum level of assurance that economic standards are being
met and to make public judgements on governance and financial
viability".[37]
The Framework defines the standard as follows:
Financial viability
Registered providers shall manage their resources
effectively to ensure their viability is maintained.
Governance
Registered providers shall ensure effective governance
arrangements that deliver their aims, objectives and intended
outcomes for tenants and potential tenants in an effective, transparent
and accountable manner.[38]
16. The Regulatory Framework also states that
the Regulator should publish both financial viability and governance
ratings of the larger providers:
The regulator will continue to publish graded assessments
in relation to viability and governance as these are key areas
where lenders, boards and others value assessments. The regulatory
judgment will also comment on the assurance obtained with regard
to the Value for Money standard.[39]
FINANCIAL VIABILITY RATINGS
17. Currently there are four financial viability
ratings (or grades) which are set out at Table 1 along with numbers
of social housing providers in each category in March 2013.[40]Table
1: Regulatory Judgments?HCA Regulation Committee's financial viability
ratings (March 2013)
| Grade - viability
| Description | Number of providers
| % of providers, as assessed by the Regulator, March 2013
|
| V1 |
The provider meets the requirements on viability set out in the Governance and Financial Viability standard and has the capacity to mitigate its exposures effectively.
| 108 |
80.6% |
| V2 |
The provider meets the requirements on viability set out in the Governance and Financial Viability standard but needs to manage material financial exposures to support continued compliance.
| 25 |
18.7% |
| V3 |
The provider's financial viability is of concern and in agreement with the Regulator it is working to improve its position.
| 0 |
0 |
| V4 |
The provider's financial viability is of serious concern and it is subject to regulatory intervention or enforcement action.
| 1
(Cosmopolitan Housing Association, Chester & District Housing Trust, rating suspended)
| 0.7% |
| Total
| | 134
| 100%
|
18. The Regulator told us that he was in practice
reluctant to give lower financial viability ratings because of
a fear that doing so might breach a loan covenant and thus trigger
loan re-pricing.[41]
While there are a "handful" of providers that are of
concern to the regulator and a "small but steady flow of
problem cases", no provider has yet been graded V3 (where
the provider's financial viability is of concern and in agreement
with the Regulator it is working to improve its position).[42]
The Regulator's response led us to question what value the financial
viability ratings had if the Regulator considered himself so constrained
as not to be able to rate a provider in the lower grades. In his
supplementary submission after the session the Regulator sought
to clarify the position:
I want to make it absolutely clear that we will issue
a V3 or V4 rating if we feel it is warranted. Failure to comply
with a fundamental standard is a serious matter, including because
it could impact on the price a provider pays for their existing
debt, potentially making a bad situation worse. Our regulatory
strategy is to work with any provider with weaknesses or serious
exposures to deal with issues before it gets to the stage that
a V3 or V4 is necessary; and that is why we have not issued any
V3 ratings (and only one V4 rating) to date.[43]
19. Our concerns about the shortcomings of the
published financial viability ratings were underlined by the fact
that the rating for the Cosmopolitan Housing Group published in
2008 was not updated by the Regulator until December 2012,[44]
even though the media reported that Cosmopolitan could face the
possibility of insolvency two months earlier,[45]
and the Regulator had himself been monitoring the situation since
early 2012.[46] When
we asked the Regulator why this was, he said that "the situation
was moving so fast we were not quite sure where we would place
them",[47] but in
his supplementary submission he told us that the grading was "our
rounded assessment [and] based on examination of providers' financial
planning and control framework and analysis of key financial information".[48]
We conclude that the failure
of the Regulator's published financial assessment to reflect the
serious weakening in the financial viability of the Cosmopolitan
Housing Association raises questions about the operation and usefulness
of the Regulator's financial viability ratings. In this case the
assessment of financial viability was neither timely nor useful.
The eventual downgrading of Cosmopolitan to the lowest grade amounted
to a futile exercise in locking the stable door long after the
horse had bolted. We are not surprised that Moody's paid such
close attention to the episode.
GOVERNANCE RATINGS
20. As is the case with the financial viability
ratings, there are four governance ratings (or grades) which are
set out at Table 2 along with numbers of social housing providers
in each category in March 2013.[49]
Table 2: Regulatory
Judgments?HCA Regulation Committee's governance ratings (March
2013)
| Grade - governance
| Description | Number of providers
| % of providers, as assessed by the Regulator March 2013
|
| G1 |
The provider meets the requirements on governance set out in the Governance and Financial Viability standard.
| 118 |
88.1% |
| G2 |
The provider meets the requirements on governance set out in the Governance and Financial Viability standard, but needs to improve some aspects of its governance arrangements to support continued compliance.
| 9 |
6.7% |
| G3 |
The provider does not meet all of the requirements on governance set out in the Governance and Financial Viability standard. There are issues of regulatory concern and in agreement with the regulator the provider is working to improve its position.
| 6 |
4.5% |
| G4 |
The provider does not meet the requirements on governance set out in the Governance and Financial Viability standard. There are issues of serious regulatory concern and the provider is subject to regulatory intervention or enforcement action.
| 1
(Cosmopolitan Housing Association, Chester & District Housing Trust, rating suspended)
| 0.7% |
| Total
| | 134
| 100%
|
21. When we pressed the Regulator at the oral
evidence session on the value of the financial viability ratings
he said:
We do find ways of signalling our concerns and we
have particularly used the governance rating for that purpose
because that does not have the same re-pricing trigger impact
that a V3 or V4 would have.[50]
He informed us that this "situation is well
known to lenders",[51]
but the Council of Mortgage Lenders' submission implies that lenders
take the regulatory judgements at face value:
Although the challenges for the HCA's regulation
committee at the time it was established were considerable (and
still are), we believe that it has had a strong positive impact
to date. This is evidenced by predominantly strong regulatory
judgements on financial viability and governance which most providers
enjoy. Lenders and investors place great reliance on these.[52]
The Regulator's view was that "at the root of
financial failures will almost inevitably be a failure in governance
and by carrying out our proactive regulation of governance we
seek to spot problems early and prevent them developing to the
point where they have an impact on viability".[53]
CONCLUSIONS ON RATINGS
22. Ratings published by the
Regulator should be reliable and capable of being understood at
face value. The practice of using governance ratings to signal
concerns about financial viability lacks openness and is confusing.
It is misleading to the taxpayer and tenants, and potentially
also to lenders who, it appears, are expected to understand the
coded message from the Regulator. We conclude that the practice
should cease. We recommend that the Regulator publish accurate
financial viability ratings.
23. Poor governance can undoubtedly
undermine the financial viability of a provider but we are not
persuaded by the argument that it is "almost inevitably"
the cause of financial failures in general. Financial viability
and governance ratings serve different purposes and assess the
providers against different standards. The distinction between
governance and financial viability must be maintained.
Use of statutory powers and transparency
24. The Regulator's fears on financial viability
focussed on the risks of triggering a re-pricing. The Regulator
felt unable to use many of his statutory powers. He told us:
in practice there are now severe limitations on how
we can use these powers as a consequence of the financial environment
where use of powers could lead to a breach of loan covenants and
in turn re-pricing or repayment of existing debt.[54]
There are cases, for example, where five years ago
we might have moved fairly quickly to make statutory appointments
to a board. We do not do that now. In a number of cases we have
gone to the board and said, "We are not satisfied with the
skills you have available to tackle this set of issues, and we
require you to get some additional board members with the necessary
skills." They have invariably done that to our satisfaction.
If they refused point-blank, we would make the appointments and
take the consequences.[55]
He explained that:
as far as possible, our approach has been modified
to achieve the changes we expect to see in those who are underperforming
without use of statutory powers. We are no less robust in our
analysis and identification of issues.[56]
The principal focus of our engagement is to identify
issues and get them resolved. In the main, we undertake that work
on a basis that is not greatly in the public view; it is direct
engagement between regulatory staff and the providers.[57]
25. The Regulator stated that he was "committed
to robust, independent and transparent regulation",[58]
but by favouring informal approaches over public and accountable
actions, it appears to us that the transparency of the system
is clouded. We asked the Regulator whether he had examined how
other regulators overcame what he appeared to portray as the dilemma:
the use of statutory powers or a frank assessment of concerns
about a provider's financial viability would provoke a re-pricing
and therefore undermine its viability. He told us that the Regulation
Committee has "a different architecture" to that of
most regulators, who typically operate a licensing system. He
implied that the problem he faced was exclusive to, or acute for,
the HCA regime.[59] He
appears to us to have overlooked the devolved administrations'
housing regulators. Nor are we convinced that the issues and the
dilemma faced by the social housing Regulator in England are not
encountered by other regulators in other sectors.
26. It is reasonable, and to
be expected, that the Regulator is in regular communication with
the sector and on occasion an informal approach will be sufficient.
We are concerned when the informal approach becomes a Regulator's
exclusive method of operation. First, it is inconsistent with
transparency. Lack of transparency makes it difficult for lenders,
tenants and taxpayers to see how much and what action the Regulator
is taking. Second, there is a risk that this approach may lead
to too close a relationship with providers thus compromising the
independence or judgment of the Regulator. Third, if the sector
knows that that the Regulator cannot, and will not, use his formal
powers, that must undermine his position and effectiveness.
27. We conclude that the Regulator's
relationship with providers has to have a greater element of transparency.
In addition, the Regulator should have available powers which
he can use when a social housing provider fails to meet the required
standards. We make two recommendations. First, that the Regulator
work with other regulators to examine whether they have addressed
his concerns that use of statutory powers may be counter-productive.
Second, although the new regulatory regime is still at a relatively
early stage, an experienced former regulator in another sector
should review the operation of social housing regulation. The
review's report, conclusions and recommendations should be published.
24 £41.6 billion of Social Housing Grant/Housing
Associations Grant plus £2.2 billion Other Capital Grants:
HCA, 2012 Global Accounts of Housing Providers, p
12 Back
25
Q 53 Back
26
"Ujima: why didn't anyone step in?", Inside Housing,
6 June 2008 Back
27
HCA, HCA Regulatory Judgement on Cosmopolitan Housing Group
Limited-L4375 Cosmopolitan Housing Association Limited LH1298:
Chester and District Housing Trust LH429, December 2012 Back
28
"Cosmo and Sanctuary strike historic deal", Inside
Housing, 27 March 2013 Back
29
A re-pricing can occur when a loan covenant is broken. A loan
covenant is a condition in a commercial loan or bond issue. Its
purpose is to help the lender ensure that the risk attached to
a loan does not rise unexpectedly. The breach of a covenant gives
the lender the right to demand the repayment of the loan, collect
penalty charges or increase the pricing (interest rate). Back
30
Q 6 and HCA, Sector Risk Profile, 6 June 2012, www.homesandcommunities.co.uk/sites/default/files/our-work/sector-risk-profile-120611.pdf Back
31
Moody's Investor Service, Key Drivers of Moody's Downgrade
of English Housing Associations, 17 May 2013, pp 1-2 Back
32
Q 2 Back
33
"Key Drivers of Moody's Downgrade of English Housing Associations",
Moody's Investors Service, 17 May 2013 Back
34
Ev 47 Back
35
Ev 60, para 8 Back
36
"CLG refuses to sign off on Cosmopolitan inquiry",
Inside Housing, 9 August 2013 Back
37
HCA, The Regulatory Framework for Social Housing in England
from April 2012, March 2012, para 4.19 Back
38
HCA, The Regulatory Framework for Social Housing in England
from April 2012, March 2012, p 1, which requires "Governance
arrangements shall ensure [providers]:
adhere to all relevant legislation
comply with their governing documents
and all regulatory requirements
are accountable to tenants, the regulator
and relevant stakeholders
safeguard taxpayers' interests and the
reputation of the sector
have an effective risk management and
internal controls assurance framework. Back
39
HCA, The Regulatory Framework for Social Housing in England
from April 2012, March 2012, para 4.27 Back
40
Tables on HCA website: www.homesandcommunities.co.uk/ourwork/regulatory-judgements,
www.homesandcommunities.co.uk/sites/default/files/our-work/2013_08_28_regulatory_judgements_full_table.xlsx Back
41
Q 27; see also footnote 29 above for explanation of re-pricing
and loan covenants. Back
42
Q 7 Back
43
Ev 11, para 2 Back
44
HCA, HCA Regulatory Judgement on Cosmopolitan Housing Group
Limited-L4375 Cosmopolitan Housing Association Limited LH1298:
Chester and District Housing Trust LH429, December 2012,
p 4
The HCA's regulatory assessment that
downgraded the Cosmopolitan Housing Group's governance and viability
to V4 and G4 indicated that the last regulatory judgment was published
in February 2008. This was before Chester and District Housing
Trust became a subsidiary of the Cosmopolitan Housing Group (in
December 2011). The 2008 rating was published by the predecessor
to the Tenant Services Authority (TSA), the Housing Corporation,
under a traffic light system and gave green ratings for both viability
and governance, meaning there were "no material concerns
about performance"( Housing Corporation Assessment, "Cosmopolitan
Housing Group L4375, Cosmopolitan Housing Association LH1298",
February 2008) . Chester and District Housing Trust was similarly
rated green for both viability and governance (Housing Corporation
Assessment, "Chester & District Housing Trust Ltd, LH4291",
April 2007). Back
45
"Troubled Cosmopolitan's future hangs in balance",
Inside Housing, 26 October 2012 Back
46
"Troubled Cosmopolitan in rescue merger talks", Inside
Housing, 19 October 2012 Back
47
Q 19 Back
48
Ev 11 Back
49
Tables on HCA website: www.homesandcommunities.co.uk/ourwork/regulatory-judgements,
www.homesandcommunities.co.uk/sites/default/files/our-work/2013_08_28_regulatory_judgements_full_table.xlsx Back
50
Q 47 Back
51
Q 48 Back
52
Ev 22, para 5 Back
53
Ev 11 Back
54
Ev 60, para 12 Back
55
Q 36 Back
56
Q 42 Back
57
Q 51 Back
58
www.homesandcommunities.co.uk/ourwork/regulating-standards-0
Back
59
Q 47 Back
| 
