Dean and I have just had a paper accepted by Economics Letters on the profitability of ERM loans to lenders. Economics Letters is a distinguished refereed economics journal.
Our focus is the apparent profitability (meaning profitability as it appears to those who use the bad old Discounted Projection valuation approach) vs the true profitability as determined by the Market Consistent or Black ’76 approach.
Profitability is measured as the annualised return on the amount initially loaned out.
Here is the key chart based on a set of reasonable illustrative calibrations.
Chart: Profitability of ERM Loans
The plots on the top give apparent profitability, those below give true profitability.
Note how profitability is dependent on the age and gender of the borrower at the time the loan is taken out, and how loans to younger borrowers are actually loss making. And this is before one takes account of operating costs.
The implications are not too good for lenders. If they use the DP approach, ERM loans appear profitable. But if the MC approach is correct, which it is, then the true profitability is much lower and often negative for younger borrowers.
So ERM firms will have been making distributions based on overstated profitability, effectively decapitalising themselves.
Investors in the sector might wish to reconsider their investments.
There is some good news for lenders, however.
Our work points the way to how lenders can increase their profitability. (a) They can switch to the MC approach to get a better assessment of their true profitability. (b) They can exit the market for younger borrowers and shift towards older borrowers. And (c) they can improve profitability by increasing loan rates and/or reducing LTV ratios.
(a) Strikes us as just good practice: better to know the true picture than not to know, right? (b) and (c) strike us as absolutely necessary if the sector is to be made sustainable, which it is clearly not at the moment. The only downside is that increasing loan rates and reducing LTVs would also reduce demand.
The bottom line is that the industry needs a reset. Instead of growing strongly, it should be shrinking instead.