Kevin Dowd 14 August 2018
Harvey Jones had an article in the 12 August Sunday Express on my Equity Release report, Asleep at the Wheel: The Prudential Regulation Authority and the Equity Release Sector, which was published last week by the Adam Smith Institute.
The article included some comments on the report from a number of experts, including Baroness Ros Altmann, David Cameron’s former Pensions Minister.
“I never read a book I must review; it prejudices you so,” said Oscar Wilde. If she has read the report, I see no evidence of it in her comments.
She said she would not wish to go back to the days when people did not have a no-negative equity guarantee:1 “The fall in house prices in past cycles caused enormous misery to those who found they owed much more than the value of their home and were at risk of losing it.”
My report never suggested that companies should not offer no-negative equity guarantees (NNEGs). I agree that NNEGs are a good feature of Equity Release mortgages and my report was actually about how firms should value them.
She said that equity release loans were “rather expensively priced” but that for some, an equity release loan may still be the best way to raise short-term finance to pay for emergencies such as care.
Again I agree and there is nothing in my report to suggest anything else. The report is not about over-pricing and does not suggest that equity release loans have no useful role to play.
“Property prices would have to fall enormously and people with these mortgages would have to live a very long time, before losses are incurred,” she is quoted as saying.
This statement is wrong. If it is the borrowers she is referring to, then the NNEG ensures that borrowers would suffer not any losses at all from a fall in house prices, however long they live. They can live as long as Methusalah and they would still suffer no losses.
And if it is the lenders she is referring to, then the central message of my report is that borrowers are already carrying large hidden losses because they have greatly under-valued the NNEG guarantees they have issued.
Nor did she believe that the problem is as large as I suggested: “All risk models will show different outcomes, depending on the assumptions used and there can be no ‘right’ way of assessing these things in advance, because nobody knows what will happen.”’
One can hardly disagree with this latter statement, but again she fails to address what the report actually says: she does not notice that I use a valuation model not a risk-model to value the NNEG and that I avoid forecasting altogether. What I find is that the firms are using a demonstrably incorrect method to value their NNEGs and I present evidence that this incorrect method is leading firms to greatly under-value their NNEGs.
This principle that no-one knows what will happen in the future is a profound one and self-evidently correct, but – incredibly – it is also one that the insurance companies and the regulators routinely violate in their practice of Matching Adjustment. This wonderful piece of regulatory quackery is nicely explained in the recent BBC Radio 4 programme, The Equity Release Trap, aired on Tuesday 7 August.
To quote from the transcript:
27:05 BBC journalist Howard Mustoe: [This approach assumes] that the predicted returns will come good, and [counts] some of those returns as capital itself. Known as the Matching Adjustment, it’s the approach regulators have taken with some equity release investments.
MA is, thus, a bet that more than pays for itself, because the outcome is guaranteed in advance:
27:35 Dr. Dean Buckner: A good analogy might be this. Suppose I go to my bank manager and I want to borrow some money to buy a house and I say, well, I want to borrow at 100% loan to value. I borrow what the house is currently worth. So I’ve got a London house worth £500,000. I say I have no equity, no money, can I just borrow £500,000… what is the bank manager going to say? He’s not going to look upon that too favourably, you would imagine. He wants a bit of equity, some loss absorption which consists of what I put up, my equity. But then I say, well look, house prices have always gone up – everyone knows they’ve always gone up – that house will have gone up 30%, 40% in 10 years’ time, when I repay the mortgage, than it is now, so can we regard that 100% loan to value mortgage as 60 to 70% LTV. You can imagine … what the bank manager is going to say to that. But Matching Adjustment is exactly like that. If it’s absurd in the one case it’s got to be absurd in the second case, don’t you think?
Howard Mustoe: Under Matching Adjustment the risky investments create capital for themselves, making the balance sheet look healthy … I tried this idea out at Leicester racecourse with Neil our bookie. He didn’t like it. [To Neil] ‘What would happen if the rules changed so that the people who make the rules decided that you could pay out for me and a few of my friends if we have this level of certainty’?
Neil: Well you can’t possibly know it’s really going to win. So there’s absolutely no point in me giving your money before the race, because it might not win. There’s no such thing as a racing certainty. Despite any rules [laughs].
One wonders whether it is really that wise for investors to entrust their money to people who believe in racing certainties.