My work with Kevin Dowd on the pricing of equity release mortgages has been illuminating. It has been an interesting pricing question for us geeks, of course, but also interesting was the insight into how efficiently the market acquires information that is public domain, or which can be acquired from public domain information ‘by persons exercising diligence or expertise’, as the 1993 Criminal Justice Act puts it. My impression from our recent work on pricing is that the market isn’t very efficient at all.
See the chart above on the share price of Just Group. Clearly the decline between January and March was caused by the previous private equity owners (Permira and Cinven) selling off some or all of their interest in the firm. Note for example the sharp decline on 22-23 January after Cinven sold off its remaining 5.5% share. The annual report, published in March, seemed to have encouraged the price back up, but it is not clear why. Nor is it clear why the selling of Permira’s remaining holding, about £247m or 18% of outstanding shares, which was much larger than their sell-off in the first quarter, failed to be as significant as the low-key sell-off in the first quarter.
Even more puzzling was the complete failure of the market to react to the publication on 18 June of Just’s 2017 Solvency and Financial Condition Report. This regulatory report contained at least six dire warnings about the possible ‘material negative impact’ of PRA consultation papers or supervisory statements on the regulatory capital position of the Group. It even included an ‘emphasis of matter’ by the auditor (KPMG) about the possible impact. An emphasis of matter is a sort of amber warning by auditors, not so bad as a qualified opinion, but still fairly serious.
On 2 July, the PRA published its Consultation Paper CP 13/18, which is surely what the earlier SFCR was referring to. The PRA increased its expectation on the deferment rate, which would have a significant impact on the guarantee valuation, and warned (para 2.19) that the consequence of moving to a correct valuation methodology ‘may be significant’ for some firms. It also unexpectedly stated (ibid, para 1.7) that these expectations were not a consequence of Solvency II but should apply to any firm with such embedded guarantees. This statement was a massive red flag, particularly when combined with the warnings in the SFCR. Perhaps the market failed to realise that the PRA consults regularly with affected firms, and that the warning given by the firm in June almost certainly referred to the warning that would be given by the PRA two weeks later in July?
The price subsequently declined from 133 to 124, but the nature of the warnings should have had a more significant impact. It was not until 24 July, when the firm itself published a business update, warning of the possible impact of the regulatory consultation, that the price went into free fall, collapsing to below 100 at the beginning of August. Yet the update merely repeated the warnings of 18 June. What was the market thinking? Was the warning more serious because the firm had stated it in a more prominent place, receiving significant coverage in the financial press? But what does that say about the ‘diligence or expertise’ of those who are paid to analyse such things?
The Dowd report (‘Asleep at the Wheel’) was published on 7 August 2018, and had almost no impact on the price. Perhaps this was because Kevin’s pricing methodology merely confirmed the methodology used by the PRA, together with a few well-aimed lobs at the Treasury Committee that had nothing to do with the price. The damage had been done by the PRA.
An interestingly timed report by Numis (bookbuilder for Just) briefly pushed the price back up over 105 the next day. Why anyone gave this report any credence is baffling, when it claimed that the no negative equity guarantee is not an option (it clearly is). In any case, Credit Suisse cut the target price to 94.0 from 125.0 on 20 August, which briefly drove the price as low as 86p. It has been languishing around the 95p mark for a week.
Our view, as specialists in option pricing, which most analysts seem not to be, remains that the guarantee remains substantially undervalued. We will have to wait for the outcome of the PRA consultation, but that in itself is weird. What if the PRA says it expects the price of beer to be £1 instead of £3? Does that mean the real value of beer has changed?
But enough of this forelock-tugging.