In Asleep at the Wheel, I set out a base case No-Negative Equity Guarantee (NNEG) valuation based on a bunch of assumptions. Suppose I am 70 years old, have a house worth £100 and get an equity release loan of £40. Suppose too that the risk-free interest rate is 1.5%, the net rental rate is 2%, the loan rate is 5% and so on.
In this base case, my NNEG model comes up with a NNEG valuation – this valuation is the same as the cost of the NNEG to the lender – of £20.8, which is 52% of the amount loaned.
Remember too that we value the NNEG using information available now. As Dean and I have explained in various places (see here and here), our NNEG valuation is not dependent on a forecast of any future variable.
Now imagine that immediately after the loan has been made, my house falls in value by 30%, from £100 to £70. This price drop could be because national house prices suddenly fall by that amount, or because there might be some bad news about my neighbourhood or because it has just been revealed that my house has a bad case of dry rot.
The earlier NNEG valuation will no longer apply, so the NNEG has to be revalued.
My lender is scrupulous about these matters and is in any case required to value the NNEG at current cost or market value.
So what is that new value? According to my model, the value (= cost) of the NNEG goes up to £31.3 or 78% of the amount loaned. Therefore, the fall in my house price leads the cost of the NNEG to increase by 50%.
And if the house price falls by 40% instead of 30%, then the cost of the NNEG rises by 73%.
Such falls in house prices are by no means unusual in recent historical experience in other countries.
Observe that these increases in NNEG valuations are considerably greater than the assumed house price falls because NNEGs are a leveraged bet on house prices. Remember that besides being a cost to the lender, the NNEG is also a short put option granted by the lender, and short puts are notoriously dangerous and often highly leveraged derivatives positions.
This leverage effect shows that NNEG valuations are highly exposed to a house price fall. They are highly exposed even though the prospect of the lender taking possession might be well into the future and is far from certain. No matter. The exposure is still there.
If NNEG valuations are highly exposed to the housing market, then equity release lenders are too.
And if lenders are exposed to the housing market, then investors in equity release firms – like pension funds – are also exposed to the housing market.
So for the life of me, I can’t understand why the PRA, the Treasury Committee and the equity release industry think that equity release is a wise investment for pension funds.
But then I was under the old-fashioned misunderstanding that the purpose of saving into a pension fund was to provide a secure income in retirement.
I must have been mistaken: the true purpose of a pension fund must be to finance a flutter on the housing market. Otherwise a pension fund investing in equity release makes no sense and the PRA, the Treasury Committee and the equity release industry would all be wrong.