Just’s quarterly results presentation on September 6th was a hoot. I couldn’t help noticing the cancelled dividend and the auditor (KPMG) suggesting that the final outcome of CP 13/18 could constitute a material uncertainty that may cast significant doubt on the Group’s ability to continue as a going concern. These look like red flags to me but I am not an analyst and may have missed the finer points.
One point however that did jump out at me was its innovative “NNEG loss shortfall” metric. This metric appears to be the loss that occurs when the loan is repaid and the house price is below the loan value. This metric sounds plausible at first sight and sure does make the NNEG risk look small.
Unfortunately this “NNEG shortfall” as used by the company tells us nothing about the valuation of the NNEG or the riskiness of the firm’s equity release portfolio.
Financial theory is clear that:
- Their “NNEG shortfall” approach is not a respectable (i.e., generally accepted) approach to valuation or risk measurement. As far as I know, it is nowhere to be found in the literature and has not been endorsed by any independent expert.
- The NNEG itself is a form of put option.
- Put options are typically highly exposed to the underlying variable, in this case, the house price.
- Therefore – unless the company has some magnificent housing risk hedging strategy in place – then we might expect a major fall in house prices to produce material changes in the valuation of the NNEG.
Just offer no reasons to dispute this logic, yet still claim that a major (28% percent) house price fall will lead to an increase in the “NNEG shortfall” of a mere £10m by 2025 and a £68m loss by 2028.
The suggestion here would seem to be that an immediate fall in house prices of 28% would lead Just to suffer losses of around half a percent of its IFRS capital by 2025, so nothing to see here and you may as well move on.
If that is so, then I just don’t believe it!
Even if we accept these numbers at face value, then so what?
I can only repeat that since the “NNEG shortfall” tells us nothing about the valuation of the NNEG, it cannot tell us how the NNEG valuation might change in the face of a major house price stress.
But my model can.
According to my model, an immediate fall in house prices would lead the NNEG valuation to increase by over a billion, i.e., over 100 times Just’s 2025 number, and this loss would be incurred immediately too. If this projection is anywhere near correct, then Just would certainly be exposed to a major fall in the housing market.
After years of debunking the Bank of England’s stress tests, one develops a certain instinct, not to mention a certain grudging admiration, for dodgy stress testing, and I have to say that Just’s stress test ranks right up there. One can see what is wrong with their stress test from their chart, which is reproduced below:
Just would have you take the numbers on one of these bars – the cumulative projected NNEG loss by a certain year – as indicative of the company’s exposure. Let’s go along with that. So even by ten years out, which is a long way out, the cumulative loss is only £68m. Now £68 m is not that much so we can conclude the exposure is small, right?
Er, not quite.
Notice how the curve extrapolates at a high rate of growth, but the chart cuts off after only ten years. However, these loans are very long-term assets and presumably the growth in cumulative losses continues after ten years until the entire equity release portfolio is paid off. But if there are whacking great cumulative losses coming through down the road well beyond the 10-year horizon, then the company should be taking those into account now. The loss metric should be the expected value now of the (very) long term cumulative loss, and you shouldn’t truncate at 10 years when the cumulative losses are just starting to get interesting.
Still, nice try.