(Geeks only). Thanks to T Pocock for pointing out this amazing page of data on Aviva ERM securitisations, some of them dating back to 2001. Lots of stuff to dig out or back out, including data on NNEG claims. The chart above shows cumulative NNEG claims on ERF4, which was set up in 2004.
No surprise at first. Most ERMs start with a loan to value of lower than 50%, and property prices have gone up in most areas of the UK since 2004, so it takes a few years for the compound loan amount to reach current property value and reach NNEG territory.
But there is a real surprise in store.
The exercise of the NNEG was in no case due to the compound loan value hitting the house price index. Aviva helpfully provide (i) and ‘indexed house value’ at exit, together with (ii) the original valuation and (iii) the realised sale value. The indexed value is simply the original value projected by the increase in the Halifax index since the valuation.
It turns out that if all properties had followed the index, no NNEG would have been exercised, and all properties would have been safely out of the money. The exercise was in all cases due to the underperformance, often a dramatic underperformance, of the properties used as collateral.
As an extraordinary example, consider the property that caused the large blip in 2016. It was originally valued at £1.2m, with an estimated LTV of 45%, i.e. a loan value of about £540,000. (Aviva do not provide an explicit loan rate, but I estimate about 7% based on redemptions and loan amounts at exit). The loan value at exit was £1.4m, but the sale price of the house was only £625,172, leaving a NNEG loss of £763,225.
In other words, while the Halifax index went up 70%, with the indexed house value being over £2m – easily enough to cover the loan value at exit of £1.4m – the property not only failed to follow the index, but actually fell in value (by about 50%). And so it was with 44% of the properties where the NNEG was exercised. I.e. nearly half the properties used as collateral for equity release not only failed to match the index, but were worth less than when they first collateralised the loan. What is happening here?
It’s not entirely clear, but the indication is that as people get older, they are less inclined, or less able, to maintain their property to the national standard. Nor do they have any incentive, given that they have mortgaged it away – why spend money maintaining something in order for the lender to benefit? To be sure, the dilapidation effect is reasonably well known. According to PRA CP 48/16
Opinion on the appropriate adjustment was divided, suggestions included adjustments to property value, property volatility, HPI, and a margin for dilapidation. Some felt that systematic underperformance risk due to adverse selection should be allowed for in the valuation.
But the magnitude of the effect is surprising.
How could we model this? To be continued.