by Kevin Dowd
A scenario analysis is a hypothetical ‘what if’ exercise in which we examine what might happen to some variable of interest (e.g., a NNEG or ERM valuation) if some future scenario were to occur.
For example, we might examine what would happen according to our model if future house prices were to behave in a particular way.
A stress test is a scenario analysis in which the posited scenario is an adverse one (e.g., a large drop in house prices).
One type of scenario analysis/stress test is to model the impact of an immediate one-off house price fall. We assume that house prices fall five minutes after the ERM loan has been made. This exercise is ridiculously easy to carry out and can be very revealing. It should therefore be an essential tool in every ERM risk manager’s toolkit.
We first value the NNEG or ERM at the initial house price value. We then re-value them immediately after the house price fall using the new LTV. So, for example, if the initial LTV = 40% and house prices fall by 50%, then the new LTV will be 0.4×1/(1-0.5)=80%. For this type of stress test we do not make any projections of future variables, e.g., future house prices, other than that house prices fall shortly after the ERM loan is made. All we do is stress house prices, allow the LTV to adjust, and re-value the NNEG and thence the ERM.
Table 1 gives the impact of an immediate one-off house price fall of 50% in our baseline case for a 70 year old male borrower.
Table 1: Impact of an Immediate 50% Fall in House Prices
| L | NNEG | ERM | |
| Pre-stress | £74.8 | £32.2 | £42.7 |
| Post-stress | £74.8 | £48.4 | £26.4 |
| ∆L | ∆NNEG | ∆ERM | |
| Impact of stress | £0 | £16.2 | -£16.2 |
| % Impact | 0 | 50.4 | -38.1 |
Notes: NNEG is the is the present value of the NNEG guarantee and ERM is the present value of the Equity Release Mortgage. Based on the baseline assumptions: male aged 70, r=1.5%, l=5.25%, q=4.2% and σ=14.8%. For the pre-stress scenario, we assume house price = £100 and LTV=40%; for the stress scenario, we assume house price = £50 and LTV=80%. Exit probabilities are based on M5-CBD model projections using England & Wales male deaths rate data spanning years 1971:2017 and ages 55:89.
For the given set of calibrations, the 50% house price fall leads NNEG to rises by 50.4% and ERM to fall by 38.1%.
Figure 1 shows the impact on NNEG and ERM valuations of a range of house price falls:
Figure 1: Impact of a Range of Immediate House Price Falls on NNEG and ERM
Notes: As per Table 1.
Don’t ever let them tell you that ERMs are safe against a house price collapse.
This said, the good news is that ERMs are still as safe as houses.