Well we said we would be back. Here is the newly released PRA Policy Statement 19/19, and there is some really weird stuff in there. We start with section A, ‘Reviewing and updating the minimum deferment rate,’ and in particular the part which starts at paragraph 2.6, ‘The PRA considers that the approach of linking changes in the minimum deferment rate to changes in real interest rates is economically sound and appropriate for the intended purpose of a diagnostic test.’
They write:
The PRA considered net rental yields in paragraph 2.59 of PS31/18 and agrees that net rental yields could be a reasonable starting point for determining deferment rates over short terms, as they are a measure of the income foregone by an ERM investor as compared to a direct owner of a property. However, a net rental yield is a short-term measure of deferment.
Which is very strange indeed.
We discussed the connection between short term net rental rate and deferment rate in our July post here. We showed there that they are mathematically one and the same, so the idea that one is merely a ‘short term’ measure of the other is simply incorrect. Of course the net rental will change over time, so is short term in that sense, but if you follow the proof in the link, the dividend discount formula takes care of that. The growth in rental g is balanced by the discount r + π, where r is the risk free rate, and π the risk premium. Our main point is that because the net rental rate and the deferment rate are mathematically identical, there is no mathematically correct way in which one can drive a wedge between them. We really shouldn’t have to point this out.
Now the PRA could object that our derivation depends on the assumption that the dividend discount (or ‘Gordon’) model is true. Possibly, but there are two reasons why we should doubt that objection.
The first is that the dividend discount model depends only on the assumption that the value of a perpetual is the present value of all the cashflows, an assumption which is crucial to a lot of financial mathematics, and not really to be questioned. After all, many of the Bank’s own models depend on it. So is the Bank now proposing to trash most of its own models? No, we thought not.
The second is that the PS 19/19 assumes the correctness of the Sportelli model, which is itself a version of the dividend discount model, albeit a flawed one. So the Bank would have us believe that the discount dividend model is incorrect on principle, but correct in the case of the flawed Sportelli model, a position that violates the laws of logic. There is, you might say, no perspective from which the Bank’s position makes sense.
They go on to say that the Sportelli formula can be rearranged to express the deferment rate as the long-term nominal risk-free rate, plus a risk premium, less long-term capital growth.
That’s almost correct, and in our post here, where we say that one proposal in the PRA’s earlier Consultation Paper CP 7/19 is a bit bonkers, we start with the dividend discount equation:
q+g=r+π
I.e. deferment rate q plus rental growth equals risk free rate plus risk premium. Note that g is growth in the rental rate, not ‘capital growth’, as they claim in the current policy statement. Oh dear.
Then we show that the deferment rate is equal to the risk free rate if and only if the following four assumptions are correct, namely (i) the risk premium is zero, (ii) the imputed growth in net rental is equal to the general inflation rate, (iii) the nominal rate r is the sum of the expected general inflation rate and the real rate rr and (iv) expected and actual inflation are the same.
But those assumptions don’t hold. A property portfolio is not risk free; rental inflation and general inflation are likely to be correlated, but are not the same; and the expected future rate of inflation is unobservable whereas the net rental yield, which we proved is mathematically identical with the deferment rate, is relatively simple to observe.
Hence
… if the PRA wants to monitor the deferment rate – which we think is a reasonable idea – then it should monitor developments in the net rental yield. But monitoring an irrelevant variable like the real risk-free rate makes about as much sense as monitoring the frog population to see how the llamas are getting on.
Quite.