Our friend Golden Retriever at golden.retriever@dogs.gov writes in about our last post on the profitability of equity release mortgage loans:
My first thought was that, surely with any investment, you know the profitability only once the asset has been redeemed, sold, or otherwise disposed of. At this point, you don’t need Black 76, or any other model, to work out profitability: you just look at actual cash inflows and outflows. Do I therefore take it that what you are looking at is actually expected profitability?
To quote Churchill:
The trouble with the ex post measure of profitability is precisely that you don’t know it until the loan has been repaid. We are interested in assessing expected profitability because we want to work out the valuations of the NNEG and ERM ex ante, so that firms have solid valuations at the time the loans are taken out. The only alternative ex ante I can think of is a crystal ball that works.
Of course, we recognise that NNEG valuation is a bit of a dog’s dinner.
GR continues:
If this is the case, there are two points I am struggling with.
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A market consistent approach clearly tells you the value of the asset – but does it tell you anything at all about expected profitability?
It’s a great question, Fido, er, GR. (Sorry I was getting confused with the Irish nationalist hero of the same a different name. I had to bone up on this one.) Let’s start with valuation first and then move to expected profitability.
If an asset is traded on a thick liquid (etc.) market, then the MC valuation of an asset is simply the market price. (It has just occurred to me that the word ‘thick’ might be ambiguous here, but let’s move on.) But if the asset is not sold in such a market – think of ERMs – then we must value it using a suitable model calibrated as much as possible on market-based calibrations of its key parameters.
We then use our valuation model to obtain projections of expected profitability interpreted as the expected internal rate of return on the lender’s investment in an ERM. Let’s suppose that the house is worth £100 and the lender makes a loan of £40 to the ERM borrower. We then estimate the value of the ERM to the lender at the point of inception. The ratio, of the value of the ERM to the lender to the amount the lender loans out, gives the expected profit over the lifetime of the loan. We then use an estimate of the expected lifetime of the loan to obtain an estimate of the internal rate of return on the loan, which is our measure of its expected profitability. It’s looks doggone convoluted when you say it in English, but it is simple enough when you think in programming terms as you would if you were writing in, say, R as in ‘Ruff’.
ERMs are not unique, by any means. Bosch would go through similar calculations to determine the expected profitability of its washing machines. That’s what producers do. Well, it’s what they should do. And if they don’t, they look like Volkswagen.
2. If a market-consistent approach does tell you something about expected profitability, then what exactly would this be used for?
One reason why we might use them is that if I were the lender, I would want to have a best estimate of the profitability of the loan before I made it. What I wouldn’t want to do is work to a model that undervalued the costs of the guarantees I was handing out with my washing machines in order to produce the profitability estimates I wanted. That would be the tail wagging the dog. The term ‘bone-headed’ also comes to mind, but I really don’t want to bone pick here.
In the case of our profitability projections, we found that ERM loans to younger females – by which we mean females in their early seventies or younger – are loss making. The clear implication is that firms would increase their profits by not lending to women in this age range. Loans to younger men are also not profitable.
There are also useful implications for investors. Speaking hypothetically, if you were confident that the people valuing these things were doing it wrongly – say, they were over-valuing them – then you might infer that it would be wise to take a bearish position on the shares of the firms involved. You might also infer that equity release analysts taking a bullish position might be talking bull S–T.
Or, to quote our Churchillian friend:
Woof woof!