Author: db

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Back to the 80s

Source OECD, Nationwide

Here’s an intriguing chart I found in the archives. This is the nominal mortgage cost of the average UK house from 1980 to the end of 2017. Don’t take it too seriously. The crude methodology is as follows. Take the average UK house price from the Nationwide index, andihe short term interest rate for the relevant quarter, adding on 50bp for the likely spread charged by the lender. It turns out the nominal (not the real) cost of the interest charged has not changed significantly since 1980.

I have to pinch myself every time I look at this. Impossible! Think how much earnings have gone up since the days of pinstripe suits and hairstyles that were a fire hazard.

But it’s true, because we forget how high interest rates used to be. In March 1980 the average house would cost you about £23,000. But the interest would have been about 15%, so the interest cost would have been about £3,500 a year. Fast forward to the end of 2017, when the average house now costs over a quarter of a million. But the interest rate has fallen to below 2%, resulting in an interest cost of about £4,500. Result: no housing crisis, housing is very cheap! Indeed a member of my immediate family was offered a deal of 1.8%, immediately halving the cost of rent.

As Ian Mulheirn suggests, see e.g. my post here, is it the fall in global interest rates that has driven the phenomenal increase in housing prices across the world?

Of course it’s not nearly as simple as that, but enough for now.

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Mulheirn versus Harding

Source: Ian Mulheirn

There was a fascinating discussion between Ian Mulheirn and Robin Harding in the letters section of the FT a while ago (August 29 2018). Mulheirn, replying to an article by Harding (‘Planning rules are driving the global housing crisis’, FT August 15 2018), argued that:

The theory and the data clearly indicate that a shortage of homes has not contributed to the 150 per cent rise in UK real prices over the past two decades. Those who reject that conclusion should explain whether it’s the economic theory that’s wrong or the rent data.

The letter is behind a paywall in the comments section, but the substance is broadly as follows.

Continue reading “Mulheirn versus Harding”

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Lords lording it

Kevin spotted this discussion at the House of Lords on 5 September. Lord Bates:

My Lords, the Government take the issues raised in this report very seriously. Equity release offers an effective way for home owners to enhance their standard of living in later life, but must not threaten their financial stability or place consumers at risk. The Prudential Regulation Authority is alert to the issue. It is acting to set a clear and more precise prudential expectation for insurance companies’ risk management of equity release mortgages.

Incorrect. The PRA expectations are about the valuation of ERMs not risk management. See our August 23 post. Although to be fair, Bates later on says that it is ‘an issue of pricing’.

Baroness Altmann:

…as the Equity Release Council figures show, most equity release loans are only about 30% of loan to value—some may be around 50%? Even if house prices were to decline by 30% or more, the problems in the conventional mortgage market would be far greater than those in the equity release market. I was rather surprised to see such scary headlines on this particular segment of the market.

This is the ‘loan to value’ fallacy. If we are modelling the embedded guarantee as a series of European put options, then all such options have a strike price, which will be the compounded loan value at expiry, i.e. the value rolled up without periodic interest payments as with a conventional mortgage. For long periods this strike will be a significant multiple of the original loan to value, and certainly not the 30-50% that Altmann quotes.

Kevin commented on Altmann in an earlier post on August 14. ‘If she has read the report, I see no evidence of it in her comments.’

Fair enough, noble lords.

 

 

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Not the new ideas

Keynes, somewhere: ‘the difficulty lies, not in the new ideas, but in escaping the old ones’.

Very true, and while I don’t want to blame actuaries too much, they have to take the blame for much of the present crisis. Their profession has grown up around the practice of forecasting future events over which we have little control in the present, indeed the whole point of insurance is to compensate for bad but unpreventable things happening. We don’t insure against stubbing our toe, for example. So actuaries are taught to assess the future value of health treatment, mortality, windstorms etc then discount at risk free, which is perfectly correct.

But it is perfectly false when the forecast tries to compete with what other people are forecasting. Can an actuary accurately predict the value of the FTSE at the end of 2025? No.  The value of the FTSE at that date is itself a market forecast of the present value of future dividends in perpetuity. On what basis or evidence is the actuary forecasting this, and why are other rational people apparently ignoring this basis or evidence?

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HBOS: Gone but not forgotten

Today is the 10th anniversary of Lloyds TSB acquiring HBOS. An awful lot has been written about this, but there has been comparatively little about why a regulatory approach that was implemented in early 2008, and which was meant to protect the bank from losing its capital with a probability of 1 in 1,000 years, failed so spectacularly only 9 months later. What went wrong?

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A date for your diary

On Monday 1 October 2018, Kevin and I will be presenting ‘Is Equity Release a Second Equitable Life?’  at the London School of Economics.

The seminars start at 17.45 and end at 19.00 (unless otherwise stated) and are held in OLD 3.21, 3rd floor, Old Building, LSE.

Yay and naysayers alike are welcome! There will be a lively debate I am sure.

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Just a minute?

Neil Collins in the FT today.

Just a minute Things are grim at Just Group, provider of annuities for those expecting short lives, but better known for its lifetime mortgages. These allow ageing homeowners to cash in on their property gains with loans where the interest is not paid, but rolls up with the debt. This latter business is relatively new, and pricing the risk that the house will be worth less than the accumulated debt at the homeowner’s death is exercising the Prudential Regulation Authority. It will want more capital from the lenders, and Just has already sacrificed its half-time dividend in anticipation, warning of a capital raise to follow. The shares have halved in four months, and at 74p are discounting a thumping rights issue to appease the PRA. Only then can the market price the risk that the mortgaged property will fetch less in 20 years’ time than its value today. It does not seem remotely likely. At this price, Just shares are discounting housing Armageddon.

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UnBuffetted

A postbag objector objects to my post on Monday, saying that Warren Buffett explicitly disagrees with quarterly P/L swings on derivative positions, given that they are based on B-S valuations. See e.g. his 2010 newsletter p.21. Given that Buffett is taking in billions of premium without collateral, which he can then invest however he likes, why should this strategy be equivalent to taking a long position, even on no-collateral terms, when the latter would have produced nothing up front?

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Reply to Guy

Guy Thomas has an interesting post (‘No-negative-equity guarantees: Black-Scholes and its discontents’, guythomas.org.uk, Thursday 06 September 2018), arguing that the use of the Black-Scholes formula in the context of valuing the no-negative-equity guarantee (NNEG) in equity release mortgages, is flawed in ways that are more fundamental than the PRA blandly suggests.

You can read his article for yourself, but his key points are (1) that the Black-Scholes argument depends crucially on the idea of dynamic hedging and arbitrage, which is not met in the case of housing assets, and ‘is simply not possible in any shape or form’; (2) that Black-Scholes assumes when constructing the dynamic hedge that the underlying asset follows a geometric Brownian motion; (3) that there is no meaningful market in deferment prices [sic] over the periods of 20-40 years most relevant to NNEGs, and furthermore a deferred interest might well be more attractive, particularly if in the form of cash-settled financial contracts, so that all the problems of current interests (nasty tenants, management costs, legal risk etc) are permanently avoided.

Let’s look at these arguments carefully.

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Did Buffett get lucky?

We now have a well-stocked cupboard of dodgy option pricing arguments to reply to at some point or another, and it’s not often a new one turns up. Yet that’s what happened the other day. One of our firm-friendly friends told us that Warren Buffett thinks long-dated options are over-priced by Black-Scholes, and that he has proved this claim both by theoretical methods and by practical means, i.e. by making a ton of money. Let’s take a look.

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