Author: kd

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Market Consistent or Real World?

Although we have often criticised it, the Discounted Projection aka ‘Real World’ Approach used by the equity release industry to value their NNEGs and ERMs has two significant things going for it. The first is fantastic marketing. Who could be against a ‘real world’ approach, especially when the alternative is a Market Consistent or ‘Risk Neutral’ approach? Everyone knows that most people are not risk-neutral. ‘Real world’ or ‘risk neutral? It’s a no-brainer.

The other thing that the DP/’Real World’ approach has going for it is that it produces much lower valuations. Hosty et alia (2007) hit the nail right on the head:

7.3.3 Market consistent or real world?

On our proxy market consistent approach we have derived a cost for the NNEG which would render the product non-profitable, whilst real world modelling has produced a significantly lower cost.

The importance of commercial considerations as a reason for preferring this approach was confirmed by Tom Kenny at the 28 February 2019 Staple Inn launch event for the Tunaru report. Mr Kenny was the chair of the event, and is Director of Actuarial & Underwriting, Retirement Lending at Just Group plc in his day job: “clearly if we move down a purely market consistent route … it’s going to be extremely expensive,” he said.

 Darn right it’s going to be expensive.

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The Discounted Projection Approach

The standard approach used by UK ERM actuaries to value NNEGs and ERMs is the Discounted Projection (DP) approach, which its adherents like to call the ‘real world’ approach.

This approach is based on the use of a projection of future house price growth to value the NNEG. In particular, it replaces the forward house price as the underlying in the Market Consistent (i.e., correct) approach with some expected future house price ‘forecast’ that a cynic (not us!) might say was indistinguishable from a convenient guess.

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Roll up and Other Misconceptions

Pete Matthew of Meaningfulmoney has an interesting series of videos on equity release. The one that caught my eye was this published on 24 Aug 2011. He writes,

One of the main concerns for those contemplating Equity Release is that the interest building up so fast, there’ll be no equity left in their home to leave to the kids. Here, I show that it’s really not as bad as all that by looking at some realistic examples.

He then goes through the mechanics of the hare vs. tortoise race between rolled up loan amount and house prices. He also gives examples based on an example case in which there is a house worth £200k, an ERM loan of £50k, a loan rate of 7% and an hpi of 3%, with discrete annual compounding.

His results for the Lifetime Mortgage case are shown in the following screenshot:

The key finding is that it takes an awfully long time for the house price to overtake the loan amount and push the loan into negative equity.

That might not be the whole picture, however.

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At Last, a Refereed Article on NNEG Valuation

… that uses the correct valuation approach. Disclosure: we are two of the co-authors, so we would say that.

The article, “The Valuation of No-Negative Equity Guarantees and Equity Release Mortgages” by Kevin Dowd, David Blake, Dean Buckner and John Fry has just been accepted by the well regarded academic economics journal, Economics Letters.

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The Mysterious Mystery Shop

Dean’s article “Just one in the Eye for Age UK?” (22 Aug 2019) tells an interesting story from the latest issue of Private Eye about a mystery shopper who contacted Hub financial via the Age UK website, enquiring about an equity release mortgage (ERM). When he took Age UK’s advice to “dip his toe” into equity release, his enquiry was channelled through Hub’s independent panel of lenders and he was offered an ERM loan from one particular firm. This offer came as a bit of a surprise to the toe tipper, however, because he had already been offered an ERM loan from another firm that was also on Hub’s panel, and in his opinion, this previous offer from the other firm was a better one. So one wonders what is going on.

These articles got me thinking: how would one go about establishing the potential loss to an ERM borrower from going with one lender, when an alternative lender would have given them better terms?

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Just a NNEG Securitisation

In a recent (July 30) posting, Dean wrote that

Since Just Group’s trading update last week, there has been much speculation about the ‘pioneering no negative equity guarantee (NNEG) hedging transaction’ announced by the firm. It is not clear whether the firm has put the hedge in place, or whether they are still waiting to establish ‘appropriate regulatory treatment’ with PRA. The current thinking is that the hedge will be transacted through a major reinsurer, and that it will be a purchase of some form of long dated put option on the housing index.

A related possibility is that the hedge, if there is one, is some kind of NNEG swap, which then raises the question: what is Just’s NNEG valuation?

Short answer: we don’t know and it would be naughty of us to speculate. We don’t have enough information about the firm’s ERM portfolio or enough information about the firm’s valuation approach.

But this got us thinking …

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The Bank’s ‘Stress’ Tests

My report on the Bank of England’s latest (November 2018) stress tests was published by the Adam Smith Institute on August 3rd.

The purpose of the stress tests is, in essence, to persuade us that the banking system is in good shape on the basis of a make-believe exercise which purports to show what might happen in the event of a supposed severe stress scenario as modelled by a central bank with a dodgy model and a vested interest in showing that the banking system is in great shape thanks to its own wise policies.

We are expected to believe that the central bank has managed to rebuild the banking system despite enormous pressure placed on it by the institutions it regulates, whose principal objective is to run down their capital ratios (or equivalently, maximise their leverage) in order to boost their returns on equity and resulting short-term profits, and never mind the systemic risks and associated costs imposed on everyone else or the damage their high leverage did in the Global Financial Crisis.

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A Few Loose Ends

Anyone with the intestinal fortitude to wade through our Eumaeus Guide might have noticed that in several places in the report we promised to post two spreadsheets: one giving the calculations underlying our volatility chapter, Chapter 10, and the other the hedging example discussed in the Appendix to Chapter 20.
So why didn’t we post them as promised when we published the report?
Simple: because we, er, forgot. Sorry.

So here (1) they are (2), and see also our new models page

A word of explanation about these spreadsheets.

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Turning Japanese

Turning Japanese

In a previous posting, we discussed a type of stress test in which house prices fall immediately after an ERM contract has been entered into.

However most stress tests are passage-of-time stress tests in which we posit some hypothetical stress over time and then use our model to see how that stress would effect something we are interested in, over the passage of time.

For example, we might assume a hypothetical rate of growth of hpi and show how the ERM valuation would behave over time under the posited scenario.

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A Back of the Envelope House Price Stress Test for ERMs

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.

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