Keeping an eye on things
The chart above shows one of the stranger features of equity release mortgages: the wide variation between the projected indexed value of a property, and the actual sale value it achieved at auction. The data is based on Aviva’s Equity Release Funding No. 4.
The red line is the rebased value of the property index used by the fund, the Halifax, from October 2007 to July 2020.
From the Just Group 2020 interim:
There has been significant academic and market debate concerning the valuation of no negative equity guarantees in recent years, including proposals to use risk-free based methods rather than best estimate assumptions to project future house price growth.
To be sure, there has been significant debate about the subject, but there still seems to be significant confusion about what the debate is.
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.
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.
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.
Continue reading “A Back of the Envelope House Price Stress Test for ERMs”
The PRA’s Consultation Paper CP 7/19 makes some sensible points on a number of issues, but one proposal is a bit bonkers. We refer to S2.4 where it proposed “to take account of movements in real risk-free rates when setting the deferment rate,”’ in order to prevent variability in the real risk-free rate causing variability in the forward rate:
The PRA would increase (reduce) the deferment rate if the review shows there has been a material increase (reduction) in long-term real risk-free interest rates since the last update.
In an earlier post, however, we showed that the deferment rate is equal to the current net rental yield, i.e. the nominal net rental payment divided by the current nominal house price. The real risk-free rate does not even enter into it!
These two rates are frequently run together, so which is to be preferred?
A trick question!
The answer is that they are mathematically identical, but they are defined differently.
THE EUMAEUS GUIDE TO EQUITY RELEASE VALUATION
Restating the Case for a Market Consistent Approach
The 180 page guide, by Dr Dean Buckner (Eumaeus) and Professor Kevin Dowd (Durham University and Eumaeus) is the most comprehensive work on the valuation of equity release mortgages to date.
The guide emphasises the team’s previous warnings about poor valuation practice in the equity release sector. “As far as we are aware, not a single equity release firm is valuing its No-Negative Equity Guarantees (NNEGs) correctly,” said Dowd.
The result is a guarantee-undervaluation problem akin to that we saw two decades ago in the Equitable Life fiasco.
Key findings include that:
The guide develops the team’s previous work on the valuation of the guarantee embedded in equity release mortgages. There is a new mathematical derivation of the ERM “deferment rate” from first principles. “The deferment rate is important not only for the valuation of equity release mortgages, but also for the valuation of leasehold extensions,” said Buckner. “Equity release is a form of lease to the borrower, and this work shows how both can be valued in an objective and scientific way, unlike existing approaches.”
The report also contains results on the complex mathematics of the volatility used in the option formula underlying the guarantee, as well as new work on property dilapidation, mortality and long-term care, drawdown, prepayment and ERM stress-testing.