Category: valuation

Posted on

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.

Continue reading “Reply to Guy”

Posted on

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.

Continue reading “Did Buffett get lucky?”

Posted on

A bet on the house

In Asleep at the Wheel, I set out a base case No-Negative Equity Guarantee (NNEG) valuation based on a bunch of assumptions. Suppose I am 70 years old, have a house worth £100 and get an equity release loan of £40. Suppose too that the risk-free interest rate is 1.5%, the net rental rate is 2%, the loan rate is 5% and so on.

In this base case, my NNEG model comes up with a NNEG valuation – this valuation is the same as the cost of the NNEG to the lender – of £20.8, which is 52% of the amount loaned.

Remember too that we value the NNEG using information available now. As Dean and I have explained in various places (see here and here), our NNEG valuation is not dependent on a forecast of any future variable.
Continue reading “A bet on the house”

Posted on

How Big is the NNEG Across the Equity Release Sector?

Most UK Equity Release mortgages1 involve a no-negative equity guarantee (NNEG) by which the lender guarantees that the borrower (or their estate, if they have passed away by then) will never need to pay back more than the value of their house when the loan is repaid.

The valuation of these NNEGs has become an issue in light of recent reports – Howard Mustoe’s BBC story “Home equity release may cost pension firms billions” and my Adam Smith Institute report, “Asleep at the Wheel: the Prudential Regulation Authority and the Equity Release Sector.”

In particular, our reports claimed that Equity Release firms are undervaluing their NNEG guarantees – and to a considerable extent.

So how big is the NNEG valuation ‘problem’ across the Equity Release sector?

Continue reading “How Big is the NNEG Across the Equity Release Sector?”

Posted on

Net Rental Rates and Deferment Prices

Character property with attractive open views and real scope for improvement

Kevin Dowd  28 August 2018

A number of our readers continue to be puzzled about why Dean and I have been insisting (see, e.g., here, here and here) that the net rental or q rates used for NNEG valuations should be positive.

This point matters because we are interested in how NNEG valuations are affected by deferment property prices.
Continue reading “Net Rental Rates and Deferment Prices”

Posted on

Just in spotlight

Oliver Ralph of the FT has a piece ‘just’ out, on fears about the impact of proposed new PRA rules on Just Group’s capital base.

The PRA’s consultation paper suggested tougher treatment for these type of mortgages, to take account of the risk created by the no negative equity guarantees.

That’s not quite right, as we have pointed out here and elsewhere. The PRA’s consultation paper CP 13/18 (02 July 2018) is not about the risk of such mortgages, i.e. capital requirements, which  the PRA has so far been silent about, but rather their valuation, which impacts capital available or ‘capital resources’ as the regulator calls it.
Continue reading “Just in spotlight”

Posted on

“How scam values on equity release loans affect leaseholders”

An article of mine has just been published by Leasehold Knowledge Partnership, which campaigns for a better deal for leaseholders. The introduction is by Seb O’Kelly, in his inimitable style (he used to be a journalist at the Daily Mail). The point of the article is that the deferment rate used to value equity release mortgages is the same as the rate which would in theory be used to value a leasehold extension. Lower rates favour landlords, higher rates favour leaseholders. The PRA seems not to have spotted the connection between the two political issues. In coming in with an apparently unevidenced 2%, they are imposing a valuation model that affects the interests of a whole bunch of people that they haven’t so far consulted. Now is the time. If you think you may be affected, write to the CP (CP13_18@bankofengland.co.uk), asking for the PRA to make its thinking clearer, and for a place at the table, if you wish.