The spate of publicity surrounding ‘Asleep at the Wheel’ unleashed a torrent of nonsense into the printed media and the internet. It will take some time to unravel this, although Kevin has already posted on the subject. See here, on Baroness Altmann’s mistaken idea that he was publishing a risk-model, rather than a valuation model, and here, on the Equity Release Council’s misconception that ‘price trends’ are in any way relevant for pricing or valuing the NNEG.
Absolutely the most common misconception was that we (and the PRA) are worried about shocks to the housing market, and that firms are not ‘setting aside’ sufficient capital resources to withstand such a shock. For example, Stephen Lowe, director at Just Group,1 felt he had to reassure us that ‘firms should be prudent and set aside sufficient resources to allow for shocks in the economy’. Dean Mirfin, chief product officer at equity release advisor Key Retirement said ‘Our typical customer is 71-years old, which means these loans typically have 15 or more years to run, giving plenty of time for prices to bounce back’. Or see the Daily Telegraph who say the concern is that ‘the equity release market could be sent into meltdown if house prices were to fall substantially in future’.
This was not Kevin’s point, and only briefly does he discuss housing stress in his report. His central point is that the approach used by firms to value their NNEGs is not correct, and he provides quotes from the firms’ own reports as evidence to support this claim. This means that, regardless of the future path of house prices, firms who are using the wrong methodology (which seems to be all of them) are already sitting on large losses which need to be recognised.
A further misconception is that Kevin’s model (and the PRA’s) limits house price growth to the risk free rate.2 This is wrong: neither model mandates this. To see this, suppose I want to speculate on growth in the housing market over 10 years. I can do this by (1) buying a house and renting it out with a net rental yield (headline rental minus management, maintenance costs etc) of 2%, or (2) buying a ‘deferment’ i.e. the right to possession of the house in 10 years’ time, but not before. The Dowd/PRA model assumes that a rational buyer will want an approximately 20% discount on the deferment price because of the loss of rental income that he would have got if he went for choice (1). And that’s all it is assuming.
Does the deferment assumption constrain house price growth to risk free or any other number? Of course not. Suppose the house costs 100, and the deferment costs 80, and assume it costs 150 in 10 years time. That’s about 4% growth plus 2% annual rental income if I go for the buy to let route, total return about 6%. If I buy the deferment, by contrast, I don’t get the income, but I only bought at 80, so I get the same total return of 6%. In both cases we get the growth plus notional rental, and in neither case does the growth have to be a the risk free rate. House prices can grow at whatever rate you like. The crucial point is that the deferment must be priced lower on a rational basis, because the buyer will receive no net rental.
It’s all actually very simple, if people paused for a few seconds to think it through, which they don’t.
- The Express, Sunday 12 August 2018
- See e.g. this, by ex PRA insider Andrew Bulley, who should know better.