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Trend or mean reversion?

Many readers, not all, will be familiar with the Herengracht chart shown above. As Wikipedia explains, the index – of house prices along the Herengracht canal in Amsterdam – was created by real estate finance professor Piet Eichholz of Maastricht University. Eichholz was frustrated by the tendency of papers to take a ‘long run’ view of house prices that only went back 20 years or so. He suspected there was a myth which says that real-estate values go up significantly over time, and that this is especially true for central city locations, so he began studying transaction records for the Herengracht area going back to the mid 16th century. More than 300 years of data should be sufficiently ‘long run’, right? His data ended up challenging that myth. Note that the chart here is adjusted for the Dutch retail price index.

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Minsky moment?

According to the Equity-release-graph, the product continues to grow apace. £1bn lent in the third quarter of 2018. But if the trend continues, it will lead to the first of the two problems I highlighted in this previous post. Lending will follow house price growth, house price growth will fuel the capitalisation model used by ERM firms, which will capitalise future predicted growth.  This will then result in the second problem, namely that if the growth is not realised, it will go horribly wrong. Note ‘not realised’. It will go horribly wrong even if the growth is flat, and because of the large amounts lent, it will be horribly wrong in a horrible way.

You have to ask what the BoE, the guardian of financial stability, was thinking of when it approved these models in 2016. Actually I know what it was thinking of, but cannot say.

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Time decay

Most people with even the slightest familiarity with option pricing will know of time decay, or the tendency of the option value to decrease through time independent of any interest rate effect. The chart above shows the price of call option through 40 years, struck at 100 with the underlying price also constantly at 100, and with interest rate set to zero to remove the effect of interest carry. I.e. the only change to the model is the time to expiry. The effect of time decay or theta is apparent.

Now I have discussed in several posts, such as here, how a real option can be replicated by means of a synthetic option – a series of linear positions in the underlying market adjusted frequently to match the delta or sensitivity of the real option.

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The whole truth

I wrote on 10 August1 about how possibly material facts – in this case a missing £1bn itemised as ‘other valuation differences’ – have been hidden in plain view, scattered across different reports or couched in opaque regulatory language. But there was something else in plain view that I failed to notice. Page 4 of Just Group’s 2017 Solvency and Financial Condition Report states

The main reason for the change since the publication in March 2018 follows the Group’s decision to change the assumptions underlying the valuation and credit rating of the LTM notes (described in D.2.6) in the Matching Adjustment in JRL as at 31 December 2017.

My emphasis. Further on it says that the impact of the reduction in Matching Adjustment was £470m. I had previously queried this with the firm on 31 July, via their publicist Alex Child-Villiers, who simply reiterated the same statement, and declined to answer my question about the £1bn. I asked again, and the whole firm (and their auditor KPMG) went into radio silence. A number of others have asked since then, and received the same stony silence.

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