Posts

Posted on

Jam tomorrow

There certainly was a ‘lively debate’ at the LSE on Monday evening. The house was packed, with guests including our friends at the Treasury, the PRA, and a number of analysts. Kevin will be writing some more about this, meanwhile here are the slides. Note that we covered them in a slightly different order. I discussed slides 16-19 (and mostly slide 16) on the ‘upper bound principle’ after Kevin’s main presentation.

The upper bound continues to be misunderstood, as I commented in our reply to the Institute yesterday. It does not depend in any way on arbitrage arguments, complete markets, geometric Brownian motion or any of that stuff.

Simply, jam today worth more than jam tomorrow, and should be valued as such by accountants such as KPMG. Yes?

 

 

 

Posted on

EUMAEUS Concerns About CP 13/18

We replied at the last minute to the CP 13/18, our letter is here. For those who don’t have time to read it, the main points are:

  • A jolly good set of proposals, but why did the PRA take nearly 4 years to decide on the pricing of a simple European put option? I shall be commenting upon this enigma at the discussion at the LSE this (Monday) afternoon.
  • The CP does not consider the capital treatment of ERMs, yet an autocorrelated market such as residential property poses considerable problems for Var -type capital treatment.
  • The Matching adjustment regime is completely impenetrable. “We believe the PRA should make it a priority to work on possible reforms to Solvency II or on a UK successor to Solvency II to bring it into line with accounting standards such as IFRS”.
  • IFRS 17 is not consistent with the regulatory accounting treatment of Solvency II

I look forward to seeing our readers at the LSE tomorrow. There will be drinks.

[Update: The Institute of Actuaries has just published its response to CP 13/18. We will be commenting on this tomorrow, but note they also bring up the autocorrelation point, although, like many others, they confuse a valuation question with a risk management one.]

Posted on

News from nowhere

Ian Mulheirn writes

The price of a property is overwhelmingly determined by the value of the land it sits on, which makes it inherently positional, and not something you can cut to zero. For example, you can’t reduce the value of the land in the City to zero (or even make a material dent in it) by liberalising planning in Surrey. The reason is that the value of the land is determined by the discounted stream of rent you can get from it. This is unrelated to the cost of building. If you build somewhere where nobody wants to live, the discounted stream of rent, and hence the property value, will be zero.

My emphasis. Any offers on that house?

Posted on

True purpose of pension fund

Kevin writes: ‘I must have been mistaken: the true purpose of a pension fund must be to finance a flutter on the housing market.’

When I first joined the world of insurance, it was explained to me somewhat cynically that banks borrow short term from depositors, and use the money to speculate with. If the bet turns sour and depositors want their money back, it goes horribly wrong very quickly.

Insurance companies, by contrast, borrow long term from future pensioners and use the money to speculate with. If the bet turns sour, it takes about 20 years for things to go horribly wrong, after the prime movers are safely retired (preferably not with a pension for the firm they worked for).

Posted on

1 in 200

Source: Dallas Federal Reserve

The chart shows the Japan housing index 1975-2018 Q1. There is a fascinating history behind this but I won’t go into that now. The point is about the risk of something similar happening here. Banking and insurance capital models work on the principle of Value at Risk, i.e. the amount required to sustain a loss over a specific time horizon, to a specified probability. For example, the advanced Basel IRB model has a time horizon of 1 year, with a probability of 1 in 1,000. The Solvency II model has the same time horizon, but a probability of 1 in 200. So the first would last us from the succession of Cnut the Great in Denmark in 1018 until now, the second from the birth of Karl Marx in 1818 until now.

But I wonder. Could the probability of a Japanese-style collapse here in the UK (or anywhere else in the West) be only 1 in 200? Ask most professionals in the business of capital management and they will say so. The fact that it happened in Japan doesn’t mean it could possibly happen here. Japan is such a terribly different, utterly different place from Britain, that no connection can be drawn between the two scenarios.

But I still wonder. There is a good FT article (31 August 2018) by Gillian Tett about a Japanese central banker warning that a financial crisis was about to explode. Déjà vu, he was saying, presumably not in Japanese, referring to the banking crisis sparked off by the collapse of the baburu keiki, or bubble of the 1980s, leaving about $1tn of bad loans.

If it happened there, could it happen here?

Posted on

Back to the 80s

Source OECD, Nationwide

Here’s an intriguing chart I found in the archives. This is the nominal mortgage cost of the average UK house from 1980 to the end of 2017. Don’t take it too seriously. The crude methodology is as follows. Take the average UK house price from the Nationwide index, andihe short term interest rate for the relevant quarter, adding on 50bp for the likely spread charged by the lender. It turns out the nominal (not the real) cost of the interest charged has not changed significantly since 1980.

I have to pinch myself every time I look at this. Impossible! Think how much earnings have gone up since the days of pinstripe suits and hairstyles that were a fire hazard.

But it’s true, because we forget how high interest rates used to be. In March 1980 the average house would cost you about £23,000. But the interest would have been about 15%, so the interest cost would have been about £3,500 a year. Fast forward to the end of 2017, when the average house now costs over a quarter of a million. But the interest rate has fallen to below 2%, resulting in an interest cost of about £4,500. Result: no housing crisis, housing is very cheap! Indeed a member of my immediate family was offered a deal of 1.8%, immediately halving the cost of rent.

As Ian Mulheirn suggests, see e.g. my post here, is it the fall in global interest rates that has driven the phenomenal increase in housing prices across the world?

Of course it’s not nearly as simple as that, but enough for now.

Posted on

Mulheirn versus Harding

Source: Ian Mulheirn

There was a fascinating discussion between Ian Mulheirn and Robin Harding in the letters section of the FT a while ago (August 29 2018). Mulheirn, replying to an article by Harding (‘Planning rules are driving the global housing crisis’, FT August 15 2018), argued that:

The theory and the data clearly indicate that a shortage of homes has not contributed to the 150 per cent rise in UK real prices over the past two decades. Those who reject that conclusion should explain whether it’s the economic theory that’s wrong or the rent data.

The letter is behind a paywall in the comments section, but the substance is broadly as follows.

Continue reading “Mulheirn versus Harding”

Posted on

Lords lording it

Kevin spotted this discussion at the House of Lords on 5 September. Lord Bates:

My Lords, the Government take the issues raised in this report very seriously. Equity release offers an effective way for home owners to enhance their standard of living in later life, but must not threaten their financial stability or place consumers at risk. The Prudential Regulation Authority is alert to the issue. It is acting to set a clear and more precise prudential expectation for insurance companies’ risk management of equity release mortgages.

Incorrect. The PRA expectations are about the valuation of ERMs not risk management. See our August 23 post. Although to be fair, Bates later on says that it is ‘an issue of pricing’.

Baroness Altmann:

…as the Equity Release Council figures show, most equity release loans are only about 30% of loan to value—some may be around 50%? Even if house prices were to decline by 30% or more, the problems in the conventional mortgage market would be far greater than those in the equity release market. I was rather surprised to see such scary headlines on this particular segment of the market.

This is the ‘loan to value’ fallacy. If we are modelling the embedded guarantee as a series of European put options, then all such options have a strike price, which will be the compounded loan value at expiry, i.e. the value rolled up without periodic interest payments as with a conventional mortgage. For long periods this strike will be a significant multiple of the original loan to value, and certainly not the 30-50% that Altmann quotes.

Kevin commented on Altmann in an earlier post on August 14. ‘If she has read the report, I see no evidence of it in her comments.’

Fair enough, noble lords.