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Not the new ideas

Keynes, somewhere: ‘the difficulty lies, not in the new ideas, but in escaping the old ones’.

Very true, and while I don’t want to blame actuaries too much, they have to take the blame for much of the present crisis. Their profession has grown up around the practice of forecasting future events over which we have little control in the present, indeed the whole point of insurance is to compensate for bad but unpreventable things happening. We don’t insure against stubbing our toe, for example. So actuaries are taught to assess the future value of health treatment, mortality, windstorms etc then discount at risk free, which is perfectly correct.

But it is perfectly false when the forecast tries to compete with what other people are forecasting. Can an actuary accurately predict the value of the FTSE at the end of 2025? No.  The value of the FTSE at that date is itself a market forecast of the present value of future dividends in perpetuity. On what basis or evidence is the actuary forecasting this, and why are other rational people apparently ignoring this basis or evidence?

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HBOS: Gone but not forgotten

Today is the 10th anniversary of Lloyds TSB acquiring HBOS. An awful lot has been written about this, but there has been comparatively little about why a regulatory approach that was implemented in early 2008, and which was meant to protect the bank from losing its capital with a probability of 1 in 1,000 years, failed so spectacularly only 9 months later. What went wrong?

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A date for your diary

On Monday 1 October 2018, Kevin and I will be presenting ‘Is Equity Release a Second Equitable Life?’  at the London School of Economics.

The seminars start at 17.45 and end at 19.00 (unless otherwise stated) and are held in OLD 3.21, 3rd floor, Old Building, LSE.

Yay and naysayers alike are welcome! There will be a lively debate I am sure.

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Just a minute?

Neil Collins in the FT today.

Just a minute Things are grim at Just Group, provider of annuities for those expecting short lives, but better known for its lifetime mortgages. These allow ageing homeowners to cash in on their property gains with loans where the interest is not paid, but rolls up with the debt. This latter business is relatively new, and pricing the risk that the house will be worth less than the accumulated debt at the homeowner’s death is exercising the Prudential Regulation Authority. It will want more capital from the lenders, and Just has already sacrificed its half-time dividend in anticipation, warning of a capital raise to follow. The shares have halved in four months, and at 74p are discounting a thumping rights issue to appease the PRA. Only then can the market price the risk that the mortgaged property will fetch less in 20 years’ time than its value today. It does not seem remotely likely. At this price, Just shares are discounting housing Armageddon.

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Deferment Price Less Than Spot Price? What Else Could It Be?

In a recent posting Guy Thomas takes issue with my new friends at the Prudential Regulation Authority on Consultation Paper CP13/18 which deal with the valuation of the no-negative-equity guarantees (NNEGs) in equity release mortgages. Dean has responded to Guy here, but I would like to stick my own oar in the water too, particularly on the issue of whether the deferment price on a property should be less than the current price.

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UnBuffetted

A postbag objector objects to my post on Monday, saying that Warren Buffett explicitly disagrees with quarterly P/L swings on derivative positions, given that they are based on B-S valuations. See e.g. his 2010 newsletter p.21. Given that Buffett is taking in billions of premium without collateral, which he can then invest however he likes, why should this strategy be equivalent to taking a long position, even on no-collateral terms, when the latter would have produced nothing up front?

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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.

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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.

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I Just Don’t Believe it!

Just’s quarterly results presentation on September 6th was a hoot. I couldn’t help noticing the cancelled dividend and the auditor (KPMG) suggesting that the final outcome of CP 13/18 could constitute a material uncertainty that may cast significant doubt on the Group’s ability to continue as a going concern. These look like red flags to me but I am not an analyst and may have missed the finer points.

One point however that did jump out at me was its innovative “NNEG loss shortfall” metric. This metric appears to be the loss that occurs when the loan is repaid and the house price is below the loan value. This metric sounds plausible at first sight and sure does make the NNEG risk look small.

Unfortunately this “NNEG shortfall” as used by the company tells us nothing about the valuation of the NNEG or the riskiness of the firm’s equity release portfolio.

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When in doubt

As discussed in yesterday’s post, the Just Group auditors stated that the final outcome of CP 13/18 could have a materially negative effect on the regulatory capital position and financial condition etc. of the Group, and constitute a material uncertainty that may cast significant doubt on the Group’s ability to continue as a going concern. You might have thought that was clear enough, but lest you should have been misled, Rodney Cook (Group CEO) clarified matters at a presentation. [1:11:00]

“Let me just cover off the word ‘doubt’, that is an auditing and accounting and statutory set of words, and that is why it is in there.”

That makes sense. ‘Material uncertainty’, ‘significant doubt’, ‘going concern’ etc do not have their usual English meaning, but are merely accounting and auditing technical terms, signifying nothing in particular as Mr. Cook notes.

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