Tag: Bank of England

The UK Prudential Regulation Authority (PRA) has released a discussion paper (DP) on equity release mortgage (ERM), or reverse mortgages. Given the complex nature of these products, their valuation, risk assessment and capital treatment are under review, and the regulator is seeking industry input. They are especially focussing on what “fair value” for these mortgages might be.

The PRA has observed that firms writing ERMs typically restrict the initial valuation to the amount lent (which is a transaction price observed in a market), for example by including a spread of appropriate size when discounting ERM cashflows, and updating the valuation (including the spread, where appropriate) to allow for new information affecting the valuation as it emerges.

In Australia, reverse mortgages have not really taken flight, with the latest APRA data showing about $2.7 bn of reverse mortgages outstanding (compared with $1.35 trillion all home loans), comprising around 29,000 loans outstanding, and an average balance of just $96,000.  There has been little growth in recent years.

That said, the recent run up in house prices here, and the aging population may suggest a growing demand. Therefore it is worth looking at the issues the UK regulators are wrestling with. This is a complex product area requiring careful regulation.

ERMs are a type of lifetime mortgage. This DP is directly relevant to lifetime mortgage products with the following features: they are restricted to older customers, they do not have a fixed term, they generally have a no negative equity guarantee, and there is no obligation to make regular interest payments on the capital. For simplicity, this sub-set of equity release products is referred to as ‘ERMs’ for the purpose of this paper, but the PRA is aware that other definitions of ERMs are used in the industry.

ERMs allow capital to be released from residential properties without requiring the property to be sold. ERMs are loans secured by way of a mortgage on a residential property, repayable on ‘exit’ (death; or move to a care home; or voluntary repayment, either for an individual borrower or a couple) rather than at a fixed maturity date. In the United Kingdom (UK), loans are advanced as a lump sum, or through flexible drawdown facilities. In general it is possible to ‘port’ ERMs from one property to another if the borrowers wish to move house, subject to certain restrictions, which may include a requirement to make a partial repayment of the outstanding loan.

Loan interest is generally at a fixed rate, but can be variable or vary subject to a cap. In general, interest accrues to the loan balance without regular payments being made, so that the final repayment is larger than the amount lent, often significantly so. Sometimes interest payments can be made and these may be lower than the interest that would otherwise accrue. Such interest payments can be terminated by the borrower, in which case interest starts to accrue again. The accruing nature of the interest leads to the name ‘reverse mortgage’ being used in some territories.

In the UK, there is often a guarantee that on certain forms of repayment any excess of the accrued loan amount above the (sale) value of the property will be written off or waived by the lender, subject to certain conditions. This is known as a ‘no negative equity guarantee’ (NNEG). For an ERM product to meet the Product Standards within the Statement of Principles of the Equity Release Council, it must incorporate a NNEG. This means the NNEG has become a standard feature of the UK ERM market.

ERMs receivables are held – either directly or indirectly – by a range of different financial institutions, including life insurers, banks, building societies and other lenders. ERMs require long-term funding that is sufficiently flexible to adapt to the timing and amount of repayments, both of which may vary from expectations. In particular, annuity writers have liabilities with long-term and relatively predictable cashflows. So (taking into account their other capital and liquidity resources) some of these firms consider that cashflows from a suitable portfolio of ERMs offer a sufficiently good match for some of their annuity liabilities and provide a good risk/return trade-off, given the long duration and reasonably predictable cashflows of a sufficiently large portfolio of ERMs.

In the UK, ERMs are not actively traded in a secondary market, although the PRA is aware of some bilateral transactions between firms. Some ERM holdings have been externally securitised in the past, but the PRA is not aware of widespread use of securitisation as a means of funding ERMs in the UK.

It is common for lenders to require properties to be insured and maintained as part of the loan terms and conditions. There is a risk that maintenance may reduce over time as borrowers become older and potentially cash-poor, and the financial interest of the borrowers in the property reduces. This ‘dilapidation risk’ may lead to the performance (as an asset) of residential properties connected with an ERM being inferior to the performance of similar properties that do not have such a connection. Conversely, if the loan advanced is used to improve the property, then performance may be superior to similar but unimproved properties.

The responsibility for the sale of the property upon exit may, in some circumstances, rest with the lender who, for risk management purposes, may be willing to reduce the sale price in order to reflect a ‘quick sale discount’ on a vacant property, subject to obtaining the best price for the owner within reasonable timescales. If so, this will further increase the value of the NNEG. There may be a relationship between the desirability of offering a quick sale discount and market-wide movements in house prices.

Part of the loan interest rate can be considered as a charge for the cost of the NNEG. Higher interest rates lead to higher NNEG costs, other things being equal, and so (depending on how the ERM is priced) there is potentially a limit to how much the cost of the NNEG can be recouped through an increase in interest rates. Lenders therefore control their overall exposure to NNEGs primarily by restricting loan-to-value (LTV) ratios. LTVs are typically age-dependent, with LTVs lower at younger ages and increasing with age, reflecting changes in expected exit rates. Some lenders offer to advance larger amounts to borrowers in poor health, based on medical underwriting.

From the provider’s point of view, the future value of the ERM at any given exit date depends on whether or not the NNEG bites. If the NNEG does not bite, the loan plus accrued interest is repaid to the provider in full; if it does bite, the repayment is restricted to the value of the property. Thus the present value of the ERM is equal to the sum of: (i) the present value of the loan plus accrued interest at exit date, if and only if the NNEG does not bite; and (ii) the present value of receiving the property, if and only if the NNEG does bite. The computation of this involves, amongst other things, estimating the present value of receiving the property at exit, and – in order to estimate the probability of the NNEG biting – the volatility of the underlying property price.

Thus when the probability of the NNEG biting is low (typically at shorter durations) the value of the ERM approximates to the present value of receiving the loan plus accrued interest at exit. When it is high (typically at longer durations), the value of the ERM approximates to the present value of receiving the property at exit. Note that the present value of the ERM can never exceed the present value of receiving the property at exit, where a NNEG is in place.

The proportion of loans assumed to exit at any given date depends on the probabilities of death, entry into long-term care and early repayment. The mortality experience of the remaining borrowers can be expected to change as borrowers go into long-term care.

The challenges of valuing ERMs include estimating exit probabilities, estimating drawdown rates (for products permitting future drawdowns) and setting property-related assumptions. In addition, appropriate discount rates need to be set for the cashflows being valued. Some of these challenges are explored in the chapters that follow.

The former Individual Capital Adequacy Standards (ICAS) regime permitted insurers to derive a liquidity premium directly from ERMs. Where appropriate, this led to a reduction in the value of liabilities backed by ERMs. The current Solvency II regime has a similar concept in the form of the matching adjustment, but with more prescriptive rules than ICAS. In particular, ERMs do not have fixed cashflows and so do not meet the Solvency II eligibility criteria for inclusion in an MA portfolio. This has led some firms to restructure their ERM portfolios to meet these eligibility criteria

On 6 November 2015 the PRA published a Solvency II Directors’ update1 stating that during 2016 it would undertake an industry-wide review of ERM valuations and capital treatment. The Directors’ update referred to mark-to-model assets more generally but specifically mentioned ERMs, where there are particular challenges and a range of perspectives on the degree of risk embedded in ERMs and how they should be valued. This DP is the first part of this review.

ERM industry stakeholders (including without limitation life insurers, banks, building societies, other lenders, trade bodies, brokers, credit rating agencies, consultants, actuaries and auditors) are invited to participate in the DP by providing answers to the questions. The PRA also invites responses from academics, particularly those with experience of property valuation and the valuation of contingent claims in incomplete markets.

The Bank of England’s Financial Policy Committee (FPC) assesses the outlook for financial stability by identifying the risks faced by the financial system and weighing them against the resilience of the system.  In doing so, its aim is to ensure the financial system can continue to provide essential services to the real economy, even in adverse circumstances. In today’s release, they highlight financial stability risks, raise the counter-cyclical capital buffer in 2017 and underscore potential threats to financial stability from rapid growth in buy-to-let mortgage lending.

The FPC judges that the outlook for financial stability in the United Kingdom has deteriorated since it last met in November 2015.  Some pre-existing risks have crystallised, drawing on the resilience of the system.  Other risks stemming from the global environment have increased.  Domestic risks have been supplemented by risks around the EU referendum.  Weighed against these developments, the resilience of the core banking system has improved further since November 2015, though investor expectations of future profitability have weakened, with possible implications for banks’ ability to build resilience in the future.  In some financial markets, underlying liquidity conditions have continued to deteriorate.

In December, the Committee signalled its intention to set the UK countercyclical capital buffer rate in the region of 1% in a standard risk environment.   Consistent with the Committee’s assessment of the current risk environment, and its intention to move gradually, the Committee has decided to increase the UK countercyclical capital buffer rate from 0% to 0.5% of risk-weighted assets.  This new setting will become binding with effect from 29 March 2017, at which time the overlapping aspects of Pillar 2 supervisory capital buffers will be lifted.  This will increase transparency and sharpen the incentives of the buffer system.

The FPC also took account of the review by the PRA Board of the overlap between the risks captured by current supervisory capital buffers and a positive UK countercyclical capital buffer. Following its review, the PRA Board has concluded that existing Pillar 2 supervisory capital buffers should be reduced, where possible, by the full 0.5% UK countercyclical capital buffer. This is a one-off adjustment reflecting the transition to the new capital framework and will take place when the new setting of the UK countercyclical capital buffer rate comes into force in March 2017.

The removal of any overlap means that banks accounting for around three quarters of the outstanding stock of UK lending will not see their overall regulatory capital buffers increase as a result of the UK countercyclical capital buffer rate being increased to 0.5%. Other banks will effectively have the period over which they must meet new requirements extended. This will be documented in a forthcoming statement by the PRA Board. The FPC’s action will raise the future regulatory capital buffer of some banks, including many smaller banks that have contributed around half of the increase in net lending to the real economy over the past year. Almost all of these banks currently carry capital in excess of the 2019 Basel III requirements and the 0.5% UK countercyclical capital buffer. The FPC recognises that these banks may wish to build capital over time in order to retain some excess over regulatory capital buffers, but their current position means that any such action will be able to take place gradually.

The UK countercyclical capital buffer rate will apply to all UK banks and building societies and to investment firms that have not been exempted by the Financial Conduct Authority. Under European Systemic Risk Board rules, it will apply to branches of EU banks lending into the United Kingdom. The FPC will work with other authorities to achieve reciprocity, consistent with its own policy on reciprocity.

The Committee assesses the risks around the referendum to be the most significant near-term domestic risks to financial stability. It will continue to monitor the channels of risk closely and support mitigating actions where possible. In that regard, the FPC has considered the results of the 2014 stress test of major UK banks, which incorporated an abrupt change in capital flows, a sharp depreciation of sterling, a marked increase in unemployment and a prolonged recession. The results of that test, when combined with revised bank capital plans, suggested that the banking system was strong enough to continue to serve households and businesses during the severe shock1. Since then, UK banks’ resilience has increased further.

The FPC remains alert to potential threats to financial stability from rapid growth in buy-to-let mortgage lending. The outstanding stock of buy-to-let mortgages has risen by 11.5% in the year to 2015 Q4. The macroprudential risks centre on the possibility that buy-to-let investors could behave pro-cyclically, amplifying cycles in the housing market, as well as affecting the resilience of the banking system and its capacity to sustain lending to the wider real economy in a stress.

Overall, the Committee judges that, although measures of bank resilience have improved since November 2015, investors expect weaker future profitability.

Measures of bank resilience have continued to strengthen. Major UK banks’ aggregate common equity Tier 1 (CET1) ratio has increased further, to 12.6% at end-2015. The aggregate Tier 1 capital ratio of major UK banks reached 13.8% and the Tier 1 leverage ratio reached 4.8% – both a little higher than the FPC’s view of the steady state capital requirements for the major UK banks as currently measured3.

At the same time, investors expect future bank profitability to be weaker. UK bank share prices have fallen by around 15% since November 2015, though there are significant differences in expectations of performance across bank business models. If expectations of weaker earnings were to materialise, the future capacity of the system to withstand shocks through internal capital generation would be reduced.

In a speech delivered at Nottingham University, Martin Weale discussed a range of unconventional policy options available to central banks. He underlined that he not believe the UK’s Monetary Policy Committee (MPC) will need to expand its use of unconventional policy any time soon, but it was important to assess these options as “the Committee does not want to be a monetary equivalent of King Æthelred the Unready”.

Martin analysed the historical experience of the four main unconventional strategies that had been deployed by central banks: quantitative easing; forward guidance; monetary finance; and negative interest rates.

On quantitative easing, Martin outlined his own analysis of its impact in the UK and US. While noting arguments that QE would be less effective now than it had been in the past, Martin said his own analysis contradicted that suggestion – a finding which was part of the reason why he had been more inclined to vote for interest rate rises than his colleagues in recent years: “There is less reason to delay policy tightening if you are confident that you have a means of providing material further support should it be needed”.

In addition, Martin pointed out that the MPC could, in future, expand the range of assets it purchases under QE, noting that in the early 1980s it held substantial amounts of non-government securities. He said: “While there were, at that time, very good reasons why the Bank of England did not want to make substantial purchases of private-sector assets, it is not clear to me how far those are necessarily an insuperable obstacle.”

Turning to forward guidance, Martin found that state-contingent forward guidance tended to have a “relatively modest effect on output and inflation.” Martin noted that this finding depends on where the relevant threshold was set and, in any case, the MPC has only considered such thresholds as reference points rather than rules. Without a rule-based system, he argued, it is hard to be clear about the circumstances in which this sort of state-based guidance will be used, and thus its impact cannot be easily evaluated. He said: “The Monetary Policy Committee does not follow a rule for interest rates and it therefore cannot amend such a rule. It can, of course, do what it did in August 2013, but it is not clear how such a policy can be transformed into a general part of the policy armoury in a way which makes it possible to assess its effects”.

Moving beyond policies the Bank of England has pursued in recent years, Martin stated that – assuming that central bank reserves would continue to be remunerated – he struggled to see a clear difference between some versions of monetary finance and QE. The difference between the two, conceptually, has generally been that the former is seen as permanent and the latter as temporary. However, Martin noted it is not possible for a government to force its successors to maintain a ‘helicopter drop’ as a permanent feature of the landscape. He said: “That is not to say that asset purchases are monetary financing…but rather that an attempt at monetary financing may blur into something not very different from asset purchases, in that both shorten the maturity of public sector debt.” He observed that if some form of reserve requirement were imposed, with reserves unremunerated, the effect was not very different from a tax on banks which would eventually lead to lower spending.

Addressing recent global discussions about negative interest rates, Martin believes they “probably do provide some support, but the extent of this depends on how banks behave, and whether they are able to pass on the full amount of the rate reduction to borrowers”. However, while some challenges – such as banks moving reserves from central banks into cash – could potentially be overcome, Martin underlined that “there is a risk of adverse side-effect and it would be wrong to introduce negative interest rates without being confident that these side-effects were going to be small.” He added: “Equally, measures designed to protect the domestic economy from the effects of negative interest rates mean that the policy becomes close to one of beggar-my-neighbour exchange rate management”.

Martin concluded by arguing that “it is appreciably more likely that monetary tightening rather than monetary easing will be needed in the United Kingdom over the next two years”, noting that financial markets and commodity prices have recovered over the last month, while disappointing recent productivity indicated that unit labour wage costs were stronger than is apparent in headline wage figures. “Nevertheless”, he concluded, “should the need for further easing arise because of a sharp weakening in the outlook for inflation, the scope for further asset purchases is substantial, while the obstacles we saw to reducing Bank Rate below 1/2 per cent are no longer material. These observations should allay concerns that it will be difficult to bring inflation back to target”.