The UK’s prudential regulator has come under fire for being slow to act on the potential systemic threat of equity release mortgage (ERM) lending by insurers.
In a report published today, Kevin Dowd, professor of finance and economics at Durham University and a senior fellow at free market neoliberal think-tank the Adam Smith Institute, warned: “There is a scandal brewing in the equity release mortgage sector.
“This scandal is similar in nature to the Equitable Life scandal of nearly two decades ago – involving the under-estimation of opaque long-term guarantees.”
The root of the problems lie in the valuation of ERMs in light of their no-negative equity guarantee (NNEG).
The NNEG stops borrowers from being liable if the price of their property falls below the size of the loan. This in effect creates a short option position for insurers that is hard to quantify, given it involves projecting residential property markets for decades to come, and it depends on morbidity and mortality trends.
One of the main assumptions commonly used by insurers is that house prices will continue to rise at 4% per year. Dowd describes this a “whopper” of an error.
“Instead of using some proxy for forward house prices, which would have been the sensible approach, these firms instead apparently use a projection of future house price growth,” he writes.
“Their modellers appear to have confused forward house prices, which will decline in the typical low-interest-rate case where the net rental yield (the rental rate minus the risk-free rate) is positive, and future house prices, bearing in mind that house prices have tended to rise in recent years, even though their future growth is always uncertain.”
He adds: “I am not aware of a single firm that has demonstrated that it is valuing its NNEGs using a defensible valuation methodology.”
The UK Prudential Regulation Authority (PRA) last month launched a consultation paper on ERMs, which attempts to address many of Dowd’s concerns. InsuranceERM describes the impact of the paper in a feature also published today.
Dowd also lambasts the UK parliament’s Treasury Committee for bending to the will of industry lobbying.
In a BBC story on the report, John Mann, MP for Bassetlaw and vice chair of the Treasury Committee, said: “We need to hold a new hearing, a new session, to go into the issue.”
He added: “I think some financial institutions have pushed the boat out too far with this, and that creates a potential systemic risk.”
The BBC also quotes Dean Buckner, a former senior technical specialist at the PRA who retired in May. He said progress at his former employer in fixing these loans had been slow. Part of that may be the nature of the regulator and the many roles it must fulfil.
“The regulator is there both to protect firms and to protect the general public,” he said.
“The Bank of England has part of its mission statement to protect the good of the people or something like that. I think it’s a horrible failure of regulation and I’m very sorry about that.”
The Bank of England and PRA declined to comment.