ILS FOR THE FINANCIAL SERVICES AUTHORITY (FSA)

It is assumed that the reader is by now familiar with the meaning of wealth as defined here and of true interest, true cost, and true value. There is a Glossary page if needed as a reminder.

When regulating the quotations and presentation of mortgages, you good people at the FSA should not devote so much attention to insisting on comparisons based on APR or on interest rates; and you should avoid making comparisons in overall money cost terms or in real cost terms. none of these things tell the borrower what their mortgage might actually cost. An educational series should be mounted to explain .to the media and the people what true costs and wealth costs are. Read the earlier pages (all of them) and then read on...

You should ask the lenders to project the amount of wealth that the mortgage will cost the borrower – how much income will be taken from them in repayments if their income keeps pace with the AEG index. It will cost more if their incomes fall behind, but no one can say whose income will be left behind or by how much. This is a fact, no matter what kind of mortgage people use - it always costs more if you have less income.

When I produce bar charts showing the '% of income' taken from borrowers every year and compare any two different systems the bar heights assume we are discussing an average borrower on average rising income (or falling). The effect on the height of those bars is exactly the same percentage increase for all of the bars in all of the mortgage models on the chart: if one increases by 10% so do all the others. So we can only do projections of cost based on the index or based on a person falling behind the index by a specified amount or rate.

You should ask lenders to agree, or set up a committee to create, an index (IngramSure (UK) Ltd can help with this) which is fair to all participants:. The index should represent the average income of borrowers, which may not be exactly the same as the average income of the nation. But neither should it be too much different,for fear of discouraging investors.

Lenders are obliged to offer quotations with some estimate of the total true cost of a mortgage in a way that enables borrowers to compare the various bids / offers made to them by lenders. The present basis for doing this is not satisfactory. I will give an example to illustrate this shortly.

You should ask lenders to project the total cost to wealth that would be involved in repaying the mortgage both at current rates of true interest and in the event that the true interest rate is 3% p.a. over the whole repayments period. Why? Because that is about the average true rate of interest for mortgages going back over past data and ignoring the pre-crisis data which was neither representative nor sustainable. We can discuss this figure, and possible variants, if you wish. All of this is best understood if classes are set up to teach it. We can offer that.

You should ensure that someone is monitoring what the average true rate of interest might be, since 3% is a historic average and demographics could change this figure, as could other factors, but probably not by very  much. I have a list of factors to be considered. But this is a detail and is not important just now.

When lenders offer too large a mortgage and when they ask for costs up front, both of these will swell the total wealth cost (cost to the borrower's income) that they have to project in their mortgage quotations. A cost paid at the start carries a lot more weight than a cost which comes later, because incomes will have risen later. This kind of projection replaces any real  need for an APR correction,  a feature which some people do not understand anyway. But it would be possible to give a true rate APR figure if you wish.

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An example of what not to do became very clear when I projected the money cost and the true cost of a mortgage in which interest rates and average incomes were rising at 1% p.a. every year, starting at 1% interest and 1% p.a. AEG .

A 100,000 ILS mortgage cost 352,000 to repay, but the total borrowed was 4.84 times income (higher than I recommend as you may have noted above), which was identical to the total cost to income (the true cost) borrowed: also 4.84 times income. The money figures showed a net money cost of 252% and yet the true net cost was zero. The high money  figure was caused by a 25% p.a. rate of decline in the value of money in the final year and similarly high numbers in the run up to the last year..

Interestingly, the ILS payments fell in money terms in the first years, not getting higher than th initial cost until  the seventh year by which time the payments were down to 23% of income; and they fell at 4% p.a. relative to the ‘standard rental (or AEG% p.a.), every year, exactly on schedule in this example.

In contrast, the traditional loan lent 6.61 times income and the payments having started at the same 30% of income rose every year at first as a '% of income', not returning to below 30% until the fourteenth year. The net true cost was also zero, because the total mortgage  payments cost the borrower exactly 6.61 years’ income - again the same as the amount borrowed. This kind of 'magical effect' always occurs in the true rate of interest is zero. That is, if the interest rate r% = AEG% at all times. So although the money costs were very high: both ILS and LP Mortgage models cost nothing in true terms - nothing more than repaying the wealth that had been borrowed.

Here is a bar chart comparing the two mortgage models on the basis of the 'cost to income' year by year, of these mortgages:

This is what an engineer calls a Ramp Test - to find out how a system responds when the input (the interest rate in this case), rises every year at a constant rate. In this example the ILS System was allowed to be over-sized compared to the recommended size but the LP mortgage was as usual far too large at 6.61 times income.

Source: Edward C D Ingram Spreadsheets

Such large LP loans, caused by low interest rates, (it started at 1% p.a.), would inflate property prices forcing everyone to pay and to borrow that kind of huge sum. Then when the true interest rate rose back to the 3% long term average level, the mortgage would become unaffordable. What happened in the USA was that the true rate started at -1% or so and the Fed raised the rate by over 4% to get above the average true rate to slow inflation in other sectors. The mortgage pain was not felt until later because people were on fixed interest rates for three years or more. 

So it is important to evaluate the likely cost at the mid-cycle or average true rate of interest, because eventually almost every borrower will have to be able to afford that at some point along the way.  So the risk managers must keep a close eye on this figure and I suggest that you regulators think about having the lenders do a least one of their main projections based on that cost or an estimate of that cost.

In fact, at 3% true interest rate, that 6.61years' income mortgage would have a projected cost of about 30% more income than the income borrowed, which would be 8.6 years’ income – just for a house which should have cost and maybe later would be worth nearer to 3.5 years’ income. That is what happens when lenders are allowed to inflate property prices by making mortgage payments too small. The key figure to regulate, the figure most related to the measurement of risk, is the entry cost for a mortgage. This is defined as the percentage of the sum borrowed that mist be paid in the first months and year of the mortgage.

A typical 3.5 times income 25 year mortgage at 3% true interest would cost about 4.69 years’ income to repay, using traditional methods and exactly the same figure for an ILS Mortgage in steady mid-cycle conditions. That is based on my definition of the mid-cycle rate. Both systems usually give fairly similar overall figures in developed economies with low inflation rates.