ILS FOR REGULATORS AND RISK MANAGERS

RISK MANAGERS AND REGULATORS OF ALL KINDS SHOULD READ ALL OF THE PREVIOUS PAGES FIRST.

The higher the marginal (true) rate of interest goes, (The marginal rate above Average Earnings / Incomes Growth (AEG% p.a.  - see the GLOSSARY), the less space there is for lending as much. That is because when the marginal rate of interest is zero with the interest exactly equal to The rate at which incomes / earnings are rising, AEG% p.a., the amount or wealth (income multiple) that is lent is exactly equal to the amount of wealth Income multiple) that gets repaid. 

FIG 1 Zero True Interest at Nominal 5% Interest

Check the bottom line in each FIG - i year's income is borrowed and 1 year's income is repaid but the money cost is 5% more than was borrowed.

FIG 2 As in FIG 1 but over 3 years

Add up the % figures in the final column. The total is 1 year's income or 100% as before.

But for every 1% more marginal interest, it costs the borrower more wealth (more years of income) to repay the mortgage.

FIG 3 - The debt is repaid after 1 year out of increased income at 3% true interest

The loan was 3 years' income but 3% true interest increased the amount of income needed to repay by 3% x 3 Years' Income making a net cost of 9% of a year's income to repay the debt.

This is the kind of arithmetic that risk managers and regulators need to understand.

Since interest rates always revert to mean value, at least true interest rates do, it is not safe to lend more just because interest rates are lower. Regulators and risk managers need to attend classes in the mathematics of lending.

The outcome will be that property price bubbles will not develop when interest rates are low, but mortgages will get slightly bigger - not much, and they will get cheaper and repaid sooner or more easily.

AND the arrears risk usually linked to interest rate increases will almost vanish. Since collateral will not crash, deposits can reduce and the BASEL Committee can get back to their desks because some of their problems will have gone away.

FACT: People only have so much income that they can devote to repaying a mortgage over a 25 year period.

FACT: Interest rates vary, but the true rate of interest cannot rise too high nor fall too low and stay very high or stay very low because if they rise very high then lending will be more profitable than any other kind of investment and few people will be able to afford to borrow. If they stay very low for very long inflation will take off.

The mid-range rate (or the undistorted and sustainable rate) of true interest appears to be below the rate of return from equities and above zero. For the UK and the USA it appears to be around 3% on average. See the page on finding the mid-cycle rate of interest.

SO: to ensure that the borrowers can always afford to borrow, and that they can always afford the repayments using variable rate mortgages, of whatever kind, ILS or any other kind, the entry cost (the cost of the initial payments) must be set at a level that can cope with this rate of true interest.

HERE IS WHAT HAPPENS IF YOU IGNORE THIS RULE
You lend too much and then interest rates rise to the mid-cycle rate and stay there on average for the remaining repayments period.

It does not matter what kind of mortgage model you use, if you lend too much, the total cost of the mortgage will rise, and as it rises, even if your mortgage payments are not jumping up through the roof initially, the best that you can hope for is that the downwards slope shown (Repayments Depreciation rate relative to incomes) will get more level and less downwards. Eventually, it gets totally level - at best.

Source: Edward C D Ingram Spreadsheets showing how a typical 3.5 years' income ILS Mortgage would turn out at 3% true interest rate up to 5% true interest rate. At 5% payments fall behind the index at only 2% p.a. as shown. But the rate of return is higher than is obtainable from USA or UK equities over the long term. So it is not sustainable.

For a 4% p.a. rate of easement in the payments as described in the first section hereof (ILS FOR BORROWERS), the entry cost should be around 8.5% p.a. of the mortgage, payable in twelve monthly installments.

This will produce a mortgage size of 3.5 times the borrower’s income. In the UK that is what a house used to cost on average in the past – 3.5 times average incomes, according to the latest (July 2012) IMF Country Report for the UK, recently issued.

Exactly the same figures for everything just given also apply to the current Level Payments (LP) Mortgages that are mostly used: 3.5 times income with easement of 4% p.a. but only if average incomes are rising at 4% p.a. and interest rates are 3% higher, as is / was the norm. Refer once more the the page entitled 'Finding the Mid-Cycle Rate of Interest'.

When interest rates drop lower, the LP Mortgage size gets inflated. When a new loan reaches 5.2 times income, a true interest rate of 1% p.a., and a 2% p.a. rate of easement in the payments *the downwards slope in the bar charts) will repay the loan, but that low level of true interest is not sustainable. This makes it  difficult to rescue a lender and a borrower when that amount of income (wealth) is lent for home purchase. What happens with a traditional LP mortgage in these circumstances, when the interest rate returns to the norm or mid-range, is that as the interest rate is raised, new mortgage sizes plummet and monthly payments rocket. We all know where that leads.

For an ILS MORTGAGE, the consequence of lending too much could be that the easement in payments would reduce to zero – it would be like paying a standard rental, with payments rising as fast as average incomes every year. Not everyone could manage that. For a traditional mortgage which over-lent when the interest rate was low, this can be total disaster.