A comprehensive round-up of some of Mr Ingram's work (of IngramSure (UK) Ltd) on investigating the instability and risk that is built into the foundations of the world's economies. Edward thinks that this is where Risk Managers need to assert themselves by getting involved in the design of the products that they are risk managing.
BORIS - Edward you have been telling me and much of the world on your blogs about your researches.
It seems that your approach to risk management is somewhat unique. Can you tell us about that?
Edward – Yes Boris it is very different because I am not employed to manage risk. I am free to say, “This is not something that we should be managing the risk of.”
BORIS – Can you give an example of that?
Edward – Yes the prime example of something that is not correctly structured is mortgage finance. The way it is repaid is just asking for trouble and the way it decides how much should be lent / is costed is asking for trouble.
The fact is that mortgage finance and property price values and the budgets of borrowers are all at risk.
BORIS – Yes you have explained that before and I have to agree that risk managers frequently say that interest rate risk is virtually impossible to manage. You once told me that it has even been said that adding reserves to the lenders’ bank balances will not work “Because the waves are bigger than the ship.”
But before you go into that, can you name anything else that is creating insuperable problems for risk managers?
Edward – Government debt is another one which is important because it is so big. And on the opposite side of that government borrowing are investors who are trying desperately to create a retirement plan which does not put their hard earned investments at risk.
BORIS – What you are saying is that there are no investments out there that are AAA rated to protect the investments that people are putting aside for their retirement. Is that right?
Edward – That is absolutely right.
It is all sourced basically from the one common thread that we have put close to our hearts and around which we have constructed almost everything financial.
“What is that?” I hear you asking.
Let me put it this way – I think I am right when I say that for most people, interest and capital are two different things - right?
If you take away the interest what you are left with is the capital. This is a commonly accepted theorem or definition of interest and capital.
But then everyone also knows that money is constantly changing its value. Where does that fit in? It is not fully recognised by any of the financial structures that are on offer. And it is that inbuilt kind of structure, that insistence that all of the interest must be paid on a mortgage or a government bond, which makes the whole foundation upon which our economies are built, unsafe and unstable.
So the outcome is that we have nothing that is safe either in terms of its investment value or in terms of a safe budget that repays a safely affordable amount of value so that the borrower is not put at risk of default by the lender.
BORIS – What about index-linked investments and mortgages?
Edward – In principle this is a much better idea but there are some objections.
One is that the public are not educated into them, so to overcome that one I have created a hybrid mortgage in which it appears to be and starts out as the usual level payments thing, but if the interest rate rises then the borrower has a safety net which in effect turns the mortgage into a rent-to-buy model with the payments rising less quickly than incomes. This ongoing easement in the cost of payments has the effect of preventing what is called Payments Fatigue and it helps to keep all of the borrowers on board because not everyone’s income rises as fast as the average - at least not all the time. Most incomes rise faster at times and slower at other times. It may also be argued that younger people may be on a promotion path, leaving older borrowers income increases lagging behind the average.
So for various reasons the lender has to take care about what index is used for this exercise. Defining the average has its own issues. If in doubt, use the national average index but make sure that the payments fall away fairly fast relative to that index. I think that around 4% p.a. will do the trick. This means that every three years the cost burden in value or average income terms eases by almost 12%. It means that if incomes are standing still payments will be falling every year by 4% p.a. It means that you have to repay more value at first and less later on. I have been asked to illustrate that which I have now done in FIG 0 below.
FIG 0 – 3.55 times income (near mid-range) mortgage repayment table with zero income increases, and falling payments.
Source: Edward C D Ingram Spreadsheets.
The total amount of income repaid in this table for this 3.55 times income mortgage, if you add up all of the ‘% of income’ data is around 35.2% more than was borrowed at 4.8 years' income, which is about the normal additional cost-to-income based on average rates for the UK 1970 – 2002.
This model even works when incomes are falling. As long as interest rates are lower or mortgages are smaller, the payments will fall even faster in that case.
In the same conditions, (3% interest and zero income increases), the Level Payments Model would lend the same amount on an income of 19,143 p.a. compared to this ILS mortgage needing 28,185 p.a. That amounts to lending 5.2 years’ income (inflating property prices because all income groups can borrow more). The traditional model will cost 30% of income p.a. every year for 25 years, if incomes are not rising, a total cost of 7.5 years' income. The IMF July 2012 UK Country Report estimates that UK House Prices are normally 3.5 times income on average, based on past data, and currently they are 4.5 times income on average due to lowered interest rates.
BORIS – That kind of thinking rather puts use of the prices index outside the realm of mortgage finance.
Edward – Yes it does. In fact all of the experiments done by lenders using the prices index have fallen into the dustbin of history. The nearest anyone has got to my mortgage model as far as I know, is in Turkey where they have a model that increases the payments at the same rate as the wages index of Civil Servants. The mortgages are then offered to Civil Servants. I understand it is not popular. I am sure that must be because it creates Payments Fatigue. The advantage, which also applies to my mortgage model by the way, is that more can be lent at high interest and inflation rates.
If you ignore some of the more practical issues that can arise, in theory, my model can lend the same amount in any economy, provided that... quite a long list of things are well managed.
BORIS – How does the risk management work? You say it should not only eliminate most of the arrears cases but it also stabilises property values.
Edward – I have developed some equations and a chart for risk management which are named after myself – Ingram’s Risk Management Charts. There is the related Safe Entry Cost Equation, which is really just an equation that breaks down the state of any kind of mortgage or other regular payments debt structure into three elements which added together make up the current level of payments. They are the current capital payment element, the current rate of easement of the payments cost relative to income, called the rate of Payments Depreciation, and the current rate at which value is being added to the mortgage. I will come back to this later.
I am also preparing a follow-on paper for this discussion which I would like readers to see when it is ready.
TRAINING RISK MANAGERS AND PRODUCT DESIGNERS
In fact much of that has already been done in much greater details in LESSONS 3 to 8 at:
http://ingram-school.blogspot.com, but it needs to be done more professionally sometime. I am also creating a new, hopefully better written version of all that to be sold with an interactive spreadsheet so that every kind of test imaginable can be done on the various mortgage models by risk managers and product designers world-wide.
What the equation shows is that if you start with too large a mortgage you then find that you are charging too little in entry cost (the early monthly payments) because the borrowers usually cannot afford to pay more for a larger mortgage. This means that you, the lender, are at huge risk of arrears and default when interest rates rise. Later on, the interest rate and the payments rise because they have to. The mortgage you started with was too big because interest rates were too low to stay low. Interest rates always revert to mean, just like share prices and P/Es tend to do.
STABILISING PROPERTY VALUES AS RISK MANAGERS TAKE OVER
The outcome if all lenders over-lend in this way, is that property values get pushed sky high and when interest rates revert to mean, the collateral security has gone and the arrears jump through the roof. You don’t need any sub-prime idiocy to make that happen.
So the amount that it is safe to lend does not enlarge a lot if interest rates fall, and vice versa, it does not reduce a lot if interest rates rise above the mean value. What counts for affordability is the income multiple originally lent and the longer term averages for interest rates relative to incomes growth rate. This approach to risk management should make property values much more stable and it should preserve the collateral security that is needed.
BORIS – You gave an example of what happened in America – the Fed tried to raise what had been 3.5% interest up past the mean to around the 8% mark at which point the inference was that mortgage payments would cost over 50% more.
Edward –That is correct, and that is why property prices came tumbling down. It was not just because of forced sales and sub prime.
BORIS – On that basis are not property prices still over-valued?
Edward – Yes I believe they are. When QE finishes and interest rates have to rise, there will be a repeat of the same dilemma. In fact many people are strongly opposed to QE because it is robbing the elderly of their wealth and it may be robbing lenders of some future lending capacity. Certainly it is distorting the economy, for which there is always a price to pay.
THE PROBLEMS FOR ECONOMIC RECOVERY
BORIS – You said that there is a solution to this dilemma - a way to keep property values high even as interest rates return to normal, which means that QE may be not necessary. Please tell us about it.
Edward – Basically my risk management chart shows that only if you stick to the middle ground of mortgage sizes and entry costs can you manage the interest rate risk and the payments fatigue.
As I said earlier, the Safe Entry Cost Equation (the one that gives a breakdown into component parts of any current level of payments including the proposed entry cost), says that any regular mortgage / debt repayment level has three basic elements as follows:
- The current Capital Repayment content C% p.a.
- The current Mortgage Fatigue avoidance element called Payments Depreciation (relative to incomes), D% p.a.
- The current True Cost element which is the part of the interest rate that makes a borrower have to repay more value than the value that was borrowed, I% p.a.
Just add these together and you get the current level of Payments, P% p.a. of the amount borrowed.
P% = C% + D% + I% (all p.a.)
This equation applies to ALL mortgage repayment models. They only differ in how they manage the elements - the Payments Depreciation D% , and the Capital Repayment Content C%. How these components are allowed or forced to behave by the particular mortgage repayments model determines how the total repayments behave at any given time and how safe from arrears they will be.
If you stick close to the middle ground in mortgage sizes (income multiples) you can probably lend around 3.5 years’ income repayable over 25 years in the UK. In the USA they go for 30 years but that is a bit more risky in my opinion, so I stick with 25 years.
The rate of easement – the Payments Depreciation, D% p.a. - can then be around 4% p.a. or a fraction more if the third element in the Safe Entry Cost Equation, I%, is currently low – below what I think is the average, or median, level.
Now in order to support the kind of property values that are around today, many lenders are offering mortgages as much as five times income. QE is being used to keep the interest rate low for this reason – to support the collateral security of lenders and to boost the confidence of borrowers and home owners. It is claimed that this helps with economic recovery, which in the short term is true. But there is no clear plan about what to do when QE ceases and interest rates have to rise.
My equations and spreadsheets shows that this support for property values can be done by lending the same amount, around five times income, even as interest rates are rising towards the median rate of interest of say 7% interest if Payments Depreciation, D% p.a., then falls towards 2% p.a. That is stretching things a bit and is not for the longer term. Some borrowers will get stressed but they will not all crash out at the same time and they may move on before their arrears grow much and their property value may be still safe. And the mortgage money sizes will not actually start rising at these rates. So borrowers may want to opt for this route as interest rates rise.
But it does mean that if Lenders / Risk Managers are directed to lend this much, then property prices can stay high to protect those assets and balance sheets, whilst incomes do the catching up to reduce that five times income multiple back to the norm of say 3.5 times income, as the economy recovers. This removes one distortion at least - that of low interest rates caused by QE (or any other intervention measures), and both borrowers and bankers will survive the recovery which the current alternative plan using the traditional mortgages, may not do so easily.
BORIS – Thank you Edward. I am sure that your full paper on this will be absolutely fascinating. It appears that you have shown that if the risk management is done correctly then property values will stabilise and that going forward to a new era after economic recovery, mortgages will almost always be affordable for almost everyone with an ongoing income.
GOVERNMENT BONDS TOO
I understand that you wanted to tell us about a similar and very costly misunderstanding involving government debt. You told me that investors in government debt have been reaping very high returns that have cost tax payers huge amounts in terms of value, and that this is largely due to the wealth risk exposure that the fixed interest rate model imposes. Unfortunately we have run out of time, but maybe another time we can go into that.
Edward – Yes Boris it is a great shame because if a value-protecting, index-linked bond structure was used, linking the value of bonds to national average incomes, or to GDP even, then that would revolutionise retirement planning. Then, all kinds of other things that are troubling the governments of the world would come right. From the data I have seen it could also save tax payers a great deal of money. Some of the most costly things that both people and an economy can face is insecure wealth and uncertain costs. I can show that the outcome of these instabilities is enlarged business cycles in place of relatively shallow ones, and lots of personal financial problems at every level. I believe that the instability of government debt value also considerably complicates and worsens austerity measures when they have to be applied.
BORIS – I understand that you are preparing another paper to illustrate and explain more of all this. Please let us know when and where we can see that. Thank you for being with us today.
Edward – Yes I will and Thank You, it has been my pleasure.