The recent PRA consultation paper as part of Solvency II throws the spotlight on how holders of mortgage assets monitor and value long term risk in equity release mortgages [‘ERM’].
The previous consultation set out a test for firms to measure the risks in the form of an Effective Value Test [‘EVT’] and this reflects the fact that ERMs are very different risks to other assets:
• A typical ERM is a loan to a person aged 60-80 and is initially for 25-50% of the LTV of their home
• Most do not include payment of interest, with interest accruing over time, increasing the debt
• The loan is repaid from the proceeds of the house sale when the borrower dies or moves into long-term care and
• Lenders offer guarantees that the loan cannot exceed the value of the house, called a ‘no negative equity guarantee’ [‘NNEG’]
Whilst the product sales market tends to focus on conduct risks, it is the longer-term prudential risk of NNEGs that are highlighted by the recent paper. Various commentators have already referred to this issue as “a scandal brewing” and a “ticking time bomb”.
Where firms have recently entered the market and/or are just beginning to grow their portfolios, the NNEG risk on maturity may be decades away and such firms can probably ride out property market adjustments, provided long-term house price inflation reflects past performance. However, that long period to maturity compounds several issues that influence risk:
• Interest rates (higher is riskier)
• LTV ratio (higher is riskier)
• HPI (lower is riskier)
• Borrower’s age (younger is riskier)
The PRA wants to assess how equity release providers assess their liabilities by way of the Effective Value Test and that could require lenders to hold more capital and result in more regular reviews of the parameters lenders and insurers use to oversee their loan books.
We are often asked our opinion on ERM portfolio valuations and what constitutes best practice and we regularly help lenders and holders of portfolios understand the risks and performance of their assets.
Give us a call, we will be happy to discuss the consultation paper and share our experiences to aid firms with comprehensive responses.