Narrative anchoring is always a dangerous trait and I must admit that in the last few months I’ve become progressively more cautious about stock markets. Which is possibly why I’m always on the lookout for signals of impending trouble – safely confirming my own internal narrative. Today, for instance, brought news that the Chinese are threatening to look again at how Apple is taking the local market by storm. There are undefined calls for the trillion dollar business to “share” in some of its gains. Investor’s really can’t be surprised that the Chinese are going to play dirty if President Trump sets such a bad example.

Yesterday, by contrast, brought a rather more concerning story about equity release schemes in a paper by Prof Kevin Down at Durham – you can see the Adam Smith Institute paper HERE

I’ve pasted in the short summary of the research below. I have to say that I’ve always been a big proponent of equity release if only because it seems the only sensible way of unlocking capital for older investors here in the UK. Sensibly designed it can be incredibly useful. But the design, of course, is always the problem especially when financial services businesses offer ‘guarantees’. The worry for Prof Dowd is that the guarantees against debts exceeding the value of the house are unsustainable. His worry is that within the options pricing models built into these schemes is an implicit assumption that house prices will keep increasing. Longevity, by contrast, is largely assumed to stay stable, which might not be unreasonable assumption given government numbers released over the last few days which suggested that the longevity bonus is fading in the UK. Clearly, the good professor is on to something – I think it is a dangerous assumption that we can keep increasing house prices. Yet I also think that a big fall in house prices is unlikely, though not impossible. But what I guess and what goes into an actuarial analysis are two very different things. Insurers need to prepare for the worst and if these guarantees are not worth the paper they are written we have another Equitable Life on our hands.

But having read through the report another worry appears. Dowd quite rightly suggests that another major problem is that equity release products are essentially illiquid assets. He also namechecks infrastructure assets which are also essentially illiquid. This is an important warning. One of the reasons that many yield-based assets have been chased is that they are in demand from big institutions desperate for a yield above 5%. I’ve always found this slightly alarming. As an adventurous type, I’ve always liked infra assets and other illiquids but that’s because I think they are still risky. The language from big insurers and pension funds are that they also like illiquidity because in effect these assets are safe – in the long term. I’m not so sure those assumptions are valid especially if the regulators turn around and reclassify many illiquids as risky. We could then see a big sell-off.

Back on the broader picture, this is yet another warning that many of the assumptions that have anchored markets for the last decade may be called into question moving forward. Slowly we begin to see the deep plate tectonics of modern finance start to shift as we enter a new rates regime. Some of these risks will never materialise but what should alarm investors is that volatility might explode – especially as current levels for the Vix, Vstoxx and VFTSE are back at record low levels.

So, against this backdrop, I’ve been profit taking. I’ve sold another chunk of mainstream equity positions yesterday including closing down my position in Enquest retail bonds – which have had a great run since I bought them a few years back. I retain my position in Premier Oil bonds. Overall I’m now running at 20% cash and may increase that even more over the next few months, possibly hitting 30%. I’ve also got a reasonable slug of bonds and other alternatives in my portfolios which means I’ll probably end up pushing below 50% for equities overall by the mid-autumnn. On a side note, I observe that recent numbers from RIT CP investment trust put their net equity position at 45% (excluding a big chunk of private assets).

Summary of Adam Smith paper on Equity release

Professor of finance and economics at the University of Durham, Kevin Dowd, takes a critical look at the Equity Release Mortgage sector and finds something really quite worrying:

  • 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 – it involves the underestimation of opaque long-term guarantees – but on a larger scale.
  • The guarantees at the heart of this problem are the No-Negative Equity Guarantees issued by lenders in the Equity Release market. These guarantee that the maximum repayment on Equity Release loans can be no greater than the property price at the time of repayment.
  • This under-valuation problem is a ticking time bomb that could do serious damage to the financial health of the Equity Release sector.
  • The regulator, the Prudential Regulation Authority, has made half-hearted efforts to address this under-valuation problem, but has for years failed to rein in firms that used inadequate valuation methods for their No Negative Equity Guarantees.
  • A recent Treasury Committee investigation into the UK life industry missed these problems and unwisely set up the Equity Release sector as a poster child to be promoted.
  • This Equity Release guarantee scandal raises far-reaching questions not just about the Equity Release sector, but also about the PRA’s supervision of it.