Abstract
AbstractIf the general level of house prices falls a long way, policymakers may introduce new policies which seek to support prices. This paper considers the effect of such interventions on the valuation of no-negative-equity guarantees (NNEG) in equity release mortgages. I model interventions by a reflecting barrier expressed as a fraction of the current level of house prices. Reflection at the barrier is instantaneous, so the no-arbitrage property is preserved, and hence risk-neutral valuation of NNEG is possible. The reflecting barrier can alternatively be justified as a representation of the different economic nature of the underlying housing (and particularly freehold land) assets in NNEG valuations, compared with the underlying equity assets in many other option valuations.
Highlights
1.1 Motivation In 2018, I published a blog post on the valuation of no-negative-equity guarantees (NNEG) in equity release mortgages, which included the following passage:[A] deep and prolonged fall in house prices, with the attendant collapse in mortgage lending, widespread repossessions and distress in the electorate, seems overwhelmingly likely to induce a policymaker response
Stated differently: much of the Black–Scholes value of NNEG may derive not from poor scenarios where house prices merely stagnate or fall, but from extreme scenarios where they fall by 50% or more over the term of the NNEG
If we expect policymakers to intervene in this type of scenario with attempts to support house prices, valuations of NNEG made without consideration of policymaker actions may be overstated
Summary
1.1 Motivation In 2018, I published a blog post on the valuation of no-negative-equity guarantees (NNEG) in equity release mortgages, which included the following passage:. Since several papers and notes on equity release mortgages and NNEG in the specific United Kingdom and Ireland context have been published (e.g. Tunaru & Quaye, 2019; Jeffery & Smith, 2019; Buckner & Dowd, 2019; Dowd et al, 2019; Turnbull, 2019a, 2019b, 2019c). As far as I am aware, no published work has considered the effect of future policymaker interventions on house prices and valuation of NNEG. This paper models such interventions by means of a lower reflecting barrier under house prices, expressed as a fraction of the level of prices today. If we expect policymakers to intervene in this type of scenario with attempts to support house prices, valuations of NNEG made without consideration of policymaker actions may be overstated
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