LESSON 4 - and ECONOMIC RECOVERY PLAN

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MANAGING INTEREST RATE RISK

FIG 4.1 The sensitivity of monthly / yearly total payments to the nominal rate of interest.

The Mortgage Size / Income Ratio is proportionately and inversely sensitive.

Source: Edward C D Ingram Spreadsheets.

PAYMENTS DEPRECIATION

The normal expectation when a person takes out a Mortgage is that it will cost as much as can be afforded in the first year, somewhere around 30% of income for most people; but over time they expect the payments will be eroded by the fact that incomes generally rise most of the time. There are reasons for these two issues:

1. Houses are expensive. Good houses are very expensive. People compete for Mortgage Funds and borrow as much as they can afford.

2. People expect their incomes to rise over time. This makes the almost unbearably high early cost gradually more affordable - IF interest rates do not jump up the payments and IF the economy does not go into recession or austerity mode.

The problem is that THE RATE OF PAYMENTS DEPRECIATION is not managed by the lender.

When incomes start falling or rising less quickly than expected the cost of a fixed interest rate mortgage rises. 

When incomes start rising faster than expected, the fixed interest rate impoverishes the savings available for lending.

Anything unexpected is a problem.

And even with fixed interest rate mortgages, whereby new loans are enlarged or reduced  there is an unwanted effect on property values which is greater than any price change in almost any other sector of the economy except equities which are supposed to absorb risk.

For variable interest rates this is compounded by the way that current monthly payments can rise and fall as shown in FIG 4.1 above.

FIG 4.2 This FIG shows how payments and risk can both escalate out of control when using the current variable interest rate mortgage model.

The jump to the right illustrated here was the same as that which was produced when the Bank of England raised interest rates by 1.25% in circa 2005/6. AEG% p.a. was around 4% p.a. and the jump in payments was over three times that at around 15%, or more than three years' AEG% p.a. as shown.

This caused the Bank of England to retract the full increase in the interest rate as it was slowing economic growth. We are still facing this rapid cost escalation problem today and it creates a Low Inflation Trap.

The trap is that interest rates fall when inflation is low and the cost escalation is faster when interest rates rise. This can cause a banking crisis and a recession or a depression as the USA found out in 2008, and if the Central Bank retracts and reduces the interest rate slightly to prevent a major problem, then inflation gets out of control, or goes above the prescribed limit as the Bank of England found out in 2004/5.

FIG 4.2 is an illustration of how things interact. There is no known or fixed curve slope. 

What we do know is that the sensitivity of the payments when they are confined to the Y-Axis is far too great to provide us with a safe lending model. It creates this dynamic gearing to the cost of mortgage payments.

In fact, staying on the Y-axis prevents the correct pricing of the monthly repayments which would otherwise enable a balance to be found between the supply and the demand for funds.

SOLVING THE PROBLEM

DEFINITION

Payments Depreciation, D%.

D% = AEG% - e% - 4(i) Definition.

FIG 4.3 - Showing where D% fits on the Chart

When you place an 'X' on the Risk Management Chart to the left of the AEG% p.a. line, D% is the distance of your 'X' from the AEG% line.

THE KEY TO SUCCESS

The following statements are those which the remainder of the mathematics and the data and experimental testing are designed to prove can be achieved.

If borrowers are to be comfortable with their payments, we need that distance 'D%' to be always positive, or should that not be possible all of the time, then it needs to be true most of the time.

The mathematics continues in LESSON 5