LESSON 5 ANNEXE

ILLUSTRATING THE PROPOSED NEW ILS MODEL FOR MORTGAGES

The Ingram Lending and Savings (ILS) Model for mortgages

A lot of illustrations can be very helpful, but nothing can replace having the interactive spreadsheets and conducting your own experiments. The spreadsheets on offer make automated comparisons between the ILS Model and the LP Model on a year by year basis, and they provide a set of 10 bar charts as well as the spreadsheets for each mortgage model to illustrate the findings.

Another spreadsheet has been created to enable lenders to examine the implications for cash flows and profits of variations in the following variables:

AEG% p.a., two taxation regimes (AEG% interest is tax free or is not), the tax rate on deposits, on profits, and on investments made by the lender, the true interest rate, and the nominal interest rate, and the rate of early redemptions in each year, among other things.

A set of six illustrations with various different bar charts can be seen at the end of this page (click link), where some data was invented to simulate 2008 in the USA and how the crisis could have been minimised despite the 4 to 4.5% increase in the interest rate.

WHAT THE SPREADSHEETS SHOW

This could be a very long page or several pages. For now, this is just a start.

Rather than showing the actual output from those spreadsheets this first section offers simplified sketches and explanations:

SKETCH 1

This is just a rectangle, 30% of income in height and 25 years in width.

If a borrower was to pay 30% of income every year for 25 years this would cost 7.5 years' income.

Lenders have to work within this rectangle if they are to have little or no arrears.

SKETCH 2

The shaded area is always the same as the total cost to income.

Mathematically if one draws a column for each year equal in size to the % of income paid, then all of the columns standing one above the other will give the total. When standing side by side the area is the total.

SKETCH 3

This is how payments reduce very fast for a fixed interest level payments model when AEG% p.a. is high.

Remember that D% p.a. = AEG% p.a. with this model. That high level of D% and the lack of control over D% is a major defect in the model.

Very little wealth will be repaid by this model in these conditions and so very little can be lent. This will not sustain a healthy property sector

SKETCH 4

This time AEG% has gone negative. We are in Europe and incomes are falling. But the LP model using a fixed rate of interest or a variable rate that cannot get any lower, is being used.

The result is catastrophic.

A similar result has befallen their governments because of using fixed interest bonds, with the result that they cannot repay until the economy recovers and government revenues rise. Meantime, lenders get nervous and raise the interest rate higher, making the situation more fragile still. A vicious spiral.

SKETCH 5

This is about what can happen to a variable rate mortgage using the LP model. It is called Level Payments but it isn't.

Lenders discovered that when the interest rate was supposed to revert to mean or more (around 7% to 8% - see Finding the Mid-Cycle Interest Rate), the payments of 30 year adjustable mortgages were set to increase by 58%.

Lenders have also found both in the UK and the USA that borrowers had used their credit cards and were not able to increase their repayments.

CONCLUSION - Avoid rising '% of income' in the repayments model. Use the ILS model. Ensure that there is a steady average downwards slope to the repayments.

Remember the equation:

P% = C% + D% + I% - leaving P% and C% to follow their natural paths, when I% rises, D% (the slope) gets shallower. That is only if you have control. If you have Level Payments then D% varies with AEG%. You have no control.

THE ILS MODEL
In order to ensure that this can be done, that D% will be generally positive, and that the repayments will fit into the rectangle, then the mid-cycle true interest rate has to be considered and the amount of wealth lent has to be considered. Taking the two together, you find the amount of wealth that has to be repaid. Does it fit inside the rectangle? At what D% p.a.? How many borrowers are you catering for - all or 95% or 40%? D% gives you the figure for the drop-out rate after some homework. Those that cannot keep pace drop out as costs rise out of reach. Just like in rented property. There is no catastrophic jump in mortgage repayment costs taking everyone down together. Property prices will be stable. If D% is high like 4% p.a. the arrears rate will be negligible.

Answer all of those questions and you have to limit the amount of wealth (income) that is lent no matter where you are in the business cycle at the time.

Do that and you can lend 100% mortgages with reasonable collateral  security. And the construction sector can get properly organised knowing that prices property are stable. They can plan. The economy will prosper. Lenders will  have more clients, and wealthier ones.

SKETCH 6

The entry cost is set correctly and does not follow nominal interest rates down. It is stable over the business cycle.

It is assumed that the true interest rate will average something close to its usual figure (for the particular economy) over the repayment period and so it is known approximately how much wealth will have to be repaid.

That is the shaded area.

The shaded area has a slope defined by D% p.a. the rate of Payments Depreciation. At 4% p.a. if that is maintained, this will mean that a person who pays a constant 21% of income in rentals will be paying more than the ILS borrower somewhat before the mid-term point of 12.5 years as a general rule.

SALES AID

This rental comparison method is a valuable sales aid because rentals respond to aggregate incomes and / or average incomes and so to say that it would prove to be more expensive to rent after say 12 years, is something that is mathematically consistent and is something that people can relate to.

Whereas if you get into the argument of how a person's income will change over the period you can get lost very fast.

The nice thing about this sketch is that it does not alter even if AEG% p.a. is negative. See SKETCHES 1 to 4 above for a comparison with the LP model. Whereas, you never know what the LP model will do to your borrowing costs nor to the value of the lender's repayment revenues as AEG% p.a. varies. Nor do you know whether you will  be able to raise enough funds to meet the cash outflows.

The ILS Model solves the arrears rate and interest rate risk problems and the cash flow problem. Market forces will ensure that the true rate of interest stays positive most of the time, maybe all of the time when the economy is working better. So the savings accounts and the income of savers will be looked after, growing with some linkage to AEG% p.a. The lending industry should become stable and sustainably stable.

SKETCH 6

Here the slope (D% p.a.) is shown with 5 different values from zero (horizontal) to 4% p.a. It could show slopes of 5% ,6%, and more p.a. if the true rate of interest was very low.

The difference in slope is the due to different values of D%.

Let us suppose that the lender can raise funds at a fixed I% p.a. rate and then lends at a higher fixed I% p.a. rate for a similar number of years, after which new rates are set. 

Suppose that the first rate is continued for the full repayment period. This is called a Defined Cost ILS Mortgage. The slope is pre-defined and the area (cost-to-income / wealth as measured in National Average Units - say NAE - see GLOSSARY) is pre-defined. So the total cost is pre-defined. So are the benefits to the lender which can be shared with the investor that provided the funds.

The full ILS Model may not be the best place to start. See the HYBRID and RENT-TO-Buy variants, below.

As just stated, average people may not understand NAE and units of wealth; they may be happy with the rental comparison as long as they understand that the new way of lending has come to stay for the good health of everyone and the economy;  but institutional fund managers will understand AEG% p.a. and NAE, and they can be enticed into buying into this mortgage model if the contract is well drafted. There are several ways to do that.

But that is not where to start. First we need to read up on the IMPLEMENTATION agenda. That Agenda is a part of the syllabus that has been drafted for a government or international commission of enquiry, which, after the introduction, occupies 10 pages. Implementation has to be managed from the top, but the top, the commission, will include representatives from all sectors of the financial services sector and Edward, just like the previous, voluntary and unpaid, commission of enquiry did.

ILS VARIANTS

VARIABLE AND ADJUSTABLE RATE ILS
The defined rate of true interest and D% p.a. may not last the full term and then the slope can vary with each new true rate that is negotiated by the lender, as between investors and borrowers, to  balance supply with demand. It does not alter the amount of wealth that will be offered very much UNLESS the slope gets too shallow for comfort and the lender decides to lend less. The risk of lending less is that property values can fall. But it may be necessary. The alternative of lending longer is much too expensive in the writer's opinion. It has social consequences, mopping up too much of life's income and thrusting it into property rather than into pensions, schooling, food and other essentials.

A table of figures will be added here to illustrate the point.

A fully variable rate of true interest will mean that the slope, D% p.a. varies as already discussed.

THE ILS HYBRID

The ILS Hybrid Mortgage model starts with the LP regime and the borrower feels comfortable with the familiarity of that. But in case the payments start rising  towards an unaffordable level or if incomes start falling, the lender can switch the borrower to the ILS slope. This assumes that too much has not been lent so that there is a slope to offer.

RENT-TO-BUY

The result of switching to the ILS model might sometimes be a rising year end money debt / balance. The lender can offer an HP (Hire and Purchase) or a rent-to-buy option to hide the debt. The maths goes on as before and the debt gets repaid on schedule. Moving house presents a problem for the contract drafting, but the maths is the same. Moving house should not present a problem.

OTHER ISSUES
There is work to be done addressing or changing the legal and taxation framework. This can be done in collaboration with the relevant authorities. Hence the need for a commission of enquiry or a powerful alternative. Edward is available to guide the process.

To be continued in ANNEXE 2. Keep visiting.