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A safer economy for all

Jan 22 2014 07:07
*Edward Ingram
Escape from QE - Part 2

THIS week readers need to have read a few earlier essays. Each one is fascinating and I provide the links.

Last week I showed how Wealth bonds can create stability in and reduce government debt costs. This will lead to a rise in confidence in bond investments as well as helping to stabilise the economy generally.

The same kind of stability can be created for mortgage and business finance as previously explained in my essays on Safe alternatives and Better business finance.

The overall combination can bring us all close to the Pure inflation idea (a particularly popular essay), so that any inflation within reason does as little damage as possible.

The only real problems left to address are the value of the currency, lenders’ cash flows, and the fact that the mortgage models currently in use lend too much to be safe.

Currently used mortgage models are the main reason why house prices are unsafe, as explained in my first essay and my essay of last week on the relationship between mortgage finance and house prices.

Lenders

For lenders, the problem is trusting that once the ILS Model has been implemented they can raise funds as needed to ensure that the mortgage demand on their books can be funded.

Lenders have never had that kind of freedom before and they are quite scared about that. But Adam Smith would have told them that the price (the interest rate) is there to balance the supply with the demand.

It works for everything else, and it can work for lenders as long as lenders can alter their interest rates upwards without having a crisis of arrears and repossessions.

Currencies

For currencies and foreign ownership of government bonds, there will be some adjustments made. But the wealth bond swap idea explained last week and the idea that the economy will start to grow and become stable should both help, now and in future.

Investments made by foreigners will look less volatile and have better ongoing growth prospects. There will be little for them to worry about on the inflation front.

The economy

Finally, we need to ensure that mortgages remain inflated in size (the loan/income multiple must initially remain high), even as interest rates and maybe inflation rates increase until such time as incomes have risen enough to reduce these multiples.

Whereas with the current mortgage models, as interest rates rise the result would be too many arrears cases and properties crashing down in value and another tide of repossessions. The ILS Model can cope much better.

The '% of a median borrower's' income taken by an ILS Mortgage of say 3.5 times income is represented by this sketch.



For a normal 3.5 times income mortgage the rate of ‘Payments Depreciation’ (the downwards slope), would normally be able to fall by around 4% p.a. meaning that most people, even those whose incomes were not rising as fast as the average, would be able to repay their mortgages without much stress after the first few years.

In fact, a mortgage would be cheaper in monthly payments than a typical rental for the same property, costing say 21% of income, around half way through the repayments period.

The difference when mortgages are too large to allow that is that the downwards slope is reduced, and the area under the repayments line enlarges. This means that more wealth has to be repaid.

As already explained in more detail in the Safe alternatives essay, there is a range of ILS mortgage models from which to choose. These include:

A straight ILS mortgage, either with a fixed or variable true rate of interest and a fixed slope or variable payments depreciation slope depending upon the fixed or variable true rate of interest that the lender is able to offer.

A Rent-to Buy model in which the same things happen, but the legal contract leaves the main financial liabilities with the lender and maybe in some cases in America, with a government support agency. Depending on legislation, the risks are low enough to be managed/insured.

Then there is the ILS Hybrid Model, in which borrowers sign up for the usual type of mortgage but if rising interest rates become too much for them they can switch to one of the above ILS models.

If a borrower is still not able to cope because true interest rates are now back to normal or above, and their mortgage was far too large and their income is not rising as fast as others, then they may become stressed and have to consider moving to a less costly property. Or the government can help them out. If not too many would be in need, a subsidy might be afforded.

The issues for lenders

This is worth repeating. Most importantly, lenders will be able to keep funds flowing in for two reasons:

Firstly, they can raise interest rates without borrowers all defaulting at the same time and as house prices also crash. This is a key safety feature (for everyone) of the ILS mortgage model.

Secondly, when lenders do raise the true rate of interest to a level that is more than competitive with other investment options at least over medium to long term periods, they will not have any shortage of funds. There will be fewer new borrowers, faster repayments and redemptions, and more funds to lend.

Like the central banks/treasuries, mortgage lenders could also offer wealth bonds over five or 10 years or more, with a fixed low rate of true interest. There is a huge market for safe investments which protect wealth from inflation and other hazards over longer periods.

The main risk is offering too much fixed true interest for too long and having mortgagees redeem early. Like the governments, while interest rates remain low lenders may even be able to offer wealth bonds at a premium so that the net return to the investor is a small loss of wealth overall, but at least they will know how much that loss will be.

Their borrowers will be very happy with levels of payments depreciation at or above 4% p.a. on such large mortgages.

In summary, it is possible to create a safer economy for everyone and a safer way out of the QE Low interest rate trap.

But is the government and are the financial institutions capable of managing this changeover? It will take a lot of thought and management, but it really can be done.

Everyone wants financial safety. And they want it now. It can be an election winner. It can be done later, but by then will the motives be there? Maybe not until the next crisis...or it can be done more gradually. That can be easily managed.

For more information on all of the above, readers may like to visit my blog and read the draft book and other draft chapters. There is a linked blog devoted to outlining how such changes can be managed.

Next week I will open a new series on how to manage an economy. Do economies really need a stimulus?

- Fin24

* Edward Ingram has a strong and growing support base. One American has started a petition asking President Barack Obama and/or his senate committees to look into these ideas. Ingram says: “Why not here in South Africa? The ideas are universal.”



edward ingram

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