Safe alternatives

Dec 24 2013 12:04
*Edward Ingram

CONTINUED from last week's essay on the low inflation trap, Edward Ingram looks at new ways to offer safer mortgages.

Replacement bonds

Fixed Interest Bonds have significantly worsened Europe’s problems and they form a part of the low inflation trap discussed last week. Besides that, they take confidence in any recovery away as holders of those bonds (and mortgages and housing) are very vulnerable.

It would be safer for everyone including the economy, to offer wealth bonds in their place and to do so at a discount because a wealth bond creates confidence and protects wealth. Losing some wealth now rather than later when inflation rises is a faster and better way forward for everyone.

In summary, if governments would offer ‘wealth bonds’ that index-link the capital borrowed / invested by people and institutions to Average Earnings Growth (AEG% p.a.) they would be able to plan their costs better; and their average cost of borrowing would be reduced because our savings and pension plans invested in them would be as safe from inflation and other hazards as anything can be.

People pay more or accept lower interest rates to invest in safer bonds. There is a range of such wealth bonds. These can be designed to meet all of the usual market needs as regards cash flows and maturity dates.

For example, an annuity would require repayments of wealth (capital) and interest. A fund manger would want the same to ensure a high cash flow. An indexed fund may not require a cash flow. Many others simply need a stable proportion of up to 100% invested to protect their wealth until maturity – just invest and forget. Let the interest roll up.

A government might need to offer new issues to fund the repayments – and at the current market price / true interest rate. There is nothing new about that.

Replacement mortgages

This is more difficult to explain – here is an outline

Mortgage size and systemic risk

Mortgage finance can also be made very safe.  

Firstly, mortgage finance can be regulated in a way that will make property prices relatively steady. It is a matter of regulating the systemic risk related to interest rate volatility. Systemic risk is the risk which is in the system as opposed to the risk of lending to a particular borrower. Let me explain:

It is not safe to lend too much when interest rates are low because interest rates will rise again. And it is not necessary to lend a lot less when interest rates are high because interest rates will fall again.

In other words we have to take out the greater part of the interest rate sensitivity on that front – on how much wealth is lent and has to be repaid with interest. That is a beginning.

Regulating systemic risk in this way will ensure that property prices track rising incomes more closely, like all other prices in the economy are supposed to do unless there are special factors operating. They will not bubble and crash along the way. Property will become a more reliable store of wealth, tracking alongside average incomes / earnings growth.

Secondly, having said that, we have to know that the most important interest rate we are talking about is the marginal rate of interest above AEG% p.a. called the true interest rate. I have to refer readers to a previous column that I wrote, and maybe other columns as well. It is this marginal (true) rate which moves the wealth from the borrower to the lender and thus to the lender’s savings accounts.

Once lenders have stopped over- and under-lending due to the regulations just mentioned, which the lenders will in any case need to impose on themselves once they have read my mathematics of safe lending, we know from those studies that the amount of wealth that has been lent can be afforded no matter what happens to interest rates.
Average incomes can be rising (positive AEG) as in Africa or falling (negative AEG) as in some European nations, yet the mortgage repayments can still be affordable  if the amount of wealth lent is right. Interest rates have to tag alongside AEG rates and market forces will always ensure that the marginal (true) rate of interest above AEG will not get too high to be afforded for long enough to be a major hazard.

Interest rate boundaries

If this marginal (true) interest rate gets too high there will soon be a lack of borrowers and if it gets too low there will soon be a lack of investors and savings, or the central bank will raise rates to avoid run-away inflation.

The difference between too high and too low true interest is estimated to be around 2%. But there can be major spikes up and down that can be averaged out by the new mortgage models. It may be worth mentioning here that those spikes will probably stop occurring as a result of the greater orderliness created by safer financial services.
Based upon this, but even without any stability in true interest rates, according to tests done for extreme conditions, lenders will be able to offer a range of mortgage models.

These include the usual variable interest rate ones, but with repayment smoothing options added, a fixed true rate mortgage costing a guaranteed amount of wealth, and a rent-to-buy model in which the payments are forced to fall relative to the selected index of average incomes / earnings at say around 4% p.a. but by less than 4% in extreme conditions.

In fact all of the new mortgage models have that ‘payments depreciation’ as a feature.

There will be no rising interest rate panics; and compared to mortgage costs, rentals should cost more than the mortgage after some years. As already mentioned, interest rate spikes can be smoothed over.

The shaded area of the sketch below shows how the payments would fall every year on a ‘% of average income’ cost basis if the true rate of interest was fixed. Payments may start at 30% of income and fall over 25 years to just over 11% of income.

Rentals are represented by the ‘21% of income’ line. Rentals tend to keep pace with incomes (AEG% p.a.), but the mortgage costs fall every year relative to the same index.

As just mentioned, there are other ways to offer safer mortgages, including a mix of the usual methods and a standby rescue model to be used if payments are forced up too fast, or if incomes start falling; and a rent-to-buy model with fixed or variable true rates of interest. In all cases, the payments would be unlikely to rise as fast as average incomes.

* Next week we will look at how business finance and the whole economy can benefit.

If you are new to Edward’s column, please read the following (mind-bending but factual) past columns in this series.
A New Baseline for Investors, explains that the growth rate of every investment is powered in some way by aggregate demand; Average Earnings Growth (AEG% p.a.) is used as a proxy for that.
Preserving Wealth, explains that keeping pace with prices does not preserve your share of the national wealth nor would it provide a decent pension. You have to keep pace with AEG% p.a.
Wealth Bonds v Fixed Interest, shows just how dangerous it is for governments to use fixed interest bonds.

- Fin24

* Edward Ingram is a leading specialist in mortgage finance and macro-economic design for sustainable growth who is involved in studies in macro-economic reforms.

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property  |  interest rates  |  inflation



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