The value of equity release mortgage values may be overstated, leading to significant portfolio risks, Bank Underground says.

Bank Underground is a blog written by Bank of England staff on an individual capacity, therefore the articles do not speak for the bank itself.

The blog’s argument hinges on the no-negative equity guarantee (NNEG), which states that when an equity release mortgage is repaid, the lender cannot receive more than the house is sold for.

It says that option pricing, which is used to value a mortgage’s NNEG, “takes an up-to-date price of the underlying house as a given.”

However, Bank Underground says, the most recent transaction price may be decades old and, “for mortgages that have been in-force for many years, a considerable time may have passed since the house was last subject to a surveyor’s valuation.”

Applying a simple house price index return to the most recent valuation or transaction price “ignores the idiosyncratic risk element in the evolution of the house price,” the blog continues, “and will, on average, understate a portfolio of NNEG values and hence overstate mortgage portfolio values.”

The blog runs 1,000 equity release mortgages through a model using Black-Scholes option pricing. This portfolio is then valued using both simulated ‘true’ prices and price estimates produced through simulated house price index returns with a volatility relative to individual house prices assumed at 12%.

“The indexed approach results in higher returns being generated by the portfolio over time, as a result of the NNEG values being systematically understated by the use of indexation,” concludes the blog.

“At maturity, the true house prices are ‘revealed’, and this sometimes results in unanticipated write-downs at maturity.”

Median portfolio valuation error after 10 years, the analysis reveals is “around” 3%. “As the period over which indexation is applied grows, the potential for very material valuation errors also grows,” the blog says.

It recommends adjusting mortgage portfolio values not through ‘drive-by’ valuations, which are implemented to some extent already, but through progressively larger adjustment factors.

“The scale of these adjustment factors will heavily depend on the assumed level of house price idiosyncratic risk.

“The greater the idiosyncratic risk, the greater will be the implied valuation adjustment.”

The blog’s author, Craig Turnbull, writes: “The purpose of this analysis is not to propose a specific parameterisation, but to highlight that analytical techniques can be used to shed light on the mortgage valuation errors that can arise from the use of indexed house prices.”