NEW FINANCIAL PRODUCTS RESULTING



3rd December 2017
This page is currently under revision
My apologies.

I tried to make it more readable
 but I failed.

The reason why I failed was because I was trying to write something readable by the general public but I ended up trying to write something academic. 


I must have confused everyone. 

What is clear, if you do read it, is that this is not the product of some lazy researcher. 

There are things here which will jolt the mind of academics. For example, retaining wealth is not the same as retaining purchading power. There is an illustration below in which that concept might lose 99% of the wealth in a savings account with capital inxed linked to consumer inflation over a century.

10% could be lost in under four years.

There are two ways to combat this:

To allow interest rates to be pushed around by market forces and not to be manipulated.

To index-link the capital of savings and loans to an index which is more suited to preservation of wealth.

In my book I make a case for using National Average Earnings, NAE, for this.

The resulting savings and lending models are beautiful to behold.

There are two parts to any price, cost (of repayments in this case), and asset values.

There is the core adjustment which is needed to offset the falling value of money. This means that all prices, costs, and values must rise along with rising NAE. So your repayments will increase at that rate on this part of the adjustment.

and

There are the real economic adjustments which in the case of a mortage repayment plan using fixed interest (above the core interest rate) is only market related at the start of the plan, just as fixed rates of interest vary for new borrwers at present.

To determing how much must be paid in the first year, (the entry cost), a calculation is done which sets the intial payments higher than later payments will be. So although the payments may be rising at a core rate of Average National Earnings Growth, (AEG% p.a. for short), if AEG% p.a. is not greater than 4% p.a. (incomes / earnings are rising less quickly that 4% pa.), the actual money payments to be collected from borrowers will actually fall evert year.

Every year the number of NAE repaid will reduce.

It is vasically the same idea that lenders had when they assumed that vorrowers' incomes would always rise and the set the rate of interest at a fixed 7% or so.

4% of that 7% interest was inflation and the other 3% was a real cost.

My studies have shown that the real cost needs to average out over long periods of time at around 2% to 3% p.a. so as to prevent property prices from reaching infinity, which in theory they would do if interest rates did not balance the supply of credit (and linited credit) with the demand for it.

The role of the policy makers is to ensure that the supply of credit is indeed limited so that this happens.

Their other role is to ensure that there is enough spending money circulation and being spent to consume the national output.
If they get that wrong and there is too much then prices and incomes and costs and asset prices must be free to rise to offset the falling value of money which is seen as prices costs and values rise.

Everything needs to keep step

When that happens, the excess money circulating and being spenf is miooed up by thise higher prices.

Pension funds can collect 10 NAE from savers. When retirement comes, they can repay 10 NAE ver 20 years. Every year the client will get 05 NAE as income. Then he drops dead. Will statistically that is what happens wth a little refinement to allow for profits and interest earned by the fund. This is a defined cost and defined benefit system which has never been possible before. It is good to know that if your children's generation are doubling their income and earning twice than what you did for doing the same amunt of work, your pension income will also double. To pay for their own pensions the simply pay in that same percentage of their income that you did.

There may be some difficulties with aging populations which can reduce investment returns on savings. If fewer young people are buying investments through their savings and pensions then when it is time for you or your fund to sell your investment to them you will not get as good a price. Or if they have to work to an older age that will sort it out.

I hope this new red script is helpful.



HERE ARE THE NEW PRODUCTS

Meantime I am editing the first part.

Sorry for any inconvenience

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You may also like to join the "MACRO-ECONOMIC DESIGN Group at LinkedIn" (Google that) where you can discuss issues with other collaborators..


NEW TEXT
The kind of protective new financial contracts / products that can be offered / written are described on this web page. 


Readers should refer to the definitions below only after they have read the text which uses them. Wealth preservation is not the same as the preservation of purchasing power. The early paragraphs explain why the preservation of wealth is better measured in units of National Average Earnings, NAE.


INTRODUCTION
The following definitions are based upon a conclusion reached when doing thought experiments on how to estimate the rate at which prices would need to rise in order to offset the falling value of money.

Money can buy many things including assets of all kinds, debt as an investment such as bonds, property, hiring people (incomes), in fact anything which you may be able to pay for including your mortgage repayments.

If we were to replace the usual basket of goods with such a basket, and defined the rate of inflation accordingly we might get a more accurate figure for the value of money and its rate of change.

That is the first point.

The second point is that the usual CPI index of consumer prices contains two parts of any price adjustments:

The core price adjustment needs to adjust for the falling value of money.

The other part, the real economic part of the price of things, adjusts to hep with balancing supply with demand.

The total gives the nominal figure as in the CPI.

In searchinng for an index which is both practical and approximate over the medium to longer term, it was thought that National Average Earnings, NAE could be that figure.

As earnings rise, so does expenditure although it ebbs and flows. It undulates as people save, dis-save, borrow, repay, import and export. But all else being equal including demographics maybe, this is a zero sum game.

The point is not that this proves the point. The point is that NAE allows us to design a better financial infrastructure.

It would not be a perfect measure but it is possible to improve the stability and the manageability of much of the economy by writing contracts as if this was the measure to use.

Here are the concepts to sell to people and the financial services products which go along with that. The overwhelming advantage of using NAE as a benchmark is that so many liabilities in the financial sector and so many revenues all rise at a rate which is linked to that. What people earn is ultimately what they spend after leaving some proportion aside on deposit or in cash for easy access.

As already stated, sometimes they save and the savings get lent, sometimes they spend their savings or pass them on to the next generation. Sometimes people import more and that takes spending out of the economy. At other times the import less giving a boost to it. 

Sometimes people borrow more and sometimes they borrow less.

On average over the longer term apart from funds needed for immediate access all earnings get spent or they would be accumulating somewhere. No such treasure has been found on planet earth.

LOOKING TO THE FINANCIAL PRODUCTS RESULTING

Most people will want their investments to keep pace with the rising income of others, their pension payments to do the same, and they can relate to repaying the amount of National Average Earnings, NAE, which they have borrowed, out of income, plus interest.

A loan is an investment to one entity, a debt to another. It is an investment with a claim to a share of the future earnings / income of the borrower.

So it makes a lot of sense to use these NAE units in the construction of contract, or in the calculations needed to find a safe level of repayments. All such repayments are of value. They do not have to rise and fall as nominal rates of interest vary.

Whether or not the investment will provide a positive return in terms of adding units of NAE is up to the rate of interest relative to the rate at which NAE is rising. That comes down to market forces acting in the credit market - always remember that.

With that in mind a considerable amount of research has been done to see if the return on lending would be positive, given free market pricing of interest rates and other prices being free, and given a sustainably growing economy without too much money in circulation or too little plus or minus undulations.

The conclusion reached from several viewpoints is that the return on secured loans would be positive. The key viewpoint is that cheap money leads to abused resources and in some situations to run-away inflation. It has to cost some NAE to restrain the aggregate level of borrowing and the money creation which goes with that. There is a mean rate of marginal interest above the rate of growth of NAE, Average Earnings Growth % p.a.

Too much credit is risky.

If we do not adopt any such index and just aim to repay money, not value, we will always be in a crisis or moving in or out of one because the way that the repayments are calculated is highly unstable in outcome.

And bond values can crash down fast under the influence of a small interest rate increase. There is a report that a 1% rise in USA interest rates would slash $2trillion off asset values which is considerably more than the losses in 2008.

We really need to take out that kind of asset value and cost of repayments instability for otherwise monetary policy or the rate of free market interest (in either scenario) will have too many conflicting pressures to cope with. See the LOW INFLATION TRAP.

Another key point which needs to be raised is this: if all prices are not free to adjust to all market forces including those which ought to exist relating to the offsetting of prices to the falling value of money, then the prices will be distorted in every such case. Fixed interest bonds and mortgage repayment costs are just two of the things which are doing this.

Distorted prices lead to re-distribution of wealth, broken businesses and repossessed homes and they provide a great platform for extreme political movements and the fall of good governments.

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DEFINITIONS:
1. ILS Model Stands for Ingram Lending and Savings Model / Mortgage.
2. Wealth is measured in units of National Average Earnings / Incomes, NAE.
3. The rate of growth of NAE is the Average Earnings Growth rate, AEG% p.a.
4. The true rate of interest is the marginal rate above AEG% p.a The true rate of return is the rate above AEG% p.a.
5. Wealth is increased if there is a positive true rate of interest I% adding NAE the fund, or in the case of capital gains, if the true return on capital is positive.
6. Wealth (NAE) is paid over to a lender if more NAE is repaid than is borrowed.
7. Wealth Bonds are bonds in which the agreement is that the capital value will rise at AEG% p.a. and a true interest coupon will be paid. The coupon is an annual, or a periodic, interest payment. The interest may be re-invested at the option of the contract writer or by agreement.
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Please be patient and learn this introduction. It will completely change your understanding of savings and lending.



KEEPING PACE WITH INFLATION IS NOT WHAT IT SEEMS

Before readers can write a contract that gives any certainty about how many NAE will be repaid, it is important to get familiar with the following fictitious example of what happened to an investment which specified that the fund must retain its purchasing power over a 100 year period.



AEG% p.a.  is short for Average Earnings Growth (for the nation). It is the rate at which NAE is rising / growing.



Now read this:

Take a savings account of 20 NAE, about half a life time's earnings for an average person - 20 years earnings. Let it attract AEG% p.a. growth, or interest equal to AEG% p.a. After 100 years there will still be 20 NAE in the fund. But if the fund rises 3% p.a. more slowly, at the rate of prices inflation, say, there will be only 1 NAE - a single year's spendable income in the fund.



If the true rate of interest, 2% p.a.  (it is the marginal rate above AEG% p.a.), and if AEG% p.a. = 5% then the nominal, or total rate of interest, is 7%.



If we say that r% is the nominal rate of interest, then it has two parts: AEG% (the core rate) and I% the real economic rate, or marginal rate above AEG%.

r% = AEG% + I%. 

Now read this:
I like to explain that I% has a very special meaning in finance and economics which has been missed in the text books.

If I% true interest is then the number of NAE in savings the fund will increase. 

If the fund is lent to a borrower, the number of NAE needed to repay that loan will be quite a lot higher if I% is a positive figure.

But that depends upon how the contract is written. Will I% even be mentioned? Or will it vary as r% varies? How will r% vary?

r% has two components, AEG% and I%. Both of these can vary.

When borrowing using a fixed interest r%, the number of NAE which you will repay depends upon the ever changing value of AEG% p.a.

Let us say that you agree to pay 5% interest and that AEG% = 5%. If that never changes then the number of NAE which you borrowed will be the exact number of NAE which you will repay. The fact that NAE may triple in the meantime from, say 10,000, to 30,000 in the meantime, (in any currency), makes no difference.

Here is an example.

Source: E C D Ingram Spreadsheet.

The value of r% is all over the place but AEG% follows it exactly. The payment is made not in the current year but after 12 moths and after the pay increase at AEG%. The total % of AEG is found by adding up the figures in the final column. The total NAE paid is the same as the 1 NAE borrowed.


OLD TEXT



The problem is that one borrower's income never looks like the National Average Income or Earnings (NAE), which is what we have to use to evaluate the cost. Each borrower's income grows or falls in its own way. But there is no way to evaluate that or to use that unknown as a way of projecting / estimating the cost.

One thing to note: This calculation can be applied to ANY form of mortgage or loan repayment. It has advantages over comparing the money or costing relative to the prices index - the so called real cost.

Firstly, it IS what it really costs in terms of national average wealth or NAE more specifically.

Secondly, any up-front costs get the highest weighting as they need to.

Thirdly, money costs can be highly misleading, as can real costs. People have a limited resource called income. They do not have purchasing power only. How that income is deployed tells us what can be afforded for housing and pensions and everything else. The purchasing power may rise, but that happens to everyone. It may fall and that happens to everyone.

When purchasing power falls, it falls for everyone. Wealth falls for everyone. true rates of interest (above AEG% p.a.) may fall, or not, but AEG% p.a. may fall relative to prices. At least anyone keeping pace with AEG% p.a. keeps their share of wealth and the borrowers can afford to repay because market forces will tend to keep true interest rates within the expected range over the medium term.

THE GENERAL EQUATION FOR LENDING
Here is an equation that describes pretty well every kind of lending ever invented. Do not be scared by the equation - it is just easier to explain things this way because every loan has each of the variables shown here as explained next:

P% = C% + D% + I%

Every loan has a current level of payments P% p.a.
Every Loan repays some of the debt, C% p.a.
Every loan has a rate of easement of the cost D% p.a.
Every loan has a rate at which wealth is added to the debt by the marginal (true) interest rate I% p.a.

The interest rate I% used is not the nominal rate of interest: it is the marginal rate above the rate of increase of average incomes growth (AEG% p.a.) or of nominal GDP% growth p.a. Only if the nominal interest rate is higher than (nominal)  GDP% p.a. growth rate or AEG% p.a. does wealth get added to the debt. Then more income (share of GDP) will be needed to repay than the income or share of GDP that was borrowed. This is the big thing to watch. But there is another big thing to watch too...

...What makes a lending model unsafe is when there is no control over the value of D% p.a.

D% p.a. is the rate at which the amount (portion) of your income or national wealth (NAE) needed to repay the debt reduces every year. Remember we are not really talking so much about your income, as the share of GDP or the number of NAE that is owed and how much of that is repaid every year. If your income is rising as fast as average then the value of D% will apply to you. Typically D% may be around 4% p.a. so every year 4% less wealth / NAE should be needed to make the payments, or maybe 12% less every three years.

That is the target used for the new ILS Mortgage model.

The problem for other models like fixed interest mortgages and variable rate mortgages is that they have no real control over D%. D% is then equal to the rate at which incomes are rising - until the interest rate changes. Then it leaps around. Completely unsatisfactory.

To ensure that D% can always be positive the theory on the maths pages shows that the initial income multiple lent must not vary much over an interest rate cycle.

This has a stabilising effect on what can be borrowed and on the price of and affordability of housing.



HERE ARE THE NEW PRODUCTS


1. An ILS Defined Cost Mortgage. What the ILS Defined Cost Mortgage does is to fix the value of I% pa. This means that the lender has to sell fixed true interest rate 'wealth bonds' as the financing method. That protects the wealth of the bondholder.

This way the value of D% p.a. can also be fixed. There will always be a falling cost for the repayments if D% is positive and if D% p.a. is a fixed rate of 4% p.a. then the outcome will look something like this:

FIG 1 - all figures use an index of average incomes, not individual incomes.

The total amount of wealth repaid is always given by the size of the shaded area which represents a series of columns of income paid each year and added to together to give the area.

After a few years the cost of the defined cost mortgage should become less than the cost of renting a similar property, as shown in FIG 2 below. Rentals tend to follow the dashed line, keeping pace with average incomes and costing a steady 21% (say) of income in this illustration. The Mortgage costs more at first at 30% but falls towards 11% over time as shown.

FIG 2 - ILS Defined Cost Mortgage Payments v Rental Costs




In all of these illustrations the total wealth paid across is given by the shaded area which is like a series of columns of annual payments set side by side. So the total area is the total cost to income / share of GDP.

The problem with most mortgage models is that they do not have control over either I% or D%.

We will see how that affects the shape of the above sketch a little later.

VARIABLE RATE ILS MORTGAGES With the ILS Model, variable interest rates (and so variable I%) can also be offered. In this case no sudden increases in costs should occur even if interest rates rise significantly because interest rates always revert to mean and the initial set-up and the amount lent will usually have been based more with the mean conditions in mind than with current conditions.

The difference between this and the defined cost mortgage is that the steepness of the slope varies and is not a constant.

ILS MODELS CAN ALWAYS COMPETE
Traditional mortgages often over-lend when nominal interest rates are low, and then they inflate property prices. If the interest rate is not fixed then when interest rates rise again there are large numbers of defaults and arrears which have significant social and economic and lending costs.

The ILS Model can be used to rescue lenders and borrowers in such conditions. However, normally, the ILS models are based on maintaining control of the arrears risk: D% must be positive so that the steepness of the slope must always be downwards. 

Broadly speaking, it achieves this by using the median rates of interest as the basis when deciding the safe amount to lend. This lowers the risk of arrears and it stabilises mortgage sizes if the model is widely adopted or enforced. If all lenders were to abide by these rules then that in turn would stabilise property values so that smaller deposits will be needed, and property price bubbles will not appear and then threaten the stability of wealth invested in property nor the health of the economy.

PROBLEMS WITH FIXED INTEREST RATES  - using the traditional mortgage model It is not healthy for an economy to have people struggling with their mortgage payments during a recession, as can happen with fixed interest mortgages or having their mortgage costs jumping up by many times more than next years' pay rise, as can happen when interest rates rise after a period of low interest rates or booming economic growth.

With fixed interest rates the value of I% varies all the time. If incomes start falling or do not rise as fast as hoped, then the mortgage will cost far more than expected.

Here is what happens when fixed interest rates are used for mortgages during a period of austerity:

FIG 3


The lender starts the repayments using 30% of income as always, but because incomes are not rising the payments get stuck at 30% of income.

FIG 4 - It can be worse if incomes are falling:

MORE ACCURATELY
The Ingram Lending and Savings (ILS) Model for Mortgages
The above illustrations use straight lines to illustrate declining payment costs. If we use an EXCEL sheet to calculate them and then display this as a bar chart it may look more like this:

FIG 5 - Here a Fixed Interest rate Mortgage (NOT ILS) is illustrated with incomes rising at 10% p.a. which reduces the 'wealth cost' (% of income) by 10% p.a. D% = 10% p.a.





The big problem here is that much less can be lent: 2.72 years' income compared to 3.5 years' income for the mid-range mortgage model used by ILS in the same conditions. 

FIG 6 - Level Payments with Fixed Interest cost too much when incomes are rising slowly and interest rates are low. Here the interest rate is 1% and the mortgage is 6.61 years' income.

Not only is the mortgage too big, but incomes are barely rising to reduce the cost. D% = 1% p.a. as incomes are rising at 1% p.a. - at least on average. For some it may be less.

The downwards slope is now 1% p.a. in the FIG. It never costs less than rental till after the mortgage is paid off.

This is NOT recommended. Too much wealth has been lent because the interest rate was low at the start. Even if less had been lent at a higher interest rate this FIG shows how it would look. The total wealth repaid would still the same! Same total cost, smaller loan.

Why? Because the lender will always lend as much as can be afforded on repayments of 30% of your income. Thereafter the money cost is fixed by the fixed interest rate and the easement in cost to income / wealth (D% p.a.) depends on incomes rising. If they rise at 1% p.a. then the total cost will be the same as shown above.

FIG 7 - Here, again is how traditional Fixed Interest Rate Mortgage costs look when incomes are not rising. D% = 0% p.a.
Imagine the situation if incomes were not rising at all. Even at zero fixed interest rate the amount borrowed (7.5 years' income) just would not get repaid. No one wants to spend 7.5 years of a lifetime's income repaying their (typically) 3.5 years' income mortgage at a flat 30% of income every year. 

It costs the same amount of wealth (7.5 years' income) at ANY rate of interest if incomes are not rising. The difference is that you cannot borrow nearly as much when interest rates are higher, but it still costs you 7.5 years' income to repay. At 7% fixed interest you might be able to borrow 3.5 years' income but if incomes are not rising this will cost 7.5 years' income to repay.



VARIABLE RATE MORTGAGE MODELS
COMPARING NEW WITH OLD

FIG 8 - This is how a Variable rate LP Mortgage Cost can take people by surprise, and how the ILS Alternative Mortgage Model protects. BOTH MODELS ARE USING THE SAME INCOME AND INTEREST RATES. The Fig shows the cost to income for each mortgage type.
The problem with variable interest rate mortgages of the traditional (LP) kind is that you never know when the cost may jump up. In the developed economies like the USA or the UK the cost is most likely to rise fastest after the interest rate has reached a record low level, and the mortgage is large, say when the interest rate is below 5% or 6%.

THE DANGER OF LOW INTEREST RATES: Here (above) the low interest rate (around 3.5%) led to far too much wealth being lent. In 2006 that did not last long. If it had been possible to raise the interest rate back to the 8%  level that was apparently targeted by the Fed, the cost would have jumped up by over 50% at the end of the third year - rates were adjusted every third year. The worry today is what will happen to interest rates and property prices once Quantitative Easing ends.

It is strongly recommended that risk managers and regulators look at the cost of a mortgage at mid-cycle rates when determining how much wealth should be lent. Doing that will enable them to manage the repayment levels and keep them relatively safe.

ILS is highly competitive
Normally, when an economy is functioning properly, unless forced to do so by competition from such careless lenders, the ILS Mortgage would not have lent too much and so it would have avoided the problem. But then, when the interest rate rise came along, the variable rate ILS Mortgage would just about manage to prevent those bars in the bar chart from rising. The slope gets shallow but the monthly costs stay affordable - just. So the ILS Model can over-lend if necessary to beat the competition and it can raise interest rates more easily to beat the competition in attracting funds. Funds go to the safest lenders and they also go to the higher interest rates. ILS combines both features because it manages the value of D% best and keeps it positive.

BALANCED BOOKS
This competitive edge also means that the ILS Model can raise interest rates to retain the funds that it needs to balance its books and to balance the supply of funds with the level of demand.
MORE NEW PRODUCTS

2. Wealth Bonds. 
A wealth bond is a bond whose value is index-linked either to average incomes or to a measure of GDP that represents average incomes in an acceptable way. The interest coupon would be fixed and would be the fixed value I% in the general equation above.

Defined Cost Mortgages are funded by wealth bonds in which I% is fixed. Such a wealth bond would suit a pension fund or anyone wanting a relatively risk-free place to put their savings.

Currently there are no wealth bonds available to a pension fund or to anyone else, except in Turkey where a mortgage model somewhat similar to the ILS Model is in use for Civil Servants. The problem is that the value of D% = 0%. That is far too low for comfort.

HOW THIS WORKS
A wealth bond repays the same amount of wealth (lifetime's income) as was lent plus the interest coupon.

To raise funds with a wealth bond you will almost certainly have to pay an interest coupon. 

If the market rate for wealth bond interest is higher then more wealth (income) will be repaid by an average borrower whose income keeps pace with the index. 

LENDER'S LIQUIDITY: If a mortgage is funded by such a bond the lender will have much reduced liquidity / funding problems, with, as just mentioned, virtually no arrears except due to redundancy etc. 


REDUNDANCY: If the borrower loses his/her income in the early years this might be insured for long enough to repay enough of the wealth so that after that the repayments might be suspended allowing the interest to roll up for a while. In the last resort, a repossession of sale of the property will protect the investment made in the mortgage.

MORE USES FOR WEALTH BONDS

2a. House for life no matter what. Some retiring older people may have repaid 90% of their mortgage and then they retire. Then the lender can slow down the payments to interest only or less. The equity in the home can pass to the lender if necessary, and well, we can discuss what the possibilities are to give them their home for life. 


2b. Lifetime Annuity. In these circumstances a lender might offer a home for life on a group basis, taking equity in return for life tenancy. The longer lived could be financed by the shorter lived. In other words the home becomes a lifetime annuity.

2c. Low deposits, safer wealth.  With more stable property values (assuming that lenders stop over-lending when interest rates fall), more can be lent to first time buyers; and this kind of annuity for retiring people (in 2b) also looks more practical because the value of the property at death can be better relied upon. 

MORE ILS MORTGAGE MODELS

3. A Hybrid Mortgage. People do not like trying new things unless they have to save their home or something they hold dear.

An ILS Hybrid Mortgage is the familiar variable rate LP mortgage with an option to switch to the ILS model when interest rates rise. 

When the ILS Model clicks in it ensures that the rate of increase in the repayments does not exceed the rate of increase of average incomes (AEG% p.a.). If the suggested regulations on mortgage sizes (maximum wealth lent and minimum repayment level) are enforced to prevent over-lending, or if the lender's own risk manager enforces this, then there will be no problem here for lenders. Then the ILS payments will be able to fall at about the usual 4% p.a. as in FIG 1. The lender may be able to arrange a Defined Cost replacement Mortgage, or if not, the slope of the bars will vary somewhat over time.

In the event that the lender lent too much then the slope of the bar s will be less because too much was lent.

3a. ILS Rescue Mortgage. This is the same Hybrid arrangement but unplanned in advance. Because too much was lent under the traditional mortgage model, the rate at which payments can fall relative to AEG% p.a. will be reduced. If possible lenders will shop around for an attractive Defined Cost option. The cost depends upon the market rate set by investors wanting a defined benefit bond, otherwise known as a 'wealth bond' because it protects and adds to wealth in return for protecting the borrower's wealth and funding the mortgage.

An illustrated example of how an ILS Rescue might have looked in 2008 in the USA is given at the bottom of this page.



4. Rent-to-buy options. This is a useful way of hiding the mortgage from view if interest rates are high and the mortgage has to rise in money value in the early years. As long as the property collateral is good and incomes are rising faster than the debt by a good margin, and as long as the payments are rising faster than the amount of the debt, there is no problem. The debt will be repaid on time. In the meantime, the lender will take ownership of the property which will be rented to the buyer in terms of legal rights.  The risk of this failing can be predetermined by the risk manager who decides the maximum safe loan to offer. The risk can be very small even for a sizable loan. 

This is ideal for some developing nations. Zero deposits are possible with this model because it starts life as a pure rental.



SALES LITERATURE 

For all of the above there is the sales literature to create. Edward Ingram's interactive spreadsheets are a wonderful tool to see exactly how to present what is going on. They can be seen on the SNIPPITS Blog - ABOUT page.



RISK MANAGEMENT AID

 Ingram's Risk Management Charts can be seen at the Ingram School (online). These  provide a simple way for the risk manager to see what is going on. 


STILL MORE NEW PRODUCTS
5. Wealth Bonds can come in various forms and have various uses
A wealth Bond can be issued by a lender or a private person or a business.



A wealth Bond is basically an AEG-linked Bond or a GDP- linked Bond with interest added. The indexation can be done as a variable rate of interest that tax free and is equal to the rate of Average Earnings / Incomes Growth (AEG as defined by the lender or the national authority), or maybe the link could be to GDP. Governments may prefer GDP but sales may be faster for AEG.

6. RETIREMENT PLANNING

Gamma Rated Funds

For investment funds for where wealth protection is needed using AAA rated government bonds or secured mortgage bonds a wealth bond is very attractive. This is especially so if you are involved in retirement planning and fund management. For example:

WAS BETA, NOW GAMMA 
Whereas sales people and financial planners usually talk of Beta (volatility relative to the market) we will be able to introduce (shall we say) gamma - 'volatility relative to wealth'. 


A Gamma Rating will be a measure of wealth risk. A Gamma Rating of 1.0 is much more interesting than a Beta Rating of 1.0 to those that want to invest and at the same time protect their wealth.

Here is an extract taken from a web page:
"Beta ratings are a measure of stock-market volatility. Stocks with a beta of 1.0 have exactly the same degree of volatility as the market they trade in, based on a comparison of fluctuations in the stock and the market index over a period of time, usually five years."

If a stock market investment’s beta is below 1.0, the stock is less volatile than the market. High-beta stocks above 1.0 are generally more volatile than the market. (If a stock has a negative beta, it has an inverse relationship with the market; it tends to fall when the market goes up, and vice versa.)

A gamma rated fund (more volatile than stable wealth with a Gamma Rating of say 1.2 might have 80% or more invested in AEG-linked mortgage bonds and/or government-issues wealth bonds if the government bonds were AAA rated with the balance invested in, say equities.

A higher risk, gamma rated fund, (maybe around 1.8 or even more), would have maybe 20% invested in wealth bonds and 80% in equities.

A person wanting to get completely out of risky investments in pre-retirement would go for a 100% AEG-linked mortgage bond (wealth bond) or a government wealth bond similarly index-linked - if it was on offer. Financial advisers will readily suggest this as they have told Edward (the innovator going back to the 1970s although others have claimed to be have made the same invention since) when asked. 



A fund that is 100% invested in wealth bonds would be a 1.0 rated on gamma, (no wealth risk) but with two cautions: 


1. No investment is ever quite risk free. For the risk look for the credit rating and look for a AAA rating.

2. Average incomes are defined by a third party and may not be quite the average / index that the person might prefer. Hopefully, we will be able to set up an official measure for AEG indices that takes account fairly of the various interest groups.

BUSINESS FINANCE
Wealth Bonds can also finance businesses and also get an investor risk rating. The risk rating is not the same as the Gamma Rating. As just explained, the risk rating is what it always has been - AAA or less. The Gamma rating is just the wealth protection rating in the event that the investment itself was entirely risk-free - beyond AAA.


Wealth Bonds will make business borrowing much safer and more flexible, thus improving their own risk rating and possibly reducing the cost of financing a business.

7. Annuities. The high cash flow obtainable from mortgage bonds can be matched to annuities and at the same time take out the considerable wealth risk of a fixed interest annuity. Some clients may want a mixture of more than one kind of annuity. Secured AAA rated Index-linked investments for annuities would extend their choice. 



8. Government and Business Debt. Both governments and businesses may have a range of cash flow needs and so do investors. A market will develop to match the interests of all parties as far as practical.


Some wealth bonds will pay interest only until maturity. Others will repay the debt as if it was a mortgage over various selected periods so as to tap into the market at an economic rate for the borrower.



DEFINITION OF WEALTH


The wealth that a person may be able to accumulate in a lifetime is the product of their lifetime's income.There are at least two kinds of inflation:


Prices Inflation

Incomes Inflation


In an economy where incomes all rise on average by 300% over a long time, if the output of the economy has not altered, then it just takes 300% more money to buy everything. Money has been devalued. 

If you want to preserve the wealth that you saved you have to preserve the value of your savings with a 300% increase in the money value. If you get less, then you can buy less of the national output. Others can buy more of the national output because you can buy less. Some of your invested wealth (spendable income) has moved from you to others because you lent it too cheaply.

If the part of that lifetime's income that is invested / lent can be protected from incomes inflation, then that amount of wealth is protected. 



It is not enough to protect the savings from inflation of prices.



For another example:

If you lend me 3 years' income and I repay you with two of my years' income (taking into account all of the interest that I pay to you as well as the rate at which incomes are rising), you will lose a year's income. I will spend the three years' income and then I will repay two years' income and then I will spend another years' income (of yours) that you let me have by lending to me too cheaply.

Here is a tabulation of that happening:

FIG 9 - Average incomes (AEG% p.a.) are rising 3% p.a. faster than the interest rate giving a -3% true rate of interest (the difference). When true rates are negative wealth flows from the lender to the borrower. The figures at the bottom add up the '% of income' (total wealth cost) used every year (final column) and show the total number of years of income spent in repaying the debt as well as the number of years of income borrowed. The two figures, wealth borrowed and wealth repaid, are compared in 'years' of income' at the base of the table.
4.23 years' income was lent and 3.20 years' income was used to repay. The net wealth transfer from the lender to the borrower is 1.03 years' (average) income (last column but one, bottom line). The index, AEG% p.a. (first column), is used to determine how fast incomes are growing. The percentage of that income spent in the repayments every year is calculated (last column). The total is the total cost-to-income (bottom line, last column but two).


Remember - the total wealth that each person may be able to spend is the total of their life-time's income plus or minus any income that is lost to them through investments and/or through lending. Any wealth gained or lost in those ways comes from another person or from the community as a whole or from an inheritance maybe. Total National Income does not vanish - it gets spent by someone or saved, and then spent or held (bank deposits) by others in return for an interest rate cost.

Here is another way to say this:
Suppose that everyone got a 5% raise on the same day. This does not increase national output. It devalues money by 5%. It does not matter that in practice this increase is not instantaneous, nor that it is not the same increase for everyone. The outcome is the same, only changing if the prices and costs of goods and services have had time to alter.


So in terms of wealth we have to keep pace with rising incomes (AEG% p.a.) to protect wealth (income) that has been saved / invested.


For a defined cost mortgage you define how many years' income will be repaid based upon an agreed, or an appropriate index of incomes. You define the true rate of interest that will be applied. You also agree that more will be repaid in the early years at say 4% less every succeeding year. You have no arrears problem. Your collateral security is good. The investment in the loan is AAA rated. The lender gets wealth protection.

FIG 10 -  Here is an illustration of how a defined cost mortgage may have worked for South Africa 1981 - 2005. The interest rate is defined by the rate of AEG% plus an agreed 3% (true interest):
Comment received from a reader: The debt rises a lot, not falling below the original value till year 22, and the value of the property may not rise enough to cover that. 

But compare how the money balance compares to income at the end of every year. The income is rising much faster. Note that the mortgage starts at over 3 times income and by end year 9 it is only twice income. A year's income (wealth) has been repaid already. This can be dressed up as a rent-to-buy contract so as to give the buyer some peace of mind. For more comment see the reply at the end - below.

This is a case where the rent-to-buy format should be used.

And

FIG 11 - The same figures, in Bar Chart format, showing the percentage of income paid every year declining at 4% p.a. regardless of what is happening in the economy.

Whereas people are well used to mortgage costs jumping around all over the place, sometimes with crisis outcomes, the defined cost mortgage arrangement prevents any crisis, pre-defines what the total repayments will cost to the borrower's wealth, and pre-defines the wealth increase for the lender (the same figure less costs).
INDEXATION ISSUES
The assumption made is that the borrower's income will change alongside the average, which clearly it will not do. But that difference affects the cost-to-wealth of every kind of mortgage with very similar effects: less well paid people ALWAYS feel more stress and vice versa.

When we measure wealth we cannot measure it in terms of one person's income or lifetime's expected income. We can only use national statistics to measure wealth. We can only say what part of the national wealth an individual has earned or has saved and owns.

Does this mean that lenders must always use the national figures to define AEG% p.a. - the index of average incomes growth? They don't have to. But if the rate at which the repayments fall relative to the national index is set high enough it should suit most people. 

And it is something that investors in mortgage bonds, wanting to know what wealth they have and what wealth increase to expect, will be able to understand.

REPLY TO A READER
Based upon the rate of incomes growth the value of the property should be moving up somewhat similarly over time. A deposit would help as suggested by the reader, of course.

But look - the income starts at about a third of 100, 000 but BY YEAR 9 it reaches 100,000. Properties tend to rise with average incomes so they might be worth three times as much by then.

On the other hand, you don't package high interest rate mortgages this way. You have to do a rent-to-buy model to hide the rising debt.


Furthermore, if you read the earlier pages of this blog you would hope that all lenders are doing things this way and that this and the other measures suggested would end such volatility in the property markets. Because there are a lot of distortions taken out of the economy by the ILS Models and by Wealth Bonds, interest rates may also calm significantly. That is one of the BIG objectives of having these financial products.


The other point made by the same reader was that in America interest rates jumped up by over 4% and property values crashed in 2008...

There is a detailed illustration of how an ILS Rescue Model could have coped with much of that. In fact, based on some projections, despite interest rates leaping up from 3.5% or so to 8% the ILS mortgage debt did not rise above the starting level, (FIG R1 below), yet the payments were made affordable and so property values need not have crashed so much. Sub-prime would have taken its toll but not so much as it did. Here are some of the illustrations of that:



AMERICAN RESCUE BY ILS HYBRID

The ILS Hybrid model starts like an ordinary variable rate or adjustable rate mortgage. The ILS  model clicks in to rescue the lenders and the borrowers when the 'experts' at the central banks, the regulators, and the lenders all get it entirely wrong like they did in the USA.

WHAT TO AVOID
It is NOT recommended that lenders get it wrong but then they did didn't they? They lent far too much and lowered the entry cost of first year mortgage payments far too low as interest rates reduced. The mathematics of risk management done by Edward on the INGRAM SCHOOL pages says that is not the way to do things. Mortgage sizes and costs should not be greatly influenced by the nominal rate of interest. Property prices would not then over-inflate by much - the estimate is less than 10% even in extremely low interest rate cases.


FULL ILLUSTRATION

MAKING UP THE TEST FIGURES
The figures made up for this illustration show incomes rising at 4.5% p.a. (on an upward trend) while interest rates on 30 year mortgages were fixed for three years at 3.5%. In the fourth year they leap up to 8% which is about 1% above Edward's projected level to rein in inflation in a balanced economy (the mid-cycle rate of interest) and was about the same as the Fed had eventually estimated by trial and error, was needed.

In this illustration, only the first years were deemed to be a problem so economic undulations in incomes growth and interest rates after the early years have not been included in the later years' data. They have been set at long term average rates for a stable economy, based on past data averages.

FIG R1 below - Here the ILS Model intervenes to rescue the American Banks from arrears due to a rise in interest rates from 3.5% to 8% all in one jump at the end of their third year fixed rate term (this is called an Adjustable Rate Mortgage). 

Notice that despite the cost of the payments not rising much at all at first after the fourth year jump in interest rates and slowly thereafter  (see FIG R2 below) this does not lead to the mortgages increasing above the original amount of 100,000. See Orange year-end balances.
FIG R2 below - Here are the figures used for the ILS Rescue Model. The year end balances and the income figures and the payment figures appear in FIG R1 above.




FIG R3 below - These are the same interest rate and AEG figures as seen in FIG 2 above and applied to the traditional US Adjustable Rate Model. 

The outcome for the payments is very different. They become unaffordable in year 4 for prime borrowers after a 58% jump from 5,437 p.a. to 8595 p.a., never mind sub-prime. Many prime borrowers had no capacity to increase payments as they had credit cards to repay.



FIG R4 below - shows the Money costs for the traditional US Adjustable Mortgage Model year by year. Figures sourced from the above table.





FIG R5 below - Shows the Money Cost for the ILS Hybrid (Rescue) Model. It follows the Adjustable Model until the payments become unaffordable in year 4. There is zero jump up in the payments. Source: the above table FIG R2.


FIG R6 below - Compares the two models on the '% of income' needed basis for each year's repayments. Source the two spreadsheet tables above.

The mortgage is so large at 5.22 years' income that there is little room left for payments depreciation, now set at 0.5% p.a. for the ILS Rescue Model, as shown. The ILS Model normally aims to repay in 25 years, whereas the Americans like to offer 30 year terms. A 30 year term allows more to be lent but it raises the cost of all properties and reduces margins of safety. It increases the total cost-to wealth disproportionately as interest has to be paid on high value debt fro an extra 5 years at the start. The alternative ILS Rescue Model here would be to extend the repayment period which actually gives a lot of relief allowing the downwards slope (payments depreciation to reach 2% p.a.).




FIG R7 below - shows how all of the % of income figures may have compared if rentals had cost 70% of the first year mortgage cost and then risen as fast as average incomes (AEG% p.a.). Normally, the ILS Model is cheaper after around 12 years, but that is when the mortgage size is set correctly to allow 4% p.a. payments depreciation. If you buy these spreadsheets all of these bar charts are generated automatically and you can insert whatever assumptions you wish. Rental can start at any figure, not only 70% as here, for example.







TOOL TO ESTIMATE THE LENDER'S ACCOUNTS

For sale: There is also a set of spreadsheets for estimating profits and cash flows under various models and several different tax regimes, all of the tax and inflation and interest rates can be set for the tests.



ALL READERS AND COLLABORATORS

You may also like to join the LinkedIn Group named MACRO-ECONOMIC DESIGN where you can discuss issues with other collaborators.


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