By Dr. Darrel Welch, Managing Director, MIAC Analytics Ltd.
Lifetime mortgage (LTM) is one of the latest asset classes to be implemented in Vision™, MIAC’s advanced ALM system.
UK’s lifetime mortgage sector saw a borrowing boom in 2021, with annual lending growth year-on-year from £3.86 to £4.8 billion (24%). So far in 2022, this growth shows no signs of slowing, so MIAC is in the process of further enhancing the software for use with other products such as the corresponding “reverse” mortgage in the US.
In 2019, MIAC partnered with a financial institution that has significant exposure to the UK LTM market in order to deliver a software solution for risk management, valuation and analyses of lifetime mortgage assets in the UK. MIAC has provided this partner with new software solutions for data management, reporting, and analytics for their LTM portfolios. These operational benefits and insights have been specified by both industry experts and technical teams at MIAC, and we are now ready to deliver the software to other financial institutions who are looking for solutions in the UK LTM space.
Due to the complexity of modelling lifetime mortgages, and the increase in the number of originations over the past few years, many institutions are looking to replace their spreadsheet models with a more efficient software solution. Additionally, the following challenges require enhancements outside the reach of spreadsheet capability:
- Issues in run times due to the increasing size of the book and the complexity of the calculations involved. Spreadsheet solutions reach a point where they fail to be scalable with the business.
- Spreadsheet solutions do not lend themselves well to ongoing data management and reporting requirements. They are particularly prone to implementation error and version control, a major source of model risk.
- Constraints by the Black Scholes option pricing model for estimating loss and the embedded assumptions, including:
• Normality of house price returns
• Markov property
- Difficulties of implementing simulation capabilities for a large portfolio of loans means analysts are limited to deterministic scenarios and probabilistic cash flows.
- Further enhancements are required, including
• Pricing with/without liquidity premiums
• Provisioning under CECL/IFRS9
• Simulation of macroeconomic variables, mortality, prepayment, and drawdown
MIAC is continuously extending Vision’s functionality to accommodate new classes of assets and liabilities. Partnering with an established LTM investor was the perfect opportunity to work with LTM market professionals and extend the list of products which can be modelled in Vision to include this growing asset class.
Because Vision is a database application, it does not suffer from many of the restrictions and limitations posed by spreadsheet models. The partnership provided an existing internal spreadsheet model which was replicated in Vision. MIAC then added numerous enhancements requested by the client.
DataRaptor®, MIAC’s ETL software application, was also licenced by the client to solve issues relating to data management and reporting. DataRaptor handles a wide range of tasks, including data aggregation, normalisation, auditing, encryption, automation, and reporting. DataRaptor users can:
- Input data in any format from multiple sources
- Apply a set of data auditing rules, transformations, and aggregation
- Output to multiple downstream applications, such as Vision
The result is an end-to-end solution, from original data source through sophisticated analytics and insights, presented in configurable reports for consumption by stakeholders across the enterprise.
Replication of the existing spreadsheet model, which produces probabilistic cash flows at the loan level, has provided the ability to run many scenarios more efficiently and in a fraction of the time than it previously took with the spreadsheet model.
Clients who licence Vision for LTM purposes benefit from additional functionality within the application, such as cash flows analysis (both probabilistic and realised), loss calculations, pricing, CECL/IFRS9, agency replication grades, sensitivity analysis, and VaR calculations.
Vision’s stochastic scenario tool produces deterministic cash flows, which are then aggregated over many simulated paths, so that the user understands the future distribution of all cash flow elements rather than just the probabilistic expectation. The tool is highly flexible and allows users to calibrate stochastic models to macroeconomic variables (such as interest rates, house prices, and unemployment). This calibration can be fully automated or customized by the user. Correlations can be automatically calibrated or manually adjusted so that the resulting joint distribution of scenarios is reasonable. The scenario tool also allows users to stress test correlations, which can be important for LTMs.
Additionally, simulations of mortality, long-term care and prepayment are provided so that the full variability of the unknowns is flexed in an intended and well understood manner. Another main benefit of using the simulation approach is that users are not constrained by the Black-Scholes methodology used with the probabilistic approach for the calculation of the “No Negative Equity Guarantee” (NNEG). The NNEG feature of LTMs provides that the obligor will never be responsible for paying back more than the value of their home. Equivalently, it is an option held by the borrower to put the house back to the lender for the loan balance. With stochastic home price paths, the entire distribution of loan losses can be calculated and assessed.
Vision has removed inefficient multiple spreadsheet dependencies and has become a valuable analytical resource for LTM clients who require cash flows analysis (both probabilistic and simulated deterministic), loss calculation, pricing, CECL/IFRS9, agency replication grades, sensitivity analysis and VaR calculations.
Software support is included with all MIAC software licencing. MIAC has dedicated global teams in the UK, US and Asia for round-the-clock support, ready to help with any technical or software-related queries. This enables our clients to quickly acquire operational software knowledge and encourages a constant exchange of ideas and solutions between LTM experts and MIAC’s analytic, development, and support teams.
We will continue to collaborate with lifetime mortgage experts in this important product segment so that Vision includes the functionality and features required by both market participants and regulatory agencies, in the current market and into the future.
MIAC Perspectives: Lifetime Mortgage in Vision™
Dr. Darrel Welch, Managing Director, MIAC Analytics Ltd