Focus on the probable

This article examines the use of probability in mortgage risk assessment. We believe millions of aspiring homeowners would be tens, if not hundreds, of thousands of pounds better off in retirement if banks – and their regulators – stopped speculating about wildly improbable risk scenarios. Loans designed with more realistic guard rails would help people in their twenties get a foothold on the housing ladder. Some will inevitably fall. But the data suggest it's best to focus on ways to help the many millions who risk getting left behind.

Number Eighteen: The Infinite Improbability Drive

A spaceship equipped with an Infinite Improbability Drive could cross interstellar distances in a mere nothingth of a second. Activate the Drive and the ship would pass through every conceivable point in the universe simultaneously. All one need do is alight when you reach your destination.? In this scenario from the Hitchhiker's Guide to the Galaxy, an incredible range of highly improbable scenarios were accorded the same weight, no matter how ludicrous.

No laughing matter

This allegory sheds light on the real but measurably remote risk that making deposits optional might pose for mortgage banks. Rules designed to reduce systemic risk are critical but must be seen in context. More time should be spent analysing likely outcomes, good and bad. Less time should be spent on fanciful what-if scenarios.

Closing off opportunities for people to rise creates a different type of systemic risk; one that unfolds on a generational timescale. Imagine if removing barriers to buying a home in your twenties would make two million families a hundred thousand pounds better off in retirement. That's a cool two hundred billion of value in aggregate – about four times the ￡46 billion the government invested to rescue Royal Bank of Scotland in 2008. Stepping further back, two hundred billion is about 7% of Britain's ￡2.7 trillion national debt. And my suggestion wouldn't cost the taxpayer a penny.

First the facts?

According to UK Finance – the banking industry body – some eight, nine, or maybe ten mortgages are foreclosed daily.? Count them on your fingers and toes. Given nine million mortgages outstanding, the annual probability of foreclosure is about four events per ten thousand loans.?Each such event is a tragedy for the family concerned.

Your home is at risk if you fail to keep up repayments. Go back to renting. Do not pass Go. Do not collect two hundred dollars. People who lose their homes suffer the same fate as those denied the chance to buy in the first place.

All lessons about probability start with tossing coins. Imagine giving ten thousand recent medical graduates a pound coin each. Those that toss tails return their pound to you and take a seat, leaving roughly five thousand still standing – not fifty, not nine thousand.? Those two extremes are possible but are only probable if you have an Improbability Drive handy.?

Repeat the exercise ten more times and there’s a decent chance you’ll have four doctors left in the game – comparable to the annual risk of mortgage foreclosure.

For those who want to follow along at home, try multiplying ten thousand by fifty percent, raised to the power of eleven

Default risks were higher during the financial crisis but not meaningfully so. We're talking Hollyoaks, not Hollywood. Movies like The Big Short and Margin Call were set in America, not Britain – notwithstanding Jeremy Irons' scene-stealing performance as a patrician if rapacious, British banker in the latter film. Mortgage risk sloppily repackaged into collateralised debt obligations is not the same as primary foreclosure risk in Merseyside, Teesside, or Tyneside.

A bank's loss given default might be 25% of the outstanding loan (it’s not that high, but humour me). In this analogy, starting with ten thousand pounds, you will probably lose a pound.? How many risk managers would you pay to dream up strategies to reduce that loss to fifty pence?

The future is unknowable but not chaotic

Risk management is about avoiding downside but not at any cost. There are dozens of ways for a borrower to default. Equally, there are millions of ways for borrowers to pay their debts in full without incident. Generating value for shareholders, customers, and their children means embracing at least some risk.? Making home loans illegal would eliminate mortgage default risk at a stroke but at what cost??

To quantify how much risk is prudent, one must expend considerable effort thinking through scenarios that are highly likely to happen.?

It takes decades to buy a home; for most that means the whole of their working lives. This chart depicts median income for people employed full-time in Britain divided into age cohorts. The chart assumes that today's twentysomethings will enjoy the same uplift in earnings as their careers progress that enjoyed by prior cohorts of twentysomethings over the last forty years. Given the rapid pace of technological change, that's not assured but it's not improbable.

Cost of living in a home of one's own

The red component of each bar represents 40% of the initial income for these twentysomethings, anchored as a constant number – a proxy for a forty-year fixed rate loan from a bank enlightened enough to issue one.? See Perenna's product range, for example. In this construct, the loan becomes easier to service as time passes. And, if the loan repayments are fixed, few shocks will upset this picture.

These data reflect the assumption that earnings might grow at 1% per annum in real terms, broadly in line with an anaemic economy on a generational timescale. Nudge the real growth rate up a smidge and the proportion of income required to service the loan will fall further still as the decades roll by.

Likewise, as the mortgage is fixed in nominal terms, I have assumed 2% annual average inflation, bang in line with the Bank of England's long-term target. To make the analysis starker, I have assumed that none of these kids, partner up with another income earner and halve the cost burden at a stroke.

Bottom line: buying a home in your twenties could benefit millions of people if the deposit hurdle were scrapped. The loan repayments might be expensive, at first, but no more so than renting. Moreover, these payments will become more affordable over time, probably.

If you've read this far, you might imagine banks are keen to lend to doctors on any reasonable terms. Not so. A pair of medical graduates might pull in about ￡70,000 – well above median household income. In all probability, they are no more likely to default than other home buyers. And yet, they lack savings, almost all carry a lot of student debt and very few have rich parents. So, they struggle to buy homes without a substantial deposit. Don't look at me. Ask them.

Banks are missing a trick

Making mortgage deposits optional only for junior doctors would be a lucrative area of focus. Ten thousand doctors a year?translates into five, six, seven thousand homes worth perhaps ￡300,000 each. That's around two billion pounds of business going begging annually. To put this in perspective, Atom Bank and Generation Home came out of the blocks as new banks lending about a billion each in their first year of launch.

Trigger warning. More maths. Take five years' worth of rent – say ￡20,000 per annum for a total of ￡100,000 – and invest these savings in a house for forty years. That house might appreciate at a compound annual rate of 2% faster than inflation – in line with the worst performing towns in Britain in the last couple of decades. Even on these lazy assumptions, these doctors would have an asset worth an incremental ￡200,000 at retirement.?

There’s a fair chance these doctors could achieve a 4% average annual rate of return, in which case, they would be half a million pounds better off in retirement.? Half a million could buy a decent home, even in the home counties. These are likely scenarios. Fearing that a tossed coin might land on heads eleven times in a row is like a scenario straight out of the Hitchhiker's Guide.

Denied the chance to buy for just five years, wealth will be transferred from these essential workers to their landlords.?A government hell-bent on robbing Peter to pay Paul can always depend on the support of Paul. But, last I checked, Peter gets a vote too.

A swift modest proposal

Let's form a bank that only lends to GenZ doctors willing to pay extra for the privilege of buying a home immediately after graduating.?Eight pounds a day sounds about right. That's like forfeiting a cup of coffee each for a couple of house hunters. Over forty years giving up caffeine costs about ￡120,000. That sounds like massive compensation for little risk to me, but still, how many young docs would jump at the chance??

I use young doctors as an example, to make a point. Who doesn't love a junior doctor? They earn about ten percent more than the average person in their twenties and their earnings rise faster. Then again, three oncology nurses sharing a place in their early twenties earn slightly more than a pair of junior doctors. Perhaps they too could join the fun. After all, the chart above is based on increases in average incomes, not the career trajectory for brain surgeons.

What would be the likely default losses to a bank that specialised in lending to oncology nurses only? And would all that Starbucks money be sufficient compensation??

Answers on a self-addressed postcard, please.

#fintechinnovation starts at home

?Ike Udechuku | Cofounder | CEO | The Pathway Club

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