Friday, September 21, 2012


Ongoing re-writes, updates, and additional material are noted on the LATEST UPDATES page.


Blog launched Late Friday 21st September 2012
Re-written 7th October 2012,
Edited again 14th October 2012, 29th November 2012. Only slight grammar changes since then.

People are worried about the effect of all these QE money printing activities.
They should also be concerned about a Low Interest Rate Trap of our own making.
And some are concerned because incomes are falling, not rising.
All of these problems can be more easily resolved if we adopt wealth protection contracts for government debt and for mortgages and business finance.

The QE problem:

These three economists, (see link below),

famous for forecasting the economic crisis, are forecasting hyper-inflation or at least enough to ruin savings by 2015. It would not take much: 20% inflation halves money value in three and a half years. Imagine if you are holding 20 year fixed interest bonds yielding next to nothing. Even the forecast can affect people's behaviour which may have unexpected consequences. There are some signs, with banks stocking up on gold, for example. But gold is also an unstable asset not well suited to a bank that wants stable reserves that can grow as fast as the demand for new loans - at least as fast as incomes are growing.

Whether you are worried about inflation or are worried about interest rates rising during a recovery or you are worried about  average incomes falling, you should read this:


Regardless of what people think will happen, one day, economic recovery is inevitable,  and that creates a problem for Housing Finance and Bonds. The currently used Level Payments (LP) debt structure obstructs rapid interest rate adjustments made by central banks. Varying the interest rate is the most important instrument used by central banks for managing inflation and it can help with speeding economic recovery from within the economy, but there are limits. Interest rates also find their own level in the broader sense, leaving central banks to make only moderate changes. That is, if they don't undermine the currency by printing too much money after which they may not have the means to harness to slow inflation. Anyway, why are they doing it? It enriches the the Central Bank and takes wealth from everyone else. It creates a new imbalance and is very painful for people with savings.

That apart, with the recovery comes rising interest rates. This is true whether we get hyper - or mild inflation, or neither. We are expecting interest rates to exceed 7% at some point - best scenario - as explained below. And this brings us to the problem. Have a look at Fig 1.

Fig 1.

Here is a table showing what happens for a 25 year variable rate mortgage – the figures are worse for a 30 year mortgage. The initial cost of the mortgage rises by 13.5% in response to the first 1% increase in interest rates and by 12.8% to the second raise and so forth if we start at 0% interest.

Even if we start at 5% interest a 1% raise in the interest rate will take up the cost of a new mortgage by 10.3%.

So raising rates by 4% from a level close to 4% (say) like the Fed was doing will take payments up by 46% from say 6,401 p.a. to 9,368 p.a.

And there is another effect: property prices get thrown around. As interest rates fall property prices go through the roof. When the interest rate rises again, they crash.

It does not matter whether we use fixed interest rate mortgages or not. New mortgage sizes run amok and the cost of a new mortgage and the effects on wealth linked to property prices and on collateral security and the effect on 'the temptation to borrow' runs wild.

This is not the kind of mortgage model that we want at the centre of our economies. It has nothing to do with Adam Smith's expected pricing response to an imbalance.

The question is this: How fast and how far should the response in mortgage costs go and what is the driving force?

The driving force, which raises interest rates, is rising spending which comes primarily from rising incomes, AEG% p.a. Rising demand causes rising prices and it also causes rising interest rates. Interest rates may also be raised further so as to keep a grip on inflation and on the risk to the wealth of the lender. If the currently favoured Annuity / Level Payments (LP) Model is used.especially if fixed rates are offered, that risk to the lender's wealth can be significant. If the variable rate model is used, the higher the risk to wealth the faster interest rates have to rise to compensate, and this creates much higher risk of default and risk to property values, leading to a crash of the whole system.

To keep mortgage costs in balance mortgage payments need to rise at a similar pace to Average Earnings / Incomes Growth, AEG% p.a., like rentals do, not ten times faster and vice versa when interest rates are falling. To meet Adam Smith's pricing expectations, mortgage payments must be designed to mimic rentals - rising as incomes rise. Rising incomes take the demand for everything higher, and a proportionate increase in interest rates and in mortgage repayments is called for. Not a multiple of that. By taking out the multiple we can solve the problem.

If the RATE at which incomes are rising (AEG% p.a.) changes then a change in the rate of interest is signaled. Central banks also like to add other changes to interest rates besides the natural rate changes and there may be other factors at play. But this is the broad picture.

Lenders are unable to cope with rapidly rising interest rates because they find that the Level Payments (LP) mortgage model in use does not allow them to raise interest rates much. The LP mortgage model obstructs the whole principle of adjusting interest rates to counter rising incomes, even when the rise is only about 2% from a low starting level of 3%.

It gets easier to make the adjustment if you are starting from a higher interest rate level, as most other nations did when the crisis years began. Some nations claim that they had some, less than obvious, superior model, or regulations, in use; but that explanation is not needed to explain their escape from the crisis. With smaller mortgages and fewer home owners with less owed they were not so vulnerable.

We can see that from the figures in Fig 1. This shows that higher initial interest rates takes us to a less sensitive part of the table. That, combined with lower sensitivity to increases in interest rates, and faster rising incomes linked to the higher starting point for interest rates, is all the explanation that is needed to explain why Canada and South Africa, to name two examples, escaped the worst.


To bring mortgage structures into line, we can use the Ingram Lending and Savings (ILS) Model. The starting point is the behaviour of interest rates. If we are to have a sensible response to rising demand in the economy, when incomes rise by 1% we may expect interest rates to follow suit so as to keep things in balance. That is pure and simple 'Adam Smith's pricing mechanism' at work, as explained here:

Below is a table which illustrates several things at once:
NOTE: AEG stands for Average Earnings/Incomes Growth.

The loan starts at 100,000 in any currency. Interest starts at 1% so 1,000 is added at the end of year 1. Payments start at 6,200, payable at the end of year 1, and the year end balance is 94,800.

The following year, the ILS model gives two instructions about the level of payments in the second year. Firstly it instructs the payments to rise by the rate of AEG% because rising incomes create rising demand, and in this illustration the interest rate rises to 2% because by then incomes are rising at 2% p.a. in response to increased spending power (OK the fugues are fixed but let that pass and wait for the explanation). But that is not all. Secondly, the ILS System also instructs the payments to fall by 4%, (the D% Column), so the net effect is that the payments would fall by AEG% - 4% = -3% at the end of year 1. The payments because AEG at 1% p.a. is lower than D% at 4% p.a. (D% stands for Payments Depreciation (relative to incomes, or AEG). Consequently, payments only rise above the initial level in year 7, despite interest rates rising by 1% p.a. for the full 25 years:

Fig 2

Source: Edward C D Ingram Spreadsheets
Now if you look at the ‘% of income’ column you see that although incomes keep on rising faster and faster, the ‘% of income' needed to repay the mortgage falls every year by D% = 4%. See the 'Average % of Income' column. There is a slightly different figure in the final year for reasons that have not yet been discovered. But then we can add up the total income that has been spent by adding up all of the ‘% of income’ payments from year 1 to year 25. This comes to 4.84 years’ income for this theoretical borrower whose income has been rising at the same rate as AEG% p.a.

To find out how many years' income was borrowed, we take the 100,000 loan and divide it by the initial income of 20,667. This is also shown in the table at the bottom as 'Loan Size as a multiple of income = 4.84 years’ income.'

The two figures, the amount of income borrowed and the amount of income repaid, are identical, although incomes have been rising and interest has been added. The fact that both AEG% p.a. and the nominal rate of interest both rose at the same rate and both rates were always equal guaranteed this outcome. This has something to do with why interest rates have to rise when incomes are rising - it helps to keep borrowing costs and demand in balance.

PLEASE NOTE: The illustration is not a description of how the ILS mortgage model works in practice. For that please read other web pages and read the mathematics.

So a significantly over-sized mortgage loan was afforded and despite incomes rising, taking interest rates up with them every year for 25 years, the borrower experienced no discomfort. Even borrowers whose incomes did not rise quite as fast as AEG every year would be OK with this.

The same data on interest rates and AEG was applied to the Level Payments (LP) mortgage model that we usually use. Then the ‘% of income’ paid by the borrower each year for both models was compared in this bar chart:

Fig 3

Source: Data from Fig 2 above and Fig 4 below
Now we see that the LP model lent far too much at 6.61 years' income. Both models started by using 30% of income in year one, but as soon as interest rates started to rise, the LP model responded far too fast and so it was immediately in difficulties. It also lent far too much because of that dynamic over-response which took the 'entry cost' (the first year cost) down due to the 1% nominal interest rate. The  result: the ‘% of income’ needed to repay the debt did not fall below 30% until year 14.

And in the spreadsheet where the total ‘% of income’ paid was added up it came to the same 6.61 years’ income exactly. The interest cost-to-income of borrowing 6.61 years' income was nothing even though the nominal rate of interest was always rising and finished at 25%. It was not the interest rate that caused the over-lending and the arrears problem. It was the LP repayments model which caused those two problems.

Here is the spreadsheet:

Fig 4

Source: Edward C D Ingram Spreadsheets

You see here that the LP model does not control D%. The payments would get easier by the amount by which incomes are rising: that is to say, at AEG% p.a. And that is what has been written into this table in the 'D% column'. 

So what have we learned?
We have found out that the LP model is unsafe.
And we have found that if the interest rate rises as fast as AEG% and is equal to AEG% it costs no income to borrow money. This is a good reason to expect interest rates to rise as fast as AEG% p.a. rises. Otherwise, if interest rates got left behind, the borrowers would repay less income than they borrowed and then they would have some spare income to spend after repaying the loan. The loser is the lender and the saver's income saved - or wealth. Wealth (spendable income) moves from lender to borrower. Here is how this works:

When that interest rate r% is not equal to AEG% there is a cost, either to the lender if the interest rate is less than AEG%, or to the borrower if it is higher than AEG%. We are ignoring administration and risk costs here. Economists call this the marginal rate of interest, the difference. But there is no term for this in any dictionary, so herein it has been called the ‘True Interest, I%’. So by definition:

I% = r% - AEG%.

See APPENDIX 'A' at the bottom of this page for an illustration.

Here is a table (with some additional information for later) that shows how much extra income is needed to repay a 25 year mortgage at various FIXED rates of true interest (the above example was an illustration of a Fixed true rate with the true rate fixed at zero):

Fig 5 assumes that 3.5 years’ income has been borrowed and that AEG= 4% p.a. But it is fairly accurate for any normal range figures. Ignore the first column for now. What is important is the true interest rate which can be altered by altering either AEG% p.a. or by altering the interest rate. 

I% = r% - AEG%, so I% rises if AEG% falls or if r% rises and AEG% does not.

Fig 5
Source: Edward C D Ingram spreadsheets based on various true rates of interest. The profit and loss figures are not very different at other rates of AEG% p.a. and interest, r%, within reason.

The true interest rate varies either as AEG% varies, if we keep the nominal interest rate fixed, or in this case as tabulated, if the nominal interest rate varies and we keep AEG% fixed.

If we ignore the left had column, and go by the true interest rate column only, the table can be used to see the effect of the resulting true rate of interest, no matter which effect changed its value. In this case, we could equally be looking at the effect of changing AEG% p.a. on a Fixed Interest mortgage bond as the value of AEG% varies.

If we assume that the effects on the wealth of the lenders and on the wealth of the borrowers is caused by rising AEG% and that the lenders and borrowers are using fixed rate Bonds, we can begin to see what all the panic is about. If QE results in a lot of inflation then the bondholder will make losses as shown in the last column when the true interest rate is negative. How does that work?

Say the borrower is offered a 3% fixed interest loan and AEG% started at 1%. The true rate is 2% so the lenders were expecting a profit of 22.2% over 25 years, (see the table), less administration costs and negligible risk costs.

But then AEG% rises to 7% making the true interest rate fall to -4%. Now they will lose 37.5% of the wealth that they invested. 15.8 months of spendable income will be saved by the borrower. Instead of having to repay the 36 months of income borrowed, it will only cost  20.2 months of (average) income to repay the mortgage. The cost to a particular borrower will be different but we can only measure averages.

But that is not all. The bondholder may have lent for the full 25 years allowing the bank to re-lend all of the repayments. In that case the loss on the Bond will be as shown in the final column = 64% loss. This 64% loss figure also applies to the loss by an investor on a 25 year government bond where the true interest rate falls to -4%.

And that is only for an AEG% = 7% p.a. Some economists are forecasting AEG of way over 10% p.a. even 20% p.a. for a time. Those Fixed Interest Bonds will be worthless. Mortgages will be unaffordable and property prices will first collapse, and later rebound, as and when the economy recovers. That is how it happened in Zimbabwe. The Building Societies,  largely steered by my co-director Graham Hollick, switched from lending, to investing in property. So they survived.

In my new ILS mortgage model, we cater for this eventuality in the fine print. This gives the lender the right to a stake in the properties in place of collecting unaffordable repayments, thus protecting borrowers from eviction and the lenders from bankruptcy.

What will happen to lenders? For lenders to raise new money as AEG% p.a. is rising as economic recovery sets in, and to avoid offering negative true interest to investors, interest rates will have to gallop ahead.

Have a look at how that affects the LP model and how it affects the ILS model – go back to Fig 3. The bars for the LP Mortgage Model rise too fast and loan sizes crash down. In that illustration, in Fig 3, the rate of increase in the interest rises slowly at 1% p.a. In reality the rise will be much faster and the shock will be much more severe.

But this is not just a problem for high inflation times. Remember that the LP Model responds to rising interest rates much faster when starting at low interest rates. See Fig 1. We also saw from Figs 2 and 4 that as an economic recovery tries to click in (AEG% rising), that must raise interest rates just as fast as AEG% rises in order to protect lenders and investors. If we just leave central bank interventions out of it that is probably what will happen plus or minus some lags in the system.

Otherwise, if the interest rate rises less quickly, the hard earned income that has been lent will be spent by lucky borrowers who repay less income than they have borrowed and they will save a few months of income in their repayment cost as in Fig 5 above. The aftermath will be lenders short of funds to lend, impacting on the economy. And an older generation that becomes less wealthy and more dependent on their families and on the state. That is neither economically healthy nor socially acceptable as a policy.

So now we fall into the Low Inflation Trap. If interest rates rise with the recovery, property values will fall. The mortgage sizes and the cost of repayments using the LP System cannot cope with a return to the mid-cycle interest rate associated with a healthy economic recovery. A discussion on where the Mid-cycle rate of interest may be can be found here:

Even if our inflation fears (where this essay started) are not going to come about, we still earnestly hope for a recovery in the economy. And here again we have to agree with the findings of those alarmist writers referenced herein. They also say that interest rates will always return to 7.5% or thereabout. 

In outline:

Do we know where that mid-cycle interest rate should be?
There is a formula for estimating that:

True interest rates in more normal times, say in the UK from 1970 to 2002 for which there are figures, averaged +3% on UK prime mortgages. See Fig B in the Appendix below.

Assume that this 3% true interest rate is the mid-cycle rate for UK prime mortgages, the rate at which supply and demand come into balance for risk free (almost) lending.

Allow inflation to be targeted at 1% say. This is the middle of the UK inflation target range.

Add the real rate of economic growth that economists think is sustainable, say 3% p.a. for the UK. Now we have average incomes rising at about 1% + 3% = 4%: 1% for inflation, plus 3% for incomes rising faster than inflation to  give  real economic growth.

Put nominal interest r% = 4% and you get a zero true interest rate = cost free borrowing: what is borrowed is the same income multiple as what is repaid. Add 3% true interest to restrain the demand for borrowing and you get a nominal interest rate r% = 7%. Put target inflation at 1.5% and you get r% = 7.5% and so forth. Yes, as the authors wrote, 7.5% is not an unexpected rate of interest.

Edward used this formula to forecast that the Fed would need to raise interest rates by 4% + just to grab hold of inflation in 2006 – 2008 and indeed that is exactly what they tried to do. His forecast was far more accurate than the expert opinion at the time.

So now we have a pretty convincing argument saying that interest rates will return to 7% or more when we get full economic recovery.

As stated at the start, we need new debt structures. We need debt structures that protect the wealth of the lender and the costs of the borrower. If you study the Blogs, or join the online school and take the lessons, you will know all of the whys and wherefores and how it all works. Policymakers that do this and lenders will know what to do.

How do we sell the idea to borrowers? Here is a first 'draft video' on U Tube:

We also need regulations that limit the low end of the entry cost (the initial mortgage payments) so that the mortgage sizes are kept under some kind of control - always somewhere near to the mid-cycle range. Now we have some idea of where that mid-cycle area is based upon the formula above, we can do that.

 Look for these pages:

The reader might now consider looking at the essay on Wealth Bonds here:


Fig A
Source: Slide prepared by Edward C D Ingram for University Lectures

Fig B

The faint yellow line is the difference between the interest rate r% and the rate of AEG% - incomes growth in the UK. It is called the true  rate of interest or the marginal rate above AEG%.
Source: Edward C D Lecture for Universities.

RELATED BLOGS - Research Findings and Board of Directors - Implementation plus some research findings - Free online school in macro-economic design - Tentative suggestions for policy makers and other uses of the research findings.