Monday, July 25, 2016

Mortgage literature bleg

Do any readers know of literature proposing the use of mortgages with adjustable interest rates but fixed payment rates?  Sort of like an option ARM, but without the option.  The payment doesn't adjust with the interest rate, the principal does.

Does anyone know if there are detailed proposals of this sort of thing, or if there is anywhere where mortgages like this are used?

15 comments:

  1. I looked into this back in 08 when I was in undergrad. I didn't find anything then.

    It seems like many would benefit from it. Certainty in payments but at a reduced price from taking on duration risk.

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    1. My thoughts exactly! Thanks for the input. The potential social gains seem significant.

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  2. Why not just rent? Buying a house with no certainty that you will ever own it seems a bit absurd, although if you bet right....

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    1. The mortgage can easily be set up so that it fully amortizes over 30 years in either form.

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    2. Hi Kevin, I get that. But, if interest rates go up, and the payment doesn't, and the money not paid is tacked on the end of the loan, wouldn't that mean that under inflationary circumstances it would be difficult to pay off? I don't think we will have much inflation as the worlds' economies mature, but it is theoretically possible.

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    3. No. The payment would be fixed as a % of principal, not in absolute dollars, so in your scenario the payment would still slowly decline over time in real terms.

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  3. There are negative amortization loans.

    https://www.mortgageloan.com/negative-amortization-mortgage

    In California, the law requires non-recourse property loans, at least on residential property. There may be some conflicts there.

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    1. What I am thinking of is something where the terms are stable and the amortization period remains set. It is a more stable mechanism than I would have thought. The problem with these negative amortization, option ARM, etc. loans is that, for some reason, they tend to come with discontinuities in their terms.

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  4. If it's not a negative amortization loan (as you say) and the borrower accepts duration risk in exchange for a lower price (as you say) and the borrower has a set amortization period (as you say), then the borrower cannot be allowed to payoff the loan prior to maturity.

    I think there is an impossible trinity here, with the borrower's acceptance of duration risk being incompatible with the borrower's right to prepay prior to maturity.

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    1. There is no duration risk. The interest rate would be floating on short term resets. Any difference between the interest rate and the repayment rate would be amortized over the remaining life of the mortgage. The amortized interest would have to be repaid at the time of prepayment. Given that, the bank would be indifferent to prepayment, since there would be no duration risk.
      I admit the post was a little light on details. Does that clear it up?

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  6. I don't think so.

    If rates fall, there is nothing extra to be amortized so it's an adjustable rate mortgage where the borrower guessed right.

    If rates rise, and the excess to be amortized has not been paid at the time the mortgage is paid off early, it's a negative amortization mortgage, where a balloon payment of the unamortized part is added to make the bank indifferent.

    A different way to look at it is that if that all of these features, like a) giving the borrower the ability to prepay without penalty (standard in residential, not in commercial) or b) floating rates with deferred amortization on incremental payments, are equivalent to put or call options on the underlying security. The bank has to price these options as part of the rates it offers the borrower. My question in this context is exactly what option are you proposing to offer the borrower and how is it priced? Someone has to bear the economic cost of this option.

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    1. Again, I think this is my fault for lacking detail in the post. The payment would change to reflect the new principal. Let's say the payment rate was 5%. The borrower would make payments as if it was a 30 year 5% mortgage. If rates in a given year were 6%, then the next year the principal and the payment amount would increase by 1%. So there would be an adjustment in payments over time, but the real payment amount would still tend to decline.

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  7. The real payment amount would tend to decline because the principal is being amortized.

    Where is the economic transfer or the risk transfer taking place in the variation you're describing?

    I suggested that one way to make this explicit was describe and price the options embedded in the mortgage, like the right to prepay without penalty.

    Another way to make this explicit is to specify what type of hedge the bank would have to buy to offset the risk of the mortgage not delivering the expected rate of return.

    It's almost certainly the case that the bank can define, price, and acquire the hedge positions or options at a lower cost than the individual borrower. It's also the case that the bank is better able to diversify against any idiosyncratic risk (no pun intended) than the borrower but the bank has to know what risk it's trying to diversify against.

    For the mortgage you're suggesting, can you specify these risks or the options / methods that would be used to hedge them or diversify against them?

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    1. If the payment rate is based on 5% interest, and the market rate is 5% for the life of the loan, payments would remain level for the life of the loan. Payments only change if the market rate moves above or below the payment rate.
      It's floating rate but the bank takes some payment in the form of principal instead of cash. There is nothing to hedge. No risk from prepayment.

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