The Ace of Mortgages

I am upset that the federal government in Canada will not compensate me for losses when I go to the casino, and I hope that that seems like an unreasonable request. Residents and potential home buyers in upscale Monterey California are upset that the U.S. federal government will no long assume the downside risk on residential real estate in their area. This should also seem like an unreasonable request.

The issue was brought to light in a recent article in the NY Times. The federal government has reduced the maximum mortgage insurance amount in Monterey County to $483,000, well below the average selling price. This transfers the risk of housing prices onto home owners.

Mortgages can, and have been modelled as put options on real estate. Put options are more commonly understood in the context of equities, or stocks. A put option on Exxon shares gives the buyer (holder) the right to sell the Exxon shares at a predetermined price (the exercise price) prior to some preset date (the expiry date) and imposes an obligation on the seller (writer) of the option to purchase those Exxon shares. The writer is assuming some of the downside risk on the Exxon shares and the holder pays the writer a premium for assuming this risk. A put option is not unlike an insurance policy on a stock. The amount of the premium is related to the amount of time until expiry, the risk free interest rate and the probability that the price of the stock will fall to the exercise price – which depends on the difference between the current price of the stock and the exercise price, and the volatility of the stock price.

A home owner with a mortgage always has the option of defaulting on the mortgage, essentially selling the home back to the lender for the amount of the mortgage. The probability of a homeowner defaulting depends on the loan to value ratio and the interest rate. As housing prices fall, homeowners are more likely to default. Who bears the risk of a default depends on whether the mortgage is insured. If it is, the insurer bears the risk, if it is not insured, the mortgage holder bears the risk. This could be the initiating lender, the holder of a mortgage-backed security, or a government sponsored enterprise such as Fannie Mae or Freddie Mac.

Without government participation in the housing market, mortgage interest rates and down payments would be determined by a potential buyers income and credit score. Lower income and/or low credit scores would require higher down payments and higher interest rates to compensate the lender for the higher risk of default. This is not unlike the pricing of stock options. It is for this reason that Monterey County homeowners are upset. If the government will not assume their risk, they will be required to pay the higher option premium when there is higher risk.

For more information on options see the Chicago Board Options Exchange education center.

For more information on mortgages as put options, see the article by Ronel Elul in the FRSB of Philadelphia Business Review Q3 2006.