Note on the chart above, it shows a loss to the owner of a straddle at asset prices close to the strike price. That’s because it usually costs money to acquire a straddle (or any other option). In those situations, for the long straddle to make money, the asset price has to move far enough into the money to cover the straddle’s cost. So if a straddle costs $10, the asset price has to move $10 into the money to break even (rise above the zero line of the y-axis on the chart above). Every penny further into the money is profit.
However, in the case of the options acquired by homeowners with “zero down” mortgages, the straddle was essentially free. In other words, homeowners get the profit if prices rise and they get to stick someone else with the asset if prices fall. Prices have fallen. Hence, the title of this article.
See below for more of my comments, plus the article that inspired this posting.
My thoughts on this Wall Street Journal article are as follows:
- When you give someone a “zero down” mortgage you have given them a free ATM (at the money) call and a free ATM put. ATM means the option’s strike price equals the asset’s current market price.
- The call remains valid as long as the homeowner makes the schedule payments.
- The homeowner makes the scheduled payments as long as the asset price is rising.
- When the asset price rises, the value of the put approaches zero and the value of the call increases exponentially. The put is “out of the money” and the call is “in the money.”
- To realize the value of the call, the homeowner sells the house, repays the debt and pockets the difference. Everybody’s happy.
- However if the value of the asset falls, the value of the call approaches zero and the value of the put increases exponentially.
- To realize the value of the put, the homeowner stops making scheduled payments and “puts” the house to the lender (i.e., sends in the keys or waits until foreclosure). The put’s value equals the amount it is in the money (strike price minus the current market price), less transaction costs.
It’s funny and sad that lenders and investors (sucker institutions) didn’t realize, or more likely didn’t care, that the house of cards they built would topple if asset prices fell. The real problem is the perverse incentive system and corruption in all parts of the food chain.
The Rise of the Mortgage ‘Walkers’
By NICOLE GELINAS
February 8, 2008; Page A17
Fitch Ratings, while telling investors last Friday to expect additional “widespread and significant downgrades” on $139 billion worth of subprime loans, has cited a new factor in their “worsening performance.”
“The apparent willingness of borrowers to ‘walk away’ from mortgage debt,” the analysts noted, “has contributed to extraordinary high levels of early default” on loans issued during the 18 months before the mortgage bubble burst. It expects losses to reach 21% of initial loan balances for subprime mortgages issued in 2006 and 26% for those issued in early 2007.
Such behavior, where not precipitated by willful fraud, shows that American homebuyers supposedly duped by their lenders aren’t so dumb. They’re perfectly capable of acting rationally without political interference.
While mortgage fraud has abounded in recent years, voluntary foreclosures are not by themselves evidence of a newfound irresponsibility on Americans’ part. To be sure, until recently, mass-scale voluntary foreclosures were unthinkable. But markets have changed, and people are changing their behavior in response.
A decade ago, most people started off with enough equity in their homes to make foreclosure irrational from a financial standpoint. Consider: If you made a 20% down payment on a house, prices would have to fall by 20%, almost immediately, before you lost all your money and had much incentive to walk away. This scenario was unlikely, particularly since an independent appraiser had assigned a clear value to the home. Foreclosure was remote, absent a personal financial crisis, for another reason: Every month your mortgage payment would reduce your debt and increase your equity, giving you more room for prices to fall.
But over the past few years — until last spring — banks and the mortgage-backed securities investors who bought the loans the banks packaged weren’t demanding substantial down payments; they were happy with 5% or even nothing down. They also didn’t worry about whether or not borrowers were building up equity. “Interest-only” loans, quick mortgage refinancings to cash out any equity, and other inventions often led to just the opposite.
Now the bloom is off the residential mortgage-backed securities (RMBS) rose. And some borrowers, even those who can theoretically afford to keep their homes, realize they owe much more than what comparable houses in the neighborhood are selling for — and think that prices won’t rebound anytime soon. So they’re walking away, according to anecdotal reports as well as recent statements by top executives of both Wachovia and Bank of America.
In most cases, once a homebuyer splits, the mortgage-securities investors are stuck with the loss. In some states, including California and Arizona, this provision is the letter of the law. In others, the bank forgives the balance of the loan — a common practice that’s unlikely to change now, given the criminal and civil investigations banks are already sweating through.
Essentially, mortgage-bond investors, seemingly unwittingly, sold homebuyers a put option, without properly pricing it, and now homeowners are exercising that option. Moreover, prime borrowers in many markets face the same incentives.
Yes, this behavior is new — but only when it comes to houses. Americans have long been able to cut their losses from bad investments and start over. It stands to reason that when the market made houses into yet another speculative investment, Americans would do the same.
Borrowers acted rationally in response to market forces and incentives during the bubble: Buy a house because prices always go up; you can’t lose. Many are acting rationally now: Mail the keys back and un-borrow the money, because prices are sinking fast while the debt isn’t. When the house was purchased not as a first home but as a rental investment, the decision is even easier.
Imagine: Politicians keep saying that Americans need protection from their big, bad lenders — but that protection is already there.
Of course, there’s a price. Mortgage “walkers” will take a hit to their personal credit rating. Yet this once-forbidding punishment may be discounted. That’s because, just as when markets change their behavior, people change, when people change their behavior, markets change also.
If hundreds of thousands of people with decent work histories are going to have less-than-stellar credit because of foreclosures this year and next, they won’t suffer so much as in the past. Many walkers are going to want to buy houses again some day; and when they do, lenders are going to want to make money lending them money to do so (hopefully requiring a good down payment). Investors searching for yield likely won’t bypass what could be a large pool of borrowers.
This rapid transformation shows that the continuing political hand-wringing over what to do about failed mortgages isn’t needed. It’s beginning to dawn on lenders and their agents — who assumed that borrowers who could afford to do so would make payments no matter what — that they could be stuck owning hundreds of thousands of houses at a minimum. This realization will pressure the companies administering those mortgage loans to renegotiate more quickly with borrowers in cutting loan balances. Thus, some version of the “Paulson plan” would have happened without Treasury Secretary Henry Paulson’s pressure on the capital markets in December.
Nobody is going to debtors’ prison. Nobody is going to have to toil for 30 years and sacrifice their kids’ future to pay off burdensome loans that they’re stuck with forever because they overreached. (Even if banks and mortgage administrators pursue judgments for post-foreclosure loan balances, there’s always bankruptcy as a last resort.)
As for Sen. Hillary Clinton and her proposed “moratorium on foreclosures”: She may soon find that borrowers, not just lenders, are screaming to let them act within their contractual rights.