A good lesson in finance is to sell what you can hedge. That is, a guiding principle in product design is to produce a structure that leaves your book looking good, either because it hedges risk you have already, or because you can find a liquid hedge instrument with no nasty basis risks or unquantifyable factors to spoil your risk reports.
On that criteria, participating mortgages look good. Here rather than loaning money against property collateral, the bank also has an equity stake in the house. If the house value goes up, the mortgage redemption amount does too. Crucially though if property values fall, then so does the mortgage amount, protecting both borrower and lender from the trap of negative equity. As FT alphaville points out in coverage of a speech by Andrew Haldane,
a traditional mortgage incentivises cash-machine like use, either through equity withdrawal or ‘trading up’ when assets are appreciating — hence accelerating the house price rise effect — it happens also to amplify the exact opposite behaviour when asset prices depreciate.
The good news first. This type of mortgage would have a direct hedge using property derivatives. Banks could sell their house price exposure on to investors in a very clean fashion. (A conventional mortgage has house price risk via the property prices fall-defaults rise-mortgage losses rise spiral, but there is no accurate hedge for the exposure.)
Moreover, as Haldane says, this type of mortgage would be good for the financial system by reducing the amplitude of the credit cycle. There would be fewer defaults, and this would be good for borrower and lending.
To see the idea in action, suppose I buy a house for £100,000, with an 80% mortgage. If house prices go up 20%, then my place is worth £120,000. Presumably under Haldane’s proposal, my mortgage amount goes up from £80,000: for instance under a 50% participating mortgage, the bank would get half of the increase in value, so if I sold, I would have to repay £90,000 (minus whatever principal I had paid off while the loan was in force). Therefore I walk away with £30,000: my original deposit, plus half of the property price appreciation.
However, the kind of place I want to live in now costs £120,000. My thirty grand will get me a 75% LTV loan on a new place worth this much. I have deleveraged my property exposure, but not as much as I would have done with a conventional mortgage.
If property prices had fallen 20%, though, my loan amount would fall to around £70,000, and I would not have lost my whole deposit. I would still have positive equity, and hence an incentive to perform on the mortgage.
[Obviously we can imagine more complex participation structures, for instance where the mortgage holder is effectively long a put spread on some of the notional and short a call spread.]
The bad news is of course that the borrower makes less from rising house prices in this structure. They have less leverage. Hence I suspect the structure would not prove that popular even if banks were to offer it. It’s an intriguing (and very Islamic) idea though.
Posted in:
Mortgages
by
David
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