Mortgages Were Viewed as Option Contracts by Speculators

By Robert Thomson | May 3, 2009 | Popularity: 1% (?)

The options market is a speculator’s paradise. Buying and selling options contracts requires a knowledge of how they work and what gives them value. During the Great Housing Bubble, residential mortgages took on the characteristics of options contracts. This was not by design. The practices of lenders created this problem, and in the end, it cost lenders and investors a great deal of money.

An option contract provides the contract holder the option to force the contract writer to either buy or sell a particular asset at a given price. A typical option contract has an expiration date, and if the contract holder does not exercise his contract rights by a given date, he loses his contractual right to do so. An option giving the holder the right to buy is a “call” option, and the option giving the holder the right to sell is a “put” option. Writers of option contracts are typically obtain a price premium for taking on the risk that prices may move against their position and the contract holder may exercise his right. The holder of an options contract willingly pays this premium to limit his losses to the premium paid if the investment does not go as planned. Most options expire worthless.

Mortgages took on the characteristics of options contracts in the Great Housing Bubble. Speculators utilized 100% financing and Option ARMs with low teaser rates to minimize the acquisition and holding costs of a particular property. The small amount they were paying was the “call premium” they were providing the lender. If prices went up, the speculator got to keep all the gains from appreciation, and if prices went down, the speculator could simply walk away from the mortgage and only lose the cost of the payments made, particularly when this debt was a non-recourse, purchase-money mortgage.

Another method speculators and homeowners alike used was the “put” option refinance. Late in the bubble when prices were near their peak, many homeowners refinanced their properties and took out 100% of the equity in their homes. In the process, they were buying a “put” from the lender: if prices went down (which they did,) they already had the sales proceeds as if they had actually sold the property at the peak; if prices went up, they got to keep those profits as well. The only price for this “put” option was the small increase in monthly payments they had to make on the large sum they refinanced. In fact, on a relative cost basis, the premium charged to these speculators and homeowners was a small fraction of the premiums similar options cost on stocks.

Of course, mortgages are not option contracts, and lenders did not view themselves as selling option premiums to profit from the premium payments; however, speculators certainly did view mortgages in this manner and treated them accordingly.

The “put” and “call” option features of mortgages during the bubble are the direct result of 100% financing. Speculators and homeowners have too little to lose to behave responsibly when 100% financing is available. Without increasing the cost to speculators through downpayments or a loan-to-value limit on refinances, speculators are going to utilize these mortgage products in ways they were not intended. There are many expensive lessons learned by lenders concerning 100% financing during the Great Housing Bubble.

Lawrence Roberts is the author of The Great Housing Bubble: Why Did House Prices Fall?
Learn more and get FREE eBooks at: http://www.thegreathousingbubble.com/
Read the author’s daily dispatches at The Irvine Housing Blog: http://www.irvinehousingblog.com/ Visit Mortgages Were Viewed as Option Contracts by Speculators.

Article kindly provided by UberArticles.com

(No Ratings Yet)

 Loading ...

Topics: Mortgage Refinance | Comments Off

Reprint Rights

Comments are closed.