Thursday, February 14, 2008

Puts, Calls and Mortgages

"As the housing slump drags on, some builders have a deal for potential buyers: Sign a contract, and if the cost of comparable homes drops before closing, you get the lower price. ... As the residential market continues to deteriorate, more buyers are having trouble securing mortgages and selling existing homes. ... The resulting barrage of chilling headlines has left builders fighting to reassure customers that now is, in fact, a safe time to buy", WSJ, 6 February 2008.

''The apparent willingness of borrowers to "walk away" from mortgage debt,' the [Fitch] 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% for subprime mortgages issued in 2006 and 26% for those issued in early 2007. ... Such behaviour, where not precipitated by wilful fraud, shows that American homebuyers aren't so dumb.. They're perfectly capable of acting rationally without political interference. ... 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. ... 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 downpayments; 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 equity, and other inventions often led to just the opposite. ... Essentially, mortgage-bond investors, seeemingly unwittingly, sold homebuyers a put option, without properly pricing it, and now homeowners are exercising that option. ... It's beginning to dawn on lenders and their agents ... that they could be stuck with hundreds of thousands of houses at a minimum", my emphasis, Nicole Gelinas (NG) at the WSJ, 8 February 2008.

What the builders need is "put option" mortgages to help unload their inventory, like those NG describes.

Bravo, NG! As soon as I saw nothing down loans, I concluded the underlying real estate was not sold, but had 30-day renewable call options issued on it. By combining ownership with puts you can create synthetic calls. See my 10 December post as to MLEC's real reason. That the rating agencies couldn't see this is amazing. What do their analysts analyze?

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