The historic default rates on mortgages have been generally much lower than on other consumer and corporate loans. They have also generally remained low even when borrowers have significant levels of negative equity. There are a number of reasons why this should be the case:
People have to live somewhere. Negative equity represents an unrealized loss. There is no incentive to realize this loss provided the borrower can service the loan. The advantage of moving to cheaper rented accommodation has to be balanced against the disadvantages of defaulting. Bankruptcy avoidance. If a borrower defaults on a property with significant levels of negative equity they are likely to face bankruptcy proceedings. In addition to the stress and loss of assets that such proceedings bring they are also likely to make it impossible for the borrower to ever own their own property.
Long dated option. A mortgage can be viewed as a long dated option. Given long enough most property markets eventually recover, even though it may take years. Option holders do not simply throw away an option that is out-of-the-money for the simple reason that it also has a “time value”. Given the typical term of mortgages the time value is significant, particularly as the “premium” they have paid (the down payment) represents a significant portion of their accumulated savings.
The level of defaults in the UK rose sharply after the residential property market crashed in 1986. A close examination of the problem showed that many defaulters had not actually made any down payment on their mortgage. Instead the lending bank had sold indemnity policies to them issued by an insurance company. These policies protected the banks from the first 20% of losses. Having paid very little for the option and being well out-of-the-money borrowers had little incentive to stay current and simply dropped off the keys after moving out.
The actual losses experienced by banks were relatively modest and the insurance companies simply responded by increasing the premiums charged for these policies. Few banks went through formal bankruptcy proceedings and, in the absence of a central register of defaulters, borrowers were able to go to another bank and took out a new mortgage on a different property. It’s a wonderful world.
Tags: Credit, interest, loan, mortgage
We need to estimate the level of new mortgages drawn down over time. If residential mortgages were rising very rapidly (and this is usually the case when real estate bubbles develop) a reasonable first approximation is to take the net increase in mortgage loans and assume that it is close to the gross increase. This may be done at the system level or for individual banks. Some countries actually publish gross drawdowns and these should be used when available.
Next we estimate how much of these loans have been repaid. Based on our example of a 20-year mortgage we know approximately how much capital is repaid in each year.
We are only interested in the loans made in 1995, 1996 and 1997. These are the only loans that are at risk of being “under water”. A mortgage taken out in 1995 is approximately six years old and hence approximately 17% of the original principal has been repaid. This could be done on a quarter by quarter basis but besides from adding complexity and increasing the risk of computational error it does little to increase the accuracy of the estimates.
We then calculate the estimated balance outstanding and subtract it from the current estimated value of the properties bought. This shows that the only properties at risk were those bought between 1Q96 and 4Q96.
Finally, we can make a reasonable first-cut estimate of the level of negative equity. Approximately 12% of mortgage loans, by value, have negative equity with the level of negative equity highest for people who bought in 3Q96 at approximately 30% of their outstanding balance.
Part of the reason for including this example is to illustrate how in an imperfect world, where the data to arrive at a definitive answer either does not exist or is not reported, it is still possible with many problems to make some reasonable quantified conclusions using the data that is available, some clear approximations and a bit of creativity.
This method of estimating the level of mortgages with negative equity will not work in markets with significant levels of mortgage securitization.
Tags: banks, credits, loans, mortgages
Negative interactions mean that the sum of the parts is worth less than the parts individually. In this case, projects have negative influences on one another, and thereby decrease one another’s value. Economists sometimes call negative externalities diseconomies of scale. Here are a few examples.
Pollution and Congestion If there is only one major road to two divisions, and the traffic of one division clogs up the traffic to the other division, it can cause a loss of cash flow in the other division. A division that wants to expand and thereby clog up more of the existing infrastructure will not want to pay for the congestion cost that its own expansion will impose on the other divisions. (Of course, it is the overall firm’s headquarters that should step in and allow the expansion only if the NPV is positive after taking into account the negative externalities imposed on other divisions.)
Cannibalization If a new Apple computer can produce $100,000 in NPV compared to the older Windows machine that only produced $70,000 in NPV, how should we credit the Apple machine? The answer is that the Apple would eliminate the positive cash flows produced by the existing Windows machine, so the cash flow of the project “replace Windows with Apple” is only the $100,000 minus the $70,000 that the now unused Windows machine had produced.
Bureaucratization and Internal Conflict If more projects are adopted, project management may find it increasingly difficult to make good decisions in a reasonable time frame. This may require more cumbersome bureaucracy and reduce cash flows for all other divisions.
Resource Exhaustion Perhaps the most common source of negative externalities—and often underestimated—is limited attention span. Management can only pay so much attention to so many different issues. An extra project distracts from the attention previously received by existing projects.
Although costs always include opportunity costs, in the case of negative project externalities, they are more obvious. If your project cannibalizes another project or requires more attention, it’s clearly an opportunity cost.
Tags: cash flow, Credit, loan, mortgage
Property markets are at their most dangerous after they have enjoyed a strong run for many years. First time buyers start to panic as the prices of houses and apartments threaten to move out of reach. They become desperate to get a foot on the ladder. They are egged on by friends who have already done so and are sitting on large unrealized gain. The high level of gearing that mortgages provide accentuates this. Suppose someone buys an apartment for $750 000 with an initial down payment of $150 000, equivalent to 20% of the purchase price. If the market value of the apartment rises by 10% their equity increases by 50% to $225 000. If the market value goes up by 20% then their equity doubles.
Suddenly all the talk at dinner parties centers on how much prices have gone up for particular types of properties and locations. The market develops a momentum of its own with property prices rising well above the level implied by historic affordability measures such as average transaction prices versus average salaries.
All parties have to come to an end, however. The trigger is usually a change in the economic environment. Higher property prices increase the level of mortgage payments for people trading up and for first time buyers. Asset inflation also feeds through in the form of higher rents as landlords try to maintain yields. Employees then seek wage increases to maintain the real value of their earnings. These put upward pressure on inflation.
The usual response of central banks to rising inflationary pressures is to raise interest rates to slow the economy and choke off inflation. Interest rates for mortgages with floating rate loans follow and monthly payments start to rise. In countries where fixed rate mortgages are the norm the cost of new mortgages rises. This makes it harder for first time buyers to buy and for people looking to trade up to afford the payments on the next mortgage.
First, the volume of property transactions falls. Potential sellers are reluctant to cut asking prices. With the higher mortgage payments potential buyers cannot afford to meet the monthly mortgage payments implied by asking prices. The immediate result is that there is no market clearing price, that is a price at which sellers are prepared to sell and buyers to buy. At that time “appraised value”, the value that realtors and surveyors assign to properties, becomes increasingly meaningless.
In time these appraised valuations adjust to reflect the new reality. Sellers are urged to cut asking prices to “realistic” levels. As these agents make their money from commissions based on actual transactions they have a strong incentive to ensure that a clearing level is reached. Their profitability is more dependent on the actual volume of transactions than the absolute prices being paid.
It is at this point that first time and highly geared borrowers begin to realize that they are in a serious predicament. The gearing that works so well when prices are rising now kicks in with a vengeance when prices are falling. The borrowers find themselves facing the “negative equity” trap. This means that the market value of their property is less than the principal outstanding on the mortgage.
Tags: market, ownership, property, real estate
The law of diminishing marginal utility applies: as the rate of consumption increases, the marginal utility derived from consuming additional units of a good will decline. Utility is a term economists use to describe the subjective personal benefits that result from taking an action. The law of diminishing marginal utility states that the marginal (or additioanal) utility derived from consuming successive units of a product will eventually decline as the rate of consumption increases. For example, the law says that even though you might like ice cream, your marginal satisfaction from additional ice cream will eventually decline as you eat more and more of it. Ice cream at lunchtime might be great. An additional helping for dinner might also be good. However, after you have had it for lunch and dinner, another serving as a midnight snack will be less attractive. When the law of diminishing marginal utility sets in, the additional utility derived from still more units of ice cream declines.
The law of diminishing marginal utility explains why, even if you really like a certain product, you will not spend your entire budget on it. As you increase your consumption of any good, including those that you like a lot, the utility you derive from each additional unit will become smaller and smaller and eventually it will be less than the cost of the unit. At that point, you will not want to purchase any more units of the good.
Tags: consumption, economists, economy, insurance, stocks
Now that I have pointed out the shortcomings of the normal distribution assumption in quantifying price change distributions, I intend to develop an option pricing model based on this very assumption. There is method in such an apparently contradictory approach. Knowing the limitations of a theoretical model in advance may allow us to correct its deficiencies after the fact using empirical information extracted from real price data. This pragmatic approach, I submit, is quite different from the conventional theoretical approach to option pricing which revolves around a mathematically perfect formula not applicable in the real world.
There are other benefits from proceeding initially on the normal assumption. Perhaps most important, the reader will be able to directly compare the simplified option pricing model I’m going to develop from first principles with the “million dollar formula” that dominates options literature. Before attemping to construct this model, I would like to make a few observations on price distributions in general and discuss ways of expressing these distributions as succinctly as possible.
Tags: banks, Credit, finance, interest, loan, money
By looking at demand elasticity, we can determine changes in total consumer spending on a product when its price changes. We can do this in three different ways: by looking at (1) changes in an individual’s total spending, using the demand elasticity from his or her demand curve for the product, (2) changes in the total combined spending of all consumers, using the elasticity from the total market demand curve, or (3) changes in total consumer spending on the product, using the demand curve facing that firm that produces it. In other words, this third method allows us to look at elasticity based not on what consumers spend, but on what the producer receives from selling the product.
Total expenditures (or revenues) simply amount to the price of the product times the number of units of it purchased (or sold).
Because total expenditures are equal to the price times the quantity, and because the price and the quantity move in opposite directions, the net effect of a price change on the total spending on a product depends upon whether the (percentage) price change or the (percentage) quantity change is greater.
When demand is inelastic, the price elasticity coefficient is less than 1. This means that the percentage change in price is greater than the percentage change in quantity. Therefore, when demand is inelastic, the change in the price will dominate and, as a result, the price and total expenditures will change in the same direction. In other words, when the price of an inelastic product (say, cigarettes) increases, spending on it will increase, too – and vice cress. On the other hand, when demand is elastic, the change in quantity will be greater than the change in the price. As a result, the impact of the change in quantity will dominate, and therefore the price and expenditures will move in opposite directions. In other words, when the price of an elastic product (say, a ballpoint pen) – increases, spending on it will decrease and vice versa. When demand elasticity is unitary, the change in quantity demanded will be equal in magnitude to the change in price. With regard to their impact on total expenditures, these two effects will exactly offset each other. Thus, when price elasticity of demand is equal to 1,total expenditures will remain unchanged as price changes.
The demand curves can also be used to show the link between elasticity and changes in total spending. In the case of cigarettes (part b), the price elasticity of demand for the price increase from $1.00 to $1.50 is 0.26, indicating that demand is inelastic. This increase in cigarette prices leads to an increase in spending on the product from $100 million ($1.00 X 100 million units) to $135 million ($1.50 X 90 million units). If the change had occurred in the opposite direction, with the price falling from $1.50 to $1.00, total expenditures would have declined.
The price elasticity of demand for a ballpoint pen when its price increases from $1.00 to $1.50 is 3.0, indicating that demand is elastic. This increase in the price of ballpoint pens lowers total consumer spending on the product from $100,000 ($1.00 X 100,000 pens) to $37,500 ($1.50 X 25,000 pens). If the change had occurred in the opposite direction, with the price falling from $1S O to $1.00, total expenditures would have risen.
You can see how important it is for business decision makers to understand the concept of elasticity.When a fm increases the price of its product, its revenues may rise, fall, or remain the same. If the demand for the firm’s product is inelastic, the higher price will expand the firm’s total revenue. However, if the demand for the firm’s product is elastic, a price increase will lead to substantially lower sales and a decline in total revenue. In the case of unitary elasticity, the price increase will leave total revenue unchanged.
Beyond the price elasticity of demand, two other elasticity relationships are important in any given market.
Tags: Expenditures, financial market, insurance, payday loans, price changes
The United States has a vast array of subsidy programs. Spending on these programs and the taxes that finance them are major items in the government budget. Some subsidy programs, such as Medicare and food stamps, provide payments to buyers. Others, such as the subsidies to the arts, public broadcasting, and sports stadiums, are directed toward suppliers. As we discussed, however, the party granted the subsidy may not be the one who captures the larger share of the actual benefit from the subsidy.
Still other subsidy programs are combined with price controls. Many agriculture subsidies fall into this category. The government fixes the prices of products like wheat, corn, cotton, and tobacco above the market equilibrium. To maintain the above-equilibrium price, the government purchases any amount produced that cannot be sold at the artificially high price. The government also restricts the acreage farmers are permitted to plant for these crops. If it were not for the planting restrictions, huge surpluses of these products would develop.
Sometimes government subsidies are granted only to a select group, or subset, of buyers (or sellers). Consider the structure of health-care subsidies in the United States. The Medicare program subsidizes the health-care purchases of senior citizens, and the Medicaid program provides subsidies to low-income households. These subsidies increase the demand for health care and drive up the prices of medical service for all consumers, including those ineligible for either program. In cases where only some of the buyers in a market are subsidized, groups that are ineligible for the subsidies will generally be harmed because they will have to pay higher prices for the good or service than they would otherwise have to, even though they do not receive a subsidy.
Subsidy programs are often highly complex, and it is sometimes difficult to determine whom they really benefit. As we proceed, we will analyze several of these programs in more detail. The supply and demand model presented here will facilitate our analysis..
Tags: banks, demand, mortgage, subsidies, supply
Commodity prices are expressed in such diverse units as cents per pound, dollars per bushel, and yen per dollar. Since we will be interested in price changes rather than in absolute prices, and since we will be wanting to compare price change distributions across a number of different commodities, it will be immensely useful to express all price changes as percentages of their absolute price levels.
If every daily price change- whether the commodity be soy- beans, live cattle, sugar, or Japanese yen- is made dimensionless by dividing that price change by the absolute price of its future and then multiplying by one hundred, then all resulting measures of “spread” will be expressed as dimensionless percentages and will thereby be directly comparable. (If every option price is also expressed as a percentage of its futures price, then every option price will also be expressed in the same units as the daily price changes in its future.) One thing is immediately clear from the “spread” of each of these distributions about its mean value: During 1996, coffee prices were much more variable than silver prices.
The degree of “spread” of a set of numbers about the average value (mean) of that set of numbers is most commonly specified by its standard deviation, a statistic which can be calculated for any set of numbers or for any continuously variable distribution. The calculation of the standard deviation of a set of numbers involves taking the square root of squares of differences from the mean. Another measure of spread of a distribution is its mean absolute h a t i o n , which, in the case of daily price changes, is the average value of these price changes taking all readings as positive. In classical statistical analysis, the mean absolute deviation is much less used than the standard deviation. This is unfortunate, since the mean absolute deviation as a measure of variability has many advantages, not least of which is its ease of visualization and its simplicity of calculation.
Be that as it may, there is no denying that the standard deviation is the statistic conventionally used in developing option price models. Realistically, therefore, and for comparison purposes if for nothing else, the standard deviation has to be incorporated into any independently derived option pricing formula that I or anyone else dares to come up with!
Tags: commodities, commodity prices, debt, interest, loans, spread
Perhaps history provides the best answer to this question. If the corporate structure were not an effective form of business organization, it would not have continued to survive, nor would it be so prevalent today. Rival forms of business organization, including proprietorships, partnerships, consumer cooperatives, employee ownership, and mutually owned companies can and do compete in the marketplace for investment funds and customers. In certain industries, some of these alternative forms of business organization are dominant. Nonetheless, in most industries, the corporate structure is the dominant form of business organization.This is strong evidence that, despite its defects, the corporation is generally a cost-efficient, consumer-sensitive form of organization.
Tags: banking, business, Corporation, industry