Subject to regulatory restrictions there is no real limit on the different ways that housing loans can be structured. A loan could have a monthly payment that steadily increases over time. This might be attractive to young people who expect their earnings to rise relatively sharply. A loan could be structured with negative amortization, where the monthly payments are insufficient to pay interest and reduce outstanding principal. Unpaid interest is rolled into the outstanding principal and this grows over time. This could be advantageous if property prices are rising or the borrower expects a large capital inflow, possibly from a bequest, in the future.
Retired people may find themselves where they own a valuable asset (their house) but have insufficient income to meet their needs. Where there is a demand financiers will look for ways to meet those demands and make a profit. Insurance companies and banks both offer competing products to such customers. A typical policy from an insurance company pays a perpetuity until death, allows the customer to continue to live in the house but eventually gets title to the house. A competing bank product would be for the bank to make a loan to the retiree with the property as collateral. The retiree would then redeposit this loan as a deposit with the bank and live off the interest earned. The interest due on the loan would be capitalized. The total outstanding balance is then paid off from the proceeds from the borrower’s estate when he or she dies.
Housing loans
December 11th, 2009Home equity
December 10th, 2009Home equity loans are second mortgages secured against a residential property. They are possible when either property prices have risen sufficiently to increase the homeowner’s equity or the borrower has paid down a significant proportion of their original mortgage. Such loans may be used for home improvements, to repay higher cost debt, to make investments or for consumer spending.
Endowment/investment linked mortgages
December 6th, 2009Endowment or investment linked mortgages are a combination of a standard loan and an investment policy. Monthly payments go to pay interest on the loan as in a traditional mortgage loan but a part also goes to pay the premiums on an investment policy. The investment policy is normally invested in bonds and equities. The intention is that the endowment policy will generate sufficient returns that when the loan has to be repaid there will be sufficient investment profits to pay the principal and a bonus to the policyholder.
Actual monthly payments are in line with those of a traditional mortgage in which a part of the principal is paid off each month. Banks liked these because they were able to extract upfront fees for the policy. Mortgagors liked it less when they found that returns on their investment policies were insufficient to repay the outstanding principal at term.
Floating rate mortgages
December 1st, 2009These are much more common in Asia, Latin America and Europe than in the US. The main advantage to the issuer is that making such loans leaves them less exposed to interest rate and prepayment risk. The main disadvantage is that default risk is likely to be higher in the event of a sharp rise in interest rates.
In those countries where floating rate mortgages are the norm banks will generally only offer fixed rate mortgages when they expect interest rates to fall, and in many cases the fixed rate offer normally applies only to the early years of the mortgage before reverting to floating
Fixed rate mortgages
November 23rd, 2009Fixed rate mortgages are the dominant form in the US. The advantage to the mortgagor is that the monthly payments are not affected by rising interest rates and this also reduces the risk of default to the issuer. The two disadvantages to the issuer are: Banks are funded largely with short-term deposits. If interest rates rise their cost of funds will increase but the return from their fixed rate mortgages remains unchanged. This exposes the lending organization to significant interest rate risk. Mismanagement of this risk was an important factor in the US S&L (saving and loans) crisis of the 1980s. If on the other hand banks seek to avoid this risk by obtaining matching fixed rate funding they are left exposed to prepayment risk. That is the risk that interest rates fall and that mortgagors pay off their existing loans and take out a new mortgage at the prevailing lower rates. The lender has, in effect, sold a loan with an embedded put option.
Fire sale prices
November 18th, 2009The buffer provides a margin for valuation error and the likelihood that in the event of foreclosure the bank will not succeed in gaining the maximum price possible. The bank cares about recovering its losses but has little incentive to maximize any surplus to be returned to the debtor.
Commodity prices
November 13th, 2009Although all commodity prices go through their own particular bull and bear phases, over the long term prices do not change dramatically. Periods of high prices in a commodity induce greater supplies along with a contraction in demand, and periods of low prices curtail supplies and stimulate demand. There is a long-term secular rise in the overall commodity price level, but it is small- 1 or 2 percentage points a year, perhaps. Very occasionally, a global power shift will cause a sudden sustained change in the price of a commodity, such as happened with oil and gold in the early 1970s. Neglecting these one-time shocks to the system, even gold and oil have behaved like typical commodities for the last 20 years. Of all the major contracts, only the Standard and Poor’s stock index can be said to be something of a one-way street, and even that juggernaut may eventually regress to a more gently sustainable uptrend.
Price stability over the long term implies that daily price changes observed in a specific commodity are going to form a distribution that is centered very close to zero. It is accepted that commodity prices changes are very close to being random in the short-term, and it is well-understood that repeated observations of random variables often approximate normal curves, or “bell” curves, when plotted as frequency distributions. If daily price change is a random variable centered very close to zero- and we know this to be substantially true- the question naturally arises: Why shouldn’t daily commodity price changes be normally distributed?
Before attempting to answer this question, it’s worth reviewing the properties of a normal distribution- in reality, a technical term for a rather fancy equation which in many cases accurately describes the distribution of a random variable.
The normal distribution is known to accurately describe such random variables as the heights or weights of people within clearly defined populations. For example, the average height for males in the United States is around 5’9″ with above-average and below-average heights reasonably symmetrically distributed around this average value. The most widely accepted statistic defining a normal distribution is the standard deviation, a statistic whose value can be estimated from a large sample drawn from the population in question.
Once the standard deviation of a distribution is estimated, it is possible to predict, on the assumption of normality, the probability of occurrence of extreme values within that distribution. If the observed extreme values follow the expected probabilities, one can confidently assume that the original premise of normality is sound- at least, there will be no reason to suspect that the premise is unsound. But what if extreme observed values fail to conform in a big way with values projected from a normal distribution based on the sample data? What would be a reasonable and logical conclusion in the light of this finding?
One might conclude that the sample is nonrepresentative of the population it is drawn from and that the true distribution really is normal. Or one might infer that the population distribution is not normal at all. This second choice is not popular, because, if the normal assumption is suspect, it renders invalid much of the mathematical analysis that fills option textbooks.
Overwhelming evidence favors the hypothesis that price change populations are significantly nonnormal. There are simply too many occurrences of wildly improbable price changes- improbable, that is, on the normal assumption- to ascribe these aberrations to sampling error.
Margin loans
November 10th, 2009Loans made to support customer share trading. The loans are secured against the value of the stock. In the event of the stock falling the bank may issue a “margin call” requiring the customer to “top up” their account with a cash deposit or face a forced sale of their stock.
Price changes
November 6th, 2009Why do price changes refuse to respect the normal distribution when so many naturally occurring random variables do so? Well, for one thing there is nothing natural about a commodity future; it is an abstraction by definition, and the pattern of prices it generates is the result of a highly complex set of human inter- actions. Is it possible then for commodity prices to be random, but random in some abnormal way?
When we talk about prices following a random walk, we are really talking about market player’s Y reactions in a freely trading market being random. If we could isolate that part of futures price variability represented by players’ reactions after news is “in the market’) from that part of price variability arising from external market shocks, then indeed we might have a normal distribution of price variability.
But the reality is that all commodity markets are subjected to sudden and unpredictable infusions of information which result in sudden instantaneous price adjustments: I’m talking about things like crop forecast surprises, unexpected political developments, weather scares, and so on. The price change distributions resulting from “external shocks” are by definition massively unquantifiable. However, there is no denying their existence.
When we look at a frequency distribution of daily commodity price changes, we are really looking at two distributions, one very normal, one highly abnormal. A failure to recognize this reality- an almost universal failure in conventional theory-can lead to many erroneous conclusions about how options are really priced in the marketplace.