Saturday, September 27, 2008

Economic Plan

Economist Arthur De Vany has an idea about how to price mortgage-backed securities:
Pricing Mortgage Securities When Nobody Knows Anything

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Designing option-like contracts lets you pay when you do know.

It is easy to apply the Pay When You Know option principle to these distressed mortages and their derivatives. Let every holder of these instruments sell call options on their value. Make the options at least 5 years (preferably 10 years) before they expire so that they do not expire before there is time for a return of liquidity to the market. This would give time for the housing market to recover as well. The option would contain several strike points so that investors with different expectations, risk preferences, and current asset positions can choose to cash in at lower strike points for a quick return while others choose to wait for higher returns. At each strike point, the option would pay a percentage of the value of the asset.

The option would be designed so that the buyer earns a share of the future value of the mortgage security if it rises. The option would be of no value and would not be exercised if the value of the mortgage security fails to exceed the first, lower strike price. The homeowner also should receive a share of the future appreciation. This would give all the parties to the mortgage a share in the future appreciation. Had options of this sort been issued at the initial purchase of the home, the speculative aspect would have been properly separated from the homeowner aspect and this whole mess would not have happened. The homeowner/speculator would have sold all or some of the risk of future appreciation to the market.

So, through the use of the call options on appreciation, the security holder, the homeowner, and buyer of the option could all share in the future appreciation of the home. This creates good incentives for the homeowner to stay with the mortgage. The cash proceeds of the sale of the option would be shared by the mortgage holder and the homeowner. This gives the holder and the homeowner immediate cash which can be used to pay the mortgage and for the holder to improve the balance sheet.

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Putting Mortgage options on a liquid and visible exchange would restore much of the liquidity to the mortgage and mortgage securities market that is so sorely lacking. I think it would solve most of the present crisis.


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