Earlier this week I presented a problem, that dynamic pricing was incredibly difficult within financial services where the transaction mattered. Here is one of our solutions. This is theoretical and multiple answers do exist.
Group Mortgages (Many Houses, Many Borrowers)
One of our long-term goals is a group mortgage, which straddles across both the sharing economy for wealth and cross-generational cashflow mismatches.
By creating groups of borrowers with a similar purpose (owning their homes), we naturally break down both the dead-weight loss segregation (we have created something unique to separate borrowers) and finite resource issues above (the group will have an open window with greater time constraints).
The final question here is does it add-value, either by reducing risks for lenders and lowering interest rates for borrowers? We think this is the case.
Why a group mortgage reduces the risk:
This is all about average loan-to-value ratios and resources (LVR or LTV, depending where you are from, and debt serviceability). In a portfolio of individual mortgages, average LVR is a bit false. The weakest borrowers, often with the higher LVR or high debt-load versus income, will usually drive the first losses as the riskier borrowers run out of financial resources first.
You can’t really look at average LVR and should look at the distribution of LVR, particularly when you tranche the portfolio for mortgages for a residential mortgage-backed securitisation, which ultimately drives the mortgage interest rate pricing if used as a wholesale funding source.
In a group mortgage structure, each borrower can cross-guarantee every other borrower. As such, the weakest borrower risk is removed as they can consume financial resources from the strongest borrower. The result is that you can use average LVR and average resources as a gauge for loss absorbing capacity. This will reduce the risk for the lender. The major question to answer here is, if the safer borrower will be willing to take part in this transaction with the other counterparties.
The answer to this is that they might, if either they can benefit from a reduced interest rate. The group of borrowers might need to organise the guarantee system to lower the borrower interest payments for the net guarantee providers, i.e. a payment for the having lower risk. Alternatively, the less risky borrower has the ability to acquire the financial resources from others if they provide support (in effect, covering mortgage payments buys into ownership of other homes). Here, we have outsourced some of the risk bearing a bank might take into the group (sharing economy). The natural alignment of a group mortgage comes into play when families or community groups band together to help each other out – in this scenario, we think people will be more open to share the risk.
Better without Banks?
If we can achieve this, we offer benefits to both lenders and borrowers and have found a more aligned method to create dynamic pricing, as risk has become a major influencing part of the transaction and other constraints become less of an impact.
The final delivery of this then reverts back to flight tickets. Whilst the window for a group is open, dynamic pricing can exist.
We expect this is unlikely to function within the banking system: rigorous definitions of residential mortgages exist and the transferability and cross guarantee start to look more like a commercial mortgage portfolio, which has significantly higher bank regulatory capital requirements due to default history.
However, achieving credit ratings and non-bank funding or equity is far easier if various parties can understand the reduced risk in this system, if sufficient diversification (or low correlation in borrowers) can be achieved. So the question regarding dynamic pricing: it might need to exist outside the banking system.
Caveats to this model:
- Borrowers would need to be willing and able to share financial risk and assets. This suggests fractional ownership of property
- Price growth assumptions, constant pricing data and commitments to service would be required – not trivial and better in a stable price environment (not high growth). This has a relationship to inflation but house prices are usually left out of those calculations.
- I’m still to decide if the higher portfolio concentration is a major negative: we remove the likelihood of a small number of defaults (ability to bail out a weaker borrower) but have increased the ability for an entire portfolio default (correlation goes to 1 in a crisis). Asset security helps here but most likely the mortgage debt would not be able to be irrevocable. Another positive to borrowers but a major problem for lenders. More work required.