One of the main features about US mortgages leading up to the GFC and subprime crisis was that borrowers were able to hand back the keys of their property. As prices fell and negative equity appeared, to many it was seen as better to default on your mortgage than pay off a debt that was more than the house’s market value.
Arguing the merits and risks of a “hand-back-the-keys” model is tough. Whilst it looks like a riskier lending option, it allows borrowers to default and move on to look for work elsewhere, in a severe recession without being locked into a debt they cannot afford. In any case, liquidity and commercial real estate is what kills banks.
In the US, the 100% or even 120% mortgage existed. A 100% mortgage essentially offered the home buyer the property in exchange for debt. As the borrower could walk away, this was then latterly described as giving borrowers a “free call option” on property prices. The 120% mortgage took this a little further as the property purchase had costs: taxes, decoration & refurbishment and advertising for a tenant (in some cases). You could describe the 120% mortgage as somewhere between a free call option on property prices or being paid for a free call option (you could argue being paid was a reflection that the property was overpriced).
And ultimately everyone loved a free call option and this led to large price increases and financial instability as people handed back the keys and homes to the the banks.
The question that needs to be asked: are free call options available today and is the “free” the problem?
What is a Free Call Option?
Firstly, there needs to be a definition: What is a true free call option vs. what someone perceives as a free call option?
Given the negative gearing and capital gains tax incentives, the shortage of land and appropriate new housing supply, being a property investor to many is seen as having a free call option on property:
- rent roughly covers the cost of mortgage (particularly after tax deductions)
- the downside risk is mostly not a factor
So investors are so positive that they believe they have the right to accept the gains in house prices but don’t face any cost. This is a natural part of credit and business cycles and the last quarter of a century has helped remove any perception of risk. Regular recessions and keeping price appreciation in check are good mechanisms here, but micro management of private asset prices is not seen as desirable (though I believe that price appreciation should form part of inflation measurement!).
In the case of investors, they are simply owning the asset and don’t have the ability to pass the asset back to the lender without consequence. So it isn’t a financial derivative.
Free Call Options:
This is where is gets technical, there is no free option as there are no 100% loans now that loopholes with personal loans have closed. What we do have is a potential paid call option in the off-the-plan market that may have the same risk profile. This is also where it gets mathematical.
- S = Current Property Price = $250k
- Deposit = 10% = $25k (what was paid)
- t = Completion & Settlement date = 2 years
- r = Risk Free Rate (Bank deposit Rate) = 3%
- K = Strike Price = $225k
Making various assumptions we obtain a call option price of between $25k and $40k, which is either equal to the deposit (very low volatility and setting yield = risk free rate) or that the buyer has bought an option worth $40k for $25k.
This isn’t a disaster and there is likelihood that the development profits easily cover the lost value in selling the option. However, options are more than value: where does the physical asset go?
Delivery of Asset
The key piece to all this is that in option trading you can end up being exposed to the underlying physical asset (taking delivery). This occurs if you cannot find a buyer to take the market price.
In the apartment market, the scenario where the would-be buyers don’t use their option is when the current market price falls below the strike price (a 10% price decline to below $225k in our example). At this point, the developer/seller needs to find another buyer. However, this may not occur as many would-be buyers may take the same option strategy and compound the price declines. The developer is then left holding the underlying properties, is unable to repay its bank loans (for the development) and the banks themselves might need to claim the collateral (the apartments).
If the banks themselves had short-term borrowings, then the collateral might also be a problem for them (liquidity squeeze).
So whilst we do see developers and banks (indirectly) selling call options at below market values, it is the potential delivery of the asset that causes the risk.
And this has more similarities with the US mortgage bust in 2006-2009 than we might think.