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  • Continuous Workout Mortgages: Efficient Pricing and Systemic Implications

    Rights statement: This is the author’s version of a work that was accepted for publication in Journal of Economic Behavior & Organization. Changes resulting from the publishing process, such as peer review, editing, corrections, structural formatting, and other quality control mechanisms may not be reflected in this document. Changes may have been made to this work since it was submitted for publication. A definitive version was subsequently published in Journal of Economic Behavior & Organization, 157, 2019 DOI: 10.1016/j.jebo.2017.12.006

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Continuous Workout Mortgages: Efficient Pricing and Systemic Implications

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<mark>Journal publication date</mark>1/01/2019
<mark>Journal</mark>Journal of Economic Behavior and Organization
Volume157
Number of pages31
Pages (from-to)244-274
Publication statusPublished
Early online date22/12/17
Original languageEnglish

Abstract

This paper studies the Continuous Workout Mortgage (CWM), a two in one product: a fixed rate home loan coupled with negative equity insurance, to advocate its viability in mitigating financial fragility. In order to tackle the many issues that CWMs embrace, we perform a range of tasks. We optimally price CWMs and take a systemic market-based approach, stipulating that mortgage values and payments should be linked to housing prices and adjusted downward to prevent negative equity. We illustrate that amortizing CWMs can be the efficient home financing choice for many households. We price CWMs as American option style, defaulting debt in conjunction with prepayment within a continuous time, analytic framework. We introduce random prepayments via the intensity approach of We also model the optimal embedded option to default whose exercise is motivated by decreasing random house prices. We adapt the (BAW) approach to work within amortizing mortgage context. We derive new closed-form and new analytical approximation methodologies which apply both for pricing CWMs, as well as for pricing the standard US 30-year Fixed Rate Mortgage (FRM).

Bibliographic note

This is the author’s version of a work that was accepted for publication in Journal of Economic Behavior & Organization. Changes resulting from the publishing process, such as peer review, editing, corrections, structural formatting, and other quality control mechanisms may not be reflected in this document. Changes may have been made to this work since it was submitted for publication. A definitive version was subsequently published in Journal of Economic Behavior & Organization, 157, 2019 DOI: 10.1016/j.jebo.2017.12.006