TY - JOUR

T1 - Continuous Workout Mortgages

T2 - Efficient Pricing and Systemic Implications

AU - Shiller, Robert J.

AU - Wojakowski, Rafal

AU - Ebrahim, Shahid

AU - Shackleton, Mark Broughton

N1 - 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

PY - 2019/1/1

Y1 - 2019/1/1

N2 - 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 Jarrow and Turnbull (1995). We also model the optimal embedded option to default whose exercise is motivated by decreasing random house prices. We adapt the Barone-Adesi and Whaley (1987) (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).

AB - 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 Jarrow and Turnbull (1995). We also model the optimal embedded option to default whose exercise is motivated by decreasing random house prices. We adapt the Barone-Adesi and Whaley (1987) (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).

KW - Negative equity

KW - House price index indexation

KW - Repayment mortgage

KW - Insurance

KW - Embedded option to default

KW - Prepayment intensity

U2 - 10.1016/j.jebo.2017.12.006

DO - 10.1016/j.jebo.2017.12.006

M3 - Journal article

VL - 157

SP - 244

EP - 274

JO - Journal of Economic Behavior and Organization

JF - Journal of Economic Behavior and Organization

SN - 0167-2681

ER -