Readings: Options & mortgages, Walter Schloss, Subprime lending
- Calculated Risk: Options Theory and Mortgage Pricing
Residential real estate sales and mortgage loans do not, actually, literally, have puts and calls in them. If you buy a home today, you assume the risk that its price may fall in the future. Your contract does not include an option for you to sell the house at the price you paid for it. Nor does the seller of the house have a “call”; the seller cannot force you to sell the house back to him at the original price if its value rises.
The “implied put” in a mortgage contract is the borrower’s ability to default . . . We do not, generally, consider “distress” . . . as an “implied put.” Some borrowers will fall on hard times and be unable to fulfill their mortgage contracts. This is a matter of “credit risk” and it is, analytically, a different matter of mortgage contract valuation. The “implied put” analysis is trying to capture the possible cost to the lender/investor of what we call the “ruthless” borrower. “Ruthless” . . . is in fact the term we use to describe borrowers who can pay their debts but choose not to, because there is a greater financial return to that borrower in defaulting as opposed to not defaulting. It is “ruthless” precisely because there is not a contractual option to do this: the only way you can exercise the “implied put” is to default on your contract.
Long, but informative.
- Forbes: Experience
Schloss has a laid-back approach that fast-money traders couldn’t comprehend. He has never owned a computer and gets his prices from the morning newspaper. A lot of his financial data come from company reports delivered to him by mail, or from hand-me-down copies of Value Line, the stock information service.
Schloss screens for companies ideally trading at discounts to book value, with no or low debt, and managements that own enough company stock to make them want to do the right thing by shareholders. If he likes what he sees, he buys a little and calls the company for financial statements and proxies. He reads these documents, paying special attention to footnotes. One question he tries to answer from the numbers: Is management honest (meaning not overly greedy)? That matters to him more than smarts.
“There’re too many people with money running around who have read Graham,”
The Federal Bureau of Investigation is investigating 14 corporations for possible accounting fraud and other crimes related to the subprime lending crisis . . .
The probes include reviews of subprime lenders, housing developers and Wall Street firms that package loans as securities . . .
“We’re looking at the accounting fraud that goes through the securitization of these loans.”
The Andersen/Enron/Worldcoms of the 2003-2007 bull market?
Related Posts: