Continuous Workout Mortgages: Efficient Pricing and Systemic Implications

Robert J. Shiller (), Rafal M. Wojakowski, M. Shahid Ebrahim and Mark B. Shackleton
Additional contact information
Robert J. Shiller: Cowles Foundation, Yale University, https://economics.yale.edu/people/faculty/robert-shiller
Rafal M. Wojakowski: Surrey Business School, University of Surrey
M. Shahid Ebrahim: Durham University Business School
Mark B. Shackleton: Lancaster University Management School

No 2116, Cowles Foundation Discussion Papers from Cowles Foundation for Research in Economics, Yale University

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 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).

Keywords: Negative equity; House price index indexation; Repayment mortgage; Insurance; Embedded option to default; Prepayment intensity (search for similar items in EconPapers)
JEL-codes: C63 D11 D14 D92 G13 G21 R31 (search for similar items in EconPapers)
Pages: 64 pages
Date: 2017-12
New Economics Papers: this item is included in nep-ure
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (2)

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Journal Article: Continuous Workout Mortgages: Efficient pricing and systemic implications (2019)
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