The Billions (Trillions?) of Dollars Of Options For $995.00
Derivatives are unsentimental in seeking embedded options structures. Like x-rays seeking bones.
If one were to look for optionality imbedded in the US housing market over the last few years, one would find the appearance of mortgage lenders having sold at-the-money housing straddles for little to no premium. It begs the question: were homes "bought" or were homes given to "buyers" incentivised by free options?
... Free housing straddle positions... Free options... a $995.00 cancellation charge (paid to someone not even attached to the original transaction) if "buyer" wants to return (put) the house...?
A straddle is the purchase or sale of an equal number of puts and calls with the same strike price and expiration dates. To purchase a straddle, the buyer needs to pay the seller a premium amount.
The market was able to "buy" houses the last few years with no money down. This transaction has obvious leverage, but does not have obvious optionality ... it's just a 100% financed housing purchase. Now, when you look at exit strategies (AKA... selling the house), there appear to be options that the "homeowner" now has regarding his risk in "owning" that house. This 100% financed "buyer" was given, for nearly no consideration, a free call and a free put. (Did the "homeowner" ever really "own" the house? Did the straddle underwriter "own" the house the whole time?)
The call: the "homeowner" has a free call in that if the house price rises, the "owner" can sell it and keep all the capital gain. The only cash cost (AKA... premium) to the homeowner for the call appears to be the carry charges. The non-cash cost appears to be potential credit "impairment" should the house be abandoned by the "owner."
The put: the "homeowner" over the last few years feels as if they have the ability to put the house back to the lender at virtually no cash cost should the home "owner" see the value of "his" home go below "purchase price" (the only cost looks like impaired credit score to the buyer for potentially as short as two years). So, the home "buyer" has this put at a seemingly small premium. Again, the only cash cost (AKA... premium) to the "homeowner" for the put appears to be the carry charges.
Calculated Risk has a great article that articulates how the "homeowner" arrives at the decision to exercise this "free" put option.
The home "buyer" was granted a straddle by the credit markets for monthly carry charges and some potentially foregone personal credit rating that can auto revert to the "buyer's" original credit rating over time. Seems almost free.
There is a new company in San Diego called You Walk Away that does just what its name says. For $995, it helps people walk away from their homes, ceding them to the banks in foreclosure. Could this be the cash premium paid at an exercise date, paid not even to the straddle "seller?"
Exercising the put strategy in this example entails the moral hazard and unpredictable risks of impaired credit.... the option model here would put a cash cost on that risk variable. So, maybe the put component of the straddle is out-of-the-money to account for the credit impairment to the home "owner."
Nonetheless, the US housing market is behaving as if at-the-money housing straddles were doled out to home "buyers" for:
1. no money down (cash premium paid);
2. a monthly carry charge (not an extraordinary charge, everyone has to pay for a roof in the form of rent or a mortgage); and
3. a small cash payment ($995.00) should the "homeowner" decide to exercise the put (no expiration date).
Exercising the call (i.e., selling the house) has no cash premium, credit score impairment nor $995.00 walk away fee.
Neither the call nor the put option has an expiration date. They can be exercised when the ARM resets or when the housing market moves against the "homeowner."
Housing derivatives allow for financially-settled options to be traded that settle against housing price indices. The major difference is that all options in the derivatives markets cost cash money (AKA... premium). These are certainly better options to sell - the underwriter collects a premium up front for taking on that risk. Admittedly, nothing in the derivatives world is better than free options.... which the derivatives market does not offer.
Hat tip to Joe D. for helping articulate the embedded put structure.
