Participating Mortgages and the Efficiency of Financial Intermediation

Abstract

The aim of this paper is to establish a basic framework of financing with a highly flexible instrument, of Participating Mortgages (PMs), to improve the efficiency of the financial system. We distinguish these from convertible mortgages and derive closed-form solutions to price a whole framework of facilities under the PM umbrella. As most contracts are of definite tenure, our contribution includes finite maturity pricing formulae, which are scarce in real estate finance. We also focus on random tenure mortgages, which occur in the context of default and pre-payment risk. Finally, we conclude our study with a public policy implication of employing PMs as workout loans especially in the ongoing sub-prime crisis.

Keywords: Participating Mortgage (PM), Shared Appreciation Mortgage (SAM), Shared Income Mortgage (SIM), Shared Equity Mortgage (SEM), Profit Caps and Floors.

JEL Classification: C63, D11, D14, D92, G13, G21, R31