Participating Mortgages and the Efficiency of Financial Intermediation

Abstract

This paper offers a means to enhance the efficiency of the financial system in the form of Participating Mortgages (PMs) to make it more resilient and to mitigate systemic risk. We establish a basic setup to study the variants of PMs, distinguish them from convertible mortgages and derive closed-form solutions to price a range of PMs. We obtain new results for Shared Appreciation Mortgages, Shared Income Mortgages and Shared Equity Mortgages. We illustrate our findings with examples showing that PMs are attractive in an environment with prepayments. Finally, we conclude our study with the public policy implications of employing PMs as workout loans, especially in the current sub-prime crisis.

Participating Mortgages have the capacity to manage risk at the micro-economic level with the potential for reducing default at the macro-economic level. They are more appealing than convertible mortgages as they are more versatile and retain features of debt through the tenure of the facility (without diluting control rights of its investors). We proceeded by investigating variants of participating mortgages (such as Shared Income, Shared Appreciation and Shared Equity Mortgages) and demonstrate, that the closed-form profit cap formula allows tractability. We thus contribute by evaluating closed-form finite maturity pricing conditions, which are scarce in real estate finance.

We also focus on random tenure mortgages, which arise in the context of default and prepayment risk. Furthermore, we illustrate the general applicability of the variants of a PM in a range of projects ranging from infrastructure to technology start-up's. Finally, we illustrate the employment of PMs as work-out loans especially in the recent sub-prime crisis. A PM is basically a financial innovation that matches the income in addition to the appreciation in value of the property instead of just the borrowers permanent income.

Keywords: Participating mortgage, Shared appreciation mortgage, Shared income mortgage, Shared equity mortgage, Profit caps and floors, Prepayment risk intensity

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