Wednesday, September 26, 2007

Implied Call Option In Prosper Loans

Tanta over at Calculated Risk has gone off an obscure topic for mortgages, but it has relevance for Prosper lenders and borrowers. She had previously touched on the idea of an embedded option in a previous post, but really rounds it out here. From her A Clockwork Mortgage post:

... so suffice it to say that the main issue is the imbedded options in mortgage loans. In options theory terms, a mortgage gives the borrower a put (the right to default or "send jingle mail") and call (the right to prepay the mortgage with proceeds of a refinance or any other funds). Although both options have costs--especially if you have a prepayment penalty on your loan--those costs can end up being much lower than the cost of keeping your current mortgage. Because the "strike price" of these options is so heavily dependent on local and national economic conditions, interest rate levels, and home price changes, it is notoriously difficult to predict for any given borrower over any given stated loan maturity.

The lender, on the other hand, is "long a bond, short an option." Mortgages cannot be called or accelerated by the lender, except in case of default. No lender can make you refinance ... On the other hand, if market rates drop, you may exercise your right to prepay, which means that the lender loses your old higher-rate mortgage and must reinvest its funds at new, lower market rates.

Tanta compares the borrower's ability to prepay a loan to there being a call option built into the loan. The borrower can exercise the option to pay down their loan ahead of schedule any time they want. In typical options markets, the seller of the option (the lender) is usually compensated by the option buyer (the borrower) for the option.

I've brought this all up because Prosper allows prepayments and it's an interesting mathematical way to view prepayment risk. There is an intrinsic value to the prepayment option, and it's value should be captured. Because of this, I'll be adding a prepayment risk factor to my Prosper loan value modeling.

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