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  • "The market can remain irrational longer than you can remain solvent" - John Maynard Keynes

    Thursday, July 17, 2003

    With all the talk of interest rates I was considering home buyers and how they could hedge against rising rates if they were not ready to buy today. Since working on some of the numbers last night Motley Fool had an interesting article on home owners and refinancing. It turns out that nearly 25% of all home loans originated in 2002 had some variable rate provision such as an ARM (where the rate is fixed for 5 years and then floats). Those ARMS would have $300 more a month to pay when their rates go up by 40 basis points in five years based on a 100k house. How financially illiterate must people be to not lock in historically low rates. You can get a 30 year mortgage for around 9 points more than the same 30 year Treasury bond. That is about 5.8% for the mortgage with 30 yr treasuries at 4.9%. The historical mean from 1972 to 2002 for mortgage rates is 9.7% (median 9.05%). The standard deviation is only 26 points; we are 2 standard deviations below the mean right now for 30 year mortgages!!

    So what are some of the hedging strategies available? Well unfortunately you can't just lock in the loan today and buy your house in 2.5 years time; this would be the simplest solution. Really all you can do is calculate the additional cost if mortgages go back to historical levels and then try to make this money through some hedge. From today's 5.8% rate a rise of 10 basis points adds about $12k to the cost of your loan for a 100k house (Discounted back to today. That is this considers inflation and the fact that you don't have to pay the money until some time in the future and you could invest it today). Each 10 basis point rise adds about another $12-$13k. For each drop of 10 basis points your cost reduces by $10-$11k.

    I spent a while investigating what financial instruments could be used to hedge this rise. The only one I could find were the CBOT treasury options (mentioned in this post). There are options on the yield of the 30 year Treasury bond, these are cash settled at $100 * yield change for each contract. As we expect rates to rise and we want to profit from that rise then buying calls would be the most appropriate strategy. A hedge using only calls costs about $11,025 for a 2.5 year option (CBOT apparently have TYX-30 year treasury LEAPS, but I couldn't find their pricing so I used Black Scholes based of the implied volatility of the shorter term options listed).

    * If yields rise by 10 points your option would generate $3150 in cash but cost you 11k to enter and your mortgage now costs $12k more. Net you are out $20k.
    * If, however, yields rise to 7.8% your option generates $24k in cash, cost you 11k to enter and the mortgage is $24k more. Net you are out $11k.
    * If yields rise to 8.8% your option generates $45k in cash, cost you 11k to enter and the mortgage is $38k more. Net you are out $4k.

    You could offset this somewhat by selling puts and effectively entering a collar. The put prices are very low though, as the 30 year bonds are not likely to go much lower. Selling puts could decrease the call price by about $2400 and if rates drop 10 points you owe about $11k on the puts (not a great position to be in when you are about to apply for a mortgage) immediately, even though you have saved $11k in today's dollars due to the rate decrease. The difference is that you have to pay the $11k today to settle the put, the savings in your mortgage come over the next 30 years. The chances of rates decreasing to 4.8% for mortgages in 2.5 years seem quite remote. Importantly the TYX options are European style, (that is they cannot be exercised until expiry day) so there is no risk in the intervening time.

    Given that rates are likely to return to around the 8.8% level by the end of 2005 your 11k on calls saving you 45k in mortgages is probably well spent.

    Interestingly the market somewhat hedges you automatically. When interest rates are so low, housing prices increase dramatically so a $100k house today may sell for closer to 60-70k when interest rates increase back towards the mean of 9.7% or even higher. By waiting 2.5 years to buy a house you could be hedging your interest rate exposure today and taking advantage of historically low rates. Additionally by waiting for a few years you can also take advantage of lower housing costs when money is more expensive and those with 5 year ARMS have $300 more a month to pay.
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    Disclaimer and Disclosure Analyses are prepared from sources and data believed to be reliable, but no representation is made as to their accuracy or completeness. I am not paid by covered companies. Strategies or ideas are presented for informational purposes and should not be used as a basis for any financial decisions.
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