Wednesday, April 23, 2008

Walking away and out-of-the-money options

(Underbelly) Just got through explaining to my students how equity is an option on the assets, where the exercise price is the payoff cost of the debt. Made the point that it might be rational to pay a positive sum for equity on an upside-down/underwater balance sheet (that would be you, BS) as lottery ticket value against the prospect that Something May Turn Up. (“Maybe I die! Maybe the king dies! Maybe a horse learns to talk!). In the jargon, it’s not valueless, it is just “out of the money.” Out of the money options trade all the time.

I also make the point that in a place like here in California, where most of our mortgage debt is “nonrecourse”—the creditor can look to the property only, no deficiency right against the debtor—then the real estate is just another option play.

Then back to the aggregator, where I read more about default rates, foreclosure epidemics, blah blah, and this fascinating thread at Kevin Drum that leads from arson to cannibalism (link).

And it occurs to me—wait a minute, whoa. A lot of these owners are underwater now, in the respect that the loan value exceeds the market value. And a lot of them simply can never expect to get current on their obligations; might as well walk. But for some unknown percentage—but it can’t be that small—for some unknown percentage here, what we are talking about is an out-of-the-money option. Shouldn’t we/they be giving some value to the possibility that “something might turn up?”

For Extra Credit: Felix Salmon’s instructive piece on an effort by the Ohio attorney general to force workouts on lenders, against their will and for their own good (link).

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