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LOS c: Explain how subprime mortgage borrowers are granted a free at-the-money call option on the value of their property.

An interest-only mortgage with a balloon payment equal to the original principal is best described as:

A)	a speculative unit.

B)	a free in-the-money call.

C)	an at–the-money call with a cost equal to the interest payments.

In the speculative unit, the levered investment is riskier than the hedge unit. Here the borrower purchases an asset that is backed by enough cash flow to pay back the interest but not the principal. An example is an interest-only mortgage with a balloon payment equal to the original principal. This mortgage can be tempting to borrowers because of its lower monthly payment.

William Banner has just been granted a subprime mortgage. In the model where the mortgage is essentially a free at-the-money call option, the strike price of Banner’s “option” is the:

A)	down payment and origination fees.

B)	value of the property at the time of the mortgage.

C)	the cumulative interest of the mortgage.

The value of the property is the strike price because if the property value increases above the purchase (strike) price, all of the gains accrue to Banner.

One explanation for how a subprime mortgage borrower is granted a free at-the-money call option on the value of their property is that:

A)	no down payment was required although there were still origination fees to obtain the mortgage.

B)	no down payment or origination fees were required to obtain the mortgage.

C)	no origination fees were required but there was still a down payment required to obtain the mortgage.

The option is free because no down payment or origination fees is required to obtain the mortgage. It is a call because, if the property value increases above the purchase (strike) price, all of the gains accrue to the borrower (the option holder).

Subprime mortgage borrowers were granted a free at-the-money call option on the value of their property because:

A)	adding a long call position on REITs was a usual deal sweetener.

B)	they did not put any money down, earned a profit if the home value increased but lost nothing if the home value decreased.

C)	adding a long call position on a real-estate index was a usual deal sweetener.

Borrowers had been granted a free at-the-money call option on the property. The option was free because no down payment or origination fees were required to obtain the mortgage. It was a call option because, if the property value increased above the purchase (strike) price, all of the gains accrued to the borrower (the option holder). If prices declined, the borrower did not lose any money.