The Hold-to-Maturity Nonsense
By Arnold Kling
This morning, I realized why people think you can make money holding mortgage securities to maturity. They think that these securities are bonds. In reality, they are (or include) short option positions.A short option position is not something that you can just finance. It may be exercised against you.
The option that is embedded in mortgages is the borrower’s option to default. That was the insight of Chet Foster and Bob Van Order that I referred to in my chapter. The default option tends to be “in the money” when the house price falls by more than the amount of the down payment. A lot of mortgages out there have default options that are in the money or close to it.
Anyway, you cannot talk about holding to maturity a portfolio of short positions in options. Sure, if nobody defaults you get to hold to maturity. But depending on circumstances, some people will default, at great cost to you as the security-holder.
If Bernanke and Paulson really believe the hold-to-maturity argument, then they know even less about mortgage crecit risk than I thought. Let me offer a variation on the explanation in the update to my previous post.
Suppose we play a dice game, where you roll one six-sided die. If it comes up 1, 2, 3, 4, or 5, I give you one dollar. If it comes up 6, you give me everything in all your bank accounts. Will you probably win playing this game?
An old AP statistics exam had a question quite like this (I teach AP stats in high school). The correct response was to contrast the most likely outcome (winning) with the average outcome (losing). That is the sort of game that the government is playing in buying mortgage securities.
But win or lose, the government is not necessarily buying undervalued securities. It is buying securities whose value has been marked down because they are like short positions in options that are not far out of the money, if at all. That markdown may be quite large, but that does not necessarily mean that it is inappropriate.