Mortgage contract design and systemic risk immunization ☆ Geoffrey Poitras a, ⁎, Giovanna Zanotti b a Beedie School of Business, Simon Fraser University, Vancouver, BC V5A 1S6, Canada b Dept. of Mgmt., Economics, and Quantitative Methods, Università degli studi di Bergamo, Via Salvecchio, 19-24129 Bergamo, Italy abstract article info Available online 29 October 2014 Keywords: Classical fixed income immunization theory Mortgage contract design Systemic risk management This paper provides theoretical results for the design of contracts used in the market for residential household mortgages and mortgage securities. Critical elements in the problem of immunizing systemic risk through effi- cient contract design are identified. Using an extension of classical immunization theory, this paper demonstrates that systemic risk of long amortization mortgage contracts is reduced when term to maturity of the contract at origination is significantly less than the amortization period. In addition, incorporating prepayment and limited recourse default options into the mortgage contract increases systemic risk when compared with full recourse mortgage contracts having yield maintenance prepayment penalties. The theoretical results are used to evaluate the systemic risk management problems that have plagued the US mortgage funding system. © 2014 Elsevier Inc. All rights reserved. 1. Introduction The primary objective of this paper is to illustrate the implications of mortgage contract design for immunization of systemic interest rate and house price risks inherent in the residential mortgage funding sys- tem. The classical fixed income portfolio immunization model is ex- tended to assess the implications of systemic interest rate and house price risk, e.g., Redington (1952), Reitano (1991a,b), and Poitras (2007, 2013). It is demonstrated that shortening mortgage term to ma- turity and having a ‘yield maintenance’ prepayment penalty reduces the systemic risk inherent in the origination of long amortization period, single-family residential mortgages. 1 In addition to mitigating the diffi- culty of determining an actuarially sound fair market value at origina- tion, shortening mortgage term to maturity strengthens adherence to underwriting standards by requiring borrowers (mortgagors) to peri- odically reaffirm both the equity value in the underlying asset and the source of household income required to service the mortgage. Even if the mortgage contract has no prepayment penalty and includes a no re- course default option, reducing mortgage term to maturity still signifi- cantly reduces the market value of these options when the mortgage is priced at origination, thereby reducing the systemic risk associated with the exercise of options that are unpriced or incorrectly priced. 2 2. Mortgage contract design The history of the mortgage contract stretches back to antiquity. Cu- neiform tablets from the second millennium BC record debt-bondage contracts for consumption loans in ancient Mesopotamia that were structured with landed property as security. Much of mortgage contract history is concerned with: evolving legal interpretations of the contract, such as the remedies available to mortgagee and mortgagor in the event of default; and, how mortgage contract language can be structured to achieve a particular objective, such as including a power of sale clause to avoid costs of foreclosure for the mortgagee. 3 In the modern era, mortgage contract design varies substantively across countries and over time. These differences are the result of the unique evolution of the mortgage contract in each country. In particular, Campbell (2013, Fig. 2) demonstrates that mortgage contract design in the US is anoma- lous compared to other countries in having a long amortization period International Review of Financial Analysis 45 (2016) 320–331 2 This follows from the distribution free property of options that the price of an option with a longer term to maturity cannot be less than an option with the same contract fea- tures but with a shorter term to maturity. This is not a statement about the total value of these options over the full amortization period. More precisely, for a mortgage with a term to maturity that is less than the amortization period, the contract options can be divided into those that are priced over the initial term to maturity and those that are priced over the term remaining between the initial maturity date and the end of the amortization pe- riod. It is possible that the value of options priced at origination when term to maturity and amortization period are equal may be less than the sum of option values over the amorti- zation period for the shorter term to maturity mortgage. 3 Older sources on the history of mortgage contracts includes Anonymous (1856), Frederiksen (1894), Sakolski (1932), Fahey (1934), Rabinowitz (1945) and Skilton (1946). ☆ The authors are Professor of Finance at Simon Fraser University and Associate Professor at the University of Bergamo. This paper was partially written while the first au- thor was a visiting Professor in the Faculty of Commerce and Accountancy, Thammasat University, Bangkok, Thailand. ⁎ Corresponding authors. E-mail address: poitras@sfu.ca (G. Poitras). URL: http://www.sfu.ca/~poitras (G. Poitras). 1 By allowing periodic review of borrower creditworthiness, term to maturity restric- tion also enhances achievement of adequate underwriting standards. The approach of restricting mortgage contract term to maturity to manage systemic risk of residential mortgage funding is not new. Included in the long history of studies up to the S&L crisis advocating some variation of this approach are Guthmann (1938), Muth (1962), Clickner (1967), Findlay and Capozza (1977) and Eskridge (1984). http://dx.doi.org/10.1016/j.irfa.2014.10.011 1057-5219/© 2014 Elsevier Inc. All rights reserved. Contents lists available at ScienceDirect International Review of Financial Analysis