best way to hedge mortgage

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billyjoerob

Embedded in most mortgages is the option to refinance in case rates decline. Most borrowers don't realize that they're paying for this option, and that the mortgage would be substantially cheaper (potentially) without this option. I remember reading Bill Gross a few years ago saying that Pimco got about 100 basis points in return by buying Fannie Mae paper and collecting this refinance risk premium.

So lets say you were to get a mortgage with no refinance option, presumably it would be cheapr than a normal mortgage. The mortgage also is I/O. Of course, if rates decline, you don't benefit . . . but let's assume you also buy a zero coupon bond at the same time. The bond matures at the same time as you I/O mortgage. If rates decline, you can cash in the zero and benefit without paying for that option. If rates go up, well, you just cash in the zero when the mortgage comes due, or sell and realize a tax loss.

There are three potential benefits to this plan . . . that you don't pay for the refinance option, and that you still benefit from lower rates with the zero, and still benefit from the mortgage interest deduction through the life of the mortgage.
 
Quote from billyjoerob:



So lets say you were to get a mortgage with no refinance option, presumably it would be cheapr than a normal mortgage. The mortgage also is I/O. Of course, if rates decline, you don't benefit . . . but let's assume you also buy a zero coupon bond at the same time. The bond matures at the same time as you I/O mortgage. If rates decline, you can cash in the zero and benefit without paying for that option. If rates go up, well, you just cash in the zero when the mortgage comes due, or sell and realize a tax loss.
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What's I/O? Interest only? If I have the ability to buy a bond, why I am taking out a mortgage? Why don't I just pay cash for the property?
 
Whenever I hear Zero coupon bond, I think of Carlton Sheets "no money down" program. He had this trick where he would get the owners to finance so much of the property and give them a zero coupon bond for the downpayment. It was quite a scam as only people that didnt understand bonds would go for it.

For instance, he would buy a $100k property and get the owner to finance say 70% and then give them a ZC bond with a face value of $30k knowing full well that he wasnt paying anywhere near $30k for the bond and thereby getting instant equity in the property. So if he paid $10k for the ZC bond, he got $20k instant equity in the property and instead of paying on a $90k loan, he was paying only on a $70k loan thereby giving himself an extra $100 or $150 in cash flow every month.

Worked alot better 20-25 years ago before everyone and their mother knew real estate though.
 
Quote from Retief:

What's I/O? Interest only? If I have the ability to buy a bond, why I am taking out a mortgage? Why don't I just pay cash for the property?
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There are tax advantages to a mortgage, like the MID. I'm not saying this is the greatest idea, and buying a zero when interest rates are pretty close to zero is not the best idea. Just trying to figure out how you would do it if you were fanatically committed to paying as little in taxes and as little in mortgage payments as possible.
 
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