Cash flow models for pricing mortgages

A number of recent trends have led academics and practitioners to question the separation in theory, practice and regulation between the insurance and banking industries. These trends have included corporate integration and the creation of financial conglomerates, the creation of products such as credit derivatives and credit insurance, which involve underwriting similar risks in both banks and non-banks, and the recent development of more standardized accounting practices. Until recently, the methodologies for pricing insurance and banking products were quite separate. This paper presents an approach to pricing mortgages that is commonly used for pricing insurance products. Pricing the two should not be radically different, since the fundamental financial characteristics of the products offered are similar. The model explicitly identifies different elements of the cash flows to the providers of equity capital and prices the loan to achieve an appropriate risk-adjusted rate of return on equity capital. Expenses, size of loan, term of loan and special ‘features’ (such as cash backs) can be as, or more, important than default risk when pricing mortgages. Methodologies similar to the one proposed are now used in the banking sector for analysing the profitability of a new product prior to launch. However, credit scoring techniques would still generally be used in taking lending decisions in individual cases.