When a house with mortgage is better than a house without one

You are in the market to buy a new house. You have 10L ready cash with you and the current interest rate is 8% (Assume same rate for both lending and borrowing).

You have two options: two exactly identical houses

1. Without a mortgage, priced at 10L.
2. With a mortgage that involves interest at 5%. (The mortgage was taken at the time of low interest rate. The present value of the payments to bank comes to 10L i.e. you can make the asset mortgage free by paying the bank 10L. The mortgage is assumable. Which means that you can assume the mortgage that is in the name of the current owner.)

In this scenario it is profitable to buy the house that has mortgage. Assume the mortgage and invest the 10L at 8%. If you take the first option, you own an asset worth 10L while in the second case you own (?) an asset worth 10L plus you get interest income of (8-5 = ) 3%.

What are the flaws in this argument?

The market is efficient. The arbitrage opportunity that this situation presents will result in increase in price of the house with the mortgage to balance out the riskless profit opportunity.

Edited: As mentioned by Amit, other factors like mortgage market being less liquid and high transaction cost involved may also have an effect.

Soft Dollars

Something I had written for a class assignment.

Soft Dollars – Defined
Soft Dollars is a quid pro quo arrangement in which an investment house gets research service from a brokerage house in return for carrying out trades through that brokerage firm. This is in contrast to hard dollars where in the investment house pays the brokerage house directly (in dollars).

In the United States, Soft Dollar transactions are governed under section 28(e) of the Securities Exchange Act of 1934. More complex example of Soft Dollar involves providing increased commision to a brokerage firm for a service provided by a third party. The brokerage firm then redirects the payment to the third party. For Example, an investment firm (INV) rents private jets for its senior management from a travel agency (TA) and pays an increased commission to its brokerage firm (BF). The brokerage firm then redirects the payment to the travel agency. If INV pays directly to TA, it has to issue a check (or a wire transfer) to the agency and this transaction would have to be recorded in the companies books. The cost is then passed on to the clients of INV. By using Soft Dollars, INV is able to hide this transaction in the transaction cost of the trades. The cost is eventually passed on to the clients.

The major concern about soft dollars is that it is not suffiently transparent.

Section 28(e) provided a safe harbor for advisors who paid extra commission for research and other services. In 1986 SEC extended its interpretation of Section 28(e) to include other mixed services including computer hardware.
The major expenditure on SD is to buy investment research, the value of which is very difficult to quantify. Using SD to pay for the research rather than Hard Dollar results in less due dilligence in making sure that you are getting the bang for the money spent. John C Bogle contends that soft dollar expenditures reduces the quality of internal research making the firms more dependent on external research and thus increasing soft dollar expenditure. This eventually results in reduced share holder value.

Thus in conclusion, though Soft Dollar is an attractive tool for the investment firms, its utility to the clients of the firm is highly doubtful. As it takes the transaction off the books, proper accounting of the deals do not take place thus increasing the chances for fraud.

Basis Risk

We will be taking a look at a finance related topic for a change today.

Basis is the difference between spot price and the futures price. So if S1 and S2 are two spot prices at time t1 and t2 and F1 and F2 are the futures price for a futures contract at time t1 and t2 based on the same underlying asset.

Basis at time t1 = S1 – F1 = b1

Basis at time t2 = S2 – F2 = b2

Now consider that the futures contract that we are considering expires at time t2 and we have entered into a short hedge at time t1. This short hedge is to ensure the price for an asset that we are going to sell at time t2. Now the total payoff at time t2 would be the sum of S2 (The spot price at which we are selling the asset) and any profit that we get by selling the futures at t2.

payoff = S2 + F1 – F2 = F1 + b2

The b2 is the basis risk. In an ideal hedge we would be expecting that the spot and the futures price would converge at the futures expiration date (or the date when we are selling the asset. This is the purpose of the hedge.). But there are scenarios where the S2 and F2 do not converge. Its possible that

  1. Since we did not find a futures contract expiring at the same date as the date when we are selling the asset, we purchased a futures with a little longer expiration. Hence S2 not equal to F2.
  2. The asset and the underlying asset for the futures do not match. e.g. our asset is gasoline while the contract is based on West Texas Intermediate (Texas Light Sweet) (A crude oil is called sweet if its Sulphur content is low. Less than 0.5%. Sweet oil tastes sweet hence the name.) http://news.bbc.co.uk/2/hi/business/904748.stm
  3. Transportation cost of the delivery may increase the actual cost of the asset as compared to the contract.