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INTRODUCTION
Price-level adjusted mortgages (PLAMs) are designed to protect borrowers and lenders from inflation by using a real rate of interest as the basis for loan repayments. Both the monthly payments and the outstanding principal are periodically adjusted by the rate of inflation. Many economists favor the development of PLAMs because PLAMs provide borrowers who have stable real incomes with a stable consumption stream. Milton Friedman, for example, advocated the use of PLAMs in Newsweek (1983). They were introduced in Utah in 1981 [see Weiner(1983), p. 12], but are currently not available. In January 1989, HUD authorized PLAMs for FHA insurance [Woodward and Crowe (1988), p. 2]. A subsequent demonstration program, however, has not been implemented [Woodward and Crowe, pp. 5 and 7; Peek and Wilcox (1991), p. 65].
Most studies examining PLAMs focus narrowly on the instrument itself. Cassidy (1981), Kaufman and Erdevig (1981) and Cohn and Lessard (1976), for example, concentrate on the mechanics of the instrument. Others focus on broader issues, such as taxation [Peiser, Ferris, and Rene (1983)] and default [Pesandro and Turnbull (1985) and Manchester (1985)]. Peek and Wilcox discuss several risks faced by lenders, such as Savings and Loan Associations. Explaining the rarity of the instrument, however, requires a full evaluation of those risks.
The purpose of this paper is to consider the risks inherent in PLAMs from the mortgage lender' s perspective. The mechanics of PLAMs are described in the next section. In the third section, the riskiness of PLAMs is evaluated and compared to other instruments. The volatility of real interest rates is examined in the fourth section. The last section concludes that lenders do not offer PLAMs because while eliminating price risk, they increase other kinds of risk.
THE PRICE-LEVEL ADJUSTED MORTGAGE
To evaluate the riskiness of PLAMs, one must understand how they are constructed. First, payments on PLAMs are calculated in real terms as follows (Shim, et al, 1986).
m = P sub o r/[1 - (1 + r) sup -T ],--(1)
where
m = payment (per period) calculated at rate r
P sub o = principal at time of origination
r = contractual real rate of interest per period
T = number of amortization periods.
Second, this payment and the principal are adjusted...