Tax liens: a novel application of asset pricing theory (Q2425556)

Tax lien certificates are legal claims to unpaid real estate taxes issued by various state counties. Tax liens are auctioned to the public and they give the holder the right to future payments of overdue taxes plus penalties and interest. If the property owner does not pay within a prespecified period, the maturity period, the tax lien holder can claim the underlying real estate through a foreclosure. The property owner has the right (option) to redeem the tax lien certificate from the holder during the maturity period and even afterwards until the foreclosure date, by paying the overdue taxes plus penalties and interest. Although relatively obscure, the market for distressed real estate tax liens exists in over 30 U.S. states, with a market size estimated to be around 20 billion dollars. While this niche asset class is relatively unknown to academics, internet advertising hypes tax liens to the populace as providing extraordinary returns. Not yet scientifically studied, this market provides a fertile and untouched area for the application of the asset pricing theory. Using insights from option pricing, credit risk and the asset pricing literature, the authors develop a simple pricing model for tax liens. The option to redeem prior to the foreclosure date is modelled via an intensity process, similar to the modelling of a default event in the reduced form credit risk models or prepayment in the residential mortgage back literature. The developed model is tested empirically using data obtained from the annual tax lien markets in Miami Dade County, Florida for the years 2002-2004. Although limited in scope, the data, as the authors claim, are sufficient to test their simplified model providing some useful empirical results. These empirical results support the general validity of the proposed pricing model, although extensions may improve its fit. Moreover, the results indicate the increasing competitiveness of the tax lien market, and an unfair tax auction bidding mechanism for property owners that may provide extraordinary returns to investors, lending some credibility to the industry claims.