Academic journal article Real Estate Economics

Do Riskier Borrowers Borrow More?

Academic journal article Real Estate Economics

Do Riskier Borrowers Borrow More?

Article excerpt

Conventional wisdom in the mortgage industry holds that loan-to-value (LTV) ratios are positively correlated with mortgage default rates. However, not all empirical studies of mortgage loan performance support this view. This paper offers a theoretical signaling model of why the correlation between LTV ratios and default risk is contingent upon the default costs of the borrower. Specifically, the model proposes that when default costs are high there exists a separating equilibrium in which risky borrowers will self-select into lower LTV loans to reduce the probability of facing a costly default, while safe borrowers will self-select into higher LTV loans as a signal of their enhanced creditworthiness. This adverse selection process gives rise to the possibility of higher default probabilities for lower LTV loans. Conversely, when default costs are low the conventional result, in which risky borrowers select higher LTV loans than safe borrowers, is obtained. Empirical results, based on a sample of 859 single-family residential mortgage loans drawn from the portfolio of a national mortgage lender, are consistent with the separating equilibria predicted by the model.

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Do risky borrowers borrow more? Specifically, does the loan-to-value (LTV) ratio choice of a borrower serve as a signal of that borrower's risk type? (1) The answer to this question is crucial to the mortgage lending industry as it would better enable lenders to screen risky borrowers from safe borrowers and price the default risk of each loan contract correctly.

Mortgage underwriters and academicians have conventionally subscribed to the view that loan-to-value ratios positively influence default rates. The argument usually made is the following: The greater the financial leverage (i.e., the higher the LTV ratio), the greater the debt service requirement, and hence the higher the probability the borrower will ultimately encounter financial distress. Theoretical signaling models, such as those presented by Rothschild and Stiglitz (1976) or Brueckner (2000), lend credibility to this paradigm, while a number of empirical studies, such as Von Furstenberg (1969) or Deng, Quigley and Van Order (2000), provide evidence consistent with the proposition.

Interestingly, however, not all empirical evidence supports this view of the world. Nearly 20 years ago, Campbell and Dietrich (1983) first reported the apparently counterintuitive finding that mortgage loans characterized by high LTV ratios at origination actually exhibit lower default rates over time compared to their low LTV counterparts. They conclude that the pattern of coefficients on the original loan-to-value dummy variables in their model is consistent with the presence of adverse selection in the underwriting process, particularly with respect to mortgages with original LTV ratios below 85%. Recent studies from multifamily and commercial mortgage markets also fail to document any positive relationship between LTV and borrower risk. For example, Archer et al. (1999, 2002) investigate pools of mortgage loans securitized by the Resolution Trust Corporation (RTC) for the Federal Deposit Insurance Corporation (FDIC) during the early to mid-1990s and find no significant relationship between LTV ratios at origination and ultimate loan performance (i.e., the probability of default). Similarly, Ambrose and Sanders (2001) find a lack of significance for LTV in their commercial mortgage performance investigation, and they argue this is entirely consistent with lenders using a compensatory model of credit evaluation, where risky borrowers upon any given dimension are held to more stringent standards along alternative dimensions.

The purpose of the current investigation is to bridge the gap between conventional wisdom and the seemingly counterintuitive empirical results which fail to consistently document a relationship between financial leverage and mortgage loan performance. …

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