What is the mechanism by which high loan-to-value ratios increase the risk of mortgage default? ?

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With respect to the subprime mortgage crisis: are homeowners acting like rational investors who willingly decide to default when the amount of their loan begins to exceed the value of their house, or does a high ltv ratio somehow compromise a homeowner’s ability to pay? It seems that if we employ the latter hypothesis, the explanatory mechanism would somehow have to invoke the idea that the homeowner becomes credit constrained when the ltv increases. If that were the case however, wouldn’t it take a widespread economic shock to account for the fact that so many mortgages are being defaulted on all at once?

I guess rate resets on adjustable rate mortgages could be this shock, but not all suprime mortgages are adjustable rate mortgages. Moreover, default rates seem to have been increasing, albeit to a lesser extent, in the prime and near-prime mortgage markets as well. Rising interest rates doesn’t seem to explain much either, given the Fed’s rate cuts. Am I wrong in suggesting that being credit constrained puts a homeowner in a vulnerable situation, but is by itself generally not sufficient to lead to a default?

Sorry for the wordiness of this question — it’s just my way of making sure that I’m reaching a knowledgeable audience!

  1. Reply
    Ronnie F
    February 2, 2011 at 10:39 am

    Mortgage Risk USA 2008 is the not-to-be-missed, practitioner-led conference that addresses the challenges faced by those who invest in and manage the risk of mortgage portfolios.

    As the industry is faced with unprecedented malaise stemming from high default rates in the sub-prime area, effective risk management techniques have become more important than ever. This event will address the needs of mortgage finance professionals by delivering strategic information on how to manage the changing nature of mortgage portfolio risk, house-price appreciation, credit-risk modeling and more.

    Key benefits of attending include:
    • Learn how adjust house-price appreciation models to account for a declining prices
    • Gain transparency by accurately assessing underlying credit risk of mortgage portfolios
    • Assess credit performance in a distressed market
    • Determine which sectors of the market are most resilient and learn diversification techniques that mitigate risk
    • Discuss the future of mortgage finance and the potential impact on domestic economic conditions
    • Meet your colleagues and enjoy the opportunity to debate these issues in the relaxed setting of the Mortgage Risk USA cocktail reception

    The nature of the default risk

    Defaulting is the decisive precondition for sanctioning a mortgagor by forcing the sale of the property he pledged as a security for the mortgage in default. Default is distinct from “delinquency”, ie the failure to make mortgage payments (principal and/or interest) when they are due. Generally, if the payment is delinquent for thirty days after the due date, the mortgage is ‘in default”. In the event of default, the mortgage may give the lender the right to accelerate payments, take possession of the property and receive rents and start the foreclosure process. “Foreclosure” is the legal process by which the mortgagor is finally extinguished of all rights, title and interest on the underlying real property due to failure to comply with terms and conditions of the mortgage.

    Mortgage default can have different reasons. It is important to know something about their respective empirical relevance because only limited resources should be allocated to hedges against infrequent risks for efficiency reasons. On the other hand the frequent risks require ample resources. In theory, the last Dollar spent for hedging against a certain default risk should equal the decrease in the probability of default caused by it times the individual cost of defaulting.

    There are two alternative views of home mortgage default behaviour (Jackson and Kasserman, 1980). The equity theory of default holds that borrowers base their default decisions on a rational comparison of financial costs and returns involved in continuing or terminating mortgage payments. The alternative is the ability-to-pay theory of default. According to this approach, mortgagors refrain from loan default as long as income flows are sufficient to meet the periodic payment without undue financial burden.

    Under the equity theory, the Current Loan to Value Ratio (CLTV), which measures the equity position of the borrower (ie market value of the mortgaged property divided by the outstanding mortgage loan at each point of time), is considered to be the most important factor in default decisions. By contrast, under the ability-to-pay model, the Current Debt Servicing Ratio (CDSR), defined as the monthly repayment obligations as a percentage of current monthly income, which captures the repayment capability of the borrower, plays a critical role in accounting for defaults.

    The 2005 Chicago Mortgage Default Counselling Survey of borrowers in default confirms the conventional wisdom that job loss, health crisis, and a death in family are most often the initial cause of a mortgage default. We can add rising interest rates and falling house prices to the list.

    The most important default reason is income reduction, in most cases a consequence of job loss. The importance of job loss as a default reason will vary between countries as different countries have different labour market regulation (influencing the duration of unemployment) and different social insurance schemes (influencing the level and the duration of unemployment benefit).

    Another serious default risk is additional credit taken for home repairs/ improvements or other purposes (cars, credit cards, etc). A lack of long term financial planning often seems to go hand in hand with the unwillingness or inability to adapt spending habits to the necessities of homeownership.

  2. Reply
    Ed Atun
    February 2, 2011 at 11:26 am

    The buyers could afford a nice $ 200,000 house. The cheapest price (because of the boom) was $ 300,000. So the buyers stretched and the mortgage companies stretched and ….. magically the buyers were approved for a $ 300,000 loan. So the amount of LTV has little relevance. They could never afford this loan in the first place but they got it and now it’s their problem to deal with. If the house goes up to $ 500,000 in 5 years, they win..

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