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