Abstract

http://ssrn.com/abstract=767944
 
 

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Default, Credit Scoring, and Loan-to-Value: A Theoretical Analysis Under Competitive and Non-Competitive Mortgage Markets


Danny Ben-Shahar


Tel Aviv University

July 2005


Abstract:     
Consistent with existing literature, we first show that when borrowers' default probability on the mortgage loan is unobservable to the lender, the latter can screen borrowers by their combined choice of loan-to-value (LTV) ratio and interest rate. We further demonstrate that when borrowers also signal their default risk by acquiring a credit score, then a combined separating signaling and screening equilibrium is attained. If the signaling cost is sufficiently small, the combined signaling and screening equilibrium dominates the screening only equilibrium under both competitive and non-competitive market frameworks. However, while, under the competitive setting, borrowers benefit from constituting a credit scoring signaling system, the prospective gain is shifted to lenders under collusion. Finally, we show that under both competitive and non-competitive combined signaling and screening equilibria, high and low risk borrowers, while acquiring distinct credit scores (and therefore paying different interest rates) might realize higher, lower, or identical LTV ratios. Hence, any empirical test of the relation between LTV ratio and default risk must incorporate the interrelation among the LTV ratio, credit score, and interest rate.

Number of Pages in PDF File: 31

Keywords: loan-to-value, asymmetric information, mortgage, credit score, default

JEL Classification: D82, G21, L13, R29

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Date posted: August 8, 2005  

Suggested Citation

Ben-Shahar, Danny, Default, Credit Scoring, and Loan-to-Value: A Theoretical Analysis Under Competitive and Non-Competitive Mortgage Markets (July 2005). Available at SSRN: http://ssrn.com/abstract=767944 or http://dx.doi.org/10.2139/ssrn.767944

Contact Information

Danny Ben-Shahar (Contact Author)
Tel Aviv University ( email )
Tel Aviv
Israel
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