The Optimal Mortgage Loan Portfolio in UK Regional Residential Real Estate

Posted: 19 Nov 2012 Last revised: 2 Dec 2013

See all articles by Youngha Cho

Youngha Cho

Oxford Brookes University

Soosung Hwang

Sungkyunkwan University - Department of Economics

Stephen E. Satchell

University of Cambridge - Faculty of Economics and Politics

Date Written: November 19, 2012

Abstract

In this study, we propose a method based on large deviation theory (LDT), which minimises credit risk (expected loss). We demonstrate how mortgage loan portfolios can be optimised using geographical differences in the risk characteristics of mortgage loans in the UK. Our empirical results show that credit risk can be reduced by a third when the LDT method is used instead of the benchmark portfolios that we calculate with regional-gross-value-added weights and equal weights. More importantly, the difference in the expected loss between these portfolios increases further during bearish housing markets. To see that such numbers matter, in an extreme scenario, the UK mortgage lenders could lose more than 2% a year as the consequence of mortgage defaults, which is equivalent to an annual loss of approximately 20 billion pounds in the UK. Although this extreme state would not continue for a long time, it nevertheless represents a huge potential loss for mortgage lenders and investors.

Keywords: Large deviation theory, Mortgage loans, Optimal portfolio, Regional allocation

Suggested Citation

Cho, Youngha and Hwang, Soosung and Satchell, Stephen E., The Optimal Mortgage Loan Portfolio in UK Regional Residential Real Estate (November 19, 2012). Journal of Real Estate Finance and Economics, Vol. 45, No. 3, 2012. Available at SSRN: https://ssrn.com/abstract=2178027

Youngha Cho

Oxford Brookes University ( email )

Gipsy Lane
Oxford, Oxon OX3 0BP
United Kingdom
44-1865-483941 (Phone)
44-1865-483927 (Fax)

Soosung Hwang (Contact Author)

Sungkyunkwan University - Department of Economics ( email )

25-2 Sungkyunkwan-ro
Jongno-Gu
110-745 Seoul
+82 (0)2 760 0489 (Phone)
+82 (0)2 744 5717 (Fax)

Stephen E. Satchell

University of Cambridge - Faculty of Economics and Politics ( email )

Austin Robinson Building
Sidgwick Avenue
Cambridge, CB3 9DD
United Kingdom
44 (0)1223 335213 (Phone)
44 (0)1223 335475 (Fax)

HOME PAGE: http://www.econ.cam.ac.uk/faculty/satchell/index.h

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