House Price, Loan-to-Value Ratio and Credit Risk

40 Pages Posted: 24 Apr 2018

See all articles by Xun Bian

Xun Bian

Longwood University

Zhenguo (Len) Lin

Florida International University (FIU) - Hollo School of Real Estate

Yingchun Liu

Dept. of Finance, Insurance, Real Estate and Law, University of North Texas

Date Written: March 16, 2018

Abstract

Real estate transactions are often established through financing. We study the effect of financing on property prices. We show that properties can transact at prices well above their collateral values. Therefore, the commonly used loan-to-value (LTV) ratio suffers a bias that can significantly understate credit risk. This bias is exacerbated when mortgages are originated with longer terms, at higher LTV ratios, or when sellers possess stronger bargaining power. Furthermore, this bias is larger under aggressive lending products, e.g. interest-only loans and mortgages allowing negative amortization. Our simulation results suggest that many mortgages originated at the peak of the housing bubble are, in fact, "under water" at origination. In particular, the loan amount of a 30-year mortgage at a 95% LTV can be 15% greater than the collateral value of the property, suggesting the mortgage is already deep "under water" at origination. These findings call into questions underwriting and risk control practices in mortgages and other collateralized debts.

Keywords: Prices, Bargaining, Mortgage Financing, Loan-to-Value Ratio, Credit Risk

JEL Classification: R3, G3, G21

Suggested Citation

Bian, Xun and Lin, Zhenguo and Liu, Yingchun, House Price, Loan-to-Value Ratio and Credit Risk (March 16, 2018). Journal of Banking and Finance, Forthcoming, Available at SSRN: https://ssrn.com/abstract=3157663

Xun Bian

Longwood University ( email )

201 High Street
Farmville, VA 23901
United States
(434) 395-2231 (Phone)
(434) 395-2203 (Fax)

Zhenguo Lin (Contact Author)

Florida International University (FIU) - Hollo School of Real Estate ( email )

Miami, FL 33199
United States
3057799248 (Phone)

Yingchun Liu

Dept. of Finance, Insurance, Real Estate and Law, University of North Texas ( email )

1155 Union Circle #305340
Denton, TX 76203
United States

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