Do Riskier Borrowers Borrow More?

Posted: 2 Sep 2004

See all articles by Abdullah Yavas

Abdullah Yavas

University of Wisconsin - School of Business - Department of Real Estate and Urban Land Economics

David Harrison

Texas Tech University

Abstract

Conventional wisdom in the mortgage industry holds that loan-to-value (LTV) ratios are positively correlated with mortgage default rates. However, not all empirical studies of mortgage loan performance support this view. This paper offers a theoretical signaling model of why the correlation between LTV ratios and default risk is contingent upon the default costs of the borrower. Specifically, the model proposes that when default costs are high there exists a separating equilibrium in which risky borrowers will self-select into lower LTV loans to reduce the probability of facing a costly default, while safe borrowers will self-select into higher LTV loans as a signal of their enhanced creditworthiness. This adverse selection process gives rise to the possibility of higher default probabilities for lower LTV loans. Conversely, when default costs are low the conventional result, in which risky borrowers select higher LTV loans than safe borrowers, is obtained. Empirical results, based on a sample of 859 single family residential mortgage loans drawn from the portfolio of a national mortgage lender, are consistent with the separating equilibria predicted by the model.

Keywords: Default risk, separating equilibrium, loan to value ratio

JEL Classification: D82, G21

Suggested Citation

Yavas, Abdullah and Harrison, David, Do Riskier Borrowers Borrow More?. Real Estate Economics, Vol. 32, 2004. Available at SSRN: https://ssrn.com/abstract=584242

Abdullah Yavas (Contact Author)

University of Wisconsin - School of Business - Department of Real Estate and Urban Land Economics ( email )

School of Business
975 University Avenue
Madison, WI 53706
United States

David Harrison

Texas Tech University ( email )

2500 Broadway
Lubbock, TX 79409
United States

Here is the Coronavirus
related research on SSRN

Paper statistics

Abstract Views
653
PlumX Metrics