A comment on LTV, risk and incentives in mortgage markets

Abstract

This paper comments on the increase in LTV ratios experienced in a number of countries in the years preceding the financial crisis. Highlighting the capital structure of housing investments and the excess return to housing a framework incorporating the incentives for as well as the risks associated with higher LTV ratios among both mortgagees and mortgagors is set out. First, we relate LTV ratios to the return to home equity (RHE) for homeowners to illustrate the incentives for increasing LTV ratios among mortgagors that accompany excess return to housing. RHE is split between a price gain and a leverage gain, where the latter is related to the LTV ratio. Second, we introduce credit risk policy to highlight the increased mortgagor risk that accompanies a higher LTV-ratio. Finally, taking mortgagees nominal return targets into account we show the short-term gains for mortgagees by accepting higher LTV ratios in their mortgage portfolio as well as the risk pricing necessary to eliminate these incentives.