The optimal LTV-ratio, mortgage market variability and monetary policy regimes: A demand side perspective

Abstract

The purpose of this paper is twofold: First, it derives the optimal LTV-ratio for a mortgagor that maximizes the return to home equity when considering the capital structure of housing investment. Second, it analyses the demand side contribution to mortgage market variability across monetary policy regimes. The paper endogenises both the relation between the loan-tovalue (LTV) ratio and the mortgage rate and the relation between LTV and the rate of appreciation. When analyzing LTV-variance and the demand side contribution to mortgage market variability we consider three stylized regimes. The paper finds an intuitive ranking of LTV-ratios across regimes, where the optimal LTV-ratio peaks during a housing boom. The demand side contribution to market variability is however at its highest during “normal” market conditions in housing and mortgage markets when monetary policy ignores asset inflation. Hence, there is a potentially humped shaped relation between the risk exposure of individual mortgagors and the demand side contribution to mortgage market variability.