Do Riskier Borrowers Borrow More?

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.

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