Reflections on LTV, risk and incentives in mortgage markets

Abstract

PurposeThe purpose of this paper is to highlight the short run incentives for increasing LTV ratios that develop among mortgagees and mortgagors in the presence of excess return to housing. The paper provides a conventional framework for analyzing the capital structure of housing investments where higher LTV‐ratios comes about as stronger appreciation is met by increased mortgage rates and both mortgagees and mortgagors are short sighted.Design/methodology/approachThe comment applies a capital structure approach to housing investments, highlighting the return to home equity. The paper distinguishes between price and leverage gains and presents a framework where the excess return to housing provides incentives for increasing LTV ratios. To illustrate, the Norwegian housing market is applied. The paper discusses short run market developments and the potential need for macro prudential regulations while introducing credit risk policy, nominal return targets and risk pricing.FindingsThe implementation of a simplistic capital structure approach to housing investments brings about a framework that allows us to present the incentives for, as well as the risk associated with, higher LTV ratios for both mortgagees and mortgagors. Short sightedness among mortgagees, driven by nominal return targets, allows mortgagors higher LTV‐ratios and increased risk taking.Originality/valueWhile standard when analyzing commercial real estate, the capital structure approach – and the formal distinction between price and leverage gains for homeowners – is to the best of the authors' knowledge novel when analyzing housing finance. To understand the mechanisms impacting this playing field is important for both market analysts and regulators.