Risk-Based Pricing of High Loan-To-Value Mortgage

High loan-to-value (LTV) mortgage are residential mortgage loans with LTV ratio greater or equal to 90\%. Lenders are increasingly engaged in risk-based pricing. If properly quantified, the additional credit risk taken when originating high LTV mortgage can be compensated by higher interest rate charged to customers. High LTV mortgage is regulated to meet higher capital requirement and thus have higher funding cost. Current regulation raises regulatory capital requirement of banks on all high LTV mortgage holdings. However, it is not efficient to differentiate the risk between a high LTV first mortgage and a second lien mortgage with the same LTV. In the paper, I show how LTV ratio affects credit risk in mortgage. A structured credit modeling approach is taken to quantify the credit risk of first mortgage and second mortgage. The total risk in a combination of first and second mortgage is shown to be equal to that of a first mortgage with the same aggregate LTV. Default risk is derived implicitly. Optionality of defaultable debt results in an upward sloping credit supply curve in terms of a function of interest rate with respect to LTV. Current regulation in high LTV mortgage creates a funding advantage in seperating a high LTV mortgage into a lower funding cost first mortgage and a higher cost second mortgage