Why LTV ratios aren’t always a good default predictor

By Felix Salmon
June 25, 2009

John Carney responds to my post about his anti-CRA crusade this morning:

That deal has a ridiculous LTV. You go wrong by calculating only the bank loan, and not the total financing. A slight drop in home values puts this buyer underwater, which hugely increases odds of default. LTV is meaningless for predicting defaults unless you are considering all the debt that goes into the financing.

This is simply not true. LTV is useful for predicting defaults because it gives an indication of how much home prices need to fall before the homeowner is underwater. But LTV is not a default predictor on its own — it can only be useful when combined with a second key variable, which is the ratio of mortgage payments to prevailing rents.

During the housing boom, nearly all houses were more expensive to buy than to rent: your mortgage payments would be higher than it would cost to rent the same place. (Or, to put it another way, if you immediately rented the place out, you’d be losing money every month, although you might be making money on a mark-to-market basis if the value of the home was rising quickly.)

When it’s cheaper to rent than to buy, a huge amount of work is done by the homeowner’s equity: it’s the main economic incentive to keep current on a non-recourse mortgage. On the other hand, if it’s cheaper to buy than to rent, the amount of equity that a homeowner has is pretty much irrelevant. If the borrower defaults and loses his home, his monthly costs go up rather than down — in Carney’s example, from $550 a month to $750 a month.

Paying $550 a month and owning your own home is clearly superior in every way to defaulting on your mortgage, ruining your credit, and renting for $750 a month instead. As a result, when a homebuyer is saving money every month a result of buying his home, LTV is pretty much useless as a default predictor.

I’m on the board of a financial institution which helps underserved poor New Yorkers buy homes — in our case, normally apartments in HDFC (Housing Development Fund Corporation) buildings which have severe restrictions on resale and which often cost about $20,000. It’s hardly surprising that our default rate on those loans is basically zero: our borrowers might have high LTVs, but they’re managing to live in Manhattan for a few hundred dollars a month, and you can’t beat that deal.

Carney’s example was along similar lines: it was all about helping first-time homeowners into low-income housing. Trying to extrapolate from that to the speculative subprime bubble is ludicrious — not least because most subprime borrowers were not low-income at all.

Carney says that I would “make a terrible mortgage lender” — actually, no. Look at the default history on mortgages issued by CDCUs around the country, and you’ll find it’s very good indeed. Partly because all these loans are scrupulously underwritten, and are generally kept on the lender’s books. There’s just no comparison to the toxic assets being churned out by subprime originators during the boom, and I can’t for the life of me work out why Carney insists on trying to draw one.

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I’m not extrapolating anything. I’m providing examples of when the government urged risky mortgages.

Also, you are over-stating the predictive value of the relative price of renting versus owning. Every study I’ve seen says the rental rate is not a good predictor of default rates. The problem is that the price-rent ratio is too volatile. If you make loans on this basis, you’re just gambling. You’re better off sticking to LTV.

Um, Mr. Carney, the extrapolation takes place when you look at a CRA mortgage and call it risky. What Felix is pointing out is that these mortgages have few if any characteristics of a subprime mortgage. You seem to be harping on LTV because it the only characteristic that might be similar. It appears that you think that adjustable rates, negative amortization, stated income, etc. had nothing to do with the current crisis. Sorry, if the rest of us don’t agree with you.

Posted by Anon | Report as abusive

As near as I can tell, Carney is arguing that slippery slopes really do exist. The logic runs something like this: the CRA forced banks to make what appear to be suspect loans in certain under-served areas, and thus the entire mortgage industry had to make truly awful loans everywhere else. Why CRA directed lending in, say, Compton, would lead to subprime lending in Orange County isn’t made clear.

I browsed some comments over at his gossip rag and found this gem by Carney:

“But because policies often have unintended consequences, what the “CRA is designed to promote” is irrelevant. The Iraq war was designed to promote democracy. How’d that work out?”

‘Nuff said.

Posted by anon of the moment | Report as abusive

Enjoyable as a well-fought flame war can be to watch, I’d recommend both combatants retire from the field until he can return with data, models and predictions. There have to be dozens of Fed and NBER papers on these subjects. Pick a few and get back to us, please.

This series of posts floors me. Ridiculous.

And if the argument is that the CRA is a step onto a slippery slope, then a) everything is and thus we should never do anything because everything has bad effects and b) the CRA has worked and continues to work and a slippery slope argument requires this step be bad not good.

Facts about the CRA are readily available. Note that CRA institutions are mostly the local banks and associations that are currently healthy – except maybe for the CRE exposure.

Posted by jonathan | Report as abusive

The Community Reinvestment Act is a good program. There are many low-income, borrowers with mattress money and non-traditional credit who can make fine homeowners. These loans just have to be carefully underwritten, and the guidelines (debt-to-income, and reserves in particular) have to be realistic and prudent. In my opinion, the APPLICATION of the program by the lenders was flawed. I’m a mortgage underwriter with a major bank. I underwrote CRA loans in 2006 and 2007 when the guidelines were ridiculously liberal. In 2008 and 2009, I’ve been underwriting primarily FHA and Conventional loans. I went back today to re-review the guidelines for one of the CRA programs and am happy to report, the credit history, number of tradelines, employment history, income, debt-to-income ratio requirements, and level of documentation have all returned to sane, rational standards.

Using LTV as a default predictor, or even monthly rental amounts, assumes that people make logical financial decisions which they absolutely do not! I’ve seen borrowers who made $8.00 an hour working a factory line at a poultry plant in Arkansas pay off a home and buy an investment property, and I’ve seen borrowers who make $20,000.00 a month, who have to get a gift for their 3% down payment. I’ve also seen high income borrowers (over $400,000.00 a year) who have plenty of money in the bank, but lousy credit because they are “too busy” to pay their bills on time. I’ve also seen borrowers in California lose 30% of the value of their home in two short years, yet they continue to pay their mortgage, and some even buy investment properties now that houses are cheaper, because their sense of financial responsibility is greater than any worry they may have about capital gain or loss, or using equity as future savings.

Behavioral psychologists are beginning to open up a separate field of study that deals specifically with financial attitudes and behavior. Making a good loan decision involves taking ALL the layers of risk, into account. It’s not simple, and one or two variables, can’t tell the whole story. There’s a reason risk-based, automated underwriting systems are constantly modifying their models. That’s because good underwriting is art, as well as science.

Let’s not throw out the baby with the bath water. The Community Reinvestment Act is good for America.

Carney’s one of those blowhards who’s in so far over his head that he doesn’t even know what he doesn’t know.

The world needs fewer of these ignorant gas pots and more refective solutions.

Guys like him are responsible for the disaster we’re in because guys like him get the moron voters of the US right wing to put brainless shells like Bush in power, and look where we end up.

Posted by RN | Report as abusive

Now I recognize Carney – he’s that baffoon doing the Ostrich Pose down at the best sand in OC!!! What a joke!!!

the value of a low LTV is that it reduces financial risk for the lender. if the LTV is low, then in most scenarios (including default) the lender does not lose money. this keeps lenders’ direct exposure to housing prices low.

Posted by q | Report as abusive