Loss given default in residential mortgage loans in Portugal

Expected costs of mortgage default depend on the borrower’s probability of default (PD) and the loss in the event of default (LGD). This paper studies the factors that characterize LGD using comprehensive loan-level data obtained from the Portuguese Central Credit Register.

The paper finds that the initial loan-to-value (LTV) ratio is the most important determinant of the LGD of mortgage loans, although the relation between these two variables is not linear. A higher LTV ratio is associated with a higher LGD of mortgage loans, but only above a certain threshold that is at least 80%.

In addition, the paper finds that the housing cycle history before loan origination also plays a relevant role, with distinct short and long-term effects. A housing price appreciation just before loan origination reduces the future LGD, as a house price increase tends to have a positive short-term serial correlation. On the other hand, the long-term effect suggests that when housing cycles are endemic, the initial price appreciation is associated with higher loss in the event of default.

These results offer several insights to financial regulators. From a macroprudential perspective, as an increasing number of countries have been adopting borrower-based measures to constrain lending and banking fragility, which typically include limits on the LTV ratio of new mortgage loans, the paper offers insights into the relevant values of LTV to constrain. On what concerns microprudential regulation, the results support the current use of a through-the-cycle LGD, given the mean reversion pattern of house prices towards an equilibrium level in the long run.

Click here to go to the paper by Ângelo Ramos and Márcio Mateus.