As many HEL investors might suspect, a borrower's loan-to-value ratio is perhaps the leading factor in a given loan's loss severity. Studies show that borrowers are far less likely to abandon their homes - instead attempting to refinance or find a way to pay their monthly mortgage payment - when they have built substantial equity in them.
The findings are particularly relevant to portfolio selection, investors say, as home price appreciation sputters in states that have experienced unprecedented growth in recent years.
Loans originated in states with a high level of HPA - such as California and Florida - have experienced lower loss severities than those loans in such states as Ohio, Michigan and Iowa. However, loans from high HPA states will likely begin to catch up with the latter states given the recent housing downturn, Citigroup analysts wrote last week. The analysts studied the main drivers of loss severity within securitized subprime pools in the last decade.
They found the appraisal value of properties at loan origination was, on average, higher than actual market value, leading to a greater degree of loss for the securitized loans. Such appraisal inflation was most prevalent in cash-out loans, followed by rate refinance and purchase loans, Citigroup analysts found.
Indeed, as HPA abates in previously hot housing markets, defaults and reported incidents of fraud on mortgage applications are creeping up. California and Florida became the top two states in terms of reported cases of mortgage fraud in proportion to loans originated in 2006, according to the Mortgage Asset Research Institute (see article page 6).
And while many assume a loan's LTV affects loan performance primarily because of the borrowers' ability to refinance out of their mortgages, or even afford the home in the first place, a study of Mexico's attempt to curtail borrower default following the country's currency devaluation of December 1994 paints a different story.
According to some market sources, a subprime borrower's motivation to file the necessary paperwork to qualify for help refinancing could taint this scenario.
Assuming borrowers were defaulting on their mortgages because they simply could not afford them, the Mexican government provided borrowers with an interest rate subsidy, and later a monthly payment subsidy, if they restructured their loans. But according to a Harvard University Joint Center for Housing Studies paper written by former Goldman Sachs associate Natalie Pickering in 2000, net home equity was the primary influence on whether borrowers chose to default or restructure their mortgage loan.
And while regulators, members of Congress and private parties are advocating loan modifications to help stem the tide of subprime loan defaults, the study suggests that reducing a borrower's loan balance would have a more positive impact on ultimate loss severity than reducing a borrower's monthly payment.
Aside from LTV, delinquency status is the most important factor in determining loss severity, Citigroup found. Losses were highest for loans in REO, followed by foreclosed loans and those sold in a preforeclosure sale. State foreclosure laws that determine a foreclosure time line are key in determining loss severities, they noted.
Citigroup analysts further found loss severities were higher on smaller loans - those with a balance less than $100,000 - because of the costs associated with their liquidation and the time it generally takes to do so. Loss severities are also higher for borrowers in bankruptcy, loans with higher coupons and for loans with current LTV ratios higher than 80%.
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