The blind spot in residential mortgages: Increasing default option value in the face of declining house prices

Abstract

The interest rate hikes intended to combat inflation have not only significantly increased mortgage payments, but also significantly depressed house prices. The probability of default for mortgages is typically estimated through the debt servicing ability of the obligor. The alternative estimation based on the default option, although well studied in literature, is typically not used by practitioners. This option is normally ‘deep out of money’ and moves in the money if the loan to value (LTV) increases significantly, even creating negative equity. This is typically a remote probability due to the down payment requirements, but not as much under the current environment, where the house price depreciation has significantly increased LTVs, especially for newer mortgages underwritten when house prices were at their peak. This paper discusses the potential risk management oversights in this environment, illustrating that the increasing default risk is not adequately captured in probability of default (PD) models based on debt servicing ability alone. This is also true for the loss given default (LGD) risk if the contemporaneous LTV effects are not captured. Numerical examples are provided to demonstrate the material increase in PD, LGD and the combined expected loss risk with increasing LTV. It also discusses an alternative default option PD model, its calibration and its usage for stress testing along with LGD modelling, which together capture the contemporaneous LTV effects.