Loan-to-what?

19 Aug 2014 | Richard Kemmish


The value of his house is a popular subject of middle class dinner party bores everywhere, although never the far more important ‘makes me get up to work every morning’ ratio of his loan to value. Similarly securitisation market bores can’t help but go on about how pfandbrief don’t even report loan-to-value ratios for their cover pools.

No more. The latest iteration of the regulations now requires pfandbrief issuers to disclose loan-to-value ratios. In fairness though, it’s a bit of a half-hearted attempt, looks like people are being inconsistent in the way that they calculate it and its far less important than its cracked up to be.
 
What do I mean by all of that? Well, the half-hearted bit is that they simply report an average number across the entire pool. Averages aren’t the problem, for L-T-V ratios it’s the amount of the pool in the high risk buckets that investors need to worry about. Reporting LTVs by bucket would have been a lot more useful.

Then there are the inconsistencies. Whereas the law stipulates that all eligible loans are capped at a 60% LTV a couple of issuers appear to be reporting average LTVs over that number. Presumably this reflects the total LTV of the mortgage, not the first 60% which is transferred to the cover pool.

Should you report the whole loan LTV or just that part in the cover pool? A high LTV is a potential credit problem for two totally different reasons.

Firstly, you are more likely to default on your mortgage if you have a high LTV as you have less equity in your house. This is a far greater risk than it was before the crisis. We haven’t quite reached the situation in the US where a borrower can usually just walk away from negative equity, but with bankruptcy laws across Europe becoming far more creditor friendly, the walk away risk increases.
 
Secondly, if you do walk away the higher LTV means the bank suffers a greater loss. But the part of the mortgage outside the cover pool takes the bigger hit.

So, focus on the whole LTV is you want to look at probability of the borrower defaulting or the portion in the pool if you want to look at the pool’s potential loss.

The discrepancies in Germany mirror those in Sweden until a couple of years ago. Despite the homogeneity of the Swedish market (and the pragmatism of the banks), every bank there had its own way to calculate LTV with vastly different results being reported.

But how much does it really matter? Our friends in the securitisation market may base their whole analysis on this ratio but in the land of revolving pools it is far less material. And then there is the artificiality of comparing LTVs in different countries. Different jurisdictions have vastly different ways of calculating value: purchase price, long term sustainable value or – my personal favourite – theoretical value (guess the country). They also have vastly different volatility of underlying property markets and average times to repossession (ask any bank collection department and they will tell you that the value of the property is often more closely linked to how long its been inevitable that it was going to be repossessed). 

Which doesn’t meant that LTVs are irrelevant. Just treat them with caution.


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