Prudent LGD Estimation for Mortgages

Bogie Ozdemir

The financial crisis of 2007–08 is considered by many economists to have been the worst since the Great Depression of the 1930s. The bursting of the housing bubble in the US, which peaked in 2004, caused the value of securities tied to US real estate prices to plummet, damaging FIs globally. Policies that encouraged home ownership, easy access to loans for subprime borrowers and overvaluation of bundled subprime mortgages based on the assumption that housing prices would continue to escalate are considered the strongest triggers of the crisis. House prices are on the rise in the US again, and there is fear that a correction is due in Canada as well, especially in overheated markets such as Vancouver and Toronto. The next house price correction continues to be a concern.

Both A and Alt-A lending are vulnerable to potential house price corrections. LTV is a key metric used for deal acceptance, and LGD drives the capital assigned to the deal. However, both LTV calculations and the LGD estimations under AIRB may have significant biases. The historical loss data used for calibration may be coming from a period when house prices were going up. There could also be appraisal biases that