Question

A pool of mortgage loans with an estimated combined loan to value ratio of 1.0 has experienced an average severity (loss given default) of 20%. Assuming that the only variable cost in liquidating properties out of the pool is the value of the property, what do you expect the severity to be if house prices fall by an additional 40%?

Answer 1

Answer:-

Loan to value ratio (LTV) = 1.0
LTV = Loan amount / Appraisal value = 1.0
Therefore Loan amount = Appraisal value

Given Average severity ( Loan given default ) = 20%

Variable cost in liquidating properties out of pool = Value of the property

The house property falls by an additional 40%

Loss given default = 1 - recovery rate = 20 %

Recovery rate (R1) = 1 - 20% = 1 - 0.20 = 0.80 = 80 %
The fall in house prices = 40%
Recovery rate = 1 - 40% = 1 - 0.40 = 0.60 ( Since value of property is equal to the cost of liquidating properties out of pool)
Recovery rate (R2) = 60%

The recovery rate after additional fall of 40% = R1 x R2 = 80% x 60%= 0.8 x 0.6 = 0.48

The severity or Loss given default after fall of additional 40% = 1- recovery rate = (1 - 0.48) =0.52 = 52%

Hence the Loss given default = 52%