Chapter 32

Impact of Collateral on Valuation Models

The Example of Home Prices in the Credit Crisis

The 2006–2011 credit crisis has reemphasized what careful bankers have known for decades—collateral can have a significant impact on mitigating the credit risk of a particular loan structure. Lack of such collateral can have the opposite effect, which became obvious when slight declines in home prices triggered almost instantaneous defaults on mortgage loans made at 100 percent loan-to-value ratio levels. That is, those loans for which lenders were willing to lend 100 percent of the appraised value of the house on the assumption that increases in the home price would soon restore a prudent level of collateral.

In this chapter, we add collateralized transactions to our list of assets and liabilities that can be valued in a total risk management framework. Again, our objective in this effort is to be able to value the Jarrow-Merton put option on the value of the assets (and liabilities) of the firm as a measure of total integrated risk, including interest rate risk, market risk, liquidity risk, and credit risk.

THE IMPACT OF CHANGING HOME PRICES ON COLLATERAL VALUES IN THE CREDIT CRISIS

Up until 2006 in the United States and until the peak of the Japanese bubble in December 1989, bankers were willing to lend as much as 100 percent of the value of the home in the form of a first mortgage loan. This compares to a much more prudent, long-term “normal” level of an 80 percent loan-to-value ...

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