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An Empirical Analysis of Information Asymmetry in Home Equity Lending

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Abstract

We analyze more than 74,000 home equity loans and lines of credit to study the role of information asymmetry. This credit market is characterized by borrowers who face a menu of contract options with varying collateral requirements and prices. Our results show that a less credit worthy applicant is more likely to select a credit contract that requires less collateral. Further analysis on the borrower’s repayment behavior after controlling for observable risk attributes indicates that the lender faces adverse selection and moral hazard due to private information.

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Notes

  1. In this classic case, the lender’s overall loan profitability declines because the quality of the average borrower declines as the interest rate or collateral increases since only higher risk borrowers are willing to pay higher interest rates or post greater collateral. As a result, the lenders ration credit.

  2. To test these theories, a number of studies examine the relation between borrower risk and the collateral pledged. The findings are mixed. Some studies report a positive relation (e.g., Berger and Udell 1990; Machauer and Weber 1998; John et al. 2003; Brick and Palia 2007; Godlewski and Weill 2011), while others find a negative relation (e.g., Degryse and Van Cayseele 2000; Jimenez and Saurina 2004; Agarwal and Hauswald 2010; Berger et al. 2011).

  3. Given that the home equity menu of contracts is not a continuous risk-based pricing menu but necessarily offers a set of coarse interest rates and collateral requirements, the problems of information asymmetry might be reduced, but cannot be completely eliminated.

  4. See Federal Reserve Statistical Release, Z.1 (2012).

  5. Credit rationing is not from the entire market because other lenders might offer the borrower credit.

  6. Both first lien loans and second lien loans are secured obligations of the borrowers. However, in the event of a bankruptcy or liquidation, the assets used by the borrowers as security would first be provided to the first lien secured lender as repayment of the first lien loans. After satisfying the borrowers’ obligations to the first lien secured lenders, any additional proceeds from the sale of the pledged assets would then be made available to the second lien lenders as repayment of the second lien loans. Usually, a borrower will take a second lien home equity loan either at the same time or after taking a traditional first lien mortgage loan. The specific rights of the first lien and second lien home equity loans are established in the credit agreements between the borrowers and each class of lenders.

  7. To verify the robustness of the preceding results, we follow Agarwal et al. (2011) and estimate a multinomial logit model on an applicant’s choice of a LTV contract. The results are fully consistent with the findings in Table 2.

  8. A borrower with a second lien also has an obligation towards the primary mortgage. On average, their total debt burden will be higher; this will impact the probability of the default. Moreover, the average interest rate for the second-lien products is 30 basis points higher than the first-lien products. This will negatively impact the borrower’s debt service burden resulting in higher default rates.

  9. Agarwal et al. (2006b) note that the default and prepayment behavior of loans and lines are different. Thus, we also estimated the Cox proportional hazard model for loans and lines independently. While the results confirm that loans have a higher probability of default and lines have a higher probability of prepayment, estimating the models separately does not impact the findings for the dummy variables of information asymmetry.

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Authors and Affiliations

  1. National University of Singapore, 15 Kent Ridge Drive, Singapore, 119245, Singapore

    Sumit Agarwal

  2. Office of the Comptroller of the Currency, 400 7th Street SW, Washington, DC, 20219, USA

    Souphala Chomsisengphet

  3. University of Nevada, Reno, Reno, NV, 89557, USA

    Chunlin Liu

Authors
  1. Sumit Agarwal
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  2. Souphala Chomsisengphet
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  3. Chunlin Liu
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Corresponding author

Correspondence to Chunlin Liu.

Additional information

The authors thank Regina Villasmil for excellent research assistance and Han Choi for editorial assistance. We also thank Amy Crew-Cutts, Shubhasis Dey, John Driscoll, Dennis Glennon, Robert Hauswald, Bert Higgins, Doug McManus, Donna Nickelson, Karen Pence, Calvin Schnure, Nick Souleles, Jon Zinman, and seminar participants at the 2007 ASSA meeting, the FDIC Center for Financial Research, Maastricht University, MEA, NCAER, the Office of the Comptroller of the Currency, The Pennsylvania State University, and the University of Kentucky for helpful comments and suggestions. The views expressed in this research are those of the authors and do not necessarily represent the policies or positions of the Office of the Comptroller of the Currency, and any offices, agencies, or instrumentalities of the United States Government.

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Agarwal, S., Chomsisengphet, S. & Liu, C. An Empirical Analysis of Information Asymmetry in Home Equity Lending. J Financ Serv Res 49, 101–119 (2016). https://doi.org/10.1007/s10693-015-0216-z

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  • DOI: https://doi.org/10.1007/s10693-015-0216-z

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