Legal Restrictions in Personal Loan Markets
BRENT W. AMBROSE
University of Kentucky, Lexington, KY 40506-0034, USA
ANTHONY B. SANDERS
The Ohio State University, Columbus, OH 43210, USA
This study examines the pricing of personal loans in the form of second mortgages to determine whether state-
specific default laws have an effect on the availability and cost of that debt. We examine the pricing of loans to
higher risk borrowers and whether borrowers in states that limit lender ability to seek default remedies pay
higher credit costs. Our results indicate that, for the most part, lenders rationally price loans to higher risk
borrowers. However, when we focus on borrowers with low credit scores, the results indicate that mean actual
loan rates are higher than those predicted by our model. The results also indicate that state-specific default laws
have an effect on the price of credit. Finally, the results show that there is a greater degree of error in the pricing
of second mortgage loans to borrowers with low credit scores than to borrowers with high credit scores.
Key Words: credit risk, mortgage pricing, second mortgages
Debt usage contains important signals regarding borrower quality and thus reveals
information. While the use of debt is widely recognized in the information asymmetry
literature, unfortunately, few studies have tied the signaling aspect of debt usage to
broader market conditions where legal restrictions and regulations also interact to
determine optimal debt usage. Given the debate currently surrounding the issue of
predatory lending practices, it is important for public policy analysts to understand the
equilibrium tradeoff between debt amount and cost and the effect that the regulatory
environment has on this tradeoff.
Several observations can be made regarding the effects of high debt levels. First, in the
residential mortgage market it is well understood that second mortgage loans such as
high loan-to-value (LTV) loans carry significant default risk. Traditional option pricing
models, where default is endogenous and determined only by interaction of house value
and interest rates, find that the default option value is significant when the LTV is greater
than 100 percent.
As a result, high-LTV loans are usually junior debt with lower priority
of claim on the asset, with the majority of high-LTV loans originated for the purpose of
debt consolidation. Furthermore, high debt levels are also correlated with the probability
The Journal of Real Estate Finance and Economics, 30:2, 133–151, 2005
2005 Springer Science + Business Media, Inc. Manufactured in The Netherlands.