This paper studies the impact of housing market cycles on loss given default (LGD). Previous studies have shown that the current loan-to-value ratio (CLTV) is the most important determinant of LGD. This paper establishes another linkage which is between the house price cycles before the time of mortgage origination and LGD. The empirical analysis is based on a large loan-level sub-prime residential mortgage loss dataset from 1998 to 2009. Results show that house price history has a long memory in explaining LGD. Its explanatory power far exceeds the original LTV and other loan characteristics. This paper offers a countercyclical view of LGD risk. The model can be combined with a default probability model to serve as a regulatory prudential tool. Such a tool provides a solution to the inherent procyclical bias in BASEL II capital requirements, and can contribute to the safety and soundness of banking institutions.

On November 1, 2007, the Office of the Comptroller of the Currency (OCC) approved a final rule implementing the advanced approaches of the Basel II Capital Accord.1 This new rule allows banks, through the Advanced Internal Ratings Based Approach (A-IRB), to calculate their minimum regulatory capital. Under A-IRB, banks could use their own quantitative models to estimate PD (probability of default), EAD (Exposure at Default), LGD (Loss Given Default) and other parameters required for calculating RWA (Risk Weighted Assets). Then total required capital is calculated as a fixed percentage of the estimated RWA. There have been many studies on PD. The research on LGD, however, remains more limited in the literature. This paper focuses on the LGD component of the A-IRB under Basel II. In particular, we provide a model of LGD that includes the impact of the housing market cycle. Previous studies have shown that the current loan-to-value (CLTV) is the single most important determinant of LGD.2 However, to determine LGD at the time of loan origination for risk based pricing and capital allocation, only information available at the time of origination is known. Knowing that the CLTV is driven by the historical house price change, we investigate the linkage between house price cycles before mortgage origination and LGD.