Optimal loan size and mortgage rationing

Introduction Residential mortgage loans are the major instrument of housing finance. A mortgage arrangement is equivalent to an exchange of a loan today for a stream of future payments. In general, a household or investor will borrow whenever the marginal cost of borrowing is less than the marginal utility or benefit derived from the asset. Mortgage loans are secured by the real property, and provide a schedule of payments of interest and repayment of the principal to a bank. Most mortgage contracts arrange for loans to be fully amortized with adjustable mortgage interest rates and either payment or maturity is fixed for the term of the loan. The mortgage market is important for housing because it makes the investments of real property divisible thereby allowing households more flexibility in adjusting intertemporal allocation of savings and housing consumption between the present and the future as desired. In neoclassical economics, the higher the mortgage is relative to the value of a house, the higher the interest rate the household is charged. In this regard, housing leverage is strictly an increasing function of the price of credit it will be charged. Consequently, the mortgage interest rate will equate the amount of credit demanded with the amount available for supply. However, it has been observed that bankers often behave in a somewhat different manner. If we consider, for example, the requirement of a minimum downpayment, the banks’ policy in order to share the loan default risks between the mortgage borrowers and the banks themselves, a rational profit-maximizing banker would not lend the maximum acceptable amount of loans even if the borrower was willing to pay higher interest rates. The presence of imperfections in capital market creates differences between borrowing and lending rates confronting households (Dolde, 1978). The argument for such an observation is that banks tend to use non-price rationing, using for example the basis of borrower’s income proof and credit history to allocate their loans consistent with loan underwriting practice. In general, credit rationing refers to loans made based on the creditworthiness of a prospective borrower rather than the rate of interest. In other words, allocation of credit is not solely price-determined. As such, the practice of mortgage rationing takes two forms. The first type occurs when a bank refuses to make any loan to a borrower if some or all of the lending criteria