An Empirical Investigation of Collateral and Sorting in the HELOC Market

This research explores the role that collateral plays in sorting borrowers according to risk classes in the secured credit market. Two distinct paradigms exist in the commercial loan market literature on risk-sorting based on collateral: (a) the sorting-by-observed-risk paradigm, which predicts a positive association between collateral and borrower risk; and (b) the sorting-by-private-information paradigm, which postulates a negative relationship. We empirically test which of these paradigms explains the risk/interest rate dispersion in the market for collateralized Home Equity Lines of Credit (HELOCs). Whereas for traditional loans the focus is on Loan-to-Value ratios, here we introduce the concept of Borrowing-to-Value ratio, which is the relevant criterion for lines of credit since credit extended is not necessarily borrowed. Using a maximum likelihood procedure, we simultaneously estimate the HELOC borrowing level and the HELOC rate of interest. Our results support the sorting-by-private-information paradigm. ____________________ * Dey, Senior Economic Analyst, Bank of Canada, Ottawa, Canada; Dunn, Professor of Economics, Ohio State University, Columbus, Ohio.