Collateral and Sorting: An Empirical Investigation of the Market for HELOCs

Collateral has always played an important role in commercial lending and in the real estate market. With the emerging importance of home equity lending, secured credit is also gaining ground in the consumer credit market via the rapid growth of Home Equity Lines of Credit (HELOCs). An examination of the HELOC market raises many questions about interest rates and the role of collateral. The dispersion of interest rates in the secured credit market depends primarily on how collateral helps to sort borrowers according to their riskiness. Theoretical studies have predicted different roles for collateral in the sorting equilibria of the secured credit market. The two major explanations of the collateral-risk connection are (a) the sorting-by-observed-risk paradigm whereby observably riskier borrowers must pledge more collateral than less risky borrowers; and (b) the sorting-by-private-information paradigm whereby low-risk borrowers signal their superior risk-type by pledging more collateral than their high-risk counterparts. Here we empirically investigate these two opposing hypotheses that have not previously been tested in the market for collateralized HELOCs.