Mortgage risk
Encyclopedia
Mortgage underwriting is the process a lender uses to determine if the risk
(especially the risk that the borrower will default
) of offering a mortgage loan
to a particular borrower is acceptable. Most of the risks and terms that underwriters consider fall under the three C’s of underwriting: credit
, capacity and collateral
.
To help the underwriter assess the quality of the loan, banks and lenders create guidelines and even computer models that analyze the various aspects of the mortgage
and provide recommendations regarding the risks involved. However, it is always up to the underwriter to make the final decision on whether to approve or decline a loan.
Critics have suggested that the complexity inherent in mortgage securitization can limit investors ability to monitor risk, and that competitive mortgage securitization markets with multiple securitizers may be particularly prone to sharp declines in underwriting standards as lenders reach for revenue and market share. Private, competitive mortgage securitization is believed to have played an important role in the U.S. subprime mortgage crisis.
Liquidity risk
occurs when a borrower is required to pay higher amounts than what he currently can afford to pay in a mortgage. This can happen for various reasons. For example, option mortgages popular at the crux of the financial crisis, offered low teaser rate
s, which enticed borrowers, but then, according to contract, reset to higher interest rates, hence higher mortgage payments, which put many financially pressed homebuyers behind with their mortgage dues.
Depending on a mortgage contract, negative liquidity scenarios can eventually cause default on the mortgage, and foreclosure on the lien property, or, in other cases a "workout" with the lender that will allow the borrower, often with some penalties, to come up with make up payments later on.
Even if a payment growth does not trigger a default
or insolvency
, it is still worthy to the borrower to know if they could be required by the mortgage they undertake to pay an amount that will squeeze out of the budget many other important necessity expenditures. For these reasons, clearly, it is important to know how big a mortgage payment can potentially get and compare with borrower's income.
The other type of risk involves a significant increase (or minimal decrease) of the size of the balance owing on the mortgage over time. This again can happen for various reasons, the major one of which is again an increase of the interest rate of an adjustable-rate mortgage. A spike in the interest rate, combined with a capped mortgage payment (which can also appear when interest rate vs. payment rate are different) can lead to negative amortization
or a reduced loan principal repayment, which, when accumulated over time, would support a very high level of outstanding principal. The level of the loan balance has a significance when a borrower is required (or has decided for various reasons) to move out of the property, e.g. due to a job relocation, i.e. when he needs to sell the property that could had potentially moved in price under its associated loan amount. This situation is colloquially known as "underwater mortgage".
Even if a the loan amount does not increase more than a property value, the reduced difference of the two would mean a lesser in-pocket cash flow for the borrower/seller at the time of the sale of the property. This, although on a lesser scale, is also an ostensible risk.
Both payment and outstanding balance risks could be explored with tools described under the Mortgage Calculator
article.
If a rate on a mortgage contract increases significantly, this is generally a windfall for the lender. But only up to the point that the interest rate forces the borrower into default, in which case it could be necessary to foreclose the property, possibly at a suppressed value.
The growth of an outstanding balance of a loan over that of the underlying property in itself represents a risk to the lender. In this case of a moral hazard
, the borrower, facing a buying price for a similar property elsewhere, which is lower than the amount that he currently owes, may decide to steer to his own bankruptcy, and hand over the keys to the property to the lender, effectively exchanging a lower value property for a higher loan amount.
One additional risk for lenders is prepayment. If market interest rates drop, a borrower could refinance the mortgage, leaving the lender with an amount that now can be invested at a lower rate of return. This risk can be mitigated by various sorts of prepayment penalties that will make it non-profitable to refinance even if rates of other lenders decrease.
Risk
Risk is the potential that a chosen action or activity will lead to a loss . The notion implies that a choice having an influence on the outcome exists . Potential losses themselves may also be called "risks"...
(especially the risk that the borrower will default
Default
Default may refer to:*Default , the failure to do something required by law**Default judgment*Default , failure to satisfy the terms of a loan obligation or to pay back a loan*Default , a preset setting or value...
) of offering a mortgage loan
Mortgage loan
A mortgage loan is a loan secured by real property through the use of a mortgage note which evidences the existence of the loan and the encumbrance of that realty through the granting of a mortgage which secures the loan...
to a particular borrower is acceptable. Most of the risks and terms that underwriters consider fall under the three C’s of underwriting: credit
Credit (finance)
Credit is the trust which allows one party to provide resources to another party where that second party does not reimburse the first party immediately , but instead arranges either to repay or return those resources at a later date. The resources provided may be financial Credit is the trust...
, capacity and collateral
Collateral (finance)
In lending agreements, collateral is a borrower's pledge of specific property to a lender, to secure repayment of a loan.The collateral serves as protection for a lender against a borrower's default - that is, any borrower failing to pay the principal and interest under the terms of a loan obligation...
.
To help the underwriter assess the quality of the loan, banks and lenders create guidelines and even computer models that analyze the various aspects of the mortgage
Mortgage loan
A mortgage loan is a loan secured by real property through the use of a mortgage note which evidences the existence of the loan and the encumbrance of that realty through the granting of a mortgage which secures the loan...
and provide recommendations regarding the risks involved. However, it is always up to the underwriter to make the final decision on whether to approve or decline a loan.
Critics have suggested that the complexity inherent in mortgage securitization can limit investors ability to monitor risk, and that competitive mortgage securitization markets with multiple securitizers may be particularly prone to sharp declines in underwriting standards as lenders reach for revenue and market share. Private, competitive mortgage securitization is believed to have played an important role in the U.S. subprime mortgage crisis.
Risks for the borrower
There are two types of risk facing a borrower in a residential mortgage. The first one concerns the size of the cash flow to service the mortgage and the other concerns the size of the balance owing on the mortgage. Respectively related with those two risks are the concepts of liquidity and net worth.Liquidity risk
Liquidity risk
In finance, liquidity risk is the risk that a given security or asset cannot be traded quickly enough in the market to prevent a loss .-Types of Liquidity Risk:...
occurs when a borrower is required to pay higher amounts than what he currently can afford to pay in a mortgage. This can happen for various reasons. For example, option mortgages popular at the crux of the financial crisis, offered low teaser rate
Teaser rate
A teaser rate is a low, adjustable introductory interest rate advertised for a loan, credit card, or deposit account in order to attract potential customers to obtain the service. The teaser rates are normally too good to be true for the long term, and are far below the common realistic rate for...
s, which enticed borrowers, but then, according to contract, reset to higher interest rates, hence higher mortgage payments, which put many financially pressed homebuyers behind with their mortgage dues.
Depending on a mortgage contract, negative liquidity scenarios can eventually cause default on the mortgage, and foreclosure on the lien property, or, in other cases a "workout" with the lender that will allow the borrower, often with some penalties, to come up with make up payments later on.
Even if a payment growth does not trigger a default
Default (finance)
In finance, default occurs when a debtor has not met his or her legal obligations according to the debt contract, e.g. has not made a scheduled payment, or has violated a loan covenant of the debt contract. A default is the failure to pay back a loan. Default may occur if the debtor is either...
or insolvency
Insolvency
Insolvency means the inability to pay one's debts as they fall due. Usually used to refer to a business, insolvency refers to the inability of a company to pay off its debts.Business insolvency is defined in two different ways:...
, it is still worthy to the borrower to know if they could be required by the mortgage they undertake to pay an amount that will squeeze out of the budget many other important necessity expenditures. For these reasons, clearly, it is important to know how big a mortgage payment can potentially get and compare with borrower's income.
The other type of risk involves a significant increase (or minimal decrease) of the size of the balance owing on the mortgage over time. This again can happen for various reasons, the major one of which is again an increase of the interest rate of an adjustable-rate mortgage. A spike in the interest rate, combined with a capped mortgage payment (which can also appear when interest rate vs. payment rate are different) can lead to negative amortization
Negative amortization
In finance, negative amortization, also known as NegAm, deferred interest or graduated payment mortgage, occurs whenever the loan payment for any period is less than the interest charged over that period so that the outstanding balance of the loan increases...
or a reduced loan principal repayment, which, when accumulated over time, would support a very high level of outstanding principal. The level of the loan balance has a significance when a borrower is required (or has decided for various reasons) to move out of the property, e.g. due to a job relocation, i.e. when he needs to sell the property that could had potentially moved in price under its associated loan amount. This situation is colloquially known as "underwater mortgage".
Even if a the loan amount does not increase more than a property value, the reduced difference of the two would mean a lesser in-pocket cash flow for the borrower/seller at the time of the sale of the property. This, although on a lesser scale, is also an ostensible risk.
Both payment and outstanding balance risks could be explored with tools described under the Mortgage Calculator
Mortgage Calculator
Mortgage calculators are used to help a current or potential real estate owner determine how much they can afford to borrow on a piece of real estate...
article.
Risks for the lender
Risks for the lender generally parallel the risks for the borrower, but with different consequences.If a rate on a mortgage contract increases significantly, this is generally a windfall for the lender. But only up to the point that the interest rate forces the borrower into default, in which case it could be necessary to foreclose the property, possibly at a suppressed value.
The growth of an outstanding balance of a loan over that of the underlying property in itself represents a risk to the lender. In this case of a moral hazard
Moral hazard
In economic theory, moral hazard refers to a situation in which a party makes a decision about how much risk to take, while another party bears the costs if things go badly, and the party insulated from risk behaves differently from how it would if it were fully exposed to the risk.Moral hazard...
, the borrower, facing a buying price for a similar property elsewhere, which is lower than the amount that he currently owes, may decide to steer to his own bankruptcy, and hand over the keys to the property to the lender, effectively exchanging a lower value property for a higher loan amount.
One additional risk for lenders is prepayment. If market interest rates drop, a borrower could refinance the mortgage, leaving the lender with an amount that now can be invested at a lower rate of return. This risk can be mitigated by various sorts of prepayment penalties that will make it non-profitable to refinance even if rates of other lenders decrease.