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Risk in Home Loan Business*
Posted On: 2020-09-02 Author : R.S. Garg

It is a common knowledge that risk and rewards go together. Like any other business, home loan or mortgage lending business also have various kinds of risk associated with it e.g. credit risk, operational risk, marketing risk, prepayment risk, property assessment risk legal risk etc. However, in any business risk cannot be eliminated. Let us therefore understand these different types of risks and the way they can be reduced or minimised.

Credit Risk : Credit risk is defined as the risk of expected loss, i.e. the probability of the lender not being able to recover the outstanding exposure. In relation to mortgage based lending business, credit risk is the risk associated with the loan asset in the books of lending institution. The risk arises as the loan may not be paid at all or not paid in full or not paid on time. In this type of business, because of collateralization by house property, the chances of total loss are unlikely except in case of frauds or defects in title. However, there is always risk of delinquency, which may be even for genuine reasons such as borrower is sick, or lost his job or crop failure etc.

Credit risk can be managed or contained by using proper underwriting and property appraisal systems, strong documentation & strong recovery teams. IT can also be managed by portfolio pricing, ascertainment of economic capital, pool level risk transfer devices such as securitisation or credit derivates etc. To manage asset level credit risk, an entity should focus on strengthening its underwriting system, which includes various procedures such as obtaining and verifying details of the prospect, credit scoring and credit bureau reports, credit evaluation by the credit team, property appraisal and legal searches etc. Where risk is observed to be high, entity can use credit enhancement devices such as over collateralisation, cash deposits, guarantee etc. Further, it is important to price the credit risk. If the risk is high, it should be matched by higher spreads so as to fully recover risk of expected loss. Securitisation can be used to contain the pool level losses where the originator takes first loss upto certain level and transfer the remaining risk to the investors.

Market Risk : Market risk is the risk that arises due to market forces, beyond the control of the entity. This is also known as systemic risk. The biggest market risk is the interest rate risk which arises due to asset liability mismatches. Mismatch may arise due to short term assets and long term liabilities or vice versa. It may also arise due to fixed rate assets and floating rate liabilities or vice versa. It may also arise due to difference in base rate where basis based on which the interest float are different. Interest rate risk is significant risk in mortgage business because of long term nature of assets.

Prepayment Risk: Where an entity finances its long term assets with a liability of similar tenure and the asset is paid off before time, there arises the risk as the entity has to deploy the funds for the remainder period which may be at a different rate of interest or may find it difficult to deploy for the remaining period. Thus, prepayment exposes an entity to both kinds of risks i.e. risk of principal and that of interest.

The interest rate risk can be managed by going for interest rate derivatives such as interest rate futures, interest rate swaps, forward rate agreements, investment in inverse interest rate products etc. Interest rate and prepayment risk can also be managed by securitisation.

Housing Market Risk : Another kind of risk associated with the market is the price of property financed. In cases housing prices goes up and LTV ratio goes beyond 100%, the borrower is likely to default as he has no equity left in the property.

Operation Risk : Operation risk is the risk arising due to failure of systems or men or occurrence of fraud or legal risk. The only effective safeguard against operational risk is the system of internal controls, standards of procedures, and internal audit and compliance system. In case of purchase of pooled assets, the credit underwriting processes of the originators are vetted and periodical checks are carried out to establish their adherence.

Legal Risk : Mortgage of the residential property financed is the primary security in lending for housing. It is, therefore, necessary that the mortgages created by the borrowers in favour of banks and HFCs to secure the housing loans are legally valid and capable of enforcement in the event of default. The primary credit risk is supported by solid security that does not move and which normally maintains its value. The incentive to avoid default is high, especially with residential property because a borrower will make every effort to avoid losing his home. Broadly, the legal risks associated with residential mortgage lending can be related to title (or lack thereof), uncertainty in mortgage laws and bottlenecks in their implementation.

LIQUDITY RISK : Liquidity risk is the risk that arises when an entity is not able to maintain or generate sufficient cash resources to meet its payment obligations in full when they become due. This also include inability to disburse a sanctioned loan. Liquidity risk is different from risk of insolvency – an entity may be solvent, but may be fully invested in long-term assets and may not have sufficient liquid resources to meet its obligations.

COMPIIANCE RISK : Compliance risk is the risk associated with the non compliance or omission to comply or failure to comply with the regulation connected with the business. HFCs are to comply with the various directions and guidelines issued by its regulators besides complying with the general laws in conducting its business. Failure to observe laws and regulations exposes an entity to fines, payment of damages, penalties. It also results in loss of reputation, inability to enforce of contractual obligations etc.