Calculating risks.

Author:Wolcott, Hunter W.
Position:Management tools for effective loans and risk management
 
FREE EXCERPT

To risk means to expose to a chance of loss. Known or accurately predicted losses are not risks; they are considered part of the price of doing business. Some risks stem from the choice made by mortgage lenders to retain the servicing on a loan rather than opting for the risk-free choice of selling it.

For instance, prepayment risk stems from the chance that prepayment forecasts will not turn out fully on-the-mark. Likewise, default risk arises from the possibility that foreclosure probability or default severity will be worse than anticipated.

Risk, in and of itself, is neither good nor bad. Lenders must assume some risks, however, because a risk-free rate of return will not compensate a mortgage business for the value of its capital. Lenders who survive and prosper will be those who get the best assistance from sophisticated management tools designed to help price loans and manage risks most effectively.

One such portfolio management system that has been created to help mortgage bankers is the RF/Spectrum system developed by Reserve Financial Systems Corporation, the technology affiliate of Miami-based Reserve Financial Group.

For four years, clients have been assisted in making many types of management decisions with the help of this system. Here are some examples of the types of decisions and information that companies have used the system for:

* Decisions on selling servicing in order to meet accounting needs for income and to achieve reduction of prepayment risk.

* Evaluations of condition and composition of potential purchases.

* Evaluation of servicing department performance for such items as advances, uncollected late charges and delinquency progression that are not otherwise immediately apparent.

* Pricing of new production.

* Executive compensation decisions. (Can be used to implement a top management bonus plan based on real value gains and losses on servicing values measured quarterly.)

* Servicing hedging decisions. The system can evaluate whether a hedging proposal is worth as much, or more, than it costs.

* Dynamic portfolio optimization. This helps lenders set goals for servicing in the areas of REO, interest rate sensitivity and geographic risk distribution. The portfolio is reviewed quarterly to examine the gap between actual servicing position and goals that have been set. The system sets action plans to close those gaps.

* Management of default risk is handled by a subsystem of RF/Spectrum called the Residential Mortgage Default Risk System (RMDRS). Used by banks making acquisitions, this program tests a target bank's portfolio for default risk.

In mid-1991, this portfolio management system will become accessible directly to end-users through a mainframe system available through a non-exclusive licensing arrangement with Computer Power, Inc. (CPI).

The role of a decision-support system is to provide the insights, analysis and guidance to take faster and better actions. Although the mortgage industry has many talented risk-management specialists in secondary marketing, pipeline management and hedging, these tasks are highly challenging, and most of these specialists can only handle a set number of loans at one time.

The size and complexity of mortgage servicing portfolios, however, is beyond small systems' abilities. The sheer volume of data, lack of a central source and the complexity of the decisions to be made require large-scale technology with the speed to satisfy executives who require immediate action.

RF/Spectrum is designed to analyze portfolios by incorporating hundreds of bits of information about each loan to consider dozens of key elements affecting demographic, behavioral and real estate trends. These trends, in turn, help the lender evaluate risk. This article shows in detail how default, prepayment and production-pricing probabilities can be forecast using a large-scale portfolio-management system.

Types of risks

All risks can be divided into two categories. Systematic risks are common to all mortgage assets. They cannot be stripped away by making a portfolio more diversified, because they are associated with broad economic trends and financial market conditions such as the health of the national real estate economy and the movement of interest rates. For example, falling mortgage rates hurt servicing values of existing loans by increasing prepayment expectations and shortening the expected life of servicing assets.

Nonsystematic risks, by contrast, are specific to individual assets and can be reduced by diversification, or they can be eliminated surgically, one loan at a time. An example are those produced by damaging regional market conditions, such as the high prepayment behavior of 1987 California loans, or the losses produced by 1981 Texas originations. Another example of nonsystematic risk would be loan-type risks, such as high loan-to-value ratios or investor loans.

An obvious example of a nonsystematic risk-control measure would be the underwriting of a new borrower. Although this measure occurs just once in a loan's lifetime, the default risk is ongoing.

Mortgage risk management involves several components. First, it requires an understanding of each of the risks in servicing or asset lending...

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