Guidelines are the means of determining whether to make a loan. When a borrower doesn’t meet the guidelines, this indicates
that the lender doesn’t think the borrower is sufficiently creditworthy. In other words, the loan is too risky to make. So risky, in fact, that we don’t know how great the risk is we just know it’s beyond the bounds that the lender deems acceptable.
This is the first post in a new four part blog series: When The Lender Deviates From Guidelines. As a lender, you need better information about whether you are sticking to your guidelines. Without the correct information, you may not recognize deeper root causes of failures that result from increased risk. Do you know the risks ahead on your off-road trek?
If the borrower does meet the guidelines, the information collected in underwriting is used to determine how risky the loan is and how much the risk is offset by the collateral available.
- Risk that an adverse event prevents a borrower from repaying a loan.
- Risk that the value of the collateral is too low and will not be sufficient.
- Systemic risk where many people are affected simultaneously because of an economic downturn.
In common parlance:
- Borrower Risk = The borrower gets hit by a bus.
- Collateral Risk = The property gets overrun by a bus.
- Systemic Risk = A fleet of buses runs rampant.
The guidelines are crucial to multiple other parties they set the standard for determining the risk in a loan or a large pool of loans. The guidelines are the standard for pricing a loan if it is sold. The guidelines are the standard for insuring the stream of payments from the loan for the lender or for a potential purchaser of the loan.
THE GUIDELINES ARE OF THE GREATEST IMPORTANCE TO:
- The Lender who makes the loan and takes on the risks cited above.
- The Investor/Shareholder making the money available to make the loan and expects a return.
- An Insurer who is offering Personal Mortgage Insurance (PMI) to cover the risk in loans where the collateral may not be sufficient to cover a default by the borrower.
- The Federal Housing Administration (FHA) and the Veterans Administration (VA) offer insurance for some types of loans: the risk is transferred to the FHA, VA, and taxpayers.
- An Investor who is purchasing a securitization – the stream of payments of principal and interest that comes from a pool of loans held in a trust.
- A Monoline Insurer that offers credit enhancements to guarantee a return for low-risk streams of payments of principal and interest from a securitization or other investment vehicle.
- The Federal Deposit Insurance Corporation (FDIC) and the National Credit Union Administration (NCUA) if losses from loans are so severe that a bank or a credit union fails.
MEH – WHAT COULD GO WRONG?
With all of these entities interested in the outcomes, you would expect that guidelines would be crucial in lending. And they are, in that they keep very risky borrowers from getting a loan. Guidelines also help the lender ensure that appropriate interest rates are
charged to offset risk.
The disarming name “Guidelines” is a term that doesn’t have the same evocative force as “Rules” or “Commandments.” But there are consequences to not following the guidelines, consequences found in examining how interest rates relate to risk. For 1,000 loans, deviations add up.
One faulty airbag in a car that might never crash may never surface as an issue. Thousands of faulty airbags, and suddenly
you have a massive recall, hundreds of deaths, thousands of injuries, and numerous lawsuits and Federal investigations. Avoiding
a flaw in the first place is more prudent.
Interest rates are computed by relating potential gain to cost. As the borrower’s likelihood of default increases, the interest
rate that needs to be charged increases. If the loan-to-value ratio increases, the interest rate rises to offset the risk of the collateral not covering any losses.
Do we actually know the borrower’s likelihood to default on the loan? No, we predict it for each borrower using data about the past and trends that are estimated by using statistics.
For a Cost of Capital of 1%, an Originator Profit of 1%, a Borrower with 80% LTV, and a 6.5% risk of default, the interest on a loan is
6%. This is the interest rate for all similar loans, so the originator can cover the 1% cost of capital and earn a profit of 1% on
average. “On Average” Is The Key.
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