Risk management is how a lender assesses, manages, and controls the risks associated with lending money. Lenders must identify and manage the risks inherent in lending in order to defend their bottom line, and protect their customers’ savings from potential losses.
Inadequate risk management by mortgage lenders can lead to serious financial problems for lenders themselves, as well as for borrowers and investors. For example, a lender who does not correctly assess the risks associated with a loan may inadvertently approve a loan that the borrower cannot repay. This can lead to the borrower defaulting on the loan, which can damage the lender’s business and reputation, and ruin the borrower’s credit.
Letting risk levels go unchecked can also lead to the lender losing money on the loan. If the borrower were to default on the loan, the lender might be unable to recover the full amount owed; particularly in a sideways or declining market. Market factors, combined with long, costly, and arduous foreclosure processes, increase the likelihood of a lender having to write off the loan or accept less than the full amount owed, which ultimately impacts a lender’s balance sheet. Thus, proper risk management is essential for lenders if they want to protect their financial interests.
Lenders should carefully assess the risks associated with each loan and only approve loans they are confident the borrower will be able to repay. By taking these steps, lenders can minimize the chances of default and protect their financial interests.
Lenders must manage two main types of risk: credit risk and interest rate risk. Credit risk refers to the risk that a borrower will default on their loan. Interest rate risk is the risk that interest rates will rise and the loan’s overall value will decrease.
Lenders use a variety of methods to manage these risks. These methods include diversification, hedging, and collateralization.
Diversification involves spreading your loan portfolio across a number of different borrowers. This technique reduces your exposure to any one borrower defaulting on a particular loan.
When you have all your eggs in one basket, you’re more at risk if that one basket gets dropped. But if you have a mix of different types of loans, then even if one loan goes bad, the others can help to offset the losses. This diversification can help to reduce your overall risk.
Hedging is a risk management technique that involves removing the risk of rising interest rates causing a decrease in loan value. This guards the lender against losses if interest rates do rise.
There are many benefits to hedging your loan portfolio. First, it can help to protect your portfolio from losses in the event of a market decline. Second, hedging can help reduce your portfolio’s volatility, making it more predictable and easier to manage.
One hedging method gaining steam in 2022 is the use of lender safeguards, like AXY WrapTM by Axylyum. This solution, and others like it, are designed to act as a market hedge specific to the portfolio makeup and unique needs of retail and wholesale private lenders.
AXY WrapTM shifts default risk off your books and out of your head, letting you take a breath and plan your next move in the lending space.
Collateralization is a risk management technique that involves using collateral to secure a loan. Collateral refers to any asset that can be seized and sold if the borrower defaults on their loan. Collateral provides the lender with some security against losses if the borrower defaults.
Secured loans undoubtedly reduce lending risk. First, they act as a deterrent to default because borrowers who could lose their property by failing to repay a loan are much less likely to default. Second, even if a borrower does default on a secured loan, the lender can still sell or foreclose on the collateral to recoup the funds a borrower failed to repay and minimize losses. The takeaway: By collateralizing your loans, you can ensure at least partial repayment on a loan, even if the borrower defaults. Collateral isn’t always enough to cover full repayment, however. With unpredictable markets, fluctuating housing prices, and complicated foreclosure processes throughout the country, lenders may still end up recovering only a portion of the debt through disposition of the collateral. Adding AXY WrapTM to your lending portfolio removes this uncertainty.