Mortgage underwriting

Mortgage underwriting is the process a lender uses to determine if the risk (especially the risk that the borrower will default^[1] ) 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. ^[2]

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 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 rates, 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.

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, 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.

Mortgage underwriting in the United States

Main article: Mortgage underwriting in the United States

See also

• Credit risk

References

1. ^ RG Quercia, MA Stegman (1992), "Residential mortgage default: A review of the literature", Journal of Housing Research, http://www.knowledgeplex.org/programs/jhr/pdf/jhr_0302_quercia.pdf 
2. ^ Michael Simkovic, Competition and Crisis in Mortgage Securitization