Imagine managing a loan portfolio with ten 30-year fixed rate mortgages. In a perfect world, your borrowers would pay their mortgage payments on time for the life of the loan. But the world is not perfect, and borrowers do not stay in their jobs or homes forever and these are the types of loan decisions you need to make. Circumstances and market conditions change, affecting even the most qualified of borrowers from time to time. Now imagine what would happen if all ten of your borrowers defaulted on or paid off their mortgages early? Your business would be impacted dramatically.
While this isn’t likely to happen at that scale, all loan portfolios have both internal and external risks. Use the following steps to manage and reduce loan portfolio risk:
1. Do a loan portfolio risk analysis – Once you know what risks your firm is susceptible to, you can then monitor them as well as take steps to reduce the risk. Risk should be examined at the loan level, the portfolio level, and the market level. While you may not be able to control external risks such as the economy, you should be aware of them
2. Identify the most risky loans in your loan portfolio – Consider the Pareto principle which is known as the “80/20″ rule. Under this theory, 20 percent of your loans could be responsible for 80 percent of your risk. By focusing on the most risky 20 percent, you could potentially slash your loan portfolio’s risk by a much larger percentage.
3. Eliminate loans that are too risky for your firm’s comfort level – The mortgage business is risky by its nature; it’s impossible to avoid risk completely. However, each firm must decide how much risk is acceptable and then work to eliminate loans that exceed those thresholds. This may mean selling risky loans, working with borrowers to get them into a more suitable product, adjusting loan pricing to account for high risk levels, or being more selective about the types of loans you originate. (Source: Mortgage and Loan Pipeline Management by NYLX)