We begin 2012 with the certain knowledge that many new regulations and responsibilities have made significant and costly demands on lenders, servicers, mortgage brokers, banks, investors, and mortgage securitizers to revise and strengthen plans to assure their economic survival. Many compliance departments throughout the country have set forth robust compliance calendars in order to monitor, test for, and implement federal and state guidelines. [*]
The primary source of revenue for the aforementioned companies (collectively, “financial institutions”) is the negotiating, extending, administering, and packaging of credit. Extension of credit and credit risk are really inseparable features of mortgage loan originations – one does not exist without the other.
Credit risk is quite measurable, especially with respect to any activity that poses a risk to earnings and capital. It is no secret that inadequate risk management is a leading cause of the failure of financial institutions. Just as credit risk and extension of credit are inseparable, so also are they inseparable from risk management. Only to the extent that credit risk and appropriate risk management procedures are identified, analyzed, established, and implemented may financial institutions claim to have safe and sound lending practices.
Risk management (often referred to, generically, as Compliance) should not formally come under the rubric of the so-called “Best Practices” section of corporate governance. In my view, risk management is not an elective, a negotiable issue, a good operating practice, a mere technique consistently providing superior results, a Six Sigma template, or a business management strategy. Rather, risk management is, and ought to be, an inherent and essential, evaluative and ministerial function reaching to virtually all intrinsic aspects of a financial institution’s business model. This is why I coined the term “Mortgage Risk Management,” because it stands on its own, a specialization that provides a firm foundation to the residential mortgage loan flow process – from point of sale to securitization. Put otherwise, it is the one and only “fail-safe” means by which a board of directors may ensure that management effectively implements internal processes designed to identify, measure, monitor, and control credit risk. [†]
Close consideration of appropriate risk management practices is vital to a financial institution’s stability, most especially in the outset of a new year and at all other times. But what is risk management? And, how does risk management affect a financial institution’s way of doing business?
In this article I will provide a brief outline of two key areas where credit risk review and risk management conjoin directly to impact a financial institution’s capability to conduct business and manage a thicket of regulations. Drawing on my own experience in working with our clients, I will offer an overview of what risk management entails, whether conducted internally or through external resources.
To get a sense of a typical approach involved in evaluating credit risk and the concurrent role played by risk management, I will outline the following areas: Quantity of Risk and Quality of Risk Management.
In a penultimate section, entitled Implementing Risk Management, I will offer some guidance about how to use credit risk information effectively to fortify a financial institution.
Quantity of Risk
I define quantity of risk as the level of credit risk associated with the credit portfolio of a financial institution.
Generally, there are three levels for quantity of risk: low, moderate, or high.
In evaluating credit risk, there are nine areas of review that should be undertaken.
1) Risk Level
- Consider in the analysis the size of the exposure associated with each of the areas bulleted below, their risk profiles, credit quality indicators, amounts, volatility, and trends:
- delinquencies
- criticized and classified loans
- nonaccrual or nonperforming loans
- losses
- other credit quality metrics used by the financial institution (i.e., weighted average: risk grade or default probability)
- underwriting standards
- exceptions to policy
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2) Risk Implications
- There are two areas in particular that are determinative with respect to risk implications:
- Significant growth in the size of a credit risk exposure, including whether such growth might be masking deterioration in credit quality indicators, and
- Material changes in policies, procedures, or underwriting standards.
