Mortgage Loan Metrics

Mortgage metrics allow the lender and the consumer to assess the loan-associated credit risks.

A mortgage lender currently uses one of several methods to measure so-called "credit risk" for first-mortgage products. These methods include the following criteria.

Economic capital (EC): a statistic figure that summarizes the institution's measurement of risk of the portfolio, serves many purposes, including helping to establish a general level of capital adequacy within the bank. EC also is used in the denominator of Risk-Adjusted Return on Capital (RAROC) calculations. The institution attempts to invest in activities for which the calculated return to allocated economic capital exceeds some targeted rate, generally taken to be the weighted-average cost of capital. Only by investing in such high RAROC activities can the bank maximize Shareholder Value-Added (SVA), defined as the excess of returns over the market rate of return required for the level of capital needed to maintain the bank's targeted soundness level.

Soundness. No bank can manage to a zero probability of insolvency, so a bank needs to decide the level of insolvency probability it does wish to manage. Some banks manage to a high soundness standard (high bond rating, low insolvency probability), while others manage to a lower soundness standard with a correspondingly higher insolvency probability. Soundness is generally defined as a particular probability of insolvency, over a particular horizon, to which the bank aspires. Often, this targeted insolvency probability is expressed in terms of a targeted bond rating for the institution's debt. In this theoretical framework, EC is the level of capital that, given the bank's portfolio, is sufficient to reduce to an acceptable level the probability that losses will exceed that level of capital.

Loss probability density function. To measure the Economic capital to maintain the targeted soundness, the bank must estimate the probability that any particular bad loss on the portfolio will actually occur. The risk practitioner thinks of this as estimating a loss probability density function, more commonly referred to as a "loss distribution," for the bank's current portfolio. Such loss distributions, estimated for credit risk, are notoriously fat-tailed - the thicker the tail of the distribution, the riskier the portfolio.

Unexpected loss. The expected losses (EL) can be priced so that yields on performing assets can "cover" the losses on those assets in the portfolio that actually default. The risk, however, involves the chance that portfolio losses will exceed this expected amount. Economic capital, in turn, is defined as the portfolio loss that would occur with the targeted small probability - for example, 1-2% over a five-year horizon - less the expected loss level covered by the yields on good assets. This difference-loss at the chosen "confidence interval" on the loss distribution minus EL - is equivalently called unexpected loss (UL).

From Consumer perspective, the following mortgage aspects should be reviewed when considering a mortgage loan.

Amortization Term - the maximum amortization term on a conventional real estate mortgage. Typically, amortization term is 30 years. Loan Points - a fee charged to a borrower by lending institutions for the privilege of obtaining a loan. Annual Percentage Rates (APR) - the artificial measurement of the relative cost of the mortgage. The actual interest rate is a part of the APR calculation. The APR allows the customer to compare different mortgage loans and the relative cost of each loan. However, a lower APR does not necessarily ensure that it is the best mortgage.

In conclusion, testing the probability of losses within single mortgage loans should be a vital part of risk management.

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