COLLATERAL RISK
Black’s Law Dictionary says Collateral Risk is “The
risk of loss arising from errors in the nature,
quantity, pricing, or characteristics of collateral
securing a transaction with credit risk. Institutions
that actively accept and deliver collateral and are
unable to manage the process accurately are
susceptible to loss. A subcategory of process risk.”
Collateral risk in residential mortgage lending is the
potential for the value of the property securing a loan
for the lender to recover 100% of outstanding
principal, interest, and expenses associated with
obtaining title and disposing of the property.
Credit risk in lending is generally measured as the
product of two factors: the probability of default
(PD), and the loss given default (LGD). The product of
these two factors, PD X LGD, is the expected credit
loss associated with a loan or pool of loans. The
purpose of collateral is to reduce LGD. It should be
then LGD and expected loss will be zero. No
risk – what’s not to love about that?
In fact, residential mortgage loans are theoretically
“over-collateralized,” meaning that the value of the
property should be greater than the loan amount.
Or, looking at it another way, the ratio of the loan
amount to the property value, the Loan-To-Value
(LTV) ratio, is less than 100%. A lower LTV indicates
greater over-collateralization and greater security to
the lender.
Alas, these facts do not guarantee that there is zero
14 | APPRAISAL BUZZ FALL 2020
credit risk in residential mortgage lending. Even if the
amount (the loan principal), the lender also must
recover unpaid interest and expenses associated
with the foreclosure, REO, and sale of the property.
And, of course, the sale price at the end of that
process is uncertain, though it can be expected that
value for foreclosure sales.
determining the LGD component of credit risk for
mortgage lending. Further, most mortgage lending
in the United States is either legally or practically
non-recourse, meaning the lender’s only source of
funds to cover any shortfall is the property. As a
the likelihood of the borrower defaulting on the loan.
This theoretical consideration became starkly real
with the sharp rise in “strategic defaults” in
2008-2012.
The potential impact of property value on both
LGD and PD highlights the importance of valuation
in mortgage lending, particularly considering that
around 70% of all home purchase loans have LTV in
excess of 80%. It is, therefore, important for all
participants in the mortgage market to understand
the sources of property value risk.
There are two key aspects of property
Establishing current value at the time of underwriting
the loan and understanding risks to the potential
future value in the event of a default. From these, we
can observe that there are four types of risk
associated with collateral (property value):