What Is Fallout Risk?
Fallout risk is the risk to a mortgage lender that an individual borrower backs out of a loan during the period between the formal offer of a loan and the closing of that loan. A mortgage is a loan that a lender or bank extends to a borrower for the purchase of a home. When a borrower backs out of the loan before signing the documents, called the close, it’s referred to as mortgage fallout.
- Fallout risk is the risk to a mortgage lender that a borrower backs out of a loan after a formal offer has been made and before the closing.
- When a borrower backs out of the loan before signing the documents, it’s referred to as mortgage fallout.
- Mortgage lenders have a few options available to them to hedge against fallout risk to prevent losses.
How Does Fallout Risk Work?
Mortgage fallout is a metric that mortgage lenders use, which shows the percentage of loans in their pipeline that have not closed. Banks and mortgage brokers, which help originate the loans, attempt to forecast the potential mortgage fallout in their loan pipeline. A mortgage pipeline represents all of the mortgage applications that have yet to be approved by a lender but may have had an interest rate lock put in place between the loan applicant and the bank.
Typically, lenders require borrowers to lock in a rate no later than 10 days before the closing date, but each lender can vary somewhat.
The risk that a borrower could back out before the closing date of the mortgage is called fallout risk. Typically, lenders might extend a loan offer that's good for up to 60 days until the loan closing. In doing so, the bank is at risk that the borrower withdraws from the mortgage agreement during the period prior to completing the loan transaction.
If a mortgage originator is involved—who helps to facilitate the loan process—they will hold the loan in their pipeline until the loan closes. After which the loan would either go to the bank's loan portfolio, but more likely, the loan would be sold in the secondary market.
Oftentimes, a mortgage loan is bundled with other loans to create a mortgage-backed security (MBS). Individuals can invest in an MBS and get paid interest, which is in part, based on the interest rates for the loans that make up the MBS. If a borrower backs out of the loan, the lender loses out on the opportunity to profit from the loan's interest rate and any loan fees. The mortgage originator and the lender can also lose out on the fees that would have been earned had they sold the mortgage loan in the secondary market.
Another component of pipeline risk is known as price risk. This is posed by the probability that, during the period prior to closing, prevailing interest rates fall, and the borrower is able to receive an alternative loan with a more favorable interest rate. Such a change can threaten the price that the mortgage originator can get for the loan on the secondary market.
How is Fallout Risk Used?
Common strategies for managing pipeline market risk include using forward-sale commitments—direct commitments to sell to the investor at some point in the future—and hedging using capital market instruments, according to a paper by the Financial Managers Society.
Hedging Fallout Risk
Fallout risk is an unavoidable aspect of the lending process due to the time it takes to underwrite or process the loan application, financial documents, and all of the legal paperwork that needs to be readied for the closing. During this process, there's a possibility that the borrower withdraws from the mortgage loan. As a result, lenders have a few options available to them that can help to hedge against mortgage fallout and protect themselves from losses.
One way to do so is to structure the sale of a completed loan on the secondary market on a best efforts basis. An agreement might be made with a secondary loan purchaser, such as Fannie Mae or Freddie Mac, which are government-sponsored enterprises (GSE)s that guarantee, buy, and package loans to be sold as investments.
Under a best-effort basis, the GSE might agree to waive the fee, which would otherwise be charged when the originator cannot deliver a specific mortgage. This can have a downward effect on the price, but this change in price is generally less than the fee.
Another hedge against fallout risk involves the use of the to be announced (TBA) market for mortgage securities. On this market, lenders are able to sell loans that satisfy certain criteria without identifying the specific loans. Typically, the securities or loans are not announced until 48 hours (called the 48-hour rule) before the preset settlement date for the transaction in the TBA market. As a result, the lender can replace a loan whose borrower has withdrawn with another completed loan by the settlement date, if necessary.