Question

During our analysis of mortgages, we focused on two of the four risks associated with mortgages. We started by emphasizing Credit Risk and how the mortgage market aims to control for Credit Risk. Please discuss in details what the tools for controlling for Credit Risk are

Answer 1

Credit Risk is the one of the counter party credit risk (which can be further divided into retail and wholesale) which deals with the risk of defauting on the payment of the debts. In order to analyse the risk worthiness of the counterparty, we need to have an understanding on the ability and the willingness to pay back the debts. This can be analysed by looking at the historical activities of the counterparty and profile them into categories identified and segregated into different levels of risks. In case the counterparty falls in the high risk category, there are various ways of countering the threat. One of the ways is by offering the debt at a high interest rate. This would help the lender to get back the maximum amount possible before a condition of default arises, thus covering for the default to the maximum extent possible. Another way to counter this risk is by the help of mortgage. Mortgage is the mechanism by which the lender has the right to gain possession of the property, in case it is certain that the counterparty is no position to pay back the debt. Usually, the value of the mortgaged property is more than that of the debt amount. Thus minimizing the risk to a lender. The lender can also give loans against Fixed deposits or any other negotiable instrument which the lender can keep possession of until the debt is repayed back on time in full. This type of product is called a Lien. This instrument can also in the form of any precious traded metals whose value is easily accessible.