Below are the risks associated with Mortgage loans
Credit Risk is the risk to earnings from borrowers failure to meet the bank’s contract
Interest rate risk to earnings from fluctuation of interest rates in market
Price risk is the risk to earning from changes in the values of foreign exchange, equity etc
Transaction risk is the risk to earnings from delay of services and product delivery.
Liquidity Risk is the risk from bank’s inability to manage the unplanned decreases in funds resources.
Compliance Risk is the risk to earnings from the violation of rules, laws and ethical standards by the underwriter or broker.
Strategic Risk is the risk to earnings from the improper strategies applied in mortgage lending business
Below are the major risks associated with Mortgage Backed Securities
Default Risk: Payment default or credits are the most common risks in MBS market. It happens whenever borrowers are not in position to pay their mortgage installments.
Prepayment: Prepayment risk is something which is not at all easily predictable. Depends upon interest rates in market, economic growth, and employment opportunities, extra sources of income, etc, borrowers might call off the loan by pre paying the entire principle amount. This leads to pre-closure of the loan. Prepayment increases risk for the MBS investors as it impacts their future agreed receipt of payments.
Low Returns: Mortgage Backed Securities usually have low returns as compared to the stocks and other corporate bonds when compared in terms of annual return.
Long Maturity: MBS are normally offered for long maturity and one might get stuck in them for that much duration. We can however sell the MBS into the secondary market according to the prevailing market situation.