Fallout Risk in Mortgage Lending: Definition, Strategies, and Impact

Fallout risk is a term commonly used in the mortgage lending industry to describe the potential loss that lenders face when borrowers withdraw from a loan agreement after a formal offer has been extended but before the loan is closed. This risk arises due to the time gap between offering a loan and its closing, during which borrowers may change their minds or find alternative financing options.

Mortgage lenders assess fallout risk by tracking the percentage of loans in their pipeline that fail to close. The mortgage pipeline comprises all loan applications that have not yet been approved but may have an interest rate lock in place. Lenders typically require borrowers to lock in a rate within a specific timeframe before the closing date, usually up to 60 days.

During this period, lenders are exposed to the possibility of fallout risk, as borrowers may withdraw from the agreement or secure better loan terms elsewhere. Mortgage originators, who facilitate the loan process, hold these loans in their pipeline until closure or sale in the secondary market.

If a borrower backs out of the loan, the lender may lose out on potential profits from interest payments and fees associated with the loan. Additionally, mortgage loans are often bundled into mortgage-backed securities (MBS), and fallout risk can impact investors who hold these securities.

Price risk is another component of fallout risk, which arises when prevailing interest rates decrease before the loan closing. In such cases, borrowers may seek alternative loans with more favorable rates, affecting the price lenders can command for their loans on the secondary market.

To manage fallout risk effectively, mortgage lenders employ various strategies, including forward-sale commitments and hedging using capital market instruments. Forward-sale commitments involve agreements to sell loans to investors at a future date, while hedging helps mitigate losses resulting from fallout risk.

Hedging against fallout risk is essential for lenders to protect themselves from potential losses. One common strategy is to structure loan sales on a best-efforts basis, where agreements are made with secondary loan purchasers such as government-sponsored enterprises (GSEs) like Fannie Mae or Freddie Mac. Under this arrangement, the GSEs may waive fees for undelivered mortgages, reducing the impact on lender profitability.

Another hedge against fallout risk is the use of the to be announced (TBA) market for mortgage securities. In this market, lenders can sell loans that meet specific criteria without identifying individual loans until shortly before settlement. This flexibility allows lenders to replace withdrawn loans with alternative options before settlement, mitigating fallout risk.

Mortgage fallout refers to the risk that borrowers withdraw from a loan agreement after a formal offer has been made but before the loan is closed.

Lenders track the percentage of loans in their pipeline that fail to close to assess fallout risk. This is typically done by monitoring the mortgage pipeline and analyzing historical data.

Common strategies include using forward-sale commitments, hedging with capital market instruments, and structuring loan sales on a best-efforts basis.

Fallout risk can result in financial losses for lenders, including lost interest income and fees associated with the loan. It can also affect investor confidence and liquidity in the secondary market.

GSEs such as Fannie Mae and Freddie Mac often purchase mortgage loans from lenders, providing liquidity and mitigating fallout risk. They may also offer assistance and incentives to lenders to manage fallout risk effectively.