All Loan To Values were not created equal

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A Home Equity Severity Framework

The attached whitepaper provides a framework for integrating loss severity into Home Equity loan credit policy, pricing, and strategic decision-making.

Conceptually, from a Credit Risk Management perspective, severity is defined as the loss in the event of default. In other words, after the bank attempts collection on the loan and determines it is not collectible, the bank will attempt to recover the loan (and associated expenses) by liquidating collateral. In the case of Home Equity, this occurs by foreclosing on the real property held as collateral. In order to properly price and understand the balance at risk at any particular time, it is important for the bank to estimate the severity.

Naturally, not all home equity defaults lead to foreclosure. There may be cases where the cost of foreclosure is greater than the value anticipated from the foreclosure. This is known as a "dead loss." The bank typically will walk away from dead loss collateral.

This paper supports the following recommendations:

  • Risk Segments: Utilize CLTV with Severity % as the defining dimension. Also, add “Severity %” as a measure of key reporting dimensions.

  • Add a severity component to make underwriting decisions. This could be added as an additional dimension to the CLTV dimension. This would be especially useful in high-balance loans. Testing to include swapping in lower severity, higher CLTV credits.

  • Update the pricing model. This could either be fully implemented or severity could be used to help justify exception pricing. Ultimately, when enough data has been gathered, redeveloping the loss model using severity will be appropriate.

  • Include severity as defining dimension for ongoing portfolio management, including potential credit line management.

Jeff Hulett - Home Equity Severity Framework white paper v2 (2) (3)
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