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.

Fallout risk refers to a risk assumed by a mortgage lender that a borrower withdraws from a mortgage agreement during the period prior to completing a loan transaction. Regulations require that a lender extend a specific offer for up to 60 days until the closing date. During this period, the mortgage originator typically makes plans to sell the loan to a mortgage aggregator who will bundle it with other loans in a mortgage-backed security (MBS). If a borrower backs out of the loan, the lender loses out on the opportunity to profit from the securitization of the loan.

Fallout risk is also referred to as borrower fallout. It is one of two components of pipeline risk, named in reference to the pipeline through which closed mortgages typically travel from the original offer to closing, and then to securitization on the secondary mortgage market. The second 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.

Fallout risk is an unavoidable aspect of the lending process due to 60-day requirement and the possibility of borrower withdrawal during that period. To protect against losses, lenders can create a hedge against mortgage fallout. One way to do so is to structure the sale of a completed loan on the secondary market on a best efforts basis. Under such an agreement, the secondary loan purchaser, often Fannie Mae or Freddie Mac, agrees to waive a fee that 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.

A second 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. This allows the lender to replace a loan whose borrower has withdrawn with a completed loan if necessary.