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Mortgage credit risk describes the wider economic consequences of mortgage holders failing to repay their loans. In the modern economy, this can cover a wide range of risks. At its simplest, mortgage credit risk simply refers to the risk posed to a specific lender on a specific home loan. In a more complicated sense, it can refer to risks in the market for mortgage-backed securities. In the most extreme case, it can refer to risks for an economy as a whole.
There is an element of risk every time a bank lends money to a homeowner. The simplest measure of mortgage credit risk is the risk of the homeowner failing to repay; this is usually assessed by a combination of the borrower's income level, the loan amount, and the borrower's credit rating such as a FICO score. Banks will usually assess the risk in a more sophisticated sense, taking into account the state of the housing market, which will affect how much money can be recovered if the mortgage has to be foreclosed.
The straightforward arrangement between a borrower and a lender is not the only mortgage credit risk, however. This is because of the practice of securitization. This involves banks raising money by issuing mortgage-backed securities. These are financial products where the income ultimately stems from the mortgage repayments of the customers, with the accompanying risk that the customers may default and thus the income won't be there.
Usually, such products involve packaging multiple mortgages together into a single pool, then dividing this pool among many investors. Each investor thus has the rights to a tiny proportion of the income from each mortgage in the pool. The theory is that this lowers the risk to investors as they have less to lose from an individual borrower defaulting.
In reality, there are two elements that can increase this form of mortgage credit risk. One is that a factor that affects one mortgage holder's repayment ability, such as unemployment or rising interest rates, may be widespread meaning many mortgage holders default at the same time. The other is that the way mortgages are packaged together can make it more difficult to assess the individual credit risks and thus the overall risk level of the mortgage-backed security.
In a wider context this can pose a mortgage credit risk to the entire economy. In 2007 to 2008, rising mortgage default levels created financial problems for some major banks when they were forced to revalue assets including mortgage-backed securities. This revaluation caused some banks and other financial institutions to face liquidity problems. While some went out of business, others were given financial assistance by national governments in the interests of maintaining the banking system as a whole. This had consequences for fiscal finances and has been blamed for worsening public deficits.