Guaranteed Purchase Risk
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Bullseye
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- Guaranteed loans are often purchased at 0.125% to 15% premiums. A $100 loan at a 7% premium sells for a $107 price.
- Premiums are paid upfront; returns earn the premium back and more over time. So, risk of loss is lower when premiums are lower OR return is higher.
- Risk and return normally move together.
Outer Rings – Prepays Drive Premium Risk
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- One loan’s prepayments can’t be estimated, but a portfolio of loans can.
- Key prepay drivers include loan age (seasoning), prepayment penalties, ability to refinance, and rate changes from origination to now.
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- Some of the more impactful diversifications have been premiums across borrowers, rate products, loan ages, and originators.
Missed the Board – Not Related to Premium Net of Return Risk
Frequently Asked Questions
“Life is inherently risky. There is only one big risk you should avoid at all costs, and that is the risk of doing nothing.” – Denis Waitley
Why take on guaranteed purchases with premium risk?
It reduces the risk you already have.
Wait what, adding premium risk loans reduces risk? Yes, it can.
Take a before portfolio with 5% risk of yearly credit losses exceeding earnings. Add 10% more loans with guaranteed purchase. After portfolio with 4.55% (5% / 110%) risk of yearly credit losses exceeding earnings with credit risk and guaranteed purchase premium diversification.
But wait, wouldn’t the guaranteed portfolio have losses in the same years as the credit portfolio? Normally no. Most prepays are voluntary refinancing, free cash flow, or selling. These go down when credit conditions worsen.
Wouldn’t par (no premium) guaranteed loans reduce risk more? No. Premium assets carry most of the return that offsets with credit risk loans’ potential for losses.
What about the risk of entering a new type of loan?
Guaranteed Partners is here to help guide you through setting up policies, broker and settlement review processes, and more.