For financial institutions like banks and credit unions, loans are a primary source of revenue as well as risk. One way to manage credit risk effectively is to implement different diversification strategies. Besides reducing the risk inherent in loan portfolios, diversification allows financial institutions to lower the risk of their overall activities and maximize returns.
Why Diversification Is Important
Let’s say that your portfolio includes loan products that are spread relatively evenly across just one asset class. If a specific adverse economic event affects that asset class, leading to a decrease in the origination volumes of your loans, your portfolio will experience a noticeable drop in performance.
On the other hand, if your portfolio contains a mixture of loan products across different asset classes, including manufactured home lending, it’s less likely to be negatively impacted when the loan products that belong to a specific asset class begin to underperform due to certain economic factors.
Over the past few months, for instance, the home loan originations have increased, while the indirect auto loans and credit card lending have declined significantly. During the pandemic and the ensuing lockdowns, many people have realized that owning a home is more important than buying a car or spending money on nonessential items. That’s because a home isn’t only a haven from the pandemic; the people who own their homes can also transform different rooms into anything they want, including home offices, gyms, or movie theaters. On the other hand, the people who rent their homes cannot make any major changes without getting permission from the landlord.
Given the increasing origination volumes of manufactured home loans, a credit union that currently offers different manufactured home financing options as part of its portfolio could easily balance out some of the losses resulting from underperforming loan products, such as credit cards and indirect auto loans.
Ways to Achieve Portfolio Diversification
According to existing literature on diversification, the financial institutions that diversify their loan portfolios to different degrees, across various asset classes, will improve their profitability as well as their variability in portfolio performance. Although diversification cannot protect against loss, investing in various interest-earning assets that will react differently to the same economic event is one of the few things you can do in order to reduce your portfolio’s vulnerability to market fluctuations and reach your long-term financial goals.
An effective diversification strategy involves adopting loan products that not only react differently but also have different levels of risk tolerance to the same economic event. In other words, you should opt for loan products that are negatively correlated. As negative correlation means that the origination volumes of certain loan products rise when the origination volumes of other loan products decrease, the more uncorrelated your loan products are with one another, the better. Only when loan products are spread across multiple uncorrelated asset classes, a portfolio is genuinely diversified and truly able to handle market volatility.
Another important aspect is that some loan products that relate to a specific asset class, while considered risky, could offer a good investment opportunity for a loan portfolio that needs diversification. For instance, home loans are often regarded as risky investments, given their default history and cash flow volatility. However, opting for certain types of home loans might help you decrease the overall risk of your portfolio.
While the conventional home loans tend to follow the general economy, niche home loan programs, like manufactured home loans, are gradually detaching themselves from the major economic trends. Historical data has already shown that manufactured home loans and conventional mortgages tend to respond differently, even oppositely, to the same market conditions and changes in the economic environment. As the demand for affordable housing is projected to increase in the future, the origination volumes of the loans that offer financing for these types of homes are expected to increase as well.
Although diversification minimizes the risk, it cannot eliminate all the risks. That’s because it’s not always possible to know the precise correlation of specific asset classes and how they will evolve during a specific economic event. Additionally, opting for aggressive diversification strategies and adding riskier types of loans to your portfolio without sufficient capital cushions to absorb potential financial shocks could pose a threat to the ability of your organization to remain stable in emerging markets, irrespective of the economic context.
On the other hand, constructing your loan portfolio based on strict risk and correlation analysis could give you a significant strategic advantage over other financial institutions that may not pay attention to how their credit risk strategies align. For more information about manufactured home loans and how you could use them to enhance your portfolio, please get in touch with our financial experts today!