What Is a Credit Loss Ratio?
A credit loss ratio measures the ratio of credit-related losses to the par value of a mortgage-backed security (MBS). Credit loss ratios can be used by the issuer to measure how much risk they assume. Different mortgage-backed securities and different sections within a mortgage-backed security—also referred to as tranches—have different credit-risk profiles.
- A credit loss ratio measures the ratio of credit-related losses to the par value of a mortgage-backed security.
- MBS issuers can use credit loss ratios to measure how much risk they assume.
- Securities can have varying degrees of credit loss ratios, so those with higher credit risk profiles are more likely to sustain losses than those with lower credit risk profiles.
- The use of credit loss ratios has become especially important to help issuers mitigate losses following the 2007-08 Financial Crisis.
Understanding Credit Loss Ratios
A mortgage-backed security is an asset-backed investment vehicle made up of a bundle of different mortgage loans. These home loans are purchased from financial institutions, grouped together, and then sold off to investors. Similar to a bond, investors receive regular periodic payments from their investment.
Credit loss ratios measure just how much risk the issuer assumes for an investment such as a mortgage-backed security. These ratios can take different two forms. The first version of the credit loss ratio measures current credit-related losses to the current par value of the MBS. The par value is the face value of the security. The second form measures the total credit-related losses to the original par value of the mortgage-backed security.
As noted above, different kinds of securities can have varying degrees of credit loss ratios. Higher credit risk profile securities are more likely to sustain losses than securities with lower credit risk profiles. This means higher credit risk profile securities are likely to have different credit loss ratios compared with lower credit risk profile securities. Credit loss ratios are a very important part of the financial industry, especially for the issuing institution. That's because the ratio demonstrates just how much risk is involved in the investment vehicle.
Credit loss ratios became especially important following the 2007-08 Financial Crisis. Mortgage-backed securities consisting of many subprime mortgage loans played a big part in the crisis. Because credit loss ratios outline the amount of risk, the issuer can then determine what kinds of steps they need to take in order to mitigate that risk and avoid future losses. An important point to note, though, is that even tranches that are considered low risk may sustain losses if the environment is right.
When investing in non-agency mortgage-backed securities or other types of mortgage-backed securities, it may be a good idea for an investor to consider the credit loss ratio for the tranche they are considering. But there are certain cases where the credit loss ratio isn't as important.
When reviewing which tranche to invest in, investors should consider the credit loss ratio.
Average investors don't necessarily need to worry about an agency instrument's credit loss ratio, since most agency mortgage-backed securities are backed by U.S. government agencies. For example, bonds issued by Fannie Mae or Freddie Mac, and government mortgage-backed securities issued by Ginnie Mae, do not have credit risk. These agencies guarantee principal and interest repayment to the bondholder in the event of default by the underlying borrower.
But from an internal point of view, the agency mortgage-backed security issuers do need to consider their credit loss ratios, because doing so will allow them to analyze whether their holdings are overexposed in certain types of riskier properties.