DEFINITION of Credit Loss Ratio
Credit loss ratio measures the ratio of credit-related losses to the par value of a mortgage-backed security (MBS). The ratio can take two forms. The first version of the credit loss ratio measures current credit-related losses to the current par value of the mortgage-backed security (MBS). The second form measures the total credit-related losses to the original par value of the mortgage-backed security. Different types of mortgage-backed securities and different sections, or tranches, within a mortgage-backed security have different credit-risk profiles. Higher credit-risk profile securities are more likely to sustain losses than lower credit-risk profile securities. Therefore, the higher credit-risk profile securities are likely to have different credit loss ratios from the lower credit-risk profile securities. The credit loss ratio can be used by the issuer to measure how much risk they have taken on.
BREAKING DOWN Credit Loss Ratio
Average investors do not need to significantly worry about an agency instrument's credit loss ratio. This is because most agency mortgage-backed securities are backed by the faith and credit of U.S. government agencies. Agency mortgage backed securities — for example, bonds issued by Fannie Mae or Freddie Mac, and government mortgage-backed securities issued by Ginnie Mae — do not have credit risk, or are perceived by the market to not have credit risk. This is because these agencies guarantee the payment of principal and interest to the bondholder in the event of default by the underlying borrower. However, 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.
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 examining. As witnessed during the 2008 global financial crisis, even tranches that are considered low risk may sustain losses if the environment is right.