Credit Loss Ratio
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 utilized by the issuer to measure how much risk they accept. Different mortgage-backed securities and various segments inside a mortgage-backed security — likewise alluded to as tranches — have different credit-risk profiles.
Figuring out Credit Loss Ratios
A mortgage-backed security is an asset-backed investment vehicle comprised of a bundle of various mortgage loans. These home loans are purchased from financial institutions, gathered, and afterward sold off to investors. Like a bond, investors receive normal periodic payments from their investment.
Credit loss ratios measure just how much risk the issuer expects for an investment, for example, a mortgage-backed security. These ratios can take different two forms. The primary rendition 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 subsequent form measures the total credit-related losses to the original par value of the mortgage-backed security.
As noted above, various types of securities can have shifting degrees of credit loss ratios. Higher credit risk profile securities are bound to support losses than securities with lower credit risk profiles. This means higher credit risk profile securities are probably going to have different credit loss ratios compared with lower credit risk profile securities. Credit loss ratios are a vital part of the financial industry, especially for the responsible institution. That is on the grounds that the ratio exhibits just how much risk is implied in the investment vehicle.
Credit loss ratios turned out to be especially important following the 2007-08 Financial Crisis. Mortgage-backed securities comprising of numerous subprime mortgage loans had a big impact in the crisis. Since credit loss ratios frame the amount of risk, the issuer can then figure out what sorts of steps they need to take to moderate that risk and stay away from future losses. An important point to note, however, is that even tranches that are viewed as low risk might support losses in the event that the environment is right.
Special Considerations
While investing in non-agency mortgage-backed securities or different types of mortgage-backed securities, it could be really smart for an investor to consider the credit loss ratio for the tranche they are thinking about. Yet, there are certain situations where the credit loss ratio isn't as important.
While surveying which tranche to invest in, investors ought to think about the credit loss ratio.
Average investors don't be guaranteed to have to worry about an agency instrument's credit loss ratio, since most agency mortgage-backed securities are backed by U.S. government agencies. For instance, bonds issued by Fannie Mae or Freddie Mac, and government mortgage-backed securities issued by Ginnie Mae, don't have credit risk. These agencies guarantee principal and interest repayment to the bondholder in the event of default by the underlying borrower.
However, according to an internal point of view, the agency mortgage-backed security issuers truly do have to think about their credit loss ratios, on the grounds that doing so will allow them to dissect whether their holdings are overexposed in certain types of riskier properties.
Features
- MBS issuers can utilize credit loss ratios to measure how much risk they accept.
- The utilization of credit loss ratios has become especially important to assist issuers with alleviating losses following the 2007-08 Financial Crisis.
- A credit loss ratio measures the ratio of credit-related losses to the par value of a mortgage-backed security.
- Securities can have shifting degrees of credit loss ratios, so those with higher credit risk profiles are bound to support losses than those with lower credit risk profiles.
