Why is it necessary for a nonagency mortgage-backed security to have credit enhancement?

What will be an ideal response?

Credit enhancement is a key part of the securitization transaction in structured finance, and is important for credit rating agencies when rating a securitization. Credit enhancement involves the process of reducing credit risk by requiring collateral, insurance, or other agreements to provide the lender with reassurance that it will be compensated if the borrower defaulted. RMBS issued in the nonagency MBS market require that credit enhancement be provided to protect against losses from the loan pool. More details are given below.

The nonagency MBS market is divided into the private-label MBS market and subprime MBS market. Private-label MBS, also referred to as prime or residential deals, are backed by prime mortgage loans; subprime MBS are backed by subprime loans and are commonly classified as part of the asset-backed securities sector and referred to as mortgage-related asset-backed securities. Nonagency MBS are issued by commercial banks, thrifts, and private conduits. Private conduits purchase nonconforming mortgages, pool them, and then sell pass-throughs in which the collateral is the underlying pool of nonconforming mortgages. The private conduits that issue RMBS are doing what the government created the agency conduits to do, without any guarantees (implicit or explicit) from the U.S. government. Nonagency MBS must be registered with the Securities and Exchange Commission. They are rated by the same rating agencies.

The amount of credit enhancement necessary to obtain a particular credit rating is determined by the rating agencies and is referred to as sizing the transaction. The four forms of credit enhancement are (1) senior-subordinated structure, (2) excess spread, (3) overcollateralization, and (4) monoline insurance. Common in structures with subprime mortgage loans for senior-subordinated structures is the shifting interest mechanism. The cash flow of a nonagency MBS depends on defaults and prepayments. Default rates are measured in terms of the conditional default rate and the cumulative default rate. A standardized benchmark for default rates was formulated by PSA.

We can compare what is being done to distribute credit risk in a nonagency MBS with what is done in an agency CMO. In an agency CMO, there is no credit risk for Ginnie Mae-issued structures and the credit risk of the loan pool for Fannie Mae and Freddie Mac issued structure is viewed until recent years as small. What is being done in creating the different bond classes in an agency CMO is the redistribution of prepayment risk. In contrast, in a nonagency MBS, there is both credit risk and prepayment risk. By creating the senior-subordinated bond classes, credit risk is being redistributed among the bond classes in the structure. Hence, what is being done is credit tranching.