The system of US housing finance has changed profoundly in recent years. Despite the dominant role of the government-sponsored housing finance agencies, non-agency mortgage underwriters account for a steadily increasing share of US housing finance. While the agencies specialize in the underwriting of mortgage loans to prime households, growth in non-agency lending has been to non-prime borrowers. This implies lending not only to borrowers with somewhat blemished credit histories, but also to those unable or unwilling to either finance required down payments with own funds or document their sources of income.

The securitization of non-prime housing loans represents a significant change for one of the biggest and most important financial markets in the world. Most US residential mortgages are packaged and resold in mortgage-backed securities (MBSs), and foreign investment in these securities has soared. As with the restructuring of mortgages and the secondary sale by the housing finance agencies of pass-through securities, non-prime loans have also come to be routinely incorporated into pass-through securities via a Similarly structured process. However, in contrast to agency-backed securities, which are exposed to prepayment risk but protected against loan defaults by guarantees, investment in non-agency securities involves exposure to both prepayment and default risk. In this article, we argue that the significance of this additional risk has been disguised in recent years by housing price appreciation. In consequence, a turn in the housing market might remind holders of these securities of some of their downside risk characteristics.

The remainder of this special feature  is structured as follows. The next section presents a broad overview of recent developments in MBS markets. The section which follows focuses on innovations in mortgage contracts, the employment of credit scoring measures to calibrate default risk, and new challenges in forecasting prepayments. We finish with some brief concluding remarks.

Recent developments

Mortgage-backed securities are now well established as one of the largest and most significant financial markets in the world, as well as the most prevalent form of securitization. More than half of all US residential mortgages are incorporated in MBSs. Since the mid-1990s, the share of MBSs in US bond markets has surged to nearly one third of the total outstanding and has remained at a high level (Graph 1, left-hand panel). The market has also become more global: the stock of foreign investment in US mortgage securities has increased more than fourfold since 1990, to nearly $1 trillion. Although much of this foreign investment is accounted for by holdings of agency-issued straight debt securities, recent survey data suggest that foreign investors have assumed sizeable stakes in MBS investments as well.

 

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