Before reading this article, you should first read our article on agency mortgage backed securities. Non-agency mortgage backed securities primarily fit into two buckets:
- Mortgages for really expensive homes that banks cannot sell to an agency, because the agencies cannot buy mortgages beyond a certain dollar amount. Many of these loans are prime loans with relatively low default risk when compared to sub prime mortgages.
- On the other end of the spectrum, there are sub-prime mortgages that cannot be sold to agencies because the loans don’t meet the agency’s minimum credit criteria. These two buckets each represent about ⅓ of the market for non-agency mortgage backed securities.
Non-agency mortgage backed securities are not guaranteed against defaults of principal or interest. For sub-prime mortgages, the lifetime default rate on mortgages is estimated to be as high as 80-95% by money manager TCW. For prime mortgages, their estimate is “only” 10-25%. (Its important to remember that default does not mean the entire value of the loan is lost. However, TCW estimates with sub-prime, you should expect less than 20% of your money back in the case of a default. The estimate for prime is 50%) As a result of the default risk, non agency mortgage backed securities typically trade at substantial discount to the remaining principal.
Analyzing non-agency mortgage backed securities is very complicated. You have to think about interest rate risk, prepayments, and credit risk (defaults and recovery). To compensate for all these risks and uncertainties, non-agency mortgage backed securities typically yield around the same as junk bonds.
For the definition and meaning of other bond related terms visit the Learn Bonds Glossary where we provide the explanation of many other terms.