When MBS issued by Freddie Mac, Fannie Mae and Ginnie Mae dominated the secondary market, these government-sponsored enterprises assumed virtually all of the credit risk, leaving investors to worry principally about prepayment risk. Over the last two to three years, the non-agency share of the secondary market has exploded, leaving investors to confront the "two-headed risk monster" of both prepayment risk and credit risk. To account for the addition of credit risk, Andrew Davidson & Co. has developed a behavioral model that provides projections of prepayment, delinquency, and default for non-agency MBS.
Kyle Lundstedt, the director of credit modeling at AD&Co., explained that credit risk traditionally has been the focus in origination or underwriting, while prepayment risk was the domain of portfolio management. "Over the last two decades, agencies comprised the vast majority of available mortgage securities, so investors principally focused on interest rate and prepayment risk," Lundstedt said. "Now, over half the secondary market is comprised of non-agency securities with a wide range of collateral characteristics, so investors must assume the credit risk themselves."