FRM Exam Part I · Mortgages and Mortgage-Backed Securities

Non-Agency MBS, Securitization and the Subprime Crisis

Updated 11 October 2026 · Fact-checked

Non-agency MBS are private-label securities backed by mortgages with no government or GSE guarantee, so investors bear credit risk. Issuers use credit enhancement such as subordination and overcollateralization to protect senior tranches. To solve questions, find the pool loss, then allocate it from the bottom tranche upward.

Understand Non-Agency MBS, Securitization and the Subprime Crisis

Agency MBS are issued or guaranteed by Ginnie Mae, Fannie Mae or Freddie Mac. The guarantee covers timely payment of principal and interest, so the main risk is prepayment. Agency pools hold only conforming loans.

Non-agency MBS (private-label) carry no such guarantee. Investors face credit risk as well as prepayment risk. Pools often hold loans that agencies cannot buy: jumbo, subprime, Alt-A and others with weak documentation or high loan-to-value ratios. Because default risk sits with investors, the structure must protect the senior bondholders. That protection is credit enhancement.

There are two kinds. Internal enhancement is built into the deal: subordination (a senior/subordinate or waterfall structure where junior tranches absorb losses first), overcollateralization (collateral balance exceeds bond balance), excess spread (loan interest above bond coupons and fees, used to cover losses) and reserve accounts. External enhancement comes from outside: bond insurance from monoline insurers, or guarantees and letters of credit. External enhancement adds the credit risk of the provider.

The originate-to-distribute model has lenders originate loans, sell them to a sponsor or SPV, and securitize them. The originator earns fees and passes on the credit risk. This weakens incentives to screen borrowers. It is a moral hazard problem, and underwriting standards fell, with low-documentation and high-LTV loans becoming common.

In the 2007-2009 crisis, house prices fell and subprime defaults rose. Losses hit the lower tranches, then tranches of CDOs built from lower-rated MBS tranches. Rating agencies had given high ratings that relied on weak default-correlation assumptions and limited data. Investors also relied on ratings and did not do their own analysis. Short-term funding of off-balance-sheet vehicles and high leverage amplified the damage. The lessons: align incentives (risk retention), stress correlation, do not rely only on ratings, and watch liquidity and leverage.

Key formulas to remember

Pool loss: Pool loss = Collateral balance × Default rate × Loss severity; Loss severity = 1 − recovery rate. Use the loss amount, not the default amount, in the waterfall.
Loss allocation (waterfall): Loss to a tranche = min(tranche balance, remaining loss after junior tranches); Losses hit the equity or junior tranche first, then move up. Senior tranches lose only after all junior balances are gone.
Subordination (credit enhancement) level: Subordination to a tranche = Balance of all tranches junior to it ÷ Total pool balance; A larger percentage means more loss absorption below that tranche.
Overcollateralization: OC = Collateral balance − Total bond balance; OC % = OC ÷ Collateral balance; OC is a cushion that absorbs losses before any bond loses principal.
Excess spread: Excess spread = Weighted average coupon on loans − (bond coupons + fees); Expressed as an annual percentage of the pool. It is the first line of defence in many deals.
Agency vs non-agency: Agency: prepayment risk. Non-agency: prepayment risk + credit risk; Agency guarantee covers credit risk. Non-agency relies on credit enhancement.

How to solve Non-Agency MBS, Securitization and the Subprime Crisis questions

Use this sequence for any numerical or conceptual question on non-agency MBS and securitization.

1Decide whether the pool is agency or non-agency. If agency, credit risk is guaranteed and prepayment is the focus.
2List the tranches from most senior to most junior with their balances. Check whether OC or excess spread exists.
3Compute the pool loss: balance × default rate × severity. Use severity = 1 − recovery.
4Subtract any excess spread or reserve first if the question says it is applied to losses.
5Allocate the remaining loss from the bottom tranche upward, capping each tranche at its balance.
6Compute enhancement percentages or tranche losses as asked. Divide by the correct base (pool or tranche).
7For conceptual questions, identify the incentive or modelling failure: originate-to-distribute, correlation, ratings or leverage.
8Check that tranche losses add up to the total loss absorbed.

Quickest way: Bottom-up loss fill

When to use it: Use it for any tranche loss or subordination calculation with a simple waterfall.

Write the pool loss in one number.
Write junior balances as a running total from the bottom: equity, then mezzanine, then senior.
Find where the loss falls in that running total. Every tranche below is wiped out, the one it reaches is partly hit, and those above lose nothing.
For subordination, add the junior balances and divide by the pool.

Common mistakes in Non-Agency MBS, Securitization and the Subprime Crisis

Using the default amount as the loss.
The question gives a default rate and students stop there.
Fix: Multiply by severity (1 − recovery) before running the waterfall.
Saying agency MBS have no risk.
The guarantee is confused with protection from all risks.
Fix: The guarantee covers credit risk only. Agency MBS still carry prepayment and interest rate risk.
Dividing a tranche loss by the pool balance when asked for tranche loss percentage.
The base is not checked.
Fix: Read the question. Tranche loss % uses the tranche balance. Subordination % uses the pool.
Treating overcollateralization and subordination as the same thing.
Both add a loss cushion.
Fix: Subordination is a tranche ordering. OC is collateral exceeding bonds. Each works differently in the waterfall.
Blaming the crisis on a single cause such as rating agencies alone.
Narrative answers pick one favourite.
Fix: List the chain: weak underwriting from originate-to-distribute, falling house prices, correlation underestimated, ratings reliance, leverage and short-term funding.
Assuming external enhancement removes credit risk.
Insurance sounds like a full guarantee.
Fix: External enhancement transfers risk to the guarantor, so the guarantor's credit quality now matters.

Worked examples

Example 1

A non-agency pool has $500 million of loans funding three tranches: senior $400 million, mezzanine $70 million, equity $30 million. The default rate is 12% and loss severity is 45%. Ignore excess spread. What loss does the mezzanine tranche take?

Show the solution

Pool loss = 500 × 12% × 45% = 500 × 0.054 = $27 million.
Equity absorbs first: min(30, 27) = $27 million.
Remaining loss for mezzanine = 27 − 27 = $0.

Answer: The mezzanine tranche loses $0. Equity absorbs the whole $27 million loss, leaving $3 million of equity.

Example 2

A securitization has collateral of $1,000 million and bonds of $940 million, split into senior $800 million, mezzanine $100 million and junior $40 million. The pool loss is $85 million. Compute the overcollateralization percentage, the subordination of the senior tranche, and the loss to the senior tranche.

Show the solution

OC = 1,000 − 940 = $60 million. OC % = 60 ÷ 1,000 = 6%.
Subordination to the senior tranche as a share of the pool: (100 + 40) ÷ 1,000 = 14%.
Losses are first absorbed by OC of $60 million. Remaining loss = 85 − 60 = $25 million.
Junior tranche absorbs min(40, 25) = $25 million. Mezzanine and senior take nothing.

Answer: OC is 6%, senior subordination is 14% of the pool, and the senior tranche loses $0. The junior tranche loses $25 million after OC is used up.

Exam tips

Always run the waterfall from the bottom. Questions often include a senior tranche that takes no loss.
Check whether the loss is given as a default rate with severity or as a final loss amount.
Know the agency versus non-agency contrast cold: guarantee, loan types, risks borne by investors.
For crisis questions, link each failure to a cause: incentives, correlation, ratings, leverage, funding.
Read the base of every percentage: pool for subordination and OC, tranche for tranche loss.

Practice questions from Mortgages and Mortgage-Backed Securities

Non-Agency MBS, Securitization and the Subprime Crisis: frequently asked questions

What is the difference between agency and non-agency MBS?

Agency MBS are issued or guaranteed by Ginnie Mae, Fannie Mae or Freddie Mac, so investors do not bear credit risk. Non-agency MBS are private-label with no such guarantee. Investors face credit risk and rely on credit enhancement.

What is the originate-to-distribute model?

Lenders originate loans and sell them to be securitized instead of holding them. They earn fees and pass on the credit risk. This weakens the incentive to screen borrowers and contributed to the decline in underwriting standards before the crisis.

What is the difference between subordination and overcollateralization?

Subordination ranks tranches so junior tranches absorb losses first. Overcollateralization means the collateral balance exceeds the bond balance, which gives an extra cushion. Both are internal credit enhancement and often appear together.

What caused the subprime mortgage crisis?

It was a chain of failures: weak underwriting under originate-to-distribute, falling house prices, and rising defaults. Models underestimated default correlation and ratings were over-relied upon. Leverage and short-term funding then amplified the losses.