(a) The type of mortgage-related default risk (systematic or non-systematic) depends on the reason of default. Reasons of default such as unanticipated increase in interest rates, and falling home prices make the default risk systematic. As these factors affect the financial industry as a whole and are present everywhere, they cannot be diversified away, but can be hedged.
On the other hand, reasons of default that are borrower-focused such as loss of job, occupational disability, and finance mismanagement make default risk non-systematic. This is because stricter underwriting processes and the borrowers’ insurance policies can reduce default risks triggered by these reasons.
By combining these two categories of default reasons, mortgage-related default risk can now co-exist as both a systematic and non-systematic risk.
Since systematic mortgage default risks cannot be diversified away, the lender cannot enjoy reduced aggregated default risk from a large pool of borrowers. Hence, the exposure to systematic mortgage default risk depends on the lender’s hedging strategy to the point where the last pound spent for hedging equals to the expected cost of defaulting.
For diversifiable default risks, assuming that the event of a mortgage default for all borrowers are independent random variables, the aggregate risk of default decreases as the pool of borrowers increase in size. Therefore, a large lender will be exposed to decreasing non-systematic default risks as the pool increases in size.
A Mortgage-Backed Security (MBS) is a bond secured against a pool of mortgages. Instead of fixed coupon payments, the mortgage lender passes cash flows from borrowers with interest (less servicing fee) to investors. If borrowers default payments, the bond default payments. As such, the mortgage lender effectively transfers the exposure to default risk to investors at the expense of sharing interest profits.
By issuing MBS to raise...