A non-conforming loan is a loan that does not meet the lending criteria of government-sponsored enterprises (GSEs). GSEs are government-backed entities that purchase mortgages from lenders and then package them into mortgage-backed securities (MBS).
Non-conforming loans can be securitised, but they are typically considered to be riskier than conforming loans. This is because non-conforming loans are more likely to default, and they may not be as easy to sell to investors.
There are a number of reasons why a loan might be considered non-conforming. Some of the most common reasons include:
- The loan amount is too large.
- The borrower's credit score is too low.
- The borrower's debt-to-income ratio is too high.
- The property being financed is not considered to be a good investment.
Non-conforming loans can be securitised in a number of different ways. One common way is to create a special purpose vehicle (SPV) to hold the non-conforming loans. The SPV will then issue securities to investors, and the proceeds from the sale of the securities will be used to pay off the non-conforming loans.
Another way to securitise non-conforming loans is to create a synthetic securitisation. In a synthetic securitisation, the SPV does not actually hold the non-conforming loans. Instead, the SPV enters into a series of derivative contracts with investors. These derivative contracts replicate the cash flows of the non-conforming loans, and the investors receive payments from the SPV based on the performance of the derivative contracts.
Non-conforming loans can be a source of diversification for investors. Because non-conforming loans are typically riskier than conforming loans, they can offer investors the potential for higher returns. However, it is important to note that non-conforming loans also carry a higher risk of default.
Here are some of the applications of non-conforming loans in the context of securitisation:
- Diversification: Non-conforming loans can be used to diversify the risk of an investment portfolio. This is because non-conforming loans are typically riskier than conforming loans, and they can offer investors the potential for higher returns.
- Risk management: Non-conforming loans can be used to manage the risk of a securitisation transaction. By including non-conforming loans in a securitisation transaction, investors can reduce their exposure to the risk of default on conforming loans.
- Regulation: Non-conforming loans can be used to regulate securitisation transactions. Regulators can use non-conforming loans to set limits on the amount of debt that can be securitised.
Overall, non-conforming loans can be a valuable tool for investors and securitisation transactions. However, it is important to understand the risks associated with non-conforming loans before investing in them.