Final answer:
The expected loss of a mortgage loan in a collateral pool is determined by the product of the loan's probability of default and loss given default, factors that were especially relevant during the expansion of subprime loans turned into mortgage-backed securities.
Step-by-step explanation:
The expected loss of a mortgage loan in a collateral pool is the product of that loan’s probability of default (PD) and loss given default (LGD).
The financial industry measures the risk of mortgage loans by estimating the likelihood that a borrower will default on a loan (probability of default) and the amount of loss an institution will face if a default occurs (loss given default). Loans are sold as parts of collateral pools, where different investors might assume various tiers of risk, with some agreeing to absorb initial losses up to certain percentages.
These mortgage-backed securities' arrangement meant varied loss exposure at different investment levels. For example, if a particular subprime loan pool experiences defaults, the agreed structure would dictate who bears the impact first, potentially protecting investors who hold securities with less exposure to initial losses. The idea behind this structure is to reduce the risk to certain investors, while offering higher returns to those who agree to take on more of the initial risk. However, if the pool experiences higher than expected defaults, as might happen in an economic downturn, this could lead to substantial losses across the board and impact the stability of financial institutions.