The two major ratios for assessing credit risk are the borrower’s ability to make the payments (PITI and sometimes HOA fees), e.g., payment/income , and the borrower’s equity in the home (down payment) which reduces the loan/value and indicates that the borrower has a greater ability to absorb any decreases in value of the home and has a strong interest in maintaining the home and the loan.
The use of private mortgage-backed securities (MBS) allowed an originate-to-distribute (or sell) business model where these risky loans were knowingly made, but as long as investors would buy them they would be made. ( See Greenspan )
Private MBS were 49% of new home mortgages from 2004 to 2006, while in 2004 they represented about 13% of outstanding home mortgages.
High quality ratings by rating agencies (Moody’s, S&P, Fitch) gave the appearance that these MBS were less risky than they were.
Many of the MBS have two problems: (1) credit risk, and (2) liquidity risk. The lack of liquidity makes it very difficult to assess the fair value. The idea is that these securities will have a higher value when the markets return to normalcy, i.e., more liquidity, and these securities can be sold.