Residential mortgage-backed securities (RMBS) are debt-based security, which is similar to a specific type of bond, secured against a large pool of home loans. The interest on loans such as mortgages, home-equity loans, and subprime mortgages is considered to be something with a comparatively low rate of default and a comparatively high rate of interest since there is a high demand for the ownership of a personal or family residence. Instead of just two or three loans, RMBS notes typically group together hundreds if not thousands of home loans. Lenders put together hundreds of millions (sometimes one billion-plus) worth of home loans before breaking them up into ‘smaller classes. These smaller classes are usually still worth hundreds of millions of dollars. Investors who are attracted to this kind of security also want to be protected from the risk of default inherent with individual loans of this kind. This risk is mitigated by pooling many such loans to minimize the risk of an individual default.
Four key stakeholders in a Residential Mortgage-Backed Security transaction:
- Originator: this is the organization that originates the home loan, such as a bank or credit union. The quality of the loans within the RMBS will be affected by the lending procedures of the originators.
- Trustee: the trustee is primarily responsible for protecting the interests of the security investors.
- Servicer: responsible for managing the loan pool, the servicer calculates the charging of fees, interest and principal, the collection of any payments, performance reporting and more.
- Rating Agency: the rating agencies consider the quality and history of the loan pool and prepare detailed analysis about the performance of the RMBS.
How a Residential Mortgage-Backed Security (RMBS) works
Residential mortgage-backed security is constructed by one of two sources: a government agency such as the Federal National Mortgage Association and the Federal Home Loan Mortgage Corporation or by a non-agency investment-banking firm.
- Entities sell or control a large number of residential loans.
- The packages a large number of them together into a single pool of loans.
- Entities essentially sell bonds backed by this pool of loans.
The payments on these loans flow through to the investors who bought into this pool, and the interest rates they receive are better than typical U.S. government-backed bonds. The issuing institutions keep a fee for the management of the pool, and the risks of default on these mortgages are shared by both the issuing entities and the investors. Because each of these loans is a small part of the larger, collected pool of loans, the default of any one of these loans has less impact on the investors than if they were to invest in any one of these loans individually.
Advantages of a Residential Mortgage-Backed Security
- It provides less risk and greater profitability to the investors.
- It also allows the issuing entities to raise more cash for reserves, against which they can make more loans. This in turn makes more investment capital available to business owners and entrepreneurs.
- These institutions benefit from having an efficient way to invest billions of dollars in higher-interest rate investments than government bonds, while yet still taking an acceptable risk.
- An RMBS can contain a slew of various types of mortgages. The securities can contain all of one type of mortgage or a mix of different types. They may contain mortgages with fixed rates, floating rates, adjustable rates, and mortgages of varying credit quality including prime and subprime. This variety helps allay the risk of default.
Disadvantage of a Residential Mortgage-Backed Security
The complexity of all RMBS, as an investment type, creates some difficult-to-quantify disadvantages.
- The first is a systemic risk or the risk that the financial system stresses could uniformly affect all investments within the pool that underlies the RMBS. This risk was evident in the 2008 financial crisis.
- The second is that because investors are more distanced from individual mortgage holders, they have less stake in their success. Ten years later this risk seems of little concern to investors since the default rate fell below one percent.