What are residential mortgage-backed securities (RMBS)?
Residential mortgage-backed securities (RMBS) are debt-based securities (similar to bonds) that are backed by interest on a home loan. Interest on loans such as mortgages, home equity loans, and subprime mortgages are considered something that has relatively low default rates and relatively high-interest rates because of the high demands placed on ownership of an individual or family home. Investors are attracted to the securities while also wanting protection from the default risk inherent in such personal loans. This risk can be mitigated by pooling many of these loans to minimize the risk of an individual defaulting.
KEY TAKEAWAYS
- Residential mortgage-backed securities (RMBS) are similar to bonds based on many personal mortgage payments.
- For investors, the renminbi can increase profits and reduce risks.
- If the RMB bond is not properly structured, it will also generate huge systemic risks.
- Many poorly structured renminbi issuances contributed to the 2008 financial crisis.1
How Residential Mortgage-Backed Securities (RMBS) Work
Residential mortgage-backed securities are structured from one of two sources: a government agency, such as the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac), or by a non-agent investment banking firm. First, these entities sell or control a large number of residential loans. Next, they package a large number of loans into a single loan pool. In the end, these entities are essentially selling bonds backed by these loan pools.
Repayments on these loans go to investors who buy this pool of money, and they receive higher interest rates than typical US government-backed bonds. The issuer retains a pool management fee, and the default risk of these mortgages is shared between the issuing entity and the investor. Because each of these loans is a small part of a larger set of loans, the default on any one loan will have less impact on the investor than if the investor were to invest in any of them individually.
Advantages and disadvantages of RMBS
The advantage of RMB securitization is that it provides investors with less risk and greater profitability. It also allows the issuing entity to raise more cash reserves and make more loans accordingly. This in turn provides business owners and entrepreneurs with more investment capital.
As an indicator of its efficiency and effectiveness, it can be seen that the largest single category of RMB investors is life insurance companies. These institutions benefit from having an efficient way to invest billions of dollars in investments with higher interest rates than government bonds, while still taking on acceptable risk.
The renminbi can contain a large number of different types of mortgages. Securities can contain all one type of collateral or a mix of different types. They may include fixed-rate, variable-rate, adjustable-rate mortgages, and mortgages of varying credit quality, including primary and subprime mortgages. This diversity helps reduce default risk.
As an investment type, the complexity of all the renminbi creates some disadvantages that are hard to quantify. The first is systemic risk, that is, the risk that financial system stress may uniformly affect all investments in the RMB-based asset pool. This risk was evident in the 2008 financial crisis. The second reason is that because investors are further apart from individual mortgage holders, they have less stake in their success. While the historical default rate hovers around 2%, in 2009 it was closer to 5%. A decade later, with defaults falling below 1%, investors seem less concerned about this risk.
Invest in residential mortgage-backed securities
Investing in residential mortgage-backed securities exposes investors to prepayment risk and credit risk. Prepayment risk is the risk that the mortgage holder will repay the mortgage before the due date, which reduces the amount investors should have interest earned. In this sense, prepayment refers to the payment of more than the predetermined principal. This can happen if the current market rate is lower than the predetermined rate, as the homeowner is more likely to refinance the mortgage. Credit risk for RMBS investors arises when borrowers stop paying their mortgages
Mortgage-backed securities are used by financial institutions such as insurance companies due to their cash flow characteristics and relatively long lifespan, which can offset long-term liabilities assumed by insurance companies. In addition, buyers of residential mortgage-backed securities tend to be invested in the way they are constructed, so they can be uniquely tailored to offset liabilities or to suit other investors’ preferences for risk, reward, and cash flow timing.