Residential mortgage-backed securities (RMBS) are debt securities whose interest and principal are paid from the cash collected on a pool of home loans. A lender, or a firm that has bought loans from lenders, sells the pool to a separate legal entity, which funds the purchase by issuing bonds to investors. Homeowners' monthly payments then pass through to the bondholders. Banks and other lenders use RMBS to raise funding and move loans off their balance sheets, and investors buy them for yield and for exposure to housing credit.
RMBS are one branch of the wider mortgage-backed security market. The other main branch is commercial mortgage-backed securities, which are backed by loans on offices, shops and other income-producing property. Both are forms of securitization.
How an RMBS is structured
The originator sells a pool of loans, often several thousand, to a special purpose vehicle that is legally separate from the seller, so that the loans are beyond the reach of the seller's creditors if it fails. A servicer, frequently the original lender, continues to collect payments, deal with borrowers and manage arrears; this work is described under loan servicing. A trustee holds the security over the loans on behalf of investors.
The simplest form is a pass-through, in which every investor owns a proportionate share of the pool and receives a matching share of each month's collections. Most privately issued deals instead use tranching: the bonds are split into classes that are paid in order of priority. The senior tranche is paid first and carries the highest rating; a mezzanine tranche and then an equity tranche absorb losses before it. The order of payments is set out in the securitisation waterfall.
Agency and private-label RMBS
In the United States the market is divided into two parts. Agency RMBS are issued or guaranteed by Fannie Mae, Freddie Mac or Ginnie Mae. Investors in these bonds are protected against borrower default by the guarantor, so their main concern is the timing of repayments rather than credit loss. Loans must meet the agencies' standards on size and underwriting to be eligible.
Private-label, or non-agency, RMBS are issued by banks and other financial firms without such a guarantee. They are backed by loans that fall outside agency limits, such as very large loans or loans to borrowers with weaker credit, and they rely on credit enhancement within the structure. In Europe, the United Kingdom and Australia there is no equivalent of the US agencies, and RMBS are issued by lenders directly, often through master trust programmes.
Risks for investors
RMBS carry a mix of risks that differ from those of an ordinary bond:
- Prepayment risk. Borrowers can usually repay early, typically by refinancing when rates fall or by moving home. Investors then receive principal sooner than expected and must reinvest at lower rates.
- Extension risk. When rates rise, prepayment slows and the bonds remain outstanding longer than planned at a below-market yield.
- Credit risk. In deals without a guarantee, defaults and falling house prices reduce the cash available. Junior classes are hit first.
- Servicing and legal risk. Poor collection practices, missing loan documents or the failure of the servicer can delay or reduce recoveries.
Because the timing of cash flows is uncertain, RMBS are usually analysed by weighted average life under an assumed prepayment speed rather than by a fixed maturity date.
The 2007 to 2009 crisis and later reforms
RMBS were at the centre of the global financial crisis. In the years before 2007, large volumes of US sub-prime mortgages were packaged into private-label deals, and lower-rated classes were often repackaged again into collateralized debt obligations. When house prices fell and defaults rose, losses reached bonds that had been rated as very safe, and the private-label market largely closed.
Regulators responded with rules intended to align the interests of issuers and investors. Both the United States and the European Union introduced risk retention, under which the originator or sponsor must generally keep a material economic interest, commonly five per cent, in the deals it creates. The EU Securitisation Regulation, which has applied since 2019, added due diligence and disclosure duties and a label for simple, transparent and standardised transactions. Bank capital rules for securitisation holdings were also tightened under Basel III.