Key Takeaways
- Securities backed by pooled residential mortgages.
- Tranches offer varying risk and return levels.
- Agency RMBS have government guarantees.
- Provides predictable monthly cash flows to investors.
What is Residential Mortgage-Backed Security (RMBS)?
Residential Mortgage-Backed Securities (RMBS) are fixed-income instruments created by pooling residential mortgage loans, such as home mortgages and home-equity loans, which are then securitized and sold to investors. These securities provide investors with cash flows derived from borrowers' principal and interest payments, making RMBS a key component of the housing finance system.
RMBS allow lenders to free up capital and issue more loans while offering investors bond-like income streams. Many agency RMBS are backed by government-sponsored enterprises like AGNC, which enhances their credit quality.
Key Characteristics
RMBS possess several distinct features that influence their risk and return profiles.
- Pooling of Loans: Thousands of residential mortgages are bundled based on criteria like credit quality and loan-to-value ratios, reducing individual loan risk.
- Tranches: Securities are divided into classes with varying priorities and risk levels, often including senior and junior tranches, similar to concepts associated with AAA ratings for top-tier risk.
- Monthly Cash Flows: Investors receive monthly payments of principal and interest, reflecting the underlying mortgage repayments.
- Government Guarantees: Agency RMBS often carry implicit or explicit guarantees, improving liquidity and creditworthiness.
- Prepayment Sensitivity: RMBS returns are affected by borrowers' prepayment behavior, which can complicate expected cash flows.
How It Works
Mortgage originators sell pools of loans to issuers who securitize them into RMBS, issuing securities backed by the borrowers' mortgage payments. Investors receive payments according to the structure of the RMBS, which can be simple pass-through securities or more complex collateralized mortgage obligations (CMOs).
These securities’ cash flows are distributed in a priority order among tranches, protecting senior investors while junior tranches absorb more risk. Understanding concepts like Macaulay duration helps you evaluate the interest rate sensitivity and timing of these payments.
Examples and Use Cases
RMBS play a critical role in capital markets and mortgage financing.
- Agency RMBS: Issued or guaranteed by government-sponsored entities like AGNC, these securities provide relatively stable income with lower credit risk.
- Non-Agency RMBS: Private issuers create RMBS without government backing, often including subprime loans, which carry higher risk and yield.
- Investment Portfolios: Investors may combine RMBS with broad bond funds like BND or diversify with low-cost index funds such as those highlighted in best low-cost index funds.
Important Considerations
When investing in RMBS, you should assess credit risk, prepayment risk, and market liquidity. Non-agency RMBS can be less liquid and more volatile during market stress. It’s crucial to understand the underlying obligors’ creditworthiness and factors like the obligor's ability to repay.
Additionally, RMBS performance is sensitive to interest rate changes, so incorporating duration measures and risk management strategies improves your portfolio's resilience.
Final Words
Residential Mortgage-Backed Securities offer a way to invest in home loan cash flows with varying risk and return profiles depending on the tranche chosen. To make informed decisions, compare agency versus non-agency RMBS and assess credit quality before investing.
Frequently Asked Questions
RMBS are fixed-income securities created by pooling residential mortgage loans, such as home mortgages and home-equity loans, which are then securitized and sold to investors. Investors receive payments from the borrowers' principal and interest through these securities.
Mortgage originators sell loans to a sponsor who pools thousands of similar loans into a trust. The trust issues securities that represent claims on the pooled cash flows from borrowers' monthly mortgage payments, which are then paid out to investors.
The simplest RMBS are pass-through securities where investors receive a pro-rata share of payments. More complex forms like Collateralized Mortgage Obligations (CMOs) or Real Estate Mortgage Investment Conduits (REMICs) divide the pool into tranches with varying risk and payment priorities.
Agency RMBS are issued by government-sponsored entities like Ginnie Mae, Fannie Mae, or Freddie Mac and often have government guarantees or implicit backing. Non-agency RMBS are issued by private entities and do not have government guarantees, often including subprime or jumbo loans.
RMBS offer higher yields compared to Treasuries, diversification across thousands of loans, liquidity in capital markets, customizable risk-return profiles through tranches, and predictable monthly income from borrowers' payments.
Securitization allows banks to offload mortgage loans from their balance sheets, freeing up capital to issue new loans. This process supports liquidity in the housing market and enables more homeownership opportunities.
Investors face credit risk if borrowers default on their loans, especially in junior tranches which absorb losses first. Non-agency RMBS carry higher risk due to lack of government guarantees, while agency RMBS tend to have lower credit risk.
