Residential Mortgage-Backed Security (RMBS)

DEFINITION of 'Residential Mortgage-Backed Security (RMBS)'

A type of mortgage-backed debt obligation whose cash flows come from residential debt, such as mortgages, home-equity loans and subprime mortgages. A residential mortgage-backed security is comprised of a pool of mortgage loans created by banks and other financial institutions. The cash flows from each of the pooled mortgages is packaged by a special purpose entity into classes and tranches, which then issues securities and can be purchased by investors.

BREAKING DOWN 'Residential Mortgage-Backed Security (RMBS)'

Residential mortgage-backed securities and commercial mortgage-backed securities serve as the foundation for other financial instruments, such as collateralized mortgage obligations (CMO). Their complexity depends on the income provided to investors and the amount of risk that investors assume. A pass-through style of RMBS allows an investor to receive a share of interest and principal payments, while a CMO may have a structure that allows investors to assume more risk but also potentially more return.

Investing in a residential-mortgage backed security can expose the investor to prepayment risk and credit risk. Prepayment risk is the risk that the mortgage holder will pay back the mortgage before its maturity date, which reduces the amount of interest the investor would have otherwise received. Prepayment, in this sense, is a payment in excess of the scheduled principal payment. This situation may arise if the current market interest rate falls below the interest rate of the mortgage, since the homeowner is more likely to refinance the mortgage.

Residential mortgage-backed securities are considered one of the precipitating factors in the 2007-2008 financial crisis. Investors in RMBS and other mortgage-backed derivatives were exposed to an increase in foreclosures and falling home prices, as well as falling interest rates.

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