Residential Mortgage-Backed Security Defined, Pros & Cons

What is a Residential Mortgage-Backed Security (RMBS)?

Residential mortgage-backed securities (RMBS) are a debt-based security (similar to a bond), backed by the interest paid on loans for residences. 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. Investors 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.

How a Residential Mortgage-Backed Security (RMBS) works

A residential mortgage-backed security is constructed by 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-agency investment-banking firm. First these entities sell or control a large number of residential loans. Next they package a large number of them together into a single pool of loans. Finally these 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 and Disadvantages of an RMBS

The construction of an RMBS has the advantage of providing 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 investing capital available to business owners and entrepreneurs.

As an indicator of their efficiency and benefit, it could be noted that the biggest single category of RMBS investors is life insurance companies. 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 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.

The complexity of all RMBS, as an investment type, creates some difficult-to-quantify disadvantages. The first is systemic risk, or the risk that financial system stress 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. While historical default rates hovered around two percent, during 2009 this rate was near five percent. Ten years later this risk seems of little concern to investors since the default rate fell below one percent.

Investing in Residential Mortgage-Backed Securities

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. Credit risk for RMBS investors arises when the borrower stops making payments on his mortgage

Residential mortgage-backed securities are utilized by financial institutions like insurance companies because of their cash flow characteristics and their relatively long lives, which can offset long-term liabilities taken on by insurance companies. Moreover, buyers of residential mortgage-backed securities often have input into how they are constructed, so they can be uniquely tailored to offset a liability or to fit other investor preferences for risk, return and timing of cash flows, for example.