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

Residential mortgage-backed securities (RMBS) are a type of mortgage-backed debt obligation created 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.

Residential mortgage-backed securities 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. Residential mortgage-backed securities can also have government backing from agencies such as the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac), which offer credit protection to investors. Residential mortgage-backed securities can also be non-agency, meaning that they are not backed by the government and are issued privately by banks and other financial institutions.

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.

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.

Residential Mortgage-backed Securities in the Financial Crisis

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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