What it means
When a bank writes a home loan, it can keep the loan on its books for 25 or 30 years, or it can sell it. Selling thousands of similar loans into a trust that issues bonds against them is called securitisation, and the bonds that come out the other end are residential mortgage-backed securities.
The point of the exercise is that a single mortgage is illiquid and hard to price, while a bond backed by 4,000 mortgages is a tradeable instrument that an insurer or pension fund can buy in size. Banks get their capital back to lend again, and investors get access to household credit risk without having to originate loans themselves.
Most RMBS deals are sliced into tranches, which are layers of claims on the same cash flow. The senior tranche is paid first and takes losses last, so it carries the lowest yield; the junior and equity tranches absorb the first defaults and are paid more to accept that.
The quirk that catches new investors out is prepayment. Homeowners can refinance or sell at any time, so when interest rates fall the pool pays down faster and investors get their money back at exactly the moment reinvestment options look worst.
A useful distinction is agency versus non-agency paper. Agency RMBS carry a government-linked guarantee on timely payment of principal and interest, so investors mainly worry about prepayment; non-agency deals carry the full credit risk of the underlying borrowers and are priced accordingly.
In practice
Real-world examples.
Example
A regional bank originates $500,000,000 of home loans a year but only wants to hold $150,000,000 on its balance sheet. It packages the remaining $350,000,000 into an RMBS, sells the bonds to institutional buyers, and recycles the proceeds into new lending.
Example
A pension fund needs predictable monthly cash to pay retirees. It buys $80,000,000 of senior agency RMBS yielding 5.2% because the payments arrive monthly and the credit risk sits with a government-linked guarantor.
Example
A credit union treasurer notices that mortgage rates have fallen by a full percentage point. She models faster prepayments on the $25,000,000 RMBS position she holds and shortens the fund's expected average life from seven years to four.
Think of it
“RMBS is bonds backed by home mortgages-securitized residential loans.
Formula
Calculation
Investor pass-through rate = weighted average coupon of the pool - servicing fee - guarantee fee. Annual investor interest = face value held x pass-through rate.
Take a pool of $500,000,000 of home loans with a weighted average coupon of 6.00%. The servicer keeps 0.25% for collecting payments and the guarantor charges 0.25%, so total fees are 0.50% and the pass-through rate is 6.00% - 0.50% = 5.50%.
Across the whole pool that is $500,000,000 x 5.50% = $27,500,000 of interest paid to bondholders in the first year.
An investor holding $1,000,000 of face value receives $1,000,000 x 5.50% = $55,000 a year, or $55,000 / 12 = $4,583.33 a month, plus a share of principal as borrowers pay down their loans.Case study
Seen in the real world.
Northgate Savings Bank is a fictional lender created to illustrate this concept. It had $1,200,000,000 of home loans on its books and almost no room left under its capital rules to write more, even though demand in its region was strong.
Northgate's treasury team pooled $600,000,000 of seasoned loans into a trust and issued RMBS against them: a senior tranche of $540,000,000 rated highly and paying 5.1%, and a junior tranche of $60,000,000 paying 8.4% that Northgate retained so buyers could see it kept a stake in the outcome. The senior bonds sold within a week.
Two years later, rates fell sharply and prepayments doubled. Senior investors were repaid faster than they had modelled and complained about reinvesting at lower yields, which taught Northgate's team to disclose prepayment sensitivity far more prominently in its next deal.
Watch out
Common mistakes.
- Treating all RMBS as equally safe because they are backed by houses. A junior tranche of a non-agency deal and a senior agency bond sit at opposite ends of the risk spectrum.
- Ignoring prepayment and quoting yield to maturity as if the bond will run its full term. Most pools pay down far earlier than the stated maturity, which changes the return dramatically.
- Assuming a high credit rating removes the need to look at the underlying loans. Borrower credit scores, loan-to-value ratios and geographic concentration all matter, whatever the rating says.
Questions
People also ask.
What is the difference between an RMBS and a CMBS?
An RMBS is backed by home loans made to households, while a CMBS is backed by loans on commercial property such as offices, shopping centres and warehouses.
Can an ordinary investor buy RMBS?
Rarely one directly, because minimum sizes are large, but plenty of bond funds and exchange-traded funds hold them, so most people own some indirectly.
Why did RMBS get such a bad reputation?
Poor underwriting and optimistic assumptions in the mid-2000s meant many non-agency deals held loans that were far weaker than their ratings implied, and losses followed.
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