What it means
A lender gathers a few thousand mortgages, transfers them into a separate legal vehicle, and that vehicle issues bonds secured on the loan payments. The cash homeowners pay each month flows through to bondholders after servicing fees, and the originating bank gets its money back immediately to lend again.
The pool is carved into tranches, ranked by who gets paid first and who takes losses first. The senior tranche receives cash before anyone else and absorbs losses last, so it pays the lowest yield; the equity or first-loss tranche keeps whatever is left over and takes the first hit from defaults.
This ordering is known as the waterfall. For businesses outside banking, RMBS matter because they set the price of mortgage credit.
When investors will pay a high price for these bonds, mortgage rates fall and housing activity picks up; when the market shuts, lenders ration credit even if their own deposits are perfectly healthy. RMBS became notorious in 2007 and 2008, when pools of poorly underwritten US mortgages defaulted at rates the credit ratings had never contemplated.
The instruments themselves were less the problem than the quality of the loans inside them and the confidence placed in the models, and post-crisis rules now oblige issuers to retain a slice of the risk so the originator keeps money at stake. Two risks dominate: credit risk, meaning borrowers defaulting, and prepayment risk, meaning borrowers repaying early and cutting off the interest stream.
Prepayment is the one that catches people out, because a wave of refinancing when rates fall hands investors their capital back exactly when it can only be reinvested at lower yields.
In practice
Real-world examples.
Example
A building society sells $600,000,000 of its mortgage book into an RMBS structure to free capital for new lending. The sale converts a twenty five year asset into cash within weeks, allowing the society to write fresh loans without raising new deposits.
Example
A pension fund buys the senior tranche of an RMBS yielding 4.2%, preferring it to corporate bonds at a similar yield because the mortgage pool is spread across thousands of borrowers in different regions. The fund accepts that early repayments may shorten the life of its investment.
Example
A hedge fund buys a mezzanine tranche at a discount after a housing market wobble, judging that defaults will stay well below the level needed to reach its layer. When arrears peak at 3% rather than the 9% the market feared, the tranche pays in full and the fund books a large gain.
Think of it
“RMBS is the abbreviation for residential mortgage-backed securities-home loan bonds.
Formula
Calculation
There is no single formula, but the cash waterfall can be worked through directly: pool interest is paid to tranches in order of seniority, and whatever remains belongs to the equity tranche.
A vehicle buys 4,000 mortgages averaging $250,000 each, a pool of $1,000,000,000. It issues a senior tranche of $800,000,000 paying 4%, a mezzanine tranche of $150,000,000 paying 6%, and a $50,000,000 equity tranche that keeps the residual.
The pool yields 5.5%, producing $55,000,000 of interest a year. The senior tranche takes $800,000,000 x 4% = $32,000,000 and the mezzanine takes $150,000,000 x 6% = $9,000,000, leaving $55,000,000 - $32,000,000 - $9,000,000 = $14,000,000 for the equity tranche, a return of $14,000,000 / $50,000,000 = 28%.
Now assume losses on the pool reach 2%, or $20,000,000. The equity tranche absorbs all of it, so its $50,000,000 of principal falls to $30,000,000 while the senior and mezzanine holders are untouched, which is exactly the protection the senior investors paid for by accepting a 4% coupon.Case study
Seen in the real world.
The following is an illustrative and clearly fictional scenario. Meridian Coastal Bank, an invented regional lender, wrote $1,000,000,000 of home loans and found itself short of capital to keep growing. Rather than slow down, it securitised the pool, issuing senior, mezzanine and equity tranches to institutional buyers.
The structure worked as intended for three years, until the fictional regional economy hit a downturn and arrears climbed. Losses reached $18,000,000, which was absorbed entirely by the $50,000,000 equity tranche that Meridian had itself retained under risk retention rules, leaving the outside investors whole.
Management concluded that keeping the first-loss piece had been uncomfortable but useful, because it had forced the credit team to underwrite the pool as though the bank would keep every loan. The illustrative lesson is that securitisation transfers risk best when the originator still has something to lose.
Watch out
Common mistakes.
- Assuming a AAA rating on a senior tranche means the underlying mortgages are high quality, when the rating reflects the protection of the junior tranches rather than the loans themselves.
- Ignoring prepayment risk and modelling an RMBS as though it will pay a fixed coupon for its full stated term.
- Treating all RMBS as identical, when pools differ enormously by borrower credit quality, loan-to-value ratio and geographic concentration.
Questions
People also ask.
What is the difference between an RMBS and a covered bond?
An RMBS moves the loans off the bank's balance sheet into a separate vehicle, while a covered bond keeps them on the balance sheet and gives investors recourse to both the pool and the bank.
Who actually buys these securities?
Mostly pension funds, insurers and bank treasuries for the senior tranches, with hedge funds and specialist credit funds taking the riskier layers.
Does an RMBS change anything for the homeowner?
No, the mortgage terms are unchanged, though the servicer collecting the payments may be a different company from the original lender.
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