Residential Mortgage Backed Securities
Residential mortgaged backed securities (RMBS) are a type of mortgage backed security based on mortgages issued on residential real estate. A RMBS derives its cash flows from payments on residential debt such as mortgages, home-equity loans and subprime mortgages.
An RMBS comprises a large amount of pooled residential mortgages. Holders of an RMBS receive interest and principal payments that come from the holders of the residential debt. This simplest form of an RMBS is a mortgage pass-through. With this structure, all principal and interest payments (less a servicing fee) from the pool of mortgages are passed directly to investors each month.
A 30-year fixed-rate residential mortgage makes a fixed payment each month until its maturity. Over time, as more of the principal is paid off, the size of the interest payment declines. Accordingly, the portion of each payment representing principal repayment increases over the life of the mortgage.
Although the scheduled payments on a mortgage are fixed from one month to the next, the cash flows to the holder of a mortgage pass-through are not fixed. This is because mortgage holders have the option of prepaying their mortgages. When a mortgage holder exercises that option, the principal prepayment is passed to investors in the pass-through. This accelerates the cash-flows to the investors, who receives the principal payments early but never receive the future interest payments that would have been made on that principal.
According to the SEC, the Government National Mortgage Association (Ginnie Mae), a U.S. government agency, or the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac), U.S. government-sponsored enterprises. Ginnie Mae, backed by the full faith and credit of the U.S. government, guarantees that investors receive timely payments.
Fannie Mae and Freddie Mac also provide certain guarantees and, while not backed by the full faith and credit of the U.S. government, have special authority to borrow from the U.S. Treasury. Some private institutions, such as brokerage firms, banks, and homebuilders, also securitize mortgages, known as "private-label" mortgage securities.
The private-label RMBS market was largely blamed for the collapse of the credit markets in 2008. Starting in the early 2000s, private label RMBS were increasingly issued on pools of risky sub-prime mortgages. For the first time, RMBS posed significant credit risk. Despite this, the market for these risky instruments grew rapidly until 2007.
The collapse of the housing bubble in 2007 unleashed a flood of home foreclosures and defaults on subprime loans, which made investors unwilling to buy complex securities, including RMBSs, backed by mortgages. From there, the problems spread, taking down prominent investment banks like Lehman Bros. and Bears Sterns. Eventually, the federal government was forced to enact a $700 billion bailout in an attempt to stem the bleeding.