What are Residential Mortgage Backed Securities?
Residential Mortgage Backed Securities (RMBS) are a type of debt security secured by a pool of home loans. RMBS are a subset of a larger group of Asset Backed Securities (ABS) which can be built around many types of cash flow receivables including (but not limited to) residential mortgages, commercial mortgages, credit card payments and auto loans.
Typically home loans are illiquid and private in nature, however by combining them into a large and diversified pool via a trust and then breaking the combined pool into smaller, marketable classes the RMBS become attractive to investors who would otherwise be unable to take exposure to the underlying mortgage sector. The trust raises less debt securities than the total value of the mortgages (the difference being the level of overcapitalisation, and not dissimilar to the concept of gearing).
The concept of breaking the pool into varying classes of securities allows investors with specific risk appetites to target the appropriate class, and thus returns they are seeking. In this way, the classes act like a normal company capital structure, where investors with the lowest risk appetite target the senior bonds (or in the case of RMBS, the highest classes) and those with a higher risk appetite target the lower ranked capital, like hybrids or equity (or in the case of RMBS, the lowest ranking classes).
RMBS come about due to the need of lenders (banks and other financial institutions) to source funding for their lending activities. RMBS provides another source of funding for lenders in addition to customer deposits and corporate borrowings. Virtually all Australian Prudential Regulation Authority (APRA) regulated lenders use RMBS as a source of funding. Investors in RMBS include super funds, insurance companies, high net worth investors, and more recently, the Commonwealth Government. Prior to the financial crisis around 25% of housing credit in Australia was funded through RMBS, and while this level has decreased, RMBS still represents around 10% of housing credit funding in the Australian market.
The RMBS process
![rmbs graph](https://www.fiig.com.au/images/default-source/wire-articles/rmbs-graph.jpg?sfvrsn=0)
Who are the key players in an RMBS transaction?
There are a number of key players in an RMBS structure. An understanding of these key parties and their roles forms part of the analysis of any RMBS investment.
- Originator – the originator is the organisation that originates the home loan. In the case of RMBS, examples of originators are banks, credit unions and specialised home loan providers. The quality of the loans within an RMBS is affected by the quality of the lending procedures of the originator, and is taken into account in the assessment of credit ratings and of the quality of the RMBS
- Trustee – the trustee is the issuer of the bonds
- Servicer – the key management of the loan pool is undertaken by the servicer. This includes the calculation and charging of fees; interest and principal; the collection of payments (excluding any arrears); issuance of borrower statements; performance reporting on the loan book and monitoring insurance. In addition there is often a ‘special servicer’, usually the originator, which is responsible for entering loan details and settlement
- Banker – provides banking services to the trust. This may include providing liquidity facilities and interest rate swaps, as well as normal banking services
- Rating agencies - the rating agencies play a key role in RMBS and in its analysis. The rating agencies get full access to the details of the underlying loans which form the asset pool and undertake detailed analysis of the individual loans. They prepare and issue quarterly statements for investors about the performance of the RMBS
As part of its review, the rating agency will consider the quality and history of the key players in the structure such as the originator, service providers, counterparties, as well as the underlying structures of the cash flow waterfall, and liquidity provisions.