Residential mortgage-backed security

Residential mortgage-backed securities (RMBS) are a type of bond commonly issued in American security markets. They are a type of mortgage-backed security which are backed by mortgages on residential rather than commercial real estate.

Origins

The origins of modern residential mortgage-backed securities can be traced back to the Government National Mortgage Association (Ginnie Mae), although variations on mortgage securitization existed in the U.S. in the late 1800s and early 1900s. In 1968, Ginnie Mae was the first to issue a new type of government-backed bond, known as the residential mortgage-backed security. This bond took a number of home loans, pooled the monthly principal and interest payments and then used the monthly cash flows as backing for the bond(s). The principal of these mortgages was guaranteed by Ginnie Mae, but not the risk that borrowers pay off the principal balance early or opt to refinance the loan, a set of possible future outcomes known as "prepayment risk." Selling pools of mortgages in this way allowed Ginnie Mae to acquire new funds with which to buy additional home loans from mortgage brokers which furthered the agency's Congressionally mandated mission to "expand affordable housing".

Because these bonds had the full faith and backing of the United States government, they received high credit ratings and "paid an interest rate that was only slightly higher than Treasury bonds." Following the success of Ginnie Mae's offerings, the other two government-sponsored housing agencies, Fannie Mae and Freddie Mac, began offering their own versions of RMBS. The government's guarantee of the mortgage loans assured investors that if the borrower defaulted, they would be repaid in full. But in return for that guarantee, borrowers were held to strict underwriting standards. For example, with Fannie Mae, homebuyers had to make a minimum down payment of 10 percent of the home value, and the buyer's income had to be well documented and preferably from a periodic salary.

Expanding the concept

In the late 1970s, a team from Salomon Brothers worked with Bank of America to create the first residential-mortgage backed security that wasn't government-guaranteed. A Salomon Brothers' bond-trader by the name of Lewis Ranieri was instrumental in this effort. He coined the term "securitizing" during this period after joining the project in 1977. Ranieri's ambition was to revolutionize the mortgage market, which at this time was heavily dependent on the government sponsored housing insurance institutions (Ginnie Mae, Fannie Mae and Freddie Mac). His plan was to discover a way to make the mortgage market a fully private affair., and to bring that goal to a reality, his team wished to create a security product "that could be bought and sold among investors". The idea was to allow private banks to issue loans and then sell those loans to willing investors looking for a steady stream of income, freeing up capital with which the bank could then issue additional loans. Despite working on the project for three years, the bonds the Salomon team developed were a commercial failure due to various state regulations and federal securities laws dating back to the Great Depression

To fix this problem, Ranieri helped create and defend before Congress the Secondary Mortgage Market Enhancement Act of 1984 (SMMEA). Alyssa Katz, in her 2009 book on the recent history of the American real estate market, wrote the following about Ranieri and SMMEA:

[SMMEA] called on bond-rating agencies -— at the time, Moody’s and Standard & Poor’s -— to weigh in on each mortgage pool. As long as a bond got one of the top ratings from the agencies —- meaning that in the agencies’ opinions, investors ought to be confident of getting paid -— it could be sold. While the Securities and Exchange Commission would oversee the trading of these securities just as it did all investments for sale, no longer would the U.S. government exclusively manage the market in mortgage-backed securities, as it had through Ginnie Mae. “We believe that the ratings services do offer substantial investor protection,” Ranieri testified before Congress in early 1984.

This law opened up the door to allow "federally-charted financial institutions, including credit unions," the ability to "invest in mortgage-related securities subject only to limitations that the appropriate regulating board might impose." Loosening these restrictions created the private market for these products that did not exist when Ranieri was first developing them in 1977.

Continued growth and lower standards

The private mortgage securitization market continued to grow, and by 2004, had overtaken government/GSE mortgage backed securities issuance. Private MBS grew primarily by lowering their standards and securitizing more low quality, high risk mortgages such as Alt-A, and subprime mortgages. Scholars have argued that this relaxation of standards was due to greater competition between securitizers for loans, and greater market power for loan originators. GSEs also relaxed their standards in response, but GSE standards remained higher than private market standards, and GSE securitizations continued to perform well compared to the rest of the market.

Market collapse

The rapid growth in low quality mortgages, financed through securitization, is widely believed to be a major cause of the late 2000s financial crisis, also known as the Subprime mortgage crisis. The private RMBS market largely collapsed after 2008 and has been replaced by government-backed securitization characterized by much tighter underwriting and higher standards.

Continuing evolution

Residential mortgage backed securities and similar sounding products would continue to expand throughout the 1980s. For example, in 1983 Freddie Mac marketed the first collateralized mortgage obligation (CMO)

Ranieri also had a hand in developing the concept of "tranches", which were used to put a spin on a typical RMBS. With tranches, a pool of mortgages would be divided into different layers of varying risk. "Senior" tranches were the safest part of the investment, and the purchasers of these slices would be paid back in full before the next lower tranche, called "mezzanine", would see any return. Likewise, "mezzanine" would be paid in full before the lowest level, or "junior," tranche received any payments. Such an investment organization allowed for the sophisticated investor to earn higher returns if he/she bought the "junior" or "mezzanine" tranches, as they carried higher interest rates to compensate for the added risk of incurring loss.

Eventually structured finance would explode with the development of the collateralized debt obligation, or CDO in 1987 and even further inventions, like the CDO squared. CDOs were originally used to pool many different RMBSs (which were themselves pools of residential mortgages) and then divide them up into tranches and sell them off to investors. The end result of these financial innovations was a secondary mortgage market existing outside of the government sponsored entities that provided a massive growth opportunity for Wall Street banks. According to former International Monetary Fund chief economist Simon Johnson, the "total volume of private mortgage-backed securities (excluding those issued by Ginnie Mae, Fannie Mae and Freddie Mac) grew from $11 billion in 1984 to over $200 billion in 1994 to close to $3 trillion in 2007."

See also

• Bonds
• Mortgage loan (section The United States mortgage finance industry)
• Subprime mortgage crisis
• Fixed income securities

External links

• Summary of Secondary Mortgage Market Enhancement Act of 1984