Residential mortgage-backed security
Encyclopedia
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
.
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.
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 burdensome 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:
(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 together 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."
Bond (finance)
In finance, a bond is a debt security, in which the authorized issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay interest to use and/or to repay the principal at a later date, termed maturity...
commonly issued in American
United States
The United States of America is a federal constitutional republic comprising fifty states and a federal district...
security markets. They are a type of mortgage-backed security
Mortgage-backed security
A mortgage-backed security is an asset-backed security that represents a claim on the cash flows from mortgage loans through a process known as securitization.-Securitization:...
which are backed by mortgages on residential rather than commercial real estate
Real estate
In general use, esp. North American, 'real estate' is taken to mean "Property consisting of land and the buildings on it, along with its natural resources such as crops, minerals, or water; immovable property of this nature; an interest vested in this; an item of real property; buildings or...
.
Origins
The origins of residential mortgage-backed securities can be traced back to the Government National Mortgage Association (Ginnie Mae). 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 together the monthly principal and interest payments and then used the monthly cash flowsCash flow
Cash flow is the movement of money into or out of a business, project, or financial product. It is usually measured during a specified, finite period of time. Measurement of cash flow can be used for calculating other parameters that give information on a company's value and situation.Cash flow...
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 BrothersSalomon Brothers
Salomon Brothers was a bulge bracket, Wall Street investment bank. Founded in 1910 by three brothers along with a clerk named Ben Levy, it remained a partnership until the early 1980s, when it was acquired by the commodity trading firm Phibro Corporation and then became Salomon Inc. Eventually...
worked with Bank of America
Bank of America
Bank of America Corporation, an American multinational banking and financial services corporation, is the second largest bank holding company in the United States by assets, and the fourth largest bank in the U.S. by market capitalization. The bank is headquartered in Charlotte, North Carolina...
to create the first residential-mortgage backed security that wasn't government-guaranteed.A Salomon Brothers' bond-trader by the name of Lewis Ranieri
Lewis Ranieri
Lewis S. Ranieri is a former bond trader and former vice chairman of Salomon Brothers. He is considered the "godfather" of mortgage finance for his role in pioneering securitization and mortgage-backed securities...
was instrumental in this effort.
He coined the term "securitizing
Securitization
Securitization is the financial practice of pooling various types of contractual debt such as residential mortgages, commercial mortgages, auto loans or credit card debt obligations and selling said consolidated debt as bonds, pass-through securities, or Collateralized mortgage obligation , to...
" 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 burdensome state regulations and federal securities laws dating back to the Great Depression
Great Depression
The Great Depression was a severe worldwide economic depression in the decade preceding World War II. The timing of the Great Depression varied across nations, but in most countries it started in about 1929 and lasted until the late 1930s or early 1940s...
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.
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 obligationCollateralized mortgage obligation
A collateralized mortgage obligation is a type of financial debt vehicle that was first created in 1983 by the investment banks Salomon Brothers and First Boston for U.S. mortgage lender Freddie Mac. A collateralized mortgage obligation (CMO) is a type of financial debt vehicle that was first...
(CMO)
Ranieri also had a hand in developing the concept of "tranches
Tranche
In structured finance, a tranche is one of a number of related securities offered as part of the same transaction. The word tranche is French for slice, section, series, or portion, and is cognate to English trench . In the financial sense of the word, each bond is a different slice of the deal's...
", 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
Collateralized debt obligation
Collateralized debt obligations are a type of structured asset-backed security with multiple "tranches" that are issued by special purpose entities and collateralized by debt obligations including bonds and loans. Each tranche offers a varying degree of risk and return so as to meet investor demand...
, or CDO in 1987 and even further inventions, like the CDO squared. CDOs were originally used to pool together 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
International Monetary Fund
The International Monetary Fund is an organization of 187 countries, working to foster global monetary cooperation, secure financial stability, facilitate international trade, promote high employment and sustainable economic growth, and reduce poverty around the world...
chief economist Simon Johnson
Simon Johnson (economist)
Simon Johnson is a British American economist. He is the 'Ronald A. Kurtz Professor of Entrepreneurship at the MIT Sloan School of Management and a senior fellow at the Peterson Institute for International Economics. He has held a wide variety of academic and policy-related positions, including...
, 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
- BondsBond (finance)In finance, a bond is a debt security, in which the authorized issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay interest to use and/or to repay the principal at a later date, termed maturity...
- Mortgage loanMortgage loanA mortgage loan is a loan secured by real property through the use of a mortgage note which evidences the existence of the loan and the encumbrance of that realty through the granting of a mortgage which secures the loan...
(section The United States mortgage finance industry) - Subprime mortgage crisisSubprime mortgage crisisThe U.S. subprime mortgage crisis was one of the first indicators of the late-2000s financial crisis, characterized by a rise in subprime mortgage delinquencies and foreclosures, and the resulting decline of securities backed by said mortgages....
- Fixed income securities