Residential mortgage-backed security

A residential mortgage-backed security (RMBS) is a reference to the general package of financial agreements that typically represents cash yields that are paid to investors and that are supported by cash payments received from homeowners who pay interest and principal according to terms agreed to with their lenders; it is a funding instrument created by the "originator" or "sponsor" of the mortgage loan; without cross-collateralizing individual loans and mortgages (because it would be impossible to receive permission from individual homeowners), it is a funding instrument that pools the cash flow received from individuals and pays these cash receipts out with waterfall priorities that enable investors to become comfortable with the certainty of receipt of cash at any point in time.

There are multiple important differences between mortgage loans originated and serviced by banks and kept on the books of the bank and a mortgage loan that has been securitized as part of an RMBS. Chief among these is the result that the principal who interacts with the borrower, and drives the decision making of the "Servicer" who is newly introduced into the relationship, no longer has an obligation towards the responsibilities associated with the public trust and banking charter that traditionally controlled the loan relationships between banks and their customers. Unless a loan is reconstituted onto the balance sheet of an original lender, the retail-to-consumer relationship between the borrower and his bank is changed to a relationship that is between the original customer and a sophisticated accredited investor for whom the bank Servicer acts as a front.

An RMBS is often confusingly referred to as a "bond-like" financial investment as a RMBS can be portrayed to have similar characteristics, including a "principal investment" and a "yield"; the "principal investment," however, does not represent the purchase of an individual promissory note issued by a homeowner, but rather represents the payment of "principal" for the right to receive cash flow from an investment agreement that involves many other understandings. Likewise, the "yield" is only the calculation of an imputed interest yield that stems from the receipt of the cashflows. The RMBS market represents the largest source of funding of residential mortgage loans to US homeowners (see below).

The performance of these securities has generally been considered more predictable than commercial mortgage-backed securities, because of the large number of individual and geographically diversified loans that exist within any individual RMBS pool. There are many different types of RMBS, including mortgage pass-throughs, collateralized mortgage obligations (CMOs), and collateralized debt obligations (CDOs).

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 banks and other mortgage originators could sell their mortgages in an RMBS, they used the proceeds to make new mortgage loans.

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