Residential mortgage-backed securities (RMBS) are securities backed by residential mortgages. In the US, such securities are often categorized into (a) agency RMBS, those issued either by a federal government agency (such as Ginnie Mae) or a government-sponsored enterprise such as Finnie Mae and Freddie Mac), and (b) non-agency RMBS, those issued by a private issuer.

The securities issued by any federal agency carry the full faith and credit of the government while those issued by government-sponsored enterprises do not.

Agency RMBS differs from non-agency RMBS in the following ways:

  • The credit risk of GSE-sponsored RMBS is reduced by the guarantee provided by the GSE itself against insurance while in the case of non-agency RMBS, it is reduced by credit enhancements.
  • Securitized assets in GSE-sponsored RMBS must be a conforming mortgage, i.e. it must meet certain criteria regarding maximum loan amount, documentation requirements, maximum LTV ratio, and whether insurance is required.

Mortgage pass-through securities

A mortgage pass-through security is created when mortgages are pooled and used as collateral to issue participation certificates. They pay monthly cash flows to investors which equals the interest and principal repayments/prepayments of the underlying mortgages minus the servicing and administrative costs fees.

The interest rate on a mortgage pass-through security is called the pass-through rate which is less than the weighted average coupon (WAC) rate by the factor of servicing and administrative fee.

The WAC is calculated by multiplying each individual mortgage rate with the ratio of the outstanding principal balance of that mortgage rate to the sum of principal balances of all mortgages. The weighted average maturity (WAM) is calculated using the same approach and it represents the weighted-average life of the mortgage pass-through security.

Collateralized mortgage obligations

A collateralized mortgage obligation is a security backed by a mortgage pass-through securities and structured such that different tranches have different exposure to prepayment risk.

CMOs do not eliminate prepayment risk but distribute them among different tranches so that they are better fitted to the risk and return requirements of different investors.

There are different types of CMOs:

Sequential-pay CMOs

A CMO in which different tranches are created such that they have a descending claim on any principal repayments received. For example, if a CMO contains three tranches, A, B, and C with A being the first claimant on principal repayment, any principal payments (repayments plus prepayments) shall be used to pay off tranche A, then tranche B and only then tranche C. This guards tranche A from extension risk and tranche B and C from contraction risk. A has a shorter weighted average life than the average life of the collateral and C has a longer weighted average life.

CMO structures with PAC and support tranches

A CMO in which there are one or more planned amortization class (PAC) tranche and one or more support tranche. The prepayment rate of the PAC is kept within a range stipulation initially called the initial PAC collar. Any prepayment in excess of the upper range of the PAC is absorbed by the support tranche and any shortfall in case of actual prepayment less than the lower PAC is bridged by the support tranche. Under this structure, the PAC structure is protected to some extent against both contraction risk and extension risk. However, if support tranche is already paid off, no protection is available to the PAC tranche.

The average life of the PAC tranche remains constant if prepayment is within the band required by the PAC, but it changes if prepayment rates are too slow or too fast.

Other structures

Some CMOs are structured such that the tranches pay a floating rate. Even if the collateral pays a fixed rate, it is possible to create floating tranches by creating one as a floater and another as an inverse floater.

Non-agency residential mortgage-backed securities

Thrift institutions, commercial banks, and private conduits create non-agency RMBS by packing together non-conforming mortgages and using them as collateral to issue securities. Since they are not guaranteed by the government or government-sponsored enterprise, they have significant credit risk and internal or external credit enhancements are needed to secure a favorable credit rating and increase the marketability of the securities. Credit tranching (subordination) is the most popular form of credit enhancement, even though over-collateralization and reserve accounts also exist. Due to the peculiar characteristics of RMBS, prepayments and defaults may reduce credit enhancement available to senior tranches in which case the subordinated tranches are locked out for a while through the “shifting interest mechanism.”

In forecasting cash flows from non-agency RMBS, assumptions about the default rate and the recovery rate are important. This is because even if a borrower defaults, some proportion of the loan is recoverable through foreclosure.


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