Plus, some of the main reasons investors purchase RMBS
What are residential mortgage-backed securities?
Residential mortgage-backed securities, otherwise known as RMBS, allow wholesale investors to select the risk-and-return they want, with the securities offering a yield premium greater than similarly rated corporate bonds. More complex than vanilla corporate bonds, residential mortgage-backed securities are securitised bonds with a tranched capital structure, meaning that, compared to equivalently rated bonds, the investor earns a high yield.
Residential mortgage-backed securities can also be viewed as a dedicated pool of residential mortgages, or mortgage collateral pool, that secure a collection of interrelated bonds. To pay the interest and principal on those interrelated bonds, mortgagors pay the interest and principal on the underlying mortgage collateral.
Essentially, residential mortgage-backed securities have been an alternate way for banks to make deposits to fund residential mortgages. This is of particular importance for non-authorized deposit-taking institutions, or non-ADIs, that have less access to term funding markets or deposit funding, or for smaller authorized deposit-taking institutions, otherwise called ADIs. Ultimately, residential mortgage-backed securities encourage competition among lenders in the residential mortgage market by allowing smaller institutions to raise money in the capital markets.
Does Australia have mortgage-backed securities?
Yes. However, Australian residential mortgage-backed securities being issued to third-party investors dropped off after the global financial crisis when the securities were negatively impacted by lost confidence in the asset class worldwide, regardless of the lower level of mortgage defaults in Australia comparatively. Prior to that global financial crisis, residential mortgage-backed securities were rising consistently in Australia in the early 2000. Over the past few years, they’ve witnessed something of a revival.
The RMBS market and the liquidity it provides allow mortgage originators access to a big pool of funding to support ongoing lending to residential property borrowers. Because of this, the Australian Prudential Regulation Authority and the Reserve Bank of Australia, and the federal government understand the importance of the residential mortgage-backed securities market.
Cutting that source of funding would have an adverse affect on property prices in Australia, which could cause a chain reaction that would negatively impact the Australian economy.
Given the low level of yields in the RMBS market generally, there is currently a good relative value in residential mortgage-backed securities in Australia. In determining this value, assessing the structure of the transaction and every individual pool of mortgages is critical.
What is the purpose of mortgage-backed securities?
The purpose of residential mortgage-backed securities is to act as a residential property loan extended to borrowers and secured by an underlying property, such as land, a house, or a unit. These are the underlying assets that support a residential mortgage-backed security transaction and generate the necessary cash flow.
The benefit of constructing a residential mortgage-backed security is that it provides more profitability and less risk to the investors. Additionally, RMBS also provide the opportunity to issue entities to raise more cash for reserves, meaning they can create additional loans. Doing so will create more investing capital accessible to entrepreneurs and business owners. Typically, life insurance companies are the largest single category of residential mortgage-backed securities investors, which is a good indication of RMBS’s benefits and efficiencies. Life insurance companies benefit from efficiently investing large amounts of money in high-interest rate investments.
Why do investors buy mortgage-backed securities?
Investors buy residential mortgage-backed securities to have input into how the RMBS is constructed and so they can be specifically tailored to fit other investor preferences for risk, time of cash flows, or to offset liability. Because of their relatively long lives and their cashflow characteristics, RMBS are utilized by insurance companies and other financial institutions. RMBS can also offset long-term liabilities accrued by insurance companies.
On the other hand, investing in residential mortgage-backed securities might expose investors to credit risk and prepayment risk, meaning the risk a mortgage holder takes that they will repay the mortgage prior to the maturity date, reducing the interest the investor would otherwise earn.
In this context, prepayment is in excess of the scheduled principal payment, a situation that could happen if the market interest rate drops below the mortgage interest rate. In that instance, homebuyers are more likely to refinance the mortgage. When borrowers stop making payments on their mortgage, credit risks for residential mortgage-backed securities can arise.
