how a residential mortgage backed security rmbs works
a residential mortgage backed security is constructed by a government agency such as the federal national mortgage association fannie mae and the federal home loan mortgage corporation freddie mac or a non agency investment banking firm these entities sell or control a large number of residential loans they package them together into a single pool of loans and essentially sell bonds backed by this pool of loans the payments on these loans flow through to the investors who bought into this pool and the interest rates they receive can be better than those offered by u s government backed bonds the issuing institutions keep a fee for the management of the pool and the risks of default on these mortgages are shared by both the issuing entities and the investors advantages and disadvantages of an rmbsan rmbs has the advantage of providing less risk and greater profitability to investors it allows the issuing entities to raise more cash for reserves against which they can make more loans rmbs investors include life insurance companies that benefit from an efficient way to invest billions of dollars in higher interest rate investments than government bonds while still taking acceptable risks an rmbs can contain various types of mortgages they may contain mortgages with fixed rates floating rates adjustable rates and mortgages of varying credit quality risks associated with rmbs include financial system stress that uniformly affects all investments within the pool that underlies the asset this risk was evident in the 2008 financial crisis rmbs investinginvesting in a residential mortgage backed security can expose the investor to prepayment risk and credit risk prepayment is when the mortgage holder pays back the mortgage before its maturity date reducing the interest the investor receives credit risk for rmbs investors arises when the borrower stops making payments on his mortgage residential mortgage backed securities are utilized by financial institutions like insurance companies to provide cash flow over an extended period buyers of residential mortgage backed securities often help determine how they are constructed so they can be uniquely tailored to offset a liability or to fit investor preferences for risk return and timing of cash flows 