What is an RMBS?

author-avatar By on April 30, 2020
What is an RMBS?

Photo by La-Rel Easter on Unsplash

Mortgage-backed securities, infamous for playing a part in triggering the 2007-08 global financial crisis, have a colourful reputation. You may heard of them through films like The Big Short and Inside Job. But what is a mortgage backed security? It’s a lot simpler than you think.

There's a lot of jargon out there, used by financial types who love to make things sound more complex than they are. You probably don't need to bother learning all of the jargon, but it helps, even if it sounds like you’re speaking Klingon.

It might not seem important, and in regular life, it probably isn’t. But just know there's strings being pulled in high finance that can affect what's going on at the consumer level, such as what you pay on your mortgage.

Buying a home or looking to refinance? The table below features home loans with some of the lowest variable interest rates on the market for owner occupiers.

Base criteria of: a $400,000 loan amount, variable, principal and interest (P&I) owner-occupied home loans with an LVR (loan-to-value) ratio of at least 80%. If products listed have an LVR <80%, they will be clearly identified in the product name along with the specific LVR. Monthly repayments were calculated based on the selected products’ advertised rates, applied to a $400,000 loan with a 30-year loan term.

What is an RMBS? A crash course

Residential mortgage-backed securities (RMBS) - or mortgage bonds - are essentially pools of home loans that investors put their money into for a steady return, either at a maturity date or at certain intervals.

There are other types of securities, such as asset-backed securities (ABS), that pool automobile and other machinery loans together, but for the sake of simplicity we’ll focus on residential mortgage-backed securities - ‘mortgage bonds’ for short.

The bonds have certain pools of home loans sorted by credit-worthiness and investors can put their money into these levels - called tranches. The injection of money gives the home loan originators more cash to play with, and to potentially offer lower interest rates for the borrower.

How do I know if a mortgage bond is safe?

If you were around for the global financial crisis (GFC), or even if you’ve just watched The Big Short, you might think mortgage bonds are pretty risky assets.

There’s always going to be some sort of risk involved - it is after all an investment product - but mortgage bonds are historically safer than other types of investments, but know that past performance is not an indicator of future performance.

Fun Fact: In Australia, no prime RMBS has ever caused an investor to lose money through default.

To assess mortgage bonds' relative safety, they are rated by the top credit agencies such as Fitch, Moody's, and Standard and Poor's (S&P) into categories such as AAA, AA+, AA, AA-, and so on (slight variations may occur between agencies). 

AAA is described as 'almost no risk of default' - anything below BBB- is rated 'non investment grade' or highly risky.

The higher the rating, the earlier your interest is paid but the lower your rate of return - for assuming more risk you get a higher interest rate, but you are paid last. Depending on the particulars of an RMBS issuance, if you invest in the BBB tranche, for example, and the AAA tranche starts defaulting, you’ve almost got no chance of being paid interest. That’s how RMBS are potentially risky.

For reference, below is a table from S&P and Moody’s on default rates up until 2008 of US corporate bonds i.e. how often the underlying investments - home loan borrowers - fail (in percentage terms).

You can see that there is a sharp uptick in default rates once you slip below investment grade.

Ratings

Moody’s - default rates

S&P - default rates

Aaa/AAA

0.52

0.60

Aa/AA

0.52

1.50

A/A

1.29

2.91

Baa/BBB

4.64

10.29

Ba/BB

19.12

29.93

B/B

43.34

53.72

Caa-C/CCC-C

69.18

69.19

Investment Grade Overall (i.e. BBB<)

2.09

4.14

Non-Invest Grade

31.37

42.35

All

9.70

12.98

Source: US Government Publishing Office, 110th Congress

How does the everyday person invest in mortgage bonds?

Here’s the thing - you can’t. Well, at least not directly. You can’t just go to Commonwealth Bank, for example, and say, “I’d like to invest in your A2 tranche of your ‘Generic Bond Name’ issuance please”.

You either need serious cash i.e. in the tens of millions to invest through a hedge fund, or you need to be an institution. There are very few options for the everyday punter, however there are a few indirect avenues:

  • Firstmac High Livez: High Livez is a managed fund that invests in prime RMBS from institutions such as Westpac, CommBank, BOQ and more. Investors can start with as little as $10,000.

  • Through your super: Depending on your super fund, of course, you may be investing in bonds. However, this is more likely to be bonds issued by the Treasury i.e. Government bonds.

  • Through investment funds: Investment funds like ETFs (exchange-traded funds) and LICs (listed investment companies) may contain RMBS in their portfolios, particularly ones with a big portion of fixed income assets. While there are many RMBS-focused ETFs in the US, there are very few, if any, in Australia. However there is at least one RMBS-focused LIC listed on the ASX, namely the Gryphon Capital Investment Trust (CGI).

We aren’t endorsing any one area of investment, and you should know that every investment comes with some form of risk. In the interests of full disclosure, Savings.com.au is part of the Firstmac Group.

Securitisation and the Global Financial Crisis

RMBS and other securities may carry a bit of a bad smell, a hangover from the global financial crisis, when they were one of the catalysts for big bank collapses in the US.

Investment banks such as Lehman Brothers, and Bear Stearns, were all heavily leveraged (had a lot of exposure) in the area.

The problem there was the credit ratings agencies were not doing their due diligence, and rated subprime pools of mortgages as investment-grade. 

This was due to pressure by investment banks, which paid big money for credit agencies to rate their bonds favourably.

The situation was made worse by investment banks deliberately pooling subprime loans into investment products, and calling them CDOs, or collateralised debt obligations.

CDOs were generally far riskier, yet somehow achieved higher ratings than they were worth.

  • The situation was made even worse, when the investment banks - which quickly learned of the failing mortgage market - hedged their bets with insurance companies by buying ‘credit default swaps’ or CDS. A CDS essentially puts the burden of the debt on the insurer, who in turn receives a premium.

  • A lot of insurance companies such as AIG thought they were swapping safe mortgage bonds, not junk bonds, so they saw the premiums as ‘free’ money. However, they soon assumed a lot of debt as the bonds started defaulting, which ultimately caused AIG to fail.

At the ground level, lenders' relatively loose and predatory lending criteria at the time also had a huge part to play.

  • For example, in the US it was common to sell fixed-rate mortgages to low-income borrowers that transitioned to adjustable-rate mortgages with sky-high interest rates two years later, called teaser rates.

  • Worse still, some products had ‘payment holiday’ periods at the start of the loan, say for two years, where a consumer didn’t have to pay anything but the interest rate was still accruing, essentially ‘kicking the can down the road’.

All of this may have gone unnoticed if homes continued to go up in value, but the glut of houses being built in the US between 2001 and 2006 - and the amount of risky borrowers lured into the market by teaser rates - made the situation a brewing storm. 

When homes lost value, and subprime borrowers defaulted on their mortgages and walked away from their homes thanks to non-recourse lending, the AAA securities investors thought they were piling into, were revealed to be BBB- or worse as the default rates climbed.

The mortgage bond market ended up imploding, causing investors to lose money and withdraw from the market.

Watch this clip from the 2015 film The Big Short for an explainer. WARNING: Not Safe For Work / Foul language.

What about mortgage bonds recently?

In March 2020, the Federal Government, through its debt management arm the Australian Office of Financial Management (AOFM), announced a $15 billion package to support smaller lenders and non-banks by investing in their mortgage bonds.

This was designed to generate cash for these lenders at a time when not many banks are trading with one another, due to the credit crunch caused by coronavirus. Westpac reported that in Q1 2020, only around $6.5 billion was placed in the public Australian securitisation market - a small amount considering that over the whole of 2019, more than $45 billion was issued. This credit freeze is why the AOFM is ramping up investments.

Generally, the AOFM is targeting relatively safe mortgage bonds, like it did in the past. However, this time it announced it will have a ‘warehouse facility’ arrangement, investing in other types of debt such as assets (cars, machinery etc), and small business lending. This basically opens the investments up to other types of securities with other ratings.

The Government previously had a similar arrangement in 2008 when the world was in the grips of the Global Financial Crisis. However, in those transactions, the Government only invested in AAA mortgage bonds. This was also a $15 billion deal, and was wound-down in 2013.

An illustration of what the Government is doing in 2020 is below (confusing, right?)

AOFM

Jargon and acronyms explained

Bust these out at the family barbecue and you’ll be much cooler than your cousins talking about lame cryptocurrencies, which are so 2017*.

  • AOFM - Australian Office of Financial Management: Part of the Federal Treasury, and manages the Government’s debt portfolio.
  • BBSW - Bank Bill Swap Rate: The interest rate at which banks decide to lend to each other, managed by the Australian Securities Exchange (ASX).
  • CDO - Collateralised Debt Obligation: Pools of subprime mortgage bonds and their tranches re-packaged as investment products.
  • CDS - Credit Default Swap: An insurance policy used to hedge risk on mortgage bonds. A derivative investment product offered by the big insurance corporations.
  • Non-Conforming: Tranches and bonds that carry lower-rated mortgage pools in them.
  • Prime: Mortgage bonds that carry credit ratings of BBB- or better. Subprime is anything below that.
  • RMBS: Residential Mortgage Backed Securities i.e. mortgage bonds.
  • Tranche: A ‘slice’ of a mortgage bond that investors can buy into e.g. the BBB tranche of a mortgage bond.

*You may be told to shut up by Uncle Herb and barred from any future gatherings.


Disclaimers

The entire market was not considered in selecting the above products. Rather, a cut-down portion of the market has been considered which includes retail products from at least the big four banks, the top 10 customer-owned institutions and Australia’s larger non-banks:

  • The big four banks are: ANZ, CBA, NAB and Westpac
  • The top 10 customer-owned Institutions are the ten largest mutual banks, credit unions and building societies in Australia, ranked by assets under management in November 2019. They are (in descending order): Credit Union Australia, Newcastle Permanent, Heritage Bank, Peoples’ Choice Credit Union, Teachers Mutual Bank, Greater Bank, IMB Bank, Beyond Bank, Bank Australia and P&N Bank.
  • The larger non-bank lenders are those who (in 2020) has more than $9 billion in Australian funded loans and advances. These groups are: Resimac, Pepper, Liberty and Firstmac.

Some providers' products may not be available in all states. To be considered, the product and rate must be clearly published on the product provider's web site.

In the interests of full disclosure, Savings.com.au, Performance Drive and Loans.com.au are part of the Firstmac Group. To read about how Savings.com.au manages potential conflicts of interest, along with how we get paid, please click through onto the web site links.

*The Comparison rate is based on a $150,000 loan over 25 years. Warning: this comparison rate is true only for this example and may not include all fees and charges. Different terms, fees or other loan amounts might result in a different comparison rate.

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author-avatar
Harrison joined Savings in 2020. He is a journalist with more than four years of experience, with previous stints at News Corp and financial comparison site Canstar. With a keen interest in personal finance, Harrison is passionate about helping consumers make more informed financial decisions.

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