Residential mortgage-backed security

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." Because banks and other mortgage originators could sell their mortgages in an RMBS, they used the proceeds to make new mortgage loans. Because these bonds had the full faith and backing of the United States government, they received high credit ratings and "paid an interest rate that was only slightly higher than Treasury bonds." Following the success of Ginnie Mae's offerings, the other two government-sponsored housing agencies, Fannie Mae and Freddie Mac,{{cite book == Development of private-label MBSs==

. (source: Final Report of the National Commission on the Causes of the Financial and Economic Crisis in the United States, p.69 figure 5.1) In the late 1970s, a team from Salomon Brothers worked with Bank of America to create the first residential-mortgage backed security that wasn't government-guaranteed. Alyssa Katz, in her 2009 book on the recent history of the American real estate market, writes that SMMEA called on bond-rating agencies — at the time, Moody’s and Standard & Poor’s — to weigh in on each mortgage pool. As long as a bond got one of the top ratings from the agencies — meaning that in the agencies’ opinions, investors ought to be confident of getting paid — it could be sold. While the Securities and Exchange Commission would oversee the trading of these securities just as it did all investments for sale, no longer would the U.S. government exclusively manage the market in mortgage-backed securities, as it had through Ginnie Mae. “We believe that the ratings services do offer substantial investor protection,” Ranieri testified before Congress in early 1984. It created the market for the private label MBS that did not exist when Ranieri was first developing them in 1977. File:RMBS.gif|thumb|450px|source: Final Report of the National Commission on the Causes of the Financial and Economic Crisis in the United States, p.73, figure 5.3 According to David Maxwell of Fannie Mae, the developers of "private-label" mortgage-backed securities did not seek to — or at least end up — undercutting and replacing the Fannie and Freddie's "agency" MBSs. They wanted "to find products they could profit from where they didn't have to compete with Fannie." Tranches The MBSs of the "government-sponsored enterprise", Fannie and Freddie were considered to be "the equivalent of AAA-rated bonds" because of their high standards and suggestions of guarantee by the US government. While private-label subprime mortgages would never be able to make that claim, by "slicing" the pooled mortgages into "tranches", each having a different priority in the stream of monthly or quarterly principal and interest stream, the top buckets/tranches (in theory) had considerable creditworthiness and could earn the highest credit ratings, making them salable to money market and pension funds that would not otherwise deal with subprime mortgage securities. File:RMBS selected investors.GIF|thumb|400px|source: Final Report of the National Commission on the Causes of the Financial and Economic Crisis in the United States, p. 116 figure 7.2 The first private label deals in the late 1980s and early 1990 often had only two tranches, but by 2005–06 the deals became more complex. The more "junior" the tranche, the higher its risk and the higher its interest rate in compensation. ==Growth, innovation, corruption==

Residential mortgage-backed securities and similar sounding products would continue to expand and become more complex throughout the 1980s. For example, in 1983 Freddie Mac marketed the first collateralized mortgage obligation (CMO) The private mortgage securitization market continued to grow. In 2004 the "commercial banks, thrifts, and investment banks caught up with Fannie Mae and Freddie Mac in securitizing home loans", and by 2005 they overtook them. Private MBS grew primarily by lowering their standards and securitizing more low-quality, high-risk mortgages such as Alt-A, and subprime mortgages. GSEs also relaxed their standards in response, but GSE standards generally remained higher than private market standards, and GSE securitizations generally continued to perform well compared to the rest of the market. ==Market collapse==

The very rapid growth in low-quality mortgages, financed through securitization, is widely believed to be one of the major causes of the Great Recession and the subprime mortgage crisis. The private RMBS market largely collapsed after 2008 and has been replaced by government-backed securitization characterized by much tighter underwriting and higher standards. == See also ==