Residential Mortgage-Backed Security (RMBS)
Candlefocus EditorInvestors can use RMBS to increase profits, diversify their portfolio and decrease risk associated with investing in just one single mortgage. When investing in an RMBS, the investor can spread their risk across many mortgages and can even take advantage of different interest rates. The investment is more secure since a foreclosure of one property only affects a portion of the investment.
However, RMBS can also be a source of systemic risk in the economy if structured improperly. The issuance of many RMBS during the run-up to the 2008 financial crisis was one of the major contributory factors to the crisis. Many of these mortgages contained incentives for buyers or lenders to purchase or extend risky mortgages due to their high coupon rate, which contributed to a bubble in the housing market. In addition, many of these securities contained clauses that enabled buyers to make profits even if the mortgages defaulted, thus increasing the incentives to buy risky mortgages.
To prevent similar occurrences in the future, more stringent regulations were put in place, such as the Dodd-Frank Wall Street Reform and Consumer Protection Act. The Act introduced a variety of reforms that are designed to reduce systemic risk associated with RMBS and other financial instruments. For example, it requires lenders to keep skin in the game to reduce incentives to contain riskier mortgages. The Act also introduced more stringent capital requirements and limitations on mortgage products.
Overall, RMBS can be a great investment for investors as long as they are structured properly and borrowers are evaluated under rigorous standards. However, if these securities are misused, they can create great systemic risk and negatively impact the economy. Investors and outgoing borrowers should be aware of the potential dangers associated with this kind of investment and should consult a financial professional before investing in a RMBS.