The Basics Of Residential Mortgage Securities
Residential mortgages are divided into three distinct markets.  Nearly three quarters of U.S. home loans have been packaged into residential mortgage-backed securities (RMBS)-bonds whose coupon and principal payments are funded by the underlying mortgage loan payments.  Most of the nation's housing debt has been bought by one of the three large government sponsored enterprises (GSEs)-Fannie Mae, Freddie Mac or Ginnie Mae-bundled into pools and resold as agency RMBS, which carry a government guarantee. Mortgages not qualified for purchase by one of the agencies may have been similarly packaged and sold in the securities market by banks and other mortgage lenders as non-agency RMBS.  Financial institutions own most of the remaining quarter of the market as non-securitized whole loans that can be bought and sold individually.

Agency RMBS.  Given the government guarantee, there is no question that agency RMBS principal will be repaid, but the timing of that repayment depends on when borrowers pay off their mortgages (primarily by selling their homes or refinancing.)  That timing-the "prepayment speed" in mortgage jargon-is a key driver of returns, particularly for bonds bought at a premium or discount to par.

Non-Agency RMBS.  Non-agency bonds carry no government guarantee but pay higher yields than their agency counterparts to compensate for the additional risk.  In addition, non-agency investors can choose to be somewhat insulated from loss of principal because non-agency RMBS are structured like corporate debt. The most junior bonds suffer losses before those that are senior.  The senior securities are further protected by being first in line to receive principal payments made on the underlying mortgages and liquidation proceeds from defaults. 

Whole Loans.  By purchasing individual mortgages rather than bonds, whole loan buyers step into the shoes of the mortgage lender and servicer.  Whole loan strategies are more operationally intensive than bond investing because they require holders to service loans.  Loan servicing-the business of collecting payments, working with delinquent borrowers, managing foreclosures and other related services-is expensive, more so when loans become troubled.  Whole loan investment managers frequently cite superior servicing capability as a competitive advantage and a meaningful barrier to entry.  Unlike agency RMBS investors, holders of whole loans do not benefit from government guarantees, nor can they rely on junior bondholders to absorb losses. But they do enjoy far more control and an informational advantage. 


Todd Gorelick is managing partner and Ben Brostoff is an analyst at Gorelick Brothers Capital LLC, an investment management firm specializing in alternative investments and residential mortgage strategies. Partners Rael Gorelick and Christopher Skardon and portfolio manager David Piho contributed to this article.

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