Mortgage Putback

What is a residential mortgage-backed security and mortgage putback?

A residential mortgage-backed security, or RMBS, is a type of asset backed security (ABS).  In the case of an RMBS, the “asset” is a mortgage loan.  This type of security is sometimes referred to as a “collateralized mortgage obligation”[1] orCMO. As with whole loans, theRMBS investor’s return is tied to the cash flow generated by the mortgage payment.  If the mortgage borrower defaults, the security holder has some recourse for recovering their investment through the value of the mortgage loan collateral (the borrower’s home via foreclosure).

To create a basic RMBS, mortgages are conveyed into a trust.  Within the trust multiple mortgages are grouped together to form a pool, from which securities are issued.  The performance of these securities will be linked to the collective performance of all mortgages in the pool from which the securities are issued.

It is common for the basic RMBSdescribed above to be further subdivided into risk classes, or “tranches.”    In this case the cash flow from a pool of mortgages is divided into tiers, ranging from most senior to most junior,[2] and different securities are issued from each tier.  This is analogous to the “waterfall” by which profits in a limited partnership are distributed when senior and junior classes of partners are involved. In a mortgage securitization, the tiers are referred to as “tranches”. When the cash flow of the pool is interrupted due to defaults, securities issued from senior tranches receive their due portion of the cash flow before junior tranches.  Senior tranches are therefore safer, lower-yield investments.

What is the purpose of securitizing mortgages?

From the investor’s viewpoint, securitizing mortgages spreads risk.  Because investors own an interest in a pool of loans, rather than a single whole loan, they are less affected when a single borrower defaults.  Securitization provides further opportunity for risk minimization through the tranches: risk adverse investors can select securities issued from the senior tranches.

Mortgage-backed securities also provide greater than liquidity than whole loan ownership, allowing investors to divest the securities in the event their portfolio needs or risk analyses change.

What are the problems associated with mortgage-backed securities?

Like any other security, mortgage-backed securities have an inherent level of risk.  However, families and individuals historically prioritize their housing costs.  In the face of financial trouble, people have continued to pay mortgage and rent obligations even as they defaulted on other obligations.[3]  Because of this behavior, securities backed by mortgages were, in the past, regarded as relatively safe investments.  Credit rating agencies bolstered this perception through their high ratings of these securities.

Originally many spectators viewed senior tranche mortgage-backed securities as virtually risk free – it was unthinkable that a pool of high rated residential mortgages would ever face a borrower delinquency rate so high as to impair the flow of funds to those securities.  However, in 2007, the unthinkable happened.  Record mortgage delinquency levels devastated entire security pools, and as the default rates climbed, so did the decimation of RMBSs- including senior tranches.

In retrospect, the vulnerability of RMBSs issued from 2004 to 2007 is easily explained.  The standards employed in underwriting the underlying mortgage loans were a severe departure from traditional residential mortgage underwriting standards, and led to vastly different performance results.  Unfortunately for investors, the credit rating agencies failed to recognize this in their evaluations of the securities, instead affording high ratings to securities tied to poorly underwritten mortgages.

In addition to the high default rates, housing values declined nationwide, which in many cases left the securities under collateralized.  Foreclosure moratoriums and modification programs imposed by state and local governments further diminished RMB liquidity.

You may be an investor looking for information about why your residential mortgage whole loan or securities portfolio is failing. You also need to know what remedies are available to you. You’ve come to the right place. To learn more about the mortgage industry crisis that has led many investors to seek mortgage putback remedies, please contact us. We’ll continue to bring you news on the industry and all things mortgage putback related, so visit us often.

[1] Collateralized mortgage obligations are also classified as collateral debt obligations, or CDOs.