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Residential mortgage backed security

In general, a mortgage is a loan, which is secured by underlying assets that can be repossessed in case of default. A residential mortgage backed security (RMBS) is a loan made to the owners of one or more family residential homes, and they are secured by underlying property, which includes land and structures built in the land. Residential mortgage backed security is financed through cash flows from a pool of mortgages instead of payment of fixed coupons and principal (Holton, 2011). After the loan is issued, it is serviced by collection of fee from the borrowers to investors. The servicer of the loan can interface with the borrowers if they become delinquent on their payment and take a position of managing disposition of the underlying asset if the loan goes into foreclosure (Fabozzi, et, al, 2011).

The loans are classified as either prime loans or subprime loans depending on the credit history of the borrower. Where the borrower has a good credit history with an income sufficient to service the loan with low rate of compromising their creditworthiness, they are classified as prime loans. On the other hand, loans of lower credit quality, with expectation to experience high rate of default rate, they are classified as subprime loans. There are various types of mortgage backed security. However, the simplest one is the mortgage pass-through where the interest is paid from a pool of mortgages to the investor each month. For example, twenty year residential Mortgage-backed security making fixed payments each month to its maturity. The monthly payments represent a partial payment of the principal and interest. As the principal declines overtime, the amount of interest also declines (Holton, 2011). 

 

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The payment of a pass-through fixed rate mortgage involves payment of a part of the principal as well as the accrued interest rate. As the principal declines the interest rate paid from the mortgage also declines. For example, from the diagram above, the interest paid in the first five years is high since the principal is also high. As the principle declines the interest rate paid from the mortgage also declines.

Residential mortgage backed security played an imperative role in 2007-2009 financial crises. Banks created and used residential mortgages backed security to solve the problem of mismatched maturities. The problem mismatched securities arose from the fact that banks used short term deposits to lend money used for long term loans and illiquid mortgages (Fabozzi, et al, 2011). Therefore, the mismatch arose since depositors could withdraw their funds any time. Residential mortgage backed security includes monthly payment of interest and part of the principal. The banks were able to predict the income flow from such mortgages statistically. In addition, the borrowers could pay someone else to service their loans and take management of the property on foreclosure of the loan default (Schwartz, n.d). Residential mortgage backed security was an important form of more liquid long term loan, which could solve the problem of mismatched security of long term borrowing and short term deposits.

Financial instruments have been recovering slowly after financial crises. However, through residential mortgage backed securities many homes have been bought and sold to investors. The government interventions through providing guarantees in the event of default have led to growth of the use of residential securities. However, the private package of the residential mortgage backed security does not conform to the standards of the government, hence making the housing market fragile. Uncertainty of the regulatory authority has been a major factor causing the fragility of the housing sector. The rates of mortgages have declined as a result of the government intervention to guarantee most of the investors. Residential mortgage backed security has encouraged securitization, which diversifies the risk by pulling different kinds of loans (Economist online, 2011). This has led to the decline of rate of the mortgage rates due to the reduced rates of defaults.

Interest Rate Swaps

An interest rate swap is a contract between two counterparties, where each party to the agreement agrees to pay a certain periodic payment to the other for a certain period of time based on the assumed principal. The principal is an assumption since there is no need to exchange identical actual currency. However, the notional principal is important, since the parties of the contract will be able to compute the exact amount of cash exchanged throughout the period. An interest rate swap is very liquid derivative and has been used in the money market for the purposes of hedging and speculating. In a bank, an interest rate swap is a contract between two counterparties to an underlying loan agreement, where parties may exchange fixed interest rate payment for a floating payment (FSA, 2012).

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 As the base rate rises, the floating interest payment increases and a customer can receive certain amounts, which he can use to offset any increase in the loan repayments. However, if the base rates decrease is resulting in the decrease of the floating rates payments, the customer will be required to make an additional payment to the bank but enjoy loan repayment (FSA, 2012). Interest rate swaps can also be used in speculation through hedging of funds to take advantage of the changes in the interest rates. Investors use a floating or a fixed interest rate swap, where a fall in the rates would result in the payment of low floating rates exchanging them for a fixed rate. Therefore, interest rates’ swaps are highly liquid and can be used by investors for the purpose of hedging and speculation of risks as investors seek to diversify their risks (Kennon, 2012).

Risk Definitions

Interest rate risk is the risk that would result in the change in the value of security as a result of variation in the rates of interest rates. It is the risk of loss due to variation of the interest rates. For example, as the interest rates rise the values of the bond decreases hence decreasing their prices. Understanding of the interest rates and associated risks are important, since it enables the investors to identify various methods, which they can use to diversify the resulting risks (Fabozzi, et, al, 2003).

Inflation risk is also called the purchasing power risk, and it represents variations of the real return that an investor realizes on adjusting them to the rate of inflation. For example, if an investors’ rate of return is 5%, the economy rate of inflation is 6%. The investor may have a positive rate of return in absolute terms but on adjusting the returns to the rate of inflation the investor incurs a loss of 1% on returns. This mostly affects securities with fixed rate of returns (Economy Watch, 2010).

Liquidity risks are risks that arise from inability of a business to turn investments into cash within a short period of time. Mismanagement of the liquidity risks by investor can lead to bankruptcy, even when such investors possess lots of assets and massive illiquid cash. It can lead to massive losses in the business enterprises, since when the business has an urgent need for cash it will have to mark down prices of assets to attract buyers. This may lead to the loss for the business enterprises (Kennon, 2012).

Credit risks are risks faced by investors as a result of the possibility of loss in case of the borrowers’ defaults. Credit risks are risks arising from the possibility of defaults of loans or non-compliance of the borrower to the terms of the loan agreement. Management of risks includes adjustment of rates of lending to the rates of defaults to reduce the possibility of loss for the investor (Coen, 1999).

Case Study of the Federal Long Term Interest Rates

The federal open market committee has made various attempts to reduce the long term interest rates as a way of stimulating lending to risky and risk free debts. For example, in December 2008 it lowered the federal refunds rate target range to 0 to 25 basis points. However, this was faced by challenge of the deteriorating economy owing to the financial crises. To address this challenge, the Federal Reserve made attempts of purchasing assets with medium and long term maturities to drive the rate of lending to the private sector. The large scale assets purchase (LSAP) increased the Federal Reserve’s balance sheet significantly as the government was adopting various measures of dealing with financial crises (Gagnon, et al, 2010). Federal open market committee in 2009 also decided to expand its purchases of securities related to the agency and long term treasury securities. In regard to that decision, assets worth more than $ 1.75 trillion were bought, which was twice the total long term assets and agency related securities purchased in 2008. According to FOMC, purchase of the agency related securities would support mortgage lending, hence development and growth of the housing market.

After the global financial crises the rate of recovery has been slow and many policy makers in different countries, such as central market, have been forced to adopt unconventional monetary policies. Quantitative easing has been one of the major unconventional methods that have been used by central bank in attempts to ease the financial crises. The US Federal Open Market Committee sets the target at which interbank lending can be done. When there is slowed growth and development of the economy, FOMC reduces the target to stimulate lending. The conventional monetary policies also advocate for buying of financial assets in exchange of federal reserves. Fed announced that it would buy debts of government sponsored enterprises (GSEs) i.e. Fannie Mae and Freddie Mac, as well mortgage based securities sponsored by government enterprises. The objective of these actions was to lower the cost of borrowing and ease the conditions of credit in the housing market. This has been pursued through the Large-Scale Asset Purchases. In addition, Fed announced the purchase of additional long term assets in 2010 and 2011 as part of the quantitative easing (Fawley, 2012).

Adoption of large scale asset plan would not lead to the short term changes of the interest rates but would affect the long term lending interest. Since the majority of the economists agree that medium and long term interest rates have a substantial impact in stimulating investment and consumption. They are influenced by three factors, which are the average expected overnight interest rates, risk premium and expected inflation. The conventional methods, which included quantitative easing, do not affect the future interest rates expressly, but make the short term market conditions worse; hence, the low, short term interest rate will last for a longer period. In addition, quantitative easing influences the risk premiums. For example, the federal reserve purchases all the 10 year bonds reducing or removing them from the bond market. Investors would require smaller premiums of holding the unavailable 10 year bond. These effects on the premium offered to the investors are referred to as portfolio balance (Fawley, 2012). Therefore, the approaches adopted by federal open market committee would facilitate reduction of the long term interest rate, hence stimulating the lending to the private sector.