Welcome to my presentation on mortgage backed securities
Let’s get started. This is going to be part of a whole new series of presentations because I think what’s happening right now in the credit markets is pretty significant from a personal finance point of view and from a historic point of view and I want to do a whole set of videos just so people understand how everything fits together and what the possible repercussions could be. But, we have to start with the basics.
So, what is a mortgage backed security?
You probably have already read a lot about these. Historically what happens when I went to get a loan for a house, let’s say 20 years ago. I need a $1 million loan to buy a house. This is going to be a mortgage that is going to be backed by my house. When I say backed by my house or secured by my house, that means that I’m going to borrow $1 million and from a bank and if I can’t pay back the loan, then the bank gets my house. That’s all it means. And often times it will only be secured by the house, which means I can just give them back the keys, they get the house and I have no other responsibility. But of course, my credit gets messed up.
But I need a million dollar loan
The traditional way I got a million dollar loan is; I would go and talk to the bank. They would give me $1 million and I would pay them some type of interest. Let’s say I would pay them 10% interest. And for the sake of simplicity, I’m going to assume that the loans in this presentation are interest only loans. In a traditional mortgage, your payment actually has some part interest and some part principal. Principal is actually when you are paying down the loan. The math is a little more difficult with that. So, what we are going to do is in this case, is assume that I only pay the interest portion and at the end of the loan, I pay the whole loan amount.
Let’s say that this is a 10 year loan. So for each year of the 10 years, I am going to pay $100,000 in interest, and then in year 10, I am going to pay the $100,000 and I am also going to pay back the $1 million.
So if we think about it from year 1, 2, 3..... 10. Year one I pay $100, 000, year two I pay $100,000, year three I pay $100,000.....year nine I pay $100,000 and then in year 10 I pay the $100,000 plus I pay back the million dollars. So I pay back $1.1 million.
That is kind of how the cash is going to be transferred between me and the bank. The important thing to realize is that the bank would have kept the loan. These payments I would have been making would have been directly to the bank. And that is what the business that the banks were historically in.
Another person, you, let’s say you are extremely wealthy and you would put $1 million dollars into the bank, your life savings or you inherited it from your uncle and the bank would pay you 5% and take that $1 million and give it to me at 10% on what I just borrowed, and then bank makes the difference. We can go later into how they can pull this off and what happens when you have to withdraw the money, etc. But the important thing to realize is that these payments I make are to the bank. That’s how loans worked before the mortgage backed security industry really got developed.
Now, let’s do the example with a mortgage backed security
There is still me, and I still need $1 million. Let’s say I go to the bank, the bank is still there, and like before, the bank gives me $1 million and I give the bank 10% per year. So it looks very similar to our old model, but in the old model, the bank would keep these payments itself and the $1 million that it had is now used to pay for my house. Then there was an innovation. Instead of having to get more deposits to keep giving out loans, the bank said, well, why don’t I sell these loans to a third party and let them do something with it. And I know that might sound a little confusing; how do you sell a loan? Well, let’s say there is me, and there is a thousand of me, and we each are borrowing money from the bank. There is a thousand of me, and collectively we have borrowed a thousand times a million. So we have collectively borrowed $1 billion dollars from the bank and we are collectively paying 10% on that. Because each of us are going to pay 10% per year, we are each going to pay 10% on that billion dollars. 10% on that billion dollars is $100 million interest. So, this 10% equals $100 million.
Now the bank says, ok, the $1 billion dollars that I had in my vault, there is no physical money, but in my data base, is now out in people’s pockets, I want to get more money, so what the bank does, it that it takes all these loans together, that billion dollars in loans, and says hey, investment bank, why don’t you give me $1 billion. So the investment bank gives them $1 billion and instead of me, and the other thousand of me paying the money to this bank, we are now paying it to this new party.
What just happened?
This bank sold the loans; they grouped all of the loans together and sold it on a wholesale basis, and sold a thousand loans to this bank. This bank paid a billion dollars for the right to get the interest and principal payments on those loans. So all that happened, is this guy got the cash and the bank will now get the set of payments. So, you might wonder why did this bank do it. Well, I kind of glazed over the details, but he probably got a whole lot of fees for doing this, or maybe he just likes giving loans to his customers, but the actual right answer is that he got fees for doing this and he is actually probably going to transfer a little bit less value to this guy.
Now, hopefully you understand the notion of actually transferring the loan. This guy pays money and then the payments are essentially going to be funnelled to him. The next presentation I am going to focus on what this guy can now do with the loan to turn it into a mortgage backed security. This guy is an investment back instead of a commercial bank and that detail is not that important in understanding what a mortgage backed security is, but that will have to wait until the next presentation.
See you soon.
