Welcome back.
Where we left off is there were a thousand people who all needed $1 million dollars each and they were all going to pay 10% on their loans. They borrowed it from this bank; a standard commercial bank. And this bank just handed out a billion dollars and I am getting these interest payments, and my vaults are empty, I want to have money back in my vaults or I want to have money back on my balance sheet, so I am going to sell these loans, I am going to bundle them all together, and sell them to this investment bank.
Now, what is this investment bank going to do with these loans?
We had the investment bank, and now we have me and a thousand me’s and we are now going to make all of our mortgage payments, the 10% payment to this investment bank. But the investment bank is not in the business of servicing loans or keeping loans on their balance sheet, so what they do, they create a corporation; they create a special purpose entity.
They create a company and what they do is, they will take this billion dollars and take the rights to these payments they got. They paid a billion dollars to the first bank in order to get the payments from all of these people. And they say the rights on those payments, that’s the asset, and they are now going to transfer to this other corporation. So now, everyone is going to essentially send there money, and all their mortgage payments are going to be funneled into this entity. And this is a corporation so what the bank will do is issue shares in this corporation. Let’s say it issues, for simplicity, 100 shares. The entire corporation gets the mortgage payments on the billion dollars in loans. It has $1 billion dollars in loans outstanding; it’s going to get 10% a year, so it’s going to get $100 million per year for 10 years and at the end of the 10 years it is also going to get $1 billion.
That’s its asset is has. Its asset is the rights on those payments streams that are going to come into this corporation. And then it has 100 shares, but what does that entitle the owner of each of those shares to? Well, it entitles me to 100th of what this corporation gets. If I have a share, I’m going to get 100th of this thing. And normally you wouldn’t have 100 shares; you would have a million shares. Actually let me make it a million shares cause I think in some strange way, it is more realistic. If there are 1 million shares, each share will get 1 millionth of the cash flow stream that is titled to this entity.
Instead of getting a $100 million dollars every year, it gets 1 millionth of that, so it gets $100 per year, and then on the last year, instead of getting a billion dollars, it gets $1,000 so what the bank will do is, it will take these shares and then it will sell it to the general public. It will IPO it essentially. You can think of it that way. Tons of people will buy it especially hedge funds, pension funds, mutual funds, and bond investors.
Now when they sell these shares at this entity, people are going to give them, hopefully more than what they paid for it. Maybe there is a lot of demand for this type of asset where I get this type of an income stream. Maybe once they sell all the shares, they get $1.1 billion for them.
The investors collectively buy these shares for $1.1 billion, essentially they paid $1.1 million for 1 million shares; they paid $1,100 per share. Each of the investors paid $1,100 for each of the shares, so that $1.1billion goes into this special purpose entity, and if you think about it, the bank made out like a bandit, because the bank paid $1billion for the rights to these mortgage payments and it’s getting $1.1billion from the investors. All the bank has to do is set this whole legal structure up and service the loans. Actually it doesn’t even have to service the loans; we will go into that later.
All of these people need to buy houses, and they collectively get $1 million each and they each use that $1 million to buy their house. Originally, that $1 billion came from their local bank, and when that $1 billion came from that local bank, all the mortgage, the payments, the interest payments went to bank.
Then an investment bank came along said I want to buy the rights to those payments, I am going to give you $1 billion and now instead of you getting the payments, I get the payments and then the bank sets up a special purpose entity, essentially it sells a bunch of shares, it sells a million shares, and let’s say, was able to sell each of those shares for $1,100 from the investing public. So it raises $1.1 billion. The value of this company is $1.1 billion and now the payment stream goes to the special purpose entity instead of the bank. And the bank did well because it paid $1billion and it got $1.1 billion so it made $100 million just for doing t his transaction. I am not saying that’s how much a bank will actually would make, but this shows you what every person is doing in this value chain.
Also, as I said before, this bank probably took some fees, or sold the loans for slightly more than issued the loans for.
Each of these 1 million shares, this is a mortgage backed security. And it makes sense. It is a security, a security is an ownership that is tradable by a company and that company has the right to payments that are secured by mortgages. If all these people promised that they would pay, and they are going to pay to this special purpose entity, but if by chance one of these people lose their job or they can’t pay for whatever reason, instead of the payments, this entity is going to have the rights to their property. And that’s why we say it is a mortgage backed security. It’s not just a promise to get money, the money is actually backed by peoples mortgages.
That’s what a mortgage backed security is. Hopefully I didn’t confuse you too much. My next presentation I’m going to take it to a further level of confusion and show you what a collateralized debt obligation is and then I’ll do a more philosophical video why these things even exist and why they are useful.
