Welcome back to my series of presentations on Mortgage Backed Securities. Let’s review what we have already gone over.
We started with borrowers that need to buy houses. Each of them borrowed $1 million and there were 1,000 of them. So 1 million times $1,000 is $1 billion they needed and they said that they would pay 10% per year on that money that they borrowed so that’s 10% for each of them is $100,000. As we said, there are 1,000 borrowers so they are going to put in $100 million. $100,000 times 1000 is $100 million. So just to simplify, keep it in your mind, $1billion goes to 1,000 borrowers and each year those borrowers are going to give the special purpose entity, a corporation designed to structure these mortgage backed securities, they are going to give 10% of the billion, or $100 million back into this. And then we said, where does that money for that special purpose entity for this corporation come from? Well, it comes from the investors in the actual mortgage backed securities.
The money came from when the owners of each of these mortgage backed securities, each let’s say paid $1,000 for the mortgage backed securities and in return they are going to get 10% on their money. So, each security costs $1,000 and they are going to get $100 back per month. And we said there are 1million of these securities. $1,000 times 1 million, that’s where the billion dollars comes from that is essentially lent to the borrowers.
Now, one thing I want you to keep in mind is that they get 10% only if every one of these borrowers pays their loans, never defaults, never prepays, prepaying a mortgage is just saying I sold a house, I’m done with the mortgage so I just pay it off. So it is only 10% indefinitely if all the borrowers pay all the money and never default or anything like that. So this 10% is kind of in an ideal world. Everyone knows it is not going to be exactly 10%. Some percent of these borrowers are going to default on their mortgages, some are going to pay ahead of time. That’s what the buyer of the mortgage backed security should try to figure out. And all sorts of buyers are going to have all sorts of different assumptions, and this is what you have probably read some articles about. These hedge funds use computer models to value their mortgage backed securities. They try to look at historical data and figure out, in a given population pool and in a given part of the country, what percentage of them are able to pay off their mortgage, what percentage are of them default on their mortgage and when they default what is the recovery. If they default on a $1 million mortgage and then the special entity would get control of that house and then if that house is sold for $500,000 because the property value went down, then the recovery would be 50%.
That’s all of the things that someone needs to factor in when what will be the real return. 10% is if everyone pays. But let’s make some very simple assumptions for ourselves. Let’s say that we are interested in investing in a mortgage backed security and we want to gauge for ourselves what we think the return is going to be. Let’s say we know that this pool of borrowers that 20% will default, (we’re not going to worry about prepayment rates at all) and then on those 20% that default (of these 1000 borrowers, 200 of them are going to lose their job or they can’t afford a mortgage any more) and of those 20% that default, we have a 50% recovery. That means, borrower X defaulted on his loan and then when we go and get the property because the loan is secured by the property and we auction off the property, we only got $500,000 for it. So we get a 50% recovery. 50% of the original value of the loan. If 20% default and then there is a 50% recovery, then on average you are going to get 10% of the loan is worthless. And I am going to make some sort of hand waving assumptions there, but you can assume statistically, that since this is a large number of borrowers, 1,000, if there is only one borrower it would be hard to gauge when he would default, if he defaults at all, we just have the 20% chance, but when there is a large number of borrowers, you can do the math and say, on average 200 of these guys are going to default and instead of actually getting 10%, I am going to get 10% less of this 10%. So, I am going to get 9%.
This is based on the model we just constructed. This is a much simpler model than what most people use, but based on the model that we just constructed, I think the real return we are going to get on this mortgage backed security is 9%. If there was another investor that was deemed a 50% default rate but with a high recovery, he or she would have a different expected return from this security.
Why is this even useful? Before in the case when someone just borrows from the bank, the bank has very specific lending requirements, they have their own model, so there`s a whole class of borrowers that they might not have been able to service. There might be people with really good credit scores, really good incomes who don`t have a down payment. If they don`t meet what the banks requirements are, they will never get a loan. But there are probably some investors out there that would say, for the right interest rate and the for the right assumptions in my model I am willing to give anybody a loan as long as I am compensated for it. And this is what the mortgage backed security market allows. This group of borrowers don`t have the traditional 25% down and they don`t have the traditional requirements to get a mortgage, but if I pool a bunch of people together who don`t have those traditional requirements but they are good in other ways, they have a high credit score or a high income, I can go through this alternate mechanism to find investors that are willing to loan them money. So essentially, from the borrower’s point of view, it allows more access to loan funding than they would have otherwise not been able to do. And from an investor point of view, it allows another place for me to invest in.
Maybe I feel that the computer models that I have are really good at predicting things like default rates and recovery rates and what a loan is worth. And I feel that I can in some way be a better loan officer than the bank. This would be an attractive place for me to invest in. It might also have a risk reward characteristic that doesn`t exist in the market already and it allows you to diversify to one other asset class.
That is the value across the entire spectrum. Now, on the next presentation, I am going to show how you can further complicate this even more so that you can open up the investment to even a larger pool of investors. Because you can think about it right now, there are probably some people who will try to do these models and make their own assumptions and say this is going to give me 9% a year, but then there are a whole bunch of people who are going to say this is too complicated for me, this seems risky, I don`t have any fancy models, I only like to invest in things that I know I will get my money. Very highly rated debt is where I am going to invest my money. And then there is another group of people who say 9% is nice and everything, but I am a gambler, 9% isn`t the type of returns I want. I want to take more risk and more return. And then there should be something for those people as well.
So that is what we are going to show you in the presentation on collateralized debt obligations.
See you soon.
