Mortgage-backed securities I Part I of the introduction to mortgage-backed securities
Mortgage-backed securities I
- Welcome to my presentation on mortgage-backed securities.
- Let's get started.
- And 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, I guess, a
- personal finance point of view and just from a
- historic point of view.
- And I want to do a whole set of videos just so people
- understand, I guess, 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've probably read a lot about these.
- So historically, let's think about what historically
- happens when I went to get a loan for a house, let's say,
- 20 years ago.
- And I'm going to simplify some things.
- And later we can do a more nuanced.
- Where'd my pen go?
- Let's say I need $100,000.
- No, let me say $1 million, because that's actually closer
- to how much houses cost now.
- Let's say I need a $1 million loan to buy a house, right?
- This is going to be a mortgage that's going to be
- backed by my house.
- And when I say backed by my house, or secured by my house,
- that means that I'm going to borrow $1 million from a bank,
- and if I can't pay back the loan, then the
- bank gets my house.
- That's all it means.
- And oftentimes it'll only be secured by the house, which
- means that I could 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 $1 million loan.
- The traditional way I got a $1 million loan is I would go and
- talk to the bank.
- This is the bank.
- They have the money.
- And then they would give me $1 million and I would pay them
- some type of interest. I'll make up a number.
- The interest rates obviously change, and we'll do future
- presentations on what causes the interest rates to change.
- But 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, you actually, your payment has
- some part interest and some part principal.
- Principal is actually when you're paying down the loan.
- The math is a little bit more difficult with that, so what
- we're going to do 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.
- So let's say that this is a 10-year loan.
- So for each year of the 10 years, I'm going to pay
- $100,000 in interest. $100,000 per year, right?
- And then in year 10, I'm going to pay the $100,000 and I'm
- also going to pay back the $1 million.
- Year 1, 2, 3, dot, dot, dot, dot, 9, 10.
- So in year one, I pay $100,000.
- Year two, I pay $100,000.
- Year three, I pay $100,000.
- Dot, dot, dot, dot.
- Year nine, I pay $100,000.
- And then year 10, I pay the $100,000 plus I pay back the
- $1 million.
- So I pay back $1.1 million.
- So that's kind of how the cash is going to be transferred
- between me and the bank.
- And this is how a-- I don't want to say a traditional
- loan, because this isn't a traditional loan, an
- interest-only loan-- but for the sake of this presentation,
- how it's different than a mortgage-backed security, 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's what the business that,
- historically, banks were in.
- Another person, you-- and you have a hat-- let's say you're
- extremely wealthy and you would put $1
- million into the bank.
- That's just your life savings or you inherited
- it from your uncle.
- And the bank would pay you, I don't know, 5%.
- And then take that $1 million, give it to me, and get 10% on
- what I just borrowed.
- And then the bank makes the difference, right?
- It's paying you 5% percent and then it's getting 10% from me.
- And we can go later into how they can pull this off, like
- what happens when you have to withdraw the money,
- et cetera, et cetera.
- 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.
- Now there's still me.
- I still exist. And I still need $1 million.
- Let's say I still go to the bank.
- Let's say I go to the bank.
- The bank is still there.
- And like before, the bank gives me $1 million.
- And then 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 that $1 million it had is now used to pay for my house.
- Then there was an innovation.
- Instead of having to get more deposits in order 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 that might be a little confusing.
- How do you sell a loan?
- Well let's say there's me.
- And let's say there's a thousand of me.
- There's a bunch of Sals in the world.
- And we each are borrowing money from the bank.
- So there's a thousand of me.
- I'm just saying any kind of large number.
- It doesn't have to be a thousand.
- And collectively we have borrowed a
- thousand times a million.
- So we've collectively borrowed $1 billion from the bank.
- And we are collectively paying 10% on that, right?
- Because each of us are going to pay 10% per year, so we're
- each going to pay 10% on that $1 billion.
- So 10% on that $1 billion is $100 million in interest. So
- this 10% equals $100 million.
- Now the bank says, OK, all the $1 billion that I had in my
- vaults, or whatever-- I guess now there's no physical money,
- but in my databases-- is now out in people's pockets.
- I want to get more money.
- So what the bank does is it takes all these loans
- together, that $1 billion in loans, and it says, hey,
- investment bank-- so that's another bank-- why don't you
- give me $1 billion?
- So the investment bank gives them $1 billion.
- And then instead of me and the other thousands of me paying
- the money to this bank, we're now paying it to this new
- party, right?
- I'm making my picture very confusing.
- So what just happened?
- When this bank sold the loans-- grouped all of the
- loans together and it folded it into a big, kind of did it
- on a wholesale basis-- it's sold a thousand
- loans to this bank.
- So this bank paid $1 billion for the right to get the
- interest and principal payment on those loans.
- So all that happened is, this guy got the cash and then this
- 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
- lot of fees for doing this, or maybe he just likes giving
- loans to his customers, whatever.
- But the actual right answer is that he got
- fees for doing this.
- And he's 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 now the payments are essentially
- going to be funnelled to him.
- I only have two minutes left in this presentation, so in
- the next presentation I'm going to focus on what this
- guy can now do with the loan to turn it into a
- mortgage-backed security.
- And this guy's an investment bank instead of
- a commercial bank.
- 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.
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