Mortgage-backed securities II Part II of the introduction to mortgage-backed securities
Mortgage-backed securities II
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- Welcome back.
- So where we left off is, there was 1,000 people who all
- needed, let's say, $1 million loans each.
- And they were all going to pay 10% on their loans.
- And they borrowed it from this bank.
- It's kind of a standard commercial bank.
- And this bank says, well you know, I just handed out $1
- billion and I'm 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'm going to sell these loans.
- I'm going to bundle them all together and sell them to this
- investment bank.
- And now what is this investment bank going to do
- with these loans?
- And why is it doing it?
- So let me delete this.
- So we had the investment bank.
- I randomly picked the color green, but I think it is
- appropriate for the investment bank.
- So now I have all of the, you know, me-- that's a little
- smiley face.
- There's 1,000 of me, and we are now going to pay the 10%.
- We're now going to make all of our mortgage payments, the 10%
- payment, to this bank, this investment bank.
- But the investment bank, they're not in the business of
- servicing loans or keeping loans on their balance sheets.
- So what they do is, they create a corporation.
- They create an entity, maybe a special purpose entity,
- whatever you want to call it.
- So they create a company.
- Let me make that in purple, another color.
- So they created this company.
- And what they do is, they will take their rights to these
- payments that they got.
- They paid $1 billion to that first bank in order to get the
- payments from all of these people.
- And they say, you know what?
- The rights on those payments-- that's the asset.
- They bought all these loans.
- The rights on those payments, we are now going to transfer
- to this special purpose entity, to this other
- So now everyone is going to, essentially-- all their
- mortgage payments are going to be funnelled into this entity.
- And this is a corporation.
- And so what the bank will do is issue shares in this
- So let's say that it issues, let's sat for simplicity, a
- hundred shares.
- So what's in this corporation?
- The entire corporation gets the mortgage payments on the
- $1 billion in loans, right?
- It has $1 billion of loans outstanding.
- And it is going to get 10% a year.
- So it's going to get $100 million per year right?
- Because it's a thousand loans out there.
- It's going to get $100 million per year for 10 years.
- And at the end of the 10 years it's also going to get $1
- billion, right?
- That's its asset it has.
- Its asset is the rights on those payments streams that
- are going to come into this corporation.
- And it has 100 shares.
- The way I think about is you can split
- this company 100 ways.
- And I'm doing this to further confuse you.
- So what is each of those-- the owner of each of those shares,
- what does it entitle them to?
- Well, it entitles me to 1/100 of what this corporation gets.
- So if I have a share-- let's make it look like a share, a
- stock certificate-- I'm going to get 1/100 of this thing.
- And normally you wouldn't have 100 shares.
- You would have, let's say, a million shares.
- Actually let me make it a million shares, just because I
- think that's, in some strange way, more realistic.
- So let's say there are a million shares.
- So if there are 1 million shares, each share will get 1
- millionth of the cash flow stream that's
- entitled to this entity.
- So instead of getting $100 million every year, it gets
- one millionth of that.
- So it gets $100 per year.
- And then on the last year, instead of getting $1 billion
- it gets $1000.
- So what the bank will do is it'll take these shares and
- then it'll sell it to the general public.
- It'll IPO it, essentially.
- You can think of it that way.
- And tons of people will buy it, especially hedge funds,
- and pension funds, and mutual funds, and bond investors.
- And it's important to think about how the money's flowing.
- So now when they sell these shares in this entity, people
- are going to give them, well, hopefully more than what they
- paid for it, right?
- Maybe there's a lot of demand for this type of asset, where
- I get this type of income stream.
- So maybe once they sell all the shares, they get, I don't
- know, they get $1.1 billion for them, right?
- So this is the investors.
- And the investors collectively buy these
- shares for $1.1 billion.
- Essentially, let's say they paid $1.1 billion for a
- million shares, so they paid $1,100 per share.
- Each of the investors paid $1,100 for each of these
- shares, so that $1.1 billion goes into this
- special purpose entity.
- And if you think about it, the bank made out
- like a bandit, right?
- Because the bank paid $1 billion for the rights to
- these mortgage payments, and it's getting $1.1 billion from
- the investors.
- And all the bank has to do is kind of set this whole legal
- structure up and service the loans.
- It actually doesn't even have to service the loans.
- We'll go into that later.
- So let me summarize, I guess.
- Just because I know this can be a little bit
- of a daunting subject.
- Let me summarize.
- And this purple I don't like.
- So you have tons of investors.
- So, each of these is an investor.
- Actually a mortgage, a borrower.
- All of these people need to buy houses.
- These are all smiley faces.
- They all need to buy houses.
- And then they collectively get $1 billion.
- Right? $1 million each.
- And they each use that $1 million to buy their house.
- And then that $1 billion initially came from just their
- local bank.
- And when the $1 billion came from that local bank, all the
- payments, the interest payments, went to the bank.
- But then an investment bank came along and said, well no,
- I want to buy the rights to those payments.
- And an investment bank came along and says, well, I'm
- 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.
- Let's say it sells a million shares.
- And let's say it was able to sell each of those shares for
- $1,100 from the investing public.
- So it raises $1.1 billion, right?
- So the value of this company is $1.1 billion that now goes
- to the bank.
- And now the payment stream instead of going to-- let me
- do a different color-- now the payment stream goes to this
- special purpose entity instead of the bank.
- And the bank essentially made out like a bandit because it
- paid $1 billion and it got $1.1 so it made $100 million
- just for doing this transaction.
- I'm not saying that's how much a bank actually would make,
- but this shows you why every person is kind of, what
- they're doing in this value chain.
- And as I said before, this bank also probably did
- something similar.
- They probably took some fees or sold the loans for slightly
- more than they issued the loans for.
- So these shares-- each of these one million shares--
- this is a mortgage-backed security.
- And it makes sense.
- It's a security.
- A security is an ownership that's tradable in a company.
- And that company has the right to payments that are secured
- by mortgages.
- So if all these people promised they would pay, and
- they're going to pay to this special purpose entity.
- But if, by chance, one of these people lose their jobs
- or they can't pay, or for whatever reason, instead of
- the payments, this entity is going to have the rights to
- their property.
- And that's why we say that it's a
- mortgage-backed security.
- So it's not just a promise to get money.
- The money is actually backed by people's mortgages.
- And of course, then this entity is going to, if this
- guy defaults on his loan-- he's one of a million, so
- statistically you might be able to predict that.
- I don't to put too much stock in these statistical models--
- then this entity will just have that property auctioned
- off or sold.
- And the cash flow will come back to it.
- So 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 on why
- these things even exist, and why they're useful, and why
- people may benefit or may not benefit from these things.
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