If you're seeing this message, it means we're having trouble loading external resources on our website.

If you're behind a web filter, please make sure that the domains *.kastatic.org and *.kasandbox.org are unblocked.

Main content
Current time:0:00Total duration:7:56

Video transcript

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 and in the credit markets is pretty significant from I guess about 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 is 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 read a lot about these so historically let's think about what happens when I 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 but let's say I need well we would my pin go let's say I need a hundred thousand dollars now let me say 1 million dollars because that's actually closer to how much how is this cost now let's say I need 1 million dollar loan to buy a house right this is going to be a mortgage that it'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 a million dollars from a bank and if I can't pay back the loan then the bank gets my house that's all it means that um 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 million dollar loans the traditional way I got a million dollar loan is you know I would go and talk to the bank this is the bank and they have the money and then they would give me 1 million dollars and I would pay them some type of interest probably let's just say I'll make up a number I mean the interest rates obviously change and we'll do future future presentations on what causes the interest rates to change but let's say I would pay them 10 percent 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 principle principle 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 and case is assumed 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 let's say it's 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 year 10 I'm going to pay the hundred thousand and I'm also going to pay back the $1,000,000 right so if we think about it from you know let me just year 1 2 3 deaded 9 10 so in year 1 I pay a hundred thousand year two I pay a hundred thousand your 3f a hundred thousand that is it a year nine I pay a hundred thousand and then your 10 I pay the hundred thousand plus I pay back the million dollars 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 say traditional loan because this isn't a traditional an interest-only loan but for the sake of this presentation I want to how it's different than a mortgage-backed security the important thing to realize is that 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 you know another person you and you have a you have a hat you would let's say you're extremely wealthy and you would put a million dollars into the bank right that's just your life savings where you inherited it from your uncle and the bank would pay you I don't know 5% the bank would pay you 5% and then take that million dollars give it to me and get 10% on on what I just borrowed and then the bank makes a difference right it's paying you 5% and then it's getting 10% from me and we can go later into you know how they can pull this off like what happens when you have to withdraw the money etc etc but the important thing to realize is that the these these payments I make are two of 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 a million dollars instead of going to the bank where actually let me let's say I still go to the bank let's say I go to the bank the bank is still there the bank is still there and like before the bank gives me a million dollars and then I give the bank ten percent per year right so it looks very similar to our old model but in the old model the bank would keep would keep these payments itself and that million dollars that it had is now used to pay for my house then there was a 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 sound alone well let's say there's me and let's say there's a thousand of me right there's a bunch of Sal's in the world right and we each are borrowing money from the bank so let's so there's a thousand of me right I'm just saying any kind of large number doesn't have to be a thousand right and collectively we have borrowed a thousand times a million so we've collectively borrowed 1 billion dollars 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 we're going to pay 10% on that billion dollars right so 10% on that billion dollars is 100 million dollars in interest so this 10% equals 100 million now the bank says okay I just all the dollar one billion dollars that I had in my vaults or whatever and you know I guess now there's no physical money but in my database this 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 billion dollars in loans and says hey investment bank so that's another bank why don't you give me a billion dollars so the investment bank gives them a billion dollars and then instead of me and the other thousands of me the money to to this Bank its we're now paying it to this new this new party right making my picture very confusing so what just happened when this bank sold the loans they grouped all the loans together and it sold it in a big kind of it did it on a wholesale basis it sold a thousand loans to this Bank so this Bank paid a billion dollars for the right to get the interest and principle 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 did 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 they actually had right answers 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 funneled 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 is an investment bank instead of a commercial bank and that's import well that details not that important in understanding the mortgage-backed security is but that will have to wait until the next presentation see you soon