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Mortgage-backed securities I

Part I of the introduction to mortgage-backed securities. Created by Sal Khan.

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  • hopper cool style avatar for user albi
    Why is it necessary to have an investment bank in the "value" chain. Wouldn't it be possible for the bank that provided the loan in the beginning to create the SPI directly? Is there a difference in the legal setup of "normal banks" as compared to investment banks that prevents them from setting up the SPI? at
    (19 votes)
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    • leaf grey style avatar for user Shlomo Fingerer
      Investment banks are retailers. Yes Coca Cola could stop selling to Wal Mart & go directly to you, but why bother? Investment banks try to buy securities, from banks or from companies wishing to go public, at wholesale prices. They then sell them to individuals. Think Wal Mart.
      (31 votes)
  • blobby green style avatar for user Diego Armando Romero
    So your house ends up costing $2,100,000? If you are paying 100K per year and at the end you pay 1.1M..
    (6 votes)
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  • blobby green style avatar for user Lenny
    Please, I REALLY need this clarified. What does he mean at when he says at year ten you pay back the million dollars? I'm assuming / hoping he means in total. Surely you're not expected to pay back a lump some of 1 million on year ten??
    (5 votes)
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    • aqualine ultimate style avatar for user Abdulaziz.Saja
      Well he did state that this is an interest only loan, for simplicity. In real life, most mortgages payments would include a portion of the principal so you (the borrower) don't have to pay back a lump sum at maturity. You would have actually reduced the outstanding principal amount along with paying the interest on that.

      However, should you opt for an interest only mortgage, then you only service the interest for the life of the loan and thus not reduce the outstanding principal amount ($1 million) and are expected in year 10 to pay back that principal in full along with the last interest payment ($100,000 calculated at 10% of the principal amount).
      (9 votes)
  • leaf grey style avatar for user Shlomo Fingerer
    I wonder if part of the reason why banks have stopped giving real interest on deposits,is because they don't need it? In the past they needed my money to make loans. Now they don't really give the loans, they are just servicers.
    (7 votes)
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  • leaf green style avatar for user T.J. Kyner
    How does the bank that gave out the loans originally make money if they sell the loans to the investment bank for the same amount they gave out? I know Sal said that they may make some money from fees and stuff but I have a feeling that it would be less than the 10% from the loans. Why wouldn't the bank just keep the loans and make more money off of the interest?
    (5 votes)
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    • blobby green style avatar for user abhayshankar0000
      1. They get a fee for selling these mortgages to Investment Banks
      2. This frees up the capital which was earlier tied to the collateral i.e. homes. With $1B that they get from Investment Bank, they can further extend loans and earn a fee by selling these to the investment banks.
      3. This also reduces, rather eliminates their exposure to the risk of any default by the homeowners
      (3 votes)
  • piceratops ultimate style avatar for user Dicky Wira Senjaya
    at he asked "Why the first bank sell to the investment bank?" the answer is because the first bank will get a lot of fees, right?
    My question is, who give the first bank that fees? from the investment bank?
    (3 votes)
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    • male robot hal style avatar for user Andrew M
      The bank often gets fees from the borrower at the time the loan is made. On top of that, the bank sells the loans on to the investment bank at a higher price than what the bank lent out. That's the banks compensation for "originating" the loan.
      (5 votes)
  • duskpin ultimate style avatar for user Fred12
    I dont understand, lets say my house cost 100.000 $ , can I loan 1 million from the bank or is the house not security enough for the bank?
    and after I cant pay back the credit, my house gets lost but I have spend the 1 million $ into some other bussiness lets say in thailand or anywhere where the bank does not get aware of the 1 million $... would that be possible? I would have made 900.000 $ win ;P
    (1 vote)
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    • duskpin ultimate style avatar for user Jan Stefan
      A smart bank will not loan $1,000,000 with a $100,000 house as security. If they did, then they might not get there money back. Usually they would require you to put in $25,000(down payment) of your own money and only loan $75000. They would also want you to have a job that pays enough to make the payments. Then they know you will work hard to pay off the loan so you do not lose the $25,000 of your own money that you put into the house.
      That kind of sanity can go out the window when the government guarantees the loan so the bank can't lose or. if they plan to sell their side of the loan quick, they may not care if you can afford the loan for more than the first few months,
      (6 votes)
  • blobby green style avatar for user Thuyen Ringel
    Can you clarify why the commercial bank who first lend you money sell the loans packages to investment bank? What were the fees? How dis it work in making commercial bank giving away the big loans ? At
    (1 vote)
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    • piceratops seed style avatar for user andypfunk
      When you purchased your house you paid origination fees for one (remember all those closing costs when you bought your house and got a mortgage?). The commercial bank also can make money by acting as your loan servicer, they make money just by collecting your mortgage payment each month in the form of servicing fees.
      If the bank held all the loans they originate on their own books they would at some point run out of deposits to loan out. Back in the day this was the problem for people that lived in rural places, their local bank just didn't have the deposits to originate a lot of loans so they charged higher prices.
      When your commercial bank sells your loan to an investment bank they've just freed up their capital to go out and make more loans, collect those origination fees, and hopefully retain the rights to act as your mortgage servicer.
      (2 votes)
  • male robot hal style avatar for user Enn
    Do mortgage based securities still exist after the financial crisis ?
    (1 vote)
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  • leaf green style avatar for user Aleksander L. Rasch
    Is there a reason why Sal is using the Interest-Only model of mortgage payments for these videos? Isn't that one of the rarer models used?
    (1 vote)
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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 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. Right? 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. Right? 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. Right? 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. Right? There's a bunch of Sals in the world. Right? And we each are borrowing money from the bank. So there's a thousand of me. Right? 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. Right? 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.