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Mortgage-backed securities II

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

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  • blobby green style avatar for user gnmnkch
    Why would the IB buy the mortgages from the commercial bank for a slightly larger amount than what the commercial bank issued the loans for? Similarly, why would the investors buy the security for 1100 dollars when their share is worth 1000 dollars? Basically, how is it possible for each level to take a cut - why didn't the IB just issue loans in the first place cutting one middle man, or better yet why didn't the investors just lend the money in the first place cutting two middle men?
    (59 votes)
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    • blobby green style avatar for user Seán Casey
      If you look at the total value of the principle that would have been returned to the commercial bank at the end of the 10 year term, it is $1B. But the 10% interest over 10 years means the commercial bank would have actually received $2B (principle + interest) at the end of the term. The investment bank pays a little more than $1B to the commercial bank, allowing it to make a quick profit, but the future value of the assets is still $2B. Likewise, the special purpose entity set up by the investment bank is able to sell shares for $1100 (and pass on the risk) because at the end of 10 years, the shareholder expects have $2,000 (one-millionth of that $2B) if everything goes smoothly. So, the investment bank makes a quick $100M by selling all the assets to investors, but the shareholders will also make a profit eventually.
      (108 votes)
  • leaf green style avatar for user alanprusak
    Maybe a silly question but what does the original home buyer "see" during all these transactions? Do they keep receiving new payment books for each new "owner" of their home mortgage? Thanks
    (19 votes)
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    • blobby green style avatar for user dgrotts
      I believe they don't generally see anything. The original bank will usually continue to service the loan (they charge the special purpose entity a fee for this). Neither the investment bank nor the special purpose entity have the infrastructure for servicing loans.
      (17 votes)
  • blobby green style avatar for user lakshyakalra123
    so the only reason why an investment bank transfers the responsibility (or for that matter even the typical bank ) to another entity is to make a quick buck. If the typical bank was to follow the normal scheme of things ( i.e not sell the rights of the loan to a IB), then over the course of 10 yrs it would have made more money. But this way , even though it makes less money , it does so in just one yr and now has more money to loan out. i realize this is not really a question , i just wanted to know if my reasoning was right ?
    (5 votes)
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  • leaf green style avatar for user ll.kishan.ll
    Just to clarify, with this example will everyone who bought one share of the mortgage backed security for $1100 receive $2200 total at the end of 10 years? (assuming that nobody defaults).
    (2 votes)
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  • blobby green style avatar for user jingyong.aod
    Dear Sal, why did the investment banks use Special Purpose Entities rather than create a division within itself? Are there some legal implications, e.g. transferring liabilities, to the S.P.E. away from the investment bank? Thanks!
    (4 votes)
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  • blobby green style avatar for user Paul Mooney
    At in the video the special purpose entity that has claims to $1B sells those claims for an aggregate of > $1B. How does that happen?
    (2 votes)
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  • piceratops ultimate style avatar for user Jimmy Chung
    why are special purpose entities required?

    Once all the loans have been re payed with interest, what happens to the SPEs? Do the investment banks get rid of them?
    (3 votes)
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  • blobby green style avatar for user Azian Madun
    If the bank is getting 10% from the customer, then the issuer of the mortgage -backed securities cannot pay more than 10% to its investors; otherwise how can the issuer get the money from. Essentially the interest on the asset-backed securities cannot be higher than the interest paid by the bank's customer. Am I wrong?
    (2 votes)
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    • ohnoes default style avatar for user Tejas
      The investors get everything that the customers pay, other than a small fee that the bank charges for servicing the loan. If the bank gets 10% from the customers, then the investors get 10% from the bank. The issuer gets no money beyond the fees for servicing the loan, unless the issuer is one of those investors.
      (2 votes)
  • blobby green style avatar for user psawant
    As an investor, why would i pay 1100 bucks for a 1000 buck stock. Based on the information you provided, it does not look like it will worth more in the future.
    (1 vote)
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    • blobby green style avatar for user mrcyriac
      Simpler explanation: You are not paying $1100 for a $1000 stock. You are expecting to get ten interest payment installments of $100 each and also the principal of $1000 at the end. So you are paying $1100 in the hopes of getting $2000 (in ten years), assuming that the borrower fulfills his/her end of the mortgage agreement. If the borrower is not able to repay the mortgage, then bad things happen.
      (2 votes)
  • aqualine ultimate style avatar for user suryas545
    then what is the difference between mbs and factoring
    (1 vote)
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    • piceratops seed style avatar for user andypfunk
      Factoring is when a company sells its accounts receivables (i.e. money they are owed) in order to get their cash more quickly. This is not how mortgage backed securities work. Mortgage-backed securities earn interest over a long period of time, accounts receivables do not.
      (2 votes)

Video transcript

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. Right? 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 corporation. So now everyone is going to, essentially-- all their mortgage payments are going to be funnelled into this entity. Right? And this is a corporation. And so what the bank will do is issue shares in this corporation. 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. Right? 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. Anyway. 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.