Mortgage-backed securities III

welcome back to my series of presentations on mortgage-backed securities so let's let's review what we've already gone over so I've already drawn here I actually prepared ahead of time so I've already drawn here kind of what we've already talked about so we started with borrowers who need to buy houses each of them borrowed a million dollars so actually let me write that down let me change the color my pen where'd my pen go there you go ok so each of these people borrowed 1 million dollars 1 million oh that's too fat out pen wears a thinner pen ok each of them Bardem a million dollars and there were a thousand on them right so a million dollars times a thousand that's a billion dollars that they needed and then they said that they would pay 10% a year on that money that they borrowed so that's 10% for each of them is $100,000 and then as we said there's a thousand borrowers so they're going to put in 100 million dollars right a hundred thousand times 1000 is a hundred million so just to simplify keep it in your mind 1 billion dollars goes to a bunch of borrowers goes to a thousand bars to be specific and then each year those borrowers are going to give the Specht the special purpose entity this is just a corporation designed to to kind of structure these mortgages but these mortgage-backed securities they're going to give 10% of the billion or 100 million dollars back into this and then we said ok well where does that money for this special purpose entity or for this corporation comes from well it comes from the investors in the actual mortgage-backed securities so let's say that there's a and and it just will be clear so the asset within within this entity is the loans or are the loans amazing in their in my pen go so loans the loans are the main asset that's inside of the special purpose entity and the loans are just the right on these 10% payments and so the money came from when the owners of each of these mortgage-backed securities each let's say paid $1,000 for the mortgage-backed securities and in return they're going to get 10% on their money so each security costs $1,000 and then they're going to get $100 back per month and we said there are a million of these securities so $1000 times a million that's where the billion dollars comes from me my things been acting up that's where the billion dollars comes from that essentially is lent to the bars and these guys will get 10% now one thing I want you to keep in mind is they get 10% only if every one of these borrowers pays their loans never default never prepay spree paying a mortgage is just you know saying I sold a house so I don't need the mortgage anymore so I just pay it off so it's only 10% indefinitely if if all the borrowers pay all the money and never default or anything like that so this 10% is kind of in an ideal world well everyone knows that it's not going to be exactly 10% some percentage of these borrowers are going to default on their mortgage some of them are going to pay ahead of time and actually that's what the buyer of the mortgage-backed security should should try to figure out and all sorts of buyers are going to have all sorts of different assumptions and this is what you've probably read some articles about about these hedge funds with these computer models to to value their their mortgage-backed securities and that's what those computer models do they try to look at historical data and figure out okay for given population pool in a given part of the country what percentages of them are able to pay off their mortgage what percentage of them default on their mortgage and when they default what is kind of the recovery you know if it's a they default on a million dollar mortgage and then the special purpose entity would get control of that house and then if that house is sold for I don't know five hundred thousand dollars because the property value went down then the recovery would be 50% so that's all of the things that someone needs to factor in when they figure out what will be the real return 10% is if everyone pays so let's let's make some very simple assumptions for ourselves to kind of let's say we are thinking about investing in a mortgage-backed security and we want to gauge for ourselves what we think the return is going to be well let's say we know that this pool of borrowers that let me see it my pen keeps not working that 20% will default 20% will default we're not going to worry about prepayment rates and all things like that let's say 20% are going to default and then on those 20% that default so these are you know of these thousand borrowers 200 of them just going to lose their job or whatever they can't afford a mortgage anymore and of those 20 percent the default we have a 50 percent recovery 50 percent recovery so that means no borrower X defaulted on his loan and then when we we go and get the property because that the loan was secured by the property and we auction off the property we only get five hundred thousand dollars for it so we get a fifty percent recovery fifty percent of the original value of the loan so if 20 percent default and then there's a 50 percent of recovery then on average you're going to get 10 percent 10 percent of the loan is worthless and I'm going to make some kind of hand waving assumptions here there but you can you can assume statistically and since this is a large number of bars it's a thousand right if there's only one borrower it would be hard to kind of gauge when he default if he defaults at all we would just know that there's a 20 percent chance but when there's a large number of bars you can kind of do the math and say okay on average 200 of these guys are going to default and instead of actually getting a 10 percent since 20 cents 10 percent of the loans are going to be worthless I'm going to get 10 percent less than this 10 percent so I'm going to get 9 percent so this is based on the model that we just constructed right the model is this is the model that we constructed this is a much simpler model than what most people use but based on the model that we just constructed I think the real return we're going to get on this mortgage-backed security is 9 percent if there was another investor who assumed a 50 percent default rate but with a high recovery he or she would have a different kind of expected return from this security so why is this even useful well think about it before in the case we did in the first video when someone just borrows from the bank the bank has has very specific lending requirements they have their own model they have so there's a whole class of borrowers that they might have not been able to service right there might be people with really good credit scores really good incomes who don't have a down payment and if they don't meet the what the bank requirements are never get a loan but there are probably some investors out there that would say you know what for the right interest rate and for the right you know assumptions in my model I'm willing to give anybody a loan as long as I'm compensated for it enough and this is what this mortgage-backed security market allows it allows let's say this group of borrowers let's say this pool of borrowers right here actually didn't this pool of bar is right here let me see something about mine this pool of bar is actually aren't the traditional you know they don't have 25 percent down and they don't and they don't have the and they don't have kind of the traditional requirements to get a normal mortgage but if if I pull a bunch of people who don't have those traditional acquirements but they're good in other ways if they have a high income or high credit score I can go through this alternate mechanism to find investors that are willing to loan them money so essentially from the borrower's point of view it allows more access to loan funding that they would have otherwise not been able to and from an investor point of view it allows another place for me to invest in maybe my specialty is maybe I feel that the computer models that I have are really good at predicting things like default rates and recovery rates and you know what alone is worth and I feel that I can in some in some ways be a better loan officer than the banks and this would be an attractive place for me to invest in it's also it just might just have a risk reward characteristic that isn't exists that doesn't exist in the market already and it allows you to to kind of diversify into one other asset class so that's the value that it has across the entire spectrum now in the next presentation I'm going to show how you can I guess further complicate this even more so that so that you can open up the investment to even a larger group of investors because you can think about it right now there's probably some people who say ok you know I already said some people will do these models and try to make their own assumptions and say ok this is going to give me nine percent a year but there's a whole bunch of people who are going to say well this is too complicated for me this seems risky I don't have any fancy models I only like to invest in things where I know I get my money you know very highly rated debt is where I'm going to invest my money and then there's another group of people who say okay 9% that's nice and everything but I'm a hotshot I'm a gambler 9% are isn't the type of returns I want I want to take more risk and more return and and so there should be something maybe for those people as well so that's what we're going to show you in the presentation on collateralized debt obligations see you soon