# Mortgage-backed securitiesÂ III

## Video transcript

Welcome back to my series
of presentations on mortgage-backed securities. So 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 start with borrowers
who need to buy houses. Each of them borrowed
$1 million. Actually let me write
that down. Let me change the
color of my pen. Where'd my pen go? OK. So each of these people
borrowed $1 million. OK. Each of them borrowed $1 million
and there were 1,000 of them, right? So $1 million times 1,000. That's $1 billion that
they needed. And 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 1,000 borrowers. So they're going to put in
$100 million, right? 100,000 times 1,000
is 100 million. So just to simplify. Keep it in your mind. $1 million
goes to a bunch of borrowers, goes to 1,000
borrowers, to be specific. And then each year, those
borrowers are going to give the special purpose entity--
this is just a corporation designed to kind of structure
these mortgage-backed securities-- they're going to
give 10% of the billion, or $100 million back into this. And then we said, OK, well where
does that money for this special purpose entity, or for
this corporation, come from? Well it comes from the investors
in the actual mortgage-backed securities. And just to be clear, so
the asset within this entity are the 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 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 cost $1,000. And then they're going to
they're going to get $100 back per month. And we said there are a million
of these securities, so $1,000 times 1 million,
that's where the $1 billion comes from. My thing's been acting up. That's where the $1 billion
comes from. And that essentially is
lent to the borrowers. 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 defaults, never
pre-pays. Pre-paying a mortgage is just
saying, I sold the house. I don't need the mortgage
anymore, so I just pay it off. So it's only 10%, indefinitely,
if all of 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 try
to figure out. And all sorts of buyers are
going to have all sorts of different assumptions. And this is what you probably
read some articles about, these hedge funds with these
computer models to value their mortgage-backed securities. And that's what those
computer models do. They try to look at historical
data and figure out, OK, for a given population pool in a given
part of the country, what percentage 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? Say they default on a $1 million
mortgage, and then the special purpose entity would
get control of that house. And then if that house is sold
for $500,000 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 make some very simple
assumptions for ourselves. 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-- my pen keeps not working--
that 20% will default. We're not going to worry about
pre-payment rates and all things like that. Let's say 20% are going
to default. Of these 1,000 borrowers, 200 of
them are just going to lose their job or whatever. They can't afford a
mortgage anymore. And of those 20% that default,
we have a 50% recovery. So that means borrower X
defaulted on his loan. And then when we go and get
the property-- because the loan was secured by the
property-- when we auction off the property, we only
get $500,000 for it. So we get a 50% recovery. 50% of the original
value of the loan. So if 20% default and then
there's a 50% recovery, then on average you're going to get
10% of the loan is worthless. And I'm going to make
some kind of handwaving assumptions here. But you can assume
statistically, and since this is a large number of borrowers--
it's 1,000, right? If there's only one borrower
it would be hard to kind of gauge when he defaults,
if he defaults at all. We would just know that
there is a 20% chance. But when there's a large number
of borrowers, you can kind of do the math and say,
OK, on average 200 of these guys are going to default, and
instead of actually getting 10%, since 10% of the loans are
going to be worthless, I'm going to get 10% less
than this 10%. So I'm going to get 9%. So this is based on the
model that we just constructed, right? 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%. If there was another investor
who assumed a 50% default rate, but with a higher
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 very specific lending requirements. They have their own model. 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 what the
bank's requirements are, they would 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 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 borrowers
actually aren't the traditional-- they don't have
25% down and they don't have kind of the traditional
requirements to get a normal mortgage-- but if I pool a bunch
of people who don't have those traditional requirements,
but they're good in other ways-- 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 I feel that the computer
models that I have are really good at predicting things like
default rates, and recovery rates, and what a
loan is worth. And I feel that I can, in some
ways, be a better loan officer than the banks. And this would be an attractive
place for me to invest in. It also might just have a risk
reward characteristic that doesn't exist in the market
already, and it allows you to 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 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, 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 9% a year. But there's a whole bunch of
people who are going to say this is just 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. Very highly rated debt
is where I'm going to invest my money. And there's another group of
people who say, OK, 9%, that's nice and everything, but I'm
a hotshot, I'm a gambler. 9% isn't the type of
returns I want. I want to take more risk
and more return. 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.