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## Finance and capital markets

### Course: Finance and capital markets>Unit 10

Lesson 3: Credit crisis

# Mortgage-backed securities III

More on mortgage-backed securities. Created by Sal Khan.

## Want to join the conversation?

• At Khan seems to think that the net effect of 20% of people defaulting with a 50% recovery rate will lead to only a 10% decrease in returns. This is confusing because I did a crude calculation (assuming all defaults happen at end of year and defaulters pay interest until they default), and I got that at the end of the first year you would have 100M from house sales, 100M from interest and 800M owed to you.

In other words, it seems that the return would at best 0%. Am I mistaken?
• I think the math is actually a little more complicated and the new rate of return will actually be less than 9% but not 0%.

If all \$1B of loans are being repaid, then the return is \$100M per year and you'll get \$100 back (or 10%) on your \$1000 share.

If 20% of the loans default and there is zero recovery, the stock just lost \$200M in assets and only \$800M is now being repaid. Thus the return is \$80 (8%) on your \$1000 share.

If 20% of the loans default and there is 50% recovery, the asset lost only \$100M; however, only \$800M is now being repaid just like in the previous example. The \$100M recovered does not generate any income because those debts were retired when the properties were sold. Until this \$100M cash-on-hand is re-invested the return is \$80 (8%) on your \$1000 share.
• I like this series of videos. But why don't we explore these banking operations further by making a series on how things like insurance, stocks, government bonds originated and developed? The picture we are getting is of a system that already became very complex. Why not show historically how new operations were developed? I am sure you could make it very interesting.
• the money don't add up. home owners borrowed the \$1B from the investment bank, whom then creates and sold shares of special entities for \$1.1B. From the flow of money, the investment banks already got return on investment. When home owner foreclose on the loan, investment banks takes ownership of the house; which in essence a FREE house. So, why we need to bailout the banks during the housing crisis? I don't notice the investments banks losing any money.

NOTE: the stock holders don't own the houses.
(1 vote)
• The banks did lose a lot of money. If you lend \$1 million and then you get back a house that you can only sell for \$500,000, you lost money. That doesn't mean they should or shouldn't be bailed out, of course.
• Is the recovery percentage always the same regardless of when the borrower defaults on the loan? For example, if I default on a \$1 million home loan after having made payments for many years, taking the remaining principal down to say \$600,000 is the recovery percentage still 50% if the bank sells my home for \$500,000. Or would it be 90%, the \$400,000 I had already paid off plus the \$500,000 the bank got for selling my home? Or something else entirely?
• The recovery percentage in your example would be 500/600.

Normally you do not see recovery percentages like that because if the bank can sell it for \$500, a more patient seller might be able to sell it for more, and therefore the owner is unlikely to default rather than just sell the property. But it could happen.
• Do we have an option to short on these MBS investment ?
• Shorting asset-backed securities is done using Credit Default Swaps.
• What is a Special Purpose Entity? Is it the bank and the investment bank?
(1 vote)
• So as I understand the chain of causes/events... Values of Houses decreased drastically ---> Values of the Mortgage Notes decreased drastically ---> Values of Mortgage Backed Securities decreased drastically ---> Values of the Investments from Institutional Investors (mutual funds, pension funds, banks other companies, etc.) decreased drastically ---> Danger/Fear that entire Financial System would collapse ---> Infusion of Money from Gov't (the "bailout") into the Companies selling the Mortgage backed Securities to essentially Replace the Value Lost in the securities and the subsequent values of investments by others.... is that about right? If that's more-or-less true, what I don't understand is if the values of the securities were "restored" for the Mortgage Backed Security institutions by this bailout, why weren't the values of the original securities (i.e., the initial mortgages) also "restored" (i.e., any difference in value of the loan minus the value of the "under-water" houses, essentially made up by this bailout cash)? It would kinda be like the bailout monies being infused into the entire system/chain at the start, with the initial securities rather than in the middle of the system, no? Or am i totally missing something?
(1 vote)
• How does the owner of MBS get those 10% per year. In the form of dividend or some other way? That means that the owner of MBS will get 100% of his investment in 10 years, but how does he get any profit out of it, because MBS is worth 0 after 10 years? Thank you for your answer.
(1 vote)
• Can you please tell if the following scenario happened or could it have happened or is there a banking regulation that prevents it from happening ?
"say , \$1b worth loans are sold by commercial banks to investment banks ... now if the same \$1b is again used to get the same type of loans and again sold to same investment bank as another bunch of loans .... and so on .... this is like an infinite loop where banks can profit !! "
(1 vote)
• Why don't the banks which give out the loans just create the SPE themselves?
(1 vote)
• Because this task requires a different skillset than originating the mortgages. The bank may have two divisions, an investment bank side and a commercial bank side, and the people that work for each side have defined expertise in what they do.
(1 vote)