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Studying for a test? Prepare with these 7 lessons on Options, swaps, futures, MBSs, CDOs, and other derivatives.
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Video transcript
Let's say I'm some type of the Investment Bank. Can I go out there and I buy a whole bunch of mortgages. So right here are a whole bunch of people's mortgages. And when I say buy a mortgage it means the home-owners who borrow the money instead of the money going to the mortgage broker whom the home-owner think they got the loan from the servicer who they think they are paying the check to. Since I now have bought these mortgages, I've essentially become the lender to the home-owner, and so the home-owner's morgage payment will now come to me the Investment Bank . So I do this for a bunch of home-owners right over there. But I don't want to be the end holder of the paper. I really want to be the intermediary. So what I do is I set up a Special Purpose Entity, which is really just a corporation that I set up. And I stick all of the mortgages inside that Special Purpose Entity. So I stick them all inside of that. So now the Special Purpose Entity is the owner of the mortgages . The investment bank at least starting off with all of the shares of the Special Purpose Entity. And so the Investment Bank could then sell shares. It could split the Special Purpose Entity into a million or ten million shares and then sell those shares to investors. And these shares would be called Mortgage-Backed Securities. or sometimes MBSes. There are a part of a general class called Asset-Backed Securities because what is going to happen now is that all of this money flowing from home-owners will go the mortgages which is now on the Specail Purpose Entity. So all ended up inside the Special Purpose Entities . And some of them will default,some of them won't. But on average this Special Purpose Entity will then be able to pay a dividend. Essentially you can almost fueled on interest to the owner of the Mortgage-Backed Security.