Mortgage-backed securities I
Welcome to my presentation on mortgage-backed securities. Let's get started. And this is going to be part of a whole new series of presentations, because I think what's happening right now in the credit markets is pretty significant from, I guess, a personal finance point of view and just from a historic point of view. And I want to do a whole set of videos just so people understand, I guess, how everything fits together, and what the possible repercussions could be. But we have to start with the basics. So what is a mortgage-backed security? You've probably read a lot about these. So historically, let's think about what historically happens when I went to get a loan for a house, let's say, 20 years ago. And I'm going to simplify some things. And later we can do a more nuanced. Where'd my pen go? Let's say I need $100,000. No, let me say $1 million, because that's actually closer to how much houses cost now. Let's say I need a $1 million loan to buy a house, right? This is going to be a mortgage that's going to be backed by my house. And when I say backed by my house, or secured by my house, that means that I'm going to borrow $1 million from a bank, and if I can't pay back the loan, then the bank gets my house. That's all it means. And oftentimes it'll only be secured by the house, which means that I could just give them back the keys. They get the house and I have no other responsibility, but of course my credit gets messed up. But I need a $1 million loan. The traditional way I got a $1 million loan is I would go and talk to the bank. This is the bank. They have the money. And then they would give me $1 million and I would pay them some type of interest. I'll make up a number. The interest rates obviously change, and we'll do future presentations on what causes the interest rates to change. But let's say I would pay them 10% interest. And for the sake of simplicity, I'm going to assume that the loans in this presentation are interest-only loans. In a traditional mortgage, you actually, your payment has some part interest and some part principal. Principal is actually when you're paying down the loan. The math is a little bit more difficult with that, so what we're going to do in this case is assume that I only pay the interest portion, and at the end of the loan I pay the whole loan amount. So let's say that this is a 10-year loan. So for each year of the 10 years, I'm going to pay $100,000 in interest. $100,000 per year, right? And then in year 10, I'm going to pay the $100,000 and I'm also going to pay back the $1 million. Right? Year 1, 2, 3, dot, dot, dot, dot, 9, 10. So in year one, I pay $100,000. Year two, I pay $100,000. Year three, I pay $100,000. Dot, dot, dot, dot. Year nine, I pay $100,000. And then year 10, I pay the $100,000 plus I pay back the $1 million. So I pay back $1.1 million. So that's kind of how the cash is going to be transferred between me and the bank. And this is how a-- I don't want to say a traditional loan, because this isn't a traditional loan, an interest-only loan-- but for the sake of this presentation, how it's different than a mortgage-backed security, the important thing to realize is that the bank would have kept the loan. These payments I would have been making would have been directly to the bank. And that's what the business that, historically, banks were in. Another person, you-- and you have a hat-- let's say you're extremely wealthy and you would put $1 million into the bank. Right? That's just your life savings or you inherited it from your uncle. And the bank would pay you, I don't know, 5%. And then take that $1 million, give it to me, and get 10% on what I just borrowed. And then the bank makes the difference, right? It's paying you 5% percent and then it's getting 10% from me. And we can go later into how they can pull this off, like what happens when you have to withdraw the money, et cetera, et cetera. But the important thing to realize is that these payments I make are to the bank. That's how loans worked before the mortgage-backed security industry really got developed. Now let's do the example with a mortgage-backed security. Now there's still me. I still exist. And I still need $1 million. Let's say I still go to the bank. Let's say I go to the bank. The bank is still there. And like before, the bank gives me $1 million. And then I give the bank 10% per year. Right? So it looks very similar to our old model. But in the old model, the bank would keep these payments itself. And that $1 million it had is now used to pay for my house. Then there was an innovation. Instead of having to get more deposits in order to keep giving out loans, the bank said, well, why don't I sell these loans to a third party and let them do something with it? And I know that that might be a little confusing. How do you sell a loan? Well let's say there's me. And let's say there's a thousand of me. Right? There's a bunch of Sals in the world. Right? And we each are borrowing money from the bank. So there's a thousand of me. Right? I'm just saying any kind of large number. It doesn't have to be a thousand. And collectively we have borrowed a thousand times a million. So we've collectively borrowed $1 billion from the bank. And we are collectively paying 10% on that, right? Because each of us are going to pay 10% per year, so we're each going to pay 10% on that $1 billion. Right? So 10% on that $1 billion is $100 million in interest. So this 10% equals $100 million. Now the bank says, OK, all the $1 billion that I had in my vaults, or whatever-- I guess now there's no physical money, but in my databases-- is now out in people's pockets. I want to get more money. So what the bank does is it takes all these loans together, that $1 billion in loans, and it says, hey, investment bank-- so that's another bank-- why don't you give me $1 billion? So the investment bank gives them $1 billion. And then instead of me and the other thousands of me paying the money to this bank, we're now paying it to this new party, right? I'm making my picture very confusing. So what just happened? When this bank sold the loans-- grouped all of the loans together and it folded it into a big, kind of did it on a wholesale basis-- it's sold a thousand loans to this bank. So this bank paid $1 billion for the right to get the interest and principal payment on those loans. So all that happened is, this guy got the cash and then this bank will now get the set of payments. So you might wonder, why did this bank do it? Well I kind of glazed over the details, but he probably got a lot of fees for doing this, or maybe he just likes giving loans to his customers, whatever. But the actual right answer is that he got fees for doing this. And he's actually probably going to transfer a little bit less value to this guy. Now, hopefully you understand the notion of actually transferring the loan. This guy pays money and now the payments are essentially going to be funnelled to him. I only have two minutes left in this presentation, so in the next presentation I'm going to focus on what this guy can now do with the loan to turn it into a mortgage-backed security. And this guy's an investment bank instead of a commercial bank. That detail is not that important in understanding what a mortgage-backed security is, but that will have to wait until the next presentation. See you soon.