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Current time:0:00Total duration:9:36

Video transcript

welcome back so where we left off is there was a thousand people who all needed let's say a million dollar loans each and they were all going to pay 10% on their loans and they borrowed it from this Bank you know it's kind of a standard commercial bank and this bank says well you know I just handed out a billion dollars and I'm getting these interest payments and my you know vaults are empty I want to have money back in my vaults or you know I want to have money back on my balance sheet so I'm going to sell these loans I'm going to bundle them all together and sell them to this investment bank and now this and what is this investment bank going to do with these loans and why is it doing it so let me let me delete this so we had the investment bank so we have the investment bank I randomly picked the color green but I think it is appropriate for the investment bank so now I have all of the you know me that's a little smiley face you know there's a thousand of me and we are now going to pay the 10% we're now going to make all of our mortgage payments the 10% payment to this bank this investment bank but the investment bank they're not in the business of of servicing loans or keeping loans on their balance sheets so what they do is they create a corporation they create an entity though you know maybe a special-purpose entity whatever you want to call it so they create a company let's let me make that in purple and other color so they create this company and what they do is they will take this this billion dollars well not the billion dollars they take their rights to these payments that they got right they paid a billion dollars to that first bank in order to get the payments from all of these people and they say you know the rights on that on those payments right that's the asset they bought all these loans the rights on those payments we are now going to transfer to this special purpose entity to this other corporation so now everyone is going to essentially all their money all their mortgage payments are going to be funneled into this into this entity right and this is a corporation and so what the bank will do is issue shares in this corporation so let's say that it issues let's say for simplicity 100 shares so there's 100 shares 100 shares so what's in this corporation there's each the the entire corporation gets the mortgage payments on the billion dollars in loans right it has a billion dollars of loans outstanding it's going to get 10% a year so it's going to get 100k 100 million per year right because it's it's a thousand loans out there it's going to get a hundred million per year for ten years and at the end of the ten years it's also going to get a billion dollars right that's its asset it has its asset is the right on those those those payment streams that are going to come into this corporation and then it has a hundred shares so if you the way I think about it is you can split this company a hundred ways and I'm doing this to further confuse you so what is each of those the owner of each of those shares what does it entitle them to well it entitles me to one hundredth of what this corporation gets so each share so if I have a share let's make it look it looks like I share a stock certificate I'm going to get one hundredth of this thing and normally you wouldn't have one hundred shares you would have let's say a million shares actually let me make it a million shares because I think that that's in some strange way more realistic so let's say there are million shares so if there are million shares each share we'll get one millionth of the cash flow stream that's entitled to this entity so instead of getting a hundred million dollars every year it gets one millionth of that so it gets a hundred dollars per year and then on the last year instead of getting a billion dollars it gets a thousand dollars so what the bank will do is it'll take these shares and then it'll sell it to the general public it'll you know it'll I P owe it essentially you can think of it that way and tons of people will buy it especially hedge funds and pension funds and mutual funds and bond investors and and and it's just important to think about how the money is flowing so now when they share it when they sell these these shares and this entity people are going to give them well hopefully more than what they paid for it right maybe maybe there's a lot of demand for this type of asset where I get this type of a income stream so maybe once they sell all the shares they get I don't know they get 1.1 billion dollars for of them right so this is the investors investors and the investors collectively buy these shares for 1 point 1 billion dollars essentially let's say they pay they paid their I mean 1 point 1 billion dollars 4 million shares so they paid $1,100 per share right $1,100 per share each of the investor is paid $1,100 for each of these shares so then 1 point 1 billion dollars goes into the special purpose entity and if you think about it the bank made out like a bandit right because the bank paid a billion dollars for the rights to these mortgage payments and it's getting 1.1 billion dollars went from the investors and all the bank has to do is kind of set this whole legal structure up and and service the loans actually doesn't even have to service loans we'll go into that later so let me let me summarize I guess just because I know this can be a little bit of a daunting subject let me summarize so let me this purple I don't like it's a little bit anyway so you have tons of investors so each of these is an investor I know actually a mortgage a borrower all of these people need to buy houses these are all smiley faces these are all smiley faces right they all need to buy houses and then they collectively they collectively get a billion dollars right a million dollars each and they each use that million dollars to buy their house to buy their elgyn house and then that billion dollars initially came from you know just their local their local bank and then and when when the billion dollars came from that local bank all the mortgage the payments the interest payments went to the bank but then then an investment bank came along and said well no I want to buy the rights to those payments an investment bank came along and says well I'm going to give you a billion dollars 1 billion and now instead of you getting the payments I get the payments and then the bank sets up a special-purpose entity it said essentially it sells a bunch of shares let's say it sells a million shares 1 million shares and let's say it was able to sell each of those shares for for $1100 right from from the investment investing public so it's able to sell each of them formula so it raises 1.1 billion dollars right so it the value of this company is 1.1 billion that now goes to the bank and now the payment stream instead of going to let me do a different color now the payment stream goes to the special-purpose entity instead of the bank and the bank essentially made out like a bandit because it paid a billion dollars and it got 1.1 so it made a hundred million dollars just for doing this transaction I'm not saying that's how much a bank actually would make but this shows you why every person is kind of what what they're doing in this in this value chain and as I said before this bank also probably did something similar they probably took some fees or sold the loans for slightly more than they issued the loans for so this these shares each of these 1 million shares you know these shares that I said this is a mortgage-backed security mortgage-backed security and it makes sense it's a security of securities an ownership that's tradable in a company and that company has the right to payments that are secured by mortgages so if all these people promised they would pay and they're going to pay to this to this special-purpose entity but if by chance one of these peoples loot you know that one of these people lose their jobs or they can't pay for whatever reason the instead of the payments this entity is going to have the rights to their property and that's why we say that it's a mortgage-backed security it's not just a promise to get money the money is actually backed by people's mortgages and of course in this entity is going to if this guy defaults on his loan he's one of a million so you know statistically you might be able to predict that I don't want to put too much stock in these statistical models then this entity will just have that that property auctioned off or sold and then it'll just you know the cash flow will come back to it so that's what a mortgage-backed security is hopeful I didn't convince confuse you too much my next presentation I'm going to take it to a further level of confusion and show you what a collateralized debt obligation is and then I'll do a more philosophical video on why these things even exist and why they're useful and why people may benefit or may not benefit from these things