Welcome to my presentation on mortgage bank securities. Let’s get started. And this is going to be a part of a whole new series of presentation because I think what’s happening right now in the credit markets is pretty significant from a personal finance point of view and just from a historic point of view. I want to do a whole set of videos just so people understand how everything is fixed together and what the possible repercussions could be but we have to start with the basics.
So what is a mortgage bank security? You probably read a lot about this. 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 new ones. Let’s say I need $1 million, because that’s actually how much houses cost now. Let’s say I need $1 million loan to buy a house. 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 often times it will only be secured by the house which means that I can 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 $1 million loan.
The traditional way I got $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 dollars and I would pay them some type of interest probably. Let’s just say I’ll make up a number, I mean the interest rates obviously change and we’ll do future presentations on what causes the interest rates to change. But let’s say that I would pay them 10 percent interest. And for the sake of simplicity, I’m going to assume that the loans in this presentation are interest only loans. In the traditional mortgage, your payment has some part interest and some part principal. Principal is actually when you are 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. And then in year 10 I’m going to pay the $100,000 and I’m also going to pay the $1 million. So if we think about it from year one, two, three, nine, ten. So year one I pay 100,000, year two I pay 100,000, year three I pay 100,000, year nine I pay 100,000, and then year ten 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, I don’t want to say traditional. Because this isn’t a traditional in interest only loan. But for the sake of this presentation, I want to show you how it’s different in a mortgage bank security. The important thing to realize is that 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 aimed. Another person, you, and you have a hat. Let’s say you’re extremely wealthy and you would put $1 million into the bank. That’s just your life savings, you inherited from your uncle. And the bank would pay you five percent and then take that $1 million, give it to me and get ten percent on what I just borrowed and then the bank makes the difference, right. It’s paying you five percent and then it’s getting ten percent from me. And we can go later into how they can pull this off like what happens if you 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 bank security industry really got developed. Now let’s do the example with the mortgage bank security.
There’s still me, I still exist, and I still need $1 million. Instead of going to the bank or actually I still go to the bank, the bank is still there. And like before, the bank gives me $1 million and then I give the bank ten percent per year. So it looks very similar to our old model but in the old model the bank would keep these payments itself and the $1 million that it’s 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, “Why don’t I sell these loans to a third party and let them do something with it.” And I know that that will 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, there’s a bunch of Sal’s in the world. And we each are borrowing money from the bank. So there’s a thousand of me 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 ten percent on that because each of us are going to pay ten percent per year. So we each are going to pay ten percent on that $1 billion. So ten percent of that $1 billion is $100 million in interest.
Now the bank says, “Ok, I just owe the $1 billion that I have in my vault in my database and it 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 of loans and says, “Hey, investments bank,” so that’s another bank, “why don’t you give me $1 billion?” so the investments 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.
So what just happened? When this bank sold the loans, they grouped all the loans together and they sold it in a whole sale basis, it sold a thousand loans to this bank, so this bank paid a $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 glaze over the details, but he probably got a lot of fees for doing this or maybe he just likes giving loans to his customers or whatever. But, the right answer is that he got fees for doing this and he is 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 phoned to him. I only have two minutes on this presentation so the next presentation I’m going to focus on what this guy can now do with the loan to turn it into a mortgage bank security. This guy is an investment bank instead of a commercial bank and that detail is not that important in understanding what a mortgage back security is but that will have to wait until the next presentation. See you soon.
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