Welcome back to my series of presentation on mortgage bank securities. So let's review of what we already gone over. So, I've already drawn here, I actually prepared it in time. So I already drawn here kind of what we've already talked about.
So we started with borrowers who need to buy houses. Each of them borrowed a million dollars. Actually, let me write that down, let me change the color of my pen. Okay. So each of these people borrowed $1 million. Each of them borrowed a million dollars and there were thousands of them. Right. So million dollars times a thousand, that’s a billion dollars that they needed. And they said that they would pay 10% a year on that money that they borrowed. So that’s 10% for each of them, so that’s a hundred thousand dollars. And then if we said, there's a thousand borrowers. So they're going to put in $100 million, right. 100,000 times 1000 is a hundred million.
So just to simplify, keep in your mind, $1 billion goes to a bunch of borrowers, Goes to a thousand of borrowers to be specific. And then each year, those borrowers are going to give the special purpose entity, this is just a corporation designed to structure this mortgage bank securities. They're going to give 10% of a billion. Or $100 million back into this.
And then we said, okay, where does that money for the special purpose entity or for this corporation comes from? Well it comes from the investors in the actual mortgage bank securities.
So let's say that there's, and just to be clear, the asset within this entity is the loans or are the loans. Loans are the main asset that’s inside the special purpose entity. And the loans are just the derive on this 10% in payments. And so money came from, when the owners of each mortgage bank securities, each paid $1000 for the mortgage bank securities. And in return, they’re going to get 10% on their money.
So each security cost a thousand dollars. Then they're going to get a thousand dollars back per month. And we said there are millions of these securities. So thousand dollars times a million, that’s where the billion dollars comes from. That’s where the billion dollars comes from. That is essentially lent to the borrowers. And these guys will get 10%.
Now one thing I want you to keep in mind is, they get 10% only if everyone of these borrowers pays their loans, never defaults, never prepays. Prepaying a mortgage is just saying I sold a house, I don’t need the mortgage anymore so I’ll just pay it off. So it’s only 10% indefinitely if all the borrowers pay all the money and never to fall or anything like that.
So this 10% is kind of an ideal world. Well everyone knows, it’s not going to be exactly 10%. Some percentage of these borrowers are going to default in their mortgage. Some of them will pay ahead of time, and actually that’s what the buyer of the mortgage bank securities should try to figure out. And all sorts of buyers are going to have all sorts of different assumptions. And this is what you probably read some articles about these hedge funds and this computer models to value their mortgage bank securities. And that’s what those computer models do. They try to look at historical data and figure out, okay, for given population pool for a given part of the country. What percentages of them are able to pay off their mortgage? What percentage of them default on their mortgage and when they default, what is kind of the recovery? Say they default in a million dollar mortgage and then the special purpose entity would get control of that house. And then if that house is sold for, I don’t know, $500,000 because of the property value down. Then the recovery would be 50%.
So that’s all the things that someone needs to factor in when they figure out what would be the real return. 10% is if everyone pays. So let's make some very simple assumptions for ourselves, let's say we are thinking about investing in a mortgage bank securities and we want to gauge for ourselves what we think the return is going to be.
Well let's say we know that this pool of borrowers that 20% will default. We’re not going to worry about prepayment rates and all things like that. Let’s say 20% are going to default and then on those 20% that defaults. Of this thousand borrowers, 200 of them are just going to lose their job or whatever. They can't afford the mortgage anymore. And of those 20% that defaults, we have a 50% recovery. 50% recovery. So that means borrower X defaulted on his loan, and then when we go and get the property because the loan is secured by the property. When we auction off the property, we only get $500,000. So we get a 50% recovery. 50% of the original value of the loan. So if 20% defaults and then there's a 50% recovery, then on average you're going to get 10% of the loan is worthless.
And I'm going to make some kind of hand waving assumptions here. But you can assume statistically, this is a large number of borrowers, it’s a thousand, right. If there is only one borrower, it would be hard to kind of gauge when he default, if he defaults at all. You just know there's a 20% chance. But when there's a large number of borrowers, you can kind of do the math and say, okay, on average 200 of these guys are going to default. And instead of actually getting 10%, since 10% of the loans are going to be worthless, I'm going to get 10% less than this 10%. So I'm going to get 9%.
So this is base on the model that we just constructed. Right. The model is, this is the model that we constructed. This is a much simpler model that what most people use. But base on the model that we just constructed, I think the real return were going to get on this mortgage bank securities is 9%. If there is another investor who assumed 50% of default rate with a higher recovery, he or she would have a different kind of expected return from this security.
So why is this even useful? Well think about it, in the case we did in the first video when someone just borrows from the bank, the bank has very specific lending requirements. They have their own model. So there’s a whole class of borrowers, that they might have not been able to serve this. There might be people with really good credit scores, really good incomes, who don’t have a down payment. And if they don’t meet what the bank requirements are, they would never get a loan. But there are probably some investors out there who would say, you know what, for the right interest rate and for the right assumptions in my model, I'm willing to give anybody a loan as long as I'm compensated for enough. And this is what this mortgage bank securities market allows. It allows, let's say this group of borrowers right here aren't the traditional, they don’t have 25% down and they don’t have the kind of the traditional requirements to get a mortgage. But if I pull a bunch of people who don’t have those traditional requirements, they're good in other ways. They have a high income or high credit score. I can go through this alternate mechanism to find investors that are willing to loan the money.
So it essentially, from the borrowers point of view, it allows more access to loan funding and they would have otherwise not been able to. And from an investor point of view, it allows another place for me to invest in. maybe I feel computer models that I have are really good for predicting things like default rates and recovery rates and one loan is worth. And I feel that I can in some ways be a better loan officer than the bank. And this would be attractive place for me to invest in. it’s also, it might just have a risk-reward characteristic that doesn’t exist in the market already. And it allows you to kind of diversify to one other asset.
So that’s the value that has across the entire spectrum. Now in the next presentation, I'm going to show how you can, I guess further complicate this even more so that you can open up the investment even a larger group of investors. You can think about it right now, there's probably some people who say, okay, and I already said. Some people will do these models and try to make their own assumptions and say okay, this is going to be 9% a year. But then there's a whole bunch of people who are going to say, this is too complicated for me. This seems risky, I don’t have any fancy models. I only like to invest in things where I know I get my money. You know it's very highly debt is where I'm going to invest my money. And then there's another group of people who’ll going to say, okay, 9% that’s nice and everything. But I'm a hotshot, I'm a gambler, 9% isn’t the type of returns I want. I want to take more risk and more return. And so there should be something maybe for those people as well.
So that’s what we’re going to show you on the presentation on collateralize debt obligations. See you soon.
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