Learn about Mortgage-Backed securities II

Khan Academy Presents: Part II of the introduction to mortgage-backed securities

Welcome back, so where we left off is there are 1000 people who all needed, let's say a million dollar loans each. And they are all going to pay 10% on their loans. And they borrowed it from this bank, 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 interests payments. And my vaults are empty, I want to have money back in my vault. I want to have money back for 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 what is this investment bank, I'm going to do with these loans and why is it doing it? So let me delete this. So we have the investment bank, I randomly pick the color green, but I think it’s appropriate for the investment bank. So now I have all of the, me, that’s a little smiley face. There's 1000 of me, and we are now going to pay the 10%. Now I'm going to make all of our mortgage payments, the 10% payment to this investment bank. But the investment bank, they're not in the business of servicing loans or keeping loans on their balance sheets. So what they do is they create a corporation. They create an entity, that special purpose entity. Whatever you want to call it. So they create a company, let me make that in purple. So they create this company. And what they do is they will take these billion dollars, not the billion dollars, they take their rights to these payments that they got. They paid the billion dollars to that first bank in order to get the payments from all of these people. And they say, you know what, the rights on those payments. 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 mortgage payments are going to be filed into this entity. Right. And this is a corporation, and so what the bank would 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. So what's in this corporation? The entire corporation gets the mortgage payments on the billion dollars in loans. It has a billion dollars of loans outstanding, it’s going to get 10% a year. So it’s going to get 100 million per year. Right. Because it’s 1000 loans out there. It’s going to get 100 million per year for 10 years. And at the end of the 10 years, it’s also going to get a billion dollars. Right. That's its asset it has. Its asset is the right on those payment streams that are going to come into this corporation. And then it has 100 shares, so the way I think about it is you can split this company 100 ways. And I'm doing this to further confuse you. So what is the owner of each of those shares, what is entitled them to? Well, it entitles me to 100th of what this corporation gets. So each share, so if I have a share, let's make it look like a stock certificate. I'm going to get 100th of this thing. And normally you wouldn’t have 100 shares, you would have a million shares. Actually, let me make it a million shares. Because I think that’s in some strange way make it more realistic. So let's say, there are a million shares. So if there are a million shares, each share will get 1 millionth of the cash flow stream that’s entitled to this entity. So instead of getting $100 million every year, it gets 1 millionth of that. So it's gets $100 per year. And then on the last year, instead of getting a billion dollars, it gets $1000. So what the bank would do is it will take these shares and then it will sell it to the general public. IPO essentially, if 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 it’s just important to think about how the money is flowing. So now, when they sell these shares in this entity, people are going to give them, well hopefully more than they paid for. Right. Maybe there's a lot of demands for this type of asset. Where I get this type of income stream. So maybe, once they sell all the shares, they get $1.1 billion for them, right. So these are the investors. And the investors collectively buy these shares for $1.1 billion, and essentially let's say they paid. That’s $1.1 billion dollars for a million shares. So they paid $1100 per share. Right. Each of the investors paid $1100 for each of these shares. So then $1.1 billion goes into this 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 from the investors. And all the bank has to do is kind of set this whole legal structure up and service the loans. Actually it doesn’t have to service the loans, were going to that later. So let me summarize, I guess, just because I know this can be little bit of a daunting subject. Let me summarize. I'm going to use, this purple I don’t like, anyway. So you have tons of investors, so each of this is an investor. No, actually a mortgage, a borrower. All of these people need to buy houses. These are all smiley faces. They all need to buy houses and then they collectively get a billion dollars. Right. A million dollars each. And they each use a million dollars to buy their house. And then that billion dollars initially came from just their local bank. And when that billion dollars came from that local bank, all the interest payments went to the bank. But then, the investment bank came along and said, well no, I want to buy the rights to those payments. The investment says, I'm going to give you a billion dollars. And now, instead of you getting the payments I get the payments. And then the bank sets up a special purpose entity, essentially it sells a bunch of shares. It sells a million shares, and let's says it was able to sell each of those shares for $1100. Right. From the investing public. So it raises $1.1 billion dollars. Right. So the value of this company is 1.1 billion 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 this special purpose entity instead of the bank. And the bank essentially made out like a bandit because it paid the billion dollars and it got 1.1, so it made $100 million 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 they're doing in this value chain. And as I said before, this bank also probably did something similar. They probably took some fees or sold a loan for slightly more than they issued them. So these shares, each of these 1 million shares, this is a mortgage back security. And it make sense, it’s a security. A security is 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 promise they would pay and they're going to pay to this special purpose entity. But if by chance, one of these people lose their jobs or they can't pay or for whatever reason, 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 back security. So it’s not just a promise to get money, the money is actually backed by people mortgages. And of course in this entity, if this guy defaults on his loan, he’s one of a million. So 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 property auctioned off or sold. And it will just, the cash flow will come back to it. So that’s what the mortgage back security is. Hope I didn’t confuse you too much. My next presentation, I'm going to take it to further level of confusion and show you what a collateralize 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 this things?