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.