Mortgage-backed securities I | Finance & Capital Markets | Khan Academy
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Mortgage-backed securities I | Finance & Capital Markets | Khan Academy


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.

About James Carlton

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100 thoughts on “Mortgage-backed securities I | Finance & Capital Markets | Khan Academy

  1. A good mortgage is like a work of art.

    mortgageartist. com

    Your path to the best mortgage information resource around.

    Educating yourself costs you nothing, ignorance can cost you everything.

  2. there is a mistake in your presentation, $1M at 10% means you have to pay $1.1k. If you make a credit on 10 years it means each year you have to pay 110.000$

  3. I think why the mortgagor bank doesn't do the whole process rather than pass it to the investment bank is because it wants to make the mortgage under a separate entity that has its own credit rating, so the rating will be higher than the mortgagor rating itself. Am I right?

    thanks

  4. anyone know why we cant just pay the developer of the property directly (in installments)? why go to the middleman (the bank), obtain a loan, pay the developer, then pay the bank the interest?

  5. @yowmer WTH?! so with most of these housing loans the total sum you end up paying is like what….TWICE the principal? (100k X 10 + 1M = 2M?)

  6. Bank mortgages should be outlawed…illegal.
    A mortgage should be setup such that the monthly interest is 1/2 the payment, and the other half is the principle. If you can't afford it, then no loan….no house…no soaring house prices…people can now afford homes, and they can pay them off much sooner…The current structure of banking causes prices to soar, and you wind up trapped in a 30 year debt…the current structure is a complete and total ripoff..its criminal!….

  7. Hey just a quick question. On the first half of your presentation when you finshed paying the Ballon Pymt loan of 1M dollars your total was 1.1M after 10 years of intrest. Isn't it 2M after ten yrs of intrest plus the principal. Thanks.

  8. @pauli3100 i noticed that too. would be good to get some video notes up there to indicate this mistake

  9. Mortgage Backed Securities are not sold by investment banks. They are sold by the government sponsored enterprises (GSEs), Fannie Mae, Freddie Mac, and Ginnie Mae. GSEs purchase mortgages from lending banks.

    Investment banks also purchase mortgages, and (indirectly) sell securities backed by them (through SPVs), but these are called collateralized debt obligations (CDOs). The SPVs either buy the mortgages or sell mortgage default insurance (CDS). Either way, investors purchase CDOs from SPVs.

  10. Mortgage Backed Securities are not sold by investment banks. They are sold by the government sponsored enterprises (GSEs), Fannie Mae, Freddie Mac, and Ginnie Mae. GSEs purchase mortgages from lending banks.

    Investment banks also purchase mortgages, and (indirectly) sell securities backed by them (through SPVs), but these are called collateralized debt obligations (CDOs). The SPVs either buy the mortgages or sell mortgage default insurance (CDS). Either way, investors purchase CDOs from SPVs.

  11. Khan sounds genuinely excited to talk about financial markets 😀 You can feel the latent hedge fund analyst in his voice :DD

  12. @ThyHolyHandgrenade What he means is that you don't have to pay off a part of the loan principal alongside your interest payment every month. You just pay it in bulk at the end. Normally you pay the 10% interest plus some percentage of your loan. In which case at the end of your term, you don't have any principal to pay.

  13. @dandreoli1973 He's oversimplifying for the less financial-market-savvy students. There's a video where he talks about this in slightly greater detail.

    See "Housing Price Conundrum (part 3)"

  14. @ThyHolyHandgrenade i think all loans require a prinicipal repayment but i think what sal is supposing in this example is that the borrower is only paying the interest during the course of the ten years and the prinicipal repayment at the end (just to make the maths a bit easier)

  15. Eliminate mortgage backed securities. Without your knowledge your money has been taken over and sold. Using a home to gamble is a wrong idea

  16. Your maths is wrong. If you pay $100,000 for 10 years it equates to $1 million, not $1.1 million as you said at 3:08.

    That would be $10,000 per year repayments, not $100,000

  17. Can you explain how the fees work? Like does bank # 1 sell the $1B loan bundle for more than $1B? Just making sure I understand this correctly. I understand the concept that bank #1 would not have sold the loans without making money on it, but I am just not clear on HOW they make this money.

  18. Khan Academy glossed over the fact that banks charge you fees for filling out paper work (they have to look at how good you are at paying back loans, how good the property is if you don't pay the loan back, etc). I don't know how it works for residential properties, but for commercial properties, the fees are often tacked on to the loan.

  19. Khan covers this in the previous two videos. It would be best if you were to watch it through his site as opposed to youtube. The site leads you through the videos nicely

  20. cool video. i love the way you simplify it.
    one question tho, why is it important that the loans are bundled up for sale to the investment bank?

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  23. The only way this could ever make sense to me would be if Bank1 sold the loans for more than 1B$ to Bank2, in which case Bank1 makes some money fast and Bank2 over time makes a little less than 100m$. Is this the case?

    I mean Bank1 lends out 1B and takes 10% interest (100m)
    Bank2 buys the loans for 1B + 50m
    Bank1 makes 50$ right away
    Bank2 earns its' 50$ over time from the debtor

    Help, please!

  24. Needs to be more to the point and about Mortgage Backed Securities rather than traditional loans! Hardly have any time to go through a collection of videos. 

  25. High street banks don't lend money that other people have saved! They simply create most of it out of thin air!!  

    (the banker jargon for this is 'fractional reserve banking')

  26. there should be lesson on how fire is started next to this….
    the change of change, when change on change can't keep up, there is fire….delta..gamma…..30 mortages reek of usury…..

  27. Everybody is quick to bitch about the banks in all this mess, but the common man needs to man up. people shouldn't have taken on loans they couldn't afford. of we had all been just a bit more responsible none of this would have happened

  28. Banks do not lend other peoples money, they create the money at the point the loan is issued and it is simultaneously added as an Asset (The Loan) and a Liability (The Bank Deposit Cash created out of thin air), this then balances the Banks Balance Sheet. They don't need money to lend money – Banks create 97% of our money when they make loans. That's why we had a credit crunch – more accurately should have been called a Money crunch.

  29. Because this explanation does not seem to understand how Banks create money when they make a loan, I have no confidence that anything else relating to how MBS affect a Banks and Investment Banks balance sheets. How do MBS really work? What about how SPVs and SPEs (Special Purpose Vehicles & Special Purpose Entities)?

  30. To those wondering why bank 1 would sell the 1B$ in loans for that same amount, as opposed to more in order to cover the 1B$ debts obligations plus interest it has coming to it, much less without getting a "profit" on top of that, understand that in the real world, bank 1 never actually had a billion dollars to loan.  Because of 1/10 fractional reserve requirements, it only really needed 1/10 of 1B$ in order to make the 1B$ in loans, which is an extra 9/10ths of 1B$ it would then have magically added to it's deposits right out of thin air.  But these are not "profits," because it isn't the bank's money, but rather, the depositors' until they finally pay them back.  Upon that time, the bank will have made 9/10ths of 1B$ on that initial 1/10ths of 1B$, which doesn't even include interest (can we say, CHAH-CHING!).  But that takes time, and the bank needs more money to loan right now, in order to continue making even more money in the meantime, so what appears to be taking a loss in the short run really isn't.  To the contrary, it has made gains, and no, not as much as would have been otherwise (because they lose the interest they otherwise would have received), but they still made massive profits in right now, in one fail swoop (in very short order to say the least), whereas bank 2 has all that money coming to it over time, who is able to do so because it already has plenty of cash on hand to do it's own business, and isn't in any need of replacement deposits at present.  If bank 1 had to charge MORE than 1B$ in order to sell the loans, then it would make less sense for bank 2 to buy them when it can just make out it's own 1B$ n loans on it's own.  But of course, investment banks aren't really in the mortgage business.  But presented with an opportunity to buy up an entire package, might do so.  Granted, if they knew now what they knew then about just how sub-prime these mortgages really were, would probably not have done so.  (Of course, when the govt is requiring people to make them, as was the case in the debacle that came to a head in 2008, it's kinda inevitable.)  Cheers, all.

  31. I think I need to watch this series before watching 'The Big Short' because so far, it looks like I won't understand ANYTHING in that film.

  32. Im not sure if i'm right, but if you got confused about the first part about paying the bank a total of 2 million after 10 years ( 100k x 9 + 1.1m). Don't forget that the bank gave you 1 million to begin with. The bank will earn 1 million dollars and you will be paying a total of 1 million at the end. Here's an example, the toy gun on the shelf at the toy store is worth 10 cookies. I have no cookies, so my friend (the bank) tells me that he can lend me 10 cookies, but for 9 days i have to pay him back an interest of 1 cookie and on the 10th i have to pay back an interest of 1 cookie plus the original 10 cookies that he lends you. You may think this sounds unfair because I have to give a total of 20 cookies at the end. But dont forget your friend lent you 10 cookies to begin with plus 10 extra days to gather 10 more cookies. At the end you are paying the full amount but the bank allows you to pay for it over a period of time.

  33. Just started watching The Big Short from PB. Quality is watchable. This subject of Mortgage-Back Securities immediately came up (or Private labelled MBS as they also call it in the movie). I knew I had to watch these from Khan to understand it. Wolf of Wall street was enjoyable to watch but it would have been better if I understood what was going on financially. Not making the same mistake with this movie!

  34. I don't get why the first bank that let 1000 people borrow a million each (total of $1 Billion they lent out) would want to sell all of those mortgages for $1 billion. How did they make their money?

  35. The major reason the bank sells the loan to the investment bank is so that what was receivables before for the bank is now liquid cash. So now, they can lend even more with the cash they receive. (basically liquidation of illiquid assets)…Not just for the fees!

  36. wait do you mean that you have to pay the one million on interest alone and then at year 10 you pay the initial principal as well?

  37. Apart from the reason given in the video for the commercial bank to sell the (loan portfolio) if i may say so, to the Investment bank, could it also be that they perhaps wanted to safeguard against any sort of credit risk, such as in case the customers failed to pay the EMIs and defaulted?

  38. Lovely video, I now understand, have ben struggling with my studies in finance lecturers teaching s so boring. that's why I got on youtube. weldone khan academy

  39. Great video. Only thing that is incorrect is that banks don't loan deposits. Otherwise very helpful!

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