A Simple Narration to make you understand Mortgage-Backed Securities (MBS)
Tony owns a small bank. Alice wants to buy a home but can't afford to pay for it upfront, so she heads over to Tony's bank to get a mortgage. Tony carefully analyzes her financial situation, knowing that if he gives Alice a very long term, a relationship will be established where Alice makes payments to Tony's Bank over many years. This is what we could call a traditional banking relationship. Tony has all the reasons in the world to think twice before lending Alice money.
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Nowadays, we also have Bill, a modern-day banker, and Dave who wants to buy a home and needs a mortgage just like Alice. As far as Dave is concerned, the process is similar. He heads over to Bill's bank and asks for a loan. Unlike Tony, however, Bill isn't as worried about the relationship with Dave and is willing to ignore many of his problems. Why? Well, unlike Tony, Bill doesn't have as much skin in the game because:
- He gives Dave a loan.
- He then sells Dave's loan to an investment bank and receives a bunch of money.
- The investment bank takes Dave's loan as well as several other loans and creates a package called a mortgage-backed security or MBS, and then sells the mortgage-backed security to investors and receives a bunch of money.
In the end, it's those investors who end up taking on risk and being rewarded if people keep paying their mortgages.
The Evolution of Mortgage-Backed Securities (MBS)
Since 2008, mortgage-backed security safeguards and risk management tools have evolved, strengthening the market and supporting US homeownership. Each day, billions of dollars of mortgage pools move through banks and non-banks as they migrate to agencies like Freddie Mac and Fannie Mae, which package them into agency MBS. Mortgage pools are sold forward like derivatives and called "to be announced" or TBAs. TBAs do not require collateral; instead, counterparties keep lists and limits with whom they are willing to trade TBAs.
While the Depository Trust and Clearing Corporation (DTCC) provides clearing services for TBAs, many firms do not centrally clear. Recently, CME Group launched TBA Futures, centrally cleared margin products that deliver physical TBAs through DTCC. Standardization of centrally cleared TBAs and robust margin processes remove counterparty risk while providing transparent pricing. The growth since the launch of TBA Futures has been rapid, showing strong demand for risk management in the mortgage market.
Mortgage-backed securities Part 1 and Finance & Capital Markets
This is going to be part of a whole new series of articles because I think what's happening right now in the credit markets is pretty significant from both a personal finance point of view and a historic point of view. I want to do a whole set of articles to help people understand 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 happened when I went to get a loan for a house, let's say, 20 years ago.
And I'm going to simplify some things. Later, we can delve into more explanations. Let's say I need a $1 million loan to buy a house. The traditional way I got a $1 million loan is I would go and talk to the bank. They have the money. They would give me $1 million, and I would pay them some type of interest. Let's say I would pay them 10% interest. For the sake of simplicity, let's assume the loans in this presentation are interest-only loans.
In a traditional mortgage, your payment has some part interest and some part principal. Principal is when you're paying down the loan. In this case, let's assume 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. For each year of the 10 years, I'm going to pay $100,000 in interest. Then in year 10, I'm going to pay the $100,000 and also pay back the $1 million. So I pay back $1.1 million. That's how the cash is transferred between me and the bank. This is how an interest-only loan differs from a mortgage-backed security. The important thing to realize is that the bank would have kept the loan, and these payments I would have been making would have been directly to the bank. That's what the business that historically banks were in.
Additional Example
Now let's consider the example with a mortgage-backed security. There's still me, and I still need $1 million. Let's say I go to the bank, and like before, the bank gives me $1 million. Then I give the bank 10% per year. 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 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? How do you sell a loan? Let's say there's me and a thousand others like me. We each borrow money from the bank. So collectively, we've borrowed $1 billion from the bank, paying 10% interest on that.
So, the bank takes all these loans together, that $1 billion, and says, "Hey, investment bank, why don't you give me $1 billion?" The investment bank gives them $1 billion, and now instead of us paying the money to the bank, we're paying it to this new party. So the bank sold the loans, grouping all of them together, and sold them to another bank. This bank paid $1 billion for the right to get the interest and principal payment on those loans. The investment bank probably got fees for doing this, or maybe it just likes giving loans to its customers. But the actual reason is that they got fees for doing this, and they're probably going to transfer a little bit less value to the original bank. So now, the payments are essentially funneled to the investment bank. That's how the mortgage-backed security system works.