Welcome back to my series of presentations on
mortgage-backed securities.
So let's review what we've already gone over.
So I've already drawn here-- I actually prepared ahead of
time-- so I've already drawn here kind of what we've
already talked about.
So we start with borrowers who need to buy houses.
Each of them borrowed $1 million.
Actually let me write that down.
Let me change the color of my pen.
Where'd my pen go?
OK.
So each of these people borrowed $1 million.
OK.
Each of them borrowed $1 million and there were 1,000
of them, right?
So $1 million times 1,000.
That's $1 billion 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 is $100,000 and then as we
said, there's 1,000 borrowers.
So they're going to put in $100 million, right?
100,000 times 1,000 is 100 million.
So just to simplify.
Keep it in your mind. $1 million goes to a bunch of
borrowers, goes to 1,000 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 kind of structure these mortgage-backed
securities-- they're going to give 10% of the billion, or
$100 million back into this.
And then we said, OK, well where does that money for this
special purpose entity, or for this corporation, come from?
Well it comes from the investors in the actual
mortgage-backed securities.
And just to be clear, so the asset within this
entity are the loans.
The loans are the main asset that's inside of the special
purpose entity.
And the loans are just the right on these 10% payments.
And so money came from when the owners of each of these
mortgage-backed securities-- each, let's say, paid $1,000
for the mortgage-backed securities.
And in return, they're going to get 10% on their money.
So each security cost $1,000.
And then they're going to they're going to get
$100 back per month.
And we said there are a million of these securities,
so $1,000 times 1 million, that's where the $1 billion
comes from.
My thing's been acting up.
That's where the $1 billion comes from.
And that essentially is 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 every one of these borrowers pays their loans,
never defaults, never pre-pays.
Pre-paying a mortgage is just saying, I sold the house.
I don't need the mortgage anymore, so I just pay it off.
So it's only 10%, indefinitely, if all of the
borrowers pay all the money and never default or
anything like that.
So this 10% is kind of in an ideal world.
Well everyone knows that it's not going to be exactly 10%.
Some percentage of these borrowers are going to default
on their mortgage.
Some of them are going to pay ahead of time.
And actually that's what the buyer of the mortgage-backed
security 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 with these computer models to value their
mortgage-backed securities.
And that's what those computer models do.
They try to look at historical data and figure out, OK, for a
given population pool in a given part of the country,
what percentage 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 on a $1 million mortgage, and then the
special purpose entity would get control of that house.
And then if that house is sold for $500,000 because the
property value went down, then the recovery would be 50%.
So that's all of the things that someone needs to factor
in when they figure out what will 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-backed security 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--
my pen keeps not working-- that 20% will default.
We're not going to worry about pre-payment rates and all
things like that.
Let's say 20% are going to default.
Of these 1,000 borrowers, 200 of them are just going to lose
their job or whatever.
They can't afford a mortgage anymore.
And of those 20% that default, we have a 50% recovery.
So that means borrower X defaulted on his loan.
And then when we go and get the property-- because the
loan was secured by the property-- when we auction off
the property, we only get $500,000 for it.
So we get a 50% recovery.
50% of the original value of the loan.
So if 20% default 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
handwaving assumptions here.
But you can assume statistically, and since this
is a large number of borrowers-- it's 1,000, right?
If there's only one borrower it would be hard to kind of
gauge when he defaults, if he defaults at all.
We would just know that there is a 20% chance.
But when there's a large number of borrowers, you can
kind of do the math and say, OK, 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 based on the model that we just
constructed, right?
This is the model that we constructed.
This is a much simpler model than what most people use.
But based on the model that we just constructed, I think the
real return we're going to get on this mortgage-backed
security is 9%.
If there was another investor who assumed a 50% default
rate, but 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.
Before, 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 service.
Right?
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's requirements are,
they would never get a loan.
But there are probably some investors out there that 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 it enough.
And this is what this mortgage-backed security
market allows.
It allows-- let's say this group of borrowers-- let's say
this pool of borrowers right here actually didn't--
This pool of borrowers actually aren't the
traditional-- they don't have 25% down and they don't have
kind of the traditional requirements to get a normal
mortgage-- but if I pool a bunch of people who don't have
those traditional requirements, but 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 them money.
So essentially, from the borrower's point of view, it
allows more access to loan funding that 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 that the computer models that I have are really
good at predicting things like default rates, and recovery
rates, and what a loan is worth.
And I feel that I can, in some ways, be a better loan officer
than the banks.
And this would be an attractive place for
me to invest in.
It also might just have a risk reward characteristic that
doesn't exist in the market already, and it allows you to
diversify into one other asset class.
So that's the value that it 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 to even a
larger group of investors.
Because you can think about it right now, there's probably
some people who say, OK, I already said, some people will
do these models and try to make their own assumptions and
say, OK, this is going to give me 9% a year.
But there's a whole bunch of people who are going to say
this is just 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.
Very highly rated debt is where I'm going
to invest my money.
And there's another group of people who say, OK, 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 in the presentation
on collateralized debt obligations.
See you soon.