We are going to look at 3 further specific types of financial assets in preparation for one of the biggest topics of discussion in modern economics. Think of our next few articles as teasers for what’s to come. The first of these assets are called mortgage-backed securities (MBSs). The mortgage industry is no small one, being worth roughly $16.6 trillion. As such, it should be no surprise that investors and financiers try and find clever new ways to make money in the home-loaning business, which is precisely what an MBS is.
Now there’s a reason we decided to follow up our derivatives article with an MBS one; like derivatives, MBSs are backed up by an underlying entity, namely loans. Not just a single loan, but rather, a grouping of them. The way these assets are put together, actually fundamentally change how home lending works. Traditionally, a prospective home buyer would go to the bank, get a mortgage, pay off the interest every year and would then own the house once everything has been paid in full. The mortgage in this case is “backed up” by the actual home, which is to say that in case the mortgage borrower can’t pay the money, they’ll have to give their house to the bank.
From the bank’s point of view, they lend out these mortgages to a bunch of other lenders, and that’s largely how they make their money. In other words - the bank owns all those mortgages. Here’s how mortgage lending works with MBSs: the home buyer still goes to the bank and gets their mortgage, but the bank doesn’t keep these loans; they sell them to an investment bank (which are concerned more with stocks, bonds, and other investment products as opposed to savings accounts and deposits). It works similar to how bonds work: the ownership is transferred from the commercial bank to the investment bank.
If 1000 people each buy a $1000/month 30-year fixed rate loan at 4% interest, so they’ve collectively borrowed $360 million:
And since it’s a 4% interest, those 1000 people are going to collectively pay an additional 4% of that $360 million, so $14.4 million in interest. That bank from which the one thousand people borrowed turns around to an investment bank and sells those thousand mortgages for what they’re initially worth, namely $360 million. What does that mean for the borrowers? Instead of paying to the commercial bank, they’re paying it to the investment bank. But the process doesn’t stop there. Remember, investment banks aren’t in the business of handling loans, so they’re not going to treat the thousand loans that they just bought the way a commercial bank might treat them.
So what they do is create a corporation. Now just to clarify exactly what this is, it’s not a big faceless building filled with business people running around in suits. A corporation is simply a legal entity that is separate and distinct from its owners, meaning it can be legally treated the same way an individual would. Corporations pay taxes, enter contracts, be sued, etc. Corporations come in all shapes and sizes; they are not synonymous with “big businesses.”
So when an investment bank creates a corporation to house these mortgages, they are essentially creating an entity which is granted the right to own and receive payments from those mortgages. Now since this is a corporation, shares can be issued. Say 100,000 shares are issued, so a shareholder is entitled to one ten-thousandth of the interest that the corporation receives, which is $144 per year. When the loan is to be paid in full, the shareholder is going to be entitled to their respective percentage of the principal amount, or $3.6k (360,000,000 / 100,000).
Knowing this, the investment bank is going to try and sell the shares for as much as possible in order to make a profit from their purchase of the thousand mortgages. So say they sell the 100,000 shares for a total of $361 million ($3,610 per share), that means the investment bank made a profit of $1 million ($361 million - $360 million). Those stocks worth $3,610 each? Those are mortgage-backed securities; they are financial assets built off of mortgages.
And just as you thought you finally understood how MBSs work, we’re going to add another layer of complexity here for you to think about. If all $360 million in loans is being paid off, then the corporation’s return is $14.4 million per year and the shareholder’s return is $144 per year (which is a roughly 4% profit from the $3,610). An MBS owner in our example would be entitled to 1/100,000 of the total interest of $14.4 million. But that’s a pretty big “if”. You see, the 4% yield for both the corporation and the investor(s) assumes that none of the mortgage borrowers will default or prepay (meaning they pay off their mortgage early).
What happens if the mortgage default rate of those one thousand borrowers is 5%, and the recovery is 50%. The recovery refers to how much the bank, or in this case specifically the investment bank, can restore themselves from a lost borrower. So if someone buys the $360k mortgage, defaults on it, then gives the house to the bank, the bank is going to try and sell that house. But home prices aren’t static, so it’s possible that the bank can only sell the house for $130k. This ultimately means that the recovery is 50%, since the house was sold for 50% of the mortgage’s principal amount.
Let’s set those conditions and see what happens. 5% of thousand borrowers default, so that’s $18 million lost:
But the bank is able to recover 50% of that lost money:
And we can double check the math here by seeing how much money the bank would from selling the 50 houses at an 50% markup:
Factor this new money into the balance sheet:
The net loss is thus $9 million. Since the investors bought shares of the corporation, they are thus entitled to this recovery money.
What’s happening here is that the corporation loses 5% from their mortgages ($18 million), and so investors incur that loss and now receive $351 million. The total interest from that is $14.04 million which means that each share yields $140.4 in interest. Thus, the return from each share went from 4% to 3.9%. The drop may obviously appear insignificant, but the point is clear: if you’re investing in MBSs, you’re basically left to the mercy of mortgage borrowers.
Econ IRL:
The traditional prescription to the issue of informing consumers as to what they’re buying has been government regulation, typically in the form of occupational licensing and regulatory inspections. But online reviews out of all things are proving themselves to be an effective tool in achieving that goal. This week’s paper documents how the authors used machine learning models to gauge hygiene ratings from Yelp and then look at how informative these ratings actually are from the perspective of the hygiene criteria that government inspectors use.
Turns out that some government criterias can actually be fulfilled from the online reviews, namely how the restaurants deal with pests and handle food overall. But the researchers also found that reviews are less informative in other areas such as worker hygiene and the maintenance of facilities. Following this, the effect of reviews on restaurant demand is explored. Restaurants with poor hygiene signals are a lot less likely to sell out the weeks following the review’s publication, which suggests that restaurants may in fact take into account the impact of online reviews when choosing the hygiene standards they plan to maintain.
‘Till next time,
SoBasically