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I do not know if this is the right place to ask this question and if it is not, you may delete this post, if this is the right place then I would like to understand MBS better

  1. I buy a home for 200,000 with 20,000 down payment. I get a loan for 180,000 from a local bank
  2. If the bank sells the loan to an investment firm, in the past, like solomon brothers. What does the local bank get? 180,000 from solomon brothers or the investment firm?
  3. The investment firm then takes thousands of these loans and creates Mortgage Backed Security, MBS, which they sell it to different states pension funds, as said in the movie The Big Short.
  4. Does MBS basically mean, here is an entity (MBS) where inside this entity is thousands of mortgages thus making it mortgage Backed security? Security because the home owner is paying interest? Is interest a security?
  5. The states that end up investing 5 million in MBS, what are they getting? the interest payments from the home owners?

Is my understanding accurate? I feel that, I know that it has holes and I am trying to understand better.

Thank you

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A security is a class of financial instrument you can trade on the market. A share of stock is a kind of security, for example, as is a bond.

In the case of your mortgage, what happens:

  1. You take out a loan for $180k. The loan has two components.

    a. The payment stream (meaning the principal and the interest) from the loan

    b. The servicing of the loan, meaning the company who is responsible for accepting payments, giving the resulting income to whomever owns it.

Many originating banks, such as my initial lender, do neither of these things - they sell the payment stream to a large bank or consortium (often Fannie Mae) and they also sell the servicing of the loan to another company.

The payment stream is the primary value here (the servicing is worth essentially a tip off the top). The originating bank lends $180k of their own money. Then they have something that is worth some amount - say $450k total value, $15k per year for 30 years - and they sell it for however much they can get for it. The actual value of $15k/year for 30 years is somewhere in between - less than $450k more than $180k - since there is risk involved, and the present value is far less. The originating bank has the benefit of selling that they can then originate more mortgages (and make money off the fees) plus they can reduce their risk exposure.

Then a security is created by the bigger bank, where they take a bunch of mortgages of different risk levels and group them together to make something with a very predictable risk quotient. Very similar to insurance, really, except the other way around. One mortage will either default or not at some % chance, but it's a one off thing - any good statistician will tell you that you don't do statistics on n=1. One hundred mortgages, each with some risk level, will very consistently return a particular amount, within a certain error, and thus you have something that people are willing to pay money on the market for.

  • In making those other types of MBS the bank would slice the cash flow from all of those hundreds of mortgages into tranches: money.stackexchange.com/questions/42005/what-is-a-tranche As each tranche would have a different risk characteristic which would appeal to different financial institutions. Which means once a tranche has been sold it would mean more money to buy more MBS/mortgages etc. – Morrison Chang Aug 24 '16 at 22:25
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A Mortgage Backed Security or MBS is the security. It's not an entity, it's essentially a contract. As an investment they function more or less the same way a bond does.

There is nothing wrong with the concept behind a Mortgage Backed Security. Functionally securities like these allows banks and other institutions to lend to high-risk borrowers. You package small slices of a wide range of risk from a large number of mortgages and the investor sill receive something similar to the average of the rates being charged. Essentially from a big pool of mortgages of varying risk you will create a different big pool of bonds that can be sold to investors based on some sort of expected return.

For a frame of reference on a much smaller scale look at peer to peer lending sites like LendingClub and Prosper. The idea is lots of people of varying risk profiles make requests for loans of varying amounts. You bring your $2,500 and invest $25 in to 100 different loans. This way even if a few default you will still eek out a profit. It also allows you to include riskier borrowers without materially impacting your expected return.

  • LendingClub, not LendingTree - I've made that mistake a bunch of times, though, the names are pretty easy to confuse ;). And the difference there is that with sites like LendingClub, you're not buying a bundle, you are actually buying individual 25$ micro-notes (you can pick out each note separately if you're crazy! Or more likely tell an algorithm to pick them for you. I don't think investors of MBS's can do that, pick out individual mortgages they want to invest in slices of? :p) – neminem Aug 24 '16 at 21:31
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    @quid "Our financial crisis was not the fault of MBSs and diversified risk those concepts are sound" that's a somewhat contentious statement. Diversified risk is good, but it has to be genuinely diversified. One of the factors leading up to the financial crisis was that the major players drastically underestimated the extent of correlation among US housing prices. Starting in 2007, housing prices declined across the entire country, something that was never supposed to happen. – Charles E. Grant Aug 24 '16 at 22:43
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    @quid, I completely agree about the role of derivatives, but surely there would have been a substantial problem just from the mis-pricing of the underlying MBS wouldn't there? – Charles E. Grant Aug 24 '16 at 23:08
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    @neminem my understanding is that the MBS actually started out reasonably enough (other than underestimating the overall correlation of the US real estate market), but eventually the banks ran out of high quality mortgages to package. They didn't want to give up the fees associated with the business, so they started packaging the dreck. – Charles E. Grant Aug 24 '16 at 23:14
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    @CharlesE.Grant, the MBSs weren't necessarily mis-priced, the derivatives were. MBSs, and other bundled debt securities, are functionally similar to any other bond or debt security. You buy X future value for Y present value. All that can be lost is what was invested. While with the derivatives millions of dollars of liability were being sold for just a few basis points, and nobody kept track of the total liability. – quid Aug 24 '16 at 23:17

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