Sunday, April 12, 2009

Mortgage Backed Securities and Loan Selling

Continuing from where I left in my last post, I would like to explain in detail about the Mortgage Backed Securities (MBS) and why Banks sell loans at all. I have received the following questions from one Amol and my answers follow.

Do the Banks get a cut by selling loans and why do they sell Loans?

Yes they do. They get commissions by selling loans. I do not know the exact percentage of commission they get but I think it is somewhere around 1 percent of the loan amount they sell. Suppose if Bank of America sells 1 Billion dollar worth of Loans to Fannie Mae, then Bank of America might get around 10 Million dollars (1 %) as commission. The following example shows why banks sell loans.

As I said in my last post, Banks sell loans to mobilize more capital and it is an easier form of capital generation than other available options. So, if they sell loans, then they can free up more capital to lend similar loans to more customers. Apart from that they get commission upfront which is more profitable than what they get through interest rates if they keep the loans with them.

Example: Assume Bank of America has 1 Billion dollars worth of housing loans and they have given those loans at an average interest rate of about 6 percent. If they keep the 1 Billion dollars worth of loans in their books and get interest income, then they would make about 60 Million dollars of income for that particular year. But if they sell the 1 Billion dollar worth of loans to Fannie May, they get two advantages. One is they get 10 Million Dollar commission and the other is 1 Billion Dollar loan amount which they can loan it again to customers. So, if they repeat this process once in a month, then at the end of the year, they would make 120 Million dollars in commissions alone apart from loaning 12 Billion dollars to customers. So, by selling loans Bank of America makes an additional profit of about 60 Million dollars apart from attracting more customers (Because BOA has distributed 12 Billion worth of Loans). Hope now it is clear why Banks sell loans.


What do you mean by "Banks sell loans as securities"?

This is again the same concept like shares. Take the same example given in the first question. Bank of America sells 1 Billion dollar worth of loans to Fannie Mae. Like bank of America, there are thousands of other Banks that do the same. Fannie Mae collects all these loans and remember Fannie May pay to all the Banks. So, Fannie May is no cash machine to create money. Hence, they also depend on private investments. Hence, what they do, they just pool all these loans and make it as an investment portfolio just like a company. Where does the investment portfolio get earnings? From high interest rates paid by subprime customers. So, the investment portfolio issues securities just like shares that can be traded in the secondary market and many private investors invest in it including Investment Banks, Insurance Companies, Fannie Mae, Freddie Mac, Hedge Funds and Mutual Funds. All these companies invest in mortgage backed securities because of high earnings potential but it also comes with extreme risk. As you know, when people lost jobs, they started defaulting the loan amount and all the mortgage backed securities bought by companies like Lehman Brothers became worthless and the rest is history.


In sub prime crisis, loans were sold many times by many players. So first thing that comes in my mind is why someone would buy a loan?

As I said in the previous questions, the loans were converted in to secondary market tradable securities. Remember all these subprime loans attracted exorbitant interest rates like 18 % to 20 % taking advantage of the customer’s poor credit history. So, investors started believing that Mortgage Backed Securities would give exceptional returns and invested in it. They bought loans to make more money and lost all of them.

8 comments:

Amol April 13, 2009 at 1:06 AM  

Thanks again Kumaran for answering my queries in such a nice and clear way.

Home Loans May 22, 2009 at 5:45 AM  

I would like to appreciate Kumaran for the so nice post including the explanation of many points.

FHA Loan Guidelines August 25, 2009 at 1:41 AM  

I agree with you. It helps people understand the issue very well and leave some insights for them on what to do if they experience some of these.

Palmdale Homes for Sale July 23, 2010 at 12:25 AM  

I guess in retrospect, the investors buying up these subprime loans should have known better to buy when the market was already so high, but I guess they couldn't have known that. Housing prices just seemed to continually rise without showing signs of stopping. The only exception was the ARM loans and balloon payments that were coming due with a lot of the financing and refinancing that was going on.

home buyer March 21, 2011 at 4:46 PM  

Glad I drop by! This is a great site and contains fantastic contents. Thanks for sharing this to us.

Ditech Home Loan June 7, 2011 at 12:05 PM  

As a result of the subprime crisis, the government will now roll out new mortgage reforms. Many prospective homeowners will not be able to meet the stringent income to mortgage payment ratio of 28% and heftier down payments. As a result we will see more renters.

Payday Loan December 30, 2011 at 6:17 AM  

I was completely unaware of the fact that banks also take commissions for selling loan.In such situation I came to a conclusion in my mind that all are chained for profits against customer needs.

HDFC Home Loans July 19, 2012 at 2:18 AM  

One of the best information on the mortgage loan topic. Lot of time a search on internet for this topic but didn’t get the information in a best way like this.

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