In my last post I talked about how banks make a profit by taking your deposits, and paying you interest on them and lending out those deposits to people who want to borrow money, charging a higher rate of interest on the loans than they pay on deposits - this difference being the bank's profit.
This assumes that the banks simply keep the loans on their own books and collect the loan payments over time. However, banks will often sell these loans off to investors, which is called securitization.
A good example is David Bowie (stay with me). In 1997 David Bowie calculated what he expected his royalty earnings from record sales to be for the next ten years, and decided he'd rather have the money now. So he packaged up the rights to his royalty earnings and sold them to investors in the form of Bowie Bonds. Bowie was paid $55m in 1997 for these bonds, and over the next ten years the investors collected whatever royalties Bowie would have earned on his record sales.
In effect, this is what banks do with mortgages. They lend out, say, £10m in mortgages. If they were to keep the mortgages on their own books, they would earn (for example) £15m in mortgage payments over 10 years. But rather than do that, the bank instead takes this package of £10m worth of mortgages and sells it to investors for the market price. These investors then receive a return on this investment, in the form of mortgage payments from those who borrowed money from the bank in the first place.
Again, wikipedia is much better than me at explaining these things:
XYZ Bank loans 10 people $100,000 a piece, which they will use to buy homes. XYZ has invested in the success and/or failure of those 10 home buyers -- if the buyers make their payments and pay off the loans, XYZ makes a profit. Looking at it another way, XYZ has taken the risk that some borrowers won't repay the loan. In exchange for taking that risk, the borrowers pay XYZ interest on the money they borrow.
From the perspective of XYZ, those loans are 10 different assets. They have value -- one, if the loan fails, XYZ takes ownership of the house. Two, if the loan succeeds, XYZ gets their money back along with the interest they charge.
XYZ can do two things with those loans. They can hold them for 30 years and, they would hope, make a profit on their investment. Or they could sell them to some other investor, and walk away. In doing this, they would make less profit than if they held onto them long term, but they would benefit in that they make some profit while also getting their original investment back. They give up some of the reward (profit) in exchange for not having the risk.
So XYZ Bank decides they'd rather have the cash now. They could sell those 10 loans to 10 investors. Each investor would be taking a risk in buying those loans, because if any loan defaults, that one investor loses. Naturally, investors would not be willing to pay very much for those loans, knowing the risk involved. XYZ wants to sell those loans for the best price they can get, so they decide to securitize those loans. They combine the 10 loans into one entity, and then they split that one entity into 10 equal shares. Each investor still pays the same $100,000, but instead of owning one loan, they will own 10% of all 10 loans. If one loan fails, every investor loses 10%.
The result is that XYZ bank is able to sell their assets for more money, and investors are insulated from the volatility of directly owning mortgages.
Such is the power of securitization. And this is basically what happened with all the subprime mortgages lent out in the US. They were packaged into securities and then sold to investors.Next post on how this affected banks so badly.