Historically, when someone needed a loan to buy a house, they would approach a bank for the funds.
For example, if a borrower needed $1 million for a home, they would take out a mortgage secured by the house itself. This meant that if the borrower couldn’t repay the loan, the bank could take ownership of the house.
Traditional Mortgage Lending
The borrower would then make payments directly to the bank, typically with interest. Assuming an interest-only loan for simplicity, a borrower with a 10-year, 10% loan would pay $100,000 annually in interest, and at the end of the term, they would repay the original $1 million in full.
Banks traditionally funded these loans through customer deposits. A depositor might place $1 million in a bank, earning 5% interest, while the bank lent that money out at 10%, making a profit on the difference.
The Introduction of Mortgage-Backed Securities
With the emergence of mortgage-backed securities, the traditional lending model changed. Banks sought alternative ways to continue lending without being constrained by the deposits they had available. Instead of keeping loans on their books, banks began selling them to third parties.
For example, consider a scenario where a bank lends $1 million each to 1,000 borrowers. Collectively, those borrowers owe $1 billion and pay 10% interest, amounting to $100 million in annual payments.
Instead of waiting years to recover these funds, the bank sells the loans to an investment bank for $1 billion upfront.
The Role of Investment Banks
When the investment bank purchases these loans, the original borrowers no longer send their payments to the lending bank but to the investment bank instead.
The lending bank benefits by receiving immediate capital, which it can then use to issue new loans. Meanwhile, the investment bank now owns a large pool of loans and begins structuring them into securities.
Investment banks engage in this process because they can earn significant fees for bundling and selling these loans. While the selling bank profits from fees and liquidity, the investment bank gains access to a steady stream of payments from borrowers.
Preparing for the Next Step
At this stage, the loans have been transferred to the investment bank, but they are not yet structured as mortgage-backed securities. The next step involves transforming these loans into tradable assets, a topic that will be explored in the next discussion.