Consumption and Real Estate
How do banks benefit from Residential Mortgage-Backed Security?
Question : How do banks benefit from Residential Mortgage-Backed Security?
residential mortgage
Best answer:
Answer by Hello G
For any mortgage there is a “default risk”, which is the risk that the person who owns the house will not be able to pay the mortgage. Banks use mortgage backed securities to bundle the risk of the mortgages and transfer the risk of the mortgages to others who are better able to bear it. (We know that they are better able to bear it because they are willing and able to pay for them.)
What happened with the current crisis (part of it) is that these mortgage-backed securities became structured in crazier and crazier ways, swapped for other risk-transfer securities called Credit Default Swaps, and so muddled that it was difficult to put a value on the assets. Eventually people realized what was going on and were no longer willing and able to buy those securities (that is called a liquidity problem). The banks were stuck holding the ball and were no longer able to sell those securities for cash, which they would lend out to companies and individuals. So, that is where some of the credit crisis comes from.
EDIT: I heard a great radio program about this, with experts explaining in very easy to understand terms. I will link to the podcast below. The hour-long show is DEFINITELY worth listening to.
The radio program recommended by the first answer is great.
But to answer your question, there are two ways banks make money: interest on loans and fees.
Because of the Federal Reserve’s reserve requirements, there is a limit on how much money a bank can lend out,
http://en.wikipedia.org/wiki/Reserve_requirement
which means that there is a limit on how much profit they can get from the interest on loans. If they want to make twice as much, they have to have twice as much money.
But when they securitize a mortgage and sell it as a Residential Mortgage-Backed Security, the loan is no longer on their books – it belongs to whoever bought the security.
The bank gets the fees for setting up the mortgage and from collecting the monthly payments, but they can lend the “same” money out over and over again. Now that fee income can really pile up.
When the bank holds the mortgage, if the borrower defaults, the bank loses money. So the bank will be careful about whom it loans to; it want to make sure it will get repaid.
But after the bank has sold the securitized mortgage, it doesn’t care. If the borrower defaults, the owner of the security loses the money, not the bank.
So for the bank, the way to make more money is to make lots of mortgage loans, and it doesn’t matter to the bank how risky those loans are.