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.
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?
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