Banks: Slightly more complicated (Part II Bank Series)

The next step in dissecting bank involves something called securitization.  Securitization is a method of turning an asset (e.g. a bunch of loans) into securities.  Let’s say ACME Bank has 5 home loans with a balance of $200K each — or $1M in mortgage assets.  It can divvy this $1M bundle of loans into 100 pieces each with a nominal value of $10K each.   Companies or people can buy these mortgage backed securities (MBS).   This is the basic idea, anyhow.

Basically banks can make loans and repackage them into various MBSs.    The simplest kind is a pass-through MBS.   In the example for ACME each “share” of the MBS would get 1 percent of the mortgage pool payment stream (less fees).

There are other methods of slicing and dicing MBSs such as collateralized mortgage obligations or CMOs.  CMOs repartion the mortgage pool into different flavors or tranches.  For example there may be a principal-only tranche that pays only the principal stream and an interest-only tranche that pays out from the interest portion of mortgage payments.

One thing MBSs allow banks to do is to take assets off their balance sheet.  They can turn a pile of loans into a bunch of securities they can sell at the market for cash.  The other thing banks and investment companies can do is buy MBOs.

Now the basic idea is a pretty good one.  The securitization process worked pretty well for many years.  And it still does work even today (check out Bill Gross’s excellent PIMCO Total return fund for example).  But things can and did go wrong when companies quit buying certain MBOs due to legitimate concerns.  No buyer equals no market.  And no market spells trouble for companies with too many unpopular MBOs on their books.

I’ve only scratched the surface of this more complicated portion of the bank mess.   This is partially to keep the discussion interesting (or at least less boring) and partially because I don’t have more specific data at this time.

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