1. Title Slide
Welcome back! In this video, we will review transactions in the capital markets.
2. Financial system
Recall from the financial system diagram that lenders sell their loans to financial institutions in the capital markets. Financial institutions purchase these loans to earn the interest borrowers pay. This transaction is known as a trade: they are trading money for loan agreements.
3. The U.S. mortgage market
Before we dive into trading, let's first talk about the mortgage market in the US.
In the first quarter of 2023, Americans owed 12 trillion dollars in mortgage debt. For comparison, the annualized US gross domestic product, a measurement of total economic activity, was an estimated 25 trillion in the same period.
In addition, mortgage debt makes up almost 75% of all the household debt Americans owe.
So mortgages account for a large portion of the US debt and economy, and much of the 12 trillion dollars in mortgage debt was traded in the capital markets.
4. Whole loan trading
When mortgages are sold to investors, they are often put into groups called "pools". A pool can be one or more mortgage loans.
There are two types of common transactions in mortgage trades. The first is a whole loan trade.
5. Whole loan trading
A whole loan mortgage transaction is a trade in which an investor individually bids on each mortgage. This is pretty straightforward, as the investor knows exactly which mortgages they purchase.
However, this type of transaction is inefficient as the investor needs to analyze each loan, which can be time-consuming.
6. Mortgage-backed securities
Securiziation is the most common type of transaction seen in the mortgage capital markets.
7. Mortgage-backed securities
With securitizations, mortgage pools are bundled into a new financial asset, called a mortgage-backed security, and the investor buys the security instead of the individual mortgage.
Securitization allows investors to buy many more mortgages than in whole loan trading, as they don't have to analyze each mortgage but rather just the performance of the MBS bond.
8. Mortgage-backed securities
Securitizations are usually formed from mortgage pools with similar characteristics, for example, rate, term, loan-to-value, location, or even the lender who originated the loan.
9. Mortgage-backed securities
However, not every loan is eligible for securitization, as they need to meet the requirements set forth by the security creator, known as a securitizer. These requirements become the qualification guidelines lenders must use to sell their loans to securitizers. We covered some of those qualification guidelines in the previous chapter.
10. Mortgage-backed securities
Fannie Mae and Freddie Mac are two of the largest mortgage securitizers in the US. They purchase about 70% of all mortgages in the US and pool them into their securities, which they call "uniform mortgage-backed securities", or UMBS. This is because all mortgage loans must meet their underwriting guidelines.
11. Bidding and prices
Once an investor has identified which mortgage or MBS bond they want, they will place a bid on it with a price.
The trade price is expressed as a percentage of the loan's principal balance.
The trade amount is the total dollar amount paid for the loan. This is the product of the trade price and principal balance. Remember that the principal balance is just the current balance of the loan.
The trade premium is the difference between the principal balance and the trade amount and shows the extra amount the investor paid to own the mortgage.
For example, if a mortgage is trading at a price of 101, it means that the buyer will pay $101,000 for a $100,000 principal balance, which is a trade premium of $1,000.
12. Bid analysis in this case study
Once bids have been received, the seller must decide which investor to transact with.
In this case study, we will replicate a whole loan transaction, where investors can bid on any individual loan they want. We'll use a technique to find the highest price.
As a lender, we can choose to sell through a whole loan trade or a securitization, so we'll compare the whole loan prices to UMBS prices to ensure we're maximizing profit.
13. Let's trade!
Now that you have the trading basics down, it's time to review the bids on our pool and get this trade started.