This is my understanding of the mortgage backed security.Banks will give loans to customers, and then they decide to sell the loans to investment banks and charge a fee with it to earn profit. Now the investment banks will be earning the principal amount as well as the interest. But since, investment banks are not in the business of servicing loans or keeping loans on balance sheet, they create a special purpose entity. All mortgage payments will now go to this entity.

Now since, its a new entity and will be earning good amount of money through interest every year, investors will be willing to invest in this new entity. Investment bank also knows this and hence they issue shares

This is what happened during the financial crisis according to what I understood. But here is the question If the sub prime lenders and prime lenders default, how is it going to impact the share price. Also, let's say the share prices go down because people default and they aren't able to pay the interest rate then how is it going to impact the investment banks. Investment banks have already earned the money by selling the shares My third question is, why are these shares being called mortgage backed securities? The home owners are not buying these shares, it is the investors who are buying the shares. So let's say tomorrow company decides to sell the shares, how is that going to impact the home owner?

  • $\begingroup$ Hi: As you know, the whole MBS process is involved, so it's probably best to read Frank Fabozzi's big book on MBS. ( I assume it's still around ). Just to be brief, there are no shares allocated by the investment bank. The MBS are sold kind of like bonds but with prepayment risk or are put in a layer of a CMO. There was a shorter red book called fixed income mathematics that also might be of help. I'll go on amazon and see if I can get the links. $\endgroup$
    – mark leeds
    Jul 27 at 10:46
  • $\begingroup$ The cover changed but this is the first book I was referring to above. amazon.com/Handbook-Fixed-Income-Securities-Eighth/dp/… $\endgroup$
    – mark leeds
    Jul 27 at 10:48
  • $\begingroup$ I'm not one hundred percent sure because the cover used to be red but this might be the second one I was referring to. amazon.com/Fixed-Income-Mathematics-Analytical-Statistical/dp/… $\endgroup$
    – mark leeds
    Jul 27 at 10:50
  • $\begingroup$ @markleeds Hey, I will try to simplify my question. Suppose lenders have to pay 1 billion dollar to investment banks at 10% rate of interest. So the investment bank set up a special purpose entity and issue shares to get the amount quickly as they dont want to wait for 15-20 years for lenders to pay loans. Now suppose the lenders default, due to which the share prices of entity will go down. Then how is that going to make an investment bank bankrupt, they already raised the required capital by issuing shares. Why then US government had to bailout JP Morgan and other investment banks $\endgroup$ Jul 27 at 12:28
  • $\begingroup$ Money was already raised by shares, so even if the prices go down that wont impact the company right? How is this going to impact lenders? $\endgroup$ Jul 27 at 12:28

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