Ok, so at its most fundamental level, the value of a bond is the sum of its coupon payments plus the original principal. Therefore, an amortizing bond price is the sum of the interest and principal payment alone.
So, taking a $20 million pool of loans at 4% interest with 5 year amortization gets $22,099,826.47 in total payments. So, theoretically, one could sell this pool of $20mm in loans for $22,099,826.47, correct?
So, tell me if this makes sense:
A bank has $22,222,222.22 in deposits and a reserve ratio of 10%. Therefore, it loans out $20,000,000 in a pool of standardized loans in, say, mortgages or auto loans. After making the loans, it bundles the $20mm in loans into Asset-backed Securities (ABS) and sells them for $22,099,826 and makes a gross profit of $2,099,826.
Is this correct? This scenario, less investment banking fees, etc. seems too good to be true. Is this math correct?
(This isn't for school--I've just been running scenarios about banking finance scenarios...because I have no life).
If you're trading a bond you're really betting on future interest rates. So it's not too good to be true.
So you're telling me this is at least somewhat on target? I mean, if this were true I'd think depository institutions would sell their souls for deposits and buy up as much paper as possible, even at premiums, package the debt and sell it off. With my numbers $100mm = $10 mm of profit in about 3 weeks of work.
What am I missing here? I know I'm missing something.
So, with $20 million in 30-year mortgages with an average life of 7 years and 5% average interest rate, the $20 million would be worth around $26.6 million as a bond. What am I missing? It seems to me that a bank--a simple depository institution--could issue $20 mm in mortgage debt and sell it in the secondary market for $26.6 million. Is this correct? It can't be.
I am trying to understand what you are saying. The stream of cash flows is the same (right?) so your rate must be different? From reading your original post, it sounds like you are forgetting to discount the cash flows generated by the bond, but I am assuming I am missing something...
Ok, here's what I'm saying:
1) $20 mm in loans amortizing over 30 years with a 5% interest rate with average payoff at 7 years 2) Running a full 30-year amortization table, my monthly payment is $107,364.32. 3) Sum of 7 years of principal and interest payments is $9,018,603 with $17,589,003.03 balance (I was wrong in my previous post) 4) Therefore, imputed price of the bond is $26,607,606.29 ($9mm + $17.5 mm).
I guess what I'm saying is that this seems "too good to be true", that I must be missing something. It seems like a depository institution could issue, say, $20 million in mortgages and turn around and sell them in the secondary market to investors and make a quick $6.6 million in profits, which I know can't be the case.
I guess my question is more along the lines of how are MBS/ABS cash flows priced out. If it were this profitable I'd think depository institutions would be attempting murder to get deposits.
assuming your math is right, you're correct. banks are lent money (deposits) and lend money. they take the spread in between.
the reason your number looks ridiculous is a few things: one is the bank barely takes anything (ie takes in money at 4% and lends it at 4.3% maybe). second you have risks of withdrawal/lack of liquidity etc.., and third is the money is coming in interest payments. That 2MM in the first example isn't received all at once, it's received over 5 years.
the risk factor can't be ignored. note:
bond A: 8% coupon, 10yr maturity, 1000 face bond B: 8% coupon, 10yr maturity, 1000 face
these may trade at different prices and you may jump at that and say it's an arbitrage. but not really: one has substantially higher risk. banks have this problem to deal with as well.
so it's not that easy, but fundamentally you are right about the cash flows.
Ahhhhh, hold on, so you're saying an ABS/MBS is different than a traditional, say, corporate bond in how the investors pay?
Whereas a bond investor pays the full, say, $1,000 face all at once in cash, an ABS/MBS is paid by the investor as the cash flow comes in? Therefore, the depository institution is not necessarily selling the MBS for $26.6 million and getting the cash all at once. Is that what I was missing? Is that how an ABS works?
F8ck. I'm in the business of mortgages and real estate and I don't even know how an ABS works. This is embarrassing. It makes me feel better that my boss--one of the owners--knows even less.
VT,
Either:
Why are you not discounting those cash flows back to PV?
Also, as stated before, you didn't discount the cash flows. I just did a quick calculation in Excel. The Present Value of the bond in question would be around $20,106,917.10. And that's not considering the risk free interest rate. It's not as profitable as it seems.
So you started with a PV, computed 30-year amortization schedule, picked an arbitrary point in the middle of schedule (7 years), split cash-flows into 2 [principal/interest payments and PV (balance) @ t = 7], discounted, and recombined, but ended up with a result greater than original PV? That doesn't sound right...
I could be missing something here, but the investor is not going to pay $22,099,000 for the ABS, they will pay approximately $20mm (assuming that the coupon is in line with market interest rates) and you as a bank have to pay them 4% coupon for purchasing the bond until you repay it, so as a bank your net profit is still essentially the interest on the loans, but now you can issue another $20 million in loans because you have pushed the previous $20 off your balance sheet.
disagree.
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