Questions about the Economy Topic: only the most serious need apply

Andy001 · Spaghetti

Questions about the Economy Topic: only the most serious need apply

MorisUkunRasik · World's Strongest Millionaire

http://en.wikipedia.org/wiki/Mortgage-backed_security

Andy001 · Spaghetti

Shockingly enough, I've been spending a good part of the evening reading that and similar pages. I was hoping we could discuss it in more informal terms, but never mind.

Andy001 · Spaghetti

I suppose what I'm trying to understand is: what is the financial benefit to buying up a big package of someone else's debt? How does that turn around into a profit for someone? (Or alternatively, am I mistaken for thinking that's how it works?)

MorisUkunRasik · World's Strongest Millionaire

I could be wrong but my understanding was that you buy the debt so that the lender can continue lending and eventually gives you a cut of the profit.

Andy001 · Spaghetti

Gracias.

MorisUkunRasik · World's Strongest Millionaire

Andy001 wrote:

Andy001 · Spaghetti

Indeed.
I think I should read up about derivatives too. More exciting chat to come, probably tomorrow!

MATHSEX · MASTER BATOR

Andy001 wrote:

Indeed.
I think I should read up about derivatives too. More exciting chat to come, probably tomorrow!

the only important derivative. all other uses of the word are, shall we say, derivative

Ozpunker · Senior Member

I learned about mortgage backed securities and stuff in Land Valuation.... but my final exam for that was yesterday so I don't care anymore...
My math exam is on Thursday so I do still care about derivatives however.

john31584 · Zinc Saucier

Andy001 wrote:

I suppose what I'm trying to understand is: what is the financial benefit to buying up a big package of someone else's debt? How does that turn around into a profit for someone? (Or alternatively, am I mistaken for thinking that's how it works?)

I keep getting notices that my student loans might be sold to third parties. Basically, when you buy debt, you're buying somebody's obligation to pay you.

Suppose I owe you $100,000, with interest. I've paid off about $50,000 of the principal, so I've still got well over $50,000 to pay you. To make it simple, let's say I still owe you $60,000.

Somebody might come in and offer to buy my $60,000 in debt for $55,000. That's less than you expected to get originally, but it's still a profit, since you're getting back more than you loaned me. If you're less than confident about my ability to pay you back, you might be happy to sell my debt at this price. Of course, the buyer is betting that I'll be able to pay it back in full.

If you sell the debt, my obligation is now to pay the full $60,000 and any subsequent interest to the buyer. I see absolutely no change on my end, but you're up $5,000, and don't have to worry about trying to collect from me anymore. If all goes according to plan, the buyer will also end up at least $5,000 ahead.

My understanding is that a huge number of these transactions took place during the housing bubble; people were buying huge packages of mortgage debt. They figured that housing prices would keep going up, and even if they had to foreclose, they'd turn a profit when they sold the house. Prices plummeted, debtors defaulted, and people realized that they were just pouring money into a hole.

-- Edited by john31584 at 14:59, 2008-11-18

Andy001 · Spaghetti

Thank you John, that is immensely helpful.
Would you agree with me, though, that when carried out on a large scale, that is a very risky way to go about business, especially when many of the mortages purchased came from subprime lending, which is by definition a risk? As you said yourself, lenders have the most incentive to sell on the debt when they suspect that they may not be repaid, and given that it seems to be a truism of finance that house prices can never go on rising indefinately, I just feel that people should have learned to stop much sooner than they did.

john31584 · Zinc Saucier

That's really the extent of my understanding of the matter.

I would guess, however, that a combination of factors led to investors acting in economically irrational ways. Part of it is that the system was so complicated that they didn't really know what they were getting into when they bought up a lot of this debt. Another part of it was probably government policies creating warped incentives.

Andy001 · Spaghetti

Yeah, the problem of the packages being too complicated for the purchasers to really understand is something I have heard quite a bit.

It's good to exchange views on this, I must say. As tragic as it is for the state of the world, it is somehow a very interesting topic.

MATHSEX · MASTER BATOR

Ozpunker wrote:
My math exam is on Thursday so I do still care about derivatives however.

derivatives are mighty in their glory and their importance