Question

James borrows \(\$ 300,000\) for a home from Bank A. Bank A resells the right to collect on that loan to Bank B. Bank B securitizes that loan with hundreds of others and sells the resulting security to a state pension plan, which at the same time purchases an insurance policy from AIG that will pay off if James and the other people whose mortgages are in the security can't pay off their mortgage loans. Suppose that James and all the other people can't pay off their mortgages. Which financial entity is legally obligated to suffer the loss? a. Bank A. b. Bank B. c. The state pension plan. d. AIG.

Short answer

The financial entity legally obligated to suffer the loss is AIG.

Step-by-step solution

Understanding the Transaction Sequence

James borrows 00,000 from Bank A. Bank A sells this loan to Bank B. Bank B groups this loan with others and sells the resulting mortgage-backed security to a state pension plan. The pension plan also buys an insurance policy from AIG to cover defaults on these mortgages.

Identifying Obligations

When the state pension plan purchases the mortgage-backed security from Bank B, it assumes the risk of default on the mortgages included in the security. However, they mitigate this risk through an insurance policy from AIG, which agrees to pay if defaults occur, thereby transferring the risk to AIG.

Assessing the Default Scenario

If James and others fail to pay their mortgages, the pension plan, as the owner of the security, initially faces the financial loss. But since the pension plan has insurance from AIG, AIG is legally obligated to cover the losses as per the insurance agreement.

Key concepts

Mortgage-Backed Securities

Mortgage-backed securities (MBS) are financial products that allow investors to buy a piece of a mortgage loan bundle. These bundles contain countless loans, making them part of everyday financial markets. By purchasing an MBS, an investor is essentially lending money to homebuyers.
One major advantage of MBS is that they provide a steady income stream as borrowers make their regular mortgage payments. However, they also carry some risks, primarily the possibility of defaults.
The value of an MBS can vary, depending on:

• The prevailing interest rates.
• The creditworthiness of borrowers making up the pool.
• The ability of borrowers to fulfill their payment obligations.

When mortgage loans default, the income from the security can decrease, affecting its investment value. This is why investors often seek protective measures against the default risks.

Insurance Policy

An insurance policy is a contract that provides financial protection against specific risks, including defaults in the context of mortgage-backed securities. In our scenario, the state pension plan bought an insurance policy from AIG.
This policy acts as a safeguard. If homeowners like James cannot make their mortgage payments, triggering a default, AIG steps in to cover the loss incurred by the pension plan.
Features of such insurance policies can include:

• Clear terms that define what constitutes a 'default.'
• A defined payout amount or condition upon default.
• A premium that the insured must pay to maintain the coverage.

This insurance support helps mitigate the financial blow for the investor due to defaults, transferring the risk from the investor, like a pension plan, to the insurance provider.

Default Risk

Default risk refers to the probability that borrowers, like homeowners in a mortgage-backed security, will fail to make their payments. It represents the financial uncertainty of a borrower's inability to meet their loan obligations.
This risk is crucial for all parties involved in a mortgage security transaction.
Understanding default risk involves considering factors such as:

• The economic environment and housing market conditions.
• The credit scores and financial stability of borrowers.
• Interest rate fluctuations that could affect borrower payment capability.

Investors and financial institutions use these assessments to manage and hedge against possible losses. An insurance policy is one common method used to manage default risk, thereby reducing potential impacts on the investor's returns.

Financial Institutions

Financial institutions play a crucial role in the securitization process and the broader financial markets. These entities, including banks and insurance companies, facilitate the movement of money and the distribution of financial risks.
In the context of mortgage-backed securities, different financial institutions have:

• Bank A, which initially provides the loan.
• Bank B, which packages and securitizes these loans.
• Insurance companies like AIG, which offer policies to minimize risks tied to defaults.

Each institution has different responsibilities and bears different risks. Understanding these roles helps in grasping how funds and risks are managed in complex financial systems.
Financial institutions thus not only enable the creation and sale of mortgage-backed securities but also aid in spreading out risks among different market participants.