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

AIG is legally obligated to suffer the loss.

Step-by-step solution

Identify Original Loan Holder

Bank A is the entity that originally lent James the money for his home in the form of a mortgage of \(\$300,000\).

Transfer of Loan Rights

Bank A resells the right to collect on James's loan to Bank B. This transfer means Bank A is no longer directly involved with the obligations of the loan.

Securitization and Sale

Bank B securitizes James's loan with others and sells this security to a state pension plan. By selling the security, Bank B has transferred the mortgage risk to the pension plan.

Insurance Coverage

The state pension plan purchases an insurance policy from AIG, which is designed to cover losses if the mortgages within the security default, including James's mortgage.

Identify Legal Obligation

Since AIG issued an insurance policy to cover defaults on the mortgages inclusive of James's, AIG is legally obligated to cover the loss if all the individuals, including James, fail to pay their mortgages.

Key concepts

Securitization

Securitization is a financial process that transforms various financial assets, such as mortgages, into marketable securities. This allows financial institutions, like banks, to pool multiple assets and resell them in the form of a security to investors. In the example, Bank B pooled James’ mortgage with others and created a new financial product, which was then sold to a state pension plan.

• The process begins by banks or financial institutions bundling similar loans, like mortgages, into a group known as a pool.
• These pools are then transferred into a special purpose vehicle (SPV), which is an entity created solely for this purpose.
• The SPV issues securities, like bonds, that are sold to investors, providing them with a share of the cash flow generated by the pooled assets.

This method offers liquidity to banks because they can convert loans into cash and benefit from the spreading of risk. Investors, on the other hand, gain access to products that might offer higher returns.

Mortgage Default

Mortgage default occurs when a borrower fails to meet the legal obligations or conditions of a mortgage loan, typically by not making payments. When defaults increase, as in the example where neither James nor the others in the mortgage pool could fulfill their payments, it raises significant financial concerns for all parties involved.

• Defaults can result from various factors such as financial hardship, unemployment, or decreases in home values, impacting a borrower's ability to pay.
• A high rate of defaults within a mortgage pool can lead to a loss of revenue for investors who purchased the securities backed by these mortgages.
• This is why investors or financial institutions may seek safeguards, such as insurance policies, to mitigate potential losses due to defaults.

It's essential for financial markets to manage defaults well since they directly affect the stability and profitability of investments.

Insurance Policy Coverage

An insurance policy is a contract between an insurer and the policyholder to provide financial protection against certain risks or losses. In financial markets, investors or institutions often purchase insurance to protect against default risks. In the scenario provided, the state pension plan bought an insurance policy from AIG.

• This policy was specifically designed to cover losses from defaults within the security derived from James and other borrowers' mortgages.
• When defaults occur, such as when James and others cannot pay their mortgages, the insurance company, like AIG in this case, is obligated to cover the losses up to the insured amount.
• Insurance provides a safety net for investors, allowing them to take calculated risks knowing they have coverage for substantial losses.

However, the cost of these policies and the associated premiums affects the overall return on investment for the purchasers of such insurance policies.

Loan Transfer

Loan transfer is the process by which the rights to collect payments on a loan are transferred from one party to another. This is a common practice in financial markets, helping institutions manage their balance sheets and risk exposure. In the example provided, Bank A originally lent money to James but transferred the collection rights to Bank B.

• The initial lender, Bank A, receives upfront payments by selling these rights, thereby reducing their exposure to the loan's risks.
• For the purchasing entity, such as Bank B, gaining these loan rights may serve a strategic purpose, like pooling loans for securitization.
• This transfer of rights is formalized by using legal instruments ensuring the purchasing entity now has the right to collect payments.
• The process can benefit both parties: the selling bank gets immediate capital; the buying entity potentially profits from long-term income or through subsequent securitization.

Such transfers are vital for the fluidity and efficiency of financial markets, facilitating the redistribution of assets and associated risks.