Part 10. How debt circulates
The debt you owe to a bank can be sold to any other bank or investor through money, capital, or mortgage markets depending on the type and duration of debt. As promised in part 6, we will now look at how debt circulates in the banking system.
We will start from scratch with our two banks, 1st Bank and 2nd Bank, and with empty sets of accounts. We will consider a mortgage loan for a house purchase by a customer that banks with 1st Bank, and then securitise the mortgage loan and sell part of it to 2nd Bank.
To allow us to easily settle between banks, we will include an equity release loan taken out at 2nd Bank by a different customer who banks with 1st Bank. We will assume that the accounts needed for deferred settlements between banks are already set up and empty. Other accounts will be created as they are needed.
For the mortgage loan, we will need two new accounts, Mortgage Loan Account #1 and Deposit Account #1. The loan will be for £100,000. The double entry for the mortgage loan creation is shown in Figure 10.1.
Figure 10.1. The mortgage loan creation for a customer at 1st Bank.
For the house purchase, we will need a new deposit account belonging to the house seller. This we will call House Seller's Deposit Account, and we will assume the house seller banks with 2nd Bank. The house purchase transaction is as shown in Figure 10.2.
Figure 10.2. The house purchase transaction.
As this is an interbank transaction, we need to carry out a deferred settlement double entry as shown in Figure 10.3.
Figure 10.3. The deferred settlement double entry for the interbank deposit transfer for the house purchase.
And the balance sheets of both banks are shown in Figure 10.4.
Figure 10.4 Balance sheets after the mortgage loan and house purchase.
For the equity release loan we will need two new accounts at 2nd Bank: Equity Release Loan Account and Equity Release Deposit Account, both belonging to the customer taking out the equity release. We will assume this loan will be for £50,000. The creation of the equity loan is shown in Figure 10.5.
Figure 10.5. The equity loan creation.
However, the customer taking out the equity loan banks with 1st Bank, so we will need to transfer the deposit in Equity Release Deposit Account to this customer's deposit account at 1st Bank. We will call the customer's deposit account Deposit Account #2. The deposit transfer is shown in Figure 10.6.
Figure 10.6. The equity release deposit transfer from 2nd Bank to 1st Bank.
As this is, again, a transaction between banks, we also need to carry out a deferred settlement double entry, as shown in Figure 10.7.
Figure 10.7. The deferred settlement double entry for the equity release deposit transfer.
After these double entries, the balance sheets of both banks are as shown in Figure 10.8.
Figure 10.8 Balance sheets after both loans are issued.
Buying debt has risk associated with it since there is no guarantee the borrower will pay the repayments and interest due. Therefore, multiple loans are normally bundled together and sliced and diced to reduce risk before being sold, in a process known as securitisation. We will consider a simple scenario where Loan Account #1 is securitised and £50,000 of it sold to 2nd Bank.
To create the mortgage-backed security, we will need two new accounts at 1st Bank, one an asset account called Mortgage-backed Securities, the other a liability account called Mortgage Loan Account #1 Security. The reason we need separate accounts to hold securities in is because we don't want to alter the original mortgage loan account, Mortgage Loan Account #1. The mortgagor (the borrower) continues to pay 1st Bank as normal, oblivious of who owns their debt.
In creating the security, we carry out a double entry for the amount of the mortgage debt in Mortgage Loan Account #1 between these new accounts, as shown in Figure 10.9.
Figure 10.9. Mortgage-backed security creation.
Now, because a loan can only be securitised once, the bank has to link or ringfence Mortgage Loan Account #1 to the security liability account as shown in Figure 10.10.
Figure 10.10. Mortgage-backed security link to Mortgage Loan Account #1.
The double-headed red arrow does not represent a new double entry, but indicates that the two accounts are now inextricably connected and will be run down together as the mortgagor pays back the loan. The actual principle and interest repayments will be passed through to whoever owns the security as it is sold and resold, i.e. circulated. The details of this are given later in part 13.
After the security creation, the balance sheet at 1st Bank looks as shown in Figure 10.11 (2nd Bank again remains unchanged).
Figure 10.11 Balance sheet after the mortgage-backed security is created at 1st Bank.
To transfer £50K of the security, we will also need a new securities account at 2nd Bank which we will also call Mortgage-backed Securities (the account also has the bank's name on it so it will be clear which one we are referring to). The security transfer from 1st Bank to 2nd Bank is shown in Figure 10.12.
Figure 10.12. Mortgage-backed security transfer.
And as this is an interbank transfer, we defer settlement for the security as shown in Figure 10.13.
Figure 10.13. Deferred settlement double entry for the security transfer.
The banks' balance sheets after the security transfer are shown in Figure 10.14, the blue arrows indicating the amounts that need settling.
Figure 10.14 Bank's balance sheet after the security transfer.
Since each bank owes the other £100,000, these obligations will cancel when the banks settle at the end of the trading period. Let's assume we have reached that point. A transfer of £100,000 from 2nd Bank's deposit account to 2nd Bank's loan account will reduce both balances to zero. This is shown in Figure 10.15.
Figure 10.15. Double entry to reduce 2nd Bank's balance at 1st Bank.
We can also transfer £100,000 from 1st Bank's deposit account to 1st Bank's loan account to, again, reduce both balances to zero, as shown in Figure 10.16.
Figure 10.16. Double entry to reduce 1st Bank's balance at 2nd Bank.
As there are no outstanding obligations, the banks are now settled. The final balance sheets are shown in Figure 10.17.
Figure 10.17 Balance sheets after the banks have settled.
As we can see, transferring debt is a little trickier than transferring money because of the securitisation process and the debtor's link to the bank that originated the loan. Once securitised though, the security can be sold to other banks and investors and used as collateral for borrowing additional funds.
The process by which the debt payments behind the security are made is also tricker, and we will look at that in part 13 — after we have introduced bank reserves and clearing or central banks, which will make it easier to demonstrate.
back to Part 9