Part 13. How circulated debt is paid back
We saw in part 10 that debt circulates in the form of a security. This means when the debtor pays back the debt additional steps have to be taken to pass the repayments through to the owner of the security, which we will now look at.
Let's continue with our banks and sets of accounts from part 12, and look at what happens when the mortgagor repays the 1st month's mortgage repayment.
Recall in part 10 that the mortgagor's deposit account was Deposit Account #1. At the moment this is empty but lets assume a £1,000 transfer from Deposit Account #2 is made prior to the 1st repayment. This is shown in Figure 13.1.
Figure 13.1 Deposit transfer from Deposit Account #2 to Deposit Account #1.
Next consider that the mortgage conditions are the same as those in the example in part 7 with payments of £660 a month. The 1st month's payment is made as shown in Figure 13.2.
Figure 13.2 Month 1 mortgage repayment made from Deposit Account #1.
We will round the interest charge to £420 and, hence, the principle to to £240. That way we do not need to deal in fractions of £s later. Also, we will use the Mortgage Loan Account #1 Security account to hold the interest charge in. This is shown in Figure 13.3. The reason for doing this is because we need to divide the charge paid, as well as the principle paid, between security holders later.
Figure 13.3 Month 1 interest charged.
Let's look at a snapshot of 1st Bank's balance sheet. This is shown in Figure 13.4.
Figure 13.4 Balance sheet of 1st Bank after the 1st month's mortgage repayment and interest charge.
As mentioned in part 10, the two accounts pointed to by the double-headed red arrow are run down together. The difference between them is equivalent to the mortgage repayment, £660, and this amount needs to be passed through to the holders of the security. Central Bank holds half the security whilst the other half is still owned by 1st Bank.
Let's start with 1st Bank. We transfer half the mortgage repayment amount from the Mortgage Loan Account #1 Security account to a new account at 1st Bank we will call Earnings as shown in Figure 13.5.
Figure 13.5 Month 1 principle and interest payment for 1st Bank's mortgage-backed security.
And for Central Bank, we transfer the other half of the mortgage repayment amount from the same account to a new account at Central Bank we will also call Earnings as shown in Figure 13.6.
Figure 13.6 Month 1 principle and interest payment for Central Bank's mortgage-backed security.
And the corresponding interbank double entry is between reserve accounts to reduce reserves at 1st Bank as shown in Figure 13.7.
Figure 13.7 Reserves double entry.
The balance sheets of Central Bank and 1st Bank now look as shown in Figure 13.8. We can see that Mortgage Loan Account #1 and Mortgage Loan Account #1 Security are now back in alignment.
Figure 13.8 Balance sheets after the reserves double entry.
The final stage in the process is to write down the value of each security at each bank. This is because the face value of the security must correspond to the mortgage loan outstanding, and this is reduced by the principle paid back each time a repayment is made.
Let's start with 1st Bank. We transfer half the principle amount, that is £120, from the earnings account to the securities account as is shown in Figure 13.9.
Figure 13.9 Write down of 1st Bank's mortgage-backed security.
Finally we transfer the same amount from Central Bank's earnings account to the securities account as is shown in Figure 13.10.
Figure 13.10 Write down of Central Bank's mortgage-backed security.
The final balance sheets for all banks are shown in Figure 13.11. 2nd Bank was not involved in any of these transactions since it sold its security to Central Bank, but we have shown it for completeness.
Figure 13.11 Balance sheets after the completion of the 1st month's mortgage repayment and pass through of funds.
The balance sheets above show that the securities accounts and mortgage loan outstanding are in agreement. Further, the earnings of both security holders represents the interest earned on the security. The reduction in value of the security has been offset by a reduction in liabilities; in the case of Central Bank by reserves, and with 1st Bank by its liabilities to deposit holders.
As already mentioned, circulating debt is trickier to handle than circulating money because of the debtor's link to the bank that originated the loan. Since banks use computerised systems, procedures are pretty much automated. However, automation cannot prevent a bank from failing. How banks fail is discussed next.
back to Part 12