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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.

Deposit Account #2 1st Bank Description Debits Credits Balance Previous balance £45,000 (CR) Transferred to Deposit Account #1 £1,000 £44,000 (CR) Deposit Account #1 1st Bank Description Debits Credits Balance Previous balance £0 Received from Deposit Account #2 £1,000 £1,000 (CR)

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.

Deposit Account #1 1st Bank Description Debits Credits Balance Previous balance £0 Received from Deposit Account #2 £1,000 £1,000 (CR) Month 1 loan repayment £660 £340 (CR) Mortgage Loan Account #1 1st Bank Description Debits Credits Balance Previous balance £100,000 (DR) Month 1 payment received £660 £99,340 (DR)

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.

Mortgage Loan Account #1 Security 1st Bank Description Debits Credits Balance Previous balance £100,000 (CR) Month 1 interest received £420 £100,420 (CR) Mortgage Loan Account #1 1st Bank Description Debits Credits Balance Previous balance £100,000 (DR) Month 1 payment received £660 £99,340 (DR) Month 1 interest charged £420 £99,760 (DR)

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.

1st Bank's Assets Mortgage Loan Account #1 £99,760 Mortgage-backed Securities £50,000 Digital Reserves £5,000 Total assets £154,760 1st Bank's Liabilities Deposit Account #1 £340 Deposit Account #2 £44,000 Mortgage Loan Account #1 Security £100,420 Deposit Account #3 £10,000 Total liabilities £154,760

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.

Mortgage Loan Account #1 Security 1st Bank Description Debits Credits Balance Previous balance £100,000 (CR) Month 1 interest received £420 £100,420 (CR) Month 1 payment made £330 £100,090 (CR) Earnings 1st Bank Description Debits Credits Balance Starting balance £0 Month 1 payment received £330 £330 (CR)

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.

Mortgage Loan Account #1 Security 1st Bank Description Debits Credits Balance Previous balance £100,000 (CR) Month 1 interest received £420 £100,420 (CR) Month 1 payment made £330 £100,090 (CR) Month 1 payment made £330 £99,760 (CR) Earnings Central Bank Description Debits Credits Balance Starting balance £0 Month 1 payment received £330 £330 (CR)

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.

Digital Reserves 1st Bank Description Debits Credits Balance Previous balance £5,000 (DR) Transfer reserves £330 £4,670 (DR) 1st Bank's Digital Reserves Central Bank Description Debits Credits Balance Previous balance £5,000 (CR) Transfer reserves £330 £4,670 (CR)

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.

Central Bank's Assets Mortgage-backed Securities £50,000 Total assets £50,000 Central Bank's Liabilities 2nd Bank's Digital Reserves £45,000 1st Bank's Digital Reserves £4,670 Total liabilities £49,670 Central Bank's Equity Earnings £330 Total equity £330 1st Bank's Assets Mortgage Loan Account #1 £99,760 Mortgage-backed Securities £50,000 Digital Reserves £4,670 Total assets £154,430 1st Bank's Liabilities Deposit Account #1 £340 Deposit Account #2 £44,000 Mortgage Loan Account #1 Security £99,760 Deposit Account #3 £10,000 Total liabilities £154,100 1st Bank's Equity Earnings £330 Total equity £330

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.

Earnings 1st Bank Description Debits Credits Balance Starting balance £0 Month 1 payment received £330 £330 (CR) Security write down £120 £210 (CR) Mortgage-backed Securities 1st Bank Description Debits Credits Balance Previous balance £50,000 (DR) Security write down £120 £49,880 (DR)

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.

Earnings Central Bank Description Debits Credits Balance Starting balance £0 Month 1 payment received £330 £330 (CR) Security write down £120 £210 (CR) Mortgage-backed Securities Central Bank Description Debits Credits Balance Previous balance £50,000 (DR) Security write down £120 £49,880 (DR)

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.

Central Bank's Assets Mortgage-backed Securities £49,880 Total assets £49,880 Central Bank's Liabilities 2nd Bank's Digital Reserves £45,000 1st Bank's Digital Reserves £4,670 Total liabilities £49,670 Central Bank's Equity Earnings £210 Total equity £210 1st Bank's Assets Mortgage Loan Account #1 £99,760 Mortgage-backed Securities £49,880 Digital Reserves £4,670 Total assets £154,310 1st Bank's Liabilities Deposit Account #1 £340 Deposit Account #2 £44,000 Mortgage Loan Account #1 Security £99,760 Deposit Account #3 £10,000 Total liabilities £154,100 1st Bank's Equity Earnings £210 Total equity £210 2nd Bank's Assets Equity Release Loan Account £50,000 Digital Reserves £45,000 Total assets £95,000 2nd Bank's Liabilities House Seller's Deposit Account £90,000 Deposit Account #4 £5,000 Total liabilities £95,000

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 than circulationg 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