Collateralized debt obligations
Collateralized Debt Obligation (CDO) Introduction to collateralized debt obligations (to be listen to after series on mortgage-backed securities.
Collateralized Debt Obligation (CDO)
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- Welcome back.
- Well, in the last presentation, we described a
- situation where you had a bunch of borrowers.
- They needed $1 billion collectively, because there's
- 1000 of them and they each needed $1 million
- to buy their house.
- And they borrowed the money essentially from a special
- purpose entity.
- They borrowed it from their local mortgage broker, who
- then sold it to a bank, or to an investment bank, who
- created the special purpose entity, and then they IPO the
- special purpose entity and raise the money from people
- who bought the mortgage-backed securities.
- But essentially what happened is the investors in the
- mortgage-backed securities provided the money to the
- special purpose entity to
- essentially loan to the borrowers.
- And then the reason why we call it a security is because,
- not only are these people getting this 10% a year, but
- if they want to -- let's say that you had one of these
- mortgage-backed securities and you paid $1000 for it.
- And you're getting this 10% a year, but then all of a
- sudden, you think that the whole mortgage industry is
- about to collapse, a bunch of people are going to default,
- and you want out.
- If you just gave someone a loan, there'd be
- no way to get out.
- You'd have to sell that loan to someone else.
- But if you have a mortgage-backed security, you
- can actually trade the security with someone else.
- And they might pay you, who knows, they might pay more
- than $1000.
- They might pay you less.
- But there will be at least some type of a market in the
- security, so you could have what you could call liquidity.
- Liquidity just means that I have the security
- and I can sell it.
- I could trade it just like I could trade a share of IBM or
- I could trade a share of Microsoft.
- But like we said before, this security, in order to place a
- value on it, you have to do some type of analysis of what
- you think it's worth.
- Or what you think the real interest will be after you
- take into account people pre-paying their mortgage,
- people defaulting on their mortgage, and other things
- like short-term interest rates, et cetera, et cetera.
- And there is only maybe a small group of people who are
- sophisticated enough to be able to figure that out to
- make some type of models and who knows if even they're
- sophisticated enough.
- There might be a whole other class of investors
- here, say this guy.
- He would love to kind of invest in securities, but he
- thinks this is too risky.
- He'd be willing to take a lower return as long as he was
- allowed to invest in less risky investments.
- Maybe by law, maybe he's a pension fund or he's some type
- of a mutual fund, that's forced to invest in something
- of a certain grade.
- And say that there's another investor here, and he thinks
- that this is boring.
- You know, 9%, 10%.
- Who cares about that?
- He wants to see bigger and bigger returns.
- So there's no way for him to invest in this security and to
- get better returns.
- So now we're going to take this mortgage-backed security
- and introduce one step further kind of permutation or
- derivative of what this is.
- That's all derivatives are.
- You've probably heard the term derivatives and people do a
- lot of hand-waving saying, oh, it's a more complicated form
- of security.
- All derivative means is you take one type of asset and you
- slice and dice it in a way to spread the risk, or whatever.
- And so you create a derivative asset.
- It's derived from the original asset.
- So let's see how we could use this same asset pool, the same
- pool of loans, and satisfy all of these people.
- Satisfy this guy, who wants maybe a lower return but lower
- risk, and this guy, who's willing to take a little bit
- higher risk in exchange for higher return.
- So now in this situation, we have the same borrowers.
- They borrowed $1 billion collectively, right, because
- there's 1000 of them, et cetera, et cetera.
- And they're still a special purpose entity, but now,
- instead of just slicing up the special purpose entity a
- million ways, what we're going to do is we're going to split
- it up first into three, what we could call, tranches.
- A tranche is just a bucket, if you will, of the asset.
- And we're going to call the three tranches: equity,
- mezzanine, and senior.
- These are the words that are commonly
- used in this industry.
- A senior just means, if this entity were to lose money,
- these people get their money back first. So it's the least
- risk out of all of the tranches.
- Mezzanine, that just means the next level or middle.
- And these guys are some place in between.
- They have a little bit more risk, and they still get a
- little bit more reward than senior, but they have less
- risk than this equity tranche.
- Equity tranche.
- These are the people who first lose money.
- Let's say some of these borrowers start defaulting.
- It all comes out of the equity tranche.
- So that's what protects the senior tranche and the
- mezzanine tranche from defaults.
- So in this situation what we did is we raised -- out of the
- $1 billion we needed -- $400 million from the senior
- tranche, $300 million from the mezzanine tranche, and then
- $300 million from the equity tranche.
- The $400 million senior tranche we raised from
- 1000 senior securities, collateralized debt
- These are these, right here.
- Say there were 400,000 of these and these each cost
- $1000, right?
- Let's say these cost $1000.
- And we issued 400,000 of these.
- So we raised $400 million.
- Let's say we give these guys a 6% return.
- And you might say, 6%, that's not much.
- But these guys, it is pretty low risk, because in order for
- them to not get their 6%, the value of this $1 billion asset
- or these $1 billion loans, would have to go down below
- $400 million.
- Maybe I'll do a little bit more math in another example.
- But I think it'll start making sense to you.
- For example, every year we said there's going to be $100
- million in payments, right?
- Because it's 10%.
- $100 million in payments.
- Of that $100 million in payments, 6% on the $400
- million, that's $24 million in payments.
- So $24 million in payments will go to the senior tranche.
- Similarly we issued 300,000 shares at $1000 per share on
- the mezzanine tranche.
- This is also 1000.
- This is the mezzanine tranche.
- And let's say they get 7%, a slightly higher return.
- And these percentages are usually determined by some
- type of market or what people are willing to get.
- But let's just say it's fixed for now.
- Let's say it's 7%.
- So 300,000 shares, seven 7%.
- These guys are going to get $21 million.
- So out of the $100 million every year, $24 million is
- going to go to these guys, $21 million is going to go to
- these guys, and then whatever's left over is going
- to go to the equity tranche.
- So the $300 million from equity, they're going to get
- $55 million assuming that there are no defaults or
- pre-payments or anything shady happens with the securities.
- But these guys are going to get $55 million.
- Or on $300 million, that's a 16.5% return.
- And I know what you're thinking.
- Boy, Sal, that sounds amazing.
- Why wouldn't everyone want to be an equity investor?
- I don't know.
- My pen has stopped working.
- But anyway, I'll try to move on without my pen.
- So you're saying, why wouldn't everyone want to
- be an equity investor?
- Well, let me ask you a question.
- What happens if -- let's go to that scenario where we talked
- before -- 20% of the borrowers just say, you know what?
- I can't pay this mortgage anymore.
- I'm going to hand you back the keys to these houses.
- And of that 20%, you only get a 50% return.
- So for each of those $1 million houses, you're only
- able to sell it for $500,000.
- So then instead of getting $100 million per year, you're
- only going to get $90 million per year.
- I wish I could use my pen.
- Something about my computer has frozen.
- So instead of $100 million a year, you're now only going to
- get $90 million a year.
- And all of a sudden, these guys are not
- going to be cut off.
- This guy is still going to get $24 million, this guy is still
- going to get $21 million, but now this guy is going to get
- $45 million.
- But he's still getting above average yield.
- Now let's say it gets even worse.
- Let's say a bunch of borrowers start
- defaulting on their loans.
- And instead of getting $90 million per year, you start
- only getting $50 million in per year.
- Now you pay this guy $24 million.
- You pay this guy $21 million -- or this group of guys or
- gals -- $21 million.
- And then all you have left is $5 million for this guy.
- And $5 million on $300 million, now he's getting less
- than a 2% return.
- So this guy took on higher risk for higher reward.
- If everyone pays, sure, he gets 16.5%.
- But then if you start having a lot of defaults, if, let's
- say, the return on what you get every month goes in half,
- this guy takes the entire hit.
- So his return goes to 0%.
- So he had higher risk, higher reward, while
- these guys get untouched.
- Of course, if enough people start defaulting, even these
- people start to get hurt.
- So this is a form of a collateralized debt
- This is actually a mortgage-backed collateralized
- debt obligation.
- You can actually do this type of a structure with any type
- of debt obligation that's backed by assets.
- So we did the situation with mortgages, but you could do it
- with a bunch of assets.
- You could do it with corporate debt.
- You could do it with receivables from a company.
- But what you read about the most right now in the
- newspapers is mortgage-backed collateralized debt
- And to some degree, that's what's been getting a lot of
- these hedge funds in trouble.
- And I think I'll do another presentation on exactly how
- and why they have gotten in trouble.
- Look forward to talking to you
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