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Collateralized debt obligation (CDO)

Introduction to collateralized debt obligations (to be listen to after series on mortgage-backed securities. Created by Sal Khan.

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  • blobby green style avatar for user Guy Brown
    So as i understand, a Mortgage Backed Security is a pool of mortgages. Are Collateralised Debt Obligations a pool of Mortgage Backed Securities? Just a bit confused.

    Thanks in advance!
    (30 votes)
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    • blobby green style avatar for user calvingarfield
      Mortgage Backed Securities are just a pool of mortgages sold in the securities form. These securities are divided into various risk categories as shown in video above. Depending on which category you want to invest in, you will get the corresponding returns. If you think there will be less mortgages default you can be in the equity tranche and get higher returns and on the contrary if you think there is high chance of default you can be in the Senior category and get less return and also less risk. So you can say that CDO is a pool of mortgage backed securities and the pools are classified by the amount of risk.
      (67 votes)
  • blobby green style avatar for user ghshtalt
    At , he says that the Equity tranche gets $55m or a "16.5% return" (on $300m). Shouldn't this be 55/300 = 18.3% ? Or am I missing something?
    (25 votes)
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  • blobby green style avatar for user wyt168
    Since MBS is a security and has liquidity, as Sal has pointed out in the video, it can be traded, which means its price fluctuates. I am trying to figure out how its price is related to the mortgage interest. My broker showed me a chart of FNMA 30yr, and told me that the underlying security shows opposite trend of the mortgage rate, i.e. the higher the price of the stock, the lower the interest rate, and vice versa. I haven't figured out why this is the case.
    (5 votes)
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    • blobby green style avatar for user Aaronjosiah05
      I like to think of it as the law of supply and demand. Mortgage interest rates reflect the rate of return on Mortgage Backed Securities. When regular stocks are doing well, investors don't put much of their money into MBS since the return is low compared to other stocks. As a result, mortgage interest rates must increase to make MBS more attractive to investors. But when the stock market suddenly becomes volatile (like after a traumatic global event), investors start moving their money into MBS since this is generally considered a less risky safehaven. When investors start buying lots of MBS all of a sudden, this drives the MBS share price up. At the same time, the average MBS rate of return (i.e. mortgage interest rate) falls since the higher rate is no longer needed to attract investors. In short, what's good for the economy is bad for mortgage rates, and vice versa. Hence, most stock market fiascos are followed by great mortgage rates! Incidentally, the reason mortgage rates have been so low since November 2008 is due to the government's policy of "Quantitative Easing"--meaning the government has been constantly buying billions of dollars worth of MBS to "stimulate the economy." This forces mortgage interest rates to remain low, which creates a domino affect (new housing construction etc.) that spurs economic growth.
      (15 votes)
  • blobby green style avatar for user vnyand
    My only question is, I'm at a loss finding upside risk in the securities. The MBS is priced based on the CFs from the mortgages, what would cause the security to trade at a premium? Would it just be speculation given the number of mortgages in the pool having variable interest rates? And as a side question to that, what motivation does the IB have to purchase these mortgages at anything more than par, back to the upside risk question, shouldn't the mortgager have to sell at a discount?
    (2 votes)
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    • male robot hal style avatar for user Eric McCormick
      Well, it used to be that the default rate was very low. So even though they knew they were funding people who could never pay, they were blinded by the money. They thought they would all just flip the property in a couple years and move on and that would happen forever with infinite inflation. On top of that, the borrowers were being blinded by the sums. They were being told, "You can afford this fabulous home that was always out of reach!" So people were borrowing stupidly because they thought there was some way they could afford it or else the loan would not be made to them. So the rating on the housing loans were very high because people were selling and not defaulting, so on and so forth. But then, people got to where they could not even make the minimum payment on an interest only loan. Someone puled back the curtain, we all saw the wizard pulling the levers, insurance companies stopped backing the titles, and the house of cards got blown over.
      (5 votes)
  • female robot grace style avatar for user katieldouglass
    It seems odd to me how Sal keeps saying that the money for the mortgages originally comes from the investors in the MBS's, like at . Doesn't the money originally come from the bank where the borrower went to get the mortgages in the first place?
    (2 votes)
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    • leaf green style avatar for user Drew Culpepper
      While the bank or mortgage broker provides the direct funds to finance the loan, investors are simultaneously replenishing the bank's supply of cash for future loans. So the investors are the ultimate source of money for these mortgages, or at least this is how I think of it.
      (4 votes)
  • leaf green style avatar for user soap1984
    I have a question regarding Sal's rate of return. He mentions in the previous video it would be 9% (approximately) but he seems to describe it as 9% of the money that is owed by the mortgagees (which we think is $1b, i.e. the amount of their mortgages). Thus they would get approximately $90 a year and then the $900 after ten years. However the owners of the MBSs all paid $1100 for their shares; isn't your rate of return usually calculated compared to your investment, and therefore lower than 9%?
    (2 votes)
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  • starky ultimate style avatar for user Sudhanshu Sisodiya
    Was one of the core problems of the credit bubble the very fact that traditionally "illiquid" assets (mortgages) became very liquid due to mortgage-backed securities and CDOs? If so, why was it problematic?
    (2 votes)
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    • ohnoes default style avatar for user Tejas
      Yes, and this became problematic because illiquid assets also tend to be very opaque, because there really is no need to divulge information on assets that are practically impossible to sell. When these mortgages became liquid, their opaqueness remained. That meant that investors had no idea what they were buying, and so had no idea that the banks were lowering their standards. For traditionally liquid assets, transparency is almost always present.
      (3 votes)
  • blobby green style avatar for user Operations6110
    If my 325k mortgage has a 7% intrest, how can anyone get 16% from that mortgage? I realize that there are many mortgages in a tranche but surely, not all of them are 16% or higher. Where does the money come from to pay investors?
    (2 votes)
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    • ohnoes default style avatar for user Tejas
      The mortgages are 10% interest. The senior tranche get 6%, and the mezzanine traunche get 7%. If you take the weighted average of the 6%, the 7%, and the 16.5%, it will turn out to be 10%.
      (2 votes)
  • male robot johnny style avatar for user peter.deutscher
    Sal,

    One question which came to mind whilst watching these presentations on CDOs and MBSs is this: Why do the commercial banks not engage in the practice of investment banking (or merge with/acquire said investment bank), given that it seems to be very profitable? The only reason that came to mind is that there must exist financial regulations that specifically prevent this, presumably due to conflict of interest/incentive structures for bad loaning practices.

    Cheers
    (2 votes)
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  • blobby green style avatar for user Ashe
    Besides the investment banks, who issues collateralized debt obligation?. Where is it most prominently used?
    (2 votes)
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Video transcript

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 insecurities, 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 soon. 1000 senior securities, collateralized debt obligations. 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. Right? 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. Right? 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. Right? 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 obligation. 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 obligations. 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