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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.
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