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Current time:0:00Total duration:9:44

Video transcript

welcome back well in the last presentation we described the situation where you had a bunch of borrowers they needed a billion dollars collectively because there's a thousand of them then they each needed a million dollars to buy their house and they borrow the money essentially from a special-purpose entity I mean 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 the IPO the special purpose entity and raised 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 the 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 $1,000 for it and you're getting this 10% a year but then all of a sudden you think that the mortgage that the whole mortgage entry is about to collapse a bunch of people 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 $1,000 they might pay you less but they'll be at least there'll be some type of a market in the security so you could have what you could call the quiddity liquidity it 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 where I could ship trade a share 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 this real yield or this real the real interest will be after you take into account people pre paying their mortgage people defaulting on their mortgage and other things like you know short-term interest rates etc etc and there's 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 so now there might be another investor here let me make my pen tool work there might be a whole other class of investors let me where is the pen there might be a whole other class of investors we draw 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 but as long as he was allowed to as long as he was allowed to invest in less risky investments maybe by law maybe he's a pension fund or he 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 oh I don't know what my PIN keeps changing and and he thinks that this is boring you know nine ten percent 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 and introduce one step of further kind of a permutation or I guess a derivative of what this is and that's all what derivatives are you probably heard the term derivatives and people do a lot of hand waving saying oh you know it's a it's a more complicated form of security all derivative means is you take one type of asset and you slice and dice it away to spread the risk or whatever and so you create a derivative asset it's derived from the original asset so let's let's see how we could use the 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 been willing to take a little bit higher risk in in exchange for higher return so now in this situation we have the same borrowers they borrowed a billion dollars collectively right because there's a thousand dollar Mike cetera et cetera and there's 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 we're going to split it up first into three what we could call tranches the tranche is just you know a bucket if you will of the asset and what we're going to call the three tranches equity mezzanine and senior and these are the things that are these are kind of the these are the words that are commonly used in this industry a senior just means these people if 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 you know next level or middle and these guys are someplace in between they have a little bit more risk but they still get and they 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 from defaults so in this situation what we did is we raised out of the billion dollars we needed we raised 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 a thousand a thousand senior securities collateralized debt obligations these are these right here and they say let's cost say there were 400,000 of these and these each cost a thousand dollars right where'd my PIN go and now I need to make sure I'm on the right layer so let's say these cost a thousand dollars and we issued four hundred thousand of these so we raised four hundred what my PIN messed up again so we raised four hundred million dollars and let's say we give these guys a 6% return and this is you might say oh six percent that's not much but these guys it is pretty low risk because in order for in order for them to not get their 6% the the value of this billion dollar asset or these billion dollar loans would have to go down below 400 million dollars maybe I'll explain I'll do a little bit more math in another example but I think I think it'll start making sense to you for example every every year we said there's gonna be 100 million in payments right because it's ten percent 100 million in payments of that hundred million in payments six percent on the four hundred million that's 24 million in payments right so 24 million in payments will go to the senior tranche similarly we issued three hundred thousand shares at $1,000 per share on the mezzanine tranche this is also a thousand this is a mezzanine tranche and let's say they get seven percent slightly higher in return and these percentages are usually determined by some type of market or what people are willing to get but let's say let's just say it's fixed for now let's say it's seven percent so three hundred thousand shares seven percent these guys are going to get twenty-one million dollars right so out of the 100 million dollars every year 24 million is going to go to these guys 21 million is going to go to these guys and then whatever is left over is going to go to the equity to the equity tranche so the hundred million dollars from equity they're going to get fifty five million dollars assuming that there are no default or pre payments or anything shady happens with the securities so these guys I don't know what my pen is stopped working but these guys are going to get fifty five million dollars or on three hundred million dollars it's a sixteen point five percent return and I know you're thinking boy salad that sounds amazing why wouldn't everyone want to be an equity investor I don't know my pendant 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 if 10% let's go that scenario where we talked before that 20% of the borrower's 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 million dollar houses you're only able to sell it for $500,000 so then instead of getting a hundred 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 dollars a year you're now only going to get ninety million dollars a year right and all of a sudden these guys are not going to be cut off from this guys still going to get twenty four million this guy's still going to get 21 million but now this guy's going to get forty five million dollars so he already got 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 a hundred million dollars or ninety million dollars per year you start only getting 50 million dollars in per year now you pay this guy twenty four million you pay this guy twenty-one million or this group of guys or gals twenty-one million and then all you have left is five million for this guy and five million on three hundred million dollars now he's getting you know it's like less than a two percent return so this guy took on higher risk for higher reward if everyone pays sure he gets sixteen point five percent but then if you start if you start having a lot of defaults if let's say you know the return on what you get every month that goes in half this guy takes the entire hit so his return goes to zero so we had higher risk high 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 split do this type of a structure with any type of any type of debt obligation that's backed by assets so you know we did this situation with mortgages but you could do it with a bunch of assets you could do it with a corporate debt you could do it with receivables from a company but when 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 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 soon