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How CDOs can give different investors different levels of risk and returns with the same underlying assets. Created by Sal Khan.
Video transcript
We see that an investment bank can buy a bunch of mortgages which essentially makes them the lender to the home owners and then it can stick those mortgages inside of a special purpose entity and then it can sell the shares in that special entity and that these shares will be called mortgage back securities. Lets just say just for the sake of argument when it sells these shares it sells them at $10 a share and it promises dividend at $10 a share the equivalent of an 8% yield so maybe the home owners are paying higher than 8% interest some of them default once you average everything out and the invesmtnet bank keeps a little bit for itself and to do the operations and the overhead and so it can actually give the investor an 8% yield. This might be good for a whole class of investors they might like the safety profile, the risk profile of the special purpose entity of this mortgage back security and they might like the return and they might go for it. But there might be a class of investors, maybe very risk-adverse investors like pensions that says that this mortgage back security is too risky. They have looked at what we are holding and they are like hey some of these are sub-prime mortgages, some of these are shady, some of these are to risky borrowers, I don't like where this is going and even if they can't look under the hood to see what this is the investment bank may have hired a ratings agency to essentially look under the hood and tell investors what's there. The rating agency might look at this special purpose entity and look at these securities and say look, I would say that these securities should be rated double B. So not super safe but not super risky either, but for pensions that is not safe enough. Now, on the other hand you might have people who want more risk so you might have a risky hedge fund, not all hedge funds are risky, but lets say that there are some risky hedge funds and they say this yield is too low and the investment bankers they are very creative people they say well look here are people who want to buy securities but these securities are too risky for them and there are people who want to buy securities who are able to take on more risks but they say the yield is too low so instead of losing out on these investors why don't I split up this special purpose entity in a different way. Why don't I split it up into tranches so instead of all of the securities being the same why don't I put them into classes and there so often called the senior tranche, the mezzanine tranche then the equity tranche. and the way it works in a mortgage back security everyone gets paid the same amount. In this situation when you split it this way the owner of the senior tranche securities are going to get paid first only when they are made whole are the owners of the mezzanine security tranche securities are going to get paid and only when they are made whole will the owners of the equity tranche securities get paid. This scenerio right here is called the collateralized debt obligation CDO and it's really a derivative security from the mortgages We sliced it and diced it in a slightly different way. How does this solve the problem? Well, now the ratings agency will say if the senior people are going to get paid before everyone else then I'm going to give them a higher rating and they can even get insurance on this and get a credit default swap and maybe give it a triple A rating which means that the pensions can now buy the senior rated CDO and they'll pay them less interest maybe they'll pay them 5% the mezzaninie they'll get paid next and they'll get maybe a still a double B rating and they'll get the 8% and then the equity tranche they'll get a higher interest so they'll get say a 15% interest in exchange for being the last person to get paid and maybe they don't get any rating at all so you can almost view this as a junk rating if you want to view it that way. That makes both people happy. Pensions get safe, lower yield, hedge funds get something risky but it has a higher yield.