How CDOs can give different investors different levels of risk and returns with the same underlying assets. Created by Sal Khan.
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- I dont really understand the CDO situation, the ratings agency's are rating the tronches, and what do the tronches mean?(6 votes)
- 1) Essentially, you can simply consider Tranches as Levels of Payment. Three Tranches represent three Level of Payment: Level One (Senior), Level Two (Mez) and Level Three (Equity). Each Level has it's own Interest Rate dependent upon the risk of the corresponding level: Senior is the safest, therefore the yield is lowest (5%); Mez is a bit riskier but still safe (6%); and Equity is the riskiest of the three (15% return yet they are the first to take all the hits from defaults)
2) The Rating Agencies are rating Tranches to provide Investors with different (psychological) personality: Senior is for those who are risk-averse as it is AAA, or safest. Mez is for those who still want to play safe but a little more adventurous than Senior. Equity is completely unsafe at all: if everything is good they get paid the most, but when disaster strikes they get nothing in return.(4 votes)
- At1:55, Sal says that the hedge fund says the yield is too low. I understand they have a bigger risk tolerance than the Pension funds, but wouldn't that be the same as saying that like for the Pension funds, the risk is even too high for the hedge funds?(3 votes)
- Good question. Investors are making two decisions when looking at a product: 1) is the yield in line with the risk, and 2) is the yield in line with my investment objectives.
When Sal has the hedge fund saying "the yield is too low", he is giving an answer to the second question above, not the first. The hedge fund's objective may be to make investments with higher expected yields (and of course with the commensurate higher risk). A low yield, low risk investment, no matter how great the value, just wouldn't appeal to the fund.(7 votes)
- Are Collateralised Debt Obligations basically Mortgage Backed Securities sorted by their risk of default ?(3 votes)
- CDO's are very complicated structures. They can be made up of mortgage backed securities, asset backed securities, other CDO's and/or a combination of all three.
They take all of those assets and they split them up into "tranches" which investors can then buy and sell. There is pretty much an infinite number of ways you can split assets into tranches. Essentially the goal of a CDO is to distribute interest rate risk, credit risk and prepayment risk between different investors. Each tranche will be subject to different rules and will be desirable to different investors.(5 votes)
- My impression from the video was that an MBS does not have tranches but a CDO does. However, this graphic shows standard MBSs as having tranches and the CDOs actually being a repackaged version of the lower tranches of MBSs; is this something that Sal forgot to mention?
- MBS' are a type of CDO. CDO is the broad category.
Having said that, your diagram describers a theory of 'nested' CDOs. It would be like making coffee by pouring coffee into the spot where water ought to go.
Each CDO (including an MBS), 1) holds assets, and 2) issues a security backed by those assets.
In your diagram, it goes like this:
Vehicle 1: Holds: mortgages; Issues: MBS1
Vehicle 2: Holds: MBS1; Issues: CDO1
Vehicle 3: Holds: CDO1; Issues: CDO2
So the diagram depicts one particularly tangled way that CDOs were created, but not necessarily the typical way. The reasons why the first CDO in the diagram is labeled as a MBS, is that it is the only one that actually holds mortgages. The rest hold only the structured products and are thus most correctly called by the general term, CDO.(4 votes)
- Very good video, but Sal is actually describing CMOs (collateralized mortgage obligations) not CDOs (collateralized debt obligations). A CDO could contain mortgage-backed bonds or other types of debt. It is similar to a CMO by the tranching method for different risk tolerances as described above.(4 votes)
- Why a AA senior investor is allowed to buy the BB MBS? If AA investor can't get BB MBS, I think the pension fund don't find a way to buy BB MBS in market...(1 vote)
- And the rating changes because it removes a portion of the risk associated with the housing market by giving priority in payouts, so even though there may still be the same statistical likelihood of default in the MBS, the senior tranche will get paid first from whatever value is recovered on the house. Think of it like the difference in expected return between a debt security and an equity security for a given company. You'll expect a higher return on equity in part because if the company liquidates, the debt holders are paid first.(6 votes)
- Hello all,
I'm a newbie and I'm wondering if anyone could explain the difference between a "pool" in MBS and a "tranch". Are they synonymous?(1 vote)
- The pool is the entire collection of securities.
A tranche is a particular subset of the securities in the pool.(2 votes)
- Just to clarify, is a CDO a type of derivative which the underlying security of the CDO is the MBS? I am a bit confused. From what I gather, separating them out into tranches would also make them more affordable instead of buying a MBS itself? Thanks.(1 vote)
- So the S.P.E. has to dicide what to do (issue MBSs or CDOs), or how does that work in real life?(1 vote)
We've seen that an investment bank can buy a bunch of mortgages, which essentially makes them the lender to the homeowners, and then it could stick those mortgages inside of a special purpose entity. And then it could sell the shares in that special purpose entity, and that these shares would be called mortgage-backed securities. And let's just say, just for the sake of argument, when it sells these shares it sells them at $10 a share, and it promises dividends at $10 a share, the equivalent of an 8% yield. So maybe the homeowners here are paying a higher than 8% interest, some of them default, once you average everything out, and the investment bank keeps a little bit for itself and to do all the operations and all the overhead, and so it can actually give the investors 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-backed security, and they might like the return, and they might go for it. But there might be a class of investors, may be very risk-averse investors like pensions, that says that this mortgage-backed security is too risky. They've looked at what we're 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 might have hired a ratings agency. So maybe a ratings agency to essentially look under the hood and tell investors what's there. So the ratings 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 BB. 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, maybe there's some risky hedge funds, and not all hedge funds are risky, but let's say that there are some risky hedge funds, and then they say that this yield is too low. And the investment bankers, they're very creative people, they say, well, look, here's some people who want to buy securities, but these securities are too risky for them. And there's other people who want to buy securities who are able to take on more risk, but they say the yield is too low. So instead of losing out on these investors, why don't I just 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 they're often called the senior tranche, the mezzanine tranche, I'll just write "Mez" for short or the middle tranche, and then the equity tranche. And the way it works, in a mortgage-backed security everyone gets paid the same amount. In this situation, when you split it this way, the holders of the senior tranche securities are going to get paid first. Only when they are made whole are the owners of the mezzanine tranche security is going to get paid, and only when they are made whole will the owners of the equity tranche security will get paid. And this scenario right over here is called a collateralized debt obligation, CDO. And it's really a derivative security from the mortgages. We've sliced it and diced it in a slightly different way. Now you might be saying, how does this solve the problem? Well, now the ratings agency will say, well, look 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 then maybe they'll give it a AAA rating, and which means that the pensions can now buy the senior rated CDO's. But they'll pay them less interest. Maybe they'll pay them 5%. Maybe the mezzanine, they get paid next, they'll get maybe still a BB 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 ratings at all. So you could almost view this as a junk rating if you want to view it that way. But that makes both people happy. Pensions get something safe, lower yield. Hedge funds get something risky, but it has a higher yield.