Collateralized debt obligation overview

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.