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Current time:0:00Total duration:10:44

Bailout 11: Why these CDOs could be worth nothing

Video transcript

the government has said a lot about the fact that this seven hundred billion dollars might not just be a blank check that were actually buying assets and who knows maybe we'll even make a profit on the assets and I've hinted and other people of hinted that well that's very unlikely because these assets they're probably not worth what the government's going to pay for it and one could argue that even some of these are worth zero and I've gotten some letters and I've heard other people on the news actually say well how could they be worth zero they're backed by mortgages which are backed by houses which are the collateral that's where the collateral comes from the collateralized debt obligations so in this video I'm going to do hopefully a reasonably straightforward example to show you why some of these collateralized debt obligations could be worth very little or maybe even nothing so let's say let's just do something simple let's not talk in terms of you know millions of homes let's talk in terms of 10 homes let's say I would I were to create a very small mortgage-backed security essentially I give out 10 mortgages right let's say each mortgage it is a million dollars let's say that's 10 times 1 million more 10 times $1,000,000 and I and the people who I give those mortgages do by 10 million-dollar houses right so I create a corporation a special-purpose entity whatever for the sake of this mortgage-backed security or for constructing these collateralized debt obligations that's my company I create the balance sheet of it what are the assets well I have 10 mortgages times a million so I have 10 million in loans essentially 10 million in mortgages and they're collateralized or they're backed by the underlying houses that were that these mortgages were used to buy 10 million in mortgages 10 million more right now how is this special-purpose entity we'll call it an SPE how is this SPE funded well it's essentially funded by the people who are buying the collateralized debt obligations and collateralized debt obligations are essentially just debt that is used to fund the ease these mortgages and what's interesting about a collateralized debt obligation Cena in a mortgage-backed security I would have just given these 10 million mortgages and then then this in in this corporation I would have just issued you know I don't know I would have issued a thousand shares and so each share would hold one one thousandth of this value right that's a mortgage-backed security but in a collateralized debt obligations I split it into buckets so what I do is let's say I borrow I borrow three tranches I just call that buckets I'll make these the three buckets so I go to some people and I borrow I don't know if that 10 million that I essentially lent out I borrow I don't know let me say I'll make up a number five million dollars five million from these people and these are the senior debt holders so essentially these people are going to get both this debt holder and this debt holder has to get wiped out before this guy gets impaired and impaired just means that you get less money than you lend right so I borrow five million from somebody else and they're going to get to let the the lowest I'm going to pay them the lowest interest rate because this is the safest bucket so think of it this way let's say these these ten mortgages let's say that I'm getting I don't let's say I'm getting eight percent and let's say that I'm paying let me draw the they're giving me five million dollars let's say that I'll pay these guys five percent and why are they willing to take a lower interest rate because essentially any defaults on this side will hit these two buckets before it hits these people so this will be a very very safe debt instrument or arguably very safe that instrument and I'll do more about that in a second and let's say I borrow another let's see how to make the numbers worth write another four million from some other people so they give me four million dollars I have to pay a little bit higher interest to them I have to pay I have to pay let's say I have to pay six percent interest to them all right and then finally I borrow some I borrow let's see I need another million dollars I borrow a million dollars from people who are willing to take the biggest risk so if there's any defaults over here these people are going to be wiped out before these people get touched and actually we can figure out the appropriate amount of interest right how much money is coming in per month before anyone starts defaulting see I'm getting $800,000 in per month that's the inflow and then on the outflow so you have to pay these people five million times five percent that's $250,000 so that's how much I'm paying to that tranche two hundred fifty thousand and then four times six percent that's two hundred six 240,000 minus two hundred forty so that's what eight hundred minus four ninety so then I have three hundred and ten thousand left all right three hundred ten thousand so I can essentially pay this three hundred ten thousand per year to this tranche so they're going to actually get a thirty one percent interest and that sounds great and that's why they call that the equity tranche normally in a CDO because those people get a lot of upside but get guess what if there's any defaults these people get wiped out first and just to make this example clear let's let's just do it very simply because you could model this out and assume some type of prepayment etc etc let's zoom that a year out let me scratch this out right here let's say that one year out half of the mortgages I don't know the people refinance or they move or they sell their house whatever so they just pay off they just prepay the mortgage so let's say in one year let me redraw this balance sheet in one year so in one year let's say five of those borrowers so this is a year later magenta is my color for a year later a year later half of those borrowers just refinance or they sell their house so and so they just pay us back five million dollars right so we get five million dollars I'll put that on the asset side of the balance sheet right this is assets assets liabilities and there's a bunch of videos on assets and liabilities and balance sheets if this confuses you and there's no equity in this company right because assets minus liabilities equity and I did that because these are special purpose entities their whole purpose is to structure these securities the purpose really isn't to be an ongoing operation that has you know net income in and of itself although there probably was equity in the bank who constructed this probably took it all but anyway assets and liabilities okay so said half the people refinance those people were great they were worth giving the money to because they paid off their loans and whole but guess what the other half of the people they were the the the the title of subprime was was deserving of them and they default and we have to foreclose on them a year later right but all is not lost right we don't lose that five million that we let to another that other those other five million people because they had homes right these are collateralized debt obligations we are able to take their houses unfortunately it's a really weak real estate market and let's say just for the sake of argument that we only get we take those five houses from the people who didn't pay right five paid five didn't pay we take the five who didn't pay his houses and let's say when we sell them we're only able to get let's say we're only able to get I don't know 60% on those houses right so sixty percent of five million we're essentially only able to get three million dollars for the houses we've closed on so a year later what are all her assets we get the five million dollars in cash from the people who are good and and and paid off their mortgages and then we get the three million from the people who foreclosed and then we only got sixty percent of the original purchase price of the homes we only got that on the foreclosure that makes sense because credits getting tighter and it's a tough mortgage market in all of these houses were in South Florida or Las Vegas or whatever but now what happens what happens now there's really no purpose for this entity even exist anymore because everyone's paid off there's no income streams coming in or out so essentially we'll just dissolve the corporation give everyone what their due well this guy he gets first dibs on it right he took the lowest interest rate in exchange for having the lowest risk so that guy right there I'll draw him in Green's because he's good to go this tranche right here he gets a full five million that's great he got five percent Interest and he's fully he got all of his money back sounds great these CDOs look safe so far but what about this next tranche this four million guy well he didn't he didn't do so good right the four million guy that's what he was oh that's what he essentially lent the special-purpose entity this four million tranche of CDOs he's owed four million but guess what after you paid this guy five million there's only three million left so this guy only gets three million dollars so for every four dollars he lent he only gets three dollars so this guy gets 75 cents on the dollar seventy five on a seventy five cents on the dollar right that's a seven right there I write my sevens like a European it's I think it makes me sound more well anyway but what happens to that equity tranche this guy up here this $1,000,000 right he thought he was a genius he he lent this money and he was getting a 31 percent interest sounded good and frankly it probably he that the bank probably wasn't able to unload this to anyone because pension funds and a lot of these foreign governments they only buy the safer assets right so this is the stuff that's probably sitting on a lot of these investment bank balance sheets these are the smelly toxic stinky assets that people are talking about and guess what there's nothing left to pay this million dollars to this guy there's we paid five to this guy this guy didn't he only got 75 cents on the dollar right he was impaired by a million dollars here and then this last tranche up here he gets nothing so the question is these CDOs that are on bank's balance sheet are they these CDOs are they a share in that tranche of debt in which case they're very safe but I would argue in which case the bank's probably aren't looking to unload them as quickly or they can probably find buyers are they this trash in which case maybe they're worth 75 cents but you know even at 75 cents you're going to break even maybe they're worth you know at 60 cents on the dollar maybe they're a good deal or are they this stuff and if there's this stuff then they really really really are worth nothing at least in the example I just gave