Collateralized Debt Obligation (CDO)

Welcome back.

Well, in the last presentation,
we described a

situation where you had
a bunch of borrowers.

They needed $1 billion
collectively, because there's

1000 of them and they each
needed $1 million

to buy their house.

And they borrowed the money
essentially from a special

purpose entity.

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 they IPO the

special purpose entity and raise
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
it a 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 $1000 for it.

And you're getting this 10%
a year, but then all of a

sudden, you think that the whole
mortgage industry is

about to collapse, a bunch of
people are 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 $1000.

They might pay you less.

But there will be at least some
type of a market in the

security, so you could have what
you could call liquidity.

Liquidity 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 or

I could trade a 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 the real
interest will be after you

take into account people
pre-paying their mortgage,

people defaulting on their
mortgage, and other things

like short-term interest rates,
et cetera, et cetera.

And there is 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.

There might be a whole other
class of investors

here, say this guy.

He would love to kind of invest
in insecurities, but he

thinks this is too risky.

He'd be willing to take a lower
return as long as he was

allowed to invest in less
risky investments.

Maybe by law, maybe he's a
pension fund or he's 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, and he thinks

that this is boring.

You know, 9%, 10%.

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 introduce one step further
kind of permutation or

derivative of what this is.

That's all derivatives are.

You've probably heard the term
derivatives and people do a

lot of hand-waving saying, oh,
it's a more complicated form

of security.

All derivative means is you take
one type of asset and you

slice and dice it in a way to
spread the risk, or whatever.

And so you create a
derivative asset.

It's derived from the
original asset.

So let's see how we could use
this 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
willing to take a little bit

higher risk in exchange
for higher return.

So now in this situation, we
have the same borrowers.

They borrowed $1 billion
collectively, right, because

there's 1000 of them, et
cetera, et cetera.

And they're 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 split

it up first into three, what
we could call, tranches.

A tranche is just a bucket,
if you will, of the asset.

And we're going to call the
three tranches: equity,

mezzanine, and senior.

These are the words
that are commonly

used in this industry.

A senior just means, 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
the next level or middle.

And these guys are some
place in between.

They have a little bit more
risk, and they still 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 defaults.

So in this situation what we did
is we raised -- out of the

$1 billion we needed -- $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 soon.

1000 senior securities,
collateralized debt

obligations.

These are these, right here.

Say there were 400,000 of these
and these each cost

$1000, right?

Let's say these cost $1000.

And we issued 400,000
of these.

So we raised $400 million.

Let's say we give these
guys a 6% return.

And you might say, 6%,
that's not much.

But these guys, it is pretty low
risk, because in order for

them to not get their 6%, the
value of this $1 billion asset

or these $1 billion loans, would
have to go down below

$400 million.

Maybe I'll do a little bit more
math in another example.

But I think it'll start
making sense to you.

For example, every year we said
there's going to be $100

million in payments, right?

Because it's 10%.

$100 million in payments.

Of that $100 million in
payments, 6% on the $400

million, that's $24 million
in payments.

Right?

So $24 million in payments will
go to the senior tranche.

Similarly we issued 300,000
shares at $1000 per share on

the mezzanine tranche.

This is also 1000.

This is the mezzanine tranche.

And let's say they get 7%,
a slightly higher return.

And these percentages are
usually determined by some

type of market or what people
are willing to get.

But let's just say it's
fixed for now.

Let's say it's 7%.

So 300,000 shares, seven 7%.

These guys are going
to get $21 million.

Right?

So out of the $100 million every
year, $24 million is

going to go to these guys, $21
million is going to go to

these guys, and then whatever's
left over is going

to go to the equity tranche.

So the $300 million from equity,
they're going to get

$55 million assuming that
there are no defaults or

pre-payments or anything shady
happens with the securities.

But these guys are going
to get $55 million.

Or on $300 million, that's
a 16.5% return.

And I know what you're
thinking.

Boy, Sal, that sounds amazing.

Why wouldn't everyone want
to be an equity investor?

I don't know.

My pen has 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 -- let's go to
that scenario where we talked

before -- 20% of the borrowers
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 $1 million
houses, you're only

able to sell it for $500,000.

So then instead of getting $100
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 a
year, you're now only going to

get $90 million a year.

Right?

And all of a sudden,
these guys are not

going to be cut off.

This guy is still going to get
$24 million, this guy is still

going to get $21 million, but
now this guy is going to get

$45 million.

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 $90
million per year, you start

only getting $50 million
in per year.

Now you pay this guy
$24 million.

You pay this guy $21 million
-- or this group of guys or

gals -- $21 million.

And then all you have left is
$5 million for this guy.

And $5 million on $300 million,
now he's getting less

than a 2% return.

So this guy took on higher
risk for higher reward.

If everyone pays, sure,
he gets 16.5%.

But then if you start having a
lot of defaults, if, let's

say, the return on what you get
every month goes in half,

this guy takes the entire hit.

So his return goes to 0%.

So he had higher risk,
higher 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 do this type
of a structure with any type

of debt obligation that's
backed by assets.

So we did the situation with
mortgages, but you could do it

with a bunch of assets.

You could do it with
corporate debt.

You could do it with receivables
from a company.

But what 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 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