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Collateralized debt obligation overview | Finance & Capital Markets | Khan Academy - YouTube
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We've seen that an
investment bank can
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buy a bunch of mortgages,
which essentially makes them
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the lender to the
homeowners, and then it
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could stick those mortgages
inside of a special purpose
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entity.
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And then it could sell the
shares in that special purpose
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entity, and that
these shares would
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be called mortgage-backed
securities.
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And let's just say, just
for the sake of argument,
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when it sells these shares
it sells them at $10 a share,
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and it promises
dividends at $10 a share,
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the equivalent of an 8% yield.
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So maybe the homeowners
here are paying
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a higher than 8%
interest, some of them
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default, once you
average everything out,
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and the investment bank
keeps a little bit for itself
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and to do all the operations
and all the overhead,
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and so it can actually give
the investors an 8% yield.
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This might be good for a
whole class of investors.
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They might like the safety
profile, the risk profile
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of the special purpose entity of
this mortgage-backed security,
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and they might like the return,
and they might go for it.
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But there might be a
class of investors,
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may be very risk-averse
investors like pensions,
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that says that this
mortgage-backed security is
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too risky.
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They've looked at
what we're holding,
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and they are like, hey, some of
these are sub-prime mortgages,
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some of these are shady, some
of these are to risky borrowers.
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I don't like where
this is going.
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And even if they can't
look under the hood
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to see what this is,
the investment bank
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might have hired
a ratings agency.
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So maybe a ratings agency to
essentially look under the hood
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and tell investors what's there.
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So the ratings agency might look
at this special purpose entity
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and look at these
securities and say,
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look, I would say that these
securities should be rated BB.
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So not super safe, but
not super risky either,
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but for pensions that
is not safe enough.
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Now on the other hand, you might
have people who want more risk.
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So you might have, maybe
there's some risky hedge funds,
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and not all hedge
funds are risky,
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but let's say that there
are some risky hedge funds,
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and then they say that
this yield is too low.
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And the investment
bankers, they're
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very creative people,
they say, well, look,
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here's some people who
want to buy securities,
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but these securities
are too risky for them.
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And there's other
people who want
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to buy securities who are
able to take on more risk,
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but they say the
yield is too low.
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So instead of losing
out on these investors,
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why don't I just split
up this special purpose
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entity in a different way?
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Why don't I split
it up into tranches?
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So instead of all of the
securities being the same,
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why don't I put
them into classes?
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And they're often called
the senior tranche,
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the mezzanine tranche,
I'll just write "Mez"
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for short or the middle tranche,
and then the equity tranche.
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And the way it works, in
a mortgage-backed security
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everyone gets paid
the same amount.
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In this situation, when
you split it this way,
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the holders of the
senior tranche securities
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are going to get paid first.
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Only when they
are made whole are
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the owners of the
mezzanine tranche security
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is going to get paid, and only
when they are made whole will
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the owners of the equity
tranche security will get paid.
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And this scenario
right over here
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is called a collateralized
debt obligation, CDO.
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And it's really a derivative
security from the mortgages.
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We've sliced it and diced it
in a slightly different way.
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Now you might be saying, how
does this solve the problem?
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Well, now the ratings
agency will say,
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well, look if the
senior people are
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going to get paid
before everyone else,
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then I'm going to give
them a higher rating.
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And they can even get insurance
on this and get a credit
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default swap, and then maybe
they'll give it a AAA rating,
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and which means that the
pensions can now buy the senior
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rated CDO's.
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But they'll pay
them less interest.
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Maybe they'll pay them 5%.
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Maybe the mezzanine,
they get paid next,
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they'll get maybe still a BB
rating, and they'll get the 8%.
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And then the equity tranche,
they'll get a higher interest.
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So they'll get say a
15% interest in exchange
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for being the last
person to get paid.
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And maybe they don't
get any ratings at all.
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So you could almost view
this as a junk rating
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if you want to view it that way.
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But that makes
both people happy.
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Pensions get something
safe, lower yield.
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Hedge funds get something risky,
but it has a higher yield.
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