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Collateralized debt obligation (CDO) | Finance & Capital Markets | Khan Academy - YouTube
Channel: Khan Academy
[1]
Welcome back.
[2]
Well, in the last presentation,
we described a
[3]
situation where you had
a bunch of borrowers.
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They needed $1 billion
collectively, because there's
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1000 of them and they each
needed $1 million
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to buy their house.
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And they borrowed the money
essentially from a special
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purpose entity.
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They borrowed it from their
local mortgage broker, who
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then sold it to a bank, or to
an investment bank, who
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created the special purpose
entity, and then they IPO the
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special purpose entity and raise
the money from people
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who bought the mortgage-backed
securities.
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But essentially what happened
is the investors in the
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mortgage-backed securities
provided the money to the
[31]
special purpose entity to
[33]
essentially loan to the borrowers.
[34]
And then the reason why we call
it a security is because,
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not only are these people
getting this 10% a year, but
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if they want to -- let's say
that you had one of these
[42]
mortgage-backed securities and
you paid $1000 for it.
[44]
And you're getting this 10%
a year, but then all of a
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sudden, you think that the whole
mortgage industry is
[49]
about to collapse, a bunch of
people are going to default,
[50]
and you want out.
[52]
If you just gave someone
a loan, there'd be
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no way to get out.
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You'd have to sell that
loan to someone else.
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But if you have a
mortgage-backed security, you
[58]
can actually trade the security
with someone else.
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And they might pay you, who
knows, they might pay more
[61]
than $1000.
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They might pay you less.
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But there will be at least some
type of a market in the
[65]
security, so you could have what
you could call liquidity.
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Liquidity just means that
I have the security
[70]
and I can sell it.
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I could trade it just like I
could trade a share of IBM or
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I could trade a share
of Microsoft.
[77]
But like we said before, this
security, in order to place a
[80]
value on it, you have to do some
type of analysis of what
[84]
you think it's worth.
[85]
Or what you think the real
interest will be after you
[91]
take into account people
pre-paying their mortgage,
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people defaulting on their
mortgage, and other things
[95]
like short-term interest rates,
et cetera, et cetera.
[97]
And there is only maybe a small
group of people who are
[100]
sophisticated enough to be able
to figure that out to
[102]
make some type of models and
who knows if even they're
[105]
sophisticated enough.
[115]
There might be a whole other
class of investors
[118]
here, say this guy.
[120]
He would love to kind of invest
in insecurities, but he
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thinks this is too risky.
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He'd be willing to take a lower
return as long as he was
[128]
allowed to invest in less
risky investments.
[130]
Maybe by law, maybe he's a
pension fund or he's some type
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of a mutual fund, that's forced
to invest in something
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of a certain grade.
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And say that there's another
investor here, and he thinks
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that this is boring.
[147]
You know, 9%, 10%.
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Who cares about that?
[149]
He wants to see bigger
and bigger returns.
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So there's no way for him to
invest in this security and to
[154]
get better returns.
[155]
So now we're going to take this
mortgage-backed security
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and introduce one step further
kind of permutation or
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derivative of what this is.
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That's all derivatives are.
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You've probably heard the term
derivatives and people do a
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lot of hand-waving saying, oh,
it's a more complicated form
[172]
of security.
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All derivative means is you take
one type of asset and you
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slice and dice it in a way to
spread the risk, or whatever.
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And so you create a
derivative asset.
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It's derived from the
original asset.
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So let's see how we could use
this same asset pool, the same
[189]
pool of loans, and satisfy
all of these people.
[192]
Satisfy this guy, who wants
maybe a lower return but lower
[195]
risk, and this guy, who's
willing to take a little bit
[198]
higher risk in exchange
for higher return.
[204]
So now in this situation, we
have the same borrowers.
[207]
They borrowed $1 billion
collectively, right, because
[209]
there's 1000 of them, et
cetera, et cetera.
[211]
And they're still a special
purpose entity, but now,
[214]
instead of just slicing up the
special purpose entity a
[218]
million ways, what we're going
to do is we're going to split
[222]
it up first into three, what
we could call, tranches.
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A tranche is just a bucket,
if you will, of the asset.
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And we're going to call the
three tranches: equity,
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mezzanine, and senior.
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These are the words
that are commonly
[237]
used in this industry.
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A senior just means, if this
entity were to lose money,
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these people get their money
back first. So it's the least
[247]
risk out of all of
the tranches.
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Mezzanine, that just means
the next level or middle.
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And these guys are some
place in between.
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They have a little bit more
risk, and they still get a
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little bit more reward than
senior, but they have less
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risk than this equity tranche.
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Equity tranche.
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These are the people who
first lose money.
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Let's say some of these
borrowers start defaulting.
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It all comes out of the
equity tranche.
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So that's what protects the
senior tranche and the
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mezzanine tranche
from defaults.
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So in this situation what we did
is we raised -- out of the
[278]
$1 billion we needed -- $400
million from the senior
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tranche, $300 million from the
mezzanine tranche, and then
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$300 million from the
equity tranche.
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The $400 million senior tranche
we raised from soon.
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1000 senior securities,
collateralized debt
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obligations.
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These are these, right here.
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Say there were 400,000 of these
and these each cost
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$1000, right?
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Let's say these cost $1000.
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And we issued 400,000
of these.
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So we raised $400 million.
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Let's say we give these
guys a 6% return.
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And you might say, 6%,
that's not much.
[325]
But these guys, it is pretty low
risk, because in order for
[329]
them to not get their 6%, the
value of this $1 billion asset
[335]
or these $1 billion loans, would
have to go down below
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$400 million.
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Maybe I'll do a little bit more
math in another example.
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But I think it'll start
making sense to you.
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For example, every year we said
there's going to be $100
[347]
million in payments, right?
[348]
Because it's 10%.
[350]
$100 million in payments.
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Of that $100 million in
payments, 6% on the $400
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million, that's $24 million
in payments.
[357]
Right?
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So $24 million in payments will
go to the senior tranche.
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Similarly we issued 300,000
shares at $1000 per share on
[367]
the mezzanine tranche.
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This is also 1000.
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This is the mezzanine tranche.
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And let's say they get 7%,
a slightly higher return.
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And these percentages are
usually determined by some
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type of market or what people
are willing to get.
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But let's just say it's
fixed for now.
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Let's say it's 7%.
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So 300,000 shares, seven 7%.
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These guys are going
to get $21 million.
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Right?
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So out of the $100 million every
year, $24 million is
[390]
going to go to these guys, $21
million is going to go to
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these guys, and then whatever's
left over is going
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to go to the equity tranche.
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So the $300 million from equity,
they're going to get
[399]
$55 million assuming that
there are no defaults or
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pre-payments or anything shady
happens with the securities.
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But these guys are going
to get $55 million.
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Or on $300 million, that's
a 16.5% return.
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And I know what you're
thinking.
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Boy, Sal, that sounds amazing.
[419]
Why wouldn't everyone want
to be an equity investor?
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I don't know.
[423]
My pen has stopped working.
[425]
But anyway, I'll try to move
on without my pen.
[427]
So you're saying, why wouldn't
everyone want to
[429]
be an equity investor?
[430]
Well, let me ask
you a question.
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What happens if -- let's go to
that scenario where we talked
[434]
before -- 20% of the borrowers
just say, you know what?
[440]
I can't pay this mortgage
anymore.
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I'm going to hand you back
the keys to these houses.
[444]
And of that 20%, you only
get a 50% return.
[447]
So for each of those $1 million
houses, you're only
[449]
able to sell it for $500,000.
[452]
So then instead of getting $100
million per year, you're
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only going to get $90
million per year.
[459]
I wish I could use my pen.
[463]
Something about my computer
has frozen.
[466]
So instead of $100 million a
year, you're now only going to
[468]
get $90 million a year.
[470]
Right?
[471]
And all of a sudden,
these guys are not
[473]
going to be cut off.
[474]
This guy is still going to get
$24 million, this guy is still
[476]
going to get $21 million, but
now this guy is going to get
[480]
$45 million.
[483]
But he's still getting
above average yield.
[484]
Now let's say it gets
even worse.
[485]
Let's say a bunch of
borrowers start
[487]
defaulting on their loans.
[488]
And instead of getting $90
million per year, you start
[494]
only getting $50 million
in per year.
[496]
Now you pay this guy
$24 million.
[498]
You pay this guy $21 million
-- or this group of guys or
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gals -- $21 million.
[502]
And then all you have left is
$5 million for this guy.
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And $5 million on $300 million,
now he's getting less
[510]
than a 2% return.
[511]
So this guy took on higher
risk for higher reward.
[515]
If everyone pays, sure,
he gets 16.5%.
[518]
But then if you start having a
lot of defaults, if, let's
[522]
say, the return on what you get
every month goes in half,
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this guy takes the entire hit.
[529]
So his return goes to 0%.
[531]
So he had higher risk,
higher reward, while
[533]
these guys get untouched.
[534]
Of course, if enough people
start defaulting, even these
[537]
people start to get hurt.
[539]
So this is a form of a
collateralized debt
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obligation.
[543]
This is actually a
mortgage-backed collateralized
[545]
debt obligation.
[546]
You can actually do this type
of a structure with any type
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of debt obligation that's
backed by assets.
[555]
So we did the situation with
mortgages, but you could do it
[558]
with a bunch of assets.
[559]
You could do it with
corporate debt.
[561]
You could do it with receivables
from a company.
[564]
But what you read about the
most right now in the
[566]
newspapers is mortgage-backed
collateralized debt
[569]
obligations.
[570]
And to some degree, that's
what's been getting a lot of
[573]
these hedge funds in trouble.
[574]
And I think I'll do another
presentation on exactly how
[578]
and why they have gotten
in trouble.
[580]
Look forward to talking to you
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