Bailout 11: Why these CDOs could be worth nothing

Bailout 11: Why these CDOs could be worth nothing

The government has said a lot
about the fact that this $700 billion might not just be a
blank check, that we're actually buying assets. And, who knows, maybe
we'll even make a profit on the assets. And I've hinted and other people
have 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 0. And I've gotten some letters and
I've heard other people on the news actually say, well,
how could they be worth 0? 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 do something simple. Let's not talk in terms of
millions of homes, let's talk in terms of 10 homes. Let's say I were to create
a very small mortgage-backed security. Essentially, I give
out 10 mortgages. Right? Let's say each mortgage
is $1 million. Let's say that's 10 times
1 million more. 10 times $1 million. And the people who I give those
mortgages to buy ten $1 million houses.

Right? So, I create a corporation, a
special purpose entity, for the sake of this mortgage-backed
security 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 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 S.P.E.– how is this S.P.E. 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 these mortgages. And what's interesting about
a collateralized debt obligation– see in a
mortgage-backed security, I would have just given these
$10 million mortgages and then, in this corporation, I
would have just issued a thousand shares. And so each share would hold
1/1000 of this value, right? That's a mortgage-backed

But in a collateralized
debt obligation, I split it into buckets. So what I do is, let's say
I borrow three tranches. Just call that buckets. So I go to some people and I
borrow, I don't know, of that $10 million that I said you lent
out, I borrow– I don't know– let me say– I'll make
up a number– $5 million. %5 million from these people,
and these are the senior debt holders. So essentially, both this debt
holder and this debt holder has to get wiped out before
this guy gets impaired.

Impaired just means that
you get less money than you lent, right? So I borrow $5 million from
somebody else and 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 10 mortgages, let's say that I'm getting 8%. And let's say that I'm paying,
let me draw, they're giving me $5 million. Let's say that I'll
pay these guys 5%. And why are they willing to take
a lower interest rate? Because essentially any default
on this side will hit these two buckets before
it hits these people. So this'll be an arguably very
safe debt instrument. And I'll do more about
that in a second. And let's say I borrow
another $4 million from some other people.

So they gave me $4 million. I have to pay a little bit
higher interest to them. I have to pay 6% interest
to them, right? And then, finally, I borrow
another $1 million. I borrow $1 million 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? Let's see, I'm getting $800,000
in per month. That's the inflow. And then on the outflow, I have
to pay these people 5 million times 5%. That's $250,000. So that's how much I'm paying
to that tranche.

$250,000. And then four times 6%. That's $240,000, minus 240. So that's what, 800 minus 490. So then I have 310,000
left, right? So I can essentially pay
this $310,000 per year to this tranche. So they're going to actually get
a 31% interest. And that sounds great. That's why they call that the
equity tranche normally in a CDO because those people
get a lot of upside. But guess what: if there's any
default, these people get wiped out first. And just to
make this example clear, let's do it very simply because you
could model this out and assume some type of prepayment
et cetera, et cetera.

investment bank balance sheets

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 or whatever. So 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. And so they just pay us back
$5 million, right? So we get $5 million. I'll put that on the
asset side of the balance sheet, right? This is assets. 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 liability
is equity.

And I did that because these are
special purpose entities. Their whole purpose is to
structure these securities. Their purpose really isn't to
be an ongoing operation that has net income in and of
itself, although there probably was equity in the
bank who constructed this probably took at all. OK, so we said half the
people refinance. Those people were great. They were worth giving the money
to because they paid off their loans in whole. But guess what? The other half of the people,
the title of subprime 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 $5 million
that we lent those other 5 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, 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 houses.

And let's say, when we sell
them, let's say we're only able to get, I don't know, 60%
on those houses, right? So 60% of $5 million. We're essentially only able to
get $3 million for the houses we've foreclosed on. So a year later, what are
all of our assets? We get the $5 million in cash
from the people who are good and paid off their mortgages. And then we get the $3 million
from the people who foreclosed. And then we only got 60% of
the original purchase price of the homes. We only got that on
the foreclosure.

That makes sense because
credit's getting tighter, and it's a tough mortgage market,
and all these houses were in South Florida or Las
Vegas or whatever. But what happens now? There's really no purpose for
this entity to even exist anymore because everyone's
paid off. There's no income streams
coming in or out. So essentially we will just
dissolve the corporation and give everyone what
they're 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 because he's good to go. This tranche right here, he
gets a full $5 million. That's great. He got 5% interest and he got
all of his money back.

Sounds great. The CDOs look safe so far. But what about this next
tranche, this $4 million guy. He didn't do so good, right? The $4 million guy, that's what
he was owed, that's what he essentially lent the special
purpose entity. This $4 million tranche
of CDOs. He's owed $4 million,
but guess what? After you pay this guy $5
million, there's only $3 million left. So this guy only gets
$3 million. So for every $4 he lent,
he only gets $3. So this guy gets $0.75
on the dollar. That's a seven, right there. I write my sevens
like a European. But what happens to that equity tranche, this guy up here? This $1 million, right? He thought he was a genius. He lent this money and he was
getting a 31% interest. Sounded good and, frankly, 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
$1 million to this guy. You pay $5 to this guy. This guy only got $0.75
on the dollar, right? He was impaired by
$1 million here. And then this last tranche
up here: he gets nothing. So the question is: these CDOs
that are on banks's balance sheets, 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 banks probably aren't looking to unload them as
quickly, or they can probably find buyers. Are they this tranche, in which
case maybe they're worth $0.75, but you know even at
$0.75, you're just going to break even? Maybe they're worth, at $0.60
on the dollar, maybe they're a good deal. Or are they this stuff? And if they're this stuff,
then they really, really, really are worth nothing,
at least in the example I just gave.

As found on YouTube

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