Collateralized Debt

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