Bailout 11: Why these CDOs could be worth nothing

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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 security.

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.

$250,000.00 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.

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.

번역 0%

Bailout 11: Why these CDOs could be worth nothing발음듣기

다른 번역문 등록

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.발음듣기

다른 번역문 등록

And, who knows, maybe we'll even make a profit on the assets.발음듣기

다른 번역문 등록

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.발음듣기

다른 번역문 등록

And one could argue that even some of these are worth 0.발음듣기

다른 번역문 등록

And I've gotten some letters and I've heard other people on the news actually say, well, how could they be worth 0?발음듣기

다른 번역문 등록

They're backed by mortgages, which are backed by houses, which are the collateral.발음듣기

다른 번역문 등록

That's where the collateral comes from, the collateralized debt obligations.발음듣기

다른 번역문 등록

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.발음듣기

다른 번역문 등록

So let's do something simple.발음듣기

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Let's not talk in terms of millions of homes, let's talk in terms of 10 homes.발음듣기

다른 번역문 등록

Let's say I were to create a very small mortgage-backed security.발음듣기

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Essentially, I give out 10 mortgages. Right?발음듣기

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Let's say each mortgage is $1 million.발음듣기

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Let's say that's 10 times 1 million more.발음듣기

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10 times $1 million.발음듣기

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And the people who I give those mortgages to buy ten $1 million houses. Right?발음듣기

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So, I create a corporation, a special purpose entity, for the sake of this mortgage-backed security for constructing these collateralized debt obligations.발음듣기

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That's my company I create, the balance sheet of it.발음듣기

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What are the assets?발음듣기

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Well, I have 10 mortgages times a million so I have $10 million in loans, essentially, $10 million in mortgages.발음듣기

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And they're collateralized or they're backed by the underlying houses that these mortgages were used to buy.발음듣기

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$10 million in mortgages, $10 million more, right?발음듣기

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Now, how is this special purpose entity - we'll call it an S.P.E. - how is this S.P.E. funded?발음듣기

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Well, it's essentially funded by the people who are buying the collateralized debt obligations.발음듣기

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And collateralized debt obligations are essentially just debt that is used to fund these mortgages.발음듣기

다른 번역문 등록

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.발음듣기

다른 번역문 등록

And so each share would hold 1/1000 of this value, right?발음듣기

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That's a mortgage-backed security.발음듣기

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But in a collateralized debt obligation, I split it into buckets.발음듣기

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So what I do is, let's say I borrow three tranches.발음듣기

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Just call that buckets.발음듣기

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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.발음듣기

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$5 million from these people, and these are the senior debt holders.발음듣기

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So essentially, both this debt holder and this debt holder has to get wiped out before this guy gets impaired.발음듣기

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Impaired just means that you get less money than you lent, right?발음듣기

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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.발음듣기

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So think of it this way: let's say these 10 mortgages, let's say that I'm getting 8%.발음듣기

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And let's say that I'm paying, let me draw, they're giving me $5 million.발음듣기

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Let's say that I'll pay these guys 5%.발음듣기

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And why are they willing to take a lower interest rate?발음듣기

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Because essentially any default on this side will hit these two buckets before it hits these people.발음듣기

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So this'll be an arguably very safe debt instrument.발음듣기

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And I'll do more about that in a second.발음듣기

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And let's say I borrow another $4 million from some other people.발음듣기

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So they gave me $4 million.발음듣기

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I have to pay a little bit higher interest to them.발음듣기

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I have to pay 6% interest to them, right?발음듣기

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And then, finally, I borrow another $1 million.발음듣기

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I borrow $1 million from people who are willing to take the biggest risk.발음듣기

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So if there's any defaults over here, these people are going to be wiped out before these people get touched.발음듣기

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And actually, we can figure out the appropriate amount of interest, right?발음듣기

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How much money is coming in per month before anyone starts defaulting?발음듣기

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Let's see, I'm getting $800,000 in per month.발음듣기

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That's the inflow.발음듣기

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And then on the outflow, I have to pay these people 5 million times 5%.발음듣기

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That's $250,000.발음듣기

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So that's how much I'm paying to that tranche.발음듣기

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$250,000.00 And then four times 6%.발음듣기

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That's $240,000, minus 240.발음듣기

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So that's what, 800 minus 490.발음듣기

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So then I have 310,000 left, right?발음듣기

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So I can essentially pay this $310,000 per year to this tranche.발음듣기

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So they're going to actually get a 31% interest. And that sounds great.발음듣기

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That's why they call that the equity tranche normally in a CDO because those people get a lot of upside.발음듣기

다른 번역문 등록

But guess what: if there's any default, these people get wiped out first.발음듣기

다른 번역문 등록

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.발음듣기

다른 번역문 등록

Let me scratch this out right here.발음듣기

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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.발음듣기

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So they just prepay the mortgage.발음듣기

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So let's say in one year.발음듣기

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Let me redraw this balance sheet in one year.발음듣기

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So in one year, let's say five of those borrowers - so this is a year later.발음듣기

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Magenta is my color for a year later.발음듣기

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A year later, half of those borrowers just refinance or they sell their house.발음듣기

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And so they just pay us back $5 million, right?발음듣기

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So we get $5 million.발음듣기

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I'll put that on the asset side of the balance sheet, right?발음듣기

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This is assets.발음듣기

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There's a bunch of videos on assets and liabilities and balance sheets if this confuses you.발음듣기

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And there's no equity in this company, right?발음듣기

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Because assets minus liability is equity.발음듣기

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And I did that because these are special purpose entities.발음듣기

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Their whole purpose is to structure these securities.발음듣기

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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.발음듣기

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OK, so we said half the people refinance.발음듣기

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Those people were great.발음듣기

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They were worth giving the money to because they paid off their loans in whole.발음듣기

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But guess what?발음듣기

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The other half of the people, the title of subprime was deserving of them, and they default.발음듣기

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And we have to foreclose on them a year later, right?발음듣기

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But all is not lost, right?발음듣기

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We don't lose that $5 million that we lent those other 5 million people because they had homes, right?발음듣기

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These are collateralized debt obligations.발음듣기

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We are able to take their houses.발음듣기

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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?발음듣기

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Five paid, five didn't pay.발음듣기

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We take the five who didn't pay houses.발음듣기

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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?발음듣기

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So 60% of $5 million.발음듣기

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We're essentially only able to get $3 million for the houses we've foreclosed on.발음듣기

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So a year later, what are all of our assets?발음듣기

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We get the $5 million in cash from the people who are good and paid off their mortgages.발음듣기

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And then we get the $3 million from the people who foreclosed.발음듣기

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And then we only got 60% of the original purchase price of the homes.발음듣기

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We only got that on the foreclosure.발음듣기

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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.발음듣기

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But what happens now?발음듣기

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There's really no purpose for this entity to even exist anymore because everyone's paid off.발음듣기

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There's no income streams coming in or out.발음듣기

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So essentially we will just dissolve the corporation and give everyone what they're due.발음듣기

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Well, this guy, he gets first dibs on it, right?발음듣기

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He took the lowest interest rate in exchange for having the lowest risk.발음듣기

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So that guy right there, I'll draw him in green because he's good to go.발음듣기

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This tranche right here, he gets a full $5 million.발음듣기

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That's great.발음듣기

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He got 5% interest and he got all of his money back. Sounds great.발음듣기

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The CDOs look safe so far.발음듣기

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But what about this next tranche, this $4 million guy.발음듣기

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He didn't do so good, right?발음듣기

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The $4 million guy, that's what he was owed, that's what he essentially lent the special purpose entity.발음듣기

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This $4 million tranche of CDOs.발음듣기

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He's owed $4 million, but guess what?발음듣기

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After you pay this guy $5 million, there's only $3 million left.발음듣기

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So this guy only gets $3 million.발음듣기

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So for every $4 he lent, he only gets $3.발음듣기

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So this guy gets $0.75 on the dollar.발음듣기

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That's a seven, right there.발음듣기

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I write my sevens like a European.발음듣기

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But what happens to that equity tranche, this guy up here?발음듣기

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This $1 million, right?발음듣기

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He thought he was a genius.발음듣기

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He lent this money and he was getting a 31% interest.발음듣기

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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?발음듣기

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So this is the stuff that's probably sitting on a lot of these investment bank balance sheets.발음듣기

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These are the smelly, toxic, stinky assets that people are talking about.발음듣기

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And guess what?발음듣기

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There's nothing left to pay this $1 million to this guy.발음듣기

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You pay $5 to this guy.발음듣기

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This guy only got $0.75 on the dollar, right?발음듣기

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He was impaired by $1 million here.발음듣기

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And then this last tranche up here: he gets nothing.발음듣기

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So the question is: these CDOs that are on Banks's balance sheets, are they these CDOs?발음듣기

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Are they a share in that tranche of debt, in which case, they're very safe.발음듣기

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But I would argue in which case the banks probably aren't looking to unload them as quickly, or they can probably find buyers.발음듣기

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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?발음듣기

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Maybe they're worth, at $0.60 on the dollar, maybe they're a good deal.발음듣기

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Or are they this stuff?발음듣기

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And if they're this stuff, then they really, really, really are worth nothing, at least in the example I just gave.발음듣기

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