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. 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.