Transcription:

In the last presentation, we described a situation where there’s a bunch of borrowers. They needed $1B collectively, and because there’s a thousand of them, they each needed a $1M to buy their house. They borrowed the money essentially from a special purpose entity. They borrowed it from mortgage broker who then sold it to a bank or to investment bank who created the special purpose entity. Then they IPO’d the special purchase entity and raised the money from people who bought mortgage-backed securities.

Essentially what happened is investors in the mortgage backed securities provided the money to the special purpose entity to loan to the borrowers. The reason we call these securities is because, not only are these people getting this 10% a year, but if they want to, let’s say that you had one of these mortgage-backed securities, and you paid $1K for it, and you’re getting the 10% a year. then all of a sudden, you think the whole mortgage industry’s about to collapse, a bunch of people are going to default, and you want out. If you just gave someone a loan, there’d be no way to get out. You’d have to sell that loan to someone else. If you have a mortgage-backed security, you could actually trade the security with someone else, and they might pay you more than $1K. They might pay you less. you’d have what they call liquidity. Liquidity just means, I have the security and I can sell it. Just like I can trade a share of IBM, or I can trade a share of Microsoft.

Like we said before, this security, in order to place a value on it, you have to have some type of analysis of what you think it’s worth will be after you take into account people prepaying their mortgage, defaulting, and other things like short-term interest rates. There’s only a small group of people who are sophisticated enough to figure that out, to make some models. Who knows if they’re sophisticated enough?

There might be a whole other class of investors that would love to invest in securities, but he thinks this is too risky. He’d be willing to take a lower return as long as he was allowed to invest in less risky investments. Maybe by law, he’s a pension fund or a mutual fund that’s forced to invest in something of a certain grade. Say that there’s another investor here, and he thinks that this is boring. 9%, 10%, who cares about that? He wants to see bigger returns. There’s no way for him to invest in this security and to get better returns.

So now we’re going to take this mortgage-backed security, and introduce one step further, a permutation or derivative of this. That’s all that derivatives are. You’ve probably heard the term derivatives and people do a lot of hand-waving. It’s a more complicated form of security. All derivative means is you take one type of asset, and you slice and dice it in a way to spread the risk. It’s derived from the original asset. So let’s see how we could use the same asset pool, the same pool of loans, and satisfy all of these people. Satisfy this guy who wants a lower return but lower risk. this guy who’s willing to take a higher risk in exchange for higher return.

So now in this situation, we have the same borrowers. They borrowed $1B collectively because there are a thousand of them. Instead of slicing up the special purpose entity a million ways, we’re going to split it up first into three tranches. A tranche is just a bucket if you will. We’re going to call the three tranches, Equity, Mez, and Senior. these are the words that are commonly used in this industry.

Senior just means, if this entity were to lose money, these people get their money back first. So it’s the least risky of all the tranches. Mezzanine, that just means middle, and these guys are some place in between. They have a little bit more risk, and they get a little more reward than Senior, but they have less risk than this Equity tranche. Equity tranche, these are the people who first, lose money. Let’s say some of these borrowers start defaulting. It all comes out of the Equity tranche. So that’s what protects the Senior tranche and the Mezzanine tranche from defaults.

So out of the $1B we needed, we raised $400M from the Senior $300M from the Mezzanine tranche, and then $300M from the Equity tranche. The $400M Senior tranche, we raised from a thousand Senior securities, collateralized debt obligations. There were 400K of these, and they each cost $1K. we used 400K of these, so we raised $400M. let’s say we give these guys a 6% return. you might say, 6%, that’s not much. these guys are pretty low risk. Because in order for them to not get their 6%, the value of this $1B asset would have to go down below $400M. I’ll do a little more math in another example. I think it’ll start making sense.

For example, every year, we said there was going to be $100M in payments, cause it’s 10%. Of that $100M in payments, 6% on the $400M, that’s $24M in payments. So $24M in payments will go to the Senior tranche. Similarly, we issued 300K shares at $1K per share on the Mezzanine tranche. say they get 7%, slightly higher return. these percentages are usually determined by some type of market, but let’s say it’s fixed for now. Let’s say it’s 7%. So 300K shares, 7%, these guys are going to get $21M. So out of the $100M every year, $24M is going to go to these guys, $21M is going to these guys, and whatever’s left over is going to go to the Equity tranche.

So the $300M, they’re going to $55M, assuming no defaults, nothing shady happens with the securities. So these guys are going to get $55M. Or on, $300M, it’s a 16.5% return. I know what you’re thinking. That sounds amazing. Why wouldn’t everyone want to be an equity investor?

Well, let me ask you a question. What happens if, let’s go to that scenario we talked about before. 20% of the borrowers just say, I can’t pay this mortgage anymore. I’m going to hand you back the keys to these houses. of that 20%, you only get a 50% return. So for each of those 50M houses, you’re only able to sell it for $500K. So then instead of getting $100M per year, you’re only going to get $90M per year.

And all of a sudden, these guys are not going to be cut off. This guy’s still going to get $24M. This guy’s’ going to get $21M. this guy’s going to get $45M. he’s still getting above average yield. Now let’s say it gets even worse. Let’s say a bunch of borrowers start defaulting on their loans. instead of getting $100M, or $90M per year, you start only getting $50M a year. Now you pay this guy $24M, this guy $21M, and then all you have left is $5M for this guy. $5M on $300M, now he’s getting less than a 2% return. This guy took on higher risk for higher reward. If everyone pays, sure, he gets 16.5%.

But if you start having a lot of defaults. Let’s say the return on what you get every month goes to half, this guy takes the entire hit. So his return goes to zero percent. So higher risk, higher reward. While these guys get untouched. Of course, if enough people start defaulting, even these people start to get hurt.

So this is a form of a collateralized debt obligation. This is actually a mortgage-backed collateralized debt obligation. You can actually split this type of a structure with any type of debt obligation that’s backed by assets. We did the situation with mortgages, but you could do it with a bunch of assets. You could do it with corporate debt. You could do it with receivables from a company. what you read about the most right now most in the newspapers is mortgage-backed collateralized debt obligations. To some degree, that’s what been getting a lot of these hedge funds in trouble.

And I think I’ll do another presentation on exactly how and why they have gotten in trouble. Look forward to talking to you soon.