We’ve seen that an
investment bank can buy a bunch of mortgages,
which essentially makes them the lender to the
homeowners, and then it could stick those mortgages
inside of a special purpose entity. And then it could sell the
shares in that special purpose entity, and that
these shares would be 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 paying a higher than 8%
interest, some of them default, once you
average everything out, and the investment bank
keeps a little bit for itself and 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 profile of 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 is too 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 hood to see what this is,
the investment bank might have hired
a ratings agency. So maybe a ratings agency to
essentially look under the hood and tell investors what’s there. So the ratings agency might look
at this special purpose entity and 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’re very 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 want to 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 purpose entity 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 security everyone gets paid
the same amount. In this situation, when
you split it this way, the holders of the
senior tranche securities are going to get paid first. Only when they
are made whole are the owners of the
mezzanine tranche security is going to get paid, and only
when they are made whole will the owners of the equity
tranche security will get paid. And this scenario
right over here is 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 are going 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 credit default swap, and then maybe
they’ll give it a AAA rating, and which means that the
pensions can now buy the senior rated 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 exchange for 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 rating if 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.