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Collateralized debt obligation (CDO) | Finance & Capital Markets | Khan Academy

December 3, 2019


Welcome back. Well, in the last presentation,
we described a situation where you had
a bunch of borrowers. They needed $1 billion
collectively, because there’s 1000 of them and they each
needed $1 million to buy their house. And they borrowed the money
essentially from a special purpose entity. They borrowed it from their
local mortgage broker, who then sold it to a bank, or to
an investment bank, who created the special purpose
entity, and then they IPO the special purpose entity and raise
the money from people who bought the mortgage-backed
securities. But essentially what happened
is the investors in the mortgage-backed securities
provided the money to the special purpose entity to essentially loan to the borrowers. And then the reason why we call
it a security 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 $1000 for it. And you’re getting this 10%
a year, but then all of a sudden, you think that the whole
mortgage industry is 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. But if you have a
mortgage-backed security, you can actually trade the security
with someone else. And they might pay you, who
knows, they might pay more than $1000. They might pay you less. But there will be at least some
type of a market in the security, so you could have what
you could call liquidity. Liquidity just means that
I have the security and I can sell it. I could trade it just like I
could trade a share of IBM or I could trade a share
of Microsoft. But like we said before, this
security, in order to place a value on it, you have to do some
type of analysis of what you think it’s worth. Or what you think the real
interest will be after you take into account people
pre-paying their mortgage, people defaulting on their
mortgage, and other things like short-term interest rates,
et cetera, et cetera. And there is only maybe a small
group of people who are sophisticated enough to be able
to figure that out to make some type of models and
who knows if even they’re sophisticated enough. There might be a whole other
class of investors here, say this guy. He would love to kind of invest
in insecurities, 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, maybe he’s a
pension fund or he’s some type of a mutual fund, that’s forced
to invest in something of a certain grade. And say that there’s another
investor here, and he thinks that this is boring. You know, 9%, 10%. Who cares about that? He wants to see bigger
and bigger returns. So 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
kind of permutation or derivative of what this is. That’s all derivatives are. You’ve probably heard the term
derivatives and people do a lot of hand-waving saying, oh,
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, or whatever. And so you create a
derivative asset. It’s derived from the
original asset. So let’s see how we could use
this same asset pool, the same pool of loans, and satisfy
all of these people. Satisfy this guy, who wants
maybe a lower return but lower risk, and this guy, who’s
willing to take a little bit higher risk in exchange
for higher return. So now in this situation, we
have the same borrowers. They borrowed $1 billion
collectively, right, because there’s 1000 of them, et
cetera, et cetera. And they’re still a special
purpose entity, but now, instead of just slicing up the
special purpose entity a million ways, what we’re going
to do is we’re going to split it up first into three, what
we could call, tranches. A tranche is just a bucket,
if you will, of the asset. And we’re going to call the
three tranches: equity, mezzanine, and senior. These are the words
that are commonly used in this industry. A senior just means, if this
entity were to lose money, these people get their money
back first. So it’s the least risk out of all of
the tranches. Mezzanine, that just means
the next level or middle. And these guys are some
place in between. They have a little bit more
risk, and they still get a little bit 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 in this situation what we did
is we raised — out of the $1 billion we needed — $400
million from the senior tranche, $300 million from the
mezzanine tranche, and then $300 million from the
equity tranche. The $400 million senior tranche
we raised from soon. 1000 senior securities,
collateralized debt obligations. These are these, right here. Say there were 400,000 of these
and these each cost $1000, right? Let’s say these cost $1000. And we issued 400,000
of these. So we raised $400 million. Let’s say we give these
guys a 6% return. And you might say, 6%,
that’s not much. But these guys, it is pretty low
risk, because in order for them to not get their 6%, the
value of this $1 billion asset or these $1 billion loans, would
have to go down below $400 million. Maybe I’ll do a little bit more
math in another example. But I think it’ll start
making sense to you. For example, every year we said
there’s going to be $100 million in payments, right? Because it’s 10%. $100 million in payments. Of that $100 million in
payments, 6% on the $400 million, that’s $24 million
in payments. Right? So $24 million in payments will
go to the senior tranche. Similarly we issued 300,000
shares at $1000 per share on the mezzanine tranche. This is also 1000. This is the mezzanine tranche. And let’s say they get 7%,
a slightly higher return. And these percentages are
usually determined by some type of market or what people
are willing to get. But let’s just say it’s
fixed for now. Let’s say it’s 7%. So 300,000 shares, seven 7%. These guys are going
to get $21 million. Right? So out of the $100 million every
year, $24 million is going to go to these guys, $21
million is going to go to these guys, and then whatever’s
left over is going to go to the equity tranche. So the $300 million from equity,
they’re going to get $55 million assuming that
there are no defaults or pre-payments or anything shady
happens with the securities. But these guys are going
to get $55 million. Or on $300 million, that’s
a 16.5% return. And I know what you’re
thinking. Boy, Sal, that sounds amazing. Why wouldn’t everyone want
to be an equity investor? I don’t know. My pen has stopped working. But anyway, I’ll try to move
on without my pen. So you’re saying, 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 where we talked before — 20% of the borrowers
just say, you know what? I can’t pay this mortgage
anymore. I’m going to hand you back
the keys to these houses. And of that 20%, you only
get a 50% return. So for each of those $1 million
houses, you’re only able to sell it for $500,000. So then instead of getting $100
million per year, you’re only going to get $90
million per year. I wish I could use my pen. Something about my computer
has frozen. So instead of $100 million a
year, you’re now only going to get $90 million a year. Right? And all of a sudden,
these guys are not going to be cut off. This guy is still going to get
$24 million, this guy is still going to get $21 million, but
now this guy is going to get $45 million. But 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. And instead of getting $90
million per year, you start only getting $50 million
in per year. Now you pay this guy
$24 million. You pay this guy $21 million
— or this group of guys or gals — $21 million. And then all you have left is
$5 million for this guy. And $5 million on $300 million,
now he’s getting less than a 2% return. So this guy took on higher
risk for higher reward. If everyone pays, sure,
he gets 16.5%. But then if you start having a
lot of defaults, if, let’s say, the return on what you get
every month goes in half, this guy takes the entire hit. So his return goes to 0%. So he had 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 do this type
of a structure with any type of debt obligation that’s
backed by assets. So 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. But what you read about the
most right now in the newspapers is mortgage-backed
collateralized debt obligations. And to some degree, that’s
what’s 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

71 Comments

  • Reply boeing747200lr September 19, 2010 at 2:39 pm

    @jmk1a1 I think thats bcoz one doesnt have to use his or her brain to understand Lil waynes rap. No thinkin required, so no effort. Whereas, here you have to put in effort to concentrate, think and understand and thats not everyones cup of tea.

  • Reply Danielle Kutchuk September 22, 2010 at 3:36 am

    Thank you so much for this series. I am working with an MBS client and needed a crash course– can't even tell you how much this helped! All the best.

  • Reply amalmansy October 13, 2010 at 6:45 pm

    "greed was good, now it's legal" right??

  • Reply jgc1077 October 17, 2010 at 4:10 am

    Way, way, way too fast.

  • Reply TheExxonMobil October 26, 2010 at 4:37 pm

    Okay I've got a question:
    Under the assumption that this is an interest only loan, there will be a payment of $1billion at the end of the ten years. Otherwise the borrowers wouldn't pay any interest.You said that if 20% of the borrowers default with a recovery rate of 50%, there will be a yearly payment of $90m. At which point do the borrowers default in your scenario? I can't imagine a case in which there would be a yearly payment of $90m and a full payback of the $1 billion.

  • Reply Wooly Will November 26, 2010 at 5:57 am

    Great learning tool! Top notch.

  • Reply Leon Woods December 9, 2010 at 1:39 am

    @jmk1a1 cattle go and look where they are directed

  • Reply Philipp Dombrowski February 10, 2011 at 12:42 am

    @smokenfly514
    imagine there is a market where u can trade the MBS like a general share on the exchange market. For example…the demand for the MBS is high, the price will increase.But if the supply is high (higher than the demand, the price (value) will decrease. This is how the price or value of the securities can increase or decrease

  • Reply Loubab Zarroue March 4, 2011 at 6:36 pm

    Does anyone know, which video the following part is of " Collateralized Debt Obligation (CDO)" ??????

  • Reply John McIntyre Grimau March 14, 2011 at 1:03 pm

    kill this fucking lizard

  • Reply Smilodon March 15, 2011 at 8:14 pm

    "tranche" is a french word meaning slice.

  • Reply wackojacko336 April 12, 2011 at 2:35 pm

    fuck you and your stupid ass pen…. its so fucking annoying!!! i've watched 3 of your videos and each time i felt like taking that fucking pen and sticking it up your stupid american ass….. not only do you fucking suck at explaining shit but your pen is soooo fucking annoying!!!

  • Reply KoalaBearWarrior May 7, 2011 at 7:12 pm

    One question: At 6:37, when you are explaining the Mezzanine tranche, why do they get 21 Million each year, instead of more? I thought the senior tranche was 6%, then, on a per year basis, they should get less than the Mezzanine tranche, not more. I understand, how the numbers are computed, but I don't get intuition behind them. Thanks!

  • Reply coloredreptile May 16, 2011 at 12:35 am

    @KoalaBearWarrior There are 400k shares of senor and only 300k of mezzanine. Because of each share being 1k Senor has 400m and Mez has 300m total. So with the interest rates given mez is getting 21m and senor is getting 24m. The reason mez is gaing more is because they have that 21m gain split amongst 300k shares instead of 400k. So mez would gain more per share but less total because of the total amount of shares of mez being lower.

  • Reply KoalaBearWarrior May 16, 2011 at 2:04 am

    @ABCInfinit3 I can't believe I overlooked that! Thanks man! Looks like we're helping each other out on different vids 🙂

  • Reply bibzzzz May 30, 2011 at 9:09 am

    @ThyHolyHandgrenade (For this particular example) I understood it as follows: if enough people default on their loans such that the overall return on the 1 billion dollars is under 45 million dollars, returns of the mez tranche start to diminish (and equity investors get no return). And then to take it one step further, if the overall return goes below 21m then senior class returns start to dimish (and both equity and mez tranches get no return)

  • Reply jaroslav44 June 22, 2011 at 11:04 pm

    THANK YOU

  • Reply mangonit July 15, 2011 at 3:58 pm

    mate these are some of the most helpful videos I have ever found on youtube. I spent a collective total of nearly £30 on books to do with this recently, and these free videos have explained it all 10 times better than any of those books ever did. Thanks!

  • Reply Young-leo96 Nzotarh August 12, 2011 at 11:54 am

    Wonderful videos man thank 🙂

  • Reply jcs7 August 24, 2011 at 6:26 am

    more people need to see this for sure.

  • Reply GopalaKrishna NarayanMoni September 16, 2011 at 2:53 am

    I havent seen many better videos.. Folks like Khanacademy and Bionicturtle are just too good.. thank you guys!

  • Reply MrBigEnchilada September 27, 2011 at 10:28 pm

    mbs = mortgage backed securities ~ (similar) to asset backed securities.

    yes
    watch bionicturtle he is dedicated to financial lectures.
    this is pretty much why few people understand this…khan draws a huge picture and tries hard to explain what he drew lol…ty

  • Reply adelaideuser October 11, 2011 at 9:46 am

    very well explained, thanks !

  • Reply bassammaelborno November 4, 2011 at 9:33 am

    The saying goes….."a true sign of genious is in one who can make the Complex, Easy".

    Thank you for your effort.

    It would be more helpful in a variety of ways, if perhaps, you were more structured and rehearsed prior to giving a presentation.

    There is far too much of an ad hoc approach to the 'lessons' resulting in unnecessary redundancy/repetition. You aren't losing the message to the viewer, rather losing the viewers attentiveness/patience.

  • Reply comingsoon188 November 4, 2011 at 5:56 pm

    dude you talk so fast i can't even know what are you saying. sigh :
    and i'm not western people tho so i'm not really good on it

  • Reply yougonasorry November 10, 2011 at 11:03 am

    no in my opinion this casual presentation was really good in terms of conveying a better understanding of the topic, thank you sir

  • Reply john doe January 11, 2012 at 9:30 pm

    The reason everyone isn't an equity invenstor is because Sal's pen isn't working

  • Reply Tony Nguyen January 26, 2012 at 11:37 pm

    you saved my day! great explanation.. but i think you need a new pen =) thanks!

  • Reply Ashish Shah March 18, 2012 at 5:45 pm

    Superb explanation……

  • Reply UmTheMuse May 14, 2012 at 8:06 pm

    Nobody else has spoken up, so I'll make a guess. When you invest in an "insurance pool" (by which I mean a pool of money used to share risk), you are helping to increase the number of loans that the pool can lend out. That spreads the risk out even more and lowers your risk.
    Normally, this is a really small change in the risk. However, FNMA steps in if a borrower defaults. The risk is much smaller to start out with, so your contribution actually matters.

  • Reply David Zhang May 24, 2012 at 10:39 pm

    Jesus christ, STOP talking about your pen it is extremely distracting, just keep on talking about the damn subject.

    And ffs, go buy a new pen, you are not poor.

  • Reply Tai Au June 13, 2012 at 2:06 pm

    RIGHT BEFORE THE FINANCIAL MELTDOWN GOOD JOB!

  • Reply coolpune June 17, 2012 at 1:55 am

    u speak too fast……..i assume this video was made for newbies in finance and not Einstein of finance

  • Reply rennie6767 June 30, 2012 at 2:06 am

    @vyhmhmi
    Its not that hard, I'm at about 490% and climbing. Find a better trading technique. I use this for 80% of my trades. Watch this => bit.ly/NsYahX?=hwhzct

  • Reply Benjamin Anderson August 9, 2012 at 9:34 am

    Didn't realize until the end that this was before the 08 crisis. Very helpful video. thank you

  • Reply Phil.T.McNastee October 7, 2012 at 1:31 pm

    Cos they're not allowed to "gamble" directly, so they invest in this type of company and keep themselves firewalled, in theory [ha].

  • Reply Subie J October 22, 2012 at 11:05 pm

    Thank you for this video!!! It was very helpful!

  • Reply Yogesh Pawar April 24, 2013 at 6:03 pm

    Thank you very much for concepts…

  • Reply Kratos Chaitanya June 6, 2013 at 6:46 am

    Its not 16.5% Its 18.33%

  • Reply vettefever67 September 25, 2013 at 11:13 pm

    Pretty eerie this video was pre crisis

  • Reply Sarah Alloush December 24, 2013 at 6:38 pm

    Thank You for the video! I just have one question: are the  individual investors investing their money/shares into companies like a hedge fund, who then would invest that money into buying MBS? Thank You

  • Reply Stephen Bartley December 27, 2014 at 3:57 am

    Great job but I think your math is a little off your equity return should be 18.3% instead of 16.5%

  • Reply Ajinkya Kokandakar January 20, 2015 at 4:17 pm

    Shouldn't the return to the Equity tranche be 18%?

  • Reply DR Suarez April 13, 2015 at 3:52 am

    get a better pen

  • Reply yang su April 16, 2015 at 8:13 pm

    this is amazing 🙂

  • Reply 51MontyPython August 15, 2015 at 1:35 am

    I'm confused about one thing.  He says the money from the investors who bought the shares is what gave the money to the SPE in order to loan it out to the home buyers, but I thought the loans had already been made by the bank who sold them to the investment bank??  I'm confused there.  Isn't it that once the loans were bought, the debts owed on those loans were merely transferred to a different entity, but had still nevertheless been made prior to the fact?

    Or was he speaking merely of those that were foreclosed and resold?

  • Reply Brandon Daniels September 25, 2015 at 4:17 pm

    I was really hoping that Leonardo DiCaprio would explain all of this shit in The Wolf of Wall Street. **sigh**

  • Reply Nate R January 6, 2016 at 6:53 am

    The Big Short brought me here. ¯(ツ)

  • Reply Shreshtee Yadav January 10, 2016 at 1:09 pm

    I bet people are watching this video just after watching "The Big Short"

  • Reply Wang Bo January 12, 2016 at 10:07 pm

    can you speak a little slower? I'm sure it will be helpful and get more views from ppl across all over the world,-especially for ppl from non -english speaking countries.

  • Reply MrPlTA January 14, 2016 at 6:02 am

    Basically, it's big investment firms legally gambling on us paying our mortgages hidden by financial jargon.

  • Reply Othman S February 17, 2016 at 6:23 pm

    Khan saves the semester agaiiiiiiiin 😀 Thank you!

  • Reply Xiao Guo May 20, 2016 at 8:16 pm

    I wish you get a better pen

  • Reply Le Duyanh May 26, 2016 at 7:16 am

    Ok so it's different from what Anthony Bourdain described as CDO? The chef said CDO was something made up to sell nonperforming loans while here it was meant to make the gamble more interesting?

  • Reply Surf Panther September 28, 2016 at 6:36 pm

    so in your Equity tranche in this video, basically the crappy loans that default are affecting that portion of the tranche first? meaning the defualt rates are rising in theory and the next highest rated tranche takes the next hit also being a safety for the next highest rated tranche….if im following right

  • Reply Manish Kamble January 19, 2017 at 12:40 pm

    FRM Anyone?

  • Reply thomasliangus March 11, 2017 at 8:14 pm

    I have a question. How could the investors know the real default rate? Could the investment bank just makes the default rate higher and get the real return from the equity security holders?

  • Reply Ethan Rubin May 17, 2017 at 9:24 pm

    so every mortgage-backed security video should have said that the structure is this so it wouldnt confuse people… also when it is a mortgage its called a CMO. There were subprime, alt-a, option arm, and prime collateral securities.

    I think what everyone wants to know is what truly would be the CDOs that were really derivative products that really made investors lose tons of money. Basically, the issuer would sell a CMO in the structure that is similar to the video (there are wayyy more tranches in these securities). The senior tranches would sell, but they had trouble selling off the mezzanine portions. To get these securities off their books, issuers would package up thousands of the mezzanine tranches and then "re-tranche" this debt into a new senior/subordinate structure. What is baffling was the rating agencies said these were all investment grade. So, these "senior" AAA rated bonds were actually backed by "mezzanine" tranches that were shit, who's priority of payment, if a sequential pay, was last and were the first to be written up and take losses. Therefore, investors bought this senior debt for par and literally got wiped out and usually never saw a dime in principal payments!

    There were some absolutely crazy CDO's made back then that literally just had random collateral, but collateral backed securities are an integral part of the financial system and really important. Now, issuers must have skin in the game and retain either a vertical or horizontal 5% slice of the security. Asset backed securities still exist and give good returns, and are created in a way that investors have more protection against losses.

  • Reply Aaron Kettlewell July 5, 2017 at 9:14 pm

    HE KNEW IT WAS COMING

  • Reply L July 30, 2017 at 8:56 am

    legit best finance education right here

  • Reply peace of mind March 18, 2018 at 8:02 am

    @Mr khan it would be better to make video on MBO vs CDO

  • Reply Christoffer Robin Levin Myrland May 28, 2018 at 7:24 am

    that's one happy mother @#$%@# you wrote down at 2:04.. he looks like the happiest man alive

  • Reply Kamal Banga November 24, 2018 at 8:20 am

    Sal and his pen: still a better love story than Twilight!

  • Reply Chuck Valaitis February 1, 2019 at 2:11 am

    Nicely presented. The 'caveman' drawings in the videos really worked for me on understanding repos, mbs and cdos.

  • Reply ImpactoDelSur Enterprise March 8, 2019 at 7:04 am

    The sole reason for transactions, which results in cash flowing, is to create value in society. These money games create too much transactions for little net value creation.

  • Reply Stanko Crnogorac May 11, 2019 at 10:14 am

    what is the difference then between MBS and CDO both have ratings i dont get it ?

  • Reply amber M May 24, 2019 at 2:25 pm

    Can someone please clarify- when banks sell these CDOs- do banks have to repay back this purchase price back to the investors in future? Is this a situation of debt against debt?

  • Reply Daniel Ramirez July 8, 2019 at 6:26 am

    This channel is a diamond among rocks

  • Reply Carmen Sandoval September 7, 2019 at 2:58 am

    Can you please make a video explain a Escrow account shortage

  • Reply Abhinav Gautam September 23, 2019 at 1:37 pm

    Thanks for these videos. Super helpful and really well explained!!

  • Reply American Pride October 22, 2019 at 2:18 am

    2019 it's back

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