The content explains the mechanics of Collateralized Debt Obligations (CDOs) and how their misapplication, particularly during the 2008 financial crisis, led to a credit crunch. It emphasizes the importance of understanding financial products, economic context, and risk management for financial professionals.
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mortgage. So I hear houses
which is also linked to mortgage for sure.
Yeah, remember you have to be read about
strategy papers. You have to be in the
news. You have to know what is going on.
You have to know a bit of history in the
financial market as well. Yeah, like I
told you, you're going to be doing a lot
of analysis, especially in a paper like
this. It's not a paper where you just
memorize concept and think you're fine.
No, never. You have to have a good
understanding of the economy and be able
to make sensible, intelligent
intelligent
conversation in your reports because
most of your marks you will get from
writing reports, not from calculation.
So you being able to link calculations
to the reality and to
things you have based on your experience
is very critical.
You're right
mostly coming from mortgage but from
other also credit products and that's
why this 2008 we was timed like a credit
crunch period.
If you heard about credit crunch,
that was 2008. Credit crunch, that was
what we saw in 2008. And what happened?
A lot of banks were carrying a lot of
toxic assets
in their books.
Toxic assets. And toxic assets is not
like it's poisonous to people, but to
the company. That's why it was termed
tox toxic asset. And it toxic. It's it's
toxic because they have assets that they
thought would be recoverable. However,
However,
they were not recoverable. Yeah. Not
just mortgage but loans generally. What
do they do?
Banks were giving out loans.
So let me try and explain this way. So
let's say
500 million
but bank needs cash but they've given
cash to customer A customer A probably
needs to pay this back over 10 years for example
example
but rather than them waiting for
customer A to pay back bank decides to
establish lish a special purpose vehicle
and what do they do? They sell this loan
to this SPV
and what would SPV do to the bank
because they've sold Yeah,
you've sold to SPV. SPV would now need
to give cash to this bank.
So, which means in the books of this
bank, they look good because they got cash.
cash.
canceled out the receivable that they
have from customer A. So which means
this SPV is now the one that is
looking forward to receiving money from
customer A. But rather for this SPV to
wait to receive the money, guess what
SPV does again? The SPB will now start selling
selling
this pieces to investors. So you have
investors A,
B, C, D, E. So this 500 million is now
being sold to this guy in different
tanches. Maybe this guy took 100
million. Maybe this guy 200, maybe this
guy 50,
this one another 100. No like that. So
in tanches such that this investor A B
CDE E they were offered each of these
tanches at different rates depending on
how they have grouped it. So these
experts are also they were very very
very intelligent. They they ran this in
different levels. So you know that you
are kind of in risk as much as you you
want to. If you want your money to be
guaranteed your rate might be lower. So
take for instance if this 100 is given
at 5% to investment A and they say okay
this is investment grade bond that's
what they will call it then they say
okay this is less more risky which means
it's less secured then they might
increase the rate to 7%.
By the time it gets to this one they
might say this one is subordinate so
you'll be able to get 10% on it. However
just know that upon liquidation you are
not sure you'll be able to get your
capital back. So all these investors A B
CDE E they've bought into this SPV this
so-called 500 million. So this 500 could
have been mortgage most in the US most
of them were mortgages.
So bank were just giving mortgage out as
they like to because once they give them
out they repackage them into SPVS sell
them out as what you call CDO. Yeah,
that's that was popular then CDO or you
call the collaterized
CO. So they were just selling those CDs
just like you selling bonds to different
people. And guess what? The problem
started when a lot of these products
were being sold out to people because
banks were not even doing their due
diligence way they should be doing it.
So at the point they started selling to
anybody and some of these customer were
not able to repay back their loan. So
the chain started failing at the point
where this customer will not be able to
pay back because they just the were so
many that they've sold a lot of bad
bad loans to customers and when
customers are not able to pay what
happens the final investors will not be
able to get their money back because
these guys bought the bonds that they'll
be thinking will definitely mature in
the future and they will get their money
back. So these bonds were maturing and
the SPV is not able to pay back as SP is
not able to pay back. There's a problem
because the SP is supposed to be able to
pay back from the money that customer A
is paying back because the bank has
already collected the cash from SPV. So
the SP is supposed to be chasing this
customer to get this cash back such that
once they get the cash back they can
settle the investors upon the majority
of the investment and that was when
everything started collapsing.
The big companies were dying and a lot
of companies have to merge. A lot of
companies were liquidated and what
happens investors lost a lot of money
and that was the credit crunch that we
had in 2008. Yeah. So the international
market that is trying to achieve
transparency, achieve flow of funds at
the same time might get to a point
whereby those situations were being
taken advantage of by investors either
deliberately or inadventedly. But
regardless the case, it still boils down
to the fact that you as an executive,
remember you're an executive and
advisor, you need to understand how
these integrations work and how a
company can actually benefit
so far from
regulations, from transparencies, or
from even trying to take advantage of
another economy in a different country.
extremely important. Yeah. Well, let
just because this I mean these are
typical things you can see short
questions that you can be part just to
test your understanding.
Yeah. On CDO because
you need to get the concept right. What
I just explained I'll put in a
calculation for you and let's work it
out together.
So let's say we have bank B.
I need you all to try this.
loan to customers of total of 500 million.
Yeah.
At 9%.
So this bank has given out loans to
customer at 9%. So remember my scenario.
So like this guy, this 500 million is at
9%. That's what we're saying. Now
Now
they don't want to do CDOS,
collateralized debt applications. Yeah.
And they trying to do it with just the 95%
95%
of the loan.
That's what they want to trade. They
want to trade 95% of this 500 million.
So which means that they they will be
of 500 million
and what will that be? Uh.95
Uh.95 times
times >> 475.
>> 475.
>> Yeah 75 million. So 75 million is what
want to sell that. Now
Now
remember the way it's been sold, it's
been sold in trenches, different ranking
and the ranking will affect the interest
rate as well because remember in FM you
learned that the higher the risk, the
higher the reward. So let's say they
want to set tranch one, tranch two and
tranch 3. TR one will be 70% of that.
Trans two will be 20%.
So for TR one
he said is a rated which means they are
protecting it secured and they ready to
give it at 7% to whoever wants to buy.
That's how the SP is selling it. The
other TRS which is TR two they are
saying is B rated.
So which means not as sure as this one
that you get your money back but you get
more interest because you are taking 10%.
10%.
and the question is what is the maximum
rate do you think this bank
what rates what rate do you think they should
should
what rate do you think they should be
given to the customers that are
subscribing to the C-rated CDOS
like I said it's not there's no it's not
it's more just working with your IQ
there because what you are checking is
when will you break even that that's
that that would be the maximum rate you
should be talking about. You want to
know the break even point.
>> Yeah, I got the same thing.
>> Very good. So let's let me work it. So
what you're asking is what is the break
even rate at this point? So which mean
your break even rate will be the rate at
So which means you need to know the
total interest income and total interest
expense. So your interest income you
already know as soon said
is going to be 9%
of the 500 million that we are talking about.
And if you do that 9% of 500 million
So which means for a b for a sensible
business you can't incur more than 45
million on that product. In fact even by
time you get to that 45 million you're
already being stupid because you're
never going to make money.
So if you ever going to make money if
you are making 45 million on the product
you cannot sell it for less. I mean for
more so you can't incure interest that
is more than 45 million because that
means that the person you gave loan to
500 million to only give you interest of
45 million so even if you want to make
money on that product to sell to other
people to carry the risk you must sell
to them such that you are able to pay
them interest that is less than 45
million that is only when it makes sense
to you. So banks are just coming in and
those are the things they were doing in
2008. They were just being
intermediaries. They are not carrying
any risk. They just collecting they
giving loans to people and selling to
other individuals.
So they the numbers is where they make
money from the volume is where they make
money. So the little spread they are
making by the time you are able to send
sell to so many people they able to make
money. And let's see what the interest
expense is. As we have for branch A, the
interest expense will be 7% of the 70%
of what they are selling. So it's 475.
>> 32 7%. Thank you.
2
>> okay millions okay okay
>> in millions yes in millions so 7 * 475
time 7%
>> that would be 23 23.275 275 million.
>> Thank you. So 23.28.
Then B
What's that?
>> 9.5 million sir. 9.5 >> 9.5
>> 9.5
C is what we want to know what rate are
we going to use. So what we need to do
is to find of pos4
what should
this interest expense be such that it is
never more than 45 million. So the total
must be 45 and for to be 45 this can
only be so this has to be 45 less 23.28
28 less 9.5 and what is that?
12 let's say 12.23.
So that is a interest expense that we
can actually incur on C. So if that's
what we can incur on C then what rate
will that amount to? So we're saying the x%
x% of
of
10% of that
75 which is our principle
is equals to 12.23
12.23
that's exactly what we are saying. So
which means the percentage that we're
looking for is equals to 12.23 divided
by 47.5.
And I believe that's what you've done.
and that gives 0 255
255
So
let me Yeah. So you're right. 25.7.
Yeah. So you're all correct. Nice. So
what you're saying is that for trans C
that is rated C this company must never give
give
give it out at more than 25.7%.
Yeah. Yeah. Because like you say yes
this led to economic crisis in 2008 but
it still remains the proper financial
product. It became a problem in 2008
because banks were getting so carried
away with it. They just want to sell as
much as possible. So they were not doing
proper due diligence with with their customers.
customers.
So they are selling to people who cannot
afford to pay back because they just
want to sell. They just want to sell
because they just want to sell as much
as possible, transfer it to investors
and move on and sell another thing, make
spread on it and keep making spread.
It's a proper product. The problem is
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