Tranches & Mortgage Backed Securities Explained

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Understand Mortgage-Backed Securities

[00:00:00] Debt Funds and Loan Pools
I find outside investors to invest their money into this fund and then I go out and loan it. So I've got a hundred million dollars worth of loans out there that are all paying somewhere between 8% and 10%.

I had one investor that was my seed investor. He's the guy that helped me start the fund and he invested $50 million. And then I've got 20 other investors that each invested $2.5 million.

[00:01:36] Tranches
The biggest investor, he wants to be paid first. We have two tranches So we're making 8.25% on our money. And the first three and a half percent goes to Mr. Morgan, who bought all of Tranch A and Tranch B, they're getting 4%.

Whatever's left over is called the "Residual". And we keep that.
We're basically making the spread. Our cost of funds was seven and a half from our investors. We originated a pool of loans at eight and a quarter. We get to keep the difference.

[00:03:26] Mortgage-Backed Securities (MBS)
Let's say the teacher's pension fund just put out an announcement that they want a billion dollars worth of investments and they need to make at least 3%. And so what'll happen is another pool of loans is a giant pool of like a thousand loans in, it has 10 slices of funds just like mine.

And what I created here when I sold these tranches is called a Mortgage-backed security, asset backed security it just means a pool of loans that's backed by something.

[00:04:57] Changes in Ratings Agencies Leading Up to '08
Right around the early 2000's, Standard & Poor's and Moody's, who were the two primary ratings agencies, they both went public. They used to be privately held family companies and they both went public.

What happens when you go public? Now you have investors. You've got outside stakeholders. You've got shareholders that are demanding you get a higher return.

Moody's and standard Poor's they get paid basis points based on the size of the investment. So a rating for a larger investment, they can charge a higher fee.

They would start competing. And what started happening behind the scenes is the guys at Moody's were like, "Let us rate that next bond that you issue. We have an incentive, because if we get this, pool, we get a bonus. Maybe instead of reading that a BBB, we'll just rate it in a AA or whatever."

There became a conflict of interest. Because now they were more profit motivated than they were objective.

And so over time, more and more often, what you would see is these bonds that were made up of all these loans that were often made up of tranches, started getting AAA ratings.

The loans that we were selling to Lehman brothers that were all subprime loans, were going into mortgage-backed securities, that were eventually getting AAA ratings.

[00:07:33] Credit Default Swaps
Now, this is where it gets really crazy. You've heard of derivatives, right? Credit Default Swaps?

If I was an investor and I bought this thing here, this pool of tranches that's clearly more risky than AAA. (This is the AAA tranch.)

They would sell me insurance called a Credit Default Swap that says, "Hey, if this thing defaults, you can swap it out for this insurance policy."

So if I'm like, "Oh, I can buy a tranch that pays, let's say four and a half instead of three and a half rated AAA. And for just a few more basis points, I can buy insurance. Why not?"

Once derivatives started coming into play, it was like putting everybody on steroids and money just started flowing in to the bond market, these mortgage-backed securities.

But the quality of these pools, these bonds was getting lower and lower, but they were still getting AAA ratings.

So you had conflicts everywhere.

[00:09:15] The Crash of '08
Eventually, the whole thing came crashing down. Because once this one defaulted, then the guys that held this insurance policy, they got screwed because they had to pay the investor. $80 billion pool just defaulted. The investor says, "Hey, I got a credit default swap, pay me my $80 billion."

And so suddenly these guys are out $80 billion and a pool that they can't get rid of because it's made up of all these defaulted borrowers.

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[fourjaindots]

Just came across this because of the FDIC claim of 95% of unrealized losses were in RMBS, this was a great explanation. Was super clear. Thank you.

[loosenup]

The best explanation ive seen on youtube, great job!

[thelifeofdru]

You break things down amazingly. The first person I really undersood.

[paulc]

Awesome video, thank you Trevor, please keep uploading and teaching!

[jacobsweet]

Great Video and explanation perfect for another looking to get into DCM

[xboygaming]

This is such a great and in depth video, I was surprised to see it only had a few thousand views. I've recently gotten an interest in finance specifically and was reading about AIG and this video helped me grasp so many concepts its crazy. Ill definitely be checking out the other videos on your channel. My professors couldn't even explain these concepts as well as you did. AND I PAY THEM.

[JoeRapisarda]

That was a very good explaination. Thank you!

[lachlanborg]

Amazing channel, keep it up! The diagrams and explanations are extremely helpful. Subsribed!!

[JamesonSharp]

This is Fantastic Display/Explanation Sir. Investment Grade! LoL nice.