Welcome back. In the last presentation, we described a situation where you have a bunch of borrowers. They needed a billion dollars collectively because there's a thousand of them. They each need a million dollars 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 the bank or to an investment bank who created this special purpose entity. And then they IPO the special purpose entity and raised the money from the people who bought the mortgage back securities.
But essentially what happens is the investors in the mortgage back securities provided the money to the special purpose entity to essentially loan to the borrowers. And then, the reason we call them securities because not only are these people getting this 10 percent a year. Let's say that you had these mortgage back securities and you paid a thousand dollars for it, you're getting this 10 percent a year. But then all of a sudden you think that the whole mortgage is about collapse, bunch of people are going to fall. And you want out. If you just gave someone a loan, there will be no way to get out. You have to sell that loan to someone else. But if you have a mortgage back security, you can actually trade the security with someone else and they might pay you, who knows, they might pay you more than the thousand dollars. They might pay you less, but they’ll be at least some type of a market in the security so you could have what you called liquidity. Liquidity just means that I have the security and I can sell it, I can trade it. Just like I can trade a share of IBM or a share of Microsoft.
But like we said before, this security, in order to place a value on it. You have to some type of analysis of what you think its worth or what you think this really yield or the real interest will be after you take into account people prepaying the mortgage. People defaulting on their mortgage and other things like short term interest rates et cetera, et cetera. And there's 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.
So there might be another investor here, let me make my pen tool work. There might be a whole other class of investors here. There might be a whole other class of investors here, say this guy. He would love to kind of 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, maybe he has a pension fund or some type of a mutual fund that’s force 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 percent, who cared about that. He wants to see bigger and bigger returns. And there's no way for him to invest in this security and to get better returns.
So now were going to take this mortgage back security and introduce one step further kind of permutation or I guess a derivative of what this is. And that’s all what derivatives are. You probably heard the term derivatives and people do a lot of hand wavings saying it’s a more complicated form of security. Derivative means is you take one type of asset and you sliced and diced it away 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 the same asset pool, the same pool of loans and satisfy all of these people. Satisfy this guy who wants maybe a lower term, 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 a billion dollars collectively. Right, because it’s a thousand of them, et cetera, et cetera. And there's still a special purpose entity, but now instead of just slicing up the special purpose entity a million ways, what were going to do is we’re going to split it up first in to three what we can call tranches. A tranche is just a bucket, if you will, of the assets. And were going to call the three tranches equity, mez, and senior. And these are the words that are commonly use in this industry.
A senior just means, these people, if this entity were to lose money. These people will get their money back first. So it’s the least risk. Got a hold of the tranches. Mezzanine, that just means next level or middle. And these guys are in some place in between. They have a little bit more risk and they 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 somebody’s borrower starts defaulting, it all comes out of the equity tranche.
So that’s what protects the senior tranche and the mezzanine tranche from defaults. So this situation, what we did is we raise out of the billion dollars we needed, we raised 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 a thousand senior securities. Collateralized debt obligations, these are these right here. And then we say, say there were 400,000 of these. And this each cost a thousand dollars. Right.
So let's say this cost a thousand dollars. And we shoot 400,000 of this, so we raised $400 million. And let's say we give these guys a 6 percent return. And you might say, 6 percent, that’s not much. But these guys, it is pretty low risk. Because in order for them to not get their 6 percent, the value of this billion dollar asset or this billion dollar loans would have to go down below $400 million. And I will go explain, I’ll do a little bit more math in another example. But I think it is starting to make sense to you.
For example, every year we said there's going to be hundred million in payment. Right, because its 10 percent. A hundred million in payment. Of that hundred million in payment, 6 percent of the hundred 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 a thousand dollars per share on the mezzanine tranche. This is also a thousand, this is the mezzanine tranche. And let's say they got 7 percent. Slightly higher in return. And these percentage are usually determined by some type of market or what people are willing to get. But let's say it’s fixed for now. Let’s say at 7 percent.
So 300,000 shares, 7 percent. These guys are going to get 21 million dollars. Alright. So out of a hundred million dollars every year, 24 million is going to go to these guys. 21 million is going to go to these guys. And then whatever is leftover is going to go to the equity tranche. So a $300 million from equity, they're going to get $55 million assuming that there are no defaults or prepayments or anything shady happens with the securities. So these guys are going to get $55 million. Or on $300 million, it’s a 16.5 percent return. I know what you're thinking, that sounds amazing. Why wouldn’t everyone want to be an equity investor? I don’t know, my pen 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 10 percent, let's go to that scenario where we talked before that 20 percent 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 percent, you will only get a 50 percent return. So for each of those million dollar houses, you will only able to sell it for $500,000.
So then, instead of getting a hundred million per year, you're only going to get 90 million per year. I wish I could use my pen. So instead of a hundred million dollars per year, you now only going to get $90 million a year. Right. And all of sudden, these guys are not going to be cut off. These guys are still going to get 24 million. These guys still going to get 21 million. But now these guys are going to get 45 million dollars. So he already got, but he’s still getting above average yield.
Now let's say a bunch of borrowers start defaulting on their loans. And instead of getting a hundred million dollars or $90 million per year, you start only getting $50 million dollars 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 from $300 million, now he’s getting less than a 2 percent return. So this guy took on higher risk for a higher reward. If everyone pays, sure, he got 16.5 percent. But then, if you start having a lot of default. If let's say the return on what you get every month goes in half, this guy takes the entire hit. So he’s return goes to 0 percent. So get 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 collateralize debt obligation. This is actually a mortgage back collateralize debt obligation. You can actually do this type of structure with any type of debt obligation that’s backed by assets. So you know, we did this situation with mortgages, but you could do it with a bunch of assets. You could do it with a corporate debt. You could do it with receivables from a company. But you read about the most right now in the newspapers is mortgage back collateralize debt obligations and to some degree that’s what's been getting a lot of these hedgepuns in trouble.
And I think I’ll do another presentation on exactly how and why they have gotten in trouble. Look forward in talking to you soon.
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