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Richard Franklin
Company Portland, OR (NCAA Football)
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November 7, 2007 The Sub-prime “meltdown” can be explained with three examples. By understanding who is exposed to these different examples, you can make an informed decision on investing in the finance industry. The three types are Collateral Debt Obligations (CDO), Leveraged Hedge Funds (LHF), and Structured Investment Vehicles (SIV). Collateral Debt Obligations Our first example is the CDO. Lets suppose you started a bank with $10,000. You promised your board of directors and stock holders better returns, approaching 12% and greater. Of course your board was excited about earning 12% on the banks investment. In addition, you told your board that you would be lending the money to borrowers, but no more than 34% of the fund would be lent to one individual. In other words you were going to “diversify” your lending. So you took your $10,000 and you lent the money to three individual’s buying real estate. A thirty year contract was signed with each borrower, and your bank was set to receive $59.96 each month in total from the three borrowers. (Three loans for $3,333.33, for 360 months @ 6%.) You contact three other banks ("investors"). You told the three investors you had a very safe investment, loans backed by real estate, but you needed funding. You combined the three real estate loans into one $10,000 bond, then divided the bond into three new separate bonds, each bond containing a portion of each original loan. This is the Collateral Debt Obligation. The three investors agreed to buy the $10,000 loan from you at a rate of 4.5% after you had collected at least three timely payments from your borrower’s (this is called “aged payments”). So you divided the $9,969.98 remaining balance (after you collected three payments) and sold the “paper” for $11,786.85, (this is the present value at 4.5% of the remaining stream of payments). Your bank profited by collecting $149.85 in interest for three months and $1,816.87 from your investors on the sale of the bond. Your entire return is 19.37%, Not bad! Now the trick of course is to continue to reinvest all this cash into new deals. You continue to tell your investors, and other investors how great CDO’s are doing, and your bank shops around for more borrowers. Now comes the problem. Lets say you collected your three payments from your borrower, but not in a timely manner. Now your three investors balk at buying the bond from you and you are are stuck with the bond. You shop around for a new investor, and finally find a buyer that agrees to purchase the bond from you, but wants a yield of 7.8% to account for the higher risk of slow payers. (This is a 30% “discount” from the present rate, typical in today’s market conditions.) You decide not to sell, but keep the bond for your own account, but you must value the bond at its current market price, which is now $8,311.70. You just “booked” a 16.58% loss! Leveraged Hedge Fund Our second example is the LHF. Let’s suppose you started a Hedge fund with $1,000 of your own money and you invited 18 friends (“investors”) to each invest $500. You promised your investors better returns, approaching 12% and greater. Of course your investors were excited about earning 12% on their investment. In addition, you told your investors that you would be lending the money to others, but no more than 34% of the fund would be lent to one person. So you took your $10,000 and you lent the money to three individuals buying real estate. A thirty year contract was signed, and your hedge fund was set to receive $59.96 each month from the three borrowers. ($10,000 for 360 months @ 6%.) You have a rich uncle, and rich sister, and a rich grandmother (“funders”). You told the three funders you had a very safe investment, loans backed by real estate, but you needed funding. The three funders agreed to buy the $10,000 loan from you at a rate of 4.5% after you had collected at least three timely payments from your borrowers (this is called “aged payments”). So you divided the $9,969.98 remaining balance (after you collected three payments) and sold the “paper” for $11,786.85, (this is the present value at 4.5% of the remaining stream of payments). Your hedge fund profited by collecting $149.85 in interest for three months and $1,816.87 from your investors. Your entire return for the hedge fund is 19.37%, and your equity return (the amount your hedge fund actually but up in cash, the original $1,000) was 109.37%. Not bad! Now the trick of course is to continue to reinvest all this cash into new deals. You continue to tell your investors how great they are doing, and your hedge fund shops around for more deals to invest in. Now comes the problem. Let’s say you collected your three payments from your borrower, but not in a timely manner. Now your three “funders” balk at buying the bond from you and your stuck with the bond. Your investors hear about the problem and demand their money back (some investors huh!). You shop around for new funder's, and finally find another hedge fund that agrees to buy the bond from you, but wants a yield of 7.8% to account for the higher risk of slow payers. (This is a 30% “discount” from the present rate, typical in today’s market conditions.) You are forced to sell, because your “investors” demand their money back but you only receive $8,311.70 from the sale, and since you do not have enough assets to cover the liabilities from the sale, remember, you “owe” your investors $9,000, you are forced to file bankruptcy. Structured Investment Vehicles Our final example is the SIV. This is similar to the two example above, except either the bank or hedge is investing long term in the CDO’s or other types of investment and borrowing the money short term to make the purchase. For example, they borrow $10,000 from another bank or hedge fund, and promise to pay the money back within one year (Promissory Note). They can usually pay the Promissory Note back because they constantly sell the CDO’s, pay back the Promissory Note, and then start all over again.
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