Well, let's now take a look of how exactly this CMO works. What's the mechanism behind this instrument. So this is CMO. Now, we said that the idea, that's what we talked about in the previous episode, was to increase the liquidity of illiquid mortgages. Now, the mechanism that I describe in this episode is grossly simplified. But still, the idea is befalling. So these are mortgages. All of them make payments, and the cash from these payments, it all is collected in a certain pool. So, the money comes here. Now, the investment bank uses this pool as collateral. And then issues CMO tranches. What is this? So we issue securities, that have different tranches. Tranche A tranche B, tranche C and sometimes this is also the last the residual tranche Z. Now the story is as follows. These cash flows in the pool, they are sort of redistributed to the holders of these tranches. In accordance with a certain procedure. Very, very roughly speaking, all the money that is in this pool first goes to the holders of tranche A. When and if, both the principal and the interest of this tranche A has been redeemed. Then the arriving cash flow starts to be passed to the holders of tranche B and so on. This is the most simplistic sort of a mortgage pass through mechanism. Now, the cash in this pool is used not only to redeem the principal of A, B, and C. But also the interest. The exact procedure how this is passed to these holders may vary, and it's not very much important for us right now. The first big question arises that while clearly a risk goes this way. So does the interest rate, and so does maturity of these tranches. So clearly, the people who hold tranche A. They are expected to receive the lowest interest, but they are protected against the risk. And the question is what kind of risk in the first place. And second of all why is that that some people, some investors are willing to buy. Bs Cs and even Zs This is not such a trivial question, because clearly. If we keep in mind all the risk of default of some of these mortgages. Then clearly the risk may be so high that, few or no one will be willing to hold Cs and Zs. The reality is different. Now, let's take a closer look at these risks. So again, A B C and then here Z, the so-called equal tranche. If, we keep in mind only the default risk then clearly it's like this. However, there are other risks associated with mortgages, the mortgage pass through cash flows. Namely mortgages can be prepaid. And in this case the people who receive all cash first, they are facing the risk of reinvestment. Maybe, at the time that they will have received all cash flows. Interest rates will go down, and it will not be very much beneficial for them to reinvest. They will lose on that. It's exacerbated by the fact, that when interest rates go down, then a lot of people prepay their mortgages and take new mortgages at lower rates to save on payments. Then indeed, some people have different risk return profiles. They may not be satisfied with low returns on tranches A. And they openly take the risk of holding lower or riskier tranches, in the hope of receiving higher interest rates. So this, supports the idea that there are investors who prefer to buy A's, and there are investors who prefer to buy Bs, Cs or even Zs. Without that there will be no explosive growth in the CMO market. However. So, I would put like various risks. However, this default risk does play the key role here. I will give you an example, when I was a student I was invited to participate in the calculation for of some of the returns, that later I learned to have been the support in a certain case. When one company that one manufacturing, Asian company that purchased one of the tranches like C in a pool that was going to raise bond obligation. And only one bond of this whole pool defaulted. And, but unfortunately all this default, the bond losses accrued to the holder of this tranche. And therefore, the company, the people woke up one day and saw that they lost 60 percent of their investment. And they sued the organizer of this CBO collateralize bond obligation. Well later they settled, but the story was that people said, we were promised to receive at 28 percent annual return. That was a miracle in the fixed income world at that time. But no one clearly explained us what the actual risk of default is. So indeed, sometimes people do care about this more, than about any other risks and that is why if we go lower here. We can see that the quality of these securities goes down progressively. And the people who have some guidelines on where to invest. Let's say they are limited to the ability to invest only in low risk instruments, then they are limited to buying tranches A. Now, it is not also that. We can say that oftentimes, and this seems sometimes a funny story because clearly this is a derivative instrument with a lot of various faces of risk. But if you limit yourself with invest with only in As, you can get a triple A rating for this tranche. And you can get insurance for that. And therefore sometimes the people who would buy these tranches would feel completely safe. Because not only they receiving cash flows first, but also they are protected by the high rating and by the insurance. Now, all that is fine when the market develops sort of well, triple growth relatively prudently. When there are no huge and massive abuses over the situation. And now we have to say a few words about what actually happened in the late 90s and early years of this century. Now again, like I said the idea was great. So, we would like to increase liquidity. But what if in the issuance of the mortgage, we progressively go further and further to the worse and worse profiles of borrowers. What if we say, we no longer need down payments. What if we say, that we give so-called liars loans. So people cannot prove that they're employed. Now, that all coincided with the growth in real estate prices, and with the interest rates that were going down. So clearly, even for the people who were fine. It was the situation in which the mortgages were issued on terms that allow these people to make smaller payments, and that was great. But that result in the fact that this avalanche of pushing for the people to take on more and more mortgages, resulted in the fact that the pool of borrowers in this case sort of play on words. This is not the pool of mortgage cash flows. The whole collection of borrowers have become progressively poorer, and as a result it became sort of normal for the people to realize that they could not actually afford to service this mortgage. But they were given specific terms. Let's say for the first couple of years you pay no interest at all. Maybe the interest will be raised further, but the people said fine. And when they handle that. Not only that, the market was selling or sending these signals to the public that the value of real estate always goes up. And as a result some people, it might sound crazy, but that happens. Some people were actual living on remortgaging. So they would take a mortgage, then the value of the real estate would go up they. Would take another mortgage for the higher amount. And the difference was collected them in cash, and they were just living on that. Accepting higher and higher debt. But when the market develops people are careless about this growing debt. All that happens until the moment when something bad occurs, and then people say, well why didn't we think that before. Now, I would like to point out that we are coming to the end of this episode, because what happened. We will see in the next one. But for now the idea is, that it again was a very risky environment. In which everyone was more or less willing to take on more and more risks, without really understanding what is behind the CMO. Because CMO is not an riskless instrument at all. This is actually a very risky derivative instrument, and ignoring the fact that it's very risky. Actually resulted in the fundamental crisis of peak of that, happened in 2007 and 2008. And the unfortunately, it still is sort of all of these waves of after crisis. We still feel right now. Now we'll talk about that in the next episode. But for now I have to tell you that, it is the idea of this risk facing. And the process by which this risk is redistributed by all these various tranches, that played the key role in the development of the crisis. In the next episode. We will see what actually happened.
