Investment Banking and Mortgage-Backed Securities

The video explains how investment banks create mortgage-backed securities by buying mortgages and placing them in a special purpose entity. These securities are sold to investors, offering an 8% yield. Different investors have varying risk appetites, leading to the creation of tranches within collateralized debt obligations (CDOs). Tranches are categorized into senior, mezzanine, and equity, each with different risk and yield profiles. Ratings agencies assess these tranches, allowing risk-averse investors like pensions to invest in safer tranches, while risk-seeking investors like hedge funds opt for higher-yield, riskier tranches.

What is the primary role of an investment bank when it buys a bunch of mortgages?

• To provide insurance for the mortgages

• To manage the properties associated with the mortgages

• To sell the mortgages directly to investors

• To become the lender to homeowners

What is the yield promised to investors when shares are sold at $10 each?

• 5%

• 12%

• 8%

• 10%

Why might some investors find mortgage-backed securities too risky?

• They are not rated by any agency

• They include sub-prime mortgages

• They offer too high a yield

• They are only available to hedge funds

What is a tranche in the context of mortgage-backed securities?

• A type of mortgage

• A class of securities with different risk levels

• A method of insuring mortgages

• A way to sell mortgages directly to homeowners

In a CDO, which tranche gets paid first?

• Equity tranche

• Mezzanine tranche

• Senior tranche

• Junior tranche

What is a collateralized debt obligation (CDO)?

• A government bond

• A direct investment in real estate

• A derivative security from mortgages

• A type of mortgage

How can a higher rating be achieved for a senior tranche?

• By reducing the number of investors

• By including more sub-prime mortgages

• By obtaining a credit default swap

• By increasing the interest rate

What interest rate might a senior tranche with a AAA rating offer?

• 5%

• 15%

• 8%

• 10%

Which tranche is considered the riskiest in a CDO?

• Mezzanine tranche

• Senior tranche

• Junior tranche

• Equity tranche

What makes both pensions and hedge funds happy in the context of CDOs?

• Both get high yield and low risk

• Both get low yield and high risk

• Pensions get low yield, hedge funds get high risk

• Pensions get high yield, hedge funds get low risk