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September 28, 2008

Toxic Debt Recipe with Free Spreadsheet

Now that it looks like the Wall Street bailout will pass - unfortunately, there's no point in crying over spilled milk; better that we all learn to make toxic debt since the government will be creating a market for it. We can't afford to waste time making software, growing crops, or building stuff – too risky if you fail. Ever eager to help in the retraining of America, Fractals of Change has managed to obtain a tested toxic debt recipe. It can be made with ingredients available almost everywhere.

First purchase $275,000,000 face value of 7% fix rate mortgages – the face value is the amount actually lent if you were afraid to ask. You buy these from an institution which lent money to someone to buy a house or from someone who bought the mortgage from someone who bought the mortgage from someone who lent money to someone who bought a house. These mortgage originators are entitled to some profit, of course, so you'll probably pay about $280,000,000 but not to worry.

Now that you have the mortgages laid out on your computer, you have to dice them into tranches. This recipe absolutely depends on your dicing skill so be sure to practice with the spreadsheet I've supplied before making the actual debt dish.

We'll try three tranches for our first exercise although good financial chefs can dice a pool of mortgages into dozens and dozens of tranches. Actually this recipe only yields one tranche of toxic debt and two rather pedestrian tranches but some waste is inevitable in all cooking.

Now the big secret of this recipe is that no one knows which mortgages are in which tranche; the tranches are distinguished by the repayment rights that go with them and the interest rates which they pay. Don't worry, I'll give an example. The total amount of the tranches, however, has to add up to the total you paid for the mortgages plus a little extra to reward you for your trouble in creating this valued product so let's say you are going to have $300,000,000 of debt to sell once you are through whipping up this batch.

The first tranche of $75,000,000 will be entitled to all of the payments which come in until it gets back all the principle it is due in a particular month plus 4% interest. This tranche is very, very safe because there would be enough money to pay it off even if more than three-quarters of the mortgages went into default. Because it's so safe, it pays very little interest. This is NOT toxic debt, just a byproduct.

The second tranche of $200,000,000 starts getting paid off once the first tranche has been satisfied each month and gets 5.5% interest. Normally this wouldn't be considered toxic either since it can't have losses until more than one sixth of the mortgages go into default

No payments go the third tranche of $25,000,000 until all payments made to the first two tranches have been satisfied. Holders of the third tranche receive a whopping 13.5% interest if there are no defaults or if defaulting properties are always sold for enough to make the mortgages whole. So how much risk is there in that? And look at the reward! Don't forget to put a sentence about risk in your prospectus, though; no one'll read it except lawyers but they'll get you if you leave it out.

So not a bad business; you sell $275,000,000 worth of mortgages which cost you $280,000,000 for $300,000,000. Of course you could do better with ten tranches and a billion dollars but you should practice this simple recipe first.

Where you might get in trouble is if you eat your own toxic tranche. This is meant for the guests but not for you; you could get sick. Read what Andy Kessler said about the pigs eating the sausage.

And don't unhide columns F through K of the spreadsheet. It's bad manners to calculate the effect of defaults during dinner. Someone might get nauseated if they see that the value of the toxic tranche drops from $25 to $7 million with a 10% default rate (net of foreclosure receipts). But that's what bailouts are for.

Instructions for spreadsheet:

  1. Fill in the values in green only. The spreadsheet will calculate the interest rate for the toxic tranche,
  2. Make sure the total face amount in C7 is less than the sum of the tranches. You need to make a profit.
  3. Unhide the default rate assumptions by selecting columns E and L, right click, and select "unhide".
  4. Don't eat the sausage.
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