FinPod

Meeyeon (00:13)
Hi everyone and welcome to another episode of What's New at CFI. Today I'm joined by my wonderful colleague, Ryan Spendelow Hi Ryan. And today we're talking about securitized products, very specifically collateralized mortgage obligations. And I have to say that in three parts because it's a mouthful, but

Ryan Spendelow (00:23)
Hey Meeyeon hello, nice to be here.

Thank

Meeyeon (00:37)
Going forward in our podcast, I'm gonna call them CMOs, and that's what they're referred to on the street that is Wall Street.

Ryan Spendelow (00:46)
So, I wonder how many of our CFI learners have ever wondered how their or their parents' mortgage might be part of a complex financial product traded on Wall Street. So.

Meeyeon (00:59)
And so this is what's really interesting about CMOs and general mortgage products is that I think this is the first place that I could think of. When I say place, mean financial product or asset where it is more of a tangible and relatable product for most people because when we purchase our homes or when most people purchase homes, people generally don't buy them in outright cash, especially in

more expensive cities like Los Angeles or New York, very few and far between people will actually go ahead and purchase a home outright in cash. And one of the reasons is not just because people don't generally have $2 million sitting around, kicking around to go and buy a house, but generally if rates are really low, you're better off taking out that mortgage loan and putting that cash to work in different places.

But what makes it really, what makes mortgage products really interesting and what we're showcasing in this course is that they can become a very, when pulled together, a really highly customizable and really interesting financial product that we as the retail consumer can say, like, I have experience with. You go to a financial institution, you take out a mortgage and guess what? Like that is going into a pool of mortgages and it's going to become a CMO eventually.

Now, without giving away too much spoilers, I'm going to go into a bit of a kind of a rapid fire style about what everyone can expect in this CMOs course. Something that makes CMOs really interesting is the structure of them to begin with, the way they're set up. And I'll touch lightly on what the legal structure is like and why it's unique and why it is necessary for CMOs.

But again, I'm not going to give too much spoilers. so CMOs, they're typically fixed income debt securities, and they're issued by something called a special purpose vehicle. Short for them is SPB or trust. And that's something that you've heard of in our first securitized products course, if you're a learner that's taken that. And it's important to understand that what an SPB is, is that it's a legally separate entity from the issuer.

whether you buy a CMO that's been issued by an investment bank or a government agency, for example, in the US, Fannie Mae of Freddie Mac, they are, an SP is a completely separate entity. So the process will kind of look like in three steps. So we have mortgage loans. And so a bunch of mortgages, residential and commercial that are pooled into something called

MBS, Mortgage Backed Securities, are passed through securities. And these MBS then they get deposited into the SPV that has been set up. This is a separate legal entity. And then the CMOs are issued by this separate entity, which then slices up the mortgage pool. This is a specific language that you're going to hear in our course. And it splits them up into something called tranches. like think of bread, sliced bread. We're putting

all the cash flows into different slices for everyone with different risk and different risk and return profile. So it's highly customizable. And with SPVs, the structure is key because this allows it to isolate the mortgage assets from the issuers balance sheet. And what this does is create something called bankruptcy of remoteness. So even if the issuer

goes bankrupt, in which case, you know, a government agency is not going to go bankrupt. But let's say somebody goes bankrupt, the actual mortgage cash flows are still going to go to the CMO investors because there is a remoteness from where the cash flow is coming from. And so the things that important that make CMOs different from MBS that we go to in the course are the cash flow structure, risk allocation, legal structure, investor customization.

and prepayment sensitivity. So those are the key things that make MBS different from CMOs and what we go through in detail in this course.

Ryan Spendelow (05:24)
Well, that's awesome, Meeyeon. Thanks ever so much for going through that course at that high level to give our learners a really good sense of what they will cover when they take this course. And you've just provided me with a really nostalgic walk down memory lane around 2007, 2008, during that financial crisis, CMOs were the three-letter word that you dare not speak, right? So, Meeyeon, tell us about...

Meeyeon (05:43)
Good times during those years.

Ryan Spendelow (05:53)
from your perspective, what do you think is the most interesting thing about CMOs that learners will learn from this course?

Meeyeon (06:00)
So CMOs, think, as you alluded to during GFC Global Financial Crisis 2007 and 2008, CMOs and MBS generally, I think it's really more so those three letters, MBS, that all of a sudden had like a red herring, like, oh my God, don't touch it, don't touch it, don't wanna be associated with that type of thing. But there's been so much regulation in the industry since then. And the most important thing to understand about MBS is that it is a...

It is as safe or as risky as any financial product. Like everything is highly regulated now. We've learned a lot of lessons from GFC, but the heart of the product itself is something that I think to me demonstrates true financial innovation. And one of the reasons why is the investor customization. What I think is so interesting about CMOs is how it creates a risk profile that is so unique.

that there is a place for anyone and everyone in that profile. So in the course, during the back half of the course, we go through various different types of CMOs. You'll learn that if you take the course, we have something called sequentials, have CMOs called PACs, we have Z bonds, we have jump Z bonds. And what all of these scenarios demonstrate is how these cash flows can be sliced up.

and diced up, so to speak, so that there is a risk profile for anyone and everyone. And so for example, when we go through a sequential CMO, we're talking about how investors take on different types of risks and they wanna be in a line of cash flows, but they are willing to wait to receive their cash to receive a little bit more reward. Whereas there's...

There's another participant that's like, no, know, like stability is really important for me. Let's say they're a fixed income manager at a pension fund. And so the structure allows, imagine you'll see this in the course through visual examples, through graphs that we take you through. But the most important thing is getting paid back and you have a fixed kind of return that you're targeting and you don't need to take anything else. So then you're first in line. So with the CMO, you're everyone, let's say there's four investors.

first is going to start getting all their principal back. Whereas every and then everyone else. So investors one, two, three, four, everyone's getting interest, but only investor one is getting their principal repaid. And then after they do investor two does. And when investor two starts getting their principal back, investors two, three and four are still getting interest, but investor one is now gone. They're out of the queue. They've received all the interest and all their principal back. Investor two will

eventually have all of their principal taken down. And then so they also move off this conveyor belt, so to speak. And then three, four, they continue to receive interest, but only investor three will get their principal back. And it creates this profile that works so that everyone gets the risk and reward profile that is that they need. And also that there will be a spread such that their originating investment bank will be able to make a buck, because otherwise they would not do this.

But the idea that there could be a CMO desk that is specialized in making sure that they can make custom tailored solutions to everyone, I think that's very unique to the mortgage market to be able to create a security like this. And there's also things that are even more interesting where we have a Z bond, where we have a investor that is willing to take on not just a little bit more risk, but of...

a significantly more risk in a different capacity, such that they structure the CMO so that as long as prepayments, because those are incredibly important, that's the most important consideration of the risk profile of CMOs. It's important, but to say at the very beginning when an originator structures the CMO, say, okay, in the beginning, we're gonna assume that prepayments

They could come in at, let's say, like 100 miles an hour or 500 miles an hour. And as long as they stay within this path, then this is our risk profile here. This is how investor one gets paid their principal and interest, two, three, four and such. And then they have this scenario where all of a sudden, let's say there is some external event in the market that makes interest rates really, really jump either really, really high or go through to the very bottom.

And all of a sudden we say, oh my gosh, like this is no longer the economic environment that we're thinking of. We have this Z bond here, this investor that's very different from everyone else that's willing to say like, okay, you know what, I can subsidize these cash flows so to speak in the beginning when prepayments are really high and we're not what we're expecting. This absorption risk investor.

What's really interesting about this course is that we go through all of these examples and we show how CMOs are, in my opinion, I think one of the most unique fixed income assets there are because it is so inclusive in that it can be custom tailored to any solution. And it's just very interesting to see all the cash flows mapped out graphically. And I think that this is a particularly interesting course for people that are interested in fixed income.

Ryan Spendelow (11:15)
Mm.

Meeyeon (11:41)
I think that the CMO desk is a very profitable desk that is kind of not underdog, but it's not something that people initially think of right away. You think about fixed income, sales and trading or equity sales, but being part of a structured products desk kind of like CMOs is a very, very interesting career path. think it's more so.

more so exciting for someone that is a little bit more mathematically inclined. And yeah, I'm just like really excited to be able to have a course that delves into a fixed income asset that I think is not widely talked about. And it's a bit technical, but I think it's going to be really exciting for people to see because there's nothing else quite like it.

Ryan Spendelow (12:32)
Awesome. Well, your passion and your interest in everything fixing comes through loud and clear and you've certainly got me interested in it. So I can't wait to take it myself and see what all their buzz and excitement's about.

Meeyeon (12:44)
Okay,

I hope that everyone will enjoy taking it. think having the more people be aware of what MBS is all about, MBS CMOs, I think it's a great part of financial education. So until next time, we'll see you all later.

Ryan Spendelow (13:02)
Thanks, Meeyeon Thank you, bye.