My Role in the Development of the CMO --- Part II: Leveling the Playing Field

Nineteen hundred and eighty-seven was a fateful year on Wall Street. In October of that year the stock market crashed, and -- even closer to home -- First Boston's talented Mortgage Finance Department was about to be blown sky high. My business partner and I were the first to depart, founding Wall Street Analytics, Inc., a financial software company. Soon after, department head Larry Fink and much of the rest of the team went off to start BlackRock, Inc., currently the largest money management firm in the world.

As that eventful year progressed, I began putting the finishing touches on the firm's CMO software model. The Cambrian Explosion of new structures continued apace, but I methodically incorporated every new innovation into my structuring language without too much trouble. An idea slowly began to germinate in my mind at the onset of that fateful year: What the world really needed at this critical point in time was not yet another bizarre bond structure. What the world really needed was a comprehensive software package that would allow all market participants, buyers and sellers alike, to compete on a level playing field. There were, perhaps, fewer than half a dozen industry veterans who knew how to build such a program, soup to nuts; and I was one of them.

Investment banking in the 1980s was still considered an elite, relationship-driven enterprise. The old guard didn't quite know how to handle the new software developers, or "quants", that were slowly transforming the nature of their business. Microsoft Corporation's veneration of developers was certainly not the culture on the 38th floor of Park Avenue Plaza. With no $4 billion transactions to my credit in 1987, and a stock market crash hurting the bottom line, my pay grade was frozen and no promotions were forthcoming. If ever there was a time to put my idea to the test, now was it!

In January of 1988, I co-founded Wall Street Analytics, Inc., a two-man operation headquartered in the working class neighborhood of Jackson Heights, Queens. My business partner, Ron Unz, was a talented software developer, businessman and political activist, who had had a brief but rocky tenure at First Boston in the summer and fall of 1987. Our new venture was destined to be both stunningly successful and stunningly ill-fated. Unfortunately, just as our firm began to prosper, our personal relationship rapidly deteriorated. I left the company, and Wall Street in general, in 1991: one of the first casualties in the boom-and-bust business that I had helped to create.

My Role in the Development of the CMO --- Part I: The Cambrian Explosion

A selection of life forms that flourished during the Cambrian Period

The Cambrian Explosion was a period in the history of life, approximately 530 million years ago, when a wild variety of life forms sprang up in a relatively short amount of time. Apparently, Nature had discovered the unique ability of carbon to mix and match to form all manner of life. Many of the most bizarre living creatures ever created rose up and then disappeared, until the "winners" finally settled out to populate the world. Only a select subset of this diversity survives to the present day.

In a similar way, near the beginning of the CMO era approximately a quarter century ago, the debt merchants on Wall Street, discovering a massive new source of raw material, zealously molded and reshaped this malleable substance into new forms of life that they hoped might appeal to their corporate clients. The mortgage market, a multi-trillion dollar behemoth, was about to be set free from the stable, boring confines of traditional banking and released into the rough-and-tumble world of investment banking.

In 1986 and 1987, the CMO market underwent its Cambrian Explosion. During those two fateful years, I found myself the head CMO modeller at First Boston, the leading structured financing house on Wall Street. How I got to that position is not entirely clear. The prior modelling guru had burned out, and the pace of innovation was so fast and furious that no one particularly wanted the job. I found I had a facility for it, being a decent computer programmer and an absolute ace at organic chemistry in college.

My task was to take all the innovations in bond design that were occurring at breathtaking speed and incorporate them into a single framework: to create a computer model that could be used to create and reverse-engineer every mortgage security ever created. The program had to be comprehensive and easy to use for our designers, who created the deals; and comprehensive and easy to use for our traders, who kept track of the deals in the secondary market.

During these two years, I built this model. By the time I left First Boston in early 1988, the system was able to model virtually every mortgage and asset-backed security ever designed up to that time. Many of the bond structures created during this period became evolutionary dead-ends; some, however, survive to the present day: interest-only strips (IOs), principal-only strips (POs), planned annuity classes (PACs), targeted annuity classes (TACs), floaters, inverse floaters, and others. My CMO structuring program handled them all.

To help you understand the magnitude of what was happening on Wall Street at the time: In October of 1986,at the age of 25, I co-developed the structure for, and my structuring system was used to create, what was to date the single largest bond offering in Wall Street history : the $4 billion GMAC ABSC Series 1. First Boston's profit on the transaction was enormous. Largely because of this deal, I received a six-figure bonus that year: a significant increase from the $7 an hour I had been earning two years before, and an even bigger jump from the $5 an hour I had received as an assembly line worker at a potato chip factory a few years before that.

What is a CMO?

It's seems a little odd that something that has grown to be one of the largest businesses in the world is almost entirely unknown to the general public. A CMO is a Collateralized Mortgage Obligation, an aggregation of mortgages in which the cash flows have been carved up into a variety of individual securities or tranches. CMOs are also sometimes referred to as REMICs (Real Estate Mortgage Investment Conduits), but I will generally stick to the more common term.

Virtually everyone knows what a mortgage is: a bank lends a prospective homeowner money to buy a house, and the homeowner must pay back this loan, with interest, over time -- typically thirty years. The bank's loan is secured by the value of the home. If a homeowner has a mortgage and makes his monthly payment, there is a very good chance that this payment will ultimately flow through a CMO. If one were to add up the monthly mortgage payments of all the homeowners in America, one would quickly realize that this is a really, really big business. Outstanding agency CMO balances in the early part of 2009 were approximately 1.3 trillion dollars!

The first CMO was created in 1983 when I was just beginning my Wall Street career. It was developed jointly by First Boston and Salomon Brothers, the two investment banks that dominated the business in its early years. The idea behind the CMO was to find an alternate source of financing for homeowners besides that provided by traditional banks. By taking the cash flows of thirty-year fixed-rate mortgages and dividing them up into securities that were acceptable to non-bank investors, a whole new source of home financing could be tapped. The advantage to the homeowner would be lower interest rates, as more money would be competing to provide financing.

The early CMOs were very simple structures. Typically the cash flows would be divided into three or four tranches of different maturities. The longer maturity tranche might appeal to a pension fund which did not need immediate cash flow. The medium maturity tranche might appeal to an insurance company with a shorter time horizon. The shortest maturity tranche might appeal to a conservative mutual fund.

The investment bank made money by buying up huge quantities of mortgages, dividing them up into tranches, and selling the tranches for more than they paid for the underlying mortgages. It was a form of arbitrage that was, in the early days, extremely profitable. In my days at First Boston in the mid-1980s, a typical deal size would be 300 to 500 million dollars. The investment bank structuring the CMO would typically make several million dollars on each deal.

My Connection to the Financial Crisis

The First Boston Corporation headquartered at Park Avenue Plaza

After graduating from college in 1983 and before attending graduate school, I landed a summer job at the First Boston Corporation, a major investment bank in New York City. I worked in the Fixed Income Research department earning $7 an hour. I was hired to write and debug software that analyzed bonds, mortgages, and a variety of other "fixed income" securities. I remember one day that summer hearing of a very sophisticated computer program that was being developed to create a new type of mortgage security: the Collateralized Mortgage Obligation or CMO.

There was a lot of curiosity and excitement about the software program, but I didn't think much about it, working busily on my own projects, and looking forward to grad school. Little did I realize that CMOs were about to explode onto the scene and that my own life would soon become intimately involved in developing the software used to create and analyze these new mortgage securities. A whole new way of banking and mortgage finance was about to be launched in the United States, and I, a twenty-something kid right out of college, was soon going to have a central role in structuring some of the largest transactions in Wall Street history.

In any explosion there are casualties. Unfortunately, I was a very early casualty, although I seem to have survived well enough to the present day. Of more significance, our entire nation ultimately got caught up in the explosive growth of this "new way" in mortgage finance and has now become a casualty. After a few manageable crises over the years, the first major systemic shock hit the United States in September of 2008: credit "froze up", the stock market collapsed, the real estate market tanked, and millions became unemployed. In the past year, the Federal Reserve, the world's Central Banks, and the U.S. Treasury have all been scrambling frantically to avoid a total meltdown of our banking and credit systems. It sounds crazy, but the very survival of democratic capitalism actually hangs in the balance.

In this blog, I will cover what I think are the primary causes of the financial meltdown and, in particular, the critical connection to that curious software program I became involved with almost a quarter-century ago.