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.
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.
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