Residential Mortgage-backed Security - Continuing Evolution

Continuing Evolution

Residential mortgage backed securities and similar sounding products would continue to expand throughout the 1980s. For example, in 1983 Freddie Mac marketed the first collateralized mortgage obligation (CMO)

Ranieri also had a hand in developing the concept of "tranches", which were used to put a spin on a typical RMBS. With tranches, a pool of mortgages would be divided into different layers of varying risk. "Senior" tranches were the safest part of the investment, and the purchasers of these slices would be paid back in full before the next lower tranche, called "mezzanine", would see any return. Likewise, "mezzanine" would be paid in full before the lowest level, or "junior," tranche received any payments. Such an investment organization allowed for the sophisticated investor to earn higher returns if he/she bought the "junior" or "mezzanine" tranches, as they carried higher interest rates to compensate for the added risk of incurring loss.

Eventually structured finance would explode with the development of the collateralized debt obligation, or CDO in 1987 and even further inventions, like the CDO squared. CDOs were originally used to pool many different RMBSs (which were themselves pools of residential mortgages) and then divide them up into tranches and sell them off to investors. The end result of these financial innovations was a secondary mortgage market existing outside of the government sponsored entities that provided a massive growth opportunity for Wall Street banks. According to former International Monetary Fund chief economist Simon Johnson, the "total volume of private mortgage-backed securities (excluding those issued by Ginnie Mae, Fannie Mae and Freddie Mac) grew from $11 billion in 1984 to over $200 billion in 1994 to close to $3 trillion in 2007."