Collateralized Mortgage Obligation - CMO

It’s a bunch of mortgages in one investment vehicle pot.

When banks and investors package mortgages together, they can treat them like an index bond fund, because these groups of mortgages pay interest, i.e. the interest comes from people who pay their mortgages.

So... why would you collateralize a mortgage obligation anyway?

Answer: Risk. By packaging lots and lots of mortgages together, the theory was that, as a whole, they would create a much less volatile environment than the former alternative of having tens of thousands of individual mortgages, many of which, at any given time, were in duress. Collateralizing this group meant simply placing all of them into one investment vehicle that could be bought and sold as if it were an ETF, or individual closed-end fund.

But Wall Street being Wall Street, where greed is good (until it’s not), abused the notion of collateralized mortgages, and actually applied the notion of collateral against them, pledging as collateral the equity in those mortgages, and then leveraging against them. This is sort of like the brilliant idea of the social chairman sending the kids to get graham crackers, marshmallows, and chocolate...along with a bonfire in the middle of a helium storage plant.

In fact, what happened in the mortgage meltdown of 2008-2009 was that the helium exploded, in the form of many of these mortgages becoming insolvent. And as one mortgage went bad, it caused a chain reaction of panic up and down the economic food chain, which resulted in the near bankruptcy of the U.S. financial system.

Basically, the people who pulled together these CMOs forgot, uh... what the “O” stands for.