in the capital markets.     Financial Innovation and Derivatives   The investment diversity desired by households is far greater than most businesses have a desire to satisfy. Most firms find it simpler to issue "plain vanilla" securities, leaving ex- otic variants to others who specialize in financial markets. This, of course, creates a profit opportunity for innovative security design and repackaging that investment bankers are only too happy to fill. Consider the astonishing changes in the mortgage markets since 1970, when mortgage pass-through securities were first introduced by the Government National Mortgage Asso- ciation (GNMA, or Ginnie Mae). These pass-throughs aggregate individual home mort- gages into relatively homogenous pools. Each pool acts as backing for a GNMA pass-through security. GNMA security holders receive the principal and interest pay- ments made on the underlying mortgage pool. For example, the pool might total $100 mil- lion of 10 percent, 30-year conventional mortgages. The purchaser of the pool receives all monthly interest and principal payments made on the pool. The banks that originated the mortgages continue to service them but no longer own the mortgage investments; these have been passed through to the GNMA security holders. Pass-through securities were a tremendous innovation in mortgage markets. The securi- tization of mortgages meant that mortgages could be traded just like other securities in na- tional financial markets. Availability of funds no longer depended on local credit conditions; with mortgage pass-throughs trading in national markets, mortgage funds could flow from any region to wherever demand was greatest. The next round of innovation came when it became apparent that investors might be in- terested in mortgage-backed securities with different effective times to maturity. Thus was born the collateralized mortgage obligation, or CMO. The CMO meets the demand for mortgage-backed securities with a range of maturities by dividing the overall pool into a series of classes called tranches. The so-called fast-pay tranche receives all the principal payments made on the entire mortgage pool until the total investment of the investors in the tranche is repaid. In the meantime, investors in the other tranches receive only interest on their investment. In this way, the fast-pay tranche is retired first and is the shortest-term mortgage-backed security. The next tranche then receives all of the principal payments un- til it is retired, and so on, until the slow-pay tranche, the longest-term class, finally receives payback of principal after all other tranches have been retired. Although these securities are relatively complex, the message here is that security de- mand elicited a market response. The waves of product development in the last two decades are responses to perceived profit opportunities created by as-yet unsatisfied de- mands for securities with particular risk, return, tax, and timing attributes. As the invest- ment banking industry becomes ever more sophisticated, security creation and customization become more routine. Most new securities are created by dismantling and rebundling more basic securities. For example, the CMO is a dismantling of a simpler mortgage-backed security into component tranches. A Wall Street joke asks how many in- vestment bankers it takes to sell a lightbulb. The answer is 100-one to break the bulb and 99 to sell off the individual fragments.