The Wild Ride of Mortgage-Backed Securities

The roots of the current home ITWASN’TSUPPOSED to hap- pen this way. The market for home mort- mortgage market crisis. gage loans was never supposed to shut. No matter the crisis—war, banking fail- ure, or presidential impeachment—the mortgage market was not supposed to deny credit to American homeowners. So how could this happen? How could the mortgage industry, a close to trillion- dollar industry, suddenly collapse? Who is to blame for the ordinary Americans being denied a mortgage to buy into the American dream? How could $80 billion to $90 billion be wiped out virtually overnight? Blame it on Lew Ranieri, father of the mortgage market. I know. I STEPHENA.ROTH was there from the beginning.

3 4 ZELL/LURIEREALESTATECENTER In 1978, I applied to Stanford dollars in concession stand sales and say- University’s Graduate School of Business. ing good-bye to everyone from security to If there was anyone who should not have the back-stage hands. When the teacher’s been allowed to attend an MBA program, assistant for dummy math went around it was me. I was a graduate of public the room and made everyone give their schools, son of a car dealer without a col- name and prior occupation, there was lege education, and my first career had dead silence after I spoke. I heard some- been as a concert promoter. What a mis- one from the back, dressed in a polo shirt fit—and I was a misfit—for what Business with kakis and tassel-loafers, say: “You’re Week had called that year the “Best in the wrong room.” Business School in the U.S.” I managed to make it through two I had somehow managed to graduate years of preppie-dom because Stanford Phi Beta Kappa from Berkeley—although was on an “Honors,” “Pass,” or “Fail” sys- I think it was largely a recognition that I tem. I never failed a course, but the only was a “most improved” student, since my honors I received were in marketing; the GPA was mediocre and my test scores were professor thought I was a genius. He did- terrible. In today’s super-competitive n’t know that I had sold cars as a summer world, I wouldn’t have stood a chance in a job in high school. I thought I was begin- business school. But I got lucky. Four years ning to fit in by my second year. I cut my earlier, Stanford had admitted Danny hair, shed the gold chain, bought a brief- Shearer, who had gone on to become Bill case, and wore penny-loafers (I wasn’t Graham’s right-hand man. Graham was quite ready for tassel-loafers). But I had the most famous concert promoter of that completely misread my acceptance by the period, manager for the Grateful Dead, mostly Ivy League-educated student Santana, Joan Baez, and briefly The body, when I announced that I planned Rolling Stones. So when another rookie to work as a trader, that is, a sales- concert promoter (me) applied, Stanford man, at upon gradua- let me in. tion. My classmates were in shock. I had I showed up a week early, to attend broken the cardinal rule that all graduates seven days of “math for dummies” classes. of top MBA schools be either manage- I had a gold chain around my neck, long ment consultants or investment bankers, greasy hair, and carried a leather and fab- never bond traders, and certainly not at ric saddlebag. I had just wrapped up a Salomon Brothers, a firm with the Saturday night Carlos Santana concert reputation of being run by scrappy, hours before, tallying up thousands of uneducated New Yorkers.

REVIEW 3 5 I will never forget when word had floor. Every day, a salesman or trader spread among my graduating class that I would give a one-hour presentation. We had taken a job as a Salomon Brothers were taught concepts such as “relative bond trader. The first classmate to value,” which turned out to be important, approach me was the son of the chairman since at bonus time if you were told that of Morgan Stanley. He stopped me in the your relative value was close to zero, even hallway and said, “Do you know what though you had done well, your bonus you’re doing? Do you have any idea what would be close to zero, too. kind of people work at Salomon When the newly created Mortgage Brothers?” I looked at him with a blank Trading Desk, founded by Lewis S. stare, unable to answer. “They are ani- Ranieri only the year before, made its mals,” he said. “They have fist-fights on presentation, I got really excited. Non- the trading floor.” I did have an answer to government-insured mortgage-backed that. I told him, “That sounds great! Just securities were brand new, less than a year my kind of place.” He walked away in dis- old. They were called “mortgage pass- gust, never to speak to me again. A female throughs” because the cash flow generated classmate came up to me soon after, and from a pool of home mortgage loans, snarled, “How can you do this to us? You placed in a “trust,” was “passed-through” have an MBA from Stanford Business to investors in the form of the newly creat- School, the number-one business school in ed bonds. The cash flow could vary the country. You’re going to drag down all because if a homeowner whose mortgage our reputations.” I looked at her and said: was placed into the trust decided to sell “I am?” She stomped away muttering their home or refinance their mortgage, something like “fool” or “jerk.” the would be paid off and the proceeds from the payoff were distrib- uted to the investor. The exact time when MORTGAGE-BACKED a mortgage was paid off was basically SECURITIES unpredictable. So unlike a typical bond that paid regularly scheduled interest pay- In 1980, and at least up until Salomon ments (coupons) twice a year, and then the Brothers was merged into , full amount of the principal of the bond at incoming bond and trader its scheduled maturity date, mortgage “trainees,” as we were called, were required pass-throughs paid only whatever the cash to sit through a three- month training pro- flow the underlying pool of mortgages gram in a classroom far from the trading generated, on a monthly basis.

3 6 ZELL/LURIEREALESTATECENTER Of course all sorts of models were was the predominant tool that investors developed to predict when and how a and mortgage salesmen and traders used pool of mortgages might pay off. for years. Although some of this work was Mortgages could pay off before their done on computers, in 1980, most people scheduled maturity date for many rea- in the investment world of mortgages con- sons. Homeowners might die, or get a sulted tables to calculate the yield of a divorce, or simply sell their houses. They mortgage pool. A portion of Bloomberg’s might refinance their mortgages if inter- vast wealth came from designing (for est rates dropped and they could get a Merrill Lynch, and later for his own com- lower interest rate on new mortgages. The pany) computer models that made it easi- mortgages themselves were designed to er and faster to price and value securities “amortize” or gradually pay off a portion backed by home mortgage pass-throughs. of their principal each year. Thus, a thir- In 1980, at the birth of the mortgage ty-year mortgage would be completely securities industry (an industry that even- paid off by the thirtieth year, even if the tually grew to close to a trillion dollars in homeowner never refinanced. mortgage securities issued), those of us on The head of mortgage research at Salomon’s Mortgage Trading Desk Solomon Brothers was a numbers geek thought we were revolutionizing the world named Michael Waldman; his associate for the better. Previously, banks, S&Ls and was (the future mayor insurance companies were the sole source of ), who helped Waldman to of funding for mortgage loans. With every design tools that would allow mortgage business cycle came an eventual credit traders to figure out how a mortgage pass- crunch, and the banks, the S&Ls and the through might behave. There were numer- insurance companies would stop making ous models developed to try to mimic mortgage loans. And, at least for a time, human behavior, based on the history of the American dream of home ownership mortgage payoffs. One model assumed would be stopped dead in its tracks. The that a fixed percentage of mortgages each Salomon Brothers Mortgage Trading year would pay off. (Why not? It was as Desk, led by Lew Ranieri, was the leader in good a guess as any.) Another model creating a public where a assumed that all thirty-year mortgages whole new class of investors could provide would pay monthly until the twelfth year, needed capital, even when the usual and then all of a sudden, all of the mort- providers shut down. We believed that by gages would pay off at once. Farfetched as creating a public capital market for mort- it now sounds, the twelve-year life model gage loans, credit would never again be

REVIEW 3 7 shut off to the American homeowner, or to who lost 10 percent in one year might still the family who desired to own a home. be picked to manage hundreds of millions The vast majority of the investors of dollars of a pension fund’s money, if his who were buying these brand new secu- competitors had lost 11 percent, or if the rities were institutional money managers overall market had declined 12 percent. who managed money for pension funds. Although the phrase “You don’t eat relative The corporate pension funds of the big value” started being used at this time, it steel and chemical companies, and the did little to deter the pension fund con- major car and truck manufacturers, were sultants from using relative performance as generally “defined benefit” plans; that is, the measure to pick pension fund advisors. the retired worker at U.S. Steel or By comparison, the hedge-fund Chrysler received a predetermined, or industry, which began in the early to “defined,” monthly pension check. mid-1990s, promised “absolute” returns. When the major discovered The would take only a 1 per- that they owed more money to their pen- cent fee for managing the money, and sioners than they had set aside, they only if the investment made money, they hired private-sector advisors to ensure would take an additional 20 percent to that their pension funds would grow suf- 30 percent of the profits. The irony is that ficiently to cover the ever-rising cost of the old-school pension fund advisors future payouts. Thus, throughout the were getting only 1 percent or less as well, 1970s and 1980s, an industry of pension though of course they never received the fund advisors was born. additional 20 percent to 30 percent. Pension fund advisors competed to win Soon, hedge funds began attracting hun- pension fund business by showing pension dreds of billions of dollars of pension funds that they could offer a slightly high- fund assets on the basis that they always er return than their rivals. This is where the made money. This tremendous growth of term “relative value” or “relative perform- the hedge fund industry is one of the keys ance” came into play. The pension fund to understanding the collapse of the advisors convinced pension funds and mortgage securities markets. pension fund consultants that it wasn’t the So what did this have to do with the actual performance of a particular manag- new mortgage loan securities and mort- er that mattered; it was their relative per- gage loan pass-throughs? To gain a per- formance as compared to their competi- formance advantage over their competi- tors, and their performance relative to the tors, pension fund advisors were always overall market. A pension fund advisor looking for a way to earn extra yield.

3 8 ZELL/LURIEREALESTATECENTER Mortgage pass-throughs provided this of Russia in 1998, the dot-com collapse of yield, since they were a brand new instru- 2000, and the week when itself ment, understood by few, and thus were was shut down after the terrorist attacks on priced at a higher yield. Even though the the World Trade Centers on September first mortgage pass-throughs carried a 11, 2001. Why now, when the American Standard & Poors or Moody’s AA rating (a economy is running near full employ- highly desirable rating available to only the ment, inflation is low, and the entire world top 100 Fortune Companies), it took an (except Africa) is experiencing unprece- additional .5 percent or even 1 percent in dented growth and prosperity, would the yield to make these securities attractive to mortgage-backed securities industry col- pension fund investors. lapse? Is it really all Lew Ranieri’s fault? In fact, the roots of the collapse didn’t start to take hold until Ranieri had long WHATWENTWRONG? left Wall Street. In the early days of the mortgage securities business, mortgage In August 2007, almost thirty years after securities salesmen were stuck selling a the first non-government-insured mort- one-trick pony. They were taking thirty- gage pass-through was created, a vast capi- year mortgages, pooling them, and then tal market with hundreds of billions of selling them to investors and helping them dollars in mortgage-backed securities sud- try to guess when those mortgages might denly shut down. It is now almost impos- pay off, the crude assumption being that sible to get a mortgage loan for all but they would pay off in the twelfth year, all individuals or families with the best credit at once. It was a hard sell. Most pension rating who want to borrow only 75 per- funds wanted some degree of certainty that cent to 80 percent of today’s value of their the yield they were buying would last for a home, and who don’t need more than certain number of years, in order to match $417,000, the maximum loan amount this asset off against their known pension that Fannie Mae or Freddie Mac will pur- liabilities. Insurance companies, too, need- chase. The U.S. economy has survived the ed more definitive maturity dates then stock market crash of 1987 that took could be provided by the standard thirty- down 20 percent in one day, the year mortgage pass-through security. But Mexican peso collapse and the default of thirty-year (or even fifteen-year) fixed-rate dozens of Latin American countries in mortgages are highly unpredictable. If 1994, the Southeast Asia currency crisis, interest rates are falling, which they did the Russian ruble collapse and the default between 1983 and 2006, mortgage rates

REVIEW 3 9 also fall. It didn’t take long before loans into separate, individual securities, American homeowners became adept at each with their own somewhat more pre- refinancing their 9 percent fixed-rate dictable maturity date, succeeded. The mortgages with 8 percent fixed-rate mort- first bonds were called “Collateralized gage, then 6 percent, then (in 2006) 5 Mortgage Obligations” or CMOs. A $100 percent. When homeowners refinance, million pool of thirty-year mortgages that the cash flow from their original 8 percent previously would have been sold as one fixed-rate mortgages disappears, and the security now was carved up into as many proceeds from the mortgage payoff pass as twenty to thirty individual classes, or through one last time to the holders of tranches, varying in credit ratings depend- that particular mortgage-backed security; ing on which tranche got paid off first. the 8 percent interest payment is gone for To further limit the potential range of good. When interest rates fall, homeown- possible maturity dates, the interest ers refinance, but if interest rates rise, they coupon of the mortgages was stripped stay put. Thus the assumption that a thirty- away and sold at a very high yield as an year mortgage will inevitably pay off in “interest-only” or I/O. The buyer of an twelve years is not always correct. In some I/O was making a bet on interest rate situations, a thirty-year mortgage might movements, since if rates went down, and stay outstanding for a lot longer than the pool of mortgagees refinanced, the twelve years. But no one wants a thirty- interest coupon would of course disappear. year mortgage pass-through security that But I/Os traded at extremely high poten- was purchased assuming a twelve-year life, tial yields, since there were plenty of spec- extending to eighteen or twenty years ulators who wanted to make a bet on when interest rates are rising. Conversely, interest rates. no one wants a thirty-year security with In 1990, I left Wall Street and started an attractive yield, paying off early as my own firm, which became the largest interest rates fall. It’s a “heads I win, tails contractor for the sale of nonperforming you lose” situation. mortgage loans for the Resolution Trust This uncertainty was a genuine , set up to liquidate the seized impediment in the early days of the assets of bankrupt S&Ls. By then the ana- mortgage-backed securities business. lysts had pretty much hijacked the mort- Investors wanted more certainty as to the gage securities industry. Wall Street was cash flow of the security they were buying. selling thousands of very small, carved-up At first, Wall Street’s attempt to carve up mortgage securities in an attempt to meet the cash flows from pools of mortgage the needs of the pension funds and insur-

4 0 ZELL/LURIEREALESTATECENTER ance companies (and sometimes banks) value of their property, but it was usually that wanted a security with a specific—or wealthy individuals who provided mort- at least more predictable—maturity date gages to these people, and enjoyed yields as and yield. This strategy broadened the base high as 15 percent to 20 percent for their of potential investors. The hedge funds troubles; now, the public capital markets became increasingly interested in the lower embraced subprime borrowing. The ana- rated, higher-yielding tranches of these lysts developed models to show that the mortgage securities. This produced a situ- default rates on subprime borrowers were ation in which single-rated original mort- only marginally higher than those of other gage pass-through securities (usually borrowers, and thus the extra yield charged AA- rated) were now made up of securities on these subprime loans easily made up for rated anywhere from AAA to B, or even their slightly higher default rates. non-rated in the case of I/Os. The other It is often said that financial markets, new device was the idea that mortgages including the market for mortgage securi- could have all sorts of credit ratings: all ties, are always battling between “greed” mortgage securities didn’t have to be and “fear.” It was greed that caused the AA-rated or government-insured, but explosion in subprime lending over the could actually be rated “junk” or below- past five years. Borrowers could refinance investment grade. their homes, pull out all of their equity, The next seemingly logical step that and still get relatively attractive interest would lead to the August 2007 collapse rates—and they could do so often with was a change in the qualifications of bor- dubious credit histories. The reason they rowers themselves, who no longer were were allowed to do this was that there was required to have stellar credit ratings. As now a secondary market for subprime hedge funds demanded more and higher- mortgages and securities backed by sub- yielding securities, Wall Street encouraged prime mortgage loans, driven by hedge mortgage companies (with whom they funds that needed the extra yield, so that were sometimes allied) to make loans to there were enough profits to justify their riskier borrowers, charging them a higher 20 percent to 30 percent cut of their interest rate. “Subprime” mortgages began investor’s return. to show up in mortgage securities. There Between 1980, when I began my career had always been a private market for bor- on Wall Street, and 1990, the original rowers whose credit rating was poor, or providers of mortgage capital, the com- who needed to borrow more than the cus- mercial banks, the S&Ls and the insurance tomary 75 percent to 80 percent loan-to- companies, stopped keeping these mort-

REVIEW 4 1 gage loans on their books and sold them But when fear began to win out over into the secondary market to be packaged greed, Wall Street and the commercial as mortgage securities. Why did they do banks stopped renewing these loans. This this? Because thirty-year or even fifteen- was similar to the Asian and Russian year mortgages, with a widely unpre- crises of 1998, when the Wall Street firms dictable maturity date, did not match the and commercial banks yanked their lines short-term nature of bank deposits and of credit to hedge funds or other financial CDs. The banks and the S&Ls predomi- or mortgage companies. Today, dozens of nately funded themselves with short-term mortgage companies have had their cred- deposits. Mortgages, on the other hand, it lines yanked and are being forced into were predominately long-term in nature. bankruptcy, like American Home This mismatch of assets and liabilities Mortgage; controlled by the giant hedge helped lead to the fall of the S&L industry fund Cerberus; or teetering on the edge and brought hundreds of commercial of bankruptcy, like the biggest mortgage banks to their knees. company in the world, Countrywide August 2007 saw a similar mismatch. Financial Corporation (at least at the Hedge funds and mutual funds specializ- time this article was written. On August ing in bonds can be considered to have 21, Bank America purchased $2 billion of short-term liabilities—that is, their Countrywide convertible preferred stock investors. As every Fidelity or Vanguard to help shore-up the company). Before mutual fund investor knows, you are just a the forty commercial banks that had pro- phone call away from asking for your vided Countrywide Financial with an money back. Most hedge funds have pro- $11.5 billion credit line could yank it, visions that do not allow immediate Countrywide on August 16, 2007 drew redemptions; instead, they “leverage” down its entire $11.5 billion credit line at invested capital by borrowing short-term once. It is better to have the money in from a Wall Street firm that was ready to your treasury and argue about whether lend them short-term funds, provided the you may technically be in default than fund bought the latest junk-rated mort- have to go begging to the banks for the gage or subprime mortgage security. money when you are in trouble. No So, even though hedge funds could doubt, the forty banks are screaming to stop a “run on the bank” by committing high heaven, but Countrywide now has their customers to five to seven-year their money. investments, they usually leveraged The final chapters of the August 2007 invested capital with short-term loans. collapse of the mortgage industry have yet

4 2 ZELL/LURIEREALESTATECENTER to be played out. It will take at least until rities as investment-grade. And we cannot early 2008, and maybe mid-2008, before forget the regulators, including the state we really know the butcher’s bill. It is like- regulators who oversee mortgage firms, as ly that the cost will be $80 billion to $90 well as the federal regulators, including the billion in losses. And thousands of individ- FDIC, the Office of the Comptroller of uals and families will lose their homes due the Currency, and the Federal Reserve to foreclosures caused by the credit crunch Board, which continued to feed this feed- that the is now experienc- ing frenzy with easy money and only in ing—real people, real families, with the spring 2007 began to warn of lax lending rug of the American dream of home own- by the banks. We have been here before. ership pulled out from underneath them. Congress will hold hearings. A few unfor- So, you can’t blame this one on Lew tunate mortgage firms will be hauled up Ranieri. It was five long years of greed rul- before committees and found to have ing over fear (and now there will probably committed some paperwork errors and be at least six months of fear ruling over will be prosecuted. New regulations will be greed). Many people have a share of the passed preventing borrowers from borrow- blame. Borrowers who borrowed the full ing 100 percent of the value of their home. value of their home with little likelihood of And then one day, the fear will fade and making the interest payments can be the greed will return. It will be back to blamed. Mortgage companies with a desire business as usual. to originate and sell off subprime mort- gages to Wall Street can be blamed. Wall Street firms, of course, are also to blame. They are in the middle—as they always are—caught between the mortgage firms and the investors who were willing to snap up poor-quality, subprime mortgage loan securities. And the investors also share in the blame, those who ignored prudent credit standards and bought these securi- ties at yields that were nowhere close to compensating them for the risk. There is more blame to go around. The rating agencies, Standard & Poor’s and Moody’s, are to blame for rating junk secu-

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