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 bond trader, that is, a sales- concert promoter (me) applied, Stanford man, at Salomon Brothers 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 mortgage loan 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 Citigroup, full amount of the principal of the bond at incoming bond and stock 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 Michael Bloomberg (the future mayor insurance companies were the sole source of New York), 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 capital market 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.