Market and Organizational Innovations

The innovations in products and processes were accompanied by a set of chang­es to the markets and firms that populated the MBS industry. In Chapter 3, I discussed how the field of the mortgage industry was transformed into the field of mortgage securitization with the collapse of the savings and loan model of products, process, and organization.

The business models for all branches of banking were in crisis in the 1980s and early 1990s, as I have already discussed. The largest banks lobbied Congress to break down state banking laws in order to allow cross-border mergers and market takeover. During the 1980s and 1990s, the mantra of the industry be­came the idea of the conglomerate or full-service bank. In a series of reforms, banking regulators gradually allowed banks to enter into new industries. In 1999, the Gramm-Leach-Bliley Act formally removed the last barrier between investment and commercial banking. As we have already documented, by the time this happened, the law was more or less not being enforced. One outcome that was less noticed was that the removal of this barrier did not bring most banks to engage in the traditional investment banking activities of selling gov­ernment bonds or helping corporations engage in mergers and initial public offerings. Ironically, instead of producing conglomerate banks as the new busi­ness model, the breakdown of the barrier between investment and commercial banking mostly led to vertical integration of banks by incorporating the origi­nation, securitization, loan servicing, and trading functions of MBS internally in their organizations.

These organization changes produced growth in a set of markets. Of course, the mortgage origination market became national. The MBS-CDO market be­came focused on Wall Street, and the products produced generated a large in­ternational market, particularly after 2003. Finally, the repo, money market, and asset-backed commercial paper (ABCP) markets expanded dramatically to pro­vide capital for banks to borrow short term to fund mortgage origination (Sti- ghum, 1989). This eventually also allowed them to borrow money to fund their investments in the securities they produced based on these mortgages.

Conclusion

The upshot of this chapter is that financial product innovation was deeply rooted in the transformation of banking and finance more generally. The impetus to all of this change was the high inflation and slow economic growth of the 1970s. This condition, called stagflation, undermined the business models of savings and loan, commercial, and investment banks. Savings and loan banks could no longer make money by borrowing at low interest rates and lending for thirty years. Commercial banks found their corporate customers going directly to the financial markets to protect themselves from high inflation, high interest rates, and potential bank control. Investment banks found that the stock market was not growing, so new businesses needed to be found in order to rekindle growth.

It is not surprising that in order to save their firms, executives lobbied to have the regulations that had governed banking and finance changed. Those barri­ers, mostly erected during the Great Depression of the 1930s, had provided sta­ble profits for forty years. But as financial institutions found that the protection afforded to their markets was no longer guaranteeing profits, they needed to change their business models. Thus, they were willing to make trade-offs to po­tentially open their protected markets to others in order to create new products and processes. In the face of a crisis in one's main line of business, these trade­offs were not hard to make.

Banking and finance circa 1975 consisted of highly regulated markets that were segregated by products, geography, and types of banking organizations.

The financial challenges of the 1970s also brought banks to create new prod­ucts in order to find customers in a slow-growth and high-inflation era. In par­ticular, the evolution of mortgages sold to home buyers and mortgage-backed securities sold to investors was propelled by creating products to overcome the objections of potential buyers. In the 1970s, interest rates were so high that mort­gagors could not afford to buy houses. In the next twenty years, new kinds of mortgages were created to allow more and more people to buy homes even as the cost of doing so rose. Selling MBSs and CDOs required creating products that overcame the objections of investors. Having high-rated securities that paid rel­atively high interest rates and appeared to have the tacit backing of the govern­ment eventually brought legions of new buyers into the market. The complexity of these instruments was the outcome of trying to please buyers who had to be convinced the product met their needs.

But the creation of these products also required new financial processes. Without high-speed computers, credit scores, and credit ratings, financial in­struments could not be created or sold. Computer programs that allowed the rapid entry of mortgagor information and a quick turnaround in mortgage ap­proval processes revolutionized the industry. They drastically lowered the costs associated with the origination of mortgages and drove a dramatic increase in the number of such mortgages that could be originated. On the other side of the market, the innovations associated with securitization became technologies that allowed the production of massive numbers of bonds out of mortgages and other financial assets that seemed too different for such treatment.

By 2000, all of the product, process, and market innovations that structured the mortgage securitization industry were in place. The largest financial insti­tutions in the country were operating in many product markets, across many states, and with a great deal of volume. As was documented in Chapter 3, the great surprise in all of this was that the main product that could be counted on to attain the scale necessary to keep financial institutions growing was the mortgage securitization industry. And the main organizational vehicle for all of this was vertical integration, whereby banks controlled or owned mortgage originators, ran investment banking units that produced mortgage-backed secu­rities, sold these securities to investors, and bought these securities for their own accounts. All of this was done using borrowed money.

This business model and the system that had been built to support it proved to be one of the most profitable of all time. The first eight years of the twenty-first century witnessed a dramatic rise in the use of this new structure as the housing refinance boom of 2001-2004 increased the origination market from about $1.5 trillion to almost $4 trillion. This opportunity brought the mortgage securitiza­tion industry to dominate not just the financial sector but the whole economy. Banks from around the world came to participate in this feeding frenzy. The financial sectors of many of the largest, most developed countries in the world, including Great Britain, France, the Netherlands, Germany, Ireland, Iceland, and Switzerland came to share in the profits generated by the mortgage securitization industry.