Most people think of innovation in the economy as being fundamentally about the production of new products.

But innovation requires not just products but also new kinds of organizations and new processes that allow new products to be produced, marketed, and regulated (Engelen et al., 2010).

In the case of mortgage finance, we have seen both sorts of innovations. The collapse of the banking system during the Depression of the 1930s created the opportunity for an entirely different kind of mortgage market with the assistance of the government. The crisis of the 1970s brought about changes in the rules in the market and a new set of products. These changes were favored by the in­cumbent savings and loan banks and agreed to by the government. When these changes did not work out and the entire industry cratered, it was swept away by a whole new way of doing mortgages, mortgage securitization. This innovation required a couple of waves of change beginning with the emergence of the GSEs in the late 1980s and later the vertically integrated private banks in the 1990s.

The innovations to create mortgage securitization were breathtaking. They required whole new kinds of organizations (the GSEs and later the vertically in­tegrated banks), whole new sets of regulations and regulators, the linking of dis­parate markets that came to supply inputs in the process of producing mortgage securities, the creation of a huge number of new processes to originate mort­gages and turn them into securities, and a plethora of new financial products, both new kinds of mortgages and new kinds of securities and other financial instruments, the output of all of this innovation. All of this was part and parcel of what financial economists saw as a massive wave of financial innovation in the 1980s. At the core of this wave was the process of securitization. Not all financial innovation was restricted to the mortgage securitization industry, but a huge amount of it was.

In the world of 1975, there was only a single kind of mortgage product, the thirty-year fixed-rate mortgage with a 20 percent down payment, which is called the conventional or prime mortgage. This product was embedded in a set of organizations and processes that had been financial innovations when they were set up in the Great Depression of the 1930s in order to resuscitate the mortgage market. The conventional mortgage was invented by the Federal Housing Ad­ministration. The savings and loan industry was built up around this product.

But the production of conventional mortgages required a set of supporting institutions and processes. The business model of the savings and loan industry relied on local funding to support their granting of conventional mortgages. The banks were able to take deposits at a fixed interest rate from local savers, loan them long term in the local community at a higher fixed interest rate, and make money by holding on to the mortgages they issued. The FDIC and the FSLIC act­ed to insure the stability of individual banks and prevent cutthroat competition by not allowing banks to compete over deposits or loans.

But the bad economic times that began in the late 1960s and accelerated in the 1970s undermined all of the Depression-era market innovations. By 1980, the government became convinced by the financial services industry that its sur­vival depended on changing the models inherited from the Great Depression. Through a set of regulatory changes, the 1980s was the most sustained period of financial innovation since the 1930s, and much of that innovation centered on the emergence of the mortgage securitization industry (Frame and White, 2012; Greenwood and Scharfstein, 2013). These opportunities created an avalanche of new products, which themselves required new processes to produce, and the rise of new forms of organization. I have already described the rise of the GSE and the emergence of the vertically integrated financial institution focused on the origination of mortgages and the production of mortgage securities. In this chapter, I take up in more detail the nature of these new products and the myriad processes necessary to produce them. Many of these innovations were entirely new. Some built on what already existed but was repurposed to new uses to sup­port the mortgage securitization model.

The shift to the mortgage securitization model reconfigured who was a player in the mortgage industry and also retooled the government's role in the market. The GSEs took up the role of coordinating the market and finding private capital to fund mortgages. The banks that participated in this reorganized market were drawn from all parts of what had previously been a segregated banking market. Investment banks, commercial banks, and new forms of mortgage banks all were attracted to the market built around mortgage-backed securities because it was so large, presented many opportunities to earn lucrative fees, produced massive numbers of financial instruments that produced excellent returns for the riski­ness of the bonds, and thereby had the potential of large profits.

This massive shift in the organization of the mortgage market was accom­panied by a more general deregulation of the financial system. The barriers be­tween the types of banks eroded both across states and across functional types. Politicians and regulators bought into the idea that banks should be bigger and more diversified in order to be more efficient. The largest banks, such as Citi­bank, led a political campaign to push this process along. To preserve their priv­ileges, politicians who had previously been under the sway of local and statewide banks, particularly savings and loan banks, ultimately bought into the logic of bank deregulation when the savings and loan industry began to tank.

This era of financial deregulation ushered in all sorts of financial product in­novation. Deregulation allowed banks of all kinds to search out new products and processes and create new forms of organizations in order to deal with the 1970s crisis of high inflation and high interest rates. The crisis affected not just the savings and loans but the business models of commercial and investment banks as well. For the savings and loan banks, the issue was, how would they find capital to make house loans if interest rates on savings accounts were low and fixed? Equally important, how would households afford mortgages if interest rates produced very high monthly payments? With high interest rates, business­es turned from using their local commercial banks for capital to either generat­ing their funds internally or going to the broader credit markets for cheaper rates and less meddling. This created an existential crisis for commercial banks, whose main line of business was threatened (Davis and Mizruchi, 1999). Who would commercial banks loan to, and how would they make money? With the stock market in the doldrums in the 1970s, investment banks too were experiencing some chaotic times. They were on the lookout for new products and markets that would rely on their ability to create and sell debt instruments.

The crisis in banking produced three sorts of innovations. First, new products would be needed to attract both investors and borrowers. In the case of mortgag­es, borrowers were offered a plethora of new types of mortgages, including ad­justable-rate mortgages (ARM), mortgages with smaller down payments, jumbo loans, mortgages with both shorter and longer terms, home equity loans, and mortgages for households with less-than-stellar credit (what became subprime mortgages).

But the most important product innovation was securitization (Carruthers and Stinchombe, 1999; Carruthers, 2010). By taking loans and turning them into bonds, banks could break up and spread different kinds of financial risk and re­turn tailored to the needs of particular customers. These bonds were then rated by the ratings firms to provide information about their relative riskiness. Given the size of the market, ratings firms innovated models to provide these rankings and their rapid use to do the ratings. For those who needed safety more than return, AAA-rated securities were paramount. Lower-rated securities provided assets for those who could afford to hold riskier assets and get higher rates of returns. Banks used securitization to spread risk and found new classes of buyers for their securities.

Second, new industrial processes needed to be developed to deal with these new products. By industrial, I mean that in order to scale up to service the poten­tial size and complexity of the mortgage market, there needed to be large-scale methods of processing mortgages, first in origination, then into securities, and finally into portfolios of those who would hold them. The industrial production of mortgages required creating new software systems to aid the processing of mortgage applications and the creation of securities by the tranching of bonds. It also required a new set of legal devices to house financial products and systems to create them and keep track of them. The mortgage servicing industry grew large and depended on computer power.

The provider of capital for these mortgages changed as well. Instead of small savers who had passbook accounts, banks began to go to capital markets di­rectly to raise money to fund mortgages. Structuring these relationships to pro­cess mass amounts of securities created a whole new set of processes. Because of securitization, these funds were usually borrowed for a short term, less than a year, and therefore had reasonable rates of interest. This created two sorts of new sources of funds, those who willingly lent banks money to fund mortgages and turn them into securities and those willing to hold on to those securities for a longer period.

Finally, these new processes and products required innovation in the nature of banks' organizational structures and the creation of new markets. By the early 1990s, financial institutions of all kinds realized that their future lay not in hav­ing long-term relationships with customers but instead in increasing the num­ber and scope of transactions. This led many financial institutions to want to get bigger to find more customers, speed along, and expand the number and kinds of transactions. Financial innovation that created the possibility of larger throughput of transactions was utilized to build bigger and bigger banks. Banks lobbied to go national in their ability to draw on customers and borrowers. As the rules governing ownership of banks changed across the country, banks set out to either buy banks in other states or set up new branches of existing banks. These larger banks also desired the ability to enter new kinds of product markets as opportunities arose. Larger banks pushed for the ability to diversify products, and the idea of the conglomerate or full-service bank became the mantra of the industry. In the case of the mortgage industry in the 1990s, as I have shown, banks became vertically integrated by incorporating the origination, securitiza­tion, loan servicing, and trading functions internally in their organizations.

The mortgage securitization industry was built from the ashes of the savings and loan model. The government had provided much of the infrastructure for securitization and had created the GSEs, without whom the mortgage securitiza­tion industry never would have formed. But private banks played an important part by first playing roles generated by the huge opportunities that mortgage securitization presented and later innovating new products and processes to ex­pand the industry and its product mix. The creation of the mortgage securitiza­tion industry is a marvel of capitalist innovation. With the help of the govern­ment, banks took pragmatic action to solve difficult problems to produce a new industry with profits like no one had ever seen.