The Great Expansion of Mortgage Securitization andthe Eventual Crisis, 2001-2008

By the turn of the twenty-first century, the mortgage-backed securities business was increasingly dominated by a smaller and smaller set of big players. The largest commercial banks, mortgage banks, and investment banks had begun extending their reach both backward to mortgage origination and forward to underwriting and servicing.

The GSEs would purchase the services of an underwriter to turn the mortgag­es into MBSs. The GSEs would then either have the underwriter sell the MBSs

or buy them for its own account. Frequently, the GSEs also used outside ser­vicers for their loans when packaged. Many of the banks that did business with the GSEs were large commercial banks. They would sell the mortgages they had originated to the GSEs and then act as underwriters for the bond process. They would then frequently buy the MBSs and hold on to them in their own invest­ment portfolio. They would borrow money to buy those bonds, thereby freeing up their money to go out and make more loans.

An astute reader would wonder why the banks sold their loans to the GSEs at all. After all, if the purpose of vertically integrated production of MBSs was to make fees, bringing in a middleman would dilute those fees. To understand why some fees were foregone, one needs to understand the role of the GSEs in the market. The GSEs essentially served two purposes. First, because they bought the mortgages and packaged them into MBSs, the eventual buyers of the bonds felt that at the end of the day, the federal government stood behind the integrity of the bonds (Ranieri, 1996).

The central role of the GSEs in the mortgage market had been changing throughout the 1990s as nonconventional mortgages grew as a share of the mar­ket. The GSEs were legally restricted in their ability to issue MBSs for noncon- ventional mortgages, and the increasing growth of that market gave financial institutions the incentive to enter into underwriting and issuing their own MBSs. From 1990 to 2003, the share of conventional mortgages as a total of all origina­tions remained high, about 70 percent. But beginning in 2003, this changed, and by 2006, 70 percent of loans were nonconventional. In 2005 and 2006, the peak years of the nonconventional market, financial firms issued $1 trillion of non­conventional MBSs, up from only $100 billion in 2001. This shift in the market brought the integration process into its final phase. In essence, because the GSEs could not package MBSs from nonconventional loans until 2006, a lucrative op­portunity opened up for financial firms. They seized this opportunity and made spectacular profits as they rode the market up.

Beginning in 2001, the overall mortgage origination market began to take off, increasing from $1 trillion a year in 2001 to almost $3.8 trillion in 2003.

But the creation of these securities required that buyers exist to hold on to them. Given the rapid increase in their availability, one is led to ask, who wanted so many of these securities and why? The low-interest-rate environment also affected investors, as it meant that the safest securities, US Treasury bonds, paid very low returns. This caused investors to seek out safe investments that paid higher returns. This phenomenon was affecting not just American investors. In­vestors from around the world, most notably Japan and western Europe, were seeking out higher returns on safe investments as well. The investment they all discovered was American MBSs. The demand for AAA-rated MBSs in a low-in­terest-rate environment was nearly infinite. Banks who had integrated made massive amounts of money originating mortgages and made even more as they sold the securities that they created to investors, who had insatiable appetites for their products.

The same banks that originated and securitized mortgages were also likely to see that holding on to some of these securities would allow them to reap large and safe profits as well. For example, commercial banks had been investing in MBSs since the early 1990s. Financial institutions turned to the short-term cred­it markets, which have become known as shadow banking, to borrow money cheaply to buy MBSs. Here, they would borrow money using the MBSs as collat­eral for that money, often a portion of the same MBSs they were themselves pro­ducing.

What remains to explain is why the nonconventional market took off in 2004. After a record year in 2003, the mortgage securitization industry experienced a supply crisis in 2004. In 2004, the drop-off in new mortgages was severe, with monthly origination volumes declining over 70 percent from $200 billion in Au­gust 2003 to under $60 billion a year later. Several factors were at play, including a slight uptick in interest rates from their historic lows. But the foremost cause was that the 2003 refinancing boom had run its course. Of the $3.8 trillion of new mortgages written in 2003, S2.53 trillion (about two-thirds) was attributable to refinancing as borrowers took advantage of low rates.

The precipitous drop in mortgage originations posed a major source of con­cern for industry actors given that the dominant business model was based on high throughput. Interest rates were still relatively low, and there still existed a large demand for MBSs from investors. Moreover, originators had grown their operations and needed new markets for their suddenly excess capacity. As an editorialist in the Mortgage Bankers Association trade newsletter wrote, “Mort­gage originators who geared up their operations to capitalize on the boom now face a dilemma. Given a saturated conforming market that is highly sensitive to interest rates, where can retail originators turn for the new business, they need to support the organizations they have built?” (Mortgage Banking, 2004).

Concerns about the raw mortgage supply reverberated down the value chain. Barclays Capital researcher Jefll Salmon noted in May 2004 that “the recent dearth of supply has caught the [secondary] market off guard” (Asset Securitization Re­port, 2004b).

Countrywide Financial was one of the most successful beneficiaries of this shift, and they became a model that other firms emulated in order to profit from nonprime lending. Their annual report boasted, “Countrywide's well-balanced business model continues to produce strong operational results amidst a tran­sitional environment. Compared to a year ago, the total mortgage origination market is smaller as a result of lower refinance volume. This impact has been mitigated by Countrywide's dramatic growth in purchase funding and record volumes of adjustable rate, home equity, and nonconventional loans” (Country­wide Financial, 2005).

The rapidity with which the main players reoriented toward nonconventional lending and securitization after 2003 is dramatic. By 2005, the nonconventional mortgage market had been rapidly transformed into the core business for the largest financial institutions in the country. Nonconventional origination and securitization turned out to be enormously profitable. According to a study by the consulting firm Mercer Oliver Wyman, nonconventional lending account­ed for approximately half of originations in 2005 but over 85 percent of profits (Mortgage Servicing News, 2005). Commercial banks, mortgage banks, and in­vestment banks learned to profit from nonconventional MBSs in multiple ways simultaneously, earning money from both fees on MBS production and invest­ment income on retained MBS assets. They could fund both the production and the investment with cheap capital, which meant enormous profit margins.

In sum, the shift toward nonconventional markets was caused by both a crisis and an opportunity. The crisis was the decline of the prime market for mortgages that began in 2004.

The reader should by now understand why the banks were unable to shut down their securitization machines when house prices stopped rising and mortgage origination slowed. They had grown so fast and were so profitable that their entire business models and organizational structures were based on the throughput of massive numbers of mortgages. As conventional mortgages dried up, they rapidly expanded the nonconventional mortgage market. When that market was exhaust­ed, they continued to look for customers and issued mortgages to any household, even those with poor credit and little chance to pay back the mortgages.

One of the ways they were able to do so was by massively expanding the supply of adjustable-rate mortgages so that poorly qualified customers could buy homes with artificially low payments for one to three years. They also took low-rated securities that they could not sell and repackaged them into new secu­rities, which allowed them to create more AAA tranches. When what appeared to be changes in the competitive conditions got bumpy, they pushed harder to keep their market shares by making riskier and riskier loans and producing more and securities of dubious quality. They stayed the course in the hope they would weather the storm.

One reason that regulators have had such a hard time understanding what happened was that when the end came, it was not because there was an obvious failure of the entire business model of vertical integration. The part of the busi­ness model that failed was the banks borrowing to invest in MBSs. The prox­imate cause of the crisis was that banks found themselves holding on to large amounts of MBSs that they were not able to liquidate at prices that would allow them to pay that money back. What regulators have failed to consider is why the banks were holding on to such a significant amount of MBSs in the first place.

This occurred only because the banks had been committed to vertical integra­tion. They might have been able to unload some of those securities as prices fell if all they were doing was selling off investments where they were losing money. But since they were committed to the production of mortgages and MBSs, they were unlikely to do anything to sell off the MBSs they held, because their busi­ness models were predicated on keeping the process going.

In essence, the degree to which this business model of banks had joined the fortunes of the housing market to the fortunes of the financial market was invis­ible to the regulators. That these two huge markets were now integrated through the activities of the biggest and most important banks in the country meant that the unwinding of the housing part of the model did not warn regulators of the dangers in the financial markets. Similarly, the troubles of some of the banks, such as Bear Stearns, were not easily traceable to their positions in the housing market. Bear Stearns appeared to be a simple case of traders who had borrowed too much money and could not cover their investments. The size of the con­nection and the high degree of leverage in the system meant that when the end came, it quickly spread across the largest integrated banks.