Vertical Integration Explored

The expansion of the nonconventional market promoted the final integration of the industrial model. The investment banks that had not already purchased originators began acquiring nonconventional originators aggressively after 2003 in a bid to feed their securitization machines (McGarity, 2006; J.

The vertical integration of mortgage finance was spurred on by the desire of banking entities to control the mortgages from the point of origination to their ultimate sale. Jonathan Levine (2007: 59) concludes, “Why have the Wall Street firms so aggressively embraced this vertical integration strategy? The answer is to protect and leverage their returns from their mortgage underwriting and se­curitization desks. In fact, revenues from the fixed income divisions currently represent the largest components of the revenue mix for commercial and invest­ment banks.”

This analysis comports with the contemporaneous rationales voiced by ex­ecutives of the leading players. Anthony Tufariello, head of the Morgan Stan­ley's Securitized Products Group, suggested in a press release distributed when Morgan Stanley bought mortgage originator Saxon Capital that “the addition of Saxon to Morgan Stanley's global mortgage franchise will help us to capture the full economic value inherent in this business.

Dow Kim, president of Merrill Lynch's Global Markets Investment Banking group, made the very same point in announcing the acquisition of First Franklin, one of the largest nonconventional originators in 2006: “[Franklin's] leading mort­gage origination and servicing franchises will add scale to our platform This

transaction accelerates our vertical integration in mortgages, complementing the other three acquisitions we have made in this area and enhancing our ability to drive growth and returns” (Merrill Lynch, 2006). According to Jeff Verschleiser, then cohead of mortgage trading at Bear Stearns, “The key point to remember is that it's not just the buying that counts. It's the integration. Simply buying a mort­gage originator and having it operate in a stand-alone capacity without leveraging the infrastructure of your institution is not something I would consider vertical integration.” In short, executives at the core of the industry expressed a common­ality in espousing an explicit orientation toward vertically integrated production of MBSs. Backward integration allowed them to secure raw product and scale up throughput to the lucrative securitization desks.

What was driving this process was the increased demand for low-risk, relatively high-return financial instruments—that is, MBSs and CDOs. There was simply an almost unlimited market for AAA-rated securities that yielded 2-3 percent more interest than government bonds in an era of low interest rates and low returns on government bonds. Nonconventional mortgages provided an important bonus for both originators and securitizers: they generated more fees for origination and al­lowed lenders to charge higher rates of interest. This meant that MBSs and CDOs could be AAA rated with higher returns, which of course made them even more attractive to investors.

I think we've had a presentation of the secondary market as mere passive, you know, purchasers of loans, that it's really the originators who decide the loan. But if you talk to people on the origination side, they'll tell you the complete opposite. They'll say, you know, our underwriting criteria are set by the secondary market. They tell us what kind of loans they want to buy. They tell us what underwriting criteria to use. And that's ahat we do because we are selling to them.

William Dallas, CEO of bankrupt mortgage seller Ownit, which was partially owned by Merrill Lynch, told the New York Times, “Merrill Lynch told me we should offer more low documentation loans in which the borrower's income is not verified. They wanted these loans because they could make more money off of them. They told me that if we did not provide these loans, we would forego profits” (New York Times, 2007a).

It is useful to see how the opportunity presented by the growth of the noncon- ventional market was taken up by the twenty-five largest financial institutions in the country. In 1998, only four of the twenty-five largest financial firms in the country were in the top twenty-five of any of the segments of the nonconvention­al MBS market. By 2006, fourteen of the twenty-five (56 percent) were involved in the nonconventional MBS market. The opportunities to make money in the nonconventional food chain were so large that a massive number of the largest financial firms could not resist. Fligstein and Goldstein (2010) also show that these same firms became vertically integrated into the nonconventional mort­gage market segments by buying originators and extending their activities to the production and servicing of these loans. In 2002, only 25 percent of these firms had these large commitments to nonconventional mortgages and participated in three or four segments in that market. But by 2006, this had risen to 45 percent. In 2002, nearly 40 percent of these firms participated in only one segment of the market, and by 2006, this had fallen to less than 20 percent.

In the face of the expanding nonconventional mortgage market, the largest financial firms—major investment, mortgage, savings and loan, and commer­cial banks—dramatically increased their operations in those markets and came to participate in multiple segments of those markets. Those markets proved so lucrative that financial firms of all kinds would originate mortgages, act as un­derwriters for bonds based on those mortgages, find customers for those bonds at home and around the world, and use the low interest rates available in the ABCP market to profit from holding a portion of those bonds themselves on their trading books.