Why Did Mortgage Securitization and the Vertical Integration of Banks Emerge?
This raises the question of why all of the banks converged on the mortgage securitization business as their main source of profit and the vertical integration of that business as their business model.
One only has to go twenty years earlier to the world of 1988, to find that savings and loan, commercial, mortgage, and investment banks were more specialized in particular businesses, smaller, and focused on different customers. Most of the customers who wanted to buy houses went to locally owned and managed savings and loan banks. These banks took in funds from the community, sold mortgages locally, and held on to the mortgages until the house was paid off or sold. Most households used the services of commercial banks for checking, savings, and loans for things like paying for home renovation, college, and cars. Commercial banks also focused on small and large businesses that came to them for banking services and loans. Only the largest corporations used the services of investment banks to issue corporate debt or engage in producing new stock issues. All of the investment banks were small and were organized as partnerships, not publicly held corporations, and their activities were concentrated in Manhattan where the stock and bond markets were located.Understanding how this fragmented financial system ended up focusing on mortgages, and more specifically mortgage securitization, is one critical piece of making sense of what happened. This requires delving into the history of the mortgage industry to understand how both crisis and opportunity shaped the business models of financial institutions. The process by which the mortgage securities industry emerged is a story that spans over five decades, with many twists and turns. Almost no one in the world of 1975 and very few in the world of 1985 would have predicted that mortgage securitization was ever going to become the dominant way that Americans would finance their mortgages.
Literally no one would have predicted that it would become the dominant business of all of the largest financial institutions and the central product around which the financial markets would be organized.To understand the crisis of 2007-2009, one needs to step back and understand the coevolution of home financing between the public and private sectors since the 1960s. Until the 1980s, this process was relatively straightforward. Individuals would find a house. They would go to their local bank (most likely a savings and loan bank) and apply for a mortgage. The bank would agree to lend the funds and then hold on to the mortgage until it was paid off or the house was sold. During this historical period, the largest holders of mortgage debt were savings and loan banks. The laws and rules that governed this process were forged during the Great Depression of the 1930s.
Since the 1980s, however, this process has become increasingly complicated. Under the mortgage securitization model, the borrower goes to a lending company (frequently a bank, but not exclusively) that is called an “originator” because they make the initial loan. Unlike the original savings and loans banks, these companies use the mortgages as input into mortgage-backed securities. The “originator” makes their money from the fees that homeowners pay to get their mortgages and from selling the mortgages to issuers or underwriters, who turn the mortgages into securities. If originators hold on to the mortgages, then they are unable to lend money again, and their ability to generate fees goes away. So, they turn around and sell the mortgages, thereby recapturing their capital, and move back into the market to lend.
The mortgages are then packaged together into a legal device called a special purpose vehicle, which creates a subsidiary company whose entire assets consist of mortgages. This is used by issuers and underwriters to create a legal entity to create the bond. Issuers and underwriters are usually investment or commercial banks.
This vehicle turns the mortgages into a security that pays a fixed rate of return based on the interest rates being paid by the people who buy houses. The financial institutions who make these special purpose vehicles divide the mortgages into what are called “tranches,” which are claims on the cash flow generated by mortgage payments. Tranches have different amounts of risk, and the interest they pay depends on that risk.Bond rating agencies consider the mortgages in a security in terms of their risk of either prepayment or foreclosure. They then assign a rating to each of the tranches of the bond based on a model that predicts how likely the mortgagors in the tranche are to stop paying their mortgage. The highest-rated tranches (AAA) have the least likelihood of failure, and the lowest-rated (BBB) have the highest rate of failure. These bonds are sometimes referred to as mortgage-backed securities (MBSs), residential mortgage-backed securities (RMBSs), collateralized debt obligations (CDOs), or MBS-CDOs. In this way, investors can buy tranches of bonds that pay a higher rate of return if they are more risky or less risky bonds that pay a lower rate of return. The special purpose vehicles are managed by servicers, who act to collect the monthly mortgage payments and disburse them to the bondholder.
In the world of the early 1990s, each of these transactions could have been undertaken by a different bank. But by 2007, most financial institutions were involved in almost all phases of the securitization process. The main exception was the servicing industry, which remained the domain of more specialist firms, although most large banks also did some of their own servicing. Circa 1975, mortgages were owned mostly by local savings and loan banks and were highly geographically dispersed. By 1993, most mortgages migrated to a few square miles of Manhattan, where in the offices of the major banks and government-sponsored enterprises (GSEs) they were packaged into special purpose vehicles.
They then were redispersed to investors all over the world and serviced from a few locations. Investors are a heterogeneous group. The largest investors in these securities are the GSEs who hold on to lots of MBSs. But MBSs are held by banks, mutual funds, and private investors here and around the world.The interesting question is, how did we move from a world where the local buyer went to their local bank to get a loan to one where most of the mortgages in the United States are now packaged into MBSs and sold into a broad national and international market? The push away from the savings and loans model of mortgage origination to the mortgage securitization market is the story of the crisis in the business model of the savings and loan industry. The savings and loan industry came under severe financial pressure in the 1970s. Savings and loan banks asked the government to try to save them by removing the rules that had previously governed interest rates and deposit insurance. The federal government complied and deregulated the industry in the hope that savings and loan banks would survive. Savings and loan banks then entered businesses where they had less expertise and made risky loans. By the late 1980s, a huge percentage of them had failed. Many had been looted by executives who took advantage of the lax oversight to try to feather their own nests.
This disaster created the opportunity for a new form of mortgage market to emerge. It will surprise most readers that the origins of mortgage securities and the complex financial structure we just presented were not invented by the financial wizards of Wall Street but instead were invented by the federal government. It is probably even more surprising that this set of inventions dates back to the 1960s. The federal government has been involved in the mortgage market to some degree since at the least the 1930s. But the roots of the modern industry begin in the 1960s.
Quinn (2019) shows that the idea to create mortgage-backed securities began during the administration of President Lyndon Johnson.
The Democratic Congress and president had three goals: to increase the housing stock for the baby boomer generation, to increase the rate of homeownership, and to help lower-income people afford housing. Quinn presents evidence that the Johnson administration did not think the fragmented savings and loan industry was in the position to provide enough credit to rapidly expand the housing market. But federal officials interested in expanding homeownership did not want the government to get in the business of supplying and holding on to mortgages. Because of the Vietnam War and the Great Society expansion of Medicaid, Medicare, and other social benefits, the government was running large and persistent debts. An expensive housing program where the government provided funds for mortgages would add to the deficit, because the government would have to borrow money for the mortgages and hold those mortgages for up to thirty years.If the government was going to stimulate the housing market, the Johnson administration would need to do it in such a way as to not add to the federal deficit. This caused them to reorganize the Federal National Mortgage Association (later known as Fannie Mae or Fannie) as a quasi-private organization, called a government-sponsored enterprise or GSE, to lend money and hold mortgages. They also created a new entity, the Federal Home Loan Mortgage Corporation (Freddie Mac or Freddie) to compete with Fannie Mae. Both Fannie Mae and Freddie Mac eventually became publicly held corporations with the assumption that should problems emerge with the securities issued by these entities, the government would intervene to protect investors. The government also created a government-owned corporation to insure those mortgages against risk of default, the Government National Mortgage Association (Ginnie Mae or Ginnie).
But taking these mortgage entities private and thereby taking their transactions off the books of the federal government was not the only innovation of the Johnson administration.
The government also pioneered the creation of mortgage-backed securities (Sellon and VanNahmen, 1988). The government did not want the GSEs to ultimately hold the mortgages because this would limit how many mortgages they could originate. Instead, it wanted to use the capital the GSEs could raise to fund the mortgages and then offer the mortgages to investors as bonds. These bonds would be seen as backed by the “full faith and credit” of the federal government and therefore would be considered as low risk as treasury bonds. The GSEs began in the 1970s to offer and guarantee the first modern mortgage-backed securities (MBSs). These bonds were then being sold directly to investors by the GSEs or through investment banks (Barmat, 1990). The first mortgage-backed security was issued on April 24, 1970, by Ginnie Mae (Wall Street Journal, 1970).The private MBS market barely grew in the 1970s. There were several issues. The savings and loan industry continued to have control over the bulk of the mortgage market where they took deposits, lent money, and held on to mortgages. But potential buyers of mortgage bonds were skeptical of buying mortgage-backed securities because of prepayment risk. The problem was that if you bought such a bond, people might prepay the mortgage before the end of the mortgage term, and bondholders would get their money back before they made much of a profit. This was made worse by the fact that mortgage holders were more likely to refinance houses when interest rates were falling, thus leaving bondholders with money to invest at interest rates lower than the original mortgages (Kendall, 1996).
This problem was ultimately solved through cooperation between the GSEs and the investment banks. They created the system of tranching, described above, in order to let investors decide which level of risk of prepayment they wanted (Brendsel, 1996). But there were also legal and regulatory issues involved in the packaging of bonds (Quinn, 2019; Ranieri, 1996). The most important was the problem of turning a mortgage into a security. The issue of a loan originator selling the mortgage into a pool of mortgages required changing the tax laws. The Tax Reform Act of 1986 cleared the way to the rapid expansion of the MBS market.
The demise of the savings and loan banks was a fortuitous collapse that in the end hastened the growth of the MBS market. The general economic crisis of the 1970-1980s produced very high interest rates. Savings and loans banks relied on individual deposits for most of their funds. The regulation known as Regulation Q fixed the rate that savings and loan banks could pay on these deposits. Savers began to flee those accounts, and the savings and loan industry faced the crisis that they could not raise enough money to make new loans. Moreover, they were holding on to a large number of mortgages that were priced at very low interest rates. Congress responded by passing the Garn-St. Germain Act. They repealed Regulation Q and allowed the banks to pay whatever interest rate they chose. They also allowed the banks to make riskier investments while still guaranteeing very large deposits.
The banks responded in several ways. First, they began to sell their mortgage holdings at a great loss in order to raise capital. These mortgages were repackaged into MBSs by primarily Salomon Brothers (Lewis, 1990). They also began to pay high interest on interest rates on government-guaranteed bank accounts. They then made very risky investments including many in commercial real estate, which helped create a commercial real estate bubble. This caused their ultimate demise (Barth, 2004).
As the savings and loan industry collapsed, the question of how Americans would get mortgages became a political issue. The obvious solution to the problem was to push for the rapid expansion of the GSEs and the mortgage securitization process as the main mechanism by which mortgages were financed. The MBS market grew enormously in the late 1980s and the early 1990s as the savings and loans banks collapsed. In 1980, the GSEs had issued only $200 billion of mortgages. This grew steadily to a peak of $4 trillion in 2003. As late as 1978, the savings and loan banks held almost 65 percent of the mortgage debt in the United States. But beginning in the late 1970s, their market share plummeted. By 1990, less than 15 percent of mortgages were held by savings and loans. By 1990, 50 percent of mortgages were being packaged into MBSs. The GSEs also held on to 10 percent or so of the mortgages as investments. Thus, the GSEs were involved in the ownership and securitization of 60 percent of US mortgages.
The GSEs acted as middlemen in making the mortgage securitization market. They would buy mortgages from mortgage originators such as commercial banks, savings and loan banks, and mortgage wholesalers and brokers. They would then secure the services of one of the five investment banks to act as the underwriter of the bond and to help sell the bonds once they were produced. Many of these MBSs would end up in the investment portfolios of commercial and savings and loans banks. This is because the mortgage securitization process had allowed individual mortgages whose risk was difficult to assess to be packaged into bonds that had high ratings (AAA in many cases) and the implicit backing of the federal government. Banks could borrow capital cheaply to hold these bonds, and they were viewed as close to riskless. Since these bonds typically paid higher interest than US Treasury bonds, they made great investments.
When the mortgage securitization industry began to take off in the late 1980s, many of the commercial and investment banks were reluctant to participate in the creation of MBSs. Indeed, the GSEs at the beginning had a hard time convincing the other banks to participate. But by 1993, banks of all kinds began to realize that the new model for mortgages had replaced the savings and loan model. This created a huge opportunity to enter a large and lucrative business. The residential real estate market contained a huge number of transaction possibilities. Mortgage securities were safe investments that paid high rates of return, returns that appeared to be backed by the government. By 1993, mortgage, commercial, investment, and the remaining savings and loans banks pivoted to find a role in the new securitization structure. This usually meant acting as an originator, wholesaler, broker, issuer, underwriter, trader, or investor. By virtue of the fragmentation of the industry around 1993, no one controlled very much market share of any of the markets except for the GSEs. But this was about to change.