Written by Hrishikesh Menon, Edited by Swastik Patel
Mortgage-backed securities or mortgage bonds are one of the greatest financial inventions of the 80s. It has revolutionized the bond market and also almost brought the entire U.S financial system down due to its abuse. There are two main eras we will focus on in the history of mortgage bonds: the 80s and late 2000s.
Freddie Mac and Fannie Mae
After the Great Depression, many changes and additions were made to the financial markets, one of them being the establishment of Freddie and Fannie, federally backed home mortgage companies. To avoid another housing market collapse and maintain stability and liquidity in the mortgage market, Freddie and Fannie would buy mortgages from lenders (usually banks), pool them, and securitize it to sell to investors. The money made by the lenders would then be used to make more mortgages. In 1971, Freddie issued its first mortgage security called a mortgage pass-through. It was called a pass-through because the interest payments made by the mortgage holder would “pass through” to the buyer of the security. The product had been invented but no one saw the value in it except a certain Salomon Brothers trader.
Lewis S. Ranieri was not a particularly talented or ambitious kid. He wanted to be a chef but a medical condition kept him from pursuing that. He initially dropped out of college but went back to finish his bachelors and got a job in the Salomon Brothers mailroom in his early 20s. He would eventually become Vice President of the investment bank. As a young trader, he was assigned to the mortgage trading department which at the time was very small and brought in little to no money. This is where Ranieri first visualized the securitization of mortgages into bonds. During the early 80s, Savings & Loans (also known as thrifts) were suffering due to high inflation and Fed rates being extremely high. Ranieri swooped in and convinced these thrifts to let Salomon Brothers pool their mortgages and sell them as bonds to other thrifts. Since the thrifts would make money from the interest payments from mortgage holders and also by selling their mortgages to Salomon, they soon agreed and were under the influence of Salomon and Ranieri’s mortgage department. The only obstacle they had was overturning federal securities regulations and legalizing mortgage-backed securities across the country and thanks to President Reagan’s neo-liberal approach, Ranieri overcame that obstacle with ease. In 1987, Ranieri was fired as his mortgage department had become so successful it was almost operating as its own business within Salomon, but unfortunately other investment banks had caught on to the mortgage frenzy and Salomon started bleeding mortgage men and eventually eliminated the department. By the time Ranieri was gone, the MBS market had ballooned up to $150 billion. Even though the mortgage frenzy came to an abrupt end at Salomon Brothers, it was only beginning in every other bank.
Party until ‘08
The mortgage market only continued its meteoric rise after the 80s until the horrific financial crash of 2007-08. The credit business had loosened so much that mortgages were being given out to virtually everyone just so the big banks could sell more mortgage securities. By early 2000s the MBS market was valued up to $2 trillion and no one saw the imminent danger until the damage was already done. When the ineligible mortgage holders began defaulting on their interest payments in masses, banks such as Lehman Brothers, AIG, Bear Stearns, etc, began to collapse as they were now holding tens of billions of worthless mortgage bonds with no one to dump it onto. Many of the banks were bailed out by the government but Lehman Brothers, along with others, fell and the markets crashed. Since then, President Obama implemented many sweeping regulations with his Dodd-Frank Act, which stabilized the mortgage security market. The MBS market still exists today and has actually increased in value to around $11 trillion but the frenzy has died and may never return due to the new regulations.
One of the greatest financial inventions in the history of US financial markets has aided the revolution of securitization and also brought a lot of evil to the financial system. Freddie Mac and Fannie Mae are organizations created by the government after the Great Depression to stabilize the mortgage market. These two organizations pool mortgages and sell them to investors. Lewie Ranieri, known to be the father of mortgage backed securities, securitized mortgages and revolutionized the bond market. The mortgage market boomed for many decades until 2008 when the speculation and misuse of the product led to near evaporation of the US financial system. Government intervention and regulations stabilized the market and made sure that such misuse would not occur again.