The Creation Process Of Mortgage-Backed Securities Explained

The creation of mortgage-backed securities (MBS) played a significant role in the 2007-2008 financial crisis, with key figures such as Lewis Ranieri being dubbed as one of the 25 people to blame by Time magazine. MBS are a type of investment where mortgages are packaged and sold, removing market risk for lenders as they no longer hold the debt for the entire loan term. The practice of securitization, championed by Ranieri, spread rapidly through the financial world, leading to federal government recognition of MBS as a valid investment class. This, in turn, contributed to the development of the bond market and the housing bubble.

The role of Lewis Ranieri

Lewis Ranieri is considered the '"father" of mortgage-backed securities and co-founded mortgage-backed securities with Anthony J. Nocella, the former CEO of Franklin Bank. He played a key role in their emergence in the 1970s during his time at Salomon Brothers, where he rose to the position of vice-chairman.

In 1968, the 21-year-old Ranieri started working in the mail room of Salomon Brothers. In the late 1970s, he joined the company's new mortgage-trading desk, where he helped create the innovative practice of securitization, a term he is said to have coined. Securitization refers to the bundling of home loans by Wall Street firms, which were then sold to institutional investors. Ranieri's role was to sell these bonds, but he did much more, creating a market for MBS trading and winning Washington lobbying battles to remove legal and tax barriers.

Ranieri also played a role in creating the collateralized mortgage obligation (CMO), another complex repackaging of debt. He bought mortgages from one savings and loan (S&L) association and sold them to another, allowing Wall Street to profit from the spread. In 1983, he and Larry Fink of First Boston created the CMO, attracting institutional investors to the market. In 1984, Congress passed the Secondary Mortgage Market Enhancement Act (SMMEA), which allowed private banks to sell mortgage-backed securities without a government guarantee. This led to the development of the bond market.

Despite his success, Ranieri faced strong criticism for his role in the subprime mortgage crisis of 2007-2009. He was named by Time magazine as one of the "25 people to blame for the financial crisis". However, in a 2018 Wall Street Journal interview, Ranieri expressed regret for how his creation of packaging mortgages into securities impacted Americans during the subprime lending crisis.

The Financial Services Moderation Act

MBS are bonds backed by the principal repayment component of property owners' mortgage payments. They are created when a bank or investment institution bundles together a group of mortgages with similar characteristics. This bundle is then put into a Special Purpose Vehicle (SPV) or Special Investment Vehicle (SIV), which markets the MBS to investors.

Despite the risks associated with MBS, the market remains highly active due to the high liquidity of these securities. MBS allow mortgage originators to replenish their funds and offer a more efficient and lower-cost source of financing compared to other bank and capital market alternatives. They also enable issuers to diversify their financing sources and improve financial ratios by removing assets from their balance sheets.

In summary, the Financial Services Moderation Act played a significant role in the creation and proliferation of MBS by allowing banks to create and sell these securities. While MBS have provided benefits to the mortgage and banking industries, they have also been associated with increased risks and regulatory challenges.

The Glass-Steagall Act

The Act was officially repealed in 1999 by the Gramm-Leach-Bliley Act, which allowed banking institutions to create and deal in mortgage-backed securities freely. This repeal is considered influential in encouraging the subprime mortgage crisis of 2008 and the subsequent global financial crisis. Many economists believe that the repeal led to increased risk-taking and speculative activities, including the rise in subprime lending. However, others argue that the crisis had multiple causes, and the repeal of Glass-Steagall was only one contributing factor among many.

The impact of the 2008 financial crisis

The 2008 financial crisis, also known as the subprime mortgage crisis, had a significant impact on the global economy and led to a severe economic recession. The crisis was caused by a combination of factors, including the collapse of the US housing market, high-interest rates, and the securitization of bad loans in the form of mortgage-backed securities (MBS).

One of the main impacts of the 2008 financial crisis was the loss of jobs and businesses. Millions of people lost their jobs as businesses struggled to stay afloat, with many eventually going bankrupt. This led to a decrease in consumer and corporate confidence worldwide, as people became concerned about the stability of the financial system. The US government intervened with measures such as the Troubled Asset Relief Program (TARP) and the American Recovery and Reinvestment Act (ARRA) to stabilize the financial system and provide relief to struggling individuals and businesses.

The crisis also had a significant impact on the housing market. As more borrowers defaulted on their mortgage payments, foreclosures increased, leading to a decline in housing prices. This placed downward pressure on homeowners' equity, as their homes became worth less than the mortgages they had taken out. By September 2008, average US housing prices had declined by over 20% from their mid-2006 peak, leading to a situation where many borrowers had zero or negative equity in their homes.

The decline in mortgage payments also reduced the value of mortgage-backed securities, which had a detrimental effect on the financial health of banks and other financial institutions. This created a vicious cycle, as the decline in the value of mortgage-backed securities further eroded the net worth of banks, leading to a downward spiral in the financial system.

The creation of collateralized mortgage obligations (CMOs)

Collateralized Mortgage Obligations (CMOs) are a type of mortgage-backed security (MBS) that contains a pool of mortgages bundled together and sold as an investment. They are often referred to as "pay-through bonds", which are typically divided into classes based on their maturity and risk profiles. CMOs are complex financial instruments that consist of several tranches or groups of mortgages, organised by their risk profiles. The risk profiles are determined by factors such as the credit scores of borrowers, their monthly debt, and interest rates.

CMOs are created by first purchasing a pool of mortgages with similar characteristics, such as credit score or loan amount. These mortgages are then packaged together into a single investment vehicle, known as a security. The security is then sold on the secondary market to investors, who become lenders to the property owners. As the property owners repay their mortgages, the investors receive payments from the principal and interest at a set schedule.

CMOs are considered passive real estate investments as they enable investors to buy residential mortgage loans with lower risk compared to other investment options such as REITs, house-flipping, or becoming a landlord. Investors in CMOs are typically large financial institutions, such as hedge funds, banks, insurance companies, and mutual funds. By investing in CMOs, these institutions can access the cash flows from mortgage repayments without directly buying or selling individual home loans.

The creation and proliferation of CMOs played a significant role in the 2008 financial crisis. Rising housing prices made CMOs appear as fail-proof investments, attracting many investors. However, the high number of subprime mortgages and adjustable-rate mortgages within these CMOs led to a significant increase in foreclosures and payment risks, resulting in losses for investors and contributing to the global financial crisis.

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