All The Devils Are Here: Unmasking the Men Who Bankrupted the World Read Online Free
Author: Joe Nocera, Bethany McLean
transferring the interest rate risk from the S&Ls to a third party: investors. Soon, Freddie was using Wall Street to market its securities. Volume grew slowly. It was not a huge success.
Though a thirty-year fixed mortgage may seem simple to a borrower, mortgages come full of complex risks for investors. Thirty years, after all, is a long time. In the space of three decades, not only is it likely that interest rates will change, but—who knows?—the borrowers might fall on hard times and default. In addition, mortgages come with something called prepayment risk. Because borrowers have the right to prepay their mortgages, investors can’t be sure that the cash flow from the mortgage will stay at the level they were expecting. The prepayment risk diminishes the value of the bond. Ginnie and Freddie’s securities removed the default risk, but did nothing about any of these other risks. They simply distributed the cash flows from the poolof mortgages on a pro rata basis. Whatever happened after that, well, that was the investors’ problem.
When Wall Street got into the act, it focused on devising securities that would appeal to a much broader group of investors and create far more demand than a Ginnie or Freddie bond. Part of the answer came from tranching, carving up the bond according to different kinds of risks. Investors found this appealing because different tranches could be jiggered to meet the particular needs of different investors. For instance, you could create what came to be known as stripped securities. One strip paid only interest; another only principal. If interest rates declined and everyone refinanced, the interest-only strips could be worthless. But if rates rose, investors would make a nice profit.
Sure enough, parceling out risk in this fashion gave mortgage-backed securities enormous appeal to a wide variety of investors. From a standing start in the late 1970s, bonds created from mortgages on single-family homes grew to more than $350 billion by 1981, according to a report by the Securities and Exchange Commission. (By the end of 2001, that number had risen to $3.3 trillion.)
Tranching was also good for Wall Street, because the firms underwriting the mortgage-backed bonds could sell the various pieces for more money than the sum of the whole. And bankers could extract rich fees. Plus, of course, Wall Street could make money from trading the new securities. By 1983, according to
BusinessWeek
, Ranieri’s mortgage finance group at Salomon Brothers accounted for close to half of Salomon’s $415 million in profits. Along with junk bonds, mortgage-backed bonds became a defining feature of the 1980s financial markets.
Tranching, however, was not the only necessary ingredient. A second important factor was the involvement of the credit rating agencies: Moody’s, Standard & Poor’s, and, later, Fitch Ratings. Ranieri pushed hard to get the rating agencies involved, because he realized that investors were never going to be comfortable with—or, to be blunt, willing to work hard enough to understand—the intricacies of the hundreds or thousands of mortgages inside each security. “People didn’t even know what the average length of a mortgage was,” Ranieri would later recall. “You needed to impose structures that were relatively simple for investors to understand, so that they didn’t have to become mortgage experts.” Investors understood what ratings meant, and Congress and the regulators placed such trust in the rating agencies that they had designated them as Nationally Recognized Statistical Ratings Organizations, or NRSROs. Among other things, the law allowed investors whoweren’t supposed to take much risk—like pension funds—to invest in certain securities if they had a high enough rating.
Up until then, the rating agencies had built their business entirely around corporate bonds, rating them on a scale from triple-A (the safest of the safe) to triple-B (the bottom rung of what
Though a thirty-year fixed mortgage may seem simple to a borrower, mortgages come full of complex risks for investors. Thirty years, after all, is a long time. In the space of three decades, not only is it likely that interest rates will change, but—who knows?—the borrowers might fall on hard times and default. In addition, mortgages come with something called prepayment risk. Because borrowers have the right to prepay their mortgages, investors can’t be sure that the cash flow from the mortgage will stay at the level they were expecting. The prepayment risk diminishes the value of the bond. Ginnie and Freddie’s securities removed the default risk, but did nothing about any of these other risks. They simply distributed the cash flows from the poolof mortgages on a pro rata basis. Whatever happened after that, well, that was the investors’ problem.
When Wall Street got into the act, it focused on devising securities that would appeal to a much broader group of investors and create far more demand than a Ginnie or Freddie bond. Part of the answer came from tranching, carving up the bond according to different kinds of risks. Investors found this appealing because different tranches could be jiggered to meet the particular needs of different investors. For instance, you could create what came to be known as stripped securities. One strip paid only interest; another only principal. If interest rates declined and everyone refinanced, the interest-only strips could be worthless. But if rates rose, investors would make a nice profit.
Sure enough, parceling out risk in this fashion gave mortgage-backed securities enormous appeal to a wide variety of investors. From a standing start in the late 1970s, bonds created from mortgages on single-family homes grew to more than $350 billion by 1981, according to a report by the Securities and Exchange Commission. (By the end of 2001, that number had risen to $3.3 trillion.)
Tranching was also good for Wall Street, because the firms underwriting the mortgage-backed bonds could sell the various pieces for more money than the sum of the whole. And bankers could extract rich fees. Plus, of course, Wall Street could make money from trading the new securities. By 1983, according to
BusinessWeek
, Ranieri’s mortgage finance group at Salomon Brothers accounted for close to half of Salomon’s $415 million in profits. Along with junk bonds, mortgage-backed bonds became a defining feature of the 1980s financial markets.
Tranching, however, was not the only necessary ingredient. A second important factor was the involvement of the credit rating agencies: Moody’s, Standard & Poor’s, and, later, Fitch Ratings. Ranieri pushed hard to get the rating agencies involved, because he realized that investors were never going to be comfortable with—or, to be blunt, willing to work hard enough to understand—the intricacies of the hundreds or thousands of mortgages inside each security. “People didn’t even know what the average length of a mortgage was,” Ranieri would later recall. “You needed to impose structures that were relatively simple for investors to understand, so that they didn’t have to become mortgage experts.” Investors understood what ratings meant, and Congress and the regulators placed such trust in the rating agencies that they had designated them as Nationally Recognized Statistical Ratings Organizations, or NRSROs. Among other things, the law allowed investors whoweren’t supposed to take much risk—like pension funds—to invest in certain securities if they had a high enough rating.
Up until then, the rating agencies had built their business entirely around corporate bonds, rating them on a scale from triple-A (the safest of the safe) to triple-B (the bottom rung of what
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