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Mortgage-Backed Securities: What Went Wrong?

Written By:
April 26, 2011 at 6:38 PM

In late 2004, Business Week magazine named Lewis S. Ranieri one of the “greatest innovators of the past 75 years.” The American Securitization Form also awarded Mr. Ranieri the Distinguished Industry Service Award. Ranieri, a college dropout, worked his way up from the Salomon Brothers' mailroom to a job at the firm's mortgage desk. He conceived of the idea of packaging mortgages into categories of 2-, 5- and 10-year- bonds and selling them to investors. Mr. Ranieri created the term “securitizing” when asked about the process

Early Mortgage Backed Securities

In 1977, Salomon Brothers collaborated with the Bank of America to offer the public the first mortgage-backed securities. Besides selling bonds, Ranieri lobbied policy makers for legal and tax issues for three years. In addition, he worked with the White House Office of Policy Development of the Regan Administration to help create the Mortgage Backed Securities capital market. When Ranieri testified to Congress in 1984, he said that homeowners would gain access to low cost loans and would save a ½ percent on interest rates. He also stated that credit rating services would protect Mortgage Backed Securities investors.

Even Fannie Mae and Freddie Mac, which were originally schedule for elimination under Reagan's plan to deregulate the markets, received permission from HUD to start securitizing loans. However, these government-sponsored enterprises only purchased mortgage loans baked with 10 to 20 percent down payments and borrowers with reliable sources of income.

How Mortgage-Based Securities Work

Some people refer to Mortgage Backed Securities as “asset-backed securities” because the investment is backed by mortgaged properties. Another name, “mortgage pass through,” refers to the mortgage payments “passed through” to security owners. Initially, mortgages were “AAA” rated bonds and provided investors with appealing risk/return profiles. Banks categorized mortgages by the quality of the borrowers' credit-- subprime, Alt-a and prime. “Alt-a” means the borrowers' credit rating fell between sub-prime and prime. This is how the basic process works:

  • Loan originators like banks, mortgage companies and savings and loans sell mortgages to investment banks, government, and quasi-governmental entities that pool the mortgages into a mortgage-backed security.
  • The investment bank sells shares of the Mortgage Backed Securities to investor by different bond classes and with various maturities.
  • The mortgage loans with the highest rated credit go into the “AAA” tranche. These loans have low risk and yield a lower return on the investment. The mortgage loans with the lowest rated credit go into the “Junk” tranche. These loans have the highest risk and offer the highest return.
  • Investors purchase tranches, which have varying degrees of risk and maturities.

Most MBSs consist mainly of long-term15- to 30-year fixed-rate mortgages. The investment products also include adjustable rate mortgages. Originally, Mortgage Backed Securities meant the investment had an “AAA” credit rating. Mortgage-backed securities guaranteed investors, including thrifts, banks, corporations, pension funds and insurance companies, timely cash flows --principal and interest -- payments from homeowners who made their monthly payments.

Leading to Government Bail Out

Shortly after involuntarily leaving Salomon Brothers in 1985, Ranieri stated in an interview complain to that instead of homeowners realizing the savings in the form of lower interest rates, sophisticated fund managers and investors realized substantial gains. A few years later, in response to concerns of banking regulators about “risky speculations” in the mortgage-backed securities market, Ranieri admitted that others could abuse his innovation. One of the major regulatory changes that occurred along the way to the meltdown that occurred in 2008 was the reduction of reserve requirement for each $100 of mortgage backed-securities from $10 to $2.

The investment bankers represented these securities to investors as safe for their portfolios. However, the state of the housing and job markets caused Mortgage Backed Securities to become exceptionally risky. Some investment banks repackage the securities into even riskier investments known as collateralized debt obligations. At some point, many Mortgage Backed Securities had little or no value. This is when Fannie Mae and Freddie Mac stepped in and purchase billions worth of theses securities during the crisis.

Mortgage Backed Securities Today

As of this article, very few private bankers issued Mortgage Backed Securities; most of the private market has dried up. Fannie Mae and Freddie Mac constitutes the bulk of the MBS market. It is difficult to estimate the value of the Mortgage Backed Securities market. However, mortgage-backed securities guaranteed by the government through Ginny, Fannie and Freddie approaches about $5 trillion. Some estimates puts the overall value of MBS in the tens of trillion of dollars when including more elaborate -- securities conceived from securities, such as credit swaps.

Many investors have ongoing litigation against the private invest banks that packaged and sold Mortgage Backed Securities. Just recently, Allstate insurance has filed litigation against Citigroup Inc. Deutsche Bank AG, JPMorgan Chase & Co and Credit Suisse Group. The primary charge contends that these firms “fraudulently” sold the home and auto insurer residential mortgage-backed securities.





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