The Invention

Mortgage-Backed Securities and the Financialization of American Life

Robert F. Dall (1934-2015) who is widely credited with popularizing Mortgage-Backed Securities on Wall Street while at Solomon Brothers in the 1970s, pictured here at Drexel Burnham Lambert in 1987

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As fig leaves were replaced by loin cloths, so too later were suits of armor succeeded by suits by Zegna. Was this a societal advancement, perhaps.

- Harley Bassman “The Convexity Maven”

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There is an inclination among financial writers to center the narrative arc of mortgage securitization around the Great Financial Crisis. The speculative fervor and subsequent fallout make for a compelling denouement, but the story of credit in the housing market straddles a longer history. Since the expansion of consumer mortgage financing in the 1970s, residential housing’s importance to not only the financial system but also to the US’s economic health has grown considerably. It has changed the nature of home ownership and the social makeup of our communities. We have evolved Thomas Jefferson’s vision of yeoman farmers¹ in ways unimaginable to the Founders or even to early 20th-century Americans. In the process, the relatively straightforward process of financing a home has become central to the plumbing of the global financial system.

The 30-year mortgage is an aberration internationally, but few Americans fully appreciate its oddity, a benefit bestowed by US Dollar hegemony. US homebuyers can, with relatively modest means, secure long-term fixed-rate debt for sums many multiples their annual wage. They can also enter derivative bets tied to their mortgage like “buying points,” restructure via cash-in refinances or add layers to the capital stack via HELOCs. In the increasingly financialized landscape of America’s economy, the home mortgage remains the ultimate consumer and financial “product.”

Despite its importance to the general wealth of the nation, the exact machinations of a mortgage are a mystery to most homeowners and many professional investors alike. A simplified enough understanding is that home mortgages are pooled and securitized for investors, and until the creation of the Ginnie Mae in 1968 (and later Fannie and Freddie) this would have been mostly accurate. The creation of the Government Sponsored Entities (GSEs) created a key layer to the mortgage market that transformed MBS into something foundational to the schema of financial markets.

A Feeble Attempt at Synthesizing MBS Dynamics…

“Sure, cried the tenant men, but it’s our land…We were born on it, and we got killed on it, died on it. Even if it’s no good, it’s still ours….That’s what makes ownership, not a paper with numbers on it."

"We’re sorry. It’s not us. It’s the monster. The bank isn’t like a man."

"Yes, but the bank is only made of men."

"No, you’re wrong there—quite wrong there. The bank is something else than men. It happens that every man in a bank hates what the bank does, and yet the bank does it. The bank is something more than men, I tell you. It’s the monster. Men made it, but they can’t control it.”

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The Grapes of Wrath

John Steinbeck

The mortgages of Steinbeck’s tenant men exemplify the primary issues with pre-GSE mortgages from a banking perspective. For banks, mortgage lending is a fraught, capital-intensive endeavor if loans must be held on their books. Harley Bassman, “Convexity Maven” and Managing Partner of Simplify Asset Management:

There are three huge problems with this sort of finance; the first (ignoring fractional leverage) is that the bank is limited to lending only its total deposits. The second is the risk they must pay depositors more than the fixed-interest they charge for the mortgage loan. And the third is the liquidity risk of a “bank run” if the depositors want their money back before the loan is paid off.²

The GSEs perform a sort of financial alchemy. Beyond simply securitizing a pool of mortgages, they wrap them in the luminescence of a government guarantee. The “if-needed” full faith and credit of the US Government. This process often uses the vernacular of the originator “selling” the loan to the GSE, but that’s not quite accurate. Rather, the GSE takes a fee for bundling mortgages into guaranteed MBS and handing it back to the originator to sell to dealers and then on to pension and mutual funds. The yield drops down at each of these transactions as each participant makes a small profit passing the security down the line. This transformation moves Mortgage Backed Securities (MBS) from something in the orbit of financial markets to the Center of the Universe. Bassman again,

…the Bond market is just much larger and more liquid than the Equity market. I remember when some wingo from the Carolinas could ask for an offer on $12bn FN 5% bonds with barely a blip in price; in contrast, a 1 million share inquiry on most single-name stocks would roil the market. At the top of the heap are Mortgage bonds, which finance the residential housing market - our largest wealth category which drives 15% of the US economy.

Fixed-income securities are collections of different types of risk: Credit, Interest Rate, Duration, Liquidity, and Volatility. The government guarantee MBS receives removes credit risk. The payments and principal are no longer at risk of the borrower welching on the loan. The remaining risks are just as material, but to an extent, more quantifiably understandable than the credit risk of individual or even pools of residential borrowers. With liquidity and credit risk effectively removed from MBS securities, what remains is a unique product in the eyes of financial markets. Guillermo Roditi Dominguez of New River Investments on Odd Lots:

I think one way to look at it is a mortgage-backed security is essentially similar to a covered call in equity terms. And that means that you have all of the downside and you know, very, very little of the upside and you trade that in for a little bit of extra coupon. And when rates were going down, everybody was upset about it because Treasury bonds were going up in price. People were making money there. If you held MBS, you got your money back and then when you went to buy new bonds, you bought them at a lower yield. And right now what we’re seeing is all of a sudden bond prices are going down, yields are going up and you’re not getting any cash flows so you don’t get to reinvest that money.

Borrowers have the penalty-free option to refinance their mortgage and tend to exercise it when rates are falling. This duration risk accounts for the higher yield MBS earns over similarly guaranteed government debt. Of course, borrowers repay their mortgage for any number of reasons and life events. Moving for a better job, death, divorce, or having a child may all impact a borrower’s propensity to repay a mortgage. Wall Street has employed armies of Ph.D.s to try to divine these prepayment rates.

The most intimate parts of many Americans’ lives are actuarially assessed and priced into assets that are then sold back to them in mutual funds, insurance policies, and savings accounts. A full circle of nominal “wealth creation” via the repackaging of risks both endogenous and exogenous.

Peter Sullivan, rocket scientist, crunching the numbers on your mortgage