CHAPTER 9
Private-Label Mortgage-Backed Securities
THERE WAS NO AMBIGUITY IN THE ATTITUDE OF TREASURY, THE Fed, and commercial banks and thrifts toward Fannie Mae’s portfolio business. They opposed it—whether for ideological, competitive, or other reasons—and consistently sought to convince Congress to remove some or all of our charter benefits in order to raise our debt costs if not eliminate the portfolio altogether. These same groups took a different approach to our mortgage-backed securities guaranty business: rather than try to constrain it, they focused on developing a private-market alternative that could compete with it.
MBSs, CMOs, and REMICs
Following its creation in 1968, Ginnie Mae was the first entity to issue mortgage-backed securities. Freddie Mac began issuing them shortly after that time (they called theirs participation certificates, or PCs). Both issued what were called “pass-through” securities, in which all interest and principal payments from the individual loans composing the securities were passed through directly to investors in proportion to their ownership. Ginnie Mae mortgage-backed securities were backed by the full faith and credit of the U.S. government and also contained loans insured by the FHA or the VA. Freddie Mac PCs contained conventional, or nongovernment insured, loans and were backed only by the company, although investors took note of Freddie Mac’s status as a government-sponsored enterprise in assessing the value of their guarantee.
In 1983, Freddie Mac and the First Boston Corporation issued the first collateralized mortgage obligation, or CMO. A CMO was a clever innovation aimed at dividing the universe of mortgage investors into segments. Unlike a traditional pass-through mortgage security, a CMO created different classes of security, called “tranches” (after the French word for “slice”). The first and simplest form of CMO was known as “fast pay, slow pay.” It had three tranches. The first tranche received pro rata interest payments but also got all the principal payments—both regular amortization and prepayments—until it was paid off. As a consequence, the first, or fast-pay, tranche had a relatively short expected life. After the first tranche was retired, scheduled and unscheduled principal payments began going to the investors in the second tranche, who would continue to receive them until they were paid off. Only then would investors in the third, or slow-pay, tranche start to get principal payments. That gave the last tranche the longest expected life of the three.
The collateralized mortgage obligation did not change the prepayment uncertainty associated with the mortgages that backed it, but by creating different payment priorities, it produced more payment certainty for one tranche at the expense of another. That small difference was enough to bring new investors into the mortgage sector. Many different types of cash flow transformation could be made in a CMO, and Wall Street quickly developed a number of popular variations on the tranching scheme.
There was, however, a problem that held back both the volume of collateralized mortgage obligations and the amount of complexity Wall Street firms felt comfortable putting into them. The tax laws that applied to the transformation of cash flows within a trust structure—which was the vehicle a CMO used—were ambiguous. Under existing law, it was possible that some types of CMO cash flows could be subject to taxation at the pool level as well as at the investor level. Wall Street firms and others interested in achieving the full potential of tranched mortgage-backed securities wanted more certainty about their tax treatment.
In 1985, serious discussions began about legislation to change the tax law governing structured mortgage transactions. The Reagan administration Treasury Department favored creating a new legal vehicle for issuing structured mortgage transactions that would resolve the tax issues, but it was firmly opposed to allowing Fannie Mae and Freddie Mac to utilize it. That potentially put us at odds with our Wall Street partners. They underwrote and traded the debt we issued to finance our portfolio purchases, and they issued and made markets in our mortgage-backed securities, but here our interests diverged. If they could align with Treasury and successfully exclude us as issuers of the new type of CMO, they would have this market to themselves.
Wall Street, the administration, and Congress had collaborated during the previous year on legislation to improve the competitiveness of what were known as “private-label” mortgage-backed securities. Salomon Brothers issued the first private-label mortgage-backed security, backed by mortgages originated by Bank of America, in 1977. The earliest types of private-label mortgage-backed securities were neither easy nor profitable to sell because they had cumbersome registration requirements and were not legal investments for most types of regulated financial institutions. To eliminate those impediments—and with the ultimate goal of putting private-label securities on an equal footing with GSE securities—the pioneer of Salomon Brothers’ mortgage department, Lew Ranieri, had worked with the administration to draft the Secondary Mortgage Market Enhancement Act (SMMEA), which Congress passed in 1984.
To make private-label securities easier and less costly to issue, the drafters of SMMEA exempted them from state antifraud (or “blue sky”) laws and registration requirements. To expand the securities’ investor base, however, the drafters elected to follow a precedent set by the Securities and Exchange Commission in 1975, when it linked broker-dealer capital requirements to credit ratings received from one or more of the three national credit rating agencies (Standard & Poor’s, Moody’s, and Fitch). SMMEA similarly made private-label security tranches legal investments for federally and state-chartered banks and thrifts—as well for as insurance companies, pension funds, and other regulated entities—provided they carried investment-grade ratings from at least one of the three credit agencies. The rating agencies had no regulator themselves, but in SMMEA they nonetheless were made the de facto regulators of credit standards in the private-label securities market.
Yet even SMMEA could not make private-label mortgage-backed securities a competitive alternative for mortgages eligible for a Fannie Mae or a Freddie Mac guaranty, because of the value investors attached to our GSE status. That was why it was an easy call for Wall Street to use the cover provided by Treasury and do its best to keep Fannie Mae and Freddie Mac from being allowed to issue CMOs in the hoped-for new legal structure.
Salomon Brothers took the lead for Wall Street on the CMO initiative, with Ranieri driving the legislative strategy. The legislation he targeted was a comprehensive tax reform bill. Ranieri positioned the proposed CMO fix as a technical cleanup to the tax code, which succeeded with the House Ways and Means Committee but got no traction in the Senate Finance Committee. Wall Street could get a CMO bill through the House, but getting it through the Senate required Main Street. For that, Ranieri was forced to turn to Maxwell and Fannie Mae. By emphasizing how the CMO taxation fix would benefit home buyers—as opposed to just financial firms, which had been the essence of Ranieri’s pitch—we were able to convince key members of the Senate Finance Committee to agree to a provision both we and Wall Street could support. The Tax Reform Act of 1986 that finally passed in December contained a section authorizing real estate mortgage investment conduits, or REMICs, as a new form of special purpose vehicle for issuing structured mortgage-backed securities.
In joining forces to get the REMIC provision in the Tax Reform Act, Ranieri and Maxwell had not agreed on the role of Fannie Mae and Freddie Mac as issuers; they agreed only to move the fight to a different forum. The act gave Fannie Mae and Freddie Mac temporary authority to issue REMICs but left to our regulators (HUD and the Federal Home Loan Bank Board, respectively) the task of determining whether we should be given this authority on a permanent basis. Wall Street did not pull any punches in making their case against it. Their argument was that keeping us out of the REMIC business was a rare opportunity for the government to arrest the growing “federalization” of the mortgage market. On our side, we emphasized that preventing us from issuing REMICs would result in fewer market efficiencies and higher REMIC issuance costs, with those costs ultimately being borne by home buyers.
As with most issues involving Fannie Mae, the question of our REMIC authority was settled politically. HUD Secretary Sam Pierce, a Reagan appointee, was sympathetic to the free-market argument made by Wall Street. We believed REMIC authority was critical to our future, and fearing we would not be able to convince Pierce to give it to us on the merits, we went back to Capitol Hill. We had good friends on the staff of the House Banking Committee, and they were able to convince the leaders of that committee to put a provision in a piece of pending legislation that stripped HUD of its authority to approve our new mortgage programs. That got Pierce’s attention. Pierce wanted to retain program authority over Fannie Mae more than he wanted to prevent us from issuing REMICs. One Saturday morning during a meeting he was having with his leadership team, Maxwell got a call from Pierce’s assistant offering a trade: HUD would give us $15 billion worth of REMIC issuance authority if we would ask the Banking Committee to pull the program authority provision. The trade was agreed to and made. Shortly afterwards, HUD lifted the cap on our REMIC authority entirely.
Resolution of the REMIC battle made it official. Fannie Mae and Freddie Mac would be the dominant secondary market entities in the conventional conforming loan market—consisting of mortgages below our loan limit that met our underwriting standards—and we would set the standards and determine the rules for business transacted in this market. In the so-called “nonconforming” loan market—consisting of mortgages Fannie Mae and Freddie Mac either could not buy (because of their loan balance) or would not buy (because of their risk features)—Wall Street firms as issuers of private-label mortgage-backed securities would be the dominant secondary market entities, and they, along with the credit rating agencies, would set the standards and determine the rules governing that market.
The Very Different Risks of GSE and Private-Label Mortgage-Backed Securities
SMMEA had been passed to spur the development of a private-market alternative to Fannie Mae and Freddie Mac mortgage-backed securities. Private-label mortgage-backed securities indeed are alternatives to GSE mortgage-backed securities, but because of their structural differences, they are by no means substitutes for them.
The most critically important difference between a Fannie Mae MBS (or a Freddie Mac PC) and a private-label MBS is the nature of the credit protection provided to the investor. Investors in a Fannie Mae MBS are protected by the company’s corporate guaranty of the timely payment of interest and principal, irrespective of how the loans backing the MBS perform. If Fannie Mae misjudges the quality of the loans in a Fannie Mae MBS, it’s the company’s problem; Fannie Mae bears the credit losses, and the investor still gets paid in full as long as Fannie Mae remains able to satisfy its obligations. In contrast, credit protection for investors in a private-label MBS is provided by structural credit enhancements built into the security by its issuer. If those credit enhancements turn out to be inadequate, it’s the investor’s problem; there is no independent guarantor to absorb the excess losses.
As the private-label market evolved, Wall Street firms and issuers developed a number of mechanisms and techniques for providing credit enhancement. These included overcollateralization (putting enough loans in a structure that investors still could get all their money back even after a certain percentage of the loans went bad), third-party insurance (a form of corporate guaranty, made by an entity other than the issuer), and letters of credit. But what became by far the most commonly used technique for private-label mortgage-backed securities was what is called the “senior-subordinated” structure.
Senior-subordinated structures work similarly to simple CMOs, except instead of prepayments being allocated to tranches in priority order, it is credit losses that are allocated that way. Senior-subordinated securities include an equity piece, typically retained by the issuer, that takes the initial amount of credit losses (anywhere between 1 and 4 percent, depending on the riskiness of the underlying loans). Losses over that amount are absorbed by the holder of the most junior tranche; when that tranche has no principal left, losses then are borne by the holder of the next most junior tranche, and so on throughout the structure.
Pursuant to SMMEA, credit rating agencies played a crucial role in the structuring of a senior-subordinated private-label mortgage-backed security. Using their own statistical models of loan performance, together with the product and risk characteristics for a particular group of loans provided by the issuer, rating agency personnel determined how many loss-absorbing junior tranches a senior-subordinated private-label MBS containing those loans needed to have—and what percentage of the total security size those junior tranches needed to make up—in order for the rest of the tranches in the structure to merit AA or AAA ratings.
The theory is a sound one. If a senior-subordinated MBS has enough loss-absorbing junior tranches, even in a highly adverse credit environment, the most senior tranches should have a vanishingly small chance of not being repaid in full and thus could safely be accorded AA or AAA ratings. But there is one glaring weakness in the design of a senior-subordinated private-label MBS compared with a Fannie Mae MBS: in a Fannie Mae MBS, the interests of the issuer are aligned with those of the investor; in a senior-subordinated private-label MBS, they are not.
Transactions in the secondary mortgage market always have had issues of risk alignment. In the primary mortgage market—where a local lender makes a loan to a borrower and retains it in portfolio—the lender has a strong financial incentive to underwrite that loan properly because it will bear the consequence of the borrower not being able to repay it. That incentive changes when a lender makes a loan for sale to or guaranty by Fannie Mae (or Freddie Mac) and transfers the risk of credit loss to the company. With Fannie Mae as a purchaser or guarantor, loans with higher amounts of credit risk actually may be more profitable for the lender, because it can charge higher fees to borrowers of riskier loans and also do a greater volume of business if it makes higher-risk loans as well as less risky ones. It was precisely because of these conflicting financial incentives that Fannie Mae devoted so many resources to mortgage credit analysis and the refinement of the underwriting standards we required our lenders to follow.
The holder of a Fannie Mae mortgage-backed security benefits from the due diligence the company has an incentive to do on its own behalf as a shareholder-owned company. If Fannie Mae properly assesses the risks it assumes in its credit guaranty business—and charges a fee that covers those risks and allows for a competitive return on its invested capital—it will be stronger financially, and its guaranty of the investor’s MBS will be worth more, even before consideration of any potential support that may be forthcoming from the U.S. government as a result of Fannie Mae’s GSE status.
In contrast, due diligence done on behalf of the investor in a senior-subordinated private-label mortgage-backed security is conducted by the credit rating agencies, whose incentives to accurately identify credit risk can conflict with their goals as profit-making enterprises. Rating agencies are paid for their ratings of private-label mortgage-backed securites by the securities’ issuers. If a rating agency is too conservative in the amount of subordination it requires in a proposed private-label transaction and the issuer does not go ahead with it, the rating agency does not get paid at all. On the reverse side, if the rating agency requires too little subordination in a proposed transaction and investors in the more highly rated tranches experience losses, the rating agency itself suffers no adverse financial consequences. Irrespective of the capability or the intent of the professionals working for them, the role the rating agencies are asked to play in the private-label MBS credit enhancement process, along with the manner in which they are compensated, creates a built-in bias toward underestimating credit risk that runs counter to the interests of the private-label security investor.
The ratings bias inherent in private-label securitization is made worse by the fact that the originators of loans financed by these securities have an unambiguous incentive to put higher-risk mortgages into them. Because Fannie Mae is a corporate guarantor, it sets limits on the types of credit risk it will accept in the loans that go into a Fannie Mae MBS. Similar limits do not exist for private-label securities; riskier loans simply mean more or larger junior tranches will be required to provide protection for the AA- and AAA-rated tranches. For a mortgage originator using private-label mortgage-backed securities as a financing outlet, the riskiest loans present the greatest opportunity for profit. If an originator can convince a group of borrowers that their loans are very risky, it can charge them large origination fees as well as very high interest rates. And if the originator then can convince the rating agencies that these same loans are not that risky, the ratings put on the tranches in the private-label security will result in interest payments to investors that are less than what the originator receives from the borrowers. The originator will pocket the difference.
Strong incentives for the originators of loans financed by private-label securities to make high-risk mortgages and understate their riskiness, weak or conflicting incentives on the part of rating agencies to detect excessive credit risk in a proposed private-label transaction, a senior-subordinated structure that once agreed to by an issuer and a rating agency has no flexibility to accommodate credit losses that are worse than envisioned at the outset, and the lack of a corporate guarantor whose role is to absorb excess losses all make a private-label mortgage-backed security a markedly more risky instrument than a Fannie Mae MBS.
Promoters of the private-label market as a competitor to GSE securitization—which included Wall Street firms, the Federal Reserve, and the Treasury—ignored these critical structural differences when they depicted the AAA-rated private-label MBS as simply the private market version of AAA-rated GSE mortgage-backed securities. They most assuredly were not, and any investors who believed them to be did so at their peril.
Subprime One
The two sectors that benefited the most from the structuring technology of private-label securities and the absence of significant restrictions on or regulation of the types of loans that could go into them were subprime mortgages and mortgages to finance manufactured housing, or mobile homes.
Subprime mortgage lending had its roots in the consumer finance industry, made up of companies like Household Finance, Beneficial, and The Associates. Customers of these companies traditionally had poor credit, could not qualify for bank loans, and were willing to pay high interest rates for either debt consolidation loans or loans to purchase consumer hard goods. Prior to the 1980s, consumer finance companies did not offer mortgages to their customers because state usury laws prevented them from charging high enough interest rates to compensate them for the credit risk they believed they were taking. In 1980, however, the Depository Institutions Deregulation and Monetary Control Act removed state usury ceilings on mortgages, and not long afterwards the Tax Reform Act of 1986 eliminated the tax deductibility of interest on consumer loans but retained it for residential mortgages.
The loss of tax-deductibility on consumer loans coupled with the legality of charging higher interest rates made mortgage lending—particularly second mortgage and cash-out refinance lending—much more attractive to finance companies. And Fannie Mae and Freddie Mac effectively ceded these lenders a very large customer base. Although this would change in the mid-1990s, at the time neither of us purchased or guaranteed mortgages made to individuals with bad credit, no matter how high their incomes or how much equity they put or had in their homes. In fact, a subprime loan then was defined with respect to Fannie Mae and Freddie Mac underwriting standards: the loans we would buy or guarantee were deemed to be prime, and any loans below those standards were “subprime.”
Subprime mortgage loans were ideal material for private-label securitization. Wall Street firms could provide subprime lenders with one-stop shopping for their financing needs—first extending short-term credit, called warehouse lines, that enabled lenders to keep newly made mortgages on their balance sheets until they could be packaged for sale, then working with the rating agencies to create private-label security structures for virtually any type or quality of loan a lender originated, and finally finding investors for the various tranches of securities that resulted from this process.
The first subprime mortgage boom was triggered by a collapse in the market for exotic types of REMIC and derivative securities. The variety and complexity of REMIC structures increased greatly following the Tax Reform Act of 1986. Sharp and persistent increases in interest rates in 1994 caused many investors, and a few Wall Street firms, to suffer large and in some cases fatal losses from complex REMICs and derivatives. These securities quickly fell out of favor, and for many investors, AAA-rated subprime mortgage securities seemed like the best alternative way to get additional yield for what appeared to be little additional risk. Between 1994 and 1998, the volume of subprime loan securitizations more than quadrupled. Spurred by readily available credit and national advertising campaigns by companies like The Money Store, subprime lending caught on with the public. And it became extremely profitable for lenders. Existing subprime lenders did so well that many new ones were formed. Wall Street firms eagerly underwrote a number of high-profile initial public offerings for subprime companies during this time.
The first subprime lending and securitization boom was short-lived. Just as sharply rising interest rates in 1994 had sparked it, an abrupt reversal in interest rates extinguished it even more quickly. In the fall of 1998, the one-two punch of the Russian debt crisis and the liquidity squeeze and subsequent failure of the hedge fund Long-Term Capital Management caused interest rates to plummet. Investors fled risky financial assets for safer investments like Treasury securities and Fannie Mae debt. Interest spreads between Treasuries and subprime securities widened dramatically, and the market for new subprime issues dried up almost overnight. Wall Street firms stopped lending to subprime originators, who then were unable to obtain financing from any source. Interest rates at their lowest levels since the 1950s led large numbers of borrowers with subprime loans to refinance them. Many subprime lenders had assumed their securitized loans would have long average lives, and they had booked income on those loans in advance. That income had to be reversed when the loans were refinanced. Coming on top of everything else, earnings restatements proved too much for many subprime lenders to survive. Large numbers of them failed.
Nobody, including the Federal Reserve and the Treasury, connected the boom and bust in subprime mortgages with the way in which they had been financed. The subprime collapse occurred in the context of a broader financial crisis that devastated other high-risk markets and instruments, and because most subprime lenders were smaller specialty firms that did home-equity rather than purchase money lending, their demise had only an indirect effect on home sales and housing starts and therefore little impact on the overall economy.
The subprime meltdown was easy for investors and regulators to dismiss as a freak event of relatively little consequence. Much less understandable is how anyone possibly could have missed the significance of what happened when Wall Street and the rating agencies met the manufactured housing industry.
A Dress Rehearsal for the Crisis
Loans for manufactured housing, or mobile homes, looked on the surface like residential mortgages. They were anything but. Most manufactured housing loans were made by manufactured home builders’ captive finance subsidiaries, whose dual objectives of facilitating sales and maintaining underwriting discipline conflicted. The pricing on manufactured housing was opaque, with added fees and charges that raised the prices of the homes but not their resale values. High sales commissions increased the chance of improper valuation. Finally, many if not most buyers of manufactured homes had below-average incomes, weak credit histories, and few financial reserves, making them relatively poor credit risks. A manufactured housing loan was an amalgam of a consumer finance loan and a sub-prime mortgage, collateralized by an asset that was notoriously difficult to value.
Manufactured housing was definitely outside the reach of financing by Fannie Mae or Freddie Mac, so it was fair game for Wall Street and the rating agencies. Still, their decision to get into the sector when they did was curious. Manufactured housing historically had been financed with 12- to 15-year fully amortizing loans. That made sense, because shorter-term loans repaid principal more quickly and built a cushion of protection for the lender or investor. But in a move to increase mobile home affordability in the early 1990s, the industry had moved to 20- to 30-year loans, often with very low down payments. Virtually no data existed on the performance of these loans in the financing of manufactured housing because they were so new.
Notwithstanding this fact—made more problematic by the complex relationship between manufactured home builders and their financing subsidiaries and the idiosyncrasies of the asset class—Wall Street and the rating agencies determined that manufactured housing was ripe for private-label securitization.
Mobile home lenders suddenly finding themselves with easy access to a deep source of low-cost financing took full advantage of it. Once the rating agencies specified the requirements for AA and AAA ratings, manufactured home loan originators met those requirements, then added new types of risk the rating agencies either did not recognize, understand, or know about. Many involved costs that could be rolled into the purchase price and financed, such as built-in accessories or even the cost of travel to the dealership. Securitized mobile home loans with stated loan-to-value ratios of 90 percent often had actual loan-to-value ratios of well over 100 percent, putting borrowers under water before their homes left the dealer’s lot.
Under the impetus of cheap, readily available financing and liberalized underwriting practices, sales of manufactured housing skyrocketed. Between 1992 and 1998, shipments of manufactured homes increased by 74 percent, while over the same period starts of “site-built” single-family homes rose by only 20 percent.
Fannie Mae did not escape the lure of the mobile home frenzy. We were very much aware that mobile homes had risen from less than 20 percent of single-family housing construction in 1992 to nearly a quarter of it in 1998. We felt we should not ignore this market, but at the same time we knew that manufactured housing loans had credit risks that were fundamentally different from loans on site-built homes. Several of our senior executives made visits to manufactured home builders to learn more about that industry, and we generally were impressed by what we found. On one of those visits, our president, Larry Small, asked about construction quality. The builder’s response was, “All our homes are tested by being towed down the highway at seventy miles per hour; how many site builders can say that?”
We decided to enter the market cautiously. Not everyone was enthusiastic about the idea—some disparagingly referred to manufactured housing loans as “deals on wheels”—but collectively we agreed that modest purchases of AAA-rated tranches of private-label manufactured housing securities would enable us to gain experience on the performance of these loans without taking on their credit risk directly. We purchased about $10 billion in manufactured housing securities in the late 1990s. The experience we got from these securities was not what we had in mind when we bought them.
The financing-driven surge in manufactured home sales was not sustainable. Sales began to fall in 1999, and by 2001 they were below where they had been when the lending and building booms began. Unsold inventories of mobile homes drove prices lower, triggering waves of delinquencies and defaults on poorly underwritten loans made previously. With falling sales of new units, servicers of manufactured housing loans found it hard to sell foreclosed mobile homes at any price. Rising defaults and astronomical loss severities led the rating agencies to belatedly begin downgrading private-label manufactured housing securities, causing their prices to plunge. Many investors, including Fannie Mae, took significant write-downs on their holdings of supposedly riskless AAA-rated tranches beginning in 2002 and 2003.
The boom and subsequent collapse of the manufactured housing industry was as clear a demonstration of the weaknesses in the private-label mortgage securitization model as it was possible to have. All of the elements were there: an absence of third-party credit standards, mortgage lenders introducing risky new products or loan features into a market, rating agencies attempting to make risk assessments on these products and features despite a lack of adequate or applicable historical experience, and a combination of relaxed underwriting and ample credit availability bringing in previously unqualified borrowers who pushed demand and prices well above sustainable levels, from which they subsequently plummeted.
The Federal Reserve and Treasury, incredibly, drew no lessons whatsoever from this experience. Their unwavering commitment to a free-market alternative to the mortgage securitizations of Fannie Mae and Freddie Mac seemingly made it impossible for them to acknowledge the obvious and irremediable flaws in the private-label securitization mechanism they championed.
Regulators’ blindness to what they did not wish to see was a failure of monumental consequence. At the very time investors were assessing their losses on the AA- and AAA-rated private-label manufactured housing securities they owned, the market for private-label subprime mortgage securities was reconstituting itself and gathering steam, ready to trigger exactly the same sequence of events all over again. Only this time the victims would not be the borrowers of and investors in home-equity and manufactured housing loans; they would be the home buyers and investors in the entire U.S. single-family housing market.