Understanding the Subprime Crisis: A Narrative, Part One

Most people, and most experts, tend to feel that the US economy is in trouble.  Many news stories are a significant part of this: the subprime mortgage “crisis”, the falling value of the dollar, the restatements of financial earnings from Wall Street.  But the actual narrative of how this happened is very poorly understood, and rarely explained in its entirety.  And much information which contradicts what we think we know exists as well: that subprime mortgages represent less than 2% of the equity market, for example, or that over half of subprime borrowers are still making timely payments.

Due to the failure of most Americans to understand the narrative of how we got here, most of us don’t understand what the problems actually are, nor do the politicians vying to “solve” the problems feel the need to address the actual underlying issues.  It is my feeling that it is therefore important to try to tell the story of how we got here in a narrative fashion.

The story begins at Salomon Brothers in the 1980s.  At the start of the 1980s, Salomon was a relatively minor Wall Street investment bank.  They were by far the leaders in bond trading, which was historically the least active and lucrative financial market, and survived mainly on providing the leading service in a niche market.  But two aspects of the bond trading business in the 1980s changed all that, and American and world financial markets as a result.

The two leaders of these sea changes in bond trading at Salomon were Lewis Ranieri, who headed the mortgage bonds group, and John Meriwether, who headed the fixed income arbitrage group.  Both the innovations led in mortgage-backed securities by Ranieri, and the arbitrage innovations by Meriwether have massive and direct impact on our present circumstance.

Part One: Lewis Ranieri and the Collateralized Mortgage Obligation

Mortgages were, prior to the 1980s, poor investments.  The rationale for this was twofold: first, mortgages are highly personalized investments.  So many small factors unique to each borrower impact the probable results that trading in individual mortgages makes little sense.  The second reason is that the rate of return on mortgages is difficult to predict, as borrowers have the option of paying back the entire principal at any time, as well as paying more than the required payment, making the rate of return on the loan excessively variable.  All this led to a stillborn mortgage trading market; who would buy a loan with an unknown chance of default, with multiple options for the borrower which could lead to minimal payoff?

As such, most Wall Street banks shuttered their mortgage groups.  But not Salomon, which had a strong loyalty at the time for Ranieri, who had begun in Salomon’s mail room.  As such, Salomon was perfectly positioned to take place of an extraordinary act of government foolishness.  On September 30, 1981, a tax break was passed which allowed Savings and Loans to sell their mortgage loans at a loss to renew their capital, and then to amortize their losses both over the course of the loans (so that the loss, which happened in real time, could be hidden over decades) and to obtain refunds from the IRS on previous year tax payments offset by current losses.  So the Savings and Loan industry was eager to sell mortgages for as little as 35 cents on the dollar, all to reap massive payouts from the IRS.  And Ranieri and Salomon were the principal buyers.  But the net effect was that the S&Ls were also eager to buy other mortgages, and didn’t much care if they took a loss on those as well.  Salomon’s mortgage trader Tom DiNapoli told Michael Lewis of a trade where he bought one hundred million dollars of thirty-year mortgages at seventy-five cents on the dollar from one S&L, and at the same time sold one hundred million dollars of thirty-year mortgages to the same S&L for eighty-five cents on the dollar.  This swap cost the S&L $10 million to hold the exact same paper, but was essential to the S&L’s balance sheet for the IRS (Liar’s Poker, Lewis, p.105).

The results from this were profound for Ranieri and Salomon Brothers.  After three years of middling results, in 1982 the mortgage group of Salomon showed a profit of $150 million.  But further changes were underway which would make that number seem minute; in 1984, a single mortgage trader at Salomon, Steve Baum, was able to show a profit of $100 million in that year.  By 1983, the mortgage group represented 40% of Salomon’s profits.  This change not only changed Salomon, it changed America.  In 1977, the holdings of mortgage bonds in the United States was valued in total at $12.6 billion.  By 1986, that number was $150 billion.

As the tax change for Savings and Loans created a rapacious market in whole mortgage bonds, Ranieri and other Wall Street lobbyists convinced the US Government to alter the rules governing the two semi-private institutions dominating the secondary mortgage market, the Federal Home Loan Mortgage Corporation (known as Freddie Mac) and the Federal National Mortgage Association (known as Fannie Mae).  Both Freddie Mac and Fannie Mae are government-sponsored enterprises – meaning that both had originally been authorized by Congress.  Fannie Mae, in fact, was originally a government agency established as part of the New Deal, but was converted into a private corporation in 1968 to help balance the Federal budget.  What Freddie Mac and Fannie Mae do, in essence, is guarantee mortgage loans made by banks.  For a fee, which varies based on the perceived risk of the mortgage loan, Freddie Mac or Fannie Mae will indemnify the lender against the risk of default.  

The reason that Ranieri and others sought a rule change was because while there was a fortune to be made in fleecing the S&Ls and the IRS, this was not enough to create a real market in mortgages.  This didn’t appear to make sense.  Mortgage bonds had a generally higher yield than corporate or government bonds of similar credit ratings, and were  either explicitly or implicitly backed by the Federal government.  The problem was that early payments and prepayments made it impossible to calculate the expected yield of whole mortgage bonds.  Ranieri and Salomon came up with the idea of the Collateralized Mortgage Obligation, which is a form of bond created by pooling mortgages into a group and selling shares in the profits of those combined mortgages.  The bonds can function in a wide variety of ways, but the purpose of all is to collectivize the risks of individual or whole mortgages (meaning everything from prepayment to default) and to make the yields for such securities more predictable.  In simple terms, this idea was to make mortgage-backed bonds similar to other kinds of bonds.  (For an interactive graphic demonstration of how collateralized debt obligations such as CMOs work, see this from Portfolio.com)

CMOs created a fortune for Salomon, along with the other innovator of their creation, First Boston.  But it also spelled the end for the windfall profits of Salomon’s mortgage group of the early 1980s.  As the members of the mortgage group made Salomon a fortune, they were rapidly poached by other Wall Street firms for higher salaries.  Meanwhile, the growth of the mortgage market, as well as the greater information available to the purchaser of a CMO, meant that mortgages were no longer badly mispriced in favor of Salomon.  But the nearly infinite number of means to create different kinds of CMOs also meant that oversight of traders was nearly impossible.  Ranieri and other Salomon executives became increasingly unaware of what their traders were doing.  In April 1986, the mortgage group of Salomon, which had earned nearly a billion dollars for the firm in the previous five years, had losses reported to be between $35 and $65 million (the traders were able to conceal the losses from management, so reliable numbers don’t exist).  In April 1987, a trader named Howie Rubin at Merrill Lynch’s mortgage desk, who had been poached from Salomon,  lost $250 million on a single unauthorized trade, which sent shockwaves through Wall Street.  In July 1987, Salomon fired Ranieri and the era of the Salomon mortgage group’s dominance was fully over.  This was possible for Salomon because John Meriwether and his arbitrage group had replaced Ranieri as Salomon’s golden goose.  

But while the era of the dominance of Salomon’s mortgage group was over, as well as the windfall profits of the early 1980s, their actions left many artifacts which still have massive impact today.  The first, and most obvious, is the CMO and the massively expanded mortgage market.  The second is that this was the first major step which led to major investment banks risking their own capital to make the bulk of their profits at the expense of their largest customers.  And the third was the herd mentality which accompanied massive profits and informational imbalances; Salomon made a fortune exploiting an advantage against the Federal government and the Savings and Loan industry, and the rest of Wall Street rushed to imitate them.  What happened then, and has been repeated more than any other event in this narrative, is that the windfall profits disappeared just as everyone decided to sink a lot of money into the market.

John Meriwether would have the ignominy of learning this lesson twice.