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The Dubious Birth of Mortgage-Backed Securities

alyssa.katz — Thu, 25 Jun 2009 18:05:46 +0000

How Wall Street, Ronald Reagan, and Congress created a financial time bomb.

This is an exclusive, adapted excerpt from Our Lot: How Real Estate Came to Own Us, published this week by Bloomsbury.

The Obama administration's new financial industry reform plan may be the beginning of banking's biggest overhaul since the Great Depression. But one of the most remarkable things is that it leaves untouched one of the main causes of the financial meltdown: the business of packaging and trading of securities made up of thousands of pureed mortgages.

Indeed, the Obama plan is designed to make that industry more efficient than ever. Imagine the credit markets are like traffic in a busy city; once the deadly pileup is cleared away regulators will be drawing lines on the street, setting up traffic signals at intersections, issuing tickets for moving violations-so that those who invest in mortgage-backed securities can be assured that they're getting the expected returns, and borrowers won't get stuck with loans they can't repay.

One might think that the mortgage-backed securities business has always been there as a backstop to the American dream, but in fact it's a very recent invention, dating back to the 1970s. And it only really took flight a decade later, when the same wave of deregulation that sparked the S&L crisis also made it possible for investment banks to make and market mortgage-backed securities on a massive scale. The Obama plan, it turns out, owes less to FDR than it does to Ronald Reagan.

In the mid 1970s, a team of traders at Salomon Brothers worked with Bank of America for three years, trying to create some kind of bond, made up of bunches of home mortgages, that they could convince large numbers of investors to buy. A former night mailroom clerk-turned-trader named Lewis Ranieri joined the project in 1977, as it neared fruition. They didn't even have a name for what they were doing, until a Wall Street Journal columnist asked them and Ranieri came up with "securitizing." That is, they were taking all these mortgages and turning them into a security, like a bond, that could be bought and sold among investors.

The first bonds found few buyers. Most states had laws forbidding pension funds and other institutional investors from buying securities that weren't registered with state officials. The Securities and Exchange Commission, too, required piles of documentation for each mortgage pool. The IRS was determined to tax the transactions. And even when Salomon figured out how to deal with the government's demands, few investors wanted to stick around for 30 years waiting to get paid as homeowners sedulously wrote their mortgage checks month after month. The hurdles to turning homes into readily tradable securities stretched out before Ranieri and his colleagues like a mountain chain.

Yet "securitization" of mortgages promised to salve a growing problem. The Federal Reserve's war on inﬂation had catapulted interest rates to new heights; for homebuyers, mortgages zoomed past 15 percent. Savings and loans, the local financial institutions that still issued most home mortgages, found themselves owing more money than they made, since they had to pay high interest rates to borrow funds but were collecting much smaller amounts of interest on loans they had made years earlier. The S&Ls' only hope was to sell those old mortgages to investors at a loss, and take a tax write-off. Meanwhile, no one was sure where affordable home mortgages were going to come from in the future.

The government-sponsored Fannie Mae, Freddie Mac, and Ginnie Mae could have supplied the solution. All three already did, or could, create mortgage-backed securities and thus generate from investors billions in new mortgage funds for the nation's homebuyers. Under their federal charters, they were exempt from the restrictions on mortgage securities trading that so vexed Lewis Ranieri and his team. Indeed, Ranieri's department had been created to sell Ginnie Mae's mortgage-backed securities to investors, and when Ranieri saw how much money there was to be made by buying up and reselling mortgages from flailing S&Ls, he persuaded Freddie Mac to create securities out of those home loans. Its sales of the Freddie Mac securities made Ranieri's division Salomon's biggest moneymaker by far.

But Ronald Reagan's election in 1980 opened up an even more attractive possibility for Salomon Brothers and other investment banks. They could now turn the creation of mortgage securities into a mass-scale, streamlined industry—and put themselves in charge. Like Salomon, the White House's economic policy office sought to unleash the power of private investors to pump vast sums of new money into the mortgage market, with the help of a President's Commission on Housing consisting of bankers, real estate pros, and Washington political hands.

The Reagan plan deregulated S&Ls and set up mortgage investment pools to succeed them as the main source of funds for home loans, with Wall Street firms such as Salomon Brothers in command. They expected to end the reign of Fannie Mae and the other government- sponsored enterprises that had been helping lenders finance home loans until then. "Eventually, the Commission believes, both FNMA [Fannie Mae] and FHLMC [Freddie Mac] should become entirely private corporations, without special access to the deep pockets of the Treasury," its members advised the president in 1982.

Working with the White House Office of Policy Development, Ranieri became closely involved in shaping what the new, privately operated mortgage marketplace would look like. He met with the President's Commission, and together they came up with the mortgage-backed security as it's known today. Their objective as they sat down in 1982 was no different from that of the toy company Coleco that year as it set out to sell millions of Cabbage Patch Kids. They were determined to mass-produce and market a product that, through simple variations on a formula, could lure their customers into a stampede to buy, whether they wanted a redhead, a preemie, or a bald one.

Investors in bonds, which mortgage-backed securities essentially are, seek predictable outcomes-and mortgages offer anything but. The biggest unknown on a thirty-year mortgage is the "prepayment risk": the possibility that a homeowner will either pay off the balance early or eventually opt to refinance with some other lender, and therefore not make all the interest payments that investors had been counting on. Statistically speaking, the longer an investor hangs on to the security, the greater the likelihood that he'll get stung by a borrower's prepayment and lose expected future proceeds.

To appeal to all kinds of investors, Ranieri and the commission struck on the idea of carving up the pools into numerous slices, or "tranches," that let investors select the commitment that best met their needs. Investors who bought into the short-term slices would get the bulk of the first payments to come in, until they were paid the full amount they'd been guaranteed. Then the next level of investors moved to the head of the line. Those who committed for the longest stretches of time generally were assured higher returns because they were taking on the greatest risks; payments from borrowers could run dry before those at the back of the line were fully paid. They were riding in the caboose on a train whose destination was clear but whose tail end might never arrive there.

To realize Ranieri's ambition for an unconstrained private mortgage marketplace, Congress would have to rewrite federal securities laws dating to the Great Depression, and meant to prevent recurrences of the abuses that had led to that cataclysm. With Reagan economic policy advisers, Ranieri set about drafting language for a proposed bill.

The Secondary Mortgage Market Enhancement Act called on bond-rating agencies to weigh in on each mortgage pool. As long as a bond got one of the top ratings from the agencies—meaning that in the agencies' opinions, investors ought to be confident of getting paid—it could be sold. While the SEC would oversee the trading of these securities just as it did all investments for sale, no longer would the U.S. government exclusively manage the market in mortgage-backed securities. "We believe that the ratings services do offer substantial investor protection," Ranieri testified to Congress in 1984.

Ranieri promised that putting private bankers and their sales forces in charge of mortgage securities would save borrowers half a percent on every loan, by allowing mortgage lenders to tap into an almost unlimited universe of investors. The Democratic-run House joined the Republican-led Senate in handing Ranieri, and the rest of Wall Street, the keys to the nation's homes.

A mortgage company with almost no money of its own, and unregulated by any of the government banking agencies, could now go to Salomon Brothers and get the funds it needed to lend to customers, as long as its loans met the investment banks' underwriting guidelines. In the coming few years, this new source of funds made it possible for lenders that weren't banks to go from making about one in five home loans to three in five.

Lewis Ranieri left Salomon Brothers the following year, forced out in a power struggle. It wasn't long before he began complaining that his industry was failing to deliver on the lower interest rates he had promised Congress. The gains from securitization were substantial, all right, but Ranieri observed they were going overwhelmingly to a few savvy fund managers and investors, who quickly found creative ways to capture the savings for themselves. In 1988, as banking regulators warned of risky speculation among mortgage securities brokers, Ranieri acknowledged that his invention could a dangerous device if mishandled. "Just because a few people abuse the technology, doesn't mean the technology is bad," he told the Bond Buyer. "I could use the same argument about guns."

No matter. Ranieri, with the Reagan administration and Congress, had redirected history. As Ranieri accurately assessed, looking back a decade later, "We won total ﬂexibility."

Delivering Movies in Slow Motion

ethan.epstein — Mon, 29 Mar 2010 19:00:11 +0000

Postal Service cutbacks could hurt Netflix’s bottom line.

In the face of naysayers who have long predicted its demise, Netflix (NFLX) has had a remarkable few years. In 2005, the Los Gatos, Calif.-based DVD rental service boasted 4.2 million subscribers and enjoyed net earnings of $41.9 million. Last year, the company netted $115.9 million, and its bright red envelopes made their way into the homes of 12.3 million subscribers nationwide. The company's NASDAQ-listed stock price tripled in that period (see chart).

2010 is shaping up to be another stellar year. On Feb. 25 of this year, Netflix enjoyed a red-envelope day of sorts: It surpassed former industry leader Blockbuster (BBI) in movie rental revenue for the first time. Meanwhile, as mom-and-pop rental stores close up shop and Blockbuster enters a period of major retrenchment (the Dallas-based company recently announced plans to close 500 stores), Netflix's subscriber base looks set to expand.

Netflix is in many ways the epitome of the 21^st century company: It's based in Silicon Valley, it sells its services exclusively online, and it employs a hip bit of Web-speak in its name. But even as it boasts many of the trappings of a New Economy juggernaut, Netflix is still almost entirely reliant on that most 19^th century of institutions: the United States Postal Service. Indeed, Netflix is the Postal Service’s biggest corporate customer.

And sadly for Netflix, its big partner is also in the red—the Postal Service lost $3.8 billion last year. In an effort to stop the bleeding, on Wednesday, the USPS took the first step toward eliminating Saturday mail delivery—it asked the Postal Regulatory Commission for an opinion on the matter. (Congress still has to approve the change.) The USPS says it hopes to implement the change in fiscal year 2011. In addition to eliminating Saturday delivery, the Postal Service has also said that it wants to raise postage fees. If these changes are implemented, Netflix's finely tuned business model could suffer a serious blow.

Among other things, Netflix's success relies on its remarkable efficiency and its affordability. The least costly subscription plan, which allows a subscriber to rent one movie at a time, costs only $8.99, and the most expensive, which allows the subscriber to have four movies out simultaneously, tops out at $23.99. And delivery really is remarkably fast: The company generally delivers in just one business day, and has 58 warehouses nationwide, meaning that you rarely stray far from one. A subscriber can expect that if he sends back a DVD on a Monday afternoon, he will receive a replacement on Wednesday. To maintain these speeds, Netflix warehouse employees are expected to process a minimum of 650 discs per hour.

Slower and costlier mail service could put an end to that. The elimination of Saturday delivery would mean that Netflix subscribers will have to endure two consecutive days of no service—nothing to scoff at in a time when consumers have come to expect high speeds and (nearly) instant gratification. And Saturday is a big movie day; the blogger who runs the online bible for Netflix fanatics, Hacking Netflix, said via telephone that many subscribers have come to expect to receive movies on Saturdays and may be very disappointed. On the plus side for Netflix’s balance sheet, the blogger did note that the elimination of Saturday delivery could mean lower labor costs as warehouse shifts are eliminated. However, as the USPS claims that mail would still be transported and that post offices would still be open on Saturdays, it is not clear if this is the case.

Higher postage costs will pose another serious problem. Postage costs have already increased four times in the past five years. To combat these cost increases, the company has simply continued to fine-tune its automation and squeeze costs out of its warehouse and distribution network. The company has also slapped on costs for premium services, such as a $1-per-month fee on Blu-Ray discs. This has eased the cost pressure somewhat, but it’s a precarious balance. As far back as 2008, Netflix said publicly that it was considering raising subscription prices. Right now, Netflix needs to collect $2 per rented DVD in order to maintain profitability and is said to spend roughly 78 cents on postage for each rented DVD.

In total, Netflix estimates that it will spend $600 million on postage in 2010. A rise in postal rates will obviously skew this formula, and generate pressure on the bottom line. If Netflix can’t mitigate these higher costs through yet more automation, the company will face two options. It could slow down turnaround time, and therefore reduce the number of DVDs that it sends each month: That is, it could sacrifice speed for affordability. Alternatively, Netflix could instead elect to sacrifice affordability for speed and raise subscription prices to compensate for higher postage fees—a gambit that the company would be loath to attempt in this economy. Either way, Netflix may have to give up one of its hallmarks: bargain-basement prices or light speeds. And these reduced speeds, of course, will come in addition to the elimination of Saturday delivery.

And don't look to the Internet to save this Internet company, either. In recent years, Netflix has increased the availability of films that subscribers can stream instantly onto their personal computers, game consoles, Internet-enabled televisions, and soon iPhones. Currently, some 17,000 of Netflix’s roughly 100,000 titles are available for instant streaming. But while instantly streamed movies obviously eliminate postage costs, they are not a cost-free proposition for Netflix. Analysts suggest that the streaming technology itself is very cheap—it costs roughly five cents to stream 90 minutes of content—but the licensing fees can be exorbitant. Netflix won’t release the data on how much it pays for online licensing, but can apparently be quite expensive. Dan Rayburn, an analyst with Streaming Media, has said that he’s seen some streaming movies that cost as much as $4 per play.

Even if Netflix did wish to abandon mail delivery altogether, it wouldn’t be possible. Hollywood studios actively limit the number of films they allow to be streamed, because they want to avoid cannibalizing their highly profitable DVD businesses. (Studios collect about 80 percent of the sales of DVDs.) That’s a big reason why Reed Hastings, the founder, CEO, and chairman of the company, recently told Bloomberg News that he expects Netflix to continue mailing DVDs for 20 more years.

Ultimately, then, Netflix is going to be faced with higher postage costs and slower delivery speeds. Maybe your emphatically unsexy and oh-so-20^th-century brick-and-mortar movie rental store isn't dead after all.

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Will the Struggling Postal Service Take Netflix Down With It?