Road to Ruin

The history of mortgage-backed securities and a warning for financialization

The rise of the financial product known as mortgage-backed securities, which led to the 2008 stock market crash, parallels the rise of financialization, or the increase of financial profits as a share of the economy. The housing market is a microcosm of the financialized economy, an economy which has fundamentally changed character in the last fifty years. Studying the historical processes that allowed housing to become a financial product can illustrate the dangers of an over-reliance on financial profits.

Federal government agencies intervened substantially in the housing market during the Great Depression as a response to widespread housing insecurity. The Home Owner’s Loan Corporation, created in 1933, bought foreclosed mortgages and restructured the terms to twenty-year, fixed-rate, and fully amortizing (in which the principal is paid over the life of the loan). The Federal Housing Administration provided insurance for these new mortgages. Prior to the innovations of these government agencies, mortgages were typically adjustable-rate, three to five year loans issued to farms and secured with farm equipment. These new standardized mortgages, subject to approval, made homeownership more accessible and would later become the building block of the mortgage securitization market.

The New Deal government support of housing extended through the post-war period. The Federal National Mortgage Association, or “Fannie Mae,” was created in 1938 and issued bonds for mortgages, removing banks’ exposure to interest rate risk, or the risk that the value of their investment would decrease due to inflation. The G.I. Bill in 1944 established the Veterans Administration mortgage insurance program. In succeeding years, the FHA loosened the terms for mortgages, making them more accessible. These policies were meant to expand homeownership, and they succeeded. By 1969, the homeownership rate had gone from 43.6% in 1940 to 64.3%.

But the gains in homeownership were reserved mostly for white people. The practice of redlining, in which the FHA shaded areas on a map to deem them unfit for preferential investment, was racially discriminatory. Predominantly black neighborhoods, independent of other factors, were denied insured loans. The growth of homeownership and its attendant wealth gains, subsidized through generous government programs, went to white households at the expense of black households.

The development of mortgage securitization was a government initiative intended to further increase the accessibility of mortgage loans. While the practice of selling the rights to receive principal and interest payments on mortgage loans dates back to at least the 1850’s, investing in insured, standardized mortgages was a long-term investment with low risk and therefore little payout. Mortgages were such a stable investment that the government began to securitize them in order to attract capital into the mortgage market. The Government National Mortgage Association, or “Ginnie Mae,” began as a government-sponsored enterprise, like Fannie Mae, to support a market for mortgage-backed securities. In 1968, the first pass-through mortgage-backed security was issued, a relatively simple financial product in which pooled mortgages allowed investors to receive payouts before the end of a mortgage’s 30-year lifespan. The Federal Home Loan Mortgage Corporation, or “Freddie Mac,” began to securitize FHA- and VA-insured mortgages in the 1970’s.

In 1983 the Federal Home Loan Mortgage Corporation, or Freddie Mac, issued the first structured mortgage-backed security, the collateralized mortgage obligation (CMO). CMO’s divide the payouts into tranches, or tiers. The most senior tranche of underlying mortgages is paid off first, making it the most secure, as it bears less interest rate risk than a pass-through MBS. Each subsequent tranche bears more risk, with the last tranche bearing the most risk but offering the highest payout. At their peak some CMO’s were issued with as many as 50 tranches.

The deregulation of finance was a policy response to the “stagflation” of the 1970’s, in which slow growth combined with heavy government deficits led to capital shortages and high inflation. Whereas the theories of John Maynard Keynes led governments to respond to the crisis of the Great Depression by fine-tuning the economy, deregulation as part of the neoliberal trend in the 1970’s was an ostensible shift toward allowing the market to settle policy questions.

Deregulation led to the consolidation of capital and the disappearance of mechanisms that channeled capital away from speculative investment. As a result of deregulation in the 1980’s and 1990’s, regulations that had caused banks to be based in individual states vanished, allowing them to consolidate and buy corporate stock. By 2000, institutional investors such as banks and insurance companies had come to own nearly 60% of corporate equity. As state law increasingly pre-empted federal law, firms began to shop around for the most beneficial state regulations.

In addition to financial innovations and the lax regulatory environment that allowed them to flourish, a cultural shift toward middle-class investing contributed to the establishment of the US mortgage market as a systemic risk in the global economy. This shift began in the late 19th century, according to both historian Julia C. Ott and business law professor Lawrence Mitchell. The transition to what Ott calls “investor democracy” required a shift away from 19th century values of thrift and hard work. Ott writes in her book When Wall Street Met Main Street, “reformers of all stripes — from Jeffersonians and Jacksonians to Populists, anti-monopolists, socialists, and organized labor — denounced the [Stock] Exchange as the tool of unaccountable, dishonest, rapacious elites.” But the years between 1870 and 1910 mortally wounded the republican ideal of economic independence as the proportion of self-employed declined from 67% to 37%. During this period, a wave of consolidation among competing industrial firms called the Great Merger Movement engendered fresh anxieties about the power of corporations. To proponents of investor democracy, the ownership of financial securities promised economic security as well as a democratic check on large corporate firms. By 1921, the New York Stock Exchange had branded itself “the people’s market”. Additionally, the reform of the legal entity of the corporation, in conjunction with the stock market, allowed for more diffuse capital investment, making it possible for the middle class to own shares in companies.

In that Gilded Age period, investing became more commonplace thanks to efforts by the federal government as well as those of industry. Prior to 1899, less than 1% of the population owned stocks or bonds. An aggressive campaign from the federal government to sell Liberty Bonds during World War I resulted in 34 million people, or one third of the population, investing in the war effort. By 1929, one quarter of households owned company stock. Elites also sought fortunes in the market. Industrial titans Andrew Carnegie and John D. Rockefeller moved from managing companies to investing late in their careers.

Federal regulation sought to tame the speculative excesses of this wave of investment. After the Panic of 1907, when the failure of two brokerage firms led to a run on banks, the government created the Federal Reserve to insure bank deposits. With the stock market crash of 1929 came new, stricter regulations, notably the Glass-Steagall law of 1933 which kept commercial banks out of the securities business.

What followed was an era of broad prosperity and stability, partly owing to what Lawrence Mitchell calls “managerialism.” In the post-war period, corporate managers were insulated from the short-term demands of the stock market and therefore made decisions for the longterm benefit of the company and its employees. This is in contrast to the “shareholder revolution” era of the 1980’s, when hostile takeovers became more commonplace as institutional investors began increasingly to own majority stakes in corporations, demanding quarterly profits and payouts.

In the 1990’s, the mortgage market expanded into “private label” securities, which did not carry the insurance and approval requirements of government-sponsored enterprises (GSE) like Fannie Mae and Freddie Mac. Where insured mortgages carry only interest rate risk, private label mortgages carry default risk, meaning that the value of the investment would be lost if a borrower defaulted on their loan. Financial regulations did not keep apace with this new, rapidly growing segment of the market. By 2006, private label mortgages had exceeded GSE securities’ share of the market at a valuation of nearly $1 trillion.

Increasingly risky, increasingly sophisticated financial instruments fueled the growth of private label mortgage lending. Banks and investors grew bold on the assumption that they had engineered away the risk in the underlying loans. Collateralized debt obligations, or CDO’s, created securities from a pool of CMO’s, themselves an engineered pool of mortgages. Credit default swaps (CDS), unregulated insurance agreements that did not have capital requirements, offered investors a putative hedge for their investments as a complement or substitute for the more-regulated bond insurance. These risky CDS’s proved to be poor hedges and would worsen the crash of 2008.

In addition to lax regulation, plentiful capital contributed to the rapid spike in house prices in the 2000’s. Federal Reserve chairman Alan Greenspan, changing course after a mid-1990’s attempt to contain a speculative stock market with high interest rates, kept interest rates low through the 2000’s. Additionally, in the early 2000’s, foreign capital and speculative capital fleeing the bursting dot.com bubble both fed into the housing market. During this period measures of housing demand predicted lower levels of appreciation than what occurred. In response to a question of when abundant credit was too much credit, Greenspan punted to the market: “I think the market [will] take us off the treadmill.”

Even in times of plenty, racial inequities persisted in the housing market. In the mid-1990’s, the subprime market had come to target minority neighborhoods with “cash-out” refinancing designed to extract equity out of homes while incurring high fees to brokers. In an echo of New Deal-era redlining, black borrowers, controlling for other factors, were six times more likely than white borrowers to receive a subprime loan. These practices ended in a foreclosure crisis concentrated in minority neighborhoods in the early 2000’s. But because financial markets managed to remain profitable despite high rates of default, the warning of the bust went unheeded.

In the wake of the 2008 crash, in which $22 trillion was lost, the destruction was sufficient to cause the most dedicated free-market advocates to question their convictions. Alan Greenspan admitted that “those of us who have looked to the self-interest of lending institutions to protect shareholders’ equity, myself included, are in a state of shocked disbelief.”

The theory that markets are inherently speculative and prone to bubbles has gained cachet following the 2008 crash. According to Robert Shiller, Nobel laureate and economist, markets rely on intrinsically irrational human actors, making a rational market impossible. As a metric for a speculative bubble, Shiller points to the price-earnings ratio of the S&P Composite Index, which peaked in 2000 at 47.2, beating the previous historical high of 32.6 that directly preceded the stock market crash of 1929. Additionally, Shiller notes that real home prices increased 52% between 1997 and 2004, indicative of a bubble that he correctly predicted would pop.

In addition to the proven risks of widespread mortgage securitization, evidence suggests that its ability to increase access to homeownership is overstated. The rate of owner-occupied homes, amid all the innovations occurring in mortgage finance, remained remarkably similar over decades. The rate was 64.3% in 1969 and 64% in 1993. Alongside a spike in real estate prices, that rate increased to a peak of 69% in 2005–2006. While in the context of the credit crunch of the 1970’s it may be argued that securitization contributed at least to the stability of the housing market, the spike in home prices in the late 1990’s real estate bubble, corresponding to a relatively minor increase in homeownership, demonstrates that much of the gains of financial innovation did not go to borrowers.

The mortgage market holds warnings for an economy increasingly reliant on financial profits. In thirty years, between $5.8 and $6.6 trillion were transferred to the finance sector, according to sociologists Donald Tomaskovic-Devey and Ken-Hou Lin. The financial sector accounted for 20% of GDP by 2010, while manufacturing fell from 30% of GDP in 1950 to 10% in 2010. In 2003, at its peak, Wall Street accounted for 40% of all corporate profits. The majority of US households since the 1990s have owned financial securities, indicating a widespread acceptance of investing as a source of wealth.

Profits during the housing bubble came mostly from financial manipulation and speculation. Similarly, in our financialized economy, non-financial firms are seeking growth through finance. Sociologist Greta Krippner, in her book Capitalizing on Crisis cites a study that found “Ford Motor Company […] has in recent years generated its profits primarily by selling loans to purchase cars rather than through the sale of the cars themselves.” Tomaskovic-Devy and Lin argue that financialization crowds out capital investment in real productive assets, based on evidence that increased financial payments had a negative effect on most firms’ new capital investment. Similarly, Lawrence Mitchell cites a survey of four hundred chief financial officers that found that a majority would delay new projects to meet short-term earnings targets, “even if it meant sacrifice in value creation.” In other words, a focus on short-term financialized profits can be a zero sum game that pulls investment away from more productive endeavors. Thomas Philippon, a finance professor, calculates that, despite dramatic increases in technology, the unit cost of financial intermediation, historically somewhere between 1.3% and 2.3% of assets, rose to almost 9 percent in 2010. Failing to find evidence that increased trading leads to better prices or better risk-sharing, Philippon calculates that financialization leads to a misallocation of $280 billion yearly in the US alone.

In addition to evidence that financial innovation, in the housing market and in the broader economy, increases risk to unsustainable levels while failing to add value, the very notion of deregulation may simply obscure the role of central planners in the economy. According to Greta Krippner, the appeal of deregulation in the 1970’s was its ability to allow policymakers to outsource difficult priority decisions to the market. The Federal Reserve played a crucial role in the recovery from stagflation of the 1970’s. In order to attack inflation, at the heart of the credit shortage, Federal Reserve chairman Paul Volcker oversaw a steep hike in the federal interest rate, peaking at 20 percent in 1981, over the course of three years beginning in 1979. The result of the “Volcker Shock” was twofold. According to Krippner, “Interest-rate-sensitive industries — especially construction, automobiles, and agriculture — came to a grinding halt, throwing the agro-industrial heartland of the country into a near depression.” Secondly, foreign capital flooded into the US seeking the high interest rates that the Fed had imposed. This foreign capital went largely into high-risk speculative investments. Foreign capital also offered the government (which had found in Volcker’s strict monetary policy a mechanism for controlling inflation) a way to fund deficits.

This analysis — that “deregulation” is a way for the federal government to obscure its role in economic policy — helps explain the convoluted structure of Fannie Mae, Ginnie Mae, and Freddie Mac. Fannie Mae was privatized in 1968 and shifted its government-insured loans onto the books of the newly created Ginnie Mae. Despite their express purpose being the expansion of homeownership and the fact that they only dealt with loans conforming to FHA and VA standards, these GSE’s carried no explicit guarantee from the federal government.

The danger of a pseudo-public GSE, as opposed to, for example, an expansion of mortgage loans through the FHA or VA with an explicit government guarantee, was that investors assumed, rightfully, that the government would bail them out in the event of a crash and ignored warning signs of Fannie Mae and Freddie Mac’s impending insolvency. This model offers the worst of both worlds, where an effective public subsidy boosts profits while encouraging risky behavior.

In the 2000’s housing bubble, the Federal Reserve played a role in exacerbating it by providing low interest rates. The Fed continues to play a role in the recovery, the spoils of which have gone almost entirely to the top 0.1% of earners, by lowering the federal interest rate to near zero. Additionally, the Fed has engaged in several rounds of experimental “quantitative easing,” programs of buying risky assets from banks in order to further stimulate lending. The fact that central banks are shuffling around trillions of dollars belies the notion that our economy functions as an unfettered market.

As we assess the causes of the 2008 crash, it is important to remain clear-eyed about the risks of letting “the market” reconfigure our economy to prioritize financial profits. It is also important to look critically at the obscured role of public institutions in influencing the economy and how equitable the results of those decisions are. Public policies should be re-democratized and made transparent lest the cycle of booms and busts continue to push the losses onto the 99%.