The Creation of the Mortgage Backed Security

Mortgage Backed Securities have been called the greatest financial innovation of the 20th century. Since the 2008 housing bubble burst and the subsequent financial crisis, Mortgage Backed Securities’ have come under a great deal of scrutiny. This article explains what Mortgage Backed Securities are and how they came about.

In October 1979, the US Federal reserve began to raise interest rates. As a result thrifts (financial institutions that primarily focus on financing home mortgages) started to lose billions of dollars. The entire structure of the home lending was on the verge of collapse. As a consequence, Congress passed a tax break for thrifts called the Thrift Partnership Act of 1981. The accounting standard of the time, allowed thrifts to amortize (gradually write off the initial costs over a period of time) the losses of loans over the life of the loans. Because of the new tax break, the loss could then be offset against any tax the thrift had paid over the ten previous years. When shown the loss, the IRS returned old tax dollars to the thrift. Thrifts started looking for a way to generate lots of losses to show the IRS. They began to sell their bad loans for losses in an effort to claw back old taxes. The cash from selling these loans could then be put to work for higher returns — often by purchasing cheap loans disgorged by other thrifts. Several thrifts began to layer a millions of dollars of new loans on top of their existing millions of dollars of loss making loans, in the hope that the new would offset the old. However, thrifts only specialized in taking deposits and originating mortgages, they needed someone to buy and sell their home loans. In comes the Wall Street Trader.

At the time, a single Wall Street Firm called Solomon Brothers had a monopoly of the then infant market of mortgage bonds, they began to buy millions of dollars’ worth of home loans from thrifts and sell them to investors. However, Solomon Brothers were an investment bank and they specialized in raising financial capital by underwriting new debt and securities (mainly bonds), not trading home loans. Therefore the mortgage trading department at Solomon Brothers began to look for a way to securitize mortgages. securitization posed two main problems; firstly home loans didn’t have a definitive maturity like other bonds, debtors were allowed to pay back their loans however early they wanted to. Who wants to lend money without knowing when they will their money back? Secondly, creditors (the owners of home loans) were at risk of losing their money if home owners defaulted on their loans, unless these loans were guaranteed by Gennie Mae (GNMA).

Fortunately for Solomon Brothers, around this time, the federal government created two new facilities alongside Gennie Mae called Freddie Mac (FHLMC) and Fannie Mae (FNMA). They guaranteed the mortgages that did not qualify for the Gennie Mae stamp. The Thrifts paid a fee to Fannie Mae or Freddie Mac to have their mortgages guaranteed. Once the loans were stamped nobody cared about defaulters anymore; mortgages had been transformed into government backed bonds. Once mortgages were protected against defaulters, investment bankers could package hundreds of similar mortgages and sell them as securities. They had created the Mortgage Backed Security as we know it today.

Over the next decade several other Wall Street firms both big and small began to trade Mortgage Backed Securities. In 1983, the collateralized mortgage obligation or the CMO was created, although, it did not dominate the market until 1986. To create a CMO, one gathered hundreds of millions of ordinary mortgage bonds (home loans) and placed them in a trust. The trust paid interest to its owners. The owners had certificates of ownership; however, all certificates were not the same. A basic CMO is usually split into three trenches. Investors in each trench received interest payments differently. The owners of the first trench received payments on the all principal (not interest) repayments from mortgage bonds held in the trust. The owners in the second trench only received prepayments when all the first trench owners were completely paid off. Not until both the first and second trench owners were paid off did second trench investors had been entirely paid off did the owners of the third trench receive prepayments. Thanks to CMO’s, home mortgages began to look like other bonds. One could say with some certainty that the maturity of the first trench would be no more than five years, the maturity of the second trench would be around seven and fifteen years, and that the maturity of the third trench would be between fifteen and thirty years. Wall Street had solved the above mentioned first problem with securitization. Since ,there have been several innovations in CMO’s; traders have created CMO’s with ten tranches, interest only CMO’s, principal only CMO’s and countless other types.