Development of Securitization

Mortgage securitization was devised in the 1970s in response to the fear that the (then healthy) thrift industry would not be capable of supplying sufficient capital to meet mort- gage market demand as the Baby Boomers entered their peak homebuying years (Ranieri 1996).20 After earlier fits and starts the first widely successful transactions were com- pleted in the early 1980s, taking pools of existing loans from thrift balance sheets and lodging them with Freddie Mac to issue ‘pass-through’ securities based on the cash flow from monthly payments on the loans in the pool. The securities carried the agency’s guarantee against credit risk (i.e., borrower delinquencies and defaults) and were under- written by Wall Street firms who sold them to investors. The term ‘pass-through’ reflects the fact that both principal and interest paid on the mortgages were ‘passed through’ to investors in proportion to their ownership stake in the pool. As the challenges facing thrifts mounted through the 1980s, billions of dollars worth of loans in thrift portfolios were securitized, along with an ever-growing share of newly originated loans.

20 _{The history of securitization presented here is drawn largely from Ranieri (1996) and to a lesser extent}

Despite playing an increasingly central role in the nation’s housing finance system, the power of securitization to attract capital to the mortgage market remained limited by the fact that only 30-year fixed-rate mortgages could be securitized and only into one type of security (30-year pass-throughs) existed. In order to broaden the marketplace appeal of the product, Wall Street worked with the GSEs to devise new types of securities called collateralized mortgage obligations (CMOs), which divided or ‘tranched’ cash flows from a pool of mortgages into claims of differing lengths and payment periods. When issued with Freddie Mac or Fannie Mae guarantee of timely payment of principal and in- terest, these new securities offered nearly risk-free returns above Treasury Bonds of equivalent maturities and were priced at extremely competitive rates relative to invest- ment alternatives such as corporate bonds. When issued by Ginnie Mae the securities car- ried the full faith and credit of the U.S. government and again were a competitive alterna- tive for the investor looking for a return modestly above the U.S. Treasury rate.

While the financial innovation of varying maturities succeeded in attracting additional capital to the mortgage market, several key legal and regulatory impediments restricted securitization’s full flowering. Among the most important were state-level restrictions on the ability of some investors to purchase pass-throughs and CMOs, limitations on the na- ture and extent of cash flow tranching imposed by the Department of the Treasury, and other tax issues (Ranieri 1996). The first problem was solved through the Secondary Mortgage Market Enhancement Act of 1984, which used federal powers of preemption to make investing in mortgage securities possible for virtually all investors, as long as the securities carried ratings from one of the credit rating agencies.

The second and third problems were dealt with in the Tax Reform Act of 1986, which created the Real Estate Mortgage Investment Conduit (REMIC). The REMIC structure at once cleared up lingering tax issues, and gave Wall Street tremendous flexibility to con- struct securities with widely ranging maturities and previously prohibited characteris-

tics.21 New securities could now be tailored to meet the maturity, yield, and risk require- ments of a broader range of institutional investors. These new securities included interest only (IO) and principal only (PO) payment ‘strips,’ and variable interest rate securities (floaters and inverse floaters). Today’s issues include dozens of classes with an increas- ing variety of maturity and yield characteristics. The market’s appetite for these products is evident from Figure 5, showing the growth in mortgage-backed security (MBS) and CMO issuance over the past two decades.

Figure 5: Agency Securities Have Exploded Since Their Introduction

The successful securitization of conforming mortgages led to the securitization of other assets, such as auto loans, credit card receivables, equipment leases, student loans, and manufactured home loans. Issues backed by collateral other than conforming mortgages are collectively referred to as asset-backed securities (ABS). This includes those backed by subprime mortgages, which Wall Street calls Home Equity Lending (HEL), in refer-

21 _{REMIC status simplifies the legal, regulatory, and accounting obstacles associated with issuing multiple}

asset classes and removes the threat of double taxation at the federal level for a securities issue backed by mortgages (Singer 2001b).

Source: GNMA, FHLMC, FNMA. (Data from The Bond Market Association website http://www.bondmarkets.com/Research/statist.shtml) 0 500 1,000 1,500 2,000 2,500 3,000 3,500 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 :Q2 bi ll ion ($ ) MBS CMOs

ence to the origins of the industry in second-mortgage lending and the continuing domi- nance of cash-out refinance loans.22

Figure 6: The Steady Growth of Subprime Mortgage Securitization

Securitization of subprime mortgages has increased steadily as the volume of originations has grown. Between 1995 and 2003 the value of home equity securities outstanding in- creased nearly tenfold, from $33.1 to $313.5 billion. As Figure 6 indicates, in 2002 the net increase in securitized loans outstanding was equal to nearly half of the $213 billion worth of subprime loans originated. While still dwarfed by the multitrillion dollar agency market, subprime mortgage securities (i.e., HEL ABS) are the now the second largest share of the $1.6 trillion in ABS outstanding, trailing only credit-card receivables ($402 billion), and ahead of auto loans ($229 billion).