FI 398
Paper on Liar’s Poker

The History of the Secondary Mortgage Market The secondary mortgage market is one of the richest asset classes in the world today. This market is formed by the trading of securities that are backed by commercial and residential mortgages. There are two main assets that are traded. These are Mortgage Backed Securities (MBS), and Collateralized Mortgage Obligations (CMOs). These two distinct asset classes make the market a very profitable one for many large investment corporations. Thanks to legislative action, most notably when Michael Lewis said, “From the early 1930s legislators had created a portfolio of incentives for Americans to borrow money to buy their homes”(121). These legislative policies made owning your own home something more attractive, because borrowing for it went on to benefit you for tax purposes. In the 1970s, the nation’s mortgage portfolio was booming in growth. As Lewis noted, “the volume of outstanding mortgage loans swelled from $55 billion in 1950 to $700 billion in 1976. In January 1980 that figure became $1.2 trillion, and the mortgage market surpassed the combined United States stock markets as the largest capital market in the world”(122). These are truly shocking numbers. The growth in the industry was completely unforeseen. While there are several similarities between mortgages and bonds, particularly after the development of MBS and CMOs, they are also different. The main difference is that bonds have a piece of paper that is a claim to ownership. Mortgages do not, with Lewis stating “Mortgages were not tradable pieces of paper; they were not bonds. They were loans made by savings banks that were never supposed to leave the savings bank. A single home mortgage was a messy investment for Wall Street, which was used to dealing in bigger numbers”(124). The big problem with the mortgages was the default uncertainty. It was not a sure bet to think people won’t default on their mortgage, especially after the advent of floating interest rates by the Fed. Thus, the mortgages were pooled up and created into assets, classed by the type of home the loans are collateralized by. In the 1980s, the bond market exploded. One main reason that the bond market exploded was that the Federal Reserve System fixed the money supply, so that interest rates would float. Lewis remembered it, when he said in his book, “At a rare Saturday press conference on October 6, 1979, Volcker announced that the money supply would cease to fluctuate with the business cycle; money supply would be fixed, and interest rates would float”(48). This major event caused the changing interest rates to generate a great profit opportunity for investment banks. Becoming a bond trader was one of the most popular positions desired by Salomon trainees. The bond traders were the new Wall Street hotshots, and they dominated the circles. Another catalyst to the boom of the bond market was the increase in American borrowing. Governments, corporations, and individuals were all looking for ways to borrow money to finance their purchases. As Lewis mentioned, American governments, consumers, and corporations borrowed money at a faster clip during the 1980s than ever before: this meant the volume of bonds exploded”(49). This happened because banks were giving out money easier than ever before. “The combined indebtedness of the three groups in 1977 was $323 billion, much of which wasn’t bonds but loans made by commercial banks. By 1985 the three groups had borrowed $7 trillion”(49). Much of this indebtedness was not, however, made from bonds. Much of it was from loans made by commercial banks. These banks gave loans to retail clients and then investors started purchasing them when interest rates began to float. The secondary mortgage market hit a big boom in the early 1980s. “So on September 30, 1981, Congress passed a nifty tax break for its beloved thrift industry. It provided massive relief for thrifts. To take advantage of it, however, the thrifts had to sell their mortgage loans”(152). Salomon became a big player in buying the mortgage loans from these thrifts. Led by Lewie Ranieri, the mortgage trading desk, the brainchild of Bob Dall was the only fully staffed desk of its type on Wall Street. Salomon’s research, led by Harry Kaufman, their director of bond research was clearly superior to that of their competition. As Lewis said, “The only fully staffed mortgage department on Wall Street was no longer awkward and expensive; it was a thriving monopoly”(152). Since Salomon was the only firm staffed to handle this boom, they were reaping the most benefit. Ranieri was buying these loans, and taking them to the US Treasury Department for stamping. “Ranieri & Co. intended to transform the “whole loans” into bonds as soon as possibly by taking them for stamping to the U.S. government bonds. For that purpose, partly as the result of Ranieri’s persistent lobbying, two new facilities had sprung up in the federal government alongside Ginnie Mae (157-8). These new facilities formed were Fannie Mae and Freddie Mac. As Lewis described, “They guaranteed the mortgages that did not qualify for the Ginnie Mae stamp. The Federal Home Loan Mortgage Corporation (called Freddie Mac) and the Federal National Mortgage Association (called Fannie Mae) between them, by giving their guarantees, were able to transform most home mortgages into government-backed bonds”(158). The government backing made these bonds very attractive for investors. It was a more legitimate investment with government backing, rather than simply getting home loans. Wall Street got involved in the secondary mortgage market by creating these debt instruments. “The beautiful inefficiency of mortgage bonds was spoiled for Salomon by one of its own creations, the collateralized mortgage obligation (CMO). It was invented in June 1982, but did not until 1986 did it dominate the mortgage market”(200). These instruments made the mortgages more attractive to the investors. Investors previously shied away from them because they did not have any substance, like a bond does. “The irony is that it achieved precisely what Ranieri had hoped: it made home mortgages look more like other bonds. But making mortgage bonds conform in appearance had the effect, in the end, of making them only as profitable as other kinds of bonds”(200). This made the mortgage bond market explode. All of the big investment banks began seeking talent from professionals who worked at Salomon, and in the late 1980s, the professionals started to grow frustrated with the lack of competitive pay and treatment, along with the general managing style of Salomon. They then began jumping ship and heading to the other banks, like Merrill Lynch, Goldman Sachs, and others. Salomon’s development of these asset classes led to an explosion of the market. They essentially created the market so that they could dominate it. Their purchases of mortgage loans from thrifts signaled a shift toward a tradable mortgage backed security. These securities rose greatly in value because of the floating interest rates. The creation of floating interest rates was the single most influential event in the bond market, and the mortgage backed securities market was modeled closely after the bond market. However, even though the traders were giving Salomon great profits, they were not compensated accordingly, in their opinions. As Michael Mortara, former Managing Director at Salomon brothers in charge of mortgage trading said, “the people who participated in the development of the mortgage market were victims or at least severely penalized by the Salomon Brothers compensation system. Their pay was way out of line with their production”(191). This lack of compensation led to an eventual shift in power among the mortgage trading market. Many top Salomon executives went on to roles in other firms and left for more competitive salaries. “Michael Mortara became the head of mortgage trading at Goldman Sachs – the leader in mortgage bond trading in the first half of 1988”(221). The exile of top executives from Salomon’s formerly leading mortgage trading desk made their desk crumble into nothing. The crumbling of the Salomon mortgage market was definitely a catalyst in the firm’s eventual demise. Preceding the stock market crash in the winter of 1987, there was a great deal of firings at Salomon. The firm that had been so influential in the development of the mortgage security market had fallen. This was a truly shocking turn of events, as they were thought of so highly on Wall Street. Salomon Brothers was the single most influential figure in the development of mortgage-backed securities. When the securitization of these mortgages happened, Salomon gained great profit from this market. However, despite this prosperity, the firm collapsed when they failed to pay their employees the salary their work deserved, and their workers went to competitors. The secondary mortgage market is one of the most major capital markets today, and it wouldn’t have been what it was had it not been for Salomon Brothers.