The Little CDO on the Prairie
Only a few years after collateralized debt obligations and other exotic investments contributed to the deepest economic crisis in decades, financial companies are on to the next big thing: complex securities that bundle rental income from properties managed by landlords such as American Homes 4 Rent and Blackstone Group LP's Invitation Homes.
The distressed, abandoned properties in areas devastated by the subprime crisis are the ones now being reborn as lucrative rental properties, and by extension, allegedly low-risk, high-yield securities.
Making the best of a bad situation through securitization isn’t a new trick for Wall Street: An earlier generation of innovators tried to pull off a similar feat after the calamitous panic of 1873.
Rightly or wrongly, one man is often blamed for the panic of 1873: Jay Cooke, who built his reputation by marketing and selling bonds on behalf of the Union during the Civil War. It is in part thanks to Cooke that the U.S. emerged from the conflict with its credit intact.
After that success, Cooke harnessed his sales acumen and formidable marketing operations to unload dubious railroad securities, many of them issued by the famous “transcontinentals.”
As the historian Richard White has argued, these much-celebrated corporations were, in fact, huge mediocrities that rarely turned a profit even though they benefited from vast government largesse.
Nonetheless, Cooke and other financiers peddled the securities of railroad corporations, notably the ill-fated Northern Pacific. But Cooke, whom the financial historian Robert Sobel described as the “most inventive banker of his era, as well as the most important,” was undeterred.
His enthusiasm wasn’t enough to save him. Cooke's company failed in September 1873, setting off a stock market supernova that destroyed dozens of railroads and brought down the global economy. Anything to do with the railroads was now viewed as pure poison as bonds went unsold and stocks collapsed.
Moreover, as White has observed, the tracks left behind by this period of overbuilding ran through areas that hadn’t been settled. Commodore Vanderbilt, assessing the wreckage, lamented the frenzy for “building railroads from nowhere to nowhere.”
One of the reasons for the lack of settlers was that the land in the arid plains states was tricky to farm. It was also expensive for farmers to get started, requiring an initial investment of about $1,000, a small fortune at the time. And given the frequent droughts, there was good reason to be skeptical, despite the railroads' claims that “rain follows the plow” -- that the very act of tilling the soil would, somehow, alter the climate and shower the new farmers with life-giving precipitation.
So by the late 1870s, investors wanted nothing to do with the Western railroads; the railroads were desperate for farmers who would grow the grain that they might profitably carry; and settlers couldn’t -- or wouldn’t -- be settled on these lands without serious help.
Eastern financiers came up with a solution: the mortgage-backed security. As described by the historian Jon Levy in his recent book, "Freaks of Fortune: The Emerging World of Capitalism and Risk in America," a cluster of corporations, including New England Mortgage Security Co., united the needs of investors, railroads and farmers.
Here’s how it worked: a farmer settling on the plains would use a mortgage loan to buy land or make improvements. Local or regional banks and brokers would approve the mortgage, but didn't own it. Instead, they funneled the loan to Eastern companies such as New England Mortgage Security.
These mortgages, Levy writes, “were securitized -- bundled together, repackaged, sliced, diced, and resold.” Bundling would reduce risk. As one booster of the stratagem explained: “The investor is not compelled to stand or fall with one mortgage or one piece of real estate. Each debenture bond is, in a sense, insured by all the rest of the series.”
Investors snapped up the bonds, and the “craze” for Western farm mortgages spread among institutional and individual investors. By the 1890s, hundreds of companies pitched the securities.
At the same time, settlers flooded into the plains states, and agricultural production expanded at staggering rates. In 1880, the wheat crop from the Dakotas was just shy of 3 million bushels; seven years later, it topped 60 million. And the railroads? As settlers flooded into the West, they now had something to carry, and a way to make money. Everyone was happy.
For a time. Then, in the late 1880s, drought hit the farming regions west of the 98th meridian, devastating farmers and prompting many to flee the area, and the stupidity of practicing conventional agriculture in an area without dependable rainfall became obvious.
The railroads began hemorrhaging money. Farmers defaulted on their mortgages, or found themselves in foreclosure. Levy reports that when debtors tried to determine who owned their mortgages, they discovered, as one Gilded Age broker observed, that a farmer “cannot treat directly with the eastern owner of the mortgage, for he cannot ascertain who that owner is.”
In the end, those owners lost their shirts, too. When the panic of 1893 hit, almost all the companies churning out mortgage-backed securities went under.
So if you’re thinking of rushing into the latest securitization craze: Caveat emptor!
(Stephen Mihm, an associate professor of history at the University of Georgia, is a contributor to the Ticker. Follow him on Twitter at @smihm.)
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