For me, a magazine advertisement in 1984 explains where it all went wrong. In a bizarre ad in the American Bankers Association journal, the chief financial officer of Freddie Mac, Leland Brendsel, appears to be consulting with gnomes on how to oversee America’s mortgage-backed securities markets.
According to the advertisement, “the gnomes of the secondary market, our omniscient associates” had brought the secret of securitization to Freddie Mac, the government-sponsored housing-finance company. Although clearly the result of an advertiser pulling an all-nighter, the gnomes reflected the supernatural aura of the collateralized mortgage obligation, which seemed to violate the rules of nature. Even to bankers, the system was mysterious. Yet its history was entirely conventional.
Financial markets require invention, and usually help from the federal government. In the Emergency Home Finance Act of 1970, Congress authorized the creation of the Federal Home Loan Mortgage Corporation, or Freddie Mac. Almost immediately, Freddie began to offer mortgage-backed securities, which had only been reauthorized for Fannie Mae, Freddie’s sister company, in 1968. Mortgage-backed securities and their predecessor, the participation certificate, had been absent from American finance since the 1930s, when the market for them collapsed during the Great Depression. State laws forbade the sale of such instruments, but their fate was in any event sealed by their toxic reputation.
Reputations can be revived, however -- especially when history is forgotten, as it was by the late 1960s.
As an easy way to turn investors’ capital into borrowers’ dreams, there is no better alchemy than the mortgage-backed security, which transforms illiquid mortgages into liquid bonds. This magic, of course, is what Freddie Mac did when it “created” the market. The gnomes of Freddie Mac bought mortgages from banks and then resold them, packaged as bonds. The first few bond sales were prearranged theater, and were federally insured, but once confidence rose, the bonds were sold like any other commodity.
Within three years, Freddie Mac was buying $1 billion in conventional mortgages every year, which was a blessing because the standard sources of borrowing -- small banks, savings-and-loans, and insurance companies -- were drying up. The president of the Mortgage Bankers Association of America, Robert Pease, declared at the annual convention that, except for Fannie Mae (and by extension Freddie Mac), “there is almost no money available for residential housing. We are in a real honest-to-goodness housing crisis!”
In 1971, an average of $50 million in mortgages flowed from the capital markets through mortgage-backed securities into housing each month, keeping the U.S. housing market afloat.
While Fannie dealt in federally insured loans -- such as Federal Housing Administration and Veterans’ Administration loans -- Freddie dealt in the so-called conventional market, which was everything else. With Freddie’s thaumaturgy, this market boomed. By January 1973, mortgage companies were originating more conventional mortgages than FHA or VA loans. By the 1980s, with interest rates rising and banks of all stripes wary of holding on to fixed-rate mortgages, the resale of conventional home mortgages only accelerated. A homeowner with a 30-year mortgage at 6 percent in 1970 would have been thrilled to watch his house appreciate through inflation, and to still be paying 6 percent every year as interest rates hit 21 percent. For the banks, this situation was a calamity. Holding long-term fixed-rate mortgages no longer made sense in an era of interest-rate volatility.
To find investors for all these fixed-rate mortgages took some serious wizardry. While so many of the other “new” financial instruments of the 1970s had existed in the 1920s and before, and then were abandoned after the Great Depression, in June 1983 Freddie Mac, in association with the investment bank Salomon Brothers and the First Bank of Boston, issued a genuinely new financial instrument: the collateralized mortgage obligation, or CMO.
The CMO managed to create many different kinds of securities out of one mortgage, through the now-familiar concept of a “tranche.” The trick was to slice the mortgage repayments into different streams, so that a 30-year mortgage could be sold as a one-year bond, a 10-year bond, and a 30-year bond, all with different interest rates.
Slicing mortgage-backed securities into tranches required elaborate calculations -- not only for Freddie Mac, but for investors, as well. As Dexter Senft, a First Boston investment banker who worked on the first CMO, said, “these products couldn’t exist without high-speed computers. They are the first really technologically driven deals we’ve seen on Wall Street.”
Innovations like the CMO gave Freddie Mac access to new sources of profit as well as new investors. Freddie Mac’s president during this period, Kenneth Thygerson, proudly said upon his retirement in 1985 that he “tried to extend the barriers to the limits of the corporation’s charter. Future opportunities will require an act of Congress, so this is the time for me to look to the private sector.” In the three years Thygerson was with Freddie Mac, its portfolio increased to $100 billion from $25 billion, and its profits increased almost fivefold.
The next appointed president of Freddie Mac, Brendsel, who had been directly responsible for the first CMO as Freddie Mac’s chief financial officer, reflected the importance of the new instrument to the company’s future. Perhaps the gnomes should have advised him that magic is, after all, better wielded by magicians than financiers.
(Louis Hyman is an assistant professor of history at Cornell University and the author of “Borrow: The American Way of Debt.” The opinions expressed are his own.)
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