A Smart Idea Spoiled
Lewis S. Ranieri, the father of securitization, never imagined his brainchild would cause so much trouble. The Brooklyn-born innovator, who started his career in the Salomon Brothers mail room and worked his way up to the investment bank's mortgage trading desk, crafted in 1977 the first private pool of home loans sold on Wall Street. His creation is now at the center of the credit crisis—an outcome he predicted in early 2005 when he warned that the mortgage market's excesses would "blow up in our faces."
Today, Ranieri, 61, is an éminence grise to Federal Reserve Chairman Ben Bernanke and Treasury Secretary Henry M. Paulson. He has a field-level view of the credit market wreckage as chair of troubled Franklin Bancorp (FBTX) and co-founder of a fund launched in May that buys distressed mortgage loans. In his first extended interview since the crisis began, Ranieri talked with Associate Editor Mara Der Hovanesian about how Wall Street took securitization to absurd limits—and how the system can be fixed.
Was securitization necessary?For most of this country's history, home lending was governed by a simple idea: make loans consumers can afford today and can afford tomorrow—i.e., 30-year, fixed-rate loans. Things stood that way until the early 1970s. With the baby boomers, the question became how to put all of these people in houses. To accommodate the demographic demand, banks had to keep raising equity, which wasn't realistic. Securitization allowed them to fund the loans off the balance sheet.
Why did it go wrong?When interest rates go up and refinancings end, the industry has to contract. It's never fun. But at the end of the last cycle in 2004-05, all of a sudden—and some of us think not accidentally—instead of normal contraction we had this amazing growth of the subprime industry. It distributed the benefit of homeownership to people who never would have qualified for mortgages otherwise.
Is that how the industry rationalized exotic loans?That was one of the excuses. In the name of trying to enfranchise everybody, we started creating unstable loans that were designed to blow up in two years. Now the loans need the tooth fairy to keep up their values.
Why did that happen?There's an old Wall Street adage that there's a nexus between fear and greed. If you diminish fear, you get more greed. People got braver issuing this stuff. All the participants felt they could act merely as agents and collect fees. Nobody was prepared to say "I have liability."
Can the system be fixed?It can be fixed very quickly if everyone stops fighting.
What are the industry players fighting over?We have never before had to restructure a large number of loans tied up in securitizations. We need to fix the issue so the servicer is empowered and paid to act like a fiduciary, with the responsibility to make changes to the terms of loans—especially new loan types like interest-only and payment-option adjustable-rate mortgages. I have always contended that such exotic loans are inherently more dangerous.
Which loans are the most problematic?If you don't fix the second mortgages, including home equity loans and piggyback loans, they will add to the downward spiral of the housing market. The first mortgage holder can't restructure a loan because the lender with the second mortgage—although underwater—doesn't want to take a loss. So that lender blocks the loan workouts and the house goes into foreclosure.
How can the problem be solved?In the end, it may very well need legislation. We're going to have to bring to bear the resources we have like Freddie Mac (FRE), Fannie Mae (FNM), and the Federal Housing Administration. We need their help to reimpose standardization of products and pricing models that work—maybe even some legislation dealing with the second-mortgage issue.
Is securitization dead?No. It's a matter of going back to basics and ascribing liability to actions. There was no reason to remove income verification and full appraisals when making loans. It's actually simple: We have to take out of the system what was never logical. If we're going to take a person who is relatively financially illiterate and give him a higher-risk loan, then it should be done with supervision and liability. Otherwise the whole notion is absurd.