When was the mortgage bond era on Wall Street? How did bankers profit from home loans in the 1980s?<\/p>\n\n\n\n
The mortgage bond market was booming in the 1970s. The number of home loans that were borrowed was at an all-time high, and the investment bank Salomon Brothers found a way to capitalize on it.<\/p>\n\n\n\n
Discover more about how people profited off the mortgage bond market, according to Michael Lewis’s book Liar’s Poker<\/em>.<\/p>\n\n\n\n\n\n\n\n The trends that led to Salomon Brothers\u2019 meteoric rise in the \u201980s began long before Lewis joined the firm. Salomon\u2019s embarrassment of riches didn\u2019t come from traditional government or corporate bonds but from its willingness to experiment in the fledgling mortgage bond market. Lewis explains how mortgage bonds work, how Salomon Brothers capitalized on the market, and how they turned the mortgage lenders\u2014the savings and loan industry\u2014into the primary customers of the mortgage bonds they created.<\/p>\n\n\n\n Lewis writes that in the 1970s, the largest and most rapidly expanding group of borrowers were homebuyers, not investors. What\u2019s more, since home loans were insured by the government, they were safe bets for lenders to make since the risk was deferred to the American taxpayer. By 1980, the mortgage industry was handling over $1 trillion in loans,<\/strong> more money than in the entire US stock market, but from Wall Street\u2019s perspective home loans were viewed as worthless. They were tiny compared to the huge transactions Wall Street banks dealt in, and on an individual basis, they were logistically difficult to trade. Instead, home loans were the bailiwick of small, local bankers whom Wall Street institutions thought of as ignorant country bumpkins.<\/p>\n\n\n\n (Shortform note: The first home loans in the US weren\u2019t made by banks at all, but by social cooperatives who pooled their members\u2019 funds<\/a> to loan back to individuals for the purpose of buying houses. The home mortgage industry was formalized by the Federal Home Loan Bank Act of 1932<\/a>, which enabled the creation of small, local banks called \u201csavings and loans\u201d<\/a> that were able to issue 30-year mortgages with affordable monthly payments. This encouraged a steady rise in home ownership from 1940-1960.<\/a> By the time that Salomon Brothers became part of the mortgage industry, the rate of home ownership in the US had plateaued between 60-65% because of inflation\u2019s effect on home prices<\/a>, though total home sales were still on the rise.)<\/p>\n\n\n\n To make home loans worth Wall Street\u2019s time and energy, bankers had to find a way to trade and profit from them in bulk. The solution is to bundle large groups of mortgages into pools. Within each pool, only a fraction of the loans should default while the pool as a whole remains a net positive investment. That pool can then be converted into a bond through which dealers can buy and sell mortgages in bulk. The bondholder receives the interest payments homeowners make on their loans while he\u2019s also able to shop the bond around like any other financial equity. Lewis points out that all through this process, the bondholder and the homeowners are completely blind to each other’s existence\u2014all that matters is the financial product.<\/p>\n\n\n\n (Shortform note: The bundling of mortgages that Lewis describes begins with the banks that issue the mortgages. Instead of retaining ownership of the loan, a bank may sell its loans in bulk<\/a> to an investment bank or a government agency such as the Federal Housing Administration<\/a>. The buying agency or bank then uses those mortgages as collateral for a bond that, when sold to investors, brings in even more capital that\u2019s used to finance more loans. A mortgage bond, then, is a tool by which investors can buy a stake in the housing market<\/a> without investing in actual real estate. Modern mortgage companies sell their loans to other banks all the time<\/a>, but when loans are bundled into pools to issue bonds, homeowners are rarely aware of it.) <\/p>\n\n\n\n The main problem with mortgage bonds (as compared to corporate or government bonds) is that they don\u2019t have a fixed maturity date. Homeowners have the option to pay off their loans early, which they usually do via refinancing when interest rates are low. When homeowners pay out, the bond turns to cash at what is generally the worst time (because of low interest rates) for the bondholder to reinvest his money. Despite this, Lewis recounts that Salomon Brothers believed the mortgage bond market would be hot in the 1980s.<\/strong> The housing business was expanding too quickly, and local banks didn\u2019t have enough money to finance all the loans they wanted to make. Mortgage bonds would act as a tool for Wall Street to provide that funding.<\/p>\n\n\n\n (Shortform note: Though computers had invaded Wall Street<\/a> by the \u201980s, replacing outdated ticker tape machines<\/a>, actual sales and trades of stocks and bonds were still carried out person-to-person. Most transactions during this period took place over the phone<\/a>\u2014clients called brokers to buy or sell a stock or bond, and the broker would then call a trader at a stock exchange (for companies that were publicly traded) or call another broker or seller directly. A bond took the form of a physical coupon<\/a> that its holder could trade for cash when it matured or sell to another investor in the interim. As Lewis points out, the maturity date of mortgage bonds was often vulnerable to change because of early payouts<\/a>.)<\/p>\n\n\n\n Right on the cusp of the 1980s, the savings and loan industry suffered a shock that threatened to stop the housing market<\/a> in its tracks. Lewis says that instead of backing out of the mortgage bond business, Salomon Brothers dove head-first into the market, turning the US government\u2019s plan to bail out local banks into a way to funnel money to itself. According to Lewis, Salomon\u2019s strategy revolved around exploiting the fears of small-town bankers, taking advantage of a crucial tax break meant to help those struggling banks, and turning those banks into the buyers of the bonds created by other banks\u2019 loans.<\/p>\n\n\n\n The \u201970s were a time of great inflation. To slow it, the Federal Reserve Bank announced in 1979 that instead of controlling interest rates, it would allow them to fluctuate according to the dictates of the market. The result was that interest rates went up. The housing market faltered since no one wanted to take out home loans at high rates of interest.<\/strong> Lewis explains that savings and loans were suddenly in trouble, since the interest they were paying to savings accounts was greater than the interest they were making on their mortgages that had been written on previous, lower interest rates. These banks needed to sell their mortgages in a hurry, and since it had cornered the mortgage bond market, Salomon was the only buyer.<\/p>\n\n\n\n Despite Salomon Brothers\u2019 roaring success with the mortgage bond market in the first half of the \u201980s, no gravy train runs forever. Beginning in 1986, Salomon\u2019s Wall Street dominance declined. Lewis recounts three separate ways that Salomon Brothers eroded their standing in the mortgage bond market\u2014they allowed other banks to snatch away their best traders, they developed a new financial product that undercut the value of traditional mortgage bonds, and the leaders of Salomon\u2019s mortgage bond department indulged in so much personal excess that Salomon\u2019s executives had to take a stand against them.<\/p>\n\n\n\n Salomon Brothers recruited many new traders from the legions of economics students in the 1980s, none of whom had any loyalty to the business. More than that, Salomon restricted their pay for the first two years of employment, regardless of how much money they brought in. This allowed other Wall Street banks to lure them away with higher salaries and bonuses. For young traders, Salomon simply became the place where they went to receive on-the-job training before sailing off to more lucrative positions. Not only did this drain Salomon\u2019s talent, but it also gave away the firm’s advantage by transferring its trading strategies and techniques\u2014along with its monopoly in the bond market\u2014into the hands of its rivals.<\/p>\n\n\n\n Lewis writes that besides the steady loss of talent at Salomon, new financial products called Collateralized Mortgage Obligations<\/a> (CMOs) defused the mortgage bond market by removing the bonds\u2019 volatility that had made them ripe for speculation.<\/strong> Salomon had actually devised these tools themselves to make mortgage bonds attractive to traditional investors. A CMO divided a bundle of mortgages into three or more \u201ctranches\u201d that matured at different rates. Money from homeowners who paid their loans early would go to the holders of tranche<\/a> #1 until their investment was paid back in full, before rolling payments to tranches #2 and #3. Therefore, tranche #1 was a short-term investment, and tranche #3 was long-term.<\/p>\n\n\n\nThe Mortgage Bond Era<\/strong><\/h2>\n\n\n\n
Target: Savings and Loans<\/strong><\/h3>\n\n\n\n
Mortgage Bonds Decline<\/strong><\/h3>\n\n\n\n