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Monday, 23 October 2017

1977: US$100m deal for Bank of America: the first private-label MBS

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From little acorns

The creation and growth of the private-label mortgage-backed securities origination and trading business on Wall Street in the late 1970s and early 1980s at Salomon Brothers in New York is legendary.

It was also a critical turning point for Wall Street, ushering in a 30-year era where the bond market was king, bond traders became the most highly rewarded heroes of investment banking, and securitisation became one of the most lucrative and innovative pockets of finance.

Of course, the “revolution” that took place at Salomon Brothers in the spring of 1978, when the very first mortgage finance department on Wall Street was formed, also arguably led, 30 years later, to the worst recession in the US since the Great Depression.

How closely the two historical events are linked has been hotly debated. Lewis Ranieri, the “godfather of securitisation”, who led that very first Wall Street mortgage department, has gone on record in recent years as saying that it was not the concept of securitisation itself, but the new exotic mortgage loans, lack of liability, and growth of the subprime industry that ultimately sealed the fate of the pre-crisis housing/credit bubble.

Either way, the invention of MBS without government backing was a seminal event in the history of Wall Street.  Immortalised in the best-selling 1989 book “Liar’s Poker” by Michael Lewis, the story of MBS typically focuses on the brash Ranieri, a Brooklyn-born, hard-nosed utility-bond trader plucked from obscurity at Salomon to lead the brand new mortgage department because of his street smarts, drive, and aggression.

Liar’s Poker focuses on the ascension of Ranieri’s powerhouse mortgage-finance business, whose profits accounted for more than half of Salomon’s overall profits by 1981.

The creation of the first collateralised mortgage obligation in 1983, for Freddie Mac, only served to spread the wealth as other banks got in on the lucrative MBS industry. Salomon and First Boston completed that first deal.

But while Ranieri is often given all of the credit for creating the mortgage “monster”, as some might say in hindsight, it was actually his original boss at Salomon, Robert Dall, who was the brainchild behind the very first private MBS.

Dall, one of the few master-traders of Ginnie Mae MBS securities in the early 1970s, created the first private issue of mortgage securities (working with fellow trader of Ginnie Mae securities Stephen Joseph) for Bank of America in 1977, almost a year before Ranieri was even in the picture. The deal was for US$100m.

That first private MBS deal was “something that just came out of my head and happened”, Dall told the New York Times in 1986.

Ginnie Mae had been securitising government-guaranteed mortgages since 1970, but its bonds suffered from a serious flaw: an embedded prepayment option. Mortgages could be paid back in full at any time, leaving investors with a heap of cash to reinvest.

Moreover, refinancing risk meant that investors would get their money back when interest rates were at their lowest – something investors were unhappy about. Dall and his peers begged Ginnie Mae to offer some type of protection to bond investors, but the GSE did not want to.

The BofA deal of 1977 changed everything. It was the first that tried to address the prepayment issue – by introducing a nifty technique called “tranching”. The simple transaction had specific maturities and credit characteristics that would appeal to a much broader array of investors.

However, the prepayment conundrum persisted throughout the initial years of the nascent MBS market, spawning MBS research and trading desks that sought to understand the complex mathematics behind predicting mortgage prepayments and taking bets on which maturities/credits to buy.

With that initial 1977 private “pass-through” MBS deal, however – as simple as it was – Dall and Joseph for the first time persuaded insurance companies and pension funds to share some of the risk of American borrowers. That had never happened before.

Dall never quite got the credit he deserved. Just months after he chose Ranieri to trade the new mortgage securities and create a market for the new asset, the latter had squeezed his boss out of his position.

Ranieri’s determination to find new investors in such securities – including lobbying the US Congress to persuade more states to consider mortgage securities as “legal” investments – combined with his creation of five-year and 10-year bonds from 30-year mortgages, led him to be the dominant figure in mortgage finance in the early 1980s. But Dall and Joseph also deserve their place in Wall Street history.

To see the digital version of this report, please click here.

To purchase printed copies or a PDF of this report, please email gloria.balbastro@thomsonreuters.com.

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