A cocktail of deregulation and financial innovation

I've just finished reading, for the second time in 15 years, Liar's Poker by Michael Lewis. It is a wickedly funny account of his meteoric rise in just two years from a mere trainee to a big-shot bond trader in New York and London with Salomon Brothers, then the world's most profitable merchant bank.

This book, along with Bonfire of The Vanities and Barbarians At The Gate, typified the sheer greed and raw ambition that fuelled Wall Street in the 1980s.

It closely follows the history of the mortgage bond market in the US. It's a story of bold financial innovation that ultimately resulted in the Commercial and Residential Mortgage Backed Securitisation (C/RMBS) - an important part of the global real estate finance landscape now.

I found it very intriguing to explore the factors that contributed to this phenomenon and nailed it down to an unusual cocktail of deregulation, government support and financial innovation.

First, the deregulation of interest rates by the US Fed in October 1979. Before securitisation, mortgage bankers (called thrifts) disbursed 20-30 year loans. Borrowers sometimes prepaid the loans, depending on their financial ability and prevailing rates. Thrifts were stuck with a loan and couldn't liquidate this. It was terrible if short-term rates rose because banks would be borrowing newly at 14 per cent whereas their old (long term) loan portfolio was lent at five per cent, and this is precisely what happened when rates were deregulated. Thrifts were forced to sell old loans and buy new ones with higher interest rates and a sort of trading market - in whole loans and not bonds - started.

Government bodies

The second was the creation of three government bodies - the Government National Mortgage Association ('Ginnie Mae'), the Federal Home Loan Mortgage Corporation ('Freddie Mac') and the Federal National Mortgage Association ('Fannie Mae'). These guaranteed mortgages, and effectively converted a high-risk loan into a government guaranteed, and hence very low risk, bond. Thrifts paid a guarantee fee and defaulting homeowners became the government's problem.

The third factor was the advent of a crude and simple form of option pricing. The biggest drawback for an investor in mortgage bonds was that the borrower could prepay, especially when rates dipped, and the timing and amount of prepayment was completely unpredictable and the maturity of the bonds was uncertain. This meant that cash flows (and hence yields) could not be calculated either.

Therefore investors were not interested. Salomon began asking investors 'At what price will you buy?' and effectively built into the bond the price of the option granted to the borrower by the investor, making the bond more attractive to the investor.

The fourth and probably one of the most important financial innovations ever was the creation of the Collateralized Mortgage Obligation (CMO). It was a simple and elegant solution to the prepayment problem. The seller 'sliced' the mortgage bond into several 'tranches', each with a different repayment period, and each tranche could be sold to a different investor. All repayments by the borrowers would first go to Tranche 1, then Tranche 2, then Tranche 3 etc.

So an investor now knew the approximate maturity of each tranche and could pick and choose tranches to fit his profile. The CMO broke the wall between several trillion dollars looking for investments and two trillion dollars of mortgages looking for investors. It led to new investors and investors from outside US pouring money into mortgage bonds for the first time, and the mortgage bond market exploded with $60 billion of CMOs being sold between 1983 and 1988!

Lenders now worried much less about liquidity or asset-liability mismatches. Lenders also ploughed back the proceeds from securitisation into more loans.

The cost of securitisation was often cheaper to the lender since risk to the investor was less and this also got passed to the homeowner. Lenders had statutory caps on home loans and securitisation helped them continue lending and hold less capital. All this meant that home finance was cheaper and more plentiful, and this, of course, had a hugely positive impact on the property market.

And as for Salomon? Acquired by Travelers Group, after the merger with Citigroup it became Salomon Smith Barney and has now disappeared into an entity called Citigroup Global Markets. So much for pioneers.

Binod Shankar is a director of finance with a leading Dubai-based property developer. The views expressed in this article are not necessarily shared by his employer.