Why Wall Street Loves Houses Again

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http://www.theatlantic.com/magazine/archive/2013/10/why-wall-street-loves-houses-again/309454/

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For more than a generation now, like it or not, Wall Street’s financial engineering has helped determine whether the average American can buy a home. Once upon a time—before Wall Street stuck its nose under the mortgage tent—the formula for homeownership was pretty simple: if the neighborhood banker thought you would pay it back, you had a pretty good chance of getting a 30-year mortgage. The local touch gave both parties the incentive to do the right thing. Keep making mortgage payments, and you get to keep your house; the banker, meanwhile, has a valuable asset on the balance sheet. Everybody’s happy.

This sensible dynamic between borrower and lender began to change in 1977. That’s when the Brooklyn-born Lew Ranieri came up with the clever idea that everyone would be better off—the borrower, the banker, and of course Salomon Brothers, his Wall Street employer—if there were a way to buy up mortgages from local banks; package them together, thereby spreading the risk presented by any one borrower across a broad portfolio of borrowers; and sell slices of the resulting bundles to investors the world over, offering varying rates of interest depending on an investor’s risk appetite. Ranieri, who started at Salomon in the mail room, assembled a team of Ph.D.s to package, slice, and sell mortgages after he realized “mortgages are math”—streams of cash flows that investors might want to buy. This powerful idea, dubbed “securitization,” was one of those once-in-a-generation innovations that revolutionized finance.

Ranieri’s idea caught on and, so the theory goes, helped reduce the cost of mortgages for borrowers all over the country, since the market for mortgages became far more liquid than when they had simply sat on a local bank’s balance sheet tying up capital for years. Salomon Brothers—and Ranieri—made a fortune by implementing his insight. In 2004, BusinessWeek dubbed Ranieri one of “the greatest innovators of the past 75 years.” But Ranieri’s innovation also forever changed the ethic of banking, from one in which a buyer knew a seller and vice versa, to one in which the decision to buy something was separated from local market knowledge.

In 2007 and 2008, we learned how that turned out, after Wall Street’s greed machine rewarded bankers and traders for manufacturing more and more of these mortgage-backed securities with lower and lower credit standards. In the ensuing crash, two of the nation’s largest and most successful investment banks (Bear Stearns and Lehman Brothers) disappeared, and two others (Merrill Lynch and Morgan Stanley) would have too, but for last-minute rescues by large commercial banks, with a timely assist from the Federal Reserve.