Wall Street brings together borrowers of money with lenders. Until the spring of 1978, when Salomon Brothers formed Wall Street’s first mortgage security department, the term borrower referred to large corporations and to federal, state, and local governments. It did not include homeowners. A Salomon Brothers partner named Robert Dall thought this strange. The fastest-growing group of borrowers was neither governments nor corporations but homeowners. From the early 1930s legislators had created a portfolio of incentives for Americans to borrow money to buy their homes. The most obvious of these was the tax deductibility of mortgage interest payments. The next most obvious was the savings and loan industry.
The savings and loan industry made the majority of home loans to average Americans and received layers of government support and protection. The breaks given savings and loans, such as deposit insurance and tax loopholes, indirectly lowered the interest cost on mortgages, by lowering the cost of funds to the savings and loans. The savings and loan lobbyists in Washington invoked democracy, the flag, and apple pie when shepherding one of these breaks through Congress. They stood for homeownership, they’d say, and homeownership was the American way. To stand up in Congress
and speak against homeownership would have been as politically astute as to campaign against motherhood. Nudged by a friendly public policy, savings and loans grew, and the volume of outstanding mortgages loans swelled from $55 billion in 1950 to $700 billion in 1976. In January 1980 that figure became $1.2 trillion, and the mortgage market surpassed the combined United States stock markets as the largest capital market in the world.
Nevertheless, in 1978 on Wall Street it was flaky to think that home mortgages could be big business. Everything about them seemed small and insignificant, at least to people who routinely advised CEOs and heads of state. The CEOs of home mortgages were savings and loan presidents. The typical savings and loan president was a leader in a tiny community. He was the sort of fellow who sponsored a float in the town parade; that said it all, didn’t it? He wore polyester suits, made a five-figure income, and worked one-figure hours. He belonged to the Lions or Rotary Club and also to a less formal group known within the thrift industry as the 3-6-3 Club: He borrowed money at 3 percent, lent money at 6 percent, and arrived on the golf course by three in the afternoon.
Each year four salesmen who sold bonds to Texas thrifts performed a skit before the Salomon training class. Two played Salomon salesmen; two played the managers of a thrift. The plot ran as follows: The Salomon salesmen enter the thrift just as the thrift managers are leaving, tennis racket in one hand and a bag of golf clubs in the other. The thrift men wear absurd combinations of checkered pants and checkered polyester jackets with wide lapels.
The Salomon salesmen fawn over the thrift men. They go so far as to admire the lapels on the jacket of one thrift manager. At this, the second thrift manager gets huffy. “You call those doodads lapels? Those tany thangs?” he says in a broad Lone Star accent. “Lapels ain’ t lapels unless you can see them from the back.” Then he turns around, and sure enough, the lapels jut like wings from his shoulders.
The Salomon salesmen, having schmoozed their client, move in to finish him off. They recommend that the thrift managers buy a billion dollars’ worth of interest rate swaps. The thrift managers clearly don’t know what an interest rate swap is; they look at each other and shrug. One of the Salomon salesmen tries to explain. The thrift men don’t want to hear; they want to play golf. But the Salomon salesmen have them by the short hairs and won’t let go. “Just give us a billion of them interest rate swaps, so we can be off,” the thrift managers finally say. End of skit.
That was the sort of person who dealt in home mortgages, a mere sheep rancher next to the hotshot cowboys on Wall Street. The cowboys traded bonds, corporate and government bonds. And when a cowboy, as it is on Wall Street traded bonds, he whipped ’em and drove ’em. He stood up and shouted across the trading floor, “I got ten million IBM eight and a halfs [8.5 percent bonds] to go [for sale] at one-oh-one, and I want these fuckers moved out the door now.” Never in a million years could he imagine himself shouting, “I got the sixty-two-thousand-dollar home mortgage of Mervin K. Finkleberger at one-oh-one. It has twenty years left on it; he’s paying a nine percent interest; and it’s a nice little three-bedroom affair just outside Norwalk. Good buy, too.” A trader couldn’t whip and drive a homeowner.
The problem was more fundamental than a disdain for Middle America. Mortgages were not tradable pieces of paper; they were not bonds. They were loans made by savings banks that were never supposed to leave the savings banks. A single home mortgage was a messy investment for Wall Street, which was used to dealing in bigger numbers. No trader or investor wanted to poke around suburbs to find out whether the homeowner to whom he had just lent money was creditworthy. For the home mortgage to become a bond, it had to be depersonalized.
At the very least, a mortgage had to be pooled with other mortgages of other homeowners. Traders and investors would trust statistics and buy into a pool of several thousand mortgage loans made by a savings and loan, of which, by the laws of probability, only a small fraction should default. Pieces of paper could be issued that entitled the bearer to a pro rata share of the cash flows from the pool, a guaranteed slice of a fixed pie. There could be millions of pools, each of which held mortgages with particular characteristics, each pool in itself homogeneous. It would hold, for example, home mortgages of less than $110,000 paying an interest rate of 12 percent. The holder of the piece of paper from the pool would earn 12 percent a year on his money plus his share of the prepayments of principal from the homeowners.
Thus standardized, the pieces of paper could be sold to an American pension fund, to a Tokyo trust company, to a Swiss bank, to a tax-evading Greek shipping tycoon living in a yacht in the harbor of Monte Carlo, to anyone with money to invest. Thus standardized, the pieces of paper could be traded. All the trader would see was the bond. All the trader wanted to see was the bond. A bond he could whip and drive. A line which would never be crossed could be drawn down then center of the market. On one side would be the homeowner; on the other, investors and traders. The two groups would never meet; this is curious in view of how personal it seems to lend a
fellowman the money to buy his home. The homeowner would see only his local savings and loan manager, from whom the money came and to whom it was, over time, returned. Investors and traders would see paper.
Bob Dall first became curious about mortgages while working for a Salomon partner named William Simon, who later became secretary of the U.S. Treasury under Gerald Ford (and even later made a billion dollars buying savings and loans cheaply from the U.S. government). Simon was supposed to monitor developments in the mortgage market, but as Dall says, “He could not have cared less.” In the early 1970s Simon traded United States treasury bonds for Salomon Brothers. He liked to do this on his feet, drinking jug after jug of ice water. Shouting bids and offers for bonds was not then a fashionable occupation outside Salomon Brothers. “When I first came into the business, trading was not a respectable profession,” he later told the writer L. J. Davis. “I never hired a B-school guy on my desk in my life. I used to
tell my traders, ‘If you guys weren’t trading bonds, you’d be driving a truck. Don’t try to get intellectual in the marketplace. Just trade.’ “
Simon was not a Harvard graduate but a Lafayette College dropout who had elbowed his way to the top. He didn ‘t attract crowds of aspiring traders on his visits to college or business school campuses because there weren’t any crowds of aspiring traders. What he said or did was of no interest to The New York Times or the Wall Street Journal. Who in the 1970s cared about treasury bonds? Still, he felt and acted big. Salomon was where opinion mattered, and inside Salomon the treasury trader was king. U.S. treasuries were the benchmark for all bonds; the man who could whip and
drive them was the benchmark for all traders.
Simon’s distaste for the home mortgage market stemmed from a dispute he had with the Government National Mortgage Association (known as Ginnie Mae) in 1970. Ginnie Mae guaranteed the home mortgages of less affluent citizens, thereby imbuing them with the full faith and credit of the U.S. Treasury. Any homeowner who qualified for a Federal Housing and Veterans Administration (FHA / YA) mortgage (about 15 percent of home buyers in America) received a Ginnie Mae stamp. Ginnie Mae sought to pool its loans and sell them as bonds. Here is where Simon came in. As the adviser to the U.S. government most knowledgeable about bonds, he was the natural man to nurture the mortgage market.
Like most mortgages, Ginnie Mae-backed loans required a gradual repayment of principal over time. Also like most mortgages, the loan could be prepaid in full at any time. This was the crippling flaw of the proposed Ginnie Mae mortgage bonds as Simon saw them. Whoever bought the bonds was, in one crucial respect, worse off than buyers of corporate and government bonds: He couldn’t be certain how long the loan lasted. If an entire neighborhood moved (paying off its mortgages), the bondholder, who had thought he owned a thirty-year mortgage bond, found himself sitting on a pile of cash instead.
More likely, interest rates fell, and the entire neighborhood refinanced its thirty-year fixed rate mortgages at the lower rates. This left the mortgage bondholder holding cash. Cash was no problem if the investor could reinvest it at the same rate of interest as the original loan, or at a higher rate. But if interest rates had fallen, the investor lost out, for his money would not earn the same rate of return as before. Not surprisingly, homeowners prefer to prepay their mortgages when interest rates fall, for then they may refinance the house at the lower rate of interest. In other words, money invested in mortgage bonds is normally returned at the worst possible time for the lender.Excerpted from ‘Liar’s Poker’ by Michael Lewis, pages 97-102