All the Devils Are Here

by Bethany McLean; Joe Nocera

  Up until then, the rating agencies had built their business entirely around corporate bonds, rating them on a scale from triple-A (the safest of the safe) to triple-B (the bottom rung of what was so-called investment grade) and all the way to D (default). At first, they resisted rating these new bonds, but they eventually came around, as they realized that rating mortgage-backed securities could be a good secondary business, especially as the volume grew. Very quickly, they became an integral part of the process, and so-called structured finance became a key source of profits for the rating agencies.

  And the third thing Ranieri and Fink needed in order to make mortgage-backed securities appealing to investors? They needed Fannie Mae and Freddie Mac.

  At around the same time Ranieri and Fink were trying to figure out how to make mortgage-backed securities work, Fannie Mae was going broke. It was losing a million dollars a day and “rushing toward a collapse that could have been one of the most disastrous in modern history,” as the Washington Post later put it. As interest rates skyrocketed, Fannie found itself in the same kind of dire trouble as many of the thrifts, and for the same reason. Unlike Freddie Mac, which had off-loaded its interest rate risk to investors, Fannie Mae had kept the thirty-year fixed-rate mortgages it bought on its books. Now it was choking on those mortgages. Things got so bad that it had a “months to go” chart measuring how long it could survive if interest rates didn’t decline. It had even devised a plan to call on the Federal Reserve to save it if the banks stopped lending it money.

  Two things saved Fannie Mae. First, the banks never did stop lending it money. Why? Because their working assumption was that Fannie Mae’s status as a government-sponsored enterprise, with its central role in making thirty-year mortgages possible for middle-class Americans, meant that the federal government would always be there to bail it out if it ever got into serious trouble. Although there was nothing in the statute privatizing Fannie Mae that stated this explicitly—and Fannie executives would spend decades coyly denying that they had an unspoken government safety net—that’s what everyone believed. Over time, Fannie Mae’s implicit government guarantee, as it came to be called, became a critical source of its power and success.

  The second thing that saved Fannie Mae was the arrival, in 1981, of David Maxwell as its new chief executive. Maxwell’s predecessor, a former California Republican congressman named Allan Oakley Hunter, was not particularly astute about business, nor were the people around him. During the Carter administration, when he should have been focusing on the effects of rising interest rates on Fannie’s portfolio, he had instead spent his time feuding with Patricia Harris, Carter’s secretary of Housing and Urban Development.

  Like Hunter, Maxwell had once been a Republican. A Philadelphia native, he graduated from Yale, where he was a champion tennis player, and then Harvard, where he studied law, before joining the Nixon administration as general counsel of HUD. When he was approached to run Fannie, he was living in California, running a mortgage insurance company called Ticor Mortgage, and he’d converted to the Democratic Party because he felt that in California that was the only way to have any influence. “I was a businessman,” Maxwell says now. A businessman was exactly what Fannie Mae needed. Jim Johnson, the Democratic power broker who succeeded Maxwell as Fannie’s CEO in the 1990s, would later say that he “stabilized the company as a long-term force in housing finance.” Judy Kennedy, an affordable housing advocate who worked for Freddie Mac as a lobbyist in the late 1980s, puts it more grandly. She calls Maxwell a “transformative figure.”

  Maxwell was gracious and charming—the sort of man who sent handwritten notes, opened his office door to all his employees, and took boxes of books with him to read on vacation—but he was also incredibly tough, with blue eyes that could turn steely cold. He did not tolerate mediocrity. He couldn’t afford to. “He was fighting for the survival of the company, and anyone, no matter what level, who was not up to the task left or was asked to leave,” says William “Bill” Maloni, who spent two decades as Fannie’s chief lobbyist. During Maxwell’s ten-year reign, Fannie had four presidents and burned through lower-level executives. When Maxwell retired, the company’s head of communications made a video that showed corporate cars moving in and out of Fannie’s offices with body bags in the trunks.

  Maxwell immediately began running Fannie in a more businesslike fashion. He tightened the standards for the loans that Fannie bought. He put in new management systems. Under Hunter, Fannie used to buy mortgages as much as a year in advance. That meant that lenders had time to see where interest rates were going, then shove off only unprofitable loans on Fannie. Maxwell changed that, too.

  What he couldn’t change was the combination of resentment and envy that Washington felt toward Fannie Mae. There was, Maxwell says, “tremendous disdain” for Fannie. “All over Washington, there were people doing stressful, important jobs for not a lot of money, and here was this place on Wisconsin Avenue where people did work that wasn’t any more challenging—and yet, by Washington standards, they made huge amounts.” He remembers taking his wife to a dinner party shortly after he arrived in town. “By the time we left, she was in tears, and I was close!” he later recalled.

  Fannie’s ostentatious headquarters didn’t help. Under Hunter, the company had moved from modest digs on Fifteenth Street to a building in Georgetown that resembled a giant mansion. The front section had been occupied by an insurance company; to build the back to match perfectly, Fannie had a brickyard reopened specifically to supply the proper brick. “To many people, it was a living symbol of power and arrogance,” says Maxwell.

  Yet for all their resentment, people were envious of Fannie Mae’s employees. They all wanted cushy jobs there—so they could get rich, too. “It happened over and over again,” Maxwell says. “The same people who had power over you, whether they were congressional staffers or HUD employees or even members of Congress, wanted jobs and would unabashedly seek them. If you didn’t hire them, then you had enemies.”

  Like Ranieri, Maxwell sang from the hymnal of homeownership. He’d later say that another reason for his conversion to the Democratic Party was his irritation at Republican attitudes toward affordable housing. Under Maxwell, Fannie created an office of low- and moderate-income housing, and the company helped pioneer the first deals that used the low-income housing tax credit program to create affordable rental housing. But he also understood that homeownership was Fannie’s trump card: it’s what made the company untouchable. Under Maxwell, Fannie also began to trumpet its contributions to affordable housing in advertisements. In addition, Fannie’s press releases began to describe it, and Freddie, as “private taxpaying corporations that operate at no cost to taxpayers.”

  Also like Ranieri, Maxwell saw how critical mortgage-backed securities were to the future of the housing market—and to his company’s bottom line. For Fannie, selling mortgage-backed securities was a way not only to get risk off its own books, but to earn big fees. Mortgage-backed securities represented an opportunity for Fannie to become even more central to the housing market than it already was, because the GSEs were the natural middleman between mortgage holders and Wall Street. If Fannie grabbed hold of that role—and kept it for itself—a profitable future was assured.

  In public settings, Ranieri and Maxwell were generous in their praise for each other. “I think he’s a genius, synonymous with Wall Street’s entrance into mortgage finance,” Maxwell told an audience of savings and loan executives in 1984. “David, as much as I, understood the implications of what I was trying to do,” says Ranieri today. “He was my ally. We needed them and they needed us.”

  But under the surface, it was always an uneasy alliance. Ranieri was part of Wall Street. No one on the Street wanted to cede huge chunks of possible profit to the GSEs. “David and I jockeyed,” Ranieri acknowledges. “The intellectual argument was, what should the government do? What should it be allowed to win at?” A person close to Ranieri put it more bluntly: “Despite
his alliance with Fannie and Freddie, [Ranieri] was against them.” He wanted Fannie and Freddie to have, at best, a junior role. Maxwell wanted to prevent Wall Street from shutting Fannie Mae out, and he wanted to establish the primacy of the GSEs in this new market. For all the noble talk about helping people buy homes, what ensued was really a fight about money and power.

  What made Fannie and Freddie indispensable in the new mortgage market was one simple fact: the mortgages they guaranteed were the only mortgages investors wanted to buy. After all, the GSE guarantee meant that the investors no longer had to worry about the risk that homeowners would default, because Fannie and Freddie were assuming that risk. For some investors, GSE-backed paper was the only type of mortgage they were even allowed to buy. In many states, it was against the law for pension funds to purchase “private” mortgage-backed securities. But it was perfectly okay for them to buy mortgage securities backed by the GSEs, because those were treated like obligations from the government. States, meanwhile, had blue sky laws designed to prevent investment fraud, meaning that Wall Street firms had to register with each of the fifty states to sell mortgage-backed deals, a process they had to repeat on every single deal. Mortgage-backed securities issued by the GSEs were exempt from blue sky laws. In 1977, in one of the earliest efforts to put together a mortgage-backed securities deal, Salomon Brothers developed a bond made up of Bank of America mortgages. It was a bust. After that, almost all the early deals were ones in which Fannie and Freddie were the actual issuers of the mortgage-backed securities, while Wall Street was essentially the marketer.

  Even before the advent of mortgage-backed securities, Fannie and Freddie had the reputation of being “difficult, prickly, and willing to throw their weight around at a senior level,” according to one person who had regular dealings with them. It didn’t matter. They couldn’t be shut out of the market, because they were the market. By June 1983, the government agencies had issued almost $230 billion in mortgage-backed securities, while the purely private sector had issued only $10 billion. That same year, Larry Fink and First Boston pioneered the very first so-called collateralized mortgage obligation, or CMO, a mortgage-backed security with three radically different tranches: one with short-term five-year debt, a second with medium-term twelve-year debt, and a third with long-term thirty-year debt. (Fink still keeps on his desk a memento from the deal; it has a tricycle to memorialize the three tranches.) But as usual, the actual issuer of the mortgages wasn’t First Boston. It was Freddie Mac. “They [the GSEs] were the enabler,” Ranieri would later explain. “They wound up having to be the point of the spear.”

  The fees from these deals were plentiful, to be sure. The sheer excitement of building this new market was exhilarating. But there was something about being subservient to the GSEs—with all the built-in advantages that came with their quasi-government status—that stuck in Ranieri’s craw. He wanted the role of the GSEs to be radically reduced. And if the only way he could get that done was to go to Washington and get some laws changed, then that’s what he would do. Thus began the quiet war between Lew Ranieri and David Maxwell.

  Ranieri had strong ties to the Reagan administration and knew he would find a receptive audience there. Like every president, Ronald Reagan professed to stand squarely on the side of the American homeowner. But David Stockman, his budget director; Larry Kudlow, one of Stockman’s key deputies; and a handful of others, didn’t believe that homeownership was necessarily synonymous with Fannie Mae. In particular, they didn’t like the implied government guarantee. As market-oriented conservatives, they believed that the private sector was perfectly capable of issuing mortgage-backed securities without Fannie and Freddie. In 1982, President Reagan’s Commission on Housing even recommended that the GSEs eventually lose their government status entirely.

  With Ranieri’s help, the administration drafted a bill to put Wall Street on a more equal footing with the GSEs. It was called the Secondary Mortgage Market Enhancement Act, although those in the know always used its slightly slippery-sounding acronym when they talked about it: SMMEA. Ranieri had another name for it: “the private sector existence bill.” Failure to pass it, he warned Congress, would risk “turning the mortgage market of America into a totally government franchise.” Ranieri was in Reagan’s office when the act was signed into law in October 1984.

  SMMEA exempted mortgage-backed securities, which constitute the secondary mortgage market (direct loans are the primary market), from state blue sky laws restricting the issue of new financial products. It removed the restrictions against institutions like state-chartered financial institutions, pension funds, and insurance companies from investing in mortgage-backed securities issued by Wall Street, even when they lacked a GSE guarantee. It also enshrined the role of the credit rating agencies, by insisting that mortgage bonds had to be highly rated to be eligible for purchase by pension funds and similar low-risk investors. Although there were worries that the rating agencies were being given too much responsibility, the bill’s supporters reassured Congress that investors wouldn’t rely solely on a rating to buy a mortgage bond. “GE Credit does not believe that investors in MBS will accept any substitute for disclosure,” testified Claude Pope Jr., the chairman of GE’s mortgage insurance business. The rating requirement “serves only as an additional independent validation of the issue’s quality.”

  Helpful though it was, SMMEA didn’t fully level the playing field. “No truly private company can compete effectively with Fannie Mae or Freddie Mac, operating under their special charter,” Pope told lawmakers. What he meant, in part, was that because of the GSEs’ implicit government guarantee, investors were willing to pay a higher price for Fannie- and Freddie-backed securities, since the federal government appeared to be standing behind them. For the same reason, Fannie and Freddie could borrow money at a lower cost than even mighty General Electric, with its triple-A rating. SMMEA or no SMMEA, the GSEs were still likely to dominate the market; in fact, they were even in a position to monopolize it, if they so chose. Investors still valued the GSE securities more than anything else Wall Street could produce.

  There was a telling moment during one of the many congressional hearings on mortgage-backed securities. A congressman asked Maxwell whether he thought, as the congressman put it, “there is enough for everybody.” “There is plenty,” responded Maxwell. In response to a similar question, Ranieri countered, “I will have to completely differ.” In truth, there was never going to be enough for both Wall Street and the GSEs.

  The vehicle for shutting out Fannie Mae and Freddie Mac—or at least trying to—was a second piece of legislation Ranieri and Wall Street wanted. Under the existing tax laws, it was quite possible that the cash flows from tranched securities could be subject to double taxation. (In 1983 the Internal Revenue Service actually challenged a Sears Mortgage Securities Corporation deal on these grounds, sending shudders of fear through investors.) So the inventors of mortgage-backed securities also wanted a bill that would lay out a specific road map for creating securities that wouldn’t be taxed twice. Ranieri was emphatic—he thought this would be a “very powerful” tool. And while he never came out and said it shouldn’t be given to the GSEs, his testimony makes it clear that that’s what he thought. “If you do not give it to them, you have the potential to have the private sector outprice the agencies,” he told Congress. “Do you wish to use [this structure] as a method to curtail the power of the agencies?” The Reagan Treasury agreed; the administration insisted that it would not support any legislation “that permits the government-related agencies to participate directly or indirectly in this new market,” as a Treasury official testified. This bill, the official continued, should be “viewed as a first step toward privatization of the secondary mortgage market.”

  “It was directly symptomatic of another problem that existed later,” Maxwell says now. “As we became bigger and had a bigger profile, everybody got scared.” Says Lou Nevins, Ranieri’s former lobbyist: “Fannie saw their
ultimate trivialization if the bill passed and they couldn’t be issuers.” Fannie, in other words, felt it was fighting for its very survival. But Wall Street was fighting for something that, to it, was just as important: money. As with all new products, the profit margins were initially very high—up to 1 percent, says Nevins, meaning, for example, $10 million for assembling a $1 billion mortgage-backed security. The feeling on Wall Street, according to Nevins, was that “this is a gravy train, a gold mine, and we’re not sure how long it is going to last, but if Fannie can be an issuer, the gold is going to dry up quickly.”

  And yet, ironically, to get a bill passed that took care of the double-taxation problem, Ranieri needed Maxwell’s support. Maxwell wanted the legislation passed, too; the double-taxation problem was simply too threatening to the potentially lucrative new market. Realizing they needed each other, Ranieri and Maxwell put aside their differences and worked together to push the thing through Congress. To this day, though, there is disagreement over who did the heavy lifting. (“We had the brainpower and did most of the work on the Hill,” Ranieri recalls; Maloni says that Fannie “did the lion’s share of the work” pushing the bill through Congress.) In 1986, after a number of fits and starts, Congress finally passed the second bill as part of the Tax Reform Act of 1986. It was known as the REMIC law, referring to the real estate mortgage investment conduit, which became the shorthand phrase for deals in which mortgage-backed securities were carved into tranches. In essence, the law created a straightforward process for issuing multiclass securities and avoiding double taxation. Needless to say, it did not specifically prevent Fannie or Freddie from doing REMIC deals; had anyone insisted on that, Maxwell would surely have fought it instead of backing the bill.