Lewis Ranieri, the structured finance pioneer of the early 1980s who helped create the modern securitisation market, seems a more modest man than the persona in Michael Lewis’s Liar’s Poker would suggest.
Tucked away at the back of the Rivoli Bar in The Ritz in London’s Mayfair, Ranieri, in the company of senior management from The Situs Companies, the commercial real estate advisory and mortgage servicing company owned by his Ranieri Partners company, sat down with CoStar News last Monday for a rare interview.
In a little over an hour, Ranieri offered his own unique account of the genesis of the securitisation market he helped create, candidly talked about where it all went wrong and what the market has learned in the last five years, and offered his take on the gulf that exists between US and European securitisation.
Ranieri needs little introduction to real estate professionals – the history books have long since described him as the ‘Godfather of Securitisation’.
His memories of the details of the early stage genesis of the securitisation market he helped pioneer almost 40 years ago are still vivid, as is his candour towards the naysayers of securitisation in the post-global financial crisis period.
Famously Ranieri joined Salomon Brothers as a 20-year old to work in the mail room. He was handpicked by then managing partner John Gutfreund in 1978 to join the Wall Street bank’s bond department, the team which would go on to build from nothing a market for traded public securities derived from housing loans.
The evolution of this securitisation tool – which was later adopted for commercial real estate loans, car loans, credit card loans, and other asset classes besides – spun spectacularly out of control in the years which led up to the global financial crisis something that, in the eyes of some, tarnished the legacy of the securitisation product.
Whichever side of the emotive argument people fall down on, the market and liquidity instrument which Ranieri and his team created in the late 1970s and early 1980s permanently changed financing markets for real estate.
Today, US residential mortgages for first-time buyers are 93% funded by the US government. According to Ranieri this is the exact demographic for which securitisation was originally envisaged, to empower with the option of getting on the housing ladder, and entering the American Middle Class.
Ranieri’s securitisation product, therefore, is not working for the original purpose it set out to achieve, but he is certain it will, eventually, come back.
In the first of a two-part CoStar News special, this is Ranieri’s own unique perspective on how it all began, in his own words.
It all began with the Baby Boomers
“In the very beginning, the issue was the Baby Boomers and the children born of the soldiers who had come back from World War II,” Ranieri begins.
The intention was to find a way to fund the need for shelter, for a generation which aspired to home ownership, a symbol in the late 1970s and early 1980s of the American Dream, and entrance into the Middle Class.
By this point in US history, home ownership was already seen as a source of growth and wealth, paying for school and college tuition fees for children, acting as something of a conveyor belt of wealth.
“The problem was when you looked at the sheer number of dollars needed to fund housing for the Baby Boomers, and what that would require in the context of a balance sheet and capital, it became prohibitive.”
The problem was the amount of equity which had to be raised when financing housing mortgages on balance sheet.
“When you tried to calculate how much equity would be needed to support the banks, thrifts and credit unions, it became pretty obvious that it would not be possible to come up with this much money.
“The thrift industry and the few banks that were involved with housing would never be able to fund the scale of housing loans required because of the enormous cost involved in raising the equity block.”
Initially, Ranieri tried working with the banks to devise a solution using financial institutions’ balance sheets, from which mortgage-backed bonds were attempted, but there was simply not enough equity to make the transactions work.
Securitisation was effectively born out of necessity, which at its most fundamental is actually a very simple notion.
“We thought: we have the credit of the house as collateral, why did we have to interpose a balance sheet? Why could we not simply use the combination of the collateral value of the house and the credit worthiness of the American homeowner?
“This was in a different time and a different place, when people cared about their reputations and had a willingness to pay their bills.
“So the combination of the collateral value and the credit worthiness of the consumers was the basis on which we said: “let’s just do away with balance sheet”.”
Building a framework and investor demand
Salomon Brothers’ first securitisation was issued in 1978 – a triple A-rated security, with the issuer Bank of America. “It was a total flop,” recalls Ranieri.
This very first residential mortgage backed securitisation faced a number of bewildering problems, both legal and investment, and kept running into double-taxation problems, while investors did not know what to make of it, more often than not.
Wherever Ranieri and the sales force tried to sell this new product they came up against new problems to solve. “I remember taking it to a pension fund in New York. Here was this security that they had never seen before backed by hundreds of small balanced home loans, but the investment requirements of this pension fund were for all loans to be at least $2m in size, which didn’t work.
“The bond had all these idiosyncrasies – it paid monthly, rather than quarterly, it didn’t fit with the accounting system, the legal system, the investment system, and no-one knew what to do about it.
“When you bring something completely new to people, who have never seen anything like it before, the system does not know how to accommodate it. We tried to fix the problem State by State, but it wasn’t effective enough, so we actually set about having to write our own rules.”
The US government understood the looming housing finance problem and were co-operative with efforts to build a new framework for these securities which made economic sense for issuers and buyers.
“We put together a group in Washington DC, Congress and the White House was particularly supportive,” Ranieri recalls. “They all believed in what we were trying to do: provide housing finance for the Baby Boomers, realising that there was no practical way of doing so on balance sheet.”
Two Bills were drafted to unblock the problems: a Bill to create an effective tax vehicle for these securities, helping to avoid double-taxation; and a Bill to solve all the issues around the selling and trading of the public securities, what Ranieri remembers as the “doing business” Bill.
The first attempt at the Tax Bill, Trust for Investment Mortgages (TIMs), took two-and-a-half years of drafting and political negotiating with Capitol Hill and was defeated at the 11th hour.
“TIMs was defeated by Treasury not because they were concerned about what we were using the Bill for, but because they were afraid that the section of the Tax Code we had proposed could be abused in other ways.
“By this point I was amazingly frustrated,” remembers Ranieri. “Everyone wanted this to happen but there were a bewildering number of hoops to jump through.
“In the House there were so many overlapping jurisdictions. The problem was not simply getting a ‘yes’ it was getting a ‘yes’ out of four different Committees, in one case for example.”
There were several legitimate concerns which, with the benefit of hindsight, sound today like precise identifiers of securitisation’s later-to-manifest fatal flaws.
“One of the early questions we faced from politicians,” recalls Ranieri, “was if you are going to create these public securities, what if the buyers are not sophisticated investors and will this create problems? And are people going to understand what it is you are selling them?”
The solution was, of course, for these new mortgage securities to be rated by at least two ratings agencies before the successor Tax Bill to TIMs could be applied.
“We needed to interpose some mechanism where every person who looked at these securities did not have to be a mortgage savant. And the ratings servicers quickly volunteered to be responsible for that role: they wanted to rate these securities and they would build the systems, the data and the research.”
With the framework of a solution agreed upon by early market participants, and all the many Committees of politicians involved, Ranieri then hired one of the Treasury’s key opponents to the first Tax Bill to draft the successor Bill, which was then put forward to the House for a legislative vote.
Ranieri adds: “My instructions to the man hired from the Treasury to draft the second attempted Tax Bill were look, if you are so smart and, you are not worried about what we are up to but are worried about what everybody else might use the Tax Code for, you write the Bill, so it stays narrowly where you want it. And he did.”
“He drafted the Bill and we renamed it Real Estate Mortgage Investment Conduit (REMIC), and it passed. Once we had REMIC and we had the ‘doing business’ Bill, it all took off.”
Early competition with the ‘Junk Bond King’
Ranieri was marketing MBS at the same period when Mike Milken – the ‘Junk Bond King’ who later went to prison for insider trading – was selling high yield bonds.
These two major fixed income innovations were concurrently seeking pension fund capital in the US in the mid 1980s.
“It was not unusual for me to turn up to pitch to a pension fund about mortgage securities and Michael had just been in before me to talk about high yield bonds,” Ranieri recalls.
“Initially, the way we tried to sell MBS was through education, because no one knew what we were talking about. We had to build academic research from the bottom up, to support this process in terms of developing.”
The first CMBS transactions were effectively private placements, rather than public securities.
“From the first CMBS, there was a special servicer in place because commercial real estate transactions comprised fewer and bigger properties than in residential securitisation.
“When you have delinquencies rolling into foreclosure in commercial real estate, you had to pay attention, because it could disproportionately affect cash flows. So, special servicers were there to deal with likely problem loans.”
The difference in early residential MBS and CMBS was this foresight in the latter for a potential catastrophic property value collapse, which was not perceived as so probable for residential values.
In the history of the US residential housing values up until the mid 1980s, the worst residential property value fall on record was in Houston, Texas, in the third quarter of 1986.
“Even that was less than 30% and prices eventually came back.”
The Rubicon for MBS for investor demand was passed, in Ranieri’s mind, in 1986.
Of all of the components for this new market – creating the securities, building the legal and tax framework, establishing the Guardians and oversight, to the research function needed to support the markets, and the modelling, and to building the investor demand itself – Ranieri points to research as the most challenging of all.
The reason it was so difficult is because there was no history of it.
From the very first issuance by Ginnie Mae – which was the securitisation of a 30-year loan backed by government income – the problem lay in establishing a convention for determining price to yield and yield to price for the securities.
Ranieri recalls that the only independent algorithm which Salomon Brothers’ bond department could find was a study by two research people, Fraiser and Stampler, on a portfolio of property loans by the Federal Housing Administration (FHA), which at the time used to originate and hold residential mortgage loans.
The FHA model was quickly adopted and then abandoned due to the huge distortions in pricing it generated.
But it was a necessary, if flawed, bridge to professionally understanding the risk and rewards of mortgage cash flows.
“Securitisation achieved two very big changes,” says Ranieri. “It equalised the access to capital, creating a national market for finance, and dramatically lowering the cost of that credit.
“Part of the Bill required a study of how this was working five years later, and in that period we had actually lowered the cost of housing by 150 basis points as well as homogenised, to a very substantial degree, access to credit.
“It is easy to understand why commercial real estate and consumer credit like credit cards and car loans, for example, lend themselves to that same model.”
In the second part of this exclusive interview will cover Ranieri’s views on where it all went wrong, what lessons can be learned, his perspective on the structural differences between the US and European real estate markets, and his outlook on the future for both regions in light of the differing macros environments, regulatory pressures and central bank policies.
Don’t miss it.