The Financial Innovation That Wasn’t.

I need to set up the urgency over the past two years to get the mortgage-backed security refinancing question just right. So I’m going to start with two long blockquotes (forgive me) from Lewis Ranieri, who created the mortgage-backed security in the 1980s. In 2004 Newsweek gave him the title of one of the greatest innovators of the past 75 years. (Awards that year for top historical innovators included James Watson, Frank Lloyd Wright, and Jonas Salk. Mortgages bonds right up there with the cure for Polio – bet someone is regretting that call.)

It is April 2007. Everyone is starting to think there’s going to be a problem with subprime loans. The smartest people realize that traditionally mortgages could be written down easily by intermediaries on the ground – someone at your local bank who you could shake hands with – but that the mortgages packed into sieves of bonds held internationally couldn’t easily be modified. Here’s Lewis Ranieri speaking at the Milken Institute Conference on financial innovation:

the real dilemma for me and I think the real issue . . . will be, we’ve never had to do substantial restructurings in housing in mortgage securities…

One of the accountants – you know, it will not be unusual, in some of these pools to have to restructure a third or more of the pool and we only have four [big accounting] firms and we had three of them in the room and one of them raised his hand and said, well you can’t do that. If you restructure that many loans, you’re going to taint the Q election and FAS 140 and what he was basically saying in English for the rest of [us] poor fools, was that there is a presumption when you – when a bank sells loans, into a securitization that it sold the loans . . . And what he was saying is wait a minute, if you guys can restructure all these loans without going back to bondholder, you obviously have control and you’ve just tainted 140 and Q election…

Well, wait a minute; we have to restructure the loans. The worst thing you can think of is freezing the pool and not being able to do what we need to do and I don’t know how long it would take us. I mean, you know you’ve just basically told us we now have a problem that we don’t quite exactly know how we’re going to fix – and another example of how crazy we can get is, when we restructured mortgage loans, in the past and we’ve done this many times, we actually really know what to do.

We restructured the loans and it was always better to negotiate around the borrower, assuming there was a borrower and for purposes of this conversation, we’re talking about homeowners, not speculative buyers, flipper and all the other guys playing games; we’re talking about people who bought a home and live in it and we, historically, structured those loans. We never send out a 1099.

We basically assume that was a renegotiation, end of story because it was in our best interest, as the lender, to do that but in a mortgage security, you don’t have that freedom because you’ve got get the outside accountants to sign off and the outside lawyers and the outside accountants and lawyers said, time out and I volunteered and said, well, wait a minute. I’ve been doing it this way all along and one of my friends [who is] now running one of the best of the combat servicing operations says, well, I’m doing that now, too and we were told, well you’re doing it wrong. You’ve got to send out a 1099.

That’s an incredibly dopey idea. We’re restructuring a loan around a borrower; he can’t afford the loan and now we’re going to take the NPV of the change and send him a tax bill so the IRS can chase him . . .?

Jump forward 1 year. May 2008. Milken Institute Conference on financial innovation. Here is Lewis Ranieri with the same worry, however he believes we will be able to “innovate” our way out of it. Video from Mark Thoma’s page, my transcript (“…” indicates skipping on my part):

[24m19s] Moderator: Lou, how do we use financial innovation to go forward?…How bad do you think the markets could become if we get mired in a fear of using financial innovation?

Lewis Ranieri: Mortgages are real estate and all real estate is essentially local. The cardinal principle in the mortgage crisis is a very old one. You are almost always better off restructuring a loan in a crisis with a borrower than going to a foreclosure. In the past that was never at issue because the loan was always in the hands of someone acting as a fudiciary. The bank, or someone like a bank owned them, and they always exercised their best judgement and their interest. The problem now with the size of securitization and so many loans are not in the hands of a portfolio lender but in a security where structurally nobody is acting as the fiduciary. And part of our dilemma here is “who is going to make the decision on how to restructure around a credible borrower and is anybody paying that person to make that decision?” And what we need here is financial innovation in the first instance because you can’t do this loan by loan, you are going to have to scale this up to a bigger level and we are going to … have to cut the gordian knot of the securitization of these loans because otherwise if we keep letting these things go into foreclosure it’s a feedback loop where it will ultimately crush the consumer economy

Moderator: How optimistic are you Lou? You used crisis, you used Great Depression a few minutes ago. That’s a little strong…

Lou: It’s not strong. I believe we know what to do because it is not remarkably different than what we’ve done in the past in the context of the housing bubble. if we are allowed to do it. We know how to restructure loans. The process has not changed and technology has made it easier….it will work because of the financial technology and internet technology…I don’t think this is an issue of the government, in fact we’d be better left to do what it is we actually know how to do, we know how to deal with housing crisis…but the difference between a foreclosure and a restructuring is frequently over 30%and because of the feedbackloop that foreclosures create you keep taking a 30% loss on a smaller number. It doesn’t get to be fun. So no this isn’t a government issue, it is something the market needs to do…

And now it is end of July 2009.



Where’s that innovation that will restructure the loans without needing foreclosures? The one thing we needed them to innovate, the one thing!, and they couldn’t pull it off. If it was a sneaky way to get 40-to-1 leverage, sure. Sell retail consumers put options hidden as bonds, all over it. Take care of the one information asymmetry in their instrument, nope. Nothing.

Instead we get this:

Many mortgage companies are reluctant to give strapped homeowners a break because the companies collect lucrative fees on delinquent loans.

Even when borrowers stop paying, mortgage companies that service the loans collect fees out of the proceeds when homes are ultimately sold in foreclosure. So the longer borrowers remain delinquent, the greater the opportunities for these mortgage companies to extract revenue — fees for insurance, appraisals, title searches and legal services.

Recall Lewis’ one problem for financial innovation to solve a year ago: “who is going to make the decision on how to restructure around a credible borrower and is anybody paying that person to make that decision?” Now notice that the solution we have in place, this innovation, is completely backwards. Someone is paying a person to not restructure loans. Lewis knew back in 2007 that this cycle would be incredibly destructive, and in 2008 look the world in the eye and said government intervention was not needed since the innovation was on the way.

Not only is it not here as they wanted, the exact opposite of it is here. Instead of incentives that line up with the investors, or even the households, the quants ended up with someone who makes the most money when both parties suffer. The one financial innovation that could have helped, finding a way to mass refinance failing mortgages, the one financial innovation people were calling for 2 years ago, hasn’t arrived, and I’m tired of waiting for a financial Godot. They have failed, the problem is growing, and the government needs to step in. Dean Baker’s Right-To-Rent should be a serious policy consideration, and I will give it coverage next week. I encourage you to do the same.

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20 Responses to The Financial Innovation That Wasn’t.

  1. financeguy says:

    Excellent. Ranieri’s level of awareness reminds me of the originators of the models who feared that their toys would be misused — as they were. Yesterday I was rereading Kling’s Dec. testimony on the collapse of Fannie and Freddie and was struck by his analysis of securitization as just a fancy way to avoid capital constraints. Which makes for an interesting question: what was the last piece of truly useful financial innovation that wasn’t about evading taxes or regulators? (One small by the way on this entry: I think it’s principal-agent, not principle-agent)

  2. Chris says:

    “Take care of the one information asymmetry in their instrument, nope. Nothing.”

    I’d say they took excellent care of that information asymmetry. It was the basis of their business model, so they couldn’t possibly do without it. Their financial innovation was intended to create information asymmetry, not to destroy it.

    Information asymmetry is power, which the holder of superior information will rarely voluntarily give up. People who study models in which everyone is perfectly informed tend to miss this point a lot, which is one of many reasons not to listen to them.

    Information asymmetry underlies principal-agent, too: when the principal controls the continuation of the relationship (which is usually), the agent cannot act against the principal’s interest without being fired – unless he disguises that fact from the principal. The agent’s superior knowledge is what allows him to cheat without being fired for it. Imagine Bernard Madoff’s investors all having the exact same information about his operation that he had.

  3. Not the Mike You're Looking For says:

    This is depressing. Yet another instance of the middleman exploiting the asset owners.

    What’s worse, my understanding is that despite all the work that went into engineering the securities, nobody has an model that calculates the NPV of foreclosure versus renegotiation. (Sorry, can’t remember where I read it. Here, maybe?)

    By the way, it’s Milken, with an ‘e.’

  4. The only thing enhanced by financial innovation seems to be the bank books of the innovators. Those people Ranieri talks about – the ones eager to buy those homes and do some living in them – really lost big as a result.

    I do not understand how anyone anywhere can point to the innovation seen lately in the mortgage business with any sense of pride and accomplishment.

  5. Mike says:

    Ok, no more blogging in the middle of the night. Too many spelling errors.

    financeguy: “what was the last piece of truly useful financial innovation that wasn’t about evading taxes or regulators?” – I’ve been giving that a lot of thought lately. I wish I could give you a good answer. Interest rate swaps?

    Not The Mike: The middlemen had got this so gamed. It is terrible. You didn’t read that here, but it doesn’t surprise me – all the models, and there are a ton of them, are about recovery. (What’s the R?) Strategic negotiation rarely come into play because these models weren’t created for home loans.

    Anne: Couldn’t agree more. The innovations on the home mortgage business is to bring back the neg amort balloon mortgage that we banned for good reason before.

  6. Mechawreck says:

    Even if the principal(s)/agency problem did not exist here (or were small enough in dollar terms to be “overridden” (bought out by the principal), why should any bank restructure anything with Uncle Tim waiting in the wings to pay dollar for dollar? Who are we kidding? These banks (and their creditors) are now fully trained and there is no going back.

  7. Beezer says:

    Small, or not so, point. Prepayment penalties. Mortgages with prepayment penalties, it is my understanding, are actually cheaper than those without. I’ve heard as much as 60 basis points.

    When the market is in the trillions gaining an extra 60 basis points (to the seller) is a lot of money. So the incentive is to not sell mortgages with prepayment penalties (c’mon, outside of flippers who is intending to pay the mortgage off in 5 years).

  8. Ed says:

    Yep, it’s right up there with the polio vaccine and the architecture, namely the horizontally-oriented ranch house, which redesigned the entire American landscape.

    Salk, Wright, Ranieri.

    It will stand the test of time.

  9. Yves Smith says:

    Hate to tell you, but I have a strong hunch Ranieri was leashed and collared. I was at the Milken conference in 2007 and saw and remember the Ranieri presentation. The cheerleading and the insistence that innovation and the private market could fix everything was close to enforced by moderators in all presentations. No joke, even Myron Schloles was reined in when he deviated from the script. The only reason Lew got away with speaking his mind the first go-round was no doubt his stature and that no one expected that toad to hop out of his mouth (the Scholes incident was on a panel with Mike himself, and Mike basically cut him off, the panel with Lew did not have someone of his level running it). I have no doubt he was told in no uncertain terms to hew the Milken party line next time.

  10. Fu says:

    There is true innovation going on:

    Chase Mortgage, as servicer of several Washington Mutual option ARM securitizations it inherited last year in acquiring WAMU, is modifying loan payments to a rate that equals its unusually high servicing fee, cutting off the cash flow to the trust that owns the mortgage.

  11. Mike says:


    I noticed in the 2008 video that he start to say “we’ll need the government to modify some laws…” and the moderator et al start to give him a stink eye about it. The audience grows uncomfortable. I totally see what you are saying, I’ll try and dig video from the 2007 if it is online.


    Woah! Thanks for sending that. I bet those servicers sleep like babies at night too.

  12. Alan says:

    Just how screwed up are the banks? See the text of my letter to Jamie Dimon:

    Mr. James Dimon
    J.P. Morgan Chase
    270 Park Ave.
    New York, NY 10017

    Re: Falsely Reported Delinquency
    Loan Mod Malfunction
    Loan #XXXXXXXXXX (WaMu)

    Mr. Dimon:

    In spite of my having made all of mortgage payments in full and in a timely manner, your bank has seen fit to report one or more of my payments as delinquent. This has resulted in reducing my credit rating from “excellent” to “fair” and causing me the loss of a $15,000 line of credit with another institution.

    In addition, after months of being told that my application for mortgage modification had been approved, I have learned as of this day that said application, submitted on April 4, 2009, under the Making Home Affordable Program, has not moved forward in any way.

    Today a bank representative informed me that an “aberration” had occurred whereby my application for modification had been erroneously assigned the status of both having been worked out and delinquent—to repeat, neither of which is the case.

    I have been informed that to remedy the erroneously reported delinquency will require rendering my initial modification null and void and that I may, should I wish to do so, begin the process anew.

    I am reluctant to do so since reaching out to your bank for help per your much ballyhooed loan modification program has only done me great, undeserved injury.


    Alan …………..

  13. James Dimon says:

    Dear Mr Alan,

    Where you drunk last year ? Or does it really work ??
    Champagne fellows it works !

    Let me tell you a word about our new core business, we’ve baptize it the “The solar hold-up”.

    The idea is the more we steal in full daylight, the more incapable are people to believe what they see. Have you heard about cognitive dissonance?

    Such a shame, this whole gangsta business is based on it. The more you can see it, the more you’ll refuse to. Such a smart idea from Hank.
    Politicians don’t even dare to “wash their hands” as Ponce Pilate did, you know they would have to admit that they have seen something…
    They lack the courage, politicians are not elected on courage, they’re elected on money, our money (sorry darling, yours since your money is our money :)….

    Our core business is nox to steal so big in such a daylight that’s people refuse to watch or even see, the fear of being blinded probably or even worst, the fear of admit that all this is true and is beyond man’s capacity for outrage.

    Sincerely yours,


    PS: Nice letter but our business model is no more to finance the so-called “real economy” or whatever, it longs to the past… Yeah sure, yo were drunk…

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