All the Devils Are Here [12]
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