All the Devils Are Here [23]
Ah, but if the securities could get a double-A or triple-A credit rating, investors like pension funds would be able to buy them, even without the GSEs’ seal of approval. It was the high rating, after all, that was required for them to hold the securities, not Fannie and Freddie’s guarantee. Even before the RTC, Wall Street had been experimenting with ways to make risky securities less risky by issuing, for instance, a letter of credit promising investors payment in the event the cash flow from the assets wasn’t enough. But the RTC allowed Wall Street to work on such techniques—“credit enhancement,” they were called—on a far broader scale. Over time, people came up with all sorts of ways to do credit enhancements. You could get insurance from a third party—a bond insurer, say. You could “overcollateralize” the structure, meaning you put in more mortgages than were needed to pay the investors, so that there was extra in case something went wrong. Or (and this would come later) you could do a so-called senior/subordinated structure, where the cash flows from the underlying mortgages were redirected so that the “senior” bonds got the money first, thereby minimizing the risk for the investors who owned those bonds. Credit enhancements helped convince the rating agencies to rate some of the tranches triple-A, which in turn helped convince investors to buy them. “The innovative techniques that the RTC developed are now in the process of being used by private sector issuers,” was the way Michael Jungman, the RTC’s director of asset sales, put it in a 1994 lecture. Indeed.
Larry Fink, obviously, had never envisioned credit enhancements. But as a 1999 paper by economists at the conservative American Enterprise Institute noted, “The attraction of this segmentation of risk is that the senior (collateralized) debts appeal to investors with limited taste for risk or limited ability to understand the risks of the underlying loans.” At last, Wall Street had a securitization business it could do on a large scale—and it didn’t have to share a penny with the GSEs.
There was a final key to the rise of the subprime business. The federal government was behind it. Not in so many words, of course—and, to be fair, it is highly unlikely that many people in government truly understood what they were unleashing. But by the 1990s, government’s long-running encouragement of homeownership had morphed into a push for increased homeownership. Thanks to the second S&L crisis, the percentage of Americans who owned their own home had actually dropped, from a historic high of 65.6 percent in 1980 to 64.1 percent in 1991. In a country where homeownership was so highly valued, this was untenable.
Thus it was that, early in his second term as president, Bill Clinton announced his National Homeownership Strategy. It had an explicit goal of raising the number of homeowners by 8 million families over the next six years. “We have a serious, serious unmet obligation to try to reverse these trends,” said Clinton, referring to the drop in the homeownership rate. To get there, the administration advocated “financing strategies fueled by creativity to help home buyers who lacked the cash to buy a home or the income to make the down payments.” Creatively putting people who lacked cash into homes was precisely what the new subprime companies purported to do.
Which also explains why the government had such a hard time cracking down on the subprime companies, even as it became apparent that there was widespread wrongdoing. Roland Arnall’s company, Long Beach Mortgage, offered a case in point. In 1993, the Office of Thrift Supervision, a new agency created by Congress to regulate the S&Ls, alleged that Long Beach was discriminating against minorities by charging them more for their loans than they charged whites. Long Beach ducked this investigation when it gave up its thrift charter, leaving the OTS with no authority over the company.
A few years later