Origins
The modern Mortgage-Backed Security (MBS) was born from the need to fund the housing demands of the baby boom generation during a period of capital scarcity in the late 1970s. While the government pioneered the form through Ginnie Mae in 1970, it was a group of “three amigos”—Lewis Ranieri (Salomon Brothers), Larry Fink (First Boston), and David Maxwell (Fannie Mae)—who transformed it into a global market.
The core problem this technology solved was the “neutron bomb” risk inherent in individual mortgages: the fact that they were long-term, illiquid, and prone to sudden prepayment when interest rates fell. By converting thousands of local loans into a standardized bond, Wall Street enabled capital to flow from global investors back to local home buyers, effectively ending the reliance on local savings deposits.
Structure & Function
The fundamental mechanism of the MBS is securitization, where loans are bundled together and their cash flows are redirected to investors. To attract different types of capital, Larry Fink developed the technique of “tranching,” which carves the bond into pieces with varying risk and return profiles.
The senior tranches were designed to be incredibly safe, receiving payments first and often earning AAA ratings from credit agencies. The risk was concentrated in the lower tranches (the equity and mezzanine slices), which served as a buffer to absorb early defaults. This structure allowed banks to remove risks from their balance sheets and satisfy risk-based capital requirements while generating rich fees.
Historical Significance
MBS technology re-engineered the American Dream by making credit more available but also more dangerous. It created a “matching strategy” where the desire for high-volume originations led to the abandonment of traditional underwriting standards. By delinking the borrower from the ultimate investor, securitization reduced the incentive to carefully screen loan quality.
Ultimately, the MBS served as the raw material for even more complex instruments like CDOs, which further obscured the underlying risks of the subprime mortgages they contained. The failure of this technology during the 2008 Financial Crisis demonstrated that rather than eliminating risk, securitization had merely hidden it in “dark corners” of the global financial system.
Key Developments
- 1970: Ginnie Mae issues the first modern mortgage-backed securities.
- 1971: Freddie Mac begins issuing MBS to compete with Fannie Mae.
- 1978: Lewis Ranieri takes over the Salomon Brothers mortgage desk, launching the private MBS market.
- 1981: David Maxwell transforms Fannie Mae into a major player in securitization.
- 1983: Larry Fink creates the first Collateralized Mortgage Obligation (CMO), standardizing tranching.
- 1984: Passage of the Secondary Mortgage Market Enhancement Act (SMMEA) legalizes MBS for institutional investors.
- 1990s: Private-label MBS (issued by Wall Street rather than GSEs) grow rapidly.
- 2003: Private-label MBS begin including significant subprime mortgages.
- 2006: Private-label MBS issuance peaks at over $1 trillion.
- 2007: The subprime crisis reveals massive losses hidden in MBS portfolios.
- 2008: The MBS market freezes as investors flee; Federal Reserve begins purchasing agency MBS.
- 2012: Private-label MBS market remains largely dormant; agency MBS dominate.