Mortgage-Bond

By JAMES R. HAGERTY
February 24, 2007; Page B1

As a star Wall Street trader more than two decades ago, Lewis Ranieri helped create a vast new business: selling bonds backed by millions of Americans' home-loan payments.

Today, that business has gone through what Mr. Ranieri calls a "staggering" transformation, and he doesn't like some of what he sees. The rumpled 60-year-old says he is worried about the proliferation of risky mortgages and convoluted ways of financing them. Too many investors don't understand the dangers.

Lewis Ranieri wonders if investors know the risks they have.

It isn't that Mr. Ranieri is risk-averse. The 1989 best-selling book "Liar's Poker" celebrated his billion-dollar trades in these bonds, along with his polyester suits and the junk-food "feeding frenzies" by him and his trading-desk partners at the old Salomon Brothers, where he worked.

Their innovation: combining regular mortgages into giant pools of loans that could be divided up and resold as bonds to pension funds and other institutional investors. These bonds come with a variety of credit ratings and are repackaged in endless permutations to meet investors' varying appetites for risk.

The problem, he says, is that in the past few years the business has changed so much that if the U.S. housing market takes another lurch downward, no one will know where all the bodies are buried. "I don't know how to understand the ripple effects through the system today," he said during a recent seminar.

The Brooklyn-born Mr. Ranieri, who today is a fund manager, has a long perspective on mortgages and Wall Street. He got his start in the 1960s, when he was 19 years old, with a job in the Salomon Brothers mailroom. After a spell trading utility bonds, he joined Salomon's embryonic mortgage-securities desk in 1978, when the idea of mortgages as big money spinners was far-fetched.

Within a few years, Salomon was making immense profits trading mortgages. After rising to become a vice chairman at Salomon, Mr. Ranieri was pushed out in 1987 amid a clash of personalities. (Salomon itself was eventually swallowed into what is now Citigroup Inc.).

Mr. Ranieri later helped rescue savings-and-loan institutions after interest-rate gyrations created huge losses in the 1980s, and built up his own mortgage-investment firm.

Mr. Ranieri, who today doesn't seem preoccupied with reliving his younger days as a mortgage-trading star, says he has never read "Liar's Poker," the memoir that made him famous beyond the mortgage market.

When the book came out in 1989, he says, "I had left the firm [Salomon], and I was attempting to turn the page."

The industry he helped to create is immense, and its investors scattered across the globe. As of Dec. 31, there were about $7 trillion of U.S. mortgage securities outstanding, easily exceeding the $4.3 trillion of U.S. Treasury securities.

Until the past few years, the business was dominated by Fannie Mae and Freddie Mac, the two government-sponsored providers of funding for home loans. But they have lost their dominance amid accounting scandals. At the same time, investors in mortgage-backed bonds became lulled by the real-estate boom into buying loans that would have been unthinkable a few years ago.

The housing boom kept loan losses unusually low, because borrowers who got into trouble could easily sell their homes for a profit or refinance into a cheaper mortgage. Many "subprime" borrowers (people with weak credit records) bought homes with no down payments. More than 40% of subprime borrowers last year weren't required to produce pay stubs or other proof of their income and assets, according to Credit Suisse Group. At the same time, some lenders have become more reliant on computer models to estimate the value of homes.

"We're not really sure what the guy's income is and...we're not sure what the house is worth," says Mr. Ranieri, who now runs his own investment businesses in Uniondale, N.Y. "So you can understand why some of us become a little nervous."

In recent months, amid a surge in early defaults, lenders have become much more cautious, insisting on down payments and doing more diligent checks of a prospective borrower's income. Those changes are too late to save many loans granted in 2005 and 2006.

During the boom, investment banks promoted new instruments that made it easy for more investors to dabble in mortgages. Chief among these is the collateralized debt obligation, or CDO. Money managers set up CDOs, which raise money by selling notes and shares to investors. The proceeds are used to buy a wide variety of mortgage securities. The target market: insurers, pension funds and other investors that lack the time or expertise to choose individual mortgage securities. Instead, they can buy into a CDO, just as a stock-market investor gets immediate diversification by buying a mutual fund.

CDOs, which are particularly popular with Asian and European institutional investors, have become huge buyers of the riskier slices of mortgage securities, the high-yielding portions that suffer some of the first losses if mortgage defaults are higher than initially expected.

One concern, Mr. Ranieri says, is that it isn't clear exactly which investors hold lots of the riskiest slices and whether they understand those risks. Investors in CDOs don't get as much information about the collateral backing their investments -- thousands of homes scattered across America -- as do traditional, specialist buyers of individual mortgage securities, he says.

Adding to the complexity: CDOs also often invest in other CDOs, putting another layer of opaqueness between investors and their collateral.

CDOs aren't bad, per se, but can bring mortgage exposure to "a much less sophisticated community," Mr. Ranieri says.

CDO investors rely heavily on ratings from firms like Standard & Poor's to guide them, but Mr. Ranieri says he believes the rating agencies are struggling to keep up with the rapid changes in mortgage finance. "It's almost overwhelming," he says.

Officials at S&P, a McGraw-Hill Cos. unit, say they are keeping up with the changes and have more than 100 analysts monitoring CDOs.

Mr. Ranieri isn't predicting Armageddon. Some of the riskier new types of mortgages probably will perform "horribly" in terms of defaults, leading to losses for some investors. But, he says, the "vast majority" of mortgages outstanding are based on sounder lending principles and should be fine.

Write to James R. Hagerty at bob.hagerty@wsj.com