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THE
FINANCIAL
CRISIS
INQUIRY REPORT
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OFFICIAL GOVERNMENT EDITION
OFFICIAL
GOVERNMENT
EDITION
Final Report of the National Commission
on the Causes of the Financial and
Economic Crisis in the United States
I SBN 978-0-16-087727-8
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FINAL REPORT OF THE NATIONAL COMMISSION
ON THE CAUSES OF THE FINANCIAL AND
ECONOMIC CRISIS IN THE UNITED STATES
OFFICIAL GOVERNMENT EDITION
THE FINANCIAL CRISIS INQUIRY COMMISSION
Submitted by
Pursuant to Public Law 111-21
January 2011
e c i f f O g n i t n i r P t n e m n r e v o G . S . U , s t n e m u c o D f o t n e d n e t n i r e p u S e h t y b e l a s r o F
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n o t g n i h s a W , C C D I p o t S : l i a M 4 0 1 2 - 2 1 5 ) 2 0 2 ( : x a F 1 0 0 0 - 2 0 4 0 2 C D ,
I SBN 978-0-16-087727-8
CONTENTS
Ccnnissicncrs vii
CcnnissicncrVctcsviii
CcnnissicnStajjIist ix
Ircjacc xi
CONCLUSI ONS OF THE
FI NANCIAL CRI SI S I NQUI RY COMMI SSI ON.....................xv
PART I : CRI SI S ON THE HORI ZON
Chaptcr+ Before Our Very Fyes .........................................................................
PART I I : SETTI NG THE STAGE
Chaptcr: Shadow Banking ...............................................................................:,
Chaptcr, Securitization and Derivatives.......................................................8
Chaptcr, Deregulation Redux.........................................................................,:
Chaptcr, Subprime Iending............................................................................o,
PART I I I : THE BOOM AND BUST
Chaptcre Credit Fxpansion..............................................................................8
Chaptcr, The Mortgage Machine.................................................................+o:
Chaptcr: The CDO Machine ........................................................................+:,
Chaptcr, All In..................................................................................................+,o
Chaptcr+o The Madness ...................................................................................+88
Chaptcr++ The Bust............................................................................................:+
v
PART I V: THE UNRAVELI NG
Chaptcr+: Farly :oo,. Spreading Subprime Worries.................................:
Chaptcr+, Summer :oo,. Disruptions in Funding....................................:o
Chaptcr+, Iate :oo, to Farly :oo8. Billions in Subprime Iosses ...........:,o
Chaptcr+, March :oo8. The Fall of Bear Stearns........................................:8o
Chaptcr+e March to August :oo8. Systemic Risk Concerns....................:,:
Chaptcr+, September :oo8.
The Takeover of Fannie Mae and Freddie Mac..................o,
Chaptcr+: September :oo8. The Bankruptcy of Iehman........................:
Chaptcr+, September :oo8. The Bailout of AIG........................................
Chaptcr:o Crisis and Panic ..............................................................................,
PART V: THE AFTERSHOCKS
Chaptcr:+ The Fconomic Fallout...................................................................8,
Chaptcr:: The Foreclosure Crisis ..................................................................o:
DI SSENTI NG VI EWS
By Keith Hennessey, Douglas Holtz-Fakin, and Bill Thomas ........................++
By Peter l. Wallison....................................................................................................+
AppcndixAG|cssary
AppcndixBIistcjHcaringsandVitncsscs
Nctcs
Indcxavai|a||ccn|incatwwwpu||icajjairs|ccksccn/jcicindcxpdj
vi tuN1iN1:
539
545
553
Phil Angelides
Chairman
Brooksley Born
Commissioner
Byron Georgiou
Commissioner
Senator Bob Graham
Commissioner
Keith Hennessey
Commissioner
Douglas Holtz-Eakin
Commissioner
Heather H. Murren, CFA
Commissioner
John W. Thompson
Commissioner
Peter J. Wallison
Commissioner
Hon. Bill Thomas
Vice Chairman
MEMBERS OF
THE FINANCIAL CRISIS INQUIRY COMMISSION
COMMISSIONERS VOTING TO ADOPT THE REPORT:

Phil Angelides, Brooksley Born, Byron Georgiou,
Bob Graham, Heather H. Murren, John W. Thompson
COMMISSIONERS DISSENTING FROM THE REPORT:

Keith Hennessey, Douglas Holtz-Eakin,
Bill Thomas, Peter J. Wallison
ShaistaI.Ahmed
HilaryJ.Allen
JonathanE.Armstrong
RobBachmann
BartonBaker
SusanBaltake
BradleyJ.Bondi
SylviaBoone
TomBorgers
RonBorzekowski
MikeBryan
RyanBubb
TroyA.Burrus
R.RichardCheng
JenniferVaughnCollins
MatthewCooper
AlbertoCrego
VictorJ.Cunicelli
JobeG.Danganan
SamDavidson
ElizabethA.DelReal
KirstinDowney
KarenDubas
DesiDuncker
BartlyA.Dzivi
MichaelE.Easterly
AliceFalk
MeganL.Fasules
MichaelFlagg
SeanJ.Flynn,Jr.
ScottC.Ganz
ThomasGreene
MaryannHaggerty
RobertC.Hinkley
AnthonyC.Ingoglia
BenJacobs
PeterAdrianKavounas
MichaelKeegan
ThomasJ.Keegan
BrookL.Kellerman
SarahKnaus
ThomasL.Krebs
JayN.Lerner
JaneE.Lewin
SusanMandel
JulieA.Marcacci
AlexanderMaasry
CourtneyMayo
CarlMcCarden
BruceG.McWilliams
MenjieL.Medina
JoelMiller
StevenL.Mintz
ClaraMorain
GirijaNatarajan
GretchenKinneyNewsom
DixieNoonan
DonnaK.Norman
AdamM.Paul
JaneD.Poulin
AndrewC.Robinson
SteveSanderford
RyanThomasSchulte
LorrettoJ.Scott
SkipperSeabold
KimLeslieShafer
GordonShemin
StuartC.P.Shroff
AlexisSimendinger
MinaSimhai
JeffreySmith
ThomasH.Stanton
LandonW.Stroebel
BrianP.Sylvester
ShirleyTang
FereshtehZ.Vahdati
AntonioA.VargasCornejo
MelanaZylaVickers
GeorgeWahl
TuckerWarren
CassidyD.Waskowicz
ArthurE.Wilmarth,Jr.
SarahZuckerman
ix
COMMISSION STAFF
WendyEdelberg, Executive Director
GaryJ.Cohen, General Counsel
ChrisSeefer,Director of Investigations
GregFeldberg,Director of Research
PREFACE
TheFinancialCrisisInquiryCommissionwascreatedtoexaminethecausesofthe
currentfnancialandeconomiccrisisintheUnitedStates.Inthisreport,theCom-
missionpresentstothePresident,theCongress,andtheAmericanpeopletheresults
ofitsexaminationanditsconclusionsastothecausesofthecrisis.
Morethantwoyearsaftertheworstofthefnancialcrisis,oureconomy,aswellas
communities and families across the country, continues to experience the after-
shocks.MillionsofAmericanshavelosttheirjobsandtheirhomes,andtheeconomy
isstillstrugglingtorebound.Thisreportisintendedtoprovideahistoricalaccount-
ingofwhatbroughtourfnancialsystemandeconomytoaprecipiceandtohelppol-
icymakersandthepublicbetterunderstandhowthiscalamitycametobe.
TheCommissionwasestablishedaspartoftheFraudEnforcementandRecovery
Act (Public Law 111-i1) passed by Congress and signed by the President in May
ioo.Thisindependent,1o-memberpanelwascomposedofprivatecitizenswithex-
perience in areas such as housing, economics, fnance, market regulation, banking,
and consumer protection. Six members of the Commission were appointed by the
DemocraticleadershipofCongressandfourmembersbytheRepublicanleadership.
TheCommissionsstatutoryinstructionssetoutiispecifctopicsforinquiryand
calledfortheexaminationofthecollapseofmajorfnancialinstitutionsthatfailedor
wouldhavefailedifnotforexceptionalassistancefromthegovernment.Thisreport
fulfllsthesemandates.Inaddition,theCommissionwasinstructedtorefertotheat-
torney general of the United States and any appropriate state attorney general any
personthattheCommissionfoundmayhaveviolatedthelawsoftheUnitedStatesin
relation to the crisis. Where the Commission found such potential violations, it re-
ferred those matters to the appropriate authorities. The Commission used the au-
thority it was given to issue subpoenas to compel testimony and the production of
documents,butinthevastmajorityofinstances,companiesandindividualsvolun-
tarilycooperatedwiththisinquiry.
Inthecourseofitsresearchandinvestigation,theCommissionreviewedmillions
of pages of documents, interviewed more than ,oo witnesses, and held 1 days of
publichearingsinNewYork,Washington,D.C.,andcommunitiesacrossthecountry
xi
thatwerehardhitbythecrisis.TheCommissionalsodrewfromalargebodyofex-
isting work about the crisis developed by congressional committees, government
agencies,academics,journalists,legalinvestigators,andmanyothers.
We have tried in this report to explain in clear, understandable terms how our
complexfnancialsystemworked,howthepiecesfttogether,andhowthecrisisoc-
curred.Doingsorequiredresearchintobroadandsometimesarcanesubjects,such
as mortgage lending and securitization, derivatives, corporate governance, and risk
management.Tobringthesesubjectsoutoftherealmoftheabstract,weconducted
casestudyinvestigationsofspecifcfnancialfrmsandinmanycasesspecifcfacets
oftheseinstitutionsthatplayedpivotalroles.ThoseinstitutionsincludedAmerican
InternationalGroup(AIG),BearStearns,Citigroup,CountrywideFinancial,Fannie
Mae,GoldmanSachs,LehmanBrothers,MerrillLynch,Moodys,andWachovia.We
lookedmoregenerallyattherolesandactionsofscoresofothercompanies.
We also studied relevant policies put in place by successive Congresses and ad-
ministrations.Andimportantly,weexaminedtherolesofpolicymakersandregula-
tors, including at the Federal Deposit Insurance Corporation, the Federal Reserve
Board,theFederalReserveBankofNewYork,theDepartmentofHousingandUr-
banDevelopment,theOmceoftheComptrolleroftheCurrency,theOmceofFed-
eral Housing Enterprise Oversight (and its successor, the Federal Housing Finance
Agency),theOmceofThriftSupervision,theSecuritiesandExchangeCommission,
andtheTreasuryDepartment.
Ofcourse,thereismuchworktheCommissiondidnotundertake.Congressdid
not ask the Commission to offer policy recommendations, but required it to delve
intowhatcausedthecrisis.Inthatsense,theCommissionhasfunctionedsomewhat
liketheNationalTransportationSafetyBoard,whichinvestigatesaviationandother
transportationaccidentssothatknowledgeoftheprobablecausescanhelpavoidfu-
tureaccidents.Norwerewetaskedwithevaluatingthefederallaw(theTroubledAs-
set Relief Program, known as TARP) that provided fnancial assistance to major
fnancial institutions. That duty was assigned to the Congressional Oversight Panel
andtheSpecialInspectorGeneralforTARP.
This report is not the sole repository of what the panel found. A website
www.fcic.govwillhostawealthofinformationbeyondwhatcouldbepresentedhere.
Itwillcontainastockpileofmaterialsincludingdocumentsandemails,videoofthe
Commissionspublichearings,testimony,andsupportingresearchthatcanbestud-
ied for years to come. Much of what is footnoted in this report can be found on the
website.Inaddition,morematerialsthatcannotbereleasedyetforvariousreasonswill
eventuallybemadepublicthroughtheNationalArchivesandRecordsAdministration.
Our work refects the extraordinary commitment and knowledge of the mem-
bersoftheCommissionwhowereaccordedthehonorofthispublicservice.Wealso
benefted immensely from the perspectives shared with commissioners by thou-
sandsofconcernedAmericansthroughtheirlettersandemails.Andwearegrateful
to the hundreds of individuals and organizations that offered expertise, informa-
tion,andpersonalaccountsinextensiveinterviews,testimony,anddiscussionswith
theCommission.
xii iiii\ti
WewanttothanktheCommissionstaff,andinparticular,WendyEdelberg,our
executive director, for the professionalism, passion, and long hours they brought to
this mission in service of their country. This report would not have been possible
withouttheirextraordinarydedication.
With this report and our website, the Commissions work comes to a close. We
presentwhatwehavefoundinthehopethatreaderscanusethisreporttoreachtheir
ownconclusions,evenasthecomprehensivehistoricalrecordofthiscrisiscontinues
tobewritten.
iiii\ti xiii
CONCLUSIONS OF THE
FINANCIAL CRISIS INQUIRY COMMISSION
TheFinancialCrisisInquiryCommissionhasbeencalledupontoexaminethefnan-
cial and economic crisis that has gripped our country and explain its causes to the
American people. We are keenly aware of the signifcance of our charge, given the
economicdamagethatAmericahassufferedinthewakeofthegreatestfnancialcri-
sissincetheGreatDepression.
Ourtaskwasfrsttodeterminewhathappenedandhowithappenedsothatwe
couldunderstandwhyithappened.Herewepresentourconclusions.Weencourage
the American people to join us in making their own assessments based on the evi-
dencegatheredinourinquiry.Ifwedonotlearnfromhistory,weareunlikelytofully
recoverfromit.SomeonWallStreetandinWashingtonwithastakeinthestatusquo
maybetemptedtowipefrommemorytheeventsofthiscrisis,ortosuggestthatno
one could have foreseen or prevented them. This report endeavors to expose the
facts, identify responsibility, unravel myths, and help us understand how the crisis
couldhavebeenavoided.Itisanattempttorecordhistory,nottorewriteit,norallow
ittoberewritten.
Tohelpourfellowcitizensbetterunderstandthiscrisisanditscauses,wealsopres-
entspecifcconclusionsattheendofchaptersinPartsIII,IV,andVofthisreport.
Thesubjectofthisreportisofnosmallconsequencetothisnation.Theprofound
eventsofioo,andioo8wereneitherbumpsintheroadnoranaccentuateddipin
thefnancialandbusinesscycleswehavecometoexpectinafreemarketeconomic
system. This was a fundamental disruptiona fnancial upheaval, if you willthat
wreakedhavocincommunitiesandneighborhoodsacrossthiscountry.
As this report goes to print, there are more than io million Americans who are
out of work, cannot fnd full-time work, or have given up looking for work. About
fourmillionfamilieshavelosttheirhomestoforeclosureandanotherfourandahalf
million have slipped into the foreclosure process or are seriously behind on their
mortgage payments. Nearly 11 trillion in household wealth has vanished, with re-
tirementaccountsandlifesavingssweptaway.Businesses,largeandsmall,havefelt
xv
thestingofadeeprecession.Thereismuchangeraboutwhathastranspired,andjus-
tifablyso.Manypeoplewhoabidedbyalltherulesnowfndthemselvesoutofwork
and uncertain about their future prospects. The collateral damage of this crisis has
beenrealpeopleandrealcommunities.Theimpactsofthiscrisisarelikelytobefelt
forageneration.Andthenationfacesnoeasypathtorenewedeconomicstrength.
LikesomanyAmericans,webeganourexplorationwithourownviewsandsome
preliminaryknowledgeabouthowtheworldsstrongestfnancialsystemcametothe
brink of collapse. Even at the time of our appointment to this independent panel,
much had already been written and said about the crisis. Yet all of us have been
deeplyaffectedbywhatwehavelearnedinthecourseofourinquiry.Wehavebeenat
various times fascinated, surprised, and even shocked by what we saw, heard, and
read.Ourshasbeenajourneyofrevelation.
Muchattentionoverthepasttwoyearshasbeenfocusedonthedecisionsbythe
federal government to provide massive fnancial assistance to stabilize the fnancial
systemandrescuelargefnancialinstitutionsthatweredeemedtoosystemicallyim-
portanttofail.Thosedecisionsandthedeepemotionssurroundingthemwillbe
debatedlongintothefuture.Butourmissionwastoaskandanswerthiscentralques-
tion:how did it come to pass that in our nation was forced to choose between two
stark and painful alternativeseither risk the total collapse of our fnancial system
and economy or inject trillions of taxpayer dollars into the fnancial system and an
array of companies, as millions of Americans still lost their jobs, their savings, and
theirhomes:
Inthisreport,wedetailtheeventsofthecrisis.Butasimplesummary,aswesee
it,isusefulattheoutset.Whilethevulnerabilitiesthatcreatedthepotentialforcri-
siswereyearsinthemaking,itwasthecollapseofthehousingbubblefueledby
lowinterestrates,easyandavailablecredit,scantregulation,andtoxicmortgages
thatwasthesparkthatignitedastringofevents,whichledtoafull-blowncrisisin
the fall of ioo8. Trillions of dollars in risky mortgages had become embedded
throughout the financial system, as mortgage-related securities were packaged,
repackaged,andsoldtoinvestorsaroundtheworld.Whenthebubbleburst,hun-
dreds of billions of dollars in losses in mortgages and mortgage-related securities
shook markets as well as financial institutions that had significant exposures to
thosemortgagesandhadborrowedheavilyagainstthem.Thishappenednotjustin
the United States but around the world. The losses were magnified by derivatives
suchassyntheticsecurities.
The crisis reached seismic proportions in September ioo8 with the failure of
LehmanBrothersandtheimpendingcollapseoftheinsurancegiantAmericanInterna-
tionalGroup(AIG).Panicfannedbyalackoftransparencyofthebalancesheetsofma-
jorfnancialinstitutions,coupledwithatangleofinterconnectionsamonginstitutions
perceivedtobetoobigtofail,causedthecreditmarketstoseizeup.Tradingground
toahalt.Thestockmarketplummeted.Theeconomyplungedintoadeeprecession.
Thefnancialsystemweexaminedbearslittleresemblancetothatofourparents
generation.Thechangesinthepastthreedecadesalonehavebeenremarkable.The
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fnancialmarketshavebecomeincreasinglyglobalized.Technologyhastransformed
theemciency,speed,andcomplexityoffnancialinstrumentsandtransactions.There
isbroaderaccesstoandlowercostsoffnancingthaneverbefore.Andthefnancial
sectoritselfhasbecomeamuchmoredominantforceinoureconomy.
From1,8toioo,,theamountofdebtheldbythefnancialsectorsoaredfrom
trilliontootrillion,morethandoublingasashareofgrossdomesticproduct.
The very nature of many Wall Street frms changedfrom relatively staid private
partnershipstopubliclytradedcorporationstakinggreaterandmorediversekindsof
risks.Byioo,,the1olargestU.S.commercialbanksheld,,oftheindustrysassets,
more than double the level held in 1o. On the eve of the crisis in iooo, fnancial
sector profts constituted i, of all corporate profts in the United States, up from
1, in 18o. Understanding this transformation has been critical to the Commis-
sionsanalysis.
Now to our major fndings and conclusions, which are based on the facts con-
tained in this report: they are offered with the hope that lessons may be learned to
helpavoidfuturecatastrophe.
We conclude this fnancial crisis was avoidable. Thecrisiswastheresultofhuman
action and inaction, not of Mother Nature or computer models gone haywire. The
captainsoffnanceandthepublicstewardsofourfnancialsystemignoredwarnings
andfailedtoquestion,understand,andmanageevolvingriskswithinasystemessen-
tial to the well-being of the American public. Theirs was a big miss, not a stumble.
Whilethebusinesscyclecannotberepealed,acrisisofthismagnitudeneednothave
occurred.ToparaphraseShakespeare,thefaultliesnotinthestars,butinus.
Despite the expressed view of many on Wall Street and in Washington that the
crisiscouldnothavebeenforeseenoravoided,therewerewarningsigns.Thetragedy
wasthattheywereignoredordiscounted.Therewasanexplosioninriskysubprime
lending and securitization, an unsustainable rise in housing prices, widespread re-
portsofegregiousandpredatorylendingpractices,dramaticincreasesinhousehold
mortgagedebt,andexponentialgrowthinfnancialfrmstradingactivities,unregu-
lated derivatives, and short-term repo lending markets, among many other red
fags. Yet there was pervasive permissiveness; little meaningful action was taken to
quellthethreatsinatimelymanner.
TheprimeexampleistheFederalReservespivotalfailuretostemthefowoftoxic
mortgages,whichitcouldhavedonebysettingprudentmortgage-lendingstandards.
The Federal Reserve was the one entity empowered to do so and it did not. The
recordofourexaminationisrepletewithevidenceofotherfailures:fnancialinstitu-
tionsmade,bought,andsoldmortgagesecuritiestheyneverexamined,didnotcare
toexamine,orknewtobedefective;frmsdependedontensofbillionsofdollarsof
borrowingthathadtoberenewedeachandeverynight,securedbysubprimemort-
gagesecurities;andmajorfrmsandinvestorsblindlyreliedoncreditratingagencies
astheirarbitersofrisk.Whatelsecouldoneexpectonahighwaywheretherewere
neitherspeedlimitsnorneatlypaintedlines:
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We conclude widespread failures in fnancial regulation and supervision
proved devastating to the stability of the nations fnancial markets. The sentries
werenotattheirposts,innosmallpartduetothewidelyacceptedfaithintheself-
correctingnatureofthemarketsandtheabilityoffnancialinstitutionstoeffectively
policethemselves.Morethan30yearsofderegulationandrelianceonself-regulation
by fnancial institutions, championed by former Federal Reserve chairman Alan
Greenspanandothers,supportedbysuccessiveadministrationsandCongresses,and
activelypushedbythepowerfulfnancialindustryateveryturn,hadstrippedaway
key safeguards, which could have helped avoid catastrophe. This approach had
openedupgapsinoversightofcriticalareaswithtrillionsofdollarsatrisk,suchas
the shadow banking system and over-the-counter derivatives markets. In addition,
the government permitted fnancial frms to pick their preferred regulators in what
becamearacetotheweakestsupervisor.
Yetwedonotaccepttheviewthatregulatorslackedthepowertoprotectthef-
nancialsystem.Theyhadamplepowerinmanyarenasandtheychosenottouseit.
Togivejustthreeexamples:theSecuritiesandExchangeCommissioncouldhavere-
quiredmorecapitalandhaltedriskypracticesatthebiginvestmentbanks.Itdidnot.
The Federal Reserve Bank of New York and other regulators could have clamped
downonCitigroupsexcessesintherun-uptothecrisis.Theydidnot.Policymakers
andregulatorscouldhavestoppedtherunawaymortgagesecuritizationtrain.They
didnot.Incaseaftercaseaftercase,regulatorscontinuedtoratetheinstitutionsthey
oversawassafeandsoundeveninthefaceofmountingtroubles,oftendowngrading
them just before their collapse. And where regulators lacked authority, they could
havesoughtit.Toooften,theylackedthepoliticalwillinapoliticalandideological
environment that constrained itas well as the fortitude to critically challenge the
institutionsandtheentiresystemtheywereentrustedtooversee.
Changesintheregulatorysystemoccurredinmanyinstancesasfnancialmar-
kets evolved. But as the report will show, the fnancial industry itself played a key
role in weakening regulatory constraints on institutions, markets, and products. It
didnotsurprisetheCommissionthatanindustryofsuchwealthandpowerwould
exert pressure on policy makers and regulators. From 1 to ioo8, the fnancial
sectorexpendedi.,billioninreportedfederallobbyingexpenses;individualsand
political action committees in the sector made more than 1 billion in campaign
contributions.Whattroubleduswastheextenttowhichthenationwasdeprivedof
the necessary strength and independence of the oversight necessary to safeguard
fnancialstability.
We conclude dramatic failures of corporate governance and risk management
at many systemically important fnancial institutions were a key cause of this cri-
sis. Therewasaviewthatinstinctsforself-preservationinsidemajorfnancialfrms
would shield them from fatal risk-taking without the need for a steady regulatory
hand, which, the frms argued, would stife innovation. Too many of these institu-
tions acted recklessly, taking on too much risk, with too little capital, and with too
much dependence on short-term funding. In many respects, this refected a funda-
xviii ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
mentalchangeintheseinstitutions,particularlythelargeinvestmentbanksandbank
holdingcompanies,whichfocusedtheiractivitiesincreasinglyonriskytradingactiv-
itiesthatproducedheftyprofts.Theytookonenormousexposuresinacquiringand
supporting subprime lenders and creating, packaging, repackaging, and selling tril-
lionsofdollarsinmortgage-relatedsecurities,includingsyntheticfnancialproducts.
LikeIcarus,theyneverfearedfyingeverclosertothesun.
Manyoftheseinstitutionsgrewaggressivelythroughpoorlyexecutedacquisition
and integration strategies that made effective management more challenging. The
CEO of Citigroup told the Commission that a o billion position in highly rated
mortgage securities would not in any way have excited my attention, and the co-
headofCitigroupsinvestmentbanksaidhespentasmallfractionof1ofhistime
onthosesecurities.Inthisinstance,toobigtofailmeanttoobigtomanage.
Financial institutions and credit rating agencies embraced mathematical models
asreliablepredictorsofrisks,replacingjudgmentintoomanyinstances.Toooften,
riskmanagementbecameriskjustifcation.
Compensation systemsdesigned in an environment of cheap money, intense
competition,andlightregulationtoooftenrewardedthequickdeal,theshort-term
gainwithoutproperconsiderationoflong-termconsequences.Often,thosesystems
encouragedthebigbetwherethepayoffontheupsidecouldbehugeandthedown-
sidelimited.Thiswasthecaseupanddownthelinefromthecorporateboardroom
tothemortgagebrokeronthestreet.
Ourexaminationrevealedstunninginstancesofgovernancebreakdownsandirre-
sponsibility.Youwillread,amongotherthings,aboutAIGseniormanagementsigno-
rance of the terms and risks of the companys , billion derivatives exposure to
mortgage-related securities; Fannie Maes quest for bigger market share, profts, and
bonuses,whichledittorampupitsexposuretoriskyloansandsecuritiesasthehous-
ing market was peaking; and the costly surprise when Merrill Lynchs top manage-
ment realized that the company held ,, billion in super-senior and supposedly
super-safemortgage-relatedsecuritiesthatresultedinbillionsofdollarsinlosses.
We conclude a combination of excessive borrowing, risky investments, and lack
of transparency put the fnancial system on a collision course with crisis. Clearly,
thisvulnerabilitywasrelatedtofailuresofcorporategovernanceandregulation,but
itissignifcantenoughbyitselftowarrantourattentionhere.
Intheyearsleadinguptothecrisis,toomanyfnancialinstitutions,aswellastoo
manyhouseholds,borrowedtothehilt,leavingthemvulnerabletofnancialdistress
orruinifthevalueoftheirinvestmentsdeclinedevenmodestly.Forexample,asof
ioo,, the fve major investment banksBear Stearns, Goldman Sachs, Lehman
Brothers, Merrill Lynch, and Morgan Stanleywere operating with extraordinarily
thincapital.Byonemeasure,theirleverageratioswereashighasoto1,meaningfor
everyoinassets,therewasonly1incapitaltocoverlosses.Lessthanadropin
assetvaluescouldwipeoutafrm.Tomakemattersworse,muchoftheirborrowing
wasshort-term,intheovernightmarketmeaningtheborrowinghadtoberenewed
eachandeveryday.Forexample,attheendofioo,,BearStearnshad11.8billionin
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equityand8.obillioninliabilitiesandwasborrowingasmuchas,obillionin
theovernightmarket.Itwastheequivalentofasmallbusinesswith,o,oooinequity
borrowing 1.o million, with io,,,o of that due each and every day. One cant
really ask What were they thinking: when it seems that too many of them were
thinkingalike.
Andtheleveragewasoftenhiddeninderivativespositions,inoff-balance-sheet
entities,andthroughwindowdressingoffnancialreportsavailabletotheinvesting
public.
ThekingsofleveragewereFannieMaeandFreddieMac,thetwobehemothgov-
ernment-sponsored enterprises (GSEs). For example, by the end of ioo,, Fannies
andFreddiescombinedleverageratio,includingloanstheyownedandguaranteed,
stoodat,,to1.
Butfnancialfrmswerenotaloneintheborrowingspree:fromioo1toioo,,na-
tionalmortgagedebtalmostdoubled,andtheamountofmortgagedebtperhouse-
hold rose more than o from 1,,oo to 1,,oo, even while wages were
essentially stagnant. When the housing downturn hit, heavily indebted fnancial
frmsandfamiliesalikewerewalloped.
The heavy debt taken on by some fnancial institutions was exacerbated by the
riskyassetstheywereacquiringwiththatdebt.Asthemortgageandrealestatemar-
ketschurnedoutriskierandriskierloansandsecurities,manyfnancialinstitutions
loadeduponthem.Bytheendofioo,,Lehmanhadamassed111billionincom-
mercial and residential real estate holdings and securities, which was almost twice
what it held just two years before, and more than four times its total equity. And
again,theriskwasntbeingtakenonjustbythebigfnancialfrms,butbyfamilies,
too.Nearlyonein1omortgageborrowersinioo,andioootookoutoptionARM
loans,whichmeanttheycouldchoosetomakepaymentssolowthattheirmortgage
balancesroseeverymonth.
Within the fnancial system, the dangers of this debt were magnifed because
transparencywasnotrequiredordesired.Massive,short-termborrowing,combined
withobligationsunseenbyothersinthemarket,heightenedthechancesthesystem
couldrapidlyunravel.Intheearlypartoftheiothcentury,weerectedaseriesofpro-
tectionstheFederalReserveasalenderoflastresort,federaldepositinsurance,am-
pleregulationstoprovideabulwarkagainstthepanicsthathadregularlyplagued
Americas banking system in the 1th century. Yet, over the past o-plus years, we
permitted the growth of a shadow banking systemopaque and laden with short-
termdebtthatrivaledthesizeofthetraditionalbankingsystem.Keycomponents
of the marketfor example, the multitrillion-dollar repo lending market, off-bal-
ance-sheet entities, and the use of over-the-counter derivativeswere hidden from
view,withouttheprotectionswehadconstructedtopreventfnancialmeltdowns.We
hadai1st-centuryfnancialsystemwith1th-centurysafeguards.
When the housing and mortgage markets cratered, the lack of transparency, the
extraordinarydebtloads,theshort-termloans,andtheriskyassetsallcamehometo
roost.Whatresultedwaspanic.Wehadreapedwhatwehadsown.
xx ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
We conclude the government was ill prepared for the crisis, and its inconsistent
response added to the uncertainty and panic in the fnancial markets. Aspartof
ourcharge,itwasappropriatetoreviewgovernmentactionstakeninresponsetothe
developing crisis, not just those policies or actions that preceded it, to determine if
anyofthoseresponsescontributedtoorexacerbatedthecrisis.
As our report shows, key policy makersthe Treasury Department, the Federal
Reserve Board, and the Federal Reserve Bank of New Yorkwho were best posi-
tionedtowatchoverourmarketswereillpreparedfortheeventsofioo,andioo8.
Other agencies were also behind the curve. They were hampered because they did
nothaveacleargraspofthefnancialsystemtheywerechargedwithoverseeing,par-
ticularlyasithadevolvedintheyearsleadinguptothecrisis.Thiswasinnosmall
measureduetothelackoftransparencyinkeymarkets.Theythoughtriskhadbeen
diversifedwhen,infact,ithadbeenconcentrated.Timeandagain,fromthespring
of ioo, on, policy makers and regulators were caught off guard as the contagion
spread, responding on an ad hoc basis with specifc programs to put fngers in the
dike.Therewasnocomprehensiveandstrategicplanforcontainment,becausethey
lacked a full understanding of the risks and interconnections in the fnancial mar-
kets. Some regulators have conceded this error. We had allowed the system to race
aheadofourabilitytoprotectit.
Whiletherewassomeawarenessof,oratleastadebateabout,thehousingbubble,
therecordrefectsthatseniorpublicomcialsdidnotrecognizethataburstingofthe
bubblecouldthreatentheentirefnancialsystem.Throughoutthesummerofioo,,
bothFederalReserveChairmanBenBernankeandTreasurySecretaryHenryPaul-
son offered public assurances that the turmoil in the subprime mortgage markets
wouldbecontained.WhenBearStearnsshedgefunds,whichwereheavilyinvested
inmortgage-relatedsecurities,implodedinJuneioo,,theFederalReservediscussed
theimplicationsofthecollapse.Despitethefactthatsomanyotherfundswereex-
posedtothesamerisksasthosehedgefunds,theBearStearnsfundswerethoughtto
berelativelyunique.DaysbeforethecollapseofBearStearnsinMarchioo8,SEC
ChairmanChristopherCoxexpressedcomfortaboutthecapitalcushionsatthebig
investment banks. It was not until August ioo8, just weeks before the government
takeoverofFannieMaeandFreddieMac,thattheTreasuryDepartmentunderstood
thefullmeasureofthedirefnancialconditionsofthosetwoinstitutions.Andjusta
month before Lehmans collapse, the Federal Reserve Bank of New York was still
seekinginformationontheexposurescreatedbyLehmansmorethanoo,oooderiv-
ativescontracts.
Inaddition,thegovernmentsinconsistenthandlingofmajorfnancialinstitutions
duringthecrisisthedecisiontorescueBearStearnsandthentoplaceFannieMae
andFreddieMacintoconservatorship,followedbyitsdecisionnottosaveLehman
BrothersandthentosaveAIGincreaseduncertaintyandpanicinthemarket.
Inmakingtheseobservations,wedeeplyrespectandappreciatetheeffortsmade
by Secretary Paulson, Chairman Bernanke, and Timothy Geithner, formerly presi-
dent of the Federal Reserve Bank of New York and now treasury secretary, and so
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many others who labored to stabilize our fnancial system and our economy in the
mostchaoticandchallengingofcircumstances.
We conclude there was a systemic breakdown in accountability and ethics. The
integrityofourfnancialmarketsandthepublicstrustinthosemarketsareessential
totheeconomicwell-beingofournation.Thesoundnessandthesustainedprosper-
ity of the fnancial system and our economy rely on the notions of fair dealing, re-
sponsibility,andtransparency.Inoureconomy,weexpectbusinessesandindividuals
topursueprofts,atthesametimethattheyproduceproductsandservicesofquality
andconductthemselveswell.
Unfortunatelyas has been the case in past speculative booms and bustswe
witnessedanerosionofstandardsofresponsibilityandethicsthatexacerbatedthef-
nancialcrisis.Thiswasnotuniversal,butthesebreachesstretchedfromtheground
level to the corporate suites. They resulted not only in signifcant fnancial conse-
quencesbutalsoindamagetothetrustofinvestors,businesses,andthepublicinthe
fnancialsystem.
Forexample,ourexaminationfound,accordingtoonemeasure,thatthepercent-
ageofborrowerswhodefaultedontheirmortgageswithinjustamatterofmonths
aftertakingaloannearlydoubledfromthesummerofioootolateioo,.Thisdata
indicatestheylikelytookoutmortgagesthattheyneverhadthecapacityorintention
topay.Youwillreadaboutmortgagebrokerswhowerepaidyieldspreadpremiums
bylenderstoputborrowersintohigher-costloanssotheywouldgetbiggerfees,of-
tenneverdisclosedtoborrowers.Thereportcataloguestherisingincidenceofmort-
gagefraud,whichfourishedinanenvironmentofcollapsinglendingstandardsand
laxregulation.Thenumberofsuspiciousactivityreportsreportsofpossiblefnan-
cial crimes fled by depository banks and their amliatesrelated to mortgage fraud
grew io-fold between 1o and ioo, and then more than doubled again between
ioo,andioo.Onestudyplacesthelossesresultingfromfraudonmortgageloans
madebetweenioo,andioo,at11ibillion.
Lenders made loans that they knew borrowers could not afford and that could
causemassivelossestoinvestorsinmortgagesecurities.AsearlyasSeptemberioo,
Countrywide executives recognized that many of the loans they were originating
could result in catastrophic consequences. Less than a year later, they noted that
certain high-risk loans they were making could result not only in foreclosures but
alsoinfnancialandreputationalcatastropheforthefrm.Buttheydidnotstop.
Andthereportdocumentsthatmajorfnancialinstitutionsineffectivelysampled
loanstheywerepurchasingtopackageandselltoinvestors.Theyknewasignifcant
percentage of the sampled loans did not meet their own underwriting standards or
those of the originators. Nonetheless, they sold those securities to investors. The
Commissionsreviewofmanyprospectusesprovidedtoinvestorsfoundthatthiscrit-
icalinformationwasnotdisclosed.
THESE CONCLUSIONS mustbeviewedinthecontextofhumannatureandindividual
and societal responsibility. First, to pin this crisis on mortal faws like greed and
xxii ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
hubriswouldbesimplistic.Itwasthefailuretoaccountforhumanweaknessthatis
relevanttothiscrisis.
Second, we clearly believe the crisis was a result of human mistakes, misjudg-
ments,andmisdeedsthatresultedinsystemicfailuresforwhichournationhaspaid
dearly.Asyoureadthisreport,youwillseethatspecifcfrmsandindividualsacted
irresponsibly.Yetacrisisofthismagnitudecannotbetheworkofafewbadactors,
andsuchwasnotthecasehere.Atthesametime,thebreadthofthiscrisisdoesnot
meanthateveryoneisatfault;manyfrmsandindividualsdidnotparticipateinthe
excessesthatspawneddisaster.
Wedoplacespecialresponsibilitywiththepublicleaderschargedwithprotecting
ourfnancialsystem,thoseentrustedtorunourregulatoryagencies,andthechiefex-
ecutivesofcompanieswhosefailuresdroveustocrisis.Theseindividualssoughtand
accepted positions of signifcant responsibility and obligation. Tone at the top does
matterand,inthisinstance,wewereletdown.Noonesaidno.
Butasanation,wemustalsoacceptresponsibilityforwhatwepermittedtooccur.
Collectively,butcertainlynotunanimously,weacquiescedtoorembracedasystem,
asetofpoliciesandactions,thatgaverisetoourpresentpredicament.

THIS REPORT DESCRIBES THE EVENTS and the system that propelled our nation to-
ward crisis. The complex machinery of our fnancial markets has many essential
gearssome of which played a critical role as the crisis developed and deepened.
Herewerenderourconclusionsaboutspecifccomponentsofthesystemthatwebe-
lievecontributedsignifcantlytothefnancialmeltdown.
We conclude collapsing mortgage-lending standards and the mortgage securi-
tization pipeline lit and spread the fame of contagion and crisis. When housing
pricesfellandmortgageborrowersdefaulted,thelightsbegantodimonWallStreet.
Thisreportcataloguesthecorrosionofmortgage-lendingstandardsandthesecuriti-
zationpipelinethattransportedtoxicmortgagesfromneighborhoodsacrossAmer-
icatoinvestorsaroundtheglobe.
Manymortgagelenderssetthebarsolowthatlenderssimplytookeagerborrow-
ers qualifcations on faith, often with a willful disregard for a borrowers ability to
pay.Nearlyone-quarterofallmortgagesmadeinthefrsthalfofioo,wereinterest-
onlyloans.Duringthesameyear,o8ofoptionARMloansoriginatedbyCoun-
trywideandWashingtonMutualhadlow-orno-documentationrequirements.
These trends were not secret. As irresponsible lending, including predatory and
fraudulentpractices,becamemoreprevalent,theFederalReserveandotherregula-
tors and authorities heard warnings from many quarters. Yet the Federal Reserve
neglecteditsmissiontoensurethesafetyandsoundnessofthenationsbankingand
fnancialsystemandtoprotectthecreditrightsofconsumers.Itfailedtobuildthe
retaining wall before it was too late. And the Omce of the Comptroller of the Cur-
rency and the Omce of Thrift Supervision, caught up in turf wars, preempted state
regulatorsfromreininginabuses.
tuNtiU:i uN: ui 1ui ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN xxiii
Whilemanyofthesemortgageswerekeptonbanksbooks,thebiggermoneycame
fromglobalinvestorswhoclamoredtoputtheircashintonewlycreatedmortgage-re-
latedsecurities.Itappearedtofnancialinstitutions,investors,andregulatorsalikethat
riskhadbeenconquered:theinvestorsheldhighlyratedsecuritiestheythoughtwere
suretoperform;thebanksthoughttheyhadtakentheriskiestloansofftheirbooks;
andregulatorssawfrmsmakingproftsandborrowingcostsreduced.Buteachstepin
themortgagesecuritizationpipelinedependedonthenextsteptokeepdemandgo-
ing. From the speculators who fipped houses to the mortgage brokers who scouted
theloans,tothelenderswhoissuedthemortgages,tothefnancialfrmsthatcreated
the mortgage-backed securities, collateralized debt obligations (CDOs), CDOs
squared,andsyntheticCDOs:nooneinthispipelineoftoxicmortgageshadenough
skininthegame.Theyallbelievedtheycouldoff-loadtheirrisksonamomentsno-
tice to the next person in line. They were wrong. When borrowers stopped making
mortgage payments, the lossesamplifed by derivativesrushed through the
pipeline.Asitturnedout,theselosseswereconcentratedinasetofsystemicallyim-
portantfnancialinstitutions.
Intheend,thesystemthatcreatedmillionsofmortgagessoemcientlyhasproven
tobedimculttounwind.Itscomplexityhaserectedbarrierstomodifyingmortgages
so families can stay in their homes and has created further uncertainty about the
healthofthehousingmarketandfnancialinstitutions.
We conclude over-the-counter derivatives contributed signifcantly to this
crisis. Theenactmentoflegislationin2000tobantheregulationbyboththefederal
and state governments of over-the-counter (OTC) derivatives was a key turning
pointinthemarchtowardthefnancialcrisis.
From fnancial frms to corporations, to farmers, and to investors, derivatives
havebeenusedtohedgeagainst,orspeculateon,changesinprices,rates,orindices
orevenoneventssuchasthepotentialdefaultsondebts.Yet,withoutanyoversight,
OTCderivativesrapidlyspiraledoutofcontrolandoutofsight,growingtoo,tril-
lion in notional amount. This report explains the uncontrolled leverage; lack of
transparency, capital, and collateral requirements; speculation; interconnections
amongfrms;andconcentrationsofriskinthismarket.
OTCderivativescontributedtothecrisisinthreesignifcantways.First,onetype
of derivativecredit default swaps (CDS)fueled the mortgage securitization
pipeline.CDSweresoldtoinvestorstoprotectagainstthedefaultordeclineinvalue
ofmortgage-relatedsecuritiesbackedbyriskyloans.Companiessoldprotectionto
thetuneof,billion,inAIGscasetoinvestorsinthesenewfangledmortgagese-
curities, helping to launch and expand the market and, in turn, to further fuel the
housingbubble.
Second, CDS were essential to the creation of synthetic CDOs. These synthetic
CDOsweremerelybetsontheperformanceofrealmortgage-relatedsecurities.They
amplifedthelossesfromthecollapseofthehousingbubblebyallowingmultiplebets
on the same securities and helped spread them throughout the fnancial system.
GoldmanSachsalonepackagedandsold,billioninsyntheticCDOsfromJuly1,
xxiv ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
ioo, to May 1, ioo,. Synthetic CDOs created by Goldman referenced more than
,oo mortgage securities, and o1o of them were referenced at least twice. This is
apart from how many times these securities may have been referenced in synthetic
CDOscreatedbyotherfrms.
Finally,whenthehousingbubblepoppedandcrisisfollowed,derivativeswerein
the center of the storm. AIG, which had not been required to put aside capital re-
servesasacushionfortheprotectionitwasselling,wasbailedoutwhenitcouldnot
meet its obligations. The government ultimately committed more than 18o billion
because of concerns that AIGs collapse would trigger cascading losses throughout
theglobalfnancialsystem.Inaddition,theexistenceofmillionsofderivativescon-
tractsofalltypesbetweensystemicallyimportantfnancialinstitutionsunseenand
unknown in this unregulated marketadded to uncertainty and escalated panic,
helpingtoprecipitategovernmentassistancetothoseinstitutions.
We conclude the failures of credit rating agencies were essential cogs in the
wheel of fnancial destruction. Thethreecreditratingagencieswerekeyenablersof
the fnancial meltdown. The mortgage-related securities at the heart of the crisis
couldnothavebeenmarketedandsoldwithouttheirsealofapproval.Investorsre-
liedonthem,oftenblindly.Insomecases,theywereobligatedtousethem,orregula-
tory capital standards were hinged on them. This crisis could not have happened
without the rating agencies. Their ratings helped the market soar and their down-
gradesthrough2007and2008wreakedhavocacrossmarketsandfrms.
In our report, you will read about the breakdowns at Moodys, examined by the
Commission as a case study. From iooo to ioo,, Moodys rated nearly ,,ooo
mortgage-related securities as triple-A. This compares with six private-sector com-
panies in the United States that carried this coveted rating in early io1o. In iooo
alone,Moodysputitstriple-Astampofapprovalonomortgage-relatedsecurities
everyworkingday.Theresultsweredisastrous:8ofthemortgagesecuritiesrated
triple-Athatyearultimatelyweredowngraded.
YouwillalsoreadabouttheforcesatworkbehindthebreakdownsatMoodys,in-
cludingthefawedcomputermodels,thepressurefromfnancialfrmsthatpaidfor
theratings,therelentlessdriveformarketshare,thelackofresourcestodothejob
despiterecordprofts,andtheabsenceofmeaningfulpublicoversight.Andyouwill
seethatwithouttheactiveparticipationoftheratingagencies,themarketformort-
gage-relatedsecuritiescouldnothavebeenwhatitbecame.

THERE ARE MANY COMPETING VIEWS astothecausesofthiscrisis.Inthisregard,the
Commissionhasendeavoredtoaddresskeyquestionsposedtous.Herewediscuss
three:capitalavailabilityandexcessliquidity,theroleofFannieMaeandFreddieMac
(theGSEs),andgovernmenthousingpolicy.
First,astothematterofexcessliquidity:inourreport,weoutlinemonetarypoli-
cies and capital fows during the years leading up to the crisis. Low interest rates,
widelyavailablecapital,andinternationalinvestorsseekingtoputtheirmoneyinreal
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estateassetsintheUnitedStateswereprerequisitesforthecreationofacreditbubble.
Those conditions created increased risks, which should have been recognized by
marketparticipants,policymakers,andregulators.However,itistheCommissions
conclusionthatexcessliquiditydidnotneedtocauseacrisis.Itwasthefailuresout-
linedaboveincludingthefailuretoeffectivelyreininexcessesinthemortgageand
fnancialmarketsthatweretheprincipalcausesofthiscrisis.Indeed,theavailabil-
ity of well-priced capitalboth foreign and domesticis an opportunity for eco-
nomicexpansionandgrowthifencouragedtofowinproductivedirections.
Second,weexaminedtheroleoftheGSEs,withFannieMaeservingastheCom-
missions case study in this area. These government-sponsored enterprises had a
deeplyfawedbusinessmodelaspubliclytradedcorporationswiththeimplicitback-
ing of and subsidies from the federal government and with a public mission. Their
, trillion mortgage exposure and market position were signifcant. In ioo, and
iooo,theydecidedtorampuptheirpurchaseandguaranteeofriskymortgages,just
as the housing market was peaking. They used their political power for decades to
wardoffeffectiveregulationandoversightspending1omilliononlobbyingfrom
1toioo8.Theysufferedfrommanyofthesamefailuresofcorporategovernance
and risk management as the Commission discovered in other fnancial frms.
Throughthethirdquarterofio1o,theTreasuryDepartmenthadprovided1,1bil-
lioninfnancialsupporttokeepthemafoat.
Weconcludethatthesetwoentitiescontributedtothecrisis,butwerenotapri-
marycause.Importantly,GSEmortgagesecuritiesessentiallymaintainedtheirvalue
throughout the crisis and did not contribute to the signifcant fnancial frm losses
thatwerecentraltothefnancialcrisis.
The GSEs participated in the expansion of subprime and other risky mortgages,
buttheyfollowedratherthanledWallStreetandotherlendersintherushforfools
gold. They purchased the highest rated non-GSE mortgage-backed securities and
theirparticipationinthismarketaddedheliumtothehousingballoon,buttheirpur-
chasesneverrepresentedamajorityofthemarket.Thosepurchasesrepresented1o.,
of non-GSE subprime mortgage-backed securities in ioo1, with the share rising to
oinioo,andfallingbacktoi8byioo8.Theyrelaxedtheirunderwritingstan-
dards to purchase or guarantee riskier loans and related securities in order to meet
stockmarketanalystsandinvestorsexpectationsforgrowth,toregainmarketshare,
andtoensuregenerouscompensationfortheirexecutivesandemployeesjustifying
theiractivitiesonthebroadandsustainedpublicpolicysupportforhomeownership.
TheCommissionalsoprobedtheperformanceoftheloanspurchasedorguaran-
teed by Fannie and Freddie. While they generated substantial losses, delinquency
ratesforGSEloansweresubstantiallylowerthanloanssecuritizedbyotherfnancial
frms.Forexample,datacompiledbytheCommissionforasubsetofborrowerswith
similar credit scoresscores below oooshow that by the end of ioo8, GSE mort-
gages were far less likely to be seriously delinquent than were non-GSE securitized
mortgages:o.iversusi8..
We also studied at length how the Department of Housing and Urban Develop-
ments (HUDs) affordable housing goals for the GSEs affected their investment in
xxvi ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
riskymortgages.Basedontheevidenceandinterviewswithdozensofindividualsin-
volvedinthissubjectarea,wedeterminedthesegoalsonlycontributedmarginallyto
FanniesandFreddiesparticipationinthosemortgages.
Finally,astothematterofwhethergovernmenthousingpolicieswereaprimary
cause of the crisis: for decades, government policy has encouraged homeownership
throughasetofincentives,assistanceprograms,andmandates.Thesepolicieswere
putinplaceandpromotedbyseveraladministrationsandCongressesindeed,both
Presidents Bill Clinton and George W. Bush set aggressive goals to increase home-
ownership.
In conducting our inquiry, we took a careful look at HUDs affordable housing
goals,asnotedabove,andtheCommunityReinvestmentAct(CRA).TheCRAwas
enactedin1,,tocombatredliningbybanksthepracticeofdenyingcredittoin-
dividualsandbusinessesincertainneighborhoodswithoutregardtotheircreditwor-
thiness.TheCRArequiresbanksandsavingsandloanstolend,invest,andprovide
services to the communities from which they take deposits, consistent with bank
safetyandsoundness.
TheCommissionconcludestheCRAwasnotasignifcantfactorinsubprimelend-
ingorthecrisis.ManysubprimelenderswerenotsubjecttotheCRA.Researchindi-
catesonlyoofhigh-costloansaproxyforsubprimeloanshadanyconnectionto
the law. Loans made by CRA-regulated lenders in the neighborhoods in which they
wererequiredtolendwerehalfaslikelytodefaultassimilarloansmadeinthesame
neighborhoodsbyindependentmortgageoriginatorsnotsubjecttothelaw.
Nonetheless,wemakethefollowingobservationaboutgovernmenthousingpoli-
ciestheyfailedinthisrespect:Asanation,wesetaggressivehomeownershipgoals
withthedesiretoextendcredittofamiliespreviouslydeniedaccesstothefnancial
markets.Yetthegovernmentfailedtoensurethatthephilosophyofopportunitywas
being matched by the practical realities on the ground. Witness again the failure of
theFederalReserveandotherregulatorstoreininirresponsiblelending.Homeown-
ershippeakedinthespringofiooandthenbegantodecline.Fromthatpointon,
thetalkofopportunitywastragicallyatoddswiththerealityofafnancialdisasterin
themaking.

WHEN THIS COMMISSION began its work 18 months ago, some imagined that the
eventsofioo8andtheirconsequenceswouldbewellbehindusbythetimeweissued
this report. Yet more than two years after the federal government intervened in an
unprecedented manner in our fnancial markets, our country fnds itself still grap-
plingwiththeaftereffectsofthecalamity.Ourfnancialsystemis,inmanyrespects,
stillunchangedfromwhatexistedontheeveofthecrisis.Indeed,inthewakeofthe
crisis,theU.S.fnancialsectorisnowmoreconcentratedthaneverinthehandsofa
fewlarge,systemicallysignifcantinstitutions.
Whilewehavenotbeenchargedwithmakingpolicyrecommendations,thevery
purposeofourreporthasbeentotakestockofwhathappenedsowecanplotanew
course. In our inquiry, we found dramatic breakdowns of corporate governance,
tuNtiU:i uN: ui 1ui ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN xxvii
profoundlapsesinregulatoryoversight,andnearfatalfawsinourfnancialsystem.
We also found that a series of choices and actions led us toward a catastrophe for
which we were ill prepared. These are serious matters that must be addressed and
resolvedtorestorefaithinourfnancialmarkets,toavoidthenextcrisis,andtore-
build a system of capital that provides the foundation for a new era of broadly
sharedprosperity.
Thegreatesttragedywouldbetoaccepttherefrainthatnoonecouldhaveseen
thiscomingandthusnothingcouldhavebeendone.Ifweacceptthisnotion,itwill
happenagain.
This report should not be viewed as the end of the nations examination of this
crisis.Thereisstillmuchtolearn,muchtoinvestigate,andmuchtofx.
This is our collective responsibility. It falls to us to make different choices if we
wantdifferentresults.
xxviii ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
PART I
Crisis on the Horizon
1
BEFORE OUR VERY EYES
InexaminingtheworstfnancialmeltdownsincetheGreatDepression,theFinancial
CrisisInquiryCommissionreviewedmillionsofpagesofdocumentsandquestioned
hundredsofindividualsfnancialexecutives,businessleaders,policymakers,regu-
lators,communityleaders,peoplefromallwalksoflifetofndouthowandwhyit
happened.
In public hearings and interviews, many fnancial industry executives and top
publicomcialstestifedthattheyhadbeenblindsidedbythecrisis,describingitasa
dramatic and mystifying turn of events. Even among those who worried that the
housing bubble might burst, fewif anyforesaw the magnitude of the crisis that
wouldensue.
CharlesPrince,theformerchairmanandchiefexecutiveomcerofCitigroupInc.,
called the collapse in housing prices wholly unanticipated.
1
Warren Buffett, the
chairman and chief executive omcer of Berkshire Hathaway Inc., which until ioo
was the largest single shareholder of Moodys Corporation, told the Commission
that very, very few people could appreciate the bubble, which he called a mass
delusion shared by oo million Americans.
i
Lloyd Blankfein, the chairman and
chiefexecutiveomcerofGoldmanSachsGroup,Inc.,likenedthefnancialcrisistoa
hurricane.

Regulators echoed a similar refrain. Ben Bernanke, the chairman of the Federal
ReserveBoardsinceiooo,toldtheCommissionaperfectstormhadoccurredthat
regulatorscouldnothaveanticipated;butwhenaskedaboutwhethertheFedslackof
aggressiveness in regulating the mortgage market during the housing boom was a
failure,Bernankeresponded,Itwas,indeed.Ithinkitwasthemostseverefailureof
the Fed in this particular episode.

Alan Greenspan, the Fed chairman during the


twodecadesleadinguptothecrash,toldtheCommissionthatitwasbeyondtheabil-
ity of regulators to ever foresee such a sharp decline. History tells us [regulators]
cannotidentifythetimingofacrisis,oranticipateexactlywhereitwillbelocatedor
howlargethelossesandspilloverswillbe.
,
Infact,therewerewarningsigns.Inthedecadeprecedingthecollapse,therewere
many signs that house prices were infated, that lending practices had spun out of
control,thattoomanyhomeownersweretakingonmortgagesanddebttheycouldill
afford, and that risks to the fnancial system were growing unchecked. Alarm bells
,
were clanging inside fnancial institutions, regulatory omces, consumer service or-
ganizations, state law enforcement agencies, and corporations throughout America,
aswellasinneighborhoodsacrossthecountry.Manyknowledgeableexecutivessaw
troubleandmanagedtoavoidthetrainwreck.WhilecountlessAmericansjoinedin
thefnancialeuphoriathatseizedthenation,manyotherswereshoutingtogovern-
ment omcials in Washington and within state legislatures, pointing to what would
becomeahumandisaster,notjustaneconomicdebacle.
Everybody in the whole world knew that the mortgage bubble was there, said
RichardBreeden,theformerchairmanoftheSecuritiesandExchangeCommission
appointedbyPresidentGeorgeH.W.Bush.Imean,itwasnthidden. . . .Youcannot
lookatanyofthisandsaythattheregulatorsdidtheirjob.Thiswasnotsomehidden
problem.ItwasntoutonMarsorPlutoorsomewhere.Itwasrighthere. . . .Youcant
maketrillionsofdollarsworthofmortgagesandnothavepeoplenotice.
o
PaulMcCulley,amanagingdirectoratPIMCO,oneofthenationslargestmoney
managementfrms,toldtheCommissionthatheandhiscolleaguesbegantogetwor-
riedaboutserioussignsofbubblesinioo,;theythereforesentoutcreditanalyststo
iocitiestodowhathecalledold-fashionedshoe-leatherresearch,talkingtoreales-
tatebrokers,mortgagebrokers,andlocalinvestorsaboutthehousingandmortgage
markets. They witnessed what he called the outright degradation of underwriting
standards,McCulleyasserted,andtheysharedwhattheyhadlearnedwhentheygot
back home to the companys Newport Beach, California, headquarters. And when
ourgroupcameback,theyreportedwhattheysaw,andweadjustedourriskaccord-
ingly,McCulleytoldtheCommission.Thecompanyseverelylimiteditsparticipa-
tioninriskymortgagesecurities.
,
Veteranbankers,particularlythosewhorememberedthesavingsandloancrisis,
knewthatage-oldrulesofprudentlendinghadbeencastaside.ArnoldCattani,the
chairmanofBakersfeld,CaliforniabasedMissionBank,toldtheCommissionthat
he grew uncomfortable with the pure lunacy he saw in the local home-building
market,fueledbyvoraciousWallStreetinvestmentbanks;hethusoptedoutofcer-
tainkindsofinvestmentsbyioo,.
8
WilliamMartin,thevicechairmanandchiefexecutiveomcerofService1stBank
ofNevada,toldtheFCICthatthedesireforahighandquickreturnblindedpeople
tofscalrealities.YoumayrecallTommyLeeJonesinMen in Black, whereheholdsa
deviceintheair,andwithabrightfashwipescleanthememoriesofeveryonewho
haswitnessedanalienevent,hesaid.

Unlike so many other bubblestulip bulbs in Holland in the 1ooos, South Sea
stocksinthe1,oos,Internetstocksinthelate1osthisoneinvolvednotjustan-
other commodity but a building block of community and social life and a corner-
stoneoftheeconomy:thefamilyhome.Homesarethefoundationuponwhichmany
ofoursocial,personal,governmental,andeconomicstructuresrest.Childrenusually
go to schools linked to their home addresses; local governments decide how much
money they can spend on roads, frehouses, and public safety based on how much
propertytaxrevenuetheyhave;housepricesaretiedtoconsumerspending.Down-
turnsinthehousingindustrycancauserippleeffectsalmosteverywhere.
, ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
When the Federal Reserve cut interest rates early in the new century and mort-
gageratesfell,homerefnancingsurged,climbingfromoobillioninioootoi.8
trillioninioo,
1o
allowingpeopletowithdrawequitybuiltupoverpreviousdecades
and to consume more, despite stagnant wages. Home sales volume started to in-
crease,andaveragehomepricesnationwideclimbed,risingo,ineightyearsbyone
measure and hitting a national high of ii,,1oo in early iooo.
11
Home prices in
many areas skyrocketed: prices increased nearly two and one-half times in Sacra-
mento,forexample,injustfveyears,
1i
andshotupbyaboutthesamepercentagein
Bakersfeld,Miami,andKeyWest.Pricesaboutdoubledinmorethan11ometropol-
itanareas,includingPhoenix,AtlanticCity,Baltimore,Ft.Lauderdale,LosAngeles,
Poughkeepsie, San Diego, and West Palm Beach.
1
Housing starts nationwide
climbed,,from1.millionin1,tomorethanimillioninioo,.Encouraged
by government policies, homeownership reached a record o.i in the spring of
ioo, although it wouldnt rise an inch further even as the mortgage machine kept
churning for another three years. By refnancing their homes, Americans extracted
i.otrillioninhomeequitybetweenioooandioo,,includingbillioniniooo
alone,morethanseventimestheamounttheytookoutin1o.
1
Realestatespecula-
torsandpotentialhomeownersstoodinlineoutsidenewsubdivisionsforachanceto
buyhousesbeforethegroundhadevenbeenbroken.Bythefrsthalfofioo,,more
thanoneoutofeverytenhomesaleswastoaninvestor,speculator,orsomeonebuy-
ingasecondhome.
1,
Biggerwasbetter,andeventhestructuresthemselvesballooned
insize;thefoorareaofanaveragenewhomegrewby1,,toi,i,,squarefeet,in
thedecadefrom1,toioo,.
Money washed through the economy like water rushing through a broken dam.
Lowinterestratesandthenforeigncapitalhelpedfueltheboom.Constructionwork-
ers,landscapearchitects,realestateagents,loanbrokers,andappraisersproftedon
MainStreet,whileinvestmentbankersandtradersonWallStreetmovedevenhigher
ontheAmericanearningspyramidandthesharepricesofthemostaggressivefnan-
cial service frms reached all-time highs.
1o
Homeowners pulled cash out of their
homestosendtheirkidstocollege,paymedicalbills,installdesignerkitchenswith
granitecounters,takevacations,orlaunchnewbusinesses.Theyalsopaidoffcredit
cards,evenaspersonaldebtrosenationally.Surveyevidenceshowsthatabout,of
homeownerspulledoutcashtobuyavehicleandoverospentthecashonacatch-
all category including tax payments, clothing, gifts, and living expenses.
1,
Renters
usednewformsofloanstobuyhomesandtomovetosuburbansubdivisions,erect-
ingswingsetsintheirbackyardsandenrollingtheirchildreninlocalschools.
In an interview with the Commission, Angelo Mozilo, the longtime CEO of
CountrywideFinancialalenderbroughtdownbyitsriskymortgagessaidthata
goldrushmentalityovertookthecountryduringtheseyears,andthathewasswept
upinitaswell:HousingpriceswererisingsorapidlyataratethatIdneverseenin
my,,yearsinthebusinessthatpeople,regularpeople,averagepeoplegotcaught
upinthemaniaofbuyingahouse,andfippingit,makingmoney.Itwashappening.
Theybuyahouse,make,o,ooo . . .andtalkatacocktailpartyaboutit. . . .Housing
suddenlywentfrombeingpartoftheAmericandreamtohousemyfamilytosettle
8ii uii uUi \ii ii: ,
downitbecameacommodity.Thatwasachangeintheculture. . . .Itwassudden,
unexpected.
18
Onthesurface,itlookedlikeprosperity.Afterall,thebasicmechanismsmaking
the real estate machine humthe mortgage-lending instruments and the fnancing
techniquesthatturnedmortgagesintoinvestmentscalledsecurities,whichkeptcash
fowingfromWallStreetintotheU.S.housingmarketweretoolsthathadworked
wellformanyyears.
But underneath, something was going wrong. Like a science fction movie in
whichordinaryhouseholdobjectsturnhostile,familiarmarketmechanismswerebe-
ingtransformed.Thetime-testedo-yearfxed-ratemortgage,withaiodownpay-
ment, went out of style. There was a burgeoning global demand for residential
mortgagebacked securities that offered seemingly solid and secure returns. In-
vestorsaroundtheworldclamoredtopurchasesecuritiesbuiltonAmericanreales-
tate,seeminglyoneofthesafestbetsintheworld.
WallStreetlaboredmightilytomeetthatdemand.Bondsalesmenearnedmulti-
million-dollar bonuses packaging and selling new kinds of loans, offered by new
kindsoflenders,intonewkindsofinvestmentproductsthatweredeemedsafebut
possessed complex and hidden risks. Federal officials praised the changesthese
financial innovations, they said, had lowered borrowing costs for consumers and
movedrisksawayfromthebiggestandmostsystemicallyimportantfinancialinsti-
tutions. But the nations financial system had become vulnerable and intercon-
nected in ways that were not understood by either the captains of finance or the
systemspublicstewards.Infact,someofthelargestinstitutionshadtakenonwhat
would prove to be debilitating risks. Trillions of dollars had been wagered on the
beliefthathousingpriceswouldalwaysriseandthatborrowerswouldseldomde-
faultonmortgages,evenastheirdebtgrew.Shakyloanshadbeenbundledintoin-
vestment products in ways that seemed to give investors the best of both
worldshigh-yield,risk-freebutinstead,inmanycases,wouldprovetobehigh-
riskandyield-free.
All this fnancial creativity was a lot like cheap sangria, said Michael Mayo, a
managingdirectorandfnancialservicesanalystatCalyonSecurities(USA)Inc.A
lotofcheapingredientsrepackagedtosellatapremium,hetoldtheCommission.It
mighttastegoodforawhile,butthenyougetheadacheslaterandyouhavenoidea
whatsreallyinside.
1
The securitization machine began to guzzle these once-rare mortgage products
with their strange-sounding names: Alt-A, subprime, I-O (interest-only), low-doc,
no-doc, or ninja (no income, no job, no assets) loans; ii8s and i,s; liar loans;
piggyback second mortgages; payment-option or pick-a-pay adjustable rate mort-
gages.Newvariantsonadjustable-ratemortgages,calledexplodingARMs,featured
lowmonthlycostsatfrst,butpaymentscouldsuddenlydoubleortriple,ifborrowers
wereunabletorefnance.Loanswithnegativeamortizationwouldeatawaythebor-
rowersequity.Soontherewereamultitudeofdifferentkindsofmortgagesavailable
on the market, confounding consumers who didnt examine the fne print, baming
ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
conscientiousborrowerswhotriedtopuzzleouttheirimplications,andopeningthe
doorforthosewhowantedinontheaction.
Manypeoplechosepoorly.Somepeoplewantedtolivebeyondtheirmeans,andby
mid-ioo,, nearly one-quarter of all borrowers nationwide were taking out interest-
only loans that allowed them to defer the payment of principal.
io
Some borrowers
opted for nontraditional mortgages because that was the only way they could get a
footholdinareassuchasthesky-highCaliforniahousingmarket.
i1
Somespeculators
saw the chance to snatch up investment properties and fip them for proftand
FloridaandGeorgiabecameaparticulartargetforinvestorswhousedtheseloansto
acquirerealestate.
ii
Someweremisledbysalespeoplewhocametotheirhomesand
persuaded them to sign loan documents on their kitchen tables. Some borrowers
naively trusted mortgage brokers who earned more money placing them in risky
loansthaninsafeones.
i
Withtheseloans,buyerswereabletobidupthepricesof
houseseveniftheydidnthaveenoughincometoqualifyfortraditionalloans.
Some of these exotic loans had existed in the past, used by high-income, fnan-
ciallysecurepeopleasacash-managementtool.Somehadbeentargetedtoborrow-
erswithimpairedcredit,offeringthemtheopportunitytobuildastrongerpayment
historybeforetheyrefnanced.Buttheinstrumentsbegantodelugethelargermarket
iniooandioo,.Thechangedoccurredalmostovernight,FaithSchwartz,thenan
executiveatthesubprimelenderOptionOneandlatertheexecutivedirectorofHope
Now, a lending-industry foreclosure relief group, told the Federal Reserves Con-
sumerAdvisoryCouncil.Iwouldsuggestmosteverylenderinthecountryisinit,
onewayoranother.
i
At frst not a lot of people really understood the potential hazards of these new
loans.Theywerenew,theyweredifferent,andtheconsequenceswereuncertain.But
it soon became apparent that what had looked like newfound wealth was a mirage
based on borrowed money. Overall mortgage indebtedness in the United States
climbed from ,. trillion in ioo1 to 1o., trillion in ioo,. The mortgage debt of
American households rose almost as much in the six years from ioo1 to ioo, as it
had over the course of the countrys more than ioo-year history. The amount of
mortgagedebtperhouseholdrosefrom1,,ooinioo1to1,,ooinioo,.
i,
With
asimplefourishofapenonpaper,millionsofAmericanstradedawaydecadesofeq-
uitytuckedawayintheirhomes.
Under the radar, the lending and the fnancial services industry had mutated. In
the past, lenders had avoided making unsound loans because they would be stuck
with them in their loan portfolios. But because of the growth of securitization, it
wasnt even clear anymore who the lender was. The mortgages would be packaged,
sliced,repackaged,insured,andsoldasincomprehensiblycomplicateddebtsecurities
toanassortmentofhungryinvestors.Noweventheworstloanscouldfndabuyer.
Moreloansalesmeanthigherproftsforeveryoneinthechain.Businessboomed
forChristopherCruise,aMaryland-basedcorporateeducatorwhotrainedloanom-
cers for companies that were expanding mortgage originations. He crisscrossed the
nation,coachingabout1o,oooloanoriginatorsayearinauditoriumsandclassrooms.
8ii uii uUi \ii ii: ,
His clients included many of the largest lendersCountrywide, Ameriquest, and
Ditechamongthem.Mostoftheirnewhireswereyoung,withnomortgageexperi-
ence,freshoutofschoolandwithpreviousjobsfippingburgers,hetoldtheFCIC.
Giventherighttraining,however,thebestofthemcouldeasilyearnmillions.
io
I was a sales and marketing trainer in terms of helping people to know how to
selltheseproductsto,insomecases,franklyunsophisticatedandunsuspectingbor-
rowers,hesaid.Hetaughtthemthenewplaybook:Youhadnoincentivewhatso-
ever to be concerned about the quality of the loan, whether it was suitable for the
borrowerorwhethertheloanperformed.Infact,youwereinawayencouragednot
to worry about those macro issues. He added, I knew that the risk was being
shuntedoff.Iknewthatwecouldbewritingcrap.Butintheenditwaslikeagameof
musicalchairs.Volumemightgodownbutwewerenotgoingtobehurt.
i,
OnWallStreet,wheremanyoftheseloanswerepackagedintosecuritiesandsold
toinvestorsaroundtheglobe,anewtermwascoined:IBGYBG,Illbegone,youll
be gone.
i8
It referred to deals that brought in big fees up front while risking much
largerlossesinthefuture.And,foralongtime,IBGYBGworkedateverylevel.
Most home loans entered the pipeline soon after borrowers signed the docu-
mentsandpickeduptheirkeys.Loanswereputintopackagesandsoldoffinbulkto
securitization frmsincluding investment banks such as Merrill Lynch, Bear
Stearns,andLehmanBrothers,andcommercialbanksandthriftssuchasCitibank,
WellsFargo,andWashingtonMutual.Thefrmswouldpackagetheloansintoresi-
dentialmortgagebackedsecuritiesthatwouldmostlybestampedwithtriple-Arat-
ingsbythecreditratingagencies,andsoldtoinvestors.Inmanycases,thesecurities
were repackaged again into collateralized debt obligations (CDOs)often com-
posedoftheriskierportionsofthesesecuritieswhichwouldthenbesoldtoother
investors. Most of these securities would also receive the coveted triple-A ratings
thatinvestorsbelievedattestedtotheirqualityandsafety.Someinvestorswouldbuy
aninventionfromthe1oscalledacreditdefaultswap(CDS)toprotectagainstthe
securitiesdefaulting.Foreverybuyerofacreditdefaultswap,therewasaseller:as
theseinvestorsmadeopposingbets,thelayersofentanglementinthesecuritiesmar-
ketincreased.
The instruments grew more and more complex; CDOs were constructed out of
CDOs,creatingCDOssquared.Whenfrmsranoutofrealproduct,theystartedgen-
eratingcheaper-to-producesyntheticCDOscomposednotofrealmortgagesecuri-
ties but just of bets on other mortgage products. Each new permutation created an
opportunitytoextractmorefeesandtradingprofts.Andeachnewlayerbroughtin
more investors wagering on the mortgage marketeven well after the market had
started to turn. So by the time the process was complete, a mortgage on a home in
south Florida might become part of dozens of securities owned by hundreds of in-
vestorsorpartsofbetsbeingmadebyhundredsmore.TreasurySecretaryTimothy
Geithner,thepresidentoftheNewYorkFederalReserveBankduringthecrisis,de-
scribedtheresultingproductascookedspaghettithatbecamehardtountangle.
i
Ralph Ciom spent several years creating CDOs for Bear Stearns and a couple of
more years on the repurchase or repo desk, which was responsible for borrowing
ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
moneyeverynighttofnanceBearStearnssbroadersecuritiesportfolio.InSeptem-
ber ioo, Ciom created a hedge fund within Bear Stearns with a minimum invest-
mentof1million.Aswascommon,heusedborrowedmoneyuptoborrowed
forevery1frominvestorstobuyCDOs.Ciomsfrstfundwasextremelysuccess-
ful;itearned1,forinvestorsiniooand1oinioo,aftertheannualmanage-
ment fee and the io slice of the proft for Ciom and his Bear Stearns teamand
grewtoalmostbillionbytheendofioo,.Inthefallofiooo,hecreatedanother,
moreaggressivefund.Thisonewouldshootforleverageofupto1ito1.Bytheend
of iooo, the two hedge funds had 18 billion invested, half in securities issued by
CDOscenteredonhousing.AsaCDOmanager,Ciomalsomanagedanother18bil-
lionofmortgage-relatedCDOsforotherinvestors.
Ciomsinvestorsandotherslikethemwantedhigh-yieldingmortgagesecurities.
That,inturn,requiredhigh-yieldingmortgages.Anadvertisingbarragebombarded
potential borrowers, urging them to buy or refnance homes. Direct-mail solicita-
tions fooded peoples mailboxes.
o
Dancing fgures, depicting happy homeowners,
boogied on computer monitors. Telephones began ringing off the hook with calls
fromloanomcersofferingthelatestloanproducts:Onepercentloan!(Butonlyfor
thefrstyear.)Nomoneydown!(Leavingnoequityifhomepricesfell.)Noincome
documentationneeded!(Mortgagessoondubbedliarloansbytheindustryitself.)
Borrowers answered the call, many believing that with ever-rising prices, housing
wastheinvestmentthatcouldntlose.
InWashington,fourintermingledissuescameintoplaythatmadeitdimculttoac-
knowledgetheloomingthreats.First,effortstoboosthomeownershiphadbroadpo-
litical supportfrom Presidents Bill Clinton and George W. Bush and successive
Congresseseventhoughinrealitythehomeownershipratehadpeakedinthespring
ofioo.Second,therealestateboomwasgeneratingalotofcashonWallStreetand
creatingalotofjobsinthehousingindustryatatimewhenperformanceinothersec-
torsoftheeconomywasdreary.Third,manytopomcialsandregulatorswerereluc-
tant to challenge the proftable and powerful fnancial industry. And fnally, policy
makersbelievedthatevenifthehousingmarkettanked,thebroaderfnancialsystem
andeconomywouldholdup.
Asthemortgagemarketbeganitstransformationinthelate1os,consumerad-
vocates and front-line local government omcials were among the frst to spot the
changes:homeownersbeganstreamingintotheiromcestoseekhelpindealingwith
mortgagestheycouldnotaffordtopay.TheybeganraisingtheissuewiththeFederal
Reserveandotherbankingregulators.
1
BobGnaizda,thegeneralcounselandpolicy
director of the Greenlining Institute, a California-based nonproft housing group,
told the Commission that he began meeting with Greenspan at least once a year
startingin1,eachtimehighlightingtohimthegrowthofpredatorylendingprac-
ticesanddiscussingwithhimthesocialandeconomicproblemstheywerecreating.
i
Oneofthefrstplacestoseethebadlendingpracticesenvelopanentiremarket
wasCleveland,Ohio.From18to1,homepricesinClevelandroseoo,climb-
ingfromamedianof,,,iooto1i,,1oo,whilehomepricesnationallyroseabout
in those same years; at the same time, the citys unemployment rate, ranging
8ii uii uUi \ii ii: ,
from ,.8 in 1o to .i in 1, more or less tracked the broader U.S. pattern.
JamesRokakis,thelongtimecountytreasurerofCuyahogaCounty,whereCleveland
islocated,toldtheCommissionthattheregionshousingmarketwasjuicedbyfip-
pingonmega-steroids,withringsofrealestateagents,appraisers,andloanorigina-
torsearningfeesoneachtransactionandfeedingthesecuritizedloanstoWallStreet.
Cityomcialsbegantohearreportsthattheseactivitieswerebeingpropelledbynew
kindsofnontraditionalloansthatenabledinvestorstobuypropertieswithlittleorno
moneydownandgavehomeownerstheabilitytorefnancetheirhouses,regardless
of whether they could afford to repay the loans. Foreclosures shot up in Cuyahoga
Countyfrom,,ooayearin1,to,,oooayeariniooo.

Rokakisandotherpublic
omcials watched as families who had lived for years in modest residences lost their
homes. After they were gone, many homes were ultimately abandoned, vandalized,
andthenstrippedbare,asscavengersrippedawaytheircopperpipesandaluminum
sidingtosellforscrap.
Securitizationwasoneofthemostbrilliantfnancialinnovationsoftheiothcen-
tury,RokakistoldtheCommission.Itfreedupalotofcapital.Ifithadbeendone
responsibly, it would have been a wondrous thing because nothing is more stable,
theres nothing safer, than the American mortgage market. . . . It worked for years.
Butthenpeoplerealizedtheycouldscamit.

OmcialsinClevelandandotherOhiocitiesreachedouttothefederalgovernment
forhelp.TheyaskedtheFederalReserve,theoneentitywiththeauthoritytoregulate
riskylendingpracticesbyallmortgagelenders,tousethepowerithadbeengranted
in 1 under the Home Ownership and Equity Protection Act (HOEPA) to issue
newmortgagelendingrules.InMarchioo1,FedGovernorEdwardGramlich,anad-
vocate for expanding access to credit but only with safeguards in place, attended a
conferenceonthetopicinCleveland.HespokeabouttheFedspowerunderHOEPA,
declaredsomeofthelendingpracticestobeclearlyillegal,andsaidtheycouldbe
combatedwithlegalenforcementmeasures.
,
Lookingback,RokakisremarkedtotheCommission,Inaivelybelievedtheydgo
back and tell Mr. Greenspan and presto, wed have some new rules. . . . I thought it
wouldresultinactionbeingtaken.Itwaskindofquaint.
o
Iniooo,whenClevelandwaslookingforhelpfromthefederalgovernment,other
citiesaroundthecountryweredoingthesame.JohnTaylor,thepresidentoftheNa-
tional Community Reinvestment Coalition, with the support of community leaders
from Nevada, Michigan, Maryland, Delaware, Chicago, Vermont, North Carolina,
New Jersey, and Ohio, went to the Omce of Thrift Supervision (OTS), which regu-
lated savings and loan institutions, asking the agency to crack down on what they
calledexploitativepracticestheybelievedwereputtingbothborrowersandlenders
atrisk.
,
The California Reinvestment Coalition, a nonproft housing group based in
Northern California, also begged regulators to act, CRC omcials told the Commis-
sion. The nonproft group had reviewed the loans of 1i, borrowers and discovered
thatmanyindividualswerebeingplacedintohigh-costloanswhentheyqualifedfor
bettermortgagesandthatmanyhadbeenmisledaboutthetermsoftheirloans.
8
.+ ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
Thereweregovernmentreports,too.TheDepartmentofHousingandUrbanDe-
velopmentandtheTreasuryDepartmentissuedajointreportonpredatorylending
inJuneiooothatmadeanumberofrecommendationsforreducingtheriskstobor-
rowers.

In December ioo1, the Federal Reserve Board used the HOEPA law to
amendsomeregulations;amongthechangeswerenewrulesaimedatlimitinghigh-
interestlendingandpreventingmultiplerefnancingsoverashortperiodoftime,if
theywerenotintheborrowersbestinterest.
o
Asitwouldturnout,thoserulescov-
ered only 1 of subprime loans. FDIC Chairman Sheila C. Bair, then an assistant
treasurysecretaryintheadministrationofPresidentGeorgeW.Bush,characterized
the action to the FCIC as addressing only a narrow range of predatory lending is-
sues.
1
In iooi, Gramlich noted again the increasing reports of abusive, unethical
andinsomecases,illegal,lendingpractices.
i
Bair told the Commission that this was when really poorly underwritten loans,
thepaymentshockloanswerebeginningtoproliferate,placingpressureontradi-
tionalbankstofollowsuit.

ShesaidthatsheandGramlichconsideredseekingrules
toreininthegrowthofthesekindsofloans,butGramlichtoldherthathethought
theFed,despiteitsbroadpowersinthisarea,wouldnotsupporttheeffort.Instead,
theysoughtvoluntaryrulesforlenders,butthateffortfellbythewaysideaswell.

Inanenvironmentofminimalgovernmentrestrictions,thenumberofnontradi-
tional loans surged and lending standards declined. The companies issuing these
loans made profts that attracted envious eyes. New lenders entered the feld. In-
vestors clamored for mortgage-related securities and borrowers wanted mortgages.
Thevolumeofsubprimeandnontraditionallendingrosesharply.Iniooo,thetopi,
nonprimelendersoriginated1o,billioninloans.Theirvolumeroseto188billion
iniooi,andthen1obillioninioo.
,
California, with its high housing costs, was a particular hotbed for this kind of
lending. In ioo1, nearly ,i billion, or i, of all nontraditional loans nationwide,
were made in that state; Californias share rose to , by ioo, with these kinds of
loans growing to , billion or by 8 in California in just two years.
o
In those
years, subprime and option ARM loans saturated California communities, Kevin
Stein,theassociatedirectoroftheCaliforniaReinvestmentCoalition,testifedtothe
Commission.WeestimatedatthattimethattheaveragesubprimeborrowerinCali-
forniawaspayingoverooomorepermonthontheirmortgagepaymentasaresult
ofhavingreceivedthesubprimeloan.
,
GailBurks,presidentandCEOofNevadaFairHousing,Inc.,aLasVegasbased
housing clinic, told the Commission she and other groups took their concerns di-
rectly to Greenspan at this time, describing to him in person what she called the
metamorphosisinthelendingindustry.Shetoldhimthatbesidespredatorylend-
ingpracticessuchasfippingloansormisinformingseniorsaboutreversemortgages,
shealsowitnessedexamplesofgrowingsloppinessinpaperwork:notcreditingpay-
mentsappropriatelyormiscalculatingaccounts.
8
Lisa Madigan, the attorney general in Illinois, also spotted the emergence of a
troubling trend. She joined state attorneys general from Minnesota, California,
Washington,Arizona,Florida,NewYork,andMassachusettsinpursuingallegations
8ii uii uUi \ii ii: ..
about First Alliance Mortgage Company, a California-based mortgage lender. Con-
sumerscomplainedthattheyhadbeendeceivedintotakingoutloanswithheftyfees.
ThecompanywasthenpackagingtheloansandsellingthemassecuritiestoLehman
Brothers, Madigan said. The case was settled in iooi, and borrowers received ,o
million.FirstAlliancewentoutofbusiness.Butotherfrmssteppedintothevoid.

Stateomcialsfromaroundthecountryjoinedtogetheragaininiootoinvesti-
gate another fast-growing lender, California-based Ameriquest. It became the na-
tions largest subprime lender, originating billion in subprime loans in
ioomostly refnances that let borrowers take cash out of their homes, but with
heftyfeesthatateawayattheirequity.
,o
MadigantestifedtotheFCIC,Ourmulti-
stateinvestigationofAmeriquestrevealedthatthecompanyengagedinthekindsof
fraudulent practices that other predatory lenders subsequently emulated on a wide
scale:infatinghomeappraisals;increasingtheinterestratesonborrowersloansor
switchingtheirloansfromfxedtoadjustableinterestratesatclosing;andpromising
borrowersthattheycouldrefnancetheircostlyloansintoloanswithbettertermsin
justafewmonthsorayear,evenwhenborrowershadnoequitytoabsorbanother
refnance.
,1
Ed Parker, the former head of Ameriquests Mortgage Fraud Investigations De-
partment, told the Commission that he detected fraud at the company within one
monthofstartinghisjobthereinJanuaryioo,butseniormanagementdidnothing
with the reports he sent. He heard that other departments were complaining he
looked too much into the loans. In November ioo,, he was downgraded from
managertosupervisor,andwaslaidoffinMayiooo.
,i
In late ioo, Prentiss Cox, then a Minnesota assistant attorney general, asked
Ameriquesttoproduceinformationaboutitsloans.Hereceivedabout1oboxesof
documents. He pulled one file at random, and stared at it. He pulled out another
and another. He noted file after file where the borrowers were described as an-
tiquesdealersinhisview,ablatantmisrepresentationofemployment.Inanother
loanfile,herecalledinaninterviewwiththeFCIC,adisabledborrowerinhis8os
who used a walker was described in the loan application as being employed in
lightconstruction.
,
ItdidnttakeSherlockHolmestofgureoutthiswasbogus,CoxtoldtheCom-
mission.AshetriedtofgureoutwhyAmeriquestwouldmakesuchobviouslyfraud-
ulent loans, a friend suggested that he look upstream. Cox suddenly realized that
thelendersweresimplygeneratingproducttoshiptoWallStreettoselltoinvestors.
Igotthatithadshifted,Coxrecalled.Thelendingpatternhadshifted.
,
Ultimately, states and the District of Columbia joined in the lawsuit against
Ameriquest,onbehalfofmorethanio,oooborrowers.Theresultwasai,mil-
lionsettlement.Butduringtheyearswhentheinvestigationwasunderway,between
iooiandioo,,Ameriquestoriginatedanotheri1,.billioninloans,
,,
whichthen
fowedtoWallStreetforsecuritization.
AlthoughthefederalgovernmentplayednoroleintheAmeriquestinvestigation,
somefederalomcialssaidtheyhadfollowedthecase.AttheDepartmentofHousing
and Urban Development, we began to get rumors that other frms were running
.z ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
wild, taking applications over the Internet, not verifying peoples income or their
ability to have a job, recalled Alphonso Jackson, the HUD secretary from ioo to
ioo8,inaninterviewwiththeCommission.Everybodywasmakingagreatdealof
money . . .andtherewasntagreatdealofoversightgoingon.Althoughhewasthe
nationstophousingomcialatthetime,heplacedmuchoftheblameonCongress.
,o
Cox, the former Minnesota prosecutor, and Madigan, the Illinois attorney gen-
eral, told the Commission that one of the single biggest obstacles to effective state
regulationofunfairlendingcamefromthefederalgovernment,particularlytheOf-
fceoftheComptrolleroftheCurrency(OCC),whichregulatednationallychartered
banksincluding Bank of America, Citibank, and Wachoviaand the OTS, which
regulated nationally chartered thrifts. The OCC and OTS issued rules preempting
statesfromenforcingrulesagainstnationalbanksandthrifts.
,,
Coxrecalledthatin
ioo1, Julie Williams, the chief counsel of the OCC, had delivered what he called a
lecturetothestatesattorneysgeneral,inameetinginWashington,warningthem
thattheOCCwouldquashthemiftheypersistedinattemptingtocontrolthecon-
sumerpracticesofnationallyregulatedinstitutions.
,8
TwoformerOCCcomptrollers,JohnHawkeandJohnDugan,toldtheCommis-
sionthattheyweredefendingtheagencysconstitutionalobligationtoblockstateef-
forts to impinge on federally created entities. Because state-chartered lenders had
morelendingproblems,theysaid,thestatesshouldhavebeenfocusingthererather
thanlookingtoinvolvethemselvesinfederallycharteredinstitutions,anarenawhere
they had no jurisdiction.
,
However, Madigan told the Commission that national
banksfundedi1ofthei,largestsubprimeloanissuersoperatingwithstatecharters,
andthatthosebanksweretheendmarketforabusiveloansoriginatedbythestate-
chartered frms. She noted that the OCC was particularly zealous in its efforts to
thwart state authority over national lenders, and lax in its efforts to protect con-
sumersfromthecomingcrisis.
oo
Many states nevertheless pushed ahead in enforcing their own lending regula-
tions, as did some cities. In ioo, Charlotte, North Carolinabased Wachovia Bank
told state regulators that it would not abide by state laws, because it was a national
bankandfellunderthesupervisionoftheOCC.MichiganprotestedWachoviasan-
nouncement,andWachoviasuedMichigan.TheOCC,theAmericanBankersAsso-
ciation, and the Mortgage Bankers Association entered the fray on Wachovias side;
the other states, Puerto Rico, and the District of Columbia aligned themselves
with Michigan. The legal battle lasted four years. The Supreme Court ruled , in
WachoviasfavoronApril1,,ioo,,leavingtheOCCitssoleregulatorformortgage
lending.Coxcriticizedthefederalgovernment:Notonlyweretheynegligent,they
wereaggressiveplayersattemptingtostopanyenforcementaction[s]. . . .Thoseguys
shouldhavebeenonourside.
o1
Nonprimelendingsurgedto,obillioniniooandthen1.otrillioninioo,,
anditsimpactbegantobefeltinmoreandmoreplaces.
oi
Manyofthoseloanswere
funneled into the pipeline by mortgage brokersthe link between borrowers and
the lenders who fnanced the mortgageswho prepared the paperwork for loans
andearnedfeesfromlendersfordoingit.Morethanioo,ooonewmortgagebrokers
8ii uii uUi \ii ii: .,
begantheirjobsduringtheboom,andsomewerelessthanhonorableintheirdeal-
ingswithborrowers.
o
Accordingtoaninvestigativenewsreportpublishedinioo8,
between iooo and ioo,, at least 1o,,oo people with criminal records entered the
feldinFlorida,forexample,including,oo,whohadpreviouslybeenconvictedof
such crimes as fraud, bank robbery, racketeering, and extortion.
o
J. Thomas Card-
well,thecommissioneroftheFloridaOmceofFinancialRegulation,toldtheCom-
mission that lax lending standards and a lack of accountability . . . created a
condition in which fraud fourished.
o,
Marc S. Savitt, a past president of the Na-
tionalAssociationofMortgageBrokers,toldtheCommissionthatwhilemostmort-
gage brokers looked out for borrowers best interests and steered them away from
riskyloans,about,o,oooofthenewcomerstothefeldnationwidewerewillingtodo
whateverittooktomaximizethenumberofloanstheymade.Headdedthatsome
loanoriginationfrms,suchasAmeriquest,wereabsolutelycorrupt.
oo
In Bakersfeld, California, where home starts doubled and home values grew
evenfasterbetweenioo1andiooo,therealestateappraiserGaryCrabtreeinitially
feltpridethathisbirthplace,11omilesnorthofLosAngeles,hadfnallybeendis-
covered by other Californians. The city, a farming and oil industry center in the
SanJoaquinValley,wasdrawingnationalattentionforthepaceofitsdevelopment.
Wide-open farm felds were plowed under and divided into thousands of building
lots. Home prices jumped 11 in Bakersfeld in iooi, 1, in ioo, i in ioo,
andimoreinioo,.
Crabtree,anappraiserfor8years,startediniooandiootothinkthatthings
werenotmakingsense.Peoplewerepayinginfatedpricesfortheirhomes,andthey
didnt seem to have enough income to pay for what they had bought. Within a few
years,whenhepassedsomeofthesesamehouses,hesawthattheywerevacant.For
sale signs appeared on the front lawns. And when he passed again, the yards were
untendedandthegrasswasturningbrown.Next,thehouseswentintoforeclosure,
and thats when he noticed that the empty houses were being vandalized, which
pulleddownvaluesforthenewsuburbansubdivisions.
The Cleveland phenomenon had come to Bakersfeld, a place far from the Rust
Belt.Crabtreewatchedasforeclosuresspreadlikeaninfectiousdiseasethroughthe
community.Housesfellintodisrepairandneighborhoodsdisintegrated.
Crabtreebeganstudyingthemarket.Iniooo,heendedupidentifyingwhathebe-
lieved were i1 fraudulent transactions in Bakersfeld; some, for instance, were al-
lowing insiders to siphon cash from each property transfer. The transactions
involvedmanyofthenationslargestlenders.Onehouse,forexample,waslistedfor
sale for ,o,,ooo, and was recorded as selling for oo,,ooo with 1oo fnancing,
thoughtherealestateagenttoldCrabtreethatitactuallysoldfor,,,ooo.Crabtree
realizedthatthegapbetweenthesalespriceandloanamountallowedtheseinsiders
topocket,o,ooo.Thetermsoftheloanrequiredthebuyertooccupythehouse,but
itwasneveroccupied.Thehousewentintoforeclosureandwassoldinadistresssale
forii,ooo.
o,
Crabtreebegancallinglenderstotellthemwhathehadfound;buttohisshock,
theydidnotseemtocare.HefnallyreachedonequalityassuranceomceratFremont
., ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
Investment&Loan,thenationseighth-largestsubprimelender.Dontputyournose
whereitdoesntbelong,hewastold.
o8
Crabtree took his story to state law enforcement omcials and to the Federal Bu-
reauofInvestigation.Iwasscreamingatthetopofmylungs,hesaid.Hegrewinfu-
riated at the slow pace of enforcement and at prosecutors lack of response to a
problemthatwaswreakingeconomichavocinBakersfeld.
o
AttheWashington,D.C.,headquartersoftheFBI,ChrisSwecker,anassistantdi-
rector,wasalsotryingtogetpeopletopayattentiontomortgagefraud.Ithasthepo-
tentialtobeanepidemic,hesaidatanewsconferenceinWashingtoninioo.We
thinkwecanpreventaproblemthatcouldhaveasmuchimpactastheS&Lcrisis.
,o
SweckercalledanothernewsconferenceinDecemberioo,tosaythesamething,
this time adding that mortgage fraud was a pervasive problem that was on the
rise.HewasjoinedbyomcialsfromHUD,theU.S.PostalService,andtheInternal
RevenueService.Theomcialstoldreportersthatrealestateandbankingexecutives
were not doing enough to root out mortgage fraud and that lenders needed to do
moretopolicetheirownorganizations.
,1
Meanwhile, the number of cases of reported mortgage fraud continued to swell.
Suspiciousactivityreports,alsoknownasSARs,arereportsfledbybankstotheFi-
nancialCrimesEnforcementNetwork(FinCEN),abureauwithintheTreasuryDe-
partment.InNovemberiooo,thenetworkpublishedananalysisthatfoundaio-fold
increase in mortgage fraud reports between 1o and ioo,. According to FinCEN,
thefgureslikelyrepresentedasubstantialunderreporting,becausetwo-thirdsofall
theloansbeingcreatedwereoriginatedbymortgagebrokerswhowerenotsubjectto
anyfederalstandardoroversight.
,i
Inaddition,manylenderswhowererequiredto
submitreportsdidnotinfactdoso.
,
The claim that no one could have foreseen the crisis is false, said William K.
Black, an expert on white-collar crime and a former staff director of the National
CommissiononFinancialInstitutionReform,RecoveryandEnforcement,createdby
Congressin1oasthesavingsandloancrisiswasunfolding.
,
Former attorney general Alberto Gonzales, who served from February ioo, to
ioo,, told the FCIC he could not remember the press conferences or news reports
about mortgage fraud. Both Gonzales and his successor Michael Mukasey, who
servedasattorneygeneralinioo,andioo8,toldtheFCICthatmortgagefraudhad
never been communicated to them as a top priority. National security . . . was an
overridingconcern,Mukaseysaid.
,,
Tocommunityactivistsandlocalomcials,however,thelendingpracticeswerea
matterofnationaleconomicconcern.RuhiMaker,alawyerwhoworkedonforeclo-
surecasesattheEmpireJusticeCenterinRochester,NewYork,toldFedGovernors
Bernanke,SusanBies,andRogerFergusoninOctoberioothatshesuspectedthat
some investment banksshe specifed Bear Stearns and Lehman Brotherswere
producingsuchbadloansthattheverysurvivalofthefrmswasputinquestion.We
repeatedlyseefalseappraisalsandfalseincome,shetoldtheFedomcials,whowere
gatheredatthepublichearingperiodofaConsumerAdvisoryCouncilmeeting.She
urged the Fed to prod the Securities and Exchange Commission to examine the
8ii uii uUi \ii ii: .,
qualityofthefrmsduediligence;otherwise,shesaid,seriousquestionscouldarise
about whether they could be forced to buy back bad loans that they had made or
securitized.
,o
Makertoldtheboardthatshefearedanenormouseconomicimpactcouldre-
sultfromaconfuenceoffnancialevents:fatordecliningincomes,ahousingbub-
ble,andfraudulentloanswithoverstatedvalues.
,,
InaninterviewwiththeFCIC,MakersaidthatFedomcialsseemedimperviousto
what the consumer advocates were saying. The Fed governors politely listened and
saidlittle,sherecalled.Theyhadtheireconomicmodels,andtheireconomicmod-
elsdidnotseethiscoming,shesaid.Wekeptgettingback,Thisisallanecdotal.
,8
Soonnontraditionalmortgageswerecrowdingotherkindsofproductsoutofthe
marketinmanypartsofthecountry.Moremortgageborrowersnationwidetookout
interest-only loans, and the trend was far more pronounced on the West and East
Coasts.
,
Becauseoftheireasycreditterms,nontraditionalloansenabledborrowers
to buy more expensive homes and ratchet up the prices in bidding wars. The loans
were also riskier, however, and a pattern of higher foreclosure rates frequently ap-
pearedsoonafter.
Ashomepricesshotupinmuchofthecountry,manyobserversbegantowonder
if the country was witnessing a housing bubble. On June 18, ioo,, the Economist
magazinescoverstorypositedthatthedayofreckoningwasathand,withthehead-
lineHousePrices:AftertheFall.Theillustrationdepictedabrickplummetingout
ofthesky.Itisnotgoingtobepretty,thearticledeclared.Howthecurrenthousing
boom ends could decide the course of the entire world economy over the next few
years.
8o
Thatsamemonth,FedChairmanGreenspanacknowledgedtheissue,tellingthe
JointEconomicCommitteeoftheU.S.Congressthattheapparentfrothinhousing
markets may have spilled over into the mortgage markets.
81
For years, he had
warnedthatFannieMaeandFreddieMac,bolsteredbyinvestorsbeliefthatthesein-
stitutionshadthebackingoftheU.S.government,weregrowingsolarge,withsolit-
tleoversight,thattheywerecreatingsystemicrisksforthefnancialsystem.Still,he
reassured legislators that the U.S. economy was on a reasonably frm footing and
thatthefnancialsystemwouldberesilientifthehousingmarketturnedsour.
Thedramaticincreaseintheprevalenceofinterest-onlyloans,aswellasthein-
troductionofotherrelativelyexoticformsofadjustableratemortgages,aredevelop-
mentsofparticularconcern,hetestifedinJune.
Tobesure,thesefnancingvehicleshavetheirappropriateuses.Butto
theextentthatsomehouseholdsmaybeemployingtheseinstrumentsto
purchaseahomethatwouldotherwisebeunaffordable,theiruseisbe-
ginningtoaddtothepressuresinthemarketplace. . . .
Although we certainly cannot rule out home price declines, espe-
cially in some local markets, these declines, were they to occur, likely
would not have substantial macroeconomic implications. Nationwide
bankingandwidespreadsecuritizationofmortgagesmakesitlesslikely
. ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
that fnancial intermediation would be impaired than was the case in
priorepisodesofregionalhousepricecorrections.
8i
Indeed,Greenspanwouldnotbetheonlyoneconfdentthatahousingdownturn
would leave the broader fnancial system largely unscathed. As late as March ioo,,
afterhousingpriceshadbeendecliningforayear,BernanketestifedtoCongressthat
the problems in the subprime market were likely to be containedthat is, he ex-
pectedlittlespillovertothebroadereconomy.
8
Some were less sanguine. For example, the consumer lawyer Sheila Canavan, of
Moab, Utah, informed the Feds Consumer Advisory Council in October ioo, that
o1 of recently originated loans in California were interest-only, a proportion that
was more than twice the national average. Thats insanity, she told the Fed gover-
nors.Thatmeanswerefacingsomethingdowntheroadthatwehaventfacedbefore
andwearegoingtobelookingatasafetyandsoundnesscrisis.
8
Onanotherfront,someacademicsofferedpointedanalysesastheyraisedalarms.
Forexample,inAugustioo,,theYaleprofessorRobertShiller,whoalongwithKarl
CasedevelopedtheCase-ShillerIndex,chartedhomepricestoillustratehowprecip-
itouslytheyhadclimbedandhowdistortedthemarketappearedinhistoricalterms.
Shillerwarnedthatthehousingbubblewouldlikelyburst.
8,
Inthatsamemonth,aconclaveofeconomistsgatheredatJacksonLakeLodgein
Wyoming, in a conference center nestled in Grand Teton National Park. It was a
whos who of central bankers, recalled Raghuram Rajan, who was then on leave
fromtheUniversityofChicagosbusinessschoolwhileservingasthechiefeconomist
of the International Monetary Fund. Greenspan was there, and so was Bernanke.
Jean-ClaudeTrichet,thepresidentoftheEuropeanCentralBank,andMervynKing,
thegovernoroftheBankofEngland,wereamongtheotherdignitaries.
8o
Rajan presented a paper with a provocative title: Has Financial Development
Made the World Riskier: He posited that executives were being overcompensated
forshort-termgainsbutletoffthehookforanyeventuallossestheIBGYBGsyn-
drome. Rajan added that investment strategies such as credit default swaps could
havedisastrousconsequencesifthesystembecameunstable,andthatregulatoryin-
stitutionsmightbeunabletodealwiththefallout.
8,
HerecalledtotheFCICthathewastreatedwithscorn.LawrenceSummers,afor-
merU.S.treasurysecretarywhowasthenpresidentofHarvardUniversity,calledRa-
janaLuddite,implyingthathewassimplyopposedtotechnologicalchange.
88
Ifelt
like an early Christian who had wandered into a convention of half-starved lions,
Rajanwrotelater.
8
SusanM.Wachter,aprofessorofrealestateandfnanceattheUniversityofPenn-
sylvanias Wharton School, prepared a research paper in ioo suggesting that the
United States could have a real estate crisis similar to that suffered in Asia in the
1os. When she discussed her work at another Jackson Hole gathering two years
later, it received a chilly reception, she told the Commission. It was universally
panned,shesaid,andaneconomistfromtheMortgageBankersAssociationcalledit
absurd.
o
8ii uii uUi \ii ii: .,
Inioo,,newsreportswerebeginningtohighlightindicationsthattherealestate
marketwasweakening.Homesalesbegantodrop,andFitchRatingsreportedsigns
that mortgage delinquencies were rising. That year, the hedge fund manager Mark
KlipschofOrixCreditCorp.toldparticipantsattheAmericanSecuritizationForum,
asecuritiestradegroup,thatinvestorshadbecomeoveroptimisticaboutthemar-
ket.Iseealotofirrationality,headded.Hesaidhewasunnervedbecausepeople
were saying, Its different this timea rationale commonly heard before previous
collapses.
1
Some real estate appraisers had also been expressing concerns for years. From
iooo to ioo,, a coalition of appraisal organizations circulated and ultimately deliv-
ered to Washington omcials a public petition; signed by 11,ooo appraisers and in-
cluding the name and address of each, it charged that lenders were pressuring
appraisers to place artifcially high prices on properties. According to the petition,
lenderswereblacklistinghonestappraisersandinsteadassigningbusinessonlyto
appraiserswhowouldhitthedesiredpricetargets.Thepowersthatbecannotclaim
ignorance, the appraiser Dennis J. Black of Port Charlotte, Florida, testifed to the
Commission.
i
The appraiser Karen Mann of Discovery Bay, California, another industry vet-
eran, told the Commission that lenders had opened subsidiaries to perform ap-
praisals, allowing them to extract extra fees from unknowing consumers and
making it easier to infate home values. The steep hike in home prices and the un-
meritedandinfatedappraisalsshewasseeinginNorthernCaliforniaconvincedher
thatthehousingindustrywasheadedforacataclysmicdownturn.Inioo,,shelaid
off some of her staff in order to cut her overhead expenses, in anticipation of the
comingstorm;twoyearslater,sheshutdownheromceandbeganworkingoutofher
home.

Despiteallthesignsthatthehousingmarketwasslowing,WallStreetjustkeptgo-
ing and goingordering up loans, packaging them into securities, taking profts,
earningbonuses.Bythethirdquarterofiooo,homepriceswerefallingandmortgage
delinquencies were rising, a combination that spelled trouble for mortgage-backed
securities.Butfromthethirdquarterofioooon,bankscreatedandsoldsome1.
trillion in mortgage-backed securities and more than ,o billion in mortgage-
relatedCDOs.

Not everyone on Wall Street kept applauding, however. Some executives were
urgingcaution,ascorporategovernanceandriskmanagementwerebreakingdown.
Refectingonthecausesofthecrisis,JamieDimon,CEOofJPMorgantestifedtothe
FCIC,Iblamethemanagementteams1ooand . . .nooneelse.
,
Attoomanyfnancialfrms,managementbrushedasidethegrowingriskstotheir
frms.AtLehmanBrothers,forexample,MichaelGelband,theheadoffxedincome,
andhiscolleagueMadelynAntoncicwarnedagainsttakingontoomuchriskinthe
faceofgrowingpressuretocompeteaggressivelyagainstotherinvestmentbanks.An-
toncic,whowasthefrmschiefriskomcerfromiootoioo,,wasshuntedaside:At
theseniorlevel,theyweretryingtopushsohardthatthewheelsstartedtocomeoff,
shetoldtheCommission.Shewasreassignedtoapolicypositionworkingwithgov-
. ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
ernmentregulators.
o
Gelbandleft;LehmanomcialsblamedGelbandsdepartureon
philosophicaldifferences.
,
AtCitigroup,meanwhile,RichardBowen,aveteranbankerintheconsumerlend-
ing group, received a promotion in early iooo when he was named business chief
underwriter. He would go on to oversee loan quality for over o billion a year of
mortgagesunderwrittenandpurchasedbyCitiFinancial.Thesemortgagesweresold
to Fannie Mae, Freddie Mac, and others. In June iooo, Bowen discovered that as
muchasoooftheloansthatCitiwasbuyingweredefective.TheydidnotmeetCiti-
groupsloanguidelinesandthusendangeredthecompanyiftheborrowerswereto
defaultontheirloans,theinvestorscouldforceCititobuythemback.Bowentoldthe
Commissionthathetriedtoalerttopmanagersatthefrmbyemail,weeklyreports,
committee presentations, and discussions; but though they expressed concern, it
nevertranslatedintoanyaction.Instead,hesaid,therewasaconsiderablepushto
build volumes, to increase market share. Indeed, Bowen recalled, Citi began to
loosenitsownstandardsduringtheseyearsuptoioo,:specifcally,itstartedtopur-
chasestated-incomeloans.Sowejoinedtheotherlemmingsheadedforthecliff,he
saidinaninterviewwiththeFCIC.
8
He fnally took his warnings to the highest level he could reachRobert Rubin,
the chairman of the Executive Committee of the Board of Directors and a former
U.S.treasurysecretaryintheClintonadministration,andthreeotherbankomcials.
HesentRubinandtheothersamemowiththewordsURGENTREADIMMEDI-
ATELY in the subject line. Sharing his concerns, he stressed to top managers that
CitifacedbillionsofdollarsinlossesifinvestorsweretodemandthatCitirepurchase
thedefectiveloans.

RubintoldtheCommissioninapublichearinginAprilio1othatCitibankhan-
dledtheBowenmatterpromptlyandeffectively.IdorecollectthisandthateitherI
orsomebodyelse,andItrulydonotrememberwho,buteitherIorsomebodyelse
sent it to the appropriate people, and I do know factually that that was acted on
promptly and actions were taken in response to it.
1oo
According to Citigroup, the
bankundertookaninvestigationinresponsetoBowensclaimsandthesystemofun-
derwritingreviewswasrevised.
1o1
BowentoldtheCommissionthatafterhealertedmanagementbysendingemails,
hewentfromsupervisingiiopeopletosupervisingonlyi,hisbonuswasreduced,
andhewasdowngradedinhisperformancereview.
1oi
Some industry veterans took their concerns directly to government omcials.
J.KyleBass,aDallas-basedhedgefundmanagerandaformerBearStearnsexecutive,
testifedtotheFCICthathetoldtheFederalReservethathebelievedthehousingse-
curitizationmarkettobeonashakyfoundation.Theiransweratthetimewas,and
thiswasalsothethoughtthatwasthatwashomogeneousthroughoutWallStreets
analystswas home prices always track income growth and jobs growth. And they
showedmeincomegrowthononechartandjobsgrowthonanother,andsaid,We
dontseewhatyouretalkingaboutbecauseincomesarestillgrowingandjobsarestill
growing.AndIsaid,well,youobviouslydontrealizewherethedogisandwherethe
tailis,andwhatsmovingwhat.
1o
8ii uii uUi \ii ii: .,
Eventhosewhohadproftedfromthegrowthofnontraditionallendingpractices
saidtheybecamedisturbedbywhatwashappening.HerbSandler,theco-founderof
themortgagelenderGoldenWestFinancialCorporation,whichwasheavilyloaded
withoptionARMloans,wrotealettertoomcialsattheFederalReserve,theFDIC,
the OTS, and the OCC warning that regulators were too dependent on ratings
agencies and there is a high potential for gaming when virtually any asset can be
churnedthroughsecuritizationandtransformedintoaAAA-ratedasset,andwhena
multi-billiondollarindustryisalltooeagertofacilitatethisalchemy.
1o
Similarly,LewisRanieri,amortgagefnanceveteranwhohelpedengineertheWall
Streetmortgagesecuritizationmachineinthe18os,saidhedidntlikewhathecalled
themadnessthathaddescendedontherealestatemarket.RanieritoldtheCommis-
sion, I was not the only guy. Im not telling you I was John the Baptist. There were
enoughofus,analystsandothers,wanderingaroundgoinglookatthisstuff,thatit
wouldbehardtomissit.
1o,
RanierisownHouston-basedFranklinBankCorporation
woulditselfcollapseundertheweightofthefnancialcrisisinNovemberioo8.
Other industry veterans inside the business also acknowledged that the rules of
the game were being changed. Poison was the word famously used by Country-
widesMozilotodescribeoneoftheloanproductshisfrmwasoriginating.
1oo
Inall
myyearsinthebusinessIhaveneverseenamoretoxic[product],hewroteinanin-
ternalemail.
1o,
Othersatthebankarguedinresponsethattheywereofferingprod-
uctspervasivelyofferedinthemarketplacebyvirtuallyeveryrelevantcompetitorof
ours.
1o8
Still, Mozilo was nervous. There was a time when savings and loans were
doing things because their competitors were doing it, he told the other executives.
Theyallwentbroke.
1o
Inlateioo,,regulatorsdecidedtotakealookatthechangingmortgagemarket.
SabethSiddique,theassistantdirectorforcreditriskintheDivisionofBankingSu-
pervisionandRegulationattheFederalReserveBoard,waschargedwithinvestigat-
inghowbroadlyloanpatternswerechanging.Hetookthequestionsdirectlytolarge
banksinioo,andaskedthemhowmanyofwhichkindsofloanstheyweremaking.
Siddique found the information he received very alarming, he told the Commis-
sion.
11o
In fact, nontraditional loans made up , percent of originations at Coun-
trywide, ,8 percent at Wells Fargo, ,1 at National City, 1 at Washington
Mutual,io.,atCitiFinancial,and18.atBankofAmerica.Moreover,thebanks
expectedthattheiroriginationsofnontraditionalloanswouldriseby1,inioo,,to
oo8.,billion.Thereviewalsonotedtheslowlydeterioratingqualityofloansdueto
looseningunderwritingstandards.Inaddition,itfoundthattwo-thirdsofthenon-
traditionalloansmadebythebanksinioohadbeenofthestated-income,minimal
documentationvarietyknownasliarloans,whichhadaparticularlygreatlikelihood
ofgoingsour.
111
ThereactiontoSiddiquesbriefngwasmixed.FederalReserveGovernorBiesre-
called the response by the Fed governors and regional board directors as divided
from the beginning. Some people on the board and regional presidents . . . just
wantedtocometoadifferentanswer.Sotheydidignoreit,orthefullthrustofit,she
toldtheCommission.
11i
z+ ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
TheOCCwasalsoponderingthesituation.Formercomptrollerofthecurrency
JohnC.DugantoldtheCommissionthatthepushhadcomefrombelow,frombank
examinerswhohadbecomeconcernedaboutwhattheywereseeinginthefeld.
11
The agency began to consider issuing guidance, a kind of nonbinding omcial
warning to banks, that nontraditional loans could jeopardize safety and soundness
andwouldinvitescrutinybybankexaminers.SiddiquesaidtheOCCledtheeffort,
whichbecameamultiagencyinitiative.
11
Biessaidthatdeliberationsoverthepotentialguidancealsostirreddebatewithin
theFed,becausesomecriticsfeareditbothwouldstifethefnancialinnovationthat
wasbringingrecordproftstoWallStreetandthebanksandwouldmakehomesless
affordable. Moreover, all the agenciesthe Fed, the OCC, the OTS, the FDIC, and
theNationalCreditUnionAdministrationwouldneedtoworktogetheronit,orit
wouldunfairlyblockonegroupoflendersfromissuingtypesofloansthatwereavail-
ablefromotherlenders.TheAmericanBankersAssociationandMortgageBankers
Associationopposeditasregulatoryoverreach.
The bankers pushed back, Bies told the Commission. The members of Con-
gresspushedback.SomeofourinternalpeopleattheFedpushedback.
11,
TheMortgageInsuranceCompaniesofAmerica,whichrepresentsmortgagein-
surance companies, weighed in on the other side. We are deeply concerned about
the contagion effect from poorly underwritten or unsuitable mortgages and home
equity loans, the trade association wrote to regulators in iooo. The most recent
markettrendsshowalarmingsignsofunduerisk-takingthatputsbothlendersand
consumersatrisk.
11o
Incongressionaltestimonyaboutamonthlater,WilliamA.Simpson,thegroups
vicepresident,pointedlyreferredtopastrealestatedownturns.Wetakeaconserva-
tivepositiononriskbecauseofourfrstlossposition,SimpsoninformedtheSenate
Subcommittee on Housing, Transportation and Community Development and the
SenateSubcommitteeonEconomicPolicy.However,wealsohaveahistoricalper-
spective.Weweretherewhenthemortgagemarketsturnedsharplydownduringthe
mid-18os especially in the oil patch and the early 1os in California and the
Northeast.
11,
WithintheFed,thedebategrewheatedandemotional,Siddiquerecalled.Itgot
verypersonal,hetoldtheCommission.Theideologicalturfwarlastedmorethana
year,whilethenumberofnontraditionalloanskeptgrowingandgrowing.
118
Consumer advocates kept up the heat. In a Fed Consumer Advisory Council
meeting in March iooo, Fed Governors Bernanke, Mark Olson, and Kevin Warsh
werespecifcallyandpubliclywarnedofdangersthatnontraditionalloansposedto
theeconomy.StellaAdams,theexecutivedirectoroftheNorthCarolinaFairHous-
ingCenter,raisedconcernsthatnontraditionallendingmayprecipitateadownward
spiralthatstartsonthecoastandthencreatespanicintheeastthatcouldhaveimpli-
cationsonourtotaleconomyaswell.
11
AtthenextmeetingoftheFedsConsumerAdvisoryCouncil,heldinJuneiooo
andattendedbyBernanke,Bies,Olson,andWarsh,severalconsumeradvocatesde-
scribedtotheFedgovernorsalarmingincidentsthatwerenowoccurringalloverthe
8ii uii uUi \ii ii: z.
country.EdwardSivak,thedirectorofpolicyandevaluationattheEnterpriseCorp.
of the Delta, in Jackson, Mississippi, spoke of being told by mortgage brokers that
propertyvalueswerebeinginfatedtomaximizeproftforrealestateappraisersand
loanoriginators.AlanWhite,thesupervisingattorneyatCommunityLegalServices
inPhiladelphia,reportedahugesurgeinforeclosures,notingthatuptohalfofthe
borrowershewasseeingwithtroubledloanshadbeenoverchargedandgivenhigh-
interest rate mortgages when their credit had qualifed them for lower-cost loans.
HattieB.Dorsey,thepresidentandchiefexecutiveomcerofAtlantaNeighborhood
Development, said she worried that houses were being fipped back and forth so
muchthattheresultwouldbeneighborhooddecay.CarolynCarteroftheNational
ConsumerLawCenterinMassachusettsurgedtheFedtouseitsregulatoryauthority
toprohibitabusesinthemortgagemarket.
1io
Thebalancewastipping.AccordingtoSiddique,beforeGreenspanlefthispostas
Fed chairman in January iooo, he had indicated his willingness to accept the guid-
ance.FergusonworkedwiththeFedboardandtheregionalFedpresidentstogetit
done.Biessupportedit,andBernankedidaswell.
1i1
MorethanayearaftertheOCChadbegandiscussingtheguidance,andafterthe
housingmarkethadpeaked,itwasissuedinSeptemberioooasaninteragencywarn-
ing that affected banks, thrifts, and credit unions nationwide. Dozens of states fol-
lowed,directingtheirversionsoftheguidancetotensofthousandsofstate-chartered
lendersandmortgagebrokers.
Then,inJulyioo8,longaftertherisky,nontraditionalmortgagemarkethaddis-
appearedandtheWallStreetmortgagesecuritizationmachinehadgroundtoahalt,
the Federal Reserve fnally adopted new rules under HOEPA to curb the abuses
about which consumer groups had raised red fags for yearsincluding a require-
mentthatborrowershavetheabilitytorepayloansmadetothem.
Bythattime,however,thedamagehadbeendone.Thetotalvalueofmortgage-
backedsecuritiesissuedbetweenioo1andioooreached1.trillion.
1ii
Therewasa
mountainofproblematicsecurities,debt,andderivativesrestingonrealestateassets
thatwerefarlesssecurethantheywerethoughttohavebeen.
Just as Bernanke thought the spillovers from a housing market crash would be
contained, so too policymakers, regulators, and fnancial executives did not under-
standhowdangerouslyexposedmajorfrmsandmarketshadbecometothepoten-
tial contagion from these risky fnancial instruments. As the housing market began
toturn,theyscrambledtounderstandtherapiddeteriorationinthefnancialsystem
andrespondaslossesinonepartofthatsystemwouldricochettoothers.
Bytheendofioo,,mostofthesubprimelendershadfailedorbeenacquired,in-
cludingNewCenturyFinancial,Ameriquest,andAmericanHomeMortgage.InJan-
uary ioo8, Bank of America announced it would acquire the ailing lender
Countrywide.Itsoonbecameclearthatriskratherthanbeingdiversifedacrossthe
fnancial system, as had been thoughtwas concentrated at the largest fnancial
frms.BearStearns,ladenwithriskymortgageassetsanddependentonfckleshort-
term lending, was bought by JP Morgan with government assistance in the spring.
zz ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
Beforethesummerwasover,FannieMaeandFreddieMacwouldbeputintoconser-
vatorship. Then, in September, Lehman Brothers failed and the remaining invest-
ment banks, Merrill Lynch, Goldman Sachs, and Morgan Stanley, struggled as they
lostthemarketsconfdence.AIG,withitsmassivecreditdefaultswapportfolioand
exposuretothesubprimemortgagemarket,wasrescuedbythegovernment.Finally,
many commercial banks and thrifts, which had their own exposures to declining
mortgageassetsandtheirownexposurestoshort-termcreditmarkets,teetered.In-
dyMac had already failed over the summer; in September, Washington Mutual be-
camethelargestbankfailureinU.S.history.InOctober,Wachoviastruckadealtobe
acquiredbyWellsFargo.CitigroupandBankofAmericafoughttostayafoat.Before
it was over, taxpayers had committed trillions of dollars through more than two
dozenextraordinaryprogramstostabilizethefnancialsystemandtopropupthena-
tionslargestfnancialinstitutions.
Thecrisisthatbefellthecountryinioo8hadbeenyearsinthemaking.Intesti-
monytotheCommission,formerFedchairmanGreenspandefendedhisrecordand
saidmostofhisjudgmentshadbeencorrect.Iwasright,oofthetimebutIwas
wrong o of the time, he told the Commission.
1i
Yet the consequences of what
wentwrongintherun-uptothecrisiswouldbeenormous.
Theeconomicimpactofthecrisishasbeendevastating.Andthehumandevasta-
tioniscontinuing.Theomciallyreportedunemploymentratehoveredatalmost1o
in November io1o, but the underemployment rate, which includes those who have
given up looking for work and part-time workers who would prefer to be working
full-time,wasabove1,.Andtheshareofunemployedworkerswhohavebeenout
ofworkformorethansixmonthswasjustaboveo.Oflargemetropolitanareas,
Las Vegas, Nevada, and RiversideSan Bernardino, California, had the highest un-
employmenttheirrateswereabove1.
Theloanswereaslethalasmanyhadpredicted,andithasbeenestimatedthatul-
timatelyasmanyas1millionhouseholdsintheUnitedStatesmaylosetheirhomes
to foreclosure. As of io1o, foreclosure rates were highest in Florida and Nevada; in
Florida, nearly 1 of loans were in foreclosure, and Nevada was not very far
behind.
1i
Nearlyone-quarterofAmericanmortgageborrowersowedmoreontheir
mortgagesthantheirhomewasworth.InNevada,thepercentagewasnearly,o.
1i,
Householdshavelost11trillioninwealthsinceiooo.
As Mark Zandi, the chief economist of Moodys Economy.com, testifed to the
Commission,ThefnancialcrisishasdealtaveryseriousblowtotheU.S.economy.
The immediate impact was the Great Recession: the longest, broadest and most se-
veredownturnsincetheGreatDepressionofthe1os. . . .Thelonger-termfallout
fromtheeconomiccrisisisalsoverysubstantial. . . .Itwilltakeyearsforemployment
toregainitspre-crisislevel.
1io
Lookingbackontheyearsbeforethecrisis,theeconomistDeanBakersaid:So
muchofthiswasabsolutepublicknowledgeinthesensethatweknewthenumberof
loans that were being issued with zero down. Now, do we suddenly think we have
thatmanymorepeoplewhoarecapableoftakingonaloanwithzerodownwhowe
8ii uii uUi \ii ii: z,
thinkaregoingtobeabletopaythatoffthanwastrue1o,1,,ioyearsago:Imean,
whatschangedintheworld:Therewerealotofthingsthatdidntrequireanyinves-
tigationatall;theseweretotallyavailableinthedata.
1i,
WarrenPeterson,ahomebuilderinBakersfeld,feltthathecouldpinpointwhen
theworldchangedtotheday.Petersonbuilthomesinanupscaleneighborhood,and
each Monday morning, he would arrive at the omce to fnd a bevy of real estate
agents, sales contracts in hand, vying to be the ones chosen to purchase the new
homeshewasbuilding.Thestreamoftramcwasconstant.OnoneSaturdayinNo-
vember ioo,, he was at the sales omce and noticed that not a single purchaser had
enteredthebuilding.
Hecalledafriend,alsointhehome-buildingbusiness,whosaidhehadnoticed
thesamething,andaskedhimwhathethoughtaboutit.
Itsover,hisfriendtoldPeterson.
1i8
z, ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
PART II
Setting the Stage
2
SHADOW BANKING
CONTENTS
Ccnncrcia|papcrandrcpcsUnjcttcrcdnarkcts:,
1hcsavingsand|cancrisis1hcyputa|ctcj
prcssurccnthcirrcgu|atcrs ,,
Thefnancialcrisisofioo,andioo8wasnotasingleeventbutaseriesofcrisesthat
rippled through the fnancial system and, ultimately, the economy. Distress in one
areaofthefnancialmarketsledtofailuresinotherareasbywayofinterconnections
andvulnerabilitiesthatbankers,governmentomcials,andothershadmissedordis-
missed.Whensubprimeandotherriskymortgagesissuedduringahousingbubble
thatmanyexpertsfailedtoidentify,andwhoseconsequenceswerenotunderstood
begantodefaultatunexpectedrates,aonce-obscuremarketforcomplexinvestment
securitiesbackedbythosemortgagesabruptlyfailed.Whenthecontagionspread,in-
vestorspanickedandthedangerinherentinthewholesystembecamemanifest.Fi-
nancialmarketsteeteredontheedge,andbrand-namefnancialinstitutionswereleft
bankruptordependentonthetaxpayersforsurvival.
Federal Reserve Chairman Ben Bernanke now acknowledges that he missed the
systemic risks. Prospective subprime losses were clearly not large enough on their
own to account for the magnitude of the crisis, Bernanke told the Commission.
Rather,thesystemsvulnerabilities,togetherwithgapsinthegovernmentscrisis-re-
sponse toolkit, were the principal explanations of why the crisis was so severe and
hadsuchdevastatingeffectsonthebroadereconomy.
1
Thispartofourreportexplorestheoriginsofrisksastheydevelopedinthefnan-
cial system over recent decades. It is a fascinating story with profound conse-
quencesacomplexhistorythatcouldyielditsownreport.Instead,wefocusonfour
keydevelopmentsthathelpedshapetheeventsthatshookourfnancialmarketsand
economy.Detailedbookscouldbewrittenabouteachofthem;westicktotheessen-
tialsforunderstandingourspecifcconcern,whichistherecentcrisis.
First, we describe the phenomenal growth of the shadow banking systemthe
investment banks, most prominently, but also other fnancial institutionsthat
freelyoperatedincapitalmarketsbeyondthereachoftheregulatoryapparatusthat
had been put in place in the wake of the crash of 1i and the Great Depression.
z,
Thisnewsystemthreatenedtheonce-dominanttraditionalcommercialbanks,and
they took their grievances to their regulators and to Congress, which slowly but
steadilyremovedlong-standingrestrictionsandhelpedbanksbreakoutoftheirtra-
ditional mold and join the feverish growth. As a result, two parallel fnancial sys-
tems of enormous scale emerged. This new competition not only benefted Wall
Street but also seemed to help all Americans, lowering the costs of their
mortgages and boostingthereturnsontheiro1(k)s.Shadowbanksandcommer-
cial banks were codependent competitors. Their new activities were very prof-
itableand,itturnedout,veryrisky.
Second, we look at the evolution of fnancial regulation. To the Federal Reserve
andotherregulators,thenewdualsystemthatgrantedgreaterlicensetomarketpar-
ticipantsappearedtoprovideasaferandmoredynamicalternativetotheeraoftradi-
tionalbanking.Moreandmore,regulatorslookedtofnancialinstitutionstopolice
themselvesderegulationwasthelabel.FormerFedchairmanAlanGreenspanput
it this way: The market-stabilizing private regulatory forces should gradually dis-
place many cumbersome, increasingly ineffective government structures.
i
In the
Fedsview,ifproblemsemergedintheshadowbankingsystem,thelargecommercial
bankswhichwerebelievedtobewell-run,well-capitalized,andwell-regulatedde-
spitethelooseningoftheirrestraintscouldprovidevitalsupport.Andifproblems
outstrippedthemarketsabilitytorightitself,theFederalReservewouldtakeonthe
responsibility to restore fnancial stability. It did so again and again in the decades
leadinguptotherecentcrisis.And,understandably,muchofthecountrycametoas-
sumethattheFedcouldalwaysandwouldalwayssavetheday.
Third,wefollowtheprofoundchangesinthemortgageindustry,fromthesleepy
days when local lenders took full responsibility for making and servicing o-year
loanstoanewerainwhichtheideawastoselltheloansoffassoonaspossible,so
thattheycouldbepackagedandsoldtoinvestorsaroundtheworld.Newmortgage
productsproliferated,andsodidnewborrowers.Inevitably,thisbecameamarketin
which the participantsmortgage brokers, lenders, and Wall Street frmshad a
greater stake in the quantity of mortgages signed up and sold than in their quality.
WealsotracethehistoryofFannieMaeandFreddieMac,publiclytradedcorpora-
tionsestablishedbyCongressthatbecamedominantforcesinprovidingfnancingto
supportthemortgagemarketwhilealsoseekingtomaximizereturnsforinvestors.
Fourth,weintroducesomeofthemostarcanesubjectsinourreport:securitiza-
tion, structured fnance, and derivativeswords that entered the national vocabu-
laryasthefnancialmarketsunraveledthroughioo,andioo8.Putsimplyandmost
pertinently, structured fnance was the mechanism by which subprime and other
mortgageswereturnedintocomplexinvestmentsoftenaccordedtriple-Aratingsby
credit rating agencies whose own motives were conficted. This entire market de-
pended on fnely honed computer modelswhich turned out to be divorced from
realityandonever-risinghousingprices. Whenthatbubbleburst, thecomplexity
bubblealsoburst:thesecuritiesalmostnooneunderstood,backedbymortgagesno
lenderwouldhavesignedioyearsearlier,werethefrstdominoestofallinthefnan-
cialsector.
z ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
A basic understanding of these four developments will bring the reader up to
speed in grasping where matters stood for the fnancial system in the year iooo, at
thedawnofadecadeofpromiseandperil.
COMMERCIAL PAPER AND REPOS:
UNFETTERED MARKETS
For most of the ioth century, banks and thrifts accepted deposits and loaned that
moneytohomebuyersorbusinesses.BeforetheDepression,theseinstitutionswere
vulnerable to runs, when reports or merely rumors that a bank was in trouble
spurreddepositorstodemandtheircash.Iftherunwaswidespread,thebankmight
nothaveenoughcashonhandtomeetdepositorsdemands:runswerecommonbe-
foretheCivilWarandthenoccurredin18,,188,18o,18,18o,and1o,.

To
stabilize fnancial markets, Congress created the Federal Reserve System in 11,
whichactedasthelenderoflastresorttobanks.
ButthecreationoftheFedwasnotenoughtoavertbankrunsandsharpcontrac-
tionsinthefnancialmarketsinthe1iosand1os.Soin1Congresspassedthe
Glass-Steagall Act, which, among other changes, established the Federal Deposit In-
suranceCorporation.TheFDICinsuredbankdepositsuptoi,,ooanamountthat
coveredthevastmajorityofdepositsatthetime;thatlimitwouldclimbto1oo,oooby
18o,whereitstayeduntilitwasraisedtoi,o,oooduringthecrisisinOctoberioo8.
Depositors no longer needed to worry about being frst in line at a troubled banks
door.Andifbankswereshortofcash,theycouldnowborrowfromtheFederalRe-
serve,evenwhentheycouldborrownowhereelse.TheFed,actingaslenderoflastre-
sort,wouldensurethatbankswouldnotfailsimplyfromalackofliquidity.
Withthesebackstopsinplace,Congressrestrictedbanksactivitiestodiscourage
them from taking excessive risks, another move intended to help prevent bank fail-
ures,withtaxpayerdollarsnowatrisk.Furthermore,CongresslettheFederalReserve
capinterestratesthatbanksandthriftsalsoknownassavingsandloans,orS&Ls
couldpaydepositors.Thisrule,knownasRegulationQ,wasalsointendedtokeepin-
stitutionssafebyensuringthatcompetitionfordepositsdidnotgetoutofhand.

The system was stable as long as interest rates remained relatively steady, which
theydidduringthefrsttwodecadesafterWorldWarII.Beginninginthelate-1oos,
however, infation started to increase, pushing up interest rates. For example, the
ratesthatbankspaidotherbanksforovernightloanshadrarelyexceededointhe
decadesbefore18o,whenitreachedio.However,thankstoRegulationQ,banks
and thrifts were stuck offering roughly less than o on most deposits. Clearly, this
was an untenable bind for the depository institutions, which could not compete on
themostbasicleveloftheinterestrateofferedonadeposit.
Competewithwhom:Inthe1,os,MerrillLynch,Fidelity,Vanguard,andothers
persuadedconsumersandbusinessestoabandonbanksandthriftsforhigherreturns.
These frmseager to fnd new businesses, particularly after the Securities and Ex-
change Commission (SEC) abolished fxed commissions on stock trades in 1,,
created money market mutual funds that invested these depositors money in
:u\iu\ 8\Nii Nt z,
short-term,safesecuritiessuchasTreasurybondsandhighlyratedcorporatedebt,
andthefundspaidhigherinterestratesthanbanksandthriftswereallowedtopay.
Thefundsfunctionedlikebankaccounts,althoughwithadifferentmechanism:cus-
tomersboughtsharesredeemabledailyatastablevalue.In1,,,MerrillLynchin-
troduced something even more like a bank account: cash management accounts
allowed customers to write checks. Other money market mutual funds quickly
followed.
,
Thesefundsdifferedfrombankandthriftdepositsinoneimportantrespect:they
were not protected by FDIC deposit insurance. Nevertheless, consumers liked the
higherinterestrates,andthestatureofthefundssponsorsreassuredthem.Thefund
sponsors implicitly promised to maintain the full 1 net asset value of a share. The
funds would not break the buck, in Wall Street terms. Even without FDIC insur-
ance,then,depositorsconsideredthesefundsalmostassafeasdepositsinabankor
thrift.Businessboomed,andsowasbornakeyplayerintheshadowbankingindus-
try, the less-regulated market for capital that was growing up beside the traditional
banking system. Assets in money market mutual funds jumped from billion in
1,,tomorethan,obillionin1,and1.8trillionbyiooo.
o
To maintain their edge over the insured banks and thrifts, the money market
fundsneededsafe,high-qualityassetstoinvestin,andtheyquicklydevelopedanap-
petite for two booming markets: the commercial paper and repo markets.
Throughtheseinstruments,MerrillLynch,MorganStanley,andotherWallStreetin-
vestment banks could broker and provide (for a fee) short-term fnancing to large
corporations.Commercialpaperwasunsecuredcorporatedebtmeaningthatitwas
backed not by a pledge of collateral but only by the corporations promise to pay.
Theseloanswerecheaperbecausetheywereshort-termforlessthanninemonths,
sometimesasshortastwoweeksand,eventually,asshortasoneday;theborrowers
usually rolled them over when the loan came due, and then again and again. Be-
causeonlyfnanciallystablecorporationswereabletoissuecommercialpaper,itwas
consideredaverysafeinvestment;companiessuchasGeneralElectricandIBM,in-
vestorsbelieved,wouldalwaysbegoodforthemoney.Corporationshadbeenissuing
commercialpapertoraisemoneysincethebeginningofthecentury,butthepractice
grewmuchmorepopularinthe1oos.
Thismarket,though,underwentacrisisthatdemonstratedthatcapitalmarkets,
too,werevulnerabletoruns.Yetthatcrisisactuallystrengthenedthemarket.In1,o,
the Penn Central Transportation Company, the sixth-largest nonfnancial corpora-
tion in the U.S., fled for bankruptcy with ioo million in commercial paper out-
standing. The railroads default caused investors to worry about the broader
commercial paper market; holders of that paperthe lendersrefused to roll over
their loans to other corporate borrowers. The commercial paper market virtually
shut down. In response, the Federal Reserve supported the commercial banks with
almost ooo million in emergency loans and with interest rate cuts.
,
The Feds ac-
tions enabled the banks, in turn, to lend to corporations so that they could pay off
theircommercialpaper.AfterthePennCentralcrisis,theissuersofcommercialpa-
pertheborrowerstypicallysetupstandbylinesofcreditwithmajorbankstoen-
,+ ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
able them to pay off their debts should there be another shock. These moves reas-
suredinvestorsthatcommercialpaperwasasafeinvestment.
Inthe1oos,thecommercialpapermarketjumpedmorethansevenfold.Thenin
the 1,os, it grew almost fourfold. Among the largest buyers of commercial paper
were the money market mutual funds. It seemed a win-win-win deal: the mutual
funds could earn a solid return, stable companies could borrow more cheaply, and
WallStreetfrmscouldearnfeesforputtingthedealstogether.Byiooo,commercial
paperhadrisento1.otrillionfromlessthan1i,billionin18o.
8
Thesecondmajorshadowbankingmarketthatgrewsignifcantlywasthemarket
forrepos,orrepurchaseagreements.Likecommercialpaper,reposhavealonghis-
tory, but they proliferated quickly in the 1,os. Wall Street securities dealers often
soldTreasurybondswiththeirrelativelylowreturnstobanksandotherconservative
investors,whiletheninvestingthecashproceedsofthesesalesinsecuritiesthatpaid
higherinterestrates.ThedealersagreedtorepurchasetheTreasuriesoftenwithina
dayataslightlyhigherpricethanthatforwhichtheysoldthem.Thisrepotransac-
tioninessencealoanmadeitinexpensiveandconvenientforWallStreetfrmsto
borrow.Becausethesedealswereessentiallycollateralizedloans,thesecuritiesdeal-
ersborrowednearlythefullvalueofthecollateral,minusasmallhaircut.Likecom-
mercialpaper,reposwererenewed,orrolledover,frequently.Forthatreason,both
forms of borrowing could be considered hot moneybecause lenders could
quickly move in and out of these investments in search of the highest returns, they
couldbeariskysourceoffunding.
Therepomarket,too,hadvulnerabilities,butit,too,hademergedfromanearly
crisisstrongerthanever.In18i,twomajorborrowers,thesecuritiesfrmsDrysdale
and Lombard-Wall, defaulted on their repo obligations, creating large losses for
lenders. In the ensuing fallout, the Federal Reserve acted as lender of last resort to
support a shadow banking market. The Fed loosened the terms on which it lent
Treasuries to securities frms, leading to a 1o-fold increase in its securities lending.
Followingthisepisode,mostrepoparticipantsswitchedtoatri-partyarrangementin
whichalargeclearingbankactedasintermediarybetweenborrowerandlender,es-
sentially protecting the collateral and the funds by putting them in escrow.

This
mechanism would have severe consequences in ioo, and ioo8. In the 18os, how-
ever,thesenewproceduresstabilizedtherepomarket.
The new parallel banking systemwith commercial paper and repo providing
cheaperfnancing,andmoneymarketfundsprovidingbetterreturnsforconsumers
andinstitutionalinvestorshadacrucialcatch:itspopularitycameattheexpenseof
thebanksandthrifts.Someregulatorsviewedthisdevelopmentwithgrowingalarm.
According to Alan Blinder, the vice chairman of the Federal Reserve from 1 to
1o,Wewereconcernedasbankregulatorswiththeerodingcompetitiveposition
ofbanks,whichofcoursewouldthreatenultimatelytheirsafetyandsoundness,due
to the competition they were getting from a variety of nonbanksand these were
mainlyWallStreetfrms,thatweretakingdepositsfromthem,andgettingintothe
loanbusinesstosomeextent.So,yeah,itwasaconcern;youcouldseeadownward
trendintheshareofbankingassetstofnancialassets.
1o
:u\iu\ 8\Nii Nt ,.
Figure i.1 shows that during the 1os the shadow banking system steadily
gainedgroundonthetraditionalbankingsectorandactuallysurpassedthebank-
ingsectorforabrieftimeafteriooo.
Banks argued that their problems stemmed from the Glass-Steagall Act. Glass-
Steagallstrictlylimitedcommercialbanksparticipationinthesecuritiesmarkets,in
parttoendthepracticesofthe1ios,whenbankssoldhighlyspeculativesecurities
todepositors.In1,o,Congressalsoimposednewregulatoryrequirementsonbanks
owned by holding companies, in order to prevent a holding company from endan-
geringanyofitsdeposit-takingbanks.
Bank supervisors monitored banks leveragetheir assets relative to equity
becauseexcessiveleverageendangeredabank.Leverage,usedbynearlyeveryfnan-
cial institution, amplifes returns. For example, if an investor uses 1oo of his own
moneytopurchaseasecuritythatincreasesinvalueby1o,heearns1o.However,
ifheborrowsanotherooandinvests1otimesasmuch(1,ooo),thesame1oin-
crease in value yields a proft of 1oo, double his out-of-pocket investment. If the
investmentsours,though,leveragemagnifesthelossjustasmuch.Adeclineof1o
coststheunleveragedinvestor1o,leavinghimwitho,butwipesouttheleveraged
investors 1oo. An investor buying assets worth 1o times his capital has a leverage
,z ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
Traditional and Shadow Banking Systems
IN TRILLIONS OF DOLLARS
SOURCE: Federal Reserve Flow of Funds Report
1980 1985 1990 1995 2000 2005 2010
Traditional
Banking
Shadow
Banking
$13.0
$8.5
The funding available through the shadow banking system grew sharply in the
2000s, exceeding the traditional banking system in the years before the crisis.
NOTE: Shadow banking funding includes commercial paper and other short-term borrowing (bankers
acceptances), repo, net securities loaned, liabilities of asset-backed securities issuers, and money market mutual
fund assets.
0
3
6
9
12
$15
Iigurc :.+
ratio of 1o:1, with the numbers representing the total money invested compared to
themoneytheinvestorhascommittedtothedeal.
In181,banksupervisorsestablishedthefrstformalminimumcapitalstandards,
whichmandatedthatcapitaltheamountbywhichassetsexceeddebtandotherlia-
bilitiesshould be at least , of assets for most banks. Capital, in general, refects
thevalueofshareholdersinvestmentinthebank,whichbearsthefrstriskofanypo-
tentiallosses.
By comparison, Wall Street investment banks could employ far greater leverage,
unhindered by oversight of their safety and soundness or by capital requirements
outside of their broker-dealer subsidiaries, which were subject to a net capital rule.
The main shadow banking participantsthe money market funds and the invest-
mentbanksthatsponsoredmanyofthemwerenotsubjecttothesamesupervision
asbanksandthrifts.Themoneyintheshadowbankingmarketscamenotfromfed-
erallyinsureddepositorsbutprincipallyfrominvestors(inthecaseofmoneymarket
funds) or commercial paper and repo markets (in the case of investment banks).
BothmoneymarketfundsandsecuritiesfrmswereregulatedbytheSecuritiesand
ExchangeCommission.ButtheSEC,createdin1,wassupposedtosupervisethe
securities markets to protect investors. It was charged with ensuring that issuers of
securities disclosed sumcient information for investors, and it required frms that
bought,sold,andbrokeredtransactionsinsecuritiestocomplywithproceduralre-
strictions such as keeping customers funds in separate accounts. Historically, the
SECdidnot focusonthesafetyandsoundnessofsecuritiesfrms,althoughitdidim-
posecapitalrequirementsonbroker-dealersdesignedtoprotecttheirclients.
Meanwhile, since deposit insurance did not cover such instruments as money
marketmutualfunds,thegovernmentwasnotonthehook.Therewaslittleconcern
aboutarun.Intheory,theinvestorshadknowinglyriskedtheirmoney.Ifaninvest-
mentlostvalue,itlostvalue.Ifafrmfailed,itfailed.Asaresult,moneymarketfunds
had no capital or leverage standards. There was no regulation, former Fed chair-
man Paul Volcker told the Financial Crisis Inquiry Commission. It was kind of a
freeride.
11
Thefundshadtofollowonlyregulationsrestrictingthetypeofsecurities
inwhichtheycouldinvest,thedurationofthosesecurities,andthediversifcationof
their portfolios. These requirements were supposed to ensure that investors shares
would not diminish in value and would be available anytimeimportant reassur-
ances, but not the same as FDIC insurance. The only protection against losses was
theimplicitguaranteeofsponsorslikeMerrillLynchwithreputationstoprotect.
Increasingly, the traditional world of banks and thrifts was ill-equipped to keep
upwiththeparallelworldoftheWallStreetfrms.Thenewshadowbankshadfew
constraints on raising and investing money. Commercial banks were at a disadvan-
tageandindangeroflosingtheirdominantposition.Theirbindwaslabeleddisin-
termediation, and many critics of the fnancial regulatory system concluded that
policy makers, all the way back to the Depression, had trapped depository institu-
tionsinthisunproftablestraitjacketnotonlybycappingtheinterestratestheycould
paydepositorsandimposingcapitalrequirementsbutalsobypreventingtheinstitu-
tionsfromcompetingagainsttheinvestmentbanks(andtheirmoneymarketmutual
:u\iu\ 8\Nii Nt ,,
funds).Moreover,criticsargued,theregulatoryconstraintsonindustriesacrossthe
entireeconomydiscouragedcompetitionandrestrictedinnovation,andthefnancial
sectorwasaprimeexampleofsuchahamperedindustry.
Years later, Fed Chairman Greenspan described the argument for deregulation:
Thoseofuswhosupportmarketcapitalisminitsmorecompetitiveformsmightar-
guethatunfetteredmarketscreateadegreeofwealththatfostersamorecivilizedex-
istence.Ihavealwaysfoundthatinsightcompelling.
1i
THE SAVINGS AND LOAN CRISIS:
THEY PUT A LOT OF PRESSURE ON THEIR REGULATORS
Traditional fnancial institutions continued to chafe against the regulations still in
place.Theplayingfeldwasntlevel,whichputalotofpressureoninstitutionstoget
higher-rate performing assets, former SEC Chairman Richard Breeden told the
FCIC.Andtheyputalotofpressureontheirregulatorstoallowthistohappen.
1
ThebanksandtheS&LswenttoCongressforhelp.In18o,theDepositoryInsti-
tutions Deregulation and Monetary Control Act repealed the limits on the interest
ratesthatdepositoryinstitutionscouldofferontheirdeposits.Althoughthislawre-
moved a signifcant regulatory constraint on banks and thrifts, it could not restore
theircompetitiveadvantage.Depositorswantedahigherrateofreturn,whichbanks
andthriftswerenowfreetopay.Buttheinterestbanksandthriftscouldearnoffof
mortgages and other long-term loans was largely fxed and could not match their
new costs. While their deposit base increased, they now faced an interest rate
squeeze.In1,,thedifferenceininterestearnedonthebanksandthriftssafestin-
vestments (one-year Treasury notes) over interest paid on deposits was almost ,.,
percentagepoints;by1,itwasonlyi.opercentagepoints.Theinstitutionslostal-
most percentage points of the advantage they had enjoyed when the rates were
capped.
1
The18olegislationhadnotdoneenoughtoreducethecompetitivepres-
suresfacingthebanksandthrifts.
Thatlegislationwasfollowedin18ibytheGarn-St.GermainAct,whichsignif-
cantlybroadenedthetypesofloansandinvestmentsthatthriftscouldmake.Theact
alsogavebanksandthriftsbroaderscopeinthemortgagemarket.Traditionally,they
hadreliedono-year,fxed-ratemortgages.Buttheinterestonfxed-ratemortgages
on their books fell short as infation surged in the mid-1,os and early 18os and
banks and thrifts found it increasingly dimcult to cover the rising costs of their
short-term deposits. In the Garn-St. Germain Act, Congress sought to relieve this
interest rate mismatch by permitting banks and thrifts to issue interest-only, bal-
loon-payment, and adjustable-rate mortgages (ARMs), even in states where state
lawsforbadetheseloans.Forconsumers,interest-onlyandballoonmortgagesmade
homeownershipmoreaffordable,butonlyintheshortterm.BorrowerswithARMs
enjoyed lower mortgage rates when interest rates decreased, but their rates would
rise when interest rates rose. For banks and thrifts, ARMs offered an interest rate
thatfoatedinrelationshiptotheratestheywerepayingtoattractmoneyfromde-
positors.ThefoatingmortgagerateprotectedbanksandS&Lsfromtheinterestrate
,, ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
squeeze caused by infation, but it effectively transferred the risk of rising interest
ratestoborrowers.
Then,beginningin18,,theFederalReserveaccommodatedaseriesofrequests
fromthebankstoundertakeactivitiesforbiddenunderGlass-Steagallanditsmodif-
cations.Thenewrulespermittednonbanksubsidiariesofbankholdingcompaniesto
engageinbank-ineligibleactivities,includingsellingorholdingcertainkindsofse-
curities that were not permissible for national banks to invest in or underwrite. At
frst, the Fed strictly limited these bank-ineligible securities activities to no more
than,oftheassetsorrevenueofanysubsidiary.Overtime,however,theFedre-
laxedtheserestrictions.By1,,bank-ineligiblesecuritiescouldrepresentuptoi,
ofassetsorrevenuesofasecuritiessubsidiary,andtheFedalsoweakenedorelimi-
natedotherfrewallsbetweentraditionalbankingsubsidiariesandthenewsecurities
subsidiariesofbankholdingcompanies.
1,
Meanwhile,theOCC,theregulatorofbankswithnationalcharters,wasexpand-
ingthepermissibleactivitiesofnationalbankstoincludethosethatwerefunction-
ally equivalent to, or a logical outgrowth of, a recognized bank power.
1o
Among
thesenewactivitieswereunderwritingaswellastradingbetsandhedges,knownas
derivatives,onthepricesofcertainassets.Between18and1,theOCCbroad-
enedthederivativesinwhichbanksmightdealtoincludethoserelatedtodebtsecu-
rities (18), interest and currency exchange rates (188), stock indices (188),
preciousmetalssuchasgoldandsilver(11),andequitystocks(1).
Fed Chairman Greenspan and many other regulators and legislators supported
andencouragedthisshifttowardderegulatedfnancialmarkets.Theyarguedthatf-
nancial institutions had strong incentives to protect their shareholders and would
therefore regulate themselves through improved risk management. Likewise, fnan-
cialmarketswouldexertstrongandeffectivedisciplinethroughanalysts,creditrat-
ing agencies, and investors. Greenspan argued that the urgent question about
governmentregulationwaswhetheritstrengthenedorweakenedprivateregulation.
TestifyingbeforeCongressin1,,heframedtheissuethisway:fnancialmodern-
ization was needed to remove outdated restrictions that serve no useful purpose,
thatdecreaseeconomicemciency,andthat . . .limitchoicesandoptionsforthecon-
sumeroffnancialservices.Removingthebarrierswouldpermitbankingorganiza-
tions to compete more effectively in their natural markets. The result would be a
moreemcientfnancialsystemprovidingbetterservicestothepublic.
1,
During the 18os and early 1os, banks and thrifts expanded into higher-risk
loans with higher interest payments. They made loans to oil and gas producers, f-
nancedleveragedbuyoutsofcorporations,andfundeddevelopersofresidentialand
commercialrealestate.Thelargestcommercialbanksadvancedmoneytocompanies
andgovernmentsinemergingmarkets,suchascountriesinAsiaandLatinAmer-
ica.Thosemarketsofferedpotentiallyhigherprofts,butweremuchriskierthanthe
banks traditional lending. The consequences appeared almost immediatelyespe-
ciallyintherealestatemarkets,withabubbleandmassiveoverbuildinginresidential
and commercial sectors in certain regions. For example, house prices rose , per
yearinTexasfrom18oto18,.
18
InCalifornia,pricesrose1annuallyfrom18,
:u\iu\ 8\Nii Nt ,,
to 1o.
1
The bubble burst frst in Texas in 18, and 18o, but the trouble rapidly
spreadacrosstheSoutheasttothemid-AtlanticstatesandNewEngland,thenswept
back across the country to California and Arizona. Before the crisis ended, house
priceshaddeclinednationallybyi.,fromJuly1otoFebruary1i
io
thefrst
such fall since the Depressiondriven by steep drops in regional markets.
i1
In the
18os, with the mortgages in their portfolios paying considerably less than current
interestrates,spiralingdefaultsonthethriftsresidentialandcommercialrealestate
loans,andlossesonenergy-related,leveraged-buyout,andoverseasloans,theindus-
trywasshattered.
ii
Almost,ooocommercialbanksandthriftsfailedinwhatbecameknownasthe
S&L crisis of the 18os and early 1os. By comparison, only i banks had failed
between 1 and 18o. By 1, one-sixth of federally insured depository institu-
tionshadeitherclosedorrequiredfnancialassistance,affectingioofthebanking
systems assets.
i
More than 1,ooo bank and S&L executives were convicted of
felonies.
i
Bythetimethegovernmentcleanupwascomplete,theultimatecostofthe
crisiswas1oobillion.
i,
Despite new laws passed by Congress in 18 and 11 in response to the S&L
crisisthattoughenedsupervisionofthrifts,theimpulsetowardderegulationcontin-
ued.Thederegulatorymovementfocusedinpartoncontinuingtodismantleregula-
tions that limited depository institutions activities in the capital markets. In 11,
theTreasuryDepartmentissuedanextensivestudycallingfortheeliminationofthe
oldregulatoryframeworkforbanks,includingremovalofallgeographicrestrictions
onbankingandrepealoftheGlass-SteagallAct.ThestudyurgedCongresstoabolish
theserestrictionsinthebeliefthatlargenationwidebankscloselytiedtothecapital
marketswouldbemoreproftableandmorecompetitivewiththelargestbanksfrom
the United Kingdom, Europe, and Japan. The report contended that its proposals
wouldletbanksembraceinnovationandproduceastronger,morediversifedfnan-
cialsystemthatwillprovideimportantbeneftstotheconsumerandimportantpro-
tectionstothetaxpayer.
io
The biggest banks pushed Congress to adopt Treasurys recommendations. Op-
posedwereinsuranceagents,realestatebrokers,andsmallerbanks,whofeltthreat-
enedbythepossibilitythatthelargestbanksandtheirhugepoolsofdepositswould
be unleashed to compete without restraint. The House of Representatives rejected
Treasurysproposalin11,butsimilarproposalswereadoptedbyCongresslaterin
the1os.
In dealing with the banking and thrift crisis of the 18os and early 1os, Con-
gresswasgreatlyconcernedbyaspateofhigh-proflebankbailouts.In18,federal
regulators rescued Continental Illinois, the nations ,th-largest bank; in 188, First
Republic,number1;in18,MCorp,numbero;in11,BankofNewEngland,
number.Thesebankshadreliedheavilyonuninsuredshort-termfnancingtoag-
gressively expand into high-risk lending, leaving them vulnerable to abrupt with-
drawalsonceconfdenceintheirsolvencyevaporated.DepositscoveredbytheFDIC
wereprotectedfromloss,butregulatorsfeltobligedtoprotecttheuninsureddeposi-
torsthosewhosebalancesexceededthestatutorilyprotectedlimitstopreventpo-
, ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
tentialrunsonevenlargerbanksthatreportedlymayhavelackedsumcientassetsto
satisfytheirobligations,suchasFirstChicago,BankofAmerica,andManufacturers
Hanover.
i,
During a hearing on the rescue of Continental Illinois, Comptroller of the Cur-
rencyC.ToddConoverstatedthatfederalregulatorswouldnotallowthe11largest
moneycenterbankstofail.
i8
Thiswasanewregulatoryprinciple,andwithinmo-
ments it had a catchy name. Representative Stewart McKinney of Connecticut re-
sponded,Wehaveanewkindofbank.ItiscalledtoobigtofailTBTFanditisa
wonderfulbank.
i
In 1o, during this era of federal rescues of large commercial banks, Drexel
Burnham Lambertonce the countrys ffth-largest investment bankfailed. Crip-
pledbylegaltroublesandlossesinitsjunkbondportfolio,thefrmwasforcedinto
thelargestbankruptcyinthesecuritiesindustrytodatewhenlendersshunneditin
thecommercialpaperandrepomarkets.Whilecreditors,includingotherinvestment
banks,wererattledandabsorbedheavylosses,thegovernmentdidnotstepin,and
Drexels failure did not cause a crisis. So far, it seemed that among fnancial frms,
onlycommercialbanksweredeemedtoobigtofail.
In11,Congresstriedtolimitthistoobigtofailprinciple,passingtheFederal
Deposit Insurance Corporation Improvement Act (FDICIA), which sought to curb
theuseoftaxpayerfundstorescuefailingdepositoryinstitutions.FDICIAmandated
thatfederalregulatorsmustinterveneearlywhenabankorthriftgotintotrouble.In
addition,ifaninstitutiondidfail,theFDIChadtoresolvethefailedinstitutionina
mannerthatproducedtheleastcosttotheFDICsdepositinsurancefund.However,
thelegislationcontainedtwoimportantloopholes.OneexemptedtheFDICfromthe
least-costconstraintsifit,theTreasury,andtheFederalReservedeterminedthatthe
failure of an institution posed a systemic risk to markets. The other loophole ad-
dressed a concern raised by some Wall Street investment banks, Goldman Sachs in
particular:thereluctanceofcommercialbankstohelpsecuritiesfrmsduringprevi-
ousmarketdisruptions,suchasDrexelsfailure.WallStreetfrmssuccessfullylobbied
foranamendmenttoFDICIAtoauthorizetheFedtoactaslenderoflastresorttoin-
vestment banks by extending loans collateralized by the investment banks
securities.
o
In the end, the 11 legislation sent fnancial institutions a mixed message: you
are not too big to failuntil and unless you are too big to fail. So the possibility of
bailouts for the biggest, most centrally placed institutionsin the commercial and
shadow banking industriesremained an open question until the next crisis, 1o
yearslater.
:u\iu\ 8\Nii Nt ,,
3
SECURITIZATION AND DERIVATIVES
CONTENTS
IannicMacandIrcddicMac1hcwhc|carnycj|c||yists,:
StructurcdnanccItwasntrcducingthcrisk,:
1hcgrcwthcjdcrivativcsByjarthcncstsignicantcvcnt
innanccduringthcpastdccadc ,,
FANNIE MAE AND FREDDIE MAC:
THE WHOLE ARMY OF LOBBYISTS
ThecrisisinthethriftindustrycreatedanopeningforFannieMaeandFreddieMac,
the two massive government-sponsored enterprises (GSEs) created by Congress to
supportthemortgagemarket.
FannieMae(omcially,theFederalNationalMortgageAssociation)waschartered
bytheReconstructionFinanceCorporationduringtheGreatDepressionin18to
buymortgagesinsuredbytheFederalHousingAdministration(FHA).Thenewgov-
ernmentagencywasauthorizedtopurchasemortgagesthatadheredtotheFHAsun-
derwriting standards, thereby virtually guaranteeing the supply of mortgage credit
thatbanksandthriftscouldextendtohomebuyers.FannieMaeeitherheldthemort-
gages in its portfolio or, less often, resold them to thrifts, insurance companies, or
other investors. After World War II, Fannie Mae got authority to buy home loans
guaranteedbytheVeteransAdministration(VA)aswell.
Thissystemworkedwell,butithadaweakness:FannieMaeboughtmortgagesby
borrowing. By 1o8, Fannies mortgage portfolio had grown to ,.i billion and its
debtweighedonthefederalgovernment.
1
TogetFanniesdebtoffofthegovernments
balancesheet,theJohnsonadministrationandCongressreorganizeditasapublicly
tradedcorporationandcreatedanewgovernmententity,GinnieMae(omcially,the
GovernmentNationalMortgageAssociation)totakeoverFanniessubsidizedmort-
gageprogramsandloanportfolio.GinniealsobeganguaranteeingpoolsofFHAand
VA mortgages. The new Fannie still purchased federally insured mortgages, but it
wasnowahybrid,agovernment-sponsoredenterprise.
Twoyearslater,in1,o,thethriftspersuadedCongresstocharterasecondGSE,
FreddieMac(omcially,theFederalHomeLoanMortgageCorporation),tohelpthe
,
thriftsselltheirmortgages.ThelegislationalsoauthorizedFannieandFreddietobuy
conventionalfxed-ratemortgages,whichwerenotbackedbytheFHAortheVA.
ConventionalmortgageswerestiffcompetitiontoFHAmortgagesbecauseborrow-
ers could get them more quickly and with lower fees. Still, the conventional mort-
gagesdidhavetoconformtotheGSEsloansizelimitsandunderwritingguidelines,
such as debt-to-income and loan-to-value ratios. The GSEs purchased only these
conformingmortgages.
Before 1o8, Fannie Mae generally held the mortgages it purchased, profting
from the differenceor spreadbetween its cost of funds and the interest paid on
thesemortgages.The1o8and1,olawsgaveGinnie,Fannie,andFreddieanother
option:securitization.Ginniewasthefrsttosecuritizemortgages,in1,o.Alender
would assemble a pool of mortgages and issue securities backed by the mortgage
pool. Those securities would be sold to investors, with Ginnie guaranteeing timely
paymentofprincipalandinterest.Ginniechargedafeetoissuersforthisguarantee.
In1,1,Freddiegotintothebusinessofbuyingmortgages,poolingthem,andthen
selling mortgage-backed securities. Freddie collected fees from lenders for guaran-
teeingtimelypaymentofprincipalandinterest.In181,afteraspikeininterestrates
caused large losses on Fannies portfolio of mortgages, Fannie followed. During the
18osand1os,theconventionalmortgagemarketexpanded,theGSEsgrewinim-
portance,andthemarketshareoftheFHAandVAdeclined.
FannieandFreddiehaddualmissions,bothpublicandprivate:supportthemort-
gage market and maximize returns for shareholders. They did not originate mort-
gages; they purchased themfrom banks, thrifts, and mortgage companiesand
either held them in their portfolios or securitized and guaranteed them. Congress
grantedbothenterprisesspecialprivileges,suchasexemptionsfromstateandlocal
taxesandai.i,billionlineofcrediteachfromtheTreasury.TheFederalReserve
providedservicessuchaselectronicallyclearingpaymentsforGSEdebtandsecuri-
tiesasiftheywereTreasurybonds.SoFannieandFreddiecouldborrowatratesal-
mostaslowastheTreasurypaid.Federallawsallowedbanks,thrifts,andinvestment
funds to invest in GSE securities with relatively favorable capital requirements and
withoutlimits.Bycontrast,lawsandregulationsstrictlylimitedtheamountofloans
banks could make to a single borrower and restricted their investments in the debt
obligations of other frms. In addition, unlike banks and thrifts, the GSEs were re-
quired to hold very little capital to protect against losses: only o., to back their
guarantees of mortgage-backed securities and i., to back the mortgages in their
portfolios. This compared to bank and thrift capital requirements of at least of
mortgagesassetsundercapitalstandards.Suchprivilegesledinvestorsandcreditors
tobelievethatthegovernmentimplicitlyguaranteedtheGSEsmortgage-backedse-
curities and debt and that GSE securities were therefore almost as safe as Treasury
bills.Asaresult,investorsacceptedverylowreturnsonGSE-guaranteedmortgage-
backedsecuritiesandGSEdebtobligations.
Mortgages are long-term assets often funded by short-term borrowings. For
example,thriftsgenerallyusedcustomerdepositstofundtheirmortgages.Fannie
:itUii 1i / \1i uN \Ni iiii \\1i \i: ,,
bought its mortgage portfolio by borrowing short- and medium-term. In 1,,
whentheFedincreasedshort-terminterestratestoquellinflation,Fannie,likethe
thrifts,foundthatitscostoffundingrosewhileincomefrommortgagesdidnot.By
the18os,theDepartmentofHousingandUrbanDevelopment(HUD)estimated
Fannie had a negative net worth of 1o billion.
i
Freddie emerged unscathed be-
causeunlikeFanniethen,itsprimarybusinesswasguaranteeingmortgage-backed
securities, not holding mortgages in its portfolio. In guaranteeing mortgage-
backedsecurities,FreddieMacavoidedtakingtheinterestrateriskthathitFannies
portfolio.
In18i,CongressprovidedtaxreliefandHUDrelaxedFanniescapitalrequire-
mentstohelpthecompanyavertfailure.Theseeffortswereconsistentwithlawmak-
ers repeated proclamations that a vibrant market for home mortgages served the
bestinterestsofthecountry,butthemovesalsoreinforcedtheimpressionthatthe
government would never abandon Fannie and Freddie. Fannie and Freddie would
soonbuyandeitherholdorsecuritizemortgagesworthhundredsofbillions,then
trillions, ofdollars.AmongtheinvestorswereU.S.banks,thrifts,investmentfunds,
andpensionfunds,aswellascentralbanksandinvestmentfundsaroundtheworld.
FannieandFreddiehadbecometoobigtofail.
While the government continued to favor Fannie and Freddie, they toughened
regulationofthethriftsfollowingthesavingsandloancrisis.Thriftshadpreviously
dominatedthemortgagebusinessaslargeholdersofmortgages.IntheFinancialIn-
stitutions Reform, Recovery, and Enforcement Act of 18 (FIRREA), Congress
imposedtougher,bank-stylecapitalrequirementsandregulationsonthrifts.Bycon-
trast,intheFederalHousingEnterprisesFinancialSafetyandSoundnessActof1i,
CongresscreatedasupervisorfortheGSEs,theOmceofFederalHousingEnterprise
Oversight (OFHEO), without legal powers comparable to those of bank and thrift
supervisorsinenforcement,capitalrequirements,funding,andreceivership.Crack-
ing down on thrifts while not on the GSEs was no accident. The GSEs had shown
their immense political power during the drafting of the 1i law.

OFHEO was
structurallyweakandalmostdesignedtofail,saidArmandoFalconJr.,aformerdi-
rectoroftheagency,totheFCIC.

Allthisaddeduptoagenerousfederalsubsidy.Oneioo,studyputthevalueof
thatsubsidyat1iibillionormoreandestimatedthatmorethanhalfofthesebene-
ftsaccruedtoshareholders,nottohomebuyers.
,
Given these circumstances, regulatory arbitrage worked as it always does: the
markets shifted to the lowest-cost, least-regulated havens. After Congress imposed
strictercapitalrequirementsonthrifts,itbecameincreasinglyproftableforthemto
securitizewithorsellloanstoFannieandFreddieratherthanholdontotheloans.
Thestampedewason.FanniesandFreddiesdebtobligationsandoutstandingmort-
gage-backed securities grew from ,, billion in 1o to 1. trillion in 1, and
i.trillioniniooo.
o
ThelegislationthattransformedFanniein1o8alsoauthorizedHUDtoprescribe
affordablehousinggoalsforFannie:torequirethatareasonableportionofthecor-
porations mortgage purchases be related to the national goal of providing adequate
,+ ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
housingforlowandmoderateincomefamilies,butwithreasonableeconomicreturn
tothecorporation.
,
In1,8,HUDtriedtoimplementthelawand,afterabarrageof
criticism from the GSEs and the mortgage and real estate industries, issued a weak
regulationencouragingaffordablehousing.
8
Inthe1iFederalHousingEnterprises
Financial Safety and Soundness Act, Congress extended HUDs authority to set af-
fordablehousinggoalsforFannieandFreddie.Congressalsochangedthelanguageto
saythatinthepursuitofaffordablehousing,areasonableeconomicreturn . . .may
belessthanthereturnearnedonotheractivities.ThelawrequiredHUDtoconsider
theneedtomaintainthesoundfnancialconditionoftheenterprises.Theactnow
orderedHUDtosetgoalsforFannieandFreddietobuyloansforlow-andmoderate-
incomehousing,specialaffordablehousing,andhousingincentralcities,ruralareas,
andotherunderservedareas.CongressinstructedHUDtoperiodicallysetagoalfor
eachcategoryasapercentageoftheGSEsmortgagepurchases.
In1,,PresidentBillClintonannouncedaninitiativetoboosthomeownership
from o,.1 to o,., of families by iooo, and one component raised the affordable
housing goals at the GSEs. Between 1 and 1,, almost i.8 million households
enteredtheranksofhomeowners,nearlytwiceasmanyasintheprevioustwoyears.
But we have to do a lot better, Clinton said. This is the new way home for the
Americanmiddleclass.Wehavegottoraiseincomesinthiscountry.Wehavegotto
increasesecurityforpeoplewhoaredoingtherightthing,andwehavegottomake
peoplebelievethattheycanhavesomepermanenceandstabilityintheirlivesevenas
theydealwithallthechangingforcesthatareoutthereinthisglobaleconomy.

The
push to expand homeownership continued under President George W. Bush, who,
for example, introduced a Zero Down Payment Initiative that under certain cir-
cumstancescouldremovethedownpaymentruleforfrst-timehomebuyerswith
FHA-insuredmortgages.
1o
In describing the GSEs affordable housing loans, Andrew Cuomo, secretary of
Housing and Urban Development from 1, to ioo1 and now governor of New
York,toldtheFCIC,Affordabilitymeansmanythings.Thereweremoderateincome
loans.Thesewereteachers,thesewerefrefghters,theseweremunicipalemployees,
these were people with jobs who paid mortgages. These were not subprime, preda-
toryloansatall.
11
FannieandFreddiewerenowcrucialtothehousingmarket,buttheirdualmis-
sionspromoting mortgage lending while maximizing returns to shareholders
were problematic. Former Fannie CEO Daniel Mudd told the FCIC that the GSE
structurerequiredthecompaniestomaintainafnebalancebetweenfnancialgoals
andwhatwecallthemissiongoals . . .therootcauseoftheGSEstroubleslieswith
their business model.
1i
Former Freddie CEO Richard Syron concurred: I dont
thinkitsagoodbusinessmodel.
1
FannieandFreddieaccumulatedpoliticalcloutbecausetheydependedonfederal
subsidiesandanimplicitgovernmentguarantee,andbecausetheyhadtodealwith
regulators,affordablehousinggoals,andcapitalstandardsimposedbyCongressand
HUD.From1toioo8,thetworeportedspendingmorethan1omilliononlob-
bying,andtheiremployeesandpoliticalactioncommitteescontributed1,million
:itUii 1i / \1i uN \Ni iiii \\1i \i: ,.
to federal election campaigns.
1
The Fannie and Freddie political machine resisted
any meaningful regulation using highly improper tactics, Falcon, who regulated
them from 1 to ioo,, testifed. OFHEO was constantly subjected to malicious
political attacks and efforts of intimidation.
1,
James Lockhart, the director of
OFHEOanditssuccessor,theFederalHousingFinanceAgency,fromiooothrough
ioo, testifed that he argued for reform from the moment he became director and
thatthecompanieswereallowedtobe . . .sopoliticallystrongthatformanyyears
theyresistedtheverylegislationthatmighthavesavedthem.
1o
FormerHUDsecre-
taryMelMartinezdescribedtotheFCICthewholearmyoflobbyiststhatcontinu-
ally paraded in a bipartisan fashion through my omces. . . . Its pretty amazing the
numberofpeoplethatwereintheiremploy.
1,
In1,,thatarmyhelpedsecurenewregulationsallowingtheGSEstocountto-
wardtheiraffordablehousinggoalsnotjusttheirwholeloansbutmortgage-related
securitiesissuedbyothercompanies,whichtheGSEswantedtopurchaseasinvest-
ments.Still,CongressionalBudgetOmceDirectorJuneONeilldeclaredin18that
thegoalsarenotdimculttoachieve,anditisnotclearhowmuchtheyhaveaffected
theenterprisesactions.Infact . . .depositoryinstitutionsaswellastheFederalHous-
ingAdministrationdevotealargerproportionoftheirmortgagelendingtotargeted
borrowersandareasthandotheenterprises.
18
Somethingelsewasclear:FannieandFreddie,withtheirlowborrowingcostsand
laxcapitalrequirements,wereimmenselyproftablethroughoutthe1os.Iniooo,
Fannie had a return on equity of io; Freddie, . That year, Fannie and Freddie
heldorguaranteedmorethanitrillionofmortgages,backedbyonly,.,billion
ofshareholderequity.
1
STRUCTURED FINANCE:
IT WASN T REDUCING THE RISK
WhileFannieandFreddieenjoyedanear-monopolyonsecuritizingfxed-ratemort-
gagesthatwerewithintheirpermittedloanlimits,inthe18osthemarketsbeganto
securitize many other types of loans, including adjustable-rate mortgages (ARMs)
and other mortgages the GSEs were not eligible or willing to buy. The mechanism
workedthesame:aninvestmentbank,suchasLehmanBrothersorMorganStanley
(orasecuritiesamliateofabank),bundledloansfromabankorotherlenderintose-
curitiesandsoldthemtoinvestors,whoreceivedinvestmentreturnsfundedbythe
principalandinterestpaymentsfromtheloans.Investorsheldortradedthesesecuri-
ties,whichwereoftenmorecomplicatedthantheGSEsbasicmortgage-backedsecu-
rities;theassetswerenotjustmortgagesbutequipmentleases,creditcarddebt,auto
loans,andmanufacturedhousingloans.Overtime,banksandsecuritiesfrmsused
securitization to mimic banking activities outside the regulatory framework for
banks. For example, where banks traditionally took money from deposits to make
loans and held them until maturity, banks now used money from the capital mar-
ketsoftenfrommoneymarketmutualfundstomakeloans,packagingtheminto
securitiestoselltoinvestors.
,z ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
Forcommercialbanks,thebeneftswerelarge.Bymovingloansofftheirbooks,
the banks reduced the amount of capital they were required to hold as protection
against losses, thereby improving their earnings. Securitization also let banks rely
lessondepositsforfunding,becausesellingsecuritiesgeneratedcashthatcouldbe
usedtomakeloans.Bankscouldalsokeeppartsofthesecuritiesontheirbooksas
collateralforborrowing,andfeesfromsecuritizationbecameanimportantsourceof
revenues.
LawrenceLindsey,aformerFederalReservegovernorandthedirectoroftheNa-
tionalEconomicCouncilunderPresidentGeorgeW.Bush,toldtheFCICthatprevi-
oushousingdownturnsmaderegulatorsworryaboutbanksholdingwholeloanson
theirbooks.Ifyouhadaregional . . .realestatedownturnittookdownthebanksin
thatregionalongwithit,whichexacerbatedthedownturn,Lindseysaid.Sowesaid
to ourselves, How on earth do we get around this problem: And the answer was,
Letshaveanationalsecuritiesmarketsowedonthaveregionalconcentration. . . .It
wasintentional.
io
Privatesecuritizations,orstructuredfnancesecurities,hadtwokeybeneftstoin-
vestors:pooling andtranching.Ifmanyloanswerepooledintoonesecurity,afewde-
faultswouldhaveminimalimpact.Structuredfnancesecuritiescouldalsobesliced
upandsoldinportionsknownastrancheswhichletbuyerscustomizetheirpay-
ments.Risk-averseinvestorswouldbuytranchesthatpaidofffrstintheeventofde-
fault, but had lower yields. Return-oriented investors bought riskier tranches with
higher yields. Bankers often compared it to a waterfall; the holders of the senior
tranchesat the top of the waterfallwere paid before the more junior tranches.
Andifpaymentscameinbelowexpectations,thoseatthebottomwouldbethefrst
tobelefthighanddry.
Securitizationwasdesignedtobeneftlenders,investmentbankers,andinvestors.
Lendersearnedfeesfororiginatingandsellingloans.Investmentbanksearnedfees
forissuingmortgage-backedsecurities.Thesesecuritiesfetchedahigherpricethanif
theunderlyingloansweresoldindividually,becausethesecuritieswerecustomized
toinvestorsneeds,weremorediversifed,andcouldbeeasilytraded.Purchasersof
thesafertranchesgotahigherrateofreturnthanultra-safeTreasurynoteswithout
muchextrariskatleastintheory.However,thefnancialengineeringbehindthese
investmentsmadethemhardertounderstandandtopricethanindividualloans.To
determine likely returns, investors had to calculate the statistical probabilities that
certainkindsofmortgagesmightdefault,andtoestimatetherevenuesthatwouldbe
lostbecauseofthosedefaults.Theninvestorshadtodeterminetheeffectofthelosses
onthepaymentstodifferenttranches.
This complexity transformed the three leading credit rating agenciesMoodys,
Standard&Poors(S&P),andFitchintokeyplayersintheprocess,positionedbe-
tweentheissuersandtheinvestorsofsecurities.Beforesecuritizationbecamecom-
mon, the credit rating agencies had mainly helped investors evaluate the safety of
municipalandcorporatebondsandcommercialpaper.Althoughevaluatingproba-
bilities was their stock-in-trade, they found that rating these securities required a
newtypeofanalysis.
:itUii 1i / \1i uN \Ni iiii \\1i \i: ,,
,, ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
Participantsinthesecuritizationindustryrealizedthattheyneededtosecurefavor-
able credit ratings in order to sell structured products to investors. Investment banks
thereforepaidhandsomefeestotheratingagenciestoobtainthedesiredratings.The
ratingagencieswereimportanttoolstodothatbecauseyouknowthepeoplethatwe
were selling these bonds to had never really had any history in the mortgage busi-
ness. . . .Theywerelookingforanindependentpartytodevelopanopinion,JimCalla-
han told the FCIC; Callahan is CEO of PentAlpha, which services the securitization
industry,andyearsagoheworkedonsomeoftheearliestsecuritizations.
i1
Withthesepiecesinplacebanksthatwantedtoshedassetsandtransferrisk,in-
vestorsreadytoputtheirmoneytowork,securitiesfrmspoisedtoearnfees,rating
agenciesreadytoexpand,andinformationtechnologycapableofhandlingthejob
the securitization market exploded. By 1, when the market was 1o years old,
about oo billion worth of securitizations, beyond those done by Fannie, Freddie,
andGinnie,wereoutstanding(seefgure.1).Thatincluded11billionofautomo-
bileloansandoveri,obillionofcreditcarddebt;nearly1,obillionworthofsecu-
ritiesweremortgagesineligibleforsecuritizationbyFannieandFreddie.Manywere
subprime.
ii
Securitization was not just a boon for commercial banks; it was also a lucrative
newlineofbusinessfortheWallStreetinvestmentbanks,withwhichthecommercial
banksworkedtocreatethenewsecurities.WallStreetfrmssuchasSalomonBroth-
ers and Morgan Stanley became major players in these complex markets and relied
increasingly on quantitative analysts, called quants. As early as the 1,os, Wall
Streetexecutiveshadhiredquantsanalystsadeptinadvancedmathematicaltheory
and computersto develop models to predict how markets or securities might
change.Securitizationincreasedtheimportanceofthisexpertise.ScottPatterson,au-
thorofThe Quants, toldtheFCICthatusingmodelsdramaticallychangedfnance.
WallStreetisessentiallyfoatingonaseaofmathematicsandcomputerpower,Pat-
tersonsaid.
i
The increasing dependence on mathematics let the quants create more complex
productsandlettheirmanagerssay,andmaybeevenbelieve,thattheycouldbetter
manage those products risk. JP Morgan developed the frst Value at Risk model
(VaR),andtheindustrysoonadopteddifferentversions.Thesemodelspurportedto
predict with at least , certainty how much a frm could lose if market prices
changed.
i
But models relied on assumptions based on limited historical data; for
mortgage-backed securities, the models would turn out to be woefully inadequate.
Andmodelinghumanbehaviorwasdifferentfromtheproblemsthequantshadad-
dressedingraduateschool.Itsnotliketryingtoshootarockettothemoonwhere
you know the law of gravity, Emanuel Derman, a Columbia University fnance
professor who worked at Goldman Sachs for 1, years, told the Commission. The
waypeoplefeelaboutgravityonagivendayisntgoingtoaffectthewaytherocket
behaves.
i,
PaulVolcker,Fedchairmanfrom1,to18,,toldtheCommissionthatregula-
torswereconcernedasearlyasthelate18osthatoncebanksbegansellinginsteadof
holding the loans they were making, they would care less about loan quality. Yet as
theseinstrumentsbecameincreasinglycomplex,regulatorsincreasinglyreliedonthe
bankstopolicetheirownrisks.Itwasalltiedupinthehubrisoffnancialengineers,
but the greater hubris let markets take care of themselves, Volcker said.
io
Vincent
Reinhart,aformerdirectoroftheFedsDivisionofMonetaryAffairs,toldtheCom-
missionthatheandotherregulatorsfailedtoappreciatethecomplexityofthenewf-
nancialinstrumentsandthedimcultiesthatcomplexityposedinassessingrisk.
i,
Securitization was diversifying the risk, said Lindsey, the former Fed governor.
Butitwasntreducingtherisk. . . .Youasanindividualcandiversifyyourrisk.Thesys-
temasawhole,though,cannotreducetherisk.Andthatswheretheconfusionlies.
i8
THE GROWTH OF DERIVATIVES: BY FAR THE MOST
SIGNIFICANT EVENT IN FINANCE DURING THE PAST DECADE
During the fnancial crisis, leverage and complexity became closely identifed with
oneelementofthestory:derivatives.Derivativesarefnancialcontractswhoseprices
aredeterminedby,orderivedfrom,thevalueofsomeunderlyingasset,rate,index,
:itUii 1i / \1i uN \Ni iiii \\1i \i: ,,
In the 1990s, many kinds of loans were packaged into asset-backed securities.
SOURCE: Securities Industry and Financial Markets Association
Asset-Backed Securities Outstanding
IN BILLIONS OF DOLLARS
0
$1,000
800
600
400
200
85 90 87 86 88 89 91 92 94 96 98 93 95 97 99
NOTE: Residential loans do not include loans securitized by government-sponsored enterprises.
Manufactured
housing
Automobile
Credit card
Equipment
Other
Student
loans
Home equity
and other
residential
Iigurc .+
, ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
or event. They are not used for capital formation or investment, as are securities;
rather,theyareinstrumentsforhedgingbusinessriskorforspeculatingonchanges
inprices,interestrates,andthelike.Derivativescomeinmanyforms;themostcom-
mon are over-the-counter-swaps and exchange-traded futures and options.
i
They
maybebasedoncommodities(includingagriculturalproducts,metals,andenergy
products),interestrates,currencyrates,stocksandindexes,andcreditrisk.Theycan
evenbetiedtoeventssuchashurricanesorannouncementsofgovernmentfgures.
Manyfnancialandcommercialfrmsusesuchderivatives.Afrmmayhedgeits
priceriskbyenteringintoaderivativescontractthatoffsetstheeffectofpricemove-
ments. Losses suffered because of price movements can be recouped through gains
onthederivativescontract.Institutionalinvestorsthatarerisk-aversesometimesuse
interest rate swaps to reduce the risk to their investment portfolios of infation and
rising interest rates by trading fxed interest payments for foating payments with
risk-taking entities, such as hedge funds. Hedge funds may use these swaps for the
purposeofspeculating,inhopesofproftingontheriseorfallofapriceorinterest
rate.
Thederivativesmarketsareorganizedasexchangesorasover-the-counter(OTC)
markets,althoughsomerecentelectronictradingfacilitiesblurthedistinctions.The
oldest U.S. exchange is the Chicago Board of Trade, where futures and options are
traded. Such exchanges are regulated by federal law and play a useful role in price
discoverythatis,inrevealingthemarketsviewonpricesofcommoditiesorrates
underlyingfuturesandoptions.OTCderivativesaretradedbylargefnancialinstitu-
tionstraditionally, bank holding companies and investment bankswhich act as
derivatives dealers, buying and selling contracts with customers. Unlike the futures
andoptionsexchanges,theOTCmarketisneithercentralizednorregulated.Norisit
transparent,andthuspricediscoveryislimited.Nomatterthemeasurementtrad-
ing volume, dollar volume, risk exposurederivatives represent a very signifcant
sectoroftheU.S.fnancialsystem.
The principal legislation governing these markets is the Commodity Exchange
Act of 1o, which originally applied only to derivatives on domestic agricultural
products.In1,,Congressamendedtheacttorequirethatfuturesandoptionscon-
tracts on virtually all commodities, including fnancial instruments, be traded on a
regulatedexchange,andcreatedanewfederalindependentagency,theCommodity
FuturesTradingCommission(CFTC),toregulateandsupervisethemarket.
o
Outside of this regulated market, an over-the-counter market began to develop
andgrowrapidlyinthe18os.ThelargefnancialinstitutionsactingasOTCderiva-
tives dealers worried that the Commodity Exchange Acts requirement that trading
occur on a regulated exchange might be applied to the products they were buying
andselling.In1,theCFTCsoughttoaddresstheseconcernsbyexemptingcer-
tainnonstandardizedOTCderivativesfromthatrequirementandfromcertainother
provisions of the Commodity Exchange Act, except for prohibitions against fraud
andmanipulation.
1
As the OTC market grew following the CFTCs exemption, a wave of signifcant
lossesandscandalshitthemarket.Amongmanyexamples,in1Procter&Gamble,
a leading consumer products company, reported a pretax loss of 1,, million, the
largestderivativeslossbyanonfnancialfrm,stemmingfromOTCinterestandforeign
exchangeratederivativessoldtoitbyBankersTrust.Procter&GamblesuedBankers
Trust for frauda suit settled when Bankers Trust forgave most of the money that
Procter&Gambleowedit.Thatyear,theCFTCandtheSecuritiesandExchangeCom-
mission(SEC)fnedBankersTrust1omillionformisleadingGibsonGreetingCards
on interest rate swaps resulting in a mark-to-market loss of i million, larger than
Gibsonsprior-yearprofts.Inlate1,OrangeCounty,California,announcedithad
lost1.,billionspeculatinginOTCderivatives.Thecountyfledforbankruptcythe
largestbyamunicipalityinU.S.history.Itsderivativesdealer,MerrillLynch,paidoo
milliontosettleclaims.
i
Inresponse,theU.S.GeneralAccountingOmceissuedare-
port on fnancial derivatives that found dangers in the concentration of OTC deriva-
tives activity among 1, major dealers, concluding that the sudden failure or abrupt
withdrawalfromtradingofanyoneoftheselargedealerscouldcauseliquidityprob-
lemsinthemarketsandcouldalsoposeriskstotheothers,includingfederallyinsured
banksandthefnancialsystemasawhole.

WhileCongressthenheldhearingsonthe
OTCderivativesmarket,theadoptionofregulatorylegislationfailedamidintenselob-
byingbytheOTCderivativesdealersandoppositionbyFedChairmanGreenspan.
In 1o, Japans Sumitomo Corporation lost i.o billion on copper derivatives
traded on a London exchange. The CFTC charged the company with using deriva-
tivestomanipulatecopperprices,includingusingOTCderivativescontractstodis-
guisethespeculationandtofnancethescheme.Sumitomosettledfor1,omillion
in penalties and restitution. The CFTC also charged Merrill Lynch with knowingly
andintentionallyaiding,abetting,andassistingthemanipulationofcopperprices;it
settledforafneof1,million.

Debateintensifedin18.InMay,theCFTCunderChairpersonBrooksleyBorn
said the agency would reexamine the way it regulated the OTC derivatives market,
given the markets rapid evolution and the string of major losses since 1. The
CFTCrequestedcomments.Itgotthem.
Somecamefromotherregulators,whotooktheunusualstepofpubliclycriticiz-
ingtheCFTC.OnthedaythattheCFTCissuedaconceptrelease,TreasurySecretary
RobertRubin,Greenspan,andSECChairmanArthurLevittissuedajointstatement
denouncing the CFTCs move: We have grave concerns about this action and its
possibleconsequences. . . .WeareveryconcernedaboutreportsthattheCFTCsac-
tion may increase the legal uncertainty concerning certain types of OTC deriva-
tives.
,
They proposed a moratorium on the CFTCs ability to regulate OTC
derivatives.
Formonths,Rubin,Greenspan,Levitt,andDeputyTreasurySecretaryLawrence
SummersopposedtheCFTCseffortsintestimonytoCongressandinotherpublic
pronouncements.AsAlanGreenspansaid:Asidefromsafetyandsoundnessregula-
tionofderivativesdealersunderthebankingandsecuritieslaws,regulationofderiv-
ativestransactionsthatareprivatelynegotiatedbyprofessionalsisunnecessary.
o
InSeptember,theFederalReserveBankofNewYorkorchestrateda.obillion
recapitalization of Long-Term Capital Management (LTCM) by 1 major OTC
:itUii 1i / \1i uN \Ni iiii \\1i \i: ,,
derivatives dealers. An enormous hedge fund, LTCM had amassed more than 1
trillioninnotionalamountofOTCderivativesand1i,billionofsecuritieson.8
billion of capital without the knowledge of its major derivatives counterparties or
federal regulators.
,
Greenspan testifed to Congress that in the New York Feds
judgment,LTCMsfailurewouldpotentiallyhavehadsystemiceffects:adefaultby
LTCM would not only have a signifcant distorting impact on market prices but
also in the process could produce large losses, or worse, for a number of creditors
and counterparties, and for other market participants who were not directly in-
volvedwithLTCM.
8
Nonetheless, just weeks later, in October 18, Congress passed the requested
moratorium.
Greenspan continued to champion derivatives and advocate deregulation of the
OTCmarketandtheexchange-tradedmarket.Byfarthemostsignifcanteventin
fnanceduringthepastdecadehasbeentheextraordinarydevelopmentandexpan-
sionoffnancialderivatives,GreenspansaidataFuturesIndustryAssociationcon-
ference in March 1. The fact that the OTC markets function quite effectively
without the benefts of [CFTC regulation] provides a strong argument for develop-
mentofalessburdensomeregimeforexchange-tradedfnancialderivatives.

The following yearafter Borns resignationthe Presidents Working Group on


FinancialMarkets,acommitteeoftheheadsoftheTreasury,FederalReserve,SEC,and
CommodityFuturesTradingCommissionchargedwithtrackingthefnancialsystem
and chaired by then Treasury Secretary Larry Summers, essentially adopted
Greenspansview.ThegroupissuedareporturgingCongresstoderegulateOTCderiv-
ativesbroadlyandtoreduceCFTCregulationofexchange-tradedderivativesaswell.
o
In December iooo, in response, Congress passed and President Clinton signed
the Commodity Futures Modernization Act of iooo (CFMA), which in essence
deregulatedtheOTCderivativesmarketandeliminatedoversightbyboththeCFTC
and the SEC. The law also preempted application of state laws on gaming and on
bucketshops(illegalbrokerageoperations)thatotherwisecouldhavemadeOTCde-
rivativestransactionsillegal.TheSECdidretainantifraudauthorityoversecurities-
based OTC derivatives such as stock options. In addition, the regulatory powers of
theCFTCrelatingtoexchange-tradedderivativeswereweakenedbutnoteliminated.
The CFMA effectively shielded OTC derivatives from virtually all regulation or
oversight.Subsequently,otherlawsenabledtheexpansionofthemarket.Forexam-
ple, under a ioo, amendment to the bankruptcy laws, derivatives counterparties
weregiventheadvantageoverothercreditorsofbeingabletoimmediatelyterminate
theircontractsandseizecollateralatthetimeofbankruptcy.
The OTC derivatives market boomed. At year-end iooo, when the CFMA was
passed,thenotionalamountofOTCderivativesoutstandinggloballywas,.itril-
lion,andthegrossmarketvaluewas.itrillion.
1
Inthesevenandahalfyearsfrom
then until June ioo8, when the market peaked, outstanding OTC derivatives in-
creasedmorethansevenfoldtoanotionalamountofo,i.otrillion;theirgrossmar-
ketvaluewasio.trillion.
i
Greenspan testifed to the FCIC that credit default swapsa small part of the
, ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
market when Congress discussed regulating derivatives in the 1osdid create
problems during the fnancial crisis.

Rubin testifed that when the CFMA passed


hewasnotopposedtotheregulationofderivativesandhadpersonallyagreedwith
Bornsviews,butthatverystronglyheldviewsinthefnancialservicesindustryin
oppositiontoregulationwereinsurmountable.

SummerstoldtheFCICthatwhile
risks could not necessarily have been foreseen years ago, by ioo8 our regulatory
frameworkwithrespecttoderivativeswasmanifestlyinadequate,andthatthede-
rivativesthatprovedtobebyfarthemostserious,thoseassociatedwithcreditdefault
swaps,increased1oofoldbetweenioooandioo8.
,
Onereasonfortherapidgrowthofthederivativesmarketwasthecapitalrequire-
mentsadvantagethatmanyfnancialinstitutionscouldobtainthroughhedgingwith
derivatives. As discussed above, fnancial frms may use derivatives to hedge their
risks.SuchuseofderivativescanlowerafrmsValueatRiskasdeterminedbycom-
putermodels.Inadditiontogainingthisadvantageinriskmanagement,suchhedges
can lower the amount of capital that banks are required to hold, thanks to a 1o
amendment to the regulatory regime known as the Basel International Capital Ac-
cord,orBaselI.
MeetinginBasel,Switzerland,in188,theworldscentralbanksandbanksuper-
visors adopted principles for banks capital standards, and U.S. banking regulators
madeadjustmentstoimplementthem.Amongthemostimportantwastherequire-
ment that banks hold more capital against riskier assets. Fatefully, the Basel rules
made capital requirements for mortgages and mortgage-backed securities looser
thanforallotherassetsrelatedtocorporateandconsumerloans.
o
Indeed,capitalre-
quirementsforbanksholdingsofFanniesandFreddiessecuritieswerelessthanfor
allotherassetsexceptthoseexplicitlybackedbytheU.S.government.
,
Theseinternationalcapitalstandardsaccommodatedtheshifttoincreasedlever-
age. In 1o, large banks sought more favorable capital treatment for their trading,
andtheBaselCommitteeonBankingSupervisionadoptedtheMarketRiskAmend-
menttoBaselI.Thisprovidedthatifbankshedgedtheircreditormarketrisksusing
derivatives, they could hold less capital against their exposures from trading and
otheractivities.
8
OTCderivativesletderivativestradersincludingthelargebanksandinvestment
banksincreasetheirleverage.Forexample,enteringintoanequityswapthatmim-
icked the returns of someone who owned the actual stock may have had some up-
front costs, but the amount of collateral posted was much smaller than the upfront
costofpurchasingthestockdirectly.Oftennocollateralwasrequiredatall.Traders
couldusederivativestoreceivethesamegainsorlossesasiftheyhadboughtthe
actualsecurity,andwithonlyafractionofabuyersinitialfnancialoutlay.

Warren
Buffett,thechairmanandchiefexecutiveomcerofBerkshireHathawayInc.,testifed
totheFCICabouttheuniquecharacteristicsofthederivativesmarket,saying,they
accentuatedenormously,inmyview,theleverageinthesystem.Hewentontocall
derivativesverydangerousstuff,dimcultformarketparticipants,regulators,audi-
tors,andinvestorstounderstandindeed,heconcluded,IdontthinkIcouldman-
ageacomplexderivativesbook.
,o
:itUii 1i / \1i uN \Ni iiii \\1i \i: ,,
A key OTC derivative in the fnancial crisis was the credit default swap (CDS),
whichofferedtheselleralittlepotentialupsideattherelativelysmallriskofapoten-
tiallylargedownside.ThepurchaserofaCDStransferredtothesellerthedefaultrisk
ofanunderlyingdebt.Thedebtsecuritycouldbeanybondorloanobligation.The
CDS buyer made periodic payments to the seller during the life of the swap. In re-
turn,thesellerofferedprotectionagainstdefaultorspecifedcrediteventssuchasa
partialdefault.Ifacrediteventsuchasadefaultoccurred,theCDSsellerwouldtypi-
callypaythebuyerthefacevalueofthedebt.
Creditdefaultswapswereoftencomparedtoinsurance:thesellerwasdescribedas
insuringagainstadefaultintheunderlyingasset.However,whilesimilartoinsurance,
CDS escaped regulation by state insurance supervisors because they were treated as
deregulatedOTCderivatives.ThismadeCDSverydifferentfrominsuranceinatleast
twoimportantrespects.First,onlyapersonwithaninsurableinterestcanobtainan
insurancepolicy.Acarownercaninsureonlythecarsheownsnotherneighbors.
ButaCDSpurchasercanuseittospeculateonthedefaultofaloanthepurchaserdoes
notown.Theseareoftencallednakedcreditdefaultswapsandcaninfatepotential
lossesandcorrespondinggainsonthedefaultofaloanorinstitution.
Before the CFMA was passed, there was uncertainty about whether or not state
insurance regulators had authority over credit default swaps. In June iooo, in re-
sponsetoaletterfromthelawfrmofSkadden,Arps,Slate,Meagher&Flom,LLP,
the New York State Insurance Department determined that naked credit default
swapsdidnotcountasinsuranceandwerethereforenotsubjecttoregulation.
,1
In addition, when an insurance company sells a policy, insurance regulators re-
quirethatitputasidereservesincaseofaloss.Inthehousingboom,CDSweresold
byfrmsthatfailedtoputupanyreservesorinitialcollateralortohedgetheirexpo-
sure.Intherun-uptothecrisis,AIG,thelargestU.S.insurancecompany,wouldac-
cumulate a one-half trillion dollar position in credit risk through the OTC market
withoutbeingrequiredtopostonedollarsworthofinitialcollateralormakingany
otherprovisionforloss.
,i
AIGwasnotalone.Thevalueoftheunderlyingassetsfor
CDSoutstandingworldwidegrewfromo.trillionattheendofiootoapeakof
,8.itrillionattheendofioo,.
,
Asignifcantportionwasapparentlyspeculativeor
nakedcreditdefaultswaps.
,
Much of the risk of CDS and other derivatives was concentrated in a few of the
verylargestbanks,investmentbanks,andotherssuchasAIGFinancialProducts,a
unitofAIG
,,
thatdominateddealinginOTCderivatives.AmongU.S.bankholding
companies, , of the notional amount of OTC derivatives, millions of contracts,
weretradedbyjustfve largeinstitutions(inioo8,JPMorganChase,Citigroup,Bank
ofAmerica,Wachovia,andHSBC)manyofthesamefrmsthatwouldfndthem-
selves in trouble during the fnancial crisis.
,o
The countrys fve largest investment
bankswerealsoamongtheworldslargestOTCderivativesdealers.
While fnancial institutions surveyed by the FCIC said they do not track rev-
enuesandproftsgeneratedbytheirderivativesoperations,somefrmsdidprovide
estimates.Forexample,GoldmanSachsestimatedthatbetweeni,and,ofits
revenuesfromiooothroughiooweregeneratedbyderivatives,including,oto
,+ ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
,,ofthefrmscommoditiesbusiness,andhalformoreofitsinterestrateandcur-
renciesbusiness.FromMayioo,throughNovemberioo8,1billion,or8o,of
the1,,billionoftradesmadebyGoldmansmortgagedepartmentwerederivative
transactions.
,,
Whenthenationsbiggestfnancialinstitutionswereteeteringontheedgeoffail-
ure in ioo8, everyone watched the derivatives markets. What were the institutions
holdings:Whowerethecounterparties:Howwouldtheyfare:Marketparticipants
andregulatorswouldfndthemselvesstrainingtounderstandanunknownbattlefeld
shapedbyunseenexposuresandinterconnectionsastheyfoughttokeepthefnan-
cialsystemfromcollapsing.
:itUii 1i / \1i uN \Ni iiii \\1i \i: ,.
4
DEREGULATION REDUX
CONTENTS
Lxpansicncj|ankingactiviticsShattcrcrcjG|ass-Stcaga|| ,:
Icng-1crnCapita|Managcncnt
1hatswhathistcryhadprcvcdtcthcn ,e
Dct-ccncrashIaycnncrcrisk,,
1hcwagcscjnanccVc||,thiscncsdcingit,schcwcanInctdcit? e+
Iinancia|scctcrgrcwth
Ithinkwccvcrdidnanccvcrsusthcrca|cccncnye,
EXPANSION OF BANKING ACTIVITIES:
SHATTERER OF GLASSSTEAGALL
By the mid-1os, the parallel banking system was booming, some of the largest
commercial banks appeared increasingly like the large investment banks, and all of
themwerebecominglarger,morecomplex,andmoreactiveinsecuritization.Some
academics and industry analysts argued that advances in data processing, telecom-
munications, and information services created economies of scale and scope in f-
nance and thereby justifed ever-larger fnancial institutions. Bigger would be safer,
the argument went, and more diversifed, innovative, emcient, and better able to
serve the needs of an expanding economy. Others contended that the largest banks
were not necessarily more emcient but grew because of their commanding market
positionsandcreditorsperceptiontheyweretoobigtofail.Astheygrew,thelarge
banks pressed regulators, state legislatures, and Congress to remove almost all re-
mainingbarrierstogrowthandcompetition.Theyhadmuchsuccess.In1Con-
gress authorized nationwide banking with the Riegle-Neal Interstate Banking and
Branching Emciency Act. This let bank holding companies acquire banks in every
state,andremovedmostrestrictionsonopeningbranchesinmorethanonestate.It
preempted any state law that restricted the ability of out-of-state banks to compete
withinthestatesborders.
1
Removing barriers helped consolidate the banking industry. Between 1o and
ioo,,,megamergersoccurredinvolvingbankswithassetsofmorethan1obil-
lioneach.Meanwhilethe1olargestjumpedfromowningi,oftheindustrysassets
,z
to,,.From18toioo,,thecombinedassetsofthefvelargestU.S.banksBank
of America, Citigroup, JP Morgan, Wachovia, and Wells Fargomore than tripled,
from i.i trillion to o.8 trillion.
i
And investment banks were growing bigger, too.
SmithBarneyacquiredShearsonin1andSalomonBrothersin1,,whilePaine
WebberpurchasedKidder,Peabodyin1,.Twoyearslater,MorganStanleymerged
with Dean Witter, and Bankers Trust purchased Alex. Brown & Sons. The assets of
the fve largest investment banksGoldman Sachs, Morgan Stanley, Merrill Lynch,
LehmanBrothers,andBearStearnsquadrupled,from1trillionin18totril-
lioninioo,.

In 1o, the Economic Growth and Regulatory Paperwork Reduction Act re-
quiredfederalregulatorstoreviewtheirruleseverydecadeandsolicitcommentson
outdated, unnecessary, or unduly burdensome rules.

Some agencies responded


with gusto. In ioo, the Federal Deposit Insurance Corporations annual report in-
cluded a photograph of the vice chairman, John Reich; the director of the Omce of
Thrift Supervision (OTS), James Gilleran; and three banking industry representa-
tivesusingachainsawandpruningshearstocuttheredtapebindingalargestack
ofdocumentsrepresentingregulations.
Lessenthusiasticagenciesfeltheat.FormerSecuritiesandExchangeCommission
chairman Arthur Levitt told the FCIC that once word of a proposed regulation got
out, industry lobbyists would rush to complain to members of the congressional
committee with jurisdiction over the fnancial activity at issue. According to Levitt,
these members would then harass the SEC with frequent letters demanding an-
swers to complex questions and appearances of omcials before Congress. These re-
quests consumed much of the agencys time and discouraged it from making
regulations. Levitt described it as kind of a blood sport to make the particular
agencylookstupidorineptorvenal.
,
However,otherssaidinterferenceatleastfromtheexecutivebranchwasmod-
est. John Hawke, a former comptroller of the currency, told the FCIC he found the
TreasuryDepartmentexceedinglysensitivetohisagencysindependence.Hissuc-
cessor,JohnDugan,saidstatutoryfrewallspreventedinterferencefromtheexecu-
tivebranch.
o
Deregulationwentbeyonddismantlingregulations;itssupporterswerealsodisin-
clined to adopt new regulations or challenge industry on the risks of innovations.
FederalReserveomcialsarguedthatfnancialinstitutions,withstrongincentivesto
protect shareholders, would regulate themselves by carefully managing their own
risks. In a ioo speech, Fed Vice Chairman Roger Ferguson praised the truly im-
pressive improvement in methods of risk measurement and management and the
growingadoptionofthesetechnologiesbymostlylargebanksandotherfnancialin-
termediaries.
,
Likewise,Fedandotheromcialsbelievedthatmarketswouldself-reg-
ulate through the activities of analysts and investors. It is critically important to
recognize that no market is ever truly unregulated, said Fed Chairman Alan
Greenspanin1,.Theself-interestofmarketparticipantsgeneratesprivatemarket
regulation. Thus, the real question is not whether a market should be regulated.
iiiitUi\1i uN iiiU\ ,,
Rather,therealquestioniswhethergovernmentinterventionstrengthensorweakens
privateregulation.
8
RichardSpillenkothen,theFedsdirectorofBankingSupervisionandRegulation
from 11 to iooo, discussed banking supervision in a memorandum submitted to
the FCIC: Supervisors understood that forceful and proactive supervision, espe-
ciallyearlyinterventionbeforemanagementweaknesseswererefectedinpoorfnan-
cial performance, might be viewed as i) overly-intrusive, burdensome, and
heavy-handed,ii)anundesirableconstraintoncreditavailability,oriii)inconsistent
withtheFedspublicposture.

To create checks and balances and keep any agency from becoming arbitrary or
infexible, senior policy makers pushed to keep multiple regulators.
1o
In 1,
Greenspan testifed against proposals to consolidate bank regulation: The current
structure provides banks with a method . . . of shifting their regulator, an effective
testthatprovidesalimitonthearbitrarypositionorexcessivelyrigidpostureofany
oneregulator.Thepressureofapotentiallossofinstitutionshasinhibitedexcessive
regulation and acted as a countervailing force to the bias of a regulatory agency to
overregulate.
11
Further,someregulators,includingtheOTSandOmceoftheComp-
trolleroftheCurrency(OCC),werefundedlargelybyassessmentsfromtheinstitu-
tionstheyregulated.Asaresult,thelargerthenumberofinstitutionsthatchosethese
regulators,thegreatertheirbudget.
Emboldenedbysuccessandthetenorofthetimes,thelargestbanksandtheirreg-
ulatorscontinuedtoopposelimitsonbanksactivitiesorgrowth.Thebarrierssepa-
rating commercial banks and investment banks had been crumbling, little by little,
andnowseemedthetimetoremovethelastremnantsoftherestrictionsthatsepa-
ratedbanks,securitiesfrms,andinsurancecompanies.
Inthespringof1o,afteryearsofopposingrepealofGlass-Steagall,theSecuri-
tiesIndustryAssociationthetradeorganizationofWallStreetfrmssuchasGold-
man Sachs and Merrill Lynchchanged course. Because restrictions on banks had
beenslowlyremovedduringthepreviousdecade,banksalreadyhadbeachheadsin
securities and insurance. Despite numerous lawsuits against the Fed and the OCC,
securities frms and insurance companies could not stop this piecemeal process of
deregulation through agency rulings.
1i
Edward Yingling, the CEO of the American
Bankers Association (a lobbying organization), said, Because we had knocked so
many holes in the walls separating commercial and investment banking and insur-
ance,wewereabletoaggressivelyentertheirbusinessesinsomecasesmoreaggres-
sivelythantheycouldenterours.Sofrstthesecuritiesindustry,thentheinsurance
companies,andfnallytheagentscameoverandsaidletsnegotiateadealandwork
together.
1
In 18, Citicorp forced the issue by seeking a merger with the insurance giant
TravelerstoformCitigroup.TheFedapprovedit,citingatechnicalexemptiontothe
Bank Holding Company Act,
1
but Citigroup would have to divest itself of many
Travelersassetswithinfveyearsunlessthelawswerechanged.Congresshadtomake
adecision:Wasitpreparedtobreakupthenationslargestfnancialfrm:Wasittime
torepealtheGlass-SteagallAct,onceandforall:
,, ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
AsCongressbeganfashioninglegislation,thebankswerecloseathand.In1,
thefnancialsectorspent18,millionlobbyingatthefederallevel,andindividuals
andpoliticalactioncommittees(PACs)inthesectordonatedioimilliontofederal
electioncampaignsintheioooelectioncycle.From1throughioo8,federallob-
byingbythefnancialsectorreachedi.,billion;campaigndonationsfromindivid-
ualsandPACstopped1billion.
1,
In November 1, Congress passed and President Clinton signed the Gramm-
Leach-Bliley Act (GLBA), which lifted most of the remaining Glass-Steagall-era re-
strictions. The new law embodied many of the measures Treasury had previously
advocated.
1o
TheNew York Times reportedthatCitigroupCEOSandyWeillhungin
his omce a hunk of woodat least feet wideetched with his portrait and the
wordsTheShattererofGlass-Steagall.
1,
Now, as long as bank holding companies satisfed certain safety and soundness
conditions,theycouldunderwriteandsellbanking,securities,andinsuranceprod-
ucts and services. Their securities amliates were no longer bound by the Feds i,
limittheirprimaryregulator,theSEC,settheironlyboundaries.Supportersofthe
legislationarguedthatthenewholdingcompanieswouldbemoreproftable(dueto
economies of scale and scope), safer (through a broader diversifcation of risks),
moreusefultoconsumers(thankstotheconvenienceofone-stopshoppingforfnan-
cialservices),andmorecompetitivewithlargeforeignbanks,whichalreadyoffered
loans,securities,andinsuranceproducts.Thelegislationsopponentswarnedthatal-
lowingbankstocombinewithsecuritiesfrmswouldpromoteexcessivespeculation
andcouldtriggeracrisislikethecrashof1i.JohnReed,formerco-CEOofCiti-
group,acknowledgedtotheFCICthat,inhindsight,thecompartmentalizationthat
was created by Glass-Steagall would be a positive factor, making less likely a cata-
strophicfailureofthefnancialsystem.
18
Towinthesecuritiesindustryssupport,thenewlawleftinplacetwoexceptions
thatletsecuritiesfrmsownthriftsandindustrialloancompanies,atypeofdeposi-
tory institution with stricter limits on its activities. Through them, securities frms
couldaccessFDIC-insureddepositswithoutsupervisionbytheFed.Somesecurities
frms immediately expanded their industrial loan company and thrift subsidiaries.
Merrillsindustrialloancompanygrewfromlessthan1billioninassetsin18to
billionin1,andto,8billioninioo,.Lehmansthriftgrewfrom88million
in18tobillionin1,anditsassetsroseashighasibillioninioo,.
1
ForinstitutionsregulatedbytheFed,thenewlawalsoestablishedahybridregula-
torystructureknowncolloquiallyasFed-Lite.TheFedsupervisedfnancialholding
companiesasawhole,lookingonlyforrisksthatcutacrossthevarioussubsidiaries
ownedbytheholdingcompany.Toavoidduplicatingotherregulatorswork,theFed
was required to rely to the fullest extent possible on examinations and reports of
thoseagenciesregardingsubsidiariesoftheholdingcompany,includingbanks,secu-
ritiesfrms,andinsurancecompanies.TheexpressedintentofFed-Litewastoelimi-
nate excessive or duplicative regulation.
io
However, Fed Chairman Ben Bernanke
toldtheFCICthatFed-Litemadeitdimcultforanysingleregulatortoreliablysee
the whole picture of activities and risks of large, complex banking institutions.
i1
iiiitUi\1i uN iiiU\ ,,
Indeed, the regulators, including the Fed, would fail to identify excessive risks and
unsoundpracticesbuildingupinnonbanksubsidiariesoffnancialholdingcompa-
niessuchasCitigroupandWachovia.
ii
The convergence of banks and securities frms also undermined the supportive
relationshipbetweenbankingandsecuritiesmarketsthatFedChairmanGreenspan
hadconsideredasourceofstability.Hecomparedittoasparetire:iflargecommer-
cial banks ran into trouble, their large customers could borrow from investment
banksandothersinthecapitalmarkets;ifthosemarketsfroze,bankscouldlendus-
ingtheirdeposits.After1o,securitizedmortgagelendingprovidedanothersource
ofcredittohomebuyersandotherborrowersthatsoftenedasteepdeclineinlending
by thrifts and banks. The systems resilience following the crisis in Asian fnancial
marketsinthelate1osfurtherprovedhispoint,Greenspansaid.
i
The new regime encouraged growth and consolidation within and across bank-
ing,securities,andinsurance.Thebank-centeredfnancialholdingcompaniessuch
asCitigroup,JPMorgan,andBankofAmericacouldcompetedirectlywiththebig
fve investment banksGoldman Sachs, Morgan Stanley, Merrill Lynch, Lehman
Brothers, and Bear Stearnsin securitization, stock and bond underwriting, loan
syndication, and trading in over-the-counter (OTC) derivatives. The biggest bank
holding companies became major players in investment banking. The strategies of
thelargestcommercialbanksandtheirholdingcompaniescametomorecloselyre-
semble the strategies of investment banks. Each had advantages: commercial banks
enjoyed greater access to insured deposits, and the investment banks enjoyed less
regulation.Bothprosperedfromthelate1osuntiltheoutbreakofthefnancialcri-
sisinioo,.However,Greenspanssparetirethathadhelpedmakethesystemless
vulnerable would be gone when the fnancial crisis emergedall the wheels of the
systemwouldbespinningonthesameaxle.
LONGTERM CAPITAL MANAGEMENT:
THAT S WHAT HISTORY HAD PROVED TO THEM
InAugust18,Russiadefaultedonpartofitsnationaldebt,panickingmarkets.Rus-
siaannounceditwouldrestructureitsdebtandpostponesomepayments.Intheaf-
termath,investorsdumpedhigher-risksecurities,includingthosehavingnothingto
do with Russia, and fed to the safety of U.S. Treasury bills and FDIC-insured de-
posits. In response, the Federal Reserve cut short-term interest rates three times in
sevenweeks.
i
Withthecommercialpapermarketinturmoil,itwasuptothecom-
mercialbankstotakeuptheslackbylendingtocorporationsthatcouldnotrollover
their short-term paper. Banks loaned o billion in September and October of
18abouti.,timestheusualamount
i,
andhelpedpreventaseriousdisruption
frombecomingmuchworse.Theeconomyavoidedaslump.
NotsoforLong-TermCapitalManagement,alargeU.S.hedgefund.LTCMhad
devastatinglossesonits1i,billionportfolioofhigh-riskdebtsecurities,including
the junk bonds and emerging market debt that investors were dumping.
io
To buy
thesesecurities,thefrmhadborrowediforevery1ofinvestorsequity;
i,
lenders
, ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
included Merrill Lynch, JP Morgan, Morgan Stanley, Lehman Brothers, Goldman
Sachs, and Chase Manhattan. The previous four years, LTCMs leveraging strategy
had produced magnifcent returns: 1., i.8, o.8, and 1,.1, while the S&P
,ooyieldedanaveragei1.
i8
Butleverageworksbothways,andinjustonemonthafterRussiaspartialdefault,
thefundlostmorethanbillionormorethan8oofitsnearly,billionincapi-
tal.Itsdebtwasabout1iobillion.Thefrmfacedinsolvency.
i
If it were only a matter of less than , billion, LTCMs failure might have been
manageable. But the frm had further leveraged itself by entering into derivatives
contracts with more than 1 trillion in notional amountmostly interest rate and
equityderivatives.
o
Withverylittlecapitalinreserve,itthreatenedtodefaultonits
obligationstoitsderivativescounterpartiesincludingmanyofthelargestcommer-
cialandinvestmentbanks.BecauseLTCMhadnegotiateditsderivativestransactions
intheopaqueover-the-countermarket,themarketsdidnotknowthesizeofitsposi-
tionsorthefactthatithadpostedverylittlecollateralagainstthosepositions.Asthe
Fednotedthen,ifallthefundscounterpartieshadtriedtoliquidatetheirpositions
simultaneously,assetpricesacrossthemarketmighthaveplummeted,whichwould
havecreatedexaggeratedlosses.Thiswasaclassicsetupforarun:losseswerelikely,
butnobodyknewwhowouldgetburned.TheFedworriedthatwithfnancialmar-
ketsalreadyfragile,theselosseswouldspillovertoinvestorswithnorelationshipto
LTCM, and credit and derivatives markets might cease to function for a period of
oneormoredaysandmaybelonger.
1
Toavertsuchadisaster,theFedcalledanemergencymeetingofmajorbanksand
securitiesfrmswithlargeexposurestoLTCM.
i
OnSeptemberi,afterconsiderable
urging, 1 institutions agreed to organize a consortium to inject .o billion into
LTCMinreturnforoofitsstock.

Thefrmscontributedbetween1oomillion
and oo million each, although Bear Stearns declined to participate.

An orderly
liquidationofLTCMssecuritiesandderivativesfollowed.
William McDonough, then president of the New York Fed, insisted no Federal
Reserve omcial pressured anyone, and no promises were made.
,
The rescue in-
volvednogovernmentfunds.Nevertheless,theFedsorchestrationraisedaquestion:
howfarwoulditgotoforestallwhatitsawasasystemiccrisis:
The Feds aggressive response had precedents in the previous two decades. In
1,o,theFedhadsupportedthecommercialpapermarket;in18o,dealersinsilver
futures;in18i,therepomarket;in18,,thestockmarketaftertheDowJonesIn-
dustrialAveragefellbyiopercentinthreedays.Allprovidedatemplateforfuture
interventions.Eachtime,theFedcutshort-terminterestratesandencouragedfnan-
cialfrmsintheparallelbankingandtraditionalbankingsectorstohelpailingmar-
kets. And sometimes it organized a consortium of fnancial institutions to rescue
frms.
o
During the same period, federal regulators also rescued several large banks that
they viewed as too big to fail and protected creditors of those banks, including
uninsureddepositors.Theirrationalewasthatmajorbankswerecrucialtothefnan-
cial markets and the economy, and regulators could not allow the collapse of one
iiiitUi\1i uN iiiU\ ,,
large bank to trigger a panic among uninsured depositors that might lead to more
bankfailures.
Butitwasacompletelydifferentpropositiontoarguethatahedgefundcouldbe
consideredtoobigtofailbecauseitscollapsemightdestabilizecapitalmarkets.Did
LTCMsrescueindicatethattheFedwaspreparedtoprotectcreditorsofanytypeof
frmifitscollapsemightthreatenthecapitalmarkets:HarveyMiller,thebankruptcy
counselforLehmanBrotherswhenitfailedinioo8,toldtheFCICthatthey[hedge
funds]expectedtheFedtosaveLehman,basedontheFedsinvolvementinLTCMs
rescue.Thatswhathistoryhadprovedtothem.
,
For Stanley ONeal, Merrills CFO during the LTCM rescue, the experience was
indelible.HetoldtheFCIC,ThelessonItookawayfromitthoughwasthathad
the market seizure and panic and lack of liquidity lasted longer, there would have
beenalotoffrmsacrosstheStreetthatwereirreparablyharmed,andMerrillwould
havebeenoneofthose.
8
Greenspanarguedthattheeventsof18hadconfrmedthesparetiretheory.He
saidina1speechthatthesuccessfulresolutionofthe18crisisshowedthatdi-
versity within the fnancial sector provides insurance against a fnancial problem
turningintoeconomy-widedistress.

ThePresidentsWorkingGrouponFinancial
Markets came to a less defnite conclusion. In a 1 report, the group noted that
LTCM and its counterparties had underestimated the likelihood that liquidity,
credit,andvolatilityspreadswouldmoveinasimilarfashioninmarketsacrossthe
worldatthesametime.
o
Manyfnancialfrmswouldmakeessentiallythesamemis-
takeadecadelater.FortheWorkingGroup,thismiscalculationraisedanimportant
issue:Asnewtechnologyhasfosteredamajorexpansioninthevolumeand,insome
cases, the leverage of transactions, some existing risk models have underestimated
theprobabilityofseverelosses.Thisshowstheneedforinsuringthatdecisionsabout
the appropriate level of capital for risky positions become an issue that is explicitly
considered.
1
Theneedforriskmanagementgrewinthefollowingdecade.TheWorkingGroup
was already concerned that neither the markets nor their regulators were prepared
fortailriskanunanticipatedeventcausingcatastrophicdamagetofnancialinstitu-
tionsandtheeconomy.Nevertheless,itcautionedthatoverreactingtothreatssuchas
LTCMwoulddiminishthedynamismofthefnancialsectorandtherealeconomy:
Policyinitiativesthatareaimedatsimplyreducingdefaultlikelihoodstoextremely
low levels might be counterproductive if they unnecessarily disrupt trading activity
andtheintermediationofrisksthatsupportthefnancingofrealeconomicactivity.
i
Following the Working Groups fndings, the SEC fve years later would issue a
ruleexpandingthenumberofhedgefundadvisorstoincludemostadvisorsthat
needed to register with the SEC. The rule would be struck down in iooo by the
UnitedStatesCourtofAppealsfortheDistrictofColumbiaaftertheSECwassued
byaninvestmentadvisorandhedgefund.

Marketswererelativelycalmafter18,Glass-Steagallwouldbedeemedunnec-
essary, OTC derivatives would be deregulated, and the stock market and the econ-
omywouldcontinuetoprosperforsometime.Likealltheothers(withtheexception
, ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
oftheGreatDepression),thiscrisissoonfadedintomemory.Butnotbefore,inFeb-
ruary 1, Time magazine featured Robert Rubin, Larry Summers, and Alan
Greenspan on its cover as The Committee to Save the World. Federal Reserve
Chairman Greenspan became a cult herothe Maestrowho had handled every
emergencysincethe18,stockmarketcrash.

DOTCOM CRASH: LAY ON MORE RISK


The late 1os was a good time for investment banking. Annual public underwrit-
ings and private placements of corporate securities in U.S. markets almost quadru-
pled,fromooobillionin1toi.itrillioninioo1.Annualinitialpublicofferings
ofstocks(IPOs)soaredfromi8billionin1to,obillioninioooasbanksand
securities frms sponsored IPOs for new Internet and telecommunications compa-
niesthedot-comsandtelecoms.
,
Astockmarketboomensuedcomparabletothe
greatbullmarketofthe1ios.Thevalueofpubliclytradedstocksrosefrom,.8tril-
lioninDecember1to1,.8trillioninMarchiooo.
o
Theboomwasparticularly
strikinginrecentdot-comandtelecomissuesontheNASDAQexchange.Overthis
period,theNASDAQskyrocketedfrom,,ito,,o8.
In the spring of iooo, the tech bubble burst. The new economy dot-coms and
telecoms had failed to match the lofty expectations of investors, who had relied on
bullishand,asitturnedout,sometimesdeceptiveresearchreportsissuedbythe
same banks and securities frms that had underwritten the tech companies initial
publicofferings.BetweenMarchioooandMarchioo1,theNASDAQfellbyalmost
two-thirds.ThisslumpacceleratedaftertheterroristattacksonSeptember11asthe
nation slipped into recession. Investors were further shaken by revelations of ac-
counting frauds and other scandals at prominent frms such as Enron and World-
com. Some leading commercial and investment banks settled with regulators over
improperpracticesintheallocationofIPOsharesduringthebubbleforspinning
(doling out shares in hot IPOs in return for reciprocal business) and laddering
(dolingoutsharestoinvestorswhoagreedtobuymorelaterathigherprices).
,
The
regulatorsalsofoundthatpublicresearchreportspreparedbyinvestmentbanksana-
lystsweretaintedbyconfictsofinterest.TheSEC,NewYorksattorneygeneral,the
NationalAssociationofSecuritiesDealers(nowFINRA),andstateregulatorssettled
enforcementactionsagainst1ofrmsfor8,,million,forbadecertainpractices,and
institutedreforms.
8
ThesuddencollapsesofEnronandWorldComwereshocking;withassetsofo
billion and 1o billion, respectively, they were the largest corporate bankruptcies
beforethedefaultofLehmanBrothersinioo8.
Following legal proceedings and investigations, Citigroup, JP Morgan, Merrill
Lynch, and other Wall Street banks paid billions of dollarsalthough admitted no
wrongdoingforhelpingEnronhideitsdebtuntiljustbeforeitscollapse.Enronand
its bankers had created entities to do complex transactions generating fctitious
earnings, disguised debt as sales and derivative transactions, and understated the
frmsleverage.Executivesatthebankshadpressuredtheiranalyststowriteglowing
iiiitUi\1i uN iiiU\ ,,
evaluationsofEnron.ThescandalcostCitigroup,JPMorgan,CIBC,MerrillLynch,
andotherfnancialinstitutionsmorethanoomillioninsettlementswiththeSEC;
Citigroup,JPMorgan,CIBC,LehmanBrothers,andBankofAmericapaidanother
o. billion to investors to settle class action lawsuits.

In response, the Sarbanes-


Oxley Act of iooi required the personal certifcation of fnancial reports by CEOs
andCFOs;independentauditcommittees;longerjailsentencesandlargerfnesfor
executiveswhomisstatefnancialresults;andprotectionsforwhistleblowers.
Somefrmsthatlenttocompaniesthatfailedduringthestockmarketbustwere
successfully hedged, having earlier purchased credit default swaps on these frms.
Regulatorsseemedtodrawcomfortfromthefactthatmajorbankshadsucceededin
transferring losses from those relationships to investors through these and other
hedging transactions. In November iooi, Fed Chairman Greenspan said credit de-
rivativesappeartohaveeffectivelyspreadlossesfromdefaultsbyEnronandother
largecorporations.Althoughheconcededthemarketwasstilltoonewtohavebeen
tested thoroughly, he observed that to date, it appears to have functioned well.
,o
The following year, Fed Vice Chairman Roger Ferguson noted that the most re-
markablefactregardingthebankingindustryduringthisperiodisitsresilienceand
retentionoffundamentalstrength.
,1
This resilience led many executives and regulators to presume the fnancial sys-
tem had achieved unprecedented stability and strong risk management. The Wall
StreetbankspivotalroleintheEnrondebacledidnotseemtotroubleseniorFedof-
fcials.InamemorandumtotheFCIC,RichardSpillenkothendescribedapresenta-
tiontotheBoardofGovernorsinwhichsomeFedgovernorsreceiveddetailsofthe
bankscomplicitycoollyandwereclearlyunimpressedbyanalystsfndings.The
messagetosomesupervisorystaffwasneitherambiguousnorsubtle,Spillenkothen
wrote.Earlierinthedecade,heremembered,senioreconomistsattheFedhadcalled
Enronanexampleofaderivativesmarketparticipantsuccessfullyregulatedbymar-
ketdisciplinewithoutgovernmentoversight.
,i
TheFedcutinterestratesaggressivelyinordertocontaindamagefromthedot-
comandtelecombust,theterroristattacks,andthefnancialmarketscandals.InJan-
uaryioo1,thefederalfundsrate,theovernightbank-to-banklendingrate,waso.,.
Bymid-ioo,theFedhadcutthatratetojust1,thelowestinhalfacentury,where
itstayedforanotheryear.Inaddition,tooffsetthemarketdisruptionsfollowingthe
/11attacks,theFedfoodedthefnancialmarketswithmoneybypurchasingmore
than1,obillioningovernmentsecuritiesandlending,billiontobanks.Italso
suspended restrictions on bank holding companies so the banks could make large
loanstotheirsecuritiesamliates.WiththeseactionstheFedpreventedaprotracted
liquiditycrunchinthefnancialmarketsduringthefallofioo1,justasithaddone
duringthe18,stockmarketcrashandthe18Russiancrisis.
Why wouldnt the markets assume the central bank would act againand again
save the day: Two weeks before the Fed cut short-term rates in January ioo1, the
Economist anticipatedit:theGreenspanputisonceagainthetalkofWallStreet. . . .
TheideaisthattheFederalReservecanberelieduponintimesofcrisistocometo
+ ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
therescue,cuttinginterestratesandpumpinginliquidity,thusprovidingafoorfor
equityprices.
,
TheGreenspanputwasanalystsshorthandforinvestorsfaiththat
theFedwouldkeepthecapitalmarketsfunctioningnomatterwhat.TheFedspolicy
wasclear:torestraingrowthofanassetbubble,itwouldtakeonlysmallsteps,suchas
warninginvestorssomeassetpricesmightfall;butafterabubbleburst,itwoulduse
all the tools available to stabilize the markets. Greenspan argued that intentionally
burstingabubblewouldheavilydamagetheeconomy.Insteadoftryingtocontaina
putativebubblebydrasticactionswithlargelyunpredictableconsequences,hesaid
inioo,whenhousingpriceswereballooning,wechose . . .tofocusonpoliciesto
mitigate the fallout when it occurs and, hopefully, ease the transition to the next
expansion.
,
This asymmetric policyallowing unrestrained growth, then working hard to
cushiontheimpactofabustraisedthequestionofmoralhazard:didthepolicy
encourageinvestorsandfnancialinstitutionstogamblebecausetheirupsidewasun-
limited while the full power and infuence of the Fed protected their downside (at
least against catastrophic losses): Greenspan himself warned about this in a ioo,
speech, noting that higher asset prices were in part the indirect result of investors
acceptinglowercompensationforriskandcautioningthatnewlyabundantliquid-
itycanreadilydisappear.
,,
Yettheonlyrealactionwouldbeanupwardmarchofthe
federalfundsratethathadbeguninthesummerofioo,although,ashepointedout
inthesameioo,speech,thishadlittleeffect.
Andthemarketswereundeterred.Wehadconvincedourselvesthatwewereina
lessriskyworld,formerFederalReservegovernorandNationalEconomicCouncil
director under President George W. Bush Lawrence Lindsey told the Commission.
Andhowshouldanyrationalinvestorrespondtoalessriskyworld:Theyshouldlay
onmorerisk.
,o
THE WAGES OF FINANCE:
WELL, THIS ONE S DOING IT, SO HOW CAN I NOT DO IT?
Asfgure.1demonstrates,foralmosthalfacenturyaftertheGreatDepression,pay
insidethefnancialindustryandoutwasroughlyequal.Beginningin18o,theydi-
verged. By ioo,, fnancial sector compensation was more than 8o greater than in
otherbusinessesaconsiderablylargergapthanbeforetheGreatDepression.
Until1,o,theNewYorkStockExchange,aprivateself-regulatoryorganization,
required members to operate as partnerships.
,,
Peter J. Solomon, a former Lehman
Brothers partner, testifed before the FCIC that this profoundly affected the invest-
mentbanksculture.Beforethechange,heandtheotherpartnershadsatinasingle
roomatheadquarters,nottosocializebuttooverhear,interact,andmonitoreach
other.Theywereallonthehooktogether.Sincetheywerepersonallyliableaspart-
ners,theytookriskveryseriously,Solomonsaid.
,8
BrianLeach,formerlyanexecu-
tive at Morgan Stanley, described to FCIC staff Morgan Stanleys compensation
practices before it issued stock and became a public corporation: When I frst
iiiitUi\1i uN iiiU\ .
z ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
startedatMorganStanley,itwasaprivatecompany.Whenyoureaprivatecompany,
you dont get paid until you retire. I mean, you get a good, you know, year-to-year
compensation.Butthebigpayoutwaswhenyouretire.
,
When the investment banks went public in the 18os and 1os, the close rela-
tionshipbetweenbankersdecisionsandtheircompensationbrokedown.Theywere
nowtradingwithshareholdersmoney.Talentedtradersandmanagersoncetethered
totheirfrmswerenowfreeagentswhocouldplaycompaniesagainsteachotherfor
more money. To keep them from leaving, frms began providing aggressive incen-
tives, often tied to the price of their shares and often with accelerated payouts. To
keepup,commercialbanksdidthesame.Someincludedclawbackprovisionsthat
would require the return of compensation under narrow circumstances, but those
provedtoolimitedtorestrainthebehavioroftradersandmanagers.
Studieshavefoundthattherealvalueofexecutivepay,adjustedforinfation,grew
Financial
Nonfnancial
Cempensatien in FinanciaI and NenEnanciaI Secters
SOURCES: Bureau of Economic Analysis, Bureau of Labor Statistics, CPI-Urban, FCIC calculations
ANNUAL AVERAGE, IN 2009 DOLLARS
0
$120,000
100,000
80,000
60,000
40,000
20,000
1929 1940 1950 1960 1970 1980 1990 2000 2009
$102,069
$58,666
Compensation in the financial sector outstripped pay elsewhere,
a pattern not seen since the years before the Great Depression.
NOTE: Average compensation includes wages, salaries, commissions, tips, bonuses, and payments for
governmenL insurance and ension rograms. Nonfnancial secLor is all domesLic emloyees exceL Lhose in
fnance and insurance.
Iigurc ,.+
onlyo.8ayearduringtheoyearsafterWorldWarII,laggingcompaniesincreasing
size.
oo
Buttheratepickedupduringthe1,osandrosefastereachdecade,reaching
1oayearfrom1,to1.
o1
Muchofthechangerefectedhigherearningsinthe
fnancial sector, where by ioo, executives pay averaged . million annually, the
highest of any industry. Though base salaries differed relatively little across sectors,
bankingandfnancepaidmuchhigherbonusesandawardedmorestock.Andbrokers
anddealersdidbyfarthebest,averagingmorethan,millionincompensation.
oi
Bothbeforeandaftergoingpublic,investmentbankstypicallypaidouthalftheir
revenuesincompensation.Forexample,GoldmanSachsspentbetweenand
ayearbetweenioo,andioo8,whenMorganStanleyallottedbetweenoand,.
Merrillpaidoutsimilarpercentagesinioo,andiooo,butgave11inioo,ayear
itsuffereddramaticlosses.
o
Asthescale,revenue,andproftabilityofthefrmsgrew,compensationpackages
soared for senior executives and other key employees. John Gutfreund, reported to
bethehighest-paidexecutiveonWallStreetinthelate18os,received.imillionin
18oasCEOofSalomonBrothers.
o
StanleyONealspackagewasworthmorethan
1millioniniooo,thelastfullyearhewasCEOofMerrillLynch.
o,
Inioo,,Lloyd
Blankfein, CEO at Goldman Sachs, received o8., million;
oo
Richard Fuld, CEO of
Lehman Brothers, and Jamie Dimon, CEO of JPMorgan Chase, received about
million and i8 million, respectively.
o,
That year Wall Street paid workers in New
Yorkroughlybillioninyear-endbonusesalone.
o8
Totalcompensationforthema-
jorU.S.banksandsecuritiesfrmswasestimatedat1,billion.
o
Stock options became a popular form of compensation, allowing employees to
buythecompanysstockinthefutureatsomepredeterminedprice,andthustoreap
rewardswhenthestockpricewashigherthanthatpredeterminedprice.Infact,the
optionwouldhavenovalueifthestockpricewasbelowthatprice.Encouragingthe
awardingofstockoptionswas1legislationmakingcompensationinexcessof1
milliontaxabletothecorporationunlessperformance-based.Stockoptionshadpo-
tentially unlimited upside, while the downside was simply to receive nothing if the
stockdidntrisetothepredeterminedprice.Thesameappliedtoplansthattiedpay
toreturnonequity:theymeantthatexecutivescouldwinmorethantheycouldlose.
These pay structures had the unintended consequence of creating incentives to in-
creasebothriskandleverage,whichcouldleadtolargerjumpsinacompanysstock
price.
Astheseoptionsmotivatedfnancialfrmstotakemoreriskandusemorelever-
age, the evolution of the system provided the means. Shadow banking institutions
faced few regulatory constraints on leverage; changes in regulations loosened the
constraints on commercial banks. OTC derivatives allowing for enormous leverage
proliferated. And risk management, thought to be keeping ahead of these develop-
ments,wouldfailtoreinintheincreasingrisks.
The dangers of the new pay structures were clear, but senior executives believed
theywerepowerlesstochangeit.FormerCitigroupCEOSandyWeilltoldtheCom-
mission,IthinkifyoulookattheresultsofwhathappenedonWallStreet,itbecame,
iiiitUi\1i uN iiiU\ ,
Well,thisonesdoingit,sohowcanInotdoit,ifIdontdoit,thenthepeoplearego-
ingtoleavemyplaceandgosomeplaceelse.Managingriskbecamelessofanim-
portantfunctioninabroadbaseofcompanies,Iwouldguess.
,o
Andregulatoryentities,onesourceofchecksonexcessiverisktaking,hadchal-
lenges recruiting fnancial experts who could otherwise work in the private sector.
LordAdairTurner,chairmanoftheU.K.FinancialServicesAuthority,toldtheCom-
mission, Its not easy. This is like a continual process of, you know, high-skilled
people versus high-skilled people, and the poachers are better paid than the game-
keepers.
,1
BernankesaidthesameatanFCIChearing:Itsjustsimplynevergoingto
bethecasethatthegovernmentcanpaywhatWallStreetcanpay.
,i
Tying compensation to earnings also, in some cases, created the temptation to
manipulatethenumbers.FormerFannieMaeregulatorArmandoFalconJr.toldthe
FCIC, Fannie began the last decade with an ambitious goaldouble earnings in ,
years to o.o [per share]. A large part of the executives compensation was tied to
meetingthatgoal.AchievingitbroughtCEOFranklinRaines,imillionofhiso
millionpayfrom18toioo.However,Falconsaid,thegoalturnedouttobeun-
achievable without breaking rules and hiding risks. Fannie and Freddie executives
workedhardtopersuadeinvestorsthatmortgage-relatedassetswerearisklessinvest-
ment,whileatthesametimecoveringupthevolatilityandrisksoftheirownmort-
gageportfoliosandbalancesheets. Fanniesestimateofhowmanymortgageholders
wouldpayoffwasoffbyoomillionatyear-end18,whichmeantnobonuses.So
Fannie counted only half the oo million on its books, enabling Raines and other
executivestomeettheearningstargetandreceive1oooftheirbonuses.
,
Compensation structures were skewed all along the mortgage securitization
chain,frompeoplewhooriginatedmortgagestopeopleonWallStreetwhopackaged
themintosecurities.Regardingmortgagebrokers,oftenthefrstlinkintheprocess,
FDIC Chairman Sheila Bair told the FCIC that their standard compensation prac-
tice . . .wasbasedonthevolumeofloansoriginatedratherthantheperformanceand
qualityoftheloansmade.Sheconcluded,Thecrisishasshownthatmostfnancial-
institutioncompensationsystemswerenotproperlylinkedtoriskmanagement.For-
mula-driven compensation allows high short-term profts to be translated into
generousbonuspayments,withoutregardtoanylonger-termrisks.
,
SECChairman
MarySchapirotoldtheFCIC,Manymajorfnancialinstitutionscreatedasymmetric
compensationpackagesthatpaidemployeesenormoussumsforshort-termsuccess,
even if these same decisions result in signifcant long-term losses or failure for in-
vestorsandtaxpayers.
,,
FINANCIAL SECTOR GROWTH:
I THINK WE OVERDID FINANCE VERSUS THE REAL ECONOMY
Forabouttwodecades,beginningintheearly18os,thefnancialsectorgrewfaster
than the rest of the economyrising from about , of gross domestic product
(GDP) to about 8 in the early i1st century. In 18o, fnancial sector profts were
about1,ofcorporateprofts.Inioo,theyhitahighofbutfellbacktoi,
, ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
iiiitUi\1i uN iiiU\ ,
in iooo, on the eve of the fnancial crisis. The largest frms became considerably
larger. JP Morgans assets increased from oo, billion in 1 to i.i trillion in
ioo8,acompoundannualgrowthrateof1o.BankofAmericaandCitigroupgrew
by1and1iayear,respectively,withCitigroupreaching1.trillioninassetsin
ioo8(downfromi.itrillioninioo,)andBankofAmerica1.8trillion.Thein-
vestment banks also grew signifcantly from iooo to ioo,, often much faster than
commercialbanks.Goldmansassetsgrewfromi,obillionin1to1.1trillion
byioo,,anannualgrowthrateofi1.AtLehman,assetsrosefrom1ibillionto
o1billion,or1,.
,o
Fannie and Freddie grew quickly, too. Fannies assets and guaranteed mortgages
increasedfrom1.trillioninioooto.itrillioninioo8,or11annually.AtFred-
die,theyincreasedfrom1trilliontoi.itrillion,or1oayear.
,,
Astheygrew,manyfnancialfrmsaddedlotsofleverage.Thatmeantpotentially
higher returns for shareholders, and more money for compensation. Increasing
leveragealsomeantlesscapitaltoabsorblosses.
Fannie and Freddie were the most leveraged. The law set the government-
sponsoredenterprisesminimumcapitalrequirementati.,ofassetspluso.,of
the mortgage-backed securities they guaranteed. So they could borrow more than
iooforeachdollarofcapitalusedtoguaranteemortgage-backedsecurities.Ifthey
wantedtoownthesecurities,theycouldborrowoforeachdollarofcapital.Com-
bined,FannieandFreddieownedorguaranteed,.trillionofmortgage-relatedas-
setsattheendofioo,againstjust,o.,billionofcapital,aratioof,,:1.
Fromioootoioo,,largebanksandthriftsgenerallyhad1otoiiinassetsfor
each dollar of capital, for leverage ratios between 1o:1 and ii:1. For some banks,
leverageremainedroughlyconstant.JPMorgansreportedleveragewasbetweenio:1
andii:1.WellsFargosgenerallyrangedbetween1o:1and1,:1.Otherbanksupped
theirleverage.BankofAmericasrosefrom18:1inioootoi,:1inioo,.Citigroups
increased from 18:1 to ii:1, then shot up to i:1 by the end of ioo,, when Citi
broughtoff-balancesheetassetsontothebalancesheet.Morethanotherbanks,Citi-
groupheldassetsoffofitsbalancesheet,inparttoholddowncapitalrequirements.
Inioo,,evenafterbringing8obillionworthofassetsonbalancesheet,substantial
assets remained off. If those had been included, leverage in ioo, would have been
8:1,orabout,higher.Incomparison,atWellsFargoandBankofAmerica,in-
cludingoff-balance-sheetassetswouldhaveraisedtheioo,leverageratios1,and
i8,respectively.
,8
Because investment banks were not subject to the same capital requirements as
commercialandretailbanks,theyweregivengreaterlatitudetorelyontheirinternal
risk models in determining capital requirements, and they reported higher leverage.
At Goldman Sachs, leverage increased from 1,:1 in iooo to i:1 in ioo,. Morgan
Stanley and Lehman increased about o, and ii, respectively, and both reached
o:1bytheendofioo,.
,
Severalinvestmentbanksartifciallyloweredleverageratios
bysellingassetsrightbeforethereportingperiodandsubsequentlybuyingthemback.
As the investment banks grew, their business models changed. Traditionally, in-
vestment banks advised and underwrote equity and debt for corporations, fnancial
institutions,investmentfunds,governments,andindividuals.Anincreasingamount
oftheinvestmentbanksrevenuesandearningswasgeneratedbytradingandinvest-
ments,includingsecuritizationandderivativesactivities.AtGoldman,revenuesfrom
tradingandprincipalinvestmentsincreasedfromofthetotalin1,too8in
ioo,.AtMerrillLynch,theygenerated,,ofrevenueiniooo,upfromiin1,.
AtLehman,similaractivitiesgeneratedupto8oofpretaxearningsiniooo,upfrom
iin1,.AtBearStearns,theyaccountedformorethan1ooofpretaxearnings
insomeyearsafteriooibecauseofpretaxlossesinotherbusinesses.
8o
Between1,8andioo,,debtheldbyfnancialcompaniesgrewfromtrillionto
otrillion,morethandoublingfrom1otoi,oofGDP.FormerTreasurySecre-
taryJohnSnowtoldtheFCICthatwhilethefnancialsectormustplayacriticalrole
in allocating capital to the most productive uses, it was reasonable to ask whether
over the last io or o years it had become too large. Financial frms had grown
mainlybysimplylendingtoeachother,hesaid,notbycreatingopportunitiesforin-
vestment.
81
In 1,8, fnancial companies borrowed 1 in the credit markets for
every1ooborrowedbynonfnancialcompanies.Byioo,,fnancialcompanieswere
borrowing,1forevery1oo.Wehavealotmoredebtthanweusedtohave,which
means we have a much bigger fnancial sector, said Snow. I think we overdid f-
nanceversustherealeconomyandgotitalittlelopsidedasaresult.
8i
ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
5
SUBPRIME LENDING
CONTENTS
Mcrtgagcsccuriti:aticn1hisstujjisscccnp|icatcdhcwis
any|cdygcingtckncw? e:
Grcatcracccsstc|cndingA|usincsswhcrcwccannakcscncncncy,:
Su|princ|cndcrsinturnci|Advcrscnarkctccnditicns,,
1hcrcgu|atcrsOh,Iscc ,,
In the early 18os, subprime lenders such as Household Finance Corp. and thrifts
suchasLongBeachSavingsandLoanmadehomeequityloans,oftensecondmort-
gages,toborrowerswhohadyettoestablishcredithistoriesorhadtroubledfnancial
histories, sometimes refecting setbacks such as unemployment, divorce, medical
emergencies,andthelike.Banksmighthavebeenunwillingtolendtotheseborrow-
ers,butasubprimelenderwouldiftheborrowerpaidahigherinterestratetooffset
the extra risk. No one can debate the need for legitimate non-prime (subprime)
lendingproducts,GailBurks,presidentoftheNevadaFairHousingCenter,Inc.,tes-
tifedtotheFCIC.
1
Interest rates on subprime mortgages, with substantial collateralthe house
werentashighasthoseforcarloans,andweremuchlessthancreditcards.Thead-
vantagesofamortgageoverotherformsofdebtweresolidifedin18owiththeTax
ReformAct,whichbarreddeductinginterestpaymentsonconsumerloansbutkept
thedeductionformortgageinterestpayments.
In the 18os and into the early 1os, before computerized credit scoringa
statisticaltechniqueusedtomeasureaborrowerscreditworthinessautomatedthe
assessment of risk, mortgage lenders (including subprime lenders) relied on other
factors when underwriting mortgages. As Tom Putnam, a Sacramento-based mort-
gagebanker,toldtheCommission,theytraditionallylentbasedonthefourCs:credit
(quantity, quality, and duration of the borrowers credit obligations), capacity
(amountandstabilityofincome),capital(sumcientliquidfundstocoverdownpay-
ments,closingcosts,andreserves),andcollateral(valueandconditionoftheprop-
erty).
i
Theirdecisionsdependedonjudgmentsabouthowstrengthinonearea,such
ascollateral,mightoffsetweaknessesinothers,suchascredit.Theyunderwrotebor-
rowersoneatatime,outoflocalomces.
,
Inafewcases,suchasCitiFinancial,subprimelendingfrmswerepartofabank
holdingcompany,butmostincludingHousehold,BenefcialFinance,TheMoney
Store, and Champion Mortgagewere independent consumer fnance companies.
Withoutaccesstodeposits,theygenerallyfundedthemselveswithshort-termlines
of credit, or warehouse lines, from commercial or investment banks. In many
cases,thefnancecompaniesdidnotkeepthemortgages.Somesoldtheloanstothe
samebanksextendingthewarehouselines.Thebankswouldsecuritizeandsellthe
loanstoinvestorsorkeepthemontheirbalancesheets.Inothercases,thefnance
company itself packaged and sold the loansoften partnering with the banks ex-
tending the warehouse lines. Meanwhile, the S&Ls that originated subprime loans
generally fnanced their own mortgage operations and kept the loans on their bal-
ancesheets.
MORTGAGE SECURITIZATION: THIS STUFF IS
SO COMPLICATED HOW IS ANYBODY GOING TO KNOW?
DebtoutstandinginU.S.creditmarketstripledduringthe18os,reaching1.8tril-
lionin1o;11wassecuritizedmortgagesandGSEdebt.Later,mortgagesecurities
made up 18 of the debt markets, overtaking government Treasuries as the single
largestcomponentapositiontheymaintainedthroughthefnancialcrisis.

Inthe1osmortgagecompanies,banks,andWallStreetsecuritiesfrmsbegan
securitizingmortgages(seefgure,.1).Andmoreofthemweresubprime.Salomon
Brothers, Merrill Lynch, and other Wall Street frms started packaging and selling
non-agency mortgagesthat is, loans that did not conform to Fannies and Fred-
diesstandards.Sellingtheserequiredinvestorstoadjustexpectations.Withsecuriti-
zationshandledbyFannieandFreddie,thequestionwasnotwillyougetthemoney
backbutwhen,formerSalomonBrotherstraderandCEOofPentAlphaJimCalla-
han told the FCIC.

With these new non-agency securities, investors had to worry


about getting paid back, and that created an opportunity for S&P and Moodys. As
LewisRanieri,apioneerinthemarket,toldtheCommission,whenhepresentedthe
conceptofnon-agencysecuritizationtopolicymakers,theyasked,Thisstuffisso
complicated how is anybody going to know: How are the buyers going to buy:
Ranierisaid,Oneofthesolutionswas,ithadtohavearating.Andthatputtherat-
ingservicesinthebusiness.
,
Non-agencysecuritizationswereonlyafewyearsoldwhentheyreceivedapow-
erful stimulus from an unlikely source: the federal government. The savings and
loancrisishadleftUncleSamwithoibillioninloansandrealestatefromfailed
thriftsandbanks.CongressestablishedtheResolutionTrustCorporation(RTC)in
18 to omoad mortgages and real estate, and sometimes the failed thrifts them-
selves,nowownedbythegovernment.WhiletheRTCwasabletosello.1billionof
these mortgages to Fannie and Freddie, most did not meet the GSEs standards.
Somewerewhatmightbecalledsubprimetoday,butothershadoutrightdocumen-
tation errors or servicing problems, not unlike the low-documentation loans that
laterbecamepopular.
o
ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
RTComcialssoonconcludedthattheyhadneitherthetimenortheresourcesto
sellofftheassetsintheirportfolioonebyoneandthriftbythrift.Theyturnedtothe
private sector, contracting with real estate and fnancial professionals to securitize
someoftheassets.BythetimetheRTCconcludeditswork,ithadsecuritizedi,bil-
lioninresidentialmortgages.
,
TheRTCineffecthelpedexpandthesecuritizationof
mortgages ineligible for GSE guarantees.
8
In the early 1os, as investors became
:U8iii \i iiNii Nt ,
Funding for Mortgages
IN PERCENT, BY SOURCE
SOURCE: Federal Reserve Flow of Funds Report
0
30
20
10
40
50
60%
0
30
20
10
40
50
60%
00 10 70 80 90 00 10 70 80 90
00 10 70 80 90 00 10 70 80 90
Commercial banks & others
Savings & loans Government-sponsored enterprises
Non-agency securities
29%
13%
54%
4%
The sources of funds for mortgages changed over the decades.
Iigurc .+
more familiar with the securitization of these assets, mortgage specialists and Wall
Street bankers got in on the action. Securitization and subprime originations grew
handinhand.Asfgure,.ishows,subprimeoriginationsincreasedfrom,obillion
in1oto1oobillioniniooo.Theproportionsecuritizedinthelate1ospeakedat
,o, and subprime mortgage originations share of all originations hovered around
1o.
Securitizations by the RTC and by Wall Street were similar to the Fannie and
Freddiesecuritizations.Thefrststepwastogetprincipalandinterestpaymentsfrom
agroupofmortgagestofowintoasinglepool.Butinprivate-labelsecurities(that
is,securitizationsnotdonebyFannieorFreddie),thepaymentswerethentranched
inawaytoprotectsomeinvestorsfromlosses.Investorsinthetranchesreceiveddif-
ferentstreamsofprincipalandinterestindifferentorders.
Most of the earliest private-label deals, in the late 18os and early 1os, used a
rudimentary form of tranching. There were typically two tranches in each deal. The
,+ ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
In 2006, $600 billion of subprime loans were originated, most of which were
securitized. That year, subprime lending accounted for 23.5% of all mortgage
originations.
Subprime Mortgage Originations
IN BILLIONS OF DOLLARS
23.5%
SOURCE: Inside Mortgage Finance
97 99 01 03 05 00 06 07 08 04 02 98 96
0
100
200
300
400
500
600
$700
9.5%
10.6%
9.8%
10.4%
10.1%
7.6% 7.4%
9.2%
1.7%
8.3%
20.9%
22.7% Subprime share of entire
mortgage market
Securitized
Non-securitized
N0TE. PercenL securiLized is defned as subrime securiLies issued divided by originaLions in a given year. ln
2007, securities issued exceeded originations.
Iigurc .:
lessriskytranchereceivedprincipalandinterestpaymentsfrstandwasusuallyguaran-
teedbyaninsurancecompany.Themoreriskytranchereceivedpaymentssecond,was
notguaranteed,andwasusuallykeptbythecompanythatoriginatedthemortgages.
Withinadecade,securitizationshadbecomemuchmorecomplex:theyhadmore
tranches, each with different payment streams and different risks, which were tai-
lored to meet investors demands. The entire private-label mortgage securitization
marketthose who created, sold, and bought the investmentswould become
highlydependentonthisslice-and-diceprocess,andregulatorsandmarketpartici-
pantsaliketookforgrantedthatitemcientlyallocatedrisktothosebestableandwill-
ingtobearthatrisk.
To demonstrate how this process worked, well describe a typical deal, named
CMLTIiooo-NCi,involving,millioninmortgage-backedbonds.

Iniooo,New
Century Financial, a California-based lender, originated and sold , subprime
mortgages to Citigroup, which sold them to a separate legal entity that Citigroup
sponsoredthatwouldownthemortgagesandissuethetranches.Theentitypurchased
theloanswithcashithadraisedbysellingthesecuritiestheseloanswouldback.The
entity had been created as a separate legal structure so that the assets would sit off
Citigroupsbalancesheet,anarrangementwithtaxandregulatorybenefts.
The , mortgages carried the rights to the borrowers monthly payments,
which the Citigroup entity divided into 1 tranches of mortgage-backed securities;
eachtranchegaveinvestorsadifferentpriorityclaimonthefowofpaymentsfrom
theborrowers,andadifferentinterestrateandrepaymentschedule.Thecreditrating
agenciesassignedratingstomostofthesetranchesforinvestors,whoassecuritiza-
tion became increasingly complicatedcame to rely more heavily on these ratings.
Trancheswereassignedletterratingsbytheratingagenciesbasedontheirriskiness.
Inthisreport,ratingsaregenerallypresentedinS&Psclassifcationsystem,whichas-
signsratingssuchasAAA(thehighestratingforthesafestinvestments,referredto
hereastriple-A),AA(lesssafethanAAA),A,BBB,andBB,andfurtherdistin-
guishesratingswith+and.AnythingratedbelowBBB-isconsideredjunk.
MoodysusesasimilarsysteminwhichAaaishighest,followedbyAa,A,Baa,
Ba, and so forth. For example, an S&P rating of BBB would correspond to a
MoodysratingofBaa.InthisCitigroupdeal,thefourseniortranchesthesafest
wereratedtriple-Abytheagencies.
Belowtheseniortranchesandnextinlineforpaymentswereelevenmezzanine
tranchesso named because they sat between the riskiest and the safest tranches.
Thesewereriskierthantheseniortranchesand,becausetheypaidoffmoreslowly,
carriedahigherriskthatanincreaseininterestrateswouldmakethelocked-ininter-
est payments less valuable. As a result, they paid a correspondingly higher interest
rate.ThreeofthesetranchesintheCitigroupdealwereratedAA,threewereA,three
wereBBB(thelowestinvestment-graderating),andtwowereBB,orjunk.
Thelasttobepaidwasthemostjuniortranche,calledtheequity,residual,or
frst-loss tranche, set up to receive whatever cash fow was left over after all the
other investors had been paid. This tranche would suffer the frst losses from any
:U8iii \i iiNii Nt ,.
defaultsofthemortgagesinthepool.Commensuratewiththishighrisk,itprovided
thehighestyields(seefgure,.).IntheCitigroupdeal,aswascommon,thispieceof
the deal was not rated at all. Citigroup and a hedge fund each held half the equity
tranche.
1o
Whileinvestorsinthelower-ratedtranchesreceivedhigherinterestratesbecause
theyknewtherewasariskofloss,investorsinthetriple-Atranchesdidnotexpect
payments from the mortgages to stop. This expectation of safety was important, so
thefrmsstructuringsecuritiesfocusedonachievinghighratings.Inthestructureof
thisCitigroupdeal,whichwastypical,,,million,or,8,wasratedtriple-A.
GREATER ACCESS TO LENDING:
A BUSINESS WHERE WE CAN MAKE SOME MONEY
Asprivate-labelsecuritizationbegantotakehold,newcomputerandmodelingtech-
nologies were reshaping the mortgage market. In the mid-1os, standardized data
with loan-level information on mortgage performance became more widely avail-
able.Lendersunderwrotemortgagesusingcreditscores,suchastheFICOscore,de-
velopedbyFairIsaacCorporation.In1,FreddieMacrolledoutLoanProspector,
anautomatedsystemformortgageunderwritingforusebylenders,andFannieMae
releaseditsownsystem,DesktopUnderwriter,twomonthslater.Thedaysoflabori-
ous, slow, and manual underwriting of individual mortgage applicants were over,
loweringcostandbroadeningaccesstomortgages.
Thisnewprocesswasbasedonquantitativeexpectations:Giventheborrower,the
home,andthemortgagecharacteristics,whatwastheprobabilitypaymentswouldbe
on time: What was the probability that borrowers would prepay their loans, either
becausetheysoldtheirhomesorrefnancedatlowerinterestrates:
In the 1os, technology also affected implementation of the Community Rein-
vestment Act (CRA). Congress enacted the CRA in 1,, to ensure that banks and
thriftsservedtheircommunities,inresponsetoconcernsthatbanksandthriftswere
refusingtolendincertainneighborhoodswithoutregardtothecreditworthinessof
individualsandbusinessesinthoseneighborhoods(apracticeknownasredlining).
11
TheCRAcalledonbanksandthriftstoinvest,lend,andserviceareaswherethey
took in deposits, so long as these activities didnt impair their own fnancial safety
andsoundness.ItdirectedregulatorstoconsiderCRAperformancewheneverabank
orthriftappliedforregulatoryapprovalformergers,toopennewbranches,ortoen-
gageinnewbusinesses.
1i
TheCRAencouragedbankstolendtoborrowerstowhomtheymayhaveprevi-
ouslydeniedcredit.Whiletheseborrowersoftenhadlower-than-averageincome,a
1, study indicated that loans made under the CRA performed consistently with
the rest of the banks portfolios, suggesting CRA lending was not riskier than the
banks other lending.
1
There is little or no evidence that banks safety and sound-
nesshavebeencompromisedbysuchlending,andbankersoftenreportsoundbusi-
nessopportunities,FederalReserveChairmanAlanGreenspansaidofCRAlending
in18.
1
,z ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
:U8iii \i iiNii Nt ,,
AA
A
BBB
BB
AAA
EQUITY TRANCHES
Residential Mortgage-Backed Securities
Lenders extend mortgages, including
subprime and Alt-A loans.
Financial institutions packaged subprime, Alt-A and other mortgages into securities. As long
as the housing market continued to boom, these securities would perform. But when the
economy faltered and the mortgages defaulted, lower-rated tranches were left worthless.
1 Originate
Residential mortgage-backed
securities are sold to
investors, giving them the
right to the principal and
interest from the mortgages.
These securities are sold in
tranches, or slices. The ow
of cash determines the rating
of the securities, with AAA
tranches getting the rst cut
of principal and interest
payments, then AA, then A,
and so on.
3 Tranche
next
etc.
2 Pool
Low risk, low yield
RMBS
TRANCHES
High risk, high yield
MEZZANINE
TRANCHES
These tranches
were often
purchased by
CDOs. See page
128 for an
explanation.
SENIOR
TRANCHES
Pool of
Mortgages
First claim to cash ow
from principal & interest
payments
Securities rms
purchase these loans
and pool them.
next
claim
Collateralized
Debt
Obligation
Iigurc .
In1,PresidentBillClintonaskedregulatorstoimprovebanksCRAperform-
ancewhilerespondingtoindustrycomplaintsthattheregulatoryreviewprocessfor
compliancewastooburdensomeandtoosubjective.In1,,theFed,OmceofThrift
Supervision (OTS), Omce of the Comptroller of the Currency (OCC), and Federal
DepositInsuranceCorporation(FDIC)issuedregulationsthatshiftedtheregulatory
focus from the efforts that banks made to comply with the CRA to their actual re-
sults.Regulatorsandcommunityadvocatescouldnowpointtoobjective,observable
numbersthatmeasuredbankscompliancewiththelaw.
FormercomptrollerJohnDugantoldFCICstaffthattheimpactoftheCRAhad
beenlasting,becauseitencouragedbankstolendtopeoplewhointhepastmightnot
havehadaccesstocredit.Hesaid,Thereisatremendousamountofinvestmentthat
goesonininnercitiesandotherplacestobuildthingsthatarequiteimpressive. . . .
Andthebankersconverselysay,Thisisproventobeabusinesswherewecanmake
some money; not a lot, but when you factor that in plus the good will that we get
fromit,itkindofworks.
1,
LawrenceLindsey,aformerFedgovernorwhowasresponsiblefortheFedsDivi-
sion of Consumer and Community Affairs, which oversees CRA enforcement, told
the FCIC that improved enforcement had given the banks an incentive to invest in
technology that would make lending to lower-income borrowers proftable by such
means as creating credit scoring models customized to the market. Shadow banks
not covered by the CRA would use these same credit scoring models, which could
draw on now more substantial historical lending data for their estimates, to under-
write loans. We basically got a cycle going which particularly the shadow banking
industrycould,usingrecenthistoricdata,showthedefaultratesonthistypeoflend-
ingwerevery,verylow,hesaid.
1o
Indeed,defaultrateswerelowduringtheprosper-
ous1os,andregulators,bankers,andlendersintheshadowbankingsystemtook
noteofthissuccess.
SUBPRIME LENDERS IN TURMOIL:
ADVERSE MARKET CONDITIONS
Amongnonbankmortgageoriginators,thelate1oswereaturningpoint.During
themarketdisruptioncausedbytheRussiandebtcrisisandtheLong-TermCapital
Managementcollapse,themarketssawafighttoqualitythatis,asteepfallinde-
mandamonginvestorsforriskyassets,includingsubprimesecuritizations.Therate
ofsubprimemortgagesecuritizationdroppedfrom,,.1in18to,.in1.
Meanwhile,subprimeoriginatorssawtheinterestrateatwhichtheycouldborrowin
creditmarketsskyrocket.Theywerecaughtinasqueeze:borrowingcostsincreased
at the very moment that their revenue stream dried up.
1,
And some were caught
holdingtranchesofsubprimesecuritiesthatturnedouttobeworthfarlessthanthe
valuetheyhadbeenassigned.
Mortgagelendersthatdependedonliquidityandshort-termfundinghadimme-
diateproblems.Forexample,SouthernPacifcFunding(SFC),anOregon-basedsub-
prime lender that securitized its loans, reported relatively positive second-quarter
,, ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
resultsinAugust18.Then,inSeptember,SFCnotifedinvestorsaboutrecentad-
versemarketconditionsinthesecuritiesmarketsandexpressedconcernaboutthe
continued viability of securitization in the foreseeable future.
18
A week later, SFC
fled for bankruptcy protection. Several other nonbank subprime lenders that were
alsodependentonshort-termfnancingfromthecapitalmarketsalsofledforbank-
ruptcyin18and1.InthetwoyearsfollowingtheRussiandefaultcrisis,8ofthe
top 1o subprime lenders declared bankruptcy, ceased operations, or sold out to
strongerfrms.
1
When these frms were sold, their buyers would frequently absorb large losses.
FirstUnion,alargeregionalbankheadquarteredinNorthCarolina,incurredcharges
of almost 1., billion after it bought The Money Store. First Union eventually shut
downorsoldoffmostofTheMoneyStoresoperations.
Conseco,aleadinginsurancecompany,purchasedGreenTreeFinancial,another
subprime lender. Disruptions in the securitization markets, as well as unexpected
mortgagedefaults,eventuallydroveConsecointobankruptcyinDecemberiooi.At
thetime,thiswasthethird-largestbankruptcyinU.S.history(afterWorldComand
Enron).
Accounting misrepresentations would also bring down subprime lenders. Key-
stone, a small national bank in West Virginia that made and securitized subprime
mortgageloans,failedin1.Inthesecuritizationprocessaswascommonprac-
ticeinthe1osKeystoneretainedtheriskiestfrst-lossresidualtranchesforits
ownaccount.Theseholdingsfarexceededthebankscapital.ButKeystoneassigned
themgrosslyinfatedvalues.TheOCCclosedthebankinSeptember1,afterdis-
covering fraud committed by the bank management, as executives had overstated
thevalueoftheresidualtranchesandotherbankassets.
io
Perhapsthemostsignif-
cant failure occurred at Superior Bank, one of the most aggressive subprime mort-
gage lenders. Like Keystone, it too failed after having kept and overvalued the
frst-losstranchesonitsbalancesheet.
Many of the lenders that survived or were bought in the 1os reemerged in
otherforms.LongBeachwastheancestorofAmeriquestandLongBeachMortgage
(whichwasinturnpurchasedbyWashingtonMutual),twoofthemoreaggressive
lendersduringthefrstdecadeofthenewcentury.AssociatesFirstwassoldtoCiti-
group, and Household bought Benefcial Mortgage before it was itself acquired by
HSBCinioo.
Withthesubprimemarketdisrupted,subprimeoriginationstotaled1oobillion
iniooo,downfrom1,billiontwoyearsearlier.
i1
Overthenextfewyears,however,
subprimelendingandsecuritizationwouldmorethanrebound.
THE REGULATORS: OH, I SEE
During the 1os, various federal agencies had taken increasing notice of abusive
subprimelendingpractices.Buttheregulatorysystemwasnotwellequippedtore-
spondconsistentlyandonanationalbasistoprotectborrowers.Stateregulators,
as well as either the Fed or the FDIC, supervised the mortgage practices of state
:U8iii \i iiNii Nt ,,
banks.TheOCCsupervisedthenationalbanks.TheOTSorstateregulatorswerere-
sponsible for the thrifts. Some state regulators also licensed mortgage brokers, a
growingportionofthemarket,butdidnotsupervisethem.
ii
Despite this diffusion of authority, one entity was unquestionably authorized by
Congress to write strong and consistent rules regulating mortgages for all types of
lenders:theFederalReserve,throughtheTruthinLendingActof1o8.In1o,the
FedadoptedRegulationZforthepurposeofimplementingtheact.ButwhileRegu-
lationZappliedtoalllenders,itsenforcementwasdividedamongAmericasmanyf-
nancialregulators.
Onestickingpointwasthesupervisionofnonbanksubsidiariessuchassubprime
lenders. The Fed had the legal mandate to supervise bank holding companies, in-
cluding the authority to supervise their nonbank subsidiaries. The Federal Trade
CommissionwasgivenexplicitauthoritybyCongresstoenforcetheconsumerpro-
tections embodied in the Truth in Lending Act with respect to these nonbank
lenders. Although the FTC brought some enforcement actions against mortgage
companies, Henry Cisneros, a former secretary of the Department of Housing and
UrbanDevelopment(HUD),worriedthatitsbudgetandstaffwerenotcommensu-
ratewithitsmandatetosupervisetheselenders.WecouldhavehadtheFTCoversee
mortgagecontracts,CisnerostoldtheCommission.ButtheFTCisuptotheirneck
inworktodaywithwhattheyvegot.Theydonthavethestafftogooutandsearch
outmortgageproblems.
i
Glenn Loney, deputy director of the Feds Consumer and Community Affairs
Division from 18 to io1o, told the FCIC that ever since he joined the agency in
1,,,FedomcialshadbeendebatingwhethertheyinadditiontotheFTCshould
enforcerulesfornonbanklenders.ButtheyworriedaboutwhethertheFedwouldbe
steppingoncongressionalprerogativesbyassumingenforcementresponsibilitiesthat
legislationhaddelegatedtotheFTC.Anumberofgovernorscameinandsaid,You
meantosaywedontlookatthese:Loneysaid.Andthenwetriedtoexplainitto
them,andtheydsay,Oh,Isee.
i
TheFederalReservewouldnotexertitsauthority
inthisarea,norothersthatcameunderitspurviewin1,withanyrealforceuntil
afterthehousingbubbleburst.
The1legislationthatgavetheFednewresponsibilitieswastheHomeOwner-
shipandEquityProtectionAct(HOEPA),passedbyCongressandsignedbyPresi-
dent Clinton to address growing concerns about abusive and predatory mortgage
lendingpracticesthatespeciallyaffectedlow-incomeborrowers.HOEPAspecifcally
noted that certain communities were being victimized . . . by second mortgage
lenders, home improvement contractors, and fnance companies who peddle high-
rate,high-feehomeequityloanstocash-poorhomeowners.
i,
Forexample,aSenate
report highlighted the case of a ,i-year-old homeowner, who testifed at a hearing
that she paid more than i,ooo in upfront fnance charges on a 1,o,ooo second
mortgage. In addition, the monthly payments on the mortgage exceeded her
income.
io
HOEPAprohibitedabusivepracticesrelatingtocertainhigh-costrefnancemort-
gageloans,includingprepaymentpenalties,negativeamortization,andballoonpay-
, ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
mentswithatermoflessthanfveyears.Thelegislationalsoprohibitedlendersfrom
makinghigh-costrefnanceloansbasedonthecollateralvalueofthepropertyalone
and without regard to the consumers repayment ability, including the consumers
currentandexpectedincome,currentobligations,andemployment.
i,
However,only
asmallpercentageofmortgageswereinitiallysubjecttotheHOEPArestrictions,be-
cause the interest rate and fee levels for triggering HOEPAs coverage were set too
hightocatchmostsubprimeloans.
i8
Evenso,HOEPAspecifcallydirectedtheFedto
actmorebroadlytoprohibitactsorpracticesinconnectionwith[mortgageloans]
that[theBoard]fndstobeunfair,deceptiveordesignedtoevadetheprovisionsof
this[act].
i
InJune1,,twoyearsafterHOEPAtookeffect,theFedheldthefrstsetofpub-
lichearingsrequiredundertheact.ThevenueswereLosAngeles,Atlanta,andWash-
ington,D.C.Consumeradvocatesreportedabusesbyhomeequitylenders.Areport
summarizingthehearings,jointlyissuedwiththeDepartmentofHousingandUrban
Development and released in July 18, said that mortgage lenders acknowledged
thatsomeabusesexisted,blamedsomeoftheseonmortgagebrokers,andsuggested
that the increasing securitization of subprime mortgages was likely to limit the op-
portunityforwidespreadabuses.Thereportstated,Creditorsthatpackageandse-
curitize their home equity loans must comply with a series of representations and
warranties. These include creditors representations that they have complied with
strictunderwritingguidelinesconcerningtheborrowersabilitytorepaytheloan.
o
But in the years to come, these representations and warranties would prove to be
inaccurate.
Still,theFedcontinuednot topressitsprerogatives.InJanuary18,itformalized
itslong-standingpolicyofnotroutinelyconductingconsumercomplianceexamina-
tionsofnonbanksubsidiariesofbankholdingcompanies,
1
adecisionthatwouldbe
criticizedbyaNovember1GeneralAccountingOmcereportforcreatingalack
of regulatory oversight.
i
The July 18 report also made recommendations on
mortgagereform.

Whilepreparingdraftrecommendationsforthereport,Fedstaff
wrotetotheFedsCommitteeonConsumerandCommunityAffairsthatgiventhe
Boardstraditionalreluctancetosupportsubstantivelimitationsonmarketbehavior,
the draft report discusses various options but does not advocate any particular ap-
proachtoaddressingtheseproblems.

Intheend,althoughthetwoagenciesdidnotagreeonthefullsetofrecommen-
dations addressing predatory lending, both the Fed and HUD supported legislative
bansonballoonpaymentsandadvancecollectionoflump-suminsurancepremiums,
strongerenforcementofcurrentlaws,andnonregulatorystrategiessuchascommu-
nityoutreacheffortsandconsumereducationandcounseling.ButCongressdidnot
actontheserecommendations.
The Fed-Lite provisions under the Gramm-Leach-Bliley Act amrmed the Feds
hands-off approach to the regulation of mortgage lending. Even so, the shakeup in
the subprime industry in the late 1os had drawn regulators attention to at least
someoftherisksassociatedwiththislending.Forthatreason,theFederalReserve,
FDIC, OCC, and OTS jointly issued subprime lending guidance on March 1, 1.
:U8iii \i iiNii Nt ,,
Thisguidanceappliedonlytoregulatedbanksandthrifts,andevenforthemitwould
notbebindingbutmerelylaidoutthecriteriaunderlyingregulatorsbankexamina-
tions.Itexplainedthatrecentturmoilintheequityandasset-backedsecuritiesmar-
kethascausedsomenon-banksubprimespecialiststoexitthemarket,thuscreating
increasedopportunitiesforfnancialinstitutionstoenter,orexpandtheirparticipa-
tionin,thesubprimelendingbusiness.
,
Theagenciesthenidentifedkeyfeaturesofsubprimelendingprogramsandthe
need for increased capital, risk management, and board and senior management
oversight.Theyfurthernotedconcernsaboutvariousaccountingissues,notablythe
valuation of any residual tranches held by the securitizing frm. The guidance went
ontowarn,Institutionsthatoriginateorpurchasesubprimeloansmusttakespecial
care to avoid violating fair lending and consumer protection laws and regulations.
Higher fees and interest rates combined with compensation incentives can foster
predatorypricing. . . .Anadequatecompliancemanagementprogrammustidentify,
monitor and control the consumer protection hazards associated with subprime
lending.
o
Inspringiooo,inresponsetogrowingcomplaintsaboutlendingpractices,andat
the urging of members of Congress, HUD Secretary Andrew Cuomo and Treasury
Secretary Lawrence Summers convened the joint National Predatory Lending Task
Force. It included members of consumer advocacy groups; industry trade associa-
tionsrepresentingmortgagelenders,brokers,andappraisers;localandstateomcials;
and academics. As the Fed had done three years earlier, this new entity took to the
feld, conducting hearings in Atlanta, Los Angeles, New York, Baltimore, and
Chicago.Thetaskforcefoundpatternsofabusivepractices,reportingsubstantial
evidenceoftoo-frequentabusesinthesubprimelendingmarket.Questionableprac-
tices included loan fipping (repeated refnancing of borrowers loans in a short
time),highfeesandprepaymentpenaltiesthatresultedinborrowerslosingtheeq-
uityintheirhomes,andoutrightfraudandabuseinvolvingdeceptiveorhigh-pres-
suresalestactics.Thereportcitedtestimonyregardingincidentsofforgedsignatures,
falsifcationofincomesandappraisals,illegitimatefees,andbait-and-switchtactics.
The investigation confrmed that subprime lenders often preyed on the elderly, mi-
norities,andborrowerswithlowerincomesandlesseducation,frequentlytargeting
individuals who had limited access to the mainstream fnancial sectormeaning
the banks, thrifts, and credit unions, which it viewed as subject to more extensive
governmentoversight.
,
Consumerprotectiongroupstookthesamemessagetopublicomcials.Ininter-
views with and testimony to the FCIC, representatives of the National Consumer
LawCenter(NCLC),NevadaFairHousingCenter,Inc.,andCaliforniaReinvestment
CoalitioneachsaidtheyhadcontactedCongressandthefourbankregulatoryagen-
cies multiple times about their concerns over unfair and deceptive lending prac-
tices.
8
Itwasapparentonthegroundasearlyasoor8 . . .thatthemarketfor
low-income consumers was being fooded with inappropriate products, Diane
ThompsonoftheNCLCtoldtheCommission.

TheHUD-Treasurytaskforcerecommendedasetofreformsaimedatprotecting
, ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
borrowersfromthemostegregiouspracticesinthemortgagemarket,includingbet-
ter disclosure, improved fnancial literacy, strengthened enforcement, and new leg-
islativeprotections.However,thereportalsorecognizedthedownsideofrestricting
the lending practices that offered many borrowers with less-than-prime credit a
chanceathomeownership.Itwasadilemma.GaryGensler,whoworkedonthere-
portasaseniorTreasuryomcialandiscurrentlythechairmanoftheCommodityFu-
turesTradingCommission,toldtheFCICthatthereportsrecommendationslasted
on Capitol Hill a very short time. . . . There wasnt much appetite or mood to take
theserecommendations.
o
But problems persisted, and others would take up the cause. Through the early
years of the new decade, the really poorly underwritten loans, the payment shock
loans continued to proliferate outside the traditional banking sector, said FDIC
ChairmanSheilaBair,whoservedatTreasuryastheassistantsecretaryforfnancial
institutionsfromioo1toiooi.IntestimonytotheCommission,sheobservedthat
these poor-quality loans pulled market share from traditional banks and created
negative competitive pressure for the banks and thrifts to start following suit. She
added,
[Subprimelending]wasstartedandthelionsshareofitoccurredinthe
nonbank sector, but it clearly created competitive pressures on
banks. . . .Ithinknippingthisinthebudinioooandioo1withsome
strong consumer rules applying across the board that just simply said
youvegottodocumentacustomersincometomakesuretheycanre-
paytheloan,youvegottomakesuretheincomeissumcienttopaythe
loanswhentheinterestrateresets,justsimpleruleslikethat . . .could
havedonealottostopthis.
1
AfterBairwasnominatedtoherpositionatTreasury,andwhenshewasmaking
the rounds on Capitol Hill, Senator Paul Sarbanes, chairman of the Committee on
Banking,Housing,andUrbanAffairs,toldheraboutlendingproblemsinBaltimore,
whereforeclosureswereontherise.HeaskedBairtoreadtheHUD-Treasuryreport
on predatory lending, and she became interested in the issue. Sarbanes introduced
legislationtoremedytheproblem,butitfacedsignifcantresistancefromthemort-
gageindustryandwithinCongress,BairtoldtheCommission.Bairdecidedtotryto
gettheindustrytoadoptasetofbestpracticesthatwouldincludeavoluntaryban
onmortgagesthatstripborrowersoftheirequity,andwouldofferborrowerstheop-
portunitytoavoidprepaymentpenaltiesbyagreeinginsteadtopayahigherinterest
rate.ShereachedouttoEdwardGramlich,agovernorattheFedwhosharedhercon-
cerns, to enlist his help in getting companies to abide by these rules. Bair said that
GramlichdidnttalkoutofschoolbutmadeitcleartoherthattheFedavenuewasnt
goingtohappen.
i
Similarly,SandraBraunstein,thedirectoroftheDivisionofCon-
sumer and Community Affairs at the Fed, said that Gramlich told the staff that
Greenspanwasnotinterestedinincreasedregulation.

When Bair and Gramlich approached a number of lenders about the voluntary
:U8iii \i iiNii Nt ,,
program, Bair said some originators appeared willing to participate. But the Wall
Streetfrmsthatsecuritizedtheloansresisted,sayingthattheywereconcernedabout
possible liability if they did not adhere to the proposed best practices, she recalled.
Theeffortdied.

Ofcourse,evenastheseinitiativeswentnowhere,themarketdidnotstandstill.
Subprime mortgages were proliferating rapidly, becoming mainstream products.
Originations were increasing, and products were changing. By 1, three of every
foursubprimemortgageswasafrstmortgage,andofthose8iwereusedforref-
nancingratherthanahomepurchase.Fifty-ninepercentofthoserefnancingswere
cash-outs,
,
helping to fuel consumer spending while whittling away homeowners
equity.
+ ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
PART III
The Boom and Bust
6
CREDIT EXPANSION
CONTENTS
HcusingApcwcrju|sta|i|i:ingjcrcc :,
Su|princ|cansBuycrswi||payahighprcniun ::
CitigrcupInvitcdrcgu|atcryscrutiny ,:
Icdcra|ru|csIntcndcdtccur|unjaircra|usivc|cnding ,,
StatcsIcng-standingpcsiticn,e
Ccnnunity-|cndingp|cdgcsVhatwcdcisrcarncurintcnticn ,,
Bankcapita|standardsAr|itragc ,,
By the end of iooo, the economy had grown straight quarters. Federal Reserve
ChairmanAlanGreenspanarguedthefnancialsystemhadachievedunprecedented
resilience.Largefnancialcompanieswereoratleasttomanyobserversatthetime,
appeared to beproftable, diversifed, and, executives and regulators agreed, pro-
tectedfromcatastrophebysophisticatednewtechniquesofmanagingrisk.
Thehousingmarketwasalsostrong.Between1,andiooo,pricesroseatanan-
nualrateof,.i;overthenextfveyears,theratewouldhit11.,.
1
Lowerinterest
ratesformortgageborrowerswerepartlythereason,aswasgreateraccesstomort-
gagecreditforhouseholdswhohadtraditionallybeenleftoutincludingsubprime
borrowers.Lowerinterestratesandbroaderaccesstocreditwereavailableforother
typesofborrowing,too,suchascreditcardsandautoloans.
Increasedaccesstocreditmeantamorestable,securelifeforthosewhomanaged
their fnances prudently. It meant families could borrow during temporary income
drops, pay for unexpected expenses, or buy major appliances and cars. It allowed
otherfamiliestoborrowandspendbeyondtheirmeans.Mostofall,itmeantashot
athomeownership,withallitsbenefts;andforsome,anopportunitytospeculatein
therealestatemarket.
Ashomepricesrose,homeownerswithgreaterequityfeltmorefnanciallysecure
and,partlyasaresult,savedlessandless.Manyotherswentonestepfurther,borrow-
ing against the equity. The effect was unprecedented debt: between ioo1 and ioo,,
mortgagedebtnationallynearlydoubled.Householddebtrosefrom8oofdispos-
ablepersonalincomein1toalmost1obymid-iooo.Morethanthree-quarters
,
of this increase was mortgage debt. Part of the increase was from new home pur-
chases,partfromnewdebtonolderhomes.
Mortgage credit became more available when subprime lending started to grow
againaftermanyofthemajorsubprimelendersfailedorwerepurchasedin18and
1.Afterward,thebiggestbanksmovedin.Iniooo,Citigroup,with8oobillionin
assets, paid 1 billion for Associates First Capital, the second-biggest subprime
lender. Still, subprime lending remained only a niche, just ., of new mortgages
iniooo.
i
Subprime lending risks and questionable practices remained a concern. Yet the
Federal Reserve did not aggressively employ the unique authority granted it by the
Home Ownership and Equity Protection Act (HOEPA). Although in ioo the Fed
fnedCitigroup,omillionforlendingviolations,itonlyminimallyrevisedtherules
for a narrow set of high-cost mortgages.

Following losses by several banks in sub-


primesecuritization,theFedandotherregulatorsrevisedcapitalstandards.
HOUSING: A POWERFUL STABILIZING FORCE
Bythebeginningofioo1,theeconomywasslowing,eventhoughunemploymentre-
mained at a o-year low of . To stimulate borrowing and spending, the Federal
ReservesFederalOpenMarketCommitteeloweredshort-terminterestratesaggres-
sively. On January , ioo1, in a rare conference call between scheduled meetings,
it cut the benchmark federal funds rateat which banks lend to each other
overnightby a half percentage point, rather than the more typical quarter point.
Laterthatmonth,thecommitteecuttherateanotherhalfpoint,anditcontinuedcut-
tingthroughouttheyear11timesinallto1.,,,thelowestinoyears.
In the end, the recession of ioo1 was relatively mild, lasting only eight months,
fromMarchtoNovember,andgrossdomesticproduct,orGDPthemostcommon
gauge of the economydropped by only o.. Some policy makers concluded that
perhaps,witheffectivemonetarypolicy,theeconomyhadreachedtheso-calledend
of the business cycle, which some economists had been predicting since before the
tech crash. Recessions have become less frequent and less severe, said Ben
Bernanke, then a Fed governor, in a speech early in ioo. Whether the dominant
cause of the Great Moderation is structural change, improved monetary policy, or
simply good luck is an important question about which no consensus has yet
formed.

Withtherecessionoverandmortgageratesato-yearlows,housingkickedinto
high gearagain. The nation would lose more than o,ooo nonfarm jobs in iooi
but make small gains in construction. In states where bubbles soon appeared, con-
struction picked up quickly. California ended iooi with a total of only i,oo more
jobs,butwithi1,1oonewconstructionjobs.InFlorida,1ofnetjobgrowthwasin
construction.Inioo,buildersstartedmorethan1.8millionsingle-familydwellings,
arateunseensincethelate1,os.Fromiooitoioo,,residentialconstructioncon-
tributed three times more to the economy than it had contributed on average since
1o.
, ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
Butelsewheretheeconomyremainedsluggish,andemploymentgainswerefrus-
tratinglysmall.Expertsbegantalkingaboutajoblessrecoverymoreproduction
without a corresponding increase in employment. For those with jobs, wages stag-
nated.Betweeniooiandioo,,weeklyprivatenonfarm,nonsupervisorywagesactu-
ally fell by 1 after adjusting for infation. Faced with these challenges, the Fed
shiftedperspective,nowconsideringthepossibilitythatconsumerpricescouldfall,
aneventthathadworsenedtheGreatDepressionsevendecadesearlier.Whilecon-
cerned,theFedbelieveddefationwouldbeavoided.Inawidelyquotediooispeech,
Bernankesaidthechancesofdefationwereextremelysmallfortworeasons.First,
the economys natural resilience: Despite the adverse shocks of the past year, our
bankingsystemremainshealthyandwell-regulated,andfrmandhouseholdbalance
sheetsareforthemostpartingoodshape.Second,theFedwouldnotallowit.Iam
confdent that the Fed would take whatever means necessary to prevent signifcant
defationintheUnitedStates. . . .[T]heU.S.governmenthasatechnology,calleda
printingpress(or,today,itselectronicequivalent),thatallowsittoproduceasmany
U.S.dollarsasitwishesatessentiallynocost.
,
The Feds monetary policy kept short-term interest rates low. During ioo, the
strongestU.S.companiescouldborrowforodaysinthecommercialpapermarket
atanaverage1.1,comparedwitho.justthreeyearsearlier;ratesonthree-month
Treasurybillsdroppedbelow1inmid-ioofromoiniooo.
o
Low rates cut the cost of homeownership: interest rates for the typical o-year
fxed-ratemortgagetraditionallymovedwiththeovernightfedfundsrate,andfrom
ioootoioo,thisrelationshipheld(seefgureo.1).Byioo,creditworthyhomebuy-
ers could get fxed-rate mortgages for ,.i, percentage points lower than three
years earlier. The savings were immediate and large. For a home bought at the me-
dianpriceof18o,ooo,withaiodownpayment,themonthlymortgagepayment
wouldbei8olessthaniniooo.Ortoturntheperspectivearoundasmanypeople
didforthesamemonthlypaymentof1,o,,,ahomeownercouldmoveupfroma
18o,ooohometoai,,oooone.
,
An adjustable-rate mortgage (ARM) gave buyers even lower initial payments or
madealargerhouseaffordableunlessinterestratesrose.Inioo1,justofprime
borrowerswithnewmortgageschoseARMs;inioo,1odid.Inioo,thepropor-
tionrosetoi1.
8
Amongsubprimeborrowers,alreadyheavyusersofARMs,itrose
fromaroundooto,o.

Aspeoplejumpedintothehousingmarket,pricesrose,andinhotmarketsthey
reallytookoff(seefgureo.i).InFlorida,averagehomepricesgained.1annually
from1,toioooandthen11.1annuallyfromioootoioo.InCalifornia,those
numbers were even higher: o.1 and 1.o. In California, a house bought for
ioo,oooin1,wasworth,,i8nineyearslater.However,soaringpriceswere
not necessarily the norm. In Washington State, prices continued to appreciate, but
moreslowly:,.annuallyfrom1,toiooo,,.,annuallyfromioootoioo.In
Ohio,thenumberswere.and.o.
1o
Nationwide,homepricesrose.8annu-
ally from iooo to ioohistorically high, but well under the fastest-growing
markets.
tiiii 1 i\i\N:i uN ,
Homeownershipincreasedsteadily,peakingato.iofhouseholdsinioo.
11
Be-
causesomanyfamilieswerebeneftingfromhigherhomevalues,householdwealth
rosetonearlysixtimesincome,upfromfvetimesafewyearsearlier.Thetop1oof
households by net worth, of whom o owned their homes, saw the value of their
primaryresidencesrisebetweenioo1andioofrom,i,8ooto,o,ooo(adjusted
forinfation),anincreaseofmorethan,,,ooo.Mediannetworthforallhouseholds
inthetop1o,afteraccountingforotherhousingvalueandassets,aswellasalllia-
bilities,was1.millioninioo.Homeownershipratesforthebottomi,ofhouse-
holdstickedupfrom1to1,betweenioo1andioo;themedianvalueoftheir
primaryresidencesrosefrom,i,,ootoo,,ooo,anincreaseofmorethan1i,ooo.
Mediannetworthforhouseholdsinthebottomi,was1,,ooinioo.
1i
Historically,every1,oooincreaseinhousingwealthboostedconsumerspending
by an estimated ,o a year.
1
But economists debated whether the wealth increases
wouldaffectspendingmorethaninpastyears,becausesomanyhomeownersatso
many levels of wealth saw increases and because it was easier and cheaper to tap
homeequity.
Higherhomepricesandlowmortgageratesbroughtawaveofrefnancingtothe
prime mortgage market. In ioo alone, lenders refnanced over 1, million mort-
gages,morethanoneinfouranunprecedentedlevel.
1
Manyhomeownerstookout
cash while cutting their interest rates. From ioo1 through ioo, cash-out refnanc-
ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
Bank Borrowing and Mortgage Interest Rates
IN PERCENT
0
5
10
15
20%
1975 1985 1980 1995 1990 2000 2005 2010
30-year
conventional
mortgage rate
SOURCE: Federal Reserve Bank of St. Louis, Federal Reserve Economic Database
Effective
federal funds
rate
Rates for both banks and homeowners have been low in recent years.
Iigurc o.+
ings netted these households an estimated i, billion; homeowners accessed an-
other o billion via home equity loans.
1,
Some were typical second liens; others
wereanewerinvention,thehomeequitylineofcredit.Theseoperatedmuchlikea
creditcard,lettingtheborrowerborrowandrepayasneeded,oftenwiththeconven-
ienceofanactualplasticcard.
AccordingtotheFedsiooSurveyofConsumerFinances,,.oofhomeowners
whotappedtheirequityusedthatmoneyforexpensessuchasmedicalbills,taxes,elec-
tronics,andvacations,ortoconsolidatedebt;another1.ouseditforhomeimprove-
ments;andtherestpurchasedmorerealestate,cars,investments,clothing,orjewelry.
A Congressional Budget Omce paper from ioo, reported on the recent history:
Ashousingpricessurgedinthelate1osandearlyiooos,consumersboostedtheir
spendingfasterthantheirincomerose.Thatwasrefectedinasharpdropintheper-
sonal savings rate.
1o
Between 18 and ioo,, increased consumer spending ac-
countedforbetweeno,and1o8ofGDPgrowthinanyyearrisingabove1oo
inyearswhenspendinggrowthoffsetdeclineselsewhereintheeconomy.Meanwhile,
thepersonalsavingratedroppedfrom,.ito1..Somecomponentsofspending
grewremarkablyfast:homefurnishingsandotherhouseholddurables,recreational
goods and vehicles, spending at restaurants, and health care. Overall consumer
spending grew faster than the economy, and in some years it grew faster than real
disposableincome.
Nonetheless, the economy looked stable. By ioo, it had weathered the brief re-
cessionofioo1andthedot-combust,whichhadcausedthelargestlossofwealthin
tiiii 1 i\i\N:i uN ,
U.S. Home Prices
INDEX VALUE: JANUARY 2000 = 100
U.S. August 2010 145
U.S. April 2006 201
1976 1985 1980 1995 1990 2005 2000 2010
0
50
100
150
200
250
300
NOTE: Sand states are Arizona, California, Florida, and Nevada.
SOURCE: CoreLogic and U.S. Census Bureau: 2007 American Community Survey, FCIC calculations
Sand states
U.S. total
Non-sand states
Iigurc o.:
decades.Withnewfnancialproductslikethehomeequitylineofcredit,households
couldborrowagainsttheirhomestocompensateforinvestmentlossesorunemploy-
ment.Defation,againstwhichtheFedhadstruckpreemptively,didnotmaterialize.
AtacongressionalhearinginNovemberiooi,Greenspanacknowledgedatleast
implicitlythatafterthedot-combubbleburst,theFedcutinterestratesinpartto
promotehousing.GreenspanarguedthattheFedslow-interest-ratepolicyhadstim-
ulated the economy by encouraging home sales and housing starts with mortgage
interestratesthatareatlowsnotseenindecades.AsGreenspanexplained,Mort-
gage markets have also been a powerful stabilizing force over the past two years of
economic distress by facilitating the extraction of some of the equity that home-
ownershadbuiltup.
1,
InFebruaryioo,hereiteratedhispoint,referringtoalarge
extractionofcashfromhomeequity.
18
SUBPRIME LOANS: BUYERS WILL PAY A HIGH PREMIUM
Thesubprimemarketroaredbackfromitsshakeoutinthelate1os.Thevalueof
subprimeloansoriginatedalmostdoubledfromioo1throughioo,to1obillion.
Iniooo,,ioftheseweresecuritized;inioo,o.
1
Lowinterestratesspurredthis
boom, which would have long-term repercussions, but so did increasingly wide-
spread computerized credit scores, the growing statistical history on subprime bor-
rowers,andthescaleofthefrmsenteringthemarket.
Subprimewasdominatedbyanarrowingfeldofever-largerfrms;themarginal
playersfromthepastdecadehadmergedorvanished.Byioo,thetopi,subprime
lendersmadeofallsubprimeloans,upfrom,in1o.
io
Therewerenowthreemainkindsofcompaniesinthesubprimeoriginationand
securitizationbusiness:commercialbanksandthrifts,WallStreetinvestmentbanks,
and independent mortgage lenders. Some of the biggest banks and thriftsCiti-
group,NationalCityBank,HSBC,andWashingtonMutualspentbillionsonboost-
ingsubprimelendingbycreatingnewunits,acquiringfrms,orofferingfnancingto
other mortgage originators. Almost always, these operations were sequestered in
nonbanksubsidiaries,leavingtheminaregulatoryno-mans-land.
Whenitcametosubprimelending,nowitwasWallStreetinvestmentbanksthat
worriedaboutcompetitionposedbythelargestcommercialbanksandthrifts.For-
merLehmanpresidentBartMcDadetoldtheFCICthatthebankshadgainedtheir
ownsecuritizationskillsanddidntneedtheinvestmentbankstostructureanddis-
tribute.
i1
So the investment banks moved into mortgage origination to guarantee a
supplyofloanstheycouldsecuritizeandselltothegrowinglegionsofinvestors.For
example,LehmanBrothers,thefourth-largestinvestmentbank,purchasedsixdiffer-
ent domestic lenders between 18 and ioo, including BNC and Aurora.
ii
Bear
Stearns, the ffth-largest, ramped up its subprime lending arm and eventually ac-
quired three subprime originators in the United States, including Encore. In iooo,
MerrillLynchacquiredFirstFranklin,andMorganStanleyboughtSaxonCapital;in
ioo,,GoldmanSachsuppeditsstakeinSenderraFunding,asmallsubprimelender.
Meanwhile,severalindependentmortgagecompaniestookstepstoboostgrowth.
ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
New Century and Ameriquest were especially aggressive. New Centurys Focus
iooo plan concentrated on originating loans with characteristics for which whole
loanbuyerswillpayahighpremium.
i
Thosewholeloanbuyerswerethefrmson
Wall Street that purchased loans and, most often, bundled them into mortgage-
backedsecurities.Theywereeagercustomers.Inioo,NewCenturysoldio.8bil-
lioninwholeloans,upfrom.1billionthreeyearsbefore,
i
launchingthefrmfrom
tenthtosecondplaceamongsubprimeoriginators.Three-quarterswenttotwosecu-
ritizing frmsMorgan Stanley and Credit Suissebut New Century reassured its
investorsthatthereweremanymoreprospectivebuyers.
i,
Ameriquest, in particular, pursued volume. According to the companys public
statements,itpaiditsaccountexecutiveslesspermortgagethanthecompetition,but
it encouraged them to make up the difference by underwriting more loans. Our
peoplemakemorevolumeperemployeethantherestoftheindustry,AseemMital,
CEOofAmeriquest,saidinioo,.Thecompanycutcostselsewhereintheorigina-
tionprocess,too.Thebackomceforthefrmsretaildivisionoperatedinassembly-
line fashion, Mital told a reporter for American Banker; the work was divided into
specialized tasks, including data entry, underwriting, customer service, account
management, and funding. Ameriquest used its savings to undercut by as much as
o.,,whatcompetingoriginatorschargedsecuritizingfrms,accordingtoanindus-
try analysts estimate. Between iooo and ioo, Ameriquest loan origination rose
from an estimated billion to billion annually. That vaulted the frm from
eleventhtofrstplaceamongsubprimeoriginators.Theyareclearlytheaggressor,
CountrywideCEOAngeloMozilotoldhisinvestorsinioo,.
io
Byioo,,Countrywide
wasthirdonthelist.
Thesubprimeplayersfolloweddiversestrategies.LehmanandCountrywidepur-
sued a vertically integrated model, involving them in every link of the mortgage
chain:originatingandfundingtheloans,packagingthemintosecurities,andfnally
selling the securities to investors. Others concentrated on niches: New Century, for
example,mainlyoriginatedmortgagesforimmediatesaletootherfrmsinthechain.
When originators made loans to hold through maturityan approach known as
originate-to-holdtheyhadaclearincentivetounderwritecarefullyandconsiderthe
risks. However, when they originated mortgages to sell, for securitization or other-
wiseknown as originate-to-distributethey no longer risked losses if the loan de-
faulted. As long as they made accurate representations and warranties, the only risk
wastotheirreputationsifalotoftheirloanswentbadbutduringtheboom,loans
were not going bad. In total, this originate-to-distribute pipeline carried more than
halfofallmortgagesbeforethecrisis,andamuchlargerpieceofsubprimemortgages.
For decades, a version of the originate-to-distribute model produced safe mort-
gages.FannieandFreddiehadbeenbuyingprime,conformingmortgagessincethe
1,os,protectedbystrictunderwritingstandards.Butsomesawthatthemodelnow
hadproblems.Ifyoulookathowmanypeopleareplaying,fromtherealestateagent
all the way through to the guy who is issuing the security and the underwriter and
theunderwritinggroupandblah,blah,blah,thennobodyinthisentirechainisre-
sponsibletoanybody,LewisRanieri,anearlyleaderinsecuritization,toldtheFCIC,
tiiii 1 i\i\N:i uN ,
nottheoutcomeheandotherinvestmentbankershadexpected.Noneofuswrote
andsaid,Oh,bytheway,youhavetoberesponsibleforyouractions,Ranierisaid.
Itwasprettyself-evident.
i,
Thestartingpointformanymortgageswasamortgagebroker.Theseindepend-
entbrokers,withaccesstoavarietyoflenders,workedwithborrowerstocomplete
theapplicationprocess.Usingbrokersallowedmorerapidexpansion,withnoneed
to build branches; lowered costs, with no need for full-time salespeople; and ex-
tendedgeographicreach.
For brokers, compensation generally came as up-front feesfrom the borrower,
from the lender, or bothso the loans performance mattered little. These fees were
oftenpaidwithouttheborrowersknowledge.Indeed,manyborrowersmistakenlybe-
lievedthemortgagebrokersactedinborrowersbestinterest.
i8
Onecommonfeepaid
bythelendertothebrokerwastheyieldspreadpremium:onhigher-interestloans,
thelendingbankwouldpaythebrokerahigherpremium,givingtheincentivetosign
theborrowertothehighestpossiblerate.Ifthebrokerdecideshesgoingtotryand
makemoremoneyontheloan,thenhesgoingtoraisetherate,saidJayJeffries,afor-
mersalesmanagerforFremontInvestment&Loan,totheCommission.Wevegota
higherrateloan,werepayingthebrokerforthatyieldspreadpremium.
i
In theory, borrowers are the frst defense against abusive lending. By shopping
around,theyshouldrealize,forexample,ifabrokeristryingtosellthemahigher-
pricedloanortoplacetheminasubprimeloanwhentheywouldqualifyforaless-
expensiveprimeloan.Butmanyborrowersdonotunderstandthemostbasicaspects
oftheirmortgage.AstudybytwoFederalReserveeconomistsestimatedatleast8
ofborrowerswithadjustable-ratemortgagesdidnotunderstandhowmuchtheirin-
terest rates could reset at one time, and more than half underestimated how high
theirratescouldreachovertheyears.
o
Thesamelackofawarenessextendedtoother
terms of the loanfor example, the level of documentation provided to the lender.
Most borrowers didnt even realize that they were getting a no-doc loan, said
MichaelCalhoun,presidentoftheCenterforResponsibleLending.Theydcomein
withtheirW-iandendupwithano-docloansimplybecausethebrokerwasgetting
paidmoreandthelenderwasgettingpaidmoreandtherewasextrayieldleftoverfor
WallStreetbecausetheloancarriedahigherinterestrate.
1
Andborrowerswithlessaccesstocreditareparticularlyillequippedtochallenge
themoreexperiencedpersonacrossthedesk.Whilemany[consumers]believethey
areprettygoodatdealingwithday-to-dayfnancialmatters,inactualitytheyengage
in fnancial behaviors that generate expenses and fees: overdrawing checking ac-
counts,makinglatecreditcardpayments,orexceedinglimitsoncreditcardcharges,
AnnamariaLusardi,aprofessorofeconomicsatDartmouthCollege,toldtheFCIC.
Comparingtermsoffnancialcontractsandshoppingaroundbeforemakingfnan-
cialdecisionsarenotatallcommonamongthepopulation.
i
Recall our case study securitization deal discussed earlierin which New Cen-
tury sold , mortgages to Citigroup, which then sold them to the securitization
trust, which then bundled them into 1 tranches for sale to investors. Out of those
, mortgages, brokers originated ,oo on behalf of New Century. For each, the
,+ ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
brokers received an average fee from the borrowers of ,,,o, or 1.81 of the loan
amount.Ontopofthat,thebrokersalsoreceivedyieldspreadpremiumsfromNew
Centuryfor1,,oftheseloans,averagingi,,8,each.Intotal,thebrokersreceived
morethan1,.,millioninfeesforthe,ooloans.

Criticsarguedthatwiththismuchmoneyatstake,mortgagebrokershadeveryin-
centivetoseekthehighestcombinationoffeesandmortgageinterestratesthemarket
will bear.

Herb Sandler, the founder and CEO of the thrift Golden West Financial
Corporation,toldtheFCICthatbrokerswerethewhoresoftheworld.
,
Asthehous-
ingandmortgagemarketboomed,sodidthebrokers.WholesaleAccess,whichtracks
the mortgage industry, reported that from iooo to ioo, the number of brokerage
frmsrosefromabouto,oooto,o,ooo.Iniooo,brokersoriginated,,ofloans;in
ioo,theypeakedato8.
o
JPMorganCEOJamieDimontestifedtotheFCICthat
hisfrmeventuallyendeditsbroker-originatedbusinessiniooafterdiscoveringthe
loanshadmorethantwicethelossesoftheloansthatJPMorganitselforiginated.
,
As the housing market expanded, another problem emerged, in subprime and
prime mortgages alike: infated appraisals. For the lender, infated appraisals meant
greaterlossesifaborrowerdefaulted.Butfortheborrowerorforthebrokerorloan
omcerwhohiredtheappraiser,aninfatedvaluecouldmakethedifferencebetween
closing and losing the deal. Imagine a home selling for ioo,ooo that an appraiser
saysisactuallyworthonly1,,,ooo.Inthiscase,abankwontlendaborrower,say,
18o,oootobuythehome.Thedealdies.Sureenough,appraisersbeganfeelingpres-
sure.Oneioosurveyfoundthat,,oftheappraisershadfeltpressedtoinfatethe
value of homes; by iooo, this had climbed to o. The pressure came most fre-
quentlyfromthemortgagebrokers,butappraisersreporteditfromrealestateagents,
lenders,andinmanycasesborrowersthemselves.Mostoften,refusaltoraisetheap-
praisal meant losing the client.
8
Dennis J. Black, president of the Florida appraisal
andbrokerageservicesfrmD.J.Black&Co.andanappraiserwithiyearsexperi-
ence,heldcontinuingeducationsessionsalloverthecountryfortheNationalAssoci-
ationofIndependentFeeAppraisers.Heheardcomplaintsfromtheappraisersthat
theyhadbeenpressuredtoignoremissingkitchens,damagedwalls,andinoperable
mechanicalsystems.BlacktoldtheFCIC,ThestoryIhaveheardmostoftenisthe
client saying he could not use the appraisal because the value was [not] what they
needed.

Theclientwouldhiresomebodyelse.
Changes in regulations reinforced the trend toward laxer appraisal standards, as
Karen Mann, a Sacramento appraiser with o years experience, explained in testi-
mony to the FCIC. In 1, the Federal Reserve, Omce of the Comptroller of the
Currency, Omce of Thrift Supervision, and Federal Deposit Insurance Corporation
loosened the appraisal requirements for the lenders they regulated by raising from
1oo,ooo to i,o,ooo the minimum home value at which an appraisal from a li-
censedprofessionalwasrequired.Inaddition,Manncitedthelackofoversightofap-
praisers,noting,Wehadavastincreaseoflicensedappraisersin[California]inspite
ofthelackofqualifed/experiencedtrainers.
o
TheBakersfeldappraiserGaryCrab-
treetoldtheFCICthatCaliforniasOmceofRealEstateAppraisershadeightinvesti-
gatorstosupervisei1,oooappraisers.
1
tiiii 1 i\i\N:i uN ,.
In ioo,, the four bank regulators issued new guidance to strengthen appraisals.
They recommended that an originators loan production staff not select appraisers.
That led Washington Mutual to use an appraisal management company, First
American Corporation, to choose appraisers. Nevertheless, in ioo, the New York
StateattorneygeneralsuedFirstAmerican:relyingoninternalcompanydocuments,
thecomplaintallegedthecorporationimproperlyletWashingtonMutualsloanpro-
duction staff hand-pick appraisers who bring in appraisal values high enough to
permit WaMus loans to close, and improperly permit[ted] WaMu to pressure . . .
appraiserstochangeappraisalvaluesthataretoolowtopermitloanstoclose.
i
CITIGROUP: INVITED REGULATORY SCRUTINY
Assubprimeoriginationsgrew,Citigroupdecidedtoexpand,withtroublingconse-
quences. Barely a year after the Gramm-Leach-Bliley Act validated its 18 merger
withTravelers,Citigroupmadeitsnextbigmove.InSeptemberiooo,itpaid1bil-
lionforAssociatesFirst,thenthesecond-largestsubprimelenderinthecountry(af-
terHouseholdFinance.).Suchamergerwouldusuallyhaverequiredapprovalfrom
the Federal Reserve and the other bank regulators, because Associates First owned
three small banks (in Utah, Delaware, and South Dakota). But because these banks
werespecialized,aprovisiontuckedawayinGramm-Leach-BlileykepttheFedoutof
themix.TheOCC,FDIC,andNewYorkStatebankingregulatorsreviewedthedeal.
Consumergroupsfoughtit,citingalongrecordofallegedlendingabusesbyAssoci-
ates First, including high prepayment penalties, excessive fees, and other opaque
charges in loan documentsall targeting unsophisticated borrowers who typically
could not evaluate the forms. Its simply unacceptable to have the largest bank in
America take over the icon of predatory lending, said Martin Eakes, founder of a
nonproftcommunitylenderinNorthCarolina.

Advocates for the merger argued that a large bank under a rigorous regulator
could reform the company, and Citigroup promised to take strong actions. Regula-
torsapprovedthemergerinNovemberiooo,andbythenextsummerCitigrouphad
startedsuspendingmortgagepurchasesfromclosetotwo-thirdsofthebrokersand
half the banks that had sold loans to Associates First. We were aware that brokers
wereattheheartofthatpublicdiscussionandwereattheheartofalotofthe[con-
troversial]cases,saidPamFlaherty,aCitigroupseniorvicepresidentforcommunity
relationsandoutreach.

ThemergerexposedCitigrouptoenhancedregulatoryscrutiny.Inioo1,theFed-
eralTradeCommission,whichregulatesindependentmortgagecompaniescompli-
ancewithconsumerprotectionlaws,launchedaninvestigationintoAssociatesFirsts
premerger business and found that the company had pressured borrowers to ref-
nanceintoexpensivemortgagesandtobuyexpensivemortgageinsurance.Iniooi,
Citigroupreachedarecordi1,millioncivilsettlementwiththeFTCoverAssoci-
atessystematicandwidespreaddeceptiveandabusivelendingpractices.
,
Inioo1,theNewYorkFedusedtheoccasionofCitigroupsnextproposedacqui-
sitionEuropeanAmericanBankonLongIsland,NewYorktolaunchitsownin-
,z ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
vestigationofCitiFinancial,whichnowcontainedAssociatesFirst.Themannerin
which [Citigroup] approached that transaction invited regulatory scrutiny, former
Fed Governor Mark Olson told the FCIC. They bought a passel of problems for
themselvesanditwasatleastatwo-year[issue].
o
TheFedeventuallyaccusedCiti-
Financialofconvertingunsecuredpersonalloans(usuallyforborrowersinfnancial
trouble)intohomeequityloanswithoutproperlyassessingtheborrowersabilityto
repay.Reviewinglendingpracticesfromioooandioo1,theFedalsoaccusedtheunit
ofsellingcreditinsurancetoborrowerswithoutcheckingiftheywouldqualifyfora
mortgagewithoutit.Fortheseviolationsandforimpedingitsinvestigation,theFed
in ioo assessed ,o million in penalties. The company said it expected to pay an-
otheromillioninrestitutiontoborrowers.
,
FEDERAL RULES:
INTENDED TO CURB UNFAIR OR ABUSIVE LENDING
As Citigroup was buying Associates First in iooo, the Federal Reserve revisited the
rulesprotectingborrowersfrompredatoryconduct.Itconducteditssecondroundof
hearings on the Home Ownership and Equity Protection Act (HOEPA), and subse-
quentlythestaffofferedtworeformproposals.Thefrstwouldhaveeffectivelybarred
lendersfromgrantinganymortgagenotjustthelimitedsetofhigh-costloansdefned
byHOEPAsolelyonthevalueofthecollateralandwithoutregardtotheborrowers
abilitytorepay.Forhigh-costloans,thelenderwouldhavetoverifyanddocumentthe
borrowersincomeanddebt;forotherloans,thedocumentationstandardwasweaker,
asthelendercouldrelyontheborrowerspaymenthistoryandthelike.Thestaffmemo
explainedthiswouldmainlyaffectlenderswhomakeno-documentationloans.The
secondproposaladdressedpracticessuchasdeceptiveadvertisements,misrepresenting
loanterms, andhavingconsumerssignblankdocumentsactsthatinvolvefraud,de-
ception,ormisrepresentations.
8
Despite evidence of predatory tactics from their own hearings and from the re-
centlyreleasedHUD-Treasuryreport,Fedomcialsremaineddividedonhowaggres-
sivelytostrengthenborrowerprotections.Theygrappledwiththesametrade-offthat
theHUD-Treasuryreporthadrecentlynoted.Wewanttoencouragethegrowthin
thesubprimelendingmarket,FedGovernorEdwardGramlichremarkedattheFi-
nancialServicesRoundtableinearlyioo.Butwealsodontwanttoencouragethe
abuses;indeed,wewanttodowhatwecantostoptheseabuses.

FedGeneralCoun-
selScottAlvareztoldtheFCIC,Therewasconcernthatifyouputoutabroadrule,
youwouldstopthingsthatwerenotunfairanddeceptivebecauseyouweretryingto
get at the bad practices and you just couldnt think of all of the details you would
need.Andifyoudidthinkofallofthedetails,youdendupwritingarulethatpeople
couldgetaroundveryeasily.
,o
Greenspan, too, later said that to prohibit certain products might be harmful.
These and other kinds of loan products, when made to borrowers meeting appro-
priate underwriting standards, should not necessarily be regarded as improper, he
said,andonthecontraryfacilitatedthenationalpolicyofmakinghomeownership
tiiii 1 i\i\N:i uN ,,
morebroadlyavailable.
,1
Instead,atleastforcertainviolationsofconsumerprotec-
tionlaws,hesuggestedanotherapproach:Ifthereisegregiousfraud,ifthereisegre-
gious practice, one doesnt need supervision and regulation, what one needs is law
enforcement.
,i
But the Federal Reserve would not use the legal system to rein in
predatorylenders.FromiooototheendofGreenspanstenureiniooo,theFedre-
ferredtotheJusticeDepartmentonlythreeinstitutionsforfairlendingviolationsre-
lated to mortgages: First American Bank, in Carpentersville, Illinois; Desert
Community Bank, in Victorville, California; and the New York branch of Socit
Gnrale,alargeFrenchbank.
Fedomcialsrejectedthestaffproposals.Aftersomewrangling,inDecemberioo1
the Fed did modify HOEPA, but only at the margins. Explaining its actions, the
boardhighlightedcompromise:Thefnalruleisintendedtocurbunfairorabusive
lendingpracticeswithoutundulyinterferingwiththefowofcredit,creatingunnec-
essarycreditorburden,ornarrowingconsumersoptionsinlegitimatetransactions.
Thestatusquowouldchangelittle.Fedeconomistshadestimatedthepercentageof
subprimeloanscoveredbyHOEPAwouldincreasefromtoasmuchas8un-
der the new regulations.
,
But lenders changed the terms of mortgages to avoid the
newrulesrevisedinterestrateandfeetriggers.Bylateioo,,itwasclearthatthenew
regulationswouldendupcoveringonlyabout1ofsubprimeloans.
,
Nevertheless,
refecting on the Federal Reserves efforts, Greenspan contended in an FCIC inter-
viewthattheFedhaddevelopedasetofrulesthathavehelduptothisday.
,,
Thiswasamissedopportunity,saysFDICChairmanSheilaBair,whodescribed
the one bullet that might have prevented the fnancial crisis: I absolutely would
have been over at the Fed writing rules, prescribing mortgage lending standards
acrosstheboardforeverybody,bankandnonbank,thatyoucannotmakeamortgage
unlessyouhavedocumentedincomethattheborrowercanrepaytheloan.
,o
The Fed held back on enforcement and supervision, too. While discussing
HOEPArulechangesiniooo,thestaffoftheFedsDivisionofConsumerandCom-
munity Affairs also proposed a pilot program to examine lending practices at bank
holdingcompaniesnonbanksubsidiaries,
,,
suchasCitiFinancialandHSBCFinance,
whose infuence in the subprime market was growing. The nonbank subsidiaries
were subject to enforcement actions by the Federal Trade Commission, while the
banksandthriftswereoverseenbytheirprimaryregulators.Astheholdingcompany
regulator,theFedhadtheauthoritytoexaminenonbanksubsidiariesforcompliance
withthe[BankHoldingCompanyAct]oranyotherFederallawthattheBoardhas
specifcjurisdictiontoenforce;however,theconsumerprotectionlawsdidnotex-
plicitlygivetheFedenforcementauthorityinthisarea.
,8
The Fed resisted routine examinations of these companies, and despite the sup-
portofFedGovernorGramlich,theinitiativestalled.SandraBraunstein,thenastaff
memberintheFedsConsumerandCommunityAffairsDivisionandnowitsdirec-
tor,toldtheFCICthatGreenspanandotheromcialswereconcernedthatroutinely
examiningthenonbanksubsidiariescouldcreateanunevenplayingfeldbecausethe
subsidiarieshadtocompetewiththeindependentmortgagecompanies,overwhich
,, ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
theFedhadnosupervisoryauthority(althoughtheFedsHOEPArulesappliedtoall
lenders).
,
InaninterviewwiththeFCIC,Greenspanwentfurther,arguingthatwith
or without a mandate, the Fed lacked sumcient resources to examine the nonbank
subsidiaries. Worse, the former chairman said, inadequate regulation sends a mis-
leadingmessagetothefrmsandthemarket;ifyouexamineanorganizationincom-
pletely, it tends to put a sign in their window that it was examined by the Fed, and
partialsupervisionisdangerousbecauseitcreatesaGoodHousekeepingstamp.
oo
Butifresourcesweretheissue,theFedchairmancouldhavearguedformore.The
FeddrawsincomefrominterestontheTreasurybondsitowns,soitdidnothaveto
askCongressforappropriations.Itwasalwaysmindful,however,thatitcouldbesub-
jecttoagovernmentauditofitsfnances.
InthesameFCICinterview,Greenspanrecalledthathesatincountlessmeetings
onconsumerprotection,butthathecouldntpretendtohavethekindofexpertiseon
thissubjectthatthestaffhad.
o1
Gramlich,whochairedtheFedsconsumersubcommittee,favoredtightersuper-
visionofallsubprimelendersincludingunitsofbanks,thrifts,bankholdingcom-
panies, and state-chartered mortgage companies. He acknowledged that because
suchoversightwouldextendFedauthoritytofrms(suchasindependentmortgage
companies) whose lending practices were not subject to routine supervision, the
changewouldrequirecongressionallegislationandmightantagonizethestates.But
withoutsuchoversight,themortgagebusinesswaslikeacitywithamurderlaw,but
nocopsonthebeat.
oi
Inaninterviewinioo,,GramlichtoldtheWall Street Journal
thatheprivatelyurgedGreenspantoclampdownonpredatorylending.Greenspan
demurredand,lackingsupportontheboard,Gramlichbackedaway.Gramlichtold
theJournal, Hewasopposedtoit,soIdidnotreallypursueit.
o
(Gramlichdiedin
ioo8ofleukemia,atageo8.)
The Feds failure to stop predatory practices infuriated consumer advocates and
somemembersofCongress.Criticschargedthataccountsofabuseswerebrushedoff
as anecdotal. Patricia McCoy, a law professor at the University of Connecticut who
servedontheFedsConsumerAdvisoryCouncilbetweeniooiandioo,wasfamil-
iar with the Feds reaction to stories of individual consumers. That is classic Fed
mindset, said McCoy. If you cannot prove that it is a broad-based problem that
threatens systemic consequences, then you will be dismissed. It frustrated Margot
SaundersoftheNationalConsumerLawCenter:IstoodupataFedmeetinginioo,
andsaid,Howmanyanecdotesmakesitreal: . . .Howmanytens[of]thousandsof
anecdoteswillittaketoconvinceyouthatthisisatrend:
o
The Feds reluctance to take action trumped the iooo HUD-Treasury report and
reportsissuedbytheGeneralAccountingOmcein1andioo.
o,
TheFeddidnot
begin routinely examining subprime subsidiaries until a pilot program in July ioo,,
undernewchairmanBenBernanke.
oo
TheFeddidnotissuenewrulesunderHOEPA
untilJulyioo8,ayearafterthesubprimemarkethadshutdown.Theserulesbanned
deceptive practices in a much broader category of higher-priced mortgage loans;
moreover,theyprohibitedmakingthoseloanswithoutregardtotheborrowersability
tiiii 1 i\i\N:i uN ,,
topay,andrequiredcompaniestoverifyincomeandassets.
o,
Theruleswouldnottake
effectuntilOctober1,ioo,whichwastoolittle,toolate.
Lookingback,FedGeneralCounselAlvarezsaidhisinstitutionsuccumbedtothe
climate of the times. He told the FCIC, The mind-set was that there should be no
regulation;themarketshouldtakecareofpolicing,unlesstherealreadyisanidenti-
fedproblem. . . .Wewereinthereactivemodebecausethatswhatthemind-setwas
oftheosandtheearlyiooos.Thestronghousingmarketalsoreassuredpeople.Al-
varez noted the long history of low mortgage default rates and the desire to help
peoplewhotraditionallyhadfewdealingswithbanksbecomehomeowners.
o8
STATES: LONGSTANDING POSITION
As the Fed balked, many states proceeded on their own, enacting mini-HOEPA
laws and undertaking vigorous enforcement. They would face opposition from two
federalregulators,theOCCandtheOTS.
In 1, North Carolina led the way, establishing a fee trigger of ,: that is, for
the most part any mortgage with points and fees at origination of more than , of
theloanqualifedashigh-costmortgagesubjecttostateregulations.Thiswascon-
siderablylowerthanthe8setbytheFedsioo1HOEPAregulations.Otherprovi-
sions addressed an even broader class of loans, banning prepayment penalties for
mortgageloansunder1,o,oooandprohibitingrepeatedrefnancing,knownasloan
fipping.
o
These rules did not apply to federally chartered thrifts. In 1o, the Omce of
ThriftSupervisionreasserteditslong-standingpositionthatitsregulationsoccupy
theentirefeldoflendingregulationforfederalsavingsassociations,leavingnoroom
for state regulation. Exempting states from a hodgepodge of conficting and over-
lappingstatelendingrequirements,theOTSsaid,wouldletthriftsdeliverlow-cost
credittothepublicfreefromundueregulatoryduplicationandburden.Meanwhile,
the elaborate network of federal borrower-protection statutes would protect
consumers.
,o
Nevertheless, other states copied North Carolinas tactic. State attorneys general
launched thousands of enforcement actions, including more than ,ooo in iooo
alone.
,1
By ioo,, i states and the District of Columbia would pass some form of
anti-predatory lending legislation. In some cases, two or more states teamed up to
producelargesettlements:iniooi,forexample,asuitbyIllinois,Massachusetts,and
Minnesotarecoveredmorethan,omillionfromFirstAllianceMortgageCompany,
eventhoughthefrmhadfledforbankruptcy.Alsothatyear,HouseholdFinance
later acquired by HSBCwas ordered to pay 8 million in penalties and restitu-
tion to consumers. In iooo, a coalition of states and the District of Columbia
settledwithAmeriquestfori,millionandrequiredthecompanytofollowrestric-
tionsonitslendingpractices.
Aswewillsee,however,theseeffortswouldbeseverelyhinderedwithrespectto
nationalbankswhentheOCCiniooomciallyjoinedtheOTSinconstrainingstates
, ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
fromtakingsuchactions.Thefederalregulatorsrefusaltoreform[predatory]prac-
ticesandproductsservedasanimplicitendorsementoftheirlegality,IllinoisAttor-
neyGeneralLisaMadigantestifedtotheCommission.
,i
COMMUNITYLENDING PLEDGES:
WHAT WE DO IS REAFFIRM OUR INTENTION
WhileconsumergroupsunsuccessfullylobbiedtheFedformoreprotectionagainst
predatorylenders,theyalsolobbiedthebankstoinvestinandloantolow-andmod-
erate-income communities. The resulting promises were sometimes called CRA
commitmentsorcommunitydevelopmentcommitments.Thesepledgeswerenot
required under law, including the Community Reinvestment Act of 1,,; in fact,
theywereoftenoutsidethescopeoftheCRA.Forexample,theyfrequentlyinvolved
lendingtoindividualswhoseincomesexceededthosecoveredbytheCRA,lending
ingeographicareasnotcoveredbytheCRA,orlendingtominorities,onwhichthe
CRA is silent. The banks would either sign agreements with community groups or
elseunilaterallypledgetolendtoandinvestinspecifccommunitiesorpopulations.
Banks often made these commitments when courting public opinion during the
mergermaniaattheturnofthei1stcentury.Oneofthemostnotablepromiseswas
madebyCitigroupsoonafteritsmergerwithTravelersin18:a11,billionlending
and investment commitment, some of which would include mortgages. Later, Citi-
groupmadea1iobillioncommitmentwhenitacquiredCaliforniaFederalBankin
iooi.WhenmergingwithFleetBostonFinancialCorporationinioo,BankofAmer-
icaannounceditslargestcommitmenttodate:,,obillionover1oyears.Chasean-
nounced commitments of 18.1 billion and 8oo billion, respectively, in its mergers
with Chemical Bank and Bank One. The National Community Reinvestment Coali-
tion, an advocacy group, eventually tallied more than ., trillion in commitments
from1,,toioo,;mortgagelendingmadeupasignifcantportionofthem.
,
Although banks touted these commitments in press releases, the NCRC says it
and other community groups could not verify this lending happened.
,
The FCIC
sentaseriesofrequeststoBankofAmerica,JPMorgan,Citigroup,andWellsFargo,
the nations four largest banks, regarding their CRA and community lending com-
mitments. In response, the banks indicated they had fulflled most promises. Ac-
cordingtothedocumentsprovided,thevalueofcommitmentstocommunitygroups
was much smaller than the larger unilateral pledges by the banks. Further, the
pledgesgenerallycoveredbroadercategoriesthandidtheCRA,includingmortgages
to minority borrowers and to borrowers with up-to-median income. For example,
onlyiiofthemortgagesmadeunderJPMorgans8oobillioncommunitydevel-
opment initiative would have fallen under the CRA.
,,
Bank of America, which
would count all low- and moderate-income and minority lending as satisfying its
pledges,statedthatjustoverhalfwerelikelytomeetCRArequirements.
Manyoftheseloanswerenotveryrisky.Thisisnotsurprising,becausesuchbroad
defnitionsnecessarilyincludedloanstoborrowerswithstrongcredithistorieslow
tiiii 1 i\i\N:i uN ,,
incomeandweakorsubprimecreditarenotthesame.Infact,Citigroupsiooipledge
of 8o billion in mortgage lending consisted of entirely prime loans to low- and
moderate-income households, low- and moderate-income neighborhoods, and mi-
norityborrowers.Theseloansperformedwell.
,o
JPMorganslargestcommitmenttoa
community group was to the Chicago CRA Coalition: 1i billion in loans over 11
years.Ofloansissuedbetweeniooandiooo,fewerthan,havebeeno-or-more-
daysdelinquent,evenasoflateio1o.
,,
Wachoviamade1ibillioninmortgageloans
betweeniooandiooounderits1oobillioninunilateralpledges:onlyabout,.
wereevermorethanodaysdelinquentoverthelifeoftheloan,comparedwithan
estimatednationalaverageof1.
,8
Thebetterperformancewaspartlytheresultof
Wachovias lending concentration in the relatively stable Southeast, and partly a re-
fectionofthecreditprofleofmanyoftheseborrowers.
DuringtheearlyyearsoftheCRA,theFederalReserveBoard,whenconsidering
whethertoapprovemergers,gavesomeweighttocommitmentsmadetoregulators.
This changed in February 18, when the board denied Continental Banks applica-
tiontomergewithGrandCanyonStateBank,sayingthebankscommitmenttoim-
provecommunityservicecouldnotoffsetitspoorlendingrecord.
,
InApril18,the
FDIC,OCC,andFederalHomeLoanBankBoard(theprecursoroftheOTS)joined
theFedinannouncingthatcommitmentstoregulatorsaboutlendingwouldbecon-
sideredonlywhenaddressingspecifcproblemsinanotherwisesatisfactoryrecord.
8o
Internal documents, and its public statements, show the Fed never considered
pledgestocommunitygroupsinevaluatingmergersandacquisitions,nordiditen-
force them. As Glenn Loney, a former Fed omcial, told Commission staff, At the
verybeginning,[we]saidwerenotgoingtobeinaposturewheretheFedsgoingto
besortofcoercingbanksintomakingdealswith . . .communitygroupssothatthey
cangettheirapplicationsthrough.
81
Infact,therulesimplementingthe1,changestotheCRAmadeitclearthatthe
FederalReservewouldnotconsiderpromisestothirdpartiesorenforceprioragree-
ments with those parties. The rules state an institutions record of fulflling these
typesofagreements[withthirdparties]isnotanappropriateCRAperformancecri-
terion.
8i
Still,thebankshighlightedpastactsandassurancesforthefuture.In18,
for example, when NationsBank said it was merging with BankAmerica, it also an-
nounceda1o-year,,obillioninitiativethatincludedpledgesof11,billionforaf-
fordablehousing,obillionforconsumerlending,18obillionforsmallbusinesses,
andi,and1obillionforeconomicandcommunitydevelopment,respectively.
Thismergerwasperhapsthemostcontroversialofitstimebecauseofthesizeof
thetwobanks.TheFedheldfourpublichearingsandreceivedmorethan1,ooocom-
ments.Supporterstoutedthecommunityinvestmentcommitment,whileopponents
decried its lack of specifcity. The Feds internal staff memorandum recommending
approvalrepeatedtheFedsinsistenceonnotconsideringthesepromises:TheBoard
considersCRAagreementstobeagreementsbetweenprivatepartiesandhasnotfa-
cilitated,monitored,judged,required,orenforcedagreementsorspecifcportionsof
agreements. . . .NationsBankremainsobligatedtomeetthecreditneedsofitsentire
, ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
community, including [low- and moderate-income] areas, with or without private
agreements.
8
Initspublicorderapprovingthemerger,theFederalReservementionedthecom-
mitmentbutthenwentontostatethatanapplicantmustdemonstrateasatisfactory
recordofperformanceundertheCRAwithoutrelianceonplansorcommitmentsfor
futureaction. . . .TheBoardbelievesthattheCRAplanwhethermadeasaplanor
as an enforceable commitmenthas no relevance in this case without the demon-
stratedrecordofperformanceofthecompaniesinvolved.
8
Sowerethesecommitmentsameaningfulstep,oronlyagesture:LloydBrown,a
managingdirectoratCitigroup,toldtheFCICthatmostofthecommitmentswould
havebeenfulflledinthenormalcourseofbusiness.
8,
Speakingoftheioo,merger
withCountrywide,AndrewPlepler,headofGlobalCorporateSocialResponsibility
at Bank of America, told the FCIC: At a time of mergers, there is a lot of concern,
sometimes,thatoneplusonewillnotequaltwointheeyesofcommunitieswherethe
acquiredbankhasbeeninvesting. . . .So,whatwedoisreamrmourintentiontocon-
tinue to lend and invest so that the communities where we live and work will con-
tinue to economically thrive. He explained further that the pledge amount was
arrivedatbyworkingcloselywithourbusinesspartnerswhoprojectcurrentlevels
ofbusinessactivitythatqualifestowardcommunitylendinggoalsintothefutureto
assurethecommunitythatpastlendingandinvestingpracticeswillcontinue.
8o
Inessence,bankspromisedtokeepdoingwhattheyhadbeendoing,andcommu-
nitygroupshadtheassurancethattheywould.
BANK CAPITAL STANDARDS: ARBITRAGE
Although the Federal Reserve had decided against stronger protections for con-
sumers,itinternalizedthelessonsof18and1,whenthefrstgenerationofsub-
prime lenders put themselves at serious risk; some, such as Keystone Bank and
Superior Bank, collapsed when the values of the subprime securitized assets they
heldprovedtobeinfated.Inresponse,theFederalReserveandotherregulatorsre-
workedthecapitalrequirementsonsecuritizationbybanksandthrifts.
InOctoberioo1,theyintroducedtheRecourseRulegoverninghowmuchcapi-
talabankneededtoholdagainstsecuritizedassets.Ifabankretainedaninterestina
residualtrancheofamortgagesecurity,asKeystone,Superior,andothershaddone,
it would have to keep a dollar in capital for every dollar of residual interest. That
seemed to make sense, since the bank, in this instance, would be the frst to take
lossesontheloansinthepool.Undertheoldrules,banksheldonly8incapitalto
protectagainstlossesonresidualinterestsandanyotherexposurestheyretainedin
securitizations; Keystone and others had been allowed to seriously understate their
risksandtonotholdsumcientcapital.Ironically,becausethenewrulemadethecap-
italchargeonresidualinterests1oo,itincreasedbanksincentivetoselltheresidual
interests in securitizationsso that they were no longer the frst to lose when the
loanswentbad.
tiiii 1 i\i\N:i uN ,,
The Recourse Rule also imposed a new framework for asset-backed securities.
Thecapitalrequirementwouldbedirectlylinkedtotheratingagenciesassessment
of the tranches. Holding securities rated AAA or AA required far less capital than
holding lower-rated investments. For example, 1oo invested in AAA or AA mort-
gage-backedsecuritiesrequiredholdingonly1.ooincapital(thesameasforsecuri-
tiesbackedbygovernment-sponsoredenterprises).Butthesameamountinvestedin
anythingwithaBBratingrequired1oincapital,or1otimesmore.
Bankscouldreducethecapitaltheywererequiredtoholdforapoolofmortgages
simplybysecuritizingthem,ratherthanholdingthemontheirbooksaswholeloans.
Ifabankkept1ooinmortgagesonitsbooks,itmighthavetosetasideabout,,in-
cluding in capital against unexpected losses and 1 in reserves against expected
losses.Butifthebankcreateda1oomortgage-backedsecurity,soldthatsecurityin
tranches, and then bought all the tranches, the capital requirement would be about
.1o.
8,
Regulatorycapitalarbitragedoesplayaroleinbankdecisionmaking,said
DavidJones,aFedeconomistwhowroteanarticleaboutthesubjectiniooo,inan
FCICinterview.Butitis nottheonlythingthatmatters.
88
Andafnalcomparison:underbankregulatorycapitalstandards,a1ootriple-A
corporatebondrequired8incapitalfvetimesasmuchasthetriple-Amortgage-
backedsecurity.Unlikethecorporatebond,itwasultimatelybackedbyrealestate.
The new requirements put the rating agencies in the drivers seat. How much
capitalabankhelddependedinpartontheratingsofthesecuritiesitheld.Tying
capitalstandardstotheviewsofratingagencieswouldcomeinforcriticismafter
the crisis began. It was a dangerous crutch, former Treasury Secretary Henry
PaulsontestifiedtotheCommission.
8
However,theFedsJonesnoteditwasbetter
than the alternativeto let the banks rate their own exposures. That alternative
wouldbeterrible,hesaid,notingthatbankshadbeencomingtotheFedandar-
guingforlowercapitalrequirementsonthegroundsthattheratingagencieswere
tooconservative.
o
Meanwhile, banks and regulators were not prepared for signifcant losses on
triple-Amortgage-backedsecurities,whichwere,afterall,supposedtobeamongthe
safestinvestments.Norweretheypreparedforratingsdowngradesduetoexpected
losses,whichwouldrequirebankstopostmorecapital.Andweredowngradestooc-
cur at the moment the banks wanted to sell their securities to raise capital, there
wouldbenobuyers.Allthesethingswouldoccurwithinafewyears.
.++ ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
tiiii 1 i\i\N:i uN .+.
COMMISSION CONCLUSIONS ON CHAPTER 6
The Commission concludes that there was untrammeled growth in risky mort-
gages. Unsustainable, toxic loans polluted the fnancial system and fueled the
housingbubble.
Subprimelendingwassupportedinsignifcantwaysbymajorfnancialinsti-
tutions. Some frms, such as Citigroup, Lehman Brothers, and Morgan Stanley,
acquiredsubprimelenders.Inaddition,majorfnancialinstitutionsfacilitatedthe
growthinsubprimemortgagelendingcompanieswithlinesofcredit,securitiza-
tion,purchaseguaranteesandothermechanisms.
Regulators failed to rein in risky home mortgage lending. In particular, the
Federal Reserve failed to meet its statutory obligation to establish and maintain
prudentmortgagelendingstandardsandtoprotectagainstpredatorylending.
7
THE MORTGAGE MACHINE
CONTENTS
IcrcigninvcstcrsAnirrcsisti||cprctcppcrtunity +o,
McrtgagcsAgccd|can +o,
Icdcra|rcgu|atcrsInnunityjrcnnanystatc|awsisasignicant|cnct +++
Mcrtgagcsccuriticsp|aycrsVa||Strcctwasvcryhungryjcrcurprcduct ++,
MccdysGivcna||ankchcck++:
IannicMacandIrcddicMacIcssccnpctitivcinthcnarkctp|acc+::
In ioo, commercial banks, thrifts, and investment banks caught up with Fannie
MaeandFreddieMacinsecuritizinghomeloans.Byioo,,theyhadtakenthelead.
Thetwogovernment-sponsoredenterprisesmaintainedtheirmonopolyonsecuritiz-
ing prime mortgages below their loan limits, but the wave of home refnancing by
prime borrowers spurred by very low, steady interest rates petered out. Meanwhile,
WallStreetfocusedonthehigher-yieldloansthattheGSEscouldnotpurchaseand
securitizeloanstoolarge,calledjumboloans,andnonprimeloansthatdidntmeet
theGSEsstandards.Thenonprimeloanssoonbecamethebiggestpartofthemar-
ketsubprimeloansforborrowerswithweakcreditandAlt-Aloans,withcharac-
teristicsriskierthanprimeloans,toborrowerswithstrongcredit.
1
Byioo,andiooo,WallStreetwassecuritizingone-thirdmoreloansthanFannie
and Freddie. In just two years, private-label mortgage-backed securities had grown
morethano,reaching1.1,trillioniniooo;,1weresubprimeorAlt-A.
i
Manyinvestorspreferredsecuritieshighlyratedbytheratingagenciesorwere
encouraged or restricted by regulations to buy them. And with yields low on other
highlyratedassets,investorshungeredforWallStreetmortgagesecuritiesbackedby
higher-yieldmortgagesthoseloansmadetosubprimeborrowers,thosewithnon-
traditional features, those with limited or no documentation (no-doc loans), or
thosethatfailedinsomeotherwaytomeetstrongunderwritingstandards.
Securitization could be seen as a factory line, former Citigroup CEO Charles
Prince told the FCIC. As more and more and more of these subprime mortgages
werecreatedasrawmaterialforthesecuritizationprocess,notsurprisinglyinhind-
sight, more and more of it was of lower and lower quality. And at the end of that
.+z
process, the raw material going into it was actually bad quality, it was toxic quality,
andthatiswhatendedupcomingouttheotherendofthepipeline.WallStreetobvi-
ouslyparticipatedinthatfowofactivity.

Theoriginationandsecuritizationofthesemortgagesalsoreliedonshort-termf-
nancingfromtheshadowbankingsystem.Unlikebanksandthriftswithaccesstode-
posits,investmentbanksreliedmoreonmoneymarketfundsandotherinvestorsfor
cash;commercialpaperandrepoloanswerethemainsources.Withhousepricesal-
readyup1from1,toioo,thisfoodofmoneyandthesecuritizationappara-
tushelpedboosthomepricesanotherofromthebeginningofioountilthepeak
in April ioooeven as homeownership was falling. The biggest gains over this pe-
riodwereinthesandstates:placesliketheLosAngelessuburbs(,),LasVegas
(o),andOrlando(,i).
FOREIGN INVESTORS:
AN IRRESISTIBLE PROFIT OPPORTUNITY
FromJuneioothroughJuneioo,theFederalReservekeptthefederalfundsrate
lowat1tostimulatetheeconomyfollowingtheioo1recession.Overthenexttwo
years,asdefationfearswaned,theFedgraduallyraisedratesto,.i,in1,quarter-
pointincreases.
In the view of some, the Fed simply kept rates too low too long. John Taylor, a
Stanfordeconomistandformerundersecretaryoftreasuryforinternationalaffairs,
blamedthecrisisprimarilyonthisaction.IftheFedhadfolloweditsusualpattern,
hetoldtheFCIC,short-terminterestrateswouldhavebeenmuchhigher,discourag-
ing excessive investment in mortgages. The boom in housing construction starts
wouldhavebeenmuchmoremild,mightnotevencallitaboom,andthebustaswell
wouldhavebeenmild,Taylorsaid.

Othersweremoreblunt:Greenspanbailedout
the worlds largest equity bubble with the worlds largest real estate bubble, wrote
WilliamA.Fleckenstein,thepresidentofaSeattle-basedmoneymanagementfrm.
,
Ben Bernanke and Alan Greenspan disagree. Both the current and former Fed
chairman argue that deciding to purchase a home depends on long-term interest
rates on mortgages, not the short-term rates controlled by the Fed, and that short-
term and long-term rates had become de-linked. Between 1,1 and iooi, the fed
funds rate and the mortgage rate moved in lock-step, Greenspan said.
o
When the
Fedstartedtoraiseratesinioo,omcialsexpectedmortgageratestorise,too,slow-
inggrowth.Instead,mortgageratescontinuedtofallforanotheryear.Theconstruc-
tionindustrycontinuedtobuildhouses,peakingatanannualizedrateofi.i,million
startsinJanuaryiooomorethanao-yearhigh.
As Greenspan told Congress in ioo,, this was a conundrum.
,
One theory
pointed to foreign money. Developing countries were booming andvulnerable to
fnancial problems in the pastencouraged strong saving. Investors in these coun-
tries placed their savings in apparently safe and high-yield securities in the United
States.FedChairmanBernankecalleditaglobalsavingsglut.
8
1ui \ui1t\ti \\tui Ni .+,
As the United States ran a large current account defcit, fows into the country
were unprecedented. Over six years from iooo to iooo, U.S. Treasury debt held by
foreignomcialpublicentitiesrosefromo.otrillionto1.trillion;asapercentage
ofU.S.debtheldbythepublic,theseholdingsincreasedfrom18.itoi8.8.For-
eigners also bought securities backed by Fannie and Freddie, which, with their im-
plicit government guarantee, seemed nearly as safe as Treasuries. As the Asian
fnancial crisis ended in 18, foreign holdings of GSE securities held steady at the
level of almost 1o years earlier, about 18o billion. By iooojust two years later
foreigners owned 8 billion in GSE securities; by ioo, 8,, billion. You had a
huge infow of liquidity. A very unique kind of situation where poor countries like
China were shipping money to advanced countries because their fnancial systems
were so weak that they [were] better off shipping [money] to countries like the
United States rather than keeping it in their own countries, former Fed governor
FredericMishkintoldtheFCIC.Thesystemwasawashwithliquidity,whichhelped
lowerlong-terminterestrates.

Foreign investors sought other high-grade debt almost as safe as Treasuries and
GSEsecuritiesbutwithaslightlyhigherreturn.Theyfoundthetriple-Aassetspour-
ingfromtheWallStreetmortgagesecuritizationmachine.Asoverseasdemanddrove
uppricesforsecuritizeddebt,itcreatedanirresistibleproftopportunityfortheU.S.
fnancialsystem:toengineerquasisafedebtinstrumentsbybundlingriskierassets
andsellingtheseniortranches,Pierre-OlivierGourinchas,aneconomistattheUni-
versityofCalifornia,Berkeley,toldtheFCIC.
1o
PaulKrugman,aneconomistatPrincetonUniversity,toldtheFCIC,Itshardto
envisageushavinghadthiscrisiswithoutconsideringinternationalmonetarycapital
movements.TheU.S.housingbubblewasfnancedbylargecapitalinfows.Sowere
SpanishandIrishandBalticbubbles.Itsacombinationof,inthenarrowsense,ofa
less regulated fnancial system and a world that was increasingly wide open for big
internationalcapitalmovements.
11
Itwasanoceanofmoney.
MORTGAGES: A GOOD LOAN
Therefnancingboomwasover,butoriginatorsstillneededmortgagestoselltothe
Street. They needed new products that, as prices kept rising, could make expensive
homes more affordable to still-eager borrowers. The solution was riskier, more ag-
gressive,mortgageproductsthatbroughthigheryieldsforinvestorsbutcorrespond-
inglygreaterrisksforborrowers.Holdingasubprimeloanhasbecomesomethingof
ahigh-stakeswager,theCenterforResponsibleLendingwarnediniooo.
1i
Subprime mortgages rose from 8 of mortgage originations in ioo to io in
ioo,.
1
About ,o of subprime borrowers used hybrid adjustable-rate mortgages
(ARMs) such as i/i8s and /i,smortgages whose low teaser rate lasts for the
frst two or three years, and then adjusts periodically thereafter.
1
Prime borrowers
alsousedmorealternativemortgages.ThedollarvolumeofAlt-Asecuritizationrose
almost,ofromiootoioo,.
1,
Ingeneral,theseloansmadeborrowersmonthly
.+, ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
1ui \ui1t\ti \\tui Ni .+,
mortgagepaymentsonevermoreexpensivehomesaffordableatleastinitially.Pop-
ular Alt-A products included interest-only mortgages and payment-option ARMs.
Option ARMs let borrowers pick their payment each month, including payments
that actually increased the principalany shortfall on the interest payment was
added to the principal, something called negative amortization. If the balance got
large enough, the loan would convert to a fxed-rate mortgage, increasing the
monthlypaymentperhapsdramatically.OptionARMsrosefromiofmortgages
iniootoiniooo.
1o
Simultaneously, underwriting standards for nonprime and prime mortgages
weakened. Combined loan-to-value ratiosrefecting frst, second, and even third
mortgagesrose.Debt-to-incomeratiosclimbed,asdidloansmadefornon-owner-
occupiedproperties.FannieMaeandFreddieMacsmarketshareshrankfrom,,
ofallmortgagespurchasediniootoiinioo,anddownto,byiooo.
1,
Tak-
ing their place were private-label securitizationsmeaning those not issued and
guaranteedbytheGSEs.
Inthisnewmarket,originatorscompetedfercely;CountrywideFinancialCorpo-
ration took the crown.
18
It was the biggest mortgage originator from ioo until the
market collapsed in ioo,. Even after Countrywide nearly failed, buckling under a
mortgage portfolio with loans that its co-founder and CEO Angelo Mozilo once
calledtoxic,Mozilowoulddescribehiso-year-oldcompanytotheCommissionas
havinghelpedi,millionpeoplebuyhomesandpreventedsocialunrestbyextending
loanstominorities,historicallythevictimsofdiscrimination:Countrywidewasone
ofthegreatestcompaniesinthehistoryofthiscountryandprobablymademoredif-
ferencetosociety,totheintegrityofoursociety,thananycompanyinthehistoryof
America.
1
Lending to home buyers was only part of the business. Countrywides
President and COO David Sambol told the Commission, as long as a loan did not
harm the company from a fnancial or reputation standpoint, Countrywide was a
seller of securities to Wall Street. Countrywides essential business strategy was
originatingwhatwassalableinthesecondarymarket.
io
Thecompanysoldorsecu-
ritized8,ofthe1.,trillioninmortgagesitoriginatedbetweeniooiandioo,.
Inioo,Moziloannouncedaveryaggressivegoalofgainingmarketdominance
bycapturingooftheoriginationmarket.
i1
Hisshareatthetimewas1i.ButCoun-
trywidewasnotunique:Ameriquest,NewCentury,WashingtonMutual,andothersall
pursued loans as aggressively. They competed by originating types of mortgages cre-
atedyearsbeforeasnicheproducts,butnowtransformedintoriskier,mass-marketver-
sions.Thedefnitionofagoodloanchangedfromonethatpaystoonethatcouldbe
sold,PatriciaLindsay,formerlyafraudspecialistatNewCentury,toldtheFCIC.
ii
a/aosen,/a,s.\justjort/cejjoreoilit;
Historically,i/i8sor/i,s,alsoknownashybrid ARMs, letcredit-impairedborrow-
ersrepairtheircredit.Duringthefrsttwoorthreeyears,alowerinterestratemeant
a manageable payment schedule and enabled borrowers to demonstrate they could
maketimelypayments.Eventuallytheinterestrateswouldrisesharply,andpayments
coulddoubleoreventriple,leavingborrowerswithfewalternatives:iftheyhades-
tablishedtheircreditworthiness,theycouldrefnanceintoasimilarmortgageorone
with a better interest rate, often with the same lender;
i
if unable to refnance, the
borrowerwasunlikelytobeabletoaffordthenewhigherpaymentsandwouldhave
to sell the home and repay the mortgage. If they could not sell or make the higher
payments,theywouldhavetodefault.
Butashousepricesroseafteriooo,thei/i8sand/i,sacquiredanewrole:help-
ingtogetpeopleintohomesortomoveuptobiggerhomes.Ashomesgotlessand
less affordable, you would adjust for the affordability in the mortgage because you
couldnt really adjust peoples income, Andrew Davidson, the president of Andrew
Davidson & Co. and a veteran of the mortgage markets, told the FCIC.
i
Lenders
qualifed borrowers at low teaser rates, with little thought to what might happen
whenratesreset.HybridARMsbecametheworkhorsesofthesubprimesecuritiza-
tionmarket.
ConsumerprotectiongroupssuchastheLeadershipConferenceonCivilRights
railed against i/i8s and /i,s, which, they said, neither rehabilitated credit nor
turnedrentersintoowners.DavidBerenbaumfromtheNationalCommunityRein-
vestment Coalition testifed to Congress in the summer of ioo,: The industry has
foodedthemarketwithexoticmortgagelendingsuchasi/i8and/i,ARMs.These
exoticsubprimemortgagesoverwhelmborrowerswheninterestratesshootupafter
anintroductorytimeperiod.
i,
Totheircritics,theyweresimplyawayforlendersto
stripequityfromlow-incomeborrowers.Theloanscamewithbigfeesthatgotrolled
intothemortgage,increasingthechancesthatthemortgagecouldbelargerthanthe
homesvalueattheresetdate.Iftheborrowercouldnotrefnance,thelenderwould
forecloseandthenownthehomeinarisingrealestatemarket.
0tion\kMs.0urmostrojiteolcmortgegcloen
Whentheywereoriginallyintroducedinthe18os,optionARMswerenicheprod-
ucts,too,butbyiootheytoobecameloansofchoicebecausetheirpaymentswere
lowerthanmoretraditionalmortgages.Duringthehousingboom,manyborrowers
repeatedlymadeonlytheminimumpaymentsrequired,addingtotheprincipalbal-
anceoftheirloaneverymonth.
An early seller of option ARMs was Golden West Savings, an Oakland, Califor-
niabasedthriftfoundedin1iandacquiredin1obyMarionandHerbertSan-
dler. In 1,,, the Sandlers merged Golden West with World Savings; Golden West
FinancialCorp.,theparentcompany,operatedbranchesunderthenameWorldSav-
ings Bank. The thrift issued about i, billion in option ARMs between 181 and
ioo,.
io
Unlikeothermortgagecompanies,GoldenWestheldontothem.
Sandler told the FCIC that Golden Wests option ARMsmarketed as Pick-a-
Payloanshadthelowestlossesintheindustryforthatproduct.Eveninioo,the
lastyearpriortoitsacquisitionbyWachoviawhenitsportfoliowasalmostentirely
inoptionARMs,GoldenWestslosseswerelowbyindustrystandards.Sandlerattrib-
utedGoldenWestsperformancetoitsdiligenceinrunningsimulationsaboutwhat
.+ ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
would happen to its loans under various scenariosfor example, if interest rates
wentupordownorifhousepricesdropped,,even1o.Foraquarterofacen-
tury, it worked exactly as the simulations showed that it would, Sandler said. And
wehaveneverbeenabletoidentifyasingleloanthatwasdelinquentbecauseofthe
structureoftheloan,muchlessalossorforeclosure.
i,
ButafterWachoviaacquired
GoldenWestinioooandthehousingmarketsoured,charge-offsonthePick-a-Pay
portfoliowouldsuddenlyjumpfromo.otoi.obySeptemberioo8.Andfore-
closureswouldclimb.
Early in the decade, banks and thrifts such as Countrywide and Washington
Mutual increased their origination of option ARM loans, changing the product in
waysthatmadepaymentshocksmorelikely.AtGoldenWest,after1oyears,orifthe
principal balance grew to 1i, of its original size, the Pick-a-Pay mortgage would
recastintoanewfxed-ratemortgage.AtCountrywideandWashingtonMutual,the
newloanswouldrecastinaslittleasfveyears,orwhenthebalancehitjust11oof
the original size. They also offered lower teaser ratesas low as 1and loan-to-
value ratios as high as 1oo. All of these features raised the chances that the bor-
rowers required payment could rise more sharply, more quickly, and with less
cushion.
In iooi, Washington Mutual was the second-largest mortgage originator, just
ahead of Countrywide. It had offered the option ARM since 18o, and in ioo, as
citedbytheSenatePermanentSubcommitteeonInvestigations,theoriginatorcon-
ductedastudytoexplorewhatWashingtonMutualcoulddotoincreasesalesofOp-
tionARMs,ourmostproftablemortgageloan.
i8
Afocusgroupmadeclearthatfew
customerswererequestingoptionARMsandthatthisisnotaproductthatsellsit-
self.
i
ThestudyfoundthebestsellingpointfortheOptionArmwastoshowcon-
sumershowmuchlowertheirmonthlypaymentwouldbebychoosingtheOption
Arm versus a fxed-rate loan.
o
The study also revealed that many WaMu brokers
felt these loans were bad for customers.
1
One member of the focus group re-
marked,Alotof(Loan)Consultantsdontbelieveinit . . .anddontthink[its]good
forthecustomer.Youregoingtohavetochangethemindset.
i
Despitethesechallenges,optionARMoriginationssoaredatWashingtonMutual
from o billion in ioo to o8 billion in ioo, when they were more than half of
WaMusoriginationsandhadbecomethethriftssignatureadjustable-ratehomeloan
product.

The average FICO score was around ,oo, well into the range considered
prime, and about two-thirds were jumbo loansmortgage loans exceeding the
maximum Fannie Mae and Freddie Mac were allowed to purchase or guarantee.

MorethanhalfwereinCalifornia.
,
CountrywidesoptionARMbusinesspeakedat1.,billioninoriginationsinthe
secondquarterofioo,,abouti,ofallitsloansoriginatedthatquarter.
o
Butithad
to relax underwriting standards to get there. In July ioo, Countrywide decided it
would lend up to o of a homes appraised value, up from 8o, and reduced the
minimumcreditscoretoaslowasoio.
,
Inearlyioo,,Countrywideeasedstandards
again,increasingtheallowablecombinedloan-to-valueratio(includingsecondliens)
to,.
8
1ui \ui1t\ti \\tui Ni .+,
The risk in these loans was growing. From ioo to ioo,, the average loan-to-
valueratioroseabout,thecombinedloan-to-valueratioroseabouto,anddebt-
to-incomeratioshadrisenfromto8:borrowerswerepledgingmoreoftheir
incometotheirmortgagepayments.Moreover,o8ofthesetwooriginatorsoption
ARMshadlowdocumentationinioo,.

Thepercentageoftheseloansmadetoin-
vestors and speculatorsthat is, borrowers with no plans to use the home as their
primaryresidencealsorose.
Thesechangesworriedthelendersevenastheycontinuedtomaketheloans.In
SeptemberiooandAugustioo,,Moziloemailedtoseniormanagementthatthese
loanscouldbringfnancialandreputationalcatastrophe.
o
Countrywideshouldnot
marketthemtoinvestors,heinsisted.Payoptionloansbeingusedbyinvestorsisa
purecommercialspec[ulation]loanandnotthetraditionalhomeloanthatwehave
successfullymanagedthroughoutourhistory,MozilowrotetoCarlosGarcia,CEO
ofCountrywideBank.SpeculativeinvestorsshouldgotoChaseorWellsnotus.Itis
alsoimportantforyouandyourteamtounderstandfrommypointofviewthatthere
isnothingintrinsicallywrongwithpayoptionsloansthemselves,theproblemisthe
qualityofborrowerswhoarebeingofferedtheproductandtheabusebythirdparty
originators. . . . [I]f you are unable to fnd sumcient product then slow down the
growthoftheBankforthetimebeing.
1
However, Countrywides growth did not slow. Nor did the volume of option
ARMsretainedonitsbalancesheet,increasingfrom,billioniniootoiobillion
in ioo, and peaking in iooo at billion.
i
Finding these loans very proftable,
through iooo, WaMu also retained option ARMsmore than oo billion with the
bulkfromCalifornia,followedbyFlorida.

Butintheend,theseloanswouldcause
signifcantlossesduringthecrisis.
Mentioning Countrywide and WaMu as tough, in our face competitors, John
Stumpf, the CEO, chairman, and president of Wells Fargo, recalled Wellss decision
not to write option ARMs, even as it originated many other high-risk mortgages.
Thesewereharddecisionstomakeatthetime,hesaid,notingwedidloserevenue,
andwedidlosevolume.

Across the market, the volume of option ARMs had risen nearly fourfold from
ioo to iooo, from approximately o, billion to i,, billion. By then, WaMu and
Countrywide had plenty of evidence that more borrowers were making only the
minimum payments and that their mortgages were negatively amortizingwhich
meant their equity was being eaten away. The percentage of Countrywides option
ARMsthatwerenegativelyamortizinggrewfromjust1iniooto,inioo,and
thentomorethanobyioo,.
,
AtWaMu,itwasiinioo,i8inioo,and8i
inioo,.
o
Declinesinhousepricesaddedtoborrowersproblems:anyequityremain-
ingafterthenegativeamortizationwouldsimplybeeroded.Increasingly,borrowers
wouldowemoreontheirmortgagesthantheirhomeswereworthonthemarket,giv-
ingthemanincentivetowalkawayfrombothhomeandmortgage.
Kevin Stein, from the California Reinvestment Coalition, testifed to the FCIC
that option ARMs were sold inappropriately: Nowhere was this dynamic more
clearly on display than in the summer of iooo when the Federal Reserve convened
.+ ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
HOEPA(HomeOwnershipandEquityProtectionAct)hearingsinSanFrancisco.At
the hearing, consumers testifed to being sold option ARM loans in their primary
non-Englishlanguage,onlytobepressuredtosignEnglish-onlydocumentswithsig-
nifcantlyworseterms.Someconsumerstestifedtobeingunabletomakeeventheir
initial payments because they had been lied to so completely by their brokers.
,
Mona Tawatao, a regional counsel with Legal Services of Northern California, de-
scribedtheborrowersshewasassistingaspeoplewhogotsteeredordefraudedinto
entering option ARMs with teaser rates or pick-a-pay loans forcing them to pay
intopay loans that they could never pay off. Prevalent among these clients are
seniors, people of color, people with disabilities, and limited English speakers and
seniorswhoareAfricanAmericanandLatino.
8
Incrvritingsteners.\crcgoingto/evcto/olournosc
Anothershiftwouldhaveseriousconsequences.Fordecades,thedownpaymentfor
aprimemortgagehadbeenio(inotherwords,theloan-to-valueratio(LTV)had
been 8o). As prices continued to rise, fnding the cash to put io down became
harder,andfromioooon,lendersbeganacceptingsmallerdownpayments.
There had always been a place for borrowers with down payments below io.
Typically,lendersrequiredsuchborrowertopurchaseprivatemortgageinsurancefor
amonthlyfee.Ifamortgageendedinforeclosure,themortgageinsurancecompany
would make the lender whole. Worried about defaults, the GSEs would not buy or
guarantee mortgages with down payments below io unless the borrower bought
theinsurance.Unluckilyformanyhomeowners,forthehousingindustry,andforthe
fnancial system, lenders devised a way to get rid of these monthly fees that had
added to the cost of homeownership: lower down payments that did not require
insurance.
Lendershadlatitudeinsettingdownpayments.In11,Congressorderedfederal
regulators to prescribe standards for real estate lending that would apply to banks
andthrifts.Thegoalwastocurtailabusiverealestatelendingpracticesinorderto
reducerisktothedepositinsurancefundsandenhancethesafetyandsoundnessof
insureddepositoryinstitutions.

CongresshaddebatedincludingexplicitLTVstan-
dards,butchosenotto,leavingthattotheregulators.Intheend,regulatorsdeclined
to introduce standards for LTV ratios or for documentation for home mortgages.
,o
The agencies explained: A signifcant number of commenters expressed concern
thatrigidapplicationofaregulationimplementingLTVratioswouldconstrictcredit,
imposeadditionallendingcosts,reducelendingfexibility,impedeeconomicgrowth,
andcauseotherundesirableconsequences.
,1
In1,regulatorsrevisitedtheissue,ashighLTVlendingwasincreasing.They
tightened reporting requirements and limited a banks total holdings of loans with
LTVsaboveothatlackedmortgageinsuranceorsomeotherprotection;theyalso
remindedthebanksandthriftsthattheyshouldestablishinternalguidelinestoman-
agetheriskoftheseloans.
,i
High LTV lending soon became even more common, thanks to the so-called
1ui \ui1t\ti \\tui Ni .+,
piggyback mortgage. The lender offered a frst mortgage for perhaps 8o of the
homesvalueandasecondmortgageforanother1oorevenio.Borrowersliked
thesebecausetheirmonthlypaymentswereoftencheaperthanatraditionalmort-
gageplustherequiredmortgageinsurance,andtheinterestpaymentsweretaxde-
ductible. Lenders liked them because the smaller frst mortgageeven without
mortgageinsurancecouldpotentiallybesoldtotheGSEs.
At the same time, the piggybacks added risks. A borrower with a higher com-
binedLTVhadlessequityinthehome.Inarisingmarket,shouldpaymentsbecome
unmanageable,theborrowercouldalwayssellthehomeandcomeoutahead.How-
ever, should the payments become unmanageable in a falling market, the borrower
mightowemorethanthehomewasworth.Piggybackloanswhichoftenrequired
nothingdownguaranteedthatmanyborrowerswouldendupwithnegativeequity
ifhousepricesfell,especiallyiftheappraisalhadoverstatedtheinitialvalue.
But piggyback lending helped address a signifcant challenge for companies like
NewCentury,whichwerebigplayersinthemarketformortgages.Meetinginvestor
demandrequiredfndingnewborrowers,andhomebuyerswithoutdownpayments
were a relatively untapped source. Yet among borrowers with mortgages originated
inioo,bySeptemberioo,thosewithpiggybackswerefourtimesaslikelyasother
mortgage holders to be oo or more days delinquent. When senior management at
New Century heard these numbers, the head of the Secondary Marketing Depart-
mentaskedforthoughtsonwhattodowiththis . . .prettycompellinginformation.
Nonetheless,NewCenturyincreasedmortgageswithpiggybacksto,ofloanpro-
ductionbytheendofioo,,upfromonlyinioo.
,
Theywerenotalone.Across
securitized subprime mortgages, the average combined LTV rose from , to 8o
betweenioo1andiooo.
,
Anotherwaytogetpeopleintomortgagesandquicklywastorequirelessin-
formationoftheborrower.Statedincomeorlow-documentation(orsometimes
no-documentation)loanshademergedyearsearlierforpeoplewithfuctuatingor
hard-to-verify incomes, such as the self-employed, or to serve longtime customers
with strong credit. Or lenders might waive information requirements if the loan
lookedsafeinotherrespects.IfImmakingao,,,,,,oloan-to-value,Imnot
going to get all of the documentation, Sandler of Golden West told the FCIC. The
process was too cumbersome and unnecessary. He already had a good idea how
muchmoneyteachers,accountants,andengineersmadeandifhedidnt,hecould
easilyfndout.Allheneededwastoverifythathisborrowersworkedwheretheysaid
theydid.Ifheguessedwrong,theloan-to-valueratiostillprotectedhisinvestment.
,,
Aroundioo,,however,low-andno-documentationloanstookonanentirelydif-
ferentcharacter.Nonprimelendersnowboastedtheycouldofferborrowersthecon-
venience of quicker decisions and not having to provide tons of paperwork. In
return, they charged a higher interest rate. The idea caught on: from iooo to ioo,,
low-andno-docloansskyrocketedfromlessthanitoroughlyofalloutstand-
ingloans.
,o
AmongAlt-Asecuritizations,8oofloansissuediniooohadlimitedor
no documentation.
,,
As William Black, a former banking regulator, testifed before
the FCIC, the mortgage industrys own fraud specialists described stated income
..+ ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
loansasanopeninvitationtofraudthatjustifedtheindustrytermliarsloans.
,8
Speakingoflendinguptoioo,atCitigroup,RichardBowen,aveteranbankerinthe
consumer lending group, told the FCIC, A decision was made that Were going to
havetoholdournoseandstartbuyingthestatedproductifwewanttostayinbusi-
ness.
,
Jamie Dimon, the CEO of JP Morgan, told the Commission, In mortgage
underwriting,somehowwejustmissed,youknow,thathomepricesdontgoupfor-
everandthatitsnotsumcienttohavestatedincome.
oo
Intheend,companiesinsubprimeandAlt-Amortgageshad,inessence,placed
alltheirchipsonblack:theywerebettingthathomepriceswouldneverstoprising.
Thiswastheonlyscenariothatwouldkeepthemortgagemachinehumming.Theev-
idence is present in our case study mortgage-backed security, CMLTI iooo-NCi,
whoseloanshavemanyofthecharacteristicsjustdescribed.
The,loansbundledinthisdealwereadjustable-rateandfxed-rateresiden-
tialmortgagesoriginatedbyNewCentury.Theyhadanaverageprincipalbalanceof
i1o,,ojustunderthemedianhomepriceofii1,ooiniooo.
o1
Thevastmajor-
ityhadao-yearmaturity,andmorethanowereoriginatedinMay,June,andJuly
iooo,justafternationalhomepriceshadpeaked.Morethanowerereportedlyfor
primaryresidences,withforhomepurchasesand8forcash-outrefnancings.
Theloanswerefromall,ostatesandtheDistrictofColumbia,butmorethanaffth
camefromCaliforniaandmorethanatenthfromFlorida.
oi
About8ooftheloanswereARMs,andmostofthesewerei/i8sor/i,s.Ina
twist,manyofthesehybridARMshadotheraffordabilityfeaturesaswell.Forex-
ample,morethaniooftheARMswereinterest-onlyduringthefrsttwoorthree
years,notonlywouldborrowerspayalowerfxedrate,theywouldnothavetopay
anyprincipal.Inaddition,morethanooftheARMswerei/i8hybridballoon
loans, in which the principal would amortize over o yearslowering the monthly
paymentsevenfurther,butasaresultleavingtheborrowerwithafnalprincipalpay-
mentattheendoftheo-yearterm.
Thegreatmajorityofthepoolwassecuredbyfrstmortgages;ofthese,hada
piggyback mortgage on the same property. As a result, more than one-third of the
mortgages in this deal had a combined loan-to-value ratio between , and 1oo.
Raisingtheriskabitmore,iofthemortgageswereno-docloans.Therestwere
full-doc,althoughtheirdocumentationwasfullerinsomecasesthaninothers.
o
In
sum,theloansbundledinthisdealmirroredthemarket:complexproductswithhigh
LTVsandlittledocumentation.Andevenasmanywarnedofthistoxicmix,thereg-
ulatorswerenotonthesamepage.
FEDERAL REGULATORS: IMMUNITY FROM
MANY STATE LAWS IS A SIGNIFICANT BENEFIT
Foryears,somestateshadtriedtoregulatethemortgagebusiness,especiallytoclamp
downonthepredatorymortgagesproliferatinginthesubprimemarket.Thenational
thriftsandbanksandtheirfederalregulatorstheOmceofThriftSupervision(OTS)
andtheOmceoftheComptrolleroftheCurrency(OCC),respectivelyresistedthe
1ui \ui1t\ti \\tui Ni ...
stateseffortstoregulatethosenationalbanksandthrifts.Thecompaniesclaimedthat
withoutoneuniformsetofrules,theycouldnoteasilydobusinessacrossthecountry,
andtheregulatorsagreed.InAugustioo,asthemarketforriskiersubprimeandAlt-
Aloansgrew,andaslenderspiledonmoreriskwithsmallerdownpayments,reduced
documentation requirements, interest-only loans, and payment-option loans, the
OCC fred a salvo. The OCC proposed strong preemption rules for national banks,
nearly identical to earlier OTS rules that empowered nationally chartered thrifts to
disregardstateconsumerlaws.
o
Backin1otheOTShadissuedrulessayingfederallawpreemptedstatepreda-
torylendinglawsforfederallyregulatedthrifts.
o,
Inioo,theOTSreferredtothese
rules in issuing four opinion letters declaring that laws in Georgia, New York, New
Jersey,andNewMexicodidnotapplytonationalthrifts.IntheNewMexicoopinion,
theregulatorpronouncedinvalidNewMexicosbansonballoonpayments,negative
amortization,prepaymentpenalties,loanfipping,andlendingwithoutregardtothe
borrowersabilitytorepay.
TheComptrolleroftheCurrencytookthesamelineonthenationalbanksthatit
regulated,offeringpreemptionasaninducementtouseanationalbankcharter.Ina
iooispeech,beforethefnalOCCruleswerepassed,ComptrollerJohnD.HawkeJr.
pointedtonationalbanksimmunityfrommanystatelawsasasignifcantbeneft
ofthenationalcharterabeneftthattheOCChasfoughthardovertheyearstopre-
serve.
oo
Inaninterviewthatyear,Hawkeexplainedthatthepotentiallossofregula-
torymarketsharefortheOCCwasamatterofconcern.
o,
In August ioo the OCC issued its frst preemptive order, aimed at Georgias
mini-HOEPAstatute,andinJanuaryiootheOCCadoptedasweepingpreemption
rule applying to all state laws that interfered with or placed conditions on national
banks ability to lend. Shortly afterward, three large banks with combined assets of
morethan1trillionsaidtheywouldconvertfromstatecharterstonationalcharters,
whichincreasedOCCsannualbudget1,.
o8
State-chartered operating subsidiaries were another point of contention in the
preemptionbattle.Inioo1theOCChadadoptedaregulationpreemptingstatelaw
regardingstate-charteredoperatingsubsidiariesofnationalbanks.Inresponse,sev-
erallargenationalbanksmovedtheirmortgage-lendingoperationsintosubsidiaries
and asserted that the subsidiaries were exempt from state mortgage lending laws.
Fourstateschallengedtheregulation,buttheSupremeCourtruledagainstthemin
ioo,.
o
OnceOCCandOTSpreemptionwasinplace,thetwofederalagencieswerethe
only regulators with the power to prohibit abusive lending practices by national
banks and thrifts and their direct subsidiaries. Comptroller John Dugan, who suc-
ceeded Hawke, defended preemption, noting that ,i of all nonprime mortgages
were made by lenders that were subject to state law. Well over half were made by
mortgagelendersthatwereexclusivelysubjecttostatelaw.
,o
LisaMadigan,theattor-
neygeneralofIllinois,fippedtheargumentaround,notingthatnationalbanksand
thrifts,andtheirsubsidiaries,wereheavilyinvolvedinsubprimelending.Usingdif-
ferent data, she contended: National banks and federal thrifts and . . . their sub-
..z ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
sidiaries . . .wereresponsibleforalmostipercentofsubprimemortgageloans,o.1
percentoftheAlt-Aloans,and,1percentofthepay-optionandinterest-onlyARMs
thatweresold.MadigantoldtheFCIC:
EvenastheFedwasdoinglittletoprotectconsumersandourfnancial
system from the effects of predatory lending, the OCC and OTS were
activelyengagedinacampaigntothwartstateeffortstoavertthecom-
ingcrisis. . . .Inthewakeofthefederalregulatorspushtocurtailstate
authority,manyofthelargestmortgage-lendersshedtheirstatelicenses
andsoughtshelterbehindtheshieldofanationalcharter.AndIthink
that it is no coincidence that the era of expanded federal preemption
gaverisetotheworstlendingabusesinournationshistory.
,1
ComptrollerHawkeofferedtheFCICadifferentinterpretation:Whilesomecrit-
icshavesuggestedthattheOCCsactionsonpreemptionhavebeenagrabforpower,
thefactisthattheagencyhassimplyrespondedtoincreasinglyaggressiveinitiatives
atthestateleveltocontrolthebankingactivitiesoffederallycharteredinstitutions.
,i
MORTGAGE SECURITIES PLAYERS:
WALL STREET WAS VERY HUNGRY FOR OUR PRODUCT
Subprime and Alt-A mortgagebacked securities depended on a complex supply
chain,largelyfundedthroughshort-termlendinginthecommercialpaperandrepo
marketwhichwouldbecomecriticalasthefnancialcrisisbegantounfoldinioo,.
TheseloanswereincreasinglycollateralizednotbyTreasuriesandGSEsecuritiesbut
byhighlyratedmortgagesecuritiesbackedbyincreasinglyriskyloans.Independent
mortgage originators such as Ameriquest and New Centurywithout access to de-
positstypicallyreliedonfnancingtooriginatemortgagesfromwarehouselinesof
credit extended by banks, from their own commercial paper programs, or from
moneyborrowedintherepomarket.
For commercial banks such as Citigroup, warehouse lending was a multibillion-
dollarbusiness.Fromioootoio1o,Citigroupmadeavailableatanyonetimeasmuch
as,billioninwarehouselinesofcredittomortgageoriginators,including,omil-
lion to New Century and more than ., billion to Ameriquest.
,
Citigroup CEO
ChuckPrincetoldtheFCIChewouldnothaveapproved,hadheknown.Ifoundout
attheendofmytenure,Ididnotknowitbefore,thatwehadsomewarehouselines
outtosomeoriginators.AndIthinkgettingthatclosetotheoriginationfunction
beingthatinvolvedintheoriginationofsomeoftheseproductsissomethingthatI
wasntcomfortablewithandthatIdidnotviewasconsistentwiththeprescriptionI
hadlaiddownforthecompanynottobeinvolvedinoriginatingtheseproducts.
,
Asearlyas18,Moodyscalledthenewasset-backedcommercialpaper(ABCP)
programs a whole new ball game.
,,
As asset-backed commercial paper became a
popular method to fund the mortgage business, it grew from about one-quarter to
aboutone-halfofcommercialpapersoldbetween1,andioo1.
1ui \ui1t\ti \\tui Ni ..,
Inioo1,onlyfvemortgagecompaniesborrowedatotalofbillionthroughas-
set-backed commercial paper; in iooo, 1 entities borrowed billion.
,o
For in-
stance, Countrywide launched the commercial paper programs Park Granada in
iooandParkSiennainioo.
,,
ByMayioo,,itwasborrowing1billionthrough
Park Granada and ,. billion through Park Sienna. These programs would house
subprimeandothermortgagesuntiltheyweresold.
,8
Commercial banks used commercial paper, in part, for regulatory arbitrage.
When banks kept mortgages on their balance sheets, regulators required them to
hold in capital to protect against loss. When banks put mortgages into off-bal-
ance-sheetentitiessuchascommercialpaperprograms,therewasnocapitalcharge
(in ioo, a small charge was imposed). But to make the deals work for investors,
banks had to provide liquidity support to these programs, for which they earned a
fee. This liquidity support meant that the bank would purchase, at a previously set
price,anycommercialpaperthatinvestorswereunwillingtobuywhenitcameupfor
renewal.Duringthefnancialcrisisthesepromiseshadtobekept,eventuallyputting
substantialpressureonbanksbalancesheets.
When the Financial Accounting Standards Board, the private group that estab-
lishes standards for fnancial reports, responded to the Enron scandal by making it
harderforcompaniestogetoff-balance-sheettreatmentfortheseprograms,thefa-
vorable capital rules were in jeopardy. The asset-backed commercial paper market
stalled.BanksprotestedthattheirprogramsdifferedfromthepracticesatEnronand
shouldbeexcludedfromthenewstandards.Inioo,bankregulatorsrespondedby
proposingtoletbanksremovetheseassetsfromtheirbalancesheetswhencalculat-
ing regulatory capital. The proposal would have also introduced for the frst time a
capitalchargeamountingtoatmost1.ooftheliquiditysupportbanksprovidedto
theABCPprograms.However,afterstrongpushbacktheAmericanSecuritization
Forum,anindustryassociation,calledthatchargearbitrary,andStateStreetBank
complained it was too conservative
,
regulators in ioo announced a fnal rule
settingthechargeatuptoo.8,orhalftheamountofthefrstproposal.Growthin
thismarketresumed.
Regulatorychangesinthiscase,changesinthebankruptcylawsalsoboosted
growthintherepomarketbytransformingthetypesofrepocollateral.Priortoioo,,
repo lenders had clear and immediate rights to their collateral following the bor-
rowers bankruptcy only if that collateral was Treasury or GSE securities. In the
BankruptcyAbusePreventionandConsumerProtectionActofioo,,Congressex-
pandedthatprovisiontoincludemanyotherassets,includingmortgageloans,mort-
gage-backed securities, collateralized debt obligations, and certain derivatives. The
resultwasashort-termrepomarketincreasinglyreliantonhighlyratednon-agency
mortgage-backed securities; but beginning in mid-ioo,, when banks and investors
became skittish about the mortgage market, they would prove to be an unstable
fundingsource(seefgure,.1).Oncethecrisishit,theseilliquid,hard-to-valuese-
curitiesmadeupagreatershareofthetri-partyrepomarketthanmostpeoplewould
havewanted,DarryllHendricks,aUBSexecutiveandchairofaNewYorkFedtask
forceexaminingtherepomarketafterthecrisis,toldtheCommission.
8o
.., ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
1ui \ui1t\ti \\tui Ni ..,
Oursampledeal,CMLTIiooo-NCi,showshowthesefundingandsecuritization
markets worked in practice. Eight banks and securities frms provided most of the
moneyNewCenturyneededtomakethe,mortgagesitwouldselltoCitigroup.
Most of the funds came through repo agreements from a set of banksincluding
Morgan Stanley (i million); Barclays Capital, a division of a U.K.-based bank
(ii1million);BankofAmerica(1,million);andBearStearns(omillion).
81
The
fnancingwasprovidedwhenNewCenturyoriginatedthesemortgages;soforabout
twomonths,NewCenturyowedthesebanksapproximatelyomillionsecuredby
themortgages.Another1imillioninfundingcamefromNewCenturyitself,includ-
ingmillionthroughitsowncommercialpaperprogram.OnAugusti,iooo,Citi-
grouppaidNewCentury,millionforthemortgages(andaccruedinterest),and
NewCenturyrepaidtherepolendersafterkeepingaimillion(i.,)premium.
8i
1/cinvcstorsint/ccel
Investorsformortgage-backedsecuritiescamefromallovertheglobe;whatmadese-
curitization work were the customized tranches catering to every one of them.
CMLTIiooo-NCihad1tranches,whoseinvestorsareshowninfgure,.i.Fannie
Mae bought the entire 1,, million triple-A-rated A1 tranche, which paid a better
return than super-safe U.S. Treasuries.
8
The other triple-A-rated tranches, worth
Broker-dealers use of repo borrowing rose sharply before the crisis.
SOURCE: Federal Reserve Flow of Funds Report
Repo Borrowing
IN BILLIONS OF DOLLARS
0
$1,500
1,200
900
600
300
300
1980 1985 1990 1995 2000 2005 2010
$396
NOTE: Net borrowing by broker-dealers.
Iigurc ;.+
.. ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
Tranche Original Balance
(MILLIONS)
Original
Rating
1
Spread
2
Selected Investors
A1 $154.6 AAA 0.14% Fannie Mae
A2-A $281.7 AAA 0.04% Chase Security Lendings Asset
Management; 1 investment fund
in China; 6 investment funds
A2-B $282.4 AAA 0.06% Federal Home Loan Bank of
Chicago; 3 banks in Germany,
Italy and France; 11 investment
funds; 3 retail investors
A2-C $18.3 AAA 0.24% 2 banks in the U.S. and Germany
M-1 $39.3 AA+ 0.29% 1 investment fund and 2
banks in Italy; Cheyne Finance
Limited; 3 asset managers
M-2 $44 .0 AA 0.31% Parvest ABS Euribor; 4 asset
managers; 1 bank in China;
1 CDO
M-3 $14.2 AA- 0.34% 2 CDOs; 1 asset manager
M-4 $16.1 A+ 0.39% 1 CDO; 1 hedge fund
M-5 $16.6 A 0.40% 2 CDOs
M-6 $10.9 A- 0.46% 3 CDOs
M-7 $9.9 BBB+ 0.70% 3 CDOs
M-8 $8.5 BBB 0.80% 2 CDOs; 1 bank
M-9 $11.8 BBB- 1.50% 5 CDOs; 2 asset managers
M-10 $13.7 BB+ 2.50% 3 CDOs; 1 asset manager
M-11 $10.9 BB 2.50% NA
CE $13.3 NR Citi and Capmark Fin Grp
P, R, Rx: Additional tranches entitled to specic payments
Selected Investors in CMLTI 2006-NC2
S
E
N
I
O
R
M
E
Z
Z
A
N
I
N
E
E
Q
U
I
T
Y
1
Standard & Poors.
2
The yield is the rate on the one-month London Interbank Ofered Rate (LIBOR), an interbank lending
interest rate, plus the spread listed. For example, when the deal was issued, Fannie Mae would have
received the LIBOR rate of 5.32% plus 0.14% to give a total yield of 5.46%.
A wide variety of investors throughout the world purchased the securities in this
deal, including Fannie Mae, many international banks, SIVs and many CDOs.
SOURCES: Citigroup; Standard & Poors; FCIC calculations
1
%
2
1
%
7
8
%
Iigurc ;.:
1ui \ui1t\ti \\tui Ni ..,
,8imillion,wenttomorethanioinstitutionalinvestorsaroundtheworld,spread-
ing the risk globally.
8
These triple-A tranches represented ,8 of the deal. Among
the buyers were foreign banks and funds in China, Italy, France, and Germany; the
FederalHomeLoanBankofChicago;theKentuckyRetirementSystems;ahospital;
andJPMorgan,whichpurchasedpartofthetrancheusingcashfromitssecurities-
lendingoperation.
8,
(Inotherwords,JPMorganlentsecuritiesheldbyitsclientsto
otherfnancialinstitutionsinexchangeforcashcollateral,andthenputthatcashto
work investing in this deal. Securities lending was a large, but ultimately unstable,
sourceofcashthatfowedintothismarket.)
The middle, mezzanine tranches in this deal constituted about i1 of the total
valueofthesecurity.Iflossesroseabove1to(bydesignthethresholdwouldin-
crease over time), investors in the residual tranches would be wiped out, and the
mezzanineinvestorswouldstarttolosemoney.Creatorsofcollateralizeddebtobliga-
tions, or CDOsdiscussed in the next chapterbought most of the mezzanine
tranchesratedbelowtriple-AandnearlyallthoseratedbelowAA.Onlyafewofthe
highest-ratedmezzaninetrancheswerenotputintoCDOs.Forexample,CheyneFi-
nanceLimitedpurchased,millionofthetopmezzaninetranche.Cheyneastruc-
tured investment vehicle (SIV)would be one of the frst casualties of the crisis,
sparking panic during the summer of ioo,. Parvest ABS Euribor, which purchased
io million of the second mezzanine tranche,
8o
would be one of the BNP Paribas
fundswhichhelpedignitethefnancialcrisisthatsummer.
8,
Typically,investorsseekinghighreturns,suchashedgefunds,wouldbuytheeq-
uity tranches of mortgage-backed securities; they would be the frst to lose if there
wereproblems.Theseinvestorsanticipatedreturnsof1,,io,oreveno.Citi-
groupretainedpartoftheresidualorfrst-losstranches,sharingtherestwithCap-
markFinancialGroup.
88
tomcnsetcvcr;vcll
Thebusinessofstructuring,selling,anddistributingthisdeal,andthethousandslike
it, was lucrative for the banks. The mortgage originators profted when they sold
loansforsecuritization.
8
Someofthisproftfoweddowntoemployeesparticularly
thosegeneratingmortgagevolume.
Part of the i million premium received by New Century for the deal we ana-
lyzedwenttopaythemanyemployeeswhoparticipated.Theoriginators,theloan
omcers,accountexecutives,basicallythesalespeople[who]werethereasonourloans
came in . . . were compensated very well, New Centurys Patricia Lindsay told the
FCIC. And volume mattered more than quality. She noted, Wall Street was very
hungryforourproduct.Wehadourloanssoldthreemonthsinadvance,beforethey
wereevenmadeatonepoint.
o
Similar incentives were at work at Long Beach Mortgage, the subprime division of
Washington Mutual, which organized its ioo Incentive Plan by volume. As WaMu
showed in a ioo, plan, Home Loans Product Strategy, the goals were also product-
specifc:todrivegrowthinhighermarginproducts(OptionARM,AltA,HomeEquity,
Subprime), recruit and leverage seasoned Option ARM sales force, and maintain a
compensationstructurethatsupportsthehighmarginproductstrategy.
1
Afterstructuringasecurity,anunderwriter,oftenaninvestmentbank,marketed
and sold it to investors. The bank collected a percentage of the sale (generally be-
tween o.i and 1.,) as discounts, concessions, or commissions.
i
For a 1 billion
deallikeCMLTIiooo-NCi,a1feewouldearnCitigroup1omillion.Inthiscase,
though, Citigroup instead kept parts of the residual tranches. Doing so could yield
largeproftsaslongasthedealperformedasexpected.
OptionsGroup,whichcompilescompensationfguresforinvestmentbanks,exam-
inedthemortgage-backedsecuritiessalesandtradingdesksat11commercialandin-
vestmentbanksfromioo,toioo,.

Itfoundthatassociateshadaverageannualbase
salariesofo,,oootoo,ooofromioo,throughioo,,butreceivedbonusesthatcould
wellexceedtheirsalaries.Onthenextrung,vicepresidentsaveragedbasesalariesand
bonusesfromioo,oooto1,1,o,ooo.Directorsaveragedoi,,oooto1,oi,,ooo.

At
thetopwastheheadoftheunit.Forexample,iniooo,DowKim,theheadofMerrills
Global Markets and Investment Banking segment, received a base salary of ,o,ooo
plusa,millionbonus,apackagesecondonlytoMerrillLynchsCEO.
,
MOODY S: GIVEN A BLANK CHECK
Theratingagencieswereessentialtothesmoothfunctioningofthemortgage-backed
securities market. Issuers needed them to approve the structure of their deals; banks
neededtheirratingstodeterminetheamountofcapitaltohold;repomarketsneeded
theirratingstodetermineloanterms;someinvestorscouldbuyonlysecuritieswitha
triple-Arating;andtheratingagenciesjudgmentwasbakedintocollateralagreements
andotherfnancialcontracts.Toexaminetheratingprocess,theCommissionfocused
onMoodysInvestorsService,thelargestandoldestofthethreeratingagencies.
The rating of structured fnance products such as mortgage-backed securities
made up close to half of Moodys rating revenues in ioo,, iooo, and ioo,.
o
From
ioootoioo,,revenuesfromratingsuchfnancialinstrumentsincreasedmorethan
fourfold.
,
Buttheratingprocessinvolvedmanyconficts,whichwouldcomeintofo-
cusduringthecrisis.
Todoitswork,Moodysratedmortgage-backedsecuritiesusingmodelsbased,in
part,onperiodsofrelativelystrongcreditperformance.Moodysdidnotsumciently
account for the deterioration in underwriting standards or a dramatic decline in
homeprices.AndMoodysdidnotevendevelopamodelspecifcallytotakeintoac-
count the layered risks of subprime securities until late iooo, after it had already
ratednearly1,ooosubprimesecurities.
8
Int/cousincssjorcvcrmorc
Credit ratings have been linked to government regulations for three-quarters of a
century.

In 11, the Omce of the Comptroller of the Currency let banks report
publiclytradedbondswitharatingofBBBorbetteratbookvalue(thatis,theprice
.. ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
they paid for the bonds); lower-rated bonds had to be reported at current market
prices,whichmightbelower.In1,1,theNationalAssociationofInsuranceCom-
missionersadoptedhighercapitalrequirementsonlower-ratedbondsheldbyinsur-
ers.
1oo
But the watershed event in federal regulation occurred in 1,,, when the
Securities and Exchange Commission modifed its minimum capital requirements
forbroker-dealerstobasethemoncreditratingsbyanationallyrecognizedstatisti-
calratingorganization(NRSRO);atthetime,thatwasMoodys,S&P,orFitch.Rat-
ingsarealsobuiltintobankingcapitalregulationsundertheRecourseRule,which,
since ioo1, has permitted banks to hold less capital for higher-rated securities. For
example, BBB rated securities require fve times as much capital as AAA and AA
rated securities, and BB securities require ten times more capital. Banks in some
countriesweresubjecttosimilarrequirementsundertheBaselIIinternationalcapi-
talagreement,signedinJuneioo,althoughU.S.bankshadnotfullyimplemented
theadvancedapproachesallowedunderthoserules.
Creditratingsalsodeterminedwhetherinvestorscouldbuycertaininvestmentsat
all. The SEC restricts money market funds to purchasing securities that have re-
ceivedcreditratingsfromanytwoNRSROs . . .inoneofthetwohighestshort-term
ratingcategoriesorcomparableunratedsecurities.
1o1
TheDepartmentofLaborre-
strictspensionfundinvestmentstosecuritiesratedAorhigher.Creditratingsaffect
evenprivatetransactions:contractsmaycontaintriggersthatrequirethepostingof
collateralorimmediaterepayment,shouldasecurityorentitybedowngraded.Trig-
gersplayedanimportantroleinthefnancialcrisisandhelpedcrippleAIG.
Importantlyforthemortgagemarket,theSecondaryMortgageMarketEnhance-
mentActof18permittedfederal-andstate-charteredfnancialinstitutionstoin-
vestinmortgage-relatedsecuritiesifthesecuritieshadhighratingsfromatleastone
ratingagency.Lookatthelanguageoftheoriginalbill,LewisRanieritoldtheFCIC.
Itrequiresarating. . . .Itputtheminthebusinessforevermore.Itbecameoneofthe
biggest,ifnotthebiggest,business.
1oi
AsEricKolchinsky,aformerMoodysmanag-
ingdirector,wouldsummarizethesituation,theratingagenciesweregivenablank
check.
1o
Theagenciesthemselves wereabletoavoidregulationfordecades.Beginningin
1,,,theSEChadtoapproveacompanysapplicationtobecomeanNRSRObutif
approved,acompanyfacednofurtherregulation.Morethanoyearslater,theSEC
gotlimitedauthoritytooverseeNRSROsintheCreditRatingAgencyReformActof
iooo. That law, taking effect in June ioo,, focused on mandatory disclosure of the
ratingagenciesmethodologies;however,thelawbarredtheSECfromregulatingthe
substanceofthecreditratingsortheproceduresandmethodologies.
1o
Many investors, such as some pension funds and university endowments, relied
oncreditratingsbecausetheyhadneitheraccesstothesamedataastheratingagen-
ciesnorthecapacityoranalyticalabilitytoassessthesecuritiestheywerepurchasing.
As Moodys former managing director Jerome Fons has acknowledged, Subprime
[residentialmortgagebackedsecurities]andtheiroffshootsofferlittletransparency
aroundcompositionandcharacteristicsoftheloancollateral. . . .Loan-by-loandata,
thehighestlevelofdetail,isgenerallynotavailabletoinvestors.
1o,
Others,evenlarge
1ui \ui1t\ti \\tui Ni ..,
fnancialinstitutions,reliedontheratings.Still,someinvestorswhodidtheirhome-
workwereskepticaloftheseproductsdespitetheirratings.ArnoldCattani,chairman
ofMissionBankinBakersfeld,California,describeddecidingtosellthebankshold-
ingsofmortgage-backedsecuritiesandCDOs:
Atonemeeting,whenthingsstartedgettingdimcult,maybeiniooo,I
askedtheCFOwhatthemechanicalstepswerein . . .mortgage-backed
securities,ifaborrowerinDesMoines,Iowa,defaulted.Iknowwhatit
is if a borrower in Bakersfeld defaults, and somebody has that mort-
gage.Butasapackagesecurity,whathappens:Andhecouldntanswer
thequestion.AndItoldhimtosellthem,sellallofthem,then,because
wedidntunderstandit,andIdontknowthatwehadthecapabilityto
understandthefnancialcomplexities;didntwantanypartofit.
1oo
Notably, rating agencies were not liable for misstatements in securities registra-
tions because courts ruled that their ratings were opinions, protected by the First
Amendment. Moodys standard disclaimer reads The ratings . . . are, and must be
construedsolelyas,statementsofopinionandnotstatementsoffactorrecommen-
dationstopurchase,sell,orholdanysecurities.GaryWitt,aformerteammanaging
directoratMoodys,toldtheFCIC,Peopleexpecttoomuchfromratings . . .invest-
mentdecisionsshouldalwaysbebasedonmuchmorethanjustarating.
1o,
Ivcr;t/ingoutt/cclc/entsittingont/cteolc
Theratingswereintendedtoprovideameansofcomparingrisksacrossassetclasses
andtime.Inotherwords,theriskofatriple-Aratedmortgagesecuritywassupposed
tobesimilartotheriskofatriple-Aratedcorporatebond.
Since the mid-1os, Moodys has rated tranches of mortgage-backed securities
usingthreemodels.Thefrst,developedin1o,ratedresidentialmortgagebacked
securities.Inioo,Moodyscreatedanewmodel,MPrime,torateprime,jumbo,
and Alt-A deals. Only in the fall of iooo, when the housing market had already
peaked,diditdevelopitsmodelforratingsubprimedeals,calledMSubprime.
1o8
Themodelsincorporatedfrm-andsecurity-specifcfactors,marketfactors,regu-
latory and legal factors, and macroeconomic trends. The M Prime model let
Moodysautomatemoreoftheprocess.AlthoughMoodysdidnotsampleorreview
individual loans, the company used loan-level information from the issuer. Relying
on loan-to-value ratios, borrower credit scores, originator quality, and loan terms
and other information, the model simulated the performance of each loan in 1,i,o
scenarios,includingvariationsininterestratesandstate-levelunemploymentaswell
as home price changes. On average, across the scenarios, home prices trended up-
wardatapproximatelyperyear.
1o
Themodelputlittleweightonthepossibility
priceswouldfallsharplynationwide.JaySiegel,aformerMoodysteammanagingdi-
rectorinvolvedindevelopingthemodel,toldtheFCIC,Theremayhavebeen[state-
level]componentsofthisrealestatedropthatthestatisticswouldhavecovered,but
.z+ ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
the8nationaldrop,stayingdownoverthisshortbutmultiple-yearperiod,ismore
stressfulthanthestatisticscallfor.Evenashousingpricesrosetounprecedentedlev-
els,Moodysneveradjustedthescenariostoputgreaterweightonthepossibilityofa
decline.AccordingtoSiegel,inioo,,Moodyspositionwasthattherewasnota . . .
nationalhousingbubble.
11o
Whentheinitialquantitativeanalysiswascomplete,theleadanalystonthedeal
convenedaratingcommitteeofotheranalystsandmanagerstoassessitanddeter-
mine the overall ratings for the securities.
111
Siegel told the FCIC that qualitative
analysis was also integral: One common misperception is that Moodys credit rat-
ingsarederivedsolelyfromtheapplicationofamathematicalprocessormodel.This
isnotthecase. . . .Thecreditratingprocessinvolvesmuchmoremostimportantly,
the exercise of independent judgment by members of the rating committee. Ulti-
mately,ratingsaresubjectiveopinionsthatrefectthemajorityviewofthecommit-
teesmembers.
11i
AsRogerStein,aMoodysmanagingdirector,noted,Overall,the
modelhastocontemplateeventsforwhichthereisnodata.
11
Afterratingsubprimedealswiththe1omodelforyears,inioooMoodysintro-
duced a parallel model for rating subprime mortgagebacked securities. Like M
Prime, the subprime model ran the mortgages through 1,i,o scenarios.
11
Moodys
omcialstoldtheFCICtheyrecognizedthatstressscenarioswerenotsumcientlyse-
vere,sotheyappliedadditionalweighttothemoststressfulscenario,whichreduced
the portion of each deal rated triple-A. Stein, who helped develop the subprime
model,saidtheoutputwasmanuallycalibratedtobemoreconservativetoensure
predicted losses were consistent with analysts expert views. Stein also noted
Moodysconcernaboutasuitablynegativestressscenario;forexample,asonestep,
analyststookthesingleworstcasefromtheMSubprimemodelsimulationsand
multiplieditbyafactorinordertoadddeterioration.
11,
Moodysdidnot,however,sumcientlyaccountforthedeterioratingqualityofthe
loansbeingsecuritized.FonsdescribedthisproblemtotheFCIC:Isatonthishigh-
levelStructuredCreditcommittee,whichyoudthinkwouldbedealingwithsuchis-
sues[ofdecliningmortgage-underwritingstandards],andneveroncewasitraisedto
thisgrouporputonouragendathatthedeclineinqualitythatwasgoingintopools,
theimpactpossiblyonratings,otherthings. . . .Wetalkedabouteverythingbut,you
know,theelephantsittingonthetable.
11o
TorateCMLTIiooo-NCi,oursampledeal,Moodysfrstuseditsmodeltosimu-
latelossesinthemortgagepool.Thoseestimates,inturn,determinedhowbigthejun-
iortranchesofthedealwouldhavetobeinordertoprotecttheseniortranchesfrom
losses.Inanalyzingthedeal,theleadanalystnoteditwassimilartoanotherCitigroup
dealofNewCenturyloansthatMoodyshadratedearlierandrecommendedthesame
amount.
11,
Thenthedealwastweakedtoaccountforcertainriskiertypesofloans,in-
cluding interest-only mortgages.
118
For its efforts, Moodys was paid an estimated
io8,ooo.
11
(S&Palsoratedthisdealandreceived1,,ooo.)
1io
As we will describe later, three tranches of this deal would be downgraded less
thanayearafterissuancepartofMoodysmassdowngradeonJuly1o,ioo,,when
housing prices had declined by only . In October ioo,, the MM11 tranches
1ui \ui1t\ti \\tui Ni .z.
weredowngradedandbyioo8,allthetrancheshadbeendowngraded.Ofallmort-
gage-backed securities it had rated triple-A in iooo, Moodys downgraded , to
junk.
1i1
Theconsequenceswouldreverberatethroughoutthefnancialsystem.
FANNIE MAE AND FREDDIE MAC:
LESS COMPETITIVE IN THE MARKETPLACE
Inioo,FannieandFreddiefacedproblemsonmultiplefronts.Theyhadviolatedac-
countingrulesandnowfacedcorrectionsandfnes.
1ii
Theywerelosingmarketshare
to Wall Street, which was beginning to dominate the securitization market. Strug-
gling to remain dominant, they loosened their underwriting standards, purchasing
andguaranteeingriskierloans,andincreasingtheirsecuritiespurchases.
1i
Yettheir
regulator, the Omce of Federal Housing Enterprise Oversight (OFHEO), focused
moreonaccountingandotheroperationalissuesthanonFanniesandFreddiesin-
creasinginvestmentsinriskymortgagesandsecurities.
Iniooi,Freddiechangedaccountingfrms.ThecompanyhadbeenusingArthur
Andersenformanyyears,butwhenAndersengotintotroubleintheEnrondebacle
(which put both Enron and its accountant out of business), Freddie switched to
PricewaterhouseCoopers.Thenewaccountantfoundthecompanyhadunderstated
itsearningsby,billionfromiooothroughthethirdquarterofiooi,inaneffortto
smooth reported earnings and promote itself as Steady Freddie, a company of
strongandsteadygrowth.Bonusesweretiedtothereportedearnings,andOFHEO
foundthatthisarrangementcontributedtotheaccountingmanipulations.Freddies
board ousted most top managers, including Chairman and CEO Leland Brendsel,
President and COO David Glenn, and CFO Vaughn Clarke.
1i
In December ioo,
FreddieagreedwithOFHEOtopaya1i,millionpenaltyandcorrectgovernance,
internal controls, accounting, and risk management. In January ioo, OFHEO di-
rectedFreddietomaintainomorethanitsminimumcapitalrequirementuntilit
reduced operational risk and could produce timely, certifed fnancial statements.
FreddieMacwouldsettleshareholderlawsuitsfor1omillionandpay,omillion
inpenaltiestotheSEC.
Fanniewasnext.InSeptemberioo,OFHEOdiscoveredviolationsofaccounting
rulesthatcalledintoquestionpreviousflings.Iniooo,OFHEOreportedthatFannie
hadoverstatedearningsfrom18throughiooiby11billionandthatit,too,had
manipulatedaccountinginwaysinfuencedbycompensationplans.
1i,
OFHEOmade
Fannieimproveaccountingcontrols,maintainthesameocapitalsurplusimposed
on Freddie, and improve governance and internal controls. Fannies board ousted
CEO Franklin Raines and others, and the SEC required Fannie to restate its results
forioo1throughmid-ioo.FanniesettledSECandOFHEOenforcementactionsfor
oo million in penalties. Donald Bisenius, an executive vice president at Freddie
Mac, told the FCIC that the accounting issues distracted management from the
mortgage business, taking a tremendous amount of managements time and atten-
tion and probably led to us being less aggressive or less competitive in the market-
place[than]weotherwisemighthavebeen.
1io
.zz ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
As the scandals unfolded, subprime private label mortgagebacked securities
(PLS)issuedbyWallStreetincreasedfrom8,billioninioo1too,billioninioo,
(showninfgure,.);thevalueofAlt-Amortgagebackedsecuritiesincreasedfrom
11 billion to i billion. Starting in ioo1 for Freddie and iooi for Fannie, the
GSEsparticularlyFreddiebecamebuyersinthismarket.Whileprivateinvestors
always bought the most, the GSEs purchased 1o., of the private-issued subprime
mortgagebackedsecuritiesinioo1.Thesharepeakedatoiniooandthenfell
back to i8 in ioo8. The share for Alt-A mortgagebacked securities was always
lower.
1i,
The GSEs almost always bought the safest, triple-A-rated tranches. From
ioo, through ioo8, the GSEs purchases declined, both in dollar amount and as a
percentage.
Theseinvestmentswereproftableatfrst,butasdelinquenciesincreasedinioo,
andioo8,bothGSEsbegantotakesignifcantlossesontheirprivate-labelmortgage
backed securitiesdisproportionately from their purchases of Alt-A securities. By
the third quarter of io1o, total impairments on securities totaled o billion at the
twocompaniesenoughtowipeoutnearlyoooftheirpre-crisiscapital.
1i8
OFHEO knew about the GSEs purchases of subprime and Alt-A mortgage
backedsecurities.Initsiooexamination,theregulatornotedFreddiespurchasesof
these securities. It also noted that Freddie was purchasing whole mortgages with
higherriskattributeswhichexceededtheEnterprisesmodelingandcostingcapabil-
ities, including No Income/No Asset loans that introduced considerable risk.
OFHEO reported that mortgage insurers were already seeing abuses with these
loans.
1i
Buttheregulatorconcludedthatthepurchasesofmortgage-backedsecuri-
tiesandriskiermortgageswerenotasignifcantsupervisoryconcern,andtheex-
amination focused more on Freddies efforts to address accounting and internal
defciencies.
1o
OFHEO included nothing in Fannies report about its purchases of
subprimeandAlt-Amortgagebackedsecurities,anditscreditriskmanagementwas
deemedsatisfactory.
11
ThereasonsfortheGSEspurchasesofsubprimeandAlt-Amortgagebackedse-
curities have been debated. Some observers, including Alan Greenspan, have linked
theGSEspurchasesofprivatemortgagebackedsecuritiestotheirpushtofulflltheir
highergoalsforaffordablehousing.TheformerFedchairmanwroteinaworkingpa-
persubmittedaspartofhistestimonytotheFCICthatwhentheGSEswerepressedto
expand affordable housing commitments, they chose to meet them by investing
heavily in subprime securities.
1i
Using data provided by Fannie Mae and Freddie
Mac, the FCIC examined how single-family, multifamily, and securities purchases
contributedtomeetingtheaffordablehousinggoals.Iniooandioo,FannieMaes
single-andmultifamilypurchasesalonemeteachofthegoals;inotherwords,theen-
terprisewouldhavemetitsobligationswithoutbuyingsubprimeorAlt-Amortgage
backedsecurities.Infact,noneofFannieMaesioopurchasesofsubprimeorAlt-A
securitieswereeversubmittedtoHUDtobecountedtowardthegoals.
Beforeioo,,,oorlessoftheGSEsloanpurchaseshadtosatisfytheaffordable
housing goals. In ioo, the goals were increased above ,o; but even then, single-
andmultifamilypurchasesalonemettheoverallgoals.
1
Securitiespurchasesdid,in
1ui \ui1t\ti \\tui Ni .z,
.z, ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
several cases, help Fannie meet its subgoalsspecifc targets requiring the GSEs to
purchaseorguaranteeloanstopurchasehomes.Inioo,,Fanniemissedoneofthese
subgoalsandwouldhavemissedasecondwithoutthesecuritiespurchases;iniooo,
thesecuritiespurchaseshelpedFanniemeetthosetwosubgoals.
ThepatternisthesameatFreddieMac,alargerpurchaserofnon-agencymort-
gagebackedsecurities.
1
EstimatesbytheFCICshowthatfromioothroughiooo,
FreddiewouldhavemettheaffordablehousinggoalswithoutanypurchasesofAlt-A
orsubprimesecurities,butusedthesecuritiestohelpmeetsubgoals.
1,
RobertLevin,theformerchiefbusinessomcerofFannieMae,toldtheFCICthat
buying private-label mortgagebacked securities was a moneymaking activityit
wasallpositiveeconomics. . . .[T]herewasnotrade-off[betweenmakingmoneyand
hitting goals], it was a very broad-brushed effort that could be characterized as
win-win-win: money, goals, and share.
1o
Mark Winer, the head of Fannies Busi-
ness,Analysis,andDecisionsGroup,statedthatthepurchaseoftriple-Atranchesof
mortgage-backed securities backed by subprime loans was viewed as an attractive
opportunitywithgoodreturns.Hesaidthatthemortgage-backedsecuritiessatisfed
The GSEs purchased subprime and Alt-A nonagency securities during the 2000s.
These purchases peaked in 2004.
Buyers of Non-GSE Mortgage-Backed Securities
IN BILLIONS OF DOLLARS
08 01 02 03 04 05 06 07 08 01 02 03 04 05 06 07
0
100
200
300
400
$500
Subprime Securities Purchases Alt-A Securities Purchases
SOURCES: Inside Mortgage Finance, Fannie Mae, Freddie Mac
Freddie Mac
Fannie Mae
Other purchasers
Iigurc ;.
1ui \ui1t\ti \\tui Ni .z,
housing goals, and that the goals became a factor in the decision to increase pur-
chasesofprivatelabelsecurities.
1,
Overall, while the mortgages behind the subprime mortgagebacked securities
wereoftenissuedtoborrowersthatcouldhelpFannieandFreddiefulflltheirgoals,
themortgagesbehindtheAlt-Asecuritieswerenot.Alt-Amortgageswerenotgener-
allyextendedtolower-incomeborrowers,andtheregulationsprohibitedmortgages
toborrowerswithunstatedincomelevelsahallmarkofAlt-Aloansfromcount-
ingtowardaffordabilitygoals.
18
LevintoldtheFCICthattheybelievedthatthepur-
chaseofAlt-AsecuritiesdidnothaveanetpositiveeffectonFannieMaeshousing
goals.
1
Instead,theyhadtobeoffsetwithmoremortgagesforlow-andmoderate-
incomeborrowerstomeetthegoals.
FannieandFreddiecontinuedtopurchasesubprimeandAlt-Amortgagebacked
securities from ioo, to ioo8 and also bought and securitized greater numbers of
riskier mortgages. The results would be disastrous for the companies, their share-
holders,andAmericantaxpayers.
COMMISSION CONCLUSIONS ON CHAPTER 7
The Commission concludes that the monetary policy of the Federal Reserve,
alongwithcapitalfowsfromabroad,createdconditionsinwhichahousingbub-
ble could develop. However, these conditions need not have led to a crisis. The
FederalReserveandotherregulatorsdidnottakeactionsnecessarytoconstrain
thecreditbubble.Inaddition,theFederalReservespoliciesandpronouncements
encouraged rather than inhibited the growth of mortgage debt and the housing
bubble.
Lending standards collapsed, and there was a signifcant failure of accounta-
bility and responsibility throughout each level of the lending system. This in-
cluded borrowers, mortgage brokers, appraisers, originators, securitizers, credit
ratingagencies,andinvestors,andrangedfromcorporateboardroomstoindivid-
uals. Loans were often premised on ever-rising home prices and were made re-
gardlessofabilitytopay.
The nonprime mortgage securitization process created a pipeline through
whichriskymortgageswereconveyedandsoldthroughoutthefnancialsystem.
Thispipelinewasessentialtotheoriginationoftheburgeoningnumbersofhigh-
riskmortgages.Theoriginate-to-distributemodelunderminedresponsibilityand
accountabilityforthelong-termviabilityofmortgagesandmortgage-relatedse-
curitiesandcontributedtothepoorqualityofmortgageloans.
(continues)
.z ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
Federalandstaterulesrequiredorencouragedfnancialfrmsandsomeinsti-
tutionalinvestorstomakeinvestmentsbasedontheratingsofcreditratingagen-
cies, leading to undue reliance on those ratings. However, the rating agencies
werenotadequatelyregulatedbytheSecuritiesandExchangeCommissionorany
otherregulatortoensurethequalityandaccuracyoftheirratings.Moodys,the
Commissionscasestudyinthisarea,reliedonfawedandoutdatedmodelstois-
sueerroneousratingsonmortgage-relatedsecurities,failedtoperformmeaning-
fulduediligenceontheassetsunderlyingthesecurities,andcontinuedtorelyon
thosemodelsevenafteritbecameobviousthatthemodelswerewrong.
Not only did the federal banking supervisors fail to rein in risky mortgage-
lendingpractices,buttheOmceoftheComptrolleroftheCurrencyandtheOf-
fceofThriftSupervisionpreemptedtheapplicabilityofstatelawsandregulatory
effortstonationalbanksandthrifts,thuspreventingadequateprotectionforbor-
rowersandweakeningconstraintsonthissegmentofthemortgagemarket.
(continued)
8
THE CDO MACHINE
CONTENTS
CDOsVccrcatcdthcinvcstcr +:,
BcarStcarnsshcdgcjundsItjuncticncdncupunti|cncday
itjustdidntjuncticn+,,
Citigrcups|iquidityputsApctcntia|ccnictcjintcrcst +,,
AIGGc|dcngccscjcrthccntircStrcct +,,
Gc|dnanSachsMu|tip|icdthccjjcctscjthccc||apscinsu|princ+,:
MccdysAchicvcdthrcughscnca|chcny +,e
SLCItsgcingtc|canawju||y|igncss+,o
Inthefrstdecadeofthei1stcentury,apreviouslyobscurefnancialproductcalledthe
collateralizeddebtobligation,orCDO,transformedthemortgagemarketbycreatinga
newsourceofdemandforthelower-ratedtranchesofmortgage-backedsecurities.
Despitetheirrelativelyhighreturns,tranchesratedotherthantriple-Acouldbe
hard to sell. If borrowers were delinquent or defaulted, investors in these tranches
wereoutofluckbecauseofwheretheysatinthepaymentswaterfall.
WallStreetcameupwithasolution:inthewordsofonebanker,theycreatedthe
investor.
1
Thatis,theybuiltnewsecuritiesthatwouldbuythetranchesthathadbe-
comehardertosell.Bankerswouldtakethoselowinvestment-gradetranches,largely
ratedBBBorA,frommanymortgage-backedsecuritiesandrepackagethemintothe
new securitiesCDOs. Approximately 8o of these CDO tranches would be rated
triple-A despite the fact that they generally comprised the lower-rated tranches of
mortgage-backedsecurities.CDOsecuritieswouldbesoldwiththeirownwaterfalls,
with the risk-averse investors, again, paid frst and the risk-seeking investors paid
last.Astheydidinthecaseofmortgage-backedsecurities,theratingagenciesgave
theirhighest,triple-Aratingstothesecuritiesatthetop(seefgure8.1).
Still,itwasnotobviousthatapoolofmortgage-backedsecuritiesratedBBBcould
betransformedintoanewsecuritythatismostlyratedtriple-A.Butmathmadeitso.
.z,
Throughoutthisbook,unlessotherwisenoted,weusethetermCDOstorefertocashCDOsbacked
byasset-backedsecurities(suchasmortgage-backedsecurities),alsoknownasABSCDOs.
The securities frms arguedand the rating agencies agreedthat if they pooled
manyBBB-ratedmortgage-backedsecurities,theywouldcreateadditionaldiversif-
cation benefts. The rating agencies believed that those diversifcation benefts were
signifcantthatifonesecuritywentbad,thesecondhadonlyaverysmallchanceof
goingbadatthesametime.Andaslongaslosseswerelimited,onlythoseinvestorsat
thebottomwouldlosemoney.Theywouldabsorbtheblow,andtheotherinvestors
wouldcontinuetogetpaid.
Relyingonthatlogic,theCDOmachinegobbleduptheBBBandotherlower-rated
.z ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1 .z ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
AAA
AA
A
EQUITY
BB
BBB
1. Purchase
Collateralized Debt Obligations
Low risk, low yield
High risk, high yield
New pool
of RMBS
and other
securities
BBB
BB
AA
A
AAA
The CDO manager and securities
rm select and purchase assets,
such as some of the lower-rated
tranches of mortgage-backed
securities.
2. Pool
The CDO manager
and securities rm
pool various assets
in an attempt to
get diversication
benets.
3. CDO tranches
Similar to
mortgage-backed
securities, the CDO
issues securities in
tranches that vary
based on their place in
the cash ow waterfall.
next
etc.
next
claim
First claim to cash ow from
principal & interest payments
Collateralized debt obligations (CDOs) are structured
financial instruments that purchase and pool
financial assets such as the riskier tranches of various
mortgage-backed securities.
Iigurc 8.+
tranchesofmortgage-backedsecurities,growingfromabitplayertoamulti-hundred-
billion-dollar industry. Between ioo and ioo,, as house prices rose i, nationally
and trillion in mortgage-backed securities were created, Wall Street issued nearly
,oo billion in CDOs that included mortgage-backed securities as collateral.
i
With
readybuyersfortheirownproduct,mortgagesecuritizerscontinuedtodemandloans
fortheirpools,andhundredsofbillionsofdollarsfoodedthemortgageworld.Inef-
fect,theCDObecametheenginethatpoweredthemortgagesupplychain.Thereisa
machinegoing,ScottEichel,aseniormanagingdirectoratBearStearns,toldafnan-
cialjournalistinMayioo,.Thereisalotofbrainpowertokeepthisgoing.

Everyone involved in keeping this machine hummingthe CDO managers and


underwriters who packaged and sold the securities, the rating agencies that gave
mostofthemsterlingratings,andtheguarantorswhowroteprotectionagainsttheir
defaultingcollected fees based on the dollar volume of securities sold. For the
bankers who had put these deals together, as for the executives of their companies,
volumeequaledfeesequaledbonuses.Andthosefeeswereinthebillionsofdollars
acrossthemarket.
Butwhenthehousingmarketwentsouth,themodelsonwhichCDOswerebased
provedtragicallywrong.Themortgage-backedsecuritiesturnedouttobehighlycor-
relatedmeaning they performed similarly. Across the country, in regions where
subprimeandAlt-Amortgageswereheavilyconcentrated,borrowerswoulddefault
in large numbers. This was not how it was supposed to work. Losses in one region
weresupposedtobeoffsetbysuccessfulloansinanotherregion.Intheend,CDOs
turnedouttobesomeofthemostill-fatedassetsinthefnancialcrisis.Thegreatest
losseswouldbeexperiencedbybigCDOarrangerssuchasCitigroup,MerrillLynch,
andUBS,andbyfnancialguarantorssuchasAIG,Ambac,andMBIA.Theseplayers
hadbelievedtheirownmodelsandretainedexposuretowhatwereunderstoodtobe
the least risky tranches of the CDOs: those rated triple-A or even super-senior,
whichwereassumedtobesaferthantriple-A-ratedtranches.
ThewholeconceptofABSCDOshadbeenanabomination,PatrickParkinson,
currently the head of banking supervision and regulation at the Federal Reserve
Board,toldtheFCIC.

CDOS: WE CREATED THE INVESTOR


Michael Milkens Drexel Burnham Lambert assembled the frst rated collateralized
debt obligation in 18, out of different companies junk bonds. The strategy made
sensepooling many bonds reduced investors exposure to the failure of any one
bond, and putting the securities into tranches enabled investors to pick their pre-
ferredlevelofriskandreturn.
ForthemanagerswhocreatedCDOs,thekeytoproftabilityoftheCDOwasthefee
and the spreadthe difference between the interest that the CDO received on the
bondsorloansthatitheldandtheinterestthattheCDOpaidtoinvestors.Throughout
the1os,CDOmanagersgenerallypurchasedcorporateandemergingmarketbonds
and bank loans. When the liquidity crisis of 18 drove up returns on asset-backed
1ui tiu \\tui Ni .z,
securities,PrudentialSecuritiessawanopportunityandlaunchedaseriesofCDOsthat
combineddifferentkindsofasset-backedsecuritiesintooneCDO.Thesemultisector
orABSsecuritieswerebackedbymortgages,mobilehomeloans,aircraftleases,mu-
tual fund fees, and other asset classes with predictable income streams. The diversity
wassupposedtoprovideyetanotherlayerofsafetyforinvestors.
MultisectorCDOswentthroughatoughpatchwhensomeoftheasset-backedse-
curitiesinwhichtheyinvestedstartedtoperformpoorlyiniooiparticularlythose
backedbymobilehomeloans(afterborrowersdefaultedinlargenumbers),aircraft
leases(after/11),andmutualfundfees(afterthedot-combust).
,
Theacceptedwis-
domamongmanyinvestmentbanks,investors,andratingagencieswasthatthewide
range of assets had actually contributed to the problem; according to this view, the
assetmanagerswhoselectedtheportfolioscouldnotbeexpertsinsectorsasdiverse
asaircraftleasesandmutualfunds.
So the CDO industry turned to nonprime mortgagebacked securities, which
CDO managers believed they understood, which seemed to have a record of good
performance,andwhichpaidrelativelyhighreturnsforwhatwasconsideredasafe
investment.Everyonelookedatthesectorandsaid,theCDOconstructworks,but
we just need to fnd more stable collateral, said Wing Chau, who ran two frms,
MaximGroupandHardingAdvisory,thatmanagedCDOsmostlyunderwrittenby
Merrill Lynch. And the industry looked at residential mortgagebacked securities,
Alt-A,subprime,andnon-agencymortgages,andsawtherelativestability.
o
CDOs quickly became ubiquitous in the mortgage business.
,
Investors liked the
combination of apparent safety and strong returns, and investment bankers liked
havinganewsourceofdemandforthelowertranchesofmortgage-backedsecurities
and other asset-backed securities that they created. We told you these [BBB-rated
securities]wereagreatdeal,andpricedatgreatspreads,butnobodysteppedup,the
Credit Suisse banker Joe Donovan told a Phoenix conference of securitization
bankersinFebruaryiooi.Sowecreatedtheinvestor.
8
Byioo,creatorsofCDOswerethedominantbuyersoftheBBB-ratedtranches
of mortgage-backed securities, and their bids signifcantly infuenced prices in the
market for these securities. By ioo,, they were buying virtually all of the BBB
tranches.

Just as mortgage-backed securities provided the cash to originate mort-


gages,nowCDOswouldprovidethecashtofundmortgage-backedsecurities.Also
byioo,mortgage-backedsecuritiesaccountedformorethanhalfofthecollateralin
CDOs, up from , in iooi.
1o
Sales of these CDOs more than doubled every year,
jumpingfromobillioniniootoii,billioniniooo.
11
Fillingthispipelinewould
requirehundredsofbillionsofdollarsofsubprimeandAlt-Amortgages.
Itveselotojcjjort
FivekeytypesofplayerswereinvolvedintheconstructionofCDOs:securitiesfrms,
CDOmanagers,ratingagencies,investors,andfnancialguarantors.Eachtookvary-
ingdegreesofriskand,foratime,proftedhandsomely.
SecuritiesfrmsunderwrotetheCDOs:thatis,theyapprovedtheselectionofcol-
.,+ ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1 .,+ ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
lateral, structured the notes into tranches, and were responsible for selling them to
investors. Three frmsMerrill Lynch, Goldman Sachs, and the securities arm of
Citigroupaccounted for more than o of CDOs structured from ioo to ioo,.
Deutsche Bank and UBS were also major participants.
1i
We had sales representa-
tivesinallthose[global]locations,andtheirjobsweretosellstructuredproducts,
NestorDominguez,theco-headofCitigroupsCDOdesk,toldtheFCIC.Wespenta
lotofefforttohavepeopleinplacetoeducate,topitchstructuredproducts.So,itwas
alotofeffort,about1oopeople.AndIpresumeourcompetitorsdidthesame.
1
The underwriters focus was on generating fees and structuring deals that they
couldsell.Underwritingdidentailrisks,however.Thesecuritiesfrmhadtoholdthe
assets, such as the BBB-rated tranches of mortgage-backed securities, during the
ramp-upperiodsixtoninemonthswhenthefrmwasaccumulatingthemortgage-
backedsecuritiesfortheCDOs.Typically,duringthatperiod,thesecuritiesfrmtook
theriskthattheassetsmightlosevalue.Ourbusinesswastomakenewissuefees,
[and to] make sure that if the market did have a downturn, we were somehow
hedged,MichaelLamont,theformerco-headforCDOsatDeutscheBank,toldthe
FCIC.
1
Chris Ricciardi, formerly head of the CDO desk at Merrill Lynch, likewise
told the FCIC that he did not track the performance of CDOs after underwriting
them.
1,
Moreover,Lamontsaiditwasnothisjobtodecidewhethertheratingagen-
ciesmodelshadthecorrectunderlyingassumptions.Thatwasnotwhatwebrought
tothetable,hesaid.
1o
Inmanycases,though,underwritershelpedCDOmanagers
selectcollateral,leadingtopotentialconficts(moreonthatlater).
The role of the CDO manager was to select the collateral, such as mortgage-
backedsecurities,andinsomecasesmanagetheportfolioonanongoingbasis.Man-
agersrangedfromindependentinvestmentfrmssuchasChaustounitsoflargeasset
managementcompaniessuchasPIMCOandBlackrock.
CDOmanagersreceivedperiodicfeesbasedonthedollaramountofassetsinthe
CDO and in some cases on performance. On a percentage basis, these may have
looked smallsometimes measured in tenths of a percentage pointbut the
amounts were far from trivial. For CDOs that focused on the relatively senior
tranches of mortgage-backed securities, annual manager fees tended to be in the
rangeofooo,oootoamilliondollarsperyearfora1billiondollardeal.ForCDOs
that focused on the more junior tranches, which were often smaller, fees would be
,,o,ooo to 1., million per year for a ,oo million deal.
1,
As managers did more
deals,theygeneratedmorefeeswithoutmuchadditionalcost.Youdhearstatements
like, Everybody and his uncle now wants to be a CDO manager, Mark Adelson,
thenastructuredfnanceanalystatNomuraSecuritiesandcurrentlychiefcreditom-
cer at S&P, told the FCIC. That was an observation voiced repeatedly at several of
the industry conferences around those timesthe enormous proliferation of CDO
managers . . .becauseitwasverylucrative.
18
CDOmanagersindustry-wideearned
atleast1.,billioninmanagementfeesbetweeniooandioo,.
1
The role of the rating agencies was to provide basic guidelines on the collateral
and the structure of the CDOsthat is, the sizes and returns of the various
tranchesin close consultation with the underwriters. For many investors, the
1ui tiu \\tui Ni .,.
triple-A rating made those products appropriate investments. Rating agency fees
were typically between i,o,ooo and ,oo,ooo for CDOs.
io
For most deals, at least
tworatingagencieswouldprovideratingsandreceivethosefeesalthoughtheviews
tendedtobeinsync.
TheCDOinvestors,likeinvestorsinmortgage-backedsecurities, focusedondif-
ferenttranchesbasedontheirpreferenceforriskandreturn.CDOunderwriterssuch
as Citigroup, Merrill Lynch, and UBS often retained the super-senior triple-A
tranchesforreasonswewillseelater.Theyalsosoldthemtocommercialpaperpro-
grams that invested in CDOs and other highly rated assets. Hedge funds often
boughttheequitytranches.
i1
Eventually,otherCDOsbecamethemostimportantclassofinvestorforthemez-
zaninetranchesofCDOs.Byioo,,CDOunderwritersweresellingmostofthemez-
zanine tranchesincluding those rated Aand, especially, those rated BBB, the
lowest and riskiest investment-grade ratingto other CDO managers, to be pack-
agedintootherCDOs.
ii
ItwascommonforCDOstobestructuredwith,or1,
oftheircashinvestedinotherCDOs;CDOswithasmuchas8oto1oooftheir
cashinvestedinotherCDOsweretypicallyknownasCDOssquared.
Finally, the issuers of over-the-counter derivatives called credit default swaps,
most notably AIG, played a central role by issuing swaps to investors in CDO
tranches,promisingtoreimbursethemforanylossesonthetranchesinexchangefor
a stream of premium-like payments. This credit default swap protection made the
CDOsmuchmoreattractivetopotentialinvestorsbecausetheyappearedtobevirtu-
allyriskfree,butitcreatedhugeexposuresforthecreditdefaultswapissuersifsignif-
icantlossesdidoccur.
ProftfromthecreationofCDOs,asiscustomaryonWallStreet,wasrefectedin
employeebonuses.And,asdemandforalltypesoffnancialproductssoaredduring
the liquidity boom at the beginning of the i1st century, pretax proft for the fve
largest investment banks doubled between ioo and iooo, from io billion to
billion;totalcompensationattheseinvestmentbanksfortheiremployeesacrossthe
worldrosefrombilliontoo1billion.
i
Apartofthegrowthcouldbecreditedto
mortgage-backed securities, CDOs, and various derivatives, and thus employees in
those areas could be expected to be compensated accordingly. Credit derivatives
tradersaswellasmortgageandasset-backedsecuritiessalespeopleshouldespecially
enjoybonusseason,afrmthatcompilescompensationfguresforinvestmentbanks
reportedinioo,.
i
To see in more detail how the CDO pipeline worked, we revisit our illustrative
Citigroup mortgage-backed security, CMLTI iooo-NCi. Earlier, we described how
mostofthebelow-triple-AbondsissuedinthisdealwentintoCDOs.OnesuchCDO
wasKlerosRealEstateFundingIII,whichwasunderwrittenbyUBS,aSwissbank.
i,
The CDO manager was Strategos Capital Management, a subsidiary of Cohen &
Company;thatinvestmentcompanywasheadedbyChrisRicciardi,whohadearlier
builtMerrillsCDObusiness.
io
KlerosIII,launchediniooo,purchasedandheld.o
millioninsecuritiesfromtheA-ratedM,trancheofCitigroupssecurity,alongwith
18,juniortranchesofothermortgage-backedsecurities.Intotal,itowned,,mil-
.,z ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1 .,z ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
lion of mortgage-related securities, of which , were rated BBB or lower, 1o A,
and the rest higher than A. To fund those purchases, Kleros III issued 1 billion of
bondstoinvestors.AswastypicalforthistypeofCDOatthetime,roughly88of
theKlerosIIIbondsweretriple-A-rated.Atleasthalfofthebelow-triple-Atranches
issuedbyKlerosIIIwentintootherCDOs.
i,
Mot/crsmilktot/c . . .merkct
ThegrowthofCDOshadimportantimpactsonthemortgagemarketitself.CDOman-
agerswhowereeagertoexpandtheassetsthattheyweremanagingonwhichtheirin-
comewasbasedwerewillingtopayhighpricestoaccumulateBBB-ratedtranchesof
mortgage-backed securities. This CDO bid pushed up market prices on those
tranches,pricingoutofthemarkettraditionalinvestorsinmortgage-backedsecurities.
Informedinstitutionalinvestorssuchasinsurancecompanieshadpurchasedthe
private-label mortgagebacked securities issued in the 1os. These securities were
typicallyprotectedfromlossesbybondinsurers,whohadanalyzedthedealsaswell.
Beginninginthelate1os,mortgage-backedsecuritiesthatwerestructuredwithsix
or more tranches and other features to protect the triple-A investors became more
common,replacingtheearlierstructuresthathadreliedonbondinsurancetopro-
tect investors. By ioo, the earlier forms of mortgage-backed securities had essen-
tially vanished, leaving the market increasingly to the multitranche structures and
theirCDOinvestors.
Thiswasacriticaldevelopment,giventhatthefocusofCDOmanagersdiffered
fromthatoftraditionalinvestors.TheCDOmanagerandtheCDOinvestorarenot
thesamekindoffolks[asthemonolinebondinsurers],whojustbackedaway,Adel-
son said. Theyre mostly not mortgage professionals, not real estate professionals.
Theyarederivativesfolks.
i8
Indeed,Chau,theCDOmanager,portrayedhisjobascreatingstructuresthatrat-
ingagencieswouldapproveandinvestorswouldbuy,andmakingsurethemortgage-
backedsecuritiesthatheboughtmetindustrystandards.Hesaidthathereliedon
the rating agencies. Unfortunately, what lulled a lot of investors, and Im in that
camp as well, what lulled us into that sense of comfort was that the rating stability
wassosolidandthatitwassoconsistent.Imean,theratingagenciesdidaverygood
jobofmakingeverythingconsistent.
i
CDOproductionwaseffectivelyonautopilot.
Mortgage traders speak lovingly of the CDO bid. It is mothers milk to the . . .
market,JamesGrant,amarketcommentator,wroteiniooo.Withoutit,feweras-
set-backedstructurescouldbebuilt,andthosethatwerewouldhavetomeetamuch
more conservative standard of design. The resulting pangs of credit withdrawal
wouldcertainlybefeltintheresidentialreal-estatemarket.
o
UBSsGlobalCDOGroupagreed,notingthatCDOshavenowbecomebulliesin
theirrespectivecollateralmarkets.Bypromotinganincreaseinboththevolumeand
the price of mortgage-backed securities, bids from CDOs had an impact on the
overallU.S.economythatgoeswellbeyondtheCDOmarket.
1
Withoutthedemand
for mortgage-backed securities from CDOs, lenders would have been able to sell
1ui tiu \\tui Ni .,,
fewermortgages,andthustheywouldhavehadlessreasontopushsohardtomake
theloansinthefrstplace.
Icvcregcisin/crcntintu0s
Themortgagepipelinealsointroducedleverageateverystep.Mostfnancialinstitu-
tions thrive on leveragethat is, on investing borrowed money. Leverage increases
proftsingoodtimes,butalsoincreaseslossesinbadtimes.Themortgageitselfcre-
atesleverageparticularlywhentheloanisofthelowdownpayment,highloan-to-
value ratio variety. Mortgage-backed securities and CDOs created further leverage
becausetheywerefnancedwithdebt.AndtheCDOswereoftenpurchasedascollat-
eralbythosecreatingother CDOswithyetanotherroundofdebt.SyntheticCDOs
consistingofcreditdefaultswaps,describedbelow,amplifedtheleverage.TheCDO,
backedbysecuritiesthatwerethemselvesbackedbymortgages,createdleverageon
leverage,asDanSparks,mortgagedepartmentheadatGoldmanSachs,explainedto
the FCIC.
i
People were looking for other forms of leverage. . . . You could either
take leverage individually, as an institution, or you could take leverage within the
structure,CitigroupsDomingueztoldtheFCIC.

Even the investor that bought the CDOs could use leverage. Structured invest-
mentvehiclesatypeofcommercialpaperprogramthatinvestedmostlyintriple-A-
rated securitieswere leveraged an average of just under 1-to-1: in other words,
theseSIVswouldhold1inassetsforeverydollarofcapital.

Theassetswouldbe
fnanced with debt. Hedge funds, which were common purchasers, were also often
highlyleveragedintherepomarket,aswewillsee.Butitwouldbecomeclearduring
thecrisisthatsomeofthehighestleveragewascreatedbycompaniessuchasMerrill,
Citigroup,andAIGwhentheyretainedorpurchasedthetriple-Aandsuper-senior
tranchesofCDOswithlittleornocapitalbacking.
Thus,inioo,whenthehomeownershipratewaspeaking,andwhennewmort-
gageswereincreasinglybeingdrivenbyserialrefnancings,byinvestorsandspecula-
tors, and by second home purchases, the value of trillions of dollars of securities
rested on just two things: the ability of millions of homeowners to make the pay-
mentsontheirsubprimeandAlt-Amortgagesandthestabilityofthemarketvalueof
homeswhosemortgageswerethebasisofthesecurities.Thosedangerswereunder-
stood all along by some market participants. Leverage is inherent in [asset-backed
securities]CDOs,MarkKlipsch,abankerwithOrixCapitalMarkets,anassetman-
agement frm, told a Boca Raton conference of securitization bankers in October
ioo.Whileitwasgoodforshort-termprofts,lossescouldbelargelateron.Klipsch
said,Wellseesomeproblemsdowntheroad.
,
BEAR STEARNS S HEDGE FUNDS: IT FUNCTIONED FINE
UP UNTIL ONE DAY IT JUST DIDN T FUNCTION
BearStearns,thesmallestofthefvelargeinvestmentbanks,starteditsassetmanage-
mentbusinessin18,whenitestablishedBearStearnsAssetManagement(BSAM).
.,, ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1 .,, ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
Assetmanagementbroughtinsteadyfeeincome,allowedbankstooffernewprod-
uctstocustomersandrequiredlittlecapital.
BSAMplayedaprominentroleintheCDObusinessasbothaCDOmanagerand
a hedge fund that invested in mortgage-backed securities and CDOs. At BSAM, by
theendofioooRalphCiomwasmanaging11CDOswith18.billioninassetsand
i hedge funds with 18 billion in assets.
o
Although Bear Stearns owned BSAM,
Bearsmanagementexercisedlittlesupervisionoveritsbusiness.
,
Theeventualfail-
ureofCiomstwolargemortgage-focusedhedgefundswouldbeanimportantevent
inioo,,earlyinthefnancialcrisis.
In ioo, Ciom launched his frst fund at BSAM, the High-Grade Structured
Credit Strategies Fund, and in iooo he added the High-Grade Structured Credit
Strategies Enhanced Leverage Fund. The funds purchased mostly mortgage-backed
securities or CDOs, and used leverage to enhance their returns. The target was for
oofassetstoberatedeitherAAAorAA.AsCiomtoldtheFCIC,Thethesisbe-
hind the fund was that the structured credit markets offered yield over and above
whattheirratingssuggestedtheyshouldoffer.
8
Ciomtargetedaleverageratioof1o
to 1 for the frst High-Grade fund. For Enhanced Leverage, Ciom upped the ante,
toutingtheEnhancedLeveragefundasaleveredversionofthe[HighGrade]fund
thattargetedleverageof1ito1.

Attheendofiooo,theHigh-Gradefundcontained
8.obillioninassets(usingo.billionofhishedgefundinvestorsmoneyand,.,
billion in borrowed money). The Enhanced Leverage Fund had . billion (using
o.billionfrominvestorsand8.,billioninborrowedmoney).
o
BSAM fnanced these asset purchases by borrowing in the repo markets, which
wastypicalforhedgefunds.AsurveyconductedbytheFCICidentifedatleasti,,
billionofrepoborrowingasofJuneioo8bytheapproximately1,ohedgefundsthat
responded.Therespondentsinvestedatleast,billioninmortgage-backedsecuri-
ties or CDOs as of June ioo,.
1
The ability to borrow using the AAA and AA
tranchesofCDOsasrepocollateralfacilitateddemandforthosesecurities.
Butrepoborrowingcarriedrisks:itcreatedsignificantleverageandithadtobe
renewedfrequently.Forexample,aninvestorbuyingastockonmarginmeaning
withborrowedmoneymighthavetoputup,ocentsonthedollar,withtheother
,o cents loaned by his or her stockbroker, for a leverage ratio of i to 1. A home-
ownerbuyingahousemightmakea1odownpaymentandtakeoutamortgage
fortherest,aleverageratioof1oto1.Bycontrast,repolendingallowedaninvestor
tobuyasecurityformuchlessoutofpocketinthecaseofaTreasurysecurity,an
investor may have to put in only o.i,, borrowing .,, from a securities firm
(oo to 1). In the case of a mortgage-backed security, an investor might pay ,
(ioto1).
i
Withthisamountofleverage,a,changeinthevalueofthatmortgage-backed
securitycandoubletheinvestorsmoneyorlosealloftheinitialinvestment.
Anotherinherentfallacyinthestructurewastheassumptionthattheunderlying
collateralcouldbesoldeasily.Butwhenitcametosellingthemintimesofdistress,
private-labelmortgage-backedsecuritieswouldprovetobeverydifferentfromU.S.
Treasuries.
1ui tiu \\tui Ni .,,
The short-term nature of repo money also makes it inherently risky and unreli-
able:fundingthatisofferedatcertaintermstodaycouldbegonetomorrow.Cioms
funds,forexample,tooktheriskthatitsrepolenderswoulddecidenottoextend,or
roll,therepolinesonanygivenday.Yetmoreandmore,repolenderswereloaning
money to funds like Cioms, rolling the debt nightly, and not worrying very much
abouttherealqualityofthecollateral.
The frms loaning money to Cioms hedge funds were often also selling them
mortgage-relatedsecurities,andthehedgefundspledgedthosesamesecuritiestose-
curetheloans.

Ifthemarketvalueofthecollateralfell,therepolenderscouldand
woulddemandmorecollateralfromthehedgefundtobacktherepoloan.Thisdy-
namicwouldplayapivotalroleinthefateofmanyhedgefundsinioo,mostspec-
tacularlyinthecaseofCiomsfunds.Therepomarket,Imeanitfunctionedfneup
untilonedayitjustdidntfunction,CiomtoldtheFCIC.Uptothatpoint,hishedge
fundscouldbuybillionsofdollarsofCDOsonborrowedmoneybecauseofthemar-
ketsbullishnessaboutmortgageassets,hesaid.Itbecame . . .amoreandmoreac-
ceptable asset class, [with] more traders, more repo lenders, more investors
obviously.[Ithada]muchbroaderfootprintdomesticallyaswellasinternationally.
Sothemarketjustreallyexploded.

BSAMtouteditsCDOholdingstoinvestors,tellingthemthatCDOswereamar-
ketopportunitybecausetheywerecomplexandthereforeundervaluedinthegeneral
marketplace.Inioo,thiswasapromisingmarketwithseeminglymanageablerisks.
Ciom and his team not only bought CDOs, they also created and managed other
CDOs.Ciomwouldpurchasemortgage-backedsecurities,CDOs,andothersecuri-
tiesforhishedgefunds.Whenhehadreachedhisfrmsinternalinvestmentlimits,
he would repackage those securities and sell CDO securities to other customers.
With the proceeds, Ciom would pay off his repo lenders, and at the same time he
wouldacquiretheequitytrancheofanewCDO.
,
Because Ciom managed these newly created CDOs that selected collateral from
hisownhedgefunds,
o
hewaspositionedonbothsidesofthetransaction.Thestruc-
ture created a confict of interest between Cioms obligation to his hedge fund in-
vestorsandhisobligationtohisCDOinvestors;thiswasnotuniqueonWallStreet,
and BSAM disclosed the structure, and the confict of interest, to potential in-
vestors.
,
Forexample,acriticalquestionwasatwhatpricetheCDOshouldpurchase
assetsfromthehedgefund:iftheCDOpaidabove-marketpricesforasecurity,that
wouldadvantagethehedgefundinvestorsanddisadvantagetheCDOinvestors.
BSAMsfagshipCDOsdubbedKlioI,II,andIIIwerecreatedinrapidsucces-
sion over ioo and ioo,, with Citigroup as their underwriter. All three deals were
mainly composed of mortgage- and asset-backed securities that BSAM already
owned,andBSAMretainedtheequitypositioninallthree;allthreewereprimarily
funded with asset-backed commercial paper.
8
Typical for the industry at the time,
theexpectedreturnfortheCDOmanager,whowasmanagingassetsandholdingthe
equitytranche,wasbetween1,andiannually,assumingnodefaultsontheun-
derlying collateral.

Thanks to the combination of mortgage-backed securities,


., ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1 ., ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
CDOs,andleverage,Ciomsfundsearnedhealthyreturnsforatime:theHigh-Grade
fundhadreturnsof1,inioo,1oinioo,,andinioooafterfees.
,o
Ciomand
Tanninmademillionsbeforethehedgefundscollapsedinioo,.Ciomwasrewarded
with total compensation worth more than 1 million from ioo, to ioo,. In ioo,,
theyearthetwohedgefundsfledforbankruptcy,Ciommademorethan1,.omil-
lionintotalcompensation.MattTannin,hisleadmanager,wasawardedcompensa-
tionofmorethan,.omillionfromioo,toioo,.
,1
Bothmanagersinvestedsomeof
their own money in the funds, and used this as a selling point when pitching the
fundstoothers.
,i
But when house prices fell and investors started to question the value of mort-
gage-backedsecuritiesinioo,,thesameshort-termleveragethathadinfatedCioms
returnswouldamplifylossesandquicklyputhistwohedgefundsoutofbusiness.
CITIGROUP S LIQUIDITY PUTS:
A POTENTIAL CONFLICT OF INTEREST
By the middle of the decade, Citigroup was a market leader in selling CDOs, often
usingitsdepositor-basedcommercialbanktoprovideliquiditysupport.Formuchof
this period, the company was in various types of trouble with its regulators, and
then-CEO Charles Prince told the FCIC that dealing with those troubles took up
morethanhalfhistime.
,
Afterpayingthe,omillionfnerelatedtosubprimemort-
gagelending,Citigroupagaingotintotrouble,chargedwithhelpingEnronbefore
that company fled for bankruptcy in ioo1use structured fnance transactions to
manipulate its fnancial statements. In July ioo, Citigroup agreed to pay the SEC
1io million to settle these allegations and also agreed, under formal enforcement
actions by the Federal Reserve and Omce of the Comptroller of the Currency, to
overhaulitsriskmanagementpractices.
,
ByMarchioo,,theFedhadseenenough:itbannedCitigroupfrommakingany
moremajoracquisitionsuntilitimproveditsgovernanceandlegalcompliance.Ac-
cordingtoPrince,hehadalreadydecidedtoturnthecompanysfocusfromanac-
quisition-drivenstrategytomoreofabalancedstrategyinvolvingorganicgrowth.
,,
RobertRubin,aformertreasurysecretaryandformerGoldmanSachsco-CEOwho
wasatthattimechairmanoftheExecutiveCommitteeofCitigroupsboardofdirec-
tors, recommended that Citigroup increase its risk takingassuming, he told the
FCIC,thatthefrmmanagedthoserisksproperly.
,o
CitigroupsinvestmentbanksubsidiarywasanaturalareaforgrowthaftertheFed
and then Congress had done away with restrictions on activities that could be pur-
suedbyinvestmentbanksamliatedwithcommercialbanks.Oneopportunityamong
manywastheCDObusiness,whichwasjustthentakingoffamidtheboomingmort-
gagemarket.
In ioo, Citis CDO desk was a tiny unit in the companys investment banking
arm, eight guys and a Bloomberg terminal, in the words of Nestor Dominguez,
thenco-headofthedesk.
,,
Nevertheless,thistinyoperationunderthecommandof
1ui tiu \\tui Ni .,,
ThomasMaheras,co-CEOoftheinvestmentbank,hadbecomealeaderinthenas-
cent market for CDOs, creating more than 18 billion in ioo and iooclose to
one-ffthofthemarketinthoseyears.
TheeightguyshadpickeduponanovelstructurepioneeredbyGoldmanSachs
andWestLB,aGermanbank.Insteadofissuingthetriple-AtranchesoftheCDOsas
long-term debt, Citigroup structured them as short-term asset-backed commercial
paper.
,8
Of course, using commercial paper introduced liquidity risk (not present
when the tranches were sold as long-term debt), because the CDO would have to
reissuethepapertoinvestorsregularlyusuallywithindaysorweeksforthelifeof
the CDO. But asset-backed commercial paper was a cheap form of funding at the
time,andithadalargebaseofpotentialinvestors,particularlyamongmoneymarket
mutual funds. To mitigate the liquidity risk and to ensure that the rating agencies
would give it their top ratings, Citibank (Citigroups national bank subsidiary) pro-
vided assurances to investors, in the form of liquidity puts. In selling the liquidity
put,foranongoingfeethebankwouldbeonthehooktostepinandbuythecom-
mercialpaperiftherewerenobuyerswhenitmaturedorifthecostoffundingrose
byapredeterminedamount.
,
TheCDOteamatCitigrouphadjumpedintothemarketinJulyioowitha1.,
billionCDOnamedGrenadierFundingthatincludeda1.billiontranchebackedby
a liquidity put from Citibank.
oo
Over the next three years, Citi would write liquidity
putsoni,billionofcommercialpaperissuedbyCDOs,
o1
morethananyothercom-
pany.BSAMsthreeKlioCDOs,whichCitigrouphadunderwritten,accountedforjust
over1obillionofthistotal,
oi
alargenumberthatwouldnotbodewellforthebank.
But initially, this strategic initiative, as Dominguez called it, was very proftable for
Citigroup.TheCDOdeskearnedroughly1ofthetotaldealvalueinstructuringfees
forCitigroupsinvestmentbankingarm,orabout1omillionfora1billiondeal.In
addition,Citigroupwouldgenerallychargebuyerso.1otoo.ioinpremiumsannu-
allyfortheliquidityputs.
o
Inotherwords,foratypical1billiondeal,Citibankwould
receive1toimillionannuallyontheliquidityputsalonepracticallyfreemoney,it
seemed,becausethetradingdeskbelievedthattheseputswouldneverbetriggered.
o
Ineffect,theliquidityputwasyetanotherhighlyleveragedbet:acontingentlia-
bilitythatwouldbetriggeredinsomecircumstances.Priortotheioochangeinthe
capital rules regarding liquidity puts (discussed earlier), Citigroup did not have to
hold any capital against such contingencies. Rather, it was permitted to use its own
risk models to determine the appropriate capital charge. But Citigroups fnancial
modelsestimatedonlyaremotepossibilitythattheputswouldbetriggered.Follow-
ingtheioorulechange,Citibankwasrequiredtoholdo.1oincapitalagainstthe
amountofcommercialpapersupportedbytheliquidityput,or1.omillionfora1
billionliquidityput.Givena1toimillionannualfeefortheput,theannualreturn
onthatcapitalcouldstillexceed1oo.Nodoubtaboutit,DomingueztoldtheFCIC,
the triple-A or similar ratings, the multiple fees, and the low capital requirements
madetheliquidityputsamuchbettertradeforCitisbalancesheet.
o,
Theeventsof
ioo,wouldrevealthefallacyofthoseassumptionsandcatapulttheentirei,billion
., ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1 ., ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
incommercialpaperstraightontothebanksbalancesheet,requiringittocomeup
withi,billionincashaswellasmorecapitaltosatisfybankregulators.
TheliquidityputswereapprovedbyCitigroupsCapitalMarketsApprovalCom-
mittee, which was charged with reviewing all new fnancial products.
oo
Deeming
themtobelowrisk,thecompanybaseditsopinionsonthecreditriskoftheunderly-
ing collateral, but failed to consider the liquidity risk posed by a general market
disruption.
o,
The OCC, the supervisor of Citigroups largest commercial bank sub-
sidiary,wasawarethatthebankhadissuedtheliquidityputs.
o8
However,thetermsof
the OCCs post-Enron enforcement action focused only on whether Citibank had a
processinplacetoreviewtheproduct,andnotontherisksoftheputstoCitibanks
balancesheet.
o
Besides Citigroup, only a few large fnancial institutions, such as AIG Financial
Products, BNP, WestLB of Germany, and Socit Gnrale of France, wrote signif-
cant amounts of liquidity puts on commercial paper issued by CDOs.
,o
Bank of
America, the biggest commercial bank in the United States, wrote small deals
through iooo but did o billion worth in ioo,, just before the market crashed.
,1
When asked why other market participants were not writing liquidity puts,
Dominguez stated that Socit Gnrale and BNP were big players in that market.
Youneededtobeabankwithastrongbalancesheet,accesstocollateral,andexist-
ingrelationshipswithcollateralmanagers,hesaid.
,i
TheCDOdeskstoppedwritingliquidityputsinearlyiooo,
,
whenitreachedits
internal limits. Citibanks treasury function had set a i billion cap on liquidity
puts;
,
itgrantedonefnalexception,bringingthetotaltoi,billion.
,,
Riskmanage-
menthadalsosetai,billionrisklimitontop-ratedasset-backedsecurities,which
included the liquidity puts. Later, in an October iooo memo, Citigroups Financial
Control Group criticized the frms pricing of the puts, which failed to consider the
risk that investors would not buy the commercial paper protected by the liquidity
putswhenitcamedue,therebycreatingai,billioncashdemandonCitibank.
,o
An
undatedandunattributedinternaldocument(believedtohavebeendraftediniooo)
also questioned one of the practices of Citigroups investment bank, which paid
traders on its CDO desk for generating the deals without regard to later losses:
Thereisapotentialconfictofinterestinpricingtheliquidityputcheep[sic]sothat
moreCDOequitiescanbesoldandmorestructuringfeetobegenerated.
,,
There-
sultwouldbelossessoseverethattheywouldhelpbringthehugefnancialconglom-
eratetothebrinkoffailure,aswewillsee.
AIG: GOLDEN GOOSE FOR THE ENTIRE STREET
In ioo, American International Group was the largest insurance company in the
worldasmeasuredbystockmarketvalue:amassiveconglomeratewith8,obillion
inassets,11o,oooemployeesin1ocountries,andiisubsidiaries.
But to Wall Street, AIGs most valuable asset was its credit rating: that it was
awardedthehighestpossibleratingAaabyMoodyssince18o,AAAbyS&Psince
1ui tiu \\tui Ni .,,
18wascrucial,becausethesesterlingratingsletitborrowcheaplyanddeploythe
money in lucrative investments. Only six private-sector companies in the United
Statesinearlyio1ocarriedthoseratings.
,8
Startingin18,AIGFinancialProducts,aConnecticut-basedunitwithmajorop-
erationsinLondon,fguredoutanewwaytomakemoneyfromthoseratings.Relying
ontheguaranteeofitsparent,AIG,AIGFinancialProductsbecameamajorover-the-
counter derivatives dealer, eventually having a portfolio of i., trillion in notional
amount.Amongotherderivativesactivities,theunitissuedcreditdefaultswapsguar-
anteeingdebtobligationsheldbyfnancialinstitutionsandotherinvestors.Inexchange
forastreamofpremium-likepayments,AIGFinancialProductsagreedtoreimburse
the investor in such a debt obligation in the event of any default. The credit default
swap (CDS) is often compared to insurance, but when an insurance company sells a
policy,regulationsrequirethatitsetasideareserveincaseofaloss.Becausecreditde-
faultswapswerenotregulatedinsurancecontracts,nosuchrequirementwasapplica-
ble. In this case, the unit predicted with .8, confdence that there would be no
realized economiclossonthesupposedlysafestportionsoftheCDOsonwhichthey
wrote CDS protection, and failed to make any provisions whatsoever for declines in
valueorunrealizedlossesadecisionthatwouldprovefataltoAIGinioo8.
,
AIGFinancialProductshadahugebusinesssellingCDStoEuropeanbanksona
varietyoffnancialassets,includingbonds,mortgage-backedsecurities,CDOs,and
other debt securities. For AIG, the fee for selling protection via the swap appeared
wellworththerisk.Forthebankspurchasingprotection,theswapenabledthemto
neutralize the credit risk and thereby hold less capital against its assets. Purchasing
creditdefaultswapsfromAIGcouldreducetheamountofregulatorycapitalthatthe
bank needed to hold against an asset from 8 to 1.o.
8o
By ioo,, AIG had written
1o, billion in CDS for such regulatory capital benefts; most were with European
banksforavarietyofassettypes.Thattotalwouldriseto,billionbyioo,.
81
ThesameadvantagescouldbeenjoyedbybanksintheUnitedStates,whereregu-
lators had introduced similar capital standards for banks holdings of mortgage-
backedsecuritiesandotherinvestmentsundertheRecourseRuleinioo1.Soacredit
defaultswapwithAIGcouldalsolowerAmericanbankscapitalrequirements.
Iniooandioo,,AIGsoldprotectiononsuper-seniorCDOtranchesvaluedat
,billion,upfromjustibillioninioo.
8i
InaninterviewwiththeFCIC,oneAIG
executivedescribedAIGFinancialProductsprincipalswapsalesman,AlanFrost,as
thegoldengoosefortheentireStreet.
8
AIGsbiggestcustomerinthisbusinesswasalwaysGoldmanSachs,consistentlya
leadingCDOunderwriter.AIGalsowrotebillionsofdollarsofprotectionforMerrill
Lynch,SocitGnrale,andotherfrms.AIGlookedliketheperfectcustomerfor
this,CraigBroderick,Goldmanschiefriskomcer,toldtheFCIC.Theyreallyticked
all the boxes. They were among the highest-rated [corporations] around. They had
what appeared to be unquestioned expertise. They had tremendous fnancial
strength.Theyhadhuge,appropriateinterestinthisspace,backedbyalonghistory
oftradinginit.
8
.,+ ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1 .,+ ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
AIGalsobestowedtheimprimaturofitspristinecreditratingoncommercialpa-
per programs by providing liquidity puts, similar to the ones that Citigroups bank
wroteformanyofitsowndeals,guaranteeingitwouldbuycommercialpaperifno
oneelsewantedit.Itenteredthisbusinessiniooi;byioo,,ithadwrittenmorethan
o billion of liquidity puts on commercial paper issued by CDOs. AIG also wrote
morethan,billioninCDStoprotectSocitGnraleagainsttherisksonliquidity
putsthattheFrenchbankitselfwroteoncommercialpaperissuedbyCDOs.
8,
What
wewouldalwaystrytodoistostructureatransactionwherethetransactionwasvir-
tuallyriskless,andgetpaidasmallpremium,GenePark,whowasamanagingdirec-
toratAIGFinancialProducts,toldtheFCIC.Andwereoneofthefewguyswhocan
dothat.Becauseifyouthinkaboutit,noonewantstobuydisasterprotectionfrom
someonewhoisnotgoingtobearound. . . .ThatwasAIGFPssalespitchtotheStreet
ortobanks.
8o
AIGs business of offering credit protection on assets of many sorts, including
mortgage-backedsecuritiesandCDOs,grewfromiobillioniniooitoi11billion
inioo,and,billioninioo,.
8,
ThisbusinesswasasmallpartoftheAIGFinan-
cial Services business unit, which included AIG Financial Products; AIG Financial
Servicesgeneratedoperatingincomeof.billioninioo,,oriofAIGstotal.
AIGdidnotpostanycollateralwhenitwrotethesecontracts;butunlikemono-
lineinsurers,AIGFinancialProductsagreedtopostcollateralifthevalueoftheun-
derlying securities dropped, or if the rating agencies downgraded AIGs long-term
debtratings.Itscompetitors,themonolinefnancialguarantorsinsurancecompa-
nies such as MBIA and Ambac that focused on guaranteeing fnancial contracts
were forbidden under insurance regulations from paying out until actual losses
occurred.ThecollateralpostingtermsinAIGscreditdefaultswapcontractswould
haveanenormousimpactonthecrisisabouttounfold.
Butduringtheboom,thesetermsdidntmatter.Theinvestorsgottheirtriple-A-
rated protection, AIG got its fees for providing that insuranceabout o.1i of the
notionalamountoftheswapperyear
88
andthemanagersgottheirbonuses.Inthe
caseoftheLondonsubsidiarythatrantheoperation,thebonuspoolwasoofnew
earnings.
8
FinancialProductsCEOJosephJ.Cassanomadetheallocationsattheend
oftheyear.
o
Betweeniooiandioo,,theleastamountCassanopaidhimselfinayear
was8million.Inthelateryears,hiscompensationwassometimesdoublethatof
theparentcompanysCEO.
1
In the spring of ioo,, disaster struck: AIG lost its triple-A rating when auditors
discovered that it had manipulated earnings. By November ioo,, the company had
reduced its reported earnings over the fve-year period by . billion.
i
The board
forced out Maurice Hank Greenberg, who had been CEO for 8 years. New York
AttorneyGeneralEliotSpitzerpreparedtobringfraudchargesagainsthim.
Greenberg told the FCIC, When the AAA credit rating disappeared in spring
ioo,, it would have been logical for AIG to have exited or reduced its business of
writingcreditdefaultswaps.

Butthatdidnthappen.Instead,AIGFinancialProd-
ucts wrote another o billion in credit default swaps on super-senior tranches of
1ui tiu \\tui Ni .,.
CDOsinioo,.

Thecompanywouldntmakethedecisiontostopwritingthesecon-
tractsuntiliooo.
,
GOLDMAN SACHS: MULTIPLIED THE EFFECTS
OF THE COLLAPSE IN SUBPRIME
HenryPaulson,theCEOofGoldmanSachsfrom1untilhebecamesecretaryof
theTreasuryiniooo,testifedtotheFCICthatbythetimehebecamesecretarymany
bad loans already had been issuedmost of the toothpaste was out of the tube
andthattherereallywasnttheproperregulatoryapparatustodealwithit.
o
Paul-
sonprovidedexamples:Subprimemortgageswentfromaccountingfor,percentof
totalmortgagesin1toiopercentbyiooo. . . .Securitizationseparatedorigina-
tors from the risk of the products they originated. The result, Paulson observed,
was a housing bubble that eventually burst in far more spectacular fashion than
mostpreviousbubbles.
,
UnderPaulsonsleadership,GoldmanSachshadplayedacentralroleinthecre-
ation and sale of mortgage securities. From ioo through iooo, the company pro-
vided billions of dollars in loans to mortgage lenders; most went to the subprime
lendersAmeriquest,LongBeach,Fremont,NewCentury,andCountrywidethrough
warehouselinesofcredit,oftenintheformofrepos.
8
Duringthesameperiod,Gold-
man acquired , billion of loans from these and other subprime loan originators,
whichitsecuritizedandsoldtoinvestors.

Fromiootoiooo,Goldmanissued18
mortgagesecuritizationstotaling18billion(aboutaquarterweresubprime),and
o CDOs totaling i billion; Goldman also issued ii synthetic or hybrid CDOs
withafacevalueof,billionbetweeniooandJuneiooo.
1oo
SyntheticCDOswerecomplexpapertransactionsinvolvingcreditdefaultswaps.
Unlike the traditional cash CDO, synthetic CDOs contained no actual tranches of
mortgage-backed securities, or even tranches of other CDOs. Instead, they simply
referencedthesemortgagesecuritiesandthuswerebetsonwhetherborrowerswould
pay their mortgages. In the place of real mortgage assets, these CDOs contained
credit default swaps and did not fnance a single home purchase. Investors in these
CDOsincludedfundedlonginvestors,whopaidcashtopurchaseactualsecurities
issued by the CDO; unfunded long investors, who entered into swaps with the
CDO, making money if the reference securities performed; and short investors,
whoboughtcreditdefaultswapsonthereferencesecurities,makingmoneyifthese-
curitiesfailed.Whilefundedinvestorsreceivedinterestifthereferencesecuritiesper-
formed, they could lose all of their investment if the reference securities defaulted.
Unfunded investors, which were highest in the payment waterfall, received pre-
mium-likepaymentsfromtheCDOaslongasthereferencesecuritiesperformedbut
wouldhavetopayifthereferencesecuritiesdeterioratedbeyondacertainpointand
iftheCDOdidnothavesumcientfundstopaytheshortinvestors.Shortinvestors,
often hedge funds, bought the credit default swaps from the CDOs and paid those
premiums.HybridCDOswereacombinationoftraditionalandsyntheticCDOs.
FirmslikeGoldmanfoundsyntheticCDOscheaperandeasiertocreatethantra-
.,z ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1 .,z ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
ditionalCDOsatthesametimeasthesupplyofmortgageswasbeginningtodryup.
Because there were no mortgage assets to collect and fnance, creating synthetic
CDOstookafractionofthetime.Theyalsowereeasiertocustomize,becauseCDO
managers and underwriters could reference any mortgage-backed securitythey
were not limited to the universe of securities available for them to buy. Figure 8.i
providesanexampleofhowsuchadealworked.
Inioo,GoldmanlauncheditsfrstmajorsyntheticCDO,Abacusioo-1adeal
worth i billion. About one-third of the swaps referenced residential mortgage-
backedsecurities,anotherthirdreferencedexistingCDOs,andtherest,commercial
mortgagebackedsecurities(madeupofbundledcommercialrealestateloans)and
othersecurities.
Goldmanwastheshortinvestorfortheentireibilliondeal:itpurchasedcredit
defaultswapprotectiononthesereferencesecuritiesfromtheCDO.Thefundedin-
vestorsIKB (a German bank), the TCW Group, and Wachoviaput up a total of
1, million to purchase mezzanine tranches of the deal.
1o1
These investors would
receivescheduledprincipalandinterestpaymentsifthereferencedassetsperformed.
If the referenced assets did not perform, Goldman, as the short investor, would re-
ceive the 1, million.
1oi
In this sense, IKB, TCW, and Wachovia were long in-
vestors, betting that the referenced assets would perform well, and Goldman was a
shortinvestor,bettingthattheywouldfail.
TheunfundedinvestorsTCWandGSCPartners(assetmanagementfrmsthat
managedbothhedgefundsandCDOs)didnotputupanymoneyupfront;theyre-
ceived annual premiums from the CDO in return for the promise that they would
pay the CDO if the reference securities failed and the CDO did not have enough
fundstopaytheshortinvestors.
1o
Goldman was the largest unfunded investor at the time that the deal was origi-
nated,retainingthe1.8billionsuper-seniortranche.Goldmansibillionshortpo-
sition more than offset that exposure; about one year later, it transferred the
unfundedlongpositionbybuyingcreditprotectionfromAIG,inreturnforanan-
nualpaymentofi.imillion.
1o
Asaresult,byioo,,AIGwaseffectivelythelargest
unfundedinvestorinthesuper-seniortranchesoftheAbacusdeal.
Alltold,longinvestorsinAbacusioo-1stoodtoreceivemillionsofdollarsifthe
reference securities performed (just as a bond investor makes money when a bond
performs).Ontheotherhand,Goldmanstoodtogainnearlyibillioniftheassets
failed.
In the end, Goldman, the short investor in the Abacus ioo-1 CDO, has received
aboutomillionwhilethelonginvestorshavelostjustaboutalloftheirinvestments.
In April ioo8, GSC paid Goldman ,. million as a result of CDS protection sold by
GSCtoGoldmanonthefrstandsecondlosstranches.InJuneioo,Goldmanreceived
8oomillionfromAIGFinancialProductsasaresultoftheCDSprotectionithadpur-
chasedagainstthesuper-seniortranche.Thesamemonthitreceivedimillionfrom
TCWasaresultoftheCDSpurchasedagainstthejuniormezzaninetranches,ando
millionfromIKBbecauseoftheCDSitpurchasedagainsttheCtranche.InAprilio1o,
IKB paid Goldman another o million as a result of the CDS against the B tranche.
1ui tiu \\tui Ni .,,
.,, ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1 .,, ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
BBB
BB
AA
A
AAA
Synthetic CDO
Unfunded investors, who typically
buy the super senior tranche, are
effectively in a swap with the CDO
and receive premiums. If the
reference securities do not
perform and there are not enough
funds within the CDO, the
investors pay.
Funded investors (bond holders)
invest cash and expect interest
and principal payments. They
typically incur losses before the
unfunded investors.
The CDO would invest cash
received from the bond holders
in presumably safe assets.
Unfunded
Investors
Short
Investors
Bond
Holders
Cash Pool
AA
SUPER SENIOR
AAA
BB
EQUITY
A
BBB
Short investors enter into credit
default swaps with the CDO,
referencing assets such as
mortgage-backed securities. The
CDO receives swap premiums. If
the reference securities do not
perform, the CDO pays out to the
short investors.
1. Short investors 2. Unfunded investors
3. Funded investors
4. Cash Pool
EQUITY
Credit
Protection
Premiums
Credit
Protection
Premiums
Cash
Invested
Interest and
Principal
Payments
CDO
Synthetic CDOs, such as Goldman Sachss Abacus 2004-1 deal, were complex
paper transactions involving credit default swaps.
Reference
Securities
CREDIT DEFAULT
SWAPS
Iigurc 8.:
ThroughMayio1o,GoldmanreceivedimillionfromIKB,Wachovia,andTCWasa
resultofthecreditdefaultswapsagainsttheAtranche.Aswascommon,someofthe
tranches of Abacus ioo-1 found their way into other funds and CDOs; for example,
TCWputtranchesofAbacusioo-1intothreeofitsownCDOs.
Intotal,betweenJuly1,ioo,andMay1,ioo,,Goldmanpackagedandsold,
synthetic CDOs, with an aggregate face value of oo billion.
1o,
Its underwriting fee
was o.,o to 1.,o of the deal totals, Dan Sparks, the former head of Goldmans
mortgagedesk,toldtheFCIC.
1oo
Goldmanwouldearnproftsfromshortingmanyof
these deals; on others, it would proft by facilitating the transaction between the
buyerandthesellerofcreditdefaultswapprotection.
Aswewillsee,thesenewinstrumentswouldyieldsubstantialproftsforinvestors
thatheldashortpositioninthesyntheticCDOsthatis,investorsbettingthatthe
housing boom was a bubble about to burst. They also would multiply losses when
housing prices collapsed. When borrowers defaulted on their mortgages, the in-
vestors expecting cash from the mortgage payments lost. And investors betting on
these mortgage-backed securities via synthetic CDOs also lost (while those betting
againstthemortgageswouldgain).
1o,
Asaresult,thelossesfromthehousingcollapse
weremultipliedexponentially.
Toseethisplayout,wecanreturntoourillustrativeCitigroupmortgage-backed
securities deal, CMLTI iooo-NCi. Credit default swaps made it possible for new
market participants to bet for or against the performance of these securities. Syn-
thetic CDOs signifcantly increased the demand for such bets. For example, there
wereabout1imillionworthofbondsintheM(BBB-rated)trancheoneofthe
mezzanine tranches of the security. Synthetic CDOs such as Auriga, Volans, and
NeptuneCDOIVallcontainedcreditdefaultswapsinwhichtheMtranchewasref-
erenced. As long as the M bonds performed, investors betting that the tranche
would fail (short investors) would make regular payments into the CDO, which
wouldbepaidouttootherinvestorsbankingonittosucceed(longinvestors).Ifthe
Mbondsdefaulted,thenthelonginvestorswouldmakelargepaymentstotheshort
investors.Thatisthebetandthereweremorethan,omillioninsuchbetsinearly
ioo, on the M tranche of this deal. Thus, on the basis of the performance of 1i
millioninbonds,morethanoomillioncouldpotentiallychangehands.Goldmans
Sparks put it succinctly to the FCIC: if theres a problem with a product, synthetics
increasetheimpact.
1o8
TheamplifcationoftheMtranchewasnotunique.A1,milliontrancheofthe
GlacierFundingCDOiooo-A,ratedA,wasreferencedin8,millionworthofsyn-
thetic CDOs. A i8 million tranche of the Soundview Home Equity Loan Trust
iooo-EQ1,alsoratedA,wasreferencedin,millionworthofsyntheticCDOs.A
1 million tranche of the Soundview Home Equity Loan Trust iooo-EQ1, rated
BBB,wasreferencedinmillionworthofsyntheticCDOs.
1o
Intotal,syntheticCDOscreatedbyGoldmanreferenced,o8mortgagesecurities,
some of them multiple times. For example, o1o securities were referenced twice. In-
deed,onesinglemortgage-backedsecuritywasreferencedinninedifferentsynthetic
1ui tiu \\tui Ni .,,
CDOscreatedbyGoldmanSachs.
11o
Becauseofsuchdeals,whenthehousingbubble
burst,billionsofdollarschangedhands.
AlthoughGoldmanexecutivesagreedthatsyntheticCDOswerebetsthatmag-
nifed overall risk, they also maintained that their creation had social utility be-
cause it added liquidity to the market and enabled investors to customize the
exposures they wanted in their portfolios.
111
In testimony before the Commission,
GoldmansPresidentandChiefOperatingOmcerGaryCohnargued:Thisisnodif-
ferentthanthetensofthousandsofswapswritteneverydayontheU.S.dollarversus
anothercurrency.Or,moreimportantly,onU.S.Treasuries . . .Thisisthewaythat
thefnancialmarketswork.
11i
Others,however,criticizedthesedeals.PatrickParkinson,thecurrentdirectorof
the Division of Banking Supervision and Regulation at the Federal Reserve Board,
noted that synthetic CDOs multiplied the effects of the collapse in subprime.
11
Otherobserverswereevenharsherintheirassessment.Idontthinktheyhavesocial
value,MichaelGreenberger,aprofessorattheUniversityofMarylandSchoolofLaw
and former director of the Division of Trading and Markets at the Commodity Fu-
turesTradingCommission,toldtheFCIC.Hecharacterizedthecreditdefaultswap
marketasacasino.Andhetestifedthattheconceptoflawfulbettingofbillionsof
dollars on the question of whether a homeowner would default on a mortgage that
wasnotownedbyeitherparty,hashadaprofoundeffectontheAmericanpublicand
taxpayers.
11
MOODY S: ACHIEVED THROUGH SOME ALCHEMY
ThemachinechurningoutCDOswouldnothaveworkedwithoutthestampofap-
proval given to these deals by the three leading rating agencies: Moodys, S&P, and
Fitch. Investors often relied on the rating agencies views rather than conduct their
owncreditanalysis.Moodyswaspaidaccordingtothesizeofeachdeal,withcapsset
at a half-million dollars for a standard CDO in iooo and ioo, and as much as
8,o,oooforacomplexCDO.
11,
InratingbothsyntheticandcashCDOs,Moodysfacedtwokeychallenges:frst,
estimatingtheprobabilityofdefaultforthemortgage-backedsecuritiespurchasedby
theCDO(oritssyntheticequivalent)and,second,gaugingthecorrelationbetween
those defaultsthat is, the likelihood that the securities would default at the same
time.
11o
Imaginefippingacointoseehowmanytimesitcomesupheads.Eachfipis
unrelated to the others; that is, the fips are uncorrelated. Now, imagine a loaf of
slicedbread.Whenthereisonemoldyslice,therearelikelyothermoldyslices.The
freshnessofeachsliceishighlycorrelatedwiththatoftheotherslices.Asinvestors
now understand, the mortgage-backed securities in CDOs were less like coins than
likeslicesofbread.
To estimate the probability of default, Moodys relied almost exclusively on its
ownratingsofthemortgage-backedsecuritiespurchasedbytheCDOs.
11,
Atnotime
didtheagencieslookthroughthesecuritiestotheunderlyingsubprimemortgages.
Wetooktheratingthathadalreadybeenassignedbythe[mortgage-backedsecuri-
., ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1 ., ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
ties] group, Gary Witt, formerly one of Moodys team managing directors for the
CDOunit,toldtheFCIC.ThisapproachwouldleadtoproblemsforMoodysand
for investors. Witt testifed that the underlying collateral just completely disinte-
gratedbelowusandwedidntreactandweshouldhave. . . .Wehadtobelookingfor
aproblem.Andwewerentlooking.
118
To determine the likelihood that any given security in the CDO would default,
Moodyspluggedinassumptionsbasedonthoseoriginalratings.Thiswasnosimple
task.Meanwhile,iftheinitialratingsturnedoutowingtopoorunderwriting,fraud,
oranyothercausetopoorlyrefectthequalityofthemortgagesinthebonds,the
error was blindly compounded when mortgage-backed securities were packaged
intoCDOs.
Evenmoredimcultwastheestimationofthedefaultcorrelationbetweenthese-
curitiesintheportfolioalwaystricky,butparticularlysointhecaseofCDOscon-
sisting of subprime and Alt-A mortgage-backed securities that had only a short
performancehistory.Sothefrmexplicitlyreliedonthejudgmentofitsanalysts.In
theabsenceofmeaningfuldefaultdata,itisimpossibletodevelopempiricaldefault
correlation measures based on actual observations of defaults, Moodys acknowl-
edgedinoneearlyexplanationofitsprocess.
11
InplainerEnglish,Wittsaid,Moodysdidnthaveagoodmodelonwhichtoesti-
matecorrelationsbetweenmortgage-backedsecuritiessotheymadethemup.He
recalled, They went to the analyst in each of the groups and they said, Well, you
know,howrelateddoyouthinkthesetypesof[mortgage-backedsecurities]are:
1io
ThisproblemwouldbecomemoreseriouswiththeriseofCDOsinthemiddleofthe
decade.WittfeltstronglythatMoodysneededtoupdateitsCDOratingmodeltoex-
plicitly address the increasing concentration of risky mortgage-related securities in
thecollateralunderlyingCDOs.
1i1
Heundertooktwoinitiativestoaddressthisissue.
First, in mid-ioo, he developed a new rating methodology that directly incorpo-
ratedcorrelationintothemodel.However,thetechniquehedevisedwasnotapplied
toCDOratingsforanotheryear.
1ii
Second,heproposedaresearchinitiativeinearly
ioo, to look through a few CDO deals at the level of the underlying mortgage-
backedsecuritiesandtoseeiftheassumptionsthatweremakingforAAACDOsare
consistent . . . with the correlation assumptions that were making for AAA [mort-
gage-backedsecurities].AlthoughWittreceivedapprovalfromhissuperiorsforthis
investigation,contractualdisagreementspreventedhimfrombuyingthesoftwarehe
neededtoconductthelook-throughanalysis.
1i
InJuneioo,,Moodysupdateditsapproachforestimatingdefaultcorrelation,but
itbasedthenewmodelontrendsfromthepreviousioyears,aperiodwhenhousing
priceswererisingandmortgagedelinquencieswereverylowandaperiodinwhich
nontraditionalmortgageproductshadbeenaverysmallniche.Then,Moodysmod-
ifedthisoptimisticsetofempiricalassumptionswithadhocadjustmentsbasedon
factors such as region, year of origination, and servicer. For example, if two mort-
gage-backed securities were issued in the same regionsay, Southern California
Moodys boosted the correlation; if they shared a common mortgage servicer,
Moodys boosted it further. But at the same time, it would make other technical
1ui tiu \\tui Ni .,,
choices that lowered the estimated correlation of default, which would improve the
ratingsforthesesecurities.Usingthesemethods,Moodysestimatedthattwomort-
gage-backedsecuritieswouldbelesscloselycorrelatedthantwosecuritiesbackedby
otherconsumercreditassets,suchascreditcardorautoloans.
1i
The other major rating agencies followed a similar approach.
1i,
Academics, in-
cluding some who worked at regulatory agencies, cautioned investors that assump-
tion-heavy CDO credit ratings could be dangerous. The complexity of structured
fnancetransactionsmayleadtosituationswhereinvestorstendtorelymoreheavily
onratingsthanforothertypesofratedsecurities.Onthisbasis,thetransformationof
riskinvolvedinstructuredfnancegivesrisetoanumberofquestionswithimportant
potentialimplications.Onesuchquestioniswhethertranchedinstrumentsmightre-
sultinunanticipatedconcentrationsofriskininstitutionsportfolios,areportfrom
theBankforInternationalSettlements,aninternationalfnancialorganizationspon-
soredbytheworldsregulatorsandcentralbanks,warnedinJuneioo,.
1io
CDOmanagersandunderwritersreliedontheratingstopromotethebonds.For
each new CDO, they created marketing material, including a pitch book that in-
vestorsusedtodecidewhethertosubscribetoanewCDO.Eachbookdescribedthe
typesofassetsthatwouldmakeuptheportfoliowithoutprovidingdetails.
1i,
With-
outexception,everypitchbookexaminedbytheFCICstaffcitedananalysisfromei-
therMoodysorS&Pthatcontrastedthehistoricalstabilityofthesenewproducts
ratings with the stability of corporate bonds. Statistics that made this case included
thefactthatbetween18andiooo,iofthesenewproductsdidnotexperience
any rating changes over a twelve-month period while only ,8 of corporate bonds
maintainedtheirratings.Overalongertimeperiod,however,structuredfnancerat-
ings were not so stable. Between 18 and iooo, only ,o of triple-A-rated struc-
turedfnancesecuritiesretainedtheiroriginalratingafterfveyears.
1i8
Underwriters
continued to sell CDOs using these statistics in their pitch books during iooo and
ioo,, after mortgage defaults had started to rise but before the rating agencies had
downgraded large numbers of mortgage-backed securities. Of course, each pitch
bookdidincludethedisclaimerthatpastperformanceisnotaguaranteeoffuture
performanceandencouragedinvestorstoperformtheirownduediligence.
AsKyleBassofDallas-basedHaymanCapitalAdvisorstestifedbeforetheHouse
Financial Services Committee, CDOs that purchased lower-rated tranches of mort-
gage-backed securities are arcane structured fnance products that were designed
specifcallytomakedangerous,lowlyratedtranchesofsubprimedebtdeceptivelyat-
tractivetoinvestors.Thiswasachievedthroughsomealchemyandsomenegligence
in adapting unrealistic correlation assumptions on behalf of the ratings agencies.
They convinced investors that 8o of a collection of toxic subprime tranches were
theratingsequivalentofU.S.Governmentbonds.
1i
Whenhousingpricesstartedtofallnationwideanddefaultsincreased,itturned
out that the mortgage-backed securities were in fact much more highly correlated
thantheratingagencieshadestimatedthatis,theystoppedperformingatroughly
thesametime.TheselossesledtomassivedowngradesintheratingsoftheCDOs.
Inioo,,ioofU.S.CDOsecuritieswouldbedowngraded.Inioo8,1would.
1o
., ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1 ., ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
Inlateioo8,MoodyswouldthrowoutitskeyCDOassumptionsandreplacethem
with an asset correlation assumption two to three times higher than used before
thecrisis.
11
In retrospect, it is clear that the agencies CDO models made two key mistakes.
First,theyassumedthatsecuritizerscouldcreatesaferfnancialproductsbydiversi-
fyingamongmanymortgage-backedsecurities,wheninfactthesesecuritieswerent
that different to begin with. There were a lot of things [the credit rating agencies]
didwrong,FederalReserveChairmanBenBernanketoldtheFCIC.Theydidnot
takeintoaccounttheappropriatecorrelationbetween[and]acrossthecategoriesof
mortgages.
1i
Second,theagenciesbasedtheirCDOratingsonratingstheythemselveshadas-
signedontheunderlyingcollateral.ThedangerwithCDOsiswhentheyarebased
on structured fnance ratings, Ann Rutledge, a structured fnance expert, told the
FCIC.Ratingsarenotpredictiveoffuturedefaults;theyonlydescribearatingsman-
agementprocess,andameanandstaticexpectationofsecurityloss.
1
Ofcourse,ratingCDOswasaproftablebusinessfortheratingagencies.Includ-
ing all types of CDOsnot just those that were mortgage-relatedMoodys rated
iiodealsinioo,oinioo,,,iniooo,and,1,inioo,;thevalueofthosedeals
rosefromobillioniniooto1oibillioninioo,,,billioniniooo,andio
billion in ioo,.
1
The reported revenues of Moodys Investors Service from struc-
turedproductswhichincludedmortgage-backedsecuritiesandCDOsgrewfrom
1millioniniooo,orofMoodysCorporationsrevenues,to88,millionin
iooo or of overall corporate revenue. The rating of asset-backed CDOs alone
contributed more than 1o of the revenue from structured fnance.
1,
The boom
years of structured fnance coincided with a company-wide surge in revenue and
profts. From iooo to iooo, the corporations revenues surged from ooi million to
ibillionanditsproftmarginclimbedfromioto,.
YettheincreaseintheCDOgroupsworkloadandrevenuewasnotparalleledbya
stamng increase. We were under-resourced, you know, we were always playing
catch-up,Wittsaid.
1o
Moodyspenny-pinchingandstingymanagementwasre-
luctanttopayupforexperiencedemployees.Theproblemofrecruitingandretain-
inggoodstaffwasinsoluble.Investmentbanksoftenhiredawayourbestpeople.As
far as I can remember, we were never allocated funds to make counter offers, Witt
said.Wehadalmostnoabilitytodomeaningfulresearch.
1,
EricKolchinsky,afor-
merteammanagingdirectoratMoodys,toldtheFCICthatfromiootoiooo,the
increaseinthenumberofdealsratedwashuge . . .butourpersonneldidnotgoup
accordingly.Byiooo,Kolchinskyrecalled,Myroleasateamleaderwascrisisman-
agement.Eachdealwasacrisis.
18
Whenpersonnelworkedtocreateanewmethod-
ology,Wittsaid,Wehadtokindofdoitinoursparetime.
1
TheagenciesworkedcloselywithCDOunderwritersandmanagersaseachnew
CDO was devised. And the rating agencies now relied for a substantial amount of
theirrevenuesonasmallnumberofplayers.CitigroupandMerrillaloneaccounted
formorethan1obillionofCDOdealsbetweenioo,andioo,.
1o
Theratingsagenciescorrelationassumptionshadadirectandcriticalimpacton
1ui tiu \\tui Ni .,,
howCDOswerestructured:assumptionsofalowercorrelationmadepossiblelarger
easy-to-sell triple-A tranches and smaller harder-to-sell BBB tranches. Thus, as is
discussed later, underwriters crafted the structure to earn more favorable ratings
fromtheagenciesforexample,byincreasingthesizeoftheseniortranches.More-
over,becauseissuerscouldchoosewhichratingagenciestodobusinesswith,andbe-
cause the agencies depended on the issuers for their revenues, rating agencies felt
pressuredtogivefavorableratingssothattheymightremaincompetitive.
Thepressureonratingagencyemployeeswasalsointenseasaresultofthehigh
turnovera revolving door that often left raters dealing with their old colleagues,
thistimeasclients.InherinterviewwithFCICstaff,YuriYoshizawa,aMoodysteam
managing director for U.S. derivatives in ioo,, was presented with an organization
chartfromJulyioo,.Sheidentifed1outof,1analystsabouti,ofthestaff
whohadleftMoodystoworkforinvestmentorcommercialbanks.
11
Brian Clarkson, who oversaw the structured fnance group before becoming the
presidentofMoodysInvestorsService,explainedtoFCICinvestigatorsthatretaining
employeeswasalwaysachallenge,forthesimplereasonthatthebankspaidmore.As
aprecaution,Moodysemployeeswereprohibitedfromratingdealsbyabankoris-
suerwhiletheywereinterviewingforajobwiththatparticularinstitution,butthere-
sponsibilityfornotifyingmanagementoftheinterviewrestedontheemployee.After
leaving Moodys, former employees were barred from interacting with Moodys on
the same series of deals they had rated while in its employ, but there were no bans
againstworkingonother dealswithMoodys.
1i
SEC: IT S GOING TO BE AN AWFULLY BIG MESS
The fve major U.S. investment banks expanded their involvement in the mortgage
andmortgagesecuritiesindustriesintheearlyi1stcenturywithlittleformalgovern-
ment regulation beyond their broker-dealer subsidiaries. In iooi, the European
UniontoldU.S.fnancialfrmsthattocontinuetodobusinessinEurope,theywould
needaconsolidatedsupervisorbyioothatis,oneregulatorthathadresponsibil-
ityfortheholdingcompany.TheU.S.commercialbanksalreadymetthatcriterion
their consolidated supervisor was the Federal Reserveand the Omce of Thrift
SupervisionsoversightofAIGwouldlateralsosatisfytheEuropeans.Thefveinvest-
mentbanks,however,didnotmeetthestandard:theSECwassupervisingtheirsecu-
rities arms, but no one supervisor kept track of these companies on a consolidated
basis. Thus all fve faced an important decision: what agency would they prefer as
theirregulator:
Byioo,thecombinedassetsatthefvefrmstotaledi.,trillion,morethanhalf
ofthe.,trillionofassetsheldbythefvelargestU.S.bankholdingcompanies.Inthe
next three years the investment banks assets would grow to . trillion. Goldman
Sachswasthelargest,followedbyMorganStanleyandMerrill,thenLehmanandBear.
These large, diverse international frms had transformed their business models over
theyears.FortheirrevenuestheyreliedincreasinglyontradingandOTCderivatives
.,+ ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1 .,+ ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
dealing, investments, securitization, and similar activities on top of their traditional
investmentbankingfunctions.RecallthatatBearStearns,tradingandinvestmentsac-
countedformorethan1ooofpretaxearningsinsomeyearsafteriooi.
The investment banks also owned depository institutions through which they
couldprovideFDIC-insuredaccountstotheirbrokeragecustomers;thedepositspro-
videdcheapbutlimitedfunding.Thesedepositoriestooktheformofathrift(super-
visedbytheOTS)oranindustrialloancompany(supervisedbytheFederalDeposit
Insurance Corporation and a state supervisor). Merrill and Lehman, which had
amongthelargestofthesesubsidiaries,usedthemtofnancetheirmortgageorigina-
tionactivities.
Theinvestmentbankspossessionofdepositorysubsidiariessuggestedtwoobvi-
ous choices when they found themselves in need of a consolidated supervisor. If a
frm chartered its depository as a commercial bank, the Fed would be its holding
company supervisor; if as a thrift, the OTS would do the job. But the investment
bankscameupwithathirdoption.TheylobbiedtheSECtodeviseasystemofregu-
lation that would satisfy the terms of the European directive and keep them from
Europeanoversight
1
andtheSECwaswillingtostepin,althoughitshistoricalfo-
cuswasoninvestorprotection.
InNovemberioo,almostayearaftertheEuropeansmadetheirannouncement,
theSECsuggestedthecreationoftheConsolidatedSupervisedEntity(CSE)program
tooverseetheholdingcompaniesofinvestmentbanksandalltheirsubsidiaries.The
CSE program was open only to investment banks that had large U.S. broker-dealer
subsidiariesalreadysubjecttoSECregulation.However,thiswastheSECsfrstforay
into supervising frms for safety and soundness. The SEC did not have express leg-
islative authority to require the investment banks to submit to consolidated regula-
tion, so it proposed that the CSE program be voluntary; the SEC crafted the new
program out of its authority to make rules for the broker-dealer subsidiaries of in-
vestmentbanks.Theprogramwouldapplytobroker-dealersthatvolunteeredtobe
subject to consolidated supervision under the CSE program, or those that already
weresubjecttosupervisionbytheFedattheholdingcompanylevel,suchasJPMor-
ganandCitigroup.TheCSEprogramwouldintroducealimitedformofsupervision
by SEC examiners. CSE frms were allowed to use a new methodology to calculate
the regulatory capital that they were holding against their securities portfoliosa
methodologybasedonthevolatilityofmarketprices.Thismethodology,referredto
asthealternativenetcapitalrule,wouldbesimilartothestandardsbasedonthe
1oMarketRiskAmendmenttotheBaselrulesthatlargecommercialbanksand
bankholdingcompaniesusedfortheirsecuritiesportfolios.
Thetraditionalnetcapitalrulethathadgovernedbroker-dealerssince1,,had
required straightforward calculations based on asset classes and credit ratings, a
bright-lineapproachthatgavefrmslittlediscretionincalculatingtheircapital.The
newruleswouldallowtheinvestmentbankstocreatetheirownproprietaryValueat
Risk(VaR)modelstocalculatetheirregulatorycapitalthatis,thecapitaleachfrm
wouldhavetoholdtoprotectitscustomersassetsshoulditexperiencelossesonits
1ui tiu \\tui Ni .,.
securities and derivatives. All in all, the SEC estimated that the proposed new re-
lianceonproprietaryVaRmodelswouldallowbroker-dealerstoreduceaveragecap-
ital charges by o. The frms would be required to give the SEC an early-warning
notice if their tentative net capital (net capital minus hard-to-sell assets) fell below
,billionatanytime.
Meanwhile,theOTSwasalreadysupervisingthethriftsownedbyseveralsecuri-
ties frms and argued that it therefore was the natural supervisor of their holding
companies. In a letter to the SEC, the OTS was harshly critical of the agencys pro-
posal,whichitsaidhadthepotentialtoduplicateorconfictwithOTSssupervisory
responsibilities over savings and loan holding companies that would also be CSEs.
TheOTSarguedthattheSECwasinterferingwiththeintentionsofCongress,which,
intheGramm-Leach-BlileyAct,carefullykepttheresponsibilityforsupervisionof
the holding company itself with the OTS or the Federal Reserve Board, depending
uponwhethertheholdingcompanywasa[thriftholdingcompany]orabankhold-
ing company. This was in recognition of the expertise developed over the years by
theseregulatorsinevaluatingtherisksposedtodepositoryinstitutionsandthefed-
eral deposit insurance funds by depository institution holding companies and their
amliates. The OTS declared: We believe that the SECs proposed assertion of au-
thorityover[savingsandloanholdingcompanies]isunfoundedandcouldposesig-
nifcant risks to these entities, their insured deposit institution subsidiaries and the
federaldepositinsurancefunds.
1
Incontrast,theresponsefromthefnancialservicesindustrytotheSECproposal
was overwhelmingly positive, particularly with regard to the alternative net capital
computation. Lehman Brothers, for example, wrote that it applauds and supports
theCommission.JPMorganwassupportiveofwhatitsawasanimprovementover
the old net capital rule that still governed securities subsidiaries of the commercial
banks: The existing capital rule overstates the amount of capital a broker-dealer
needs,thecompanywrote.DeutscheBankfoundittobeagreatstridetowardscon-
sistencywithmoderncomprehensiveriskmanagementpractices.
1,
InFCICinter-
views, SEC omcials and executives at the investment banks stated that the frms
preferred the SEC because it was more familiar with their core securities-related
businesses.
In an April ioo meeting, SEC commissioners voted to adopt the CSE program
andthenewnetcapitalcalculationsthatwentalongwithit.Overthefollowingyear
and a half, the fve largest investment banks volunteered for this supervision, al-
thoughMerrillsandLehmansthriftscontinuedtobesupervisedbytheOTS.Several
frmsdelayedentrytotheprograminordertodevelopsystemsthatcouldmeasure
theirexposurestomarketpricemovements.
HarveyGoldschmid,SECcommissionerfromiooitoioo,,toldFCICstaffthat
beforetheCSEprogramwascreated,SECstaffmemberswereconcernedabouthow
littleauthoritytheyhadovertheWallStreetfrms,includingtheirhedgefundsand
overseassubsidiaries.OncetheCSEprogramwasinplace,theSEChadtheauthor-
itytolookateverything.
1o
SECcommissionersdiscussedatthetimetherisksthey
weretakingbyallowingfrmstoreducetheircapital.Ifanythinggoeswrongitsgo-
.,z ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1 .,z ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
ingtobeanawfullybigmess,Goldschmidsaidataioomeeting.Dowefeelsecure
ifthesedropsincapitalandotherthings[occur]wereallywillhaveinvestorprotec-
tion:Inresponse,AnnetteNazareth,theSEComcialwhowouldbeinchargeofthe
program,assuredthecommissionersthatherdivisionwasuptothechallenge.
1,
ThenewprogramwashousedprimarilyintheSECsOmceofPrudentialSupervi-
sionandRiskAnalysis,anomcewithastaffof1oto1iwithintheDivisionofMarket
Regulation.
18
Inthebeginning,itwassupportedbytheSECsmuchlargerexamina-
tion staff; by ioo8 the staff dedicated to the CSE program had grown to i.
1
Still,
only1omonitorswereresponsibleforthefveinvestmentbanks;monitorswere
assignedtoeachfrm,withsomeoverlap.
1,o
TheCSEprogramwasbasedonthebanksupervisionmodel,buttheSECdidnot
try to do exactly what bank examiners did.
1,1
For one thing, unlike supervisors of
large banks, the SEC never assigned on-site examiners under the CSE program; by
comparison,theOCCaloneassignedmorethanooexaminersfull-timeatCitibank.
According to Erik Sirri, the SECs former director of trading and markets, the CSE
program was intended to focus mainly on liquidity because, unlike a commercial
bank, a securities frm traditionally had no access to a lender of last resort.
1,i
(Of
course, that would change during the crisis.) The investment banks were subject to
annualexaminations,duringwhichstaffreviewedthefrmssystemsandrecordsand
verifedthatthefrmshadinstitutedcontrolprocesses.
TheCSEprogramwastroubledfromthestart.TheSECconductedanexamfor
eachinvestmentbankwhenitenteredtheprogram.TheresultofBearStearnssen-
tranceexam,inioo,,showedseveraldefciencies.Forexample,examinerswerecon-
cerned that there were no frmwide VaR limits and that contingency funding plans
reliedonoverlyoptimisticstressscenarios.
1,
Inaddition,theSECwasawareofthe
frms concentration of mortgage securities and its high leverage. Nonetheless, the
SECdidnotaskBeartochangeitsassetbalance,decreaseitsleverage,orincreaseits
cash liquidity poolall actions well within its prerogative, according to SEC
omcials.
1,
Then,becausetheCSEprogramwaspreoccupiedwithitsownstaffreor-
ganization,Beardidnothaveitsnextannualexam,duringwhichtheSECwassup-
posedtobeon-site.TheSECdidmeetmonthlywithallCSEfrms,includingBear,
1,,
and it did conduct occasional targeted examinations across frms. In iooo, the SEC
worriedthatBearwastooreliantonunsecuredcommercialpaperfunding,andBear
reduceditsexposuretounsecuredcommercialpaperandincreaseditsrelianceonse-
cured repo lending.
1,o
Unfortunately, tens of billions of dollars of that repo lending
wasovernightfundingthatcoulddisappearwithnowarning.Ironically,inthesec-
ondweekofMarchioo8,whenthefrmwentintoitsfour-daydeathspiral,theSEC
wason-siteconductingitsfrstCSEexamsinceBearsentranceexammorethantwo
yearsearlier.
1,,
Leverageattheinvestmentbanksincreasedfromiootoioo,,growththatsome
criticshaveblamedontheSECschangeinthenetcapitalrules.Goldschmidtoldthe
FCICthattheincreasewasowedtoawildcapitaltimeandthefrmsbeingirrespon-
sible.
1,8
In fact, leverage had been higher at the fve investment banks in the late
1os, then dropped before increasing over the life of the CSE programa history
1ui tiu \\tui Ni .,,
thatsuggeststhattheprogramwasnotsolelyresponsibleforthechanges.
1,
Inioo,
SirrinotedthatundertheCSEprogramtheinvestmentbanksnetcapitallevelsre-
mainedrelativelystable . . .and,insomecases,increasedsignifcantlyoverthepro-
gram.
1oo
Still, Goldschmid, who left the SEC in ioo,, argued that the SEC had the
power to do more to rein in the investment banks. He insisted, There was much
morethanenoughmoralsuasionandkindofpracticalpowerthatwasinvolved. . . .
TheSEChasthepracticalabilitytodoalotifitusesitspower.
1o1
Overall,theCSEprogramwaswidelyviewedasafailure.Fromioountilthef-
nancial crisis, all fve investment banks continued their spectacular growth, relying
heavily on short-term funding. Former SEC chairman Christopher Cox called the
CSE supervisory program fundamentally fawed from the beginning.
1oi
Mary
Schapiro,thecurrentSECchairman,concludedthattheprogramwasnotsuccessful
inprovidingprudentialsupervision.
1o
And,aswewillseeinthechaptersahead,the
SECsinspectorgeneralwouldbequitecritical,too.InSeptemberioo8,inthemidst
ofthefnancialcrisis,theCSEprogramwasdiscontinuedafterallfveofthelargest
independent investment banks had either closed down (Lehman Brothers), merged
into other entities (Bear Stearns and Merrill Lynch), or converted to bank holding
companies to be supervised by the Federal Reserve (Goldman Sachs and Morgan
Stanley).
For the Fed, there would be a certain irony in that last development concerning
Goldman and Morgan Stanley. Fed omcials had seen their agencys regulatory
purviewshrinkingoverthecourseofthedecade,asJPMorganswitchedthecharter
ofitsbankingsubsidiarytotheOCC
1o
andastheOTSandSECpromotedtheiral-
ternatives for consolidated supervision. The OTS and SEC were very aggressive in
tryingtopromotethemselvesasaregulatorinthatenvironmentandwantedtobethe
consolidated supervisor . . . to meet the requirements in Europe for a consolidated
supervisor,saidMarkOlson,aFedgovernorfromioo1toiooo.Therewasalotof
competitivenessamongtheregulators.
1o,
InJanuaryioo8,Fedstaffhadpreparedan
internalstudytofndoutwhynoneoftheinvestmentbankshadchosentheFedasits
consolidatedsupervisor.Thestaffinterviewedfvefrmsthatalreadyweresupervised
by the Fed and four that had chosen the SEC. According to the report, the biggest
reasonfrmsoptednottobesupervisedbytheFedwasthecomprehensivenessof
theFedssupervisoryapproach,particularlywhencomparedtoalternativessuchas
Omce of Thrift Supervision (OTS) or Securities & Exchange Commission (SEC)
holdingcompanysupervision.
1oo
.,, ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1 .,, ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
1ui tiu \\tui Ni .,,
COMMISSION CONCLUSIONS ON CHAPTER 8
TheCommissionconcludesdecliningdemandforriskierportions(ortranches)
ofmortgage-relatedsecuritiesledtothecreationofanenormousvolumeofcol-
lateralized debt obligations (CDOs). These CDOscomposed of the riskier
tranchesfueleddemandfornonprimemortgagesecuritizationandcontributed
to the housing bubble. Certain products also played an important role in doing
so, including CDOs squared, credit default swaps, synthetic CDOs, and asset-
backedcommercialpaperprogramsthatinvestedinmortgage-backedsecurities
andCDOs.Manyoftheseriskyassetsendeduponthebalancesheetsofsystemi-
callyimportantinstitutionsandcontributedtotheirfailureornearfailureinthe
fnancialcrisis.
Creditdefaultswaps,soldtoprovideprotectionagainstdefaulttopurchasers
ofthetop-ratedtranchesofCDOs,facilitatedthesaleofthosetranchesbycon-
vincinginvestorsoftheirlowrisk,butgreatlyincreasedtheexposureofthesellers
ofthecreditdefaultswapprotectiontothehousingbubblescollapse.
SyntheticCDOs,whichconsistedinwholeorinpartofcreditdefaultswaps,
enabledsecuritizationtocontinueandexpandevenasthemortgagemarketdried
upandprovidedspeculatorswithameansofbettingonthehousingmarket.By
layeringoncorrelatedrisk,theyspreadandamplifedexposuretolosseswhenthe
housingmarketcollapsed.
The high ratings erroneously given CDOs by credit rating agencies encour-
aged investors and fnancial institutions to purchase them and enabled the con-
tinuing securitization of nonprime mortgages. There was a clear failure of
corporategovernanceatMoodys,whichdidnotensurethequalityofitsratings
ontensofthousandsofmortgage-backedsecuritiesandCDOs.
The Securities and Exchange Commissions poor oversight of the fve largest
investmentbanksfailedtorestricttheirriskyactivitiesanddidnotrequirethem
toholdadequatecapitalandliquidityfortheiractivities,contributingtothefail-
ureorneedforgovernmentbailoutsofallfveofthesupervisedinvestmentbanks
duringthefnancialcrisis.
9
ALL IN
CONTENTS
1hc|u|||cAcrcdit-induccd|ccn+,,
McrtgagcjraudCrinc-jaci|itativccnvircnncnts +eo
Disc|csurcandducdi|igcnccAqua|ityccntrc|issucinthcjactcry +e,
Rcgu|atcrsMarkctswi||a|wayssc|j-ccrrcct+,o
Icvcragcd|cansandccnncrcia|rca|cstatc
Ycuvcgcttcgctupanddancc +,,
IchnanIrcnncvingtcstcragc +,e
IannicMacandIrcddicMac1wcstarkchciccs+,:
Inioo,theBakersfeld,California,homebuilderWarrenPetersonwaspayingaslit-
tleas,,ooofora1o,ooo-square-footlot,aboutthesizeofthreetenniscourts.The
nextyearthecostmorethantripledto1io,ooo,asrealestateboomed.Overthepre-
viousquartercentury,Petersonhadbuiltbetweenand1ocustomandsemi-custom
homesayear.Forawhile,hewasbuildingasmanyaso.Andthencamethecrash.
I have built exactly one new home since late ioo,, he told the FCIC fve years
later.
1
In ioo, the average price was 1,,,ooo for a new house in Bakersfeld, at the
southernendofCaliforniasagriculturalcenter,theSanJoaquinValley.Thatjumped
toalmostoo,ooobyJuneiooo.
i
Byioo,moneyseemedtobecominginveryfast
and from everywhere, said Lloyd Plank, a Bakersfeld real estate broker. They
wouldpurchaseahouseinBakersfeld,keepitforashortperiodandresellit.Some-
timestheywouldfipthehousewhileitwasstillinescrow,andwouldstillmakeio
too.

Nationally, housing prices jumped 1,i between 1, and their peak in iooo,

more than in any decade since at least 1io.


,
It would be catastrophically downhill
fromthereyetthemortgagemachinekeptchurningwellintoioo,,apparentlyin-
differenttothefactthathousingpriceswerestartingtofallandlendingstandardsto
deteriorate. Newspaper stories highlighted the weakness in the housing market
evensuggestingthiswasabubblethatcouldburstanytime.Checkswereinplace,but
.,
theywerefailing.Loanpurchasersandsecuritizersignoredtheirownduediligence
onwhattheywerebuying.TheFederalReserveandtheotherregulatorsincreasingly
recognized the impending troubles in housing but thought their impact would be
contained.Increasedsecuritization,lowerunderwritingstandards,andeasieraccess
to credit were common in other markets, too. For example, credit was fowing into
commercial real estate and corporate loans. How to react to what increasingly ap-
pearedtobeacreditbubble:Manyenterprises,suchasLehmanBrothersandFannie
Mae,pusheddeeper.
Allalongtheassemblyline,fromtheoriginationofthemortgagestothecreation
andmarketingofthemortgage-backedsecuritiesandcollateralizeddebtobligations
(CDOs), many understood and the regulators at least suspected that every cog was
reliantonthemortgagesthemselves,whichwouldnotperformasadvertised.
THE BUBBLE: A CREDITINDUCED BOOM
Irvine, Californiabased New Centuryonce the nations second-largest subprime
lenderignored early warnings that its own loan quality was deteriorating and
strippedpowerfromtworisk-controldepartmentsthathadnotedtheevidence.Ina
Juneioopresentation,theQualityAssurancestaffreportedtheyhadfoundsevere
underwriting errors, including evidence of predatory lending, legal and state viola-
tions,andcreditissues,ini,oftheloanstheyauditedinNovemberandDecember
ioo. In ioo, Chief Operating Omcer and later CEO Brad Morrice recommended
these results be removed from the statistical tools used to track loan performance,
andinioo,,thedepartmentwasdissolvedanditspersonnelterminated.Thesame
year,theInternalAuditdepartmentidentifednumerousdefcienciesinloanfles;out
ofninereviewsitconductedinioo,,itgavethecompanysloanproductiondepart-
mentunsatisfactoryratingsseventimes.PatrickFlanagan,presidentofNewCen-
turys mortgage-originating subsidiary, cut the departments budget, saying in a
memo that the group was out of control and tries to dictate business practices in-
steadofaudit.
o
This happened as the company struggled with increasing requests that it buy
backsouredloansfrominvestors.ByDecemberiooo,almost1,ofitsloanswere
goingintodefaultwithinthefrstthreemonthsafterorigination.NewCenturyhad
abrazenobsessionwithincreasingloanoriginations,withoutdueregardtotherisks
associated with that business strategy, New Centurys bankruptcy examiner
reported.
,
In September ioo,seven months before the housing market peakedthou-
sandsoforiginators,securitizers,andinvestorsmetattheABSEastioo,conference
inBocaRaton,Florida,toplaygolf,dodeals,andtalkaboutthemarket.Theasset-
backedsecuritybusinesswasstillgood,buteventhemostoptimisticcouldreadthe
signs.Panelistshadthreeconcerns:Werehousingpricesoverheated,orjustdrivenby
fundamentals such as increased demand: Would rising interest rates halt the
\ii i N .,,
market: And was the CDO, because of its ratings-driven investors, distorting the
mortgagemarket:
8
Thenumberswerestark.Nationwide,housepriceshadneverrisensofar,sofast.
And national indices masked important variations. House prices in the four sand
states, especially California, had dramatically larger spikesand subsequent de-
clinesthan did the nation. If there was a bubble, perhaps, as Fed Chairman Alan
Greenspansaid,itwasonlyincertainregions.Hetoldacongressionalcommitteein
June ioo, that growth in nonprime mortgages was helping to push home prices in
somemarketstounsustainablelevels,althoughabubbleinhomepricesforthena-
tionasawholedoesnotappearlikely.

Globally,pricesjumpedinmanycountriesaroundtheworldduringtheiooos.As
Christopher Mayer, an economist from Columbia Business School, noted to the
Commission, What really sticks out is how unremarkable the United States house
price experience is relative to our European peers.
1o
From 1, to ioo,, price in-
creases in the United Kingdom and Spain were above those in the United States,
whilepriceincreasesinIrelandandFrancewerejustbelow.InanInternationalMon-
etaryFundstudyfromioo,morethanonehalfofthei1developedcountriesana-
lyzed had greater home price appreciation than the United States from late ioo1
through the third quarter of iooo, and yet some of these countries did not suffer
sharppricedeclines.
11
Notably,Canadahadstronghomepriceincreasesfollowedby
amodestandtemporarydeclineinioo.ResearchersattheFederalReserveBankof
Cleveland attributed Canadas experience to tighter lending standards than in the
UnitedStatesaswellasregulatoryandstructuraldifferencesinthefnancialsystem.
1i
Other countries, such as the United Kingdom, Ireland, and Spain, saw steep house
pricedeclines.
Americaneconomistsandpolicymakersstruggledtoexplainthehousepricein-
creases.Thegoodnewswastheeconomywasgrowingandunemploymentwaslow.
But,aFederalReservestudyinMayioo,presentedevidencethatthecostofowning
ratherthanrentingwasmuchhigherthanhadbeenthecasehistorically:homeprices
hadrisenfromiotimestheannualcostofrentingtoi,times.
1
Insomecities,the
change was particularly dramatic. From 1, to iooo, the ratio of house prices to
rentsroseinLosAngeles,Miami,andNewYorkCityby1,,1i1,and8,re-
spectively.
1
Iniooo,theNationalAssociationofRealtorsaffordabilityindexwhich
measureswhetheratypicalfamilycouldqualifyforamortgageonatypicalhome
hadreachedarecordlow.
1,
Butthatwasbasedonthecostofatraditionalmortgage
withaiodownpayment,
1o
whichwasnolongerrequired.Perhapssuchmeasures
werenolongerrelevant,whenAmericanscouldmakelowerdownpaymentsandob-
tainloanssuchaspayment-optionadjustable-ratemortgagesandinterest-onlymort-
gages,withreducedinitialmortgagepayments.Orperhapsbuyingahomecontinued
tomakefnancialsense,givenhomeownersexpectationsoffurtherpricegains.
During a June meeting, the Federal Open Market Committee (FOMC), com-
posedofFederalReservegovernors,fourregionalFederalReserveBankpresidents,
and the Federal Reserve Bank of New York president, heard fve presentations on
., ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
mortgagerisksandthehousingmarket.Membersandstaffhaddimcultydevelop-
ing a consensus on whether housing prices were overvalued and it was hard for
many FOMC participants . . . to ascribe substantial conviction to the proposition
that overvaluation in the housing market posed the major systemic risks that we
now know it did, according to a letter from Fed Chairman Ben Bernanke to the
FCIC. The national mortgage system might bend but will likely not break, and
neither borrowers nor lenders appeared particularly shaky, one presentation ar-
gued, according to the letter. In discussions about nontraditional mortgage prod-
ucts, the argument was made that interest-only mortgages are not an especially
sinisterdevelopment,andtheirriskscouldbecushionedbylargedownpayments.
Thepresentationalsonotedthatwhileloan-to-valueratioswererisingonaportion
ofinterest-onlyloans,theratiosformostremainedaround8o.Anotherpresenta-
tionsuggestedthathousingmarketactivitycouldbetheresultofsolidfundamen-
tals. Yet another presentation concluded that the impact of changes in household
wealthonspendingwouldbeperhapsonlyhalfaslargeasthatofthe1osstock
bubble. Most FOMC participants agreed the probability of spillovers to fnancial
institutionsseemedmoderate.
1,
As one recent study argues, many economists were agnostics on housing, un-
willingtorisktheirreputationsorspookmarketsbyallegingabubblewithoutfnd-
ing support in economic theory.
18
Fed Vice Chairman Donald Kohn was one.
Identifcation[ofabubble]isatrickypropositionbecausenotallthefundamental
factorsdrivingassetpricesaredirectlyobservable,Kohnsaidinaiooospeech,cit-
ingresearchbytheEuropeanCentralBank.Forthisreason,anyjudgmentbyacen-
tralbankthatstocksorhomesareoverpricedisinherentlyhighlyuncertain.
1
Butnotalleconomistshesitatedtosoundalouderalarm.Thesituationisbegin-
ning to look like a credit-induced boom in housing that could very well result in a
systemicbustifcreditconditionsoreconomicconditionsshoulddeteriorate,Federal
Deposit Insurance Corporation Chief Economist Richard Brown wrote in a March
ioo,report.Duringthepastfveyears,theaverageU.S.homehasriseninvalueby
,o, while homes in the fastest-growing markets have approximately doubled in
value.Whilethisincreasemighthavebeenexplainedbystrongmarketfundamen-
tals,thedramaticbroadeningofthehousingboominioostronglysuggeststhein-
fuenceofsystemicfactors,includingthelowcostandwideavailabilityofmortgage
credit.
io
Acoupleofmonthslater,Fedeconomistsinaninternalmemoacknowledgedthe
possibility that housing prices were overvalued, but downplayed the potential im-
pacts of a downturn. Even in the face of a large price decline, they argued, defaults
would not be widespread, given the large equity that many borrowers still had in
theirhomes.Structuralchangesinthemortgagemarketmadeacrisislesslikely,and
the fnancial system seemed well capitalized. Even historically large declines in
housepriceswouldbesmallrelativetotherecentdeclineinhouseholdwealthowing
tothestockmarket,theeconomistsconcluded.Fromawealth-effectsperspective,
thisseemsunlikelytocreatesubstantialmacroeconomicproblems.
i1
\ii i N .,,
MORTGAGE FRAUD:
CRIMEFACILITATIVE ENVIRONMENTS
NewCenturywhereoofthemortgageswereloanswithlittleornodocumenta-
tion
ii
was not the only company that ignored concerns about poor loan quality.
Across the mortgage industry, with the bubble at its peak, standards had declined,
documentation was no longer verifed, and warnings from internal audit depart-
mentsandconcernedemployeeswereignored.Theseconditionscreatedanenviron-
ment ripe for fraud. William Black, a former banking regulator who analyzed
criminalpatternsduringthesavingsandloancrisis,toldtheCommissionthatbyone
estimate,inthemid-iooos,atleast1.,millionloansannuallycontainedsomesortof
fraud,inpartbecauseofthelargepercentageofno-docloansoriginatedthen.
i
Fraudforhousingcanentailaborrowerslyingorintentionallyomittinginforma-
tiononaloanapplication.Fraudforprofttypicallyinvolvesadeceptiontogainf-
nancially from the sale of a house. Illinois Attorney General Lisa Madigan defnes
fraud more broadly to include lenders sale of unaffordable or structurally unfair
mortgageproductstoborrowers.
i
In8oofcases,accordingtotheFBI,fraudinvolvesindustryinsiders.
i,
Forex-
ample,propertyfippingcaninvolvebuyers,realestateagents,appraisers,andcom-
plicitclosingagents.Inasilentsecond,thebuyer,withthecollusionofaloanomcer
andwithouttheknowledgeofthefrstmortgagelender,disguisestheexistenceofa
secondmortgagetohidethefactthatnodownpaymenthasbeenmade.Strawbuy-
ersallowtheirnamesandcreditscorestobeused,forafee,bybuyerswhowantto
concealtheirownership.
io
In one instance, two women in South Florida were indicted in io1o for placing
ads between ioo and ioo, in Haitian community newspapers offering assistance
withimmigrationproblems;theywereaccusedofthenstealingtheidentitiesofhun-
dredsofpeoplewhocameforhelpandusingtheinformationtobuyproperties,take
title in their names, and resell at a proft. U.S. Attorney Wilfredo A. Ferrer told the
Commissionitwasoneofthecruelestschemeshehadseen.
i,
Estimatesvaryontheextentoffraud,asitisseldominvestigatedunlessproper-
ties go into foreclosure. Ann Fulmer, vice president of business relations at Inter-
thinx, a fraud detection service, told the FCIC that her firm analyzed a large
sampleofallloansfromioo,toioo,andfound1containedliesoromissions
significantenoughtorescindtheloanordemandabuybackifithadbeensecuri-
tized.Thefirmsanalysisindicatedthatabout1trillionoftheloansmadeduring
theperiodwerefraudulent.Fulmerfurtherestimated1oobillionworthoffraudu-
lentloansfromioo,toioo,resultedinforeclosures,leadingtolossesof11ibil-
lion for the holders. According to Fulmer, experts in the fieldlenders quality
assurance officers, attorneys who specialize in loan loss mitigation, and white-
collarcriminologistssaythepercentageoftransactionsinvolvinglesssignificant
formsoffraud,suchasrelativelyminormisrepresentationsoffact,couldreachoo
oforiginations.
i8
Suchloanscouldstaycomfortablyundertheradar,becausemany
borrowersmadepaymentsontime.
.+ ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
Ed Parker, the head of mortgage fraud investigation at Ameriquest, the largest
subprimelenderinioo,ioo,andioo,,toldtheFCICthatfraudulentloanswere
verycommonatthecompany.Noonewaswatching.Thevolumewasupandnow
you see the fallout behind the loan origination process, he told the FCIC.
i
David
Gussmann,theformervicepresidentofEnterpriseManagementCapitalMarketsat
FannieMae,toldtheCommissionthatinonepackageof,osecuritizedloanshisan-
alystsfoundonepurchaserwhohadbought1properties,falselyidentifyinghimself
eachtimeastheownerofonlyoneproperty,whileanotherhadboughtfveproper-
ties.
o
Fannie Maes detection of fraud increased steadily during the housing bubble
and accelerated in late iooo, according to William Brewster, the current director of
thecompanysmortgagefraudprogram.Hesaidthat,seeingevidenceoffraud,Fan-
nie demanded that lenders such as Bank of America, Countrywide, Citigroup, and
JPMorganChaserepurchaseabout,,omillioninmortgagesinioo8ando,omil-
lion in ioo.
1
Lax or practically non-existent government oversight created what
criminologists have labeled crime-facilitative environments, where crime could
thrive,saidHenryN.Pontell,aprofessorofcriminologyattheUniversityofCalifor-
nia,Irvine,intestimonytotheCommission.
i
Theresponsibilitytoinvestigateandprosecutemortgagefraudviolationsfallsto
local,stateandfederallawenforcementomcials.Onthefederallevel,theFederalBu-
reauofInvestigationinvestigatesandreferscasesforprosecutiontoU.S.Attorneys,
whoarepartoftheDepartmentofJustice.Casesmayalsoinvolveotheragencies,in-
cluding the U.S. Postal Inspection Service, the Department of Housing and Urban
Development,andtheInternalRevenueService.TheFBI,whichhasthebroadestju-
risdiction of any federal law enforcement agency, was aware of the extent of the
fraudulentmortgageproblem.

FBIAssistantDirectorChrisSweckerbegannoticing
a rise in mortgage fraud while he was the special agent in charge of the Charlotte,
NorthCarolina,omcefrom1toioo.Iniooi,thatomceinvestigatedFirstBene-
fcialMortgageforsellingfraudulentloanstoFannieMae,leadingtothesuccessful
criminalprosecutionofthecompanysowner,JamesEdwardMcLeanJr.,andothers.
FirstBenefcialrepurchasedthemortgagesafterFanniediscoveredevidenceoffraud,
butthenwithoutanyinterferencefromFannieresoldthemtoGinnieMae.

For
not alerting Ginnie, Fannie paid ,., million of restitution to the government.
McLeancametotheattentionoftheFBIafterbuyingaluxuryyachtfor8oo,oooin
cash.
,
SoonafterSweckerwaspromotedtoassistantFBIdirectorforinvestigations
inioo,heturnedaspotlightonmortgagefraud.Thepotentialimpactofmortgage
fraudisclear,Sweckertoldacongressionalcommitteeinioo.Iffraudulentprac-
ticesbecomesystemicwithinthemortgageindustryandmortgagefraudisallowed
tobecomeunrestrained,itwillultimatelyplacefnancialinstitutionsatriskandhave
adverseeffectsonthestockmarket.
o
In that testimony, Swecker pointed out the inadequacies of data regarding fraud
and recommended that Congress mandate a reporting system and other remedies
andrequirealllenderstoparticipate,whetherfederallyregulatedornot.Forexam-
ple, suspicious activity reports, also known as SARs, are reports fled by FDIC-in-
sured banks and their amliates to the Financial Crimes Enforcement Network
\ii i N ..
(FinCEN),abureauwithintheTreasuryDepartmentthatadministersmoney-laun-
dering laws and works closely with law enforcement to combat fnancial crimes.
SARsarefledbyfnancialinstitutionswhentheysuspectcriminalactivityinafnan-
cialtransaction.Butmanymortgageoriginators,suchasAmeriquest,NewCentury,
andOptionOne,wereoutsideFinCENsjurisdictionandthustheloanstheygener-
ated,whichwerethenplacedintosecuritizedpoolsbylargerlendersorinvestment
banks, were not subject to FinCEN review. William Black testifed to the Commis-
sion that an estimated 8o of nonprime mortgage loans were made by noninsured
lendersnotrequiredtofleSARs.Andasforthoseinstitutionsrequiredtodoso,he
believedhesawevidenceofunderreportinginthat,hesaid,onlyabout1ooffeder-
ally insured mortgage lenders fled even a single criminal referral for alleged mort-
gagefraudinthefrsthalfofioo.
,
Countrywide,thenationslargestmortgagelenderatthetime,hadabout,,oooin-
ternal referrals of potentially fraudulent activity in its mortgage business in ioo,,
1o,ooo in iooo, and io,ooo in ioo,, according to Francisco San Pedro, the former
seniorvicepresidentofspecialinvestigationsatthecompany.
8
Butitfledonly8,,
SARsinioo,,i,8,iniooo,andi,oi1inioo,.

Similarly,inexaminingBankofAmericainioo,,itsleadbankregulator,theOf-
fceoftheComptrolleroftheCurrency(OCC),sampled,omortgagesandfound1o
withqualityassurancereferralsforsuspiciousactivityforwhichnoreporthadbeen
fled with FinCEN. All 1o met the legal requirement for a fling. The OCC conse-
quentlyrequiredmanagementtorefneitsprocessestoensurethatSARswereconsis-
tentlyfled.
o
Darcy Parmer, a former quality assurance and fraud analyst at Wells Fargo, the
secondlargestmortgagelenderfromioothroughioo,andthelargestinioo8,told
theCommissionthathundredsandhundredsandhundredsoffraudcasesthatshe
knew were identifed within Wells Fargos home equity loan division were not re-
portedtoFinCEN.And,sheadded,atleasthalftheloansshefaggedforfraudwere
neverthelessfunded,overherobjections.
1
Despitetheunderreporting,thejumpinmortgagefrauddrewattention.FinCEN
inNovemberioooreportedaio-foldincreaseinSARsrelatedtomortgagefraudbe-
tween1oandioo,.Itnotedthattwo-thirdsoftheloansbeingcreatedwereorigi-
nated by mortgage brokers who were not subject to any federal standard or
oversight.
i
Sweckerunsuccessfullyaskedlegislatorstocompelalllenderstoforward
informationaboutcriminalfraudtoregulatorsandlawenforcementagencies.

Sweckerattemptedtogainmorefundingtocombatmortgagefraudbutwasresis-
ted.SweckertoldtheFCIChisfundingrequestswerecutateitherthedirectorlevelat
theFBI,attheJusticeDepartment,orattheOmceofManagementandBudget.He
calledhisstruggleformoreresourcesanuphillslog.

In ioo,, i,,88 SARs related to mortgage fraud were fled; in iooo there were
,,,,.Thenumberkeptclimbing,to,i,8oiinioo,,o,,ooinioo8,ando,,,o,in
ioo.
,
Atthesametime,topFBIomcials,focusingonterroristthreats,reducedthe
agentsassignedtowhite-collarcrimefromi,iintheioofscalyeartofewerthan
i,ooobyioo,.Thatyear,itsmortgagefraudprogramhadonly1ioagentsatanyone
.z ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
time to review more than ,o,ooo SARs fled with FinCEN. In response to inquiries
fromtheFCIC,theFBIsaidthattocompensateforalackofmanpower,ithaddevel-
opednewandinnovativemethodstodetectandcombatmortgagefraud,suchasa
computerapplication,creatediniooo,todetectpropertyfipping.
o
Robert Mueller, the FBIs director since ioo1, said mortgage fraud needed to be
considered in context of other priorities, such as terrorism. He told the Commis-
sionthathehiredadditionalresourcestofghtfraud,butthatwedidntgetwhatwe
hadrequestedduringthebudgetprocess.HealsosaidthattheFBIallocatedaddi-
tionalresourcestorefectthegrowthinmortgagefraud,butacknowledgedthatthose
resourcesmayhavebeeninsumcient.Iamnotgoingtotellyouthatthatisadequate
forwhatisoutthere,hesaid.Inthewakeofthecrisis,theFBIiscontinuingtoinves-
tigatefraud,andMuellersuggestedthatsomeprosecutionsmaybestilltocome.
,
AlbertoGonzales,thenationsattorneygeneralfromFebruaryioo,toSeptem-
ber ioo,, told the Commission that while he might have done more on mortgage
fraud,inhindsighthebelievedthatotherissuesweremorepressing:Idontthink
anyonecancrediblyarguethat[mortgagefraud]ismoreimportantthanthewaron
terror.Mortgagefrauddoesntinvolvetakinglossoflifesoitdoesntrankabovethe
priorityofprotectingneighborhoodsfromdangerousgangsorpredatorsattacking
ourchildren.
8
Inioo8,theOmceofFederalHousingEnterpriseOversight,theregulatorofthe
GSEs,releasedareportshowingasignifcantriseintheincidenceoffraudinmort-
gagelendinginioooandthefrsthalfofioo,.OFHEOstatedithadbeenworking
closelywithlawenforcementandwasanactivememberoftheDepartmentofJustice
MortgageFraudWorkingGroup.

Theconcernaboutmortgagefraudandfraudin
generalwasanissue,RichardSpillenkothen,headofbankingsupervisionandregu-
lationattheFedfrom11toiooo,toldtheFCIC.Andweunderstoodtherewasan
increasingincidenceof[mortgagefraud].
,o
Michael B. Mukasey, who served as U.S. attorney general from November ioo,
totheendofioo8,toldtheCommissionthatherecalledreceivingreportsofmort-
gage failures and of there being fraudulent activity in connection with fipping
houses,overvaluation,andthelike. . . .Ihaveadimrecollectionofoutsidepeople
commentingthatadditionalresourcesshouldbedevoted,andtherebeingspecula-
tionaboutwhetherresourcesthatwerebeingdivertedtonationalsecurityinvestiga-
tions,andinparticulartheterrorisminvestigationsweresomehowimpedingfraud
investigations,whichIthoughtwasabogusissue.Hesaidthatthedepartmenthad
otherpressingpriorities,suchasterrorism,gangviolence,andsouthwesternborder
issues.
,1
In letters to the FCIC, the Department of Justice outlined actions it undertook
along with the FBI to combat mortgage fraud. For example, in ioo, the FBI
launched Operation Continued Action, targeting a variety of fnancial crimes, in-
cludingmortgagefraud.Inthatsameyear,theagencystartedtopublishanannual
mortgage fraud report. The following year, the FBI and other federal agencies an-
nouncedajointeffortcombatingmortgagefraud.FromJulytoOctoberioo,,this
program, Operation Quick Flip, produced 1,o indictments, 81 arrests, and 8
\ii i N .,
convictionsformortgagefraud.Inioo,,theFBIstartedspecifcallytrackingmort-
gage fraud cases and increased personnel dedicated to those efforts. And in ioo8,
Operation Malicious Mortgage resulted in 1 mortgage fraud cases in which oo
defendantswerechargedbyU.S.Attorneysomcesthroughoutthecountry.
,i
WilliamBlacktoldtheCommissionthatWashingtonessentiallyignoredtheissue
andallowedittoworsen.TheFBIdidhaveseverelimits,becauseoftheneedtore-
spondtothe/11attacks,Blacksaid,andtheproblemwascompoundedbythelack
of cooperation: The terrible thing that happened was that the FBI got virtually no
assistance from the regulators, the banking regulators and the thrift regulators.
,
Swecker,theformerFBIomcial,toldtheCommissionhehadnocontactwithbank-
ingregulatorsduringhistenure.
,
As mortgage fraud grew, state agencies took action. In Florida, Ellen Wilcox, a
specialagentwiththestateDepartmentofLawEnforcement,teamedwiththeTampa
policedepartmentandHillsboroughCountyConsumerProtectionAgencytobring
downacriminalringscamminghomeownersintheTampaarea.Itskeymemberwas
OrsonBenn,aNewYorkbasedvicepresidentofArgentMortgageCompany,aunit
ofAmeriquest.Beginninginioo,1oinvestigatorsandtwoprosecutorsworkedfor
yearstounravelanetworkofalliancesbetweenrealestatebrokers,appraisers,home
repaircontractors,titlecompanies,notaries,andaconvictedfeloninacasethatin-
volvedsome1oloans.
,,
According to charging documents in the case, the perpetrators would walk
throughneighborhoods,lookingforelderlyhomeownerstheythoughtwerelikelyto
havesubstantialequityintheirhomes.Theywouldsuggestrepairsorimprovements
tothehomes.Thehomeownerswouldflloutpaperwork,andinsiderswouldusethe
information to apply for loans in their names. Members of the ring would prepare
fraudulentloandocuments,includingfalseW-iforms,flledwithinformationabout
invented employment and falsifed salaries, and take out home equity loans in the
homeownersnames.Eachpersoninvolvedinthetransactionwouldreceiveafeefor
hisorherrole;Benn,atArgent,receiveda,oookickbackforeachloanhehelped
secure.Whentheloanwasfunded,thecheckswerefrequentlymadeouttothebogus
homeconstructioncompanythathadproposedthework,whichwouldthendisap-
pear with the proceeds. Some of the homeowners never received a penny from the
refnancingontheirhomes.HillsboroughCountyomcialslearnedofthescamwhen
homeownersapproachedthemtosaythatscheduledrepairshadneverbeenmadeto
theirhomes,andthensometimeslearnedthattheyhadlostyearsworthofequityas
well. Sixteen of 18 defendants, including Benn, have been convicted or have pled
guilty.
,o
Wilcox told the Commission that the cost and length of these investigations
make them less attractive to most investigative agencies and prosecutors trying to
justify their budgets based on investigative statistics.
,,
She said it has been hard to
followuponothercasesbecausesomanyofthesubprimelendershavegoneoutof
business, making it dimcult to track down perpetrators and witnesses. Ameriquest,
for example, collapsed in ioo,, although Argent, and the companys loan-servicing
arm,wereboughtbyCitigroupthatsameyear.
., ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
DISCLOSURE AND DUE DILIGENCE:
A QUALITY CONTROL ISSUE IN THE FACTORY
Inadditiontotherisingfraudandegregiouslendingpractices,lendingstandardsde-
terioratedinthefnalyearsofthebubble.Aftergrowingforyears,Alt-Alendingin-
creasedanother,fromioo,toiooo.Inparticular,optionARMsgrew,during
thatperiod,interest-onlymortgagesgrew,andno-documentationorlow-docu-
mentation loans (measured for borrowers with fxed-rate mortgages) grew 1.
Overall,byiooono-docorlow-docloansmadeupi,ofallmortgagesoriginated.
Manyoftheseproductswouldperformonlyifpricescontinuedtoriseandthebor-
rowercouldrefnanceatalowrate.
,8
Intheory,everyparticipantalongthesecuritizationpipelineshouldhavehadan
interestinthequalityofeveryunderlyingmortgage.Inpractice,theirinterestswere
oftennotaligned.TwoNewYorkFedeconomistshavepointedoutthesevendeadly
frictions in mortgage securitizationplaces along the pipeline where one party
knewmorethantheother,creatingopportunitiestotakeadvantage.
,
Forexample,
thelenderwhooriginatedthemortgageforsale,earningacommission,knewagreat
deal about the loan and the borrower but had no long-term stake in whether the
mortgage was paid, beyond the lenders own business reputation. The securitizer
whopackagedmortgagesintomortgage-backedsecurities,similarly,waslesslikelyto
retainastakeinthosesecurities.
In theory, the rating agencies were important watchdogs over the securitization
process.Theydescribedtheirroleasbeinganumpireinthemarket.
oo
Buttheydid
not review the quality of individual mortgages in a mortgage-backed security, nor
didtheychecktoseethatthemortgageswerewhatthesecuritizerssaidtheywere.
So the integrity of the market depended on two critical checks. First, frms pur-
chasingandsecuritizingthemortgageswouldconductduediligencereviewsofthe
mortgage pools, either using third-party frms or doing the reviews in-house. Sec-
ond,followingSecuritiesandExchangeCommissionrules,partiesinthesecuritiza-
tionprocesswereexpectedtodisclosewhattheyweresellingtoinvestors.Neitherof
thesechecksperformedastheyshouldhave.
uuciligcnccjirms.\eivcin
As subprime mortgage securitization took off, securitizers undertook due diligence
on their own or through third parties on the mortgage pools that originators were
sellingthem.Theoriginatorandthesecuritizernegotiatedtheextentoftheduedili-
genceinvestigation.Whilethepercentageofthepoolexaminedcouldbeashighas
o,itwasoftenmuchlower;accordingtosomeobservers,asthemarketgrewand
originators became more concentrated, they had more bargaining power over the
mortgagepurchasers,andsamplesweresometimesaslowasito.
o1
Somesecu-
ritizersrequestedthattheduediligencefrmanalyzearandomsampleofmortgages
fromthepool;othersaskedforasamplingofthosemostlikelytobedefcientinsome
way,inanefforttoemcientlydetectmoreoftheproblemloans.
\ii i N .,
ClaytonHoldings,aConnecticut-basedfrm,wasamajorproviderofthird-party
duediligenceservices.
oi
AsClaytonVicePresidentVickiBealexplainedtotheFCIC,
frms like hers were not retained by [their] clients to provide an opinion as to
whether a loan is a good loan or a bad loan. Rather, they were hired to identify,
among other things, whether the loans met the originators stated underwriting
guidelinesand,insomemeasure,toenableclientstonegotiatebetterpricesonpools
ofloans.
o
Thereviewfellintothreegeneralareas:credit,compliance,andvaluation.Didthe
loans meet the underwriting guidelines (generally the originators standards, some-
times with overlays or additional guidelines provided by the fnancial institutions
purchasing the loans): Did the loans comply with federal and state laws, notably
predatory-lendinglawsandtruth-in-lendingrequirements:Werethereportedprop-
erty values accurate:
o
And, critically: to the degree that a loan was defcient, did it
haveanycompensatingfactorsthatoffsetthesedefciencies:Forexample,ifaloan
hadahigherloan-to-valueratiothanguidelinescalledfor,didanothercharacteristic
suchastheborrowershigherincomemitigatethatweakness:Theduediligencefrm
wouldthengradetheloansampleandforwardthedatatoitsclient.Reportinhand,
the securitizer would negotiate a price for the pool and could kick out loans that
didnotmeetthestatedguidelines.
BecauseofthevolumeofloansexaminedbyClaytonduringthehousingboom,
thefrmhadauniqueinsideviewoftheunderwritingstandardsthatoriginatorswere
actuallyapplyingandthatsecuritizerswerewillingtoaccept.Loanswereclassifed
into three groups: loans that met guidelines (a Grade 1 Event), those that failed to
meet guidelines but were approved because of compensating factors (a Grade i
Event), and those that failed to meet guidelines and were not approved (a Grade
Event).Overall,forthe18monthsthatendedJuneo,ioo,,Claytonrated,ofthe
11,oloansitanalyzedasGrade1,andanother18asGradeiforatotalof,i
thatmettheguidelinesoutrightorwithcompensatingfactors.Theremainingi8of
theloanswereGrade.
o,
Intheory,thebankscouldhaverefusedtobuyaloanpool,
or,indeed,theycouldhaveusedthefndingsoftheduediligencefrmtoprobethe
loansqualitymoredeeply.Overthe18-monthperiod,oftheloansthatClayton
found to be defcientGrade were waived in by the banks. Thus 11 of the
loanssampledbyClaytonwereacceptedeventhoughthecompanyhadfoundabasis
forrejectingthem(seefgure.1).
Referringtothedata,KeithJohnson,thepresidentofClaytonfromMayioooto
Mayioo,toldtheCommission,That,tomesaysthere[was]aqualitycontrol
issue in the factory for mortgage-backed securities.
oo
Johnson concluded that his
clients often waived in loans to preserve their business relationship with the loan
originatorahighnumberofrejectionsmightleadtheoriginatortoselltheloansto
a competitor. Simply put, it was a sellers market. Probably the seller had more
powerthantheWallStreetissuer,JohnsontoldtheFCIC.
o,
Thehighrateofwaiversfollowingrejectionsmaynotitselfbeevidenceofsome-
thingwrongintheprocess,Bealtestifed.Shesaidthatasoriginatorslendingguide-
lines were declining, she saw the securitizing frms introduce additional credit
. ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
\ii i N .,
guidelines.Asyouknow,therewasstatedincome,theyweretellinguslookforrea-
sonablenessofthatincome,thingslikethat.
o8
Withstricterguidelines,onewouldex-
pect more rejections, and, after the securitizer looks more closely at the rejected
loans, possibly more waivers. As Moodys Investors Service explained in a letter to
theFCIC,Ahighrateofwaiversfromaninstitutionwithextremelytightunderwrit-
ingstandardscouldresultinapoolthatislessriskythanapoolwithnowaiversfrom
an institution with extremely loose underwriting standards.
o
Nonetheless, many
prospectuses indicated that the loans in the pools either met guidelines outright or
hadcompensatingfactors,eventhoughClaytonsrecordsshowthatonlyaportionof
theloansweresampled,andthatofthosethatweresampled,asubstantialpercentage
ofGradeEventloanswerewaivedin.
Johnsonsaidheapproachedtheratingagenciesinioooandioo,togaugetheir
interest in the exception-tracking product that Clayton was developing. He said he
sharedsomeoftheircompanysresults,attemptingtoconvincetheagenciesthatthe
data would beneft the ratings process. We went to the rating agencies and said,
Wouldnt this information be great for you to have as you assign tranche levels of
Rejected Loans Waived in by Selected Banks
From January 2006 through June 2007, Clayton rejected 28% of the mortgages
it reviewed. Of these, 39% were waived in anyway.
Citigroup 58% 42% 13% 29% 31%
Credit Suisse 68 32 11 21 33
Deutsche 65 35 17 17 50
Goldman 77 23 7 16 29
JP Morgan 73 27 14 13 51
Lehman 74 26 10 16 37
Merrill 77 23 7 16 32
UBS 80 20 6 13 33
WaMu 73 27 8 19 29
Total Bank Sample 72% 28% 11% 17% 39%
Financial Institution
A
ACCEPTED
LOANS
(Event 1 & 2)/
Total pool of
loans
B
REJECTED
LOANS
(Event 3)/
Total pool of
loans
C
REJECTED
LOANS
WAIVED IN BY
FINANCIAL
INSTITUTIONS
D
REJECTED
LOANS AFTER
WAIVERS
(BC)
E
FINANCIAL
INSTITUTION
WAIVER RATE
(C/B)
NOTES: From Clayton Trending Reports. Numbers may not add due to rounding.
SOURCE: Clayton Holdings
Iigurc .+
risk: Johnson recalled. The agencies thought the due diligence frms data were
great, but they did not want the information, Johnson said, because it would pre-
sumablyproducelowerratingsforthesecuritizationsandcosttheagencybusiness
eveninioo,,astheprivatesecuritizationmarketwaswindingdown.
,o
When securitizers did kick loans out of the pools, some originators simply put
themintonewpools,presumablyinhopesthatthoseloanswouldnotbecapturedin
the next pools sampling. The examiners report for New Century Financials bank-
ruptcydescribessuchapractice.
,1
Similarly,FremontInvestment&Loanhadapol-
icyofputtingloansintosubsequentpoolsuntiltheywerekickedoutthreetimes,the
companysformerregulatorycomplianceandriskmanager,RogerEhrnman,toldthe
FCIC. As Johnson described the practice to the FCIC, this was the three strikes,
youreoutrule.
,i
Some mortgage securitizers did their own due diligence, but seemed to devote
onlylimitedresourcestoit.AtMorganStanley,theheadofduediligencewasbased
notinNewYorkbutratherinBocaRaton,Florida.Hehad,atanyonetime,twoto
fveindividualsreportingtohimdirectlyandtheywereactuallyemployeesofaper-
sonnelconsultant,Equinox.
,
DeutscheBankandJPMorganlikewisealsohadonly
smallduediligenceteams.
,
Banksdidnotnecessarilyhavebetterprocessesformonitoringthemortgagesthat
they purchased. At an FCIC hearing on the mortgage business, Richard Bowen, a
whistleblower who had been a senior vice president at CitiFinancial Mortgage in
charge of a staff of ioo-plus professional underwriters, testifed that his team con-
ductedqualityassurancechecksontheloansboughtbyCitigroupfromanetworkof
lenders, including both subprime mortgages that Citigroup intended to hold and
primemortgagesthatitintendedtoselltoFannieMaeandFreddieMac.
Forsubprimepurchases,Bowensteamwouldreviewthephysicalcreditfleofthe
loanstheywerepurchasing.Duringioooandioo,,Iwitnessedmanychangestothe
way the credit risk was being evaluated for these pools during the purchase
processes,Bowensaid.Forexample,hesaid,thechiefriskomcerinCitigroupsCon-
sumer Lending business reversed large numbers of underwriting decisions from
turndowntoapproved.
,,
AnotherpartofBowenschargewastosupervisethepurchaseofroughly,obil-
lion annually in prime loan pools, a high percentage of which were sold to Fannie
MaeandFreddieMacforsecuritization.ThesamplingprovidedtoBowensstafffor
qualitycontrolwassupposedtoincludeatleast,oftheloanpoolforagivensecu-
ritization, but this corporate mandate was usually ignored. Samples of i were
morelikely,andtheloansamplesthatBowensgroupdidexamineshowedextremely
highratesofnoncompliance.AtthetimethatIbecameinvolved,whichwasearlyto
mid-iooo,weidentifedthatotooopercentofthefleseitherhadadisagreedeci-
sion,ortheyweremissingcriticaldocuments.
,o
Bowenrepeatedlyexpressedconcernstohisdirectsupervisorandcompanyexec-
utivesaboutthequalityandunderwritingofmortgagesthatCitiMortgagepurchased
andthensoldtotheGSEs.Asdiscussedinalaterchapter,theGSEswouldlaterre-
. ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
quireCitigrouptobuyback1.,billioninloansasofNovemberio1o,fndingthat
theloansCitigrouphadsoldthemdidnotconformtoGSEstandards.
SIt.1/cclc/entint/croomist/et
vcintrcvicvt/croscctussulcmcnts
Bythetimethefnancialcrisishit,investorsheldmorethanitrillionofnon-GSE
mortgage-backed securities and close to ,oo billion of CDOs that held mortgage-
backed securities.
,,
These securities were issued with practically no SEC oversight.
And only a minority were subject to the SECs ongoing public reporting require-
ments. The SECs mandate is to protect investorsgenerally not by reviewing the
quality of securities, but simply by ensuring adequate disclosures so that investors
canmakeuptheirownminds.Inthecaseofinitialpublicofferingsofacompanys
shares,theworkhashistoricallyinvolvedalengthyreviewoftheissuersprospectus
andotherofferingmaterialspriortosale.
,8
However,withtheadventofshelfregistration,amethodofregisteringsecurities
onanongoingbasis,theprocessbecamemuchquickerformortgage-backedsecuri-
tiesrankedinthehighestgradesbytheratingagencies.Theprocessallowedissuers
tofleabaseprospectuswiththeSEC,givinginvestorsnoticethattheissuerintended
tooffersecuritiesinthefuture.Theissuerthenfledasupplementalprospectusde-
scribingeachofferingsterms.Theelephantintheroomisthatwedidntreviewthe
prospectussupplements,theSECsdeputydirectorfordisclosureincorporationf-
nance, Shelley Parratt, told the FCIC.
,
To improve disclosures pertaining to mort-
gage-backedsecuritiesandotherasset-backedsecurities,theSECissuedRegulation
ABinlateioo.Theregulationrequiredthateveryprospectusincludeadescription
ofthesolicitation,credit-grantingorunderwritingcriteriausedtooriginateorpur-
chase the pool assets, including, to the extent known, any changes in such criteria
andtheextenttowhichsuchpoliciesandcriteriaareorcouldbeoverridden.
8o
Withessentiallynorevieworoversight,howgoodweredisclosuresaboutmort-
gage-backed securities: Prospectuses usually included disclaimers to the effect that
not all mortgages would comply with the lending policies of the originator: On a
case-by-case basis [the originator] may determine that, based upon compensating
factors, a prospective mortgage not strictly qualifying under the underwriting risk
categoryorotherguidelinesdescribedbelowwarrantsanunderwritingexception.
81
Thedisclosuretypicallyhadasentencestatingthatasubstantialnumberorperhaps
asubstantialportionoftheMortgageLoanswillrepresenttheseexceptions.
8i
Citi-
groups Bowen criticized the extent of information provided on loan pools: There
was no disclosure made to the investors with regard to the quality of the fles they
werepurchasing.
8
Such disclosures were insumcient for investors to know what criteria the mort-
gages they were buying actually did meet. Only a small portionas little as i to
oftheloansinanydealweresampled,andevidencefromClaytonshowsthata
signifcantnumberdidnotmeetstatedguidelinesorhavecompensatingfactors.
8
On
\ii i N .,
theloansintheremainderofthemortgagepoolthatwerenotsampled(asmuchas
,),Claytonandthesecuritizershadnoinformation,butonecouldreasonablyex-
pectthemtohavemanyofthesamedefciencies,andatthesamerate,asthesampled
loans.Prospectusesfortheultimateinvestorsinthemortgage-backedsecuritiesdid
notcontainthisinformation,orinformationonhowfewloanswerereviewed,raising
the question of whether the disclosures were materially misleading, in violation of
thesecuritieslaws.
CDOswereissuedunderadifferentregulatoryframeworkfromtheonethatap-
pliedtomanymortgage-backedsecurities,andwerenotsubjecteventotheminimal
shelf registration rules. Underwriters typically issued CDOs under the SECs Rule
1A,whichallowstheunregisteredresaleofcertainsecuritiestoso-calledqualifed
institutionalbuyers(QIBs);theseincludedinvestorsasdiverseasinsurancecompa-
nies like MetLife, pension funds like the California State Teachers Retirement Sys-
tem,andinvestmentbankslikeGoldmanSachs.
8,
TheSECcreatedRule1Ain1o,makingsecuritiesmarketsmoreattractiveto
borrowers and U.S. investment banks more competitive with their foreign counter-
parts; at the time, market participants viewed U.S. disclosure requirements as more
onerousthanthoseinothercountries.Thenewrulesignifcantlyexpandedthemar-
ketforthesesecuritiesbydeclaringthatdistributionswhichcompliedwiththerule
wouldnolongerbeconsideredpublicofferingsandthereforewouldnotbesubject
totheSECsregistrationrequirements.In1o,Congressreinforcedthisexemption
withtheNationalSecuritiesMarketsImprovementsAct,legislationthatDeniseVoigt
Crawford,acommissionerontheTexasSecuritiesBoard,characterizedtotheCom-
missionasprohibit[ing]thestatesfromtakingpreventativeactionsinareasthatwe
now know have been substantial contributing factors to the current crisis.
8o
Under
this legislation, state securities regulators were preempted from overseeing private
placements such as CDOs. In the absence of registration requirements, a new debt
marketdevelopedquicklyunderRule1A.Thismarketwasliquid,sincequalifed
investorscouldfreelytradeRule1Adebtsecurities.ButdebtsecuritieswhenRule
1Awasenactedweremostlycorporatebonds,verydifferentfromtheCDOsthat
dominatedtheprivateplacementmarketmorethanadecadelater.
8,
Afterthecrisisunfolded,investors,arguingthatdisclosurehadntbeenadequate,
flednumerouslawsuitsunderfederalandstatesecuritieslaws.Aswewillsee,some
havealreadyresultedinsubstantialsettlements.
REGULATORS: MARKETS WILL ALWAYS SELFCORRECT
Where were the regulators: Declining underwriting standards and new mortgage
productshadbeenonregulatorsradarscreensintheyearsbeforethecrisis,butdis-
agreementsamongtheagenciesandtheirtraditionalpreferenceforminimalinterfer-
encedelayedaction.
Supervisors had, since the 1os, followed a risk-focused approach that relied
extensively on banks own internal risk management systems.
88
As internal systems
improve,thebasicthrustoftheexaminationprocessshouldshiftfromlargelydupli-
.,+ ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
cating many activities already conducted within the bank to providing constructive
feedbackthatthebankcanusetoenhancefurtherthequalityofitsrisk-management
systems,ChairmanGreenspanhadsaidin1.
8
Acrossagencies,therewasahis-
toric vision, historic approach, that a lighter hand at regulation was the appropriate
waytoregulate,EugeneLudwig,comptrollerofthecurrencyfrom1to18,told
theFCIC,referringtotheGramm-Leach-BlileyActin1.
o
TheNewYorkFed,ina
lessons-learnedanalysisafterthecrisis,pointedtothemistakenbeliefthatmarkets
willalwaysself-correct.Adeferencetotheself-correctingpropertyofmarketsinhib-
itedsupervisorsfromimposingprescriptiveviewsonbanks,thereportconcluded.
1
Therelianceonbanksownriskmanagementwouldextendtocapitalstandards.
Bankshadcomplainedforyearsthattheoriginal188Baselstandardsdidnotallow
themsumcientlatitudetobasetheircapitalontheriskinessofparticularassets.After
yearsofnegotiations,internationalregulators,withstrongsupportfromtheFed,in-
troducedtheBaselIIcapitalregimeinJuneioo,whichwouldallowbankstolower
theircapitalchargesiftheycouldshowtheyhadsophisticatedinternalmodelsfores-
timatingtheriskinessoftheirassets.WhilenoU.S.bankfullyimplementedthemore
sophisticatedapproachesthatitallowed,BaselIIrefectedandreinforcedthesuper-
visors risk-focused approach. Spillenkothen said that one of the regulators biggest
mistakeswastheiracceptanceofBaselIIpremises,whichhedescribedasdisplay-
inganexcessivefaithininternalbankriskmodels,aninfatuationwiththespecious
accuracyofcomplexquantitativeriskmeasurementtechniques,andawillingness(at
leastintheearlydaysofBaselII)totolerateareductioninregulatorycapitalinre-
turnfortheprospectofbetterriskmanagementandgreaterrisk-sensitivity.
i
Regulatorshadbeentakingnoticeofthemortgagemarketforseveralyearsbefore
the crisis. As early as ioo, they recognized that mortgage products and borrowers
had changed during and following the refnancing boom of the previous year, and
theybeganworkonprovidingguidancetobanksandthrifts.Buttoolittlewasdone,
and too late, because of interagency discord, industry pushback, and a widely held
viewthatmarketparticipantshadthesituationwellinhand.
Withintheboard,peopleunderstoodthatmanyoftheseloantypeshadgottento
anextreme,SusanBies,thenaFedgovernorandchairoftheFederalReserveBoards
subcommitteesonbothsafetyandsoundnesssupervisionandconsumerprotection
supervision, told the FCIC. So the main debate within the board was how tightly
[shouldwe]reinintheabusesthatwewereseeing.Soitwasmoreoftoadegree.

Indeed, in the same June ioo, Federal Open Market Committee meeting de-
scribed earlier, one FOMC member noted that some of the newer, more intricate
anduntestedcreditdefaultinstrumentshadcausedsomemarketturmoil.Another
participant was concerned that subprime lending was an accident waiting to hap-
pen.Athirdparticipantnotedtherisksinmortgagesecurities,therapidgrowthof
subprime lending, and the fact that many lenders had inadequate information on
borrowers,adding,however,thatrecordproftsandhighcapitallevelsallayedthose
concerns.Afourthparticipantsaidthatwecouldbeseeingthefnalgaspsofhouse
priceappreciation.Theparticipantexpressedconcernaboutcreativefnancingand
wasworriedthatpiggybacksandothernon-traditionalloans,whoseriskofdefault
\ii i N .,.
couldbehigherthansuggestedbythesecuritiestheybacked,couldbemakingthe
booksofGSEslookbetterthantheyreallywere.FedstaffrepliedthattheGSEswere
notlargepurchasersofprivatelabelsecurities.

In the spring of iooo, the FOMC would again discuss risks in the housing and
mortgage markets and express nervousness about the growing ingenuity of the
mortgagesector.Oneparticipantnotedthatnegativeamortizationloanshadtheper-
niciouseffectofstrippingequityandwealthfromhomeownersandraisedconcerns
about nontraditional lending practices that seemed based on the presumption of
continuedincreasesinhomeprices.
JohnSnow,thentreasurysecretary,toldtheFCICthathecalledameetinginlate
ioo or early ioo, to urge regulators to address the proliferation of poor lending
practices.Hesaidhewasstruckthatregulatorstendednottoseeaproblemattheir
owninstitutions.Nobodyhadafulloo-degreeview.Thebasicreactionfromfnan-
cial regulators was, Well, there may be a problem. But its not in my feld of view,
SnowtoldtheFCIC.RegulatorsrespondedtoSnowsquestionsbysaying,Ourde-
fault rates are very low. Our institutions are very well capitalized. Our institutions
[have]verylowdelinquencies.Sowedontseeanyrealbigproblem.
,
InMayioo,,thebankingagenciesdidissueguidanceontherisksofhomeequity
linesofcreditandhomeequityloans.Itcautionedfnancialinstitutionsaboutcreditrisk
management practices, pointing to interest-only features, low- or no-documentation
loans,highloan-to-valueanddebt-to-incomeratios,lowercreditscores,greateruseof
automatedvaluationmodels,andtheincreaseintransactionsgeneratedthroughaloan
broker or other third party. While this guidance identifed many of the problematic
lendingpracticesengagedinbybanklenders,itwaslimitedtohomeequityloans.Itdid
notapplytofrstmortgages.
o
In ioo,, examiners from the Fed and other agencies conducted a confdential
peer group study of mortgage practices at six companies that together had origi-
nated1.trillioninmortgagesinioo,,almosthalfthenationaltotal.Inthegroup
were fve banks whose holding companies were under the Feds supervisory
purviewBank of America, Citigroup, Countrywide, National City, and Wells
Fargoaswellasthelargestthrift,WashingtonMutual.
,
Thestudyshowedavery
rapid increase in the volume of these irresponsible loans, very risky loans, Sabeth
Siddique,thenheadofcreditriskattheFederalReserveBoardsDivisionofBanking
SupervisionandRegulation,toldtheFCIC.
8
Alargepercentageoftheirloansissued
weresubprimeandAlt-Amortgages,andtheunderwritingstandardsfortheseprod-
uctshaddeteriorated.

Once the Fed and other supervisors had identifed the mortgage problems, they
agreedtoexpressthoseconcernstotheindustryintheformofnonbindingguidance.
TherewasamongtheBoardofGovernorsfolks,youknow,somewhofeltthatifwe
justputoutguidance,thebankswouldgetthemessage,Biessaid.
1oo
The federal agencies therefore drafted guidance on nontraditional mortgages
suchasoptionARMs,issuingitforpubliccommentinlateioo,.Thedraftguidance
directedlenderstoconsideraborrowersabilitytomaketheloanpaymentwhenrates
.,z ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
adjusted, rather than just the lower starting rate. It warned lenders that low-
documentationloansshouldbeusedwithcaution.
1o1
Immediately, the industry was up in arms. The American Bankers Association
saidtheguidanceoverstate[d]theriskofnon-traditionalmortgages.
1oi
Othermar-
ketparticipantscomplainedthattheguidancerequiredthemtoassumeaworstcase
scenario,thatis,thescenarioinwhichborrowerswouldhavetomakethefullpay-
ment when rates adjusted.
1o
They disputed the warning on low-documentation
loans, maintaining that almost any form of documentation can be appropriate.
1o
Theydeniedthatbetterdisclosureswererequiredtoprotectborrowersfromtherisks
ofnontraditionalmortgages,arguingthattheywerenotawareofanyempiricalevi-
dencethatsupportstheneedforfurtherconsumerprotectionstandards.
1o,
The need for guidance was controversial within the agencies, too. We got
tremendouspushbackfromtheindustryaswellasCongressaswellas,youknow,in-
ternally,theFedsSiddiquetoldtheFCIC.Becauseitwasstifinginnovation,poten-
tially,anditwasdenyingtheAmericandreamtomanypeople.
1oo
The pressures to weaken and delay the guidance were strong and came from
manysources.OppositionbytheOmceofThriftSupervisionhelpeddelaythemort-
gageguidanceforalmostayear.
1o,
Biessaid,Therewassomerealconcernaboutif
theFedtighteneddownon[thebanksitregulated],whetherthatwouldcreateanun-
levelplayingfeld . . .[for]stand-alonemortgagelenderswhomthe[Fed]didnotreg-
ulate. Another challenge to regulating the mortgage market was Congress. She
recalledanoccasionwhenshetestifedaboutaproposedruleandmembersofCon-
gress[said]thatweweregoingtodenythedreamofhomeownershiptoAmericansif
weputthisnewstrongerstandardinplace.
1o8
When guidance was put in place in iooo, regulators policed their guidance
throughbankexaminationsandinformalmeasuressuchasvoluntaryagreements
withsupervisedinstitutions.
It also appeared some institutions switched regulators in search of more lenient
treatment.InDecemberiooo,CountrywideappliedtoswitchregulatorsfromtheFed
and OCC to the OTS. Countrywides move came after several months of evaluation
within the company about the benefts of OTS regulation, many of which were pro-
motedbytheOTSitselfoverthecourseofanoutreacheffortinitiatedinmid-ioo,
afterJohnReichbecamedirectoroftheagency.Publicly,Countrywidestatedthatthe
decisiontoswitchtotheOTSwasdrivenbythedesiretohaveone,housing-focused
regulator,ratherthanseparateregulatorsforthebankandtheholdingcompany.
1o
However,otherfactorscameintoplayaswell.TheOCCstopCountrywideexam-
iner told the FCIC that Countrywide CEO Angelo Mozilo and President and COO
DavidSambolthoughttheOCCspositiononpropertyappraisalswouldbekilling
thebusiness.
11o
AninternalJulyioooCountrywidebriefngpapernoted,TheOTS
regulationofholdingcompaniesisnotasintrusiveasthatoftheFederalReserve. In
particular,theOTSrarelyconductsextensiveonsiteexaminationsandwhentheydo
conduct an onsite examination they are generally not considered intrusive to the
holdingcompany.Thebriefngpaperalsonoted,TheOTSgenerallyisconsidereda
\ii i N .,,
less sophisticated regulator than the Federal Reserve.
111
In August iooo, Mozilo
wrotetomembersofhisexecutiveteam,ItappearsthattheFedisnowtroubledby
payoptionswhiletheOTSisnot. Sincepayoptionsareamajorcomponentofboth
our volumes and proftability the Fed may force us into a decision faster than we
wouldlike.CountrywideChiefRiskOmcerJohnMcMurrayrespondedthatbased
on my meetings with the FRB and OTS, the OTS appears to be both more familiar
andmorecomfortablewithOptionARMs.
11i
The OTS approved Countrywides application for a thrift charter on March ,,
ioo,.
LEVERAGED LOANS AND COMMERCIAL REAL ESTATE:
YOU VE GOT TO GET UP AND DANCE
Thecreditbubblewasnotconfnedtotheresidentialmortgagemarket.Themarkets
forcommercialrealestateandleveragedloans(typicallyloanstobelow-investment-
gradecompaniestoaidtheirbusinessortofnancebuyouts)alsoexperiencedsimilar
bubble-and-bustdynamics,althoughtheeffectswerenotaslargeanddamagingasin
residential real estate. From iooo to ioo,, these other two markets grew tremen-
dously, spurred by structured fnance productscommercial mortgagebacked se-
curities and collateralized loan obligations (CLOs), respectivelywhich were in
manywayssimilartoresidentialmortgage-backedsecuritiesandCDOs.Andjustas
in the residential mortgage market, underwriting standards loosened, even as the
cost of borrowing decreased,
11
and trading in these securities was bolstered by the
developmentofnewcreditderivativesproducts.
11
Historically, leveraged loans had been made by commercial banks; but a market
forinstitutionalinvestorsdevelopedandgrewinthemid-tolate1os.
11,
Anagent
bankwouldoriginateapackageofloanstoonlyonecompanyandthensellorsyndi-
catetheloansinthepackagetootherbanksandlargenonbankinvestors.Thepack-
agegenerallyincludedloanswithdifferentmaturities.Somewereshort-termlinesof
credit, which would be syndicated to banks; the rest were longer-term loans syndi-
cated to nonbank, institutional investors. Leveraged loan issuance more than dou-
bled from iooo to ioo,, but the rapid growth was in the longer-term institutional
loans rather than in short-term lending. By ioo,, the longer-term leveraged loans
roseto8,billion,upfromobillioniniooo.
11o
Startingin18,thelonger-termleveragedloanswerepackagedinCLOs,which
wereratedaccordingtomethodologiessimilartothosetheratingagenciesusedfor
CDOs.LikeCDOs,CLOshadtranches,underwriters,andcollateralmanagers.The
marketwaslessthan,billionannuallyfrom18toiooi,butthenitstartedgrow-
ing dramatically. Annual issuance exceeded o billion in ioo, and peaked above
8obillioninioo,.Fromiooothroughthethirdquarterofioo,,morethanooof
leveragedloanswerepackagedintoCLOs.
11,
As the market for leveraged loans grew, credit became looser and leverage in-
creasedaswell.Thedealsbecamelargerandcostsofborrowingdeclined.Loansthat
inioohadpaidinterestofpercentagepointsoveraninterbanklendingratewere
.,, ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
refnanced in early ioo, into loans paying just i percentage points over that same
rate.Duringthepeakoftherecentleveragedbuyoutboom,leveragedloanswerefre-
quently issued with interest-only, payment-in-kind, and covenant-lite terms.
118
Payment-in-kind loans allowed borrowers to defer paying interest by issuing new
debt to cover accrued interest. Covenant-lite loans exempted borrowers from stan-
dard loan covenants that usually require corporate frms to limit their other debts
andtomaintainminimumlevelsofcash.Privateequityfrms,thosethatspecialized
ininvestingdirectlyincompanies,founditeasierandcheapertofnancetheirlever-
agedbuyouts.Justashomepricesrose,sotoodidthepricesofthetargetcompanies.
Oneofthelargestdealsevermadeinvolvingleveragedloanswasannouncedon
Aprili,ioo,,byKKR,aprivateequityfrm.KKRsaiditintendedtopurchaseFirst
DataCorporation,aprocessorofelectronicdataincludingcreditanddebitcardpay-
ments,foraboutibillion.Aspartofthistransaction,KKRwouldissue8billion
injunkbondsandtakeoutanother1,billioninleveragedloansfromaconsortium
of banks including Citigroup, Deutsche Bank, Goldman Sachs, HSBC Securities,
LehmanBrothers,andMerrillLynch.
11
AslateasJulyioo,,Citigroupandotherswerestillincreasingtheirleveragedloan
business.
1io
CitigroupCEOCharlesPrincethensaidofthebusiness,Whenthemu-
sicstops,intermsofliquidity,thingswillbecomplicated.Butaslongasthemusicis
playing,youvegottogetupanddance.Werestilldancing.Princelaterexplainedto
theFCIC,Atthatpointintime,becauseinterestrateshadbeensolowforsolong,
theprivateequityfrmsweredrivingveryhardbargainswiththebanks.Andatthat
point in time the banks individually had no credibility to stop participating in this
lending business. It was not credible for one institution to unilaterally back away
fromthisleveragedlendingbusiness.ItwasinthatcontextthatIsuggestedthatallof
us,wewereallregulatedentities,thattheregulatorshadaninterestintighteningup
lendingstandardsintheleveragedlendingarea.
1i1
TheCLOmarketwouldseizeupinthesummerofioo,duringthefnancialcri-
sis, just as the much-larger mortgage-related CDO market seized. At the time this
would be roughly oo billion in outstanding commitments for new loans; as de-
mandinthesecondarymarketdriedup,theseloansendeduponthebanksbalance
sheets.
1ii
Commercial real estatemultifamily apartment buildings, omce buildings, ho-
tels,retailestablishments,andindustrialpropertieswentthroughabubblesimilar
to that in the housing market. Investment banks created commercial mortgage
backedsecuritiesandevenCDOsoutofcommercialrealestateloans,justastheydid
withresidentialmortgages.And,justashousesappreciatedfromioooon,sotoodid
commercial real estate values. Omce prices rose by nearly oo between ioo and
ioo8inthecentralbusinessdistrictsoftheimarketsforwhichdataareavailable.
Theincreasewas1inPhoenix,1,inTampa,1,inManhattan,and1oin
LosAngeles.
1i
Issuanceofcommercialmortgagebackedsecuritiesrosefrom,billioniniooo
to1obillioninioo,,reachingiobillioninioo,.Whensecuritizationmarkets
contracted, issuance fell to 1i billion in ioo8 and billion in ioo. When about
\ii i N .,,
one-fourthofcommercialrealestatemortgagesweresecuritizedinioo,,securitizers
issued1billionofcommercialmortgageCDOs,anumberthatagaindroppedpre-
cipitouslyinioo8.
1i
Leveraged loans and the commercial real estate sector came together on July ,
ioo,, when the Blackstone Group announced its plan to buy Hiltona hotel chain
withi,oopropertiesforiobillion,aopremiumovertheshareprice.Ayear
later,oneauthordescribedthisdealastheapogeeoftheearly-millennialmegabuy-
outfrenzy,wherecheapandreadilyavailablecredit,coupledwitharelentlessone-up-
manship, spurred private equity frms to buy out companies at often absurd
overvaluations, saddle them with massive debt, and then pay themselves hefty fees
forthetrouble.
1i,
Twentybilliondollarsinfnancingcamefromthetopfveinvest-
ment banks and large commercial banks such as Bank of America and Deutsche
Bank.
1io
BearStearnswasincreasinglyactiveinthesemarkets.WhileBeartoppedtheiooo
marketinresidentialsecuritizations,itrankedinthebottomhalfincommercialse-
curitizations.
1i,
Butitwasracingtocatchup,andinaioo,presentationboasted:In
iooo,wefrmlyestablishedBearStearnsasaglobalpresenceincommercialreales-
tatefnance.Thefrmscommercialrealestatemortgageoriginationsmorethandou-
bledbetweeniooandiooo.
1i8
Andthenthemarketcamecrashingtoahalt.Althoughthecommercialrealestate
mortgagemarketwasmuchsmallerthantheresidentialrealestatemarketinioo8,
commercialrealestatedebtwaslessthantrillion,comparedto1itrillionforres-
identialmortgages
1i
itdeclinedevenmoresteeply. Fromitspeak,commercialreal
estatefellroughly,invalue,andpriceshaveremainedclosetotheirlows.Losses
on commercial real estate would be an issue across Wall Street, particularly for
LehmanandBear.Andpotentiallyforthetaxpayer.WhentheFederalReservewould
assumeobillionofBearsilliquidassetsinioo8,thatwouldincluderoughlybil-
lion in loans from the unsold portion of the Hilton fnancing package.
1o
And the
commercialrealestatemarketwouldcontinuetodeclinelongafterthehousingmar-
kethadbeguntostabilize.
LEHMAN: FROM MOVING TO STORAGE
Evenasthemarketwasnearingitspeak,Lehmantookonmorerisk.
OnOctober,,ioo,,whencommercialrealestatealreadymadeupo.ofitsas-
sets,LehmanBrothersacquiredamajorstakeinArchstoneSmith,apubliclytraded
real estate investment trust, for ,. billion. Archstone owned more than 88,ooo
apartments,includingunitsstillunderconstruction,inoverocommunitiesinthe
UnitedStates.Itwasthebankslargestcommercialrealestateinvestment.
11
LehmaninitiallyprojectedthatArchstonewouldgeneratemorethan1.billion
inproftsover1oyearsprojectionsbasedonoptimisticassumptions,giventhestate
of the market at that point. Both Lehman and Archstone were highly leveraged:
Archstonehadlittlecushionifitsrentreceiptsshouldgodown,andLehmanhadlit-
tlecushionifinvestmentssuchasArchstoneshouldlosevalue.
1i
Althoughthefrm
., ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
had proclaimed that Risk Management is at the very core of Lehmans business
model,theExecutiveCommitteesimplyleftitsriskomcer,MadelynAntoncic,outof
theloopwhenitmadethisinvestment.
1
Since the late 1os, Lehman had also built a large mortgage origination arm, a
formidable securities issuance business, and a powerful underwriting division as
well.Then,initsMarchioooGlobalStrategyOffsite,CEORichardFuldandother
executives explained to their colleagues a new move toward an aggressive growth
strategy, including greater risk and more leverage. They described the change as a
shift from a moving or securitization business to a storage business, in which
Lehmanwouldmakeandholdlonger-terminvestments.
1
By summer iooo, the housing market faced ballooning inventories, sharply re-
ducedsalesvolumes,andwaveringprices.Seniormanagementregularlydisregarded
thefrmsriskpoliciesandlimitsandwarningsfromriskmanagersandpursued
itscountercyclicalgrowthstrategy.Ithadworkedwellduringpriormarketdisloca-
tions,andLehmansmanagementassumedthatitwouldworkagain.
1,
LehmansAu-
roraunitcontinuedtooriginateAlt-Aloansafterthehousingmarkethadbegunto
showsignsofweakening.
1o
Lehmanalsocontinuedtosecuritizemortgageassetsfor
salebutwasnowholdingmoreofthemasinvestments.Acrossboththecommercial
andresidentialrealestatesectors,themortgage-relatedassetsonLehmansbooksin-
creasedfromo,billioninioooto111billioninioo,.Thisincreasewouldbepart
ofLehmansundoingayearlater.
Lehmans regulators did not restrain its rapid growth. The SEC, Lehmans main
regulator, knew of the frms disregard of risk management. The SEC knew that
Lehmancontinuedtoincreaseitsholdingofmortgagesecurities,andthatithadin-
creasedandexceededrisklimitsfactsnotedalmostmonthlyinomcialSECreports
obtainedbytheFCIC.
1,
Nonetheless,ErikSirri,wholedtheSECssupervisionpro-
gram, told the FCIC that it would not have mattered if the agency had fully recog-
nized the risks associated with commercial real estate. To avoid serious losses, Sirri
maintained,Lehmanwouldhavehadtostartsellingrealestateassetsiniooo.
18
In-
stead,itkeptbuying,wellintothefrstquarterofioo8.
Inaddition,accordingtothebankruptcyexaminer,Lehmanunderstateditslever-
age through Repo 1o, transactionsan accounting maneuver to temporarily re-
move assets from the balance sheet before each reporting period. Martin Kelly,
Lehmans global fnancial controller, stated that the transactions had no sub-
stancetheironlypurposeormotive . . .wasreductioninthebalancesheet.Other
LehmanexecutivesdescribedRepo1o,transactionsasanaccountinggimmickand
alazywayofmanagingthebalancesheetasopposedtolegitimatelymeetingbalance
sheet targets at quarter-end. Bart McDade, who became Lehmans president and
chief operating omcer in June ioo8, in an email called Repo 1o, transactions an-
otherdrugweRon.
1
Ernst&Young(E&Y),Lehmansauditor,wasawareoftheRepo1o,practicebut
did not question Lehmans failure to publicly disclose it, despite being informed in
Mayioo8byLehmanSeniorVicePresidentMatthewLeethatthepracticewasim-
proper. The Lehman bankruptcy examiner concluded that E&Y took virtually no
\ii i N .,,
actiontoinvestigatetheRepo1o,allegations, . . .tooknostepstoquestionorchal-
lengethenon-disclosurebyLehman,andthatcolorableclaimsexistthatE&Ydid
not meet professional standards, both in investigating Lees allegations and in con-
nectionwithitsauditandreviewofLehmansfnancialstatements.
1o
NewYorkAt-
torney General Andrew Cuomo sued E&Y in December io1o, accusing the frm of
facilitating a massive accounting fraud by helping Lehman to deceive the public
aboutitsfnancialcondition.
11
TheOmceofThriftSupervisionhadalsoregulatedLehmansince1through
its jurisdiction over Lehmans thrift subsidiary. Although the SEC was regarded as
theprimaryregulator,theOTSexaminertoldtheFCIC,weinnowayjustassumed
that[theSEC]woulddotherightthing,soweregulatedandsupervisedtheholding
company.
1i
Still, not until July ioo8just a few months before Lehman failed
wouldtheOTSissueareportwarningthatLehmanhadmadeanoutsizedbeton
commercial real estatelarger than that by its peer frms, despite Lehmans smaller
size;thatLehmanwasmateriallyoverexposedtothecommercialrealestatesector;
andthatLehmanhadmajorfailingsinitsriskmanagementprocess.
1
FANNIE MAE AND FREDDIE MAC: TWO STARK CHOICES
In ioo,, while Countrywide, Citigroup, Lehman, and many others in the mortgage
and CDO businesses were going into overdrive, executives at the two behemoth
GSEs, Fannie and Freddie, worried they were being left behind. One sign of the
times: Fannies biggest source of mortgages, Countrywide, expandedthat is, loos-
enedits underwriting criteria, and Fannie would not buy the new mortgages,
CountrywidePresidentandCOOSamboltoldtheFCIC.
1
Typicalofthemarketasa
whole,Countrywidesold,iofitsloanstoFannieinioobutonly,iniooand
iinioo,.
1,
The risk in the environment has accelerated dramatically, Thomas Lund, Fan-
niesheadofsingle-familylending,toldfellowsenioromcersatastrategicplanning
meetingonJunei,,ioo,.Inabulletedlist,hetickedoffchangesinthemarket:the
proliferation of higher risk alternative mortgage products, growing concern about
housing bubbles, growing concerns about borrowers taking on increased risks and
higherdebt,[and]aggressiverisklayering.
1o
Wefacetwostarkchoices:staythecourse[or]meetthemarketwherethemarket
is,Lundsaid.IfFannieMaestayedthecourse,itwouldmaintainitscreditdiscipline,
protect the quality of its book, preserve capital, and intensify the companys public
voiceonconcerns.However,itwouldalsofacelowervolumesandrevenues,contin-
ueddeclinesinmarketshare,lowerearnings,andaweakeningofkeycustomerrela-
tionships.
1,
It was simply a matter of relevance, former CEO Dan Mudd told the
FCIC:Ifyourenotrelevant,youreunproftable,andyourenotservingthemission.
Andtherewasdangertoproftability.Imspeakingmorelongtermthaninanygiven
quarteroranygivenyear.Sothiswasarealstrategicrethinking.
18
Lund saw signifcant obstacles to meeting the market. He noted Fannies lack of
capabilityandinfrastructuretostructurethetypesofriskiermortgage-backedsecu-
., ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
ritiesofferedbyWallStreet,itsunfamiliaritywiththenewcreditrisks,worriesthat
thepriceofthemortgageswouldntbeworththerisk,andregulatoryconcernssur-
roundingcertainproducts.
1
Atthisandothermeetings,Lundrecommendedstudy-
ingwhetherthecurrentmarketchangeswerecyclicalormorepermanent,buthealso
recommended that Fannie dedicate signifcant resources to develop capabilities to
competeinanymortgageenvironment.
1,o
Citibankexecutivesalsomadeapresenta-
tion to Fannies board in July ioo,, warning that Fannie was increasingly at risk of
beingmarginalized,andthatstaythecoursewasnotanoption.Citibankproposed
that Fannie expand its guarantee business to cover nontraditional products such as
Alt-A and subprime mortgages.
1,1
Of course, as the second-largest seller of mort-
gagestoFannie,Citibankwouldbeneftfromsuchamove.Overthenexttwoyears,
CitibankwouldincreaseitssalestoFanniebymorethanaquarter,to,obillionin
theioo,fscalyear,whilemorethantriplingitssalesofinterest-onlymortgages,to
billion.
1,i
LundtoldtheFCICthatinioo,,theboardwouldadopthisrecommendation:for
thetimebeing,Fanniewouldstaythecourse,whiledevelopingcapabilitiestocom-
pete with Wall Street in nonprime mortgages.
1,
In fact, however, internal reports
showthatbySeptemberioo,,thecompanyhadalreadybeguntoincreaseitsacquisi-
tionsofriskierloans.Bytheendofioo,,itsAlt-Aloanswere181billion,upfrom
1,billioniniooand18billioninioo;itsloanswithoutfulldocumentation
werei,8billion,upfromioobillioninioo;anditsinterest-onlymortgageswere
,,billioninioo,,upfrom1ibillioninioo.(Notethatthesecategoriescanover-
lap.Forexample,Alt-Aloansmayalsolackfulldocumentation.)Tocoverpotential
lossesfromallofitsbusinessactivities,Fanniehadatotalofobillionincapitalat
theendofioo,.Planstomeetmarketsharetargetsresultedinstrategiestoincrease
purchases of higher risk products, creating a confict between prudent credit risk
management and corporate business objectives, the Federal Housing Finance
Agency(thesuccessortotheOmceofFederalHousingEnterpriseOversight)would
write in September ioo8 on the eve of the government takeover of Fannie Mae.
Sinceioo,,FannieMaehasgrownitsAlt-Aportfolioandotherhigherriskproducts
rapidlywithoutadequatecontrolsinplace.
1,
Initsfnancialstatements,FannieMaesdisclosuresaboutkeyloancharacteristics
changedovertime,makingitdimculttodiscernthecompanysexposuretosubprime
andAlt-Amortgages.Forexample,fromioo,untilioo,,thecompanysdefnitionof
asubprimeloanwasoneoriginatedbyacompanyorapartofacompanythatspe-
cialized in subprime loans. Using that defnition, Fannie Mae stated that subprime
loansaccountedforlessthan1ofitsbusinessvolumeduringthoseyearsevenwhile
it reported that , of its conventional, single-family loans in ioo,, iooo and ioo,
loansweretoborrowerswithFICOscoreslessthanoio.
1,,
Similarly, Freddie had enlarged its portfolios quickly with limited capital.
1,o
In
ioo,,CEORichardSyronfredDavidAndrukonis,Freddieslongtimechiefriskom-
cer. Syron said one of the reasons that Andrukonis was fred was that Andrukonis
wasconcernedaboutrelaxingunderwritingstandardstomeetmissiongoals.Hetold
theFCIC,Ihadalegitimatedifferenceofopiniononhowdangerousitwas.Now,as
\ii i N .,,
it turns out . . . he was able to foresee the market better than a lot of the rest of us
could.
1,,
Thenewriskomcer,AnuragSaksena,recountedtotheFCICstaffthathe
repeatedly made the case for increasing capital to compensate for the increasing
risk,
1,8
althoughDonaldBisenius,Freddiesexecutivevicepresidentforsingle-family
housing,toldFCICstaffthathedidnotrecallsuchdiscussions.
1,
Syronnevermade
Saksenapartoftheseniormanagementteam.
1oo
OFHEO,theGSEsregulator,notedtheirincreasingpurchasesofriskierloansand
securities in every examination report. But OFHEO never told the GSEs to stop.
Rather,yearafteryear,theregulatorsaidthatbothcompanieshadadequatecapital,
strongassetquality,prudentcreditriskmanagement,andqualifedandactiveomcers
anddirectors.
InMayiooo,atthesametimeasitpaidaoomillionpenaltyrelatedtodefcien-
ciesinitsaccountingpractices,Fannieagreedtolimititson-balance-sheetmortgage
portfolioto,i8billion,thelevelonDecember1,ioo,.
1o1
Twomonthslater,Fred-
die agreed to limit the growth of its portfolio to i per year.
1oi
In examination re-
ports for the year ioo,, issued to both companies in May iooo, OFHEO noted the
growthinpurchasesofriskyloansandnon-GSEsecuritiesbutconcludedthateach
GSEhadstrongassetqualityandwasadequatelycapitalized.OFHEOreportedthat
management at Freddie was committed to resolving weaknesses and its Board was
qualifedandactive.Theioo,examinationofFanniewaslimitedinscopefocus-
ing primarily on the companys efforts to fx accounting and internal control def-
cienciesbecauseoftheextensiveresourcesneededtocompleteathree-yearspecial
examinationinitiatedinthewakeofFanniesaccountingscandal.
1o
Inthatspecialexamination,OFHEOpinnedmanyoftheGSEsproblemsontheir
corporatecultures.ItsMayiooospecialexaminationreportonFannieMaedetailedthe
arrogant and unethical corporate culture where Fannie Mae employees manipulated
accountingandearningstotriggerbonusesforseniorexecutivesfrom18toioo.
1o
OFHEODirectorJamesLockhart(whohadassumedthatpositionthemonththere-
port was issued) recalled discovering during the special examination an email from
Mudd, then Fannies chief operating omcer, to CEO Franklin Raines. Mudd wrote,
Theoldpoliticalreality[atFannie]wasthatwealwayswon,wetooknoprisoners . . .
weusedto . . .beabletowrite,orhavewrittenrulesthatworkedforus.
1o,
Soonafterhisarrival,Lockhartbeganadvocatingforreform.Theneedforlegis-
lationwasobviousasOFHEOwasregulatingtwoofthelargestandmostsystemati-
cally important US fnancial institutions, he told the FCIC.
1oo
But no reform
legislationwouldbepasseduntilJulyo,ioo8,andbythenitwouldbetoolate.
aoo.Incrcescourcnctretionintosuorimc
AfterseveralyearsduringwhichFannieMaepurchasedriskierloansandsecurities,
then-ChiefFinancialOmcerRobertLevinproposedastrategicinitiativetoincrease
our penetration into subprime at Fannies January iooo board meeting.
1o,
In the
nextmonththeboardgaveitsapproval.
1o8
Fanniewouldbecomemoreandmoreag-
gressive in its purchases. During a summer retreat for Fannies senior omcers, as
.+ ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
StephenAshley,thechairmanoftheboard,introducedFanniesnewchiefriskomcer,
Enrico Dallavecchia, he declared that the new CRO would not stand in the way of
risktaking:Wehavetothinkdifferentlyandcreativelyaboutrisk,aboutcompliance,
andaboutcontrols.HistoricallythesehavenotbeenstrongsuitsofFannieMae. . . .
Todays thinking requires that these areas become active partners with the business
units and be viewed as tools that enable us to develop product and address market
needs.EnricoDallavecchiawasnotbroughton-boardtobeabusinessdampener.
1o
Iniooo,Fannieacquired,1obillionofloans;ofthose(includingsomeoverlap),
o,billion,orabout1,hadcombinedloan-to-valueratiosabove,;1,were
interest-only;andi8didnothavefulldocumentation.
1,o
Fanniealsopurchasedo
billionofsubprimeand1ibillionofAlt-Anon-GSEmortgage-backedsecurities.
1,1
Thetotalamountofriskierloansrepresentedlargermultiplesofcapitalthanbefore.
Atleastinitially,whilehousepriceswerestillincreasing,thestrategicplantoin-
creaseriskandmarketshareappearedtobesuccessful.Fanniereportednetincome
of o billion in ioo, and then billion in iooo. In those two years, CEO Mudds
compensationtotaledi.millionandLevin,whowasinterimCFOandthenchief
businessomcer,received1,.,million.
1,i
Iniooo,FreddieMacalsocontinuedtoincreaserisk,expand[ing]thepurchase
and guarantee of higher-risk mortgages . . . to increase market share, meet mission
goals, stay competitive, and be responsive to sellers needs.
1,
It lowered its under-
writingstandards,increasingtheuseofcreditpolicywaiversandexceptions.Newer
alternative products, offered to a broader range of customers than ever before, ac-
countedforaboutiofthatyearspurchases.FreddieMacsplanalsoseemedtobe
successful. The company increased risk and market share while maintaining the
samenetincomeforioo,andiooo,ibillion.
1,
CEORichardSyronscompensation
totaledi.imillionforioo,andiooocombined,
1,,
whileChiefOperatingOmcer
EugeneMcQuadereceived1.million.
1,o
Again, OFHEO was aware of these developments. Its March ioo, report noted
thatFanniesnewinitiativetopurchasehigher-riskproductsincludedaplantocap-
tureioofthesubprimemarketbyio11.AndOFHEOreportedthatcreditriskin-
creasedslightlybecauseofgrowthinsubprimeandothernontraditionalproducts.
Butoverallassetqualityinitssingle-familybusinesswasfoundtobestrong,andthe
boardmemberswerequalifedandactive.And,ofcourse,Fanniewasadequately
capitalized.
1,,
Similarly, OFHEO told Freddie in ioo, that it had weaknesses that raised some
possibilityoffailure,butthatoverall,Freddiesstrengthandfnancialcapacitymade
failure unlikely.
1,8
Freddie did remain a signifcant supervisory concern,
1,
and
OFHEOnotedthesignifcantshifttowardhigher-riskmortgages.
18o
Butagain,asin
previous years, the regulator concluded that Freddie had adequate capital, and its
assetqualityandcreditriskmanagementwerestrong.
181
TheGSEschargedafeeforguaranteeingpaymentsonGSEmortgagebackedsecu-
rities,andOFHEOwassilentaboutFanniespracticeofcharginglesstoguaranteesecu-
rities than their models indicated was appropriate. Mark Winer, the head of Fannies
Business,AnalysisandDecisionsGroupsinceMayioooandthepersonresponsiblefor
\ii i N ..
modelingpricingfees,raisedconcernsthatFannieMaewasnotchargingfeesforAlt-A
mortgagesthatadequatelycompensatedfortherisk.WinerrecalledthatLevinwascrit-
icalofhismodels,asking,Canyoushowmewhyyouthinkyourerightandeveryone
elseiswrong:
18i
Underchargingfortheguaranteefeeswasintendedtoincreasemarket
share,accordingtoToddHempstead,theseniorvicepresidentatFannieinchargeof
thewesternregion.
18
Muddacknowledgedthedifferencebetweenthemodelfeeand
thefeeactuallychargedandalsotoldtheFCICthatthescarcityofhistoricaldatafor
manyloanscausedthemodelfeetobeunreliable.
18
In the September o, ioo8, memo that would recommend that Fannie be placed
into conservatorship, OFHEO would expressly cite this practice as unsafe and un-
sound: During iooo and ioo,, modeled loan fees were higher than actual fees
charged, due to an emphasis on growing market share and competing with Wall
StreetandtheotherGSE.
18,
aoo,.Movingcccrintot/ccrcitool
Bythetimehousingpriceshadpeakedinthesecondquarterofiooo,delinquencies
hadstartedtorise.DuringtheboardmeetingheldinAprilioo,,Lundsaidthatdis-
location in the housing market was an opportunity for Fannie to reclaim market
share.Atthesametime,Fanniewouldsupportthehousingmarketbyincreasingliq-
uidity.
18o
At the next months meeting, Lund reported that Fannies market share
couldincreasetooofromabout,iniooo.
18,
Indeed,inioo,FannieMaeforged
ahead,purchasingmorehigh-riskloans.
188
Fanniealsopurchased1obillionofsub-
primenon-GSEsecurities,and,billionofAlt-A.
18
In June, Fannie prepared its ioo, fve-year strategic plan, titled Deepen Seg-
mentsDevelop Breadth. The plan, which mentioned Fannies tough new chal-
lengesa weakening housing market and slower-growing mortgage debt
marketincludedtakingandmanagingmoremortgagecreditrisk,movingdeeper
intothecreditpooltoservealargeandgrowingpartofthemortgagemarket.Over-
all, revenues and earnings were projected to increase in each of the following fve
years.
1o
Management told the board that Fannies risk management function had all the
necessarymeansandbudgettoactontheplan.ChiefRiskOmcerDallavecchiadid
notagree,especiallyinlightofaplanned1ocutinhisbudget.InaJuly1o,ioo,,
emailtoCEOMudd,Dallavecchiawrotethathewasveryupsetthathehadtohearat
theboardmeetingthatFanniehadthewillandthemoneytochangeourcultureand
supporttakingmorecreditrisk,giventheproposedbudgetcutforhisdepartmentin
ioo8afterai,reductioninheadcountinioo,.
11
Inanearlieremail,Dallavecchia
hadwrittentoChiefOperatingOmcerMichaelWilliamsthatFanniehadoneofthe
weakest control processes that he everwitnessed in [his] career, . . . was not even
closetohavingpropercontrolprocessesforcredit,marketandoperationalrisk,and
was already back to the old days of scraping on controls . . . to reduce expenses.
Thesedefcienciesindicatedthatpeopledontcareaboutthe[risk]functionorthey
dontgetit.
1i
.z ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
Muddresponded,Myexperienceisthatemailisnotaverygoodvenueforcon-
versation,ventingornegotiating.IfDallavecchiafeltthathehadbeendealtwithin
badfaith,heshouldaddressitmantoman,unlesshewantedMuddtobetheone
tocarrymessagesforyoutoyourpeers.Muddconcluded,Pleasecomeandseeme
today face to face.
1
Dallavecchia told the FCIC that when he wrote this email he
wastiredandupset,andthattheviewitexpressedwasmoreextremethanwhathe
thoughtatthetime.
1
Fannie,aftercontinuingtopurchaseandguaranteehigher-risk
mortgagesinioo,,wouldreportai.1billionnetlossfortheyear,causedbycredit
losses. In ioo,, Mudds compensation totaled 11.o million and Levins totaled
,million.
In ioo,, Freddie Mac also persisted in increasing purchases of riskier loans. A
strategic plan from March highlighted pressure on the franchise and the risk of
fallingbelowourreturnaspirations.
1,
Thecompanywouldtrytoimproveearnings
by entering adjacent markets: Freddie Mac has competitive advantages over non-
GSE participants in nonprime, the strategy document explained. We have an op-
portunity to expand into markets we have missedSubprime and Alt-A.
1o
It took
that opportunity. As OFHEO would note in its ioo, examination report, Freddie
purchasedandguaranteedloansoriginatedinioooandioo,withhigher-riskchar-
acteristics,includinginterest-onlyloans,loanswithFICOscoreslessthanoio,loans
with higher loan-to-value ratios, loans with high debt-to-income ratios, and loans
without full documentation. Financial results in ioo, were poor: a .1 billion net
lossdrivenbycreditlosses.Thevalueofthe1,ibillionsubprimeandAlt-Aprivate-
labelsecuritiesbooksuffereda1billiondeclineinmarketvalue.
1,
Inioo,,Syrons
compensationtotaled18.millionandMcQuadestotaled.8million.
\jjoreolc/ousinggoels.6SIscricoloo;murcrjorcvcr
Asdiscussedearlier,beginningin1,8,theDepartmentofHousingandUrbanDevel-
opment(HUD)periodicallysetgoalsfortheGSEsrelatedtoincreasinghomeowner-
ship among low- and moderate-income borrowers and borrowers in underserved
areas.Untilioo,,thesegoalswerebasedonthefractionofthetotalmortgagemarket
madeupoflow-andmoderate-incomefamilies.Thegoalswereintendedtobeonlya
modestreachbeyondthemortgagesthattheGSEswouldnormallypurchase.
18
From1,toiooo,iofGSEpurchaseswererequiredtomeetgoalsforlow-
andmoderate-incomeborrowers.Inioo1,thegoalwasraisedto,o.
1
Muddsaid
thataslongasthegoalsremainedbelowhalfoftheGSEslending,loansmadeinthe
normalcourseofbusinesswouldsatisfythegoals:Whatcomesinthedoorthrough
thenaturalcourseofbusinesswilltendtomatchthemarket,andthereforewilltend
tomeetthegoals.
ioo
LevintoldtheFCICthattherewasagreatdealofbusinessthat
camethroughnormalchannelsthatmetgoalsandthatmostoftheloansthatsatis-
fedthegoalswouldhavebeenmadeanyway.
io1
IniooHUDannouncedthatstartinginioo,,,ioftheGSEspurchaseswould
needtosatisfythelow-andmoderate-incomegoals.Thetargetswouldreach,,in
ioo,and,oinioo8.
ioi
Giventhedramaticgrowthinthenumberofriskierloans
\ii i N .,
originatedinthemarket,thenewgoalswereclosertowherethemarketreallywas.
But, as Mudd noted, When ,o became ,,[] ultimately, then you have to work
harder,paymoreattention,andcreateapreferenceforthoseloans.
io
Targetedgoals
loans(loansmadespecifcallytomeetthetargets),whilealwaysasmallshareofthe
GSEspurchases,roseinimportance.
Mudd testifed that by ioo8, when the housing market was in turmoil, Fannie
Maecouldnolongerbalanceitsobligationstoshareholderswithitsaffordablehous-
inggoalsandothermission-relateddemands:Theremayhavebeennowaytosat-
isfy1ooofthemyriaddemandsforFannieMaetosupportallmannerofprojects
[or]housinggoalswhichweresetabovetheoriginationlevelsinthemarketplace.
io
AsthecombinedsizeoftheGSEsrosesteadilyfrom.otrillioniniooto.tril-
lioninioo,,
io,
thenumberofmortgageborrowersthattheGSEsneededtoservein
order to fulfll the affordable housing goals also rose. By ioo,, Fannie and Freddie
werestretchingtomeetthehighergoals,accordingtoanumberofGSEexecutives,
OFHEOomcials,andmarketobservers.
Yet all but two of the dozens of current and former Fannie Mae employees and
regulatorsinterviewedonthesubjecttoldtheFCICthatreachingthegoalswasnot
theprimarydriveroftheGSEspurchasesofriskiermortgagesandofsubprimeand
Alt-A non-GSE mortgagebacked securities. Executives from Fannie, including
Mudd,pointedtoamixofreasonsforthepurchases,suchasreversingthedeclines
inmarketshare,respondingtooriginatorsdemands,andrespondingtoshareholder
demandstoincreasemarketshareandprofts,inadditiontofulfllingthemissionof
meetingaffordablehousinggoalsandprovidingliquiditytothemarket.
Forexample,LevintoldtheFCICthatwhileFannie,tomeetitshousinggoals,did
purchasesomesubprimemortgagesandmortgage-backedsecuritiesitwouldother-
wisehavepassedup,Fanniewasdriventomeetthemarketandtoreversedeclining
marketshare.Ontheotherhand,hesaidthatmostAlt-Aloanswerehigh-income-
oriented and would not have counted toward the goals, so those were purchased
solelytoincreaseprofts.
ioo
Similarly,LundtoldtheFCICthatthedesireformarket
sharewasthemaindriverbehindFanniesstrategyiniooo.Housinggoalshadbeena
factor,butnottheprimaryone.
io,
AndDallavecchialikewisetoldtheFCICthatFan-
nieincreaseditspurchasesofAlt-Aloanstoregainrelevanceinthemarketandmeet
customerneeds.
io8
Hempstead, Fannies principal contact with Countrywide, told the FCIC that
whilehousinggoalswereonereasonforFanniesstrategy,themainreasonFannieen-
teredtheriskiermortgagemarketwasthatthosewerethetypesofloansbeingorigi-
nated in the primary market.
io
If Fannie wanted to continue purchasing large
quantities of loans, the company would need to buy riskier loans. Kenneth Bacon,
Fannies executive vice president of multifamily lending, said much the same thing,
andaddedthatshareholdersalsowantedtoseemarketshareandreturnsrise.
i1o
For-
mer Fannie chairman Stephen Ashley told the FCIC that the change in strategy in
ioo,andiooowasowedtoamixofreasons,includingthedesiretoregainmarket
share and the need to respond to pressures from originators as well as to pressures
fromrealestateindustryadvocatestobemoreengagedinthemarketplace.
i11
., ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
Toensureanadequatesupplyofmortgagesincasethegoalswerenotmetinthe
normalcourseofbusiness,FannieandFreddieinstitutedoutreachprogramsinun-
derservedgeographicareasandconductededucationalprogramsfororiginatorsand
brokers.
i1i
Inaddition,asexplainedbyMikeQuinn,theFannieexecutiveresponsible
forthegoals,Fanniesetlowerfeesonloansthatmetthegoals,althoughitwouldnot
purchase mortgages that fell outside its predetermined risk targets.
i1
Ashley also
maintained that Fannie did not shift eligibility or underwriting standards to meet
goalsbutinsteaddirecteditsresourcestomarketingandpromotionalefforts,hous-
ingfairs,andoutreachprogramsrunbythecompanyspartnershipomces.Theef-
fort was really in the outreach as opposed to reduced or diminished or loosened
standards,AshleytoldtheFCIC.
i1
FormerOFHEODirectorArmandoFalconJr.testifedthattheGSEsinvestedin
subprimeandAlt-Amortgagesinordertoincreaseproftsandregainmarketshare
andthatanyimpactonmeetingaffordablehousinggoalswassimplyaby-productof
thisactivity.
i1,
Lockhart,asubsequentOFHEOdirector,attributedtheGSEschange
instrategytotheirdriveforproftandmarketshare,aswellastheneedtomeethous-
inggoals.Notingthattheaffordablehousinggoalsincreasedmarkedlyinioo,,
i1o
he
saidinanFCICinterviewthatthegoalswerejustonereason,certainlynottheex-
clusivereasonforthechange.
i1,
Theseviewswerecorroboratedbynumerousother
omcialsfromtheagency.
i18
The former HUD omcial Mike Price told the FCIC that while the GSEs cried
bloodymurderforeverwhenitcametothegoals,theytoutedtheircontributionto
increasinghomeownership.Inaddition,PriceandotherHUDomcialstoldtheFCIC
thattheGSEsneverclaimedthatmeetingthegoalswouldleavetheminanunsafeor
unsoundcondition.
i1
Indeed,thelawallowedbothFannieMaeandFreddieMactofallshortofmeeting
housing goals that were infeasible or that would affect the companies safety and
soundness.
iio
AndwhiletheGSEsoftenexceededthegoals,insomecasesthosetar-
gets were adjusted downward by HUD or, in rare cases, were simply missed by the
GSEs.
ii1
Forexample,onDecember1i,ioo,,MuddwrotetoHUD:FannieMaebe-
lievesthatthelow-andmoderate-incomeandspecialaffordablesubgoalsareinfeasi-
ble for ioo,.
iii
Fannie Maes ioo, strategic plan had already anticipated such a
communication,stating,Intheeventwereachaviewpointthatachievingthegoals
thisyearisinfeasible,wewilldeterminehowbesttoaddressthematterwithHUD
andwillcontinuetokeeptheBoardapprisedaccordingly.
ii
Infact,bothFannieand
FreddieappealedtoHUDtolowertwocomponentsofthegoalsforaffordablehous-
ing.HUDcompliedandallowedtheGSEstofallshortwithoutanyconsequences.
ii
1/cimectojt/cgoels
AtleastuntilHUDsetnewaffordablehousinggoalsforioo,,theGSEsonlysupple-
mented their routine purchases with a small volume of loans and non-GSE mort-
gagebackedsecuritiesneededtomeettheirrequirements.TheGSEsknewthatthey
might not earn as much on these targeted goal loans as they would earn on both
\ii i N .,
goal-qualifyingandnon-goal-qualifyingloanspurchasedintheusualcourseofbusi-
ness;onsomeoftheseloans,theymightevenlosemoney.Theorganizationsalsohad
administrativeandothercostsrelatedtothehousinggoals.
In June ioo Freddie Mac staff made a presentation to the Business and Risk
CommitteeoftheBoardofDirectorsonthecostsofmeetingitsgoals.Fromioooto
ioo, the cost of the targeted goal loans was effectively zero, as the goals were
reachedthroughproftableexpansionofthecompanysmultifamilybusiness.Dur-
ingtherefnanceboom,thegoalsbecamemorechallengingandcostFreddiemoney
in the multifamily business; thus, only after ioo did meeting the multifamily and
single-familygoalscosttheGSEmoney.Still,onlyaboutofallloanspurchasedby
Freddiebetweenioo,andioo8wereboughtspecifcallybecausetheycontributeto
thegoalsloansitlabeledastargetedaffordable.Theseloansdidhavehigherthan
averageexpecteddefaultrates,althoughFreddiealsochargedahigherfeetoguaran-
tee them. From ioo through ioo8, Freddies costs of complying with the housing
goalsaveragedioomillionannually.Thecostsofcomplyingwiththesegoalstook
intoaccountthreecomponents:expectedrevenues,expecteddefaults,andforegone
revenues(basedonanassumptionofwhattheymighthaveearnedelsewhere).These
costs were only computed on the narrow set of loans specifcally purchased to
achieve the goals, as opposed to goal-qualifying loans purchased in the normal
courseofbusiness.
ii,
Forcomparison,thecompanysnetearningsaveragedjustun-
derbillionperyearfromiootoiooo.
iio
In ioo, Fannie Mae retained McKinsey and Citigroup to determine whether it
would be worthwhile to give up the companys charter as a GSE, whichwhile af-
fording the company enormous beneftsimposed regulations and put constraints
on business practices, including its mission goals. The fnal report to Fannie Maes
top management, called Project Phineas, found that the explicit cost of compliance
withthegoalsfromioootoioowasclosetozero:itishardtodiscernafundamen-
talmarginalcosttomeetingthehousinggoalsonthesinglefamilybusinessside.
ii,
The report came to this conclusion despite the slightly greater dimculty of meeting
thegoalsintheioorefnancingboom:thelargenumbersofhomeownersrefnanc-
ing,inparticularthosewhoweremiddleandupperincome,necessarilyreducedthe
percentageofthepoolthatwouldqualifyforthegoals.
In calculating these costs, the consultants computed the difference between fees
chargedongoal-qualifyingloansandthehigherfeessuggestedbyFanniesownmod-
els.Butthiscostwasnotuniquetogoalqualifyingloans.Acrossitsportfolio,Fannie
chargedlowerfeesthanitsmodelscomputedforgoalsloansaswellasfornon-goals
loans.Asaresult,goalsloans,eventargetedgoalsloans,werenotsolelyresponsible
forthiscost.Infact,Fanniesdiscountwasactuallysmallerformanygoal-qualifying
loansthanfortheothersfromioootoioo.
Facingmoreaggressivegoalsinioooandioo,,FannieMaeexpandedinitiatives
to purchase targeted goals loans. These included mortgages acquired under the My
CommunityMortgageprogram,mortgagesunderwrittenwithlooserstandards,and
manufacturedhousingloans.Fortheseloans,Fannieexplicitlycalculatedtheoppor-
tunity cost (foregone revenues based on an assumption of what they might have
. ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
\ii i N .,
earnedelsewhere)alongwiththeso-calledcashfowcost,orthedifferencebetween
their expected losses and expected revenue on these loans. For iooo, as the market
waspeaking,FannieMaeestimatedthecashfowcostoftheloanstobe11,million
and the opportunity cost of the targeted goals loans o million, compared to net
incomethatyeartoFannieof.1billionafgurethatincludesreturnsonthegoal-
qualifying loans made during the normal course of business.
ii8
The targeted goals
loansamountedto18billion,or.,ofFannieMaes,ibillionofsingle-family
mortgagepurchasesiniooo.
ii
Asthemarketstightenedinthemiddleofioo,,the
opportunitycostforthatyearwasforecasttoberoughly1billion.
io
Lookingbackathowthetargetedaffordableportfolioperformedincomparison
with overall losses, the ioo presentation at Freddie Mac took the analysis of the
goalscostsonestepfurther.Whiletheoutstandingoobillionofthesetargetedaf-
fordableloanswasonlyofthetotalportfolio,thesewererelativelyhigh-riskloans
andwereexpectedtoaccountfor1oftotalprojectedlosses.Infact,asoflateioo8,
theyhadaccountedforonly8oflossesmeaningthattheyhadperformedbetter
than expected in relation to the whole portfolio. The companys major losses came
from loans acquired in the normal course of business. The presentation noted that
manyofthesedefaultedloanswereAlt-A.
i1
COMMISSION CONCLUSIONS ON CHAPTER 9
The Commission concludes that frms securitizing mortgages failed to perform
adequateduediligenceonthemortgagestheypurchasedandattimesknowingly
waived compliance with underwriting standards. Potential investors were not
fullyinformedorweremisledaboutthepoorqualityofthemortgagescontained
insomemortgage-relatedsecurities.Theseproblemsappeartohavebeensignif-
cant. The Securities and Exchange Commission failed to adequately enforce its
disclosure requirements governing mortgage securities, exempted some sales of
such securities from its review, and preempted states from applying state law to
them,therebyfailinginitscoremissiontoprotectinvestors.
TheFederalReservefailedtorecognizethecataclysmicdangerposedbythe
housingbubbletothefnancialsystemandrefusedtotaketimelyactiontocon-
strain its growth, believing that it could contain the damage from the bubbles
collapse.
Lax mortgage regulation and collapsing mortgage-lending standards and
practicescreatedconditionsthatwereripeformortgagefraud.
10
THE MADNESS
CONTENTS
CDOnanagcrsVcarcnctarcnt-a-nanagcr +:,
Crcditdcjau|tswapsDun|qucsticn+,o
CitigrcupIdcnct|c|icvcwcwcrcpcwcr|css+,,
AIGInnctgcttingpaidcncughtcstandcnthcsctracks :oo
Mcrri||Vhatcvcrittakcs:o:
Rcgu|atcrsArcunducccnccntraticnscjriskdcvc|cping? :o,
MccdysItwasa||a|cutrcvcnuc:oe
Thecollateralizeddebtobligationmachinecouldhavesputteredtoanaturalendby
thespringofiooo.Housingpricespeaked,andAIGstartedtoslowdownitsbusiness
ofinsuringsubprime-mortgageCDOs.ButitturnedoutthatWallStreetdidntneed
itsgoldengooseanymore.Securitiesfrmswerestartingtotakeonasignifcantshare
of the risks from their own deals, without AIG as the ultimate bearer of the risk of
lossesonsuper-seniorCDOtranches.Themachinekepthummingthroughoutiooo
and into ioo,. That just seemed kind of odd, given everything we had seen and
what we had concluded, Gary Gorton, a Yale fnance professor who had designed
AIGsmodelforanalyzingitsCDOpositions,toldtheFCIC.
1
The CDO machine had become self-fueling. Senior executivesparticularly at
three of the leading promoters of CDOs, Citigroup, Merrill Lynch, and UBS
apparently did not accept or perhaps even understand the risks inherent in the
products they were creating. More and more, the senior tranches were retained by
thearrangingsecuritiesfrms,themezzaninetrancheswereboughtbyotherCDOs,
and the equity tranches were bought by hedge funds that were often engaged in
complextradingstrategies:theymademoneywhentheCDOsperformed,butcould
also make money if the market crashed. These factors helped keep the mortgage
market going long after house prices had begun to fall and created massive expo-
suresonthebooksoflargefnancialinstitutionsexposuresthatwouldultimately
bringmanyofthemtothebrinkoffailure.
The subprime mortgage securitization pioneer Lewis Ranieri called the willing
suspension of prudent standards the madness. He told the FCIC, You had the
.
breakdown of the standards, . . . because you break down the checks and balances
thatnormallywouldhavestoppedthem.
i
Synthetic CDOs boomed. They provided easier opportunities for bullish and
bearishinvestorstobetforandagainstthehousingboomandthesecuritiesthatde-
pended on it. Synthetic CDOs also made it easier for investment banks and CDO
managers to create CDOs more quickly. But synthetic CDO issuers and managers
had two sets of customers, each with different interests. And managers sometimes
hadhelpfromcustomersinselectingthecollateralincludingthosewhowerebet-
ting against the collateral, as a high-profle case launched by the Securities and Ex-
changeCommissionagainstGoldmanSachswouldeventuallyillustrate.

Regulators reacted weakly. As early as ioo,, supervisors recognized that CDOs


andcreditdefaultswaps(CDS)couldactuallyconcentrateratherthandiversifyrisk,
buttheyconcludedthatWallStreetknewwhatitwasdoing.Supervisorsissuedguid-
anceinlateiooowarningbanksoftherisksofcomplexstructuredfnancetransac-
tionsbut excluded mortgage-backed securities and CDOs, because they saw the
risksofthoseproductsasrelativelystraightforwardandwellunderstood.

Disasterwasfastapproaching.
CDO MANAGERS: WE ARE NOT A RENTAMANAGER
Duringthemadness,wheneveryonewantedapieceoftheaction,CDOmanagers
facedgrowingcompetitivepressures.Managerscompensationdeclined,asdemand
for mortgage-backed securities drove up prices, squeezing the proft they made on
CDOs.Atthesametime,newCDOmanagerswereenteringthearena.WingChau,a
CDO manager who frequently worked with Merrill Lynch, said the fees fell by half
formezzanineCDOsovertime.
,
Andoverallcompensationcouldbemaintainedby
creatingandmanagingmorenewproduct.
Morethanhadbeenthecasethreeorfouryearsearlier,inpickingthecollateral
themanagerswereinfuencedbytheunderwritersthesecuritiesfrmsthatcreated
andmarketedthedeals.AnFCICsurveyofoCDOmanagersconfrmedthispoint.
o
Sometimes managers were given a portfolio constructed by the securities frm; the
managerswouldthenchoosethemortgageassetsfromthatportfolio.Theequityin-
vestorswhoofteninitiatedthedealinthefrstplacealsoinfuencedtheselection
ofassetsinmanyinstances.Still,somemanagerssaidthattheyactedindependently.
Wearenotarent-a-manager,weactuallyselectourcollateral,saidLloydFass,the
generalcounselatVerticalCapital.
,
Aswewillsee,securitiesfrmsoftenhadparticu-
lar CDO managers with whom they preferred to work. Merrill, the market leader,
had a constellation of managers; CDOs underwritten by Merrill frequently bought
tranchesofotherMerrillCDOs.
According to market participants, CDOs stimulated greater demand for mort-
gage-backed securities, particularly those with high yields, and the greater demand
inturnaffectedthestandardsfororiginatingmortgagesunderlyingthosesecurities.
8
Asstandardsfell,atleastonefrmoptedout:PIMCO,oneofthelargestinvestment
1ui \\iNi: : .,
fundsinthecountry,whoseCDOmanagementunitwasoneofthenationslargestin
ioo.Earlyinioo,,itannouncedthatitwouldnotmanageanynewdeals,inpartbe-
causeofthedeteriorationinthecreditqualityofmortgage-backedsecurities.There
is an awful lot of moral hazard in the sector, Scott Simon, a managing director at
PIMCO, told the audience at an industry conference in ioo,. You either take the
highroadoryoudontwerenotgoingtohurtaccountsordamageourreputation
for fees. Simon said the rating agencies methodologies were not sumciently strin-
gent,particularlybecausetheywerebeingappliedtonewtypesofsubprimeandAlt-
Aloanswithlittleornohistoricalperformancedata.

Noteveryoneagreedwiththis
viewpoint. Managers who are sticking in this business are doing it right, Armand
Pastine,thechiefoperatingomceratMaximGroup,respondedatthatsameconfer-
ence.TosuggestthatCDOmanagerswouldpulloutofaneconomicallyviabledeal
formoralreasonsthatsacop-out.
1o
Aswastypicalfortheindustryduringthecri-
sis, two of Maxims eight mortgage-backed CDOs, Maxim High Grade CDO I and
Maxim High Grade CDO II, would default on interest payments to investorsin-
cluding investors holding bonds that had originally been rated triple-Aand the
othersixwouldbedowngradedtojunkstatus,includingall ofthoseoriginallyrated
triple-A.
11
AnotherdevelopmentalsochangedtheCDOs:inioo,andiooo,CDOmanagers
werelesslikelytoputtheirownmoneyintotheirdeals.Earlyinthedecade,investors
hadtakenthemanagersinvestmentintheequitytrancheoftheirownCDOstobe
an assurance of quality, believing that if the managers were sharing the risk of loss,
theywouldhaveanincentivetopickcollateralwisely.Butthisfail-safelostforceas
theamountofmanagersinvestmentpertransactiondeclinedovertime.ACAMan-
agement,aunitofthefnancialguarantorACACapital,providesagoodillustration
of this trend. ACA held 1oo of the equity in the CDOs it originated in iooi and
ioo,,iando1oftwodealsitoriginatedinioo,between1oandi,ofdeals
inioo,,andbetweenoand11ofdealsiniooo.
1i
AndsyntheticCDOs,aswewillsee,hadnofail-safeatallwithregardtotheman-
agers incentives. By the very nature of the credit default swaps bundled into these
synthetics,customersontheshortsideofthedealwerebettingthattheassetswould
fail.
CREDIT DEFAULT SWAPS: DUMB QUESTION
InJuneioo,,derivativesdealersintroducedthepay-as-you-go creditdefaultswap,
acomplexinstrumentthatmimickedthetimingofthecashfowsofrealmortgage-
backedsecurities.
1
Becauseofthisfeature,thesyntheticCDOsintowhichthesenew
swapswerebundledweremucheasiertoissueandsell.
Thepay-as-you-goswapalsoenabledasecondmajordevelopment,introducedin
Januaryiooo:thefrstindexbasedonthepricesofcreditdefaultswapsonmortgage-
backedsecurities.KnownastheABX.HE,itwasreallyaseriesofindices,meanttoact
asasortofDowJonesIndustrialAverageforthenonprimemortgagemarket,andit
becameapopularwaytobetontheperformanceofthemarket.Everysixmonths,a
.,+ ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
consortium of securities frms would select io credit default swaps on mortgage-
backedsecuritiesineachoffveratings-basedtranches:AAA,AA,A,BBB,andBBB-.
Investorswhobelievedthatthebondsinanygivencategorywouldfallbehindintheir
paymentscouldbuyprotectionthroughcreditdefaultswaps.Asdemandforprotec-
tion rose, the index would fall. The index was therefore a barometer recording the
confdenceofthemarket.
SyntheticCDOsproliferated,inpartbecauseitwasmuchquickerandeasierfor
managerstoassembleasyntheticportfoliooutofpay-as-you-gocreditdefaultswaps
thantoassemblearegularcashCDOoutofmortgage-backedsecurities.Thebeauty
inawayofthesyntheticdealsisyoucanlookattheentireuniverse,youdonthaveto
goandbuythecashbonds,saidLauraSchwartzofACACapital.
1
Therewerealso
nowarehousingcostsorassociatedrisks.Andtheytendedtoofferthepotentialfor
higherreturnsontheequitytranches:oneanalystestimatedthattheequitytranche
on a synthetic CDO could typically yield about i1, while the equity tranche of a
typicalcashCDOcouldpay1.
1,
AnimportantdriverinthegrowthofsyntheticCDOswasthedemandforcredit
default swaps on mortgage-backed securities. Greg Lippmann, a Deutsche Bank
mortgage trader, told the FCIC that he often brokered these deals, matching the
shortswiththelongsandminimizinganyriskforhisownbank.Lippmannsaid
thatbetweenioooandioo,hebrokereddealsforatleast,oandmaybeasmanyas
1oo hedge funds that wanted to short the mezzanine tranches of mortgage-backed
securities.Meanwhile,onthelongside,MostofourCDSpurchaseswerefromUBS,
Merrill, and Citibank, because they were the most aggressive underwriters of [syn-
thetic]CDOs.
1o
Inmanycases,theywerebuyingthosepositionsfromLippmannto
putthemintosyntheticCDOs;asitwouldturnout,thebankswouldretainmuchof
theriskofthosesyntheticCDOsbykeepingthesuper-seniorandtriple-Atranches,
sellingbelow-triple-AtrancheslargelytootherCDOs,andsellingequitytranchesto
hedgefunds.
Issuance of synthetic CDOs jumped from 1, billion in ioo, to o1 billion just
one year later. (We include all CDOs with ,o or more synthetic collateral; again,
unlessotherwisenoted,ourdatareferstoCDOsthatincludemortgage-backedsecu-
rities.) Even CDOs that were labeled as cash CDOs increasingly held some credit
derivatives.Atotalofii,billioninCDOswereissuediniooo,includingthosela-
beledascash,hybrid,orsynthetic;theFCICestimatesthati,ofthecollateralwas
derivatives,comparedwithinioo,and,inioo.
1,
The advent of synthetic CDOs changed the incentives of CDO managers and
hedgefundinvestors.Onceshortinvestorswereinvolved,theCDOhadtwotypesof
investors with opposing interests: those who would beneft if the assets performed,
and those who would beneft if the mortgage borrowers stopped making payments
andtheassetsfailedtoperform.
Eventheincentivesoflonginvestorsbecameconficted.SyntheticCDOsenabled
sophisticatedinvestorstoplacebetsagainstthehousingmarketorpursuemorecom-
plextradingstrategies.Investors,usuallyhedgefunds,oftenusedcreditdefaultswaps
totakeoffsettingpositionsindifferenttranchesofthesameCDOsecurity;thatway,
1ui \\iNi: : .,.
they could make some money as long as the CDOs performed, but they stood to
make more money if the entire market crashed. An FCIC survey of more than 1,o
hedgefundsencompassingover1.1trillioninassetsasofearlyio1ofoundthisto
be a common strategy among medium-size hedge funds: of all the CDOs issued in
the second half of iooo, more than half of the equity tranches were purchased by
hedgefundsthatalsoshortedothertranches.
18
Thesameapproachwasbeingusedin
themortgage-backedsecuritiesmarketaswell.TheFCICssurveyfoundthatbyJune
ioo,, the largest hedge funds held i, billion in equity and other lower-rated
tranchesofmortgage-backedsecurities.Theseweremorethanoffsetby,billion
inshortpositions.
1
Thesetypesoftradeschangedthestructuredfnancemarket.Investorsintheequity
and most junior tranches of CDOs and mortgage-backed securities traditionally had
thegreatestincentivetomonitorthecreditriskofanunderlyingportfolio.Withthead-
ventofcreditdefaultswaps,itwasnolongerclearwhoifanyonehadthatincentive.
For one example, consider Merrill Lynchs 1., billion Norma CDO, issued in
ioo,.Theequityinvestor,MagnetarCapital,ahedgefund,wasexecutingacommon
strategyknownasthecorrelationtradeitboughttheequitytranchewhileshorting
othertranchesinNormaandotherCDOs.Accordingtocourtdocuments,Magnetar
wasalsoinvolvedinselectingassetsforNorma.
io
Magnetarreceived.,millionre-
latedtothistransactionandNIRCapitalManagement,theCDOmanager,waspaida
feeof,,,oooplusadditionalfees.
i1
MagnetarscounseltoldtheFCICthatthe.,
millionwasadiscountintheformofa rebateonthepriceoftheequitytrancheand
otherlongpositionspurchasedbyMagnetarandnotapaymentreceivedinreturnfor
goodorservices.
ii
CourtdocumentsindicatethatMagnetarwasinvolvedinselect-
ingcollateral,andthat NIRabdicateditsassetselectiondutiestoMagnetarwithMer-
rillsknowledge.Inaddition,theyshowthatwhenoneMerrillemployeelearnedthat
Magnetar had executed approximately ooo million in trades for Norma without
NIRsapparentinvolvementorknowledge,sheemailedcolleagues,Dumbquestion.
IsMagnetarallowedtotradeforNIR:
i
MerrillfailedtodisclosethatMagnetarwas
paid.,millionorthatMagnetarwasselectingcollateralwhenitalsohadashort
positionthatwouldbeneftfromlosses.
i
ThecounselforMerrillsnewowner,BankofAmerica,explainedtotheFCICthat
it was a common industry practice for the equity investor in a CDO, which had
the riskiest investment, to have input during the collateral selection process[;] . . .
however, the collateral manager made the ultimate decisions regarding portfolio
composition.
i,
The letter did not specifcally mention the Norma CDO. Bank of
AmericafailedtoproducedocumentsrelatedtothisissuerequestedbytheFCIC.
Federalregulatorshaveidentifedabusesthatinvolvedshortinvestorsinfuencing
thechoiceoftheinstrumentsinsidesyntheticCDOs.InAprilio1o,theSECcharged
GoldmanSachswithfraudfortellinginvestorsthatanindependentCDOmanager,
ACAManagement,hadpickedtheunderlyingassetsinaCDOwheninfactashort
investor,thePaulson&Co.hedgefund,hadplayedasignifcantroleintheselec-
tion. The SEC alleged that those misrepresentations were in Goldmans marketing
materialsforAbacusioo,-AC1,oneofGoldmansiAbacusdeals.
io
.,z ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
IraWagner,theheadofBearStearnssCDOGroupinioo,,toldtheFCICthathe
rejected the deal when approached by Paulson representatives. When asked about
GoldmanscontentionthatPaulsonspickingthecollateralwasimmaterialbecausethe
collateralwasdisclosedandbecausePaulsonwasnotwell-knownatthattime,Wagner
called the argument ridiculous. He said that the structure encouraged Paulson to
picktheworstassets.Whileacknowledgingthepointthateverysyntheticdealneces-
sarilyhadlongandshortinvestors,Wagnersawhavingtheshortinvestorsselectthe
referencedcollateralasaseriousconfictandforthatreasondeclinedtoparticipate.
i,
ACAexecutivestoldtheFCICtheywerenotinitiallyawarethattheshortinvestor
wasinvolvedinchoosingthecollateral.CEOAlanRosemansaidthathefrstheardof
PaulsonsrolewhenhereviewedtheSECscomplaint.
i8
LauraSchwartz,whowasre-
sponsibleforthedealatACA,saidshebelievedthatPaulsonsfrmwastheinvestor
takingtheequitytrancheandwouldthereforehaveaninterestinthedealperforming
well.ShesaidshewouldnothavebeensurprisedthatPaulsonwouldalsohavehada
shortposition,becausethecorrelationtradewascommoninthemarket,butadded,
Tobehonest,[atthattime,]untiltheSECtestimonyIdidnotevenknowthatPaul-
sonwasonlyshort.
i
PaulsontoldtheFCICthatanysyntheticCDOwouldhaveto
investinapoolthatbothabuyerandsellerofprotectioncouldagreeon.Hedidnt
understandtheobjections:Every[synthetic]CDOhasabuyerandsellerofprotec-
tion.SoforanyonetosaythattheydidntwanttostructureaCDObecausesomeone
wasbuyingprotectioninthatCDO,thenyouwouldntdoanyCDOs.
o
In July io1o, Goldman Sachs settled the case, paying a record ,,o million fne.
Goldmanacknowledge[d]thatthemarketingmaterialsfortheABACUSioo,-AC1
transactioncontainedincompleteinformation.Inparticular,itwasamistakeforthe
Goldman marketing materials to state that the reference portfolio was selected by
ACAManagementLLCwithoutdisclosingtheroleofPaulson&Co.Inc.intheport-
folio selection process and that Paulsons economic interests were adverse to CDO
investors.
1
The new derivatives provided a golden opportunity for bearish investors to bet
against the housing boom. Home prices in the hottest markets in California and
Floridahadblastedintothestratosphere;itwashardforskepticstobelievethattheir
upwardtrajectorycouldcontinue.Andifitdidnot,thelandingwouldnotbeasoft
one. Some spoke out publicly. Others bet the bubble would burst. Betting against
CDOs was also, in some cases, a bet against the rating agencies and their models.
JamieMaiandBenHockett,principalsatthesmallinvestmentfrmCornwallCapi-
tal,toldtheFCICthattheyhadwarnedtheSECinioo,thattheagenciesweredan-
gerously overoptimistic in their assessment of mortgage-backed CDOs. Mai and
Hockett saw the rating agencies as the root of the mess, because their ratings re-
movedtheneedforbuyerstostudypricesandperformduediligence,evenasthere
wasamassiveamountofgaminggoingon.
i
ShortingCDOswasprettyattractivebecausetheratingagencieshadgiventoo
much credit for diversifcation, Sihan Shu of Paulson & Co. told the FCIC. Paulson
established a fund in June iooo that initially focused only on shorting BBB-rated
tranches.Bytheendofioo,,Paulson&Co.sCreditOpportunitiesfund,setupless
1ui \\iNi: : .,,
than a year earlier to bet exclusively against the subprime housing market, was up
,o. Each MBS tranche typically would be o mortgages in California, 1o in
Florida,1oinNewYork,andwhenyouaggregate1ooMBSpositionsyoustillhave
the same geographic diversifcation. To us, there was not much diversifcation in
CDOs.Shusresearchconvincedhimthatifhomepricesweretostopappreciating,
BBB-rated mortgage-backed securities would be at risk for downgrades. Should
pricesdrop,,CDOlosseswouldincreaseio-fold.

And if a relatively small number of the underlying loans were to go into fore-
closure,thelosseswouldrendervirtuallyalloftheriskierBBB-ratedtranchesworth-
less. The whole system worked fne as long as everyone could refnance, Steve
Eisman,thefounderofafundwithinFrontPointPartners,toldtheFCIC.Theminute
refnancing stopped, losses would explode. . . . By iooo, about half [the mortgages
sold]wereno-docorlow-doc.Youwereatmaxunderwritingweaknessatmaxhous-
ingprices.Andsothesystemimploded.Everyonewassoleveredtherewasnoability
totakeanypain.

OnOctobero,iooo,JamesGrantwroteinhisnewsletteraboutthe
mysteriousalchemicalprocessesinwhichWallStreettransformsBBB-minus-rated
mortgagesintoAAA-ratedtranchesofmortgagesecuritiesbycreatingCDOs.Hees-
timatedthateventhetriple-AtranchesofCDOswouldexperiencesomelossesifna-
tionalhomepricesweretofalljustorlesswithintwoyears;andifpriceswereto
fall1o,investorsoftranchesratedAA-orbelowwouldbecompletelywipedout.
,
Inioo,,Eismanandotherswerealreadylookingforthebestwaytobetonthis
disasterbyshortingalltheseshakymortgage-relatedsecurities.Buyingcreditdefault
swapswasemcient.Eismanrealizedthathecouldpickwhatheconsideredthemost
vulnerabletranchesofthemortgage-backedbondsandbetmillionsofdollarsagainst
them,relativelycheaplyandwithconsiderableleverage.Andthatswhathedid.
By the end of ioo,, Eisman had put millions of dollars into short positions on
credit default swaps. It was, he was sure, just a matter of time. Everyone really did
believethatthingsweregoingtobeokay,Eismansaid.[I]thoughttheywerecertif-
ablelunatics.
o
Michael Burry, another short who became well-known after the crisis hit, was a
doctor-turned-investor whose hedge fund, Scion Capital, in Northern Californias
Silicon Valley, bet big against mortgage-backed securitiesrefecting a change of
heart, because he had invested in homebuilder stocks in iooi. But the closer he
looked,themorehewonderedaboutthefnancingthatsupportedthisboomingmar-
ket.Burrydecidedthatsomeofthenewfangledadjustableratemortgageswerethe
most toxic mortgages created. He told the FCIC, I watched those with interest as
theymigrateddownthecreditspectrumtothesubprimemarket.As[home]prices
hadincreasedonthebackofvirtuallynoaccompanyingriseinwagesandincomes,I
came to the judgment that in two years there will be a fnal judgment on housing
when those two-year [adjustable rate mortgages] seek refnancing.
,
By the middle
of ioo,, Burry had bought credit default swaps on billions of dollars of mortgage-
backed securities and the bonds of fnancial companies in the housing market, in-
cludingFannieMae,FreddieMac,andAIG.
Eisman,Cornwall,Paulson,andBurrywerenotaloneinshortingthehousingmar-
.,, ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
ket.Infact,ononesideoftensofbillionsofdollarsworthofsyntheticCDOswerein-
vestorstakingshortpositions.Thepurchasersofcreditdefaultswapsillustratetheim-
pact of derivatives in introducing new risks and leverage into the system. Although
theseinvestorsproftedspectacularlyfromthehousingcrisis,theynevermadeasingle
subprimeloanorboughtanactualmortgage.Inotherwords,theywerenotpurchasing
insurance against anything they owned. Instead, they merely made side bets on the
risks undertaken by others. Paulson told the FCIC that his research indicated that if
homepricesremainedfat,losseswouldwipeouttheBBB-ratedtranches;meanwhile,
atthetimehecouldpurchasedefaultswapprotectiononthemverycheaply.
8
Ontheothersideofthezero-sumgamewereoftenthemajorU.S.fnancialinsti-
tutionsthatwouldeventuallybebattered.BurryacknowledgedtotheFCIC,There
isanargumenttobemadethatyoushouldntallowwhatIdid.Buttheproblem,he
said,wasnottheshortpositionshewastaking;itwastherisksthatotherswereac-
cepting. When I did the shorts, the whole time I was putting on the positions . . .
therewerepeopleontheothersidethatwerejusteatingthemup.Ithinkitsacatas-
tropheandIthinkitwaspreventable.

Credit default swaps greased the CDO machine in several ways. First, they al-
lowedCDOmanagerstocreatesyntheticandhybridCDOsmorequicklythanthey
couldcreatecashCDOs.Second,theyenabledinvestorsintheCDOs(includingthe
originatingbanks,suchasCitigroupandMerrill)totransfertheriskofdefaulttothe
issuerofthecreditdefaultswap(suchasAIGandotherinsurancecompanies).Third,
they made correlation trading possible. As the FCIC survey revealed, most hedge
fund purchases of equity and other junior tranches of mortgage-backed securities
and CDOs were done as part of complex trading strategies.
o
As a result, credit de-
faultswapswerecriticaltofacilitatedemandfromhedgefundsfortheequityorother
juniortranchesofmortgage-backedsecuritiesandCDOs.Finally,theyallowedspec-
ulatorstomakebetsfororagainstthehousingmarketwithoutputtingupmuchcash.
Ontheotherhand,itcanbearguedthatcreditdefaultswapshelpedendthehous-
ingandmortgage-backedsecuritiesbubble.BecauseCDOarrangerscouldmoreeas-
ilybuymortgageexposurefortheirCDOsthroughcreditdefaultswapsthanthrough
actualmortgage-backedsecurities,demandforcreditdefaultswapsmayinfacthave
reducedtheneedtooriginatehigh-yieldmortgages.Inaddition,somemarketpartic-
ipantshavecontendedthatwithouttheabilitytoshortthehousingmarketviacredit
defaultswaps,thebubblewouldhavelastedlonger.Aswewillsee,thedeclinesinthe
ABXindexinlateiooowouldbeoneofthefrstharbingersofmarketturmoil.Once
[pessimists]can,ineffect,sellshortviatheCDS,pricesmustrefecttheirviewsand
not just the views of the leveraged optimists, John Geanakoplos, a Yale economics
professor and a partner in the hedge fund Ellington Capital Management, which
bothinvestedinandmanagedCDOs,toldtheFCIC.
1
CITIGROUP: I DO NOT BELIEVE WE WERE POWERLESS
While the hedge funds were betting against the housing market in ioo, and iooo,
CitigroupsCDOdeskwaspushingmoremoneytothecenterofthetable.
1ui \\iNi: : .,,
But after writing i, billion in liquidity putsprotecting investors who bought
commercialpaperissuedbyCitigroupsCDOsthebankstreasurydepartmenthad
put a stop to the practice. To keep doing deals, the CDO desk had to fnd another
marketforthesuper-seniortranchesoftheCDOsitwasunderwritingorithadto
fndawaytogetthecompanytosupporttheCDOproductionline.TheCDOdesk
accumulatedanother18billioninsuper-seniorexposures,mostbetweenearlyiooo
and August ioo,, which it otherwise would have been able to sell into the market
onlyforaloss.
i
Itwasalsoincreasinglyfnancingsecuritiesthatitwasholdinginits
CDOwarehousethatis,securitiesthatwerewaitingtobeputintonewCDOs.
Historically,owningsecuritieswasnotwhatsecuritiesfrmsdid.TheadageWe
areinthemovingbusiness,notthestoragebusinesssuggeststhattheywerestruc-
turingandsellingsecurities,notbuyingorretainingthem.
However,asthebiggestcommercialbanksandinvestmentbankscompetedinthe
securities business in the late 1os and on into the new century, they often touted
thebalancesheetthattheycouldmakeavailabletosupportthesaleofnewsecuri-
ties. In this regard, Citigroup broke new ground in the CDO market. Citigroup re-
tained signifcant exposure to potential losses on its CDO business, particularly
withinCitibank, the1trillioncommercialbankwhosedepositswereinsuredbythe
FDIC. While its competitors did the same, few did so as aggressively or, ultimately,
withsuchlosses.
Iniooo,Citigroupretainedthesuper-seniorandtriple-Atranchesofmostof the
CDOs it created. In many cases Citigroup would hedge the associated credit risk
fromthesetranchesbyobtainingcreditprotectionfromamonolineinsurancecom-
pany such as Ambac. Because these hedges were in place, Citigroup presumed that
theriskassociatedwiththeretainedtrancheshadbeenneutralized.
Citigroupreportedthesetranchesatvaluesforwhichtheycouldnotbesold,rais-
ingquestionsabouttheiraccuracyand,therefore,theaccuracyofreportedearnings.
Aseverybodyinanybusinessknows,ifinventoryisgrowing,thatmeansyourenot
pricingitcorrectly,RichardBookstaber,whohadbeenheadofriskmanagementat
Citigroupinthelate1os,toldtheFCIC.Butkeepingthetranchesonthebooksat
thesepricesimprovedthefnancesforcreatingthedeal.Itwasahiddensubsidyof
theCDObusinessbymispricing,Bookstabersaid.

Thecompanywouldnotbegin
writingthesecuritiesdowntowardthemarketsrealvaluationsuntilthefallofioo,.
Partofthereasonforretainingexposurestosuper-seniorpositionsinCDOswas
theirfavorablecapitaltreatment.Aswesawinanearlierchapter,undertheioo1Re-
courseRule,oneoftheattractionsoftriple-A-ratedsecuritieswasthatbankswerere-
quiredtoholdrelativelylesscapitalagainstthemthanagainstlower-ratedsecurities.
And if the bank held those assets in their trading account (as opposed to holding
themasalong-terminvestment),itcouldgetevenbettercapitaltreatmentunderthe
1oMarketRiskAmendment.Thatruleallowedbankstousetheirownmodelsto
determinehowmuchcapitaltohold,anamountthatvariedaccordingtohowmuch
marketpricesmoved.Citigroupjudgedthatthecapitalrequirementforthesuper-se-
niortranchesofsyntheticCDOsitheldfortradingpurposeswaseffectivelyzero,be-
., ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
causethepricesdidntmovemuch.Asaresult,Citigroupheldlittleregulatorycapital
againstthesuper-seniortranches.
Citibank also held unfunded positions in super-senior tranches of some syn-
theticCDOs;thatis,itsoldprotectiontotheCDO.Ifthereferencedmortgagecollat-
eral underperformed, the short investors would begin to get paid. Money to pay
themwouldcomefrstfromwipingoutlonginvestorswhohadboughttranchesthat
were below triple-A. Then, if the short investors were still owed money, Citibank
would have to pay. For taking on this risk, Citi typically received about o.io to
o.oinannualfeesonthesuper-seniorprotection;onabillion-dollartransaction,it
wouldearnanannualfeeofimilliontomillion.
Citigroup also had exposure to the mortgage-backed and other securities that
went into CDOs during the ramp-up period, which could be as long as six or nine
months, before it packaged and sold the CDO. Typically, Citigroups securities unit
wouldsetupawarehouse fundinglinefortheCDOmanager.Duringtheramp-up
period, the collateral securities would pay interest; depending on the terms of the
agreement,thatinterestwouldeithergoexclusivelytoCitigrouporbesplitwiththe
manager.FortheCDOdesk,thisfrequentlyrepresentedasubstantialincomestream.
Thesecuritiessittinginthewarehousefacilityhadrelativelyattractiveyieldsoften
1.otoi.,morethanthetypicalbankborrowingrateanditwasnotuncommon
for the CDO desk to earn 1o to 1, million in interest on a single transaction.

Tradersonthedeskwouldgetcreditforthoserevenuesatbonustime.ButCitigroup
wouldalsobeonthehookforanylossesincurredonassetsstuckinthewarehouse.
When the fnancial crisis deepened, many CDO transactions could not be com-
pleted;Citigroupandotherinvestmentbankswereforcedtowritedownthevalueof
securitiesheldintheirwarehouses.TheresultwouldbesubstantiallossesacrossWall
Street. In many cases, to omoad assets underwriters placed collateral from CDO
warehousesintootherCDOs.
A factor that made frm-wide hedging complicated was that different units of
CitigroupcouldhavevariousandoffsettingexposurestothesameCDO.Itwaspos-
sible,evenlikely,thattheCDOdeskwouldstructureagivenCDO,adifferentdivi-
sion would buy protection for the underlying collateral, and yet another division
wouldbuytheunfundedsuper-seniortranche.IfthecollateralinthisCDOraninto
trouble,theCDOimmediatelywouldhavetopaythedivisionthatboughtcreditpro-
tection on the underlying collateral; if the CDO ran out of money to pay, it would
havetodrawonthedivisionthatboughttheunfundedtranche.InNovemberioo,,
after Citigroup had reported substantial losses on its CDO portfolio, regulators
would note that the company did not have a good understanding of its frmwide
CDO exposures: The nature, origin, and size of CDO exposure were surprising to
manyinseniormanagementandtheboard.Theliquidityputexposurewasnotwell
known.Inparticular,managementdidnotconsideroreffectivelymanagethecredit
riskinherentinCDOpositions.
,
CitigroupswillingnesstouseitsbalancesheettosupporttheCDObusinesshad
thedesiredeffect.ItsCDOdeskcreated11billioninCDOsthatincludedmortgage-
1ui \\iNi: : .,,
backedsecuritiesintheircollateralinioo,andiibillioniniooo.AmongCDOun-
derwriters, including all types of CDOs, Citigroup rose from fourteenth place in
iootosecondplaceinioo,,accordingtoFCICanalysisofMoodysdata.
o
What was good for Citigroups investment bank was also lucrative for its invest-
ment bankers. Thomas Maheras, the co-CEO of the investment bank who said he
spentlessthan1ofhistimethinkingaboutCDOs,wasahighlypaidCitigroupex-
ecutive, earning more than million in salary and bonus compensation in iooo.
Co-head of Global Fixed Income Randolph Barker made about i1 million in that
sameyear.Citigroupschiefriskomcermade,.million.
,
Otherswerealsowellre-
warded. The co-heads of the global CDO business, Nestor Dominguez and Janice
Warne,eachmadeaboutomillionintotalcompensationiniooo.
8
Citi did have clawback provisions: under narrowly specifed circumstances,
compensationwouldhavetobereturnedtothefrm.ButdespiteCitigroupseventual
largelosses,nocompensationwaseverclawedbackunderthispolicy.TheCorporate
Library,whichratesfrmscorporategovernance,gaveCitigroupaC.Inearlyioo,,
theCorporateLibrarywoulddowngradeCitigrouptoaD,refectingahighdegree
of governance risk. Among the issues cited: executive compensation practices that
werepoorlyalignedwithshareholderinterests.

WherewereCitigroupsregulatorswhilethecompanypileduptensofbillionsof
dollars of risk in the CDO business: Citigroup had a complex corporate structure
and, as a result, faced an array of supervisors. The Federal Reserve supervised the
holdingcompanybut,astheGramm-Leach-Blileylegislationdirected,reliedonoth-
erstomonitorthemostimportantsubsidiaries:theOmceoftheComptrollerofthe
Currency (OCC) supervised the largest bank subsidiary, Citibank, and the SEC su-
pervisedthesecuritiesfrm,CitigroupGlobalMarkets.Moreover,Citigroupdidnot
really align its various businesses with the legal entities. An individual working on
theCDOdeskonanintricatetransactioncouldinteractwithvariouscomponentsof
thefrmincomplicatedways.
TheSECregularlyexaminedthesecuritiesarmonathree-yearexaminationcycle,
althoughitwouldalsosometimesconductotherexaminationstotargetspecifccon-
cerns.UnliketheFedandOCC,whichhadriskmanagementandsafetyandsound-
ness rules, the SEC used these exams to look for general weaknesses in risk
management.Unlikesafetyandsoundnessregulators,whoconcentratedonprevent-
ingfrmsfromfailing,theSECalwayskeptitsfocusonprotectinginvestors.Itsmost
recentreviewofCitigroupssecuritiesarmprecedingthecrisiswasinioo,,andthe
examiners completed their report in June iooo. In that exam, they told the FCIC,
they saw nothing earth shattering, but they did note key weaknesses in risk man-
agement practices that would prove relevantweaknesses in internal pricing and
valuationcontrols,forexample,andawillingnesstoallowtraderstoexceedtheirrisk
limits.
,o
Unlike the SEC, the Fed and OCC did maintain a continuous on-site presence.
During the years that CDOs boomed, the OCC team regularly criticized the com-
panyforitsweaknessesinriskmanagement,includingspecifcproblemsintheCDO
., ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
business. Earnings and proftability growth have taken precedence over risk man-
agement and internal control, the OCC told the company in January ioo,.
,1
An-
other document from that year stated, The fndings of this examination are
disappointing,inthatthebusinessgrewfarinexcessofmanagementsunderlyingin-
frastructureandcontrolprocesses.
,i
InMayioo,,areviewundertakenbypeersat
theotherFederalReservebankswascriticaloftheNewYorkFedthenheadedby
thecurrenttreasurysecretary,TimothyGeithnerforitsoversightofCitigroup.The
reviewconcludedthattheFedson-siteCitigroupteamappearedtohaveinsumcient
resources to conduct continuous supervisory activities in a consistent manner. At
Citi,muchofthelimitedteamsenergyisabsorbedbytopicalsupervisoryissuesthat
detractfromtheteamscontinuoussupervisionobjectives . . .thelevelofthestamng
withintheCititeamhasnotkeptpacewiththemagnitudeofsupervisoryissuesthat
theinstitutionhasrealized.
,
ThattheFedsioo,examinationofCitigroupdidnot
raise the concerns expressed that same year by the OCC may illustrate these prob-
lems.Fouryearslater,thenextpeerreviewwouldagainfndsubstantialweaknesses
intheNewYorkFedsoversightofCitigroup.
,
InApriliooo,theFedraisedtheholdingcompanyssupervisoryratingfromthe
previousyearsfairtosatisfactory.
,,
Itliftedthebanonnewmergersimposedthe
previous year in response to Citigroups many regulatory problems.
,o
The Fed and
OCCexaminersconcurredthatthecompanyhadmadesubstantialprogressinim-
plementing CEO Charles Princes plan to overhaul risk management. The Fed de-
clared: The company has . . . completed improvements necessary to bring the
companyintosubstantialcompliancewithtwoexistingFederalReserveenforcement
actionsrelatedtotheexecutionofhighlystructuredtransactionsandcontrols.
,,
The
followingyear,CitigroupsboardwouldalludetoPrincessuccessfulresolutionofits
regulatorycomplianceproblemsinjustifyinghisiocompensationincrease.
,8
The OCC noted in retrospect that the lifting of supervisory constraints in iooo
hadbeenakeyturningpoint.Afterregulatoryrestraintsagainstsignifcantacquisi-
tionswerelifted,Citigroupembarkedonanaggressiveacquisitionprogram,theOCC
wrotetoVikramPandit,Princesreplacement,inearlyioo8.Additionally,withthere-
movalofformalandinformalagreements,thepreviousfocusonriskandcompliance
gavewaytobusinessexpansionandprofts.Meanwhile,riskmanagersgrantedexcep-
tions to limits, and increased exposure limits, instead of keeping business units in
checkastheyhadtoldtheregulators.
,
WellafterCitigroupsustainedlargelosseson
itsCDOs,theFedwouldcriticizethefrmforusingitscommercialbanktosupportits
investmentbankingactivities.Seniormanagementallowedbusinesslineslargelyun-
challengedaccesstothebalancesheettopursuerevenuegrowth,theFedwroteinan
Aprilioo8lettertoPandit.Citigroupattainedsignifcantmarketshareacrossnumer-
ousproducts,includingleveragedfnanceandstructuredcredittrading,utilizingbal-
ance sheet for its originate to distribute strategy. Senior management did not
appropriatelyconsiderthepotentialbalancesheetimplicationsofthisstrategyinthe
caseofmarketdisruptions.Further,theydidnotadequatelyaccessthepotentialnega-
tiveimpactofearningsvolatilityofthesebusinessesonthefrmscapitalposition.
oo
1ui \\iNi: : .,,
Geithner told the Commission that he and others in leadership positions could
havedonemoretopreventthecrisis,testifying,Idonotbelievewewerepowerless.
o1
AIG: I M NOT GETTING PAID ENOUGH
TO STAND ON THESE TRACKS
Unlike their peers at Citigroup, some senior executives at AIGs Financial Products
subsidiaryhad fguredoutthatthecompanywastakingontoomuchrisk.Nonethe-
less,theydidnotdoenoughaboutit.Doubtsaboutallthecreditdefaultswapsthat
they were originating emerged in ioo, among AIG Financial Products executives,
including Andrew Forster and Gene Park. Park told the FCIC that he witnessed
FinancialProductsCEOJosephCassanoberatingasalesmanoverthelargevolume
ofcreditdefaultswapsbeingwrittenbyAIGFinancialProducts,suggestingtherewas
alreadysomehigh-leveluneasinesswiththesedeals.Toldbyaconsultant,GaryGor-
ton,thatthemultisectorCDOsonwhichAIGwassellingcreditdefaultswapscon-
sistedmainlyofmortgage-backedsecuritieswithlessthan1osubprimeandAlt-A
mortgages,ParkaskedAdamBudnick,anotherAIGemployee,forverifcation.Bud-
nick double checked and returned to say, according to Park, I cant believe it. You
know,itslike8ooro.Reviewingtheportfolioandthinkingaboutafriendwho
hadreceived1oofnancingforhisnewhomeafterlosinghisjobParksaid,This
ishorrendousbusiness.Weshouldgetoutofit.
oi
In July ioo,, Parks colleague Andrew Forster sent an email both to Alan Frost,
the AIG salesman primarily responsible for the companys booming credit default
swap business, and to Gorton, who had engineered the formula to determine how
muchriskAIGwastakingoneachCDSitwrote.Wearetakingonahugeamountof
subprimemortgageexposurehere,Forsterwrote.Everyonewehavetalkedtosays
they are worried about deals with huge amounts [of high-risk mortgage] exposure
yetIregularlyseedealswith8o[high-riskmortgage]concentrationscurrently.Are
thesereallythesameriskasotherdeals:
o
Parkandothersstudiedtheissueforweeks,talkedtobankanalystsandotherex-
perts,andconsideredwhetheritmadesenseforAIGtocontinuetowriteprotection
on the subprime and Alt-A mortgage markets. The general view of others was that
someoftheunderlyingmortgageswerestructuredtofail,[but]thatalltheborrow-
erswouldbasicallybebailedoutaslongasrealestatepriceswentup.
o
TheAIGconsultantGortonrecalledameetingthatheandothersfromAIGhad
withoneBearStearnsanalyst.Theanalystwassooptimisticaboutthehousingmar-
ket that they thought he was out of his mind and must be on drugs or some-
thing.
o,
Speaking of a potential decline in the housing market, Park related to the
FCICtherisksasheandsomeofhiscolleaguessawthem,saying,Wewerentgetting
paidenoughmoneytotakethatrisk. . . .Imnotgoingtoopineonwhethertheresa
train on its way. I just know that Im not getting paid enough to stand on these
tracks.
oo
ByFebruaryiooo,ParkandotherspersuadedCassanoandFrosttostopwriting
z++ ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
CDSprotectiononsubprimemortgagebackedsecurities.InanemailtoCassanoon
Februaryi8,Parkwrote:
Joe,
Below summarizes the message we plan on delivering to dealers later
thisweekwithregardtoourapproachtotheCDOofABSsupersenior
business going forward. We feel that the CDO of ABS market has in-
creasinglybecomelessdiverseoverthelastyearorsoandiscurrentlyat
a state where deals are almost totally reliant on subprime/non prime
residential mortgage collateral. Given current trends in the housing
market, our perception of deteriorating underwriting standards, and
the potential for higher rates we are no longer as comfortable taking
suchconcentratedexposuretocertainpartsofthenonprimemortgage
securitizations.Onthedealsthatweparticipateonwewouldliketosee
signifcantchangeinthecompositionofthesedealsgoingforwardi.e.
morediversifcationintothenon-correlatedassetclasses.
As a result of our ongoing due diligence we are not as comfortable
with the mezzanine layers (namely BBB and single A tranches) of this
assetclass. . . .WerealizethatthisislikelytotakeusoutoftheCDOof
ABS market for the time being given the arbitrage in subprime collat-
eral.However,weremaincommittedtoworkingwithunderwritersand
managers in developing the CDO of ABS market to hopefully become
more diversifed from a collateral perspective. With that in mind, we
will be open to including new asset classes to these structures or in-
creasing allocations to others such as [collateralized loan obligations]
and[emergingmarket]CDOs.

AIGscounterpartiesrespondedwithindifference.Thedaythatyou[AIG]drop
out,weregoingtohave1ootherpeoplewhoaregoingtoreplaceyou,Parksayshe
wastoldbyaninvestmentbankeratanotherfrm.
o8
Inanyevent,counterpartieshad
sometimetofndnewtakers,becauseAIGFinancialProductscontinuedtowritethe
credit default swaps. While the bearish executives were researching the issue from
the summer of ioo, onward, the team continued to work on deals that were in the
pipeline, even after February iooo. Overall, they completed , deals between Sep-
tember ioo, and July ioooone of them on a CDO backed by subprime
assets.
o
By June ioo,, AIG had written swaps on , billion in multisector CDOs, fve
timesthe1obillionheldattheendofioo,.
,o
Parkassertedthatneitherhenormost
othersatAIGknewatthetimethattheswapsentailedcollateralcallsonAIGifthe
marketvalueofthereferencedsecuritiesdeclined.
,1
Parksaidtheirconcernwassim-
ply that AIG would be on the hook if subprime and Alt-A borrowers defaulted in
largenumbers.Cassano,however,toldtheFCICthathedidknowaboutthepossible
1ui \\iNi: : z+.
calls,
,i
but AIGs SEC flings to investors for ioo, mentioned the risk of collateral
callsonlyifAIGweredowngraded.
Still,AIGneverhedgedmorethan1,omillionofitstotalsubprimeexposure.
,
SomeofAIGscounterpartiesnotonlyusedAIGsswapstohedgeotherpositionsbut
alsohedgedAIGsabilitytomakegoodonitscontracts.Aswewillseelater,Goldman
SachshedgedaggressivelybybuyingCDSprotectiononAIGandbyshortingother
securitiesandindexestocounterbalancetheriskthatAIGwouldfailtopayuponits
swapsorthatacollapsingsubprimemarketwouldpulldownthevalueofmortgage-
backedsecurities.
MERRILL: WHATEVER IT TAKES
WhenDowKimbecameco-presidentofMerrillLynchsGlobalMarketsandInvest-
mentBankingGroupinJulyioo,hewasinstructedtoboostrevenue,especiallyin
businesses in which Merrill lagged behind its competitors.
,
Kim focused on the
CDO business; clients saw CDOs as an integral part of their trading strategy, CEO
StanleyONealtoldtheFCIC.
,,
KimhiredChrisRicciardifromCreditSuisse,where
RicciardisgrouphadsoldmoreCDOsthananyoneelse.
,o
Ricciardi came through, lifting Merrills CDO business from ffteenth place in
iooitosecondplacebehindonlyCitigroupiniooandGoldmaninioo,.
,,
Then,in
Februaryiooo,heleftthebanktobecomeCEOofCohen&Company,anassetman-
agementbusiness;atCohenhewouldmanageseveralCDOs,oftendealsunderwrit-
tenbyMerrill.
AfterRicciardileft,Kiminstructedtherestoftheteamtodowhateverittakes
notjusttomaintainmarketsharebutalsototakeoverthenumberoneranking,for-
meremployeessaidinacomplaintfledagainstMerrillLynch.
,8
KimtoldFCICstaff
thathecouldntrecallspecifcconversationsbutthatafterRicciardileft,Merrillwas
stilltryingtoexpandtheCDObusinessgloballyandthathe,Kim,wantedpeopleto
knowthatMerrillwaswillingtocommititspeople,resources,andbalancesheetto
achievethatgoal.
,
Itwasindeedwilling.Despitethelossofitsrainmaker,Merrillswampedthecom-
petition, originating a total 8. billion in mortgage-related CDOs in iooo, while
thesecond-rankedfrm,MorganStanley,didonlyi1.billion,andearninganother
frst-place ranking in ioo,,
8o
on the strength of the CDO machine Ricciardi had
builta machine that brought in more than 1 billion in fees between ioo and
iooo.
81
TokeepitsCDObusinessgoing,Merrillpursuedthreestrategies,allofwhichin-
volved repackaging riskier mortgages more attractively or buying its own products
when no one else would. Like Citigroup, Merrill increasingly retained for its own
portfolio substantial portions of the CDOs it was creating, mainly the super-senior
tranches, and it increasingly repackaged the hard-to-sell BBB-rated and other low-
ratedtranchesofitsCDOsintoitsother CDOs;itusedthecashsittinginitssynthetic
CDOstopurchaseotherCDOtranches.
z+z ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
IthadlongbeenstandardpracticeforCDOunderwriterstosellsomemezzanine
tranchestootherCDOmanagers.EvenintheearlydaysofABSCDOs,theseassets
oftencontainedasmallpercentageofmezzaninetranchesofotherCDOs;therating
agenciessignedoffonthispracticewhenratingeachdeal.Butrelianceonthembe-
cameheavierasthedemandfromtraditionalinvestorswaned,asithadfortheriskier
tranchesofmortgage-backedsecurities.Themarketcametocalltraditionalinvestors
therealmoney,todistinguishthemfromCDOmanagerswhowerebuyingtranches
justtoputthemintotheirCDOs.Betweenioo,andioo,,thetypicalamountaCDO
couldincludeofthetranchesofotherCDOsandstillmaintainitsratingsgrewfrom
,too,accordingtotheCDOmanagerWingChau.
8i
Accordingtodatacompiled
by the FCIC, tranches from CDOs rose from an average of , of the collateral in
mortgage-backed CDOs in ioo to 1 by ioo,. CDO-squared dealsthose engi-
neered primarily from the tranches of other CDOsgrew from o marketwide in
ioo,to8inioooand1inioo,.Merrillcreatedandsold11ofthem.
8
Still, there are clear signs that few real money investors remained in the CDO
marketbylateiooo.ConsiderMerrill:fortheABSCDOsthatMerrillcreatedand
soldfromthefourthquarterofiooothroughAugustioo,,nearly8oofthemezza-
ninetrancheswerepurchasedbyCDOmanagers.
8
ThepatternwassimilarforChau:
an FCIC analysis determined that 88 of the mezzanine tranches sold by the 1
CDOsmanagedbyChauweresoldforinclusionintootherCDOs.
8,
Anestimated1o
different CDO managers purchased tranches in Merrills Norma CDO. In the most
extremecasefoundbytheFCIC,CDOmanagersweretheonlypurchasersofMer-
rillsNeoCDO.
8o
Marketwide,iniooCDOstookinabout1oftheAtranches,ioftheAa
tranches, and of the Baa tranches issued by other CDOs, as rated by Moodys.
(MoodysratingofAaaisequivalenttoS&PsAAA,AatoAA,BaatoBBB,andBato
BB). In ioo,, those numbers were 8,, 81, and 8, respectively.
8,
Merrill and
other investment banks simply created demand for CDOs by manufacturing new
onestobuytheharder-to-sellportionsoftheoldones.
AsSECattorneystoldtheFCIC,headingintoioo,therewasaStreetwidegentle-
mansagreement:youbuymyBBBtrancheandIllbuyyours.
88
Merrill and its CDO managers were the biggest buyers of their own products.
Merrill created and sold 1i CDOs from ioo to ioo,. All but 8 of these1
CDOssoldatleastonetrancheintoanotherMerrillCDO.InMerrillsdeals,onav-
erage, 1o of the collateral packed into the CDOs consisted of tranches of other
CDOsthatMerrillitselfhadcreatedandsold.Thiswasarelativelyhighpercentage,
but not the highest: for Citigroup, another big player in this market, the fgure was
1.ForUBS,itwasjust.
8
Managersdefendedthepractice.Chau,whomanaged1CDOscreatedandsold
byMerrillatMaximGroupandlaterHardingAdvisoryandhadworkedwithRiccia-
rdiatPrudentialSecuritiesintheearlydaysofmultisectorCDOs,toldtheFCICthat
plainmortgage-backedsecuritieshadbecomeexpensiveinrelationtotheirreturns,
even as the real estate market sagged. Because CDOs paid better returns than did
1ui \\iNi: : z+,
similarly rated mortgage-backed securities, they were in demand, and that is why
CDOmanagerspackedtheirsecuritieswithotherCDOs.
o
AndMerrillcontinuedtopushitsCDObusinessdespitesignalsthatthemarket
was weakening. As late as the spring of iooo, when AIG stopped insuring even the
verysafest,super-seniorCDOtranchesforMerrillandothers,itdidnotreconsider
its strategy. Cut off from AIG, which had already insured . billion of its CDO
bonds
1
Merrill was AIGs third-largest counterparty, after Goldman and Socit
GnraleMerrillswitchedtothemonolineinsurancecompaniesforprotection.In
the summer of iooo, Merrill management noticed that Citigroup, its biggest com-
petitorinunderwritingCDOs,wastakingmoresuper-seniortranchesofCDOsonto
itsownbalancesheetatrazor-thinmargins,andthusineffectsubsidizingreturnsfor
investors in the BBB-rated and equity tranches. In response, Merrill continued to
ramp up its CDO warehouses and inventory; and in an effort to compete and get
deals done, it increasingly took on super-senior positions without insurance from
AIGorthemonolines.
i
This would not be the end of Merrills all-in wager on the mortgage and CDO
businesses. Even though it did grab the frst-place trophy in the mortgage-related
CDObusinessiniooo,ithadcomelatetotheverticalintegrationmortgagemodel
thatLehmanBrothersandBearStearnshadpioneered,whichrequiredhavingastake
ineverystepofthemortgagebusinessoriginatingmortgages,bundlingtheseloans
intosecurities,bundlingthesesecuritiesintoothersecurities,andsellingallofthem
on Wall Street. In September iooo, months after the housing bubble had started to
defate and delinquencies had begun to rise, Merrill announced it would acquire a
subprime lender, First Franklin Financial Corp., from National City Corp. for 1.
billion. As a fnance reporter later noted, this move puzzled analysts because the
marketforsubprimeloanswassouringinahurry.

AndMerrillalreadyhada1oo
millionownershippositioninOwnitMortgageSolutionsInc.,forwhichitprovideda
warehouse line of credit; it also provided a line of credit to Mortgage Lenders Net-
work.

BothofthosecompanieswouldceaseoperationssoonaftertheFirstFranklin
purchase.
,
NordidMerrillcutbackinSeptemberiooo,whenoneofitsownanalystsissueda
reportwarningthatthissubprimeexposurecouldleadtoasuddencutinearnings,
becausedemandforthesemortgagesassetscoulddryupquickly.
o
Thatassessment
was not in line with the corporate strategy, and Merrill did nothing. Finally, at the
endofiooo,Kiminstructedhispeopletoreducecreditriskacrosstheboard.
,
Asit
wouldturnout,theyweretoolate.Thepipelinewastoolarge.
REGULATORS: ARE UNDUE CONCENTRATIONS
OF RISK DEVELOPING?
Ashadhappenedwhentheyfacedthequestionofguidanceonnontraditionalmort-
gages,indealingwiththerapidlychangingstructuredfnancemarkettheregulators
failedtotaketimelyaction.Theymissedacrucialopportunity.OnJanuaryi,ioo,
oneyearafterthecollapseofEnron,theU.S.SenatePermanentSubcommitteeonIn-
z+, ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
vestigations called on the Fed, OCC, and SEC to immediately initiate a one-time,
jointreviewofbanksandsecuritiesfrmsparticipatingincomplexstructuredfnance
products with U.S. public companies to identify those structured fnance products,
transactions,orpracticeswhichfacilitateaU.S.companysuseofdeceptiveaccount-
inginitsfnancialstatementsorreports.Thesubcommitteerecommendedtheagen-
cies issue joint guidance on acceptable and unacceptable structured fnance
products, transactions and practices by June ioo.
8
Four years later, the banking
agenciesandtheSECissuedtheirInteragencyStatementonSoundPracticesCon-
cerningElevatedRiskComplexStructuredFinanceActivities,adocumentthatwas
allofninepageslong.

Intheinterveningyears,fromiootoioo,,thebankingagenciesandSECissued
two draft statements for public comment. The ioo draft, issued the year after the
OCC,Fed,andSEChadbroughtenforcementactionsagainstCitigroupandJPMor-
ganforhelpingEnrontomanipulateitsfnancialstatements,focusedonthepolicies
andproceduresthatfnancialinstitutionsshouldhaveformanagingthestructuredf-
nance business.
1oo
The aim was to avoid another Enronand for that reason, the
statement encouraged fnancial institutions to look out for customers that, like En-
ron,weretryingtousestructuredtransactionstocircumventregulatoryorfnancial
reporting requirements, evade tax liabilities, or engage in other illegal or improper
behavior.
Industrygroupscriticizedthedraftguidanceastoobroad,prescriptive,andbur-
densome.Severalsaiditwouldcovermanystructuredfnanceproductsthatdidnot
pose signifcant legal or reputational risks. Another said that it would disrupt the
marketforlegitimatestructuredfnanceproductsandplaceU.S.fnancialinstitutions
atacompetitivedisadvantageinthemarketfor[complexstructuredfnancetransac-
tions]intheUnitedStatesandabroad.
1o1
Two years later, in May iooo, the agencies issued an abbreviated draft that re-
fectedamoreprinciples-basedapproach,andagainrequestedcomments.Mostof
therequirementswereverysimilartothosethattheOCCandFedhadimposedon
CitigroupandJPMorganintheiooenforcementactions.
1oi
WhentheregulatorsissuedthefnalguidanceinJanuaryioo,,theindustrywas
more supportive. One reason was that mortgage-backed securities and CDOs were
specifcallyexcluded:Moststructuredfnancetransactions,suchasstandardpublic
mortgage-backed securities and hedging-type transactions involving plain vanilla
derivativesorcollateralizeddebtobligations,arefamiliartoparticipantsinthefnan-
cialmarkets,havewell-establishedtrackrecords,andtypicallywouldnotbeconsid-
ered [complex structured fnance transactions] for purposes of the Final
Statement.
1o
Those exclusions had been added after the regulators received com-
mentsontheioodraft.
RegulatorsdidtakenoteofthepotentialrisksofCDOsandcreditdefaultswaps.
Inioo,,theBaselCommitteeonBankingSupervisionsJointForum,whichincludes
banking,securities,andinsuranceregulatorsfromaroundtheworld,issuedacom-
prehensivereportontheseproducts.Thereportfocusedonwhetherbanksandother
frms involved in the CDO and credit default swap business understood the credit
1ui \\iNi: : z+,
risktheyweretaking.Itadvisedthemtomakesurethattheyunderstoodthenature
oftheratingagenciesmodels,especiallyforCDOs.Anditfurtheradvisedthemto
make sure that counterparties from whom they bought credit protectionsuch as
AIG and the fnancial guarantorswould be good for that protection if it was
needed.
1o
Theregulatorsalsosaidtheyhadresearchedinsomedepth,fortheCDOandde-
rivativesmarket,thequestionAreundueconcentrationsofriskdeveloping:Their
answer: probably not. The credit risk was quite modest, the regulators concluded,
andthemonolinefnancialguarantorsappearedtoknowwhattheyweredoing.
1o,
The [Joint Forums Working Group on Risk Assessment and Capital]
hasnotfoundevidenceofhiddenconcentrationsofcreditrisk.There
are some non-bank frms whose primary business model focuses on
takingoncreditrisk.Mostimportantamongthesefrmsarethemono-
line fnancial guarantors. Other market participants seem to be fully
awareofthenatureofthesefrms.Inthecaseofthemonolines,credit
riskhasalwaysbeenaprimarybusinessactivityandtheyhaveinvested
heavily in obtaining the relevant expertise. While obviously this does
notruleoutthepotentialforoneofthesefrmstoexperienceunantici-
patedproblemsortomisjudgetherisks,theirrisksareprimarilyatthe
catastrophicormacroeconomiclevel.Itisalsoclearthatsuchfrmsare
subjectedtoregulatory,ratingagency,andmarketscrutiny.
1oo
The regulators noted that industry participants appeared to have learned from
earlierfare-upsintheCDOsector:TheWorkingGroupbelievesthatitisimportant
forinvestorsinCDOstoseektodevelopasoundunderstandingofthecreditrisksin-
volved and not to rely solely on rating agency assessments. In many respects, the
losses and downgrades experienced on some of the early generation of CDOs have
probablybeensalutaryinhighlightingthepotentialrisksinvolved.
1o,
MOODY S: IT WAS ALL ABOUT REVENUE
Likeothermarketparticipants,MoodysInvestorsService,oneofthethreedominant
rating agencies, was swept up in the frenzy of the structured products market. The
tranching structure of mortgage-backed securities and CDOs was standardized ac-
cordingtoguidelinessetbytheagencies;withouttheirmodelsandtheirgenerousal-
lotment of triple-A ratings, there would have been little investor interest and few
deals.Betweeniooiandiooo,thevolumeofMoodysbusinessdevotedtoratingres-
identialmortgagebackedsecuritiesmorethandoubled;thedollarvalueofthatbusi-
ness increased from oi million to 1o million; the number of staff rating these
dealsdoubled.Butoverthesameperiod,whilethevolumeofCDOstoberatedin-
creased sevenfold, stamng increased only i. From ioo to iooo, annual revenue
tiedtoCDOsgrewfrom1imillionto1million.
1o8
When Moodys Corporation went public in iooo, the investor Warren Buffetts
z+ ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
Berkshire Hathaway held 1, of the company. After share repurchases by Moodys
Corporation, Berkshire Hathaways holdings of outstanding shares increased to over
iobyioo8.Asofio1o,BerkshireHathawayandthreeotherinvestorsownedacom-
bined,o.,ofMoodys.Whenaskedwhetherhewassatisfedwiththeinternalcon-
trols at Moodys, Buffett responded to the FCIC that he knew nothing about the
managementofMoodys.Ihadnoidea.IdneverbeenatMoodys,Idontknowwhere
they are located.
1o
Buffett said that he invested in the company because the rating
agency business was a natural duopoly, which gave it incredible pricing power
andthesingle-mostimportantdecisioninevaluatingabusinessispricingpower.
11o
Many former employees said that after the public listing, the company culture
changeditwentfrom[aculture]resemblingauniversityacademicdepartmentto
onewhichvaluesrevenuesatallcosts,accordingtoEricKolchinsky,aformerman-
agingdirector.
111
Employeesalsoidentifedanewfocusonmarketsharedirectedby
formerpresidentofMoodysInvestorsServiceBrianClarkson.Clarksonhadjoined
Moodysin11asasenioranalystintheresidentialmortgagegroup,andaftersuc-
cessivepromotionshebecameco-chiefoperatingomceroftheratingagencyinioo,
and then president in August ioo,.
11i
Gary Witt, a former team managing director
coveringU.S.derivatives,describedtheculturaltransformationunderClarkson:My
kind of working hypothesis was that [former chairman and CEO] John Rutherford
wasthinking,Iwanttoremakethecultureofthiscompanytoincreaseproftability
dramatically[afterMoodysbecameanindependentcorporation],andthathemade
personneldecisionstomakethathappen,andhewassuccessfulinthatregard.And
thatwaswhyBrianClarksonsrisewassometeoric: . . .hewastheenforcerwhocould
changetheculturetohavemorefocusonmarketshare.
11
Theformermanagingdi-
rector Jerome Fons, who was responsible for assembling an internal history of
Moodys,agreed:Themainproblemwas . . .thatthefrmbecamesofocused,partic-
ularlythestructuredarea,onrevenues,onmarketshare,andtheambitionsofBrian
Clarkson, that they willingly looked the other way, traded the frms reputation for
short-termprofts.
11
MoodysCorporationChairmanandCEORaymondMcDanieldidnotagreewith
thisassessment,tellingtheFCICthathedidntseeanyparticulardifferenceincul-
ture after the spin-off.
11,
Clarkson also disputed this version of events, explaining
thatmarketsharewasimportanttoMoodyswellbeforeitwasanindependentcom-
pany.[TheideathatbeforeMoodys]wasspunofffromDun&Bradstreet,itwasa
sortofsleepy,academickindofcompanythatwasinanivorytower . . .isntthecase,
you know, he explained. I think [the ivory tower] was really a misnomer. I think
thatMoodyshasalwaysbeenfocusedonbusiness.
11o
Clarkson and McDaniel also adamantly disagreed with the perception that con-
cernsaboutmarketsharetrumpedratingsquality.ClarksontoldtheFCICthatitwas
fneforMoodystolosetransactionsifitwasfortherightreasons:Ifitwasananalyt-
icalreasonoritwasacreditreason,theresnotalotyoucandoaboutthat.Butifyoure
losing a deal because youre not communicating, youre not being transparent, youre
not picking up the phone, that could be problematic.
11,
McDaniel cited unforeseen
marketconditionsasthereasonthatthemodelsdidnotaccuratelypredictthecredit
1ui \\iNi: : z+,
quality.
118
HetestifedtotheFCIC,Webelievedthatourratingswereourbestopinion
atthetimethatweassignedthem.Asweobtainednewinformationandwereableto
updateourjudgmentsbasedonthenewinformationandthetrendswewereseeingin
thehousingmarket,wemadewhatIthinkareappropriatechangestoourratings.
11
Nonetheless, Moodys president did not seem to have the same enthusiasm for
compliance as he did for market share and proft, according to those who worked
withhim.ScottMcCleskey,aformerchiefcomplianceomceratMoodys,recounteda
story to the FCIC about an evening when he and Clarkson were dining with the
boardofdirectorsafterthecompanyhadannouncedstrongearnings,particularlyin
the business of rating mortgage-backed securities and CDOs. So Brian Clarkson
comes up to me, in front of everybody at the table, including board members, and
says literally, How much revenue did Compliance bring in this quarter: Nothing.
Nothing. . . .Forhimtosaythatinfrontoftheboard,thatsjustsotellingofhowhe
feltthathewasbulletproof. . . .Forhim,itwasallaboutrevenue.
1io
Clarksontoldthe
FCICthathedidntrememberthisconversationtranspiringandsaid,Frommyper-
spective,complianceisaveryimportantfunction.
1i1
AccordingtosomeformerMoodysemployees,Clarksonsmanagementstyleleft
little room for discussion or dissent. Witt referred to Clarkson as the dictator of
Moodysandsaidthatifheaskedanemployeetodosomething,eitheryoucomply
withhisrequestoryoustartlookingforanotherjob.
1ii
WhenIjoinedMoodysin
late1,,ananalystsworstfearwasthatwewouldcontributetotheassignmentofa
rating that was wrong, Mark Froeba, former senior vice president, testifed to the
FCIC.WhenIleftMoodys,ananalystsworstfearwasthathewoulddosomething,
orshe,thatwouldallowhimorhertobesingledoutforjeopardizingMoodysmar-
ketshare.
1i
Clarksondeniedhavingaforcefulmanagementstyle,andhissupervi-
sor,RaymondMcDaniel,toldtheFCICthatClarksonwasagoodmanager.
1i
Former team managing director Gary Witt recalled that he received a monthly
emailfromClarksonthatoutlinedbasicallymymarketshareintheareasthatIwas
inchargeof. . . .Ibelieveitlistedthedealsthatwedid,andthenitwouldlistthedeals
likeS&Pand/orFitchdidthatwedidntdothatwasinmyarea.Andattimes,Iwould
have to comment on that verbally or even write a written report aboutyou know,
lookintowhatwasitaboutthatdeal,whydidwenotrateit.So,youknow,itwasclear
that market share was important to him. Witt acknowledged the pressures that he
felt as a manager: When I was an analyst, I just thought about getting the deals
right. . . .OnceI[waspromotedtomanagingdirectorand]hadabudgettomeet,I
had salaries to pay, I started thinking bigger picture. I started realizing, yes, we do
haveshareholdersand,yes,theydeservedtomakesomemoney.Weneedtogetthe
ratings right frst, thats the most important thing; but you do have to think about
marketshare.
1i,
Evenasfarbackasioo1,astrongemphasisonmarketsharewasevidentinem-
ployee performance evaluations. In July ioo1, Clarkson circulated a spreadsheet to
subordinatesthatlistedanalystsandthenumberanddollarvolumeofdealseach
hadratedorNOTrated.Clarksonsinstructions:YoushouldbeusingthisinPEs
z+ ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
[performanceevaluations]andtogivepeopleaheadsuponwheretheystandrelative
to their peers.
1io
Team managing directors, who oversaw the analysts rating the
deals,receivedabasesalary,cashbonus,andstockoptions.Theirperformancegoals
generallyfellintothecategoriesofmarketcoverage,revenue,marketoutreach(such
as speeches and publications), ratings quality, and development of analytical tools,
onlyoneofwhichwasimpossibletomeasureinrealtimeascompensationwasbeing
awarded:ratingsquality.Itmighttakeyearsforthepoorqualityofaratingtobecome
clearastheratedassetfailedtoperformasexpected.
InJanuaryiooo,aderivativesmanagerlistedhismostimportantachievementsin
aioo,performanceevaluation.Atthetopofthelist:Protectedourmarketsharein
theCDOcorporatecashfowsector. . . .TomyknowledgewemissedonlyoneCLO
[collateralizedloanobligation]fromBofAandthatCLOwasunratablebyusbecause
ofits[sic]bizarrestructure.
1i,
MoreevidenceofMoodysemphasisonmarketsharewasprovidedbyanemailthat
circulatedinthefallofioo,,inthemidstofsignifcantdowngradesinthestructuredf-
nancemarket.GroupManagingDirectorofU.S.DerivativesYuriYoshizawaaskedher
teamsmanagingdirectorstoexplainamarketsharedecreasefrom8to.
1i8
Despitethisapparentemphasisonmarketshare,ClarksontoldtheFCICthatthe
mostimportantgoalforanymanagingdirectorwouldbecredibility . . .andperform-
ance[of]theratings.
1i
McDaniel,thechairmanandCEOofMoodysCorporation,
elaborated: I disagree that there was a drive for market share. We pay attention to
ourpositioninthemarket. . . .Butratingsquality,gettingtheratingstothebestpos-
siblepredictivecontent,predictivestatus,isparamount.
1o
WhateverMcDanielsorClarksonsintendedmessage,someemployeescontinued
toseeanemphasisonMoodysmarketshare.FormerteammanagingdirectorWitt
recalled that the smoking gun moment of his employment at Moodys occurred
duringatownhallmeetinginthethirdquarterofioo,withMoodysmanagement
anditsmanagingdirectors,afterMoodyshadalreadyannouncedmassdowngrades
on mortgage-related securities.
11
After McDaniel made a presentation about
Moodys fnancial outlook for the year ahead, one managing director responded: I
wasinterested,Ray,tohearyourbeliefthatthefrstthinginthemindsofpeoplein
thisroomisthefnancialoutlookfortheremainderoftheyear. . . .[M]ythinkingis
theres a much greater concern about the franchise. He added, I think that the
greateranxietybeingfeltbythepeopleinthisroomand . . .bytheanalystsiswhats
goingonwiththeratingsandwhattheoutlookis[,] . . .specifcallythesevereratings
transitionsweredealingwith . . .anduncertaintyaboutwhatsaheadonthat,therat-
ingsaccuracy.
1i
Wittrecalled,Moodysreputationwasjustbeingabsolutelylacer-
ated; and that these people are standing here, and theyre not even
addressingtheyre acting like its not even happening, even now that its already
happened. . . .[T]hatjustmadeitsocleartome . . .thatthebalancewasfartoomuch
onthesideofshort-termproftability.
1
InaninternalmemorandumfromOctoberioo,senttoMcDaniel,inasection
titled Confict of Interest: Market Share, Chief Credit Omcer Andrew Kimball
1ui \\iNi: : z+,
explainedthatMoodyshaserectedsafeguardstokeepteamsfromtooeasilysolv-
ing the market share problem by lowering standards. But he observed that these
protectionswerefarfromfail-safe,ashedetailedintwoarea.First,Ratingsareas-
signed by committee, not individuals. (However, entire committees, entire depart-
ments, are susceptible to market share objectives). Second, Methodologies &
criteria are published and thus put boundaries on rating committee discretion.
(However, there is usually plenty of latitude within those boundaries to register
marketinfuence.)
1
Moreover,thepressureformarketshare,combinedwithcomplacency,mayhave
deterredMoodysfromcreatingnewmodelsorupdatingitsassumptions,asKimball
wrote:Organizationsofteninterpretpastsuccessesasevidencingtheircompetence
and the adequacy of their procedures rather than a run of good luck. . . . [O]ur i
yearsofsuccessratingRMBS[residentialmortgagebackedsecurities]mayhavein-
ducedmanagerstomerelyfne-tunetheexistingsystemtomakeitmoreemcient,
more proftable, cheaper, more versatile. Fine-tuning rarely raises the probability of
success;infact,itoftenmakessuccesslesscertain.
1,
IfanissuerdidntlikeaMoodysratingonaparticulardeal,itmightgetabetter
rating from another ratings agency. The agencies were compensated only for rated
dealsineffect,onlyforthedealsforwhichtheirratingswereacceptedbytheissuer.
Sothepressurecamefromtwodirections:in-houseinsistenceonincreasingmarket
shareanddirectdemandsfromtheissuersandinvestmentbankers,whopushedfor
betterratingswithfewerconditions.
1o
RichardMichalek,aformerMoodysvicepresidentandseniorcreditomcer,testi-
fedtotheFCIC,Thethreatoflosingbusinesstoacompetitor,evenifnotrealized,
absolutelytiltedthebalanceawayfromanindependentarbiterofrisktowardsacap-
tive facilitator of risk transfer.
1,
Witt agreed. When asked if the investment banks
frequentlythreatenedtowithdrawtheirbusinessiftheydidntgettheirdesiredrat-
ing, Witt replied, Oh God, are you kidding: All the time. I mean, thats routine. I
mean,theywouldthreatenyouallofthetime. . . .Itslike,Well,nexttime,werejust
goingtogowithFitchandS&P.
18
Clarksonamrmedthatitwouldntsurprisemeto
hearpeoplesaythataboutissuerpressureonMoodysemployees.
1
FormermanagingdirectorFonssuggestedthatMoodyswascomplaisantwhenit
shouldhavebeenprincipled:[Moodys]knewthattheywerebeingbulliedintocav-
ingintobankpressurefromtheinvestmentbanksandoriginatorsofthesethings. . . .
Moodys allow[ed] itself to be bullied. And, you know, they willingly played the
game. . . .Theycouldhavestoodupandsaid,Imsorry,thisisnotwerenotgoing
tosignoffonthis.Weregoingtoprotectinvestors.Weregoingtostopyouknow,
weregoingtotrytoprotectourreputation.WerenotgoingtoratetheseCDOs,were
notgoingtoratethesesubprimeRMBS.
1o
KimballelaboratedfurtherinhisOctoberioo,memorandum:
Ideally,competitionwouldbeprimarilyonthebasisofratingsquality,
with a second component of price and a third component of service.
z.+ ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
Unfortunately,ofthethreecompetitivefactors,ratingqualityisproving
theleastpowerfulgiventhelongtailinmeasuringperformance. . . .The
real problem is not that the market does underweights [sic] ratings
quality but rather that, in some sectors, it actually penalizes quality by
awarding rating mandates based on the lowest credit enhancement
neededforthehighestrating.Unchecked,competitiononthisbasiscan
placetheentirefnancialsystematrisk.Itturnsoutthatratingsquality
has surprisingly few friends: issuers want high ratings; investors dont
wantratingdowngrades;andbankersgametheratingagenciesforafew
extrabasispointsonexecution.
11
MoodysemployeestoldtheFCICthatonetacticusedbytheinvestmentbankers
to apply subtle pressure was to submit a deal for a rating within a very tight time
frame. Kolchinsky, who oversaw ratings on CDOs, recalled the case of a particular
CDO:Whatthetroubleonthisdealwas,andthisiscrucialaboutthemarketshare,
wasthatthebankergaveushardlyanynoticeandanydocumentsandanytimetoan-
alyzethisdeal. . . .Becausebankersknewthatwecouldnotsaynotoadeal,couldnot
walk away from the deal because of a market share, they took advantage of that.
1i
ForthisCDOdeal,thebankersallowedonlythreeorfourdaysforreviewandfnal
judgment. Kolchinsky emailed Yoshizawa that the transactions had egregiously
pushed our time limits (and analysts).
1
Before the frothy days of the peak of the
housing boom, an agency took six weeks or even two months to rate a CDO.
1
By
iooo, Kolchinsky described a very different environment in the CDO group:
Bankerswerepushingmoreaggressively,sothatitbecamefromaquietlittlegroup
to more of a machine.
1,
In iooo, Moodys gave triple-A ratings to an average of
morethanomortgagesecuritieseachandeveryworkingday.
1o
SuchpressurecanbeseeninanAprilioooemailtoYoshizawafromamanaging
directorinsyntheticCDOtradingatCreditSuisse,whoexplained,Imgoingtohave
amajorpoliticalproblemifwecantmakethis[dealrating]shortandsweetbecause,
eventhoughIalwaysexplaintoinvestorsthatclosingissubjecttoMoodystimelines,
theyoftenchoosenottohearit.
1,
TheexternalpressurewassummedupinKimballsOctoberioo,memorandum:
Analystsand[managingdirectors]arecontinuallypitchedbybankers,issuers,in-
vestorsall with reasonable argumentswhose views can color credit judgment,
sometimesimprovingit,othertimesdegradingit(wedrinkthekool-aid).Coupled
withstronginternalemphasisonmarketshare&marginfocus,thisdoesconstitutea
risktoratingsquality.
18
The SEC investigated the rating agencies ratings of mortgage-backed securities
andCDOsinioo,,reportingitsfndingstoMoodysinJulyioo8.TheSECcriticized
Moodysfor,amongotherthings,failingtoverifytheaccuracyofmortgageinforma-
tion,leavingthatworktoduediligencefrmsandotherparties;failingtoretaindoc-
umentation about how most deals were rated; allowing ratings quality to be
compromised by the complexity of CDO deals; not hiring sumcient staff to rate
1ui \\iNi: : z..
z.z ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
CDOs; pushing ratings out the door with insumcient review; failing to adequately
disclose its rating process for mortgage-backed securities and CDOs; and allowing
confictsofinteresttoaffectratingdecisions.
1
Somattersstoodinioo,,whenthemachinethathadbeenhummingsosmoothly
andsolucrativelyslippedagear,andthenanother,andanotherandthenseizedup
entirely.
COMMISSION CONCLUSIONS ON CHAPTER 10
The Commission concludes that the credit rating agencies abysmally failed in
theircentralmissiontoprovidequalityratingsonsecuritiesforthebeneftofin-
vestors.Theydidnotheedmanywarningsignsindicatingsignifcantproblemsin
the housing and mortgage sector. Moodys, the Commissions case study in this
area,continuedissuingratingsonmortgage-relatedsecurities,usingitsoutdated
analytical models, rather than making the necessary adjustments. The business
modelunderwhichfrmsissuingsecuritiespaidfortheirratingsseriouslyunder-
minedthequalityandintegrityofthoseratings;theratingagenciesplacedmarket
shareandproftconsiderationsabovethequalityandintegrityoftheirratings.
Despitethelevelingoffandsubsequentdeclineofthehousingmarketbegin-
ning in iooo, securitization of collateralized debt obligations (CDOs), CDOs
squared, and synthetic CDOs continued unabated, greatly expanding the expo-
suretolosseswhenthehousingmarketcollapsedandexacerbatingtheimpactof
thecollapseonthefnancialsystemandtheeconomy.
During this period, speculators fueled the market for synthetic CDOs to bet
onthefutureofthehousingmarket.CDOmanagersofthesesyntheticproducts
hadpotentialconfictsintryingtoservetheinterestsofcustomerswhowerebet-
ting mortgage borrowers would continue to make their payments and of cus-
tomerswhowerebettingthehousingmarketwouldcollapse.
Therewerealsopotentialconfictsforunderwritersofmortgage-relatedsecu-
rities to the extent they shorted the products for their own accounts outside of
theirrolesasmarketmakers.
11
THE BUST
CONTENTS
Dc|inqucncics1hcturncjthchcusingnarkct :+,
RatingdcwngradcsNcvcr|cjcrc::+
CDOsC|in|ingthcwa||cjsu|princwcrry::,
Icga|rcncdicsOnthc|asiscjthcinjcrnaticn::,
IcsscsVhccwnsrcsidcntia|crcditrisk? ::e
What happens when a bubble bursts: In early ioo,, it became obvious that home
priceswerefallinginregionsthathadonceboomed,thatmortgageoriginatorswere
foundering, and that more and more families, especially those with subprime and
Alt-Aloans,wouldbeunabletomaketheirmortgagepayments.
What was not immediately clear was how the housing crisis would affect the f-
nancial system that had helped infate the bubble. Were all those mortgage-backed
securities and collateralized debt obligations ticking time bombs on the balance
sheets of the worlds largest fnancial institutions: The concerns were just that if
people . . .couldntvaluetheassets,thenthatcreated . . .questionsaboutthesolvency
ofthefrms,WilliamC.Dudley,nowpresidentoftheFederalReserveBankofNew
York,toldtheFCIC.
1
Intheory,securitization,over-the-counterderivativesandthemanybywaysofthe
shadowbankingsystemweresupposedtodistributeriskemcientlyamonginvestors.
Thetheorywouldprovetobewrong.Muchoftheriskfrommortgage-backedsecuri-
ties had actually been taken by a small group of systemically important companies
withoutsizedholdingsof,orexposureto,thesuper-seniorandtriple-Atranchesof
CDOs. These companies would ultimately bear great losses, even though those in-
vestmentsweresupposedtobesuper-safe.
Asioo,wenton,increasingmortgagedelinquenciesanddefaultscompelledthe
ratings agencies to downgrade frst mortgage-backed securities, then CDOs.
Alarmed investors sent prices plummeting. Hedge funds faced with margin calls
from their repo lenders were forced to sell at distressed prices; many would shut
down.Bankswrotedownthevalueoftheirholdingsbytensofbillionsofdollars.
z.,
Thesummerofioo,alsosawanearhaltinmanysecuritizationmarkets,includ-
ingthemarketfornon-agencymortgagesecuritizations.Forexample,atotalof,,
billioninsubprimesecuritizationswereissuedinthesecondquarterofioo,(already
down from prior quarters). That fgure dropped precipitously to i, billion in the
third quarter and to only 1i billion in the fourth quarter of ioo,. Alt-A issuance
topped1oobillioninthesecondquarter,butfellto1billioninthefourthquarter
ofioo,.Once-boomingmarketswerenowgoneonlybillioninsubprimeorAlt-
Amortgage-backedsecuritieswereissuedinthefrsthalfofioo8,andalmostnone
afterthat.
i
CDOsfollowedsuit.Fromahighofmorethanobillioninthefrstquarterof
ioo,, worldwide issuance of CDOs with mortgage-backed securities as collateral
plummeted to i billion in the third quarter of ioo, and only , billion in the
fourthquarter.AndastheCDOmarketgroundtoahalt,investorsnolongertrusted
other structured products.

Over 8o billion of collateralized loan obligations


(CLOs),orsecuritizedleveragedloans,wereissuedinioo,;only1obillionwereis-
sued in ioo8. The issuance of commercial real estate mortgagebacked securities
plummetedfromiibillioninioo,to1ibillioninioo8.

Thosesecuritizationmarketsthatheldupduringtheturmoilinioo,eventually
suffered in ioo8 as the crisis deepened. Securitization of auto loans, credit cards,
smallbusinessloans,andequipmentleasesallnearlyceasedinthethirdandfourth
quartersofioo8.
DELINQUENCIES: THE TURN OF THE HOUSING MARKET
Homepricesrose1,nationallyinioo,,theirthirdyearofdouble-digitgrowth.But
bythespringofiooo,asthesalespaceslowed,thenumberofmonthsitwouldtaketo
selloffallthehomesonthemarketrosetoitshighestlevelin1oyears.Nationwide,
homepricespeakedinApriliooo.
MembersoftheFederalReservesFederalOpenMarketCommittee(FOMC)dis-
cussed housing prices in the spring of iooo. Chairman Ben Bernanke and other
memberspredictedadeclineinhomepricesbutwereuncertainwhetherthedecline
would be slow or fast. Bernanke believed some correction in the housing market
wouldbehealthyandthatthegoaloftheFOMCshouldbetoensurethecorrection
didnotoverlyaffectthegrowthoftherestoftheeconomy.
,
InOctoberiooo,withthehousingmarketdownturnunderway,MoodysEcon-
omy.com, a business unit separate from Moodys Investors Service, issued a report
authoredbyChiefEconomistMarkZandititledHousingattheTippingPoint:The
Outlook for the U.S. Residential Real Estate Market. He came to the following
conclusion:
Nearly io of the nations metro areas will experience a crash in house
prices;adouble-digitpeak-to-troughdeclineinhouseprices. . . .These
sharpdeclinesinhousepricesareexpectedalongtheSouthwestcoastof
Florida,inthemetroareasofArizonaandNevada,inanumberofCali-
z., ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
1ui 8U:1 z.,
fornia areas, throughout the broad Washington, D.C. area, and in and
aroundDetroit.Manymoremetroareasareexpectedtoexperienceonly
house-pricecorrectionsinwhichpeak-to-troughpricedeclinesremain
inthesingledigits. . . .Itisimportanttonotethatpricedeclinesinvari-
ousmarketsareexpectedtoextendintoioo8andevenioo.
With over 1oo metro areas representing nearly one-half of the na-
tionshousingstockexperiencingorabouttoexperiencepricedeclines,
nationalhousepricesarealsosettodecline.Indeed,oddsarehighthat
nationalhousepriceswilldeclineinioo,.
o
For ioo,, the National Association of Realtors announced that the number of
salesofexistinghomeshadexperiencedthesharpestfallini,years.Thatyear,home
pricesdeclined.Inioo8,theywoulddropastunning1,.Overall,bytheendof
ioo,priceswoulddropi8fromtheirpeakiniooo.
,
Somecitiessawaparticularly
largedrop:inLasVegas,asofAugustio1o,homepricesweredown,,fromtheir
peak. And areas that never saw huge price gains have experienced losses as well:
homepricesinDenverhavefallen18sincetheirpeak.
In some areas, home prices started to fall as early as late ioo,. For example, in
OceanCity,NewJersey,wheremanypropertiesarevacationhomes,homepriceshad
risen1sinceioo1;theytoppedoutinDecemberioo,andfellinthefrsthalf
of iooo. By mid-io1o, they would be ii below their peak. Prices topped out in
SacramentoinOctoberioo,andaretodaydownnearly,o.Inmostplaces,prices
rose for a bit longer. For instance, in Tucson, Arizona, prices kept increasing for
muchofiooo,climbing,fromioo1totheirhighpointinAugustiooo,andthen
fellonlybytheendoftheyear.
8
One of the frst signs of the housing crash was an upswing in early payment de-
faultsusuallydefnedasborrowersbeingooormoredaysdelinquentwithinthefrst
year. Figures provided to the FCIC show that by the summer of iooo, 1., of loans
lessthanayearoldwereindefault.Thefgurewouldpeakinlateioo,ati.,,well
above the 1.o peak in the iooo recession. Even more stunning, frst payment de-
faultsthatis,mortgagestakenoutbyborrowerswhonevermadeasinglepayment
went above 1., of loans in early ioo,.

Responding to questions about that data,


CoreLogicChiefEconomistMarkFlemingtoldtheFCICthattheearlypaymentde-
faultratecertainlycorrelateswiththeincreaseintheAlt-Aandsubprimesharesand
theturnofthehousingmarketandthesensitivityofthoseloanproducts.
1o
Mortgagesinseriousdelinquency,defnedasthoseoormoredayspastdueorin
foreclosure,hadhoveredaround1duringtheearlypartofthedecade,jumpedin
iooo,andkeptclimbing.Bytheendofioo,.,ofmortgageloanswereseriously
delinquent.Bycomparison,seriousdelinquenciespeakedati.iniooifollowing
thepreviousrecession.
11
Seriousdelinquencywashighestinareasofthecountrythathadexperiencedthe
biggest housing booms. In the sand statesCalifornia, Arizona, Nevada, and
Floridaseriousdelinquencyrosetoinmid-ioo,and1,bylateioo,double
therateinotherareasofthecountry(seefgure11.1).
1i
z. ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
Serious delinquency also varied by type of loan (see fgure 11.i). Subprime ad-
justable-ratemortgagesbegantoshowincreasesinseriousdelinquencyinearlyiooo,
evenashousepriceswerepeaking;therateroserapidlytoioinioo,.Bylateioo,
thedelinquencyrateforsubprimeARMswaso.PrimeARMsdidnotweakenun-
tilioo,,ataboutthesametimeassubprimefxed-ratemortgages.Primefxed-rate
mortgages,whichhavehistoricallybeentheleastrisky,showedaslowincreaseinse-
riousdelinquencythatcoincidedwiththeincreasingseverityoftherecessionandof
unemploymentinioo8.
The FCIC undertook an extensive examination of the relative performance of
mortgages purchased or guaranteed by the GSEs, those securitized in the private
market, and those insured by the Federal Housing Administration or Veterans Ad-
ministration(seefgure11.).Theanalysiswasconductedusingroughlyi,million
mortgagesoutstandingattheendofeachyearfromiooothroughioo.
1
Thedata
containedmortgagesinfourgroupsloansthatweresoldintoprivatelabelsecuriti-
zationslabeledsubprimebyissuers(labeledSUB),loanssoldintoprivatelabelAlt-A
securitizations(ALT),loanseitherpurchasedorguaranteedbytheGSEs(GSE),and
loansguaranteedbytheFederalHousingAdministrationorVeteransAdministration
(FHA).
1
TheGSEgroup,inadditiontothemoretraditionalconformingGSEloans,
Arizona, California, Florida, and Nevadathe sand stateshad the most
problem loans.
Mortgage Delinquencies by Region
IN PERCENT, BY REGION
0
4
8
12
16%
1998 2000 2002 2004 2006 2008 2010
Sand
states
U.S.
total
Non-sand
states
13.6%
8.7%
7.0%
SOURCE: Mortgage Bankers Association National Delinquency Survey
NOTE: Serious delinquencies include mortgages 90 days or more past due and those in foreclosure.
Iigurc ++.+
1ui 8U:1 z.,
alsoincludesmortgagesthattheGSEsidentifedassubprimeandAlt-Aloansowing
totheirhigher-riskcharacteristics,asdiscussedinearlierchapters.
Withineachofthefourgroups,theFCICcreatedsubgroupsbasedoncharacteris-
tics that could affect loan performance: FICO credit scores, loan-to-value ratios
(LTVs), and mortgage size. For example, one subgroup would be GSE loans with a
balancebelow1,,ooo(conformingtoGSEloansizelimits),aFICOscorebetween
ooando,(aborrowerwithbelow-averagecredithistory),andLTVbetween8o
and 1oo. Another group would be Alt-A loans with the same characteristics. In
each year, the loans were broken into ,,o different subgroups1 each for GSE,
SUB,ALT,andFHA.
1,
Figure11.graphicallydemonstratestheresultsoftheexamination.Thevarious
barsshowtherangeofaveragedelinquenciesforeachofthefourgroupsexamined,
based on the distribution of delinquency rates within the 1 subgroups for each
loancategory.Theblackportionofeachbarrepresentsthemiddle,o(i,onei-
thersideofthemedian)ofthedistributionofaveragedelinquencyrates.Thefullbar,
includingbothdarkandlightshading,representsthemiddleoofthedistribution
ofaveragedelinquencyrates.Thebarsexcludethe,attheextremesofeachendof
the distribution. For example, at the end of ioo8, the black portion of the GSE bar
Iigurc ++.:
Mortgage Delinquencies by Loan Type
IN PERCENT, BY TYPE
SOURCE: Mortgage Bankers Association National Delinquency Survey
Subprime
adjustable
rate
Subprime
fx
rate
Prime
adjustable
rate
Prime
fx
rate
1998 2000 2002 2004 2006 2008 2010
NOTE: Serious delinquencies include mortgages 90 days or more past due and those in foreclosure.
Serious delinquencies started earlier and were substantially higher among
subprime adjustable-rate loans, compared with other loan types.
0
10
20
30
40
50%
spans a o.o average delinquency rate on the low end and a i. average delin-
quency rate on the high end. The full bar for the GSEs spans average delinquency
rates from o.1 to o.o. That means that only , of GSE loans were in subgroups
with average delinquency rates above o.o. In sharp contrast, the black bar for pri-
vate-label subprime securitizations (SUB) spans average delinquency rates between
i.o on the low end and 1.o on the high end, and the full bar spans average
delinquency rates between 1o.o and i.o. That means that only , of SUB loans
were in subgroups with average delinquency rates below 1o. The worst-performing
, of GSE loans are in subgroups with rates of serious delinquency similar to the
best-performing , of SUB loans.
1o
By the end of ioo, performance within all segments of the market had weakened.
The median delinquency ratethe midpoints of the black barsrose from 1 in
ioo8 to i., for GSE loans, from i to for SUB loans, from 1i to i1 for
Alt-A loans, and remained at roughly o for FHA loans.
The data illustrate that in ioo8 and ioo, GSE loans performed signifcantly bet-
ter than privately securitized, or non-GSE, subprime and Alt-A loans. That holds
true even when comparing loans in GSE pools that share the same key characteristics
with the loans in privately securitized mortgages, such as low FICO scores. For exam-
ple, among loans to borrowers with FICO scores below ooo, a privately securitized
mortgage was more than four times as likely to be seriously delinquent as a GSE.
z. ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
MIDDLE 50%
MIDDLE 90%
IN PERCENT
SOURCE: FCIC calculations, based on CoreLogic and Loan Processing Service Inc.
Bars shows distribution of average rate of serious delinquency.
2008 2009
30 20 10 0 40%
FHA
GSE
SUB
ALT
30 20 10 0 40%
FHA
GSE
SUB
ALT
Loan Performance in Various Mortgage-Market Segments
NOTE: Serious deli uencies include mortgages 90 days or more past due and those in foreclosure.
Iigurc ++.
nq
Inioo8,therespectiveaveragedelinquencyratesforthenon-GSEandGSEloans
werei8.ando.i.Thesepatternsaremostlikelydrivenbydifferencesinunder-
writing standards as well as by some differences not captured in these mortgages.
1,
Forinstance,intheGSEpool,borrowerstendedtomakebiggerdownpayments.The
FCICsdatashowthat,8ofGSEloanswithFICOscoresbelowooohadanoriginal
loan-to-valueratiobelow8o,indicatingthattheborrowermadeadownpayment
ofatleastioofthesalesprice.Thisrelativelylargedownpaymentwouldhelpoffset
theeffectofthelowerFICOscore.Incontrast,only1ofloanswithFICOscores
belowoooinnon-GSEsubprimesecuritizationshadanLTVunder8o.Thedatail-
lustratethatnon-agencysecuritizedloansweremuchmorelikelytohavemorethan
one risk factor and thereby exhibit so-called risk layering, such as low FICO scores
ontopofsmalldownpayments.
GSEmortgageswithAlt-Acharacteristicsalsoperformedsignifcantlybetterthan
mortgages packaged into non-GSE Alt-A securities. For example, in ioo8 among
loanswithanLTVaboveo,theGSEpoolshaveanaveragerateofseriousdelin-
quency of ,.,, versus a rate of 1,., for loans in private Alt-A securities.
18
These
resultsarealso,inlargepart,drivenbydifferencesinrisklayering.
Othersframethesituationdifferently.AccordingtoEdPinto,amortgagefnance
industryconsultantwhowasthechiefcreditomceratFannieMaeinthe18os,GSEs
dominatedthemarketforriskyloans.InwrittenanalysesreviewedbytheFCICstaff
and sent to Commissioners as well as in a number of interviews, Pinto has argued
thattheGSEloansthathadFICOscoresbelowooo,acombinedloan-to-valueratio
greater than o, or other mortgage characteristics such as interest-only payments
were essentially equivalent to those mortgages in securitizations labeled subprime
andAlt-Abyissuers.
UsingstrictcutoffsonFICOscoreandloan-to-valueratiosthatignorerisklayer-
ingandthusareonlypartlyrelatedtomortgageperformance(aswellasrelyingona
number of other assumptions), Pinto estimates that as of June o, ioo8, of all
mortgagesinthecountryio.,millionofthemwereriskymortgagesthathede-
fnes as subprime or Alt-A. Of these, Pinto counts 11. million, or ,, that were
purchasedorguaranteedbytheGSEs.
1
Incontrast,theGSEscategorizefewerthan
millionoftheirloansassubprimeorAlt-A.
io
Importantly, as the FCIC review shows, the GSE loans classifed as subprime or
Alt-AinPintosanalysisdidnotperformnearlyaspoorlyasloansinnon-agencysub-
primeorAlt-Asecurities.Thesedifferencessuggestthatgroupingalloftheseloans
togetherismisleading.IndirectcontrasttoPintosclaim,GSEmortgageswithsome
riskier characteristics such as high loan-to-value ratios are not at all equivalent to
those mortgages in securitizations labeled subprime and Alt-A by issuers. The per-
formancedataassembledandanalyzedbytheFCICshowthatnon-GSEsecuritized
loans experienced much higher rates of delinquency than did the GSE loans with
similarcharacteristics.
InadditiontoexaminingloansownedandguaranteedbytheGSEs,Pintoalsocom-
mentedontheroleoftheCommunityReinvestmentAct(CRA)incausingthecrisis,
declaring,ThepainandhardshipthatCRAhaslikelyspawnedareimmeasurable.
i1
1ui 8U:1 z.,
Contrarytothisview,twoFedeconomistsdeterminedthatlendersactuallymade
fewsubprimeloanstomeettheirCRArequirements.Analyzingadatabaseofnearly
1 million loans originated in iooo, they found that only a small percentage of all
higher-costloansasdefnedbytheHomeMortgageDisclosureActhadanyconnec-
tiontotheCRA.Thesehigher-costloansserveasaroughproxyforsubprimemort-
gages.Specifcally,thestudyfoundthatonlyoofsuchhigher-costloansweremade
to low- or moderate-income borrowers or in low- or moderate-income neighbor-
hoodsbybanksandthrifts(andtheirsubsidiariesandamliates)coveredbytheCRA.
The other of higher-cost loans either were made by CRA-covered institutions
thatdidnotreceiveCRAcreditfortheseloansorweremadebylendersnotcovered
bytheCRA.Usingotherdatasources,theseeconomistsalsofoundthatCRA-related
subprime loans appeared to perform better than other subprime loans. Taken to-
gether, the available evidence seems to run counter to the contention that the CRA
contributedinanysubstantivewaytothecurrentcrisis,theywrote.
ii
Subsequent research has come to similar conclusions. For example, two econo-
mistsattheSanFranciscoFed,usingadifferentmethodologyandanalyzingdataon
theCaliforniamortgagemarket,foundthatonly1oofloansmadebyCRA-covered
lenderswerelocatedinlow-andmoderate-incomecensustractsversusoveriofor
independentmortgagecompaniesnotcoveredbytheCRA.Further,fewerthano
oftheloansmadebyCRAlendersinlow-incomecommunitieswerehigherpriced,
evenatthepeakofthemarket.Incontrast,aboutone-halfoftheloansoriginatedby
independentmortgagecompaniesinthesecommunitieswerehigherpriced.Andaf-
teraccountingforcharacteristicsoftheloansandtheborrowers,suchasincomeand
creditscore,theauthorsfoundthatloansmadebyCRA-coveredlendersinthelow-
andmoderate-incomeareastheyservewerehalfaslikely todefaultassimilarloans
made by independent mortgage companies, which are not subject to CRA and are
subject to less regulatory oversight in general. While certainly not conclusive, this
suggeststhattheCRA,andparticularlyitsemphasisonloansmadewithinalenders
assessmentarea,helpedtoensureresponsiblelending,evenduringaperiodofover-
alldeclinesinunderwritingstandards,theyconcluded.
i
Overall,inioo,ioo,,andiooo,CRA-coveredbanksandthriftsaccountedforat
least oo of all mortgage lending but only between o and 1 of higher-priced
mortgages. Independent mortgage companies originated less than one-third of all
mortgages but about one-half of all higher-priced mortgages.
i
Finally, lending by
nonbank amliates of CRA-covered depository institutions is counted toward CRA
performanceatthediscretionofthebankorthrift.Theseamliatesaccountedforan-
otherroughly1oofmortgagelendingbutabout1iofhigh-pricelending.
BankofAmericaprovidedtheFCICwithperformancedataonitsCRA-qualify-
ing portfolio, which represented only , of the banks mortgage portfolio.
i,
In the
endofthefrstquarterofio1o,8ofthebanksi1ibillionportfolioofresidential
mortgageswasnonperforming:i1ofthe1,billionCRA-qualifyingportfoliowas
nonperformingatthatdate.
JohnReed,aformerCEOofCitigroup,whenaskedwhetherhethoughtgovern-
mentpoliciessuchastheCRAplayedaroleinthecrisis,saidthathedidntbelieve
zz+ ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
bankswouldoriginateabadmortgagebecausetheythoughtthegovernmentpolicy
allowed it unless the bank could sell off the mortgage to Fannie or Freddie, which
hadtheirownobligationsinthisarena.Hesaid,Itshardformetoanswer.Iftherea-
son the regulators didnt jump up and down and yell at the low-doc, no-doc sub-
primemortgagewasbecausetheyfeltthatthey,Congresshadsortofpushedinthat
direction,thenIwouldsayyes.
io
Youknow,CRAcouldbeapainintheneck,thebankerLewisRanieritoldthe
FCIC. But you know what: It always, in my view, it always did much more good
thanitdidanything.Youknow,wedidalot.CRAmadeabigdifferenceincommuni-
ties. . . .Youwerereallyputtingmoneyinthecommunitiesinwaysthatreallystabi-
lized the communities and made a difference. But lenders including Countrywide
usedpro-homeownershippoliciesasasmokescreentodoawaywithunderwriting
standardssuchasrequiringdownpayments,hesaid.Thedangeristhatitgivesair
covertoallofthiskindofmadnessthathadnothingtodowiththehousinggoal.
i,
RATING DOWNGRADES: NEVER BEFORE
Priortoioo,theratingsofmortgage-backedsecuritiesatMoodysweremonitored
by the same analysts who had rated them in the frst place. In ioo, Nicolas Weill,
Moodyschiefcreditomcerandteammanagingdirector,waschargedwithcreating
anindependentsurveillanceteamtomonitorpreviouslyrateddeals.
i8
InNovemberiooo,thesurveillanceteambegantoseeariseinearlypaymentde-
faults in mortgages originated by Fremont Investment & Loan,
i
and downgraded
several securities with underlying Fremont loans or put them on watch for future
downgrades.Thiswasaveryunusualsituationasneverbeforehadweputonwatch
dealsratedinthesamecalendaryear,WeilllaterwrotetoRaymondMcDaniel,the
chairman and CEO of Moodys Corporation, and Brian Clarkson, the president of
MoodysInvestorsService.
o
In early ioo,, a Moodys special report, overseen by Weill, about the sharp in-
creases in early payment defaults stated that the foreclosures were concentrated in
subprimemortgagepools.Inaddition,morethani.,,ofthesubprimemortgages
securitizedinthesecondquarterofiooowereoodaysdelinquentwithinsixmonths,
morethandoubletherateayearearlier(1.i,).Theexactcauseofthetroublewas
still unclear to the ratings agency, though. Moodys is currently assessing whether
this represents an overall worsening of collateral credit quality or merely a shifting
forwardofeventualdefaultswhichmaynotsignifcantlyimpactapoolsoverallex-
pectedloss.
1
Forthenextfewmonths,thecompanypublishedregularupdatesaboutthesub-
prime mortgage market. Over the next three months, Moodys took negative rating
actionson.,oftheoutstandingsubprimemortgagesecuritiesratedBaa.Then,on
July1o,ioo,,inanunprecedentedmove,Moodysdowngradedsubprimemort-
gage-backedsecuritiesthathadbeenissuedinioooandputanadditionalisecuri-
tiesonwatch.The,.ibillionofsecuritiesthatwereaffected,allratedBaaandlower,
madeup1ofthesubprimesecuritiesthatMoodysratedBaainiooo.Forthetime
1ui 8U:1 zz.
being, there were no downgrades on higher-rated tranches. Moodys attributed the
downgrades to aggressive underwriting combined with prolonged, slowing home
price appreciation and noted that about oo of the securities affected contained
mortgages from one of four originators: Fremont Investment & Loan, Long Beach
Mortgage Company, New Century Mortgage Corporation, and WMC Mortgage
Corp.
i
WeilllatertoldtheFCICstaffthatMoodysissuedamassannouncement,rather
thandowngradingafewsecuritiesatatime,toavoidcreatingconfusioninthemar-
ket.

A few days later, Standard & Poors downgraded 8 similar tranches. These
initialdowngradeswereremarkablenotonlybecauseofthenumberofsecuritiesin-
volvedbutalsobecauseofthesharpratingcutsanaverageoffournotchesperse-
curity, when one or two notches was more routine (for example, a single notch
wouldbeadowngradefromAAtoAA-).AmongthetranchesdowngradedinJuly
ioo, were the bottom three mezzanine tranches (M, M1o, and M11) of the Citi-
group deal that we have been examining, CMLTI iooo-NCi. By that point, nearly
1i of the original loan pool had prepaid but another 11 were o or more days
pastdueorinforeclosure.

Investorsacrosstheworldwereassessingtheirownexposure,andguessingatthat
ofothers,howeverindirect,totheseassets.AreportfromBearStearnsAssetMan-
agement detailed its exposure. One of its CDOs, Tall Ships, had direct exposure to
oursampledeal,owning8millionoftheM,andM8tranches.BSAMsHigh-Grade
hedge fund also had exposure through a 1o million credit default swap position
with Lehman referencing the M8 tranche. And BSAMs Enhanced Leverage hedge
fundownedpartsoftheequityinIndependenceCDO,whichinturnownedtheM
tranche of our sample deal. In addition, these funds had exposure through their
holdingsofotherCDOsthatinturnownedtranchesoftheCitigroupdeal.
,
Then, on October 11, Moodys downgraded another i,,oo tranches (. bil-
lion) of subprime mortgagebacked securities and placed ,,, tranches (i.8 bil-
lion)onwatchforpotentialdowngrade.Nowthetotalofsecuritiesdowngradedand
put on watch represented 1. of the original dollar volume of all iooo subprime
mortgagebacked securities that Moodys had rated. Of the securities placed on
watchinOctober,8tranches(o.billion)wereoriginallyAaa-ratedand,i(1o.
billion)wereAa-rated.Alltold,inthefrst1omonthsofioo,,iofthemortgage-
backedsecuritydealsissuediniooohadatleastonetranchedowngradedorputon
watch.
o
By this point in October, 1 of the loans in our case study deal CMLTI iooo-
NCiwereseriouslydelinquentandsomehomeshadalreadybeenrepossessed.The
M through M8 tranches were downgraded as part of the second wave of mass
downgrades. Five additional tranches would eventually be downgraded in April
ioo8.
,
Beforeitwasover,Moodyswoulddowngrade8ofalltheioooAaamortgage-
backedsecuritiestranchesandalloftheBaatranches.Forthosesecuritiesissuedin
the second half of ioo,, nearly all Aaa and Baa tranches were downgraded. Of all
zzz ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
tranches initially rated investment gradethat is, rated Baa or higher,o of
thoseissuedinioooweredowngradedtojunk,aswere8ofthosefromioo,.
8
CDOS: CLIMBING THE WALL OF SUBPRIME WORRY
InMarchioo,,MoodysreportedthatCDOswithhighconcentrationsofsubprime
mortgagebackedsecuritiescouldincurseveredowngrades.

Inaninternalemail
sent fve days after the report, Group Managing Director of U.S. Derivatives Yuri
Yoshizawa explained to Moodys Chairman McDaniel and to Executive Vice Presi-
dent Noel Kirnon that one managing director at Credit Suisse First Boston sees
bankslikeMerrill,Citi,andUBSstillfuriouslydoingtransactionstoclearouttheir
warehouses. . . .HebelievesthattheyarecreatingandpricingtheCDOsinorderto
removetheassetsfromthewarehouses,butthattheyareholdingontotheCDOs . . .
inhopesthattheywillbeabletosellthemlater.
o
Severalmonthslater,inareviewof
the CDO market titled Climbing the Wall of Subprime Worry, Moodys noted,
Someofthefrstquartersactivity[inioo,]wastheresultofsomearrangersfever-
ishlyworkingtoclearinventoryandreducetheirbalancesheetexposuretothesub-
prime class.
1
Even though Moodys was aware that the investment banks were
dumping collateral out of the warehouses and into CDOspossibly regardless of
qualitythefrmcontinuedtoratenewCDOsusingexistingassumptions.
FormerMoodysexecutiveRichardMichalektestifedtotheFCIC,Itwasacase
of, with respect to why didnt we stop and change our methodology, there is a very
conservative culture at Moodys, at least while I was there, that suggested that the
onlythingworsethanquicklygettinganewmethodologyinplaceisquicklygetting
the wrong methodology in place and having to unwind that and to fail to consider
theunintendedconsequences.
i
InJuly,McDanielgaveapresentationtotheboardonthecompanysioo,strate-
gicplan.HisslideshadsuchbleaktitlesasSpotlightonMortgages:QualityContin-
ues to Erode, House Prices Are Falling . . . , Mortgage Payment Resets Are
Mounting,and1.MMMortgageDefaultsForecastioo,o8.

Despitealltheevi-
dence that the quality of the underlying mortgages was declining, Moodys did not
makeanysignifcantadjustmentstoitsCDOratingsassumptionsuntillateSeptem-
ber.

Outof,1billioninCDOsthatMoodysratedafteritsmassdowngradeofsub-
primemortgagebackedsecuritiesonJuly1o,ioo,,88wereratedAaa.
,
Moodyshadhopedthatratingdowngradescouldbestavedoffbymortgagemod-
ifcationsiftheirmonthlypaymentsbecamemoreaffordable,borrowersmightstay
current.However,inmid-September,EricKolchinsky,ateammanagingdirectorfor
CDOs,learnedthatasurveyofservicersindicatedthatveryfewtroubledmortgages
werebeingmodifed.
o
WorriedthatcontinuingtorateCDOswithoutadjustingfor
known deterioration in the underlying securities could expose Moodys to liability,
KolchinskyadvisedYoshizawathatthecompanyshouldstopratingCDOsuntilthe
securities downgrades were completed. Kolchinsky told the FCIC that Yoshizawa
admonishedhimformakingthesuggestion.
,
1ui 8U:1 zz,
By the end of ioo8, more than o of all tranches of CDOs had been down-
graded. Moodys downgraded nearly all of the iooo Aaa and all of the Baa CDO
tranches. And, again, the downgrades were largemore than 8o of Aaa CDO
bondsandmorethanoofBaaCDObondswereeventuallydowngradedtojunk.
8
LEGAL REMEDIES: ON THE BASIS OF THE INFORMATION
Thehousingbustexposedthefawsinthemortgagesthathadbeenmadeandsecuri-
tized. After the crisis unfolded, those with exposure to mortgages and structured
productsincluding investors, fnancial frms, and private mortgage insurance
frmscloselyexaminedtherepresentationsandwarrantiesmadebymortgageorig-
inators and securities issuers. When mortgages were securitized, sold, or insured,
certain representations and warranties were made to assure investors and insurers
thatthemortgagesmetstatedguidelines.Asmortgagesecuritieslostvalue,investors
foundsignifcantdefcienciesinsecuritizersduediligenceonthemortgagepoolsun-
derlyingthemortgage-backedsecuritiesaswellasintheirdisclosureaboutthechar-
acteristics of those deals. As private mortgage insurance companies found similar
defcienciesintheloanstheyinsured,theyhavedeniedclaimstoanunprecedented
extent.
FannieandFreddieacquiredorguaranteedmillionsofloanseachyear.Theydele-
gatedunderwritingauthoritytooriginatorssubjecttoalegalagreementrepresenta-
tions and warrantiesthat the loans meet specifed criteria. They then checked
samples of the loans to ensure that these representations and warranties were not
breached.Iftherewasabreachandtheloanswereineligibleforpurchase,theGSE
hadtherighttorequirethesellertobuybacktheloanassuming,ofcourse,thatthe
sellerhadnotgonebankrupt.
Asaresultofsuchsampling,duringthethreeyearsandeightmonthsendingAu-
gust1,io1o,FreddieandFannierequiredsellerstorepurchase1o,,oooloanstotal-
ing.8billion.Sofar,Freddiehasreceived.1billionfromsellers, andFanniehas
received11.8billionatotalofio.billion.

Theamountputbackisnotablein
thatitrepresentsi1of1obillionincredit-relatedexpensesrecordedbytheGSEs
sincethebeginningofioo8throughSeptemberio1o.
,o
In testing to ensure compliance with its standards, Freddie reviews a small per-
centage of performing loans and a high percentage of foreclosed loans (including
well over o of all loans that default in the frst two years). In total, Freddie re-
viewed,o.8billionofloans(outof1.,1trillioninloansacquiredorguaranteed)
andfoundi1.,billiontobeineligible,meaningtheydidnotmeetrepresentations
andwarranties.
,1
Amongtheperformingloansthatweresampled,overtimeanincreasingpercent-
agewerefoundtobeineligible,risingfrom1oformortgagesoriginatedinioo,to
iinioo8.Still,Freddieputbackveryfewoftheseperformingloanstotheorigina-
tors.Amongmortgagesoriginatedfromioo,toioo8,itfoundthat1,ofthedelin-
quentloanswereineligible,aswerei,oftheloansinforeclosure.
,i
Mostofthese
wereputbacktooriginatorsagain,incasesinwhichtheoriginatorswerestillinop-
zz, ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
eration.Sometimes,ifthereasonsforineligibilityweresumcientlyminor,theloans
werenotputback.
Overall,ofthedelinquentloansandloansinforeclosuresampledbyFreddie,io
were put back. In ioo and io1o, Freddie put back signifcant loan volumes to the
followinglenders:Countrywide,1.billion;WellsFargo,1.ibillion;ChaseHome
Financial,1.1billion;BankofAmerica,,omillion;andAllyFinancial,,mil-
lion.
,
UsingamethodsimilartoFreddiestotestforloaneligibility,Fanniereviewedbe-
tween i and , of the mortgages originated since ioo,sampling at the higher
ratesfordelinquentloans.Fromioo,throughio1o,Fannieputbackloanstothefol-
lowinglargelenders:BankofAmerica,o.billion;WellsFargo,i.billion;JPMor-
gan Chase, i.i billion; Citigroup, 1., billion; SunTrust Bank, 88 million; and
AllyFinancial,88million.
,
InearlyJanuaryio11,BankofAmericareachedadeal
withFannieandFreddie,settlingtheGSEsclaimswithapaymentofmorethani.,
billion.
,,
LikeFannieandFreddie,privatemortgageinsurance(PMI)companieshavebeen
fndingsignifcantdefcienciesinmortgages.Theyarerefusingtopayclaimsonsome
insuredmortgagesthathavegoneintodefault.Thisinsuranceprotectstheholderof
themortgageifahomeownerdefaultsonaloan,eventhoughtheresponsibilityfor
the premiums generally lies with the homeowner. By the end of iooo, PMI compa-
nieshadinsuredatotalofoo8billioninpotentialmortgagelosses.
,o
As defaults and losses on the insured mortgages have been increasing, the PMI
companies have seen a spike in claims. As of October io1o, the seven largest PMI
companies,whichshare8ofthemarket,hadrejectedabouti,oftheclaims(or
o billion of i billion) brought to them, because of violations of origination
guidelines, improper employment and income reporting, and issues with property
valuation.
,,
Separatefromtheirpurchaseandguaranteeofmortgages,overthecourseofthe
housingboomtheGSEspurchasedoobillionofsubprimeandAlt-Aprivate-label
securities.
,8
TheGSEshaverecordedobillioninchargesonsecuritiesfromJanu-
ary1,ioo8toSeptembero,io1o.
,
Frustratedwiththelackofinformationfromthe
securities servicers and trustees, in many cases large banks, on July 1i, io1o, the
GSEs through their regulator, the Federal Housing Finance Agency, issued o sub-
poenas to various trustees and servicers in transactions in which the GSEs lost
money.
oo
Wheretheyfndthatthenonperformingloansinthepoolshaveviolations,
the GSEs intend to demand that the trustees recognize their rights (including any
rightstoputloansbacktotheoriginatororwholesaler).
o1
WhilethisstrategybeingfollowedbytheGSEsisbasedincontractlaw,otherin-
vestorsarerelyingonsecuritieslawtoflelawsuits,claimingthattheyweremisledby
inaccurateorincompleteprospectuses;and,inanumberofcases,theyarewinning.
As of mid-io1o, court actions embroiled almost all major loan originators and
underwritersthereweremorethanoolawsuitsrelatedtobreachesofrepresenta-
tionsandwarranties,byoneestimate.
oi
Theselawsuitsfledinthewakeofthefnan-
cial crisis include those alleging untrue statements of material fact or material
1ui 8U:1 zz,
misrepresentations in the registration statements and prospectuses provided to in-
vestors who purchased securities. They generally allege violations of the Securities
ExchangeActof1andtheSecuritiesActof1.
Bothprivateandgovernmententitieshavegonetocourt.Forexample,theinvest-
mentbrokerageCharlesSchwabhassuedunitsofBankofAmerica,WellsFargo,and
UBS Securities.
o
The Massachusetts attorney generals omce settled charges against
Morgan Stanley and Goldman Sachs, after accusing the frms of inadequate disclo-
surerelatingtotheirsalesofmortgage-backedsecurities.MorganStanleyagreedto
pay1oimillionandGoldmanSachsagreedtopayoomillion.
o
Totakeanotherexample,theFederalHomeLoanBankofChicagohassuedsev-
eraldefendants,includingBankofAmerica,CreditSuisseSecurities,Citigroup,and
GoldmanSachs,overits.billioninvestmentinprivatemortgage-backedsecuri-
ties,claimingtheyfailedtoprovideaccurateinformationaboutthesecurities.Simi-
larly, Cambridge Place Investment Management has sued units of Morgan Stanley,
Citigroup,HSBC,GoldmanSachs,Barclays,andBankofAmerica,amongothers,on
the basis of the information contained in the applicable registration statement,
prospectus,andprospectivesupplements.
o,
LOSSES: WHO OWNS RESIDENTIAL CREDIT RISK?
Through ioo, and into ioo8, as the rating agencies downgraded mortgage-backed
securitiesandCDOs,andinvestorsbegantopanic,marketpricesforthesesecurities
plunged. Both the direct losses as well as the marketwide contagion and panic that
ensuedwouldleadtothefailureornearfailureofmanylargefnancialfrmsacross
the system. The drop in market prices for mortgage-related securities refected the
higher probability that the underlying mortgages would actually default (meaning
thatlesscashwouldfowtotheinvestors)aswellasthemoregeneralizedfearamong
investors that this market had become illiquid. Investors valued liquidity because
theywantedtheassurancethattheycouldsellsecuritiesquicklytoraisecashifneces-
sary.Potentialinvestorsworriedtheymightgetstuckholdingthesesecuritiesasmar-
ketparticipantslookedtolimittheirexposuretothecollapsingmortgagemarket.
As market prices dropped, mark-to-market accounting rules required frms to
write down their holdings to refect the lower market prices. In the frst quarter of
ioo,,thelargestbanksandinvestmentbanksbegancomplyingwithanewaccount-
ing rule and for the frst time reported their assets in one of three valuation cate-
gories:Level1assets,whichhadobservablemarketprices,likestocksonthestock
exchange;Leveliassets,whichwerenotaseasilypricedbecausetheywerenotac-
tivelytraded;andLevelassets,whichwereilliquidandhadnodiscerniblemarket
pricesorotherinputs.TodeterminethevalueofLevelandinsomecasesLevelias-
setswheremarketpriceswereunavailable,frmsusedmodelsthatreliedonassump-
tions.ManyfnancialinstitutionsreportedLevelassetsthatsubstantiallyexceeded
theircapital.Forexample,forthefrstquarterofioo,,BearStearnsreportedabout
1billioninLevelassets,comparedto1billionincapital;MorganStanleyre-
zz ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
portedaboutoobillioninLevelassets,againstcapitalof8billion;andGoldman
reportedabout8billion,andcapitalof,billion.
Mark-to-marketwrite-downswererequiredonmanysecuritieseveniftherewere
noactualrealizedlossesandinsomecasesevenifthefrmsdidnotintendtosellthe
securities.Thechargesrefectingunrealizedlosseswerebased,inpart,oncreditrat-
ingagenciesandinvestorsexpectationsthatthemortgageswoulddefault.Butonly
whenthosedefaultscametopasswouldholdersofthesecuritiesactuallyhavereal-
ized losses. Determining the market value of securities that did not trade was dim-
cult,wassubjective,andbecameacontentiousissueduringthecrisis.Why:Because
thewrite-downsreducedearningsandcapital,andtriggeredcollateralcalls.
These mark-to-market accounting rules received a good deal of criticism in re-
centyears,asfrmsarguedthatthelowermarketpricesdidnotrefectmarketvalues
but rather fre-sale prices driven by forced sales. Joseph Grundfest, when he was a
member of the SECs Committee on Improvements to Financial Reporting, noted
thatattimes,markingsecuritiesatmarketpricescreatessituationswhereyouhave
togooutandraisephysicalcapitalinordertocoverlossesthatasapracticalmatter
wereneverreallythere.
oo
Butnotvaluingassetsbasedonmarketpricescouldmean
that frms were not recording losses required by the accounting rules and therefore
wereoverstatingearningsandcapital.
As the mortgage market was crashing, some economists and analysts estimated
that actual losses, also known as realized losses, on subprime and Alt-A mortgages
wouldtotaliootooobillion;
o,
sofar,byio1o,thefgurehasturnedoutnottobe
muchmorethanthat.Asofyear-endioo,thedollarvalueofallimpairedAlt-Aand
subprime mortgagebacked securities total about oo billion.
o8
Securities are im-
paired when they have suffered realized losses or are expected to suffer realized
lossesimminently.Whilethosenumbersaresmallinrelationtothe1trillionU.S.
economy,thelosseshadadisproportionateimpact.Subprimemortgagesthemselves
areaprettysmallassetclass,FedChairmanBenBernanketoldtheFCIC,explaining
how in ioo, he and Treasury Secretary Henry Paulson had underestimated the
repercussions of the emerging housing crisis. You know, the stock market goes up
and down every day more than the entire value of the subprime mortgages in the
country.Butwhatcreatedthecontagion,oroneofthethingsthatcreatedtheconta-
gion, was that the subprime mortgages were entangled in these huge securitized
pools.
o
Thelargedropinmarketpricesofthemortgagesecuritieshadlargespilloveref-
fectstothefnancialsector,foranumberofreasons.Forexample,asjustdiscussed,
whenthepricesofmortgage-backedsecuritiesandCDOsfell,manyoftheholdersof
those securities marked down the value of their holdingsbefore they had experi-
encedanyactuallosses.
In addition, rather than spreading the risks of losses among many investors, the
securitization market had concentrated them. Who owns residential credit risk:
twoLehmananalystsaskedinaSeptemberioo,report.Theanswer:three-quarters
of subprime and Alt-A mortgages had been securitizedand much of the risk in
1ui 8U:1 zz,
these securitizations is in the investment-grade securities and has been almost en-
tirely transferred to AAA collateralized debt obligation (CDO) holders.
,o
A set of
large,systemicallyimportantfrmswithsignifcantholdingsorexposuretothesese-
curities would be found to be holding very little capital to protect against potential
losses.Andmostofthosecompanieswouldturnouttobeconsideredbytheauthori-
tiestoobigtofailinthemidstofafnancialcrisis.
TheInternationalMonetaryFundsGlobalFinancialStabilityReportpublishedin
Octoberioo8examinedwherethedecliningassetswereheldandestimatedhowse-
verethewrite-downswouldbe.Alltold,theIMFcalculatedthatroughly1otrillion
inmortgageassetswereheldthroughoutthefnancialsystem.Ofthese,.8trillion
wereGSEmortgagebackedsecurities;theIMFexpectedlossesof8obillion,butin-
vestorsholdingthesesecuritieswouldlosenomoney,becauseoftheGSEsguaran-
tee. Another ., trillion in mortgage assets were estimated to be prime and
nonprimemortgagesheldlargelybythebanksandtheGSEs.Thesewereexpectedto
suffer as much as 1,o billion in write-downs due to declines in market value. The
remaining1.,trillioninassetswereestimatedtobemortgage-backedsecuritiesand
CDOs. Write-downs on those assets were expected to be ,oo billion. And, even
moretroubling,morethanone-halfoftheselosseswereexpectedtobebornebythe
investmentbanks,commercialbanks,andthrifts.Therestofthewrite-downsfrom
non-agencymortgagebackedsecuritiesweresharedamonginstitutionssuchasin-
surancecompanies,pensionfunds,theGSEs,andhedgefunds.TheOctoberreport
alsoexpectedanothero,,billioninwrite-downsoncommercialmortgagebacked
securities, CLOs, leveraged loans, and other loans and securitieswith more than
half coming from commercial mortgagebacked securities. Again, the commercial
banksandthriftsandinvestmentbankswereexpectedtobearmuchofthebrunt.
,1
Furthermore, when the crisis began, uncertainty (suggested by the sizable revi-
sionsintheIMFestimates)andleveragewouldpromotecontagion.Investorswould
realizetheydidnotknowasmuchastheywantedtoknowaboutthemortgageassets
thatbanks,investmentbanks,andotherfrmsheldortowhichtheywereexposed.To
anextentnotunderstoodbymanybeforethecrisis,fnancialinstitutionshadlever-
agedthemselveswithcommercialpaper,withderivatives,andintheshort-termrepo
markets, in part by using mortgage-backed securities and CDOs as collateral.
Lenders would question the value of the assets that those companies had posted as
collateralatthesametimethattheywerequestioningthevalueofthosecompanies
balancesheets.
Eventhehighest-ratedtranchesofmortgage-backedsecuritiesweredowngraded,
andlargewrite-downswererecordedonfnancialinstitutionsbalancesheetsbased
ondeclinesinmarketvalue.However,althoughthiscouldnotbeknowninioo,,at
the end of io1o most of the triple-A tranches of mortgage-backed securities have
avoided actual losses in cash fow through io1o and may avoid signifcant realized
lossesgoingforward.
Overall, for ioo, to ioo, vintage tranches of mortgage-backed securities origi-
nallyratedtriple-A,despitethemassdowngrades,onlyabout1oofAlt-Aandof
subprime securities had been materially impairedmeaning that losses were im-
zz ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
minent or had already been sufferedby the end of ioo (see fgure 11.). For the
lower-ratedBaatranches,o.,ofAlt-Aand,.,ofsubprimesecuritieswereim-
paired.Inall,bytheendofioo,iobillionworthofsubprimeandAlt-Atranches
hadbeenmateriallyimpairedincluding1i.obillionoriginallyratedtriple-A.The
outcomewouldbefarworseforCDOinvestors,whosefatelargelydependedonthe
performanceoflower-ratedmortgage-backedsecurities.MorethanoofBaaCDO
bondsand,1.ofAaaCDObondswereultimatelyimpaired.
,i
Thehousingbustwouldnotbetheendofthestory.AsChairmanBernanketesti-
fedtotheFCIC:WhatIdidnotrecognizewastheextenttowhichthesystemhad
fawsandweaknessesinitthatweregoingtoamplifytheinitialshockfromsubprime
andmakeitintoamuchbiggercrisis.
,
1ui 8U:1 zz,
Impairment of 2005-2007 vintage mortgage-backed securities (MBS) and CDOs as
of year-end 2009, by initial rating. A security is impaired when it is downgraded to
C or Ca, or when it suffers a principal loss.
Impaired Securities
IN BILLIONS OF DOLLARS
0
200
400
600
800
$1,000
SOURCE: Moodys Investors Service, Special Comment: Default & Loss Rates of Structured Finance Securities:
1993-2009; Moodys SFDRS.
Aa thru B Aaa Aa thru B Aaa Aa thru B Aaa
Not impaired
Impaired
Alt-A MBS
Subprime MBS CDOs
Iigurc ++.,
z,+ ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
COMMISSION CONCLUSIONS ON CHAPTER 11
The Commission concludes that the collapse of the housing bubble began the
chainofeventsthatledtothefnancialcrisis.
High leverage, inadequate capital, and short-term funding made many fnan-
cialinstitutionsextraordinarilyvulnerabletothedownturninthemarketinioo,.
Theinvestmentbankshadleverageratios,byonemeasure,ofuptooto1.This
means that for every o of assets, they held only 1 of capital. Fannie Mae and
FreddieMac(theGSEs)hadevengreaterleveragewithacombined,,to1ratio.
Leverage or capital inadequacy at many institutions was even greater than re-
ported when one takes into account window dressing, off-balance-sheet expo-
suressuchasthoseofCitigroup,andderivativespositionssuchasthoseofAIG.
TheGSEscontributedto,butwerenotaprimarycauseof,thefnancialcrisis.
Their , trillion mortgage exposure and market position were signifcant, and
theywerewithoutquestiondramaticfailures.Theyparticipatedintheexpansion
of risky mortgage lending and declining mortgage standards, adding signifcant
demand for less-than-prime loans. However, they followed, rather than led, the
WallStreetfrms.Thedelinquencyratesontheloansthattheypurchasedorguar-
anteedweresignifcantlylowerthanthosepurchasedandsecuritizedbyotherf-
nancialinstitutions.
The Community Reinvestment Act (CRA)which requires regulated banks
andthriftstolend,invest,andprovideservicesconsistentwithsafetyandsound-
ness to the areas where they take depositswas not a signifcant factor in sub-
prime lending. However, community lending commitments not required by the
CRAwereclearlyusedbylendinginstitutionsforpublicrelationspurposes.
PART IV
The Unraveling
z,,
12
EARLY 2007:
SPREADING SUBPRIME WORRIES
CONTENTS
Gc|dnanIcts|caggrcssivcdistri|utingthings:,,
BcarStcarnsshcdgcjundsIccksprcttydannug|y:,:
RatingagcncicsItcant|ca||cjasuddcn:,:
AIGVc|||iggcrthanwccvcrp|anncdjcr :,,
Overthecourseofioo,,thecollapseofthehousingbubbleandtheabruptshutdown
ofsubprimelendingledtolossesformanyfnancialinstitutions,runsonmoneymar-
ket funds, tighter credit, and higher interest rates. Unemployment remained rela-
tively steady, hovering just below ., until the end of the year, and oil prices rose
dramatically.Bythemiddleofioo,,homepriceshaddeclinedalmostfromtheir
peak in iooo. Early evidence of the coming storm was the 1., drop in November
iooo of the ABX Indexa Dow Joneslike index for credit default swaps on BBB-
tranchesofmortgage-backedsecuritiesissuedinthefrsthalfofiooo.
1
ThatdropcameafterMoodysandS&Pputonnegativewatchselectedtranchesin
onedealbackedbymortgagesfromoneoriginator:FremontInvestment&Loan.
i
In
December, the same index fell another after the mortgage companies Ownit
MortgageSolutionsandSebringCapitalceasedoperations.Seniorriskomcersofthe
fvelargestinvestmentbankstoldtheSecuritiesandExchangeCommissionthatthey
expectedtoseefurthersubprimelenderfailuresinioo,.Thereisabroadrecogni-
tion that, with the refnancing and real estate booms over, the business model of
manyofthesmallersubprimeoriginatorsisnolongerviable,SECanalyststoldDi-
rectorErikSirriinaJanuary,ioo,,memorandum.

Thatbecamemoreandmoreevident.InJanuary,MortgageLendersNetworkan-
nouncedithadstoppedfundingmortgagesandacceptingapplications.InFebruary,
New Century reported bigger-than-expected mortgage credit losses and HSBC, the
largestsubprimelenderintheUnitedStates,announceda1.8billionincreaseinits
quarterly provision for losses. In March, Fremont stopped originating subprime
loans after receiving a cease and desist order from the Federal Deposit Insurance
Corporation.InApril,NewCenturyfledforbankruptcy.
z,, ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
These institutions had relied for their operating cash on short-term funding
through commercial paper and the repo market. But commercial paper buyers and
banksbecameunwillingtocontinuefundingthem,andrepolendersbecamelessand
lesswillingtoacceptsubprimeandAlt-Amortgagesormortgage-backedsecurities
as collateral. They also insisted on ever-shorter maturities, eventually of just one
dayan inherently destabilizing demand, because it gave them the option of with-
holdingfundingonshortnoticeiftheylostconfdenceintheborrower.
Anothersignofproblemsinthemarketcamewhenfnancialcompaniesbeganto
reportmoredetailabouttheirassetsunderthenewmark-to-marketaccountingrule,
particularlyaboutmortgage-relatedsecuritiesthatwerebecomingilliquidandhard
to value. The sum of more illiquid Level i and assets at these frms was eye-
poppingintermsoftheamountofleveragethebanksandinvestmentbankshad,ac-
cordingtoJimChanos,aNewYorkhedgefundmanager.Chanossaidthatthenew
disclosuresalsorevealedforthefrsttimethatmanyfrmsretainedlargeexposures
from securitizations. You clearly didnt get the magnitude, and the market didnt
graspthemagnitudeuntilspringofo,,whenthefguresbegantobepublished,and
thenitwasasifsomeonerangabell,becausealmostimmediatelyuponthepublica-
tion of these numbers, journalists began writing about it, and hedge funds began
talkingaboutit,andpeoplebeganspeakingaboutitinthemarketplace.

In late iooo and early ioo,, some banks moved to reduce their subprime expo-
sures by selling assets and buying protection through credit default swaps. Some,
such as Citigroup and Merrill Lynch, reduced mortgage exposure in some areas of
thefrmbutincreaseditinothers.Banksthathadbeenbusyfornearlyfouryearscre-
atingandsellingsubprime-backedcollateralizeddebtobligations(CDOs)scrambled
inaboutthatmanymonthstosellorhedgewhatevertheycould.Theynowdumped
these products into some of the most ill-fated CDOs ever engineered. Citigroup,
MerrillLynch,andUBS,particularly,wereforcedtoretainlargerandlargerquanti-
tiesofthesuper-seniortranchesoftheseCDOs.Thebankerscouldalwayshope
and many apparently even believedthat all would turn out well with these super
seniors,whichwere,intheory,thesafestofall.
Withsuchuncertaintyaboutthemarketvalueofmortgageassets,tradesbecame
scarceandsettingpricesfortheseinstrumentsbecamedimcult.
Although government omcials knew about the deterioration in the subprime
markets, they misjudged the risks posed to the fnancial system. In January ioo,,
SEComcialsnotedthatinvestmentbankshadcreditexposuretostrugglingsubprime
lenders but argued that none of these exposures are material.
,
The Treasury and
Fedinsistedthroughoutthespringandearlysummerthatthedamagewouldbelim-
ited.Theimpactonthebroadereconomyandfnancialmarketsoftheproblemsin
the subprime market seems likely to be contained,
o
Fed Chairman Ben Bernanke
testifedbeforetheJointEconomicCommitteeofCongressonMarchi8.Thatsame
day,TreasurySecretaryHenryPaulsontoldaHouseAppropriationssubcommittee:
From the standpoint of the overall economy, my bottom line is were watching it
closelybutitappearstobecontained.
,
i\ii z++, :iii\ii Nt :U8iii \i \uiii i: z,,
GOLDMAN: LET S BE AGGRESSIVE DISTRIBUTING THINGS
InDecemberiooo,followingtheinitialdeclineinABXBBBindicesandafter1ocon-
secutivedaysoftradinglossesonitsmortgagedesk,executivesatGoldmanSachsde-
cidedtoreducethefrmssubprimeexposure.Goldmanmarkeddownthevalueofits
mortgage-relatedproductstorefectthelowerABXprices,andbeganpostingdaily
lossesforthisinventory.
8
Respondingtothevolatilityinthesubprimemarket,Goldmananalystsdelivered
aninternalreportonDecember1,iooo,regardingthemajorriskintheMortgage
businesstoChiefFinancialOmcerDavidViniarandChiefRiskOmcerCraigBrod-
erick.

The next day, executives determined that they would get closer to home,
meaningthattheywantedtoreducetheirmortgageexposure:sellwhatcouldbesold
asis,repackageandselleverythingelse.
1o
KevinGasvoda,themanagingdirectorfor
Goldmans Fixed Income, Currency, and Commodities business line, instructed the
salesteamtosellasset-backedsecurityandCDOpositions,evenataloss:Plsrefo-
cusonretainednewissuebondpositionsandmovethemout.Therewillbebigop-
portunitiesthenextseveralmonthsandwedontwanttobehamstrungbasedonold
inventory.Refocuseffortsandmovestuffoutevenifyouhavetotakeasmallloss.
11
InaDecember1,email,ViniardescribedthestrategytoTomMontag,theco-head
ofglobalsecurities:OnABX,thepositionisreasonablysensiblebutisjusttoobig.
Mighthavetospendalittletosizeitappropriately.Oneverythingelsemybasicmes-
sagewasletsbeaggressivedistributingthingsbecausetherewillbeverygoodoppor-
tunitiesasthemarketgoesintowhatislikelytobeevengreaterdistressandwewant
tobeinpositiontotakeadvantageofthem.
1i
Subsequent emails suggest that the everything else meant mortgage-related as-
sets.OnDecemberio,inaninternalemailwithbroaddistribution,GoldmansStacy
Bash-Polley,apartnerandtheco-headoffxedincomesales,notedthatthefrm,un-
like others, had been able to fnd buyers for the super-senior and equity tranches of
CDOs,butthemezzaninetranchesremainedachallenge.Thebesttarget,shesaid,
wouldbetoputtheminotherCDOs:Wehavebeenthinkingcollectivelyasagroup
abouthowtohelpmovesomeoftherisk.Whilewehavemadegreatprogressmoving
thetailrisks[super-senior]andequitywethinkitiscriticaltofocusonthemezz
riskthathasbeenbuiltupoverthepastfewmonths. . . .Givensomeofthefeedback
wehavereceivedsofar[frominvestors,]itseemsthatcdosmaybethebesttargetfor
movingsomeofthisriskbutclearlyinlimitedsize(andtimingrightnownotideal).
1
Itwasbecominghardertofndbuyersforthesesecurities.BackinOctober,Gold-
manSachstradershadcomplainedthattheywerebeingaskedtodistributejunkthat
nobodywasdumbenoughtotakefrsttimearound.
1
DespitethefrstofGoldmans
businessprinciplesthatourclientsinterestsalwayscomefrstdocumentsindi-
cate that the frm targeted less-sophisticated customers in its efforts to reduce sub-
prime exposure. In a December i8 email discussing a list of customers to target for
theyear,GoldmansFabriceTourre,thenavicepresidentonthestructuredproduct
correlationtradingdesk,saidtofocuseffortsonbuyandholdrating-basedbuyers
z, ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
ratherthansophisticatedhedgefundsthatwillbeonthesamesideofthetradeas
we will.
1,
The same of side of the trade as Goldman was the selling or shorting
sidethose who expected the mortgage market to continue to decline. In January,
DanielSparks,theheadofGoldmansmortgagedepartment,extolledGoldmanssuc-
cess in reducing its subprime inventory, writing that the team had structured like
madandtraveledtheworld,andworkedtheirtailsofftomakesomelemonadefrom
somebigoldlemons.
1o
Tourreacknowledgedthattherewasmoreandmoreleverage
inthesystem,andwritingofhimselfinthethirdpersonsaidhewasstandingin
middleofallthesecomplex,highlylevered,exotictradeshecreatedwithoutnecessar-
ilyunderstandingalltheimplicationsofthosemonstrosities.
1,
On February 11, Goldman CEO Lloyd Blankfein questioned Montag about the
iomillioninlossesonresidualpositionsfromolddeals,asking,Could/shouldwe
havecleanedupthesebooksbeforeandarewedoingenoughrightnowtoselloffcats
anddogsinotherbooksthroughoutthedivision:
18
The numbers suggest that the answer was yes, they had cleaned up pretty well,
evengivenaiomillionwrite-offandbillionsofdollarsofsubprimeexposurestill
retained.Inthefrstquarterofioo,,itsmortgagebusinessearnedarecordioomil-
lion,drivenprimarilybyshortpositions,includinga1obillionshortpositiononthe
bellwether ABX BBB index, whose drop the previous November had been the red
fagthatgotGoldmansattention.
Inthefollowingmonths,Goldmanreduceditsownmortgageriskwhilecontinu-
ingtocreateandsellmortgage-relatedproductstoitsclients.FromDecemberiooo
through August ioo,, it created and sold approximately i,. billion of CDOs
including1,.obillionofsyntheticCDOs.ThefrmusedthecashCDOstounload
muchofitsownremaininginventoryofotherCDOsecuritiesandmortgage-backed
securities.
1
Goldmanhasbeencriticizedandsuedforsellingitssubprimemortgagesecu-
ritiestoclientswhilesimultaneouslybettingagainstthosesecurities.SylvainRaynes,
astructuredfnanceexpertatR&RConsultinginNewYork,reportedlycalledGold-
manspracticethemostcynicaluseofcreditinformationthatIhaveeverseen,and
comparedittobuyingfreinsuranceonsomeoneelseshouseandthencommitting
arson.
io
DuringaFCIChearing,GoldmanCEOLloydBlankfeinwasaskedifhebelieved
itwasaproper,legal,orethicalpracticeforGoldmantosellclientsmortgagesecuri-
ties that Goldman believed would default, while simultaneously shorting them.
Blankfeinresponded,Idothinkthatthebehaviorisimproperandweregretthere-
sulttheconsequence[is]thatpeoplehavelostmoney
i1
Thenextday,Goldmanis-
suedapressreleasedeclaringBlankfeindidnotstatethatGoldmanspracticeswith
respecttothesaleofmortgage-relatedsecuritieswereimproper. . . .Blankfeinwasre-
spondingtoalengthyseriesofstatementsfollowedbyaquestionthatwaspredicated
ontheassumptionthatafrmwassellingaproductthatitthoughtwasgoingtode-
fault.Mr.Blankfeinagreedthat,ifsuchanassumptionwastrue,thepracticewould
beimproper.Mr.Blankfeindoesnotbelieve,nordidhesay,thatGoldmanSachshad
behavedimproperlyinanyway.
ii
i\ii z++, :iii\ii Nt :U8iii \i \uiii i: z,,
Inaddition,GoldmanPresidentandChiefOperatingOmcerGaryCohntestifed:
During the two years of the fnancial crisis, Goldman Sachs lost 1.i billion in its
residential mortgagerelated business. . . . We did not bet against our clients, and
thesenumbersunderscorethatfact.
i
Indeed, Goldmans short position was not the whole story. The daily mortgage
ValueatRiskmeasure,orVaR,whichtrackedpotentiallossesifthemarketmoved
unexpectedly, increased in the three months through February. By February, Gold-
mans company-wide VaR reached an all-time high, according to SEC reports. The
dominantdriveroftheincreasewastheone-sidedbetonthemortgagemarketscon-
tinuing to decline. Preferring to be relatively neutral, between March and May, the
mortgage securities desk reduced its short position on the ABX Index;
i
between
JuneandAugust,itagainreversedcourse,increasingitsshortpositionbypurchasing
protectiononmortgage-relatedassets.
TheBasisYieldAlphaFund,ahedgefundandGoldmanclientthatclaimstohave
invested11.i,millioninGoldmansTimberwolfCDO,suedGoldmanforfraudin
io1o. The Timberwolf deal was heavily criticized by Senator Carl Levin and other
members of the Permanent Subcommittee on Investigations during an April io1o
hearing.TheBasisYieldAlphaFundallegedthatGoldmandesignedTimberwolfto
quicklyfailsothatGoldmancouldomoadlow-qualityassetsandproftfrombetting
againsttheCDO.Withintwoweeksofthefundsinvestment,Goldmanbeganmak-
ingmargincallsonthedeal.BytheendofJulyioo,,ithaddemandedmorethan,
million.
i,
According to the hedge fund, Goldmans demands forced it into bank-
ruptcy in August ioo,Goldman received about o million from the liquidation.
GoldmandeniesBasisYieldAlphaFundsclaims,andCEOBlankfeindismissedthe
notionthatGoldmanmisledinvestors.Iwilltellyou,weonlydealtwithpeoplewho
knewwhattheywerebuying.Andofcoursewhenyoulookafterthefact,someones
goingtocomealongandsaytheyreallydidntknow,hetoldtheFCIC.
io
Inadditiontosellingitssubprimesecuritiestocustomers,thefrmtookshortpo-
sitionsusingcreditdefaultswaps;italsotookshortpositionsontheABXindicesand
onsomeofthefnancialfrmswithwhichitdidbusiness.Likeeverymarketpartici-
pant,Goldmanmarked,orvalued,itssecuritiesafterconsideringbothactualmar-
ket trades and surveys of how other institutions valued the assets. As the crisis
unfolded, Goldman marked mortgage-related securities at prices that were signif-
cantlylowerthanthoseofothercompanies.Goldmanknewthatthoselowermarks
mighthurtthoseothercompaniesincludingsomeclientsbecausetheycouldre-
quire marking down those assets and similar assets. In addition, Goldmans marks
wouldgetpickedupbycompetitorsindealersurveys.Asaresult,Goldmansmarks
couldcontributetoothercompaniesrecordingmark-to-marketlosses:thatis,the
reportedvalueoftheirassetscouldfallandtheirearningswoulddecline.
The markdowns of these assets could also require that companies reduce their
repo borrowings or post additional collateral to counterparties to whom they had
soldcreditdefaultswapprotection.InaMay11email,CraigBroderick,whoasGold-
mans chief risk omcer was responsible for tracking how much of the companys
moneywasatrisk,
i,
notedtocolleaguesthatthemortgagegroupwasintheprocess
z, ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
of considering making signifcant downward adjustments to the marks on their
mortgageportfolio[especially]CDOsandCDOsquared.Thiswillpotentiallyhavea
big[proftandloss]impactonus,butalsotoourclientsduetothemarksandassoci-
ated margin calls on repos, derivatives, and other products. We need to survey our
clientsandtakeashotatdeterminingthemostvulnerableclients,knockonimplica-
tions,etc.Thisisgettinglotsofothfoorattentionrightnow.
i8
BroderickwasrightabouttheimpactofGoldmansmarksonclientsandcounter-
parties. The frst signifcant dispute about these marks began in May ioo,: it con-
cernedthetwohigh-fying,mortgage-focusedhedgefundsrunbyBearStearnsAsset
Management(BSAM).
BEAR STEARNS S HEDGE FUNDS:
LOOKS PRETTY DAMN UGLY
In ioo, Ralph Ciom and Matthew Tannin, who had structured CDOs at Bear
Stearns,werebusymanagingBSAMsHigh-GradeStructuredCreditStrategiesFund.
Whentheyaddedthehigher-leveraged,higher-riskEnhancedFundinioootheybe-
cameevenbusier.
By April ioo,, internal BSAM risk exposure reports showed about oo of the
High-Grade funds collateral to be subprime mortgagebacked CDOs, assets that
werebeginningtolosemarketvalue.
i
Inadiarykeptinhispersonalemailaccount
becausehedidntwanttouse[his]workemailanymore,Tanninrecountedthatin
ioooawaveoffearsetover[him]whenherealizedthattheEnhancedFundwas
going to subject investors to blow up risk and we could not run the leverage as
highasIhadthoughtwecould.
o
Thisblowuprisk,coupledwithbadtiming,provedfatalfortheEnhancedFund.
Shortlyafterthefundopened,theABXBBB-indexstartedtofalter,fallinginthe
last three months of iooo; then another 8 in January and i, in February. The
marketsconfdencefellwiththeABX.InvestorsbegantobailoutofbothEnhanced
andHigh-Grade.CiomandTanninsteppeduptheirmarketing.OnMarch,,ioo,,
Tanninsaidinanemailtoinvestors,weseeanopportunityherenotcrazyoppor-
tunitybut prudent opportunityI am putting in additional capitalI think you
shouldaswell.
1
OnaMarch1iconferencecall,TanninandCiomassuredinvestors
thatbothfundshaveplentyofliquidity,andtheycontinuedtousetheinvestment
of their own money as evidence of their confdence.
i
Tannin even said he was in-
creasinghispersonalinvestment,although,accordingtotheSEC,heneverdid.

Despite their avowals of confdence, Ciom and Tannin were in full red-alert
mode.InApril,Ciomredeemedimillionofhisowno.1millioninvestmentinEn-
hancedLeverageandtransferredthefundstoathirdhedgefundhemanaged.

They
triedtosellthetoxicCDOsecuritiesheldbythehedgefunds.Theyhadlittlesuccess
sellingthemdirectlyonthemarket,
,
buttherewasanotherway.
InlateMay,BSAMputtogetheraCDO-squareddealthatwouldtakebillionof
CDOassetsoffthehedgefundsbooks.Thesenior-mosttranches,worth.ibillion,
i\ii z++, :iii\ii Nt :U8iii \i \uiii i: z,,
weresoldascommercialpapertoshort-terminvestorssuchasmoneymarketmutual
funds.
o
Critically,BankofAmericaguaranteedthosedealswithaliquidityputforafee.
Later, commercial paper investors would refuse to roll over this particular paper;
BankofAmericaultimatelylostmorethanbilliononthisarrangement.
,
:,isoomse;
Nearly all hedge funds provide their investors with market value reports, at least
monthly, based on computed mark-to-market prices for the funds various invest-
ments.Industrystandardsgenerallycalledforvaluingreadilytradedassets,suchas
stocks,atthecurrenttradingprice,whileassetsinveryslowmarketsweremarkedby
surveying price quotes from other dealers, factoring in other pricing information,
andthenarrivingatafnalnetassetvalue.Formortgage-backedinvestments,mark-
ingassetswasanextremelyimportantexercise,becausethemarketvalueswereused
toinforminvestorsandtocalculatethehedgefundstotalfundvalueforinternalrisk
managementpurposes,andbecausetheseassetswereheldascollateralforrepoand
other lenders. Crucially, if the value of a hedge funds portfolio declined, repo and
otherlendersmightrequiremorecollateral.InApril,JPMorgantoldAlanSchwartz,
BearStearnssco-president,thatthebankwouldbeaskingtheBSAMhedgefundsto
postadditionalcollateraltosupportitsrepoborrowing.
8
DealermarkswereslowtokeepupwithmovementsintheABXindices.Evenas
the ABX BBB- index recovered some in March, rebounding o, marks by broker-
dealers fnally started to refect the lower values. On April i, ioo,, Goldman sent
BSAMmarksrangingfromo,centsto1oocentsonthedollarmeaningthatsome
securitieswereworthaslittleaso,oftheirinitialvalue.

OnThursday,April1,
in preparation for an investor call the following week, BSAM analysts informed
CiomandTanninthatintheirview,thevalueofthefundsportfolioshaddeclined
sharply.
o
OnSunday,TanninsentanemailfromhispersonalaccounttoCiomsper-
sonal account arguing that both hedge funds should be closed and liquidated:
Looksprettydamnugly. . . .Ifwebelievetheruns[theanalyst]hasbeendoingare
ANYWHERECLOSEtoaccurate,IthinkweshouldclosetheFundsnow. . . .If[the
runs]arecorrectthentheentiresub-primemarketistoast.
1
Butbythefollowing
Wednesday,CiomandTanninwerebackonthesameupbeatpage.Atthebeginning
oftheconferencecall,Tannintoldinvestors,Thekeysortofbigpicturepointforus
atthispointisourconfdencethatthestructuredcreditmarketandthesub-prime
marketinparticular,hasnotsystemicallybrokendown; . . .wereverycomfortable
withexactlywhereweare.Ciomalsoassuredinvestorsthatthefundswouldlikely
fnishtheyearwithpositivereturns.
i
OnMay1,ioo,,thetwohedgefundshadat-
tracted more than oo million in new funds, but more than i8 million was re-
deemedbyinvestors.

Thatsameday,GoldmansentBSAMmarksrangingfrom,,centsto1oocentson
thedollar.

CiomdisputedGoldmansmarksaswellasmarksfromLehman,Citigroup,
z,+ ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
andJPMorgan.
,
OnMay1o,inapreliminaryestimate,Ciomtoldinvestorsthatthe
netassetvalueoftheEnhancedLeverageFundwasdowno.oinApril.
o
Incomputing
thefnalnumberslaterthatmonth,herequestedthatBSAMsPricingCommitteein-
steadusefairvaluemarksbasedonhisteamsmodeling,whichimpliedlossesthatwere
i,to,omillionlessthanlossesusingGoldmansmarks.
,
OnJune,althoughGold-
mansmarkswereconsideredlow,thePricingCommitteedecidedtocontinuetoaver-
age dealer marks rather than to use fair value. The committee also noted that the
declineinnetassetvaluewouldbegreaterthantheo.oestimate,becausemanyofthe
positionsthatweremarkeddownreceiveddealermarksafterreleaseoftheestimate.
8
The decline was revised from o.o to 1. According to Ciom, a number of factors
contributedtotheAprilrevision,andGoldmansmarkswereonefactor.

Afterthese
meetings,Ciomemailedonecommitteemember:Thereisnomarket . . .its[sic]allac-
ademic anyway1 [value] is doomsday.
,o
On June ,, BSAM announced the 1
dropandfrozeredemptions.
tener;int/cmincs/ejt
WhenJPMorgancontactedBearsco-presidentAlanSchwartzinAprilaboutitsup-
comingmargincall,Schwartzconvenedanexecutivecommitteemeetingtodiscuss
howrepolendersweremarkingdownpositionsandmakingmargincallsonthebasis
of those new marks.
,1
In early June, Bear met with BSAMs repo lenders to explain
thatBSAMlackedcashtomeetmargincallsandtonegotiateaoo-dayreprieve.Some
of these very same frms had sold Enhanced and High-Grade some of the same
CDOsandothersecuritiesthatwereturningouttobesuchbadassets.
,i
Nowall1o
refused Schwartzs appeal; instead, they made margin calls.
,
As a direct result, the
twofundshadtosellcollateralatdistressedpricestoraisecash.
,
Sellingthebonds
ledtoacompletelossofconfdencebytheinvestors,whoserequestsforredemptions
accelerated.
ShortlyafterBSAMfrozeredemptions,MerrillLynchseizedmorethan8,omil-
lionofitscollateralpostedbyBearforitsoutstandingrepoloans.Merrillwasableto
selljust181millionoftheseizedcollateralatauctionbyJuly,andatdiscountsto
its face value.
,,
Other repo lenders were increasing their collateral requirements or
refusingtorollovertheirloans.
,o
ThisrunonbothhedgefundsleftbothBSAMand
Bear Stearns with limited options. Although it owned the asset management busi-
ness,BearsequitypositionsinthetwoBSAMhedgefundswererelativelysmall.On
Aprilio,Bearsco-presidentWarrenSpectorapprovedai,millioninvestmentinto
theEnhancedLeverageFund.
,,
BearStearnshadnolegalobligationtorescueeither
thefundsortheirrepolenders.However,thoselenderswerethesamelargeinvest-
mentbanksthatBearStearnsdealtwitheveryday.
,8
Moreover,anyfailureofentities
relatedtoBearStearnscouldraiseinvestorsconcernsaboutthefrmitself.
ThomasMarano,theheadofthemortgagetradingdesk,toldFCICstaffthatthe
constantbarrageofmargincallshadcreatedchaosatBear.InlateJune,BearStearns
dispatched him to engineer a solution with Richard Marin, BSAMs CEO. Marano
nowworkedtounderstandtheportfolio,includingwhatitmightbeworthinaworst-
i\ii z++, :iii\ii Nt :U8iii \i \uiii i: z,.
case scenario in which signifcant amounts of assets had to be sold.
,
Bear Stearnss
conclusion:High-Gradestillhadpositivevalue,butEnhancedLeveragedidnot.
Onthebasisofthatanalysis,BearStearnscommittedupto.ibillionandulti-
mately loaned 1.o billionto take out the High-Grade Fund repo lenders and be-
comethesolerepolendertothefund;EnhancedLeveragewasonitsown.
DuringaJuneFederalOpenMarketCommittee(FOMC)meeting,memberswere
informedaboutthesubprimemarketandtheBSAMhedgefunds.Thestaffreported
thatthesubprimemarketwasveryunsettledandrefecteddeterioratingfundamen-
talsinthehousingmarket.TheliquidationofsubprimesecuritiesatthetwoBSAM
hedgefundswascomparedtothetroublesfacedbyLong-TermCapitalManagement
in18.ChairmanBernankenotedthattheproblemsthehedgefundsexperienced
wereagoodexampleofhowleveragecanincreaseliquidityrisk,especiallyinsitua-
tions in which counterparties were not willing to give them time to liquidate and
possiblyrealizewhatevervaluemightbeinthepositions.Butitwasalsonotedthat
theBSAMhedgefundsappearedtoberelativelyuniqueamongsponsoredfundsin
theirconcentrationinsubprimemortgages.
oo
Some members were concerned about the lack of transparency around hedge
funds, the consequent lack of market discipline on valuations of hedge fund hold-
ings,andthefactthattheFederalReservecouldnotsystematicallycollectinforma-
tionfromhedgefundsbecausetheywereoutsideitsjurisdiction.Thesefactscaused
memberstobeconcernedaboutwhethertheyunderstoodthescopeoftheproblem.
Duringthesamemeeting,FOMCmembersnotedthatthesizeofthecreditderiv-
atives market, its lack of transparency and activities related to subprime debt could
beagatheringcloudinthebackgroundofpolicy.
Meanwhile, Bear Stearns executives who supported the High-Grade bailout did
not expect to lose money. However, that support was not universalCEO James
Cayne and Earl Hedin, the former senior managing director of Bear Stearns and
BSAM, were opposed, because they did not want to increase shareholders potential
losses.
o1
Their fears proved accurate. By July, the two hedge funds had shrunk to al-
most nothing: High-Grade Fund was down 1; Enhanced Leverage Fund, 1oo.
oi
OnJuly1,bothfledforbankruptcy.CiomandTanninwouldbecriminallycharged
with fraud in their communications with investors, but they were acquitted of all
chargesinNovemberioo.CivilchargesbroughtbytheSECwerestillpendingasof
thedateofthisreport.
Looking back, Marano told the FCIC, We caught a lot of fak for allowing the
fundstofail,butwehadnooption.
o
InaninternalemailinJune,BillJamisonofFed-
eratedInvestors,oneofthelargestofallmutualfundcompanies,referredtotheBear
Stearnshedgefundsasthecanaryinthemineshaftandpredictedmoremarkettur-
moil.
o
As the two funds were collapsing, repo lending tightened across the board.
Manyrepolenderssharpenedtheirfocusonthevaluationofanycollateralwithpo-
tentialsubprimeexposure,andontherelativeexposuresofdifferentfnancialinstitu-
tions. They required increased margins on loans to institutions that appeared to be
exposedtothemortgagemarket;theyoftenrequiredTreasurysecuritiesascollateral;
in many cases, they demanded shorter lending terms.
o,
Clearly, the triple-A-rated
z,z ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
mortgage-backed securities and CDOs were not considered the super-safe invest-
mentsinwhichinvestorsandsomedealershadonlyrecentlybelieved.
CaynecalledSpectorintotheomceandaskedhimtoresign.OnSunday,August
,,Spectorsubmittedhisresignationtotheboard.
RATING AGENCIES: IT CAN T BE . . . ALL OF A SUDDEN
WhileBSAMwaswrestlingwithitstwoailingfagshiphedgefunds,themajorcredit
ratingagenciesfnallyadmittedthatsubprimemortgagebackedsecuritieswouldnot
perform as advertised. On July 1o, ioo,, they issued comprehensive rating down-
gradesandcreditwatchwarningsonanarrayofresidentialmortgagebackedsecuri-
ties.Theseannouncementsforeshadowedtheactuallossestocome.
S&Pannouncedthatithadplacedo1itranchesbackedbyU.S.subprimecollat-
eral,orsome,.,billioninsecurities,onnegativewatch.S&Ppromisedtoreview
everydealinitsratingsdatabaseforadverseeffects.Intheafternoon,Moodysdown-
gradedmortgage-backedsecuritiesissuediniooobackedbyU.S.subprimecol-
lateral and put an additional i tranches on watch. These Moodys downgrades
affected about ,.i billion in securities. The following day, Moodys placed 18
tranchesofCDOs,withoriginalfacevalueofabout,billion,onwatchforpossible
downgrade.Twodaysafteritsoriginalannouncement,S&Pdowngraded8ofthe
o1itranchesithadplacedonnegativewatch.FitchRatings,thesmallestofthethree
majorcreditratingagencies,announcedsimilardowngrades.
oo
Theseactionsweremeaningfulforallwhounderstoodtheirimplications.While
the specifc securities downgraded were only a small fraction of the universe (less
than i of mortgage-backed securities issued in iooo), investors knew that more
downgrades might come. Many investors were critical of the rating agencies, lam-
basting them for their belated reactions. By July ioo,, by one measure, housing
priceshadalreadyfallenaboutnationallyfromtheirpeakatthespringofiooo.
o,
OnaJuly1oconferencecallwithS&P,thehedgefundmanagerSteveEismanques-
tionedTomWarrack,themanagingdirectorofS&Psresidentialmortgagebackedse-
curitiesgroup.Eismanasked,Idliketoknowwhynow.Imean,thenewshasbeen
outonsubprimenowformany,manymonths.Thedelinquencieshavebeenadisaster
now for many, many months. (Your) ratings have been called into question now for
many,manymonths.Idliketounderstandwhyyouremakingthismovetodaywhen
youandwhydidntyoudothismany,manymonthsago. . . .Imean,itcantbethat
allofasudden,theperformancehasreachedalevelwhereyouvewokenup.Warrack
respondedthatS&Ptookactionassoonaspossiblegiventheinformationathand.
o8
Theratingsagenciesdowngrades,intandemwiththeproblemsatBearStearnss
hedgefunds,hadafurtherchillingeffectonthemarkets.TheABXBBB-indexfell
anotherinJuly,confrmingandguaranteeingevenmoreproblemsforholdersof
mortgagesecurities.Enactingthesameinexorabledynamicthathadtakendownthe
BearStearnsfunds,repolendersincreasinglyrequiredotherborrowersthathadput
upmortgage-backedsecuritiesascollateraltoputupmore,becausetheirvaluewas
unclearordepressed.Manyoftheseborrowerssoldassetstomeetthesemargincalls,
i\ii z++, :iii\ii Nt :U8iii \i \uiii i: z,,
andeachsalehadthepotentialtofurtherdepressprices.Ifatallpossible,theborrow-
erssoldotherassetsinmoreliquidmarkets,forwhichpriceswerereadilyavailable,
pushingpricesdownwardinthosemarkets,too.
AIG: WELL BIGGER THAN WE EVER PLANNED FOR
Ofallthepossiblelosersintheloomingrout,AIGshouldhavebeenamongthemost
concerned. After several years of aggressive growth, AIGs Financial Products sub-
sidiaryhadwritten,billioninover-the-countercreditdefaultswap(CDS)protec-
tion on super-senior tranches of multisector CDOs backed mostly by subprime
mortgages.
InaphonecallmadeJuly11,thedayafterthedowngrades,AndrewForster,the
headofcredittradingatAIGFinancialProducts,toldAlanFrost,theexecutivevice
presidentofFinancialProductsMarketingGroup,thathehadtoanalyzeexposures
because every fing . . . rating agency weve spoken to . . . [came] out with more
downgradesandthathewasincreasinglyconcerned:AboutamonthagoIwaslike,
youknow,suicidal. . . .Theproblemthatweregoingtofaceisthatweregoingtohave
justenormousdowngradesonthestuffthatwevegot. . . .Everyonetellsmethatits
tradinganditstwopointslowerandalltherestofitandhowcomeyoucantmark
your book. So its defnitely going to give it renewed focus. I mean we cant . . . we
havetomarkit.Its,its,uh,were[unintelligible]fedbasically.
o
Forster was likely worried that most of AIGs credit default swap contracts re-
quiredthatcollateralbepostedtothepurchasers,shouldthemarketvalueoftheref-
erencedsecuritiesdeclinebyacertainamount,orshouldratingagenciesdowngrade
AIGslong-termdebt.Thatis,collateralcallscouldbetriggeredeveniftherewereno
actualcashlossesin,forexample,thesuper-seniortranchesofCDOsuponwhichthe
protectionhadbeenwritten.Remarkably,topAIGexecutivesincludingCEOMar-
tin Sullivan, CFO Steven Bensinger, Chief Risk Omcer Robert Lewis, Chief Credit
Omcer Kevin McGinn, and Financial Services Division CFO Elias Habayebtold
FCICinvestigatorsthattheydidnotevenknowaboutthesetermsoftheswapsuntil
thecollateralcallsstartedrollinginduringJuly.
,o
OmceofThriftSupervisionregula-
torswhosupervisedAIGonaconsolidatedbasisdidntknoweither.
,1
Frost,whowas
thechiefcreditdefaultswapsalesmanatAIGFinancialProducts,didknowaboutthe
terms,andhesaidhebelievedtheywerestandardfortheindustry.
,i
JosephCassano,
thedivisionsCEO,alsoknewabouttheterms.
,
And the counterparties knew, of course. On the evening of July io, Goldman
Sachs,whichheldi1billionofAIGssuper-seniorcreditdefaultswaps,
,
sentnews
ofthefrstcollateralcallintheformofanemailfromGoldmanssalesmanAndrew
DavilmantoFrost:
DAVILMAN: Sorrytobotheryouonvacation.Margincallcomingyourway.Wantto
giveyouaheadsup.
FROST, minutes later:Onwhat:
DAVILMAN,one minute later:iobb[iobillion]ofsupersenior.
,,
z,, ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
Thenextday,Goldmanmadethecollateralcallomcialbyforwardinganinvoice
requesting1.8billion.
,o
Onthesameday,Goldmanpurchased1oomillionoffve-
yearprotectionintheformofcreditdefaultswapsagainstthepossibilitythatAIG
mightdefaultonitsobligations.
,,
Frost never responded to Davilmans email. And when he returned from vaca-
tion, he was instructed to not have any involvement in the issue, because Cassano
wanted Forster to take the lead on resolving the dispute.
,8
AIGs models showed
therewouldbenodefaultsonanyofthebondpaymentsthatAIGsswapsinsured.
TheGoldmanexecutivesconsideredthosemodelsirrelevant,becausethecontracts
required collateral to be posted if market value declined, irrespective of any long-
termcashlosses.
,
Goldmanestimatedthattheaveragedeclineinthemarketvalue
ofthebondswas1,.
8o
So, frst Bear Stearnss hedge funds and now AIG was getting hit by Goldmans
marksonmortgage-backedsecurities.LikeCiomandhiscolleaguesatBearStearns,
Frost and his colleagues at AIG disputed Goldmans marks. On July o, Forster was
told by another AIG trader that [AIG] would be in fne shape if Goldman wasnt
hanging its head out there. The margin call was something that hit out of the blue
and its a fing number thats well bigger than we ever planned for. He acknowl-
edged that dealers might say the marks could be anything from 8o to sort of, you
know,,becauseofthelackoftradingbutsaidGoldmansmarkswereridiculous.
81
IntestimonytotheFCIC,ViniarsaidGoldmanhadstoodreadytosellmortgage-
backed securities to AIG at Goldmans own marks.
8i
AIGs Forster stated that he
wouldnotbuythebondsatevenocentsonthedollar,becausevaluesmightdrop
further.Additionally,AIGwouldberequiredtovalueitsownportfolioofsimilaras-
setsatthesameprice.Forstersaid,InthecurrentenvironmentIstillwouldntbuy
them . . .becausetheycouldprobablygolow . . .wecantmarkanyofourpositions,
andobviouslythatswhatsavesushavingthisenormousmarktomarket.Ifwestart
buyingthephysicalbondsbackthenanyaccountantisgoingtoturnaroundandsay,
well, John,youknowyoutradedato,youmustbeabletomarkyourbondsthen.
8
Tough,lengthynegotiationsfollowed.Goldmanwasnotbudgingonitscollat-
eraldemands,accordingtoTomAthan,amanagingdirectoratAIGFinancialProd-
ucts, describing a conference call with Goldman executives on August 1. I played
almosteverycardIhad,legalwording,marketpractice,intentofthelanguage,mean-
ingofthe[contract],andalsostressedthepotentialdamagetotherelationshipand
GSsaidthatthishasgonetothehighestlevelsatGSandtheyfeelthat . . .thisisa
testcase.
8
GoldmanSachsandAIGwouldcontinuetoargueaboutGoldmansmarks,even
asAIGwouldcontinuetopostcollateralthatwouldfallshortofGoldmansdemands
and Goldman would continue to purchase CDS contracts against the possibility of
AIGsdefault.Overthenext1months,moresuchdisputeswouldcostAIGtensof
billionsofdollarsandhelpleadtooneofthebiggestgovernmentbailoutsinAmeri-
canhistory.
COMMISSION CONCLUSIONS ON CHAPTER 12
TheCommissionconcludesthatentitiessuchasBearStearnsshedgefundsand
AIGFinancialProductsthathadsignifcantsubprimeexposurewereaffectedby
thecollapseofthehousingbubblefrst,creatingfnancialpressuresontheirpar-
ent companies. The commercial paper and repo marketstwo key components
of the shadow banking lending marketsquickly refected the impact of the
housingbubblecollapsebecauseofthedeclineincollateralassetvaluesandcon-
cernaboutfnancialfrmssubprimeexposure.
i\ii z++, :iii\ii Nt :U8iii \i \uiii i: z,,
z,
13
SUMMER 2007:
DISRUPTIONS IN FUNDING
CONTENTS
IKBcjGcrnanyRca|ncncyinvcstcrs :,e
Ccuntrywidc1hatscur,/++ :,:
BNIIari|as1hcringingcjthc|c||:,o
SIVsAncasiscjca|n:,:
McncyjundsandcthcrinvcstcrsDrinkjing}jrcnarchcsc:,,
Inthesummerofioo,,asthepricesofsomehighlyratedmortgagesecuritiescrashed
and Bears hedge funds imploded, broader repercussions from the declining housing
market were still not clear. I dont think [the subprime mess] poses any threat to the
overalleconomy,TreasurySecretaryHenryPaulsontoldBloombergonJulyio.
1
Mean-
while,nervousmarketparticipantswerelookingundereveryrockforanysignofhidden
or latent subprime exposure. In late July, they found it in the market for asset-backed
commercialpaper(ABCP),acrucial,usuallyboringbackwaterofthefnancialsector.
This kind of fnancing allowed companies to raise money by borrowing against
high-quality, short-term assets. By mid-ioo,, hundreds of billions out of the 1.i
trillion U.S. ABCP market were backed by mortgage-related assets, including some
withsubprimeexposure.
i
Asnoted,theratingagencieshadgivenalloftheseABCPprogramstheirtopin-
vestment-grade ratings, often because of liquidity puts from commercial banks.
Whenthemortgagesecuritiesmarketdriedupandmoneymarketmutualfundsbe-
came skittish about broad categories of ABCP, the banks would be required under
theseliquidityputstostandbehindthepaperandbringtheassetsontotheirbalance
sheets,transferringlossesbackintothecommercialbankingsystem.Insomecases,
to protect relationships with investors, banks would support programs they had
sponsoredevenwhentheyhadmadenopriorcommitmenttodoso.
IKB OF GERMANY: REAL MONEY INVESTORS
The frst big casualty of the run on asset-backed commercial paper was a German
:U\\ii z++, ii :iUi1i uN: i N iUNii Nt z,,
bank, IKB Deutsche Industriebank AG. Since its foundation in 1i, IKB had fo-
cusedonlendingtomidsizeGermanbusinesses,butinthepastdecade,management
diversifed. In iooi, IKB created an off-balance-sheet commercial paper program,
called Rhineland, to purchase a portfolio of structured fnance securities backed by
creditcardreceivables,businessloans,autoloans,andmortgages.Itmademoneyby
usinglessexpensiveshort-termcommercialpapertopurchasehigher-yieldinglong-
term securities, a strategy known as securities arbitrage. By the end of June,
Rhinelandownedc1billion(18.billion)ofassets,,ofwhichwereCDOsand
CLOs (collateralized loan obligationsthat is, securitized leveraged loans). And at
least c8 billion (1o.8 billion) of that was protected by IKB through liquidity puts.

Importantly,GermanregulatorsatthetimedidnotrequireIKBtoholdanycapitalto
offsetpotentialRhinelandlosses.

As late as June ioo,, when so many were bailing out of the structured products
market,IKBwasstillplanningtoexpanditsoff-balance-sheetholdingsandwaswill-
ing to take long positions in mortgage-related derivatives such as synthetic CDOs.
,
ThisattitudemadeIKBafavoriteoftheinvestmentbanksandhedgefundsthatwere
desperatetotaketheshortsideofthedeal.
Inearlyioo,,whenGoldmanwaslookingforbuyersforAbacusioo,-AC1,the
synthetic CDO mentioned in part III, it looked to IKB. An employee of Paulson &
Co.,thehedgefundthatwastakingtheshortsideofthedeal,bluntlysaidthatreal
moneyinvestorssuchasIKBwereoutgunned.Themarketisnotpricingthesub-
prime [residential mortgagebacked securities] wipeout scenario, the Paulson em-
ployeewroteinanemail.Inmyopinionthissituationisduetothefactthatrating
agencies,CDOmanagersandunderwritershavealltheincentivestokeepthegame
going, while real money investors have neither the analytical tools nor the institu-
tionalframeworktotakeactionbeforethelossesthatonecouldanticipatebased[on]
the news available everywhere are actually realized.
o
IKB subsequently purchased
1,o million of the A1 and Ai tranches of the Abacus CDO and placed them in
Rhineland.
,
Itwouldlose1ooofthatinvestment.
Inmid-ioo,,Rhinelandsasset-backedcommercialpaperwasheldbyanumber
ofAmericaninvestors,includingtheMontanaBoardofInvestments,thecityofOak-
land,California,andtheRobbinsdaleAreaSchoolDistrictinsuburbanMinneapolis.
OnJulyio,IKBreassureditsinvestorsthatratingsdowngradesofmortgage-backed
securities would have only a limited impact on its business.
8
However, within days,
Goldman Sachs, which regularly helped Rhineland raise money in the commercial
papermarket,toldIKBthatitwouldnotsellanymoreRhinelandpapertoitsclients.
OnFriday,Julyi,,DeutscheBank,recognizingthattheABCPmarketswouldsoon
abandon Rhineland and that IKB would have to provide substantial support to the
program, decided that doing business with IKB was too risky and cut off its credit
lines.ThesewerenecessaryforIKBtocontinuerunningitsbusiness.DeutscheBank
alsoalertedtheGermanbankregulatortoIKBscriticalstate.Withtheregulatorsen-
couragement, IKBs largest shareholder, KfW Bankengruppe, announced on July o
thatitwouldbailoutIKB.OnAugust,,Rhinelandexerciseditsliquidityputswith
z, ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
IKB. Rhinelands commercial paper investors were able to get rid of the paper, and
KfWtookthehitinsteadwithitslossesexpectedtoeventuallyreach,.

TheIKBepisodeservednoticethatexposurestotoxicmortgageassetswerelurk-
ingintheportfoliosofevenrisk-averseinvestors.Soon,panicseizedtheshort-term
fundingmarketseventhosethatwerenotexposedtoriskymortgages.Therewasa
recognition, Id say an acute recognition, that potentially some of the asset-backed
commercialpaperconduitscouldhaveexposuretothoseareas.Asaresult,investors
in generalwithout even looking into the underlying assetsdecided I dont want
tobeinanyasset-backedcommercialpaper,Idontwanttoinvestinafundthatmay
have those positions, Steven Meier, global cash investment omcer at State Street
GlobalAdvisors,testifedtotheFCIC.
1o
From its peak of 1.i billion on August 8, the asset-backed commercial paper
marketwoulddeclinebyalmostoobillionbytheendofioo,.
COUNTRYWIDE: THAT S OUR 9/11
OnAugusti,threedaysaftertheIKBrescue,CountrywideCEOAngeloMozilore-
alized that his company was unable to roll its commercial paper or borrow on the
repomarket.Whenwetalkabout[Augusti]atCountrywide,thatsour/11,he
said. We worked seven days a week trying to fgure this thing out and trying to
workwiththebanks. . . .Ourrepurchaselineswerecomingduebillionsandbillions
ofdollars.
11
MoziloemailedLyleGramley,aformerFedgovernorandaformerCountrywide
director,Fearinthecreditmarketsisnowtendingtowardspanic.Thereislittleto
no liquidity in the mortgage market with the exception of Fannie and Freddie. . . .
Any mortgage product that is not deemed to be conforming either cannot be sold
intothesecondarymarketsoraresubjecttoegregiousdiscounts.
1i
OnAugusti,despitetheinternalturmoilatCountrywide,CFOEricSierackitold
investors that Countrywide had signifcant short-term funding liquidity cushions
andampleliquiditysourcesofourbank. . . .Itisimportanttonotethatthecompany
has experienced no disruption in fnancing its ongoing daily operations, including
placementofcommercialpaper.
1
MoodysreamrmeditsAratingsandstableout-
lookonthecompany.
Theratingsagenciesandthecompanyitselfwouldquicklyreversetheirpositions.
OnAugusto,Moziloreportedtotheboardduringaspeciallyconvenedmeetingthat,
as the meeting minutes recorded, the secondary market for virtually all classes of
mortgagesecurities(bothprimeandnon-prime)hadunexpectedlyandwithalmost
no warning seized up and . . . the Company was unable to sell high-quality mort-
gage[-]backed securities. President and COO David Sambol told the board, Man-
agement can only plan on a week by week basis due to the tenuous nature of the
situation.Moziloreportedthatalthoughhecontinuedtonegotiatewithbanksforal-
ternative sources of liquidity, the unprecedented and unanticipated absence of a
secondarymarketcouldforcethecompanytodrawdownonitsbackupcreditlines.
1
Shortly after the Countrywide board meeting, the Feds Federal Open Market
:U\\ii z++, ii :iUi1i uN: i N iUNii Nt z,,
Committee members discussed the considerable fnancial turbulence in the sub-
primemortgagemarketandthatsomefrms,includingCountrywide,wereshowing
somestrain.Theynotedthatthedatadidnotindicateacollapseofthehousingmar-
ket was imminent and that, if the more optimistic scenarios proved to be accurate,
they might look back and be surprised that the fnancial events did not have a
stronger impact on the real economy. But the FOMC members also expressed con-
cern that the effects of subprime developments could spread to other sectors and
notedthattheyhadbeenrepeatedlysurprisedbythedepthanddurationofthedete-
riorationofthesemarkets.Oneparticipant,inaparaphraseofaquoteheattributed
to Winston Churchill, said that no amount of rewriting of history would exonerate
thosepresentiftheydidnotprepareforthemoredirescenariosdiscussedinthestaff
presentations.
1,
Severaldayslater,onAugust1,CountrywidereleaseditsJulyioo,operational
results,reportingthatforeclosuresanddelinquencieswereupandthatloanproduc-
tionhadfallenby1duringtheprecedingmonth.Acompanyspokesmansaidlay-
offs would be considered. On the same day, Fed staff, who had supervised
CountrywidesholdingcompanyuntilthebankswitchedtoathriftcharterinMarch
ioo,,sentaconfdentialmemototheFedsBoardofGovernorswarningaboutthe
companyscondition:
Thecompanyisheavilyreliantonanoriginate-to-distributemodel,and,
givencurrentmarketconditions,thefrmisunabletosecuritizeorsell
any of its non-conforming mortgages. . . . Countrywides short-term
funding strategy relied heavily on commercial paper (CP) and, espe-
cially,onABCP.Incurrentmarketconditions,theviabilityofthatstrat-
egy is questionable. . . . The ability of the company to use [mortgage]
securities as collateral in [repo transactions] is consequently uncertain
inthecurrentmarketenvironment. . . .Asaresult,itcouldfacesevere
liquidity pressures. Those liquidity pressures conceivably could lead
eventuallytopossibleinsolvency.
1o
Countrywideaskeditsregulator,theOmceofThriftSupervision,iftheFedcould
provideassistance,perhapsbywaivingaFedruleandallowingCountrywidesthrift
subsidiary to support its holding company by raising money from insured deposi-
tors,orperhapsthroughdiscount-windowlending,whichwouldrequiretheFedto
accept risky mortgage-backed securities as collateral, something it never had done
andwouldnotdountilthefollowingspring.TheFeddidnotintervene:Substan-
tial statutory requirements would have to be met before the Board could authorize
lending to the holding company or mortgage subsidiary, staff wrote. The Federal
Reservehadnotlenttoanonbankinmanydecades;and . . .suchlendinginthecur-
rentcircumstancesseemedhighlyimprobable.
1,
Thefollowingday,lackinganyotherfunding,Mozilorecommendedtohisboard
thatthecompanynotifylendersofitsintentiontodrawdown11.,billiononbackup
lines of credit.
18
Mozilo and his team knew that the decision could lead to ratings
z,+ ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
downgrades. The only option we had was to pull down those lines, he told the
FCIC.Wehadapipelineofloansandweeitherhadtosaytotheborrowers,thecus-
tomers,wereoutofbusiness,werenotgoingtofundandtheresgreatrisktothat,
litigation risk, we had committed to fund. . . . When its between your ass and your
image,youholdontoyourass.
1
On the same day that Countrywides board approved the 11., billion draw-
downbut before the company announced it publicly, the Merrill Lynch analyst
KennethBruce,whohadreissuedhisbuyratingonthecompanysstocktwodays
earlier,switchedtosellwithanegativeoutlookbecauseofCountrywidesfunding
pressures,adding,ifthemarketlosesconfdenceinitsabilitytofunctionproperly,
thenthemodelcanbreak. . . .Ifliquidationsoccurinaweakmarket,thenitispossi-
blefor[Countrywide]togobankrupt.
io
The next day, as news of Bruces call spread, Countrywide informed markets
about the drawdown. Moodys downgraded its senior unsecured debt rating to the
lowest tier of investment grade. Countrywide shares fell 11, closing at 18.,; for
theyear,thecompanysstockwasdown,o.Thebadnewsledtoanold-fashioned
bankrun.MozilosingledoutanAugust1oLos Angeles Times articlecoveringBruces
report,which,hesaid,causedarunonourbankof8billiononMonday.Thearti-
clespurredcustomerstowithdrawtheirfundsbynotingspecifcaddressesofCoun-
trywidebranchesinsouthernCalifornia,MozilotoldtheFCIC.Areportercameout
withaphotographerand,youknow,interviewedthepeopleinline,andhecreated
it was just horrible. Horrible for the people, horrible for us. Totally unnecessary,
Mozilosaid.
i1
Sixdayslater,onAugustii,BankofAmericaannounceditwouldinvestibil-
lionfora1ostakeinCountrywide.Bothcompaniesdeniedrumorsthatthenations
biggestbankwouldsoonacquirethemortgagelender.Mozilotoldthepress,There
wasneveraquestionaboutoursurvival;hesaidtheinvestmentreinforcedCountry-
widespositionasoneofthestrongestandbest-runcompaniesinthecountry.
ii
InOctober,Countrywidereportedanetlossof1.ibillion,itsfrstquarterlyloss
ini,years.Ascharge-offsonitsmortgageportfoliogrew,Countrywideraisedprovi-
sions for loan losses to million from only 8 million one year earlier. On
January 11, ioo8, Bank of America issued a press release announcing a defnitive
agreementtopurchaseCountrywideforapproximatelybillion.Itsaidthecom-
binedentitywouldstoporiginatingsubprimeloansandwouldexpandprogramsto
helpdistressedborrowers.
BNP PARIBAS: THE RINGING OF THE BELL
Meanwhile,problemsinU.S.fnancialmarketshitthelargestFrenchbank.OnAu-
gust , BNP Paribas SA suspended redemptions from three investment funds that
hadplungedioinlessthantwoweeks.Totalassetsinthosefundswerei.ibillion,
with a third of that amount in subprime securities rated AA or higher.
i
The bank
saiditwouldalsostopcalculatingafairmarketvalueforthefundsbecausethecom-
plete evaporation of liquidity in certain market segments of the US securitization
At the onset of the crisis in summer 2007, asset-backed commercial paper
outstanding dropped as concerns about asset quality quickly spread. By the end of
2007, the amount outstanding had dropped nearly $400 billion.
Asset-Backed Commercial Paper Outstanding
IN BILLIONS OF DOLLARS
SOURCE: Federal Reserve Board of Governors
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
NOTE: Seasonally adjusted
0
250
500
750
1,000
$1,250
Iigurc:,.:
:U\\ii z++, ii :iUi1i uN: i N iUNii Nt z,.
markethasmadeitimpossibletovaluecertainassetsfairlyregardlessoftheirquality
orcreditrating.
i
Inretrospect,manyinvestorsregardedthesuspensionoftheFrenchfundsasthe
beginningoftheioo,liquiditycrisis.Augustwastheringingofthebellforshort-
termfundingmarkets,PaulMcCulley,amanagingdirectoratPIMCO,toldtheFCIC.
The buyers went on a buyer strike and simply werent rolling.
i,
That is, they
stopped rolling over their commercial paper and instead demanded payment on
theirloans.OnAugust,theinterestratesforovernightlendingofA-1ratedasset-
backedcommercialpaperrosefrom,.to,.,,thehighestlevelsinceJanuary
ioo1. It would continue rising unevenly, hitting o.1 in August 1o, ioo,. Figure
1.1showshow,inresponse,lendingdeclined.
InAugustalone,theasset-backedcommercialpapermarketshrankby1obil-
lion, or io. On August o, subprime lender American Home Mortgages asset-
backed commercial paper program invoked its privilege of postponing repayment,
trapping lenders money for several months. Lenders quickly withdrew from pro-
gramswithsimilarprovisions,whichshrankthatmarketfrom,billiontobil-
lionbetweenMayandAugust.
io
The paper that did sell had signifcantly shorter maturities, refecting creditors
desiretoreassesstheircounterpartiescreditworthinessasfrequentlyaspossible.The
averagematurityofallasset-backedcommercialpaperintheUnitedStatesfellfrom
z,z ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
about 1 days in late July to about i days by mid-September, though the over-
whelmingmajoritywasissuedforjust1todays.
i,
Disruptionsquicklyspreadtootherpartsofthemoneymarket.Inafighttoqual-
ity,investorsdumpedtheirrepoandcommercialpaperholdingsandincreasedtheir
holdingsinseeminglysafermoneymarketfundsandTreasurybonds.Marketpartici-
pants,unsureofeachotherspotentialsubprimeexposures,scrambledtoamassfunds
for their own liquidity. Banks became less willing to lend to each other. A closely
watched indicator of interbank lending rates, called the one-month LIBOR-OIS
spread,increased,signifyingthatbankswereconcernedaboutthecreditriskinvolved
inlendingtoeachother.OnAugust,itrosesharply,increasingthree-tofourfoldover
historicalvalues,andbySeptember,,itclimbedbyanother1,o.Inioo8,itwould
peakmuchhigher.
Thepanicintherepo,commercialpaper,andinterbankmarketswasmetbyimme-
diategovernmentaction.OnAugust1o,thedayafterBNPParibassuspendedredemp-
tions,theFedannouncedthatitwouldprovid[e]liquidityasnecessarytofacilitatethe
orderly functioning of fnancial markets,
i8
and the European Central Bank infused
billions of Euros into overnight lending markets. On August 1,, the Fed cut the dis-
countrateby,obasispointsfromo.i,to,.,,.Thiswouldbethefrstofmany
such cuts aimed at increasing liquidity. The Fed also extended the term of discount-
windowlendingtoodays(fromtheusualovernightorveryshort-termperiod)toof-
ferbanksamorestablesourceoffunds.Onthesameday,theFedsFOMCreleaseda
statement acknowledging the continued market deterioration and promising that it
waspreparedtoactasneededtomitigatetheadverseeffectsontheeconomy.
i
SIVS: AN OASIS OF CALM
InAugust,theturmoilinasset-backedcommercialpapermarketshitthemarketfor
structuredinvestmentvehicles,orSIVs,eventhoughmostoftheseprogramshadlit-
tlesubprimemortgageexposure.SIVshadastablehistorysincetheirintroductionin
188. These investments had weathered a number of credit criseseven through
early summer of ioo,, as noted in a Moodys report issued on July io, ioo,, titled
SIVs:AnOasisofCalmintheSub-primeMaelstrom.
o
Unlike typical asset-backed commercial paper programs, SIVs were funded pri-
marilythroughmedium-termnotesbondsmaturinginonetofveyears.SIVsheld
signifcantamountsofhighlyliquidassetsandmarkedthoseassetstomarketprices
daily or weekly, which allowed them to operate without explicit liquidity support
fromtheirsponsors.
TheSIVsectortripledinassetsbetweeniooandioo,.Ontheeveofthecrisis,
there were o SIVs with almost oo billion in assets.
1
About one-quarter of that
moneywasinvestedinmortgage-backedsecuritiesorinCDOs,butonlyowasin-
vestedinsubprimemortgagebackedsecuritiesandCDOsholdingmortgage-backed
securities.
Not surprisingly, the frst SIVs to fail were concentrated in subprime mortgage
:U\\ii z++, ii :iUi1i uN: i N iUNii Nt z,,
backedsecurities,mortgage-relatedCDOs,orboth.TheseincludedCheyneFinance
(managed by London-based Cheyne Capital Management), Rhinebridge (another
IKBprogram),GoldenKey,andMainsailII(bothstructuredbyBarclaysCapital).Be-
tweenAugustandOctober,eachofthesefourwasforcedtorestructureorliquidate.
InvestorssoonranfromeventhesaferSIVs.Themediawasquitehappytosen-
sationalizethecollapseofthenextleakingSIVorthenextSIV-positiveinstitution,
then-Moodys managing director Henry Tabe told the FCIC.
i
The situation was
complicatedbytheSIVslackoftransparency.Inacontextofopacityaboutwhere
risk resides, . . . a general distrust has contaminated many asset classes. What had
oncebeenliquidisnowilliquid.Goodcollateralcannotbesoldorfnancedatany-
thingapproachingitstruevalue,MoodyswroteonSeptember,.

Even high-quality assets that had nothing to do with the mortgage market were
declininginvalue.OneSIVmarkeddownaCDOtosevencentsonthedollarwhile
itwasstillratedtriple-A.

Toraisecash,managerssoldassets.Butsellinghigh-qual-
ityassetsintoadecliningmarketdepressedthepricesoftheseunimpairedsecurities
andpusheddownthemarketvaluesofotherSIVportfolios.
BytheendofNovember,SIVsstillinoperationhadliquidatedioftheirportfo-
lios,onaverage.
,
SponsorsrescuedsomeSIVs.OtherSIVsrestructuredorliquidated;
some investors had to wait a year or more to receive payments and, even then, re-
coupedonlysomeoftheirmoney.InthecaseofRhinebridge,investorslost,and
onlygraduallyreceivedtheirpaymentsoverthenextyear.
o
InvestorsinoneSIV,Sigma,
lost more than ,.
,
As of fall io1o, not a single SIV remained in its original form.
The subprime crisis had brought to its knees a historically resilient market in which
lossesduetosubprimemortgagedefaultshadbeen,ifanything,modestandlocalized.
MONEY FUNDS AND OTHER INVESTORS:
DRINKING FROM A FIRE HOSE
Thenextdominoeswerethemoneymarketfundsandotherfunds.Mostwerespon-
sored by investment banks, bank holding companies, or mutual fund complexes
such as Fidelity, Vanguard, and Federated. Under SEC regulations, money market
fundsthatserveretailinvestorsmustkeeptwosetsofaccountingbooks,onerefect-
ingthepricetheypaidforsecuritiesandtheotherthefundsmark-to-marketvalue
(theshadowprice,inmarketparlance).However,fundsdonothavetodisclosethe
shadowpriceunlessthefundsnetassetvalue(NAV)hasfallenbyo.,below1(to
o.,) per share. Such a decline in market value is known as breaking the buck
and generally leads to a funds collapse. It can happen, for example, if just , of a
fundsportfolioisinaninvestmentthatlosesjust1oofitsvalue.Soafundmanager
cannotaffordbigrisks.
But SIVs were considered very safe investmentsthey always had beenand
were widely held by money market funds. In fall ioo,, dozens of money market
funds faced losses on SIVs and other asset-backed commercial paper. To prevent
theirfundsfrombreakingthebuck,atleastsponsors,includinglargebankssuch
z,, ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
as Bank of America, US Bancorp, and SunTrust, purchased SIV assets from their
moneymarketfunds.
8
Similardramasplayedoutintheless-regulatedrealmofthemoneymarketsector
known as enhanced cash funds. These funds serve not retail investors but rather
qualifedpurchasers,whichmayincludewealthyinvestorswhoinvesti,million
or more. Enhanced cash funds fall outside most SEC regulations and disclosure re-
quirements.Becausetheyhavemuchhigherinvestmentthresholdsthanretailfunds,
and because they face less regulation, investors expect somewhat riskier investing
and higher returns. Nonetheless, these funds also aim to maintain a 1 net asset
value.
Asthemarketturned,someofthesefundsdidbreakthebuck,whilethesponsors
of others stepped in to support their value. The , billion GE Asset Management
Trust Enhanced Cash Trust, a GE-sponsored fund that managed GEs own pension
andemployeebeneftassets,ranagroundinthesummer;ithad,oofitsassetsin
mortgage-backedsecurities.Whenthefundreportedlylostioomillionandclosed
in November ioo,, investors redeemed their interests at o.o.

Bank of America
supporteditsStrategicCashPortfoliothenationslargestenhancedcashfund,with
o billion in assets at its peakafter one of that funds largest investors withdrew
iobillioninNovemberioo,.
o
An interesting case study is provided by the meteoric rise and decline of the
CreditSuisseInstitutionalMoneyMarketPrimeFund.Thefundsoughttoattractin-
vestorsthroughInternet-basedtradingplatformscalledportals,whichsuppliedan
estimatedoobilliontomoneymarketfundsandotherfunds.Investorsusedthese
portalstoquicklymovetheircashtothehighest-yieldingfund.Postingahigherre-
turncouldattractsignifcantfunds:onemoneymarketfundmanagerlatercompared
theuseofportalmoneytodrink[ing]fromafrehose.
1
Butthemoneycouldvan-
ishjustasquickly.TheCreditSuissefundpostedthehighestreturnsintheindustry
duringthe1imonthsbeforetheliquiditycrisis,andincreaseditsassetsfromabout
,billioninthesummerofioootomorethani,billioninthesummerofioo,.To
deliverthosehighreturnsandattractinvestors,though,itfocusedonstructuredf-
nanceproducts,includingCDOsandSIVssuchasCheyne.Wheninvestorsbecame
concernedaboutsuchassets,theyyankedabout1obillionoutofthefundinAugust
ioo,alone.CreditSuisse,theSwissbankthatsponsoredthefund,wasforcedtobail
itout,purchasing,.,billionofassetsinAugust.
i
Theepisodehighlightstherisks
ofmoneymarketfundsrelyingonhotmoneythatis,institutionalinvestorswho
movequicklyinandoutoffundsinsearchofthehighestreturns.
The losses on SIVs and other mortgage-tainted investments also battered local
governmentinvestmentpoolsacrossthecountry,someofwhichheldbillionsofdol-
lars in these securities. Pooling provides municipalities, school districts, and other
governmentagencieswitheconomiesofscale,investmentdiversifcation,andliquid-
ity.Insomecases,participationismandatory.
With i, billion in assets, Floridas local government investment pool was the
largestinthecountry,andintendedtooperatelikeahighlyliquid,low-riskmoney
marketfund,withsecuritieslikecash,certifcatesofdeposit, . . .U.S.Treasurybills,
COMMISSION CONCLUSIONS ON CHAPTER 13
The Commission concludes that the shadow banking system was permitted to
grow to rival the commercial banking system with inadequate supervision and
regulation.Thatsystemwasveryfragileduetohighleverage,short-termfunding,
risky assets, inadequate liquidity, and the lack of a federal backstop. When the
mortgagemarketcollapsedandfnancialfrmsbegantoabandonthecommercial
paperandrepolendingmarkets,someinstitutionsdependingonthemforfund-
ingtheiroperationsfailedor,laterinthecrisis,hadtoberescued.Thesemarkets
and other interconnections created contagion, as the crisis spread even to mar-
ketsandfrmsthathadlittleornodirectexposuretothemortgagemarket.
Inaddition,regulationandsupervisionoftraditionalbankinghadbeenweak-
ened signifcantly, allowing commercial banks and thrifts to operate with fewer
constraintsandtoengageinawiderrangeoffnancialactivities,includingactivi-
tiesintheshadowbankingsystem.
Thefnancialsector,whichgrewenormouslyintheyearsleadinguptothef-
nancial crisis, wielded great political power to weaken institutional supervision
and market regulation of both the shadow banking system and the traditional
bankingsystem.Thisderegulationmadethefnancialsystemespeciallyvulnera-
bletothefnancialcrisisandexacerbateditseffects.
andbondsissuedbyotherU.S.governmentagencies,asaninvestigationbythestate
legislaturenoted.

ButbyNovemberioo,,becauseofratingsdowngrades,thefund
held at least 1., billion in securities that no longer met the states requirements. It
hadmorethanibillioninSIVsandotherdistressedsecurities,ofwhichabout,i,
millionhadalreadydefaulted.Anditheldo,omillioninCountrywidecertifcates
ofdepositwithmaturitiesthatstretchedoutasfarasJuneioo8.

InearlyNovember,
followingaseriesofnewsreports,thefundsufferedarun.Localgovernmentswith-
drew8billioninjusttwoweeks.OrangeandPinellascountiespulledouttheiren-
tire investments. On November i, the funds managers stopped all withdrawals.
Floridas was the hardest hit, but other state investment pools also took signifcant
lossesonSIVsandothermortgage-relatedholdings.
:U\\ii z++, ii :iUi1i uN: i N iUNii Nt z,,
z,
14
LATE 2007 TO EARLY 2008:
BILLIONS IN SUBPRIME LOSSES
CONTENTS
Mcrri||IynchDawningawarcncsscvcrthcccursccjthcsunncr:,,
Citigrcup1hatwcu|dnctinanywayhavccxcitcdnyattcnticn:eo
AIGsdisputcwithGc|dnan1hcrcccu|dncvcr|c|csscs:e,
Icdcra|Rcscrvc1hcdisccuntwindcwwasntwcrking:,,
Mcnc|incinsurcrsVcncvcrcxpcctcd|csscs:,e
Whileahandfulofbankswerebailingouttheirmoneymarketfundsandcommer-
cial paper programs in the fall of ioo,, the fnancial sector faced a larger problem:
billions of dollars in mortgage-related losses on loans, securities, and derivatives,
with no end in sight. Among U.S. frms, Citigroup and Merrill Lynch reported the
mostspectacularlosses,largelybecauseoftheirextensivecollateralizeddebtobliga-
tion (CDO) businesses, writing down a total of i.8 billion and i., billion, re-
spectively, by the end of the year. Billions more in losses were reported by large
fnancialinstitutionssuchasBankofAmerica(.,billion),MorganStanley(1o.
billion),JPMorgan(,.billion),andBearStearns(i.obillion).
1
Insurancecompa-
nies, hedge funds, and other fnancial institutions collectively had taken additional
mortgage-relatedlossesofabout1oobillion.
i
The large write-downs strained these frms capital and cash reserves. Further,
market participants began discriminating between frms perceived to be relatively
healthy and others about which they were not so sure. Bear Stearns and Lehman
Brothers were at the top of the suspect list; by year-end ioo, the cost of fve-year
protectionagainstdefaultontheirobligationsinthecreditdefaultswapmarketstood
at,respectively,1,o,oooand11,oooannuallyforevery1omillion,whilethecost
fortherelativelystrongerGoldmanSachsstoodato8,ooo.

Meanwhile,theeconomywasbeginningtoshowsignsofstress.Facingturmoilin
fnancialmarkets,declininghomeprices,andoilpricesabove,,abarrel,consumer
spending was slowing. The Federal Reserve lowered the overnight bank borrowing
ratefrom,.i,earlierintheyearto.,,inSeptember,.,inOctober,andthen
.i,inDecember.
i\1i z++, 1u i\ii z++ 8i iii uN: i N :U8iii \i iu: :i: z,,
MERRILL LYNCH: DAWNING AWARENESS
OVER THE COURSE OF THE SUMMER
On October i, Merrill Lynch stunned investors when it announced that third-
quarter earnings would include a o. billion loss on CDOs and 1 billion on sub-
prime mortgages,. billion in total, the largest Wall Street write-down to that
point,andnearlytwicethe.,billionlossthatthecompanyhadwarnedinvestorsto
expect just three weeks earlier. Six days later, the embattled CEO Stanley ONeal, a
i1-yearMerrillveteran,resigned.
Much of this write-down came from the frms holdings of the super-senior
tranches of mortgage-related CDOs that Merrill had previously thought to be ex-
tremelysafe.Aslateasfalliooo,itsmanagementhadbeenbullishongrowthand
bullishon[thesubprime]assetclass.

Butlaterthatyear,thesignsoftroublewere
becomingdimcultevenforMerrilltoignore.Twomortgageoriginatorstowhichthe
frmhadextendedcreditlinesfailed:Ownit,inwhichMerrillalsohadasmallequity
stake, and Mortgage Lenders Network. Merrill seized the collateral backing those
loans:1.,billionfromMortgageLenders,1.ibillionfromOwnit.
Merrill,likemanyofitscompetitors,startedtorampupitssalesefforts,packag-
ingitsinventoryofmortgageloansandsecuritiesintoCDOswithnewvigor.Itsgoal
wastoreducethefrmsriskbygettingthoseloansandsecuritiesoffitsbalancesheet.
Yetitfoundthatitcouldnotsellthesuper-seniortranchesofthoseCDOsataccept-
ableprices;itthereforehadtotakedownseniortranchesintoinventoryinorderto
execute deals
,
leading to the accumulation of tens of billions of dollars of those
tranchesonMerrillsbooks.DowKim,thentheco-presidentofMerrillsinvestment
banking segment, told FCIC staff that the buildup of the retained super-senior
tranchesintheCDOpositionswasactuallypartofastrategybeguninlateioooto
reduce the frms inventory of subprime and Alt-A mortgages. Sell the lower-rated
CDO tranches, retain the super-senior tranches: those had been his instructions to
hismanagersattheendofiooo,Kimrecalled.Hebelievedthatthisstrategywould
reduce overall credit risk. After all, the super-senior tranches were theoretically the
safestpiecesofthoseinvestments.
o
Tosomedegree,however,thestrategywasinvol-
untary:hispeoplewerehavingtroublesellingtheseinvestments,andsomewereeven
soldataloss.
,
Initially,thestrategyseemedtowork.ByMay,theamountofmortgageloansand
securitiestobepackagedintoCDOshaddeclinedto.,billionfrom1i.8billion
in March.
8
According to a September ioo, internal Merrill presentation, the net
amount in retained super-senior CDO tranches had increased from . billion in
Septemberioootoi,.billionbyMarchioo,andi8.billionbyMay.

Butasthe
mortgagemarketcameunderincreasingpressureandasthemarketvalueofevensu-
per-seniortranchescrumbled,thestrategywouldcomebacktohauntthefrm.
Merrills frst-quarter earnings for ioo,net revenues of . billionwere its
second-highestquarterlyresultsever,includingarecordfortheFixedIncome,Cur-
renciesandCommoditiesbusiness,whichhousedtheretainedCDOpositions.These
z, ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
results were announced during a conference call with analystsan event that in-
vestorsandanalystsrelyontoobtainimportantinformationaboutthecompanyand
that,likeotherpublicstatements,issubjecttofederalsecuritieslaws.
Merrills then-CFO Jeffrey Edwards indicated that the companys results would
notbehurtbythedislocationinthesubprimemarket,becauserevenuesfromsub-
primemortgage-relatedactivitiescomprise[d]lessthan1ofournetrevenuesover
thepastfvequarters,andbecauseMerrillsriskmanagementcapabilitiesarebetter
thanever,andcrucialtooursuccessinnavigatingturbulentmarkets.Providingfur-
therassurances,hestated,Webelievetheissuesinthisnarrowsliceofthemarketre-
maincontainedandhavenotnegativelyimpactedothersectors.
1o
However, Edwards did not disclose the large increase in retained super-senior
CDOtranchesorthedimcultyofsellingthosetranches,evenatalossthoughspe-
cifcquestionsonthesubjectwereraised.
InJuly,Merrillfolloweditsstrongfrst-quarterreportwithanotherforthesecond
quarterthatenabledthecompanytoachieverecordnetrevenues,netearningsand
netearningsperdilutedshareforthefrsthalfofioo,.
11
Duringtheconferencecall
announcing the results, the analyst Glenn Schorr of UBS, a large Swiss bank, asked
theCFOtoprovidesomecoloraroundmythversusrealityonMerrillsexposureto
retainedCDOpositions.Ashehadthreemonthsearlier,EdwardsstressedMerrills
risk management and the fact that the CDO business was a small part of Merrills
overall business. He said that there had been signifcant reductions in Merrills re-
tainedexposurestolower-ratedsegmentsofthemarket,althoughhedidnotdisclose
thatthetotalamountofMerrillsretainedCDOshadreachedo.billionbyJune.
Edwards declined to provide details about the companys exposure to subprime
mortgage CDOs and any inventory of mortgage-backed securities to be packaged
into CDOs. We dont disclose our capital allocations against any specifc or even
broadergroup,Edwardssaid.
1i
On July ii, after the super-senior tranches had been accumulating for many
months, Merrill executives frst omcially informed its board about the buildup. At a
presentationtotheboardsFinanceCommittee,DaleLattanzio,co-headoftheAmer-
ican branch of the Fixed Income, Currencies and Commodities business, reported a
netexposureofibillioninCDO-relatedassets,essentiallyallofthemratedtriple-
A, with exposure to the lower-rated asset class signifcantly reduced.
1
This net
exposurewastheamountofCDOpositionsleftafterthesubtractionofthehedges
guaranteesinoneformoranotherthatMerrillhadpurchasedtopassalongitsulti-
materisktothirdpartieswillingtoprovidethatprotectionandtakethatriskforafee.
AIGandthesmallclubofmonolineinsurersweresignifcantsuppliersoftheseguar-
antees, commonly done as credit default swaps. In July ioo,, Merrill had begun to
increasetheamountofCDSprotectiontooffsettheretainedCDOpositions.
Lattanzio told the committee, [Management] decided in the beginning of this
year to signifcantly reduce exposure to lower-rated assets in the sub-prime asset
class and instead migrate exposure to senior and super senior tranches.
1
Edwards
didnotseeanyproblems.AsKiminsisted,Everyoneatthefrmandmostpeoplein
theindustryfeltthatsuper-seniorwassupersafe.
1,
i\1i z++, 1u i\ii z++ 8i iii uN: i N :U8iii \i iu: :i: z,,
Former CEO ONeal told FCIC investigators he had not known that the com-
panywasretainingthesuper-seniortranchesoftheCDOsuntilLattanziospresen-
tationtotheFinanceCommittee.Hewasstartled,ifonlybecausehehadbeenunder
the impression that Merrills mortgage-backed-assets business had been driven by
demand: he had assumed that if there were no new customers, there would be no
newofferings.IfcustomersdemandedtheCDOs,whywouldMerrillhavetoretain
CDO tranches on the balance sheet: ONeal said he was surprised about the re-
tainedpositionsbutstatedthatthepresentation,analysis,andestimationofpoten-
tial losses were not sumcient to sound alarm bells.
1o
Lattanzios report in July
indicated that the retained positions had experienced only , million in losses.
1,
Over the next three months, the market value of the super-senior tranches plum-
meted and losses ballooned; ONeal told the FCIC: It was a dawning awareness
overthecourseofthesummerandthroughSeptemberasthesizeofthelosseswere
beingestimated.
18
OnOctoberi1,Merrillexecutivesgaveitsboardadetailedaccountofhowthe
frmfounditselfwithwhatwasbythattime1,.ibillioninnetexposuretothesu-
per-seniortranchesdownfromapeakinJulyofi.ibillionbecausethefrmhad
increasinglyhedged,writtenoff,andsolditsexposure.OnOctoberi,Merrillan-
nounceditsthird-quarterearnings:astunning,.billionmortgage-relatedwrite-
down contributing to a net loss of i. billion. Merrill also reportedfor the frst
timeits1,.ibillionnetexposuretoretainedCDOpositions.Still,intheirconfer-
encecallwithanalysts,ONealandEdwardsrefusedtodisclosethegrossexposures,
excludingthehedgesfromthemonolinesandAIG.Ijustdontwanttogetintothe
details behind that, Edwards said. Let me just say that what we have provided
again we think is an extraordinarily high level of disclosure and it should be sum-
cient.
1
AccordingtotheSecuritiesandExchangeCommission,bySeptemberioo,,
Merrillhadaccumulated,,billionofgrossretainedCDOpositions,almostfour
timesthe1,.ibillionofnetCDOpositionsreportedduringtheOctobericon-
ferencecall.
io
On October o, when ONeal resigned, he left with a severance package worth
1o1., million
i1
on top of the 1. million in total compensation he earned in
iooo,whenhiscompanywasstillexpandingitsmortgagebankingoperations.Kim,
whooversawthestrategythatleftMerrillwithbillionsinlosses,hadleftinMayioo,
after being paid o million for his work in iooo, which was a proftable year for
Merrillasafrm.
ii
By late ioo,, the viability of the monoline insurers from which Merrill had pur-
chasedalmost1oobillioninhedgeshadcomeintoquestion,andtheratingagencies
weredowngradingthem,aswewillseeinmoredetailshortly.TheSEChadtoldMer-
rillthatitwouldimposeapunitivecapitalchargeonthefrmifitpurchasedadditional
credit default protection from the fnancially troubled monolines. Recognizing that
the monolines might not be good for all the protection purchased, Merrill began to
putasidelossallowances,startingwithi.obilliononJanuary1,,ioo8.Bytheendof
ioo8, Merrill would put aside a total of 1 billion related to monolines and had
recordedtotalwrite-downsonnearlybillionofothermortgage-relatedexposures.
z+ ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
CITIGROUP: THAT WOULD NOT IN ANY WAY
HAVE EXCITED MY ATTENTION
Five days after ONeals October o departure from Merrill Lynch, Citigroup an-
nouncedthatitstotalsubprimeexposurewas,,billion,whichwasibillionmore
thanithadtoldinvestorsjustthreeweeksearlier.Citigroupalsoannounceditwould
be taking an 8 to 11 billion loss on its subprime mortgagerelated holdings and
thatChuckPrincewasresigningasitsCEO.LikeONeal,Princehadlearnedlateof
hiscompanyssubprime-relatedCDOexposures.PrinceandRobertRubin,chairman
oftheExecutiveCommitteeoftheboard,toldtheFCICthatbeforeSeptemberioo,,
they had not known that Citigroups investment banking division had sold some
CDOswithliquidityputsandretainedthesuper-seniortranchesofothers.
i
PrincetoldtheFCICthateveninhindsightitwasdimcultforhimtocriticizeany
ofhisteamsdecisions.Ifsomeonehadelevatedtomylevelthatwewereputtingona
itrillionbalancesheet,obillionoftriple-A-rated,zero-riskpaper,thatwouldnot
inanywayhaveexcitedmyattention,Princesaid.Itwouldnthavebeenusefulfor
someonetocometomeandsay,Now,wehavegotitrilliononthebalancesheetof
assets.Iwanttopointouttoyouthereisaoneinabillionchancethatthisobillion
couldgosouth.Thatwouldnothavebeenusefulinformation.ThereisnothingIcan
dowiththat,becausethereisthatlevelofchanceoneverything.
i
Infact,theodds
weremuchhigherthanthat.EvenbeforethemassdowngradesofCDOsinlateioo,,
atriple-AtrancheofaCDOhada1in1ochanceofbeingdowngradedwithin,years
ofitsoriginalrating.
i,
Certainly, Citigroup was a large and complex organization. That i trillion bal-
ancesheetand1.itrillionoff-balancesheetwasspreadamongmorethani,ooo
operating subsidiaries in ioo,. Prince insisted that Citigroup was not too big to
manage.
io
But it was an organization in which one unit would decide to reduce
mortgage risk while another unit increased it. And it was an organization in which
seniormanagementwouldnotbenotifedofbillioninconcentratedexposure
i of the companys balance sheet and more than a third of its capitalbecause it
wasperceivedtobezero-riskpaper.
i,
Signifcantly,CitigroupsFinancialControlGrouphadarguediniooothattheliq-
uidityputsthatCitigrouphadwrittenonitsCDOshadbeenpricedforinvestorstoo
cheaplyinlightoftherisks.
i8
Also,inearlyiooo,SusanMills,amanagingdirectorin
the securitization unitwhich bought mortgages from other companies and bun-
dled them for sale to investorstook note of rising delinquencies in the subprime
marketandcreatedasurveillancegrouptotrackloansthatherunitpurchased.
i
By
mid-iooo,hergroupsawadeteriorationinloanqualityandanincreaseinearlypay-
mentdefaultsthatis,moreborrowersweredefaultingwithinafewmonthsofget-
ting a loan. From ioo, to ioo,, Mills recalled before the FCIC, the early payment
defaultratesnearlytripledfromito,oro.
o
Inresponse,thesecuritizationunit
slowed down its purchase of loans, demanded higher-quality mortgages, and con-
ductedmoreextensiveduediligenceonwhatitbought.However,neitherMillsnor
othermembersoftheunitsharedanyofthisinformationwithotherdivisionsinCiti-
i\1i z++, 1u i\ii z++ 8i iii uN: i N :U8iii \i iu: :i: z.
group,includingtheCDOdesk.
1
AroundMarchorAprilioo,,incontrastwiththe
securitization desk, Citigroups CDO desk increased its purchases of mortgage-
backedsecuritiesbecauseitsawthedistressedmarketasabuyingopportunity.
i
Effective communication across businesses was lacking, the companys regula-
torslaterobserved.Managementacknowledgedthat,inlookingback,itshouldhave
made the mortgage deterioration known earlier throughout the frm. The Global
ConsumerGroupsawsignsofsub-primeissuesandavoidedlosses,asdidmortgage
backedsecuritiestraders,butCDOstructuresbusinessdidsobelatedly[therewas]
nodialogueacrossbusinesses.

Co-headoftheCDOdeskJaniceWarnetoldtheFCICthatshefrstsawweaknesses
intheunderlyingmarketinearlyioo,.InFebruary,whentheABX.HE.BBB-oo-ifell
to,belowpar,theCDOdeskdecidedtoslowdownonthefnancingofmortgage
securitiesforinventorytoproduceCDOs.

Shortlythereafter,however,thesameABX
indexstartedtorally,risingtoiobelowparinMarchandholdingaroundthatlevel
throughMay.So,theCDOdeskreversedcourseandaccelerateditspurchasesofinven-
tory in April, according to Nestor Dominguez, Warnes co-head on the CDO desk.
,
Dominguezsaidhedidntseethemarketweakeninguntilthesummer,whentheindex
felltolessthanoobelowpar.
o
MurrayBarnes,theCitigroupriskomcerassignedtotheCDObusiness,approved
the CDO desks request to temporarily increase its limits on purchasing collateral.
Barnesobserved,inhindsight,thatratherthanlookingatthewideningspreadsasan
opportunity, Citigroup should have reassessed its assumptions and examined
whetherthedeclineintheABXwasasignofstraininthemortgagemarket.Head-
mittedcomplacencyaboutthedesksabilitytomanageitsrisk.
,
Theriskmanagementdivisionalsoincreased theCDOdeskslimitsforretaining
themostseniortranchesfromobillionto,billioninthefrsthalfofioo,.Asat
Merrill, traders and risk managers at Citigroup believed that the super-senior
tranchescarriedlittlerisk.
8
Citigroupsregulatorslaterwrote,Anacknowledgement
oftheriskinitsSuperSeniorAAACDOexposurewasperhapsCitigroupsbiggest
miss. . . .Asmanagementfeltcomfortablewiththecreditriskofthesetranches,itbe-
gantoretainlargepositionsonthebalancesheet. . . .Asthesub-primemarketbegan
to deteriorate, the risk perceived in these tranches increased, causing large write-
downs.

Ultimately,lossesatCitigroupfrommortgages,Alt-Amortgagebackedse-
curities, and mortgage-related CDOs would total about ,8 billion, nearly half of
Citigroupscapitalattheendofiooo.About8billionofthatlossrelatedtoprotec-
tionpurchasedfromthemonolineinsurers.
o
Barness decision to increase the CDO risk limits was approved by his superior,
EllenDuke.BarnesandDukereportedtoDavidBushnell,thechiefriskomcer.Bush-
nellwhomPrincecalledthebestriskmanageronWallStreettoldtheFCICthat
hedidnotrememberspecifcallyapprovingtheincreasebutthat,ingeneral,therisk
managementfunctiondidapprovehigherrisklimitswhenabusinesslinewasgrow-
ing.
1
He described a frm-wide initiative to increase Citigroups structured prod-
uctsbusiness.
i
Perhapswhatismostremarkableabouttheconfictingstrategiesemployedbythe
zz ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
securitizationandCDOdesksisthattheirrespectiveriskomcersattendedthesame
weeklyindependentriskmeetings.Dukerefectedthatshewasnotoverlyconcerned
whentheissuecameup,sayingsheandherriskteamwereseducedbystructuring
andfailedtolookattheunderlyingcollateral.

AccordingtoBarnes,theCDOdesk
didnt look at the CDOs underlying collateral because it lacked the ability to see
loan performance data, such as delinquencies and early payment defaults.

Yet the
surveillance unit in Citigroups securitization desk might have been able to provide
some insights based on its own data.
,
Barnes told the FCIC that Citigroups risk
managementtendedtobemanagedalongbusinesslines,notingthathewasonlytwo
omcesawayfromhiscolleaguewhocoveredthesecuritizationbusinessandyetdidnt
understandthenuancesofwhatwashappeningtotheunderlyingloans.Heregretted
notreachingouttotheconsumerbanktogetthepulseofmortgageorigination.
o
1/et/esncvcr/ecncsincct/cucrcssion
PrinceandRubinappearedtobelieveupuntilthefallofioo,thatanydownsiderisk
intheCDObusinesswasminuscule.IdontthinkanybodyfocusedontheCDOs.
Thiswasonebusinessinavastenterprise,anduntilthetroubledeveloped,itwasnt
one that had any particular profle, Rubinin Princes words, a very important
memberof[the]board
,
toldtheFCIC.Youknow,TomMaheraswasinchargeof
trading.Tomwasanextremelywellregardedtradingfgureonthestreet. . . .Andthis
is what traders do, they handle these kinds of problems.
8
Maheras, the co-head of
Citigroupsinvestmentbank,toldtheFCICthathespentasmallfractionof1of
histimethinkingaboutordealingwiththeCDObusiness.

Citigroupsriskmanagementfunctionwassimplynotveryconcernedabouthous-
ingmarketrisks.AccordingtoPrince,Bushnellandotherstoldhim,ineffect,Gosh,
housingpriceswouldhavetogodownonationwideforustohave,notaproblem
with[mortgage-backedsecurities]CDOs,butforustohaveproblems,andthathas
never happened since the Depression.
,o
Housing prices would be down much less
than o when Citigroup began having problems because of write-downs and the
liquidityputsithadwritten.
By June ioo,, national house prices had fallen .,, and about 1o of subprime
adjustable-ratemortgagesweredelinquent.YetCitigroupstilldidnotexpectthatthe
liquidityputscouldbetriggered,anditremainedunconcernedaboutthevalueofits
retainedsuper-seniortranchesofCDOs.OnJune,ioo,,Citigroupmadeapresenta-
tiontotheSECaboutsubprimeexposureinitsCDObusiness.Thepresentationnoted
thatCitigroupdidnotfactortwopositionsintothisexposure:1.obillioninsuper-
seniortranchesandi.ibillioninliquidityputs.Thepresentationexplainedthatthe
liquidityputswerenotaconcern:Theriskofdefaultisextremelyunlikely . . .[and]
certain market events must also occur for us to be required to fund. Therefore, we
viewthesepositionstobeevenlessriskythantheSuperSeniorBook.
,1
Just a few weeks later, the July ioo, failure of the two Bear Stearns hedge funds
spelled trouble. Commercial paper written against three Citigroup-underwritten
CDOs for which Bear Stearns Asset Management was the asset manager and on
i\1i z++, 1u i\ii z++ 8i iii uN: i N :U8iii \i iu: :i: z,
whichCitigrouphadissuedliquidityputsbeganlosingvalue,andtheirinterestrates
began rising. The liquidity puts would be triggered if interest rates on the asset-
backedcommercialpaperroseaboveacertainlevel.
The Omce of the Comptroller of the Currency, the regulator of Citigroups na-
tional bank subsidiary, had expressed no apprehensions about the liquidity puts in
ioo. But by the summer of ioo,, OCC Examiner-in-Charge John Lyons told the
FCIC, the OCC became concerned. Buying the commercial paper would drain i,
billionofthecompanyscashandexposeittopossiblebalance-sheetlossesatatime
whenmarketswereincreasinglyindistress.Butgiventherisingrates,Lyonsalsosaid
Citigroupdidnothavetheoptiontowait.Overthenextsixmonths,Citigrouppur-
chasedalli,billionofthepaperthathadbeensubjecttoitsliquidityputs.
,i
On a July io conference call, CFO Gary Crittenden told analysts and investors
thatthecompanyssubprimeexposureshadfallenfr