-4-color process CMYK -gritty matte UV

THE
FINANCIAL
CRISIS
INQUIRY REPORT
T
H
E
F
I
N
A
N
C
I
A
L
C
R
I
S
I
S
I
N
Q
U
I
R
Y
R
E
P
O
R
T
• 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
9 7 8 0 1 6 0 8 7 7 2 7 8
9 0 0 0 0
FC_cover.indd 1 1/20/11 2:07 PM
1ui
iiN\Nti\i
tii:i:
iNQUii¥ iiiui1

1ui
iiN\Nti\i
tii:i:
iNQUii¥ iiiui1
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
0 0 8 1 - 2 1 5 ) 2 0 2 ( a e r a C D ; 0 0 8 1 - 2 1 5 ) 6 6 8 ( e e r f l l o t : e n o h P v o g . o p g . e r o t s k o o b : t e n r e t n I
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
TheFinancialCrisisInquiryCommissionwascreatedto“examinethecausesofthe
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
iooµ.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.
TheCommission’sstatutoryinstructionssetoutiispecifctopicsforinquiryand
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 1µ 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
casestudyinvestigationsofspecifcfnancialfrms—andinmanycasesspecifcfacets
oftheseinstitutions—thatplayedpivotalroles.ThoseinstitutionsincludedAmerican
InternationalGroup(AIG),BearStearns,Citigroup,CountrywideFinancial,Fannie
Mae,GoldmanSachs,LehmanBrothers,MerrillLynch,Moody’s,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.gov—willhostawealthofinformationbeyondwhatcouldbepresentedhere.
Itwillcontainastockpileofmaterials—includingdocumentsandemails,videoofthe
Commission’spublichearings,testimony,andsupportingresearch—thatcanbestud-
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 Commission’s 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 disruption—a fnancial upheaval, if you will—that
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
preliminaryknowledgeabouthowtheworld’sstrongestfnancialsystemcametothe
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.Thosedecisions—andthedeepemotionssurroundingthem—willbe
debatedlongintothefuture.Butourmissionwastoaskandanswerthiscentralques-
tion:how did it come to pass that in  our nation was forced to choose between two
stark and painful alternatives—either 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,itwasthecollapseofthehousingbubble—fueledby
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
perceivedtobe“toobigtofail,”causedthecreditmarketstoseizeup.Tradingground
toahalt.Thestockmarketplummeted.Theeconomyplungedintoadeeprecession.
Thefnancialsystemweexaminedbearslittleresemblancetothatofourparents’
generation.Thechangesinthepastthreedecadesalonehavebeenremarkable.The
xvi ii N\Nti \i tii :i : i NQUi i¥ tu\\i : :i uN iiiui1
fnancialmarketshavebecomeincreasinglyglobalized.Technologyhastransformed
theemciency,speed,andcomplexityoffnancialinstrumentsandtransactions.There
isbroaderaccesstoandlowercostsoffnancingthaneverbefore.Andthefnancial
sectoritselfhasbecomeamuchmoredominantforceinoureconomy.
From1µ,8toioo,,theamountofdebtheldbythefnancialsectorsoaredfrom
·¡trillionto·¡otrillion,morethandoublingasashareofgrossdomesticproduct.
The very nature of many Wall Street frms changed—from relatively staid private
partnershipstopubliclytradedcorporationstakinggreaterandmorediversekindsof
risks.Byioo,,the1olargestU.S.commercialbanksheld,,ºoftheindustry’sassets,
more than double the level held in 1µµo. On the eve of the crisis in iooo, fnancial
sector profts constituted i,º of all corporate profts in the United States, up from
1,º in 1µ8o. Understanding this transformation has been critical to the Commis-
sion’sanalysis.
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,andexponentialgrowthinfnancialfrms’tradingactivities,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.
TheprimeexampleistheFederalReserve’spivotalfailuretostemthefowoftoxic
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:
tuNtiU:i uN: ui 1ui ii N\Nti \i tii :i : i NQUi i¥ tu\\i : :i uN xvii
• We conclude widespread failures in fnancial regulation and supervision
proved devastating to the stability of the nation’s 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
downonCitigroup’sexcessesintherun-uptothecrisis.Theydidnot.Policymakers
andregulatorscouldhavestoppedtherunawaymortgagesecuritizationtrain.They
didnot.Incaseaftercaseaftercase,regulatorscontinuedtoratetheinstitutionsthey
oversawassafeandsoundeveninthefaceofmountingtroubles,oftendowngrading
them just before their collapse. And where regulators lacked authority, they could
havesoughtit.Toooften,theylackedthepoliticalwill—inapoliticalandideological
environment that constrained it—as 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 1µµµ to ioo8, the fnancial
sectorexpended·i.,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-
headofCitigroup’sinvestmentbanksaidhespent“asmallfractionof1º”ofhistime
onthosesecurities.Inthisinstance,toobigtofailmeanttoobigtomanage.
Financial institutions and credit rating agencies embraced mathematical models
asreliablepredictorsofrisks,replacingjudgmentintoomanyinstances.Toooften,
riskmanagementbecameriskjustifcation.
Compensation systems—designed in an environment of cheap money, intense
competition,andlightregulation—toooftenrewardedthequickdeal,theshort-term
gain—withoutproperconsiderationoflong-termconsequences.Often,thosesystems
encouragedthebigbet—wherethepayoffontheupsidecouldbehugeandthedown-
sidelimited.Thiswasthecaseupanddowntheline—fromthecorporateboardroom
tothemortgagebrokeronthestreet.
Ourexaminationrevealedstunninginstancesofgovernancebreakdownsandirre-
sponsibility.Youwillread,amongotherthings,aboutAIGseniormanagement’signo-
rance of the terms and risks of the company’s ·,µ billion derivatives exposure to
mortgage-related securities; Fannie Mae’s quest for bigger market share, profts, and
bonuses,whichledittorampupitsexposuretoriskyloansandsecuritiesasthehous-
ing market was peaking; and the costly surprise when Merrill Lynch’s top manage-
ment realized that the company held ·,, billion in “super-senior” and supposedly
“super-safe”mortgage-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 banks—Bear Stearns, Goldman Sachs, Lehman
Brothers, Merrill Lynch, and Morgan Stanley—were operating with extraordinarily
thincapital.Byonemeasure,theirleverageratioswereashighas¡oto1,meaningfor
every·¡oinassets,therewasonly·1incapitaltocoverlosses.Lessthana¡ºdropin
assetvaluescouldwipeoutafrm.Tomakemattersworse,muchoftheirborrowing
wasshort-term,intheovernightmarket—meaningtheborrowinghadtoberenewed
eachandeveryday.Forexample,attheendofioo,,BearStearnshad·11.8billionin
tuNtiU:i uN: ui 1ui ii N\Nti \i tii :i : i NQUi i¥ tu\\i : :i uN xix
equityand·¡8¡.obillioninliabilitiesandwasborrowingasmuchas·,obillionin
theovernightmarket.Itwastheequivalentofasmallbusinesswith·,o,oooinequity
borrowing ·1.o million, with ·iµo,,,o of that due each and every day. One can’t
really ask “What were they thinking:” when it seems that too many of them were
thinkingalike.
Andtheleveragewasoftenhidden—inderivativespositions,inoff-balance-sheet
entities,andthrough“windowdressing”offnancialreportsavailabletotheinvesting
public.
ThekingsofleveragewereFannieMaeandFreddieMac,thetwobehemothgov-
ernment-sponsored enterprises (GSEs). For example, by the end of ioo,, Fannie’s
andFreddie’scombinedleverageratio,includingloanstheyownedandguaranteed,
stoodat,,to1.
Butfnancialfrmswerenotaloneintheborrowingspree:fromioo1toioo,,na-
tionalmortgagedebtalmostdoubled,andtheamountofmortgagedebtperhouse-
hold rose more than o¡º from ·µ1,,oo to ·1¡µ,,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,,Lehmanhadamassed·111billionincom-
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,theriskwasn’tbeingtakenonjustbythebigfnancialfrms,butbyfamilies,
too.Nearlyonein1omortgageborrowersinioo,andioootookout“optionARM”
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-
tections—theFederalReserveasalenderoflastresort,federaldepositinsurance,am-
pleregulations—toprovideabulwarkagainstthepanicsthathadregularlyplagued
America’s banking system in the 1µth century. Yet, over the past ¡o-plus years, we
permitted the growth of a shadow banking system—opaque and laden with short-
termdebt—thatrivaledthesizeofthetraditionalbankingsystem.Keycomponents
of the market—for example, the multitrillion-dollar repo lending market, off-bal-
ance-sheet entities, and the use of over-the-counter derivatives—were hidden from
view,withouttheprotectionswehadconstructedtopreventfnancialmeltdowns.We
hadai1st-centuryfnancialsystemwith1µth-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 makers—the Treasury Department, the Federal
Reserve Board, and the Federal Reserve Bank of New York—who 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.WhenBearStearns’shedgefunds,whichwereheavilyinvested
inmortgage-relatedsecurities,implodedinJuneioo,,theFederalReservediscussed
theimplicationsofthecollapse.Despitethefactthatsomanyotherfundswereex-
posedtothesamerisksasthosehedgefunds,theBearStearnsfundswerethoughtto
be“relativelyunique.”DaysbeforethecollapseofBearStearnsinMarchioo8,SEC
ChairmanChristopherCoxexpressed“comfortaboutthecapitalcushions”atthebig
investment banks. It was not until August ioo8, just weeks before the government
takeoverofFannieMaeandFreddieMac,thattheTreasuryDepartmentunderstood
thefullmeasureofthedirefnancialconditionsofthosetwoinstitutions.Andjusta
month before Lehman’s collapse, the Federal Reserve Bank of New York was still
seekinginformationontheexposurescreatedbyLehman’smorethanµoo,oooderiv-
ativescontracts.
Inaddition,thegovernment’sinconsistenthandlingofmajorfnancialinstitutions
duringthecrisis—thedecisiontorescueBearStearnsandthentoplaceFannieMae
andFreddieMacintoconservatorship,followedbyitsdecisionnottosaveLehman
BrothersandthentosaveAIG—increaseduncertaintyandpanicinthemarket.
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
tuNtiU:i uN: ui 1ui ii N\Nti \i tii :i : i NQUi i¥ tu\\i : :i uN xxi
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
integrityofourfnancialmarketsandthepublic’strustinthosemarketsareessential
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.
Unfortunately—as has been the case in past speculative booms and busts—we
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.Youwillreadaboutmortgagebrokerswhowerepaid“yieldspreadpremiums”
bylenderstoputborrowersintohigher-costloanssotheywouldgetbiggerfees,of-
tenneverdisclosedtoborrowers.Thereportcataloguestherisingincidenceofmort-
gagefraud,whichfourishedinanenvironmentofcollapsinglendingstandardsand
laxregulation.Thenumberofsuspiciousactivityreports—reportsofpossiblefnan-
cial crimes fled by depository banks and their amliates—related to mortgage fraud
grew io-fold between 1µµo and ioo, and then more than doubled again between
ioo,andiooµ.Onestudyplacesthelossesresultingfromfraudonmortgageloans
madebetweenioo,andioo,at·11ibillion.
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
alsoin“fnancialandreputationalcatastrophe”forthefrm.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
Commission’sreviewofmanyprospectusesprovidedtoinvestorsfoundthatthiscrit-
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
meanthat“everyoneisatfault”;manyfrmsandindividualsdidnotparticipateinthe
excessesthatspawneddisaster.
Wedoplacespecialresponsibilitywiththepublicleaderschargedwithprotecting
ourfnancialsystem,thoseentrustedtorunourregulatoryagencies,andthechiefex-
ecutivesofcompanieswhosefailuresdroveustocrisis.Theseindividualssoughtand
accepted positions of signifcant responsibility and obligation. Tone at the top does
matterand,inthisinstance,wewereletdown.Noonesaid“no.”
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
gears—some 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 borrower’s ability to
pay.Nearlyone-quarterofallmortgagesmadeinthefrsthalfofioo,wereinterest-
onlyloans.Duringthesameyear,o8ºof“optionARM”loansoriginatedbyCoun-
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
neglecteditsmission“toensurethesafetyandsoundnessofthenation’sbankingand
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
Whilemanyofthesemortgageswerekeptonbanks’books,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-loadtheirrisksonamoment’sno-
tice to the next person in line. They were wrong. When borrowers stopped making
mortgage payments, the losses—amplifed by derivatives—rushed 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,growingto·o,¡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 derivative—credit default swaps (CDS)—fueled the mortgage securitization
pipeline.CDSweresoldtoinvestorstoprotectagainstthedefaultordeclineinvalue
ofmortgage-relatedsecuritiesbackedbyriskyloans.Companiessoldprotection—to
thetuneof·,µbillion,inAIG’scase—toinvestorsinthesenewfangledmortgagese-
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 AIG’s collapse would trigger cascading losses throughout
theglobalfnancialsystem.Inaddition,theexistenceofmillionsofderivativescon-
tractsofalltypesbetweensystemicallyimportantfnancialinstitutions—unseenand
unknown in this unregulated market—added 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 Moody’s, examined by the
Commission as a case study. From iooo to ioo,, Moody’s 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,Moody’sputitstriple-Astampofapprovalon¡omortgage-relatedsecurities
everyworkingday.Theresultsweredisastrous:8¡ºofthemortgagesecuritiesrated
triple-Athatyearultimatelyweredowngraded.
YouwillalsoreadabouttheforcesatworkbehindthebreakdownsatMoody’s,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
tuNtiU:i uN: ui 1ui ii N\Nti \i tii :i : i NQUi i¥ tu\\i : :i uN xxv
estateassetsintheUnitedStateswereprerequisitesforthecreationofacreditbubble.
Those conditions created increased risks, which should have been recognized by
marketparticipants,policymakers,andregulators.However,itistheCommission’s
conclusionthatexcessliquiditydidnotneedtocauseacrisis.Itwasthefailuresout-
linedabove—includingthefailuretoeffectivelyreininexcessesinthemortgageand
fnancialmarkets—thatweretheprincipalcausesofthiscrisis.Indeed,theavailabil-
ity of well-priced capital—both foreign and domestic—is an opportunity for eco-
nomicexpansionandgrowthifencouragedtofowinproductivedirections.
Second,weexaminedtheroleoftheGSEs,withFannieMaeservingastheCom-
mission’s 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
wardoffeffectiveregulationandoversight—spending·1o¡milliononlobbyingfrom
1µµµtoioo8.Theysufferedfrommanyofthesamefailuresofcorporategovernance
and risk management as the Commission discovered in other fnancial frms.
Throughthethirdquarterofio1o,theTreasuryDepartmenthadprovided·1,1bil-
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,
buttheyfollowedratherthanledWallStreetandotherlendersintherushforfool’s
gold. They purchased the highest rated non-GSE mortgage-backed securities and
theirparticipationinthismarketaddedheliumtothehousingballoon,buttheirpur-
chasesneverrepresentedamajorityofthemarket.Thosepurchasesrepresented1o.,º
of non-GSE subprime mortgage-backed securities in ioo1, with the share rising to
¡oºinioo¡,andfallingbacktoi8ºbyioo8.Theyrelaxedtheirunderwritingstan-
dards to purchase or guarantee riskier loans and related securities in order to meet
stockmarketanalysts’andinvestors’expectationsforgrowth,toregainmarketshare,
andtoensuregenerouscompensationfortheirexecutivesandemployees—justifying
theiractivitiesonthebroadandsustainedpublicpolicysupportforhomeownership.
TheCommissionalsoprobedtheperformanceoftheloanspurchasedorguaran-
teed by Fannie and Freddie. While they generated substantial losses, delinquency
ratesforGSEloansweresubstantiallylowerthanloanssecuritizedbyotherfnancial
frms.Forexample,datacompiledbytheCommissionforasubsetofborrowerswith
similar credit scores—scores below ooo—show that by the end of ioo8, GSE mort-
gages were far less likely to be seriously delinquent than were non-GSE securitized
mortgages:o.iºversusi8.¡º.
We also studied at length how the Department of Housing and Urban Develop-
ment’s (HUD’s) 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
Fannie’sandFreddie’sparticipationinthosemortgages.
Finally,astothematterofwhethergovernmenthousingpolicieswereaprimary
cause of the crisis: for decades, government policy has encouraged homeownership
throughasetofincentives,assistanceprograms,andmandates.Thesepolicieswere
putinplaceandpromotedbyseveraladministrationsandCongresses—indeed,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 HUD’s affordable housing
goals,asnotedabove,andtheCommunityReinvestmentAct(CRA).TheCRAwas
enactedin1µ,,tocombat“redlining”bybanks—thepracticeofdenyingcredittoin-
dividualsandbusinessesincertainneighborhoodswithoutregardtotheircreditwor-
thiness.TheCRArequiresbanksandsavingsandloanstolend,invest,andprovide
services to the communities from which they take deposits, consistent with bank
safetyandsoundness.
TheCommissionconcludestheCRAwasnotasignifcantfactorinsubprimelend-
ingorthecrisis.ManysubprimelenderswerenotsubjecttotheCRA.Researchindi-
catesonlyoºofhigh-costloans—aproxyforsubprimeloans—hadanyconnectionto
the law. Loans made by CRA-regulated lenders in the neighborhoods in which they
wererequiredtolendwerehalfaslikelytodefaultassimilarloansmadeinthesame
neighborhoodsbyindependentmortgageoriginatorsnotsubjecttothelaw.
Nonetheless,wemakethefollowingobservationaboutgovernmenthousingpoli-
cies—theyfailedinthisrespect:Asanation,wesetaggressivehomeownershipgoals
withthedesiretoextendcredittofamiliespreviouslydeniedaccesstothefnancial
markets.Yetthegovernmentfailedtoensurethatthephilosophyofopportunitywas
being matched by the practical realities on the ground. Witness again the failure of
theFederalReserveandotherregulatorstoreininirresponsiblelending.Homeown-
ershippeakedinthespringofioo¡andthenbegantodecline.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 nation’s 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
hundredsofindividuals—fnancialexecutives,businessleaders,policymakers,regu-
lators,communityleaders,peoplefromallwalksoflife—tofndouthowandwhyit
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, few—if any—foresaw 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 iooµ
was the largest single shareholder of Moody’s 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,toldtheCommissiona“perfectstorm”hadoccurredthat
regulatorscouldnothaveanticipated;butwhenaskedaboutwhethertheFed’slackof
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,itwasn’thidden. . . .Youcannot
lookatanyofthisandsaythattheregulatorsdidtheirjob.Thiswasnotsomehidden
problem.Itwasn’toutonMarsorPlutoorsomewhere.Itwasrighthere. . . .Youcan’t
maketrillionsofdollars’worthofmortgagesandnothavepeoplenotice.”
o
PaulMcCulley,amanagingdirectoratPIMCO,oneofthenation’slargestmoney
managementfrms,toldtheCommissionthatheandhiscolleaguesbegantogetwor-
riedabout“serioussignsofbubbles”inioo,;theythereforesentoutcreditanalyststo
iocitiestodowhathecalled“old-fashionedshoe-leatherresearch,”talkingtoreales-
tatebrokers,mortgagebrokers,andlocalinvestorsaboutthehousingandmortgage
markets. They witnessed what he called “the outright degradation of underwriting
standards,”McCulleyasserted,andtheysharedwhattheyhadlearnedwhentheygot
back home to the company’s Newport Beach, California, headquarters. “And when
ourgroupcameback,theyreportedwhattheysaw,andweadjustedourriskaccord-
ingly,”McCulleytoldtheCommission.Thecompany“severelylimited”itsparticipa-
tioninriskymortgagesecurities.
,
Veteranbankers,particularlythosewhorememberedthesavingsandloancrisis,
knewthatage-oldrulesofprudentlendinghadbeencastaside.ArnoldCattani,the
chairmanofBakersfeld,California–basedMissionBank,toldtheCommissionthat
he grew uncomfortable with the “pure lunacy” he saw in the local home-building
market,fueledby“voracious”WallStreetinvestmentbanks;hethusoptedoutofcer-
tainkindsofinvestmentsbyioo,.
8
WilliamMartin,thevicechairmanandchiefexecutiveomcerofService1stBank
ofNevada,toldtheFCICthatthedesirefora“highandquickreturn”blindedpeople
tofscalrealities.“YoumayrecallTommyLeeJonesinMen in Black, whereheholdsa
deviceintheair,andwithabrightfashwipescleanthememoriesofeveryonewho
haswitnessedanalienevent,”hesaid.
µ
Unlike so many other bubbles—tulip bulbs in Holland in the 1ooos, South Sea
stocksinthe1,oos,Internetstocksinthelate1µµos—thisoneinvolvednotjustan-
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,climbingfrom·¡oobillioninioooto·i.8
trillioninioo¡,
1o
allowingpeopletowithdrawequitybuiltupoverpreviousdecades
and to consume more, despite stagnant wages. Home sales volume started to in-
crease,andaveragehomepricesnationwideclimbed,risingo,ºineightyearsbyone
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.

Housing starts nationwide
climbed,¡º,from1.¡millionin1µµ,tomorethanimillioninioo,.Encouraged
by government policies, homeownership reached a record oµ.iº in the spring of
ioo¡, although it wouldn’t rise an inch further even as the mortgage machine kept
churning for another three years. By refnancing their homes, Americans extracted
·i.otrillioninhomeequitybetweenioooandioo,,including·¡¡¡billioniniooo
alone,morethanseventimestheamounttheytookoutin1µµo.

Realestatespecula-
torsandpotentialhomeownersstoodinlineoutsidenewsubdivisionsforachanceto
buyhousesbeforethegroundhadevenbeenbroken.Bythefrsthalfofioo,,more
thanoneoutofeverytenhomesaleswastoaninvestor,speculator,orsomeonebuy-
ingasecondhome.
1,
Biggerwasbetter,andeventhestructuresthemselvesballooned
insize;thefoorareaofanaveragenewhomegrewby1,º,toi,i,,squarefeet,in
thedecadefrom1µµ,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,ºof
homeownerspulledoutcashtobuyavehicleandover¡oºspentthecashonacatch-
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
CountrywideFinancial—alenderbroughtdownbyitsriskymortgages—saidthata
“goldrush”mentalityovertookthecountryduringtheseyears,andthathewasswept
upinitaswell:“Housingpriceswererisingsorapidly—ataratethatI’dneverseenin
my,,yearsinthebusiness—thatpeople,regularpeople,averagepeoplegotcaught
upinthemaniaofbuyingahouse,andfippingit,makingmoney.Itwashappening.
Theybuyahouse,make·,o,ooo . . .andtalkatacocktailpartyaboutit. . . .Housing
suddenlywentfrombeingpartoftheAmericandreamtohousemyfamilytosettle
8ii uii uUi \ii¥ i¥i: ,
down—itbecameacommodity.Thatwasachangeintheculture. . . .Itwassudden,
unexpected.”
18
Onthesurface,itlookedlikeprosperity.Afterall,thebasicmechanismsmaking
the real estate machine hum—the mortgage-lending instruments and the fnancing
techniquesthatturnedmortgagesintoinvestmentscalledsecurities,whichkeptcash
fowingfromWallStreetintotheU.S.housingmarket—weretoolsthathadworked
wellformanyyears.
But underneath, something was going wrong. Like a science fction movie in
whichordinaryhouseholdobjectsturnhostile,familiarmarketmechanismswerebe-
ingtransformed.Thetime-tested¡o-yearfxed-ratemortgage,withaioºdownpay-
ment, went out of style. There was a burgeoning global demand for residential
mortgage–backed 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 changes—these
financial innovations, they said, had lowered borrowing costs for consumers and
movedrisksawayfromthebiggestandmostsystemicallyimportantfinancialinsti-
tutions. But the nation’s financial system had become vulnerable and intercon-
nected in ways that were not understood by either the captains of finance or the
system’spublicstewards.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
worlds—high-yield,risk-free—butinstead,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
what’sreallyinside.”

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; i–i8s and ¡–i,s; liar loans;
piggyback second mortgages; payment-option or pick-a-pay adjustable rate mort-
gages.Newvariantsonadjustable-ratemortgages,called“exploding”ARMs,featured
lowmonthlycostsatfrst,butpaymentscouldsuddenlydoubleortriple,ifborrowers
wereunabletorefnance.Loanswithnegativeamortizationwouldeatawaythebor-
rower’sequity.Soontherewereamultitudeofdifferentkindsofmortgagesavailable
on the market, confounding consumers who didn’t 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 proft—and
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.

Withtheseloans,buyerswereabletobidupthepricesof
houseseveniftheydidn’thaveenoughincometoqualifyfortraditionalloans.
Some of these exotic loans had existed in the past, used by high-income, fnan-
ciallysecurepeopleasacash-managementtool.Somehadbeentargetedtoborrow-
erswithimpairedcredit,offeringthemtheopportunitytobuildastrongerpayment
historybeforetheyrefnanced.Buttheinstrumentsbegantodelugethelargermarket
inioo¡andioo,.Thechangedoccurred“almostovernight,”FaithSchwartz,thenan
executiveatthesubprimelenderOptionOneandlatertheexecutivedirectorofHope
Now, a lending-industry foreclosure relief group, told the Federal Reserve’s Con-
sumerAdvisoryCouncil.“Iwouldsuggestmosteverylenderinthecountryisinit,
onewayoranother.”

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 country’s more than ioo-year history. The amount of
mortgagedebtperhouseholdrosefrom·µ1,,ooinioo1to·1¡µ,,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
wasn’t 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¥ i¥i: ,
His clients included many of the largest lenders—Countrywide, Ameriquest, and
Ditechamongthem.Mostoftheirnewhireswereyoung,withnomortgageexperi-
ence,freshoutofschoolandwithpreviousjobs“fippingburgers,”hetoldtheFCIC.
Giventherighttraining,however,thebestofthemcould“easily”earnmillions.
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,“I’llbegone,you’ll
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 frms—including investment banks such as Merrill Lynch, Bear
Stearns,andLehmanBrothers,andcommercialbanksandthriftssuchasCitibank,
WellsFargo,andWashingtonMutual.Thefrmswouldpackagetheloansintoresi-
dentialmortgage–backedsecuritiesthatwouldmostlybestampedwithtriple-Arat-
ingsbythecreditratingagencies,andsoldtoinvestors.Inmanycases,thesecurities
were repackaged again into collateralized debt obligations (CDOs)—often com-
posedoftheriskierportionsofthesesecurities—whichwouldthenbesoldtoother
investors. Most of these securities would also receive the coveted triple-A ratings
thatinvestorsbelievedattestedtotheirqualityandsafety.Someinvestorswouldbuy
aninventionfromthe1µµoscalledacreditdefaultswap(CDS)toprotectagainstthe
securities’defaulting.Foreverybuyerofacreditdefaultswap,therewasaseller:as
theseinvestorsmadeopposingbets,thelayersofentanglementinthesecuritiesmar-
ketincreased.
The instruments grew more and more complex; CDOs were constructed out of
CDOs,creatingCDOssquared.Whenfrmsranoutofrealproduct,theystartedgen-
eratingcheaper-to-producesyntheticCDOs—composednotofrealmortgagesecuri-
ties but just of bets on other mortgage products. Each new permutation created an
opportunitytoextractmorefeesandtradingprofts.Andeachnewlayerbroughtin
more investors wagering on the mortgage market—even 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-
vestors—orpartsofbetsbeingmadebyhundredsmore.TreasurySecretaryTimothy
Geithner,thepresidentoftheNewYorkFederalReserveBankduringthecrisis,de-
scribedtheresultingproductas“cookedspaghetti”thatbecamehardto“untangle.”

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
moneyeverynighttofnanceBearStearns’sbroadersecuritiesportfolio.InSeptem-
ber ioo¡, Ciom created a hedge fund within Bear Stearns with a minimum invest-
mentof·1million.Aswascommon,heusedborrowedmoney—upto·µborrowed
forevery·1frominvestors—tobuyCDOs.Ciom’sfrstfundwasextremelysuccess-
ful;itearned1,ºforinvestorsinioo¡and1oºinioo,—aftertheannualmanage-
ment fee and the ioº slice of the proft for Ciom and his Bear Stearns team—and
grewtoalmost·µbillionbytheendofioo,.Inthefallofiooo,hecreatedanother,
moreaggressivefund.Thisonewouldshootforleverageofupto1ito1.Bytheend
of iooo, the two hedge funds had ·18 billion invested, half in securities issued by
CDOscenteredonhousing.AsaCDOmanager,Ciomalsomanagedanother·18bil-
lionofmortgage-relatedCDOsforotherinvestors.
Ciom’sinvestorsandotherslikethemwantedhigh-yieldingmortgagesecurities.
That,inturn,requiredhigh-yieldingmortgages.Anadvertisingbarragebombarded
potential borrowers, urging them to buy or refnance homes. Direct-mail solicita-
tions fooded people’s 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!(Mortgagessoondubbed“liarloans”bytheindustryitself.)
Borrowers answered the call, many believing that with ever-rising prices, housing
wastheinvestmentthatcouldn’tlose.
InWashington,fourintermingledissuescameintoplaythatmadeitdimculttoac-
knowledgetheloomingthreats.First,effortstoboosthomeownershiphadbroadpo-
litical support—from Presidents Bill Clinton and George W. Bush and successive
Congresses—eventhoughinrealitythehomeownershipratehadpeakedinthespring
ofioo¡.Second,therealestateboomwasgeneratingalotofcashonWallStreetand
creatingalotofjobsinthehousingindustryatatimewhenperformanceinothersec-
torsoftheeconomywasdreary.Third,manytopomcialsandregulatorswerereluc-
tant to challenge the proftable and powerful fnancial industry. And fnally, policy
makersbelievedthatevenifthehousingmarkettanked,thebroaderfnancialsystem
andeconomywouldholdup.
Asthemortgagemarketbeganitstransformationinthelate1µµos,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
startingin1µµµ,eachtimehighlightingtohimthegrowthofpredatorylendingprac-
ticesanddiscussingwithhimthesocialandeconomicproblemstheywerecreating.
¡i
Oneofthefrstplacestoseethebadlendingpracticesenvelopanentiremarket
wasCleveland,Ohio.From1µ8µto1µµµ,homepricesinClevelandroseooº,climb-
ingfromamedianof·,,,iooto·1i,,1oo,whilehomepricesnationallyroseabout
¡µº in those same years; at the same time, the city’s unemployment rate, ranging
8ii uii uUi \ii¥ i¥i: ,
from ,.8º in 1µµo to ¡.iº in 1µµµ, more or less tracked the broader U.S. pattern.
JamesRokakis,thelongtimecountytreasurerofCuyahogaCounty,whereCleveland
islocated,toldtheCommissionthattheregion’shousingmarketwasjuicedby“fip-
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¡,,ooayearin1µµ,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,
there’s nothing safer, than the American mortgage market. . . . It worked for years.
Butthenpeoplerealizedtheycouldscamit.”
¡¡
OmcialsinClevelandandotherOhiocitiesreachedouttothefederalgovernment
forhelp.TheyaskedtheFederalReserve,theoneentitywiththeauthoritytoregulate
riskylendingpracticesbyallmortgagelenders,tousethepowerithadbeengranted
in 1µµ¡ 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.HespokeabouttheFed’spowerunderHOEPA,
declaredsomeofthelendingpracticestobe“clearlyillegal,”andsaidtheycouldbe
“combatedwithlegalenforcementmeasures.”
¡,
Lookingback,RokakisremarkedtotheCommission,“Inaivelybelievedthey’dgo
back and tell Mr. Greenspan and presto, we’d 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
called“exploitative”practicestheybelievedwereputtingbothborrowersandlenders
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.
¡µ
In December ioo1, the Federal Reserve Board used the HOEPA law to
amendsomeregulations;amongthechangeswerenewrulesaimedatlimitinghigh-
interestlendingandpreventingmultiplerefnancingsoverashortperiodoftime,if
theywerenotintheborrower’sbestinterest.
¡o
Asitwouldturnout,thoserulescov-
ered only 1º 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,
thepaymentshockloans”werebeginningtoproliferate,placing“pressure”ontradi-
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,
nonprimelendersoriginated·1o,billioninloans.Theirvolumeroseto·188billion
iniooi,andthen·¡1obillioninioo¡.
¡,
California, with its high housing costs, was a particular hotbed for this kind of
lending. In ioo1, nearly ·,i billion, or i,º of all nontraditional loans nationwide,
were made in that state; California’s share rose to ¡,º by ioo¡, with these kinds of
loans growing to ·µ, billion or by 8¡º in California in just two years.
¡o
In those
years, “subprime and option ARM loans saturated California communities,” Kevin
Stein,theassociatedirectoroftheCaliforniaReinvestmentCoalition,testifedtothe
Commission.“WeestimatedatthattimethattheaveragesubprimeborrowerinCali-
forniawaspayingover·ooomorepermonthontheirmortgagepaymentasaresult
ofhavingreceivedthesubprimeloan.”
¡,
GailBurks,presidentandCEOofNevadaFairHousing,Inc.,aLasVegas–based
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
“metamorphosis”inthelendingindustry.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¥ i¥i: ..
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.
¡µ
Stateomcialsfromaroundthecountryjoinedtogetheragaininioo¡toinvesti-
gate another fast-growing lender, California-based Ameriquest. It became the na-
tion’s largest subprime lender, originating ·¡µ billion in subprime loans in
ioo¡—mostly 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;increasingtheinterestratesonborrowers’loansor
switchingtheirloansfromfxedtoadjustableinterestratesatclosing;andpromising
borrowersthattheycouldrefnancetheircostlyloansintoloanswithbettertermsin
justafewmonthsorayear,evenwhenborrowershadnoequitytoabsorbanother
refnance.”
,1
Ed Parker, the former head of Ameriquest’s 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
“manager”to“supervisor,”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-
tiquesdealers”—inhisview,ablatantmisrepresentationofemployment.Inanother
loanfile,herecalledinaninterviewwiththeFCIC,adisabledborrowerinhis8os
who used a walker was described in the loan application as being employed in
“lightconstruction.”

“Itdidn’ttakeSherlockHolmestofgureoutthiswasbogus,”CoxtoldtheCom-
mission.AshetriedtofgureoutwhyAmeriquestwouldmakesuchobviouslyfraud-
ulent loans, a friend suggested that he “look upstream.” Cox suddenly realized that
thelendersweresimplygeneratingproducttoshiptoWallStreettoselltoinvestors.
“Igotthatithadshifted,”Coxrecalled.“Thelendingpatternhadshifted.”

Ultimately, ¡µ states and the District of Columbia joined in the lawsuit against
Ameriquest,onbehalfof“morethani¡o,oooborrowers.”Theresultwasa·¡i,mil-
lionsettlement.Butduringtheyearswhentheinvestigationwasunderway,between
iooiandioo,,Ameriquestoriginatedanother·i1,.µbillioninloans,
,,
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 . . .andtherewasn’tagreatdealofoversightgoingon.”Althoughhewasthe
nation’stophousingomcialatthetime,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
banks—including Bank of America, Citibank, and Wachovia—and 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
“lecture”tothestates’attorneysgeneral,inameetinginWashington,warningthem
thattheOCCwould“quash”themiftheypersistedinattemptingtocontrolthecon-
sumerpracticesofnationallyregulatedinstitutions.
,8
TwoformerOCCcomptrollers,JohnHawkeandJohnDugan,toldtheCommis-
sionthattheyweredefendingtheagency’sconstitutionalobligationtoblockstateef-
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 Carolina–based Wachovia Bank
told state regulators that it would not abide by state laws, because it was a national
bankandfellunderthesupervisionoftheOCC.MichiganprotestedWachovia’san-
nouncement,andWachoviasuedMichigan.TheOCC,theAmericanBankersAsso-
ciation, and the Mortgage Bankers Association entered the fray on Wachovia’s side;
the other ¡µ states, Puerto Rico, and the District of Columbia aligned themselves
with Michigan. The legal battle lasted four years. The Supreme Court ruled ,–¡ in
Wachovia’sfavoronApril1,,ioo,,leavingtheOCCitssoleregulatorformortgage
lending.Coxcriticizedthefederalgovernment:“Notonlyweretheynegligent,they
wereaggressiveplayersattemptingtostopanyenforcementaction[s]. . . .Thoseguys
shouldhavebeenonourside.”
o1
Nonprimelendingsurgedto·,¡obillioninioo¡andthen·1.otrillioninioo,,
anditsimpactbegantobefeltinmoreandmoreplaces.
oi
Manyofthoseloanswere
funneled into the pipeline by mortgage brokers—the link between borrowers and
the lenders who fnanced the mortgages—who prepared the paperwork for loans
andearnedfeesfromlendersfordoingit.Morethanioo,ooonewmortgagebrokers
8ii uii uUi \ii¥ i¥i: .,
begantheirjobsduringtheboom,andsomewerelessthanhonorableintheirdeal-
ingswithborrowers.

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.

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,were“absolutely”corrupt.
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 11º in Bakersfeld in iooi, 1,º in ioo¡, ¡iº in ioo¡,
andiµºmoreinioo,.
Crabtree,anappraiserfor¡8years,startedinioo¡andioo¡tothinkthatthings
werenotmakingsense.Peoplewerepayinginfatedpricesfortheirhomes,andthey
didn’t 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 that’s 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
involvedmanyofthenation’slargestlenders.Onehouse,forexample,waslistedfor
sale for ·,o,,ooo, and was recorded as selling for ·oo,,ooo with 1ooº fnancing,
thoughtherealestateagenttoldCrabtreethatitactuallysoldfor·,¡,,ooo.Crabtree
realizedthatthegapbetweenthesalespriceandloanamountallowedtheseinsiders
topocket·,o,ooo.Thetermsoftheloanrequiredthebuyertooccupythehouse,but
itwasneveroccupied.Thehousewentintoforeclosureandwassoldinadistresssale
for·¡ii,ooo.
o,
Crabtreebegancallinglenderstotellthemwhathehadfound;buttohisshock,
theydidnotseemtocare.HefnallyreachedonequalityassuranceomceratFremont
., ii N\Nti \i tii :i : i NQUi i¥ tu\\i : :i uN iiiui1
Investment&Loan,thenation’seighth-largestsubprimelender.“Don’tputyournose
whereitdoesn’tbelong,”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.

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
moreto“policetheirownorganizations.”
,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 1µµo 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
Congressin1µµoasthesavingsandloancrisiswasunfolding.

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
overriding”concern,Mukaseysaid.
,,
Tocommunityactivistsandlocalomcials,however,thelendingpracticeswerea
matterofnationaleconomicconcern.RuhiMaker,alawyerwhoworkedonforeclo-
surecasesattheEmpireJusticeCenterinRochester,NewYork,toldFedGovernors
Bernanke,SusanBies,andRogerFergusoninOctoberioo¡thatshesuspectedthat
some investment banks—she specifed Bear Stearns and Lehman Brothers—were
producingsuchbadloansthattheverysurvivalofthefrmswasputinquestion.“We
repeatedlyseefalseappraisalsandfalseincome,”shetoldtheFedomcials,whowere
gatheredatthepublichearingperiodofaConsumerAdvisoryCouncilmeeting.She
urged the Fed to prod the Securities and Exchange Commission to examine the
8ii uii uUi \ii¥ i¥i: .,
qualityofthefrms’duediligence;otherwise,shesaid,seriousquestionscouldarise
about whether they could be forced to buy back bad loans that they had made or
securitized.
,o
Makertoldtheboardthatshefearedan“enormouseconomicimpact”couldre-
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
magazine’scoverstorypositedthatthedayofreckoningwasathand,withthehead-
line“HousePrices: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.Congressthat“theapparentfrothinhousing
markets may have spilled over into the mortgage markets.”
81
For years, he had
warnedthatFannieMaeandFreddieMac,bolsteredbyinvestors’beliefthatthesein-
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 contained”—that is, he ex-
pectedlittlespillovertothebroadereconomy.

Some were less sanguine. For example, the consumer lawyer Sheila Canavan, of
Moab, Utah, informed the Fed’s Consumer Advisory Council in October ioo, that
o1º of recently originated loans in California were interest-only, a proportion that
was more than twice the national average. “That’s insanity,” she told the Fed gover-
nors.“Thatmeanswe’refacingsomethingdowntheroadthatwehaven’tfacedbefore
andwearegoingtobelookingatasafetyandsoundnesscrisis.”

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
“who’s who of central bankers,” recalled Raghuram Rajan, who was then on leave
fromtheUniversityofChicago’sbusinessschoolwhileservingasthechiefeconomist
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-termgainsbutletoffthehookforanyeventuallosses—theIBGYBGsyn-
drome. Rajan added that investment strategies such as credit default swaps could
havedisastrousconsequencesifthesystembecameunstable,andthatregulatoryin-
stitutionsmightbeunabletodealwiththefallout.
8,
HerecalledtotheFCICthathewastreatedwithscorn.LawrenceSummers,afor-
merU.S.treasurysecretarywhowasthenpresidentofHarvardUniversity,calledRa-
jana“Luddite,”implyingthathewassimplyopposedtotechnologicalchange.
88
“Ifelt
like an early Christian who had wandered into a convention of half-starved lions,”
Rajanwrotelater.

SusanM.Wachter,aprofessorofrealestateandfnanceattheUniversityofPenn-
sylvania’s 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
1µµos. 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.”
µo
8ii uii uUi \ii¥ i¥i: .,
Inioo,,newsreportswerebeginningtohighlightindicationsthattherealestate
marketwasweakening.Homesalesbegantodrop,andFitchRatingsreportedsigns
that mortgage delinquencies were rising. That year, the hedge fund manager Mark
KlipschofOrixCreditCorp.toldparticipantsattheAmericanSecuritizationForum,
asecuritiestradegroup,thatinvestorshadbecome“overoptimistic”aboutthemar-
ket.“Iseealotofirrationality,”headded.Hesaidhewasunnervedbecausepeople
were saying, “It’s different this time”—a rationale commonly heard before previous
collapses.
µ1
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,
lenderswere“blacklistinghonestappraisers”andinsteadassigningbusinessonlyto
appraiserswhowouldhitthedesiredpricetargets.“Thepowersthatbecannotclaim
ignorance,” the appraiser Dennis J. Black of Port Charlotte, Florida, testifed to the
Commission.
µi
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.
µ¡
Despiteallthesignsthatthehousingmarketwasslowing,WallStreetjustkeptgo-
ing and going—ordering up loans, packaging them into securities, taking profts,
earningbonuses.Bythethirdquarterofiooo,homepriceswerefallingandmortgage
delinquencies were rising, a combination that spelled trouble for mortgage-backed
securities.Butfromthethirdquarterofioooon,bankscreatedandsoldsome·1.¡
trillion in mortgage-backed securities and more than ·¡,o billion in mortgage-
relatedCDOs.
µ¡
Not everyone on Wall Street kept applauding, however. Some executives were
urgingcaution,ascorporategovernanceandriskmanagementwerebreakingdown.
Refectingonthecausesofthecrisis,JamieDimon,CEOofJPMorgantestifedtothe
FCIC,“Iblamethemanagementteams1ooºand . . .nooneelse.”
µ,
Attoomanyfnancialfrms,managementbrushedasidethegrowingriskstotheir
frms.AtLehmanBrothers,forexample,MichaelGelband,theheadoffxedincome,
andhiscolleagueMadelynAntoncicwarnedagainsttakingontoomuchriskinthe
faceofgrowingpressuretocompeteaggressivelyagainstotherinvestmentbanks.An-
toncic,whowasthefrm’schiefriskomcerfromioo¡toioo,,wasshuntedaside:“At
theseniorlevel,theyweretryingtopushsohardthatthewheelsstartedtocomeoff,”
shetoldtheCommission.Shewasreassignedtoapolicypositionworkingwithgov-
.· ii N\Nti \i tii :i : i NQUi i¥ tu\\i : :i uN iiiui1
ernmentregulators.
µo
Gelbandleft;LehmanomcialsblamedGelband’sdepartureon
“philosophicaldifferences.”
µ,
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 ·µo billion a year of
mortgagesunderwrittenandpurchasedbyCitiFinancial.Thesemortgagesweresold
to Fannie Mae, Freddie Mac, and others. In June iooo, Bowen discovered that as
muchasooºoftheloansthatCitiwasbuyingweredefective.TheydidnotmeetCiti-
group’sloanguidelinesandthusendangeredthecompany—iftheborrowerswereto
defaultontheirloans,theinvestorscouldforceCititobuythemback.Bowentoldthe
Commissionthathetriedtoalerttopmanagersatthefrmby“email,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.
µ8
He fnally took his warnings to the highest level he could reach—Robert Rubin,
the chairman of the Executive Committee of the Board of Directors and a former
U.S.treasurysecretaryintheClintonadministration,andthreeotherbankomcials.
HesentRubinandtheothersamemowiththewords“URGENT—READIMMEDI-
ATELY” in the subject line. Sharing his concerns, he stressed to top managers that
CitifacedbillionsofdollarsinlossesifinvestorsweretodemandthatCitirepurchase
thedefectiveloans.
µµ
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
bankundertookaninvestigationinresponsetoBowen’sclaimsandthesystemofun-
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
thiswasalsothethoughtthatwas—thatwashomogeneousthroughoutWallStreet’s
analysts—was home prices always track income growth and jobs growth. And they
showedmeincomegrowthononechartandjobsgrowthonanother,andsaid,‘We
don’tseewhatyou’retalkingaboutbecauseincomesarestillgrowingandjobsarestill
growing.’AndIsaid,well,youobviouslydon’trealizewherethedogisandwherethe
tailis,andwhat’smovingwhat.”
1o¡
8ii uii uUi \ii¥ i¥i: .,
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
Streetmortgagesecuritizationmachineinthe1µ8os,saidhedidn’tlikewhathecalled
“themadness”thathaddescendedontherealestatemarket.RanieritoldtheCommis-
sion, “I was not the only guy. I’m not telling you I was John the Baptist. There were
enoughofus,analystsandothers,wanderingaroundgoing‘lookatthisstuff,’thatit
wouldbehardtomissit.”
1o,
Ranieri’sownHouston-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-
wide’sMozilotodescribeoneoftheloanproductshisfrmwasoriginating.
1oo
“Inall
myyearsinthebusinessIhaveneverseenamoretoxic[product],”hewroteinanin-
ternalemail.
1o,
Othersatthebankarguedinresponsethattheywereofferingprod-
ucts“pervasivelyofferedinthemarketplacebyvirtuallyeveryrelevantcompetitorof
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.”
1oµ
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 ,µº percent of originations at Coun-
trywide, ,8º percent at Wells Fargo, ,1º at National City, ¡1º at Washington
Mutual,io.,ºatCitiFinancial,and18.¡ºatBankofAmerica.Moreover,thebanks
expectedthattheiroriginationsofnontraditionalloanswouldriseby1,ºinioo,,to
·oo8.,billion.Thereviewalsonotedthe“slowlydeterioratingqualityofloansdueto
looseningunderwritingstandards.”Inaddition,itfoundthattwo-thirdsofthenon-
traditionalloansmadebythebanksinioo¡hadbeenofthestated-income,minimal
documentationvarietyknownasliarloans,whichhadaparticularlygreatlikelihood
ofgoingsour.
111
ThereactiontoSiddique’sbriefngwasmixed.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 agencies—the Fed, the OCC, the OTS, the FDIC, and
theNationalCreditUnionAdministration—wouldneedtoworktogetheronit,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,thegroup’s
vicepresident,pointedlyreferredtopastrealestatedownturns.“Wetakeaconserva-
tivepositiononriskbecauseofourfrstlossposition,”SimpsoninformedtheSenate
Subcommittee on Housing, Transportation and Community Development and the
SenateSubcommitteeonEconomicPolicy.“However,wealsohaveahistoricalper-
spective.Weweretherewhenthemortgagemarketsturnedsharplydownduringthe
mid-1µ8os especially in the oil patch and the early 1µµos 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,raisedconcernsthatnontraditionallending“mayprecipitateadownward
spiralthatstartsonthecoastandthencreatespanicintheeastthatcouldhaveimpli-
cationsonourtotaleconomyaswell.”
11µ
AtthenextmeetingoftheFed’sConsumerAdvisoryCouncil,heldinJuneiooo
andattendedbyBernanke,Bies,Olson,andWarsh,severalconsumeradvocatesde-
scribedtotheFedgovernorsalarmingincidentsthatwerenowoccurringalloverthe
8ii uii uUi \ii¥ i¥i: z.
country.EdwardSivak,thedirectorofpolicyandevaluationattheEnterpriseCorp.
of the Delta, in Jackson, Mississippi, spoke of being told by mortgage brokers that
propertyvalueswerebeinginfatedtomaximizeproftforrealestateappraisersand
loanoriginators.AlanWhite,thesupervisingattorneyatCommunityLegalServices
inPhiladelphia,reporteda“hugesurgeinforeclosures,”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
muchthattheresultwouldbeneighborhood“decay.”CarolynCarteroftheNational
ConsumerLawCenterinMassachusettsurgedtheFedtouseitsregulatoryauthority
to“prohibitabusesinthemortgagemarket.”
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 years—including a require-
mentthatborrowershavetheabilitytorepayloansmadetothem.
Bythattime,however,thedamagehadbeendone.Thetotalvalueofmortgage-
backedsecuritiesissuedbetweenioo1andioooreached·1¡.¡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.Itsoonbecameclearthatrisk—ratherthanbeingdiversifedacrossthe
fnancial system, as had been thought—was 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
lostthemarket’sconfdence.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-
tion’slargestfnancialinstitutions.
Thecrisisthatbefellthecountryinioo8hadbeenyearsinthemaking.Intesti-
monytotheCommission,formerFedchairmanGreenspandefendedhisrecordand
saidmostofhisjudgmentshadbeencorrect.“Iwasright,oºofthetimebutIwas
wrong ¡oº of the time,” he told the Commission.
1i¡
Yet the consequences of what
wentwrongintherun-uptothecrisiswouldbeenormous.
Theeconomicimpactofthecrisishasbeendevastating.Andthehumandevasta-
tioniscontinuing.Theomciallyreportedunemploymentratehoveredatalmost1oº
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,º.Andtheshareofunemployedworkerswhohavebeenout
ofworkformorethansixmonthswasjustabove¡oº.Oflargemetropolitanareas,
Las Vegas, Nevada, and Riverside–San Bernardino, California, had the highest un-
employment—theirrateswereabove1¡º.
Theloanswereaslethalasmanyhadpredicted,andithasbeenestimatedthatul-
timatelyasmanyas1¡millionhouseholdsintheUnitedStatesmaylosetheirhomes
to foreclosure. As of io1o, foreclosure rates were highest in Florida and Nevada; in
Florida, nearly 1¡º of loans were in foreclosure, and Nevada was not very far
behind.
1i¡
Nearlyone-quarterofAmericanmortgageborrowersowedmoreontheir
mortgagesthantheirhomewasworth.InNevada,thepercentagewasnearly,oº.
1i,
Householdshavelost·11trillioninwealthsinceiooo.
As Mark Zandi, the chief economist of Moody’s Economy.com, testifed to the
Commission,“ThefnancialcrisishasdealtaveryseriousblowtotheU.S.economy.
The immediate impact was the Great Recession: the longest, broadest and most se-
veredownturnsincetheGreatDepressionofthe1µ¡os. . . .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
thatmanymorepeople—whoarecapableoftakingonaloanwithzerodownwhowe
8ii uii uUi \ii¥ i¥i: z,
thinkaregoingtobeabletopaythatoff—thanwastrue1o,1,,ioyearsago:Imean,
what’schangedintheworld:Therewerealotofthingsthatdidn’trequireanyinves-
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.
“It’sover,”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|papcrandrcpcs“Unjcttcrcdnarkcts”:,
1hcsavingsand|cancrisis“1hcyputa|ctcj
prcssurccnthcirrcgu|atcrs” ,,
Thefnancialcrisisofioo,andioo8wasnotasingleeventbutaseriesofcrisesthat
rippled through the fnancial system and, ultimately, the economy. Distress in one
areaofthefnancialmarketsledtofailuresinotherareasbywayofinterconnections
andvulnerabilitiesthatbankers,governmentomcials,andothershadmissedordis-
missed.Whensubprimeandotherriskymortgages—issuedduringahousingbubble
thatmanyexpertsfailedtoidentify,andwhoseconsequenceswerenotunderstood—
begantodefaultatunexpectedrates,aonce-obscuremarketforcomplexinvestment
securitiesbackedbythosemortgagesabruptlyfailed.Whenthecontagionspread,in-
vestorspanicked—andthedangerinherentinthewholesystembecamemanifest.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,thesystem’svulnerabilities,togetherwithgapsinthegovernment’scrisis-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-
quences—acomplexhistorythatcouldyielditsownreport.Instead,wefocusonfour
keydevelopmentsthathelpedshapetheeventsthatshookourfnancialmarketsand
economy.Detailedbookscouldbewrittenabouteachofthem;westicktotheessen-
tialsforunderstandingourspecifcconcern,whichistherecentcrisis.
First, we describe the phenomenal growth of the shadow banking system—the
investment banks, most prominently, but also other fnancial institutions—that
freelyoperatedincapitalmarketsbeyondthereachoftheregulatoryapparatusthat
had been put in place in the wake of the crash of 1µiµ 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 boostingthereturnsontheir¡o1(k)s.Shadowbanksandcommer-
cial banks were codependent competitors. Their new activities were very prof-
itable—and,itturnedout,veryrisky.
Second, we look at the evolution of fnancial regulation. To the Federal Reserve
andotherregulators,thenewdualsystemthatgrantedgreaterlicensetomarketpar-
ticipantsappearedtoprovideasaferandmoredynamicalternativetotheeraoftradi-
tionalbanking.Moreandmore,regulatorslookedtofnancialinstitutionstopolice
themselves—“deregulation”wasthelabel.FormerFedchairmanAlanGreenspanput
it this way: “The market-stabilizing private regulatory forces should gradually dis-
place many cumbersome, increasingly ineffective government structures.”
i
In the
Fed’sview,ifproblemsemergedintheshadowbankingsystem,thelargecommercial
banks—whichwerebelievedtobewell-run,well-capitalized,andwell-regulatedde-
spitethelooseningoftheirrestraints—couldprovidevitalsupport.Andifproblems
outstrippedthemarket’sabilitytorightitself,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 participants—mortgage brokers, lenders, and Wall Street frms—had 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 derivatives—words 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 models—which turned out to be divorced from
reality—andonever-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
nothaveenoughcashonhandtomeetdepositors’demands:runswerecommonbe-
foretheCivilWarandthenoccurredin18,¡,188¡,18µo,18µ¡,18µo,and1µo,.
¡
To
stabilize fnancial markets, Congress created the Federal Reserve System in 1µ1¡,
whichactedasthelenderoflastresorttobanks.
ButthecreationoftheFedwasnotenoughtoavertbankrunsandsharpcontrac-
tionsinthefnancialmarketsinthe1µiosand1µ¡os.Soin1µ¡¡Congresspassedthe
Glass-Steagall Act, which, among other changes, established the Federal Deposit In-
suranceCorporation.TheFDICinsuredbankdepositsupto·i,,oo—anamountthat
coveredthevastmajorityofdepositsatthetime;thatlimitwouldclimbto·1oo,oooby
1µ8o,whereitstayeduntilitwasraisedto·i,o,oooduringthecrisisinOctoberioo8.
Depositors no longer needed to worry about being frst in line at a troubled bank’s
door.Andifbankswereshortofcash,theycouldnowborrowfromtheFederalRe-
serve,evenwhentheycouldborrownowhereelse.TheFed,actingaslenderoflastre-
sort,wouldensurethatbankswouldnotfailsimplyfromalackofliquidity.
Withthesebackstopsinplace,Congressrestrictedbanks’activitiestodiscourage
them from taking excessive risks, another move intended to help prevent bank fail-
ures,withtaxpayerdollarsnowatrisk.Furthermore,CongresslettheFederalReserve
capinterestratesthatbanksandthrifts—alsoknownassavingsandloans,orS&Ls—
couldpaydepositors.Thisrule,knownasRegulationQ,wasalsointendedtokeepin-
stitutionssafebyensuringthatcompetitionfordepositsdidnotgetoutofhand.
¡
The system was stable as long as interest rates remained relatively steady, which
theydidduringthefrsttwodecadesafterWorldWarII.Beginninginthelate-1µoos,
however, infation started to increase, pushing up interest rates. For example, the
ratesthatbankspaidotherbanksforovernightloanshadrarelyexceededoºinthe
decadesbefore1µ8o,whenitreachedioº.However,thankstoRegulationQ,banks
and thrifts were stuck offering roughly less than oº on most deposits. Clearly, this
was an untenable bind for the depository institutions, which could not compete on
themostbasicleveloftheinterestrateofferedonadeposit.
Competewithwhom:Inthe1µ,os,MerrillLynch,Fidelity,Vanguard,andothers
persuadedconsumersandbusinessestoabandonbanksandthriftsforhigherreturns.
These frms—eager to fnd new businesses, particularly after the Securities and Ex-
change Commission (SEC) abolished fxed commissions on stock trades in 1µ,,—
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.In1µ,,,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,andthestatureofthefunds’sponsorsreassuredthem.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
1µ,,tomorethan·,¡obillionin1µµ,and·1.8trillionbyiooo.
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.Commercialpaperwasunsecuredcorporatedebt—meaningthatitwas
backed not by a pledge of collateral but only by the corporation’s promise to pay.
Theseloanswerecheaperbecausetheywereshort-term—forlessthanninemonths,
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
grewmuchmorepopularinthe1µoos.
Thismarket,though,underwentacrisisthatdemonstratedthatcapitalmarkets,
too,werevulnerabletoruns.Yetthatcrisisactuallystrengthenedthemarket.In1µ,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 railroad’s default caused investors to worry about the broader
commercial paper market; holders of that paper—the lenders—refused 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 Fed’s ac-
tions enabled the banks, in turn, to lend to corporations so that they could pay off
theircommercialpaper.AfterthePennCentralcrisis,theissuersofcommercialpa-
per—theborrowers—typicallysetupstandbylinesofcreditwithmajorbankstoen-
,+ 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.
Inthe1µoos,thecommercialpapermarketjumpedmorethansevenfold.Thenin
the 1µ,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
paperhadrisento·1.otrillionfromlessthan·1i,billionin1µ8o.
8
Thesecondmajorshadowbankingmarketthatgrewsignifcantlywasthemarket
forrepos,orrepurchaseagreements.Likecommercialpaper,reposhavealonghis-
tory, but they proliferated quickly in the 1µ,os. Wall Street securities dealers often
soldTreasurybondswiththeirrelativelylowreturnstobanksandotherconservative
investors,whiletheninvestingthecashproceedsofthesesalesinsecuritiesthatpaid
higherinterestrates.ThedealersagreedtorepurchasetheTreasuries—oftenwithina
day—ataslightlyhigherpricethanthatforwhichtheysoldthem.Thisrepotransac-
tion—inessencealoan—madeitinexpensiveandconvenientforWallStreetfrmsto
borrow.Becausethesedealswereessentiallycollateralizedloans,thesecuritiesdeal-
ersborrowednearlythefullvalueofthecollateral,minusasmall“haircut.”Likecom-
mercialpaper,reposwererenewed,or“rolledover,”frequently.Forthatreason,both
forms of borrowing could be considered “hot money”—because 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.In1µ8i,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.
µ
This
mechanism would have severe consequences in ioo, and ioo8. In the 1µ8os, how-
ever,thesenewproceduresstabilizedtherepomarket.
The new parallel banking system—with commercial paper and repo providing
cheaperfnancing,andmoneymarketfundsprovidingbetterreturnsforconsumers
andinstitutionalinvestors—hadacrucialcatch:itspopularitycameattheexpenseof
thebanksandthrifts.Someregulatorsviewedthisdevelopmentwithgrowingalarm.
According to Alan Blinder, the vice chairman of the Federal Reserve from 1µµ¡ to
1µµo,“Wewereconcernedasbankregulatorswiththeerodingcompetitiveposition
ofbanks,whichofcoursewouldthreatenultimatelytheirsafetyandsoundness,due
to the competition they were getting from a variety of nonbanks—and these were
mainlyWallStreetfrms,thatweretakingdepositsfromthem,andgettingintothe
loanbusinesstosomeextent.So,yeah,itwasaconcern;youcouldseeadownward
trendintheshareofbankingassetstofnancialassets.”
1o
:u\iu\ 8\Nii Nt ,.
Figure i.1 shows that during the 1µµos the shadow banking system steadily
gainedgroundonthetraditionalbankingsector—andactuallysurpassedthebank-
ingsectorforabrieftimeafteriooo.
Banks argued that their problems stemmed from the Glass-Steagall Act. Glass-
Steagallstrictlylimitedcommercialbanks’participationinthesecuritiesmarkets,in
parttoendthepracticesofthe1µios,whenbankssoldhighlyspeculativesecurities
todepositors.In1µ,o,Congressalsoimposednewregulatoryrequirementsonbanks
owned by holding companies, in order to prevent a holding company from endan-
geringanyofitsdeposit-takingbanks.
Bank supervisors monitored banks’ leverage—their assets relative to equity—
becauseexcessiveleverageendangeredabank.Leverage,usedbynearlyeveryfnan-
cial institution, amplifes returns. For example, if an investor uses ·1oo of his own
moneytopurchaseasecuritythatincreasesinvalueby1oº,heearns·1o.However,
ifheborrowsanother·µooandinvests1otimesasmuch(·1,ooo),thesame1oºin-
crease in value yields a proft of ·1oo, double his out-of-pocket investment. If the
investmentsours,though,leveragemagnifesthelossjustasmuch.Adeclineof1oº
coststheunleveragedinvestor·1o,leavinghimwith·µo,butwipesouttheleveraged
investor’s ·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.
In1µ81,banksupervisorsestablishedthefrstformalminimumcapitalstandards,
whichmandatedthatcapital—theamountbywhichassetsexceeddebtandotherlia-
bilities—should be at least ,º of assets for most banks. Capital, in general, refects
thevalueofshareholders’investmentinthebank,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 participants—the money market funds and the invest-
mentbanksthatsponsoredmanyofthem—werenotsubjecttothesamesupervision
asbanksandthrifts.Themoneyintheshadowbankingmarketscamenotfromfed-
erallyinsureddepositorsbutprincipallyfrominvestors(inthecaseofmoneymarket
funds) or commercial paper and repo markets (in the case of investment banks).
BothmoneymarketfundsandsecuritiesfrmswereregulatedbytheSecuritiesand
ExchangeCommission.ButtheSEC,createdin1歭,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 anytime—important 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.Theirbindwaslabeled“disin-
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.Theplayingfeldwasn’tlevel,which“putalotofpressureoninstitutionstoget
higher-rate performing assets,” former SEC Chairman Richard Breeden told the
FCIC.“Andtheyputalotofpressureontheirregulatorstoallowthistohappen.”

ThebanksandtheS&LswenttoCongressforhelp.In1µ8o,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.In1µ,µ,thedifferenceininterestearnedonthebanks’andthrifts’safestin-
vestments (one-year Treasury notes) over interest paid on deposits was almost ,.,
percentagepoints;by1µµ¡,itwasonlyi.opercentagepoints.Theinstitutionslostal-
most ¡ percentage points of the advantage they had enjoyed when the rates were
capped.

The1µ8olegislationhadnotdoneenoughtoreducethecompetitivepres-
suresfacingthebanksandthrifts.
Thatlegislationwasfollowedin1µ8ibytheGarn-St.GermainAct,whichsignif-
cantlybroadenedthetypesofloansandinvestmentsthatthriftscouldmake.Theact
alsogavebanksandthriftsbroaderscopeinthemortgagemarket.Traditionally,they
hadreliedon¡o-year,fxed-ratemortgages.Buttheinterestonfxed-ratemortgages
on their books fell short as infation surged in the mid-1µ,os and early 1µ8os 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,beginningin1µ8,,theFederalReserveaccommodatedaseriesofrequests
fromthebankstoundertakeactivitiesforbiddenunderGlass-Steagallanditsmodif-
cations.Thenewrulespermittednonbanksubsidiariesofbankholdingcompaniesto
engagein“bank-ineligible”activities,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,ºoftheassetsorrevenueofanysubsidiary.Overtime,however,theFedre-
laxedtheserestrictions.By1µµ,,bank-ineligiblesecuritiescouldrepresentuptoi,º
ofassetsorrevenuesofasecuritiessubsidiary,andtheFedalsoweakenedorelimi-
natedotherfrewallsbetweentraditionalbankingsubsidiariesandthenewsecurities
subsidiariesofbankholdingcompanies.
1,
Meanwhile,theOCC,theregulatorofbankswithnationalcharters,wasexpand-
ingthepermissibleactivitiesofnationalbankstoincludethosethatwere“function-
ally equivalent to, or a logical outgrowth of, a recognized bank power.”
1o
Among
thesenewactivitieswereunderwritingaswellastradingbetsandhedges,knownas
derivatives,onthepricesofcertainassets.Between1µ8¡and1µµ¡,theOCCbroad-
enedthederivativesinwhichbanksmightdealtoincludethoserelatedtodebtsecu-
rities (1µ8¡), interest and currency exchange rates (1µ88), stock indices (1µ88),
preciousmetalssuchasgoldandsilver(1µµ1),andequitystocks(1µµ¡).
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.
TestifyingbeforeCongressin1µµ,,heframedtheissuethisway:fnancial“modern-
ization” was needed to “remove outdated restrictions that serve no useful purpose,
thatdecreaseeconomicemciency,andthat . . .limitchoicesandoptionsforthecon-
sumeroffnancialservices.”Removingthebarriers“wouldpermitbankingorganiza-
tions to compete more effectively in their natural markets. The result would be a
moreemcientfnancialsystemprovidingbetterservicestothepublic.”
1,
During the 1µ8os and early 1µµos, 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
andgovernmentsin“emergingmarkets,”suchascountriesinAsiaandLatinAmer-
ica.Thosemarketsofferedpotentiallyhigherprofts,butweremuchriskierthanthe
banks’ traditional lending. The consequences appeared almost immediately—espe-
ciallyintherealestatemarkets,withabubbleandmassiveoverbuildinginresidential
and commercial sectors in certain regions. For example, house prices rose ,º per
yearinTexasfrom1µ8oto1µ8,.
18
InCalifornia,pricesrose1¡ºannuallyfrom1µ8,
:u\iu\ 8\Nii Nt ,,
to 1µµo.

The bubble burst frst in Texas in 1µ8, and 1µ8o, but the trouble rapidly
spreadacrosstheSoutheasttothemid-AtlanticstatesandNewEngland,thenswept
back across the country to California and Arizona. Before the crisis ended, house
priceshaddeclinednationallybyi.,ºfromJuly1µµotoFebruary1µµi
io
—thefrst
such fall since the Depression—driven by steep drops in regional markets.
i1
In the
1µ8os, with the mortgages in their portfolios paying considerably less than current
interestrates,spiralingdefaultsonthethrifts’residentialandcommercialrealestate
loans,andlossesonenergy-related,leveraged-buyout,andoverseasloans,theindus-
trywasshattered.
ii
Almost¡,ooocommercialbanksandthriftsfailedinwhatbecameknownasthe
S&L crisis of the 1µ8os and early 1µµos. By comparison, only i¡¡ banks had failed
between 1µ¡¡ and 1µ8o. By 1µµ¡, one-sixth of federally insured depository institu-
tionshadeitherclosedorrequiredfnancialassistance,affectingioºofthebanking
system’s assets.

More than 1,ooo bank and S&L executives were convicted of
felonies.

Bythetimethegovernmentcleanupwascomplete,theultimatecostofthe
crisiswas·1oobillion.
i,
Despite new laws passed by Congress in 1µ8µ and 1µµ1 in response to the S&L
crisisthattoughenedsupervisionofthrifts,theimpulsetowardderegulationcontin-
ued.Thederegulatorymovementfocusedinpartoncontinuingtodismantleregula-
tions that limited depository institutions’ activities in the capital markets. In 1µµ1,
theTreasuryDepartmentissuedanextensivestudycallingfortheeliminationofthe
oldregulatoryframeworkforbanks,includingremovalofallgeographicrestrictions
onbankingandrepealoftheGlass-SteagallAct.ThestudyurgedCongresstoabolish
theserestrictionsinthebeliefthatlargenationwidebankscloselytiedtothecapital
marketswouldbemoreproftableandmorecompetitivewiththelargestbanksfrom
the United Kingdom, Europe, and Japan. The report contended that its proposals
wouldletbanksembraceinnovationandproducea“stronger,morediversifedfnan-
cialsystemthatwillprovideimportantbeneftstotheconsumerandimportantpro-
tectionstothetaxpayer.”
io
The biggest banks pushed Congress to adopt Treasury’s recommendations. Op-
posedwereinsuranceagents,realestatebrokers,andsmallerbanks,whofeltthreat-
enedbythepossibilitythatthelargestbanksandtheirhugepoolsofdepositswould
be unleashed to compete without restraint. The House of Representatives rejected
Treasury’sproposalin1µµ1,butsimilarproposalswereadoptedbyCongresslaterin
the1µµos.
In dealing with the banking and thrift crisis of the 1µ8os and early 1µµos, Con-
gresswasgreatlyconcernedbyaspateofhigh-proflebankbailouts.In1µ8¡,federal
regulators rescued Continental Illinois, the nation’s ,th-largest bank; in 1µ88, First
Republic,number1¡;in1µ8µ,MCorp,number¡o;in1µµ1,BankofNewEngland,
number¡¡.Thesebankshadreliedheavilyonuninsuredshort-termfnancingtoag-
gressively expand into high-risk lending, leaving them vulnerable to abrupt with-
drawalsonceconfdenceintheirsolvencyevaporated.DepositscoveredbytheFDIC
wereprotectedfromloss,butregulatorsfeltobligedtoprotecttheuninsureddeposi-
tors—thosewhosebalancesexceededthestatutorilyprotectedlimits—topreventpo-
,· 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
“moneycenterbanks”tofail.
i8
Thiswasanewregulatoryprinciple,andwithinmo-
ments it had a catchy name. Representative Stewart McKinney of Connecticut re-
sponded,“Wehaveanewkindofbank.Itiscalled‘toobigtofail’—TBTF—anditisa
wonderfulbank.”

In 1µµo, during this era of federal rescues of large commercial banks, Drexel
Burnham Lambert—once the country’s ffth-largest investment bank—failed. Crip-
pledbylegaltroublesandlossesinitsjunkbondportfolio,thefrmwasforcedinto
thelargestbankruptcyinthesecuritiesindustrytodatewhenlendersshunneditin
thecommercialpaperandrepomarkets.Whilecreditors,includingotherinvestment
banks,wererattledandabsorbedheavylosses,thegovernmentdidnotstepin,and
Drexel’s failure did not cause a crisis. So far, it seemed that among fnancial frms,
onlycommercialbanksweredeemedtoobigtofail.
In1µµ1,Congresstriedtolimitthis“toobigtofail”principle,passingtheFederal
Deposit Insurance Corporation Improvement Act (FDICIA), which sought to curb
theuseoftaxpayerfundstorescuefailingdepositoryinstitutions.FDICIAmandated
thatfederalregulatorsmustinterveneearlywhenabankorthriftgotintotrouble.In
addition,ifaninstitutiondidfail,theFDIChadtoresolvethefailedinstitutionina
mannerthatproducedtheleastcosttotheFDIC’sdepositinsurancefund.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,suchasDrexel’sfailure.WallStreetfrmssuccessfullylobbied
foranamendmenttoFDICIAtoauthorizetheFedtoactaslenderoflastresorttoin-
vestment banks by extending loans collateralized by the investment banks’
securities.
¡o
In the end, the 1µµ1 legislation sent fnancial institutions a mixed message: you
are not too big to fail—until and unless you are too big to fail. So the possibility of
bailouts for the biggest, most centrally placed institutions—in the commercial and
shadow banking industries—remained an open question until the next crisis, 1o
yearslater.
:u\iu\ 8\Nii Nt ,,
3
SECURITIZATION AND DERIVATIVES
CONTENTS
IannicMacandIrcddicMac“1hcwhc|carnycj|c||yists”,:
Structurcdµnancc“Itwasn’trcducingthcrisk”,:
1hcgrcwthcjdcrivativcs“Byjarthcncstsigniµcantcvcnt
inµnanccduringthcpastdccadc” ,,
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
bytheReconstructionFinanceCorporationduringtheGreatDepressionin1µ¡8to
buymortgagesinsuredbytheFederalHousingAdministration(FHA).Thenewgov-
ernmentagencywasauthorizedtopurchasemortgagesthatadheredtotheFHA’sun-
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 1µo8, Fannie’s mortgage portfolio had grown to ·,.i billion and its
debtweighedonthefederalgovernment.
1
TogetFannie’sdebtoffofthegovernment’s
balancesheet,theJohnsonadministrationandCongressreorganizeditasapublicly
tradedcorporationandcreatedanewgovernmententity,GinnieMae(omcially,the
GovernmentNationalMortgageAssociation)totakeoverFannie’ssubsidizedmort-
gageprogramsandloanportfolio.GinniealsobeganguaranteeingpoolsofFHAand
VA mortgages. The new Fannie still purchased federally insured mortgages, but it
wasnowahybrid,a“government-sponsoredenterprise.”
Twoyearslater,in1µ,o,thethriftspersuadedCongresstocharterasecondGSE,
FreddieMac(omcially,theFederalHomeLoanMortgageCorporation),tohelpthe

thriftsselltheirmortgages.ThelegislationalsoauthorizedFannieandFreddietobuy
“conventional”fxed-ratemortgages,whichwerenotbackedbytheFHAortheVA.
ConventionalmortgageswerestiffcompetitiontoFHAmortgagesbecauseborrow-
ers could get them more quickly and with lower fees. Still, the conventional mort-
gagesdidhavetoconformtotheGSEs’loansizelimitsandunderwritingguidelines,
such as debt-to-income and loan-to-value ratios. The GSEs purchased only these
“conforming”mortgages.
Before 1µo8, Fannie Mae generally held the mortgages it purchased, profting
from the difference—or spread—between its cost of funds and the interest paid on
thesemortgages.The1µo8and1µ,olawsgaveGinnie,Fannie,andFreddieanother
option:securitization.Ginniewasthefrsttosecuritizemortgages,in1µ,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.
In1µ,1,Freddiegotintothebusinessofbuyingmortgages,poolingthem,andthen
selling mortgage-backed securities. Freddie collected fees from lenders for guaran-
teeingtimelypaymentofprincipalandinterest.In1µ81,afteraspikeininterestrates
caused large losses on Fannie’s portfolio of mortgages, Fannie followed. During the
1µ8osand1µµos,theconventionalmortgagemarketexpanded,theGSEsgrewinim-
portance,andthemarketshareoftheFHAandVAdeclined.
FannieandFreddiehaddualmissions,bothpublicandprivate:supportthemort-
gage market and maximize returns for shareholders. They did not originate mort-
gages; they purchased them—from banks, thrifts, and mortgage companies—and
either held them in their portfolios or securitized and guaranteed them. Congress
grantedbothenterprisesspecialprivileges,suchasexemptionsfromstateandlocal
taxesanda·i.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.¡,º to back their
guarantees of mortgage-backed securities and i.,º to back the mortgages in their
portfolios. This compared to bank and thrift capital requirements of at least ¡º of
mortgagesassetsundercapitalstandards.Suchprivilegesledinvestorsandcreditors
tobelievethatthegovernmentimplicitlyguaranteedtheGSEs’mortgage-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 1µ,µ,
whentheFedincreasedshort-terminterestratestoquellinflation,Fannie,likethe
thrifts,foundthatitscostoffundingrosewhileincomefrommortgagesdidnot.By
the1µ8os,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,FreddieMacavoidedtakingtheinterestrateriskthathitFannie’s
portfolio.
In1µ8i,CongressprovidedtaxreliefandHUDrelaxedFannie’scapitalrequire-
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 1µ8µ (FIRREA), Congress
imposedtougher,bank-stylecapitalrequirementsandregulationsonthrifts.Bycon-
trast,intheFederalHousingEnterprisesFinancialSafetyandSoundnessActof1µµi,
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 1µµi law.
¡
“OFHEO was
structurallyweakandalmostdesignedtofail,”saidArmandoFalconJr.,aformerdi-
rectoroftheagency,totheFCIC.
¡
Allthisaddeduptoagenerousfederalsubsidy.Oneioo,studyputthevalueof
thatsubsidyat·1iibillionormoreandestimatedthatmorethanhalfofthesebene-
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.Fannie’sandFreddie’sdebtobligationsandoutstandingmort-
gage-backed securities grew from ·,,µ billion in 1µµo to ·1.¡ trillion in 1µµ, and
·i.¡trillioniniooo.
o
ThelegislationthattransformedFanniein1µo8alsoauthorizedHUDtoprescribe
affordablehousinggoalsforFannie:to“requirethatareasonableportionofthecor-
poration’s 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.”
,
In1µ,8,HUDtriedtoimplementthelawand,afterabarrageof
criticism from the GSEs and the mortgage and real estate industries, issued a weak
regulationencouragingaffordablehousing.
8
Inthe1µµiFederalHousingEnterprises
Financial Safety and Soundness Act, Congress extended HUD’s authority to set af-
fordablehousinggoalsforFannieandFreddie.Congressalsochangedthelanguageto
saythatinthepursuitofaffordablehousing,“areasonableeconomicreturn . . .may
belessthanthereturnearnedonotheractivities.”ThelawrequiredHUDtoconsider
“theneedtomaintainthesoundfnancialconditionoftheenterprises.”Theactnow
orderedHUDtosetgoalsforFannieandFreddietobuyloansforlow-andmoderate-
incomehousing,specialaffordablehousing,andhousingincentralcities,ruralareas,
andotherunderservedareas.CongressinstructedHUDtoperiodicallysetagoalfor
eachcategoryasapercentageoftheGSEs’mortgagepurchases.
In1µµ,,PresidentBillClintonannouncedaninitiativetoboosthomeownership
from o,.1º to o,.,º of families by iooo, and one component raised the affordable
housing goals at the GSEs. Between 1µµ¡ and 1µµ,, 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.”
µ
The
push to expand homeownership continued under President George W. Bush, who,
for example, introduced a “Zero Down Payment Initiative” that under certain cir-
cumstancescouldremovethe¡ºdownpaymentruleforfrst-timehomebuyerswith
FHA-insuredmortgages.
1o
In describing the GSEs’ affordable housing loans, Andrew Cuomo, secretary of
Housing and Urban Development from 1µµ, 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-
sions—promoting mortgage lending while maximizing returns to shareholders—
were problematic. Former Fannie CEO Daniel Mudd told the FCIC that “the GSE
structurerequiredthecompaniestomaintainafnebalancebetweenfnancialgoals
andwhatwecallthemissiongoals . . .therootcauseoftheGSEs’troubleslieswith
their business model.”
1i
Former Freddie CEO Richard Syron concurred: “I don’t
thinkit’sagoodbusinessmodel.”

FannieandFreddieaccumulatedpoliticalcloutbecausetheydependedonfederal
subsidiesandanimplicitgovernmentguarantee,andbecausetheyhadtodealwith
regulators,affordablehousinggoals,andcapitalstandardsimposedbyCongressand
HUD.From1µµµtoioo8,thetworeportedspendingmorethan·1o¡milliononlob-
bying,andtheiremployeesandpoliticalactioncommitteescontributed·1,million
:itUii 1i / \1i uN \Ni iiii \\1i \i: ,.
to federal election campaigns.

The “Fannie and Freddie political machine resisted
any meaningful regulation using highly improper tactics,” Falcon, who regulated
them from 1µµµ to ioo,, testifed. “OFHEO was constantly subjected to malicious
political attacks and efforts of intimidation.”
1,
James Lockhart, the director of
OFHEOanditssuccessor,theFederalHousingFinanceAgency,fromiooothrough
iooµ, testifed that he argued for reform from the moment he became director and
thatthecompanieswere“allowedtobe . . .sopoliticallystrongthatformanyyears
theyresistedtheverylegislationthatmighthavesavedthem.”
1o
FormerHUDsecre-
taryMelMartinezdescribedtotheFCIC“thewholearmyoflobbyiststhatcontinu-
ally paraded in a bipartisan fashion through my omces. . . . It’s pretty amazing the
numberofpeoplethatwereintheiremploy.”
1,
In1µµ,,thatarmyhelpedsecurenewregulationsallowingtheGSEstocountto-
wardtheiraffordablehousinggoalsnotjusttheirwholeloansbutmortgage-related
securitiesissuedbyothercompanies,whichtheGSEswantedtopurchaseasinvest-
ments.Still,CongressionalBudgetOmceDirectorJuneO’Neilldeclaredin1µµ8that
“thegoalsarenotdimculttoachieve,anditisnotclearhowmuchtheyhaveaffected
theenterprises’actions.Infact . . .depositoryinstitutionsaswellastheFederalHous-
ingAdministrationdevotealargerproportionoftheirmortgagelendingtotargeted
borrowersandareasthandotheenterprises.”
18
Somethingelsewasclear:FannieandFreddie,withtheirlowborrowingcostsand
laxcapitalrequirements,wereimmenselyproftablethroughoutthe1µµos.Iniooo,
Fannie had a return on equity of ioº; Freddie, ¡µº. That year, Fannie and Freddie
heldorguaranteedmorethan·itrillionofmortgages,backedbyonly·¡,.,billion
ofshareholderequity.

STRUCTURED FINANCE:
“IT WASN’ T REDUCING THE RISK”
WhileFannieandFreddieenjoyedanear-monopolyonsecuritizingfxed-ratemort-
gagesthatwerewithintheirpermittedloanlimits,inthe1µ8osthemarketsbeganto
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,whichwereoftenmorecomplicatedthantheGSEs’basicmortgage-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-
kets—oftenfrommoneymarketmutualfunds—tomakeloans,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-
oushousingdownturnsmaderegulatorsworryaboutbanks’holdingwholeloanson
theirbooks.“Ifyouhadaregional . . .realestatedownturnittookdownthebanksin
thatregionalongwithit,whichexacerbatedthedownturn,”Lindseysaid.“Sowesaid
to ourselves, ‘How on earth do we get around this problem:’ And the answer was,
‘Let’shaveanationalsecuritiesmarketsowedon’thaveregionalconcentration.’ . . .It
wasintentional.”
io
Privatesecuritizations,orstructuredfnancesecurities,hadtwokeybeneftstoin-
vestors:pooling andtranching.Ifmanyloanswerepooledintoonesecurity,afewde-
faultswouldhaveminimalimpact.Structuredfnancesecuritiescouldalsobesliced
upandsoldinportions—knownastranches—whichletbuyerscustomizetheirpay-
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
tranches—at the top of the waterfall—were paid before the more junior tranches.
Andifpaymentscameinbelowexpectations,thoseatthebottomwouldbethefrst
tobelefthighanddry.
Securitizationwasdesignedtobeneftlenders,investmentbankers,andinvestors.
Lendersearnedfeesfororiginatingandsellingloans.Investmentbanksearnedfees
forissuingmortgage-backedsecurities.Thesesecuritiesfetchedahigherpricethanif
theunderlyingloansweresoldindividually,becausethesecuritieswerecustomized
toinvestors’needs,weremorediversifed,andcouldbeeasilytraded.Purchasersof
thesafertranchesgotahigherrateofreturnthanultra-safeTreasurynoteswithout
muchextrarisk—atleastintheory.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 agencies—Moody’s,
Standard&Poor’s(S&P),andFitch—intokeyplayersintheprocess,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
Withthesepiecesinplace—banksthatwantedtoshedassetsandtransferrisk,in-
vestorsreadytoputtheirmoneytowork,securitiesfrmspoisedtoearnfees,rating
agenciesreadytoexpand,andinformationtechnologycapableofhandlingthejob—
the securitization market exploded. By 1µµµ, when the market was 1o years old,
about ·µoo billion worth of securitizations, beyond those done by Fannie, Freddie,
andGinnie,wereoutstanding(seefgure¡.1).Thatincluded·11¡billionofautomo-
bileloansandover·i,obillionofcreditcarddebt;nearly·1,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 1µ,os, Wall
Streetexecutiveshadhiredquants—analystsadeptinadvancedmathematicaltheory
and computers—to develop models to predict how markets or securities might
change.Securitizationincreasedtheimportanceofthisexpertise.ScottPatterson,au-
thorofThe Quants, toldtheFCICthatusingmodelsdramaticallychangedfnance.
“WallStreetisessentiallyfoatingonaseaofmathematicsandcomputerpower,”Pat-
tersonsaid.

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 µ,º certainty how much a frm could lose if market prices
changed.

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.“It’snotliketryingtoshootarockettothemoonwhere
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
waypeoplefeelaboutgravityonagivendayisn’tgoingtoaffectthewaytherocket
behaves.”
i,
PaulVolcker,Fedchairmanfrom1µ,µto1µ8,,toldtheCommissionthatregula-
torswereconcernedasearlyasthelate1µ8osthatoncebanksbegansellinginsteadof
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,aformerdirectoroftheFed’sDivisionofMonetaryAffairs,toldtheCom-
missionthatheandotherregulatorsfailedtoappreciatethecomplexityofthenewf-
nancialinstrumentsandthedimcultiesthatcomplexityposedinassessingrisk.
i,
Securitization “was diversifying the risk,” said Lindsey, the former Fed governor.
“Butitwasn’treducingtherisk. . . .Youasanindividualcandiversifyyourrisk.Thesys-
temasawhole,though,cannotreducetherisk.Andthat’swheretheconfusionlies.”
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,or“derived”from,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.

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
discovery—thatis,inrevealingthemarket’sviewonpricesofcommoditiesorrates
underlyingfuturesandoptions.OTCderivativesaretradedbylargefnancialinstitu-
tions—traditionally, bank holding companies and investment banks—which act as
derivatives dealers, buying and selling contracts with customers. Unlike the futures
andoptionsexchanges,theOTCmarketisneithercentralizednorregulated.Norisit
transparent,andthuspricediscoveryislimited.Nomatterthemeasurement—trad-
ing volume, dollar volume, risk exposure—derivatives represent a very signifcant
sectoroftheU.S.fnancialsystem.
The principal legislation governing these markets is the Commodity Exchange
Act of 1µ¡o, which originally applied only to derivatives on domestic agricultural
products.In1µ,¡,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
andgrowrapidlyinthe1µ8os.ThelargefnancialinstitutionsactingasOTCderiva-
tives dealers worried that the Commodity Exchange Act’s requirement that trading
occur on a regulated exchange might be applied to the products they were buying
andselling.In1µµ¡,theCFTCsoughttoaddresstheseconcernsbyexemptingcer-
tainnonstandardizedOTCderivativesfromthatrequirementandfromcertainother
provisions of the Commodity Exchange Act, except for prohibitions against fraud
andmanipulation.
¡1
As the OTC market grew following the CFTC’s exemption, a wave of signifcant
lossesandscandalshitthemarket.Amongmanyexamples,in1µµ¡Procter&Gamble,
a leading consumer products company, reported a pretax loss of ·1,, million, the
largestderivativeslossbyanonfnancialfrm,stemmingfromOTCinterestandforeign
exchangeratederivativessoldtoitbyBankersTrust.Procter&GamblesuedBankers
Trust for fraud—a suit settled when Bankers Trust forgave most of the money that
Procter&Gambleowedit.Thatyear,theCFTCandtheSecuritiesandExchangeCom-
mission(SEC)fnedBankersTrust·1omillionformisleadingGibsonGreetingCards
on interest rate swaps resulting in a mark-to-market loss of ·i¡ million, larger than
Gibson’sprior-yearprofts.Inlate1µµ¡,OrangeCounty,California,announcedithad
lost·1.,billionspeculatinginOTCderivatives.Thecountyfledforbankruptcy—the
largestbyamunicipalityinU.S.history.Itsderivativesdealer,MerrillLynch,paid·¡oo
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 1µµo, Japan’s 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.Sumitomosettledfor·1,omillion
in penalties and restitution. The CFTC also charged Merrill Lynch with knowingly
andintentionallyaiding,abetting,andassistingthemanipulationofcopperprices;it
settledforafneof·1,million.
¡¡
Debateintensifedin1µµ8.InMay,theCFTCunderChairpersonBrooksleyBorn
said the agency would reexamine the way it regulated the OTC derivatives market,
given the market’s rapid evolution and the string of major losses since 1µµ¡. The
CFTCrequestedcomments.Itgotthem.
Somecamefromotherregulators,whotooktheunusualstepofpubliclycriticiz-
ingtheCFTC.OnthedaythattheCFTCissuedaconceptrelease,TreasurySecretary
RobertRubin,Greenspan,andSECChairmanArthurLevittissuedajointstatement
denouncing the CFTC’s move: “We have grave concerns about this action and its
possibleconsequences. . . .WeareveryconcernedaboutreportsthattheCFTC’sac-
tion may increase the legal uncertainty concerning certain types of OTC deriva-
tives.”
¡,
They proposed a moratorium on the CFTC’s ability to regulate OTC
derivatives.
Formonths,Rubin,Greenspan,Levitt,andDeputyTreasurySecretaryLawrence
SummersopposedtheCFTC’seffortsintestimonytoCongressandinotherpublic
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
trillioninnotionalamountofOTCderivativesand·1i,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 Fed’s
judgment,LTCM’sfailurewouldpotentiallyhavehadsystemiceffects: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 1µµ8, Congress passed the requested
moratorium.
Greenspan continued to champion derivatives and advocate deregulation of the
OTCmarketandtheexchange-tradedmarket.“Byfarthemostsignifcanteventin
fnanceduringthepastdecadehasbeentheextraordinarydevelopmentandexpan-
sionoffnancialderivatives,”GreenspansaidataFuturesIndustryAssociationcon-
ference in March 1µµµ. “The fact that the OTC markets function quite effectively
without the benefts of [CFTC regulation] provides a strong argument for develop-
mentofalessburdensomeregimeforexchange-tradedfnancialderivatives.”
¡µ
The following year—after Born’s resignation—the President’s Working Group on
FinancialMarkets,acommitteeoftheheadsoftheTreasury,FederalReserve,SEC,and
CommodityFuturesTradingCommissionchargedwithtrackingthefnancialsystem
and chaired by then Treasury Secretary Larry Summers, essentially adopted
Greenspan’sview.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·µ,.itril-
lion,andthegrossmarketvaluewas·¡.itrillion.
¡1
Inthesevenandahalfyearsfrom
then until June ioo8, when the market peaked, outstanding OTC derivatives in-
creasedmorethansevenfoldtoanotionalamountof·o,i.otrillion;theirgrossmar-
ketvaluewas·io.¡trillion.
¡i
Greenspan testifed to the FCIC that credit default swaps—a 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 1µµos—“did create
problems” during the fnancial crisis.
¡¡
Rubin testifed that when the CFMA passed
hewas“notopposedtotheregulationofderivatives”andhadpersonallyagreedwith
Born’sviews,butthat“verystronglyheldviewsinthefnancialservicesindustryin
oppositiontoregulation”wereinsurmountable.
¡¡
SummerstoldtheFCICthatwhile
risks could not necessarily have been foreseen years ago, “by ioo8 our regulatory
frameworkwithrespecttoderivativeswasmanifestlyinadequate,”andthat“thede-
rivativesthatprovedtobebyfarthemostserious,thoseassociatedwithcreditdefault
swaps,increased1oofoldbetweenioooandioo8.”
¡,
Onereasonfortherapidgrowthofthederivativesmarketwasthecapitalrequire-
mentsadvantagethatmanyfnancialinstitutionscouldobtainthroughhedgingwith
derivatives. As discussed above, fnancial frms may use derivatives to hedge their
risks.Suchuseofderivativescanlowerafrm’sValueatRiskasdeterminedbycom-
putermodels.Inadditiontogainingthisadvantageinriskmanagement,suchhedges
can lower the amount of capital that banks are required to hold, thanks to a 1µµo
amendment to the regulatory regime known as the Basel International Capital Ac-
cord,or“BaselI.”
MeetinginBasel,Switzerland,in1µ88,theworld’scentralbanksandbanksuper-
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-
quirementsforbanks’holdingsofFannie’sandFreddie’ssecuritieswerelessthanfor
allotherassetsexceptthoseexplicitlybackedbytheU.S.government.
¡,
Theseinternationalcapitalstandardsaccommodatedtheshifttoincreasedlever-
age. In 1µµo, 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
OTCderivativesletderivativestraders—includingthelargebanksandinvestment
banks—increasetheirleverage.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
couldusederivativestoreceivethesamegains—orlosses—asiftheyhadboughtthe
actualsecurity,andwithonlyafractionofabuyer’sinitialfnancialoutlay.
¡µ
Warren
Buffett,thechairmanandchiefexecutiveomcerofBerkshireHathawayInc.,testifed
totheFCICabouttheuniquecharacteristicsofthederivativesmarket,saying,“they
accentuatedenormously,inmyview,theleverageinthesystem.”Hewentontocall
derivatives“verydangerousstuff,”dimcultformarketparticipants,regulators,audi-
tors,andinvestorstounderstand—indeed,heconcluded,“Idon’tthinkIcouldman-
age”acomplexderivativesbook.
,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,thesellerofferedprotectionagainstdefaultorspecifed“creditevents”suchasa
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.Acarownercaninsureonlythecarsheowns—notherneighbor’s.
ButaCDSpurchasercanuseittospeculateonthedefaultofaloanthepurchaserdoes
notown.Theseareoftencalled“nakedcreditdefaultswaps”andcaninfatepotential
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
withoutbeingrequiredtopostonedollar’sworthofinitialcollateralormakingany
otherprovisionforloss.
,i
AIGwasnotalone.Thevalueoftheunderlyingassetsfor
CDSoutstandingworldwidegrewfrom·o.¡trillionattheendofioo¡toapeakof
·,8.itrillionattheendofioo,.

Asignifcantportionwasapparentlyspeculativeor
nakedcreditdefaultswaps.

Much of the risk of CDS and other derivatives was concentrated in a few of the
verylargestbanks,investmentbanks,andothers—suchasAIGFinancialProducts,a
unitofAIG
,,
—thatdominateddealinginOTCderivatives.AmongU.S.bankholding
companies, µ,º 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 country’s fve largest investment
bankswerealsoamongtheworld’slargestOTCderivativesdealers.
While fnancial institutions surveyed by the FCIC said they do not track rev-
enuesandproftsgeneratedbytheirderivativesoperations,somefrmsdidprovide
estimates.Forexample,GoldmanSachsestimatedthatbetweeni,ºand¡,ºofits
revenuesfromiooothroughiooµweregeneratedbyderivatives,including,oºto
,+ ii N\Nti \i tii :i : i NQUi i¥ tu\\i : :i uN iiiui1
,,ºofthefrm’scommoditiesbusiness,andhalformoreofitsinterestrateandcur-
renciesbusiness.FromMayioo,throughNovemberioo8,·1¡¡billion,or8oº,of
the·1,,billionoftradesmadebyGoldman’smortgagedepartmentwerederivative
transactions.
,,
Whenthenation’sbiggestfnancialinstitutionswereteeteringontheedgeoffail-
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|ankingactivitics“ShattcrcrcjG|ass-Stcaga||” ,:
Icng-1crnCapita|Managcncnt
“1hat’swhathistcryhadprcvcdtcthcn” ,e
Dct-ccncrash“Iaycnncrcrisk”,,
1hcwagcscjµnancc“Vc||,thiscnc’sdcingit,schcwcanInctdcit?” e+
Iinancia|scctcrgrcwth
“Ithinkwccvcrdidµnanccvcrsusthcrca|cccncny”e,
EXPANSION OF BANKING ACTIVITIES:
“SHATTERER OF GLASSSTEAGALL”
By the mid-1µµos, 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
positionsandcreditors’perceptiontheyweretoobigtofail.Astheygrew,thelarge
banks pressed regulators, state legislatures, and Congress to remove almost all re-
mainingbarrierstogrowthandcompetition.Theyhadmuchsuccess.In1µµ¡Con-
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
withinthestate’sborders.
1
Removing barriers helped consolidate the banking industry. Between 1µµo and
ioo,,,¡“megamergers”occurredinvolvingbankswithassetsofmorethan·1obil-
lioneach.Meanwhilethe1olargestjumpedfromowningi,ºoftheindustry’sassets
,z
to,,º.From1µµ8toioo,,thecombinedassetsofthefvelargestU.S.banks—Bank
of America, Citigroup, JP Morgan, Wachovia, and Wells Fargo—more than tripled,
from ·i.i trillion to ·o.8 trillion.
i
And investment banks were growing bigger, too.
SmithBarneyacquiredShearsonin1µµ¡andSalomonBrothersin1µµ,,whilePaine
WebberpurchasedKidder,Peabodyin1µµ,.Twoyearslater,MorganStanleymerged
with Dean Witter, and Bankers Trust purchased Alex. Brown & Sons. The assets of
the fve largest investment banks—Goldman Sachs, Morgan Stanley, Merrill Lynch,
LehmanBrothers,andBearStearns—quadrupled,from·1trillionin1µµ8to·¡tril-
lioninioo,.
¡
In 1µµo, 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 Corporation’s 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-
tivesusingachainsawandpruningshearstocutthe“redtape”bindingalargestack
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 agency’s time and discouraged it from making
regulations. Levitt described it as “kind of a blood sport to make the particular
agencylookstupidorineptorvenal.”
,
However,otherssaidinterference—atleastfromtheexecutivebranch—wasmod-
est. John Hawke, a former comptroller of the currency, told the FCIC he found the
TreasuryDepartment“exceedinglysensitive”tohisagency’sindependence.Hissuc-
cessor,JohnDugan,said“statutoryfrewalls”preventedinterferencefromtheexecu-
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
Greenspanin1µµ,.“Theself-interestofmarketparticipantsgeneratesprivatemarket
regulation. Thus, the real question is not whether a market should be regulated.
iiiitUi\1i uN iiiU\ ,,
Rather,therealquestioniswhethergovernmentinterventionstrengthensorweakens
privateregulation.”
8
RichardSpillenkothen,theFed’sdirectorofBankingSupervisionandRegulation
from 1µµ1 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
withtheFed’spublicposture.”
µ
To create checks and balances and keep any agency from becoming arbitrary or
infexible, senior policy makers pushed to keep multiple regulators.
1o
In 1µµ¡,
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-
ulatorscontinuedtoopposelimitsonbanks’activitiesorgrowth.Thebarrierssepa-
rating commercial banks and investment banks had been crumbling, little by little,
andnowseemedthetimetoremovethelastremnantsoftherestrictionsthatsepa-
ratedbanks,securitiesfrms,andinsurancecompanies.
Inthespringof1µµo,afteryearsofopposingrepealofGlass-Steagall,theSecuri-
tiesIndustryAssociation—thetradeorganizationofWallStreetfrmssuchasGold-
man Sachs and Merrill Lynch—changed 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,wewereabletoaggressivelyentertheirbusinesses—insomecasesmoreaggres-
sivelythantheycouldenterours.Sofrstthesecuritiesindustry,thentheinsurance
companies,andfnallytheagentscameoverandsaidlet’snegotiateadealandwork
together.”

In 1µµ8, Citicorp forced the issue by seeking a merger with the insurance giant
TravelerstoformCitigroup.TheFedapprovedit,citingatechnicalexemptiontothe
Bank Holding Company Act,

but Citigroup would have to divest itself of many
Travelersassetswithinfveyearsunlessthelawswerechanged.Congresshadtomake
adecision:Wasitpreparedtobreakupthenation’slargestfnancialfrm:Wasittime
torepealtheGlass-SteagallAct,onceandforall:
,, ii N\Nti \i tii :i : i NQUi i¥ tu\\i : :i uN iiiui1
AsCongressbeganfashioninglegislation,thebankswerecloseathand.In1µµµ,
thefnancialsectorspent·18,millionlobbyingatthefederallevel,andindividuals
andpoliticalactioncommittees(PACs)inthesectordonated·ioimilliontofederal
electioncampaignsintheioooelectioncycle.From1µµµthroughioo8,federallob-
byingbythefnancialsectorreached·i.,billion;campaigndonationsfromindivid-
ualsandPACstopped·1billion.
1,
In November 1µµµ, 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 wood—at least ¡ feet wide—etched with his portrait and the
words‘TheShattererofGlass-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 Fed’s i,º
limit—theirprimaryregulator,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.Thelegislation’sopponentswarnedthatal-
lowingbankstocombinewithsecuritiesfrmswouldpromoteexcessivespeculation
andcouldtriggeracrisislikethecrashof1µiµ.JohnReed,formerco-CEOofCiti-
group,acknowledgedtotheFCICthat,inhindsight,“thecompartmentalizationthat
was created by Glass-Steagall would be a positive factor,” making less likely a “cata-
strophicfailure”ofthefnancialsystem.
18
Towinthesecuritiesindustry’ssupport,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.
Merrill’sindustrialloancompanygrewfromlessthan·1billioninassetsin1µµ8to
·¡billionin1µµµ,andto·,8billioninioo,.Lehman’sthriftgrewfrom·88million
in1µµ8to·¡billionin1µµµ,anditsassetsroseashighas·i¡billioninioo,.

ForinstitutionsregulatedbytheFed,thenewlawalsoestablishedahybridregula-
torystructureknowncolloquiallyas“Fed-Lite.”TheFedsupervisedfnancialholding
companiesasawhole,lookingonlyforrisksthatcutacrossthevarioussubsidiaries
ownedbytheholdingcompany.Toavoidduplicatingotherregulators’work,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-Lite“madeitdimcultforanysingleregulatortoreliablysee
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.Hecomparedittoa“sparetire”:iflargecommer-
cial banks ran into trouble, their large customers could borrow from investment
banksandothersinthecapitalmarkets;ifthosemarketsfroze,bankscouldlendus-
ingtheirdeposits.After1µµo,securitizedmortgagelendingprovidedanothersource
ofcredittohomebuyersandotherborrowersthatsoftenedasteepdeclineinlending
by thrifts and banks. The system’s resilience following the crisis in Asian fnancial
marketsinthelate1µµosfurtherprovedhispoint,Greenspansaid.

The new regime encouraged growth and consolidation within and across bank-
ing,securities,andinsurance.Thebank-centeredfnancialholdingcompaniessuch
asCitigroup,JPMorgan,andBankofAmericacouldcompetedirectlywiththe“big
fve” investment banks—Goldman Sachs, Morgan Stanley, Merrill Lynch, Lehman
Brothers, and Bear Stearns—in 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.Bothprosperedfromthelate1µµosuntiltheoutbreakofthefnancialcri-
sisinioo,.However,Greenspan’s“sparetire”thathadhelpedmakethesystemless
vulnerable would be gone when the fnancial crisis emerged—all the wheels of the
systemwouldbespinningonthesameaxle.
LONGTERM CAPITAL MANAGEMENT:
“THAT’ S WHAT HISTORY HAD PROVED TO THEM”
InAugust1µµ8,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.

Withthecommercialpapermarketinturmoil,itwasuptothecom-
mercialbankstotakeuptheslackbylendingtocorporationsthatcouldnotrollover
their short-term paper. Banks loaned ·¡o billion in September and October of
1µµ8—abouti.,timestheusualamount
i,
—andhelpedpreventaseriousdisruption
frombecomingmuchworse.Theeconomyavoidedaslump.
NotsoforLong-TermCapitalManagement,alargeU.S.hedgefund.LTCMhad
devastatinglossesonits·1i,billionportfolioofhigh-riskdebtsecurities,including
the junk bonds and emerging market debt that investors were dumping.
io
To buy
thesesecurities,thefrmhadborrowed·i¡forevery·1ofinvestors’equity;
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, LTCM’s leveraging strategy
had produced magnifcent returns: 1µ.µº, ¡i.8º, ¡o.8º, and 1,.1º, while the S&P
,ooyieldedanaveragei1º.
i8
Butleverageworksbothways,andinjustonemonthafterRussia’spartialdefault,
thefundlostmorethan·¡billion—ormorethan8oºofitsnearly·,billionincapi-
tal.Itsdebtwasabout·1iobillion.Thefrmfacedinsolvency.

If it were only a matter of less than ·, billion, LTCM’s failure might have been
manageable. But the frm had further leveraged itself by entering into derivatives
contracts with more than ·1 trillion in notional amount—mostly interest rate and
equityderivatives.
¡o
Withverylittlecapitalinreserve,itthreatenedtodefaultonits
obligationstoitsderivativescounterparties—includingmanyofthelargestcommer-
cialandinvestmentbanks.BecauseLTCMhadnegotiateditsderivativestransactions
intheopaqueover-the-countermarket,themarketsdidnotknowthesizeofitsposi-
tionsorthefactthatithadpostedverylittlecollateralagainstthosepositions.Asthe
Fednotedthen,ifallthefund’scounterpartieshadtriedtoliquidatetheirpositions
simultaneously,assetpricesacrossthemarketmighthaveplummeted,whichwould
havecreated“exaggerated”losses.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
LTCMinreturnforµoºofitsstock.
¡¡
Thefrmscontributedbetween·1oomillion
and ·¡oo million each, although Bear Stearns declined to participate.
¡¡
An orderly
liquidationofLTCM’ssecuritiesandderivativesfollowed.
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,theFed’sorchestrationraisedaquestion:
howfarwoulditgotoforestallwhatitsawasasystemiccrisis:
The Fed’s aggressive response had precedents in the previous two decades. In
1µ,o,theFedhadsupportedthecommercialpapermarket;in1µ8o,dealersinsilver
futures;in1µ8i,therepomarket;in1µ8,,thestockmarketaftertheDowJonesIn-
dustrialAveragefellbyioºpercentinthreedays.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
LTCM’srescueindicatethattheFedwaspreparedtoprotectcreditorsofanytypeof
frmifitscollapsemightthreatenthecapitalmarkets:HarveyMiller,thebankruptcy
counselforLehmanBrotherswhenitfailedinioo8,toldtheFCICthat“they[hedge
funds]expectedtheFedtosaveLehman,basedontheFed’sinvolvementinLTCM’s
rescue.That’swhathistoryhadprovedtothem.”
¡,
For Stanley O’Neal, Merrill’s 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
Greenspanarguedthattheeventsof1µµ8hadconfrmedthesparetiretheory.He
saidina1µµµspeechthatthesuccessfulresolutionofthe1µµ8crisisshowedthat“di-
versity within the fnancial sector provides insurance against a fnancial problem
turningintoeconomy-widedistress.”
¡µ
ThePresident’sWorkingGrouponFinancial
Markets came to a less defnite conclusion. In a 1µµµ 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
fortailrisk—anunanticipatedeventcausingcatastrophicdamagetofnancialinstitu-
tionsandtheeconomy.Nevertheless,itcautionedthatoverreactingtothreatssuchas
LTCMwoulddiminishthedynamismofthefnancialsectorandtherealeconomy:
“Policyinitiativesthatareaimedatsimplyreducingdefaultlikelihoodstoextremely
low levels might be counterproductive if they unnecessarily disrupt trading activity
andtheintermediationofrisksthatsupportthefnancingofrealeconomicactivity.”
¡i
Following the Working Group’s fndings, the SEC fve years later would issue a
ruleexpandingthenumberofhedgefundadvisors—toincludemostadvisors—that
needed to register with the SEC. The rule would be struck down in iooo by the
UnitedStatesCourtofAppealsfortheDistrictofColumbiaaftertheSECwassued
byaninvestmentadvisorandhedgefund.
¡¡
Marketswererelativelycalmafter1µµ8,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 1µµµ, 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 hero—the “Maestro”—who had handled every
emergencysincethe1µ8,stockmarketcrash.
¡¡
DOTCOM CRASH: “LAY ON MORE RISK”
The late 1µµos was a good time for investment banking. Annual public underwrit-
ings and private placements of corporate securities in U.S. markets almost quadru-
pled,from·ooobillionin1µµ¡to·i.itrillioninioo1.Annualinitialpublicofferings
ofstocks(IPOs)soaredfrom·i8billionin1µµ¡to·,obillioninioooasbanksand
securities frms sponsored IPOs for new Internet and telecommunications compa-
nies—thedot-comsandtelecoms.
¡,
Astockmarketboomensuedcomparabletothe
greatbullmarketofthe1µios.Thevalueofpubliclytradedstocksrosefrom·,.8tril-
lioninDecember1µµ¡to·1,.8trillioninMarchiooo.
¡o
Theboomwasparticularly
strikinginrecentdot-comandtelecomissuesontheNASDAQexchange.Overthis
period,theNASDAQskyrocketedfrom,,ito,,o¡8.
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
bullish—and,asitturnedout,sometimesdeceptive—researchreportsissuedbythe
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
improperpracticesintheallocationofIPOsharesduringthebubble—forspinning
(doling out shares in “hot” IPOs in return for reciprocal business) and laddering
(dolingoutsharestoinvestorswhoagreedtobuymorelaterathigherprices).
¡,
The
regulatorsalsofoundthatpublicresearchreportspreparedbyinvestmentbanks’ana-
lystsweretaintedbyconfictsofinterest.TheSEC,NewYork’sattorneygeneral,the
NationalAssociationofSecuritiesDealers(nowFINRA),andstateregulatorssettled
enforcementactionsagainst1ofrmsfor·8,,million,forbadecertainpractices,and
institutedreforms.
¡8
ThesuddencollapsesofEnronandWorldComwereshocking;withassetsof·o¡
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 dollars—although admitted no
wrongdoing—forhelpingEnronhideitsdebtuntiljustbeforeitscollapse.Enronand
its bankers had created entities to do complex transactions generating fctitious
earnings, disguised debt as sales and derivative transactions, and understated the
frm’sleverage.Executivesatthebankshadpressuredtheiranalyststowriteglowing
iiiitUi\1i uN iiiU\ ,,
evaluationsofEnron.ThescandalcostCitigroup,JPMorgan,CIBC,MerrillLynch,
andotherfnancialinstitutionsmorethan·¡oomillioninsettlementswiththeSEC;
Citigroup,JPMorgan,CIBC,LehmanBrothers,andBankofAmericapaidanother
·o.µ billion to investors to settle class action lawsuits.
¡µ
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-
rivatives“appeartohaveeffectivelyspreadlosses”fromdefaultsbyEnronandother
largecorporations.Althoughheconcededthemarketwas“stilltoonewtohavebeen
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
Streetbanks’pivotalroleintheEnrondebacledidnotseemtotroubleseniorFedof-
fcials.InamemorandumtotheFCIC,RichardSpillenkothendescribedapresenta-
tiontotheBoardofGovernorsinwhichsomeFedgovernorsreceiveddetailsofthe
banks’complicity“coolly”andwere“clearlyunimpressed”byanalysts’fndings.“The
messagetosomesupervisorystaffwasneitherambiguousnorsubtle,”Spillenkothen
wrote.Earlierinthedecade,heremembered,senioreconomistsattheFedhadcalled
Enronanexampleofaderivativesmarketparticipantsuccessfullyregulatedbymar-
ketdisciplinewithoutgovernmentoversight.
,i
TheFedcutinterestratesaggressivelyinordertocontaindamagefromthedot-
comandtelecombust,theterroristattacks,andthefnancialmarketscandals.InJan-
uaryioo1,thefederalfundsrate,theovernightbank-to-banklendingrate,waso.,º.
Bymid-ioo¡,theFedhadcutthatratetojust1º,thelowestinhalfacentury,where
itstayedforanotheryear.Inaddition,tooffsetthemarketdisruptionsfollowingthe
µ/11attacks,theFedfoodedthefnancialmarketswithmoneybypurchasingmore
than·1,obillioningovernmentsecuritiesandlending·¡,billiontobanks.Italso
suspended restrictions on bank holding companies so the banks could make large
loanstotheirsecuritiesamliates.WiththeseactionstheFedpreventedaprotracted
liquiditycrunchinthefnancialmarketsduringthefallofioo1,justasithaddone
duringthe1µ8,stockmarketcrashandthe1µµ8Russiancrisis.
Why wouldn’t the markets assume the central bank would act again—and again
save the day: Two weeks before the Fed cut short-term rates in January ioo1, the
Economist anticipatedit:“the‘Greenspanput’isonceagainthetalkofWallStreet. . . .
TheideaisthattheFederalReservecanberelieduponintimesofcrisistocometo
·+ ii N\Nti \i tii :i : i NQUi i¥ tu\\i : :i uN iiiui1
therescue,cuttinginterestratesandpumpinginliquidity,thusprovidingafoorfor
equityprices.”

The“Greenspanput”wasanalysts’shorthandforinvestors’faiththat
theFedwouldkeepthecapitalmarketsfunctioningnomatterwhat.TheFed’spolicy
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 . . .tofocusonpolicies‘to
mitigate the fallout when it occurs and, hopefully, ease the transition to the next
expansion.’”

This asymmetric policy—allowing unrestrained growth, then working hard to
cushiontheimpactofabust—raisedthequestionof“moralhazard”: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
acceptinglowercompensationforrisk”andcautioningthat“newlyabundantliquid-
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.Beginningin1µ8o,theydi-
verged. By ioo,, fnancial sector compensation was more than 8oº greater than in
otherbusinesses—aconsiderablylargergapthanbeforetheGreatDepression.
Until1µ,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-
mentbank’sculture.Beforethechange,heandtheotherpartnershadsatinasingle
roomatheadquarters,nottosocializebutto“overhear,interact,andmonitor”each
other.Theywereallonthehooktogether.“Sincetheywerepersonallyliableaspart-
ners,theytookriskveryseriously,”Solomonsaid.
,8
BrianLeach,formerlyanexecu-
tive at Morgan Stanley, described to FCIC staff Morgan Stanley’s 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.Whenyou’reaprivatecompany,
you don’t get paid until you retire. I mean, you get a good, you know, year-to-year
compensation.”Butthebigpayoutwas“whenyouretire.”

When the investment banks went public in the 1µ8os and 1µµos, the close rela-
tionshipbetweenbankers’decisionsandtheircompensationbrokedown.Theywere
nowtradingwithshareholders’money.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.Someincluded“clawback”provisionsthat
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 þension þrograms. Nonfnancial secLor is all domesLic emþloyees exceþL Lhose in
fnance and insurance.
Iigurc ,.+
onlyo.8ºayearduringthe¡oyearsafterWorldWarII,laggingcompanies’increasing
size.
oo
Buttheratepickedupduringthe1µ,osandrosefastereachdecade,reaching
1oºayearfrom1µµ,to1µµµ.
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,GoldmanSachsspentbetween¡¡ºand¡µº
ayearbetweenioo,andioo8,whenMorganStanleyallottedbetween¡oºand,µº.
Merrillpaidoutsimilarpercentagesinioo,andiooo,butgave1¡1ºinioo,—ayear
itsuffereddramaticlosses.

Asthescale,revenue,andproftabilityofthefrmsgrew,compensationpackages
soared for senior executives and other key employees. John Gutfreund, reported to
bethehighest-paidexecutiveonWallStreetinthelate1µ8os,received·¡.imillionin
1µ8oasCEOofSalomonBrothers.

StanleyO’Neal’spackagewasworthmorethan
·µ1millioniniooo,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
Yorkroughly·¡¡billioninyear-endbonusesalone.
o8
Totalcompensationforthema-
jorU.S.banksandsecuritiesfrmswasestimatedat·1¡,billion.

Stock options became a popular form of compensation, allowing employees to
buythecompany’sstockinthefutureatsomepredeterminedprice,andthustoreap
rewardswhenthestockpricewashigherthanthatpredeterminedprice.Infact,the
optionwouldhavenovalueifthestockpricewasbelowthatprice.Encouragingthe
awardingofstockoptionswas1µµ¡legislationmakingcompensationinexcessof·1
milliontaxabletothecorporationunlessperformance-based.Stockoptionshadpo-
tentially unlimited upside, while the downside was simply to receive nothing if the
stockdidn’trisetothepredeterminedprice.Thesameappliedtoplansthattiedpay
toreturnonequity:theymeantthatexecutivescouldwinmorethantheycouldlose.
These pay structures had the unintended consequence of creating incentives to in-
creasebothriskandleverage,whichcouldleadtolargerjumpsinacompany’sstock
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,thisone’sdoingit,sohowcanInotdoit,ifIdon’tdoit,thenthepeoplearego-
ingtoleavemyplaceandgosomeplaceelse.’”Managingrisk“becamelessofanim-
portantfunctioninabroadbaseofcompanies,Iwouldguess.”
,o
Andregulatoryentities,onesourceofchecksonexcessiverisktaking,hadchal-
lenges recruiting fnancial experts who could otherwise work in the private sector.
LordAdairTurner,chairmanoftheU.K.FinancialServicesAuthority,toldtheCom-
mission, “It’s 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:“It’sjustsimplynevergoingto
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 goal—double earnings in ,
years to ·o.¡o [per share]. A large part of the executives’ compensation was tied to
meetingthatgoal.”AchievingitbroughtCEOFranklinRaines·,imillionofhis·µo
millionpayfrom1µµ8toioo¡.However,Falconsaid,thegoal“turnedouttobeun-
achievable without breaking rules and hiding risks. Fannie and Freddie executives
workedhardtopersuadeinvestorsthatmortgage-relatedassetswerearisklessinvest-
ment,whileatthesametimecoveringupthevolatilityandrisksoftheirownmort-
gageportfoliosandbalancesheets.” Fannie’sestimateofhowmanymortgageholders
wouldpayoffwasoffby·¡oomillionatyear-end1µµ8,whichmeantnobonuses.So
Fannie counted only half the ·¡oo million on its books, enabling Raines and other
executivestomeettheearningstargetandreceive1ooºoftheirbonuses.

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,beginningintheearly1µ8os,thefnancialsectorgrewfaster
than the rest of the economy—rising from about ,º of gross domestic product
(GDP) to about 8º in the early i1st century. In 1µ8o, fnancial sector profts were
about1,ºofcorporateprofts.Inioo¡,theyhitahighof¡¡ºbutfellbacktoi,º
·, 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 Morgan’s assets increased from ·oo, billion in 1µµµ to ·i.i trillion in
ioo8,acompoundannualgrowthrateof1oº.BankofAmericaandCitigroupgrew
by1¡ºand1iºayear,respectively,withCitigroupreaching·1.µtrillioninassetsin
ioo8(downfrom·i.itrillioninioo,)andBankofAmerica·1.8trillion.Thein-
vestment banks also grew signifcantly from iooo to ioo,, often much faster than
commercialbanks.Goldman’sassetsgrewfrom·i,obillionin1µµµto·1.1trillion
byioo,,anannualgrowthrateofi1º.AtLehman,assetsrosefrom·1µibillionto
·oµ1billion,or1,º.
,o
Fannie and Freddie grew quickly, too. Fannie’s assets and guaranteed mortgages
increasedfrom·1.¡trillioninioooto·¡.itrillioninioo8,or11ºannually.AtFred-
die,theyincreasedfrom·1trillionto·i.itrillion,or1oºayear.
,,
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-
sponsoredenterprises’minimumcapitalrequirementati.,ºofassetspluso.¡,ºof
the mortgage-backed securities they guaranteed. So they could borrow more than
·iooforeachdollarofcapitalusedtoguaranteemortgage-backedsecurities.Ifthey
wantedtoownthesecurities,theycouldborrow·¡oforeachdollarofcapital.Com-
bined,FannieandFreddieownedorguaranteed·,.¡trillionofmortgage-relatedas-
setsattheendofioo,againstjust·,o.,billionofcapital,aratioof,,:1.
Fromioootoioo,,largebanksandthriftsgenerallyhad·1oto·iiinassetsfor
each dollar of capital, for leverage ratios between 1o:1 and ii:1. For some banks,
leverageremainedroughlyconstant.JPMorgan’sreportedleveragewasbetweenio:1
andii:1.WellsFargo’sgenerallyrangedbetween1o:1and1,:1.Otherbanksupped
theirleverage.BankofAmerica’srosefrom18:1inioootoi,:1inioo,.Citigroup’s
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,,evenafterbringing·8obillionworthofassetsonbalancesheet,substantial
assets remained off. If those had been included, leverage in ioo, would have been
¡8:1,orabout,¡ºhigher.Incomparison,atWellsFargoandBankofAmerica,in-
cludingoff-balance-sheetassetswouldhaveraisedtheioo,leverageratios1,ºand
i8º,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,º and iiº, 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
oftheinvestmentbanks’revenuesandearningswasgeneratedbytradingandinvest-
ments,includingsecuritizationandderivativesactivities.AtGoldman,revenuesfrom
tradingandprincipalinvestmentsincreasedfrom¡µºofthetotalin1µµ,too8ºin
ioo,.AtMerrillLynch,theygenerated,,ºofrevenueiniooo,upfrom¡iºin1µµ,.
AtLehman,similaractivitiesgeneratedupto8oºofpretaxearningsiniooo,upfrom
¡iºin1µµ,.AtBearStearns,theyaccountedformorethan1ooºofpretaxearnings
insomeyearsafteriooibecauseofpretaxlossesinotherbusinesses.
8o
Between1µ,8andioo,,debtheldbyfnancialcompaniesgrewfrom·¡trillionto
·¡otrillion,morethandoublingfrom1¡oºtoi,oºofGDP.FormerTreasurySecre-
taryJohnSnowtoldtheFCICthatwhilethefnancialsectormustplaya“critical”role
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 1µ,8, fnancial companies borrowed ·1¡ in the credit markets for
every·1ooborrowedbynonfnancialcompanies.Byioo,,fnancialcompanieswere
borrowing·,1forevery·1oo.“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:aticn“1hisstujjisscccnp|icatcdhcwis
any|cdygcingtckncw?” e:
Grcatcracccsstc|cnding“A|usincsswhcrcwccannakcscncncncy”,:
Su|princ|cndcrsinturnci|“Advcrscnarkctccnditicns”,,
1hcrcgu|atcrs“Oh,Iscc” ,,
In the early 1µ8os, 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 collateral—the house—
weren’tashighasthoseforcarloans,andweremuchlessthancreditcards.Thead-
vantagesofamortgageoverotherformsofdebtweresolidifedin1µ8owiththeTax
ReformAct,whichbarreddeductinginterestpaymentsonconsumerloansbutkept
thedeductionformortgageinterestpayments.
In the 1µ8os and into the early 1µµos, before computerized “credit scoring”—a
statisticaltechniqueusedtomeasureaborrower’screditworthiness—automatedthe
assessment of risk, mortgage lenders (including subprime lenders) relied on other
factors when underwriting mortgages. As Tom Putnam, a Sacramento-based mort-
gagebanker,toldtheCommission,theytraditionallylentbasedonthefourC’s:credit
(quantity, quality, and duration of the borrower’s 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,butmost—includingHousehold,BenefcialFinance,TheMoney
Store, and Champion Mortgage—were 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 loans—often 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.creditmarketstripledduringthe1µ8os,reaching·1¡.8tril-
lionin1µµo;11ºwassecuritizedmortgagesandGSEdebt.Later,mortgagesecurities
made up 18º of the debt markets, overtaking government Treasuries as the single
largestcomponent—apositiontheymaintainedthroughthefnancialcrisis.
¡
Inthe1µµosmortgagecompanies,banks,andWallStreetsecuritiesfrmsbegan
securitizingmortgages(seefgure,.1).Andmoreofthemweresubprime.Salomon
Brothers, Merrill Lynch, and other Wall Street frms started packaging and selling
“non-agency” mortgages—that is, loans that did not conform to Fannie’s and Fred-
die’sstandards.Sellingtheserequiredinvestorstoadjustexpectations.Withsecuriti-
zationshandledbyFannieandFreddie,thequestionwasnot“willyougetthemoney
back”but“when,”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 Moody’s. 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
loancrisishadleftUncleSamwith·¡oibillioninloansandrealestatefromfailed
thriftsandbanks.CongressestablishedtheResolutionTrustCorporation(RTC)in
1µ8µ to omoad mortgages and real estate, and sometimes the failed thrifts them-
selves,nowownedbythegovernment.WhiletheRTCwasabletosell·o.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,ithadsecuritized·i,bil-
lioninresidentialmortgages.
,
TheRTCineffecthelpedexpandthesecuritizationof
mortgages ineligible for GSE guarantees.
8
In the early 1µµos, 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
in1µµoto·1oobillioniniooo.Theproportionsecuritizedinthelate1µµospeakedat
,oº, and subprime mortgage originations’ share of all originations hovered around
1oº.
Securitizations by the RTC and by Wall Street were similar to the Fannie and
Freddiesecuritizations.Thefrststepwastogetprincipalandinterestpaymentsfrom
agroupofmortgagestofowintoasinglepool.Butin“private-label”securities(that
is,securitizationsnotdonebyFannieorFreddie),thepaymentswerethen“tranched”
inawaytoprotectsomeinvestorsfromlosses.Investorsinthetranchesreceiveddif-
ferentstreamsofprincipalandinterestindifferentorders.
Most of the earliest private-label deals, in the late 1µ8os and early 1µµos, 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 subþrime 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
market—those who created, sold, and bought the investments—would become
highlydependentonthisslice-and-diceprocess,andregulatorsandmarketpartici-
pantsaliketookforgrantedthatitemcientlyallocatedrisktothosebestableandwill-
ingtobearthatrisk.
To demonstrate how this process worked, we’ll describe a typical deal, named
CMLTIiooo-NCi,involving·µ¡,millioninmortgage-backedbonds.
µ
Iniooo,New
Century Financial, a California-based lender, originated and sold ¡,¡µµ 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
Citigroup’sbalancesheet,anarrangementwithtaxandregulatorybenefts.
The ¡,¡µµ mortgages carried the rights to the borrowers’ monthly payments,
which the Citigroup entity divided into 1µ tranches of mortgage-backed securities;
eachtranchegaveinvestorsadifferentpriorityclaimonthefowofpaymentsfrom
theborrowers,andadifferentinterestrateandrepaymentschedule.Thecreditrating
agenciesassignedratingstomostofthesetranchesforinvestors,who—assecuritiza-
tion became increasingly complicated—came to rely more heavily on these ratings.
Trancheswereassignedletterratingsbytheratingagenciesbasedontheirriskiness.
Inthisreport,ratingsaregenerallypresentedinS&P’sclassifcationsystem,whichas-
signsratingssuchas“AAA”(thehighestratingforthesafestinvestments,referredto
hereastriple-A),“AA”(lesssafethanAAA),“A,”“BBB,”and“BB,”andfurtherdistin-
guishesratingswith“+”and“–.”Anythingratedbelow“BBB-”isconsidered“junk.”
Moody’susesasimilarsysteminwhich“Aaa”ishighest,followedby“Aa,”“A,”“Baa,”
“Ba,” and so forth. For example, an S&P rating of BBB would correspond to a
Moody’sratingofBaa.InthisCitigroupdeal,thefourseniortranches—thesafest—
wereratedtriple-Abytheagencies.
Belowtheseniortranchesandnextinlineforpaymentswereeleven“mezzanine”
tranches—so 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,calledthe“equity,”“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,8º,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-1µµos, standardized data
with loan-level information on mortgage performance became more widely avail-
able.Lendersunderwrotemortgagesusingcreditscores,suchastheFICOscore,de-
velopedbyFairIsaacCorporation.In1µµ¡,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 1µµos, technology also affected implementation of the Community Rein-
vestment Act (CRA). Congress enacted the CRA in 1µ,, to ensure that banks and
thriftsservedtheircommunities,inresponsetoconcernsthatbanksandthriftswere
refusingtolendincertainneighborhoodswithoutregardtothecreditworthinessof
individualsandbusinessesinthoseneighborhoods(apracticeknownasredlining).
11
TheCRAcalledonbanksandthriftstoinvest,lend,andserviceareaswherethey
took in deposits, so long as these activities didn’t impair their own fnancial safety
andsoundness.ItdirectedregulatorstoconsiderCRAperformancewheneverabank
orthriftappliedforregulatoryapprovalformergers,toopennewbranches,ortoen-
gageinnewbusinesses.
1i
TheCRAencouragedbankstolendtoborrowerstowhomtheymayhaveprevi-
ouslydeniedcredit.Whiletheseborrowersoftenhadlower-than-averageincome,a
1µµ, 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.

“There is little or no evidence that banks’ safety and sound-
nesshavebeencompromisedbysuchlending,andbankersoftenreportsoundbusi-
nessopportunities,”FederalReserveChairmanAlanGreenspansaidofCRAlending
in1µµ8.

,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 flow
of cash determines the rating
of the securities, with AAA
tranches getting the first 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 flow
from principal & interest
payments…
Securities firms
purchase these loans
and pool them.
next
claim…
Collateralized
Debt
Obligation
Iigurc ¡.¡
In1µµ¡,PresidentBillClintonaskedregulatorstoimprovebanks’CRAperform-
ancewhilerespondingtoindustrycomplaintsthattheregulatoryreviewprocessfor
compliancewastooburdensomeandtoosubjective.In1µµ,,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
numbersthatmeasuredbanks’compliancewiththelaw.
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,aformerFedgovernorwhowasresponsiblefortheFed’sDivi-
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-
ous1µµos,andregulators,bankers,andlendersintheshadowbankingsystemtook
noteofthissuccess.
SUBPRIME LENDERS IN TURMOIL:
“ADVERSE MARKET CONDITIONS”
Amongnonbankmortgageoriginators,thelate1µµoswereaturningpoint.During
themarketdisruptioncausedbytheRussiandebtcrisisandtheLong-TermCapital
Managementcollapse,themarketssawa“fighttoquality”—thatis,asteepfallinde-
mandamonginvestorsforriskyassets,includingsubprimesecuritizations.Therate
ofsubprimemortgagesecuritizationdroppedfrom,,.1ºin1µµ8to¡,.¡ºin1µµµ.
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
resultsinAugust1µµ8.Then,inSeptember,SFCnotifedinvestorsabout“recentad-
versemarketconditions”inthesecuritiesmarketsandexpressedconcernabout“the
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-
ruptcyin1µµ8and1µµµ.InthetwoyearsfollowingtheRussiandefaultcrisis,8ofthe
top 1o subprime lenders declared bankruptcy, ceased operations, or sold out to
strongerfrms.

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
downorsoldoffmostofTheMoneyStore’soperations.
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,failedin1µµµ.Inthesecuritizationprocess—aswascommonprac-
ticeinthe1µµos—Keystoneretainedtheriskiest“frst-loss”residualtranchesforits
ownaccount.Theseholdingsfarexceededthebank’scapital.ButKeystoneassigned
themgrosslyinfatedvalues.TheOCCclosedthebankinSeptember1µµµ,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 1µµos reemerged in
otherforms.LongBeachwastheancestorofAmeriquestandLongBeachMortgage
(whichwasinturnpurchasedbyWashingtonMutual),twoofthemoreaggressive
lendersduringthefrstdecadeofthenewcentury.AssociatesFirstwassoldtoCiti-
group, and Household bought Benefcial Mortgage before it was itself acquired by
HSBCinioo¡.
Withthesubprimemarketdisrupted,subprimeoriginationstotaled·1oobillion
iniooo,downfrom·1¡,billiontwoyearsearlier.
i1
Overthenextfewyears,however,
subprimelendingandsecuritizationwouldmorethanrebound.
THE REGULATORS: “OH, I SEE”
During the 1µµos, various federal agencies had taken increasing notice of abusive
subprimelendingpractices.Buttheregulatorysystemwasnotwellequippedtore-
spondconsistently—andonanationalbasis—toprotectborrowers.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,throughtheTruthinLendingActof1µo8.In1µoµ,the
FedadoptedRegulationZforthepurposeofimplementingtheact.ButwhileRegu-
lationZappliedtoalllenders,itsenforcementwasdividedamongAmerica’smanyf-
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
inworktodaywithwhatthey’vegot.Theydon’thavethestafftogooutandsearch
outmortgageproblems.”

Glenn Loney, deputy director of the Fed’s Consumer and Community Affairs
Division from 1µµ8 to io1o, told the FCIC that ever since he joined the agency in
1µ,,,Fedomcialshadbeendebatingwhetherthey—inadditiontotheFTC—should
enforcerulesfornonbanklenders.ButtheyworriedaboutwhethertheFedwouldbe
steppingoncongressionalprerogativesbyassumingenforcementresponsibilitiesthat
legislationhaddelegatedtotheFTC.“Anumberofgovernorscameinandsaid,‘You
meantosaywedon’tlookatthese:’”Loneysaid.“Andthenwetriedtoexplainitto
them,andthey’dsay,‘Oh,Isee.’”

TheFederalReservewouldnotexertitsauthority
inthisarea,norothersthatcameunderitspurviewin1µµ¡,withanyrealforceuntil
afterthehousingbubbleburst.
The1µµ¡legislationthatgavetheFednewresponsibilitieswastheHomeOwner-
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 HOEPA’s coverage were set too
hightocatchmostsubprimeloans.
i8
Evenso,HOEPAspecifcallydirectedtheFedto
actmorebroadlyto“prohibitactsorpracticesinconnectionwith[mortgageloans]
that[theBoard]fndstobeunfair,deceptiveordesignedtoevadetheprovisionsof
this[act].”

InJune1µµ,,twoyearsafterHOEPAtookeffect,theFedheldthefrstsetofpub-
lichearingsrequiredundertheact.ThevenueswereLosAngeles,Atlanta,andWash-
ington,D.C.Consumeradvocatesreportedabusesbyhomeequitylenders.Areport
summarizingthehearings,jointlyissuedwiththeDepartmentofHousingandUrban
Development and released in July 1µµ8, 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
strictunderwritingguidelinesconcerningtheborrower’sabilitytorepaytheloan.”
¡o
But in the years to come, these representations and warranties would prove to be
inaccurate.
Still,theFedcontinuednot topressitsprerogatives.InJanuary1µµ8,itformalized
itslong-standingpolicyof“notroutinelyconductingconsumercomplianceexamina-
tionsofnonbanksubsidiariesofbankholdingcompanies,”
¡1
adecisionthatwouldbe
criticizedbyaNovember1µµµGeneralAccountingOmcereportforcreatinga“lack
of regulatory oversight.”
¡i
The July 1µµ8 report also made recommendations on
mortgagereform.
¡¡
Whilepreparingdraftrecommendationsforthereport,Fedstaff
wrotetotheFed’sCommitteeonConsumerandCommunityAffairsthat“giventhe
Board’straditionalreluctancetosupportsubstantivelimitationsonmarketbehavior,
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 Fed’s
hands-off approach to the regulation of mortgage lending. Even so, the shakeup in
the subprime industry in the late 1µµos had drawn regulators’ attention to at least
someoftherisksassociatedwiththislending.Forthatreason,theFederalReserve,
FDIC, OCC, and OTS jointly issued subprime lending guidance on March 1, 1µµµ.
:U8iii \i iiNii Nt ,,
Thisguidanceappliedonlytoregulatedbanksandthrifts,andevenforthemitwould
notbebindingbutmerelylaidoutthecriteriaunderlyingregulators’bankexamina-
tions.Itexplainedthat“recentturmoilintheequityandasset-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.Thetaskforcefound“patterns”ofabusivepractices,reporting“substantial
evidenceoftoo-frequentabusesinthesubprimelendingmarket.”Questionableprac-
tices included loan fipping (repeated refnancing of borrowers’ loans in a short
time),highfeesandprepaymentpenaltiesthatresultedinborrowers’losingtheeq-
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 sector”—meaning
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
“Itwasapparentonthegroundasearlyas’µoor’µ8 . . .thatthemarketfor
low-income consumers was being fooded with inappropriate products,” Diane
ThompsonoftheNCLCtoldtheCommission.
¡µ
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,toldtheFCICthatthereport’srecommendations“lasted
on Capitol Hill a very short time. . . . There wasn’t 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]wasstartedandthelion’sshareofitoccurredinthe
nonbank sector, but it clearly created competitive pressures on
banks. . . .Ithinknippingthisinthebudinioooandioo1withsome
strong consumer rules applying across the board that just simply said
you’vegottodocumentacustomer’sincometomakesuretheycanre-
paytheloan,you’vegottomakesuretheincomeissumcienttopaythe
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
gettheindustrytoadoptasetof“bestpractices”thatwouldincludeavoluntaryban
onmortgagesthatstripborrowersoftheirequity,andwouldofferborrowerstheop-
portunitytoavoidprepaymentpenaltiesbyagreeinginsteadtopayahigherinterest
rate.ShereachedouttoEdwardGramlich,agovernorattheFedwhosharedhercon-
cerns, to enlist his help in getting companies to abide by these rules. Bair said that
Gramlichdidn’ttalkoutofschoolbutmadeitcleartoherthattheFedavenuewasn’t
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 1µµµ, three of every
foursubprimemortgageswasafrstmortgage,andofthose8iºwereusedforref-
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
Hcusing“Apcwcrju|sta|i|i:ingjcrcc” :,
Su|princ|cans“Buycrswi||payahighprcniun” ::
Citigrcup“Invitcdrcgu|atcryscrutiny” ,:
Icdcra|ru|cs“Intcndcdtccur|unjaircra|usivc|cnding” ,,
Statcs“Icng-standingpcsiticn”,e
Ccnnunity-|cndingp|cdgcs“Vhatwcdcisrca¡rncurintcnticn” ,,
Bankcapita|standards“Ar|itragc” ,,
By the end of iooo, the economy had grown ¡µ straight quarters. Federal Reserve
ChairmanAlanGreenspanarguedthefnancialsystemhadachievedunprecedented
resilience.Largefnancialcompanieswere—oratleasttomanyobserversatthetime,
appeared to be—proftable, diversifed, and, executives and regulators agreed, pro-
tectedfromcatastrophebysophisticatednewtechniquesofmanagingrisk.
Thehousingmarketwasalsostrong.Between1µµ,andiooo,pricesroseatanan-
nualrateof,.iº;overthenextfveyears,theratewouldhit11.,º.
1
Lowerinterest
ratesformortgageborrowerswerepartlythereason,aswasgreateraccesstomort-
gagecreditforhouseholdswhohadtraditionallybeenleftout—includingsubprime
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.Householddebtrosefrom8oºofdispos-
ablepersonalincomein1µµ¡toalmost1¡oºbymid-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
againaftermanyofthemajorsubprimelendersfailedorwerepurchasedin1µµ8and
1µµµ.Afterward,thebiggestbanksmovedin.Iniooo,Citigroup,with·8oobillionin
assets, paid ·¡1 billion for Associates First Capital, the second-biggest subprime
lender. Still, subprime lending remained only a niche, just µ.,º 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 ¡º. To stimulate borrowing and spending, the Federal
Reserve’sFederalOpenMarketCommitteeloweredshort-terminterestratesaggres-
sively. On January ¡, ioo1, in a rare conference call between scheduled meetings,
it cut the benchmark federal funds rate—at which banks lend to each other
overnight—by a half percentage point, rather than the more typical quarter point.
Laterthatmonth,thecommitteecuttherateanotherhalfpoint,anditcontinuedcut-
tingthroughouttheyear—11timesinall—to1.,,º,thelowestin¡oyears.
In the end, the recession of ioo1 was relatively mild, lasting only eight months,
fromMarchtoNovember,andgrossdomesticproduct,orGDP—themostcommon
gauge of the economy—dropped by only o.¡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.”
¡
Withtherecessionoverandmortgageratesat¡o-yearlows,housingkickedinto
high gear—again. 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,1¡ºofnetjobgrowthwasin
construction.Inioo¡,buildersstartedmorethan1.8millionsingle-familydwellings,
arateunseensincethelate1µ,os.Fromiooitoioo,,residentialconstructioncon-
tributed three times more to the economy than it had contributed on average since
1µµo.
·, ii N\Nti \i tii :i : i NQUi i¥ tu\\i : :i uN iiiui1
Butelsewheretheeconomyremainedsluggish,andemploymentgainswerefrus-
tratinglysmall.Expertsbegantalkingabouta“joblessrecovery”—moreproduction
without a corresponding increase in employment. For those with jobs, wages stag-
nated.Betweeniooiandioo,,weeklyprivatenonfarm,nonsupervisorywagesactu-
ally fell by 1º after adjusting for infation. Faced with these challenges, the Fed
shiftedperspective,nowconsideringthepossibilitythatconsumerpricescouldfall,
aneventthathadworsenedtheGreatDepressionsevendecadesearlier.Whilecon-
cerned,theFedbelieveddefationwouldbeavoided.Inawidelyquotediooispeech,
Bernankesaidthechancesofdefationwere“extremelysmall”fortworeasons.First,
the economy’s 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 Fed’s monetary policy kept short-term interest rates low. During ioo¡, the
strongestU.S.companiescouldborrowforµodaysinthecommercialpapermarket
atanaverage1.1º,comparedwitho.¡ºjustthreeyearsearlier;ratesonthree-month
Treasurybillsdroppedbelow1ºinmid-ioo¡fromoºiniooo.
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 ,.iº, ¡ percentage points lower than three
years earlier. The savings were immediate and large. For a home bought at the me-
dianpriceof·18o,ooo,withaioºdownpayment,themonthlymortgagepayment
wouldbe·i8olessthaniniooo.Ortoturntheperspectivearound—asmanypeople
did—forthesamemonthlypaymentof·1,o,,,ahomeownercouldmoveupfroma
·18o,ooohometoa·i¡,,oooone.
,
An adjustable-rate mortgage (ARM) gave buyers even lower initial payments or
madealargerhouseaffordable—unlessinterestratesrose.Inioo1,just¡ºofprime
borrowerswithnewmortgageschoseARMs;inioo¡,1oºdid.Inioo¡,thepropor-
tionrosetoi1º.
8
Amongsubprimeborrowers,alreadyheavyusersofARMs,itrose
fromaroundooºto,oº.
µ
Aspeoplejumpedintothehousingmarket,pricesrose,andinhotmarketsthey
reallytookoff(seefgureo.i).InFlorida,averagehomepricesgained¡.1ºannually
from1µµ,toioooandthen11.1ºannuallyfromioootoioo¡.InCalifornia,those
numbers were even higher: o.1º and 1¡.oº. In California, a house bought for
·ioo,oooin1µµ,wasworth·¡,¡,¡i8nineyearslater.However,soaringpriceswere
not necessarily the norm. In Washington State, prices continued to appreciate, but
moreslowly:,.µºannuallyfrom1µµ,toiooo,,.,ºannuallyfromioootoioo¡.In
Ohio,thenumberswere¡.¡ºand¡.oº.
1o
Nationwide,homepricesroseµ.8ºannu-
ally from iooo to ioo¡—historically high, but well under the fastest-growing
markets.
tiiii 1 i\i\N:i uN ·,
Homeownershipincreasedsteadily,peakingatoµ.iºofhouseholdsinioo¡.
11
Be-
causesomanyfamilieswerebeneftingfromhigherhomevalues,householdwealth
rosetonearlysixtimesincome,upfromfvetimesafewyearsearlier.Thetop1oºof
households by net worth, of whom µoº owned their homes, saw the value of their
primaryresidencesrisebetweenioo1andioo¡from·¡,i,8ooto·¡,o,ooo(adjusted
forinfation),anincreaseofmorethan·,,,ooo.Mediannetworthforallhouseholds
inthetop1oº,afteraccountingforotherhousingvalueandassets,aswellasalllia-
bilities,was·1.¡millioninioo¡.Homeownershipratesforthebottomi,ºofhouse-
holdstickedupfrom1¡ºto1,ºbetweenioo1andioo¡;themedianvalueoftheir
primaryresidencesrosefrom·,i,,ooto·o,,ooo,anincreaseofmorethan·1i,ooo.
Mediannetworthforhouseholdsinthebottomi,ºwas·1,,ooinioo¡.
1i
Historically,every·1,oooincreaseinhousingwealthboostedconsumerspending
by an estimated ·,o a year.

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,morethanoneinfour—anunprecedentedlevel.

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.
AccordingtotheFed’sioo¡SurveyofConsumerFinances,¡,.oºofhomeowners
whotappedtheirequityusedthatmoneyforexpensessuchasmedicalbills,taxes,elec-
tronics,andvacations,ortoconsolidatedebt;another¡1.oºuseditforhomeimprove-
ments;andtherestpurchasedmorerealestate,cars,investments,clothing,orjewelry.
A Congressional Budget Omce paper from ioo, reported on the recent history:
“Ashousingpricessurgedinthelate1µµosandearlyiooos,consumersboostedtheir
spendingfasterthantheirincomerose.Thatwasrefectedinasharpdropintheper-
sonal savings rate.”
1o
Between 1µµ8 and ioo,, increased consumer spending ac-
countedforbetweeno,ºand1o8ºofGDPgrowthinanyyear—risingabove1ooº
inyearswhenspendinggrowthoffsetdeclineselsewhereintheeconomy.Meanwhile,
thepersonalsavingratedroppedfrom,.iºto1.¡º.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,Greenspanacknowledged—atleast
implicitly—thatafterthedot-combubbleburst,theFedcutinterestratesinpartto
promotehousing.GreenspanarguedthattheFed’slow-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,referringto“alarge
extractionofcashfromhomeequity.”
18
SUBPRIME LOANS:  “BUYERS WILL PAY A HIGH PREMIUM”
Thesubprimemarketroaredbackfromitsshakeoutinthelate1µµos.Thevalueof
subprimeloansoriginatedalmostdoubledfromioo1throughioo¡,to·¡1obillion.
Iniooo,,iºoftheseweresecuritized;inioo¡,o¡º.

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
lendersmadeµ¡ºofallsubprimeloans,upfrom¡,ºin1µµo.
io
Therewerenowthreemainkindsofcompaniesinthesubprimeoriginationand
securitizationbusiness:commercialbanksandthrifts,WallStreetinvestmentbanks,
and independent mortgage lenders. Some of the biggest banks and thrifts—Citi-
group,NationalCityBank,HSBC,andWashingtonMutual—spentbillionsonboost-
ingsubprimelendingbycreatingnewunits,acquiringfrms,orofferingfnancingto
other mortgage originators. Almost always, these operations were sequestered in
nonbanksubsidiaries,leavingtheminaregulatoryno-man’s-land.
Whenitcametosubprimelending,nowitwasWallStreetinvestmentbanksthat
worriedaboutcompetitionposedbythelargestcommercialbanksandthrifts.For-
merLehmanpresidentBartMcDadetoldtheFCICthatthebankshadgainedtheir
ownsecuritizationskillsanddidn’tneedtheinvestmentbankstostructureanddis-
tribute.
i1
So the investment banks moved into mortgage origination to guarantee a
supplyofloanstheycouldsecuritizeandselltothegrowinglegionsofinvestors.For
example,LehmanBrothers,thefourth-largestinvestmentbank,purchasedsixdiffer-
ent domestic lenders between 1µµ8 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 Century’s “Focus
iooo” plan concentrated on “originating loans with characteristics for which whole
loanbuyerswillpayahighpremium.”

Those“wholeloanbuyers”werethefrmson
Wall Street that purchased loans and, most often, bundled them into mortgage-
backedsecurities.Theywereeagercustomers.Inioo¡,NewCenturysold·io.8bil-
lioninwholeloans,upfrom·¡.1billionthreeyearsbefore,

launchingthefrmfrom
tenthtosecondplaceamongsubprimeoriginators.Three-quarterswenttotwosecu-
ritizing frms—Morgan Stanley and Credit Suisse—but New Century reassured its
investorsthattherewere“manymoreprospectivebuyers.”
i,
Ameriquest, in particular, pursued volume. According to the company’s public
statements,itpaiditsaccountexecutiveslesspermortgagethanthecompetition,but
it encouraged them to make up the difference by underwriting more loans. “Our
peoplemakemorevolumeperemployeethantherestoftheindustry,”AseemMital,
CEOofAmeriquest,saidinioo,.Thecompanycutcostselsewhereintheorigina-
tionprocess,too.Thebackomceforthefrm’sretaildivisionoperatedinassembly-
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.,,ºwhatcompetingoriginatorschargedsecuritizingfrms,accordingtoanindus-
try analyst’s estimate. Between iooo and ioo¡, Ameriquest loan origination rose
from an estimated ·¡ billion to ·¡µ 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 maturity—an approach known as
originate-to-hold—theyhadaclearincentivetounderwritecarefullyandconsiderthe
risks. However, when they originated mortgages to sell, for securitization or other-
wise—known as originate-to-distribute—they no longer risked losses if the loan de-
faulted. As long as they made accurate representations and warranties, the only risk
wastotheirreputationsifalotoftheirloanswentbad—butduringtheboom,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
1µ,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 fees—from the borrower,
from the lender, or both—so the loan’s performance mattered little. These fees were
oftenpaidwithouttheborrower’sknowledge.Indeed,manyborrowersmistakenlybe-
lievedthemortgagebrokersactedinborrowers’bestinterest.
i8
Onecommonfeepaid
bythelendertothebrokerwasthe“yieldspreadpremium”:onhigher-interestloans,
thelendingbankwouldpaythebrokerahigherpremium,givingtheincentivetosign
theborrowertothehighestpossiblerate.“Ifthebrokerdecideshe’sgoingtotryand
makemoremoneyontheloan,thenhe’sgoingtoraisetherate,”saidJayJeffries,afor-
mersalesmanagerforFremontInvestment&Loan,totheCommission.“We’vegota
higherrateloan,we’repayingthebrokerforthatyieldspreadpremium.”

In theory, borrowers are the frst defense against abusive lending. By shopping
around,theyshouldrealize,forexample,ifabrokeristryingtosellthemahigher-
pricedloanortoplacetheminasubprimeloanwhentheywouldqualifyforaless-
expensiveprimeloan.Butmanyborrowersdonotunderstandthemostbasicaspects
oftheirmortgage.AstudybytwoFederalReserveeconomistsestimatedatleast¡8º
ofborrowerswithadjustable-ratemortgagesdidnotunderstandhowmuchtheirin-
terest rates could reset at one time, and more than half underestimated how high
theirratescouldreachovertheyears.
¡o
Thesamelackofawarenessextendedtoother
terms of the loan—for example, the level of documentation provided to the lender.
“Most borrowers didn’t even realize that they were getting a no-doc loan,” said
MichaelCalhoun,presidentoftheCenterforResponsibleLending.“They’dcomein
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 earlier—in which New Cen-
tury sold ¡,¡µµ mortgages to Citigroup, which then sold them to the securitization
trust, which then bundled them into 1µ tranches for sale to investors. Out of those
¡,¡µµ 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 1.81º of the loan
amount.Ontopofthat,thebrokersalsoreceivedyieldspreadpremiumsfromNew
Centuryfor1,,¡¡oftheseloans,averaging·i,,8,each.Intotal,thebrokersreceived
morethan·1,.,millioninfeesforthe¡,¡ooloans.
¡¡
Criticsarguedthatwiththismuchmoneyatstake,mortgagebrokershadeveryin-
centivetoseek“thehighestcombinationoffeesandmortgageinterestratesthemarket
will bear.”
¡¡
Herb Sandler, the founder and CEO of the thrift Golden West Financial
Corporation,toldtheFCICthatbrokerswerethe“whoresoftheworld.”
¡,
Asthehous-
ingandmortgagemarketboomed,sodidthebrokers.WholesaleAccess,whichtracks
the mortgage industry, reported that from iooo to ioo¡, the number of brokerage
frmsrosefromabout¡o,oooto,o,ooo.Iniooo,brokersoriginated,,ºofloans;in
ioo¡,theypeakedato8º.
¡o
JPMorganCEOJamieDimontestifedtotheFCICthat
hisfrmeventuallyendeditsbroker-originatedbusinessiniooµafterdiscoveringthe
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
saysisactuallyworthonly·1,,,ooo.Inthiscase,abankwon’tlendaborrower,say,
·18o,oootobuythehome.Thedealdies.Sureenough,appraisersbeganfeelingpres-
sure.Oneioo¡surveyfoundthat,,ºoftheappraisershadfeltpressedtoinfatethe
value of homes; by iooo, this had climbed to µoº. 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.andanappraiserwithi¡years’experi-
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.”
¡µ
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 1µµ¡, 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-
treetoldtheFCICthatCalifornia’sOmceofRealEstateAppraisershadeightinvesti-
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 originator’s 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,
thecomplaintallegedthecorporationimproperlyletWashingtonMutual’sloanpro-
duction staff “hand-pick appraisers who bring in appraisal values high enough to
permit WaMu’s 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 1µµ8 merger
withTravelers,Citigroupmadeitsnextbigmove.InSeptemberiooo,itpaid·¡1bil-
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 documents—all targeting unsophisticated borrowers who typically
could not evaluate the forms. “It’s 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,whichregulatesindependentmortgagecompanies’compli-
ancewithconsumerprotectionlaws,launchedaninvestigationintoAssociatesFirst’s
premerger business and found that the company had pressured borrowers to ref-
nanceintoexpensivemortgagesandtobuyexpensivemortgageinsurance.Iniooi,
Citigroupreachedarecord·i1,millioncivilsettlementwiththeFTCoverAssoci-
ates’“systematicandwidespreaddeceptiveandabusivelendingpractices.”
¡,
Inioo1,theNewYorkFedusedtheoccasionofCitigroup’snextproposedacqui-
sition—EuropeanAmericanBankonLongIsland,NewYork—tolaunchitsownin-
,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)intohomeequityloanswithoutproperlyassessingtheborrower’sabilityto
repay.Reviewinglendingpracticesfromioooandioo1,theFedalsoaccusedtheunit
ofsellingcreditinsurancetoborrowerswithoutcheckingiftheywouldqualifyfora
mortgagewithoutit.Fortheseviolationsandforimpedingitsinvestigation,theFed
in ioo¡ assessed ·,o million in penalties. The company said it expected to pay an-
other·¡omillioninrestitutiontoborrowers.
¡,
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
lendersfromgrantinganymortgage—notjustthelimitedsetofhigh-costloansdefned
byHOEPA—solelyonthevalueofthecollateralandwithoutregardtotheborrower’s
abilitytorepay.Forhigh-costloans,thelenderwouldhavetoverifyanddocumentthe
borrower’sincomeanddebt;forotherloans,thedocumentationstandardwasweaker,
asthelendercouldrelyontheborrower’spaymenthistoryandthelike.Thestaffmemo
explainedthiswouldmainly“affectlenderswhomakeno-documentationloans.”The
secondproposaladdressedpracticessuchasdeceptiveadvertisements,misrepresenting
loanterms, andhavingconsumerssignblankdocuments—actsthatinvolvefraud,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¡.“Butwealsodon’twanttoencouragethe
abuses;indeed,wewanttodowhatwecantostoptheseabuses.”
¡µ
FedGeneralCoun-
selScottAlvareztoldtheFCIC,“Therewasconcernthatifyouputoutabroadrule,
youwouldstopthingsthatwerenotunfairanddeceptivebecauseyouweretryingto
get at the bad practices and you just couldn’t think of all of the details you would
need.Andifyoudidthinkofallofthedetails,you’dendupwritingarulethatpeople
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 doesn’t 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.FromiooototheendofGreenspan’stenureiniooo,theFedre-
ferredtotheJusticeDepartmentonlythreeinstitutionsforfairlendingviolationsre-
lated to mortgages: First American Bank, in Carpentersville, Illinois; Desert
Community Bank, in Victorville, California; and the New York branch of Société
Générale,alargeFrenchbank.
Fedomcialsrejectedthestaffproposals.Aftersomewrangling,inDecemberioo1
the Fed did modify HOEPA, but only at the margins. Explaining its actions, the
boardhighlightedcompromise:“Thefnalruleisintendedtocurbunfairorabusive
lendingpracticeswithoutundulyinterferingwiththefowofcredit,creatingunnec-
essarycreditorburden,ornarrowingconsumers’optionsinlegitimatetransactions.”
Thestatusquowouldchangelittle.Fedeconomistshadestimatedthepercentageof
subprimeloanscoveredbyHOEPAwouldincreasefromµºtoasmuchas¡8ºun-
der the new regulations.

But lenders changed the terms of mortgages to avoid the
newrules’revisedinterestrateandfeetriggers.Bylateioo,,itwasclearthatthenew
regulationswouldendupcoveringonlyabout1ºofsubprimeloans.

Nevertheless,
refecting on the Federal Reserve’s 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,thestaffoftheFed’sDivisionofConsumerandCom-
munity Affairs also proposed a pilot program to examine lending practices at bank
holdingcompanies’nonbanksubsidiaries,
,,
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,theFedhadtheauthoritytoexaminenonbanksubsidiariesfor“compliance
withthe[BankHoldingCompanyAct]oranyotherFederallawthattheBoardhas
specifcjurisdictiontoenforce”;however,theconsumerprotectionlawsdidnotex-
plicitlygivetheFedenforcementauthorityinthisarea.
,8
The Fed resisted routine examinations of these companies, and despite the sup-
portofFedGovernorGramlich,theinitiativestalled.SandraBraunstein,thenastaff
memberintheFed’sConsumerandCommunityAffairsDivisionandnowitsdirec-
tor,toldtheFCICthatGreenspanandotheromcialswereconcernedthatroutinely
examiningthenonbanksubsidiariescouldcreateanunevenplayingfeldbecausethe
subsidiarieshadtocompetewiththeindependentmortgagecompanies,overwhich
,, ii N\Nti \i tii :i : i NQUi i¥ tu\\i : :i uN iiiui1
theFedhadnosupervisoryauthority(althoughtheFed’sHOEPArulesappliedtoall
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,butthathecouldn’tpretendtohavethekindofexpertiseon
thissubjectthatthestaffhad.
o1
Gramlich,whochairedtheFed’sconsumersubcommittee,favoredtightersuper-
visionofallsubprimelenders—includingunitsofbanks,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
changewouldrequirecongressionallegislation“andmightantagonizethestates.”But
withoutsuchoversight,themortgagebusinesswas“likeacitywithamurderlaw,but
nocopsonthebeat.”
oi
Inaninterviewinioo,,GramlichtoldtheWall Street Journal
thatheprivatelyurgedGreenspantoclampdownonpredatorylending.Greenspan
demurredand,lackingsupportontheboard,Gramlichbackedaway.Gramlichtold
theJournal, “Hewasopposedtoit,soIdidnotreallypursueit.”

(Gramlichdiedin
ioo8ofleukemia,atageo8.)
The Fed’s failure to stop predatory practices infuriated consumer advocates and
somemembersofCongress.Criticschargedthataccountsofabuseswerebrushedoff
as anecdotal. Patricia McCoy, a law professor at the University of Connecticut who
servedontheFed’sConsumerAdvisoryCouncilbetweeniooiandioo¡,wasfamil-
iar with the Fed’s 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:’”

The Fed’s reluctance to take action trumped the iooo HUD-Treasury report and
reportsissuedbytheGeneralAccountingOmcein1µµµandioo¡.
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,theyprohibitedmakingthoseloanswithoutregardtotheborrower’sability
tiiii 1 i\i\N:i uN ,,
topay,andrequiredcompaniestoverifyincomeandassets.
o,
Theruleswouldnottake
effectuntilOctober1,iooµ,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. . . .Wewereinthereactivemodebecausethat’swhatthemind-setwas
ofthe‘µosandtheearlyiooos.”Thestronghousingmarketalsoreassuredpeople.Al-
varez noted the long history of low mortgage default rates and the desire to help
peoplewhotraditionallyhadfewdealingswithbanksbecomehomeowners.
o8
STATES: “LONGSTANDING 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 1µµµ, North Carolina led the way, establishing a fee trigger of ,º: that is, for
the most part any mortgage with points and fees at origination of more than ,º of
theloanqualifedas“high-costmortgage”subjecttostateregulations.Thiswascon-
siderablylowerthanthe8ºsetbytheFed’sioo1HOEPAregulations.Otherprovi-
sions addressed an even broader class of loans, banning prepayment penalties for
mortgageloansunder·1,o,oooandprohibitingrepeatedrefnancing,knownasloan
“fipping.”

These rules did not apply to federally chartered thrifts. In 1µµo, the Omce of
ThriftSupervisionreassertedits“long-standingposition”thatitsregulations“occupy
theentirefeldoflendingregulationforfederalsavingsassociations,leavingnoroom
for state regulation.” Exempting states from “a hodgepodge of conficting and over-
lappingstatelendingrequirements,”theOTSsaid,wouldletthriftsdeliver“low-cost
credittothepublicfreefromundueregulatoryduplicationandburden.”Meanwhile,
“the elaborate network of federal borrower-protection statutes” would protect
consumers.
,o
Nevertheless, other states copied North Carolina’s tactic. State attorneys general
launched thousands of enforcement actions, including more than ¡,ooo in iooo
alone.
,1
By ioo,, iµ 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 HSBC—was ordered to pay ·¡8¡ million in penalties and restitu-
tion to consumers. In iooo, a coalition of ¡µ states and the District of Columbia
settledwithAmeriquestfor·¡i,millionandrequiredthecompanytofollowrestric-
tionsonitslendingpractices.
Aswewillsee,however,theseeffortswouldbeseverelyhinderedwithrespectto
nationalbankswhentheOCCinioo¡omciallyjoinedtheOTSinconstrainingstates
,· ii N\Nti \i tii :i : i NQUi i¥ tu\\i : :i uN iiiui1
fromtakingsuchactions.“Thefederalregulators’refusaltoreform[predatory]prac-
ticesandproductsservedasanimplicitendorsementoftheirlegality,”IllinoisAttor-
neyGeneralLisaMadigantestifedtotheCommission.
,i
COMMUNITYLENDING PLEDGES:
“WHAT WE DO IS REAFFIRM OUR INTENTION”
WhileconsumergroupsunsuccessfullylobbiedtheFedformoreprotectionagainst
predatorylenders,theyalsolobbiedthebankstoinvestinandloantolow-andmod-
erate-income communities. The resulting promises were sometimes called “CRA
commitments”or“communitydevelopment”commitments.Thesepledgeswerenot
required under law, including the Community Reinvestment Act of 1µ,,; 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
madebyCitigroupsoonafteritsmergerwithTravelersin1µµ8:a·11,billionlending
and investment commitment, some of which would include mortgages. Later, Citi-
groupmadea·1iobillioncommitmentwhenitacquiredCaliforniaFederalBankin
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
from1µ,,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 nation’s 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,
onlyiiºofthemortgagesmadeunderJPMorgan’s·8oobillion“communitydevel-
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
defnitionsnecessarilyincludedloanstoborrowerswithstrongcredithistories—low
tiiii 1 i\i\N:i uN ,,
incomeandweakorsubprimecreditarenotthesame.Infact,Citigroup’siooipledge
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
JPMorgan’slargestcommitmenttoa
community group was to the Chicago CRA Coalition: ·1i billion in loans over 11
years.Ofloansissuedbetweenioo¡andiooo,fewerthan,ºhavebeenµo-or-more-
daysdelinquent,evenasoflateio1o.
,,
Wachoviamade·1ibillioninmortgageloans
betweenioo¡andiooounderits·1oobillioninunilateralpledges:onlyabout,.¡º
wereevermorethanµodaysdelinquentoverthelifeoftheloan,comparedwithan
estimatednationalaverageof1¡º.
,8
Thebetterperformancewaspartlytheresultof
Wachovia’s lending concentration in the relatively stable Southeast, and partly a re-
fectionofthecreditprofleofmanyoftheseborrowers.
DuringtheearlyyearsoftheCRA,theFederalReserveBoard,whenconsidering
whethertoapprovemergers,gavesomeweighttocommitmentsmadetoregulators.
This changed in February 1µ8µ, when the board denied Continental Bank’s applica-
tiontomergewithGrandCanyonStateBank,sayingthebank’scommitmenttoim-
provecommunityservicecouldnotoffsetitspoorlendingrecord.

InApril1µ8µ,the
FDIC,OCC,andFederalHomeLoanBankBoard(theprecursoroftheOTS)joined
theFedinannouncingthatcommitmentstoregulatorsaboutlendingwouldbecon-
sideredonlywhenaddressing“specifcproblemsinanotherwisesatisfactoryrecord.”
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]saidwe’renotgoingtobeinaposturewheretheFed’sgoingto
besortofcoercingbanksintomakingdealswith . . .communitygroupssothatthey
cangettheirapplicationsthrough.”
81
Infact,therulesimplementingthe1µµ,changestotheCRAmadeitclearthatthe
FederalReservewouldnotconsiderpromisestothirdpartiesorenforceprioragree-
ments with those parties. The rules state “an institution’s record of fulflling these
typesofagreements[withthirdparties]isnotanappropriateCRAperformancecri-
terion.”
8i
Still,thebankshighlightedpastactsandassurancesforthefuture.In1µµ8,
for example, when NationsBank said it was merging with BankAmerica, it also an-
nounceda1o-year,·¡,obillioninitiativethatincludedpledgesof·11,billionforaf-
fordablehousing,·¡obillionforconsumerlending,·18obillionforsmallbusinesses,
and·i,and·1obillionforeconomicandcommunitydevelopment,respectively.
Thismergerwasperhapsthemostcontroversialofitstimebecauseofthesizeof
thetwobanks.TheFedheldfourpublichearingsandreceivedmorethan1,ooocom-
ments.Supporterstoutedthecommunityinvestmentcommitment,whileopponents
decried its lack of specifcity. The Fed’s internal staff memorandum recommending
approvalrepeatedtheFed’sinsistenceonnotconsideringthesepromises:“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.”

Initspublicorderapprovingthemerger,theFederalReservementionedthecom-
mitmentbutthenwentontostatethat“anapplicantmustdemonstrateasatisfactory
recordofperformanceundertheCRAwithoutrelianceonplansorcommitmentsfor
futureaction. . . .TheBoardbelievesthattheCRAplan—whethermadeasaplanor
as an enforceable commitment—has no relevance in this case without the demon-
stratedrecordofperformanceofthecompaniesinvolved.”

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
arrivedatbyworking“closelywithourbusinesspartners”whoprojectcurrentlevels
ofbusinessactivitythatqualifestowardcommunitylendinggoalsintothefutureto
assurethecommunitythatpastlendingandinvestingpracticeswillcontinue.
8o
Inessence,bankspromisedtokeepdoingwhattheyhadbeendoing,andcommu-
nitygroupshadtheassurancethattheywould.
BANK CAPITAL STANDARDS:  “ARBITRAGE”
Although the Federal Reserve had decided against stronger protections for con-
sumers,itinternalizedthelessonsof1µµ8and1µµµ,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,theyintroducedthe“RecourseRule”governinghowmuchcapi-
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,banksheldonly8ºincapitalto
protectagainstlossesonresidualinterestsandanyotherexposurestheyretainedin
securitizations; Keystone and others had been allowed to seriously understate their
risksandtonotholdsumcientcapital.Ironically,becausethenewrulemadethecap-
italchargeonresidualinterests1ooº,itincreasedbanks’incentivetoselltheresidual
interests in securitizations—so 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.
Thecapitalrequirementwouldbedirectlylinkedtotheratingagencies’assessment
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-backedsecuritiesrequiredholdingonly·1.ooincapital(thesameasforsecuri-
tiesbackedbygovernment-sponsoredenterprises).Butthesameamountinvestedin
anythingwithaBBratingrequired·1oincapital,or1otimesmore.
Bankscouldreducethecapitaltheywererequiredtoholdforapoolofmortgages
simplybysecuritizingthem,ratherthanholdingthemontheirbooksaswholeloans.
Ifabankkept·1ooinmortgagesonitsbooks,itmighthavetosetasideabout·,,in-
cluding ·¡ in capital against unexpected losses and ·1 in reserves against expected
losses.Butifthebankcreateda·1oomortgage-backedsecurity,soldthatsecurityin
tranches, and then bought all the tranches, the capital requirement would be about
·¡.1o.
8,
“Regulatorycapitalarbitragedoesplayaroleinbankdecisionmaking,”said
DavidJones,aFedeconomistwhowroteanarticleaboutthesubjectiniooo,inan
FCICinterview.But“itis nottheonlythingthatmatters.”
88
Andafnalcomparison:underbankregulatorycapitalstandards,a·1ootriple-A
corporatebondrequired·8incapital—fvetimesasmuchasthetriple-Amortgage-
backedsecurity.Unlikethecorporatebond,itwasultimatelybackedbyrealestate.
The new requirements put the rating agencies in the driver’s seat. How much
capitalabankhelddependedinpartontheratingsofthesecuritiesitheld.Tying
capitalstandardstotheviewsofratingagencieswouldcomeinforcriticismafter
the crisis began. It was “a dangerous crutch,” former Treasury Secretary Henry
PaulsontestifiedtotheCommission.

However,theFed’sJonesnoteditwasbetter
than the alternative—“to let the banks rate their own exposures.” That alternative
“wouldbeterrible,”hesaid,notingthatbankshadbeencomingtotheFedandar-
guingforlowercapitalrequirementsonthegroundsthattheratingagencieswere
tooconservative.
µo
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
growthinsubprimemortgage–lendingcompanieswithlinesofcredit,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
Icrcigninvcstcrs“Anirrcsisti||cprcµtcppcrtunity” +o,
Mcrtgagcs“Agccd|can” +o,
Icdcra|rcgu|atcrs“Innunityjrcnnanystatc|awsisasigniµcant|cncµt” +++
Mcrtgagcsccuriticsp|aycrs“Va||Strcctwasvcryhungryjcrcurprcduct” ++,
Mccdy’s“Givcna||ankchcck”++:
IannicMacandIrcddicMac“Icssccnpctitivcinthcnarkctp|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
securitize—loanstoolarge,calledjumboloans,andnonprimeloansthatdidn’tmeet
theGSEs’standards.Thenonprimeloanssoonbecamethebiggestpartofthemar-
ket—“subprime”loansforborrowerswithweakcreditand“Alt-A”loans,withcharac-
teristicsriskierthanprimeloans,toborrowerswithstrongcredit.
1
Byioo,andiooo,WallStreetwassecuritizingone-thirdmoreloansthanFannie
and Freddie. In just two years, private-label mortgage-backed securities had grown
morethan¡oº,reaching·1.1,trillioniniooo;,1ºweresubprimeorAlt-A.
i
Manyinvestorspreferredsecuritieshighlyratedbytheratingagencies—orwere
encouraged or restricted by regulations to buy them. And with yields low on other
highlyratedassets,investorshungeredforWallStreetmortgagesecuritiesbackedby
higher-yieldmortgages—thoseloansmadetosubprimeborrowers,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-
readyupµ1ºfrom1µµ,toioo¡,thisfoodofmoneyandthesecuritizationappara-
tushelpedboosthomepricesanother¡oºfromthebeginningofioo¡untilthepeak
in April iooo—even as homeownership was falling. The biggest gains over this pe-
riodwereinthe“sandstates”:placesliketheLosAngelessuburbs(,¡º),LasVegas
(¡oº),andOrlando(,iº).
FOREIGN INVESTORS:
“AN IRRESISTIBLE PROFIT OPPORTUNITY”
FromJuneioo¡throughJuneioo¡,theFederalReservekeptthefederalfundsrate
lowat1ºtostimulatetheeconomyfollowingtheioo1recession.Overthenexttwo
years,asdefationfearswaned,theFedgraduallyraisedratesto,.i,ºin1,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 world’s largest equity bubble with the world’s 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 1µ,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
startsinJanuaryiooo—morethana¡o-yearhigh.
As Greenspan told Congress in ioo,, this was a “conundrum.”
,
One theory
pointed to foreign money. Developing countries were booming and—vulnerable to
fnancial problems in the past—encouraged strong saving. Investors in these coun-
tries placed their savings in apparently safe and high-yield securities in the United
States.FedChairmanBernankecalledita“globalsavingsglut.”
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
foreignomcialpublicentitiesrosefrom·o.otrillionto·1.¡¡trillion;asapercentage
ofU.S.debtheldbythepublic,theseholdingsincreasedfrom18.iºtoi8.8º.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 1µµ8, foreign holdings of GSE securities held steady at the
level of almost 1o years earlier, about ·18o billion. By iooo—just 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.”
µ
Foreign investors sought other high-grade debt almost as safe as Treasuries and
GSEsecuritiesbutwithaslightlyhigherreturn.Theyfoundthetriple-Aassetspour-
ingfromtheWallStreetmortgagesecuritizationmachine.Asoverseasdemanddrove
uppricesforsecuritizeddebt,it“createdanirresistibleproftopportunityfortheU.S.
fnancialsystem:toengineer‘quasi’safedebtinstrumentsbybundlingriskierassets
andsellingtheseniortranches,”Pierre-OlivierGourinchas,aneconomistattheUni-
versityofCalifornia,Berkeley,toldtheFCIC.
1o
PaulKrugman,aneconomistatPrincetonUniversity,toldtheFCIC,“It’shardto
envisageushavinghadthiscrisiswithoutconsideringinternationalmonetarycapital
movements.TheU.S.housingbubblewasfnancedbylargecapitalinfows.Sowere
SpanishandIrishandBalticbubbles.It’sacombinationof,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 8º of mortgage originations in ioo¡ to ioº in
ioo,.

About ,oº of subprime borrowers used hybrid adjustable-rate mortgages
(ARMs) such as i/i8s and ¡/i,s—mortgages whose low “teaser” rate lasts for the
frst two or three years, and then adjusts periodically thereafter.

Prime borrowers
alsousedmorealternativemortgages.ThedollarvolumeofAlt-Asecuritizationrose
almost¡,oºfromioo¡toioo,.
1,
Ingeneral,theseloansmadeborrowers’monthly
.+, ii N\Nti \i tii :i : i NQUi i¥ tu\\i : :i uN iiiui1
1ui \ui1t\ti \\tui Ni .+,
mortgagepaymentsonevermoreexpensivehomesaffordable—atleastinitially.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 principal—any 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
monthlypayment—perhapsdramatically.OptionARMsrosefromiºofmortgages
inioo¡toµºiniooo.
1o
Simultaneously, underwriting standards for nonprime and prime mortgages
weakened. Combined loan-to-value ratios—refecting frst, second, and even third
mortgages—rose.Debt-to-incomeratiosclimbed,asdidloansmadefornon-owner-
occupiedproperties.FannieMaeandFreddieMac’smarketshareshrankfrom,,º
ofallmortgagespurchasedinioo¡to¡iºinioo¡,anddownto¡,ºbyiooo.
1,
Tak-
ing their place were private-label securitizations—meaning 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
called“toxic,”Mozilowoulddescribehis¡o-year-oldcompanytotheCommissionas
havinghelpedi,millionpeoplebuyhomesandpreventedsocialunrestbyextending
loanstominorities,historicallythevictimsofdiscrimination:“Countrywidewasone
ofthegreatestcompaniesinthehistoryofthiscountryandprobablymademoredif-
ferencetosociety,totheintegrityofoursociety,thananycompanyinthehistoryof
America.”

Lending to home buyers was only part of the business. Countrywide’s
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.” Countrywide’s essential business strategy was
“originatingwhatwassalableinthesecondarymarket.”
io
Thecompanysoldorsecu-
ritized8,ºofthe·1.,trillioninmortgagesitoriginatedbetweeniooiandioo,.
Inioo¡,Moziloannouncedaveryaggressivegoalofgaining“marketdominance”
bycapturing¡oºoftheoriginationmarket.
i1
Hisshareatthetimewas1iº.ButCoun-
trywidewasnotunique:Ameriquest,NewCentury,WashingtonMutual,andothersall
pursued loans as aggressively. They competed by originating types of mortgages cre-
atedyearsbeforeasnicheproducts,butnowtransformedintoriskier,mass-marketver-
sions.“Thedefnitionofagoodloanchangedfrom‘onethatpays’to‘onethatcouldbe
sold,’”PatriciaLindsay,formerlyafraudspecialistatNewCentury,toldtheFCIC.
ii
a/aosená,/a,s.“\ájustjort/cejjoráeoilit;”
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;

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
couldn’t really adjust people’s income,” Andrew Davidson, the president of Andrew
Davidson & Co. and a veteran of the mortgage markets, told the FCIC.

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
home’svalueattheresetdate.Iftheborrowercouldnotrefnance,thelenderwould
foreclose—andthenownthehomeinarisingrealestatemarket.
0¡tion\kMs.“0urmost¡rojiteolcmortgegcloen”
Whentheywereoriginallyintroducedinthe1µ8os,optionARMswerenicheprod-
ucts,too,butbyioo¡theytoobecameloansofchoicebecausetheirpaymentswere
lowerthanmoretraditionalmortgages.Duringthehousingboom,manyborrowers
repeatedlymadeonlytheminimumpaymentsrequired,addingtotheprincipalbal-
anceoftheirloaneverymonth.
An early seller of option ARMs was Golden West Savings, an Oakland, Califor-
nia–basedthriftfoundedin1µiµandacquiredin1µo¡byMarionandHerbertSan-
dler. In 1µ,,, 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 1µ81 and
ioo,.
io
Unlikeothermortgagecompanies,GoldenWestheldontothem.
Sandler told the FCIC that Golden West’s option ARMs—marketed as “Pick-a-
Pay”loans—hadthelowestlossesintheindustryforthatproduct.Eveninioo,—the
lastyearpriortoitsacquisitionbyWachovia—whenitsportfoliowasalmostentirely
inoptionARMs,GoldenWest’slosseswerelowbyindustrystandards.Sandlerattrib-
utedGoldenWest’sperformancetoitsdiligenceinrunningsimulationsaboutwhat
.+· ii N\Nti \i tii :i : i NQUi i¥ tu\\i : :i uN iiiui1
would happen to its loans under various scenarios—for example, if interest rates
wentupordownorifhousepricesdropped,º,even1oº.“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.o¡ºtoi.oµºbySeptemberioo8.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,º of its original size, the Pick-a-Pay mortgage would
recastintoanewfxed-ratemortgage.AtCountrywideandWashingtonMutual,the
newloanswouldrecastinaslittleasfveyears,orwhenthebalancehitjust11oºof
the original size. They also offered lower teaser rates—as low as 1º—and loan-to-
value ratios as high as 1ooº. All of these features raised the chances that the bor-
rower’s 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 1µ8o, and in ioo¡, as
citedbytheSenatePermanentSubcommitteeonInvestigations,theoriginatorcon-
ductedastudy“toexplorewhatWashingtonMutualcoulddotoincreasesalesofOp-
tionARMs,ourmostproftablemortgageloan.”
i8
Afocusgroupmadeclearthatfew
customerswererequestingoptionARMsandthat“thisisnotaproductthatsellsit-
self.”

Thestudyfound“thebestsellingpointfortheOptionArm”wastoshowcon-
sumers“howmuchlowertheirmonthlypaymentwouldbebychoosingtheOption
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)Consultantsdon’tbelieveinit . . .anddon’tthink[it’s]good
forthecustomer.You’regoingtohavetochangethemindset.”
¡i
Despitethesechallenges,optionARMoriginationssoaredatWashingtonMutual
from ·¡o billion in ioo¡ to ·o8 billion in ioo¡, when they were more than half of
WaMu’soriginationsandhadbecomethethrift’ssignatureadjustable-ratehomeloan
product.
¡¡
The average FICO score was around ,oo, well into the range considered
“prime,” and about two-thirds were jumbo loans—mortgage loans exceeding the
maximum Fannie Mae and Freddie Mac were allowed to purchase or guarantee.
¡¡
MorethanhalfwereinCalifornia.
¡,
Countrywide’soptionARMbusinesspeakedat·1¡.,billioninoriginationsinthe
secondquarterofioo,,abouti,ºofallitsloansoriginatedthatquarter.
¡o
Butithad
to relax underwriting standards to get there. In July ioo¡, Countrywide decided it
would lend up to µoº of a home’s appraised value, up from 8oº, and reduced the
minimumcreditscoretoaslowasoio.
¡,
Inearlyioo,,Countrywideeasedstandards
again,increasingtheallowablecombinedloan-to-valueratio(includingsecondliens)
toµ,º.
¡8
1ui \ui1t\ti \\tui Ni .+,
The risk in these loans was growing. From ioo¡ to ioo,, the average loan-to-
valueratioroseabout¡º,thecombinedloan-to-valueratioroseaboutoº,anddebt-
to-incomeratioshadrisenfrom¡¡ºto¡8º:borrowerswerepledgingmoreoftheir
incometotheirmortgagepayments.Moreover,o8ºofthesetwooriginators’option
ARMshadlowdocumentationinioo,.
¡µ
Thepercentageoftheseloansmadetoin-
vestors and speculators—that is, borrowers with no plans to use the home as their
primaryresidence—alsorose.
Thesechangesworriedthelendersevenastheycontinuedtomaketheloans.In
Septemberioo¡andAugustioo,,Moziloemailedtoseniormanagementthatthese
loanscouldbring“fnancialandreputationalcatastrophe.”
¡o
Countrywideshouldnot
marketthemtoinvestors,heinsisted.“Payoptionloansbeingusedbyinvestorsisa
purecommercialspec[ulation]loanandnotthetraditionalhomeloanthatwehave
successfullymanagedthroughoutourhistory,”MozilowrotetoCarlosGarcia,CEO
ofCountrywideBank.Speculativeinvestors“shouldgotoChaseorWellsnotus.Itis
alsoimportantforyouandyourteamtounderstandfrommypointofviewthatthere
isnothingintrinsicallywrongwithpayoptionsloansthemselves,theproblemisthe
qualityofborrowerswhoarebeingofferedtheproductandtheabusebythirdparty
originators. . . . [I]f you are unable to fnd sumcient product then slow down the
growthoftheBankforthetimebeing.”
¡1
However, Countrywide’s growth did not slow. Nor did the volume of option
ARMsretainedonitsbalancesheet,increasingfrom·,billioninioo¡to·iobillion
in ioo, and peaking in iooo at ·¡¡ billion.
¡i
Finding these loans very proftable,
through iooo, WaMu also retained option ARMs—more 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 Wells’s decision
not to write option ARMs, even as it originated many other high-risk mortgages.
Thesewere“harddecisionstomakeatthetime,”hesaid,noting“wedidloserevenue,
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 amortizing—which
meant their equity was being eaten away. The percentage of Countrywide’s option
ARMsthatwerenegativelyamortizinggrewfromjust1ºinioo¡to,¡ºinioo,and
thentomorethanµoºbyioo,.
¡,
AtWaMu,itwasiºinioo¡,i8ºinioo¡,and8iº
inioo,.
¡o
Declinesinhousepricesaddedtoborrowers’problems: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-
scribedtheborrowersshewasassistingas“peoplewhogotsteeredordefraudedinto
entering option ARMs with teaser rates or pick-a-pay loans forcing them to pay
into—pay 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
Inácrvritingstenáerás.“\c’rcgoingto/evcto/oláournosc”
Anothershiftwouldhaveseriousconsequences.Fordecades,thedownpaymentfor
aprimemortgagehadbeenioº(inotherwords,theloan-to-valueratio(LTV)had
been 8oº). As prices continued to rise, fnding the cash to put ioº down became
harder,andfromioooon,lendersbeganacceptingsmallerdownpayments.
There had always been a place for borrowers with down payments below ioº.
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 ioº 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.In1µµ1,Congressorderedfederal
regulators to prescribe standards for real estate lending that would apply to banks
andthrifts.Thegoalwasto“curtailabusiverealestatelendingpracticesinorderto
reducerisktothedepositinsurancefundsandenhancethesafetyandsoundnessof
insureddepositoryinstitutions.”
¡µ
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
In1µµµ,regulatorsrevisitedtheissue,ashighLTVlendingwasincreasing.They
tightened reporting requirements and limited a bank’s total holdings of loans with
LTVsaboveµoºthatlackedmortgageinsuranceorsomeotherprotection;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 8oº of the
home’svalueandasecondmortgageforanother1oºorevenioº.Borrowersliked
thesebecausetheirmonthlypaymentswereoftencheaperthanatraditionalmort-
gageplustherequiredmortgageinsurance,andtheinterestpaymentsweretaxde-
ductible. Lenders liked them because the smaller frst mortgage—even without
mortgageinsurance—couldpotentiallybesoldtotheGSEs.
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.Piggybackloans—whichoftenrequired
nothingdown—guaranteedthatmanyborrowerswouldendupwithnegativeequity
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-
mentaskedfor“thoughtsonwhattodowiththis . . .prettycompelling”information.
Nonetheless,NewCenturyincreasedmortgageswithpiggybacksto¡,ºofloanpro-
ductionbytheendofioo,,upfromonlyµºinioo¡.

Theywerenotalone.Across
securitized subprime mortgages, the average combined LTV rose from ,µº to 8oº
betweenioo1andiooo.

Anotherwaytogetpeopleintomortgages—andquickly—wastorequirelessin-
formationoftheborrower.“Statedincome”or“low-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.“IfI’mmakingao,º,,,º,,oºloan-to-value,I’mnot
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,andengineersmade—andifhedidn’t,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-docloansskyrocketedfromlessthaniºtoroughlyµºofalloutstand-
ingloans.
,o
AmongAlt-Asecuritizations,8oºofloansissuediniooohadlimitedor
no documentation.
,,
As William Black, a former banking regulator, testifed before
the FCIC, the mortgage industry’s own fraud specialists described stated income
..+ ii N\Nti \i tii :i : i NQUi i¥ tu\\i : :i uN iiiui1
loansas“anopen‘invitationtofraud’thatjustifedtheindustryterm‘liar’sloans.’”
,8
Speakingoflendinguptoioo,atCitigroup,RichardBowen,aveteranbankerinthe
consumer lending group, told the FCIC, “A decision was made that ‘We’re going to
havetoholdournoseandstartbuyingthestatedproductifwewanttostayinbusi-
ness.’”

Jamie Dimon, the CEO of JP Morgan, told the Commission, “In mortgage
underwriting,somehowwejustmissed,youknow,thathomepricesdon’tgoupfor-
everandthatit’snotsumcienttohavestatedincome.”
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¡,¡µµloansbundledinthisdealwereadjustable-rateandfxed-rateresiden-
tialmortgagesoriginatedbyNewCentury.Theyhadanaverageprincipalbalanceof
·i1o,,¡o—justunderthemedianhomepriceof·ii1,µooiniooo.
o1
Thevastmajor-
ityhada¡o-yearmaturity,andmorethanµoºwereoriginatedinMay,June,andJuly
iooo,justafternationalhomepriceshadpeaked.Morethanµoºwerereportedlyfor
primaryresidences,with¡¡ºforhomepurchasesand¡8ºforcash-outrefnancings.
Theloanswerefromall,ostatesandtheDistrictofColumbia,butmorethanaffth
camefromCaliforniaandmorethanatenthfromFlorida.
oi
About8oºoftheloanswereARMs,andmostofthesewerei/i8sor¡/i,s.Ina
twist,manyofthesehybridARMshadother“affordabilityfeatures”aswell.Forex-
ample,morethanioºoftheARMswereinterest-only—duringthefrsttwoorthree
years,notonlywouldborrowerspayalowerfxedrate,theywouldnothavetopay
anyprincipal.Inaddition,morethan¡oºoftheARMswere“i/i8hybridballoon”
loans, in which the principal would amortize over ¡o years—lowering the monthly
paymentsevenfurther,butasaresultleavingtheborrowerwithafnalprincipalpay-
mentattheendofthe¡o-yearterm.
Thegreatmajorityofthepoolwassecuredbyfrstmortgages;ofthese,¡¡ºhada
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 µ,º and 1ooº.
Raisingtheriskabitmore,¡iºofthemortgageswereno-docloans.Therestwere
“full-doc,”althoughtheirdocumentationwasfullerinsomecasesthaninothers.

In
sum,theloansbundledinthisdealmirroredthemarket:complexproductswithhigh
LTVsandlittledocumentation.Andevenasmanywarnedofthistoxicmix,thereg-
ulatorswerenotonthesamepage.
FEDERAL REGULATORS: “IMMUNITY FROM
MANY STATE LAWS IS A SIGNIFICANT BENEFIT”
Foryears,somestateshadtriedtoregulatethemortgagebusiness,especiallytoclamp
downonthepredatorymortgagesproliferatinginthesubprimemarket.Thenational
thriftsandbanksandtheirfederalregulators—theOmceofThriftSupervision(OTS)
andtheOmceoftheComptrolleroftheCurrency(OCC),respectively—resistedthe
1ui \ui1t\ti \\tui Ni ...
states’effortstoregulatethosenationalbanksandthrifts.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.

Backin1µµotheOTShadissuedrulessayingfederallawpreemptedstatepreda-
torylendinglawsforfederallyregulatedthrifts.
o,
Inioo¡,theOTSreferredtothese
rules in issuing four opinion letters declaring that laws in Georgia, New York, New
Jersey,andNewMexicodidnotapplytonationalthrifts.IntheNewMexicoopinion,
theregulatorpronouncedinvalidNewMexico’sbansonballoonpayments,negative
amortization,prepaymentpenalties,loanfipping,andlendingwithoutregardtothe
borrower’sabilitytorepay.
TheComptrolleroftheCurrencytookthesamelineonthenationalbanksthatit
regulated,offeringpreemptionasaninducementtouseanationalbankcharter.Ina
iooispeech,beforethefnalOCCruleswerepassed,ComptrollerJohnD.HawkeJr.
pointedto“nationalbanks’immunityfrommanystatelaws”as“asignifcantbeneft
ofthenationalcharter—abeneftthattheOCChasfoughthardovertheyearstopre-
serve.”
oo
Inaninterviewthatyear,Hawkeexplainedthatthepotentiallossofregula-
torymarketsharefortheOCC“wasamatterofconcern.”
o,
In August ioo¡ the OCC issued its frst preemptive order, aimed at Georgia’s
mini-HOEPAstatute,andinJanuaryioo¡theOCCadoptedasweepingpreemption
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
morethan·1trillionsaidtheywouldconvertfromstatecharterstonationalcharters,
whichincreasedOCC’sannualbudget1,º.
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,.

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 “,iº 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 . . .wereresponsibleforalmost¡ipercentofsubprimemortgageloans,¡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. . . .Inthewakeofthefederalregulators’pushtocurtailstate
authority,manyofthelargestmortgage-lendersshedtheirstatelicenses
andsoughtshelterbehindtheshieldofanationalcharter.AndIthink
that it is no coincidence that the era of expanded federal preemption
gaverisetotheworstlendingabusesinournation’shistory.
,1
ComptrollerHawkeofferedtheFCICadifferentinterpretation:“Whilesomecrit-
icshavesuggestedthattheOCC’sactionsonpreemptionhavebeenagrabforpower,
thefactisthattheagencyhassimplyrespondedtoincreasinglyaggressiveinitiatives
atthestateleveltocontrolthebankingactivitiesoffederallycharteredinstitutions.”
,i
MORTGAGE SECURITIES PLAYERS:
“WALL STREET WAS VERY HUNGRY FOR OUR PRODUCT”
Subprime and Alt-A mortgage–backed securities depended on a complex supply
chain,largelyfundedthroughshort-termlendinginthecommercialpaperandrepo
market—whichwouldbecomecriticalasthefnancialcrisisbegantounfoldinioo,.
TheseloanswereincreasinglycollateralizednotbyTreasuriesandGSEsecuritiesbut
byhighlyratedmortgagesecuritiesbackedbyincreasinglyriskyloans.Independent
mortgage originators such as Ameriquest and New Century—without access to de-
posits—typicallyreliedonfnancingtooriginatemortgagesfromwarehouselinesof
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·µ,omil-
lion to New Century and more than ·¡., billion to Ameriquest.

Citigroup CEO
ChuckPrincetoldtheFCIChewouldnothaveapproved,hadheknown.“Ifoundout
attheendofmytenure,Ididnotknowitbefore,thatwehadsomewarehouselines
outtosomeoriginators.AndIthinkgettingthatclosetotheoriginationfunction—
beingthatinvolvedintheoriginationofsomeoftheseproducts—issomethingthatI
wasn’tcomfortablewithandthatIdidnotviewasconsistentwiththeprescriptionI
hadlaiddownforthecompanynottobeinvolvedinoriginatingtheseproducts.”

Asearlyas1µµ8,Moody’scalledthenewasset-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-halfofcommercialpapersoldbetween1µµ,andioo1.
1ui \ui1t\ti \\tui Ni ..,
Inioo1,onlyfvemortgagecompaniesborrowedatotalof·¡billionthroughas-
set-backed commercial paper; in iooo, 1µ entities borrowed ·¡¡ billion.
,o
For in-
stance, Countrywide launched the commercial paper programs Park Granada in
ioo¡andParkSiennainioo¡.
,,
ByMayioo,,itwasborrowing·1¡billionthrough
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 ¡º 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
substantialpressureonbanks’balancesheets.
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.oºoftheliquiditysupportbanksprovidedto
theABCPprograms.However,afterstrongpushback—theAmericanSecuritization
Forum,anindustryassociation,calledthatcharge“arbitrary,”andStateStreetBank
complained it was “too conservative”

—regulators in ioo¡ announced a fnal rule
settingthechargeatuptoo.8º,orhalftheamountofthefrstproposal.Growthin
thismarketresumed.
Regulatorychanges—inthiscase,changesinthebankruptcylaws—alsoboosted
growthintherepomarketbytransformingthetypesofrepocollateral.Priortoioo,,
repo lenders had clear and immediate rights to their collateral following the bor-
rower’s 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,these“illiquid,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¡,¡µµmortgagesitwouldselltoCitigroup.
Most of the funds came through repo agreements from a set of banks—including
Morgan Stanley (·¡i¡ million); Barclays Capital, a division of a U.K.-based bank
(·ii1million);BankofAmerica(·1¡,million);andBearStearns(·o¡million).
81
The
fnancingwasprovidedwhenNewCenturyoriginatedthesemortgages;soforabout
twomonths,NewCenturyowedthesebanksapproximately·µ¡omillionsecuredby
themortgages.Another·1imillioninfundingcamefromNewCenturyitself,includ-
ing·¡millionthroughitsowncommercialpaperprogram.OnAugustiµ,iooo,Citi-
grouppaidNewCentury·µ,µmillionforthemortgages(andaccruedinterest),and
NewCenturyrepaidtherepolendersafterkeepinga·i¡million(i.,º)premium.
8i
1/cinvcstorsint/cácel
Investorsformortgage-backedsecuritiescamefromallovertheglobe;whatmadese-
curitization work were the customized tranches catering to every one of them.
CMLTIiooo-NCihad1µtranches,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.

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 specific 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 & Poor’s.
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 & Poor’s; FCIC calculations
1
%
2
1
%
7
8
%
Iigurc ;.:
1ui \ui1t\ti \\tui Ni ..,
·,8imillion,wenttomorethanioinstitutionalinvestorsaroundtheworld,spread-
ing the risk globally.

These triple-A tranches represented ,8º 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 i1º of the total
valueofthesecurity.Iflossesroseabove1ºto¡º(bydesignthethresholdwouldin-
crease over time), investors in the residual tranches would be wiped out, and the
mezzanineinvestorswouldstarttolosemoney.Creatorsofcollateralizeddebtobliga-
tions, or CDOs—discussed in the next chapter—bought most of the mezzanine
tranchesratedbelowtriple-AandnearlyallthoseratedbelowAA.Onlyafewofthe
highest-ratedmezzaninetrancheswerenotputintoCDOs.Forexample,CheyneFi-
nanceLimitedpurchased·,millionofthetopmezzaninetranche.Cheyne—astruc-
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,º,ioº,oreven¡oº.Citi-
groupretainedpartoftheresidualor“frst-loss”tranches,sharingtherestwithCap-
markFinancialGroup.
88
“tom¡cnsetcávcr;vcll”
Thebusinessofstructuring,selling,anddistributingthisdeal,andthethousandslike
it, was lucrative for the banks. The mortgage originators profted when they sold
loansforsecuritization.

Someofthisproftfoweddowntoemployees—particularly
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 Century’s Patricia Lindsay told the
FCIC. And volume mattered more than quality. She noted, “Wall Street was very
hungryforourproduct.Wehadourloanssoldthreemonthsinadvance,beforethey
wereevenmadeatonepoint.”
µo
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:todrive“growthinhighermarginproducts(OptionARM,AltA,HomeEquity,
Subprime),” “recruit and leverage seasoned Option ARM sales force,” and “maintain a
compensationstructurethatsupportsthehighmarginproductstrategy.”
µ1
Afterstructuringasecurity,anunderwriter,oftenaninvestmentbank,marketed
and sold it to investors. The bank collected a percentage of the sale (generally be-
tween o.iº and 1.,º) as discounts, concessions, or commissions.
µi
For a ·1 billion
deallikeCMLTIiooo-NCi,a1ºfeewouldearnCitigroup·1omillion.Inthiscase,
though, Citigroup instead kept parts of the residual tranches. Doing so could yield
largeproftsaslongasthedealperformedasexpected.
OptionsGroup,whichcompilescompensationfguresforinvestmentbanks,exam-
inedthemortgage-backedsecuritiessalesandtradingdesksat11commercialandin-
vestmentbanksfromioo,toioo,.
µ¡
Itfoundthatassociateshadaverageannualbase
salariesof·o,,oooto·µo,ooofromioo,throughioo,,butreceivedbonusesthatcould
wellexceedtheirsalaries.Onthenextrung,vicepresidentsaveragedbasesalariesand
bonusesfrom·ioo,oooto·1,1,o,ooo.Directorsaveraged·oi,,oooto·1,oi,,ooo.
µ¡
At
thetopwastheheadoftheunit.Forexample,iniooo,DowKim,theheadofMerrill’s
Global Markets and Investment Banking segment, received a base salary of ·¡,o,ooo
plusa·¡,millionbonus,apackagesecondonlytoMerrillLynch’sCEO.
µ,
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;andtheratingagencies’judgmentwasbakedintocollateralagreements
andotherfnancialcontracts.Toexaminetheratingprocess,theCommissionfocused
onMoody’sInvestorsService,thelargestandoldestofthethreeratingagencies.
The rating of structured fnance products such as mortgage-backed securities
made up close to half of Moody’s rating revenues in ioo,, iooo, and ioo,.
µo
From
ioootoioo,,revenuesfromratingsuchfnancialinstrumentsincreasedmorethan
fourfold.
µ,
Buttheratingprocessinvolvedmanyconficts,whichwouldcomeintofo-
cusduringthecrisis.
Todoitswork,Moody’sratedmortgage-backedsecuritiesusingmodelsbased,in
part,onperiodsofrelativelystrongcreditperformance.Moody’sdidnotsumciently
account for the deterioration in underwriting standards or a dramatic decline in
homeprices.AndMoody’sdidnotevendevelopamodelspecifcallytotakeintoac-
count the layered risks of subprime securities until late iooo, after it had already
ratednearly1µ,ooosubprimesecurities.
µ8
“Int/cousincssjorcvcrmorc”
Credit ratings have been linked to government regulations for three-quarters of a
century.
µµ
In 1µ¡1, 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.In1µ,1,theNationalAssociationofInsuranceCom-
missionersadoptedhighercapitalrequirementsonlower-ratedbondsheldbyinsur-
ers.
1oo
But the watershed event in federal regulation occurred in 1µ,,, when the
Securities and Exchange Commission modifed its minimum capital requirements
forbroker-dealerstobasethemoncreditratingsbya“nationallyrecognizedstatisti-
calratingorganization”(NRSRO);atthetime,thatwasMoody’s,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-
mentActof1µ8¡permittedfederal-andstate-charteredfnancialinstitutionstoin-
vestinmortgage-relatedsecuritiesifthesecuritieshadhighratingsfromatleastone
ratingagency.“Lookatthelanguageoftheoriginalbill,”LewisRanieritoldtheFCIC.
“Itrequiresarating. . . .Itputtheminthebusinessforevermore.Itbecameoneofthe
biggest,ifnotthebiggest,business.”
1oi
AsEricKolchinsky,aformerMoody’smanag-
ingdirector,wouldsummarizethesituation,“theratingagenciesweregivenablank
check.”
1o¡
Theagenciesthemselves wereabletoavoidregulationfordecades.Beginningin
1µ,,,theSEChadtoapproveacompany’sapplicationtobecomeanNRSRO—butif
approved,acompanyfacednofurtherregulation.Morethan¡oyearslater,theSEC
gotlimitedauthoritytooverseeNRSROsintheCreditRatingAgencyReformActof
iooo. That law, taking effect in June ioo,, focused on mandatory disclosure of the
ratingagencies’methodologies;however,thelawbarredtheSECfromregulating“the
substanceofthecreditratingsortheproceduresandmethodologies.”
1o¡
Many investors, such as some pension funds and university endowments, relied
oncreditratingsbecausetheyhadneitheraccesstothesamedataastheratingagen-
ciesnorthecapacityoranalyticalabilitytoassessthesecuritiestheywerepurchasing.
As Moody’s former managing director Jerome Fons has acknowledged, “Subprime
[residentialmortgage–backedsecurities]andtheiroffshootsofferlittletransparency
aroundcompositionandcharacteristicsoftheloancollateral. . . .Loan-by-loandata,
thehighestlevelofdetail,isgenerallynotavailabletoinvestors.”
1o,
Others,evenlarge
1ui \ui1t\ti \\tui Ni ..,
fnancialinstitutions,reliedontheratings.Still,someinvestorswhodidtheirhome-
workwereskepticaloftheseproductsdespitetheirratings.ArnoldCattani,chairman
ofMissionBankinBakersfeld,California,describeddecidingtosellthebank’shold-
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:Andhecouldn’tanswer
thequestion.AndItoldhimtosellthem,sellallofthem,then,because
wedidn’tunderstandit,andIdon’tknowthatwehadthecapabilityto
understandthefnancialcomplexities;didn’twantanypartofit.
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. Moody’s standard disclaimer reads “The ratings . . . are, and must be
construedsolelyas,statementsofopinionandnotstatementsoffactorrecommen-
dationstopurchase,sell,orholdanysecurities.”GaryWitt,aformerteammanaging
directoratMoody’s,toldtheFCIC,“Peopleexpecttoomuchfromratings . . .invest-
mentdecisionsshouldalwaysbebasedonmuchmorethanjustarating.”
1o,
“Ivcr;t/ingoutt/cclc¡/entsittingont/cteolc”
Theratingswereintendedtoprovideameansofcomparingrisksacrossassetclasses
andtime.Inotherwords,theriskofatriple-Aratedmortgagesecuritywassupposed
tobesimilartotheriskofatriple-Aratedcorporatebond.
Since the mid-1µµos, Moody’s has rated tranches of mortgage-backed securities
usingthreemodels.Thefrst,developedin1µµo,ratedresidentialmortgage–backed
securities.Inioo¡,Moody’screatedanewmodel,M¡Prime,torateprime,jumbo,
and Alt-A deals. Only in the fall of iooo, when the housing market had already
peaked,diditdevelopitsmodelforratingsubprimedeals,calledM¡Subprime.
1o8
Themodelsincorporatedfrm-andsecurity-specifcfactors,marketfactors,regu-
latory and legal factors, and macroeconomic trends. The M¡ Prime model let
Moody’sautomatemoreoftheprocess.AlthoughMoody’sdidnotsampleorreview
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-
wardatapproximately¡ºperyear.
1oµ
Themodelputlittleweightonthepossibility
priceswouldfallsharplynationwide.JaySiegel,aformerMoody’steammanagingdi-
rectorinvolvedindevelopingthemodel,toldtheFCIC,“Theremayhavebeen[state-
level]componentsofthisrealestatedropthatthestatisticswouldhavecovered,but
.z+ ii N\Nti \i tii :i : i NQUi i¥ tu\\i : :i uN iiiui1
the¡8ºnationaldrop,stayingdownoverthisshortbutmultiple-yearperiod,ismore
stressfulthanthestatisticscallfor.”Evenashousingpricesrosetounprecedentedlev-
els,Moody’sneveradjustedthescenariostoputgreaterweightonthepossibilityofa
decline.AccordingtoSiegel,inioo,,“Moody’spositionwasthattherewasnota . . .
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 Moody’s credit rat-
ingsarederivedsolelyfromtheapplicationofamathematicalprocessormodel.This
isnotthecase. . . .Thecreditratingprocessinvolvesmuchmore—mostimportantly,
the exercise of independent judgment by members of the rating committee. Ulti-
mately,ratingsaresubjectiveopinionsthatrefectthemajorityviewofthecommit-
tee’smembers.”
11i
AsRogerStein,aMoody’smanagingdirector,noted,“Overall,the
modelhastocontemplateeventsforwhichthereisnodata.”
11¡
Afterratingsubprimedealswiththe1µµomodelforyears,inioooMoody’sintro-
duced a parallel model for rating subprime mortgage–backed securities. Like M¡
Prime, the subprime model ran the mortgages through 1,i,o scenarios.
11¡
Moody’s
omcialstoldtheFCICtheyrecognizedthatstressscenarioswerenotsumcientlyse-
vere,sotheyappliedadditionalweighttothemoststressfulscenario,whichreduced
the portion of each deal rated triple-A. Stein, who helped develop the subprime
model,saidtheoutputwasmanually“calibrated”tobemoreconservativetoensure
predicted losses were consistent with analysts’ “expert views.” Stein also noted
Moody’sconcernaboutasuitablynegativestressscenario;forexample,asonestep,
analyststookthe“singleworstcase”fromtheM¡Subprimemodelsimulationsand
multiplieditbyafactorinordertoadddeterioration.
11,
Moody’sdidnot,however,sumcientlyaccountforthedeterioratingqualityofthe
loansbeingsecuritized.FonsdescribedthisproblemtotheFCIC:“Isatonthishigh-
levelStructuredCreditcommittee,whichyou’dthinkwouldbedealingwithsuchis-
sues[ofdecliningmortgage-underwritingstandards],andneveroncewasitraisedto
thisgrouporputonouragendathatthedeclineinqualitythatwasgoingintopools,
theimpactpossiblyonratings,otherthings. . . .Wetalkedabouteverythingbut,you
know,theelephantsittingonthetable.”
11o
TorateCMLTIiooo-NCi,oursampledeal,Moody’sfrstuseditsmodeltosimu-
latelossesinthemortgagepool.Thoseestimates,inturn,determinedhowbigthejun-
iortranchesofthedealwouldhavetobeinordertoprotecttheseniortranchesfrom
losses.Inanalyzingthedeal,theleadanalystnoteditwassimilartoanotherCitigroup
dealofNewCenturyloansthatMoody’shadratedearlierandrecommendedthesame
amount.
11,
Thenthedealwastweakedtoaccountforcertainriskiertypesofloans,in-
cluding interest-only mortgages.
118
For its efforts, Moody’s was paid an estimated
·io8,ooo.
11µ
(S&Palsoratedthisdealandreceived·1¡,,ooo.)
1io
As we will describe later, three tranches of this deal would be downgraded less
thanayearafterissuance—partofMoody’smassdowngradeonJuly1o,ioo,,when
housing prices had declined by only ¡º. In October ioo,, the M¡–M11 tranches
1ui \ui1t\ti \\tui Ni .z.
weredowngradedandbyioo8,allthetrancheshadbeendowngraded.Ofallmort-
gage-backed securities it had rated triple-A in iooo, Moody’s downgraded ,¡º 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
moreonaccountingandotheroperationalissuesthanonFannie’sandFreddie’sin-
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.Freddie’s
board ousted most top managers, including Chairman and CEO Leland Brendsel,
President and COO David Glenn, and CFO Vaughn Clarke.
1i¡
In December ioo¡,
FreddieagreedwithOFHEOtopaya·1i,millionpenaltyandcorrectgovernance,
internal controls, accounting, and risk management. In January ioo¡, OFHEO di-
rectedFreddietomaintain¡oºmorethanitsminimumcapitalrequirementuntilit
reduced operational risk and could produce timely, certifed fnancial statements.
FreddieMacwouldsettleshareholderlawsuitsfor·¡1omillionandpay·,omillion
inpenaltiestotheSEC.
Fanniewasnext.InSeptemberioo¡,OFHEOdiscoveredviolationsofaccounting
rulesthatcalledintoquestionpreviousflings.Iniooo,OFHEOreportedthatFannie
hadoverstatedearningsfrom1µµ8throughiooiby·11billionandthatit,too,had
manipulatedaccountinginwaysinfuencedbycompensationplans.
1i,
OFHEOmade
Fannieimproveaccountingcontrols,maintainthesame¡oºcapitalsurplusimposed
on Freddie, and improve governance and internal controls. Fannie’s 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 management’s 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 mortgage–backed securities
(PLS)issuedbyWallStreetincreasedfrom·8,billioninioo1to·¡o,billioninioo,
(showninfgure,.¡);thevalueofAlt-Amortgage–backedsecuritiesincreasedfrom
·11 billion to ·¡¡i billion. Starting in ioo1 for Freddie and iooi for Fannie, the
GSEs—particularlyFreddie—becamebuyersinthismarket.Whileprivateinvestors
always bought the most, the GSEs purchased 1o.,º of the private-issued subprime
mortgage–backedsecuritiesinioo1.Thesharepeakedat¡oºinioo¡andthenfell
back to i8º in ioo8. The share for Alt-A mortgage–backed 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 securities—disproportionately from their purchases of Alt-A securities. By
the third quarter of io1o, total impairments on securities totaled ·¡o billion at the
twocompanies—enoughtowipeoutnearlyooºoftheirpre-crisiscapital.
1i8
OFHEO knew about the GSEs’ purchases of subprime and Alt-A mortgage–
backedsecurities.Initsioo¡examination,theregulatornotedFreddie’spurchasesof
these securities. It also noted that Freddie was purchasing whole mortgages with
“higherriskattributeswhichexceededtheEnterprise’smodelingandcostingcapabil-
ities,” including “No Income/No Asset loans” that introduced “considerable risk.”
OFHEO reported that mortgage insurers were already seeing abuses with these
loans.
1iµ
Buttheregulatorconcludedthatthepurchasesofmortgage-backedsecuri-
tiesandriskiermortgageswerenota“signifcantsupervisoryconcern,”andtheex-
amination focused more on Freddie’s efforts to address accounting and internal
defciencies.
1¡o
OFHEO included nothing in Fannie’s report about its purchases of
subprimeandAlt-Amortgage–backedsecurities,anditscreditriskmanagementwas
deemedsatisfactory.
1¡1
ThereasonsfortheGSEs’purchasesofsubprimeandAlt-Amortgage–backedse-
curities have been debated. Some observers, including Alan Greenspan, have linked
theGSEs’purchasesofprivatemortgage–backedsecuritiestotheirpushtofulflltheir
highergoalsforaffordablehousing.TheformerFedchairmanwroteinaworkingpa-
persubmittedaspartofhistestimonytotheFCICthatwhentheGSEswerepressedto
“expand ‘affordable housing commitments,’ they chose to meet them by investing
heavily in subprime securities.”
1¡i
Using data provided by Fannie Mae and Freddie
Mac, the FCIC examined how single-family, multifamily, and securities purchases
contributedtomeetingtheaffordablehousinggoals.Inioo¡andioo¡,FannieMae’s
single-andmultifamilypurchasesalonemeteachofthegoals;inotherwords,theen-
terprisewouldhavemetitsobligationswithoutbuyingsubprimeorAlt-Amortgage–
backedsecurities.Infact,noneofFannieMae’sioo¡purchasesofsubprimeorAlt-A
securitieswereeversubmittedtoHUDtobecountedtowardthegoals.
Beforeioo,,,oºorlessoftheGSEs’loanpurchaseshadtosatisfytheaffordable
housing goals. In ioo, the goals were increased above ,oº; 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 subgoals—specifc targets requiring the GSEs to
purchaseorguaranteeloanstopurchasehomes.Inioo,,Fanniemissedoneofthese
subgoalsandwouldhavemissedasecondwithoutthesecuritiespurchases;iniooo,
thesecuritiespurchaseshelpedFanniemeetthosetwosubgoals.
ThepatternisthesameatFreddieMac,alargerpurchaserofnon-agencymort-
gage–backedsecurities.
1¡¡
EstimatesbytheFCICshowthatfromioo¡throughiooo,
FreddiewouldhavemettheaffordablehousinggoalswithoutanypurchasesofAlt-A
orsubprimesecurities,butusedthesecuritiestohelpmeetsubgoals.
1¡,
RobertLevin,theformerchiefbusinessomcerofFannieMae,toldtheFCICthat
buying private-label mortgage–backed securities “was a moneymaking activity—it
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.”
1¡o
Mark Winer, the head of Fannie’s 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 mortgage–backed securities
wereoftenissuedtoborrowersthatcouldhelpFannieandFreddiefulflltheirgoals,
themortgagesbehindtheAlt-Asecuritieswerenot.Alt-Amortgageswerenotgener-
allyextendedtolower-incomeborrowers,andtheregulationsprohibitedmortgages
toborrowerswithunstatedincomelevels—ahallmarkofAlt-Aloans—fromcount-
ingtowardaffordabilitygoals.
1¡8
LevintoldtheFCICthattheybelievedthatthepur-
chaseofAlt-Asecurities“didnothaveanetpositiveeffectonFannieMae’shousing
goals.”
1¡µ
Instead,theyhadtobeoffsetwithmoremortgagesforlow-andmoderate-
incomeborrowerstomeetthegoals.
FannieandFreddiecontinuedtopurchasesubprimeandAlt-Amortgage–backed
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,theFederalReserve’spoliciesandpronouncements
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.Moody’s,the
Commission’scasestudyinthisarea,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
CDOs“Vccrcatcdthcinvcstcr” +:,
BcarStcarns’shcdgcjunds“Itjuncticncdµncupunti|cncday
itjustdidn’tjuncticn”+,,
Citigrcup’s|iquidityputs“Apctcntia|ccnµictcjintcrcst” +,,
AIG“Gc|dcngccscjcrthccntircStrcct” +,,
Gc|dnanSachs“Mu|tip|icdthccjjcctscjthccc||apscinsu|princ”+,:
Mccdy’s“Achicvcdthrcughscnca|chcny” +,e
SLC“It’sgcingtc|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,they“createdthe
investor.”
1
Thatis,theybuiltnewsecuritiesthatwouldbuythetranchesthathadbe-
comehardertosell.Bankerswouldtakethoselowinvestment-gradetranches,largely
ratedBBBorA,frommanymortgage-backedsecuritiesandrepackagethemintothe
new securities—CDOs. Approximately 8oº 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,weusetheterm“CDOs”torefertocashCDOsbacked
byasset-backedsecurities(suchasmortgage-backedsecurities),alsoknownasABSCDOs.
The securities frms argued—and the rating agencies agreed—that if they pooled
manyBBB-ratedmortgage-backedsecurities,theywouldcreateadditionaldiversif-
cation benefts. The rating agencies believed that those diversifcation benefts were
signifcant—thatifonesecuritywentbad,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
firm select and purchase assets,
such as some of the lower-rated
tranches of mortgage-backed
securities.
2. Pool
The CDO manager
and securities firm
pool various assets
in an attempt to
get diversification
benefits.
3. CDO tranches
Similar to
mortgage-backed
securities, the CDO
issues securities in
tranches that vary
based on their place in
the cash flow waterfall.
next…
etc.
next
claim…
First claim to cash flow 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,º 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 humming—the CDO managers and
underwriters who packaged and sold the securities, the rating agencies that gave
mostofthemsterlingratings,andtheguarantorswhowroteprotectionagainsttheir
defaulting—collected 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-
related—meaning 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 Milken’s Drexel Burnham Lambert assembled the frst rated collateralized
debt obligation in 1µ8, out of different companies’ junk bonds. The strategy made
sense—pooling 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 spread—the difference between the interest that the CDO received on the
bondsorloansthatitheldandtheinterestthattheCDOpaidtoinvestors.Throughout
the1µµos,CDOmanagersgenerallypurchasedcorporateandemergingmarketbonds
and bank loans. When the liquidity crisis of 1µµ8 drove up returns on asset-backed
1ui tiu \\tui Ni .z,
securities,PrudentialSecuritiessawanopportunityandlaunchedaseriesofCDOsthat
combineddifferentkindsofasset-backedsecuritiesintooneCDO.These“multisector”
or“ABS”securitieswerebackedbymortgages,mobilehomeloans,aircraftleases,mu-
tual fund fees, and other asset classes with predictable income streams. The diversity
wassupposedtoprovideyetanotherlayerofsafetyforinvestors.
MultisectorCDOswentthroughatoughpatchwhensomeoftheasset-backedse-
curitiesinwhichtheyinvestedstartedtoperformpoorlyiniooi—particularlythose
backedbymobilehomeloans(afterborrowersdefaultedinlargenumbers),aircraft
leases(afterµ/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 mortgage–backed 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 mortgage–backed 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.
µ
Just as mortgage-backed securities provided the cash to originate mort-
gages,nowCDOswouldprovidethecashtofundmortgage-backedsecurities.Also
byioo¡,mortgage-backedsecuritiesaccountedformorethanhalfofthecollateralin
CDOs, up from ¡,º in iooi.
1o
Sales of these CDOs more than doubled every year,
jumpingfrom·¡obillioninioo¡to·ii,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 frms—Merrill Lynch, Goldman Sachs, and the securities arm of
Citigroup—accounted for more than ¡oº 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-headofCitigroup’sCDOdesk,toldtheFCIC.“Wespenta
lotofefforttohavepeopleinplacetoeducate,topitchstructuredproducts.So,itwas
alotofeffort,about1oopeople.AndIpresumeourcompetitorsdidthesame.”

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-upperiod—sixtoninemonthswhenthefrmwasaccumulatingthemortgage-
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.

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-
cies’modelshadthecorrectunderlyingassumptions.That“wasnotwhatwebrought
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-
agersrangedfromindependentinvestmentfrmssuchasChau’stounitsoflargeasset
managementcompaniessuchasPIMCOandBlackrock.
CDOmanagersreceivedperiodicfeesbasedonthedollaramountofassetsinthe
CDO and in some cases on performance. On a percentage basis, these may have
looked small—sometimes measured in tenths of a percentage point—but 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
rangeof·ooo,oootoamilliondollarsperyearfora·1billiondollardeal.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.“You’dhearstatements
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 times—the enormous proliferation of CDO
managers— . . .becauseitwasverylucrative.”
18
CDOmanagersindustry-wideearned
atleast·1.,billioninmanagementfeesbetweenioo¡andioo,.

The role of the rating agencies was to provide basic guidelines on the collateral
and the structure of the CDOs—that is, the sizes and returns of the various
tranches—in 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
tworatingagencieswouldprovideratingsandreceivethosefees—althoughtheviews
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 tranches—including those rated A—and, especially, those rated BBB, the
lowest and riskiest investment-grade rating—to other CDO managers, to be pack-
agedintootherCDOs.
ii
ItwascommonforCDOstobestructuredwith,ºor1,º
oftheircashinvestedinotherCDOs;CDOswithasmuchas8oºto1ooºoftheir
cashinvestedinotherCDOsweretypicallyknownas“CDOssquared.”
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
worldrosefrom·¡¡billionto·o1billion.

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,.

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
builtMerrill’sCDObusiness.
io
KlerosIII,launchediniooo,purchasedandheld·µ.o
millioninsecuritiesfromtheA-ratedM,trancheofCitigroup’ssecurity,alongwith
18,juniortranchesofothermortgage-backedsecurities.Intotal,itowned·µ,,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 ¡,º were rated BBB or lower, 1oº A,
and the rest higher than A. To fund those purchases, Kleros III issued ·1 billion of
bondstoinvestors.AswastypicalforthistypeofCDOatthetime,roughly88ºof
theKlerosIIIbondsweretriple-A-rated.Atleasthalfofthebelow-triple-Atranches
issuedbyKlerosIIIwentintootherCDOs.
i,
“Mot/cr’smilktot/c . . .merkct”
ThegrowthofCDOshadimportantimpactsonthemortgagemarketitself.CDOman-
agerswhowereeagertoexpandtheassetsthattheyweremanaging—onwhichtheirin-
comewasbased—werewillingtopayhighpricestoaccumulateBBB-ratedtranchesof
mortgage-backed securities. This “CDO bid” pushed up market prices on those
tranches,pricingoutofthemarkettraditionalinvestorsinmortgage-backedsecurities.
Informedinstitutionalinvestorssuchasinsurancecompanieshadpurchasedthe
private-label mortgage–backed securities issued in the 1µµos. These securities were
typicallyprotectedfromlossesbybondinsurers,whohadanalyzedthedealsaswell.
Beginninginthelate1µµos,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. “They’re mostly not mortgage professionals, not real estate professionals.
Theyarederivativesfolks.”
i8
Indeed,Chau,theCDOmanager,portrayedhisjobascreatingstructuresthatrat-
ingagencieswouldapproveandinvestorswouldbuy,andmakingsurethemortgage-
backedsecuritiesthathebought“metindustrystandards.”Hesaidthathereliedon
the rating agencies. “Unfortunately, what lulled a lot of investors, and I’m in that
camp as well, what lulled us into that sense of comfort was that the rating stability
wassosolidandthatitwassoconsistent.Imean,theratingagenciesdidaverygood
jobofmakingeverythingconsistent.”

CDOproductionwaseffectivelyonautopilot.
“Mortgage traders speak lovingly of ‘the CDO bid.’ It is mother’s 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
UBS’sGlobalCDOGroupagreed,notingthatCDOs“havenowbecomebulliesin
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 leverage—that is, on investing borrowed money. Leverage increases
proftsingoodtimes,butalsoincreaseslossesinbadtimes.Themortgageitselfcre-
atesleverage—particularlywhentheloanisofthelowdownpayment,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,”Citigroup’sDomingueztoldtheFCIC.
¡¡
Even the investor that bought the CDOs could use leverage. Structured invest-
mentvehicles—atypeofcommercialpaperprogramthatinvestedmostlyintriple-A-
rated securities—were leveraged an average of just under 1¡-to-1: in other words,
theseSIVswouldhold·1¡inassetsforeverydollarofcapital.
¡¡
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,“We’llseesomeproblemsdowntheroad.”
¡,
BEAR STEARNS’ S HEDGE FUNDS: “IT FUNCTIONED FINE
UP UNTIL ONE DAY IT JUST DIDN’ T FUNCTION”
BearStearns,thesmallestofthefvelargeinvestmentbanks,starteditsassetmanage-
mentbusinessin1µ8,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
theendofioooRalphCiomwasmanaging11CDOswith·18.¡billioninassetsand
i hedge funds with ·18 billion in assets.
¡o
Although Bear Stearns owned BSAM,
Bear’smanagementexercisedlittlesupervisionoveritsbusiness.
¡,
Theeventualfail-
ureofCiom’stwolargemortgage-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
µoºofassetstoberatedeitherAAAorAA.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,
toutingtheEnhancedLeveragefundas“aleveredversionofthe[HighGrade]fund”
thattargetedleverageof1ito1.
¡µ
Attheendofiooo,theHigh-Gradefundcontained
·8.obillioninassets(using·o.µbillionofhishedgefundinvestors’moneyand·,.,
billion in borrowed money). The Enhanced Leverage Fund had ·µ.¡ billion (using
·o.µbillionfrominvestorsand·8.,billioninborrowedmoney).
¡o
BSAM fnanced these asset purchases by borrowing in the repo markets, which
wastypicalforhedgefunds.AsurveyconductedbytheFCICidentifedatleast·i,,
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,aninvestorbuyingastockonmargin—meaning
withborrowedmoney—mighthavetoputup,ocentsonthedollar,withtheother
,o cents loaned by his or her stockbroker, for a leverage ratio of i to 1. A home-
ownerbuyingahousemightmakea1oºdownpaymentandtakeoutamortgage
fortherest,aleverageratioof1oto1.Bycontrast,repolendingallowedaninvestor
tobuyasecurityformuchlessoutofpocket—inthecaseofaTreasurysecurity,an
investor may have to put in only o.i,º, borrowing µµ.,,º from a securities firm
(¡oo to 1). In the case of a mortgage-backed security, an investor might pay ,º
(ioto1).
¡i
Withthisamountofleverage,a,ºchangeinthevalueofthatmortgage-backed
securitycandoubletheinvestor’smoney—orlosealloftheinitialinvestment.
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.Ciom’s
funds,forexample,tooktheriskthatitsrepolenderswoulddecidenottoextend,or
“roll,”therepolinesonanygivenday.Yetmoreandmore,repolenderswereloaning
money to funds like Ciom’s, rolling the debt nightly, and not worrying very much
abouttherealqualityofthecollateral.
The frms loaning money to Ciom’s hedge funds were often also selling them
mortgage-relatedsecurities,andthehedgefundspledgedthosesamesecuritiestose-
curetheloans.
¡¡
Ifthemarketvalueofthecollateralfell,therepolenderscouldand
woulddemandmorecollateralfromthehedgefundtobacktherepoloan.Thisdy-
namicwouldplayapivotalroleinthefateofmanyhedgefundsinioo,—mostspec-
tacularlyinthecaseofCiom’sfunds.“Therepomarket,Imeanitfunctionedfneup
untilonedayitjustdidn’tfunction,”CiomtoldtheFCIC.Uptothatpoint,hishedge
fundscouldbuybillionsofdollarsofCDOsonborrowedmoneybecauseofthemar-
ket’sbullishnessaboutmortgageassets,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.Whenhehadreachedhisfrm’sinternalinvestmentlimits,
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 Ciom’s 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.
BSAM’sfagshipCDOs—dubbedKlioI,II,andIII—werecreatedinrapidsucces-
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,ºandi¡ºannually,assumingnodefaultsontheun-
derlying collateral.
¡µ
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,Ciom’sfundsearnedhealthyreturnsforatime:theHigh-Grade
fundhadreturnsof1,ºinioo¡,1oºinioo,,andµºinioooafterfees.
,o
Ciomand
Tanninmademillionsbeforethehedgefundscollapsedinioo,.Ciomwasrewarded
with total compensation worth more than ·¡1 million from ioo, to ioo,. In ioo,,
theyearthetwohedgefundsfledforbankruptcy,Ciommademorethan·1,.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-termleveragethathadinfatedCiom’s
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,chargedwithhelpingEnron—before
that company fled for bankruptcy in ioo1—use 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,hehadalreadydecidedtoturn“thecompany’sfocusfromanac-
quisition-drivenstrategytomoreofabalancedstrategyinvolvingorganicgrowth.”
,,
RobertRubin,aformertreasurysecretaryandformerGoldmanSachsco-CEOwho
wasatthattimechairmanoftheExecutiveCommitteeofCitigroup’sboardofdirec-
tors, recommended that Citigroup increase its risk taking—assuming, he told the
FCIC,thatthefrmmanagedthoserisksproperly.
,o
Citigroup’sinvestmentbanksubsidiarywasanaturalareaforgrowthaftertheFed
and then Congress had done away with restrictions on activities that could be pur-
suedbyinvestmentbanksamliatedwithcommercialbanks.Oneopportunityamong
manywastheCDObusiness,whichwasjustthentakingoffamidtheboomingmort-
gagemarket.
In ioo¡, Citi’s CDO desk was a tiny unit in the company’s 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 ioo¡—close 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
reissuethepapertoinvestorsregularly—usuallywithindaysorweeks—forthelifeof
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 (Citigroup’s national bank subsidiary) pro-
vided assurances to investors, in the form of liquidity puts. In selling the liquidity
put,foranongoingfeethebankwouldbeonthehooktostepinandbuythecom-
mercialpaperiftherewerenobuyerswhenitmaturedorifthecostoffundingrose
byapredeterminedamount.

TheCDOteamatCitigrouphadjumpedintothemarketinJulyioo¡witha·1.,
billionCDOnamedGrenadierFundingthatincludeda·1.¡billiontranchebackedby
a liquidity put from Citibank.
oo
Over the next three years, Citi would write liquidity
putson·i,billionofcommercialpaperissuedbyCDOs,
o1
morethananyothercom-
pany.BSAM’sthreeKlioCDOs,whichCitigrouphadunderwritten,accountedforjust
over·1obillionofthistotal,
oi
alargenumberthatwouldnotbodewellforthebank.
But initially, this “strategic initiative,” as Dominguez called it, was very proftable for
Citigroup.TheCDOdeskearnedroughly1ºofthetotaldealvalueinstructuringfees
forCitigroup’sinvestmentbankingarm,orabout·1omillionfora·1billiondeal.In
addition,Citigroupwouldgenerallychargebuyerso.1oºtoo.ioºinpremiumsannu-
allyfortheliquidityputs.

Inotherwords,foratypical·1billiondeal,Citibankwould
receive·1to·imillionannuallyontheliquidityputsalone—practicallyfreemoney,it
seemed,becausethetradingdeskbelievedthattheseputswouldneverbetriggered.

Ineffect,theliquidityputwasyetanotherhighlyleveragedbet:acontingentlia-
bilitythatwouldbetriggeredinsomecircumstances.Priortotheioo¡changeinthe
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 Citigroup’s fnancial
modelsestimatedonlyaremotepossibilitythattheputswouldbetriggered.Follow-
ingtheioo¡rulechange,Citibankwasrequiredtoholdo.1oºincapitalagainstthe
amountofcommercialpapersupportedbytheliquidityput,or·1.omillionfora·1
billionliquidityput.Givena·1to·imillionannualfeefortheput,theannualreturn
onthatcapitalcouldstillexceed1ooº.Nodoubtaboutit,DomingueztoldtheFCIC,
the triple-A or similar ratings, the multiple fees, and the low capital requirements
madetheliquidityputs“amuchbettertrade”forCiti’sbalancesheet.
o,
Theeventsof
ioo,wouldrevealthefallacyofthoseassumptionsandcatapulttheentire·i,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
incommercialpaperstraightontothebank’sbalancesheet,requiringittocomeup
with·i,billionincashaswellasmorecapitaltosatisfybankregulators.
TheliquidityputswereapprovedbyCitigroup’sCapitalMarketsApprovalCom-
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 Citigroup’s largest commercial bank sub-
sidiary,wasawarethatthebankhadissuedtheliquidityputs.
o8
However,thetermsof
the OCC’s post-Enron enforcement action focused only on whether Citibank had a
processinplacetoreviewtheproduct,andnotontherisksoftheputstoCitibank’s
balancesheet.

Besides Citigroup, only a few large fnancial institutions, such as AIG Financial
Products, BNP, WestLB of Germany, and Société Générale 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 Société Générale and BNP were big players in that market.
“Youneededtobeabankwithastrongbalancesheet,accesstocollateral,andexist-
ingrelationshipswithcollateralmanagers,”hesaid.
,i
TheCDOdeskstoppedwritingliquidityputsinearlyiooo,

whenitreachedits
internal limits. Citibank’s treasury function had set a ·i¡ billion cap on liquidity
puts;

itgrantedonefnalexception,bringingthetotalto·i,billion.
,,
Riskmanage-
menthadalsoseta·i,billionrisklimitontop-ratedasset-backedsecurities,which
included the liquidity puts. Later, in an October iooo memo, Citigroup’s Financial
Control Group criticized the frm’s pricing of the puts, which failed to consider the
risk that investors would not buy the commercial paper protected by the liquidity
putswhenitcamedue,therebycreatinga·i,billioncashdemandonCitibank.
,o
An
undatedandunattributedinternaldocument(believedtohavebeendraftediniooo)
also questioned one of the practices of Citigroup’s 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:amassiveconglomeratewith·8,obillion
inassets,11o,oooemployeesin1¡ocountries,andii¡subsidiaries.
But to Wall Street, AIG’s most valuable asset was its credit rating: that it was
awardedthehighestpossiblerating—AaabyMoody’ssince1µ8o,AAAbyS&Psince
1ui tiu \\tui Ni .,,
1µ8¡—wascrucial,becausethesesterlingratingsletitborrowcheaplyanddeploythe
money in lucrative investments. Only six private-sector companies in the United
Statesinearlyio1ocarriedthoseratings.
,8
Startingin1µµ8,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 µµ.8,º confdence that there would be no
realized economiclossonthesupposedlysafestportionsoftheCDOsonwhichthey
wrote CDS protection, and failed to make any provisions whatsoever for declines in
value—orunrealizedlosses—adecisionthatwouldprovefataltoAIGinioo8.

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 8º to 1.oº.
8o
By ioo,, AIG had written
·1o, billion in CDS for such regulatory capital benefts; most were with European
banksforavarietyofassettypes.Thattotalwouldriseto·¡,µbillionbyioo,.
81
ThesameadvantagescouldbeenjoyedbybanksintheUnitedStates,whereregu-
lators had introduced similar capital standards for banks’ holdings of mortgage-
backedsecuritiesandotherinvestmentsundertheRecourseRuleinioo1.Soacredit
defaultswapwithAIGcouldalsolowerAmericanbanks’capitalrequirements.
Inioo¡andioo,,AIGsoldprotectiononsuper-seniorCDOtranchesvaluedat
·,¡billion,upfromjust·ibillioninioo¡.
8i
InaninterviewwiththeFCIC,oneAIG
executivedescribedAIGFinancialProducts’principalswapsalesman,AlanFrost,as
“thegoldengoosefortheentireStreet.”

AIG’sbiggestcustomerinthisbusinesswasalwaysGoldmanSachs,consistentlya
leadingCDOunderwriter.AIGalsowrotebillionsofdollarsofprotectionforMerrill
Lynch,SociétéGénérale,andotherfrms.AIG“lookedliketheperfectcustomerfor
this,”CraigBroderick,Goldman’schiefriskomcer,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.”

.,+ 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 Citigroup’s bank
wroteformanyofitsowndeals,guaranteeingitwouldbuycommercialpaperifno
oneelsewantedit.Itenteredthisbusinessiniooi;byioo,,ithadwrittenmorethan
·o billion of liquidity puts on commercial paper issued by CDOs. AIG also wrote
morethan·,billioninCDStoprotectSociétéGénéraleagainsttherisksonliquidity
putsthattheFrenchbankitselfwroteoncommercialpaperissuedbyCDOs.
8,
“What
wewouldalwaystrytodoistostructureatransactionwherethetransactionwasvir-
tuallyriskless,andgetpaidasmallpremium,”GenePark,whowasamanagingdirec-
toratAIGFinancialProducts,toldtheFCIC.“Andwe’reoneofthefewguyswhocan
dothat.Becauseifyouthinkaboutit,noonewantstobuydisasterprotectionfrom
someonewhoisnotgoingtobearound. . . .ThatwasAIGFP’ssalespitchtotheStreet
ortobanks.”
8o
AIG’s business of offering credit protection on assets of many sorts, including
mortgage-backedsecuritiesandCDOs,grewfrom·iobillioniniooito·i11billion
inioo,and·,¡¡billioninioo,.
8,
ThisbusinesswasasmallpartoftheAIGFinan-
cial Services business unit, which included AIG Financial Products; AIG Financial
Servicesgeneratedoperatingincomeof·¡.¡billioninioo,,oriµºofAIG’stotal.
AIGdidnotpostanycollateralwhenitwrotethesecontracts;butunlikemono-
lineinsurers,AIGFinancialProductsagreedtopostcollateralifthevalueoftheun-
derlying securities dropped, or if the rating agencies downgraded AIG’s long-term
debtratings.Itscompetitors,themonolinefnancialguarantors—insurancecompa-
nies such as MBIA and Ambac that focused on guaranteeing fnancial contracts—
were forbidden under insurance regulations from paying out until actual losses
occurred.ThecollateralpostingtermsinAIG’screditdefaultswapcontractswould
haveanenormousimpactonthecrisisabouttounfold.
Butduringtheboom,thesetermsdidn’tmatter.Theinvestorsgottheirtriple-A-
rated protection, AIG got its fees for providing that insurance—about o.1iº of the
notionalamountoftheswapperyear
88
—andthemanagersgottheirbonuses.Inthe
caseoftheLondonsubsidiarythatrantheoperation,thebonuspoolwas¡oºofnew
earnings.

FinancialProductsCEOJosephJ.Cassanomadetheallocationsattheend
oftheyear.
µo
Betweeniooiandioo,,theleastamountCassanopaidhimselfinayear
was·¡8million.Inthelateryears,hiscompensationwassometimesdoublethatof
theparentcompany’sCEO.
µ1
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 ·¡.µ billion.
µi
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.”
µ¡
Butthatdidn’thappen.Instead,AIGFinancialProd-
ucts wrote another ·¡o billion in credit default swaps on super-senior tranches of
1ui tiu \\tui Ni .,.
CDOsinioo,.
µ¡
Thecompanywouldn’tmakethedecisiontostopwritingthesecon-
tractsuntiliooo.
µ,
GOLDMAN SACHS: “MULTIPLIED THE EFFECTS
OF THE COLLAPSE IN SUBPRIME”
HenryPaulson,theCEOofGoldmanSachsfrom1µµµuntilhebecamesecretaryof
theTreasuryiniooo,testifedtotheFCICthatbythetimehebecamesecretarymany
bad loans already had been issued—“most of the toothpaste was out of the tube”—
andthat“therereallywasn’ttheproperregulatoryapparatustodealwithit.”
µo
Paul-
sonprovidedexamples:“Subprimemortgageswentfromaccountingfor,percentof
totalmortgagesin1µµ¡toiopercentbyiooo. . . .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.”
µ,
UnderPaulson’sleadership,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.
µ8
Duringthesameperiod,Gold-
man acquired ·,¡ billion of loans from these and other subprime loan originators,
whichitsecuritizedandsoldtoinvestors.
µµ
Fromioo¡toiooo,Goldmanissued¡18
mortgagesecuritizationstotaling·18¡billion(aboutaquarterweresubprime),and
o¡ CDOs totaling ·¡i billion; Goldman also issued ii synthetic or hybrid CDOs
withafacevalueof·¡,billionbetweenioo¡andJuneiooo.
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
CDOsincluded“funded”longinvestors,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 security—they
were not limited to the universe of securities available for them to buy. Figure 8.i
providesanexampleofhowsuchadealworked.
Inioo¡,GoldmanlauncheditsfrstmajorsyntheticCDO,Abacusioo¡-1—adeal
worth ·i billion. About one-third of the swaps referenced residential mortgage-
backedsecurities,anotherthirdreferencedexistingCDOs,andtherest,commercial
mortgage–backedsecurities(madeupofbundledcommercialrealestateloans)and
othersecurities.
Goldmanwastheshortinvestorfortheentire·ibilliondeal:itpurchasedcredit
defaultswapprotectiononthesereferencesecuritiesfromtheCDO.Thefundedin-
vestors—IKB (a German bank), the TCW Group, and Wachovia—put up a total of
·1µ, 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 ·1µ, 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
“short”investor,bettingthattheywouldfail.
Theunfundedinvestors—TCWandGSCPartners(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,retainingthe·1.8billionsuper-seniortranche.Goldman’s·ibillionshortpo-
sition more than offset that exposure; about one year later, it transferred the
unfundedlongpositionbybuyingcreditprotectionfromAIG,inreturnforanan-
nualpaymentof·i.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,Goldmanstoodtogainnearly·ibillioniftheassets
failed.
In the end, Goldman, the short investor in the Abacus ioo¡-1 CDO, has received
about·µ¡omillionwhilethelonginvestorshavelostjustaboutalloftheirinvestments.
In April ioo8, GSC paid Goldman ·,.¡ million as a result of CDS protection sold by
GSCtoGoldmanonthefrstandsecondlosstranches.InJuneiooµ,Goldmanreceived
·8oomillionfromAIGFinancialProductsasaresultoftheCDSprotectionithadpur-
chasedagainstthesuper-seniortranche.Thesamemonthitreceived·i¡millionfrom
TCWasaresultoftheCDSpurchasedagainstthejuniormezzaninetranches,and·¡o
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 Sachs’s Abacus 2004-1 deal, were complex
paper transactions involving credit default swaps.
Reference
Securities
CREDIT DEFAULT
SWAPS
Iigurc 8.:
ThroughMayio1o,Goldmanreceived·i¡millionfromIKB,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¡,andMay¡1,ioo,,Goldmanpackagedandsold¡,
synthetic CDOs, with an aggregate face value of ·oo billion.
1o,
Its underwriting fee
was o.,oº to 1.,oº of the deal totals, Dan Sparks, the former head of Goldman’s
mortgagedesk,toldtheFCIC.
1oo
Goldmanwouldearnproftsfromshortingmanyof
these deals; on others, it would proft by facilitating the transaction between the
buyerandthesellerofcreditdefaultswapprotection.
Aswewillsee,thesenewinstrumentswouldyieldsubstantialproftsforinvestors
thatheldashortpositioninthesyntheticCDOs—thatis,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
wereabout·1imillionworthofbondsintheMµ(BBB-rated)tranche—oneofthe
mezzanine tranches of the security. Synthetic CDOs such as Auriga, Volans, and
NeptuneCDOIVallcontainedcreditdefaultswapsinwhichtheMµtranchewasref-
erenced. As long as the Mµ bonds performed, investors betting that the tranche
would fail (short investors) would make regular payments into the CDO, which
wouldbepaidouttootherinvestorsbankingonittosucceed(longinvestors).Ifthe
Mµbondsdefaulted,thenthelonginvestorswouldmakelargepaymentstotheshort
investors.Thatisthebet—andthereweremorethan·,omillioninsuchbetsinearly
ioo, on the Mµ tranche of this deal. Thus, on the basis of the performance of ·1i
millioninbonds,morethan·oomillioncouldpotentiallychangehands.Goldman’s
Sparks put it succinctly to the FCIC: if there’s a problem with a product, synthetics
increasetheimpact.
1o8
TheamplifcationoftheMµtranchewasnotunique.A·1,milliontrancheofthe
GlacierFundingCDOiooo-¡A,ratedA,wasreferencedin·8,millionworthofsyn-
thetic CDOs. A ·i8 million tranche of the Soundview Home Equity Loan Trust
iooo-EQ1,alsoratedA,wasreferencedin·,µmillionworthofsyntheticCDOs.A
·1¡ million tranche of the Soundview Home Equity Loan Trust iooo-EQ1, rated
BBB,wasreferencedin·¡µmillionworthofsyntheticCDOs.
1oµ
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.
AlthoughGoldmanexecutivesagreedthatsyntheticCDOswere“bets”thatmag-
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,
Goldman’sPresidentandChiefOperatingOmcerGaryCohnargued:“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.“Idon’tthinktheyhavesocial
value,”MichaelGreenberger,aprofessorattheUniversityofMarylandSchoolofLaw
and former director of the Division of Trading and Markets at the Commodity Fu-
turesTradingCommission,toldtheFCIC.Hecharacterizedthecreditdefaultswap
marketasa“casino.”Andhetestifedthat“theconceptoflawfulbettingofbillionsof
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: Moody’s, S&P, and
Fitch. Investors often relied on the rating agencies’ views rather than conduct their
owncreditanalysis.Moody’swaspaidaccordingtothesizeofeachdeal,withcapsset
at a half-million dollars for a “standard” CDO in iooo and ioo, and as much as
·8,o,ooofora“complex”CDO.
11,
InratingbothsyntheticandcashCDOs,Moody’sfacedtwokeychallenges:frst,
estimatingtheprobabilityofdefaultforthemortgage-backedsecuritiespurchasedby
theCDO(oritssyntheticequivalent)and,second,gaugingthecorrelationbetween
those defaults—that 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, Moody’s relied almost exclusively on its
ownratingsofthemortgage-backedsecuritiespurchasedbytheCDOs.
11,
Atnotime
didtheagencies“lookthrough”thesecuritiestotheunderlyingsubprimemortgages.
“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 Moody’s team managing directors for the
CDOunit,toldtheFCIC.ThisapproachwouldleadtoproblemsforMoody’s—and
for investors. Witt testifed that the underlying collateral “just completely disinte-
gratedbelowusandwedidn’treactandweshouldhave. . . .Wehadtobelookingfor
aproblem.Andweweren’tlooking.”
118
To determine the likelihood that any given security in the CDO would default,
Moody’spluggedinassumptionsbasedonthoseoriginalratings.Thiswasnosimple
task.Meanwhile,iftheinitialratingsturnedout—owingtopoorunderwriting,fraud,
oranyothercause—topoorlyrefectthequalityofthemortgagesinthebonds,the
error was blindly compounded when mortgage-backed securities were packaged
intoCDOs.
Evenmoredimcultwastheestimationofthedefaultcorrelationbetweenthese-
curitiesintheportfolio—alwaystricky,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,” Moody’s acknowl-
edgedinoneearlyexplanationofitsprocess.
11µ
InplainerEnglish,Wittsaid,Moody’sdidn’thaveagoodmodelonwhichtoesti-
matecorrelationsbetweenmortgage-backedsecurities—sothey“madethemup.”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.WittfeltstronglythatMoody’sneededtoupdateitsCDOratingmodeltoex-
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-
backedsecuritiesandtoseeif“theassumptionsthatwe’remakingforAAACDOsare
consistent . . . with the correlation assumptions that we’re making for AAA [mort-
gage-backedsecurities].”AlthoughWittreceivedapprovalfromhissuperiorsforthis
investigation,contractualdisagreementspreventedhimfrombuyingthesoftwarehe
neededtoconductthelook-throughanalysis.
1i¡
InJuneioo,,Moody’supdateditsapproachforestimatingdefaultcorrelation,but
itbasedthenewmodelontrendsfromthepreviousioyears,aperiodwhenhousing
priceswererisingandmortgagedelinquencieswereverylow—andaperiodinwhich
nontraditionalmortgageproductshadbeenaverysmallniche.Then,Moody’smod-
ifedthisoptimisticsetof“empirical”assumptionswithadhocadjustmentsbasedon
factors such as region, year of origination, and servicer. For example, if two mort-
gage-backed securities were issued in the same region—say, Southern California—
Moody’s boosted the correlation; if they shared a common mortgage servicer,
Moody’s 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,Moody’sestimatedthattwomort-
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-
sultinunanticipatedconcentrationsofriskininstitutions’portfolios,”areportfrom
theBankforInternationalSettlements,aninternationalfnancialorganizationspon-
soredbytheworld’sregulatorsandcentralbanks,warnedinJuneioo,.
1io
CDOmanagersandunderwritersreliedontheratingstopromotethebonds.For
each new CDO, they created marketing material, including a pitch book that in-
vestorsusedtodecidewhethertosubscribetoanewCDO.Eachbookdescribedthe
typesofassetsthatwouldmakeuptheportfoliowithoutprovidingdetails.
1i,
With-
outexception,everypitchbookexaminedbytheFCICstaffcitedananalysisfromei-
therMoody’sorS&Pthatcontrastedthehistorical“stability”ofthesenewproducts’
ratings with the stability of corporate bonds. Statistics that made this case included
thefactthatbetween1µ8¡andiooo,µiºofthesenewproductsdidnotexperience
any rating changes over a twelve-month period while only ,8º of corporate bonds
maintainedtheirratings.Overalongertimeperiod,however,structuredfnancerat-
ings were not so stable. Between 1µ8¡ and iooo, only ,oº 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
bookdidincludethedisclaimerthat“pastperformanceisnotaguaranteeoffuture
performance”andencouragedinvestorstoperformtheirownduediligence.
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 8oº of a collection of toxic subprime tranches were
theratingsequivalentofU.S.Governmentbonds.”
1iµ
Whenhousingpricesstartedtofallnationwideanddefaultsincreased,itturned
out that the mortgage-backed securities were in fact much more highly correlated
thantheratingagencieshadestimated—thatis,theystoppedperformingatroughly
thesametime.TheselossesledtomassivedowngradesintheratingsoftheCDOs.
Inioo,,ioºofU.S.CDOsecuritieswouldbedowngraded.Inioo8,µ1ºwould.
1¡o
.,· 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,Moody’swouldthrowoutitskeyCDOassumptionsandreplacethem
with an asset correlation assumption two to three times higher than used before
thecrisis.
1¡1
In retrospect, it is clear that the agencies’ CDO models made two key mistakes.
First,theyassumedthatsecuritizerscouldcreatesaferfnancialproductsbydiversi-
fyingamongmanymortgage-backedsecurities,wheninfactthesesecuritiesweren’t
that different to begin with. “There were a lot of things [the credit rating agencies]
didwrong,”FederalReserveChairmanBenBernanketoldtheFCIC.“Theydidnot
takeintoaccounttheappropriatecorrelationbetween[and]acrossthecategoriesof
mortgages.”
1¡i
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 CDOs—not just those that were mortgage-related—Moody’s rated
iiodealsinioo¡,¡o¡inioo,,,¡µiniooo,and,1,inioo,;thevalueofthosedeals
rosefrom·µobillioninioo¡to·1oibillioninioo,,·¡¡,billioniniooo,and·¡io
billion in ioo,.
1¡¡
The reported revenues of Moody’s Investors Service from struc-
turedproducts—whichincludedmortgage-backedsecuritiesandCDOs—grewfrom
·1µµmillioniniooo,or¡¡ºofMoody’sCorporation’srevenues,to·88,millionin
iooo or ¡¡º of overall corporate revenue. The rating of asset-backed CDOs alone
contributed more than 1oº 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 corporation’s revenues surged from ·ooi million to
·ibillionanditsproftmarginclimbedfromioºto¡,º.
YettheincreaseintheCDOgroup’sworkloadandrevenuewasnotparalleledbya
stamng increase. “We were under-resourced, you know, we were always playing
catch-up,”Wittsaid.
1¡o
Moody’s“penny-pinching”and“stingy”managementwasre-
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-
merteammanagingdirectoratMoody’s,toldtheFCICthatfromioo¡toiooo,the
increaseinthenumberofdealsratedwas“huge . . .butourpersonneldidnotgoup
accordingly.”Byiooo,Kolchinskyrecalled,“Myroleasateamleaderwascrisisman-
agement.Eachdealwasacrisis.”
1¡8
Whenpersonnelworkedtocreateanewmethod-
ology,Wittsaid,“Wehadtokindofdoitinoursparetime.”
1¡µ
TheagenciesworkedcloselywithCDOunderwritersandmanagersaseachnew
CDO was devised. And the rating agencies now relied for a substantial amount of
theirrevenuesonasmallnumberofplayers.CitigroupandMerrillaloneaccounted
formorethan·1¡obillionofCDOdealsbetweenioo,andioo,.
1¡o
Theratingsagencies’correlationassumptionshadadirectandcriticalimpacton
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
fromtheagencies—forexample,byincreasingthesizeoftheseniortranches.More-
over,becauseissuerscouldchoosewhichratingagenciestodobusinesswith,andbe-
cause the agencies depended on the issuers for their revenues, rating agencies felt
pressuredtogivefavorableratingssothattheymightremaincompetitive.
Thepressureonratingagencyemployeeswasalsointenseasaresultofthehigh
turnover—a revolving door that often left raters dealing with their old colleagues,
thistimeasclients.InherinterviewwithFCICstaff,YuriYoshizawa,aMoody’steam
managing director for U.S. derivatives in ioo,, was presented with an organization
chartfromJulyioo,.Sheidentifed1¡outof,1analysts—abouti,ºofthestaff—
whohadleftMoody’stoworkforinvestmentorcommercialbanks.
1¡1
Brian Clarkson, who oversaw the structured fnance group before becoming the
presidentofMoody’sInvestorsService,explainedtoFCICinvestigatorsthatretaining
employeeswasalwaysachallenge,forthesimplereasonthatthebankspaidmore.As
aprecaution,Moody’semployeeswereprohibitedfromratingdealsbyabankoris-
suerwhiletheywereinterviewingforajobwiththatparticularinstitution,butthere-
sponsibilityfornotifyingmanagementoftheinterviewrestedontheemployee.After
leaving Moody’s, former employees were barred from interacting with Moody’s on
the same series of deals they had rated while in its employ, but there were no bans
againstworkingonother dealswithMoody’s.
1¡i
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
needa“consolidated”supervisorbyioo¡—thatis,oneregulatorthathadresponsibil-
ityfortheholdingcompany.TheU.S.commercialbanksalreadymetthatcriterion—
their consolidated supervisor was the Federal Reserve—and the Omce of Thrift
Supervision’soversightofAIGwouldlateralsosatisfytheEuropeans.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¡,thecombinedassetsatthefvefrmstotaled·i.,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-
countedformorethan1ooºofpretaxearningsinsomeyearsafteriooi.
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.
Theinvestmentbanks’possessionofdepositorysubsidiariessuggestedtwoobvi-
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,thiswastheSEC’sfrstforay
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 portfolios—a
methodologybasedonthevolatilityofmarketprices.Thismethodology,referredto
asthe“alternativenetcapitalrule,”wouldbesimilartothestandards—basedonthe
1µµoMarketRiskAmendmenttotheBaselrules—thatlargecommercialbanksand
bankholdingcompaniesusedfortheirsecuritiesportfolios.
Thetraditionalnetcapitalrulethathadgovernedbroker-dealerssince1µ,,had
required straightforward calculations based on asset classes and credit ratings, a
bright-lineapproachthatgavefrmslittlediscretionincalculatingtheircapital.The
newruleswouldallowtheinvestmentbankstocreatetheirownproprietaryValueat
Risk(VaR)modelstocalculatetheirregulatorycapital—thatis,thecapitaleachfrm
wouldhavetoholdtoprotectitscustomers’assetsshoulditexperiencelossesonits
1ui tiu \\tui Ni .,.
securities and derivatives. All in all, the SEC estimated that the proposed new re-
lianceonproprietaryVaRmodelswouldallowbroker-dealerstoreduceaveragecap-
ital charges by ¡oº. 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 agency’s pro-
posal,whichitsaidhad“thepotentialtoduplicateorconfictwithOTS’ssupervisory
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 SEC’s 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.DeutscheBankfoundittobe“agreatstridetowardscon-
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-
thoughMerrill’sandLehman’sthriftscontinuedtobesupervisedbytheOTS.Several
frmsdelayedentrytotheprograminordertodevelopsystemsthatcouldmeasure
theirexposurestomarketpricemovements.
HarveyGoldschmid,SECcommissionerfromiooitoioo,,toldFCICstaffthat
beforetheCSEprogramwascreated,SECstaffmemberswereconcernedabouthow
littleauthoritytheyhadovertheWallStreetfrms,includingtheirhedgefundsand
overseassubsidiaries.OncetheCSEprogramwasinplace,theSEChad“theauthor-
itytolookateverything.”
1¡o
SECcommissionersdiscussedatthetimetherisksthey
weretakingbyallowingfrmstoreducetheircapital.“Ifanythinggoeswrongit’sgo-
.,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,”Goldschmidsaidataioo¡meeting.“Dowefeelsecure
ifthesedropsincapitalandotherthings[occur]wereallywillhaveinvestorprotec-
tion:”Inresponse,AnnetteNazareth,theSEComcialwhowouldbeinchargeofthe
program,assuredthecommissionersthatherdivisionwasuptothechallenge.
1¡,
ThenewprogramwashousedprimarilyintheSEC’sOmceofPrudentialSupervi-
sionandRiskAnalysis,anomcewithastaffof1oto1iwithintheDivisionofMarket
Regulation.
1¡8
Inthebeginning,itwassupportedbytheSEC’smuchlargerexamina-
tion staff; by ioo8 the staff dedicated to the CSE program had grown to i¡.
1¡µ
Still,
only1o“monitors”wereresponsibleforthefveinvestmentbanks;¡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 SEC’s 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,duringwhichstaffreviewedthefrms’systemsandrecordsand
verifedthatthefrmshadinstitutedcontrolprocesses.
TheCSEprogramwastroubledfromthestart.TheSECconductedanexamfor
eachinvestmentbankwhenitenteredtheprogram.TheresultofBearStearns’sen-
tranceexam,inioo,,showedseveraldefciencies.Forexample,examinerswerecon-
cerned that there were no frmwide VaR limits and that contingency funding plans
reliedonoverlyoptimisticstressscenarios.
1,¡
Inaddition,theSECwasawareofthe
frm’s concentration of mortgage securities and its high leverage. Nonetheless, the
SECdidnotaskBeartochangeitsassetbalance,decreaseitsleverage,orincreaseits
cash liquidity pool—all 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-siteconductingitsfrstCSEexamsinceBear’sentranceexammorethantwo
yearsearlier.
1,,
Leverageattheinvestmentbanksincreasedfromioo¡toioo,,growththatsome
criticshaveblamedontheSEC’schangeinthenetcapitalrules.Goldschmidtoldthe
FCICthattheincreasewasowedto“awildcapitaltimeandthefrmsbeingirrespon-
sible.”
1,8
In fact, leverage had been higher at the fve investment banks in the late
1µµos, then dropped before increasing over the life of the CSE program—a history
1ui tiu \\tui Ni .,,
thatsuggeststhattheprogramwasnotsolelyresponsibleforthechanges.
1,µ
Iniooµ,
SirrinotedthatundertheCSEprogramtheinvestmentbanks’netcapitallevels“re-
mainedrelativelystable . . .and,insomecases,increasedsignifcantly”overthepro-
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.Fromioo¡untilthef-
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,concludedthattheprogram“wasnotsuccessful
inprovidingprudentialsupervision.”
1o¡
And,aswewillseeinthechaptersahead,the
SEC’sinspectorgeneralwouldbequitecritical,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 agency’s 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
reasonfrmsoptednottobesupervisedbytheFedwasthe“comprehensiveness”of
theFed’ssupervisoryapproach,“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 CDOs—composed of the riskier
tranches—fueleddemandfornonprimemortgagesecuritizationandcontributed
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
ofthecreditdefaultswapprotectiontothehousingbubble’scollapse.
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
corporategovernanceatMoody’s,whichdidnotensurethequalityofitsratings
ontensofthousandsofmortgage-backedsecuritiesandCDOs.
The Securities and Exchange Commission’s poor oversight of the fve largest
investmentbanksfailedtorestricttheirriskyactivitiesanddidnotrequirethem
toholdadequatecapitalandliquidityfortheiractivities,contributingtothefail-
ureorneedforgovernmentbailoutsofallfveofthesupervisedinvestmentbanks
duringthefnancialcrisis.
9
ALL IN
CONTENTS
1hc|u|||c“Acrcdit-induccd|ccn”+,,
Mcrtgagcjraud“Crinc-jaci|itativccnvircnncnts” +eo
Disc|csurcandducdi|igcncc“Aqua|ityccntrc|issucinthcjactcry” +e,
Rcgu|atcrs“Markctswi||a|wayssc|j-ccrrcct”+,o
Icvcragcd|cansandccnncrcia|rca|cstatc
“Ycu’vcgcttcgctupanddancc” +,,
IchnanIrcn“ncving”tc“stcragc” +,e
IannicMacandIrcddicMac“1wcstarkchciccs”+,:
Inioo¡,theBakersfeld,California,homebuilderWarrenPetersonwaspayingaslit-
tleas·¡,,ooofora1o,ooo-square-footlot,aboutthesizeofthreetenniscourts.The
nextyearthecostmorethantripledto·1io,ooo,asrealestateboomed.Overthepre-
viousquartercentury,Petersonhadbuiltbetween¡and1ocustomandsemi-custom
homesayear.Forawhile,hewasbuildingasmanyas¡o.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
southernendofCalifornia’sagriculturalcenter,theSanJoaquinValley.Thatjumped
toalmost·¡oo,ooobyJuneiooo.
i
“Byioo¡,moneyseemedtobecominginveryfast
and from everywhere,” said Lloyd Plank, a Bakersfeld real estate broker. “They
wouldpurchaseahouseinBakersfeld,keepitforashortperiodandresellit.Some-
timestheywouldfipthehousewhileitwasstillinescrow,andwouldstillmakeioº
to¡oº.”
¡
Nationally, housing prices jumped 1,iº between 1µµ, and their peak in iooo,
¡
more than in any decade since at least 1µio.
,
It would be catastrophically downhill
fromthere—yetthemortgagemachinekeptchurningwellintoioo,,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 CREDITINDUCED BOOM”
Irvine, California–based New Century—once the nation’s second-largest subprime
lender—ignored early warnings that its own loan quality was deteriorating and
strippedpowerfromtworisk-controldepartmentsthathadnotedtheevidence.Ina
Juneioo¡presentation,theQualityAssurancestaffreportedtheyhadfoundsevere
underwriting errors, including evidence of predatory lending, legal and state viola-
tions,andcreditissues,ini,ºoftheloanstheyauditedinNovemberandDecember
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,,itgavethecompany’sloanproductiondepart-
ment“unsatisfactory”ratingsseventimes.PatrickFlanagan,presidentofNewCen-
tury’s mortgage-originating subsidiary, cut the department’s 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,ºofitsloanswere
goingintodefaultwithinthefrstthreemonthsafterorigination.“NewCenturyhad
abrazenobsessionwithincreasingloanoriginations,withoutdueregardtotherisks
associated with that business strategy,” New Century’s bankruptcy examiner
reported.
,
In September ioo,—seven months before the housing market peaked—thou-
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 spikes—and subsequent de-
clines—than 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,“althougha‘bubble’inhomepricesforthena-
tionasawholedoesnotappearlikely.”
µ
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 1µµ, to ioo,, price in-
creases in the United Kingdom and Spain were above those in the United States,
whilepriceincreasesinIrelandandFrancewerejustbelow.InanInternationalMon-
etaryFundstudyfromiooµ,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
amodestandtemporarydeclineiniooµ.ResearchersattheFederalReserveBankof
Cleveland attributed Canada’s 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.

Insomecities,the
change was particularly dramatic. From 1µµ, to iooo, the ratio of house prices to
rentsroseinLosAngeles,Miami,andNewYorkCityby1¡,º,1i1º,andµ8º,re-
spectively.

Iniooo,theNationalAssociationofRealtors’affordabilityindex—which
measureswhetheratypicalfamilycouldqualifyforamortgageonatypicalhome—
hadreachedarecordlow.
1,
Butthatwasbasedonthecostofatraditionalmortgage
withaioºdownpayment,
1o
whichwasnolongerrequired.Perhapssuchmeasures
werenolongerrelevant,whenAmericanscouldmakelowerdownpaymentsandob-
tainloanssuchaspayment-optionadjustable-ratemortgagesandinterest-onlymort-
gages,withreducedinitialmortgagepayments.Orperhapsbuyingahomecontinued
tomakefnancialsense,givenhomeowners’expectationsoffurtherpricegains.
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,”andtheirrisks“couldbecushionedbylargedownpayments.”
Thepresentationalsonotedthatwhileloan-to-valueratioswererisingonaportion
ofinterest-onlyloans,theratiosformostremainedaround8oº.Anotherpresenta-
tionsuggestedthathousingmarketactivitycouldbetheresultof“solidfundamen-
tals.” Yet another presentation concluded that the impact of changes in household
wealthonspendingwouldbe“perhapsonlyhalfaslargeasthatofthe1µµosstock
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.”

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
,oº, while homes in the fastest-growing markets have approximately doubled in
value.”Whilethisincreasemighthavebeenexplainedbystrongmarketfundamen-
tals,“thedramaticbroadeningofthehousingboominioo¡stronglysuggeststhein-
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:
“CRIMEFACILITATIVE ENVIRONMENTS”
NewCentury—where¡oºofthemortgageswereloanswithlittleornodocumenta-
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.,millionloansannuallycontained“somesortof
fraud,”inpartbecauseofthelargepercentageofno-docloansoriginatedthen.

Fraudforhousingcanentailaborrower’slyingorintentionallyomittinginforma-
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.”

In8oºofcases,accordingtotheFBI,fraudinvolvesindustryinsiders.
i,
Forex-
ample,propertyfippingcaninvolvebuyers,realestateagents,appraisers,andcom-
plicitclosingagents.Ina“silentsecond,”thebuyer,withthecollusionofaloanomcer
andwithouttheknowledgeofthefrstmortgagelender,disguisestheexistenceofa
secondmortgagetohidethefactthatnodownpaymenthasbeenmade.“Strawbuy-
ers”allowtheirnamesandcreditscorestobeused,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
Commissionitwas“oneofthecruelestschemes”hehadseen.
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,andfound1¡ºcontainedliesoromissions
significantenoughtorescindtheloanordemandabuybackifithadbeensecuri-
tized.Thefirm’sanalysisindicatedthatabout·1trillionoftheloansmadeduring
theperiodwerefraudulent.Fulmerfurtherestimated·1oobillionworthoffraudu-
lentloansfromioo,toioo,resultedinforeclosures,leadingtolossesof·11ibil-
lion for the holders. According to Fulmer, experts in the field—lenders’ quality
assurance officers, attorneys who specialize in loan loss mitigation, and white-
collarcriminologists—saythepercentageoftransactionsinvolvinglesssignificant
formsoffraud,suchasrelativelyminormisrepresentationsoffact,couldreachooº
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.

David
Gussmann,theformervicepresidentofEnterpriseManagementCapitalMarketsat
FannieMae,toldtheCommissionthatinonepackageof,osecuritizedloanshisan-
alystsfoundonepurchaserwhohadbought1µproperties,falselyidentifyinghimself
eachtimeastheownerofonlyoneproperty,whileanotherhadboughtfveproper-
ties.
¡o
Fannie Mae’s detection of fraud increased steadily during the housing bubble
and accelerated in late iooo, according to William Brewster, the current director of
thecompany’smortgagefraudprogram.Hesaidthat,seeingevidenceoffraud,Fan-
nie demanded that lenders such as Bank of America, Countrywide, Citigroup, and
JPMorganChaserepurchaseabout·,,omillioninmortgagesinioo8and·o,omil-
lion in iooµ.
¡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,omcefrom1µµµtoioo¡.Iniooi,thatomceinvestigatedFirstBene-
fcialMortgageforsellingfraudulentloanstoFannieMae,leadingtothesuccessful
criminalprosecutionofthecompany’sowner,JamesEdwardMcLeanJr.,andothers.
FirstBenefcialrepurchasedthemortgagesafterFanniediscoveredevidenceoffraud,
butthen—withoutanyinterferencefromFannie—resoldthemtoGinnieMae.
¡¡
For
not alerting Ginnie, Fannie paid ·,., million of restitution to the government.
McLeancametotheattentionoftheFBIafterbuyingaluxuryyachtfor·8oo,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,wereoutsideFinCEN’sjurisdiction—andthustheloanstheygener-
ated,whichwerethenplacedintosecuritizedpoolsbylargerlendersorinvestment
banks, were not subject to FinCEN review. William Black testifed to the Commis-
sion that an estimated 8oº of nonprime mortgage loans were made by noninsured
lendersnotrequiredtofleSARs.Andasforthoseinstitutionsrequiredtodoso,he
believedhesawevidenceofunderreportinginthat,hesaid,onlyabout1oºoffeder-
ally insured mortgage lenders fled even a single criminal referral for alleged mort-
gagefraudinthefrsthalfofiooµ.
¡,
Countrywide,thenation’slargestmortgagelenderatthetime,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,8µ,iniooo,andi,oi1inioo,.
¡µ
Similarly,inexaminingBankofAmericainioo,,itsleadbankregulator,theOf-
fceoftheComptrolleroftheCurrency(OCC),sampled,omortgagesandfound1o
with“qualityassurancereferrals”forsuspiciousactivityforwhichnoreporthadbeen
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
secondlargestmortgagelenderfromioo¡throughioo,andthelargestinioo8,told
theCommissionthat“hundredsandhundredsandhundredsoffraudcases”thatshe
knew were identifed within Wells Fargo’s home equity loan division were not re-
portedtoFinCEN.And,sheadded,atleasthalftheloansshefaggedforfraudwere
neverthelessfunded,overherobjections.
¡1
Despitetheunderreporting,thejumpinmortgagefrauddrewattention.FinCEN
inNovemberioooreportedaio-foldincreaseinSARsrelatedtomortgagefraudbe-
tween1µµoandioo,.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
calledhisstruggleformoreresourcesan“uphillslog.”
¡¡
In ioo,, i,,µ88 SARs related to mortgage fraud were fled; in iooo there were
¡,,¡,,.Thenumberkeptclimbing,to,i,8oiinioo,,o,,oo¡inioo8,ando,,,o,in
iooµ.
¡,
Atthesametime,topFBIomcials,focusingonterroristthreats,reducedthe
agentsassignedtowhite-collarcrimefromi,¡¡iintheioo¡fscalyeartofewerthan
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-
oped“newandinnovativemethodstodetectandcombatmortgagefraud,”suchasa
computerapplication,creatediniooo,todetectpropertyfipping.
¡o
Robert Mueller, the FBI’s director since ioo1, said mortgage fraud needed to be
considered “in context of other priorities,” such as terrorism. He told the Commis-
sionthathehiredadditionalresourcestofghtfraud,butthat“wedidn’tgetwhatwe
hadrequested”duringthebudgetprocess.HealsosaidthattheFBIallocatedaddi-
tionalresourcestorefectthegrowthinmortgagefraud,butacknowledgedthatthose
resourcesmayhavebeeninsumcient.“Iamnotgoingtotellyouthatthatisadequate
forwhatisoutthere,”hesaid.Inthewakeofthecrisis,theFBIiscontinuingtoinves-
tigatefraud,andMuellersuggestedthatsomeprosecutionsmaybestilltocome.
¡,
AlbertoGonzales,thenation’sattorneygeneralfromFebruaryioo,toSeptem-
ber ioo,, told the Commission that while he might have done more on mortgage
fraud,inhindsighthebelievedthatotherissuesweremorepressing:“Idon’tthink
anyonecancrediblyarguethat[mortgagefraud]ismoreimportantthanthewaron
terror.Mortgagefrauddoesn’tinvolvetakinglossoflifesoitdoesn’trankabovethe
priorityofprotectingneighborhoodsfromdangerousgangsorpredatorsattacking
ourchildren.”
¡8
Inioo8,theOmceofFederalHousingEnterpriseOversight,theregulatorofthe
GSEs,releasedareportshowinga“signifcantriseintheincidenceoffraudinmort-
gagelendinginioooandthefrsthalfofioo,.”OFHEOstatedithadbeenworking
closelywithlawenforcementandwasanactivememberoftheDepartmentofJustice
MortgageFraudWorkingGroup.
¡µ
“Theconcernaboutmortgagefraudandfraudin
generalwasanissue,”RichardSpillenkothen,headofbankingsupervisionandregu-
lationattheFedfrom1µµ1toiooo,toldtheFCIC.“Andweunderstoodtherewasan
increasingincidenceof[mortgagefraud].”
,o
Michael B. Mukasey, who served as U.S. attorney general from November ioo,
totheendofioo8,toldtheCommissionthatherecalled“receivingreportsofmort-
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 8µ
\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-
spondtotheµ/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,aNewYork–basedvicepresidentofArgentMortgageCompany,aunit
ofAmeriquest.Beginninginioo¡,1oinvestigatorsandtwoprosecutorsworkedfor
yearstounravelanetworkofalliancesbetweenrealestatebrokers,appraisers,home
repaircontractors,titlecompanies,notaries,andaconvictedfeloninacasethatin-
volvedsome1¡oloans.
,,
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
homeowners’names.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,andthensometimeslearnedthattheyhadlostyears’worthofequityas
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 company’s 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,ºfromioo,toiooo.Inparticular,optionARMsgrew,ºduring
thatperiod,interest-onlymortgagesgrewµº,andno-documentationorlow-docu-
mentation loans (measured for borrowers with fxed-rate mortgages) grew 1¡º.
Overall,byiooono-docorlow-docloansmadeupi,ºofallmortgagesoriginated.
Manyoftheseproductswouldperformonlyifpricescontinuedtoriseandthebor-
rowercouldrefnanceatalowrate.
,8
Intheory,everyparticipantalongthesecuritizationpipelineshouldhavehadan
interestinthequalityofeveryunderlyingmortgage.Inpractice,theirinterestswere
oftennotaligned.TwoNewYorkFedeconomistshavepointedoutthe“sevendeadly
frictions” in mortgage securitization—places 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 lender’s own business reputation. The securitizer
whopackagedmortgagesintomortgage-backedsecurities,similarly,waslesslikelyto
retainastakeinthosesecurities.
In theory, the rating agencies were important watchdogs over the securitization
process.Theydescribedtheirroleasbeing“anumpireinthemarket.”
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.
uucáiligcnccjirms.“\eivcáin”
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
¡oº,itwasoftenmuchlower;accordingtosomeobservers,asthemarketgrewand
originators became more concentrated, they had more bargaining power over the
mortgagepurchasers,andsamplesweresometimesaslowasiºto¡º.
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 originator’s stated underwriting
guidelinesand,insomemeasure,toenableclientstonegotiatebetterpricesonpools
ofloans.

Thereviewfellintothreegeneralareas:credit,compliance,andvaluation.Didthe
loans meet the underwriting guidelines (generally the originator’s 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:

And, critically: to the degree that a loan was defcient, did it
haveany“compensatingfactors”thatoffsetthesedefciencies:Forexample,ifaloan
hadahigherloan-to-valueratiothanguidelinescalledfor,didanothercharacteristic
suchastheborrower’shigherincomemitigatethatweakness:Theduediligencefrm
wouldthengradetheloansampleandforwardthedatatoitsclient.Reportinhand,
the securitizer would negotiate a price for the pool and could “kick out” loans that
didnotmeetthestatedguidelines.
BecauseofthevolumeofloansexaminedbyClaytonduringthehousingboom,
thefrmhadauniqueinsideviewoftheunderwritingstandardsthatoriginatorswere
actuallyapplying—andthatsecuritizerswerewillingtoaccept.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,forthe18monthsthatendedJune¡o,ioo,,Claytonrated,¡ºofthe
µ11,o¡µloansitanalyzedasGrade1,andanother18ºasGradei—foratotalof,iº
thatmettheguidelinesoutrightorwithcompensatingfactors.Theremainingi8ºof
theloanswereGrade¡.
o,
Intheory,thebankscouldhaverefusedtobuyaloanpool,
or,indeed,theycouldhaveusedthefndingsoftheduediligencefrmtoprobethe
loans’qualitymoredeeply.Overthe18-monthperiod,¡µºoftheloansthatClayton
found to be defcient—Grade ¡—were “waived in” by the banks. Thus 11º of the
loanssampledbyClaytonwereacceptedeventhoughthecompanyhadfoundabasis
forrejectingthem(seefgureµ.1).
Referringtothedata,KeithJohnson,thepresidentofClaytonfromMayioooto
Mayiooµ,toldtheCommission,“That,¡ºtomesaysthere[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
originator—ahighnumberofrejectionsmightleadtheoriginatortoselltheloansto
a competitor. Simply put, it was a sellers’ market. “Probably the seller had more
powerthantheWallStreetissuer,”JohnsontoldtheFCIC.
o,
Thehighrateofwaiversfollowingrejectionsmaynotitselfbeevidenceofsome-
thingwrongintheprocess,Bealtestifed.Shesaidthatasoriginators’lendingguide-
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 Moody’s Investors Service explained in a letter to
theFCIC,“Ahighrateofwaiversfromaninstitutionwithextremelytightunderwrit-
ingstandardscouldresultinapoolthatislessriskythanapoolwithnowaiversfrom
an institution with extremely loose underwriting standards.”

Nonetheless, many
prospectuses indicated that the loans in the pools either met guidelines outright or
hadcompensatingfactors,eventhoughClayton’srecordsshowthatonlyaportionof
theloansweresampled,andthatofthosethatweresampled,asubstantialpercentage
ofGrade¡Eventloanswerewaivedin.
Johnsonsaidheapproachedtheratingagenciesinioooandioo,togaugetheir
interest in the exception-tracking product that Clayton was developing. He said he
sharedsomeoftheircompany’sresults,attemptingtoconvincetheagenciesthatthe
data would beneft the ratings process. “We went to the rating agencies and said,
‘Wouldn’t 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
(B–C)
E
FINANCIAL
INSTITUTION
WAIVER RATE
(C/B)
NOTES: From Clayton Trending Reports. Numbers may not add due to rounding.
SOURCE: Clayton Holdings
Iigurc µ.+
risk:’” Johnson recalled. The agencies thought the due diligence frm’s 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 pool’s sampling. The examiner’s report for New Century Financial’s bank-
ruptcydescribessuchapractice.
,1
Similarly,FremontInvestment&Loanhadapol-
icyofputtingloansintosubsequentpoolsuntiltheywerekickedoutthreetimes,the
company’sformerregulatorycomplianceandriskmanager,RogerEhrnman,toldthe
FCIC. As Johnson described the practice to the FCIC, this was the “three strikes,
you’reoutrule.”
,i
Some mortgage securitizers did their own due diligence, but seemed to devote
onlylimitedresourcestoit.AtMorganStanley,theheadofduediligencewasbased
notinNewYorkbutratherinBocaRaton,Florida.Hehad,atanyonetime,twoto
fveindividualsreportingtohimdirectly—andtheywereactuallyemployeesofaper-
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,Bowen’steamwouldreviewthephysicalcreditfleofthe
loanstheywerepurchasing.“Duringioooandioo,,Iwitnessedmanychangestothe
way the credit risk was being evaluated for these pools during the purchase
processes,”Bowensaid.Forexample,hesaid,thechiefriskomcerinCitigroup’sCon-
sumer Lending business reversed large numbers of underwriting decisions from
“turndown”to“approved.”
,,
AnotherpartofBowen’schargewastosupervisethepurchaseofroughly·,obil-
lion annually in prime loan pools, a high percentage of which were sold to Fannie
MaeandFreddieMacforsecuritization.ThesamplingprovidedtoBowen’sstafffor
qualitycontrolwassupposedtoincludeatleast,ºoftheloanpoolforagivensecu-
ritization, but “this corporate mandate was usually ignored.” Samples of iº were
morelikely,andtheloansamplesthatBowen’sgroupdidexamineshowedextremely
highratesofnoncompliance.“AtthetimethatIbecameinvolved,whichwasearlyto
mid-iooo,weidentifedthat¡otooopercentofthefleseitherhada‘disagree’deci-
sion,ortheyweremissingcriticaldocuments.”
,o
Bowenrepeatedlyexpressedconcernstohisdirectsupervisorandcompanyexec-
utivesaboutthequalityandunderwritingofmortgagesthatCitiMortgagepurchased
andthensoldtotheGSEs.Asdiscussedinalaterchapter,theGSEswouldlaterre-
.·· ii N\Nti \i tii :i : i NQUi i¥ tu\\i : :i uN iiiui1
quireCitigrouptobuyback·1.,billioninloansasofNovemberio1o,fndingthat
theloansCitigrouphadsoldthemdidnotconformtoGSEstandards.
SIt.“1/cclc¡/entint/croomist/et
vcáián’trcvicvt/c¡ros¡cctussu¡¡lcmcnts”
Bythetimethefnancialcrisishit,investorsheldmorethan·itrillionofnon-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 SEC’s ongoing public reporting require-
ments. The SEC’s mandate is to protect investors—generally not by reviewing the
quality of securities, but simply by ensuring adequate disclosures so that investors
canmakeuptheirownminds.Inthecaseofinitialpublicofferingsofacompany’s
shares,theworkhashistoricallyinvolvedalengthyreviewoftheissuer’sprospectus
andother“offeringmaterials”priortosale.
,8
However,withtheadventof“shelfregistration,”amethodofregisteringsecurities
onanongoingbasis,theprocessbecamemuchquickerformortgage-backedsecuri-
tiesrankedinthehighestgradesbytheratingagencies.Theprocessallowedissuers
tofleabaseprospectuswiththeSEC,givinginvestorsnoticethattheissuerintended
tooffersecuritiesinthefuture.Theissuerthenfledasupplementalprospectusde-
scribingeachoffering’sterms.“Theelephantintheroomisthatwedidn’treviewthe
prospectussupplements,”theSEC’sdeputydirectorfordisclosureincorporationf-
nance, Shelley Parratt, told the FCIC.

To improve disclosures pertaining to mort-
gage-backedsecuritiesandotherasset-backedsecurities,theSECissuedRegulation
ABinlateioo¡.Theregulationrequiredthateveryprospectusinclude“adescription
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
Thedisclosuretypicallyhadasentencestatingthat“asubstantialnumber”orperhaps
“asubstantialportionoftheMortgageLoanswillrepresenttheseexceptions.”
8i
Citi-
group’s 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.”

Such disclosures were insumcient for investors to know what criteria the mort-
gages they were buying actually did meet. Only a small portion—as little as iº to
¡º—oftheloansinanydealweresampled,andevidencefromClaytonshowsthata
signifcantnumberdidnotmeetstatedguidelinesorhavecompensatingfactors.

On
\ii i N .·,
theloansintheremainderofthemortgagepoolthatwerenotsampled(asmuchas
µ,º),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 SEC’s Rule
1¡¡A,whichallowstheunregisteredresaleofcertainsecuritiestoso-calledqualifed
institutionalbuyers(QIBs);theseincludedinvestorsasdiverseasinsurancecompa-
nies like MetLife, pension funds like the California State Teachers’ Retirement Sys-
tem,andinvestmentbankslikeGoldmanSachs.
8,
TheSECcreatedRule1¡¡Ain1µµo,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
wouldnolongerbeconsidered“publicofferings”andthereforewouldnotbesubject
totheSEC’sregistrationrequirements.In1µµo,Congressreinforcedthisexemption
withtheNationalSecuritiesMarketsImprovementsAct,legislationthatDeniseVoigt
Crawford,acommissionerontheTexasSecuritiesBoard,characterizedtotheCom-
mission“asprohibit[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
marketdevelopedquicklyunderRule1¡¡A.Thismarketwasliquid,sincequalifed
investorscouldfreelytradeRule1¡¡Adebtsecurities.ButdebtsecuritieswhenRule
1¡¡Awasenactedweremostlycorporatebonds,verydifferentfromtheCDOsthat
dominatedtheprivateplacementmarketmorethanadecadelater.
8,
Afterthecrisisunfolded,investors,arguingthatdisclosurehadn’tbeenadequate,
flednumerouslawsuitsunderfederalandstatesecuritieslaws.Aswewillsee,some
havealreadyresultedinsubstantialsettlements.
REGULATORS: “MARKETS WILL ALWAYS SELFCORRECT”
Where were the regulators: Declining underwriting standards and new mortgage
productshadbeenonregulators’radarscreensintheyearsbeforethecrisis,butdis-
agreementsamongtheagenciesandtheirtraditionalpreferenceforminimalinterfer-
encedelayedaction.
Supervisors had, since the 1µµos, 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,”ChairmanGreenspanhadsaidin1µµµ.

Acrossagencies,therewasa“his-
toric vision, historic approach, that a lighter hand at regulation was the appropriate
waytoregulate,”EugeneLudwig,comptrollerofthecurrencyfrom1µµ¡to1µµ8,told
theFCIC,referringtotheGramm-Leach-BlileyActin1µµµ.
µo
TheNewYorkFed,ina
“lessons-learned”analysisafterthecrisis,pointedtothemistakenbeliefthat“markets
willalwaysself-correct.”“Adeferencetotheself-correctingpropertyofmarketsinhib-
itedsupervisorsfromimposingprescriptiveviewsonbanks,”thereportconcluded.
µ1
Therelianceonbanks’ownriskmanagementwouldextendtocapitalstandards.
Bankshadcomplainedforyearsthattheoriginal1µ88Baselstandardsdidnotallow
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
mistakeswastheir“acceptanceofBaselIIpremises,”whichhedescribedasdisplay-
ing“anexcessivefaithininternalbankriskmodels,aninfatuationwiththespecious
accuracyofcomplexquantitativeriskmeasurementtechniques,andawillingness(at
leastintheearlydaysofBaselII)totolerateareductioninregulatorycapitalinre-
turnfortheprospectofbetterriskmanagementandgreaterrisk-sensitivity.”
µi
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,thenaFedgovernorandchairoftheFederalReserveBoard’s
subcommitteesonbothsafetyandsoundnesssupervisionandconsumerprotection
supervision, told the FCIC. “So the main debate within the board was how tightly
[shouldwe]reinintheabusesthatwewereseeing.Soitwasmoreof‘toadegree.’”
µ¡
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.Afourthparticipantsaidthat“wecouldbeseeingthefnalgaspsofhouse
priceappreciation.”Theparticipantexpressedconcernabout“creativefnancing”and
was“worriedthatpiggybacksandothernon-traditionalloans,”whoseriskofdefault
\ii i N .,.
couldbehigherthansuggestedbythesecuritiestheybacked,“couldbemakingthe
booksofGSEslookbetterthantheyreallywere.”FedstaffrepliedthattheGSEswere
notlargepurchasersofprivatelabelsecurities.
µ¡
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.“Nobodyhadafull¡oo-degreeview.Thebasicreactionfromfnan-
cial regulators was, ‘Well, there may be a problem. But it’s not in my feld of view,’”
SnowtoldtheFCIC.RegulatorsrespondedtoSnow’squestionsbysaying,“Ourde-
fault rates are very low. Our institutions are very well capitalized. Our institutions
[have]verylowdelinquencies.Sowedon’tseeanyrealbigproblem.”
µ,
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.
µo
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-
nated·1.¡trillioninmortgagesinioo,,almosthalfthenationaltotal.Inthegroup
were fve banks whose holding companies were under the Fed’s supervisory
purview—Bank of America, Citigroup, Countrywide, National City, and Wells
Fargo—aswellasthelargestthrift,WashingtonMutual.
µ,
Thestudy“showedavery
rapid increase in the volume of these irresponsible loans, very risky loans,” Sabeth
Siddique,thenheadofcreditriskattheFederalReserveBoard’sDivisionofBanking
SupervisionandRegulation,toldtheFCIC.
µ8
Alargepercentageoftheirloansissued
weresubprimeandAlt-Amortgages,andtheunderwritingstandardsfortheseprod-
uctshaddeteriorated.
µµ
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
directedlenderstoconsideraborrower’sabilitytomaketheloanpaymentwhenrates
.,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-
documentationloansshouldbe“usedwithcaution.”
1o1
Immediately, the industry was up in arms. The American Bankers Association
saidtheguidance“overstate[d]theriskofnon-traditionalmortgages.”
1oi
Othermar-
ketparticipantscomplainedthattheguidancerequiredthemtoassume“aworstcase
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,arguingthattheywere“notawareofanyempiricalevi-
dencethatsupportstheneedforfurtherconsumerprotectionstandards.”
1o,
The need for guidance was controversial within the agencies, too. “We got
tremendouspushbackfromtheindustryaswellasCongressaswellas,youknow,in-
ternally,”theFed’sSiddiquetoldtheFCIC.“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
recalledanoccasionwhenshetestifedaboutaproposedruleand“membersofCon-
gress[said]thatweweregoingtodenythedreamofhomeownershiptoAmericansif
weputthisnewstrongerstandardinplace.”
1o8
When guidance was put in place in iooo, regulators policed their guidance
throughbankexaminationsandinformalmeasuressuchas“voluntaryagreements”
withsupervisedinstitutions.
It also appeared some institutions switched regulators in search of more lenient
treatment.InDecemberiooo,CountrywideappliedtoswitchregulatorsfromtheFed
and OCC to the OTS. Countrywide’s move came after several months of evaluation
within the company about the benefts of OTS regulation, many of which were pro-
motedbytheOTSitselfoverthecourseofan“outreacheffort”initiatedinmid-ioo,
afterJohnReichbecamedirectoroftheagency.Publicly,Countrywidestatedthatthe
decisiontoswitchtotheOTSwasdrivenbythedesiretohaveone,housing-focused
regulator,ratherthanseparateregulatorsforthebankandtheholdingcompany.
1oµ
However,otherfactorscameintoplayaswell.TheOCC’stopCountrywideexam-
iner told the FCIC that Countrywide CEO Angelo Mozilo and President and COO
DavidSambolthoughttheOCC’spositiononpropertyappraisalswouldbe“killing
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.”CountrywideChiefRiskOmcerJohnMcMurrayrespondedthat“based
on my meetings with the FRB and OTS, the OTS appears to be both more familiar
andmorecomfortablewithOptionARMs.”
11i
The OTS approved Countrywide’s 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 products—commercial mortgage–backed se-
curities and collateralized loan obligations (CLOs), respectively—which 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-tolate1µµos.
11,
An“agent”
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
roseto·¡8,billion,upfrom·¡obillioniniooo.
11o
Startingin1µµ8,thelonger-termleveragedloanswerepackagedinCLOs,which
wereratedaccordingtomethodologiessimilartothosetheratingagenciesusedfor
CDOs.LikeCDOs,CLOshadtranches,underwriters,andcollateralmanagers.The
marketwaslessthan·,billionannuallyfrom1µµ8toiooi,butthenitstartedgrow-
ing dramatically. Annual issuance exceeded ·¡o billion in ioo, and peaked above
·8obillioninioo,.Fromiooothroughthethirdquarterofioo,,morethanooºof
leveragedloanswerepackagedintoCLOs.
11,
As the market for leveraged loans grew, credit became looser and leverage in-
creasedaswell.Thedealsbecamelargerandcostsofborrowingdeclined.Loansthat
inioo¡hadpaidinterestof¡percentagepointsoveraninterbanklendingratewere
.,, 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,forabout·iµbillion.Aspartofthistransaction,KKRwouldissue·8billion
injunkbondsandtakeoutanother·1,billioninleveragedloansfromaconsortium
of banks including Citigroup, Deutsche Bank, Goldman Sachs, HSBC Securities,
LehmanBrothers,andMerrillLynch.
11µ
AslateasJulyioo,,Citigroupandotherswerestillincreasingtheirleveragedloan
business.
1io
CitigroupCEOCharlesPrincethensaidofthebusiness,“Whenthemu-
sicstops,intermsofliquidity,thingswillbecomplicated.Butaslongasthemusicis
playing,you’vegottogetupanddance.We’restilldancing.”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,theseloansendeduponthebanks’balance
sheets.
1ii
Commercial real estate—multifamily apartment buildings, omce buildings, ho-
tels,retailestablishments,andindustrialproperties—wentthroughabubblesimilar
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 ooº between ioo¡ and
ioo8inthecentralbusinessdistrictsofthe¡imarketsforwhichdataareavailable.
Theincreasewas1µ¡ºinPhoenix,1,¡ºinTampa,1¡,ºinManhattan,and1¡oºin
LosAngeles.
1i¡
Issuanceofcommercialmortgage–backedsecuritiesrosefrom·¡,billioniniooo
to·1oµbillioninioo,,reaching·i¡obillioninioo,.Whensecuritizationmarkets
contracted, issuance fell to ·1i billion in ioo8 and ·¡ billion in iooµ. When about
\ii i N .,,
one-fourthofcommercialrealestatemortgagesweresecuritizedinioo,,securitizers
issued·¡1billionofcommercialmortgageCDOs,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 Hilton—a hotel chain
withi,µooproperties—for·iobillion,a¡oºpremiumovertheshareprice.Ayear
later,oneauthordescribedthisdealas“theapogeeoftheearly-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.”Thefrm’scommercialrealestatemortgageoriginationsmorethandou-
bledbetweenioo¡andiooo.
1i8
Andthenthemarketcamecrashingtoahalt.Althoughthecommercialrealestate
mortgagemarketwasmuchsmallerthantheresidentialrealestatemarket—inioo8,
commercialrealestatedebtwaslessthan·¡trillion,comparedto·1itrillionforres-
identialmortgages
1iµ
—itdeclinedevenmoresteeply. Fromitspeak,commercialreal
estatefellroughly¡,ºinvalue,andpriceshaveremainedclosetotheirlows.Losses
on commercial real estate would be an issue across Wall Street, particularly for
LehmanandBear.Andpotentiallyforthetaxpayer.WhentheFederalReservewould
assume·¡obillionofBear’silliquidassetsinioo8,thatwouldincluderoughly·¡bil-
lion in loans from the unsold portion of the Hilton fnancing package.
1¡o
And the
commercialrealestatemarketwouldcontinuetodeclinelongafterthehousingmar-
kethadbeguntostabilize.
LEHMAN: FROM “MOVING” TO “STORAGE”
Evenasthemarketwasnearingitspeak,Lehmantookonmorerisk.
OnOctober,,ioo,,whencommercialrealestatealreadymadeupo.¡ºofitsas-
sets,LehmanBrothersacquiredamajorstakeinArchstoneSmith,apubliclytraded
real estate investment trust, for ·,.¡ billion. Archstone owned more than 88,ooo
apartments,includingunitsstillunderconstruction,inover¡¡ocommunitiesinthe
UnitedStates.Itwasthebank’slargestcommercialrealestateinvestment.
1¡1
LehmaninitiallyprojectedthatArchstonewouldgeneratemorethan·1.¡billion
inproftsover1oyears—projectionsbasedonoptimisticassumptions,giventhestate
of the market at that point. Both Lehman and Archstone were highly leveraged:
Archstonehadlittlecushionifitsrentreceiptsshouldgodown,andLehmanhadlit-
tlecushionifinvestmentssuchasArchstoneshouldlosevalue.
1¡i
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 Lehman’s business
model,”theExecutiveCommitteesimplyleftitsriskomcer,MadelynAntoncic,outof
theloopwhenitmadethisinvestment.
1¡¡
Since the late 1µµos, Lehman had also built a large mortgage origination arm, a
formidable securities issuance business, and a powerful underwriting division as
well.Then,initsMarchiooo“GlobalStrategyOffsite,”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
thefrm’sriskpoliciesandlimits—andwarningsfromriskmanagers—andpursued
its“countercyclicalgrowthstrategy.”Ithadworkedwellduringpriormarketdisloca-
tions,andLehman’smanagementassumedthatitwouldworkagain.
1¡,
Lehman’sAu-
roraunitcontinuedtooriginateAlt-Aloansafterthehousingmarkethadbegunto
showsignsofweakening.
1¡o
Lehmanalsocontinuedtosecuritizemortgageassetsfor
salebutwasnowholdingmoreofthemasinvestments.Acrossboththecommercial
andresidentialrealestatesectors,themortgage-relatedassetsonLehman’sbooksin-
creasedfrom·o,billioninioooto·111billioninioo,.Thisincreasewouldbepart
ofLehman’sundoingayearlater.
Lehman’s regulators did not restrain its rapid growth. The SEC, Lehman’s main
regulator, knew of the frm’s disregard of risk management. The SEC knew that
Lehmancontinuedtoincreaseitsholdingofmortgagesecurities,andthatithadin-
creasedandexceededrisklimits—factsnotedalmostmonthlyinomcialSECreports
obtainedbytheFCIC.
1¡,
Nonetheless,ErikSirri,wholedtheSEC’ssupervisionpro-
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.
1¡8
In-
stead,itkeptbuying,wellintothefrstquarterofioo8.
Inaddition,accordingtothebankruptcyexaminer,Lehmanunderstateditslever-
age through “Repo 1o,” transactions—an accounting maneuver to temporarily re-
move assets from the balance sheet before each reporting period. Martin Kelly,
Lehman’s global fnancial controller, stated that the transactions had “no sub-
stance”—their“onlypurposeormotive . . .wasreductioninthebalancesheet.”Other
LehmanexecutivesdescribedRepo1o,transactionsasan“accountinggimmick”and
a“lazywayofmanagingthebalancesheetasopposedtolegitimatelymeetingbalance
sheet targets at quarter-end.” Bart McDade, who became Lehman’s president and
chief operating omcer in June ioo8, in an email called Repo 1o, transactions “an-
otherdrugweRon.”
1¡µ
Ernst&Young(E&Y),Lehman’sauditor,wasawareoftheRepo1o,practicebut
did not question Lehman’s 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,”andthat“colorableclaimsexistthatE&Ydid
not meet professional standards, both in investigating Lee’s allegations and in con-
nectionwithitsauditandreviewofLehman’sfnancialstatements.”
1¡o
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.
1¡1
TheOmceofThriftSupervisionhadalsoregulatedLehmansince1µµµthrough
its jurisdiction over Lehman’s thrift subsidiary. Although “the SEC was regarded as
theprimaryregulator,”theOTSexaminertoldtheFCIC,“weinnowayjustassumed
that[theSEC]woulddotherightthing,soweregulatedandsupervisedtheholding
company.”
1¡i
Still, not until July ioo8—just a few months before Lehman failed—
wouldtheOTSissueareportwarningthatLehmanhadmadean“outsizedbet”on
commercial real estate—larger than that by its peer frms, despite Lehman’s smaller
size;thatLehmanwas“materiallyoverexposed”tothecommercialrealestatesector;
andthatLehmanhad“majorfailingsinitsriskmanagementprocess.”
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: Fannie’s biggest source of mortgages, Countrywide, expanded—that is, loos-
ened—its underwriting criteria, and Fannie would not buy the new mortgages,
CountrywidePresidentandCOOSamboltoldtheFCIC.
1¡¡
Typicalofthemarketasa
whole,Countrywidesold,iºofitsloanstoFannieinioo¡butonly¡,ºinioo¡and
¡iºinioo,.
1¡,
“The risk in the environment has accelerated dramatically,” Thomas Lund, Fan-
nie’sheadofsingle-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.”
1¡o
“Wefacetwostarkchoices:staythecourse[or]meetthemarketwherethemarket
is,”Lundsaid.IfFannieMaestayedthecourse,itwouldmaintainitscreditdiscipline,
protect the quality of its book, preserve capital, and intensify the company’s public
voiceonconcerns.However,itwouldalsofacelowervolumesandrevenues,contin-
ueddeclinesinmarketshare,lowerearnings,andaweakeningofkeycustomerrela-
tionships.
1¡,
It was simply a matter of relevance, former CEO Dan Mudd told the
FCIC:“Ifyou’renotrelevant,you’reunproftable,andyou’renotservingthemission.
Andtherewasdangertoproftability.I’mspeakingmorelongtermthaninanygiven
quarteroranygivenyear.Sothiswasarealstrategicrethinking.”
1¡8
Lund saw signifcant obstacles to meeting the market. He noted Fannie’s lack of
capabilityandinfrastructuretostructurethetypesofriskiermortgage-backedsecu-
.,· ii N\Nti \i tii :i : i NQUi i¥ tu\\i : :i uN iiiui1
ritiesofferedbyWallStreet,itsunfamiliaritywiththenewcreditrisks,worriesthat
thepriceofthemortgageswouldn’tbeworththerisk,andregulatoryconcernssur-
roundingcertainproducts.
1¡µ
Atthisandothermeetings,Lundrecommendedstudy-
ingwhetherthecurrentmarketchangeswerecyclicalormorepermanent,buthealso
recommended that Fannie “dedicate signifcant resources to develop capabilities to
competeinanymortgageenvironment.”
1,o
Citibankexecutivesalsomadeapresenta-
tion to Fannie’s board in July ioo,, warning that Fannie was increasingly at risk of
beingmarginalized,andthat“staythecourse”wasnotanoption.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,Fanniewould“staythecourse,”whiledevelopingcapabilitiestocom-
pete with Wall Street in nonprime mortgages.
1,¡
In fact, however, internal reports
showthatbySeptemberioo,,thecompanyhadalreadybeguntoincreaseitsacquisi-
tionsofriskierloans.Bytheendofioo,,itsAlt-Aloanswere·181billion,upfrom
·1¡,billioninioo¡and·1¡8billioninioo¡;itsloanswithoutfulldocumentation
were·i,8billion,upfrom·ioobillioninioo¡;anditsinterest-onlymortgageswere
·,,billioninioo,,upfrom·1ibillioninioo¡.(Notethatthesecategoriescanover-
lap.Forexample,Alt-Aloansmayalsolackfulldocumentation.)Tocoverpotential
lossesfromallofitsbusinessactivities,Fanniehadatotalof·¡obillionincapitalat
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,FannieMae’sdisclosuresaboutkeyloancharacteristics
changedovertime,makingitdimculttodiscernthecompany’sexposuretosubprime
andAlt-Amortgages.Forexample,fromioo,untilioo,,thecompany’sdefnitionof
a“subprime”loanwasoneoriginatedbyacompanyorapartofacompanythatspe-
cialized in subprime loans. Using that defnition, Fannie Mae stated that subprime
loansaccountedforlessthan1ºofitsbusinessvolumeduringthoseyearsevenwhile
it reported that ,º 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,Freddie’slongtimechiefriskom-
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,Freddie’sexecutivevicepresidentforsingle-family
housing,toldFCICstaffthathedidnotrecallsuchdiscussions.
1,µ
Syronnevermade
Saksenapartoftheseniormanagementteam.
1oo
OFHEO,theGSEs’regulator,notedtheirincreasingpurchasesofriskierloansand
securities in every examination report. But OFHEO never told the GSEs to stop.
Rather,yearafteryear,theregulatorsaidthatbothcompanieshadadequatecapital,
strongassetquality,prudentcreditriskmanagement,andqualifedandactiveomcers
anddirectors.
InMayiooo,atthesametimeasitpaida·¡oomillionpenaltyrelatedtodefcien-
ciesinitsaccountingpractices,Fannieagreedtolimititson-balance-sheetmortgage
portfolioto·,i8billion,thelevelonDecember¡1,ioo,.
1o1
Twomonthslater,Fred-
die agreed to limit the growth of its portfolio to iº per year.
1oi
In examination re-
ports for the year ioo,, issued to both companies in May iooo, OFHEO noted the
growthinpurchasesofriskyloansandnon-GSEsecuritiesbutconcludedthateach
GSEhad“strong”assetqualityandwasadequatelycapitalized.OFHEOreportedthat
management at Freddie was committed to resolving weaknesses and its Board was
“qualifedandactive.”Theioo,examinationofFanniewaslimitedinscope—focus-
ing primarily on the company’s efforts to fx accounting and internal control def-
ciencies—becauseoftheextensiveresourcesneededtocompleteathree-yearspecial
examinationinitiatedinthewakeofFannie’saccountingscandal.
1o¡
Inthatspecialexamination,OFHEOpinnedmanyoftheGSEs’problemsontheir
corporatecultures.ItsMayiooospecialexaminationreportonFannieMaedetailedthe
“arrogant and unethical corporate culture where Fannie Mae employees manipulated
accountingandearningstotriggerbonusesforseniorexecutivesfrom1µµ8toioo¡.”
1o¡
OFHEODirectorJamesLockhart(whohadassumedthatpositionthemonththere-
port was issued) recalled discovering during the special examination an email from
Mudd, then Fannie’s 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
legislationwouldbepasseduntilJuly¡o,ioo8,andbythenitwouldbetoolate.
aooõ.“Incrcescour¡cnctretionintosuo¡rimc”
AfterseveralyearsduringwhichFannieMaepurchasedriskierloansandsecurities,
then-ChiefFinancialOmcerRobertLevinproposedastrategicinitiativeto“increase
our penetration into subprime” at Fannie’s January iooo board meeting.
1o,
In the
nextmonththeboardgaveitsapproval.
1o8
Fanniewouldbecomemoreandmoreag-
gressive in its purchases. During a summer retreat for Fannie’s senior omcers, as
.·+ ii N\Nti \i tii :i : i NQUi i¥ tu\\i : :i uN iiiui1
StephenAshley,thechairmanoftheboard,introducedFannie’snewchiefriskomcer,
Enrico Dallavecchia, he declared that the new CRO would not stand in the way of
risktaking:“Wehavetothinkdifferentlyandcreativelyaboutrisk,aboutcompliance,
andaboutcontrols.HistoricallythesehavenotbeenstrongsuitsofFannieMae. . . .
Today’s 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.”
1oµ
Iniooo,Fannieacquired·,1obillionofloans;ofthose(includingsomeoverlap),
·o,billion,orabout1¡º,hadcombinedloan-to-valueratiosaboveµ,º;1,ºwere
interest-only;andi8ºdidnothavefulldocumentation.
1,o
Fanniealsopurchased·¡o
billionofsubprimeand·1ibillionofAlt-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 Mudd’s
compensationtotaled·i¡.¡millionandLevin,whowasinterimCFOandthenchief
businessomcer,received·1,.,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-
countedforabouti¡ºofthatyear’spurchases.FreddieMac’splanalsoseemedtobe
successful. The company increased risk and market share while maintaining the
samenetincomeforioo,andiooo,·ibillion.
1,¡
CEORichardSyron’scompensation
totaled·i¡.imillionforioo,andiooocombined,
1,,
whileChiefOperatingOmcer
EugeneMcQuadereceived·1¡.¡million.
1,o
Again, OFHEO was aware of these developments. Its March ioo, report noted
thatFannie’snewinitiativetopurchasehigher-riskproductsincludedaplantocap-
tureioºofthesubprimemarketbyio11.AndOFHEOreportedthatcreditriskin-
creased“slightly”becauseofgrowthinsubprimeandothernontraditionalproducts.
Butoverallassetqualityinitssingle-familybusinesswasfoundtobe“strong,”andthe
boardmemberswere“qualifedandactive.”And,ofcourse,Fanniewas“adequately
capitalized.”
1,,
Similarly, OFHEO told Freddie in ioo, that it had weaknesses that raised some
possibilityoffailure,butthatoverall,Freddie’sstrengthandfnancialcapacitymade
failure unlikely.
1,8
Freddie did remain a “signifcant supervisory concern,”
1,µ
and
OFHEOnotedthesignifcantshifttowardhigher-riskmortgages.
18o
Butagain,asin
previous years, the regulator concluded that Freddie had “adequate capital,” and its
assetqualityandcreditriskmanagementwere“strong.”
181
TheGSEschargedafeeforguaranteeingpaymentsonGSEmortgage–backedsecu-
rities,andOFHEOwassilentaboutFannie’spracticeofcharginglesstoguaranteesecu-
rities than their models indicated was appropriate. Mark Winer, the head of Fannie’s
Business,AnalysisandDecisionsGroupsinceMayioooandthepersonresponsiblefor
\ii i N .·.
modelingpricingfees,raisedconcernsthatFannieMaewasnotchargingfeesforAlt-A
mortgagesthatadequatelycompensatedfortherisk.WinerrecalledthatLevinwascrit-
icalofhismodels,asking,“Canyoushowmewhyyouthinkyou’rerightandeveryone
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,.“Movingácc¡crintot/ccrcáit¡ool”
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 month’s meeting, Lund reported that Fannie’s market share
couldincreasetoooºfromabout¡,ºiniooo.
18,
Indeed,inioo,FannieMaeforged
ahead,purchasingmorehigh-riskloans.
188
Fanniealsopurchased·1obillionofsub-
primenon-GSEsecurities,and·,billionofAlt-A.
18µ
In June, Fannie prepared its ioo, fve-year strategic plan, titled “Deepen Seg-
ments—Develop Breadth.” The plan, which mentioned Fannie’s “tough new chal-
lenges—a weakening housing market” and “slower-growing mortgage debt
market”—includedtakingandmanaging“moremortgagecreditrisk,movingdeeper
intothecreditpooltoservealargeandgrowingpartofthemortgagemarket.”Over-
all, revenues and earnings were projected to increase in each of the following fve
years.
1µo
Management told the board that Fannie’s risk management function had all the
necessarymeansandbudgettoactontheplan.ChiefRiskOmcerDallavecchiadid
notagree,especiallyinlightofaplanned1oºcutinhisbudget.InaJuly1o,ioo,,
emailtoCEOMudd,Dallavecchiawrotethathewasveryupsetthathehadtohearat
theboardmeetingthatFanniehadthe“willandthemoneytochangeourcultureand
supporttakingmorecreditrisk,”giventheproposedbudgetcutforhisdepartmentin
ioo8afterai,ºreductioninheadcountinioo,.
1µ1
Inanearlieremail,Dallavecchia
hadwrittentoChiefOperatingOmcerMichaelWilliamsthatFanniehad“oneofthe
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.”
Thesedefcienciesindicatedthat“peopledon’tcareaboutthe[risk]functionorthey
don’tgetit.”
1µi
.·z ii N\Nti \i tii :i : i NQUi i¥ tu\\i : :i uN iiiui1
Muddresponded,“Myexperienceisthatemailisnotaverygoodvenueforcon-
versation,ventingornegotiating.”IfDallavecchiafeltthathehadbeendealtwithin
badfaith,heshould“addressitmantoman,”unlesshewantedMudd“tobetheone
tocarrymessagesforyoutoyourpeers.”Muddconcluded,“Pleasecomeandseeme
today face to face.”
1µ¡
Dallavecchia told the FCIC that when he wrote this email he
wastiredandupset,andthattheviewitexpressedwasmoreextremethanwhathe
thoughtatthetime.
1µ¡
Fannie,aftercontinuingtopurchaseandguaranteehigher-risk
mortgagesinioo,,wouldreporta·i.1billionnetlossfortheyear,causedbycredit
losses. In ioo,, Mudd’s compensation totaled ·11.o million and Levin’s 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.”
1µ,
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 missed—Subprime and Alt-A.”
1µo
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.Thevalueofthe·1,ibillionsubprimeandAlt-Aprivate-
labelsecuritiesbooksuffereda·1¡billiondeclineinmarketvalue.
1µ,
Inioo,,Syron’s
compensationtotaled·18.¡millionandMcQuade’stotaled·¡.8million.
\jjoráeolc/ousinggoels.“6SIscricáolooá;murácrjorcvcr”
Asdiscussedearlier,beginningin1µ,8,theDepartmentofHousingandUrbanDevel-
opment(HUD)periodicallysetgoalsfortheGSEsrelatedtoincreasinghomeowner-
ship among low- and moderate-income borrowers and borrowers in underserved
areas.Untilioo,,thesegoalswerebasedonthefractionofthetotalmortgagemarket
madeupoflow-andmoderate-incomefamilies.Thegoalswereintendedtobeonlya
modestreachbeyondthemortgagesthattheGSEswouldnormallypurchase.
1µ8
From1µµ,toiooo,¡iºofGSEpurchaseswererequiredtomeetgoalsforlow-
andmoderate-incomeborrowers.Inioo1,thegoalwasraisedto,oº.
1µµ
Muddsaid
thataslongasthegoalsremainedbelowhalfoftheGSEs’lending,loansmadeinthe
normalcourseofbusinesswouldsatisfythegoals:“Whatcomesinthedoorthrough
thenaturalcourseofbusinesswilltendtomatchthemarket,andthereforewilltend
tomeetthegoals.”
ioo
LevintoldtheFCICthat“therewasagreatdealofbusinessthat
camethroughnormalchannelsthatmetgoals”andthatmostoftheloansthatsatis-
fedthegoals“wouldhavebeenmadeanyway.”
io1
Inioo¡HUDannouncedthatstartinginioo,,,iºoftheGSEs’purchaseswould
needtosatisfythelow-andmoderate-incomegoals.Thetargetswouldreach,,ºin
ioo,and,oºinioo8.
ioi
Giventhedramaticgrowthinthenumberofriskierloans
\ii i N .·,
originatedinthemarket,thenewgoalswereclosertowherethemarketreallywas.
But, as Mudd noted, “When ,oº became ,,[º] ultimately, then you have to work
harder,paymoreattention,andcreateapreferenceforthoseloans.”
io¡
Targetedgoals
loans(loansmadespecifcallytomeetthetargets),whilealwaysasmallshareofthe
GSEs’purchases,roseinimportance.
Mudd testifed that by ioo8, when the housing market was in turmoil, Fannie
Maecouldnolongerbalanceitsobligationstoshareholderswithitsaffordablehous-
inggoalsandothermission-relateddemands:“Theremayhavebeennowaytosat-
isfy1ooºofthemyriaddemandsforFannieMaetosupportallmannerofprojects
[or]housinggoalswhichweresetabovetheoriginationlevelsinthemarketplace.”
io¡
AsthecombinedsizeoftheGSEsrosesteadilyfrom·¡.otrillioninioo¡to·¡.µtril-
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
theprimarydriveroftheGSEs’purchasesofriskiermortgagesandofsubprimeand
Alt-A non-GSE mortgage–backed securities. Executives from Fannie, including
Mudd,pointedtoa“mix”ofreasonsforthepurchases,suchasreversingthedeclines
inmarketshare,respondingtooriginators’demands,andrespondingtoshareholder
demandstoincreasemarketshareandprofts,inadditiontofulfllingthemissionof
meetingaffordablehousinggoalsandprovidingliquiditytothemarket.
Forexample,LevintoldtheFCICthatwhileFannie,tomeetitshousinggoals,did
purchasesomesubprimemortgagesandmortgage-backedsecuritiesitwouldother-
wisehavepassedup,Fanniewasdrivento“meetthemarket”andtoreversedeclining
marketshare.Ontheotherhand,hesaidthatmostAlt-Aloanswerehigh-income-
oriented and would not have counted toward the goals, so those were purchased
solelytoincreaseprofts.
ioo
Similarly,LundtoldtheFCICthatthedesireformarket
sharewasthemaindriverbehindFannie’sstrategyiniooo.Housinggoalshadbeena
factor,butnottheprimaryone.
io,
AndDallavecchialikewisetoldtheFCICthatFan-
nieincreaseditspurchasesofAlt-Aloanstoregainrelevanceinthemarketandmeet
customerneeds.
io8
Hempstead, Fannie’s principal contact with Countrywide, told the FCIC that
whilehousinggoalswereonereasonforFannie’sstrategy,themainreasonFannieen-
teredtheriskiermortgagemarketwasthatthosewerethetypesofloansbeingorigi-
nated in the primary market.
ioµ
If Fannie wanted to continue purchasing large
quantities of loans, the company would need to buy riskier loans. Kenneth Bacon,
Fannie’s 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,andiooowasowedtoa“mixofreasons,”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,andoutreachprogramsrunbythecompany’spartnershipomces.“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,attributedtheGSEs’change
instrategytotheirdriveforproftandmarketshare,aswellastheneedtomeethous-
inggoals.Notingthattheaffordablehousinggoalsincreasedmarkedlyinioo,,
i1o
he
saidinanFCICinterviewthatthe“goalswerejustonereason,certainlynottheex-
clusivereason”forthechange.
i1,
Theseviewswerecorroboratedbynumerousother
omcialsfromtheagency.
i18
The former HUD omcial Mike Price told the FCIC that while the “GSEs cried
bloodymurderforever”whenitcametothegoals,theytoutedtheircontributionto
increasinghomeownership.Inaddition,PriceandotherHUDomcialstoldtheFCIC
thattheGSEsneverclaimedthatmeetingthegoalswouldleavetheminanunsafeor
unsoundcondition.
i1µ
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 Mae’s ioo, strategic plan had already anticipated such a
communication,stating,“Intheeventwereachaviewpointthatachievingthegoals
thisyearis‘infeasible,’wewilldeterminehowbesttoaddressthematterwithHUD
andwillcontinuetokeeptheBoardapprisedaccordingly.”
ii¡
Infact,bothFannieand
FreddieappealedtoHUDtolowertwocomponentsofthegoalsforaffordablehous-
ing.HUDcompliedandallowedtheGSEstofallshortwithoutanyconsequences.
ii¡
1/cim¡ectojt/cgoels
AtleastuntilHUDsetnewaffordablehousinggoalsforioo,,theGSEsonlysupple-
mented their routine purchases with a small volume of loans and non-GSE mort-
gage–backedsecuritiesneededtomeettheirrequirements.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 iooµ 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
reachedthrough“proftableexpansion”ofthecompany’smultifamilybusiness.Dur-
ingtherefnanceboom,thegoalsbecamemorechallengingandcostFreddiemoney
in the multifamily business; thus, only after ioo¡ did meeting the multifamily and
single-familygoalscosttheGSEmoney.Still,onlyabout¡ºofallloanspurchasedby
Freddiebetweenioo,andioo8werebought“specifcallybecausetheycontributeto
thegoals”—loansitlabeledas“targetedaffordable.”Theseloansdidhavehigherthan
averageexpecteddefaultrates,althoughFreddiealsochargedahigherfeetoguaran-
tee them. From ioo¡ through ioo8, Freddie’s costs of complying with the housing
goalsaveraged·ioomillionannually.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,thecompany’snetearningsaveragedjustun-
der·¡billionperyearfromioo¡toiooo.
iio
In ioo¡, Fannie Mae retained McKinsey and Citigroup to determine whether it
would be worthwhile to give up the company’s charter as a GSE, which—while af-
fording the company enormous benefts—imposed regulations and put constraints
on business practices, including its mission goals. The fnal report to Fannie Mae’s
top management, called Project Phineas, found that the explicit cost of compliance
withthegoalsfromioootoioo¡wasclosetozero:“itishardtodiscernafundamen-
talmarginalcosttomeetingthehousinggoalsonthesinglefamilybusinessside.”
ii,
The report came to this conclusion despite the slightly greater dimculty of meeting
thegoalsintheioo¡refnancingboom:thelargenumbersofhomeownersrefnanc-
ing,inparticularthosewhoweremiddleandupperincome,necessarilyreducedthe
percentageofthepoolthatwouldqualifyforthegoals.
In calculating these costs, the consultants computed the difference between fees
chargedongoal-qualifyingloansandthehigherfeessuggestedbyFannie’sownmod-
els.Butthiscostwasnotuniquetogoalqualifyingloans.Acrossitsportfolio,Fannie
chargedlowerfeesthanitsmodelscomputedforgoalsloansaswellasfornon-goals
loans.Asaresult,goalsloans,eventargetedgoalsloans,werenotsolelyresponsible
forthiscost.Infact,Fannie’sdiscountwasactuallysmallerformanygoal-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,FannieMaeestimatedthecashfowcostoftheloanstobe·11,million
and the opportunity cost of the targeted goals loans ·¡µo million, compared to net
incomethatyeartoFannieof·¡.1billion—afgurethatincludesreturnsonthegoal-
qualifying loans made during the normal course of business.
ii8
The targeted goals
loansamountedto·18billion,or¡.¡º,ofFannieMae’s·,i¡billionofsingle-family
mortgagepurchasesiniooo.
iiµ
Asthemarketstightenedinthemiddleofioo,,the
opportunitycostforthatyearwasforecasttoberoughly·1billion.
i¡o
Lookingbackathowthetargetedaffordableportfolioperformedincomparison
with overall losses, the iooµ presentation at Freddie Mac took the analysis of the
goals’costsonestepfurther.Whiletheoutstanding·oobillionofthesetargetedaf-
fordableloanswasonly¡ºofthetotalportfolio,thesewererelativelyhigh-riskloans
andwereexpectedtoaccountfor1µºoftotalprojectedlosses.Infact,asoflateioo8,
theyhadaccountedforonly8ºoflosses—meaningthattheyhadperformedbetter
than expected in relation to the whole portfolio. The company’s major losses came
from loans acquired in the normal course of business. The presentation noted that
manyofthesedefaultedloanswereAlt-A.
i¡1
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 bubble’s
collapse.
Lax mortgage regulation and collapsing mortgage-lending standards and
practicescreatedconditionsthatwereripeformortgagefraud.
10
THE MADNESS
CONTENTS
CDOnanagcrs“Vcarcnctarcnt-a-nanagcr” +:,
Crcditdcjau|tswaps“Dun|qucsticn”+,o
Citigrcup“Idcnct|c|icvcwcwcrcpcwcr|css”+,,
AIG“I’nnctgcttingpaidcncughtcstandcnthcsctracks” :oo
Mcrri||“Vhatcvcrittakcs”:o:
Rcgu|atcrs“Arcunducccnccntraticnscjriskdcvc|cping?” :o,
Mccdy’s“Itwasa||a|cutrcvcnuc”:oe
Thecollateralizeddebtobligationmachinecouldhavesputteredtoanaturalendby
thespringofiooo.Housingpricespeaked,andAIGstartedtoslowdownitsbusiness
ofinsuringsubprime-mortgageCDOs.ButitturnedoutthatWallStreetdidn’tneed
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
AIG’smodelforanalyzingitsCDOpositions,toldtheFCIC.
1
The CDO machine had become self-fueling. Senior executives—particularly 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-
suresonthebooksoflargefnancialinstitutions—exposuresthatwouldultimately
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
hadhelpfromcustomersinselectingthecollateral—includingthosewhowerebet-
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-
tions—but excluded mortgage-backed securities and CDOs, because they saw the
risksofthoseproductsasrelativelystraightforwardandwellunderstood.
¡
Disasterwasfastapproaching.
CDO MANAGERS: “WE ARE NOT A RENTAMANAGER”
Duringthe“madness,”wheneveryonewantedapieceoftheaction,CDOmanagers
facedgrowingcompetitivepressures.Managers’compensationdeclined,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
themanagerswereinfuencedbytheunderwriters—thesecuritiesfrmsthatcreated
andmarketedthedeals.AnFCICsurveyof¡oCDOmanagersconfrmedthispoint.
o
Sometimes managers were given a portfolio constructed by the securities frm; the
managerswouldthenchoosethemortgageassetsfromthatportfolio.Theequityin-
vestors—whoofteninitiatedthedealinthefrstplace—alsoinfuencedtheselection
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,whoseCDOmanagementunitwasoneofthenation’slargestin
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
highroadoryoudon’t—we’renotgoingtohurtaccountsordamageourreputation
for fees.” Simon said the rating agencies’ methodologies were not sumciently strin-
gent,particularlybecausetheywerebeingappliedtonewtypesofsubprimeandAlt-
Aloanswithlittleornohistoricalperformancedata.
µ
Noteveryoneagreedwiththis
viewpoint. “Managers who are sticking in this business are doing it right,” Armand
Pastine,thechiefoperatingomceratMaximGroup,respondedatthatsameconfer-
ence.“TosuggestthatCDOmanagerswouldpulloutofaneconomicallyviabledeal
formoralreasons—that’sacop-out.”
1o
Aswastypicalfortheindustryduringthecri-
sis, two of Maxim’s eight mortgage-backed CDOs, Maxim High Grade CDO I and
Maxim High Grade CDO II, would default on interest payments to investors—in-
cluding investors holding bonds that had originally been rated triple-A—and the
othersixwouldbedowngradedtojunkstatus,includingall ofthoseoriginallyrated
triple-A.
11
AnotherdevelopmentalsochangedtheCDOs:inioo,andiooo,CDOmanagers
werelesslikelytoputtheirownmoneyintotheirdeals.Earlyinthedecade,investors
hadtakenthemanagers’investmentintheequitytrancheoftheirownCDOstobe
an assurance of quality, believing that if the managers were sharing the risk of loss,
theywouldhaveanincentivetopickcollateralwisely.Butthisfail-safelostforceas
theamountofmanagers’investmentpertransactiondeclinedovertime.ACAMan-
agement,aunitofthefnancialguarantorACACapital,providesagoodillustration
of this trend. ACA held 1ooº of the equity in the CDOs it originated in iooi and
ioo¡,,iºando1ºoftwodealsitoriginatedinioo¡,between1oºandi,ºofdeals
inioo,,andbetweenoºand11ºofdealsiniooo.
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,,derivativesdealersintroducedthe“pay-as-you-go” creditdefaultswap,
acomplexinstrumentthatmimickedthetimingofthecashfowsofrealmortgage-
backedsecurities.

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,youdon’thaveto
goandbuythecashbonds,”saidLauraSchwartzofACACapital.

Therewerealso
nowarehousingcostsorassociatedrisks.Andtheytendedtoofferthepotentialfor
higherreturnsontheequitytranches:oneanalystestimatedthattheequitytranche
on a synthetic CDO could typically yield about i1º, while the equity tranche of a
typicalcashCDOcouldpay1¡º.
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
“shorts”withthe“longs”andminimizinganyriskforhisownbank.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 ,oº or more synthetic collateral; again,
unlessotherwisenoted,ourdatareferstoCDOsthatincludemortgage-backedsecu-
rities.) Even CDOs that were labeled as “cash CDOs” increasingly held some credit
derivatives.Atotalof·ii,billioninCDOswereissuediniooo,includingthosela-
beledascash,“hybrid,”orsynthetic;theFCICestimatesthati,ºofthecollateralwas
derivatives,comparedwithµºinioo,and,ºinioo¡.
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
hedgefundsencompassingover·1.1trillioninassetsasofearlyio1ofoundthisto
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.TheFCIC’ssurveyfoundthatbyJune
ioo,, the largest hedge funds held ·i, billion in equity and other lower-rated
tranchesofmortgage-backedsecurities.Theseweremorethanoffsetby·¡,billion
inshortpositions.

Thesetypesoftradeschangedthestructuredfnancemarket.Investorsintheequity
and most junior tranches of CDOs and mortgage-backed securities traditionally had
thegreatestincentivetomonitorthecreditriskofanunderlyingportfolio.Withthead-
ventofcreditdefaultswaps,itwasnolongerclearwho—ifanyone—hadthatincentive.
For one example, consider Merrill Lynch’s ·1., billion Norma CDO, issued in
ioo,.Theequityinvestor,MagnetarCapital,ahedgefund,wasexecutingacommon
strategyknownasthecorrelationtrade—itboughttheequitytranchewhileshorting
othertranchesinNormaandotherCDOs.Accordingtocourtdocuments,Magnetar
wasalsoinvolvedinselectingassetsforNorma.
io
Magnetarreceived·¡.,millionre-
latedtothistransactionandNIRCapitalManagement,theCDOmanager,waspaida
feeof·,,,oooplusadditionalfees.
i1
Magnetar’scounseltoldtheFCICthatthe·¡.,
millionwasadiscountintheformofa rebateonthepriceoftheequitytrancheand
otherlongpositionspurchasedbyMagnetarandnotapaymentreceivedinreturnfor
goodorservices.
ii
CourtdocumentsindicatethatMagnetarwasinvolvedinselect-
ingcollateral,andthat NIRabdicateditsassetselectiondutiestoMagnetarwithMer-
rill’sknowledge.Inaddition,theyshowthatwhenoneMerrillemployeelearnedthat
Magnetar had executed approximately ·ooo million in trades for Norma without
NIR’sapparentinvolvementorknowledge,sheemailedcolleagues,“Dumbquestion.
IsMagnetarallowedtotradeforNIR:”

MerrillfailedtodisclosethatMagnetarwas
paid·¡.,millionorthatMagnetarwasselectingcollateralwhenitalsohadashort
positionthatwouldbeneftfromlosses.

ThecounselforMerrill’snewowner,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,hadplayeda“signifcantrole”intheselec-
tion. The SEC alleged that those misrepresentations were in Goldman’s marketing
materialsforAbacusioo,-AC1,oneofGoldman’si¡Abacusdeals.
io
.,z ii N\Nti \i tii :i : i NQUi i¥ tu\\i : :i uN iiiui1
IraWagner,theheadofBearStearns’sCDOGroupinioo,,toldtheFCICthathe
rejected the deal when approached by Paulson representatives. When asked about
Goldman’scontentionthatPaulson’spickingthecollateralwasimmaterialbecausethe
collateralwasdisclosedandbecausePaulsonwasnotwell-knownatthattime,Wagner
called the argument “ridiculous.” He said that the structure encouraged Paulson to
picktheworstassets.Whileacknowledgingthepointthateverysyntheticdealneces-
sarilyhadlongandshortinvestors,Wagnersawhavingtheshortinvestorsselectthe
referencedcollateralasaseriousconfictandforthatreasondeclinedtoparticipate.
i,
ACAexecutivestoldtheFCICtheywerenotinitiallyawarethattheshortinvestor
wasinvolvedinchoosingthecollateral.CEOAlanRosemansaidthathefrstheardof
Paulson’srolewhenhereviewedtheSEC’scomplaint.
i8
LauraSchwartz,whowasre-
sponsibleforthedealatACA,saidshebelievedthatPaulson’sfrmwastheinvestor
takingtheequitytrancheandwouldthereforehaveaninterestinthedealperforming
well.ShesaidshewouldnothavebeensurprisedthatPaulsonwouldalsohavehada
shortposition,becausethecorrelationtradewascommoninthemarket,butadded,
“Tobehonest,[atthattime,]untiltheSECtestimonyIdidnotevenknowthatPaul-
sonwasonlyshort.”

PaulsontoldtheFCICthatanysyntheticCDOwouldhaveto
investin“apoolthatbothabuyerandsellerofprotectioncouldagreeon.”Hedidn’t
understandtheobjections:“Every[synthetic]CDOhasabuyerandsellerofprotec-
tion.Soforanyonetosaythattheydidn’twanttostructureaCDObecausesomeone
wasbuyingprotectioninthatCDO,thenyouwouldn’tdoanyCDOs.”
¡o
In July io1o, Goldman Sachs settled the case, paying a record ·,,o million fne.
Goldman“acknowledge[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 Paulson’s 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,evenas“there
wasamassiveamountofgaminggoingon.”
¡i
ShortingCDOswas“prettyattractive”becausetheratingagencieshadgiventoo
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
,µoº. “Each MBS tranche typically would be ¡oº mortgages in California, 1oº in
Florida,1oºinNewYork,andwhenyouaggregate1ooMBSpositionsyoustillhave
the same geographic diversifcation. To us, there was not much diversifcation in
CDOs.”Shu’sresearchconvincedhimthatifhomepricesweretostopappreciating,
BBB-rated mortgage-backed securities would be at risk for downgrades. Should
pricesdrop,º,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
“mysteriousalchemicalprocesses”inwhich“WallStreettransformsBBB-minus-rated
mortgagesintoAAA-ratedtranchesofmortgagesecurities”bycreatingCDOs.Hees-
timatedthateventhetriple-AtranchesofCDOswouldexperiencesomelossesifna-
tionalhomepricesweretofalljust¡ºorlesswithintwoyears;andifpriceswereto
fall1oº,investorsoftranchesratedAA-orbelowwouldbecompletelywipedout.
¡,
Inioo,,Eismanandotherswerealreadylookingforthebestwaytobetonthis
disasterbyshortingalltheseshakymortgage-relatedsecurities.Buyingcreditdefault
swapswasemcient.Eismanrealizedthathecouldpickwhatheconsideredthemost
vulnerabletranchesofthemortgage-backedbondsandbetmillionsofdollarsagainst
them,relativelycheaplyandwithconsiderableleverage.Andthat’swhathedid.
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 California’s
Silicon Valley, bet big against mortgage-backed securities—refecting a change of
heart, because he had invested in homebuilder stocks in iooi. But the closer he
looked,themorehewonderedaboutthefnancingthatsupportedthisboomingmar-
ket.Burrydecidedthatsomeofthenewfangledadjustableratemortgageswere“the
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
isanargumenttobemadethatyoushouldn’tallowwhatIdid.”Buttheproblem,he
said,wasnottheshortpositionshewastaking;itwastherisksthatotherswereac-
cepting. “When I did the shorts, the whole time I was putting on the positions . . .
therewerepeopleontheothersidethatwerejusteatingthemup.Ithinkit’sacatas-
tropheandIthinkitwaspreventable.”
¡µ
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,
Citigroup’sCDOdeskwaspushingmoremoneytothecenterofthetable.
1ui \\iNi: : .,,
But after writing ·i, billion in liquidity puts—protecting investors who bought
commercialpaperissuedbyCitigroup’sCDOs—thebank’streasurydepartmenthad
put a stop to the practice. To keep doing deals, the CDO desk had to fnd another
marketforthesuper-seniortranchesoftheCDOsitwasunderwriting—orithadto
fndawaytogetthecompanytosupporttheCDOproductionline.TheCDOdesk
accumulatedanother·18billioninsuper-seniorexposures,mostbetweenearlyiooo
and August ioo,, which it otherwise would have been able to sell into the market
onlyforaloss.
¡i
Itwasalsoincreasinglyfnancingsecuritiesthatitwasholdinginits
CDOwarehouse—thatis,securitiesthatwerewaitingtobeputintonewCDOs.
Historically,owningsecuritieswasnotwhatsecuritiesfrmsdid.Theadage“We
areinthemovingbusiness,notthestoragebusiness”suggeststhattheywerestruc-
turingandsellingsecurities,notbuyingorretainingthem.
However,asthebiggestcommercialbanksandinvestmentbankscompetedinthe
securities business in the late 1µµos and on into the new century, they often touted
the“balancesheet”thattheycouldmakeavailabletosupportthesaleofnewsecuri-
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, the·1trillioncommercialbankwhosedepositswereinsuredbythe
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,thatmeansyou’renot
pricingitcorrectly,”RichardBookstaber,whohadbeenheadofriskmanagementat
Citigroupinthelate1µµos,toldtheFCIC.Butkeepingthetranchesonthebooksat
thesepricesimprovedthefnancesforcreatingthedeal.“Itwasahiddensubsidyof
theCDObusinessbymispricing,”Bookstabersaid.
¡¡
Thecompanywouldnotbegin
writingthesecuritiesdowntowardthemarket’srealvaluationsuntilthefallofioo,.
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
1µµoMarketRiskAmendment.Thatruleallowedbankstousetheirownmodelsto
determinehowmuchcapitaltohold,anamountthatvariedaccordingtohowmuch
marketpricesmoved.Citigroupjudgedthatthecapitalrequirementforthesuper-se-
niortranchesofsyntheticCDOsitheldfortradingpurposeswaseffectivelyzero,be-
.,· ii N\Nti \i tii :i : i NQUi i¥ tu\\i : :i uN iiiui1
causethepricesdidn’tmovemuch.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.ioº to
o.¡oºinannualfeesonthesuper-seniorprotection;onabillion-dollartransaction,it
wouldearnanannualfeeof·imillionto·¡million.
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, Citigroup’s securities unit
wouldsetupawarehouse fundinglinefortheCDOmanager.Duringtheramp-up
period, the collateral securities would pay interest; depending on the terms of the
agreement,thatinterestwouldeithergoexclusivelytoCitigrouporbesplitwiththe
manager.FortheCDOdesk,thisfrequentlyrepresentedasubstantialincomestream.
Thesecuritiessittinginthewarehousefacilityhadrelativelyattractiveyields—often
1.oºtoi.,ºmorethanthetypicalbankborrowingrate—anditwasnotuncommon
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.”
¡,
Citigroup’swillingnesstouseitsbalancesheettosupporttheCDObusinesshad
thedesiredeffect.ItsCDOdeskcreated·11billioninCDOsthatincludedmortgage-
1ui \\iNi: : .,,
backedsecuritiesintheircollateralinioo,and·iibillioniniooo.AmongCDOun-
derwriters, including all types of CDOs, Citigroup rose from fourteenth place in
ioo¡tosecondplaceinioo,,accordingtoFCICanalysisofMoody’sdata.
¡o
What was good for Citigroup’s investment bank was also lucrative for its invest-
ment bankers. Thomas Maheras, the co-CEO of the investment bank who said he
spentlessthan1ºofhistimethinkingaboutCDOs,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.Citigroup’schiefriskomcermade·,.¡million.
¡,
Otherswerealsowellre-
warded. The co-heads of the global CDO business, Nestor Dominguez and Janice
Warne,eachmadeabout·omillionintotalcompensationiniooo.
¡8
Citi did have “clawback” provisions: under narrowly specifed circumstances,
compensationwouldhavetobereturnedtothefrm.ButdespiteCitigroup’seventual
largelosses,nocompensationwaseverclawedbackunderthispolicy.TheCorporate
Library,whichratesfrms’corporategovernance,gaveCitigroupaC.Inearlyioo,,
theCorporateLibrarywoulddowngradeCitigrouptoaD,“refectingahighdegree
of governance risk.” Among the issues cited: executive compensation practices that
werepoorlyalignedwithshareholderinterests.
¡µ
WherewereCitigroup’sregulatorswhilethecompanypileduptensofbillionsof
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
recentreviewofCitigroup’ssecuritiesarmprecedingthecrisiswasinioo,,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 relevant—weaknesses 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,inthatthebusinessgrewfarinexcessofmanagement’sunderlyingin-
frastructureandcontrolprocesses.”
,i
InMayioo,,areviewundertakenbypeersat
theotherFederalReservebankswascriticaloftheNewYorkFed—thenheadedby
thecurrenttreasurysecretary,TimothyGeithner—foritsoversightofCitigroup.The
reviewconcludedthattheFed’son-siteCitigroupteamappearedtohave“insumcient
resources to conduct continuous supervisory activities in a consistent manner. At
Citi,muchofthelimitedteam’senergyisabsorbedbytopicalsupervisoryissuesthat
detractfromtheteam’scontinuoussupervisionobjectives . . .thelevelofthestamng
withintheCititeamhasnotkeptpacewiththemagnitudeofsupervisoryissuesthat
theinstitutionhasrealized.”

ThattheFed’sioo,examinationofCitigroupdidnot
raise the concerns expressed that same year by the OCC may illustrate these prob-
lems.Fouryearslater,thenextpeerreviewwouldagainfndsubstantialweaknesses
intheNewYorkFed’soversightofCitigroup.

InApriliooo,theFedraisedtheholdingcompany’ssupervisoryratingfromthe
previousyear’s“fair”to“satisfactory.”
,,
Itliftedthebanonnewmergersimposedthe
previous year in response to Citigroup’s many regulatory problems.
,o
The Fed and
OCCexaminersconcurredthatthecompanyhadmade“substantialprogress”inim-
plementing CEO Charles Prince’s plan to overhaul risk management. The Fed de-
clared: “The company has . . . completed improvements necessary to bring the
companyintosubstantialcompliancewithtwoexistingFederalReserveenforcement
actionsrelatedtotheexecutionofhighlystructuredtransactionsandcontrols.”
,,
The
followingyear,Citigroup’sboardwouldalludetoPrince’ssuccessfulresolutionofits
regulatorycomplianceproblemsinjustifyinghisioºcompensationincrease.
,8
The OCC noted in retrospect that the lifting of supervisory constraints in iooo
hadbeenakeyturningpoint.“Afterregulatoryrestraintsagainstsignifcantacquisi-
tionswerelifted,Citigroupembarkedonanaggressiveacquisitionprogram,”theOCC
wrotetoVikramPandit,Prince’sreplacement,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-
tiveimpactofearningsvolatilityofthesebusinessesonthefrm’scapitalposition.”
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 AIG’s 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,thatthe“multisector”CDOsonwhichAIGwassellingcreditdefaultswapscon-
sistedmainlyofmortgage-backedsecuritieswithlessthan1oºsubprimeandAlt-A
mortgages,ParkaskedAdamBudnick,anotherAIGemployee,forverifcation.Bud-
nick double checked and returned to say, according to Park, “‘I can’t believe it. You
know,it’slike8oorµoº.’”Reviewingtheportfolio—andthinkingaboutafriendwho
hadreceived1ooºfnancingforhisnewhomeafterlosinghisjob—Parksaid,“This
ishorrendousbusiness.Weshouldgetoutofit.”
oi
In July ioo,, Park’s colleague Andrew Forster sent an email both to Alan Frost,
the AIG salesman primarily responsible for the company’s 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
yetIregularlyseedealswith8oº[high-riskmortgage]concentrationscurrently.Are
thesereallythesameriskasotherdeals:”

Parkandothersstudiedtheissueforweeks,talkedtobankanalystsandotherex-
perts,andconsideredwhetheritmadesenseforAIGtocontinuetowriteprotection
on the subprime and Alt-A mortgage markets. The general view of others was that
someoftheunderlyingmortgages“werestructuredtofail,[but]thatalltheborrow-
erswouldbasicallybebailedoutaslongasrealestatepriceswentup.”

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,“Weweren’tgetting
paidenoughmoneytotakethatrisk. . . .I’mnotgoingtoopineonwhetherthere’sa
train on its way. I just know that I’m 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
CDSprotectiononsubprimemortgage–backedsecurities.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
signifcantchangeinthecompositionofthesedealsgoingforward—i.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.

AIG’scounterpartiesrespondedwithindifference.“Thedaythatyou[AIG]drop
out,we’regoingtohave1ootherpeoplewhoaregoingtoreplaceyou,”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 iooo—one of them on a CDO backed by µ¡º subprime
assets.

By June ioo,, AIG had written swaps on ·,µ billion in multisector CDOs, fve
timesthe·1obillionheldattheendofioo,.
,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 AIG’s SEC flings to investors for ioo, mentioned the risk of collateral
callsonlyifAIGweredowngraded.
Still,AIGneverhedgedmorethan·1,omillionofitstotalsubprimeexposure.

SomeofAIG’scounterpartiesnotonlyusedAIG’sswapstohedgeotherpositionsbut
alsohedgedAIG’sabilitytomakegoodonitscontracts.Aswewillseelater,Goldman
SachshedgedaggressivelybybuyingCDSprotectiononAIGandbyshortingother
securitiesandindexestocounterbalancetheriskthatAIGwouldfailtopayuponits
swapsorthatacollapsingsubprimemarketwouldpulldownthevalueofmortgage-
backedsecurities.
MERRILL: “WHATEVER IT TAKES”
WhenDowKimbecameco-presidentofMerrillLynch’sGlobalMarketsandInvest-
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
StanleyO’NealtoldtheFCIC.
,,
KimhiredChrisRicciardifromCreditSuisse,where
Ricciardi’sgrouphadsoldmoreCDOsthananyoneelse.
,o
Ricciardi came through, lifting Merrill’s CDO business from ffteenth place in
iooitosecondplacebehindonlyCitigroupinioo¡andGoldmaninioo,.
,,
Then,in
Februaryiooo,heleftthebanktobecomeCEOofCohen&Company,anassetman-
agementbusiness;atCohenhewouldmanageseveralCDOs,oftendealsunderwrit-
tenbyMerrill.
AfterRicciardileft,Kiminstructedtherestoftheteamtodo“whateverittakes”
notjusttomaintainmarketsharebutalsototakeoverthenumberoneranking,for-
meremployeessaidinacomplaintfledagainstMerrillLynch.
,8
KimtoldFCICstaff
thathecouldn’trecallspecifcconversationsbutthatafterRicciardileft,Merrillwas
stilltryingtoexpandtheCDObusinessgloballyandthathe,Kim,wantedpeopleto
knowthatMerrillwaswillingtocommititspeople,resources,andbalancesheetto
achievethatgoal.

Itwasindeedwilling.Despitethelossofitsrainmaker,Merrillswampedthecom-
petition, originating a total ·¡8.µ billion in mortgage-related CDOs in iooo, while
thesecond-rankedfrm,MorganStanley,didonly·i1.¡billion,andearninganother
frst-place ranking in ioo,,
8o
on the strength of the CDO machine Ricciardi had
built—a 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
the“realmoney,”todistinguishthemfromCDOmanagerswhowerebuyingtranches
justtoputthemintotheirCDOs.Betweenioo,andioo,,thetypicalamountaCDO
couldincludeofthetranchesofotherCDOsandstillmaintainitsratingsgrewfrom
,ºto¡oº,accordingtotheCDOmanagerWingChau.
8i
Accordingtodatacompiled
by the FCIC, tranches from CDOs rose from an average of ,º of the collateral in
mortgage-backed CDOs in ioo¡ to 1¡º by ioo,. CDO-squared deals—those engi-
neered primarily from the tranches of other CDOs—grew from ¡o marketwide in
ioo,to¡8inioooand¡1inioo,.Merrillcreatedandsold11ofthem.

Still, there are clear signs that few “real money” investors remained in the CDO
marketbylateiooo.ConsiderMerrill:forthe¡¡ABSCDOsthatMerrillcreatedand
soldfromthefourthquarterofiooothroughAugustioo,,nearly8oºofthemezza-
ninetrancheswerepurchasedbyCDOmanagers.

ThepatternwassimilarforChau:
an FCIC analysis determined that 88º of the mezzanine tranches sold by the 1¡
CDOsmanagedbyChauweresoldforinclusionintootherCDOs.
8,
Anestimated1o
different CDO managers purchased tranches in Merrill’s Norma CDO. In the most
extremecasefoundbytheFCIC,CDOmanagersweretheonlypurchasersofMer-
rill’sNeoCDO.
8o
Marketwide,inioo¡CDOstookinabout1¡ºoftheAtranches,i¡ºoftheAa
tranches, and ¡¡º of the Baa tranches issued by other CDOs, as rated by Moody’s.
(Moody’sratingofAaaisequivalenttoS&P’sAAA,AatoAA,BaatoBBB,andBato
BB). In ioo,, those numbers were 8,º, 81º, and 8µº, respectively.
8,
Merrill and
other investment banks simply created demand for CDOs by manufacturing new
onestobuytheharder-to-sellportionsoftheoldones.
AsSECattorneystoldtheFCIC,headingintoioo,therewasaStreetwidegentle-
man’sagreement:youbuymyBBBtrancheandI’llbuyyours.
88
Merrill and its CDO managers were the biggest buyers of their own products.
Merrill created and sold 1¡i CDOs from ioo¡ to ioo,. All but 8 of these—1¡¡
CDOs—soldatleastonetrancheintoanotherMerrillCDO.InMerrill’sdeals,onav-
erage, 1oº 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¡º.ForUBS,itwasjust¡º.

Managersdefendedthepractice.Chau,whomanaged1¡CDOscreatedandsold
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.
µo
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 ·µ.µ billion of its CDO
bonds
µ1
—Merrill was AIG’s third-largest counterparty, after Goldman and Société
Générale—Merrillswitchedtothemonolineinsurancecompaniesforprotection.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.
µi
This would not be the end of Merrill’s all-in wager on the mortgage and CDO
businesses. Even though it did grab the frst-place trophy in the mortgage-related
CDObusinessiniooo,ithadcomelatetothe“verticalintegration”mortgagemodel
thatLehmanBrothersandBearStearnshadpioneered,whichrequiredhavingastake
ineverystepofthemortgagebusiness—originatingmortgages,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.”
µ¡
AndMerrillalreadyhada·1oo
millionownershippositioninOwnitMortgageSolutionsInc.,forwhichitprovideda
warehouse line of credit; it also provided a line of credit to Mortgage Lenders Net-
work.
µ¡
BothofthosecompanieswouldceaseoperationssoonaftertheFirstFranklin
purchase.
µ,
NordidMerrillcutbackinSeptemberiooo,whenoneofitsownanalystsissueda
reportwarningthatthissubprimeexposurecouldleadtoasuddencutinearnings,
becausedemandforthesemortgagesassetscoulddryupquickly.
µo
Thatassessment
was not in line with the corporate strategy, and Merrill did nothing. Finally, at the
endofiooo,Kiminstructedhispeopletoreducecreditriskacrosstheboard.
µ,
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.company’suseofdeceptiveaccount-
inginitsfnancialstatementsorreports.”Thesubcommitteerecommendedtheagen-
cies issue joint guidance on “acceptable and unacceptable structured fnance
products, transactions and practices” by June ioo¡.
µ8
Four years later, the banking
agenciesandtheSECissuedtheir“InteragencyStatementonSoundPracticesCon-
cerningElevatedRiskComplexStructuredFinanceActivities,”adocumentthatwas
allofninepageslong.
µµ
Intheinterveningyears,fromioo¡toioo,,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 Enron—and 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-
fectedamore“principles-based”approach,andagainrequestedcomments.Mostof
therequirementswereverysimilartothosethattheOCCandFedhadimposedon
CitigroupandJPMorganintheioo¡enforcementactions.
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-
mentsontheioo¡draft.
RegulatorsdidtakenoteofthepotentialrisksofCDOsandcreditdefaultswaps.
Inioo,,theBaselCommitteeonBankingSupervision’sJointForum,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
oftheratingagencies’models,especiallyforCDOs.Anditfurtheradvisedthemto
make sure that counterparties from whom they bought credit protection—such as
AIG and the fnancial guarantors—would be good for that protection if it was
needed.
1o¡
Theregulatorsalsosaidtheyhadresearchedinsomedepth,fortheCDOandde-
rivativesmarket,thequestion“Areundueconcentrationsofriskdeveloping:”Their
answer: probably not. The credit risk was “quite modest,” the regulators concluded,
andthemonolinefnancialguarantorsappearedtoknowwhattheyweredoing.
1o,
The [Joint Forum’s Working Group on Risk Assessment and Capital]
hasnotfoundevidenceof‘hiddenconcentrations’ofcreditrisk.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,Moody’sInvestorsService,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,thevolumeofMoody’sbusinessdevotedtoratingres-
identialmortgage–backedsecuritiesmorethandoubled;thedollarvalueofthatbusi-
ness increased from ·oi million to ·1oµ million; the number of staff rating these
dealsdoubled.Butoverthesameperiod,whilethevolumeofCDOstoberatedin-
creased sevenfold, stamng increased only i¡º. From ioo¡ to iooo, annual revenue
tiedtoCDOsgrewfrom·1imillionto·µ1million.
1o8
When Moody’s Corporation went public in iooo, the investor Warren Buffett’s
z+· ii N\Nti \i tii :i : i NQUi i¥ tu\\i : :i uN iiiui1
Berkshire Hathaway held 1,º of the company. After share repurchases by Moody’s
Corporation, Berkshire Hathaway’s holdings of outstanding shares increased to over
ioºbyioo8.Asofio1o,BerkshireHathawayandthreeotherinvestorsownedacom-
bined,o.,ºofMoody’s.Whenaskedwhetherhewassatisfedwiththeinternalcon-
trols at Moody’s, Buffett responded to the FCIC that he knew nothing about the
managementofMoody’s.“Ihadnoidea.I’dneverbeenatMoody’s,Idon’tknowwhere
they are located.”
1oµ
Buffett said that he invested in the company because the rating
agency business was “a natural duopoly,” which gave it “incredible” pricing power—
and“thesingle-mostimportantdecisioninevaluatingabusinessispricingpower.”
11o
Many former employees said that after the public listing, the company culture
changed—itwent“from[aculture]resemblingauniversityacademicdepartmentto
onewhichvaluesrevenuesatallcosts,”accordingtoEricKolchinsky,aformerman-
agingdirector.
111
Employeesalsoidentifedanewfocusonmarketsharedirectedby
formerpresidentofMoody’sInvestorsServiceBrianClarkson.Clarksonhadjoined
Moody’sin1µµ1asasenioranalystintheresidentialmortgagegroup,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[afterMoody’sbecameanindependentcorporation],’andthathemade
personneldecisionstomakethathappen,andhewassuccessfulinthatregard.And
thatwaswhyBrianClarkson’srisewassometeoric: . . .hewastheenforcerwhocould
changetheculturetohavemorefocusonmarketshare.”
11¡
Theformermanagingdi-
rector Jerome Fons, who was responsible for assembling an internal history of
Moody’s,agreed:“Themainproblemwas . . .thatthefrmbecamesofocused,partic-
ularlythestructuredarea,onrevenues,onmarketshare,andtheambitionsofBrian
Clarkson, that they willingly looked the other way, traded the frm’s reputation for
short-termprofts.”
11¡
Moody’sCorporationChairmanandCEORaymondMcDanieldidnotagreewith
thisassessment,tellingtheFCICthathedidn’tsee“anyparticulardifferenceincul-
ture” after the spin-off.
11,
Clarkson also disputed this version of events, explaining
thatmarketsharewasimportanttoMoody’swellbeforeitwasanindependentcom-
pany.“[TheideathatbeforeMoody’s]wasspunofffromDun&Bradstreet,itwasa
sortofsleepy,academickindofcompanythatwasinanivorytower . . .isn’tthecase,
you know,” he explained. “I think [the ivory tower] was really a misnomer. I think
thatMoody’shasalwaysbeenfocusedonbusiness.”
11o
Clarkson and McDaniel also adamantly disagreed with the perception that con-
cernsaboutmarketsharetrumpedratingsquality.ClarksontoldtheFCICthatitwas
fneforMoody’stolosetransactionsifitwasforthe“rightreasons”:“Ifitwasananalyt-
icalreasonoritwasacreditreason,there’snotalotyoucandoaboutthat.Butifyou’re
losing a deal because you’re not communicating, you’re not being transparent, you’re
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.”
11µ
Nonetheless, Moody’s 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,aformerchiefcomplianceomceratMoody’s,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,that’sjustsotellingofhowhe
feltthathewasbulletproof. . . .Forhim,itwasallaboutrevenue.”
1io
Clarksontoldthe
FCICthathedidn’trememberthisconversationtranspiringandsaid,“Frommyper-
spective,complianceisaveryimportantfunction.”
1i1
AccordingtosomeformerMoody’semployees,Clarkson’smanagementstyleleft
little room for discussion or dissent. Witt referred to Clarkson as the “dictator” of
Moody’sandsaidthatifheaskedanemployeetodosomething,“eitheryoucomply
withhisrequestoryoustartlookingforanotherjob.”
1ii
“WhenIjoinedMoody’sin
late1µµ,,ananalyst’sworstfearwasthatwewouldcontributetotheassignmentofa
rating that was wrong,” Mark Froeba, former senior vice president, testifed to the
FCIC.“WhenIleftMoody’s,ananalyst’sworstfearwasthathewoulddosomething,
orshe,thatwouldallowhimorhertobesingledoutforjeopardizingMoody’smar-
ketshare.”
1i¡
Clarksondeniedhavinga“forceful”managementstyle,andhissupervi-
sor,RaymondMcDaniel,toldtheFCICthatClarksonwasa“goodmanager.”
1i¡
Former team managing director Gary Witt recalled that he received a monthly
emailfromClarkson“thatoutlinedbasicallymymarketshareintheareasthatIwas
inchargeof. . . .Ibelieveitlistedthedealsthatwedid,andthenitwouldlistthedeals
likeS&Pand/orFitchdidthatwedidn’tdothatwasinmyarea.Andattimes,Iwould
have to comment on that verbally or even write a written report about—you 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, that’s 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
subordinatesthatlisted¡µanalystsandthenumberanddollarvolumeofdealseach
had“rated”or“NOTrated.”Clarkson’sinstructions:“YoushouldbeusingthisinPE’s
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
ofit’s[sic]bizarrestructure.”
1i,
MoreevidenceofMoody’semphasisonmarketsharewasprovidedbyanemailthat
circulatedinthefallofioo,,inthemidstofsignifcantdowngradesinthestructuredf-
nancemarket.GroupManagingDirectorofU.S.DerivativesYuriYoshizawaaskedher
team’smanagingdirectorstoexplainamarketsharedecreasefromµ8ºtoµ¡º.
1i8
Despitethisapparentemphasisonmarketshare,ClarksontoldtheFCICthat“the
mostimportantgoalforanymanagingdirectorwouldbecredibility . . .andperform-
ance[of]theratings.”
1iµ
McDaniel,thechairmanandCEOofMoody’sCorporation,
elaborated: “I disagree that there was a drive for market share. We pay attention to
ourpositioninthemarket. . . .Butratingsquality,gettingtheratingstothebestpos-
siblepredictivecontent,predictivestatus,isparamount.”
1¡o
WhateverMcDaniel’sorClarkson’sintendedmessage,someemployeescontinued
toseeanemphasisonMoody’smarketshare.FormerteammanagingdirectorWitt
recalled that the “smoking gun” moment of his employment at Moody’s occurred
duringa“townhall”meetinginthethirdquarterofioo,withMoody’smanagement
anditsmanagingdirectors,afterMoody’shadalreadyannouncedmassdowngrades
on mortgage-related securities.
1¡1
After McDaniel made a presentation about
Moody’s fnancial outlook for the year ahead, one managing director responded: “I
wasinterested,Ray,tohearyourbeliefthatthefrstthinginthemindsofpeoplein
thisroomisthefnancialoutlookfortheremainderoftheyear. . . .[M]ythinkingis
there’s a much greater concern about the franchise.” He added, “I think that the
greateranxietybeingfeltbythepeopleinthisroomand . . .bytheanalystsiswhat’s
goingonwiththeratingsandwhattheoutlookis[,] . . .specifcallythesevereratings
transitionswe’redealingwith . . .anduncertaintyaboutwhat’saheadonthat,therat-
ingsaccuracy.”
1¡i
Wittrecalled,“Moody’sreputationwasjustbeingabsolutelylacer-
ated; and that these people are standing here, and they’re not even
addressing—they’re acting like it’s not even happening, even now that it’s 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+,
explainedthat“Moody’shaserectedsafeguardstokeepteamsfromtooeasilysolv-
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
deterredMoody’sfromcreatingnewmodelsorupdatingitsassumptions,asKimball
wrote:“Organizationsofteninterpretpastsuccessesasevidencingtheircompetence
and the adequacy of their procedures rather than a run of good luck. . . . [O]ur i¡
yearsofsuccessratingRMBS[residentialmortgage–backedsecurities]mayhavein-
ducedmanagerstomerelyfne-tunetheexistingsystem—tomakeitmoreemcient,
more proftable, cheaper, more versatile. Fine-tuning rarely raises the probability of
success;infact,itoftenmakessuccesslesscertain.”
1¡,
Ifanissuerdidn’tlikeaMoody’sratingonaparticulardeal,itmightgetabetter
rating from another ratings agency. The agencies were compensated only for rated
deals—ineffect,onlyforthedealsforwhichtheirratingswereacceptedbytheissuer.
Sothepressurecamefromtwodirections:in-houseinsistenceonincreasingmarket
shareanddirectdemandsfromtheissuersandinvestmentbankers,whopushedfor
betterratingswithfewerconditions.
1¡o
RichardMichalek,aformerMoody’svicepresidentandseniorcreditomcer,testi-
fedtotheFCIC,“Thethreatoflosingbusinesstoacompetitor,evenifnotrealized,
absolutelytiltedthebalanceawayfromanindependentarbiterofrisktowardsacap-
tive facilitator of risk transfer.”
1¡,
Witt agreed. When asked if the investment banks
frequentlythreatenedtowithdrawtheirbusinessiftheydidn’tgettheirdesiredrat-
ing, Witt replied, “Oh God, are you kidding: All the time. I mean, that’s routine. I
mean,theywouldthreatenyouallofthetime. . . .It’slike,‘Well,nexttime,we’rejust
goingtogowithFitchandS&P.’”
1¡8
Clarksonamrmedthat“itwouldn’tsurprisemeto
hearpeoplesaythat”aboutissuerpressureonMoody’semployees.
1¡µ
FormermanagingdirectorFonssuggestedthatMoody’swascomplaisantwhenit
shouldhavebeenprincipled:“[Moody’s]knewthattheywerebeingbulliedintocav-
ingintobankpressurefromtheinvestmentbanksandoriginatorsofthesethings. . . .
Moody’s allow[ed] itself to be bullied. And, you know, they willingly played the
game. . . .Theycouldhavestoodupandsaid,‘I’msorry,thisisnot—we’renotgoing
tosignoffonthis.We’regoingtoprotectinvestors.We’regoingtostop—youknow,
we’regoingtotrytoprotectourreputation.We’renotgoingtoratetheseCDOs,we’re
notgoingtoratethesesubprimeRMBS.’”
1¡o
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 don’t
wantratingdowngrades;andbankersgametheratingagenciesforafew
extrabasispointsonexecution.
1¡1
Moody’semployeestoldtheFCICthatonetacticusedbytheinvestmentbankers
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.”
1¡i
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, Moody’s gave triple-A ratings to an average of
morethan¡omortgagesecuritieseachandeveryworkingday.
1¡o
SuchpressurecanbeseeninanAprilioooemailtoYoshizawafromamanaging
directorinsyntheticCDOtradingatCreditSuisse,whoexplained,“I’mgoingtohave
amajorpoliticalproblemifwecan’tmakethis[dealrating]shortandsweetbecause,
eventhoughIalwaysexplaintoinvestorsthatclosingissubjecttoMoody’stimelines,
theyoftenchoosenottohearit.”
1¡,
TheexternalpressurewassummedupinKimball’sOctoberioo,memorandum:
“Analystsand[managingdirectors]arecontinually‘pitched’bybankers,issuers,in-
vestors—all with reasonable arguments—whose views can color credit judgment,
sometimesimprovingit,othertimesdegradingit(we‘drinkthekool-aid’).Coupled
withstronginternalemphasisonmarketshare&marginfocus,thisdoesconstitutea
‘risk’toratingsquality.”
1¡8
The SEC investigated the rating agencies’ ratings of mortgage-backed securities
andCDOsinioo,,reportingitsfndingstoMoody’sinJulyioo8.TheSECcriticized
Moody’sfor,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¡µ
Somattersstoodinioo,,whenthemachinethathadbeenhummingsosmoothly
andsolucrativelyslippedagear,andthenanother,andanother—andthenseizedup
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. Moody’s, the Commission’s 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|inqucncics“1hcturncjthchcusingnarkct” :+,
Ratingdcwngradcs“Ncvcr|cjcrc”::+
CDOs“C|in|ingthcwa||cjsu|princwcrry”::,
Icga|rcncdics“Onthc|asiscjthcinjcrnaticn”::,
Icsscs“Vhccwnsrcsidcntia|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 world’s largest fnancial institutions: “The concerns were just that if
people . . .couldn’tvaluetheassets,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
topped·1oobillioninthesecondquarter,butfellto·1¡billioninthefourthquarter
ofioo,.Once-boomingmarketswerenowgone—only·¡billioninsubprimeorAlt-
Amortgage-backedsecuritieswereissuedinthefrsthalfofioo8,andalmostnone
afterthat.
i
CDOsfollowedsuit.Fromahighofmorethan·µobillioninthefrstquarterof
ioo,, worldwide issuance of CDOs with mortgage-backed securities as collateral
plummeted to ·iµ 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,;only·1obillionwereis-
sued in ioo8. The issuance of commercial real estate mortgage–backed securities
plummetedfrom·i¡ibillioninioo,to·1ibillioninioo8.
¡
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,ºnationallyinioo,,theirthirdyearofdouble-digitgrowth.But
bythespringofiooo,asthesalespaceslowed,thenumberofmonthsitwouldtaketo
selloffallthehomesonthemarketrosetoitshighestlevelin1oyears.Nationwide,
homepricespeakedinApriliooo.
MembersoftheFederalReserve’sFederalOpenMarketCommittee(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,Moody’sEcon-
omy.com, a business unit separate from Moody’s Investors Service, issued a report
authoredbyChiefEconomistMarkZandititled“HousingattheTippingPoint:The
Outlook for the U.S. Residential Real Estate Market.” He came to the following
conclusion:
Nearly io of the nation’s 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-
ousmarketsareexpectedtoextendintoioo8andeveniooµ.
With over 1oo metro areas representing nearly one-half of the na-
tion’shousingstockexperiencingorabouttoexperiencepricedeclines,
nationalhousepricesarealsosettodecline.Indeed,oddsarehighthat
nationalhousepriceswilldeclineinioo,.
o
For ioo,, the National Association of Realtors announced that the number of
salesofexistinghomeshadexperiencedthesharpestfallini,years.Thatyear,home
pricesdeclinedµº.Inioo8,theywoulddropastunning1,º.Overall,bytheendof
iooµ,priceswoulddropi8ºfromtheirpeakiniooo.
,
Somecitiessawaparticularly
largedrop:inLasVegas,asofAugustio1o,homepricesweredown,,ºfromtheir
peak. And areas that never saw huge price gains have experienced losses as well:
homepricesinDenverhavefallen18ºsincetheirpeak.
In some areas, home prices started to fall as early as late ioo,. For example, in
OceanCity,NewJersey,wheremanypropertiesarevacationhomes,homepriceshad
risen1¡¡ºsinceioo1;theytoppedoutinDecemberioo,andfell¡ºinthefrsthalf
of iooo. By mid-io1o, they would be iiº below their peak. Prices topped out in
SacramentoinOctoberioo,andaretodaydownnearly,oº.Inmostplaces,prices
rose for a bit longer. For instance, in Tucson, Arizona, prices kept increasing for
muchofiooo,climbingµ,ºfromioo1totheirhighpointinAugustiooo,andthen
fellonly¡ºbytheendoftheyear.
8
One of the frst signs of the housing crash was an upswing in early payment de-
faults—usuallydefnedasborrowers’beingooormoredaysdelinquentwithinthefrst
year. Figures provided to the FCIC show that by the summer of iooo, 1.,º of loans
lessthanayearoldwereindefault.Thefgurewouldpeakinlateioo,ati.,º,well
above the 1.oº peak in the iooo recession. Even more stunning, frst payment de-
faults—thatis,mortgagestakenoutbyborrowerswhonevermadeasinglepayment—
went above 1.,º of loans in early ioo,.
µ
Responding to questions about that data,
CoreLogicChiefEconomistMarkFlemingtoldtheFCICthattheearlypaymentde-
faultrate“certainlycorrelateswiththeincreaseintheAlt-Aandsubprimesharesand
theturnofthehousingmarketandthesensitivityofthoseloanproducts.”
1o
Mortgagesinseriousdelinquency,defnedasthoseµoormoredayspastdueorin
foreclosure,hadhoveredaround1ºduringtheearlypartofthedecade,jumpedin
iooo,andkeptclimbing.Bytheendofiooµ,µ.,ºofmortgageloanswereseriously
delinquent.Bycomparison,seriousdelinquenciespeakedati.¡ºiniooifollowing
thepreviousrecession.
11
Seriousdelinquencywashighestinareasofthecountrythathadexperiencedthe
biggest housing booms. In the “sand states”—California, Arizona, Nevada, and
Florida—seriousdelinquencyroseto¡ºinmid-ioo,and1,ºbylateiooµ,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;therateroserapidlytoioºinioo,.Bylateiooµ,
thedelinquencyrateforsubprimeARMswas¡oº.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
mortgagesoutstandingattheendofeachyearfromiooothroughiooµ.

Thedata
containedmortgagesinfourgroups—loansthatweresoldintoprivatelabelsecuriti-
zationslabeledsubprimebyissuers(labeledSUB),loanssoldintoprivatelabelAlt-A
securitizations(ALT),loanseitherpurchasedorguaranteedbytheGSEs(GSE),and
loansguaranteedbytheFederalHousingAdministrationorVeteransAdministration
(FHA).

TheGSEgroup,inadditiontothemoretraditionalconformingGSEloans,
Arizona, California, Florida, and Nevada—the “sand states”—had 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
balancebelow·¡1,,ooo(conformingtoGSEloansizelimits),aFICOscorebetween
o¡oando,µ(aborrowerwithbelow-averagecredithistory),andLTVbetween8oº
and 1ooº. Another group would be Alt-A loans with the same characteristics. In
each year, the loans were broken into ,,o different subgroups—1¡¡ 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,oº(i,ºonei-
thersideofthemedian)ofthedistributionofaveragedelinquencyrates.Thefullbar,
includingbothdarkandlightshading,representsthemiddleµoºofthedistribution
ofaveragedelinquencyrates.Thebarsexcludethe,ºattheextremesofeachendof
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.oº average delinquency rate on the low end and a i.¡º average delin-
quency rate on the high end. The full bar for the GSEs spans average delinquency
rates from o.1º to o.oº. That means that only ,º of GSE loans were in subgroups
with average delinquency rates above o.oº. In sharp contrast, the black bar for pri-
vate-label subprime securitizations (SUB) spans average delinquency rates between
i¡.oº on the low end and ¡1.oº on the high end, and the full bar spans average
delinquency rates between 1o.oº and ¡i.oº. That means that only ,º of SUB loans
were in subgroups with average delinquency rates below 1oº. The worst-performing
,º of GSE loans are in subgroups with rates of serious delinquency similar to the
best-performing ,º of SUB loans.
1o
By the end of iooµ, performance within all segments of the market had weakened.
The median delinquency rate—the midpoints of the black bars—rose from 1º in
ioo8 to i.,º for GSE loans, from iµº to ¡µº for SUB loans, from 1iº to i1º for
Alt-A loans, and remained at roughly oº for FHA loans.
The data illustrate that in ioo8 and iooµ, 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.¡ºando.iº.Thesepatternsaremostlikelydrivenbydifferencesinunder-
writing standards as well as by some differences not captured in these mortgages.
1,
Forinstance,intheGSEpool,borrowerstendedtomakebiggerdownpayments.The
FCIC’sdatashowthat,8ºofGSEloanswithFICOscoresbelowooohadanoriginal
loan-to-valueratiobelow8oº,indicatingthattheborrowermadeadownpayment
ofatleastioºofthesalesprice.Thisrelativelylargedownpaymentwouldhelpoffset
theeffectofthelowerFICOscore.Incontrast,only¡1ºofloanswithFICOscores
belowoooinnon-GSEsubprimesecuritizationshadanLTVunder8oº.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
loanswithanLTVaboveµoº,theGSEpoolshaveanaveragerateofseriousdelin-
quency of ,.,º, versus a rate of 1,.,º for loans in private Alt-A securities.
18
These
resultsarealso,inlargepart,drivenbydifferencesinrisklayering.
Othersframethesituationdifferently.AccordingtoEdPinto,amortgagefnance
industryconsultantwhowasthechiefcreditomceratFannieMaeinthe1µ8os,GSEs
dominatedthemarketforriskyloans.InwrittenanalysesreviewedbytheFCICstaff
and sent to Commissioners as well as in a number of interviews, Pinto has argued
thattheGSEloansthathadFICOscoresbelowooo,acombinedloan-to-valueratio
greater than µoº, 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, ¡µº of all
mortgagesinthecountry—io.,millionofthem—wereriskymortgagesthathede-
fnes as subprime or Alt-A. Of these, Pinto counts 11.µ million, or ¡,º, that were
purchasedorguaranteedbytheGSEs.

Incontrast,theGSEscategorizefewerthan
¡millionoftheirloansassubprimeorAlt-A.
io
Importantly, as the FCIC review shows, the GSE loans classifed as subprime or
Alt-AinPinto’sanalysisdidnotperformnearlyaspoorlyasloansinnon-agencysub-
primeorAlt-Asecurities.Thesedifferencessuggestthatgroupingalloftheseloans
togetherismisleading.IndirectcontrasttoPinto’sclaim,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,thestudyfoundthatonlyoºofsuchhigher-costloansweremade
to low- or moderate-income borrowers or in low- or moderate-income neighbor-
hoodsbybanksandthrifts(andtheirsubsidiariesandamliates)coveredbytheCRA.
The other 歧 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,foundthatonly1oºofloansmadebyCRA-covered
lenderswerelocatedinlow-andmoderate-incomecensustractsversusoverioºfor
independentmortgagecompaniesnotcoveredbytheCRA.Further,fewerthan¡oº
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,andparticularlyitsemphasisonloansmadewithinalender’s
assessmentarea,helpedtoensureresponsiblelending,evenduringaperiodofover-
alldeclinesinunderwritingstandards,”theyconcluded.

Overall,inioo¡,ioo,,andiooo,CRA-coveredbanksandthriftsaccountedforat
least ooº of all mortgage lending but only between ¡oº and ¡1º of higher-priced
mortgages. Independent mortgage companies originated less than one-third of all
mortgages but about one-half of all higher-priced mortgages.

Finally, lending by
nonbank amliates of CRA-covered depository institutions is counted toward CRA
performanceatthediscretionofthebankorthrift.Theseamliatesaccountedforan-
otherroughly1oºofmortgagelendingbutabout1iºofhigh-pricelending.
BankofAmericaprovidedtheFCICwithperformancedataonitsCRA-qualify-
ing portfolio, which represented only ,º of the bank’s mortgage portfolio.
i,
In the
endofthefrstquarterofio1o,8ºofthebank’s·i1ibillionportfolioofresidential
mortgageswasnonperforming:i1ºofthe·1,billionCRA-qualifyingportfoliowas
nonperformingatthatdate.
JohnReed,aformerCEOofCitigroup,whenaskedwhetherhethoughtgovern-
mentpoliciessuchastheCRAplayedaroleinthecrisis,saidthathedidn’tbelieve
zz+ ii N\Nti \i tii :i : i NQUi i¥ tu\\i : :i uN iiiui1
bankswouldoriginate“abadmortgagebecausetheythoughtthegovernmentpolicy
allowed it” unless the bank could sell off the mortgage to Fannie or Freddie, which
hadtheirownobligationsinthisarena.Hesaid,“It’shardformetoanswer.Iftherea-
son the regulators didn’t 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-homeownershippoliciesasa“smokescreen”todoawaywithunderwriting
standardssuchasrequiringdownpayments,hesaid.“Thedangeristhatitgivesair
covertoallofthiskindofmadnessthathadnothingtodowiththehousinggoal.”
i,
RATING DOWNGRADES: “NEVER BEFORE”
Priortoioo¡,theratingsofmortgage-backedsecuritiesatMoody’sweremonitored
by the same analysts who had rated them in the frst place. In ioo¡, Nicolas Weill,
Moody’schiefcreditomcerandteammanagingdirector,waschargedwithcreating
anindependentsurveillanceteamtomonitorpreviouslyrateddeals.
i8
InNovemberiooo,thesurveillanceteambegantoseeariseinearlypaymentde-
faults in mortgages originated by Fremont Investment & Loan,

and downgraded
several securities with underlying Fremont loans or put them on watch for future
downgrades.“Thiswasaveryunusualsituationasneverbeforehadweputonwatch
dealsratedinthesamecalendaryear,”WeilllaterwrotetoRaymondMcDaniel,the
chairman and CEO of Moody’s Corporation, and Brian Clarkson, the president of
Moody’sInvestorsService.
¡o
In early ioo,, a Moody’s special report, overseen by Weill, about the sharp in-
creases in early payment defaults stated that the foreclosures were concentrated in
subprimemortgagepools.Inaddition,morethani.,,ºofthesubprimemortgages
securitizedinthesecondquarterofiooowereoodaysdelinquentwithinsixmonths,
morethandoubletherateayearearlier(1.i,º).Theexactcauseofthetroublewas
still unclear to the ratings agency, though. “Moody’s is currently assessing whether
this represents an overall worsening of collateral credit quality or merely a shifting
forwardofeventualdefaultswhichmaynotsignifcantlyimpactapool’soverallex-
pectedloss.”
¡1
Forthenextfewmonths,thecompanypublishedregularupdatesaboutthesub-
prime mortgage market. Over the next three months, Moody’s took negative rating
actionson¡.,ºoftheoutstandingsubprimemortgagesecuritiesratedBaa.Then,on
July1o,ioo,,inanunprecedentedmove,Moody’sdowngraded¡µµsubprimemort-
gage-backedsecuritiesthathadbeenissuedinioooandputanadditional¡isecuri-
tiesonwatch.The·,.ibillionofsecuritiesthatwereaffected,allratedBaaandlower,
madeup1µºofthesubprimesecuritiesthatMoody’sratedBaainiooo.Forthetime
1ui 8U:1 zz.
being, there were no downgrades on higher-rated tranches. Moody’s attributed the
downgrades to “aggressive underwriting combined with prolonged, slowing home
price appreciation” and noted that about ooº 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
WeilllatertoldtheFCICstaffthatMoody’sissuedamassannouncement,rather
thandowngradingafewsecuritiesatatime,toavoidcreatingconfusioninthemar-
ket.
¡¡
A few days later, Standard & Poor’s downgraded ¡µ8 similar tranches. These
initialdowngradeswereremarkablenotonlybecauseofthenumberofsecuritiesin-
volvedbutalsobecauseofthesharpratingcuts—anaverageoffournotchesperse-
curity, when one or two notches was more routine (for example, a single notch
wouldbeadowngradefromAAtoAA-).AmongthetranchesdowngradedinJuly
ioo, were the bottom three mezzanine tranches (Mµ, M1o, and M11) of the Citi-
group deal that we have been examining, CMLTI iooo-NCi. By that point, nearly
1iº of the original loan pool had prepaid but another 11º were µo 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,owning·8millionoftheM,andM8tranches.BSAM’sHigh-Grade
hedge fund also had exposure through a ·1o million credit default swap position
with Lehman referencing the M8 tranche. And BSAM’s Enhanced Leverage hedge
fundownedpartsoftheequityinIndependenceCDO,whichinturnownedtheMµ
tranche of our sample deal. In addition, these funds had exposure through their
holdingsofotherCDOsthatinturnownedtranchesoftheCitigroupdeal.
¡,
Then, on October 11, Moody’s downgraded another i,,oo tranches (·¡¡.¡ bil-
lion) of subprime mortgage–backed securities and placed ,,, tranches (·i¡.8 bil-
lion)onwatchforpotentialdowngrade.Nowthetotalofsecuritiesdowngradedand
put on watch represented 1¡.¡º of the original dollar volume of all iooo subprime
mortgage–backed securities that Moody’s had rated. Of the securities placed on
watchinOctober,¡8tranches(·o.µbillion)wereoriginallyAaa-ratedand,iµ(·1o.µ
billion)wereAa-rated.Alltold,inthefrst1omonthsofioo,,µiºofthemortgage-
backedsecuritydealsissuediniooohadatleastonetranchedowngradedorputon
watch.
¡o
By this point in October, 1¡º 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,Moody’swoulddowngrade8¡ºofalltheioooAaamortgage-
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 grade—that is, rated Baa¡ or higher—,oº of
thoseissuedinioooweredowngradedtojunk,aswere8µºofthosefromioo,.
¡8
CDOS: “CLIMBING THE WALL OF SUBPRIME WORRY”
InMarchioo,,Moody’sreportedthatCDOswithhighconcentrationsofsubprime
mortgage–backedsecuritiescouldincur“severe”downgrades.
¡µ
Inaninternalemail
sent fve days after the report, Group Managing Director of U.S. Derivatives Yuri
Yoshizawa explained to Moody’s 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,” Moody’s noted,
“Someofthefrstquarter’sactivity[inioo,]wastheresultofsomearrangersfever-
ishlyworkingtoclearinventoryandreducetheirbalancesheetexposuretothesub-
prime class.”
¡1
Even though Moody’s was aware that the investment banks were
dumping collateral out of the warehouses and into CDOs—possibly regardless of
quality—thefrmcontinuedtoratenewCDOsusingexistingassumptions.
FormerMoody’sexecutiveRichardMichalektestifedtotheFCIC,“Itwasacase
of, with respect to why didn’t we stop and change our methodology, there is a very
conservative culture at Moody’s, 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,McDanielgaveapresentationtotheboardonthecompany’sioo,strate-
gicplan.Hisslideshadsuchbleaktitlesas“SpotlightonMortgages:QualityContin-
ues to Erode,” “House Prices Are Falling . . . ,” “Mortgage Payment Resets Are
Mounting,”and“1.¡MMMortgageDefaultsForecastioo,–o8.”
¡¡
Despitealltheevi-
dence that the quality of the underlying mortgages was declining, Moody’s did not
makeanysignifcantadjustmentstoitsCDOratingsassumptionsuntillateSeptem-
ber.
¡¡
Outof·,1billioninCDOsthatMoody’sratedafteritsmassdowngradeofsub-
primemortgage–backedsecuritiesonJuly1o,ioo,,88ºwereratedAaa.
¡,
Moody’shadhopedthatratingdowngradescouldbestavedoffbymortgagemod-
ifcations—iftheirmonthlypaymentsbecamemoreaffordable,borrowersmightstay
current.However,inmid-September,EricKolchinsky,ateammanagingdirectorfor
CDOs,learnedthatasurveyofservicersindicatedthatveryfewtroubledmortgages
werebeingmodifed.
¡o
WorriedthatcontinuingtorateCDOswithoutadjustingfor
known deterioration in the underlying securities could expose Moody’s to liability,
KolchinskyadvisedYoshizawathatthecompanyshouldstopratingCDOsuntilthe
securities downgrades were completed. Kolchinsky told the FCIC that Yoshizawa
“admonished”himformakingthesuggestion.
¡,
1ui 8U:1 zz,
By the end of ioo8, more than µoº of all tranches of CDOs had been down-
graded. Moody’s downgraded nearly all of the iooo Aaa and all of the Baa CDO
tranches. And, again, the downgrades were large—more than 8oº of Aaa CDO
bondsandmorethanµoºofBaaCDObondswereeventuallydowngradedtojunk.
¡8
LEGAL REMEDIES: “ON THE BASIS OF THE INFORMATION”
Thehousingbustexposedthefawsinthemortgagesthathadbeenmadeandsecuri-
tized. After the crisis unfolded, those with exposure to mortgages and structured
products—including investors, fnancial frms, and private mortgage insurance
frms—closelyexaminedtherepresentationsandwarrantiesmadebymortgageorig-
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
foundsignifcantdefcienciesinsecuritizers’duediligenceonthemortgagepoolsun-
derlyingthemortgage-backedsecuritiesaswellasintheirdisclosureaboutthechar-
acteristics of those deals. As private mortgage insurance companies found similar
defcienciesintheloanstheyinsured,theyhavedeniedclaimstoanunprecedented
extent.
FannieandFreddieacquiredorguaranteedmillionsofloanseachyear.Theydele-
gatedunderwritingauthoritytooriginatorssubjecttoalegalagreement—representa-
tions and warranties—that the loans meet specifed criteria. They then checked
samples of the loans to ensure that these representations and warranties were not
breached.Iftherewasabreachandtheloanswere“ineligible”forpurchase,theGSE
hadtherighttorequirethesellertobuybacktheloan—assuming,ofcourse,thatthe
sellerhadnotgonebankrupt.
Asaresultofsuchsampling,duringthethreeyearsandeightmonthsendingAu-
gust¡1,io1o,FreddieandFannierequiredsellerstorepurchase1o,,oooloanstotal-
ing·¡¡.8billion.Sofar,Freddiehasreceived·µ.1billionfromsellers, andFanniehas
received·11.8billion—atotalof·io.µbillion.
¡µ
Theamountputbackisnotablein
thatitrepresentsi1ºof·1o¡billionincredit-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 µoº of all loans that default in the frst two years). In total, Freddie re-
viewed·,o.8billionofloans(outof·1.,1trillioninloansacquiredorguaranteed)
andfound·i1.,billiontobeineligible,meaningtheydidnotmeetrepresentations
andwarranties.
,1
Amongtheperformingloansthatweresampled,overtimeanincreasingpercent-
agewerefoundtobeineligible,risingfrom1oºformortgagesoriginatedinioo,to
i¡ºinioo8.Still,Freddieputbackveryfewoftheseperformingloanstotheorigina-
tors.Amongmortgagesoriginatedfromioo,toioo8,itfoundthat1,ºofthedelin-
quentloanswereineligible,aswerei,ºoftheloansinforeclosure.
,i
Mostofthese
wereputbacktooriginators—again,incasesinwhichtheoriginatorswerestillinop-
zz, ii N\Nti \i tii :i : i NQUi i¥ tu\\i : :i uN iiiui1
eration.Sometimes,ifthereasonsforineligibilityweresumcientlyminor,theloans
werenotputback.
Overall,ofthedelinquentloansandloansinforeclosuresampledbyFreddie,ioº
were put back. In iooµ and io1o, Freddie put back signifcant loan volumes to the
followinglenders:Countrywide,·1.µbillion;WellsFargo,·1.ibillion;ChaseHome
Financial,·1.1billion;BankofAmerica,·¡,omillion;andAllyFinancial,·¡,¡mil-
lion.

UsingamethodsimilartoFreddie’stotestforloaneligibility,Fanniereviewedbe-
tween iº and ,º of the mortgages originated since ioo,—sampling at the higher
ratesfordelinquentloans.Fromioo,throughio1o,Fannieputbackloanstothefol-
lowinglargelenders:BankofAmerica,·o.µbillion;WellsFargo,·i.¡billion;JPMor-
gan Chase, ·i.i billion; Citigroup, ·1., billion; SunTrust Bank, ·8µ8 million; and
AllyFinancial,·8¡8million.

InearlyJanuaryio11,BankofAmericareachedadeal
withFannieandFreddie,settlingtheGSEs’claimswithapaymentofmorethan·i.,
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-
nieshadinsuredatotalof·oo8billioninpotentialmortgagelosses.
,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,whichshareµ8ºofthemarket,hadrejectedabouti,ºoftheclaims(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
housingboomtheGSEspurchased·oµobillionofsubprimeandAlt-Aprivate-label
securities.
,8
TheGSEshaverecorded·¡obillioninchargesonsecuritiesfromJanu-
ary1,ioo8toSeptember¡o,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
underwriters—thereweremorethan¡oolawsuitsrelatedtobreachesofrepresenta-
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
ExchangeActof1歭andtheSecuritiesActof1歭.
Bothprivateandgovernmententitieshavegonetocourt.Forexample,theinvest-
mentbrokerageCharlesSchwabhassuedunitsofBankofAmerica,WellsFargo,and
UBS Securities.

The Massachusetts attorney general’s omce settled charges against
Morgan Stanley and Goldman Sachs, after accusing the frms of inadequate disclo-
surerelatingtotheirsalesofmortgage-backedsecurities.MorganStanleyagreedto
pay·1oimillionandGoldmanSachsagreedtopay·oomillion.

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;and“Level¡assets,”whichwereilliquidandhadnodiscerniblemarket
pricesorotherinputs.TodeterminethevalueofLevel¡andinsomecasesLevelias-
setswheremarketpriceswereunavailable,frmsusedmodelsthatreliedonassump-
tions.ManyfnancialinstitutionsreportedLevel¡assetsthatsubstantiallyexceeded
theircapital.Forexample,forthefrstquarterofioo,,BearStearnsreportedabout
·1µbillioninLevel¡assets,comparedto·1¡billionincapital;MorganStanleyre-
zz· ii N\Nti \i tii :i : i NQUi i¥ tu\\i : :i uN iiiui1
portedabout·oobillioninLevel¡assets,againstcapitalof·¡8billion;andGoldman
reportedabout·¡8billion,andcapitalof·¡,billion.
Mark-to-marketwrite-downswererequiredonmanysecuritieseveniftherewere
noactualrealizedlossesandinsomecasesevenifthefrmsdidnotintendtosellthe
securities.Thechargesrefectingunrealizedlosseswerebased,inpart,oncreditrat-
ingagencies’andinvestors’expectationsthatthemortgageswoulddefault.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 SEC’s Committee on Improvements to Financial Reporting, noted
thatattimes,markingsecuritiesatmarketprices“createssituationswhereyouhave
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
wouldtotal·iooto·¡oobillion;
o,
sofar,byio1o,thefgurehasturnedoutnottobe
muchmorethanthat.Asofyear-endiooµ,thedollarvalueofallimpairedAlt-Aand
subprime mortgage–backed securities total about ·¡oo billion.
o8
Securities are im-
paired when they have suffered realized losses or are expected to suffer realized
lossesimminently.Whilethosenumbersaresmallinrelationtothe·1¡trillionU.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.”

Thelargedropinmarketpricesofthemortgagesecuritieshadlargespilloveref-
fectstothefnancialsector,foranumberofreasons.Forexample,asjustdiscussed,
whenthepricesofmortgage-backedsecuritiesandCDOsfell,manyoftheholdersof
those securities marked down the value of their holdings—before 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 securitized—and “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.
TheInternationalMonetaryFund’sGlobalFinancialStabilityReportpublishedin
Octoberioo8examinedwherethedecliningassetswereheldandestimatedhowse-
verethewrite-downswouldbe.Alltold,theIMFcalculatedthatroughly·1otrillion
inmortgageassetswereheldthroughoutthefnancialsystem.Ofthese,·¡.8trillion
wereGSEmortgage–backedsecurities;theIMFexpectedlossesof·8obillion,butin-
vestorsholdingthesesecuritieswouldlosenomoney,becauseoftheGSEs’guaran-
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
remaining·1.,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-agencymortgage–backedsecuritiesweresharedamonginstitutionssuchasin-
surancecompanies,pensionfunds,theGSEs,andhedgefunds.TheOctoberreport
alsoexpectedanother·o,,billioninwrite-downsoncommercialmortgage–backed
securities, CLOs, leveraged loans, and other loans and securities—with more than
half coming from commercial mortgage–backed 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-downswererecordedonfnancialinstitutions’balancesheetsbased
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,onlyabout1oºofAlt-Aand¡ºof
subprime securities had been “materially impaired”—meaning that losses were im-
zz· ii N\Nti \i tii :i : i NQUi i¥ tu\\i : :i uN iiiui1
minent or had already been suffered—by the end of iooµ (see fgure 11.¡). For the
lower-ratedBaatranches,µo.,ºofAlt-Aandµ,.,ºofsubprimesecuritieswereim-
paired.Inall,bytheendofiooµ,·¡iobillionworthofsubprimeandAlt-Atranches
hadbeenmateriallyimpaired—including·1¡i.obillionoriginallyratedtriple-A.The
outcomewouldbefarworseforCDOinvestors,whosefatelargelydependedonthe
performanceoflower-ratedmortgage-backedsecurities.MorethanµoºofBaaCDO
bondsand,1.¡ºofAaaCDObondswereultimatelyimpaired.
,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: Moody’s Investors Service, “Special Comment: Default & Loss Rates of Structured Finance Securities:
1993-2009”; Moody’s 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,ofupto¡oto1.This
means that for every ·¡o of assets, they held only ·1 of capital. Fannie Mae and
FreddieMac(theGSEs)hadevengreaterleverage—withacombined,,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 deposits—was 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|dnan“Ict’s|caggrcssivcdistri|utingthings”:,,
BcarStcarns’shcdgcjunds“Iccksprcttydannug|y”:,:
Ratingagcncics“Itcan’t|ca||cjasuddcn”:,:
AIG“Vc|||iggcrthanwccvcrp|anncdjcr” :,,
Overthecourseofioo,,thecollapseofthehousingbubbleandtheabruptshutdown
ofsubprimelendingledtolossesformanyfnancialinstitutions,runsonmoneymar-
ket funds, tighter credit, and higher interest rates. Unemployment remained rela-
tively steady, hovering just below ¡.,º until the end of the year, and oil prices rose
dramatically.Bythemiddleofioo,,homepriceshaddeclinedalmost¡ºfromtheir
peak in iooo. Early evidence of the coming storm was the 1.,º drop in November
iooo of the ABX Index—a Dow Jones–like index for credit default swaps on BBB-
tranchesofmortgage-backedsecuritiesissuedinthefrsthalfofiooo.
1
ThatdropcameafterMoody’sandS&Pputonnegativewatchselectedtranchesin
onedealbackedbymortgagesfromoneoriginator:FremontInvestment&Loan.
i
In
December, the same index fell another ¡º 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,announceda·1.8billionincreaseinits
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
day—an 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 didn’t get the magnitude, and the market didn’t
graspthemagnitudeuntilspringof’o,,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-
tiesofthe“super-senior”tranchesoftheseCDOs.Thebankerscouldalwayshope—
and many apparently even believed—that 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 we’re 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-
cidedtoreducethefrm’ssubprimeexposure.Goldmanmarkeddownthevalueofits
mortgage-relatedproductstorefectthelowerABXprices,andbeganpostingdaily
lossesforthisinventory.
8
Respondingtothevolatilityinthesubprimemarket,Goldmananalystsdelivered
aninternalreportonDecember1¡,iooo,regarding“themajorriskintheMortgage
business”toChiefFinancialOmcerDavidViniarandChiefRiskOmcerCraigBrod-
erick.
µ
The next day, executives determined that they would get “closer to home,”
meaningthattheywantedtoreducetheirmortgageexposure:sellwhatcouldbesold
asis,repackageandselleverythingelse.
1o
KevinGasvoda,themanagingdirectorfor
Goldman’s Fixed Income, Currency, and Commodities business line, instructed the
salesteamtosellasset-backedsecurityandCDOpositions,evenataloss:“Plsrefo-
cusonretainednewissuebondpositionsandmovethemout.Therewillbebigop-
portunitiesthenextseveralmonthsandwedon’twanttobehamstrungbasedonold
inventory.Refocuseffortsandmovestuffoutevenifyouhavetotakeasmallloss.”
11
InaDecember1,email,ViniardescribedthestrategytoTomMontag,theco-head
ofglobalsecurities:“OnABX,thepositionisreasonablysensiblebutisjusttoobig.
Mighthavetospendalittletosizeitappropriately.Oneverythingelsemybasicmes-
sagewaslet’sbeaggressivedistributingthingsbecausetherewillbeverygoodoppor-
tunitiesasthemarketgoesintowhatislikelytobeevengreaterdistressandwewant
tobeinpositiontotakeadvantageofthem.”
1i
Subsequent emails suggest that the “everything else” meant mortgage-related as-
sets.OnDecemberio,inaninternalemailwithbroaddistribution,Goldman’sStacy
Bash-Polley,apartnerandtheco-headoffxedincomesales,notedthatthefrm,un-
like others, had been able to fnd buyers for the super-senior and equity tranches of
CDOs,butthemezzaninetranchesremainedachallenge.The“besttarget,”shesaid,
wouldbetoputtheminotherCDOs:“Wehavebeenthinkingcollectivelyasagroup
abouthowtohelpmovesomeoftherisk.Whilewehavemadegreatprogressmoving
thetailrisks—[super-senior]andequity—wethinkitiscriticaltofocusonthemezz
riskthathasbeenbuiltupoverthepastfewmonths. . . .Givensomeofthefeedback
wehavereceivedsofar[frominvestors,]itseemsthatcdo’smaybethebesttargetfor
movingsomeofthisriskbutclearlyinlimitedsize(andtimingrightnownotideal).”

Itwasbecominghardertofndbuyersforthesesecurities.BackinOctober,Gold-
manSachstradershadcomplainedthattheywerebeingaskedto“distributejunkthat
nobodywasdumbenoughtotakefrsttimearound.”

DespitethefrstofGoldman’s
businessprinciples—that“ourclients’interestsalwayscomefrst”—documentsindi-
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,Goldman’sFabriceTourre,thenavicepresidentonthestructuredproduct
correlationtradingdesk,saidto“focusefforts”on“buyandholdrating-basedbuyers”
z,· ii N\Nti \i tii :i : i NQUi i¥ tu\\i : :i uN iiiui1
ratherthan“sophisticatedhedgefunds”that“willbeonthesamesideofthetradeas
we will.”
1,
The “same of side of the trade” as Goldman was the selling or shorting
side—those who expected the mortgage market to continue to decline. In January,
DanielSparks,theheadofGoldman’smortgagedepartment,extolledGoldman’ssuc-
cess in reducing its subprime inventory, writing that the team had “structured like
madandtraveledtheworld,andworkedtheirtailsofftomakesomelemonadefrom
somebigoldlemons.”
1o
Tourreacknowledgedthattherewas“moreandmoreleverage
inthesystem,”and—writingofhimselfinthethirdperson—saidhewas“standingin
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,
evengivena·iomillionwrite-offandbillionsofdollarsofsubprimeexposurestill
retained.Inthefrstquarterofioo,,itsmortgagebusinessearnedarecord·ioomil-
lion,drivenprimarilybyshortpositions,includinga·1obillionshortpositiononthe
bellwether ABX BBB index, whose drop the previous November had been the red
fagthatgotGoldman’sattention.
Inthefollowingmonths,Goldmanreduceditsownmortgageriskwhilecontinu-
ingtocreateandsellmortgage-relatedproductstoitsclients.FromDecemberiooo
through August ioo,, it created and sold approximately ·i,.¡ billion of CDOs—
including·1,.obillionofsyntheticCDOs.ThefrmusedthecashCDOstounload
muchofitsownremaininginventoryofotherCDOsecuritiesandmortgage-backed
securities.

Goldmanhasbeencriticized—andsued—forsellingitssubprimemortgagesecu-
ritiestoclientswhilesimultaneouslybettingagainstthosesecurities.SylvainRaynes,
astructuredfnanceexpertatR&RConsultinginNewYork,reportedlycalledGold-
man’spractice“themostcynicaluseofcreditinformationthatIhaveeverseen,”and
compareditto“buyingfreinsuranceonsomeoneelse’shouseandthencommitting
arson.”
io
DuringaFCIChearing,GoldmanCEOLloydBlankfeinwasaskedifhebelieved
itwasaproper,legal,orethicalpracticeforGoldmantosellclientsmortgagesecuri-
ties that Goldman believed would default, while simultaneously shorting them.
Blankfeinresponded,“Idothinkthatthebehaviorisimproperandweregretthere-
sult—theconsequence[is]thatpeoplehavelostmoney”
i1
Thenextday,Goldmanis-
suedapressreleasedeclaringBlankfeindidnotstatethatGoldman’s“practiceswith
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 mortgage–related business. . . . We did not bet against our clients, and
thesenumbersunderscorethatfact.”

Indeed, Goldman’s short position was not the whole story. The daily mortgage
“ValueatRisk”measure,orVaR,whichtrackedpotentiallossesifthemarketmoved
unexpectedly, increased in the three months through February. By February, Gold-
man’s company-wide VaR reached an all-time high, according to SEC reports. The
dominantdriveroftheincreasewastheone-sidedbetonthemortgagemarket’scon-
tinuing to decline. Preferring to be relatively neutral, between March and May, the
mortgage securities desk reduced its short position on the ABX Index;

between
JuneandAugust,itagainreversedcourse,increasingitsshortpositionbypurchasing
protectiononmortgage-relatedassets.
TheBasisYieldAlphaFund,ahedgefundandGoldmanclientthatclaimstohave
invested·11.i,millioninGoldman’sTimberwolfCDO,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.Withintwoweeksofthefund’sinvestment,Goldmanbeganmak-
ingmargincallsonthedeal.BytheendofJulyioo,,ithaddemandedmorethan·¡,
million.
i,
According to the hedge fund, Goldman’s demands forced it into bank-
ruptcy in August ioo,—Goldman received about ·¡o million from the liquidation.
GoldmandeniesBasisYieldAlphaFund’sclaims,andCEOBlankfeindismissedthe
notionthatGoldmanmisledinvestors.“Iwilltellyou,weonlydealtwithpeoplewho
knewwhattheywerebuying.Andofcoursewhenyoulookafterthefact,someone’s
goingtocomealongandsaytheyreallydidn’tknow,”hetoldtheFCIC.
io
Inadditiontosellingitssubprimesecuritiestocustomers,thefrmtookshortpo-
sitionsusingcreditdefaultswaps;italsotookshortpositionsontheABXindicesand
onsomeofthefnancialfrmswithwhichitdidbusiness.Likeeverymarketpartici-
pant,Goldman“marked,”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
mighthurtthoseothercompanies—includingsomeclients—becausetheycouldre-
quire marking down those assets and similar assets. In addition, Goldman’s marks
wouldgetpickedupbycompetitorsindealersurveys.Asaresult,Goldman’smarks
couldcontributetoothercompaniesrecording“mark-to-market”losses: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-
man’s chief risk omcer was responsible for tracking how much of the company’s
moneywasatrisk,
i,
notedtocolleaguesthatthemortgagegroupwas“intheprocess
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.Thisisgettinglotsof¡othfoorattentionrightnow.”
i8
BroderickwasrightabouttheimpactofGoldman’smarksonclientsandcounter-
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,werebusymanagingBSAM’sHigh-GradeStructuredCreditStrategiesFund.
Whentheyaddedthehigher-leveraged,higher-riskEnhancedFundinioootheybe-
cameevenbusier.
By April ioo,, internal BSAM risk exposure reports showed about ooº of the
High-Grade fund’s collateral to be subprime mortgage–backed CDOs, assets that
werebeginningtolosemarketvalue.

Inadiarykeptinhispersonalemailaccount
becausehe“didn’twanttouse[his]workemailanymore,”Tanninrecountedthatin
iooo“awaveoffearsetover[him]”whenherealizedthattheEnhancedFund“was
going to subject investors to ‘blow up risk’” and “we could not run the leverage as
highasIhadthoughtwecould.”
¡o
This“blowuprisk,”coupledwithbadtiming,provedfatalfortheEnhancedFund.
Shortlyafterthefundopened,theABXBBB-indexstartedtofalter,falling¡ºinthe
last three months of iooo; then another 8º in January and i,º in February. The
market’sconfdencefellwiththeABX.InvestorsbegantobailoutofbothEnhanced
andHigh-Grade.CiomandTanninsteppeduptheirmarketing.OnMarch,,ioo,,
Tanninsaidinanemailtoinvestors,“weseeanopportunityhere—notcrazyoppor-
tunity—but prudent opportunity—I am putting in additional capital—I think you
shouldaswell.”
¡1
OnaMarch1iconferencecall,TanninandCiomassuredinvestors
thatbothfunds“haveplentyofliquidity,”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,Ciomredeemed·imillionofhisown·o.1millioninvestmentinEn-
hancedLeverageandtransferredthefundstoathirdhedgefundhemanaged.
¡¡
They
triedtosellthetoxicCDOsecuritiesheldbythehedgefunds.Theyhadlittlesuccess
sellingthemdirectlyonthemarket,
¡,
buttherewasanotherway.
InlateMay,BSAMputtogetheraCDO-squareddealthatwouldtake·¡billionof
CDOassetsoffthehedgefunds’books.Thesenior-mosttranches,worth·¡.ibillion,
i\ii¥ z++, :iii\ii Nt :U8iii \i \uiii i: z,,
weresoldascommercialpapertoshort-terminvestorssuchasmoneymarketmutual
funds.
¡o
Critically,BankofAmericaguaranteedthosedealswithaliquidityput—forafee.
Later, commercial paper investors would refuse to roll over this particular paper;
BankofAmericaultimatelylostmorethan·¡billiononthisarrangement.
¡,
“:,·isáoomsáe;”
Nearly all hedge funds provide their investors with market value reports, at least
monthly, based on computed mark-to-market prices for the fund’s 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
toinforminvestorsandtocalculatethehedgefund’stotalfundvalueforinternalrisk
managementpurposes,andbecausetheseassetswereheldascollateralforrepoand
other lenders. Crucially, if the value of a hedge fund’s portfolio declined, repo and
otherlendersmightrequiremorecollateral.InApril,JPMorgantoldAlanSchwartz,
BearStearns’sco-president,thatthebankwouldbeaskingtheBSAMhedgefundsto
postadditionalcollateraltosupportitsrepoborrowing.
¡8
DealermarkswereslowtokeepupwithmovementsintheABXindices.Evenas
the ABX BBB- index recovered some in March, rebounding oº, marks by broker-
dealers fnally started to refect the lower values. On April i, ioo,, Goldman sent
BSAMmarksrangingfromo,centsto1oocentsonthedollar—meaningthatsome
securitieswereworthaslittleaso,ºoftheirinitialvalue.
¡µ
OnThursday,April1µ,
in preparation for an investor call the following week, BSAM analysts informed
CiomandTanninthatintheirview,thevalueofthefunds’portfolioshaddeclined
sharply.
¡o
OnSunday,TanninsentanemailfromhispersonalaccounttoCiom’sper-
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; . . .we’reverycomfortable
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.
¡¡
CiomdisputedGoldman’smarksaswellasmarksfromLehman,Citigroup,
z,+ ii N\Nti \i tii :i : i NQUi i¥ tu\\i : :i uN iiiui1
andJPMorgan.
¡,
OnMay1o,inapreliminaryestimate,Ciomtoldinvestorsthatthe
netassetvalueoftheEnhancedLeverageFundwasdowno.oºinApril.
¡o
Incomputing
thefnalnumberslaterthatmonth,herequestedthatBSAM’sPricingCommitteein-
steadusefairvaluemarksbasedonhisteam’smodeling,whichimpliedlossesthatwere
·i,to·,omillionlessthanlossesusingGoldman’smarks.
¡,
OnJune¡,althoughGold-
man’smarkswereconsideredlow,thePricingCommitteedecidedtocontinuetoaver-
age dealer marks rather than to use fair value. The committee also noted that the
declineinnetassetvaluewouldbegreaterthantheo.oºestimate,because“manyofthe
positionsthatweremarkeddownreceiveddealermarksafterreleaseoftheestimate.”
¡8
The decline was revised from o.oº to 1µº. According to Ciom, a number of factors
contributedtotheAprilrevision,andGoldman’smarkswereonefactor.
¡µ
Afterthese
meetings,Ciomemailedonecommitteemember:“Thereisnomarket . . .its[sic]allac-
ademic anyway—1µº [value] is doomsday.”
,o
On June ,, BSAM announced the 1µº
dropandfrozeredemptions.
“tener;int/cmincs/ejt”
WhenJPMorgancontactedBear’sco-presidentAlanSchwartzinAprilaboutitsup-
comingmargincall,Schwartzconvenedanexecutivecommitteemeetingtodiscuss
howrepolendersweremarkingdownpositionsandmakingmargincallsonthebasis
of those new marks.
,1
In early June, Bear met with BSAM’s 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 Schwartz’s appeal; instead, they made margin calls.

As a direct result, the
twofundshadtosellcollateralatdistressedpricestoraisecash.

Sellingthebonds
ledtoacompletelossofconfdencebytheinvestors,whoserequestsforredemptions
accelerated.
ShortlyafterBSAMfrozeredemptions,MerrillLynchseizedmorethan·8,omil-
lionofitscollateralpostedbyBearforitsoutstandingrepoloans.Merrillwasableto
selljust·181millionoftheseizedcollateralatauctionbyJuly,—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,Bear’sequitypositionsinthetwoBSAMhedgefundswererelativelysmall.On
Aprilio,Bear’sco-presidentWarrenSpectorapproveda·i,millioninvestmentinto
theEnhancedLeverageFund.
,,
BearStearnshadnolegalobligationtorescueeither
thefundsortheirrepolenders.However,thoselenderswerethesamelargeinvest-
mentbanksthatBearStearnsdealtwitheveryday.
,8
Moreover,anyfailureofentities
relatedtoBearStearnscouldraiseinvestors’concernsaboutthefrmitself.
ThomasMarano,theheadofthemortgagetradingdesk,toldFCICstaffthatthe
constantbarrageofmargincallshadcreatedchaosatBear.InlateJune,BearStearns
dispatched him to engineer a solution with Richard Marin, BSAM’s 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 Stearns’s
conclusion:High-Gradestillhadpositivevalue,butEnhancedLeveragedidnot.
Onthebasisofthatanalysis,BearStearnscommittedupto·¡.ibillion—andulti-
mately loaned ·1.o billion—to take out the High-Grade Fund repo lenders and be-
comethesolerepolendertothefund;EnhancedLeveragewasonitsown.
DuringaJuneFederalOpenMarketCommittee(FOMC)meeting,memberswere
informedaboutthesubprimemarketandtheBSAMhedgefunds.Thestaffreported
thatthesubprimemarketwas“veryunsettledandrefecteddeterioratingfundamen-
talsinthehousingmarket.”TheliquidationofsubprimesecuritiesatthetwoBSAM
hedgefundswascomparedtothetroublesfacedbyLong-TermCapitalManagement
in1µµ8.ChairmanBernankenotedthattheproblemsthehedgefundsexperienced
wereagoodexampleofhowleveragecanincreaseliquidityrisk,especiallyinsitua-
tions in which counterparties were not willing to give them time to liquidate and
possiblyrealizewhatevervaluemightbeinthepositions.Butitwasalsonotedthat
theBSAMhedgefundsappearedtobe“relativelyunique”amongsponsoredfundsin
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 universal—CEO 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 µ1º; Enhanced Leverage Fund, 1ooº.
oi
OnJuly¡1,bothfledforbankruptcy.CiomandTanninwouldbecriminallycharged
with fraud in their communications with investors, but they were acquitted of all
chargesinNovemberiooµ.CivilchargesbroughtbytheSECwerestillpendingasof
thedateofthisreport.
Looking back, Marano told the FCIC, “We caught a lot of fak for allowing the
fundstofail,butwehadnooption.”

InaninternalemailinJune,BillJamisonofFed-
eratedInvestors,oneofthelargestofallmutualfundcompanies,referredtotheBear
Stearnshedgefundsasthe“canaryinthemineshaft”andpredictedmoremarkettur-
moil.

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-
mentsinwhichinvestors—andsomedealers—hadonlyrecentlybelieved.
CaynecalledSpectorintotheomceandaskedhimtoresign.OnSunday,August
,,Spectorsubmittedhisresignationtotheboard.
RATING AGENCIES: “IT CAN’ T BE  .  .  . ALL OF A SUDDEN”
WhileBSAMwaswrestlingwithitstwoailingfagshiphedgefunds,themajorcredit
ratingagenciesfnallyadmittedthatsubprimemortgage–backedsecuritieswouldnot
perform as advertised. On July 1o, ioo,, they issued comprehensive rating down-
gradesandcreditwatchwarningsonanarrayofresidentialmortgage–backedsecuri-
ties.Theseannouncementsforeshadowedtheactuallossestocome.
S&Pannouncedthatithadplacedo1itranchesbackedbyU.S.subprimecollat-
eral,orsome·,.¡,billioninsecurities,onnegativewatch.S&Ppromisedtoreview
everydealinitsratingsdatabaseforadverseeffects.Intheafternoon,Moody’sdown-
graded¡µµmortgage-backedsecuritiesissuediniooobackedbyU.S.subprimecol-
lateral and put an additional ¡i tranches on watch. These Moody’s downgrades
affected about ·,.i billion in securities. The following day, Moody’s placed 18¡
tranchesofCDOs,withoriginalfacevalueofabout·,billion,onwatchforpossible
downgrade.Twodaysafteritsoriginalannouncement,S&Pdowngraded¡µ8ofthe
o1itranchesithadplacedonnegativewatch.FitchRatings,thesmallestofthethree
majorcreditratingagencies,announcedsimilardowngrades.
oo
Theseactionsweremeaningfulforallwhounderstoodtheirimplications.While
the specifc securities downgraded were only a small fraction of the universe (less
than iº 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
priceshadalreadyfallenabout¡ºnationallyfromtheirpeakatthespringofiooo.
o,
OnaJuly1oconferencecallwithS&P,thehedgefundmanagerSteveEismanques-
tionedTomWarrack,themanagingdirectorofS&P’sresidentialmortgage–backedse-
curitiesgroup.Eismanasked,“I’dliketoknowwhynow.Imean,thenewshasbeen
outonsubprimenowformany,manymonths.Thedelinquencieshavebeenadisaster
now for many, many months. (Your) ratings have been called into question now for
many,manymonths.I’dliketounderstandwhyyou’remakingthismovetodaywhen
you—andwhydidn’tyoudothismany,manymonthsago. . . .Imean,itcan’tbethat
allofasudden,theperformancehasreachedalevelwhereyou’vewokenup.”Warrack
respondedthatS&P“tookactionassoonaspossiblegiventheinformationathand.”
o8
Theratingsagencies’downgrades,intandemwiththeproblemsatBearStearns’s
hedgefunds,hadafurtherchillingeffectonthemarkets.TheABXBBB-indexfell
another¡¡ºinJuly,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, AIG’s Financial Products sub-
sidiaryhadwritten·,µbillioninover-the-countercreditdefaultswap(CDS)protec-
tion on super-senior tranches of multisector CDOs backed mostly by subprime
mortgages.
InaphonecallmadeJuly11,thedayafterthedowngrades,AndrewForster,the
headofcredittradingatAIGFinancialProducts,toldAlanFrost,theexecutivevice
presidentofFinancialProduct’sMarketingGroup,thathehadtoanalyzeexposures
because “every f¯¯¯ing . . . rating agency we’ve spoken to . . . [came] out with more
downgrades”andthathewasincreasinglyconcerned:“AboutamonthagoIwaslike,
youknow,suicidal. . . .Theproblemthatwe’regoingtofaceisthatwe’regoingtohave
justenormousdowngradesonthestuffthatwe’vegot. . . .Everyonetellsmethatit’s
tradingandit’stwopointslowerandalltherestofitandhowcomeyoucan’tmark
your book. So it’s defnitely going to give it renewed focus. I mean we can’t . . . we
havetomarkit.It’s,it’s,uh,we’re[unintelligible]f¯¯¯edbasically.”

Forster was likely worried that most of AIG’s credit default swap contracts re-
quiredthatcollateralbepostedtothepurchasers,shouldthemarketvalueoftheref-
erencedsecuritiesdeclinebyacertainamount,orshouldratingagenciesdowngrade
AIG’slong-termdebt.Thatis,collateralcallscouldbetriggeredeveniftherewereno
actualcashlossesin,forexample,thesuper-seniortranchesofCDOsuponwhichthe
protectionhadbeenwritten.Remarkably,topAIGexecutives—includingCEOMar-
tin Sullivan, CFO Steven Bensinger, Chief Risk Omcer Robert Lewis, Chief Credit
Omcer Kevin McGinn, and Financial Services Division CFO Elias Habayeb—told
FCICinvestigatorsthattheydidnotevenknowaboutthesetermsoftheswapsuntil
thecollateralcallsstartedrollinginduringJuly.
,o
OmceofThriftSupervisionregula-
torswhosupervisedAIGonaconsolidatedbasisdidn’tknoweither.
,1
Frost,whowas
thechiefcreditdefaultswapsalesmanatAIGFinancialProducts,didknowaboutthe
terms,andhesaidhebelievedtheywerestandardfortheindustry.
,i
JosephCassano,
thedivision’sCEO,alsoknewabouttheterms.

And the counterparties knew, of course. On the evening of July io, Goldman
Sachs,whichheld·i1billionofAIG’ssuper-seniorcreditdefaultswaps,

sentnews
ofthefrstcollateralcallintheformofanemailfromGoldman’ssalesmanAndrew
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
requesting·1.8billion.
,o
Onthesameday,Goldmanpurchased·1oomillionoffve-
yearprotection—intheformofcreditdefaultswaps—againstthepossibilitythatAIG
mightdefaultonitsobligations.
,,
Frost never responded to Davilman’s 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
AIG’s models showed
therewouldbenodefaultsonanyofthebondpaymentsthatAIG’sswapsinsured.
TheGoldmanexecutivesconsideredthosemodelsirrelevant,becausethecontracts
required collateral to be posted if market value declined, irrespective of any long-
termcashlosses.

Goldmanestimatedthattheaveragedeclineinthemarketvalue
ofthebondswas1,º.
8o
So, frst Bear Stearns’s hedge funds and now AIG was getting hit by Goldman’s
marksonmortgage-backedsecurities.LikeCiomandhiscolleaguesatBearStearns,
Frost and his colleagues at AIG disputed Goldman’s marks. On July ¡o, Forster was
told by another AIG trader that “[AIG] would be in fne shape if Goldman wasn’t
hanging its head out there.” The margin call was “something that hit out of the blue
and it’s a f¯¯¯ing number that’s 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,µ,”becauseofthelackoftradingbutsaidGoldman’smarkswere“ridiculous.”
81
IntestimonytotheFCIC,ViniarsaidGoldmanhadstoodreadytosellmortgage-
backed securities to AIG at Goldman’s own marks.
8i
AIG’s Forster stated that he
wouldnotbuythebondsatevenµocentsonthedollar,becausevaluesmightdrop
further.Additionally,AIGwouldberequiredtovalueitsownportfolioofsimilaras-
setsatthesameprice.Forstersaid,“InthecurrentenvironmentIstillwouldn’tbuy
them . . .becausetheycouldprobablygolow . . .wecan’tmarkanyofourpositions,
andobviouslythat’swhatsavesushavingthisenormousmarktomarket.Ifwestart
buyingthephysicalbondsbackthenanyaccountantisgoingtoturnaroundandsay,
well, John,youknowyoutradedatµo,youmustbeabletomarkyourbondsthen.”

Tough,lengthynegotiationsfollowed.Goldman“wasnotbudging”onitscollat-
eraldemands,accordingtoTomAthan,amanagingdirectoratAIGFinancialProd-
ucts, describing a conference call with Goldman executives on August 1. “I played
almosteverycardIhad,legalwording,marketpractice,intentofthelanguage,mean-
ingofthe[contract],andalsostressedthepotentialdamagetotherelationshipand
GSsaidthatthishasgonetothe‘highestlevels’atGSandtheyfeelthat . . .thisisa
‘testcase.’”

GoldmanSachsandAIGwouldcontinuetoargueaboutGoldman’smarks,even
asAIGwouldcontinuetopostcollateralthatwouldfallshortofGoldman’sdemands
and Goldman would continue to purchase CDS contracts against the possibility of
AIG’sdefault.Overthenext1¡months,moresuchdisputeswouldcostAIGtensof
billionsofdollarsandhelpleadtooneofthebiggestgovernmentbailoutsinAmeri-
canhistory.
COMMISSION CONCLUSIONS ON CHAPTER 12
TheCommissionconcludesthatentitiessuchasBearStearns’shedgefundsand
AIGFinancialProductsthathadsignifcantsubprimeexposurewereaffectedby
thecollapseofthehousingbubblefrst,creatingfnancialpressuresontheirpar-
ent companies. The commercial paper and repo markets—two key components
of the shadow banking lending markets—quickly refected the impact of the
housingbubblecollapsebecauseofthedeclineincollateralassetvaluesandcon-
cernaboutfnancialfrms’subprimeexposure.
i\ii¥ z++, :iii\ii Nt :U8iii \i \uiii i: z,,
z,·
13
SUMMER 2007:
DISRUPTIONS IN FUNDING
CONTENTS
IKBcjGcrnany“Rca|ncncyinvcstcrs” :,e
Ccuntrywidc“1hat’scur,/++” :,:
BNIIari|as“1hcringingcjthc|c||”:,o
SIVs“Ancasiscjca|n”:,:
Mcncyjundsandcthcrinvcstcrs“Drinkjing}jrcnaµrchcsc:,,
Inthesummerofioo,,asthepricesofsomehighlyratedmortgagesecuritiescrashed
and Bear’s hedge funds imploded, broader repercussions from the declining housing
market were still not clear. “I don’t 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 1µi¡, 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,
Rhinelandownedc1¡billion(·18.µbillion)ofassets,µ,ºofwhichwereCDOsand
CLOs (collateralized loan obligations—that 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,bluntlysaidthat“real
money”investorssuchasIKBwereoutgunned.“Themarketisnotpricingthesub-
prime [residential mortgage–backed 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.
,
Itwouldlose1ooºofthatinvestment.
Inmid-ioo,,Rhineland’sasset-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
alsoalertedtheGermanbankregulatortoIKB’scriticalstate.Withtheregulator’sen-
couragement, IKB’s 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. Rhineland’s commercial paper investors were able to get rid of the paper, and
KfWtookthehitinstead—withitslossesexpectedtoeventuallyreachµ,º.
µ
TheIKBepisodeservednoticethatexposurestotoxicmortgageassetswerelurk-
ingintheportfoliosofevenrisk-averseinvestors.Soon,panicseizedtheshort-term
fundingmarkets—eventhosethatwerenotexposedtoriskymortgages.“Therewasa
recognition, I’d say an acute recognition, that potentially some of the asset-backed
commercialpaperconduitscouldhaveexposuretothoseareas.Asaresult,investors
in general—without even looking into the underlying assets—decided ‘I don’t want
tobeinanyasset-backedcommercialpaper,Idon’twanttoinvestinafundthatmay
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
marketwoulddeclinebyalmost·¡oobillionbytheendofioo,.
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,that’sourµ/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”
and“ampleliquiditysourcesofourbank. . . .Itisimportanttonotethatthecompany
has experienced no disruption in fnancing its ongoing daily operations, including
placementofcommercialpaper.”

Moody’sreamrmeditsA¡ratingsandstableout-
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.

Shortly after the Countrywide board meeting, the Fed’s 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-
tionhadfallenby1¡ºduringtheprecedingmonth.Acompanyspokesmansaidlay-
offs would be considered. On the same day, Fed staff, who had supervised
Countrywide’sholdingcompanyuntilthebankswitchedtoathriftcharterinMarch
ioo,,sentaconfdentialmemototheFed’sBoardofGovernorswarningaboutthe
company’scondition:
Thecompanyisheavilyreliantonanoriginate-to-distributemodel,and,
givencurrentmarketconditions,thefrmisunabletosecuritizeorsell
any of its non-conforming mortgages. . . . Countrywide’s 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,perhapsbywaivingaFedruleandallowingCountrywide’sthrift
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
andwouldnotdo—untilthefollowingspring.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
thatthecompanynotifylendersofitsintentiontodrawdown·11.,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,‘we’reoutofbusiness,we’renotgoingtofund’—andthere’sgreatrisktothat,
litigation risk, we had committed to fund. . . . When it’s between your ass and your
image,youholdontoyourass.”

On the same day that Countrywide’s board approved the ·11., billion draw-
down—but before the company announced it publicly, the Merrill Lynch analyst
KennethBruce,whohadreissuedhis“buy”ratingonthecompany’sstocktwodays
earlier,switchedto“sell”witha“negative”outlookbecauseofCountrywide’sfunding
pressures,adding,“ifthemarketlosesconfdenceinitsabilitytofunctionproperly,
thenthemodelcanbreak. . . .Ifliquidationsoccurinaweakmarket,thenitispossi-
blefor[Countrywide]togobankrupt.”
io
The next day, as news of Bruce’s call spread, Countrywide informed markets
about the drawdown. Moody’s downgraded its senior unsecured debt rating to the
lowest tier of investment grade. Countrywide shares fell 11º, closing at ·18.µ,; for
theyear,thecompany’sstockwasdown,oº.Thebadnewsledtoanold-fashioned
bankrun.MozilosingledoutanAugust1oLos Angeles Times articlecoveringBruce’s
report,which,hesaid,“causedarunonourbankof·8billiononMonday.”Thearti-
clespurredcustomerstowithdrawtheirfundsbynotingspecifcaddressesofCoun-
trywidebranchesinsouthernCalifornia,MozilotoldtheFCIC.Areporter“cameout
withaphotographerand,youknow,interviewedthepeopleinline,andhecreated—
it was just horrible. Horrible for the people, horrible for us. Totally unnecessary,”
Mozilosaid.
i1
Sixdayslater,onAugustii,BankofAmericaannounceditwouldinvest·ibil-
lionfora1oºstakeinCountrywide.Bothcompaniesdeniedrumorsthatthenation’s
biggestbankwouldsoonacquirethemortgagelender.Mozilotoldthepress,“There
wasneveraquestionaboutoursurvival”;hesaidtheinvestmentreinforcedCountry-
wide’spositionasoneofthe“strongestandbest-runcompaniesinthecountry.”
ii
InOctober,Countrywidereportedanetlossof·1.ibillion,itsfrstquarterlyloss
ini,years.Ascharge-offsonitsmortgageportfoliogrew,Countrywideraisedprovi-
sions for loan losses to ·µ¡¡ million from only ·¡8 million one year earlier. On
January 11, ioo8, Bank of America issued a press release announcing a “defnitive
agreement”topurchaseCountrywideforapproximately·¡billion.Itsaidthecom-
binedentitywouldstoporiginatingsubprimeloansandwouldexpandprogramsto
helpdistressedborrowers.
BNP PARIBAS: “THE RINGING OF THE BELL”
Meanwhile,problemsinU.S.fnancialmarketshitthelargestFrenchbank.OnAu-
gust µ, BNP Paribas SA suspended redemptions from three investment funds that
hadplungedioºinlessthantwoweeks.Totalassetsinthosefundswere·i.ibillion,
with a third of that amount in subprime securities rated AA or higher.

The bank
saiditwouldalsostopcalculatingafairmarketvalueforthefundsbecause“thecom-
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.”

Inretrospect,manyinvestorsregardedthesuspensionoftheFrenchfundsasthe
beginningoftheioo,liquiditycrisis.Augustµ“wastheringingofthebell”forshort-
termfundingmarkets,PaulMcCulley,amanagingdirectoratPIMCO,toldtheFCIC.
“The buyers went on a buyer strike and simply weren’t rolling.”
i,
That is, they
stopped rolling over their commercial paper and instead demanded payment on
theirloans.OnAugustµ,theinterestratesforovernightlendingofA-1ratedasset-
backedcommercialpaperrosefrom,.¡µºto,.,,º—thehighestlevelsinceJanuary
ioo1. It would continue rising unevenly, hitting o.1¡º in August 1o, ioo,. Figure
1¡.1showshow,inresponse,lendingdeclined.
InAugustalone,theasset-backedcommercialpapermarketshrankby·1µobil-
lion, or ioº. On August o, subprime lender American Home Mortgage’s asset-
backed commercial paper program invoked its privilege of postponing repayment,
trapping lenders’ money for several months. Lenders quickly withdrew from pro-
gramswithsimilarprovisions,whichshrankthatmarketfrom·¡,billionto·¡bil-
lionbetweenMayandAugust.
io
The paper that did sell had signifcantly shorter maturities, refecting creditors’
desiretoreassesstheircounterparties’creditworthinessasfrequentlyaspossible.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-
whelmingmajoritywasissuedforjust1to¡days.
i,
Disruptionsquicklyspreadtootherpartsofthemoneymarket.Inafighttoqual-
ity,investorsdumpedtheirrepoandcommercialpaperholdingsandincreasedtheir
holdingsinseeminglysafermoneymarketfundsandTreasurybonds.Marketpartici-
pants,unsureofeachother’spotentialsubprimeexposures,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.OnAugustµ,itrosesharply,increasingthree-tofourfoldover
historicalvalues,andbySeptember,,itclimbedbyanother1,oº.Inioo8,itwould
peakmuchhigher.
Thepanicintherepo,commercialpaper,andinterbankmarketswasmetbyimme-
diategovernmentaction.OnAugust1o,thedayafterBNPParibassuspendedredemp-
tions,theFedannouncedthatitwould“provid[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,obasispoints—fromo.i,ºto,.,,º.Thiswouldbethefrstofmany
such cuts aimed at increasing liquidity. The Fed also extended the term of discount-
windowlendingto¡odays(fromtheusualovernightorveryshort-termperiod)toof-
ferbanksamorestablesourceoffunds.Onthesameday,theFed’sFOMCreleaseda
statement acknowledging the continued market deterioration and promising that it
was“preparedtoactasneededtomitigatetheadverseeffectsontheeconomy.”

SIVS: “AN OASIS OF CALM”
InAugust,theturmoilinasset-backedcommercialpapermarketshitthemarketfor
structuredinvestmentvehicles,orSIVs,eventhoughmostoftheseprogramshadlit-
tlesubprimemortgageexposure.SIVshadastablehistorysincetheirintroductionin
1µ88. These investments had weathered a number of credit crises—even through
early summer of ioo,, as noted in a Moody’s report issued on July io, ioo,, titled
“SIVs:AnOasisofCalmintheSub-primeMaelstrom.”
¡o
Unlike typical asset-backed commercial paper programs, SIVs were funded pri-
marilythroughmedium-termnotes—bondsmaturinginonetofveyears.SIVsheld
signifcantamountsofhighlyliquidassetsandmarkedthoseassetstomarketprices
daily or weekly, which allowed them to operate without explicit liquidity support
fromtheirsponsors.
TheSIVsectortripledinassetsbetweenioo¡andioo,.Ontheeveofthecrisis,
there were ¡o SIVs with almost ·¡oo billion in assets.
¡1
About one-quarter of that
moneywasinvestedinmortgage-backedsecuritiesorinCDOs,butonlyoºwasin-
vestedinsubprimemortgage–backedsecuritiesandCDOsholdingmortgage-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-
sationalizethecollapseofthenext‘leakingSIV’orthenext‘SIV-positive’institution,”
then-Moody’s managing director Henry Tabe told the FCIC.
¡i
The situation was
complicatedbytheSIVs’lackoftransparency.“Inacontextofopacityaboutwhere
risk resides, . . . a general distrust has contaminated many asset classes. What had
oncebeenliquidisnowilliquid.Goodcollateralcannotbesoldorfnancedatany-
thingapproachingitstruevalue,”Moody’swroteonSeptember,.
¡¡
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,SIVsstillinoperationhadliquidatedi¡ºoftheirportfo-
lios,onaverage.
¡,
SponsorsrescuedsomeSIVs.OtherSIVsrestructuredorliquidated;
some investors had to wait a year or more to receive payments and, even then, re-
coupedonlysomeoftheirmoney.InthecaseofRhinebridge,investorslost¡,ºand
onlygraduallyreceivedtheirpaymentsoverthenextyear.
¡o
InvestorsinoneSIV,Sigma,
lost more than µ,º.
¡,
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:
“DRINKING 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-
ingthepricetheypaidforsecuritiesandtheotherthefund’smark-to-marketvalue
(the“shadowprice,”inmarketparlance).However,fundsdonothavetodisclosethe
shadowpriceunlessthefund’snetassetvalue(NAV)hasfallenbyo.,ºbelow·1(to
·o.µµ,) per share. Such a decline in market value is known as “breaking the buck”
and generally leads to a fund’s collapse. It can happen, for example, if just ,º of a
fund’sportfolioisinaninvestmentthatlosesjust1oºofitsvalue.Soafundmanager
cannotaffordbigrisks.
But SIVs were considered very safe investments—they always had been—and
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,atleast¡¡sponsors,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,”whichmayincludewealthyinvestorswhoinvest·i,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 GE’s own pension
andemployeebeneftassets,ranagroundinthesummer;ithad,oºofitsassetsin
mortgage-backedsecurities.Whenthefundreportedlylost·ioomillionandclosed
in November ioo,, investors redeemed their interests at ·o.µo.
¡µ
Bank of America
supporteditsStrategicCashPortfolio—thenation’slargestenhancedcashfund,with
·¡o billion in assets at its peak—after one of that fund’s largest investors withdrew
·iobillioninNovemberioo,.
¡o
An interesting case study is provided by the meteoric rise and decline of the
CreditSuisseInstitutionalMoneyMarketPrimeFund.Thefundsoughttoattractin-
vestorsthroughInternet-basedtradingplatformscalled“portals,”whichsuppliedan
estimated·¡oobilliontomoneymarketfundsandotherfunds.Investorsusedthese
portalstoquicklymovetheircashtothehighest-yieldingfund.Postingahigherre-
turncouldattractsignifcantfunds:onemoneymarketfundmanagerlatercompared
theuseofportalmoneyto“drink[ing]fromafrehose.”
¡1
Butthemoneycouldvan-
ishjustasquickly.TheCreditSuissefundpostedthehighestreturnsintheindustry
duringthe1imonthsbeforetheliquiditycrisis,andincreaseditsassetsfromabout
·,billioninthesummerofioootomorethan·i,billioninthesummerofioo,.To
deliverthosehighreturnsandattractinvestors,though,itfocusedonstructuredf-
nanceproducts,includingCDOsandSIVssuchasCheyne.Wheninvestorsbecame
concernedaboutsuchassets,theyyankedabout·1obillionoutofthefundinAugust
ioo,alone.CreditSuisse,theSwissbankthatsponsoredthefund,wasforcedtobail
itout,purchasing·,.,billionofassetsinAugust.
¡i
Theepisodehighlightstherisks
ofmoneymarketfunds’relyingon“hotmoney”—thatis,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, Florida’s local government investment pool was the
largestinthecountry,and“intendedtooperatelikeahighlyliquid,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 state’s requirements. It
hadmorethan·ibillioninSIVsandotherdistressedsecurities,ofwhichabout·,i,
millionhadalreadydefaulted.Anditheld·o,omillioninCountrywidecertifcates
ofdepositwithmaturitiesthatstretchedoutasfarasJuneioo8.
¡¡
InearlyNovember,
followingaseriesofnewsreports,thefundsufferedarun.Localgovernmentswith-
drew·8billioninjusttwoweeks.OrangeandPinellascountiespulledouttheiren-
tire investments. On November iµ, the fund’s managers stopped all withdrawals.
Florida’s 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||Iynch“Dawningawarcncsscvcrthcccursccjthcsunncr”:,,
Citigrcup“1hatwcu|dnctinanywayhavccxcitcdnyattcnticn”:eo
AIG’sdisputcwithGc|dnan“1hcrcccu|dncvcr|c|csscs”:e,
Icdcra|Rcscrvc“1hcdisccuntwindcwwasn’twcrking”:,,
Mcnc|incinsurcrs“Vcncvcrcxpcctcd|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(·µ.,billion),MorganStanley(·1o.¡
billion),JPMorgan(·,.¡billion),andBearStearns(·i.obillion).
1
Insurancecompa-
nies, hedge funds, and other fnancial institutions collectively had taken additional
mortgage-relatedlossesofabout·1oobillion.
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,oooand·11µ,oooannuallyforevery·1omillion,whilethecost
fortherelativelystrongerGoldmanSachsstoodat·o8,ooo.
¡
Meanwhile,theeconomywasbeginningtoshowsignsofstress.Facingturmoilin
fnancialmarkets,declininghomeprices,andoilpricesabove·,,abarrel,consumer
spending was slowing. The Federal Reserve lowered the overnight bank borrowing
ratefrom,.i,ºearlierintheyearto¡.,,ºinSeptember,¡.,ºinOctober,andthen
¡.i,ºinDecember.
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.µ billion loss on CDOs and ·1 billion on sub-
prime mortgages—·,.µ 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 O’Neal, a
i1-yearMerrillveteran,resigned.
Much of this write-down came from the frm’s holdings of the super-senior
tranches of mortgage-related CDOs that Merrill had previously thought to be ex-
tremelysafe.Aslateasfalliooo,itsmanagementhadbeen“bullishongrowth”and
“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
wastoreducethefrm’sriskbygettingthoseloansandsecuritiesoffitsbalancesheet.
Yetitfoundthatitcouldnotsellthesuper-seniortranchesofthoseCDOsataccept-
ableprices;itthereforehadto“takedownseniortranchesintoinventoryinorderto
execute deals”
,
—leading to the accumulation of tens of billions of dollars of those
tranchesonMerrill’sbooks.DowKim,thentheco-presidentofMerrill’sinvestment
banking segment, told FCIC staff that the buildup of the retained super-senior
tranchesintheCDOpositionswasactuallypartofastrategybeguninlateioooto
reduce the frm’s 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·¡.,billionfrom·1i.8billion
in March.
8
According to a September ioo, internal Merrill presentation, the net
amount in retained super-senior CDO tranches had increased from ·µ.¡ billion in
Septemberioooto·i,.¡billionbyMarchioo,and·i8.µbillionbyMay.
µ
Butasthe
mortgagemarketcameunderincreasingpressureandasthemarketvalueofevensu-
per-seniortranchescrumbled,thestrategywouldcomebacktohauntthefrm.
Merrill’s frst-quarter earnings for ioo,—net revenues of ·µ.µ billion—were 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 analysts—an event that in-
vestorsandanalystsrelyontoobtainimportantinformationaboutthecompanyand
that,likeotherpublicstatements,issubjecttofederalsecuritieslaws.
Merrill’s then-CFO Jeffrey Edwards indicated that the company’s results would
notbehurtbythedislocationinthesubprimemarket,because“revenuesfromsub-
primemortgage-relatedactivitiescomprise[d]lessthan1ºofournetrevenues”over
thepastfvequarters,andbecauseMerrill’s“riskmanagementcapabilitiesarebetter
thanever,andcrucialtooursuccessinnavigatingturbulentmarkets.”Providingfur-
therassurances,hestated,“Webelievetheissuesinthisnarrowsliceofthemarketre-
maincontainedandhavenotnegativelyimpactedothersectors.”
1o
However, Edwards did not disclose the large increase in retained super-senior
CDOtranchesorthedimcultyofsellingthosetranches,evenataloss—thoughspe-
cifcquestionsonthesubjectwereraised.
InJuly,Merrillfolloweditsstrongfrst-quarterreportwithanotherforthesecond
quarterthat“enabledthecompanytoachieverecordnetrevenues,netearningsand
netearningsperdilutedshareforthefrsthalfofioo,.”
11
Duringtheconferencecall
announcing the results, the analyst Glenn Schorr of UBS, a large Swiss bank, asked
theCFOtoprovidesome“coloraroundmythversusreality”onMerrill’sexposureto
retainedCDOpositions.Ashehadthreemonthsearlier,EdwardsstressedMerrill’s
risk management and the fact that the CDO business was a small part of Merrill’s
overall business. He said that there had been signifcant reductions in Merrill’s re-
tainedexposurestolower-ratedsegmentsofthemarket,althoughhedidnotdisclose
thatthetotalamountofMerrill’sretainedCDOshadreached·¡o.¡billionbyJune.
Edwards declined to provide details about the company’s exposure to subprime
mortgage CDOs and any inventory of mortgage-backed securities to be packaged
into CDOs. “We don’t 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
presentationtotheboard’sFinanceCommittee,DaleLattanzio,co-headoftheAmer-
ican branch of the Fixed Income, Currencies and Commodities business, reported a
“net”exposureof·¡ibillioninCDO-relatedassets,essentiallyallofthemratedtriple-
A, with exposure to the lower-rated asset class signifcantly reduced.

This net
exposurewastheamountofCDOpositionsleftafterthesubtractionofthehedges—
guaranteesinoneformoranother—thatMerrillhadpurchasedtopassalongitsulti-
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.”

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 O’Neal told FCIC investigators he had not known that the com-
panywasretainingthesuper-seniortranchesoftheCDOsuntilLattanzio’spresen-
tationtotheFinanceCommittee.Hewasstartled,ifonlybecausehehadbeenunder
the impression that Merrill’s 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: O’Neal said he was surprised about the re-
tainedpositionsbutstatedthatthepresentation,analysis,andestimationofpoten-
tial losses were not sumcient to sound “alarm bells.”
1o
Lattanzio’s 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; O’Neal told the FCIC: “It was a dawning awareness
overthecourseofthesummerandthroughSeptemberasthesizeofthelosseswere
beingestimated.”
18
OnOctoberi1,Merrillexecutivesgaveitsboardadetailedaccountofhowthe
frmfounditselfwithwhatwasbythattime·1,.ibillioninnetexposuretothesu-
per-seniortranches—downfromapeakinJulyof·¡i.ibillionbecausethefrmhad
increasinglyhedged,writtenoff,andsolditsexposure.OnOctoberi¡,Merrillan-
nounceditsthird-quarterearnings:astunning·,.µbillionmortgage-relatedwrite-
down contributing to a net loss of ·i.¡ billion. Merrill also reported—for the frst
time—its·1,.ibillionnetexposuretoretainedCDOpositions.Still,intheirconfer-
encecallwithanalysts,O’NealandEdwardsrefusedtodisclosethegrossexposures,
excludingthehedgesfromthemonolinesandAIG.“Ijustdon’twanttogetintothe
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.”

AccordingtotheSecuritiesandExchangeCommission,bySeptemberioo,,
Merrillhadaccumulated·,,billionof“gross”retainedCDOpositions,almostfour
timesthe·1,.ibillionof“net”CDOpositionsreportedduringtheOctoberi¡con-
ferencecall.
io
On October ¡o, when O’Neal resigned, he left with a severance package worth
·1o1., million
i1
—on top of the ·µ1.¡ 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-
chasedalmost·1oobillioninhedgeshadcomeintoquestion,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,startingwith·i.obilliononJanuary1,,ioo8.Bytheendof
ioo8, Merrill would put aside a total of ·1¡ billion related to monolines and had
recordedtotalwrite-downsonnearly·¡¡billionofothermortgage-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 O’Neal’s October ¡o departure from Merrill Lynch, Citigroup an-
nouncedthatitstotalsubprimeexposurewas·,,billion,whichwas·¡ibillionmore
thanithadtoldinvestorsjustthreeweeksearlier.Citigroupalsoannounceditwould
be taking an ·8 to ·11 billion loss on its subprime mortgage–related holdings and
thatChuckPrincewasresigningasitsCEO.LikeO’Neal,Princehadlearnedlateof
hiscompany’ssubprime-relatedCDOexposures.PrinceandRobertRubin,chairman
oftheExecutiveCommitteeoftheboard,toldtheFCICthatbeforeSeptemberioo,,
they had not known that Citigroup’s investment banking division had sold some
CDOswithliquidityputsandretainedthesuper-seniortranchesofothers.

PrincetoldtheFCICthateveninhindsightitwasdimcultforhimtocriticizeany
ofhisteam’sdecisions.“Ifsomeonehadelevatedtomylevelthatwewereputtingona
·itrillionbalancesheet,·¡obillionoftriple-A-rated,zero-riskpaper,thatwouldnot
inanywayhaveexcitedmyattention,”Princesaid.“Itwouldn’thavebeenusefulfor
someonetocometomeandsay,‘Now,wehavegot·itrilliononthebalancesheetof
assets.Iwanttopointouttoyouthereisaoneinabillionchancethatthis·¡obillion
couldgosouth.’Thatwouldnothavebeenusefulinformation.ThereisnothingIcan
dowiththat,becausethereisthatlevelofchanceoneverything.”

Infact,theodds
weremuchhigherthanthat.EvenbeforethemassdowngradesofCDOsinlateioo,,
atriple-AtrancheofaCDOhada1in1ochanceofbeingdowngradedwithin,years
ofitsoriginalrating.
i,
Certainly, Citigroup was a large and complex organization. That ·i trillion bal-
ancesheet—and·1.itrillionoff-balancesheet—wasspreadamongmorethani,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
seniormanagementwouldnotbenotifedof·¡¡billioninconcentratedexposure—
iº of the company’s balance sheet and more than a third of its capital—because it
wasperceivedtobe“zero-riskpaper.”
i,
Signifcantly,Citigroup’sFinancialControlGrouphadarguediniooothattheliq-
uidityputsthatCitigrouphadwrittenonitsCDOshadbeenpricedforinvestorstoo
cheaplyinlightoftherisks.
i8
Also,inearlyiooo,SusanMills,amanagingdirectorin
the securitization unit—which bought mortgages from other companies and bun-
dled them for sale to investors—took note of rising delinquencies in the subprime
marketandcreatedasurveillancegrouptotrackloansthatherunitpurchased.

By
mid-iooo,hergroupsawadeteriorationinloanqualityandanincreaseinearlypay-
mentdefaults—thatis,moreborrowersweredefaultingwithinafewmonthsofget-
ting a loan. From ioo, to ioo,, Mills recalled before the FCIC, the early payment
defaultratesnearlytripledfromiºto,ºoroº.
¡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, Citigroup’s CDO desk increased its purchases of mortgage-
backedsecuritiesbecauseitsawthedistressedmarketasabuyingopportunity.
¡i
“Effective communication across businesses was lacking,” the company’s 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¡,ºbelowpar,theCDOdeskdecidedtoslowdownonthefnancingofmortgage
securitiesforinventorytoproduceCDOs.
¡¡
Shortlythereafter,however,thesameABX
indexstartedtorally,risingtoioºbelowparinMarchandholdingaroundthatlevel
throughMay.So,theCDOdeskreversedcourseandaccelerateditspurchasesofinven-
tory in April, according to Nestor Dominguez, Warne’s co-head on the CDO desk.
¡,
Dominguezsaidhedidn’tseethemarketweakeninguntilthesummer,whentheindex
felltolessthanooºbelowpar.
¡o
MurrayBarnes,theCitigroupriskomcerassignedtotheCDObusiness,approved
the CDO desk’s request to temporarily increase its limits on purchasing collateral.
Barnesobserved,inhindsight,thatratherthanlookingatthewideningspreadsasan
opportunity, Citigroup should have reassessed its assumptions and examined
whetherthedeclineintheABXwasasignofstraininthemortgagemarket.Head-
mitted“complacency”aboutthedesk’sabilitytomanageitsrisk.
¡,
Theriskmanagementdivisionalsoincreased theCDOdesk’slimitsforretaining
themostseniortranchesfrom·¡obillionto·¡,billioninthefrsthalfofioo,.Asat
Merrill, traders and risk managers at Citigroup believed that the super-senior
tranchescarriedlittlerisk.
¡8
Citigroup’sregulatorslaterwrote,“Anacknowledgement
oftheriskinitsSuperSeniorAAACDOexposurewasperhapsCitigroup’s‘biggest
miss.’ . . .Asmanagementfeltcomfortablewiththecreditriskofthesetranches,itbe-
gantoretainlargepositionsonthebalancesheet. . . .Asthesub-primemarketbegan
to deteriorate, the risk perceived in these tranches increased, causing large write-
downs.”
¡µ
Ultimately,lossesatCitigroupfrommortgages,Alt-Amortgage–backedse-
curities, and mortgage-related CDOs would total about ·,8 billion, nearly half of
Citigroup’scapitalattheendofiooo.About·8billionofthatlossrelatedtoprotec-
tionpurchasedfromthemonolineinsurers.
¡o
Barnes’s decision to increase the CDO risk limits was approved by his superior,
EllenDuke.BarnesandDukereportedtoDavidBushnell,thechiefriskomcer.Bush-
nell—whomPrincecalled“thebestriskmanageronWallStreet”—toldtheFCICthat
hedidnotrememberspecifcallyapprovingtheincreasebutthat,ingeneral,therisk
managementfunctiondidapprovehigherrisklimitswhenabusinesslinewasgrow-
ing.
¡1
He described a “frm-wide initiative” to increase Citigroup’s structured prod-
uctsbusiness.
¡i
Perhapswhatismostremarkableabouttheconfictingstrategiesemployedbythe
z·z ii N\Nti \i tii :i : i NQUi i¥ tu\\i : :i uN iiiui1
securitizationandCDOdesksisthattheirrespectiveriskomcersattendedthesame
weeklyindependentriskmeetings.Dukerefectedthatshewasnotoverlyconcerned
whentheissuecameup,sayingsheandherriskteamwere“seducedbystructuring
andfailedtolookattheunderlyingcollateral.”
¡¡
AccordingtoBarnes,theCDOdesk
didn’t 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 Citigroup’s securitization desk might have been able to provide
some insights based on its own data.
¡,
Barnes told the FCIC that Citigroup’s risk
managementtendedtobemanagedalongbusinesslines,notingthathewasonlytwo
omcesawayfromhiscolleaguewhocoveredthesecuritizationbusinessandyetdidn’t
understandthenuancesofwhatwashappeningtotheunderlyingloans.Heregretted
notreachingouttotheconsumerbankto“getthepulse”ofmortgageorigination.
¡o
“1/et/esncvcr/e¡¡cncásincct/cuc¡rcssion”
PrinceandRubinappearedtobelieveupuntilthefallofioo,thatanydownsiderisk
intheCDObusinesswasminuscule.“Idon’tthinkanybodyfocusedontheCDOs.
Thiswasonebusinessinavastenterprise,anduntilthetroubledeveloped,itwasn’t
one that had any particular profle,” Rubin—in Prince’s 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
Citigroup’sinvestmentbank,toldtheFCICthathespent“asmallfractionof1º”of
histimethinkingaboutordealingwiththeCDObusiness.
¡µ
Citigroup’sriskmanagementfunctionwassimplynotveryconcernedabouthous-
ingmarketrisks.AccordingtoPrince,Bushnellandotherstoldhim,ineffect,“‘Gosh,
housingpriceswouldhavetogodown¡oºnationwideforustohave,notaproblem
with[mortgage-backedsecurities]CDOs,butforustohaveproblems,’andthathas
never happened since the Depression.”
,o
Housing prices would be down much less
than ¡oº when Citigroup began having problems because of write-downs and the
liquidityputsithadwritten.
By June ioo,, national house prices had fallen ¡.,º, and about 1oº of subprime
adjustable-ratemortgagesweredelinquent.YetCitigroupstilldidnotexpectthatthe
liquidityputscouldbetriggered,anditremainedunconcernedaboutthevalueofits
retainedsuper-seniortranchesofCDOs.OnJune¡,ioo,,Citigroupmadeapresenta-
tiontotheSECaboutsubprimeexposureinitsCDObusiness.Thepresentationnoted
thatCitigroupdidnotfactortwopositionsintothisexposure:·1¡.obillioninsuper-
seniortranchesand·i¡.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 Citigroup’s 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,
billionofthecompany’scashandexposeittopossiblebalance-sheetlossesatatime
whenmarketswereincreasinglyindistress.Butgiventherisingrates,Lyonsalsosaid
Citigroupdidnothavetheoptiontowait.Overthenextsixmonths,Citigrouppur-
chasedall·i,billionofthepaperthathadbeensubjecttoitsliquidityputs.
,i
On a July io conference call, CFO Gary Crittenden told analysts and investors
thatthecompany’ssubprimeexposureshadfallenfrom·i¡billionattheendofiooo
to·1¡billiononJune¡o.Buthemadenomentionofthesuper-seniorexposuresand
liquidityputs.“Ithinkourriskteamdidanicejobofanticipatingthatthiswasgoing
tobeadimcultenvironment,andsosetaboutinaprettyconcentratedefforttore-
duceourexposureoverthelastsixmonths,”

hesaid.Aweeklater,onaJulyi,call,
Crittenden reiterated that subprime exposure had been cut: “So I think we’ve had
goodriskmanagementthathasbeenanticipatingsomemarketdislocationhere.”

ByAugust,asmarketconditionsworsened,Citigroup’sCDOdeskwasrevaluing
itssuper-seniortranches,thoughithadnoeffectivemodelforassigningvalue.How-
ever,asthemarketcongealed,thenfroze,thepaucityofactualmarketpricesforthese
tranchesdemandedamodel.TheNewYorkFedlaternotedthat“themodelforSuper
SeniorCDOs,basedonfundamentaleconomicfactors,couldnotbefullyvalidated
byCitigroup’scurrentvalidationmethodologiesyetitwasrelieduponforreporting
exposures.”
,,
Barnes, the CDO risk omcer, told the FCIC that sometime that summer he met
withtheco-headsoftheCDOdesktoexpresshisconcernsaboutpossiblelosseson
boththeunsoldCDOinventoryandtheretainedsuper-seniortranches.Themessage
got through. Nestor Dominguez told the FCIC, “We began extensive discussions
abouttheimplicationsofthe . . .dramaticdeclineoftheunderlyingsubprimemar-
kets,andhowthatwouldfeedintothesuper-seniorpositions.”
,o
Alsoatthistime—
for the frst time—such concerns reached Maheras. He justifed his lack of prior
knowledgeofthebillionsofdollarsininventoryandsuper-seniortranchesbypoint-
ing out “that the business was appropriately supervised by experienced and highly
competentmanagersandbyanindependentriskgroupandthatIwasproperlyap-
prisedofthegeneralnatureofourworkinthisareaanditsattendantrisks.”
,,
Theexactdatesarenotcertain,butaccordingtoBushnell,heremembersadiscus-
sionata“BusinessHeads”meetingaboutthegrowingmark-to-marketvolatilityon
those super-senior tranches in late August or early September, well after Citigroup
startedtobuythecommercialpaperbackingthesuper-seniortranchesoftheCDOs
that BSAM managed.
,8
This was also when Chairman and CEO Prince frst heard
about the possible amount of “open positions” on the super-senior CDO tranches
that Citigroup held: “It wasn’t presented at the time in a startling fashion . . . [but]
z·, ii N\Nti \i tii :i : i NQUi i¥ tu\\i : :i uN iiiui1
then it got bigger and bigger and bigger, obviously, over the next ¡o days.”

In late
August, Citigroup’s valuation models suggested that losses on the super-senior
tranchesmightrangefrom·1,millionto·ibillion.Thisnumberwasrecalculatedas
·¡ooto·,oomillioninmid-September,asthevaluationmethodologywasrefned.
oo
Intheweeksahead,thosenumberswouldskyrocket.
“uIIt0X cells”
To get a handle on potential losses from the CDOs and liquidity puts, starting on
September µ Prince convened a series of meetings—and later, nightly “DEFCON
calls”—with members of his senior management team; they included Rubin, Ma-
heras,Crittenden,andBushnell,aswellasLouKaden,thechiefadministrativeom-
cer.
o1
Rubin was in Korea during the frst meeting but Kaden kept him informed.
oi
RubinlateremailedPrince:“AccordingtoLou,Tom[Maheras]neverdidprovidea
clear and direct answer on the super seniors. If that is so, and the meeting did not
bringthattoahead,isn’tthatdeeplytroublingnotastowhathappened—thatisadif-
ferentquestionthatisalsotroubling—butastoprovidingfullandclearinformation
andanalysisnow.”Princedisagreed,writing,“Ithought,forfrstmtg,itwasgood.We
weren’ttryingtogettofnalanswers.”

A second meeting was held September 1i, after Rubin was back in the country.
This meeting marked the frst time Rubin recalled hearing of the super-senior and
liquidityputexposure.Helatercommented,“AsfarasIwasconcernedtheywereall
onething,becauseiftherewasaputbacktoCitiunderanycircumstance,however
remotethatcircumstancemightbe,youhadn’tfullydisposedoftherisk.”

And,of
course,thecircumstancewasnotremote,sincebillionsofdollarsinsubprimemort-
gageassetshadalreadycomebackontoCitigroup’sbooks.
PrincetoldtheFCICthatMaherashadassuredhimthroughoutthemeetingsand
theDEFCONcallsthatthesuperseniorsposednorisktoCitigroup,evenasthemar-
ketdeteriorated;headdedthathebecameincreasinglyuneasywithMaheras’sassess-
ment. “Tom had said and said till his last day at work [October 11]: ‘We are never
goingtoloseapennyonthesesuperseniors.Wearenevergoingtoloseapennyon
thesesuperseniors. . . .’AndaswewentalongandIwasmoreandmoreuncomfort-
ablewiththisandmoreandmoreuncomfortablewithTom’sconclusionsonultimate
valuations,thatiswhenIreallybegantohavesomeveryseriousconcernsaboutwhat
wasgoingtohappen.”
o,
DespitePrince’sconcerns,Citigroupremainedpubliclysilentabouttheadditional
subprimeexposurefromthesuper-seniorpositionsandliquidityputs,evenasitpre-
announcedsomedetailsofitsthird-quarterearningsonOctober1,ioo,.
OnOctober11,theratingagenciesannouncedthefrstinaseriesofdowngrades
onthousandsofsecurities.InPrince’sview,thesedowngradeswere“theprecipitating
event in the fnancial crisis.”
oo
On the same day, Prince restructured the investment
bank,amovethatledtotheresignationofMaheras.
Four days later, the question of the super-senior CDOs and liquidity puts was
specifcallyraisedattheboardofdirectors’CorporateAuditandRiskManagement
i\1i z++, 1u i\ii¥ z++· 8i iii uN: i N :U8iii \i iu: :i: z·,
Committeemeetingandbroughtuptothefullboard.Apresentationconcludedthat
“total sub-prime exposure in [the investment bank] was ·1¡bn with an additional
·1obninDirectSuperSeniorand·i,bninLiquidityandParPuts.”
o,
Citigroup’stotal
subprime exposure was ·,o billion, nearly half of its capital. The calculation was
straightforward,butduringananalysts’conferencecallthatdayCrittendenomitted
anymentionofthesuper-senior-andliquidity-put-relatedexposureashetoldpar-
ticipantsthatCitigrouphadunder·1¡billioninsubprimeexposure.
o8
A week later, on Saturday, October i,, Prince learned from Crittenden that the
companywouldhavetoreportsubprime-relatedlossesof·8to·11billion;onMon-
dayhetenderedhisresignationtotheboard.Helaterrefected,“WhenIdrovehome
andGarycalledmeandtoldmeitwasn’tgoingtobetwoor¡oomillionbutitwasgo-
ing to be eight billion—I will never forget that call. I continued driving, and I got
home,Iwalkedinthedoor,Itoldmywife,Isaidhere’swhatIjustheardandifthis
turnsouttobetrue,Iamresigning.”

OnNovember¡,Citigrouprevealedtheaccuratesubprimeexposure—nowesti-
mated at ·,, billion—and it disclosed the subprime-related losses. Though Prince
had resigned, he remained on Citigroup’s payroll until the end of the year, and the
boardofdirectorsgavehimagenerouspartingcompensationpackage:·11.µmillion
incashand·i¡millioninstock,bringinghistotalcompensationto·,µmillionfrom
ioo¡ to ioo,.
,o
The SEC later sued Citigroup for its delayed disclosures. To resolve
the charges, the bank paid ·,, million. The New York Fed would later conclude,
“Therewaslittlecommunicationsontheextensivelevelofsubprimeexposureposed
bySuperSeniorCDO. . . .Seniormanagement,aswellastheindependentRiskMan-
agementfunctionchargedwithmonitoringresponsibilities,didnotproperlyidentify
andanalyzetheserisksinatimelyfashion.”
,1
Prince’sreplacementsaschairmanandCEO—RichardParsonsandVikramPan-
dit—were announced in December. Rubin would stay until January iooµ, having
beenpaidmorethan·11,millionfromioootoiooµ
,i
duringhistenureatthecom-
pany,includinghisroleaschairmanoftheExecutiveCommittee,apositionthatcar-
ried“nooperationalresponsibilities,”RubintoldtheFCIC.“MyagreementwithCiti
providedthatI’dhavenomanagementofpersonneloroperations.”

JohnReed,formerco-CEOofCitigroup,attributedthefrm’sfailuresinparttoa
culturechangethatoccurredwhenthebanktookonSalomonBrothersaspartofthe
1µµ8Travelersmerger.HesaidthatSalomonexecutives“wereusedtotakingbigrisks”
and“hadahistory . . .[of]makingalotofmoney . . .butthengettingintotrouble.”

AIG’ S DISPUTE WITH GOLDMAN:
“THERE COULD NEVER BE LOSSES”
BeginningonJulyio,ioo,,whenGoldman’sDavilmansenttheemailthatdisrupted
thevacationofAIG’sAlanFrost,thedisputebetweenGoldmanandAIGovertheneed
forcollateraltobackcreditdefaultswapscapturedtheattentionoftheseniormanage-
mentofbothcompanies.For1¡months,GoldmanpresseditscaseandsentAIGafor-
mal demand letter every single business day. It would pursue AIG relentlessly with
z·· ii N\Nti \i tii :i : i NQUi i¥ tu\\i : :i uN iiiui1
demands for collateral based on marks that were initially well below those of other
frms—whileAIGanditsmanagementstruggledtocometogripswiththeburgeoning
crisis.
The initial collateral call was a shock to AIG’s senior executives, most of whom
hadnotevenknownthatthecreditdefaultswapswithGoldmancontainedcollateral
callprovisions.
They had known there were enormous exposures—·,µ billion, backed in large
partbysubprimeandAlt-Aloans,inioo,,
,,
comparedwiththeparentcompany’sto-
tal reported capital of ·µ,.8 billion—but executives said they had never been con-
cerned. “The mantra at [AIG Financial Products] had always been (in my
experience) that there could never be losses,” Vice President of Accounting Policy
JosephSt.Denissaid.
,o
Then came that frst collateral call. St. Denis told FCIC staff that he was so
“stunned”whenhegotthenewsthathe“hadtositdown.”
,,
Thecollateralprovisions
surprisedevenGenePark,theexecutivewhohadinsisted18monthsearlierthatAIG
stop writing the swaps. He told the FCIC that “rule Number 1 at AIG FP” was to
neverpostcollateral.Thiswasparticularlyimportantinthecreditdefaultswapbusi-
ness,hesaid,becauseitwastheonlyunhedgedbusinessthatAIGran.
,8
But Jake Sun, the general counsel of the Financial Products subsidiary, who re-
viewedtheswapcontractsbeforetheywereexecuted,toldtheFCICthattheprovi-
sions were standard both at AIG and in the industry.

Frost, who was the frst to
learnofthecollateralcall,agreedandsaidthatotherfnancialinstitutionsalsocom-
monlydiddealswithcollateralpostingprovisions.
8o
PierreMicottis,theParis-based
headoftheAIGFinancialProducts’EnterpriseRiskManagementdepartment,told
the FCIC that collateral provisions were indeed common in derivatives contracts—
butsurprisinginthesuper-seniorCDScontracts,whichwereconsideredsafe.
81
In-
surance supervisors did not permit regulated insurance companies like MBIA and
Ambactopayoutexceptwhentheinsuredentitysufferedanactualloss,andthere-
forethosecompanieswereforbiddentopostcollateralforadeclineinmarketvalue
orunrealizedlosses.BecauseAIGFinancialProductswasnotregulatedasaninsur-
ancecompany,itwasnotsubjecttothisprohibition.
As disturbing as the senior AIG executives’ surprise at the collateral provisions
wastheirfrm’sinabilitytoassessthevalidityofGoldman’snumbers.AIGFinancial
Products did not have its own model or otherwise try to value the CDO portfolio
thatitguaranteedthroughcreditdefaultswaps,nordidithedgeitsexposure.Gene
Parkexplainedthathedgingwasseenasunnecessaryinpartbecauseofthemistaken
beliefthatAIGwouldhavetopaycounterpartiesonlyifholdersofthesuper-senior
tranchesincurredactuallosses.HealsosaidthatpurchasingahedgefromUBS,the
Swiss bank, was considered, but that Andrew Forster, the head of credit trading at
AIG Financial Products, rejected the idea because it would cost more than the fees
that AIG Financial Products was receiving to write the CDS protection. “We’re not
goingtopayadimeforthis,”ForstertoldPark.
8i
Therefore,AIGFinancialProductsreliedonanactuarialmodelthatdidnotpro-
vide a tool for monitoring the CDOs’ market value. The model was developed by
i\1i z++, 1u i\ii¥ z++· 8i iii uN: i N :U8iii \i iu: :i: z·,
Gary Gorton, then a fnance professor at the University of Pennsylvania’s Wharton
School, who began working as a consultant to AIG Financial Products in 1µµo and
wasclosetoitsCEO,JoeCassano.TheGortonmodelhaddeterminedwithµµ.8,º
confdencethattheownersofthesuper-seniortranchesoftheCDOsinsuredbyAIG
FinancialProductswouldneversufferrealeconomiclosses,eveninaneconomyas
troubledastheworstpost–WorldWarIIrecession.Thecompany’sauditors,Pricewa-
terhouseCoopers (PwC), who were apparently also not aware of the collateral re-
quirements, concluded that “the risk of default on [AIG’s] portfolio has been
effectivelyremovedandasaresultfromariskmanagementperspective,thereareno
substantiveeconomicrisksintheportfolioandasaresultthefairvalueoftheliability
streamonthesepositionsfromariskmanagementperspectivecouldreasonablybe
consideredtobezero.”

InspeakingwiththeFCIC,Cassanowasadamantthatthe“CDSbook”waseffec-
tivelyhedged.HesaidthatAIGcouldneversufferlossesontheswaps,becausethe
CDScontractswerewrittenonlyonthesuper-seniortranchesoftop-ratedsecurities
withhigh“attachmentpoints”—thatis,manysecuritiesintheCDOswouldhaveto
defaultinorderforlossestoreachthesuper-seniortranches—andbecausethebulk
oftheexposurecamefromloansmadebeforeiooo,whenhethoughtunderwriting
standardshadbeguntodeteriorate.

Indeed,accordingtoGenePark,Cassanoputa
halttoa·1,omillionhedge,inwhichAIGhadtakenashortpositionintheABXin-
dex.AsParkexplained,“Joestoppedthatbecauseafterweputonthefrst1,o . . .the
marketmovedagainstus . . .wewerelosingmoneyonthe1,omillion. . . .Joesaid,
‘Youknow,Idon’tthinktheworldisgoingtoblowup . . .Idon’twanttospendthat
money.Stopit.’”
8,
Despitethelimitedmarkettransparencyinthesummerofioo,,Goldmanused
whatinformationtherewas,includinginformationfromABXandotherindices,to
estimate what it considered to be realistic prices. Goldman also spoke with other
companies to see what values they assigned to the securities. Finally, Goldman
lookedtoitsownexperience:inmostcases,whenthebankboughtcreditprotection
on an investment, it turned around and sold credit protection on the same invest-
menttoothercounterparties.Thesedealsyieldedmorepriceinformation.
8o
UntilthedisputewithGoldman,AIGreliedontheGortonmodel,whichdidnot
estimatethemarketvalueofunderlyingsecurities.SoGoldman’smarkscaughtAIG
bysurprise.WhenAIGpushedback,GoldmanalmostimmediatelyreduceditsJuly
i,collateraldemandfrom·1.8billionto·1.ibillion,amovethatunderscoredthe
dimculty of fnding reliable market prices. The new demand was still too high, in
AIG’s view, which was corroborated by third-party marks. Goldman valued the
CDOsbetween8oandµ,centsonthedollar,whileMerrillLynch,forexample,val-
uedthesamesecuritiesbetweenµ,and1oocents.
8,
On August ,, Cassano told PwC that there was “little or no price transparency”
andthatitwas“dimculttodeterminewhether[collateralcalls]wereindicativeoftrue
marketlevelsmoving.”
88
AIGmanagersdidcallotherdealersholdingsimilarbonds
to check their marks in order to help its case with Goldman, but those marks were
not “actionable”—that is, the dealers would not actually execute transactions at the
z·· ii N\Nti \i tii :i : i NQUi i¥ tu\\i : :i uN iiiui1
quotedprices.“Theaboveestimatedvalues . . .donotrepresentactualbidsoroffers
byMerrillLynch”wasthedisclaimerinalistingofestimatedmarketvaluesprovided
byMerrilltoAIG.

GoldmanSachsdisputedthereliabilityofsuchestimates.
“\it/outocingjli¡¡ent”
OnAugustµ,forthefrsttime,AIGexecutivespubliclydisclosedthe·,µbillionin
creditdefaultswapsonthesuper-seniortranchesofCDOsduringthecompany’ssec-
ond-quarterearningscall.Theyacknowledgedthatthegreatmajorityoftheunderly-
ing bonds thus insured—·o¡ billion—were backed by subprime mortgages. Of this
amount,·1µbillionwaswrittenonCDOspredominantlybackedbyriskyBBB-rated
collateral.Onthecall,Cassanomaintainedthattheexposureswerenoproblem:“Itis
hardforus,withoutbeingfippant,toevenseeascenariowithinanykindofrealmor
reasonthatwouldseeuslosing·1inanyofthosetransactions.”Heconcluded:“We
see no issues at all emerging. We see no dollar of loss associated with any of [the
CDO]business.Anyreasonablescenariothatanyonecandraw,andwhenIsayrea-
sonable,Imeanasevererecessionscenariothatyoucandrawoutforthelifeofthe
securities.”SeniorVicePresidentandChiefRiskOmcerRobertLewissecondedthat
reassurance: “We believe that it would take declines in housing values to reach de-
pression proportions, along with default frequencies never experienced, before our
AAAandAAinvestmentswouldbeimpaired.”
µo
Theseassurancesfocusedontheriskthatactualmortgagedefaultswouldcreate
realeconomiclossesonthecompany’screditdefaultswappositions.
µ1
Butmoreim-
portantatthetimeweretheothertremendousrisksthatAIGexecutiveshadalready
discussed internally. No one on the conference call mentioned Goldman’s demand
for ·1.i billion in collateral; the clear possibility that future, much-larger collateral
callscouldjeopardizeAIG’sliquidity;ortheriskthatAIGwouldbeforcedtotakean
“enormousmark”onitsexistingbook,theconcernForsterhadnoted.
Thedayaftertheconferencecall,AIGposted·¡,omillionincashtoGoldman,
its frst collateral posting since Goldman had requested the ·1.i billion. As Frost
wrotetoForsterinanAugust1o,ioo,,email,theideawas“togeteveryonetochill
out.”
µi
Foronething,someAIGexecutives,includingCassano,hadlate-summerva-
cationsplanned.Cassanosignedoffonthe·¡,omillion“goodfaithdeposit”before
leavingforacyclingtripthroughGermanyandAustria.
µ¡
Thepartiesexecutedaside
lettermakingclearthatbothdisputedtheamount.Forthetimebeing,twocompa-
niesthathadbeendoingbusinesstogetherfordecadesagreedtodisagree.
On August 1¡, Frost went to Goldman’s omces to “start the dialog,” which had
stalledwhileCassanoandotherkeyexecutiveswereonvacation.Twodayslater,Frost
wrotetoForster:“Trustme.Thisisnotthelastmargincallwearegoingtodebate.”
µ¡
He was right. By September 11, Société Générale—known more commonly as Soc-
Gen—haddemanded·¡omillionincollateralonCDSithadpurchasedfromAIGFi-
nancial Products, UBS had demanded ·o, million, and Goldman had upped its
demand by ·¡oo million. The SocGen demand was based on an 8i., bid price pro-
vided by Goldman, which AIG disputed. Tom Athan, managing director at AIG Fi-
i\1i z++, 1u i\ii¥ z++· 8i iii uN: i N :U8iii \i iu: :i: z·,
nancialProducts,toldForsterthatSocGen“receivedmarksfromGSonpositionsthat
would result in big collateral calls but SG disputed them with GS.”
µ,
Several weeks
later, Cassano told AIG Financial Services CFO Elias Habayeb that he believed the
SocGenmargincallhadbeen“spurredbyGoldman,”andthatAIG“disputedthecall
and[had]notheardfromSocGenagainonthatspecifccall.”
µo
Inthesecondweekof
October,theratingagenciesannouncedhundredsofadditionaldowngradesaffecting
tens of billions of dollars of subprime mortgage–backed securities and CDOs. By
Novemberi,Goldman’sdemandhadalmostdoubled,to·i.8billion.OnNovembero,
Bensinger,theCFO,informedAIG’sAuditCommitteethatFinancialProductshadre-
ceivedmargincallsfromfvecounterpartiesandwasdisputingeverysingleone.
µ,
Thisstancewasrootedinthecompany’scontinuingbeliefthatGoldmanhadset
valuestoolow.AIG’spositionwascorroborated,atleastinpart,bythewidedisparity
inmarksfromothercounterparties.Atonepoint,MerrillLynchandGoldmanmade
collateral demands on the very same CDS positions, but Goldman’s marks were al-
most ¡,º lower than Merrill’s.
µ8
Goldman insisted that its marks represented the
“constantly evolving additional information from our market making activities, in-
cluding trades that we had executed, market activity we observed, price changes in
comparablesecuritiesandderivativesandthecurrentpricesofrelevantliquid . . .in-
dices.”
µµ
Trading in the ABX would fall from over ¡oo trades per week through the
endofSeptemberioo,tolessthani,operweekinthefourthquarterofioo,;trad-
ing in the TABX, which focuses on lower-rated tranches, dropped from roughly ,o
tradesperweekthroughmid-Julytoalmostzerobymid-August.
1oo
But Cassano believed that the quick reduction in Goldman’s frst collateral de-
mand (from ·1.8 billion on July i, to ·1.i billion on August i) and the interim
agreementonthe·¡,omilliondepositconfrmedthatGoldmanwasnotascertainof
its marks as it later insisted. According to Cassano, Michael Sherwood, co-CEO of
GoldmanSachsInternational,toldhimthatGoldman“didn’tcoverourselvesinglory
during this period” but that “the market’s starting to come our [Goldman’s] way”;
CassanotookthosecommentsasanimplicitadmissionthatGoldman’sinitialmarks
hadbeenaggressive.
1o1
“Morclovcnotcs”
Inmid-August,ForstertoldFrostinanemailthatGoldmanwaspursuingastrategy
of aggressively marking down assets to “cause maximum pain to their competi-
tors.”
1oi
PricewaterhouseCoopers, which served as auditor for both AIG and Gold-
man during this period, knew full well that AIG had never before marked these
positionstomarket.Inthethirdquarterofioo,,withthecollateraldemandspiling
up,PwCpromptedAIGtobegindevelopingamodelofitsown.PriortotheGold-
man margin call, PwC had concluded that “compensating controls” made up for
AIG’snothavingamodel.Amongthosewasnoticefromcounterpartiesthatcollat-
eralwasdue.
1o¡
Inotherwords,oneofAIG’sriskmanagementtoolswastolearnofits
ownproblemsfromcounterpartieswhodidhavetheabilitytomarktheirownposi-
tionstomarketpricesandthendemandcollateralfromAIG.
z,+ ii N\Nti \i tii :i : i NQUi i¥ tu\\i : :i uN iiiui1
Thedecisiontodevelopavaluationmodelwasnotunanimous.Inmid-Septem-
ber,CassanoandForstermetwithHabayebandotherstodiscussmarkingtheposi-
tions down and actually recording valuation losses in AIG’s fnancial statements.
Cassanostillthoughtthevaluationprocessunnecessarybecausethepossibilityofde-
faults was “remote.”
1o¡
He sent Forster and others emails describing requests from
Habayebas“morelovenotes . . .[askingustogothrough]thesamedrillofdrafting
answers.”
1o,
Nevertheless,byOctober,andinconsultationwithPwC,AIGstartedto
evaluate the pricing model for subprime instruments developed and used by
Moody’s.CassanoconsideredtheMoody’smodelonlya“gutcheck”untilitwasfully
validatedinternally.
1oo
AIGcoupledthismodelwithgenericCDOtranchedatasold
byJPMorganthatwereconsideredtoberelativelyrepresentativeofthemarket.Of
course,bythistime—andforseveralprecedingmonths—therewasnoactivemarket
formanyofthesetranches.Everyoneunderstoodthatthiswasnotaperfectsolution,
but AIG and its auditors thought it could serve as an interim step. The makeshift
modelwasupandrunninginthethirdquarter.
“tonjiácntinourmerks”
On November ,, when AIG reported its third-quarter earnings, it disclosed that it
wastakinga·¡,imillioncharge“relatedtoitssuperseniorcreditdefaultswapport-
folio” and “a further unrealized market valuation loss through October ioo, of ap-
proximately·,,omillionbeforetax[onthat]portfolio.”Onaconferencecall,CEO
Sullivan assured investors that the insurance company had “active and strong risk
management.”Hesaid,“AIGcontinuestobelievethatitishighlyunlikelythatAIGFP
willberequiredtomakepaymentswithrespecttothesederivatives.”Cassanoadded
that AIG had “more than enough resources to meet any of the collateral calls that
mightcomein.”
1o,
Whilethecompanyremainedadamantthattherewouldbenore-
alizedeconomiclossesfromthecreditdefaultswaps,itusedthenewlyadopted—and
adapted—Moody’smodeltoestimatethe·¡,imillioncharge.Infact,PwChadques-
tionedtherelevanceofthemodel:ithadn’tbeenvalidatedinadvanceoftheearnings
release,itdidn’ttakeintoaccountimportantstructuralinformationabouttheswap
contracts,andtherewerequestionsaboutthequalityofthedata.
1o8
AIGdidn’tmen-
tionthosecaveatsonthecall.
Twoweekslater,onNovemberi¡,Goldmandemandedanadditional·¡billionin
cash.AIGprotested,butpaid·1.,,billion,bringingthetotalpostedto·ibillion.
1oµ
Fourdayslater,CassanocirculatedamemofromForsterlistingthepertinentmarks
for the securities from Goldman Sachs, Merrill Lynch, Calyon, Bank of Montreal,
andSocGen.
11o
Themarksvariedwidely,fromaslittleas,,ºofthebonds’original
valuetovirtuallyfullvalue.Goldman’sestimatedvaluesweremuchlowerthanthose
ofotherdealers.Forexample,GoldmanvaluedoneCDO,theDunhillCDO,at,,º
ofpar,whereasMerrillvalueditatµ,ºofpar;theOrientPointCDOwasvaluedat
ooºofparbyGoldmanbutatµ,ºofparbyMerrill.Forstersuggestedthatthemarks
validated AIG’s long-standing contention that “there is no one dealer with more
knowledge than the others or with a better deal fow of trades and all admit to
i\1i z++, 1u i\ii¥ z++· 8i iii uN: i N :U8iii \i iu: :i: z,.
‘guesstimating’pricing.”
111
Cassanoagreed.“Nooneseemstoknowhowtodiscerna
market valuation price from the current opaque market environment,” Cassano
wrotetoacolleague.“Thisinformationislimitedduetothelackofparticipants[will-
ing]toevengiveindicationsontheseobligations.”
11i
One week later, Cassano called Sherwood in Goldman’s London omce and de-
manded reimbursement of ·1.¡ billion. He told both AIG and Goldman executives
that independent third-party pricing for ,oº of the ¡,,oo securities underlying the
CDOsonwhichAIGFPhadwrittenCDSandAIG’sownvaluationfortheother¡oº
indicatedthatGoldman’sdemandwasunsupported—thereforeGoldmanshouldre-
turnthemoney.
11¡
Goldmanrefused,andinsteaddemandedmore.
11¡
BylateNovember,therewasrelativeagreementwithinAIGandwithitsauditor
thattheMoody’smodelincorporatedintoAIG’svaluationsystemwasinadequatefor
valuing the super-senior book.
11,
But there was no consensus on how that book
should be valued. Inputting generic CDO collateral data into the Moody’s model
wouldresultina·1.,billionvaluationloss;usingGoldman’smarkswouldresultina
·,billionvaluationloss,whichwouldwipeoutthequarter’sprofts.
11o
OnNovember
iµ, PwC auditors met with senior executives from AIG and the Financial Products
subsidiarytodiscussthewholesituation.AccordingtoPwCmeetingnotes,AIGre-
ported that disagreements with Goldman continued, and AIG did not have data to
disputeGoldman’smarks.ForsterrecalledthatSullivansaidthathewasgoingtohave
a heart attack when he learned that using Goldman’s marks would eliminate the
quarter’sprofts.
11,
SullivantoldFCICstaffthathedidnotrememberthispartofthe
meeting.
118
AIG adjusted the number, and in doing so it chose not to rely on dealer quotes.
JamesBridgewater,theFinancialProductsexecutivevicepresidentinchargeofmod-
els, came up with a solution. Convinced that there was a calculable difference be-
tween the value of the underlying bonds and the value of the swap protection AIG
had written on those bonds, Bridgewater suggested using a “negative basis adjust-
ment,”whichwouldreducetheunrealizedlossestimatefrom·,.1billion(Goldman’s
fgure) to about ·1., billion. With their auditor’s knowledge, Cassano and others
agreedthatthenegativebasisadjustmentwasthewaytogo.
SeveraldocumentsgiventotheFCICbyPwC,AIG,andCassanorefectdiscus-
sionsduringandaftertheNovemberiµmeeting.Duringasecondmeetingatwhich
onlytheauditorandparentcompanyexecutiveswerepresent(FinancialProductsex-
ecutives, including Cassano and Forster, did not attend), PwC expressed signifcant
concerns about risk management, specifcally related to the valuation of the credit
default swap portfolio, as well as to the company’s procedures in posting collateral.
AIGFinancialProductshadpaidout·ibillionwithoutactiveinvolvementfromthe
parentcompany’sEnterpriseRiskManagementgroup.Anotherissuewas“thewayin
whichAIGFP[had]been‘managing’theSS[supersenior]valuationprocess—saying
PwCwillnotgetanymoreinformationuntilaftertheinvestordaypresentation.”
11µ
TheauditorslaidouttheirconcernsaboutconfictingstrategiespursuedbyAIG
subsidiaries. Notably, the securities-lending subsidiary had been purchasing mort-
gage-backed securities, using cash raised by lending securities that AIG held on
z,z ii N\Nti \i tii :i : i NQUi i¥ tu\\i : :i uN iiiui1
behalfofitsinsurancesubsidiaries.FromtheendofiooothroughSeptemberioo,,
itsholdingsrosefrom·oµbillionto·88billion.Meanwhile,FinancialProducts,act-
ingonitsownanalysis,haddecidedinioootobeginpullingbackonwritingcredit
defaultswapsonCDOs.InPwC’sview,inallowingonesubsidiarytoincreaseexpo-
sure to subprime while another subsidiary worked to exit the market entirely, the
parentcompany’sriskmanagementfailed.PwCalsosaidthatthecompany’ssecond
quarterofioo,fnancialdisclosureswouldhavebeenchangediftheexposureofthe
securities-lending business had been known. The auditors concluded that “these
items together raised control concerns around risk management which could be a
material weakness.”
1io
Kevin McGinn, AIG’s chief credit omcer, shared these con-
cernsabouttheconfictingstrategies.InaNovemberio,ioo,,email,McGinnwrote:
“All units were apprised regularly of our concerns about the housing market. Some
listenedandresponded;otherssimplychosenottolistenandthen,toaddinsultto
injury,nottospotthemanifestsigns.”Heconcludedthatthiswasakinto“Neroplay-
ing the fddle while Rome burns.”
1i1
On the opposite side, Sullivan insisted to the
FCICthattheconfictingstrategiesinthesecurities-lendingbusinessandatAIGFi-
nancialProductssimplyrevealedthatthetwosubsidiariesadopteddifferentbusiness
models,anddidnotconstituteariskmanagementfailure.
1ii
OnDecember,,sixdaysafterreceivingPwC’swarnings,Sullivanboastedonan-
otherconferencecallaboutAIG’sriskmanagementsystemsandthecompany’sover-
sight of the subprime exposure: “The risk we have taken in the U.S. residential
housingsectorissupportedbysoundanalysisandariskmanagementstructure. . . .
webelievetheprobabilitythatitwillsustainaneconomiclossisclosetozero. . . .We
areconfdentinourmarksandthereasonablenessofourvaluationmethods.”Charlie
Gates, an analyst at Credit Suisse, a Swiss bank, asked directly about valuation and
collateraldisputeswithcounterpartiestowhichAIGhadalludedinitsthird-quarter
fnancialresults.Cassanoreplied,“Wehavefromtimetotimegottencollateralcalls
frompeopleandthenwesaytothem,wellwedon’tagreewithyournumbers.And
theygo,oh,andtheygoaway.Andyousaywellwhatwasthat:It’slikeadrive-byina
way.Andtheothertimestheysatdownwithus,andnoneofthisishostileorany-
thing,it’sallverycordial,andwesitdownandwetryandfndthemiddlegroundand
comparewhereweare.”
1i¡
Cassano did not reveal the ·i billion collateral posted to Goldman, the several
hundredmilliondollarspostedtoothercounterparties,andthedailydemandsfrom
Goldman and the others for additional cash. The analysts and investors on the call
were not informed about the “negative basis adjustment” used to derive the an-
nounced·1.,billionmaximumpotentialexposure.Investorsthereforedidnotknow
that AIG’s earnings were overstated by ·¡.o billion—and they would not learn that
informationuntilFebruary11,ioo8.
“Metcrielvcekncss”
ByJanuaryioo8,AIGstilldidnothaveareliablewaytodeterminethemarketprice
ofthesecuritiesonwhichithadwrittencreditprotection.Nevertheless,onJanuary
i\1i z++, 1u i\ii¥ z++· 8i iii uN: i N :U8iii \i iu: :i: z,,
1o,CassanosentanemailtoMichaelSherwoodandCFODavidViniaratGoldman
demanding that they return ·1.1 billion of the ·i billion posted.
1i¡
He attached a
spreadsheetshowingthatAIGvaluedmanysecuritiesatpar,asiftherehadbeenno
decline in their value. That was simply not credible, Goldman executives told the
FCIC.
1i,
Meanwhile, Goldman had by then built up ·1.¡, billion in protection by
purchasingcreditdefaultswapsonAIGtocoverthedifferencebetweentheamount
ofcollateraltheyhaddemandedandtheamountthatAIGhadpaid.
1io
OnFebruaryo,ioo8,PwCauditorsmetwithRobertWillumstad,thechairmanof
AIG’s board of directors. They informed him that the “negative basis adjustment”
usedtoreachthe·1.,billionestimatedisclosedontheDecember,investorcallhad
beenimproperandunsupported,andwasasignthat“controlsovertheAIGFinan-
cialProductssuperseniorcreditdefaultswapportfoliovaluationprocessandover-
sightthereofwerenoteffective.”PwCconcludedthat“thisdefciencywasamaterial
weaknessasofDecember¡1,ioo,.”
1i,
Inotherwords,PwCwouldhavetoannounce
thatthenumbersAIGhadalreadypubliclyreportedwerewrong.Whytheauditors
waitedsolongtomakethispronouncementisunclear,particularlygiventhatPwC
hadknownabouttheadjustmentinNovember.
In the meeting with Willumstad, the auditors were broadly critical of Sullivan;
Bensinger,whomtheydeemedunabletocompensateforSullivan’sweaknesses;and
Lewis, who might not have “the skill sets” to run an enterprise-wide risk manage-
mentdepartment.Theauditorsconcludedthat“alackofleadership,unwillingnessto
makedimcultdecisionsregarding[FinancialProducts]inthepastandinexperience
in dealing with these complex matters” had contributed to the problems.
1i8
Despite
PwC’sfndings,Sullivanreceived·1o,millionoverfouryearsincompensationfrom
AIG,includingaseverancepackageof·18million.Whenaskedaboutthesefgures
at a FCIC hearing, he said, “I have no knowledge or recollection of those numbers
whatsoever,sir. . . .Icertainlydon’trecallearningthatamountofmoney,sir.”
1iµ
Thefollowingday,PwCmetwiththeentireAIGAuditCommitteeandrepeated
the analysis presented to Willumstad. The auditors said they could complete AIG’s
audit,butonlyifCassano“didnotinterfereintheprocess.”RetainingCassanowasa
“managementjudgment,butthecultureneededtochangeatFP.”
1¡o
OnFebruary11,
AIGdisclosedinanSECflingthatitsauditorhadidentifedthematerialweakness,
acknowledgingthatithadreduceditsDecembervaluationlossestimatesby·¡.obil-
lion—thatis,thedifferencebetweentheestimatesof·,.1billionand·1.,billion—
becauseoftheunsupportablenegativebasisadjustment.
Theratingagenciesrespondedimmediately.Moody’sandS&Pannounceddown-
grades,andFitchplacedAIGon“RatingsWatchNegative,”suggestingthatafuture
downgradewaspossible.AIG’sstockdeclined1iºfortheday,closingat·¡¡.,¡.
AttheendofFebruary,Goldmanheld·ibillionincashcollateral,wasdemand-
ing an additional ·i., billion, and had upped to ·i.1, billion its CDS protection
against an AIG failure. On February i8, AIG disappointed Wall Street again—this
time with dismal fourth-quarter and fscal year ioo, earnings. The company re-
portedanetlossof·,.iµbillion,largelydueto·11.1ibillioninvaluationlossesre-
lated to the super-senior CDO credit default swap exposure and more than ·i.o
z,, ii N\Nti \i tii :i : i NQUi i¥ tu\\i : :i uN iiiui1
billion in losses relating to the securities-lending business’s mortgage-backed pur-
chases.Alongwiththelosses,SullivanannouncedCassano’sretirement,butthenews
wasn’tallbadfortheformerFinancialProductschief:Hemademorethan·¡oomil-
lionfromthetimehejoinedAIGFinancialProductsinJanuaryof1µ8,untilhisre-
tirement in ioo8, including a ·1 million-a-month consulting agreement after his
retirement.
1¡1
InMarch,theOmceofThriftSupervision,thefederalregulatorinchargeofregu-
latingAIGanditssubsidiaries,downgradedthecompany’scompositeratingfroma
i,signifyingthatAIGwas“fundamentallysound,”toa¡,indicatingmoderatetose-
vere supervisory concern. The OTS still judged the threat to overall viability as re-
mote.
1¡i
Itdidnotscheduleafollow-upreviewofthecompany’sfnancialcondition
foranothersixmonths.
Bythen,itwouldbetoolate.
FEDERAL RESERVE:
“THE DISCOUNT WINDOW WASN’ T WORKING”
Over the course of the fall, the announcements by Citigroup, Merrill, and others
made it clear that fnancial institutions were going to take serious losses from their
exposurestothemortgagemarket.Stocksoffnancialfrmsfellsharply;bytheendof
November,theS&PFinancialsIndexhadlostmorethan1oºfortheyear.Between
July and November, asset-backed commercial paper declined about ¡oº, which
meantthatthoseassetshadtobesoldorfundedbyothermeans.Investmentbanks
and other fnancial institutions faced tighter funding markets and increasing cash
pressures.Asaresult,theFederalReservedecidedthatitsinterestratecutsandother
measuressinceAugusthadnotbeensumcienttoprovideliquidityandstabilitytof-
nancialmarkets.TheFed’sdiscountwindowhadn’tattractedmuchbankborrowing
becauseofthestigmaattachedtoit.“Theproblemwiththediscountwindowisthat
people don’t like to use it because they view it as a risk that they will be viewed as
weak,”WilliamDudley,thenheadofthecapitalmarketsgroupattheNewYorkFed
andcurrentlyitspresident,toldtheFCIC.
1¡¡
Banks and thrifts preferred to draw on other sources of liquidity; in particular,
during the second half of ioo,, the Federal Home Loan Banks—which are govern-
ment-sponsoredentitiesthatlendtobanksandthrifts,acceptingmortgagesascollat-
eral—boostedtheirlendingby·i¡,billionto·8,,billion(a¡,ºincrease)whenthe
securitization market froze. Between the end of March and the end of December
ioo,,WashingtonMutual,thelargestthrift,increaseditsborrowingfromtheFederal
Home Loan Banks from ·i8 billion to ·,¡ billion; Countrywide increased its bor-
rowing from ·i, billion to ·¡8 billion; Bank of America increased its borrowing
from·¡8billionto·,obillion.TheFederalHomeLoanBankscouldthusbeseenas
thelenderofnexttolastresortforcommercialbanksandthrifts—theFedbeingthe
lastresort.
1¡¡
Inaddition,thelossofliquidityinthefnancialsectorwasmakingitmoredim-
i\1i z++, 1u i\ii¥ z++· 8i iii uN: i N :U8iii \i iu: :i: z,,
cultforbusinessesandconsumerstogetcredit,raisingtheFed’sconcerns.FromJuly
to October, the percentage of loan omcers reporting tightening standards on prime
mortgagesincreasedfrom1,ºtoabout¡oº.Overthattime,thepercentageofloan
omcersreportingtighteningstandardsonloanstolargeandmidsizecompaniesin-
creasedfrom8ºto1µº,itshighestlevelsinceioo¡.
1¡,
“TheFederalReservepursued
a whole slew of nonconventional policies . . . very creative measures when the dis-
count window wasn’t working as hoped,” Frederic Mishkin, a Fed governor from
ioootoioo8,toldtheFCIC.“Theseactionswereveryaggressive,[and]theywereex-
tremely controversial.”
1¡o
The frst of these measures, announced on December 1i,
wasthecreationoftheTermAuctionFacility(TAF).Theideawastoreducethedis-
countwindowstigmabymakingthemoneyavailabletoallbanksatoncethrougha
regularauction.Theprogramhadsomesuccess,withbanksborrowing·¡obillionby
theendoftheyear.Overtime,theFedwouldcontinuetotweaktheTAFauctions,of-
feringmorecreditandlongermaturities.
AnotherFedconcernwasthatbanksandotherswhodidhavecashwouldhoard
it.Hoardingmeantforeignbankshaddimcultyborrowingindollarsandwerethere-
foreunderpressuretoselldollar-denominatedassetssuchasmortgage-backedsecu-
rities. Those sales and fears of more sales to come weighed on the market prices of
U.S. securities. In response, the Fed and other central banks around the world an-
nounced (also on December 1i) new “currency swap lines” to help foreign banks
borrow dollars. Under this mechanism, foreign central banks swapped currencies
with the Federal Reserve—local currency for U.S. dollars—and lent these dollars to
foreignbanks.“Duringthecrisis,theU.S.bankswereveryreluctanttoextendliquid-
itytoEuropeanbanks,”Dudleysaid.
1¡,
Centralbankshadusedsimilararrangements
in the aftermath of the µ/11 attacks to bolster the global fnancial markets. In late
ioo1,theswaplinestotaled·88billion.Duringthefnancialcrisissevenyearslater,
theywouldreach·,8obillion.
The Fed hoped the TAF and the swap lines would reduce strains in short-term
moneymarkets,easingsomeofthefundingpressureonotherstrugglingparticipants
such as investment banks. Importantly, it wasn’t just the commercial banks and
thriftsbutthe“broaderfnancialsystem”thatconcernedtheFed,Dudleysaid.“His-
torically,theFederalReservehasalwaystendedtosupplyliquiditytothebankswith
theideathatliquidityprovidedtothebankingsystemcanbe[lenton]tosolventin-
stitutions in the nonbank sector. What we saw in this crisis was that didn’t always
takeplacetotheextentthatithadinthepast. . . .Idon’tthinkpeoplegoinginreally
hadafullunderstandingofthecomplexityoftheshadowbankingsystem,theroleof
[structuredinvestmentvehicles]andconduits,thebackstopsthatbankswereprovid-
ingSIVconduitseitherexplicitlyorimplicitly.”
1¡8
Burdened with capital losses and desperate to cover their own funding commit-
ments,thebankswerenotstableenoughtofllthevoid,evenaftertheFedlowered
interestratesandbegantheTAFauctions.InJanuaryioo8,theFedcutratesagain—
andthenagain,twicewithintwoweeks,ahighlyunusualmovethatbroughtthefed-
eralfundsratefrom¡.i,ºto¡.oº.
z,· ii N\Nti \i tii :i : i NQUi i¥ tu\\i : :i uN iiiui1
The Fed also started plans for a new program that would use its emergency au-
thority,theTermSecuritiesLendingFacility,thoughitwasn’tlauncheduntilMarch.
“The TLSF was more a view that the liquidity that we were providing to the banks
through the TAF was not leading to a signifcant diminishment of fnancing pres-
sureselsewhere,”DudleytoldtheFCIC.“Somaybeweshouldthinkaboutbypassing
thebankingsystemand[try]tocomeupwithavehicletoprovideliquiditysupport
totheprimarydealercommunitymoredirectly.”
1¡µ
OnMarch,,theFedincreasedthetotalavailableineachofthebiweeklyTAFauc-
tions from ·¡o billion to ·,o billion, and guaranteed at least that amount for six
months.TheFedalsoliberalizeditsstandardforcollateral.Primarydealers—mainly
the investment banks and the broker-dealer amliates of large commercial banks—
could post debt of government-sponsored enterprises, including GSE mortgage–
backedsecurities,ascollateral.TheFedexpectedtohave·1oobillioninsuchloans
outstandingatanygiventime.
Alsoatthistime,theU.S.centralbankbegancontemplatingastepthatwasrevo-
lutionary: a program that would allow investment banks—institutions over which
the Fed had no supervisory or regulatory responsibility—to borrow from the dis-
countwindowontermssimilartothoseavailabletocommercialbanks.
MONOLINE INSURERS: “WE NEVER EXPECTED LOSSES”
Meanwhile,theratingagenciescontinuedtodowngrademortgage-backedsecurities
andCDOsthroughioo,.ByJanuaryioo8,asaresultofthestressinthemortgage
market,S&Phaddowngraded¡,¡8µtranchesofresidentialmortgage–backedsecuri-
tiesand1,¡8¡tranchesfrom¡ioCDOs.MBIAandAmbac,thetwolargestmonoline
insurers,hadtakenonacombined·io,billionofguaranteesonmortgagesecurities
and other structured products. Downgrades on the products that they insured
brought the fnancial strength of these companies into question. After conducting
stressanalysis,S&PestimatedinFebruaryioo8thatAmbacwouldneedupto·¡oo
million in capital to cover potential losses on structured products.
1¡o
Such charges
would affect the monolines’ own credit ratings, which in turn could lead to more
downgradesoftheproductstheyhadguaranteed.
Likemanyofthemonolines,ACA,thesmallestofthem,keptrazor-thincapital—
lessthan·,oomillion—againstitsobligationsthatincluded·oµbillionincreditde-
fault swaps on CDOs. In late ioo,, ACA reported a net loss of ·1., billion, almost
entirelyduetocreditdefaultswaps.
Thiswasnews.Thenotionof“zero-losstolerance”wascentraltotheviabilityof
the monoline business model, and they and various stakeholders—the rating agen-
cies, investors, and monoline creditors—had traditionally assumed that the mono-
lines never would have to take a loss. As Alan Roseman, CEO of ACA, told FCIC
staff:“Weneverexpectedlosses. . . .Wewereprovidinghedgesonmarketvolatilityto
institutionalcounterparties. . . .Wewerepositioned,webelieved,totakethevolatil-
ity because we didn’t have to post collateral against the changes in market value to
ourcounterparty,numberone.Numbertwo,weweretoldbytheratingagenciesthat
i\1i z++, 1u i\ii¥ z++· 8i iii uN: i N :U8iii \i iu: :i: z,,
ratedusthatthatmark-to-marketvariationwasnotimportanttoourrating,froma
fnancialstrengthpointofviewattheinsurancecompany.”
1¡1
InearlyNovember,theSECcalledthegrowingconcernaboutMerrill’suseofthe
monolinesforhedging“aconcernthatwealsoshare.”
1¡i
ThelargeWallStreetfrms
attempted to minimize their exposure to the monolines, particularly ACA. On De-
cember 1µ, S&P downgraded ACA to junk status, rating the company CCC, which
wasfatalforacompanywhoseCEOsaidthatits“ratingisthefranchise.”
1¡¡
Firmslike
Merrill Lynch would get virtually nothing for the guarantees they had purchased
fromACA.
Despitethestressesinthemarket,theSECsawthemonolineproblemsaslargely
confnedtoACA.AJanuaryioo8internalSECdocumentsaid,“Whilethereisaclear
sentimentthatcapitalraisingwillneedtocontinue,thefactthattheguarantors(with
theexceptionofACA)arerelativelyinsulatedfromliquiditydrivenfailuresprovides
hopethatevent[s]inthissectorwillunfoldinamanageablemanner.”
1¡¡
Still,theratingagenciestoldthemonolinesthatiftheywantedtoretaintheirstel-
lar ratings, they would have to raise capital. MBIA and Ambac ultimately did raise
·1.o, billion and ·1., billion, respectively. Nonetheless, S&P downgraded both to
AAinJuneioo8.Asthecrisisunfolded,mostofthemonolinesstoppedwritingnew
coverage.
The subprime contagion spread through the monolines and into a previously
unimpairedmarket:municipalbonds.Thepathofthesefallingdominoesiseasyto
follow: in anticipation of the monoline downgrades, investors devalued the protec-
tionthemonolinesprovidedforothersecurities—eventhosethathadnothingtodo
withthemortgage-backedmarkets,includingasetofinvestmentsknownasauction
rate securities, or ARS. An ARS is a long-term bond whose interest rate is reset at
regularlyscheduledauctionsheldeveryonetosevenweeks.
1¡,
Existinginvestorscan
choosetorebidforthebondsandnewinvestorscancomein.Thedebtisfrequently
municipalbonds.AsofDecember1¡,ioo,,stateandlocalgovernmentshadissued
·1o, billion in ARS, accounting for half of the ·¡¡o billion market. The other half
wereprimarilybundlesofstudentloansanddebtofnonproftssuchasmuseumsand
hospitals.
The key point: these entities wanted to borrow long-term but get the beneft of
lowershort-termrates,andinvestorswantedtogetthesafetyofinvestinginthesese-
curitieswithouttyinguptheirmoneyforalongtime.Unlikecommercialpaper,this
market had no explicit liquidity backstop from a bank, but there was an implicit
backstop: often, if there were not enough new buyers to replace the previous in-
vestors,thedealersrunningtheseauctions,includingfrmslikeUBS,Citigroup,and
Merrill Lynch, would step in and pick up the shortfall. Because of these interven-
tions,therewereonly1¡failuresbetween1µ8¡andearlyioo,inmorethan1oo,ooo
auctions. Dealers highlighted those minuscule failure rates to convince clients that
ARSwereveryliquid,short-terminstruments,evenintimesofstress.
1¡o
However,ifanauction didfail,thepreviousARSinvestorswouldbeobligatedto
retaintheirinvestments.Incompensation,theinterestratesonthedebtwouldreset,
oftenmuchhigher,butinvestors’fundswouldbetrappeduntilnewinvestorsorthe
z,· ii N\Nti \i tii :i : i NQUi i¥ tu\\i : :i uN iiiui1
dealer stepped up or the borrower paid off the loan. ARS investors were typically
veryriskaverseandvaluedliquidity,andsotheywerewillingtopayapremiumfor
guaranteesontheARSinvestmentsfrommonolines.Itnecessarilyfollowedthatthe
monolines’ growing problems in the latter half of ioo, affected the ARS market.
Fearing that the monolines would not be able to perform on their guarantees, in-
vestors fed. The dealers’ interventions were all that kept the market going, but the
stressbecametoogreat.Withtheirownproblemstocontendwith,thedealerswere
unabletostepinandensuresuccessfulauctions.InFebruary,enmasse,theypulled
up stakes. The market collapsed almost instantaneously. On February 1¡, in one of
thestarkestmarketdislocationsofthefnancialcrisis,8oºoftheARSauctionsfailed;
thefollowingweek,o,ºfailed.
Hundreds of billions of dollars were trapped by ARS instruments as investors
wereobligatedtoretaintheirinvestments.Andretailinvestors—individualsinvest-
ing less than ·1 million, small businesses, and charities—constituted more than
·11o billion of this ·¡¡o billion market.
1¡,
Moreover, investors who chose to re-
maininthemarketdemandedapremiumtotakeontherisk.Betweeninvestorde-
mandsandinterestrateresets,countlessgovernments,infrastructureprojects,and
nonprofits on tight budgets were slammed with interest rates of 1oº or higher.
ProblemsintheARSmarketcostGeorgetownUniversity,aborrower,·omillion.
1¡8
NewYorkStatewasstuckwithinterestratesthatsoaredfromabout¡.,ºtomore
than1¡ºon·¡billionofitsdebt.ThePortAuthorityofNewYorkandNewJersey
sawtheinterestrateonitsdebtjumpfrom¡.¡ºtoioºinasingleweekinFebru-
ary.
1¡µ
In ioo8 alone, the SEC received more than 1,ooo investor complaints regarding
the failed ARS auctions. Investors argued that brokers had led them to believe that
ARS were safe and liquid, essentially the equivalent of money market accounts but
with the potential for a slightly higher interest rate. Investors also reported that the
frozen market blocked their access to money for short-term needs such as medical
expenses, college tuition, and, for some small businesses and charities, payroll. By
iooµ,theSEChadsettledwithfnancialinstitutionsincludingBankofAmerica,RBC
Capital Markets, and Deutsche Bank to resolve charges that the frms misled in-
vestors. As a result, these and other banks made more than ·,o billion available to
payofftensofthousandsofARSinvestors.
1,o
COMMISSION CONCLUSIONS ON CHAPTER 14
The Commission concludes that some large investment banks, bank holding
companies, and insurance companies, including Merrill Lynch, Citigroup, and
AIG, experienced massive losses related to the subprime mortgage market be-
causeofsignifcantfailuresofcorporategovernance,includingriskmanagement.
Executive and employee compensation systems at these institutions dispropor-
tionallyrewardedshort-termrisktaking.
Theregulators—theSecuritiesandExchangeCommissionforthelargeinvest-
ment banks and the banking supervisors for the bank holding companies and
AIG—failedtoadequatelysupervisetheirsafetyandsoundness,allowingthemto
take inordinate risk in activities such as nonprime mortgage securitization and
over-the-counter (OTC) derivatives dealing and to hold inadequate capital and
liquidity.
i\1i z++, 1u i\ii¥ z++· 8i iii uN: i N :U8iii \i iu: :i: z,,
z·+
15
MARCH 2008:
THE FALL OF BEAR STEARNS
CONTENTS
“Ircqucstcdscncjcr|carancc” ::+
“Vcwcrcsuita||yskcptica|”:::
“1urnintcadcathspira|” ::,
“Dutytcprctcctthcirinvcstcrs” ::e
“1hcgcvcrnncntwcu|dnctpcrnitahighcrnun|cr” ::,
“Itwashcadingtca||ackhc|c”:,o
After its hedge funds failed in July ioo,, Bear Stearns faced more challenges in the
secondhalfoftheyear.TakingouttherepolenderstotheHigh-GradeFundbrought
nearly·1.obillioninsubprimeassetsontoBear’sbooks,contributingtoa·1.µbillion
write-down on mortgage-related assets in November. That prompted investors to
scrutinizeBearStearns’sfnances.Overthefall,Bear’srepolenders—mostlymoney
market mutual funds—increasingly required Bear to post more collateral and pay
higherinterestrates.Then,injustoneweekinMarchioo8,arunbytheselenders,
hedgefundcustomers,andderivativescounterpartiesledtoBear’shavingtobetaken
overinagovernment-backedrescue.
MortgagesecuritizationwasthebiggestpieceofBearStearns’smost-proftabledi-
vision, its fxed-income business, which generated ¡,º of the frm’s total revenues.
Growing fast was the Global Client Services division, which included Bear’s prime
brokerageoperation.BearStearnswasthesecond-biggestprimebrokerinthecoun-
try,withai1ºmarketshareiniooo,trailingMorganStanley’si¡º.
1
Thisbusiness
wouldfgureprominentlyinthecrisis.
Inmortgagesecuritization,Bearfollowedaverticallyintegratedmodelthatmade
money at every step, from loan origination through securitization and sale. It both
acquired and created its own captive originators to generate mortgages that Bear
bundled,turnedintosecurities,andsoldtoinvestors.
i
Thesmallestofthefvelarge
investment banks, it was still a top-three underwriter of private-label mortgage–
backedsecuritiesfromioootoioo,.
¡
Iniooo,itunderwrote·¡obillionincollateral-
ized debt obligations of all kinds, more than double its ioo, fgure of ·1¡., billion.
\\itu z++· 1ui i\ii ui 8i\i :1i\iN: z·.
The total included ·o.¡ billion in CDOs that included mortgage-backed securities,
puttingitinthetop1iinthatbusiness.
¡
AswastypicalonWallStreet,thecompany’s
viewwasthatBearwasinthemovingbusiness,notthestoragebusiness—thatis,it
sought to provide services to clients rather than take on long-term exposures of its
own.
,
Bearexpandeditsmortgagebusinessdespiteevidencethatthemarketwasbegin-
ningtofalter,asdidotherfrmssuchasCitigroupandMerrill.AsearlyasMayiooo,
Bearhadlost·¡millionrelatingtodefaults
o
onmortgageswhichoccurredwithinµo
daysoforigination,whichhadbeenrareinthedecade.ButBearpersisted,assuming
the setback would be temporary. In February ioo,, Bear even acquired Encore
Credit,itsthirdcaptivemortgageoriginatorintheUnitedStates,doublingitscapac-
ity.ThepurchasewasconsistentwithBear’scontrarianbusinessmodel—buyinginto
distressedmarketsandwaitingforthemtoturnaround.
,
OnlyamonthafterthepurchaseofEncore,theSecuritiesandExchangeCommis-
sionwroteinaninternalreport,“Bear’smortgagebusinessincurredsignifcantmarket
risklosses”onitsAlt-Amortgageassets.
8
Thelossesweresmall,buttheSECreported
that“riskmanagersnote[d]thattheseeventsrefectamorerapidandseveredeteriora-
tionincollateralperformancethananticipatedinexantemodelsofstressevents.”
µ
“I REQUESTED SOME FORBEARANCE”
VacationingonNantucketIslandwhenthetwoBear-sponsoredhedgefundsdeclared
bankruptcy on July ¡1, ioo,, former Bear treasurer Robert Upton anticipated that
the rating agencies would downgrade the company, raising borrowing costs. Bear
fundedmuchofitsoperationsborrowingshort-termintherepomarket;itborrowed
between ·,o and ·,o billion overnight.
1o
Even a threat of a downgrade by a rating
agencywouldmakefnancingmoreexpensive,startingthenextmorning.
Investors,analysts,andthecreditratingagenciescloselyscrutinizedleveragera-
tios,availableattheendofeachquarter.ByNovemberioo,,Bear’sleverageratiohad
reachednearly¡8to1.Bytheendofioo,,Bear’sLevel¡assets—illiquidassetsdim-
cult to value and to sell—were ioµº of its tangible common equity; thus, writing
downtheseilliquidassetsby¡,ºwouldwipeouttangiblecommonequity.
At the end of each quarter, Bear would lower its leverage ratio by selling assets,
only to buy them back at the beginning of the next quarter. Bear and other frms
bookedthesetransactionsassales—eventhoughtheassetsdidn’tstayoffthebalance
sheetforlong—inordertoreducetheamountofthecompany’sassetsandlowerits
leverageratio.Bear’sformertreasurerUptoncalledthemove“windowdressing”and
saiditensuredthatcreditorsandratingagencieswerehappy.
11
Bear’spublicflingsre-
fected this, to some degree: for example, its ioo, annual report said the balance
sheet was approximately 1iº lower than the average month-end balance over the
previoustwelvemonths.
1i
To forestall a downgrade, Upton spoke with the three main rating agencies,
Moody’s, Standard & Poor’s, and Fitch, in early August.

Several times in ioo,—
z·z ii N\Nti \i tii :i : i NQUi i¥ tu\\i : :i uN iiiui1
includingAprilµandJuneii—S&PhadconfrmedBear’sstrongratings,notingin
April that “Bear’s risk profle is relatively conservative” and “strong senior manage-
mentoversightandastrongculturethroughoutthefrmarethefoundationofBear’s
risk management process.” On June ii, Moody’s had also confrmed its A1 rating,
andFitchhadconfrmedits“stable”outlook.
Now,inearlyAugust,UptonprovidedtheminformationaboutBearandargued
that management had learned its lesson about governance and risk management
fromthefailureofthetwohedgefundsandwasgoingtorelylessonshort-termun-
secured funding and more on the repo market. Bear and other market participants
didnotforeseethatBear’sownrepolendersmightrefusetolendagainstriskymort-
gageassetsandeventuallynotevenagainstTreasuries.
“Irequestedsomeforbearance”fromS&P,UptontoldtheFCIC.

Hedidnotget
it.OnAugust¡,justthreedaysafterthetwoBearStearnshedgefundsdeclaredbank-
ruptcy,S&Phighlightedthefunds,Bear’smortgage-relatedinvestments,anditsrela-
tivelysmallcapitalbaseasitplacedBearona“negativeoutlook.”
1,
Askedhowhefeltabouttheratingagency’sactions,JimmyCayne,Bear’sCEOun-
tilioo8,said,“Anegativeoutlookcantouchanumberofpartsofyourbusinesses. . . .
It was like having a beautiful child and they have a disease of some sort that you
neverexpecttohappenanditdid.HowdidIfeel:Lousy.”
1o
Toreassureinvestorsthatnomoreshoeswoulddrop,Bearinvitedthemonacon-
ferencecallthatsameday.Thecalldidnotgowell.Bytheendoftheday,Bear’sstock
slidoº,to·1o8.¡,,¡oºbelowitsall-timehighof·1oµ.o1,reachedearlierinioo,.
“WE WERE SUITABLY SKEPTICAL”
OnSunday,August,,twodaysaftertheconferencecall,Bearhadanotheropportu-
nitytomakeitscase:thistime,withtheSEC.ThetwoSECsupervisorswhovisited
the company that Sunday were Michael Macchiaroli and Matthew Eichner, respec-
tively, associate director and assistant director of the division of market regulation.
TheregulatorsreviewedBear’sexposurestothemortgagemarket,includingthe·1¡
billioninadjustable-ratemortgagesonthefrm’sbooksthatwerewaitingtobesecu-
ritized. Bear executives gave assurances that inventory would shrink once investors
returned in September from their retreats in the Hamptons. “Obviously, regulators
arenotsupposedtolistentohappytalkandgoawaysmiling,”EichnertoldtheFCIC.
“ThirteenbillioninARMsisnojoke.”Still,EichnerdidnotbelievetheBearexecu-
tiveswerebeingdisingenuous.Hethoughttheywerejustemphasizingtheupside.
1,
AlanSchwartz,theco-presidentwholatersucceededJimmyCayneasCEO,and
ThomasMarano,headofGlobalMortgagesandAssetBackedSecurities,seemedun-
concerned.Butotherexecutiveswereleery.WendydeMonchaux,theheadofpropri-
etarytrading,urgedMaranototrimthemortgageportfolio,asdidStevenMeyer,the
co-head of stock sales and trading.
18
According to Chief Risk Omcer Michael Alix,
formerchairmanAlanGreenbergwouldsay,“thebesthedgeisasale.”

Bearfnally
reducedtheportfoliofrom·,obillioninthethirdquarterofioo,to·¡o.1billionin
thefourthquarter,butitwastoolittletoolate.
\\itu z++· 1ui i\ii ui 8i\i :1i\iN: z·,
Thatsummer,theSECfeltBear’sliquiditywasadequatefortheimmediatefuture,
butsupervisors“weresuitablyskeptical,”Eichnerinsisted.AftertheAugust,meet-
ing, the SEC required that Bear Stearns report daily on Bear’s liquidity. However,
Eichneradmittedthatheandhisagencyhadgrosslyunderestimatedthepossibility
ofaliquiditycrisisdowntheroad.
io
Every weeknight Upton updated the SEC on Bear’s ·¡oo billion balance sheet,
withspecifcsonrepoandcommercialpaper.OnSeptemberi,,BearStearnsraised
approximately·i.,billioninunsecured1o-yearbonds.Thereportsslowedtooncea
week.
i1
The SEC’s inspector general later criticized the regulators, writing that they
didnotpushBeartoreduceleverageor“makeanyeffortstolimitBearStearns’mort-
gage securities concentration,” despite “aware[ness] that risk management of mort-
gagesatBearStearnshadnumerousshortcomings,includinglackofexpertisebyrisk
managers in mortgage backed securities” and “persistent understamng; a proximity
ofriskmanagerstotraderssuggestingalackofindependence;turnoverofkeyper-
sonnelduringtimesofcrisis;andtheinabilityorunwillingnesstoupdatemodelsto
refectchangingcircumstances.”
ii
Michael Halloran, a senior adviser to SEC Chairman Christopher Cox, told the
FCIC the SEC had ample information and authority to require Bear Stearns to de-
crease leverage and sell mortgage-backed securities, as other fnancial institutions
weredoing.Halloransaidthatasearlyasthefrstquarterofioo,,hehadaskedErik
Sirri, in charge of the SEC’s Consolidated Supervised Entities program, about Bear
Stearns(andLehmanBrothers),“Whycan’twemakethemreducerisk:”According
toHalloran,SirrisaidtheSEC’sjobwasnottotellthebankshowtoruntheircompa-
niesbuttoprotecttheircustomers’assets.

“TURN INTO A DEATH SPIRAL”
InAugust,aftertheratingagenciesrevisedtheiroutlookonBear,Caynetriedtoob-
tain lines of credit from Citigroup and JP Morgan. Both banks acknowledged Bear
hadalwaysbeenaverygoodcustomerandmaintainedtheywereinterestedinhelp-
ing.

“Wewantedtotrytobebelts-and-suspenders,”saidCFOSamuelMolinaro,as
Bearattemptedbothtoobtainlinesofcreditwithbanksandtoreinforcetraditional
sources of short-term liquidity such as money market funds. But, Cayne told the
FCIC, nothing happened. “Why the [large] banks were not more willing to partici-
pateandprovidelinesduringthatperiodoftime,Ican’ttellyou,”Molinarosaid.
i,
Amajormoneymarketfundmanager,FederatedInvestors,haddecidedonOcto-
ber 1 to drop Bear Stearns from its list of approved counterparties for unsecured
commercial paper,
io
illustrating why unsecured commercial paper was traditionally
seenasariskierlifelinethanrepo.Throughoutioo,,BearStearnsreduceditsunse-
curedcommercialpaper(from·io.,billionattheendofioootoonly·¡.µbillionat
theendofioo,)andreplaceditwithsecuredrepoborrowing(whichrosefrom·oµ
billion to ·1oi billion). But Bear Stearns’s growing dependence on overnight repo
wouldcreateadifferentsetofproblems.
Thetri-partyrepomarketusedtwoclearingbanks,JPMorganandBNYMellon.
z·, ii N\Nti \i tii :i : i NQUi i¥ tu\\i : :i uN iiiui1
Duringeverybusinessday,theseclearingbanksreturncashtolenders;takeposses-
sionofborrowers’collateral,essentiallykeepingitinescrow;andthenlendtheirown
cashtoborrowersduringtheday.Thisisreferredtoas“unwinding”therepotransac-
tion; it allows borrowers to change the assets posted as collateral every day. The
transactionisthen“rewound”attheendoftheday,whenthelenderspostcashtothe
clearingbanksinreturnforthenewcollateral.
Thelittle-regulatedtri-partyrepomarkethadgrownfrom·8oobillioninaverage
dailyvolumeiniooito·1.,trillioninioo,,·i.¡trillioninioo,,and·i.8trillionby
early ioo8.
i,
It had become a very deep and liquid market. Even though most bor-
rowers rolled repo overnight, it was also considered a very safe market, because
transactionswereovercollateralized(loansweremadeforlessthanthecollateralwas
worth).Thatwasthegeneralviewbeforetheonsetofthefnancialcrisis.
AsBearincreaseditstri-partyrepoborrowing,itbecamemoredependentonJP
Morgan, the clearing bank. A risk that was little appreciated before ioo, was that
JPMorganandBNYMelloncouldfacelargelossesifacounterpartysuchasBearde-
faultedduringtheday.Essentially,JPMorganservedasBear’sdaytimerepolender.
Evenlong-termrepoloanshavetobeunwoundeverydaybytheclearingbank,if
notbythelender.SethCarpenter,anomcerattheFederalReserveBoard,compared
ittoamortgagethathastoberefnancedeveryweek:“Imaginethatyourmortgageis
onlyaweek.Insteadofa¡o-yearmortgage,you’vegotaone-weekmortgage.Ifevery-
thing’sgoingfne,yougettotheendoftheweek,yougooutandyourefnancethat
mortgage because you don’t have enough cash on hand to pay off the whole mort-
gage.Andthenyougettotheendofanotherweekandyourefnancethatmortgage.
Andthat’s,forallintentsandpurposes,whatreposarelikeformanyinstitutions.”
i8
During the fall, Federated Investors, which had taken Bear Stearns off its list of
approved commercial paper counterparties, continued to provide secured repo
loans.

Fidelity Investments, another major lender, limited its overall exposure to
Bear,andshortenedthematurities.
¡o
InOctober,StateStreetGlobalAdvisorsrefused
anyrepolendingtoBearotherthanovernight.
¡1
Often, backing Bear’s borrowing were mortgage-related securities and of these,
·1,.ibillion—morethanBear’sequity—wereLevel¡assets.
In the fourth quarter of ioo,, Bear Stearns reported its frst quarterly loss, ·¡,µ
million.Still,theSECsaw“noevidenceofanydeteriorationinthefrm’sliquiditypo-
sitionfollowingthereleaseandrelatednegativepresscoverage.”TheSECconcluded,
“BearStearns’liquiditypoolremainsstable.”
¡i
Inthefallofioo,,Bear’sboardhadcommissionedtheconsultantOliverWyman
toreviewthefrm’sriskmanagement.Thereport,“RiskGovernanceDiagnostic:Rec-
ommendationsandCaseforEconomicCapitalDevelopment,”waspresentedonFeb-
ruary ,, ioo8, to the management committee. Among its conclusions: risk
assessment was “infrequent and ad hoc” and “hampered by insumcient and poorly
alignedresources,”“riskmanagers[were]noteffectivelypositionedtochallengefront
omcedecisions,”andriskmanagementwas“understaffed”andconsidereda“lowpri-
ority.”SchwartztoldtheFCICthefndingsdidnotindicatesubstantialdefciencies.
Hewasn’tlookingforpositivefeedbackfromtheconsultants,becausetheWymanre-
\\itu z++· 1ui i\ii ui 8i\i :1i\iN: z·,
portwasmeanttoprovidearoadmapofwhat“thegoldstandard”inriskmanage-
mentwouldbe.
¡¡
InJanuaryioo8,beforethereportwascompleted,CayneresignedasCEO,after
receiving·µ¡.omillionincompensationfromioo¡throughioo,.

Heremainedas
non-executivechairmanoftheboard.Someseniorexecutivessharplycriticizedhim
and the board. Thomas Marano told the FCIC that Cayne played a lot of golf and
bridge.
¡,
Speakingoftheboard,PaulFriedman,aformerseniormanagingdirectorat
Bear Stearns, said, “I guess because I’d never worked at a frm with a real board, it
neverdawnedonmethatatsomepointsomebodywouldhaveorshouldhavegotten
theboardinvolvedinallofthis,”althoughhetoldtheFCICthathemadethesecom-
ments in anger and frustration in the wake of Bear’s failure.
¡o
In its fnal report on
Bear, the Corporate Library, which researches and rates frms for corporate gover-
nance,gavethecompanya“D,”refecting“ahighdegreeofgovernancerisk”resulting
from“highlevelsofconcernrelatedtotheboardandcompensation.”
¡,
Whenaskedif
hehadmademistakeswhileatBearStearns,CaynetoldtheFCIC,“Itakeresponsi-
bilityforwhathappened.I’mnotgoingtowalkawayfromtheresponsibility.”
¡8
AtBear,compensationwasbasedlargelyonthereturnonequityinagivenyear.
Forseniorexecutives,abouthalfofeachbonuswaspaidincash,andabouthalfinre-
strictedstockthatvestedoverthreeyearsandhadtobeheldforfve.
¡µ
Theformulafor
the size of each year’s compensation pool was determined by a subcommittee of the
board.Stockholdersapprovedtheperformancecompensationplanandcapitalaccu-
mulation plan for senior managing directors. Cayne told the FCIC he set his own
compensationandthecompensationforallfvemembersoftheExecutiveCommit-
tee.AccordingtoCayne,noone,includingtheboard,questionedhisdecisions.
¡o
Forioo,,evenwithitslosses,BearStearnspaidout,8ºofrevenuesincompensa-
tion.Alix,whosatontheCompensationCommittee,toldFCICstaffthefrmtypically
paid,oºbutthatthepercentageincreasedinioo,becauserevenuesfell—ifmanage-
ment had lowered compensation proportionately, he said, many employees might
have quit.
¡1
Base salaries for senior managers were capped at ·i,o,ooo, with the re-
mainderofcompensationadiscretionarymixofcash,restrictedstock,andoptions.
¡i
Fromiooothroughioo8,thetopfveexecutivesatBearStearnstookhomeover
·¡io.,millionincashandover·1.1billionfromstocksales,formorethanatotalof
·1.¡billion.ThisexceededtheannualbudgetfortheSEC.
¡¡
AlanSchwartz,whotook
overasCEOafterCayneandhadbeenaleadingproponentofinvestinginthemort-
gage sector, earned more than ·8, million from ioo¡ to ioo,. Warren Spector, the
co-presidentresponsibleforoverseeingthetwohedgefundsthathadfailed,received
more than ·µ8 million during the same period. Although Spector was asked to re-
sign,Bearneveraskedhimtoreturnanymoney.Iniooo,Cayne,Schwartz,andSpec-
toreachearnedmorethan1otimesasmuchasAlix,thechiefriskomcer.
¡¡
Caynewasout,Schwartzwasin,andBearStearnscontinuedhangingoninearly
ioo8. Bear was still able to fund its balance sheet through repo loans, though the
interest rates the frm had to pay had increased.
¡,
Marano said he worried this in-
creasedcostwouldsignaltothemarketthatBearwasdistressed,whichcould“make
ourproblemsturnintoadeathspiral.
”¡o
z·· ii N\Nti \i tii :i : i NQUi i¥ tu\\i : :i uN iiiui1
“DUTY TO PROTECT THEIR INVESTORS”
OnWednesday,January¡o,ioo8,TreasurerUptonreportedaninternalaccounting
errorthatshowedBearStearnstohavelessthan·,billioninliquidity—triggeringa
reporttotheSEC.Whilethecompanyidentifedtheerror,theSECreinstituteddaily
reportingbythecompanyofitsliquidity.
¡,
Lenders and customers were more and more reluctant to do business with the
company. On February 1,, Bear Stearns had ·¡o., billion in mortgages, mortgage-
backedsecurities,andasset-backedsecuritiesonitsbalancesheet,downalmost·1o
billionfromNovember.Nearly·iobillionweresubprimeorAlt-Amortgage–backed
securitiesandCDOs.
ThehedgefundsthatwereclientsofBear’sprimebrokerageserviceswereparticu-
larly concerned that Bear would be unable to return their cash and securities. Lou
Lebedin, the head of Bear’s prime brokerage, told the FCIC that hedge fund clients
occasionallyinquiredaboutthebank’sfnancialconditioninthelatterhalfofioo,,
butthatsuchinquiriespickedupatthebeginningofioo8,particularlyasthecostin-
creasedofpurchasingcreditdefaultswapprotectiononBear.Theinquiriesbecame
withdrawals—hedge funds started taking their business elsewhere. “They felt there
weretoomanyconcernsaboutusandfeltthatthiswasashort-termmove,”Lebedin
said. “Often they would tell us they’d be happy to bring the business back, but that
theyhadthedutytoprotecttheirinvestors.”RenaissanceTechnologies,oneofBear’s
biggest prime brokerage clients, pulled out all of its business. By April, Lebedin’s
prime brokerage operation would be holding ·µo billion in assets under manage-
ment,downmorethan¡oºfrom·1oobillioninJanuary.
¡8
Nonetheless,duringtheweekofMarch¡,whenSECstaffinspectedBear’sliquid-
ity pool, they identifed “no signifcant issues.” The SEC found Bear’s liquidity pool
rangedfrom·18billionto·iobillion.
¡µ
Bear opened for business on Monday, March 1o, with approximately ·18 billion
incashreserves.Thesameday,Moody’sdowngraded1,mortgage-backedsecurities
issued by Bear Stearns Alt-A Trust, a special purpose entity. News reports on the
downgrades carried abbreviated headlines stating, “Moody’s Downgrades Bear
Stearns,” Upton said.
,o
Rumors few and counterparties panicked.
,1
Bear’s liquidity
poolbegantodryup,andtheSECwasnowconcernedthatBearwasbeingsqueezed
from all directions.
,i
While “everything rolled” during the day—that is, Bear’s repo
lendersrenewedtheircommitments—SEComcialsworriedthatthiswould“proba-
blynotcontinue.”

On Tuesday, the Fed announced it would lend to investment banks and other
“primary dealers.” The Term Securities Lending Facility (TSLF) would make avail-
ableupto·ioobillioninTreasurysecurities,acceptingascollateralGSEmortgage–
backedsecuritiesandnon-GSEmortgage–backedsecuritiesratedtriple-A.Thehope
was that lenders would lend to investment banks if the collateral was Treasuries
ratherthanotherhighlyratedbutnowsuspectassetssuchasmortgage-backedsecu-
rities.TheFedalsoannounceditwouldextendloansfromovernighttoi8days,giv-
\\itu z++· 1ui i\ii ui 8i\i :1i\iN: z·,
ing investment banks an added breather from the relentless need to unwind repos
everymorning.
WiththeTSLF,theFedwouldbesettinganewprecedentbyextendingemergency
credit to institutions other than commercial banks. To do so, the Federal Reserve
Boardwasrequiredundersection1¡(¡)oftheFederalReserveActtodeterminethat
therewere“unusualandexigentcircumstances.”TheFedhadnotinvokeditssection
1¡(¡)authoritysincetheGreatDepression;itwastheFed’sfrstuseoftheauthority
sinceCongresshadexpandedthelanguageoftheactin1µµ1toallowtheFedtolend
toinvestmentbanks.

TheFedwastakingtheunusualstepofdeclaringitswilling-
nesstosoonopenitscheckbooktoinstitutionsitdidnotregulateandwhosefnan-
cialconditionithadneverexamined.
But the Fed would not launch the TSLF until March i,, more than two weeks
later—anditwasnotclearthatBearcouldlastthatlong.Thefollowingday,JimEm-
bersit of the Federal Reserve Board checked on Bear’s liquidity with the SEC. The
SECsaidBearhad·1i.,billionincash—downfromabout·18billionatthestartof
theweek—andwasabletofnanceallitsbankloansandmostofitsequitysecurities
throughtherepomarket.Hesummarized,“TheSECindicatesthatnonotablelosses
havebeensustainedandthatthecapitalpositionofthefrmis‘fne.’”
,,
Derivatives counterparties were increasingly reluctant to be exposed to Bear. In
somecasestheyunwoundtradesinwhichtheyfacedBear,andinotherstheymade
marginorcollateralcalls.
,o
InBear’slastfewyearsasanindependentcompany,ithad
substantiallyincreaseditsexposuretoderivatives.Attheendoffscalyearioo,,Bear
had·1¡.¡trillioninnotionalexposureonderivativescontracts,comparedwith·8.,
trillionatiooofscalyear-endand·,.,trillionattheendofioo,.
Derivatives counterparties who worried about Bear’s ability to make good on
theirpaymentscouldgetoutoftheirderivativepositionswithBearthroughassign-
ments or novations. Assignments allow counterparties to assign their positions to
someoneelse:iffrmX hasaderivativescontractwithfrmY, thenfrmX canassign
itspositiontofrmZ, sothatZ nowistheonethathasaderivativescontractwithY.
Novationsalsoallowcounterpartiestogetoutoftheirexposuretoeachother,butby
bringinginathirdparty:insteadofX facingY,X faces Z and Z faces Y.Bothassign-
mentsandnovationsareroutinetransactionsonWallStreet.ButonTuesday,Brian
Peters of the New York Fed advised Eichner at the SEC that the New York Fed was
“seeing some HFs [hedge funds] wishing to assign trades the clients had done with
BeartootherCPs[counterparties]sothatBear‘stepsout.’”
,,
Counterpartiesdidnot
wanttohaveBearStearnsasaderivativescounterpartyanymore.
Bear Stearns also encountered dimculties stepping into trades. Hayman Capital
Partners, a hedge fund in Texas wanting to decrease its exposure to subprime mort-
gages,haddecidedtocloseoutarelativelysmall·,millionsubprimederivativeposi-
tion with Goldman Sachs. Bear Stearns offered the best bid, so Hayman expected to
assign its position to Bear, which would then become Goldman’s counterparty in the
derivative.HaymannotifedGoldmanbyaroutineemailonTuesday,March11,at¡:oo
P.M.Thereply¡1minuteslaterwasunexpected:“GSdoesnotconsenttothistrade.”
,8
z·· ii N\Nti \i tii :i : i NQUi i¥ tu\\i : :i uN iiiui1
ThatstartledKyleBass,Hayman’smanagingpartner.HetoldtheFCIChecouldnot
recall any counterparty rejecting a routine novation.

Pressed for an explanation,
Goldmanthenextmorningofferednodetails:“Ourtradingdeskwouldprefertostay
facingHayman.WedonotwanttofaceBear.”
oo
Addingtothemystery,1ominuteslater
GoldmanagreedtoacceptBearSternsasthecounterpartyafterall.
o1
Butthedamage
wasdone.ThenewshitthestreetthatGoldmanhadrefusedaroutinetransactionwith
oneoftheotherbigfveinvestmentbanks.Themessage:don’trelyonBearStearns.
CEO Alan Schwartz hoped an appearance on CNBC would reassure markets.
Questionedaboutthisincident,Schwartzsaidhehadnoknowledgeofsucharefusal
andrhetoricallyasked,“Whydorumorsstart:”
oi
SECChairmanCoxtoldreporters
his agency was monitoring capital levels at Bear Stearns and other securities frms
“on a constant basis” and has “a good deal of comfort about the capital cushions at
thesefrmsatthemoment.”

Still, the run on Bear accelerated. Many investors believed the Fed’s announce-
ment about its new loan program was directed at Bear Stearns, and they worried
about the facility’s not being available for several weeks. On Wednesday, March 1i,
theSECnotedthatBearpaidanother·1.1billionformargincallsfrom1¡inervous
derivativescounterparties.

Repo lenders who had already tightened the terms for their contracts over the
precedingfourorfvemonthsshortenedtheleashagain,demandingmorecollateral
fromBearStearns.
o,
Worriesaboutadefaultquicklymounted.
oo
By that evening, Bear’s ability to borrow in the repo market was drying up. The
SECnotedthatsomelargeandimportantmoneyfunds,includingFidelityandMel-
lon,hadtoldBearafterthecloseofbusinessWednesdaythey“mightbehesitantto
rollsomefundingtomorrow.”TheSECsaidthatthoughtheybelievedtheamounts
were“verymanageable(between·1and·ibillion),”thewithdrawalswouldnotsend
ahelpfulsignaltothemarket.
o,
Buttheissuewasalmostmoot.SchwartzcalledNew
YorkFedPresidentTimothyGeithnerthatnighttodiscusspossibleFedfexibilityin
theeventthatsomerepolendersdidpullaway.
o8
Upton,thetreasurer,saidthatbeforethatweek,hehadneverworriedaboutthe
disappearanceofrepolending.ByThursday,hebelievedtheendwasnear.

Bearex-
ecutives informed the board that the rumors were dissuading counterparties from
doing business with Bear, that Bear was receiving and meeting signifcant margin
calls,that·1¡billioninrepowasnotgoingtorollover,andthat“therewasareason-
ablechancethattherewouldnotbeenoughcashtomeet[Bear’s]needs.”
,o
Somerepo
lenderswerealreadysoaversetoBearthattheystoppedlendingtothecompanyat
all,notevenagainstTreasurycollateral,UptontoldtheFCIC.
,1
Derivativescounter-
partiescontinuedtorunfromBear.Bythatnight,liquidityhaddwindledtoamere
·ibillion(seefgure1,.1).
Bearhadrunoutofcashinoneweek.Executivesandregulatorscontinuedtobe-
lievethefrmwassolvent,however.FormerSECChairmanCoxtestifedbeforethe
FCIC,“AtalltimesduringtheweekofMarch1oto1,,uptoandincludingthetime
ofitsagreementtobeacquiredbyJPMorgan,BearStearnshadacapitalcushionwell
abovewhatisrequired.”
,i
Bear Stearns Liquidity
IN BILLIONS OF DOLLARS, DAILY
0
10
5
15
20
$25
22 23 24 25 26 27 28 29 1 2 3 4 5 6 7 8 9 10 11 12 13
SOURCE: Securities and Exchange Commission
FEBRUARY 2008 MARCH 2008
In the four days before Bear Stearns collapsed, the company’s
liquidity dropped by $16 billion.
Iigurc:,.:
\\itu z++· 1ui i\ii ui 8i\i :1i\iN: z·,
“THE GOVERNMENT
WOULD NOT PERMIT A HIGHER NUMBER”
On Thursday evening, March 1¡, Bear Stearns informed the SEC that it would be
“unabletooperatenormallyonFriday.”

CEOAlanSchwartzcalledJPMorganCEO
JamieDimontorequesta·¡obillioncreditline.Dimonturnedhimdown,

citing,
according to Schwartz, JP Morgan’s own signifcant exposure to the mortgage mar-
ket. Because Bear also had a large, illiquid portfolio of mortgage assets, JP Morgan
wouldnotrenderassistancewithoutgovernmentsupport.SchwartzspokewithGei-
thneragain.SchwartzinsistedBear’sproblemwasliquidity,notinsumcientcapital.A
series of calls between Schwartz, Dimon, Geithner, and Treasury Secretary Henry
Paulsonfollowed.
,,
ToaddressBear’sliquidityneeds,theNewYorkFedmadea·1i.µ
billionloantoBearStearnsthroughJPMorganonthemorningofFriday,March1¡.
Standard&Poor’sloweredBear’sratingthreelevelstoBBB.Moody’sandFitchalso
downgraded the company. By the end of the day, Bear was out of cash. Its stock
plummeted¡,º,closingbelow·¡o.
The markets evidently viewed the loan as a sign of terminal weakness. After
marketsclosedonFriday,PaulsonandGeithnerinformedBearCEOSchwartzthat
theFedloantoJPMorganwouldnotbeavailableaftertheweekend.Withoutthat
loan,Bearcouldnotconductbusiness.Infact,BearStearnshadtofindabuyerbe-
foretheAsianmarketsopenedSundaynightorthegamewouldbeover.
,o
Schwartz,
z,+ ii N\Nti \i tii :i : i NQUi i¥ tu\\i : :i uN iiiui1
Molinaro, Alix, and others spent the weekend in due diligence meetings with JP
Morgan and other potential buyers, including the private equity frm J.C. Flowers
and Co. According to Schwartz, the participants determined JP Morgan was the
onlycandidatewiththesizeandstaturetomakeacredibleofferwithin¡8hours.
,,
As Bear Stearns’s clearing bank for repo trades, JP Morgan held much of Bear
Stearns’sassetsascollateralandhadbeenassessingtheirvaluedaily.
,8
Thisknowl-
edgeletJPMorganmovemorequickly.
OnSunday,March1o,JPMorganinformedtheNewYorkFedandtheTreasury
that it was interested in a deal if it included fnancial support from the Fed.

The
Federal Reserve Board, again fnding “unusual and exigent circumstances” as re-
quiredundersection1¡(¡)oftheFederalReserveAct,agreedtopurchase·iµ.µ,bil-
lion of Bear’s assets to get them off the frm’s books through a new entity called
MaidenLaneLLC(namedforastreetalongsidetheNewYorkFed).Thoseassets—
mostly mortgage-related securities, other assets, and hedges from Bear’s mortgage
tradingdesk—wouldbeunderNewYorkFedmanagement.Tofnancethepurchases,
JPMorganmadea·1.1,billionsubordinatedloanandtheNewYorkFedlent·i8.8i
billion.Becauseofitsloan,JPMorganboretheriskofthefrst·1.1,billionoflosses;
theFedwouldbearanyfurtherlossesupto·i8.8ibillion.
8o
TheFed’sloanwouldbe
repaidasMaidenLanesoldthecollateral.
On Sunday night, with Maiden Lane in place, JP Morgan publicly announced a
dealtobuyBearStearnsfor·iashare.MinutesofBear’sboardmeetingindicatethat
JP Morgan had considered ·¡ but cut it to ·i “because the government would not
permitahighernumber. . . .TheFedandtheTreasuryDepartmentwouldnotsup-
portatransactionwhere[BearStearns]equityholdersreceivedanysignifcantcon-
sideration because of the ‘moral hazard’ of the federal government using taxpayer
moneyto‘bailout’theinvestmentbank’sstockholders.”
81
Eightdayslater,onMarchi¡,BearStearnsandJPMorganagreedtoincreasethe
price to ·1o. John Chrin, co-head of the fnancial institutions mergers and acquisi-
tionsgroupatJPMorgan,toldtheFCICtheyincreasedthepricetomakeBearshare-
holders’ approval more likely.
8i
Bear CEO Schwartz told the FCIC the increase let
Bearpreservethecompany’svalue“tothegreatestextentpossibleunderthecircum-
stancesforourshareholders,our1¡,oooemployees,andourcreditors.”

“IT WAS HEADING TO A BLACK HOLE”
TheSECregulatorsMacchiaroliandEichnerwereasstunnedaseveryoneelsebythe
speed of Bear’s collapse. Macchiaroli had had doubts as far back as August, he told
the FCIC, but he and his colleagues expected Bear would be able to fund itself
throughtherepomarket,albeitathighermargins.

FedChairmanBenBernankelatercalledtheBearStearnsdecisionthetoughestof
the fnancial crisis. The ·i.8 trillion tri-party repo market had “really [begun] to
break down,” Bernanke said. “As the fear increased,” short-term lenders began de-
manding more collateral, “which was making it more and more dimcult for the f-
nancialfrmstofnancethemselvesandcreatingmoreandmoreliquiditypressureon
COMMISSION CONCLUSIONS ON CHAPTER 15
The Commission concludes the failure of Bear Stearns and its resulting govern-
ment-assistedrescuewerecausedbyitsexposuretoriskymortgageassets,itsre-
lianceonshort-termfunding,anditshighleverage.Thesewerearesultofweak
corporategovernanceandriskmanagement.Itsexecutiveandemployeecompen-
sationsystemwasbasedlargelyonreturnonequity,creatingincentivestouseex-
cessiveleverageandtofocusonshort-termgainssuchasannualgrowthgoals.
Bearexperiencedrunsbyrepolenders,hedgefundcustomers,andderivatives
counterpartiesandwasrescuedbyagovernment-assistedpurchasebyJPMorgan
because the government considered it too interconnected to fail. Bear’s failure
was in part a result of inadequate supervision by the Securities and Exchange
Commission,whichdidnotrestrictitsriskyactivitiesandwhichallowedundue
leverageandinsumcientliquidity.
them.And,itwasheadingsortoftoablackhole.”HesawthecollapseofBearStearns
as threatening to freeze the tri-party repo market, leaving the short-term lenders
withcollateraltheywouldtryto“dumponthemarket.Youwouldhaveabigcrunch
inassetprices.”
8,
“BearStearns,whichisnotthatbigafrm,ourviewonwhyitwasimportantto
save it—you may disagree—but our view was that because it was so essentially in-
volved in this critical repo fnancing market, that its failure would have brought
down that market, which would have had implications for other frms,” Bernanke
toldtheFCIC.
8o
GeithnerexplainedtheneedforgovernmentsupportforBear’sacquisitionbyJP
Morgan as follows: “The sudden discovery by Bear’s derivative counterparties that
importantfnancialpositionstheyhadputinplacetoprotectthemselvesfromfnan-
cial risk were no longer operative would have triggered substantial further disloca-
tion in markets. This would have precipitated a rush by Bear’s counterparties to
liquidate the collateral they held against those positions and to attempt to replicate
thosepositionsinalreadyveryfragilemarkets.”
8,
PaulsontoldtheFCICthatBearhadbothaliquidityproblemandacapitalprob-
lem. “Could you just imagine the mess we would have had: If Bear had gone there
werehundreds,maybethousandsofcounterpartiesthatallwouldhavegrabbedtheir
collateral,wouldhavestartedtryingtoselltheircollateral,drovedownprices,create
evenbiggerlosses.Therewashugefearabouttheinvestmentbankingmodelatthat
time.” Paulson believed that if Bear had fled for bankruptcy, “you would have had
Lehmangoing . . .almostimmediatelyifBearhadgone,andjustthewholeprocess
wouldhavejuststartedearlier.”
88
\\itu z++· 1ui i\ii ui 8i\i :1i\iN: z,.
z,z
16
MARCH TO AUGUST 2008:
SYSTEMIC RISK CONCERNS
CONTENTS
1hcIcdcra|Rcscrvc“Vhcnpccp|cgctscarcd”:,,
|IMcrgan“Rcjusingtcunwind wcu|d|cunjcrgiva||c” :,,
1hcIcdandthcSLC“Vcak|iquiditypcsiticn” :,e
Dcrivativcs“Lar|ystagcscjasscssingthcpctcntia|systcnicrisk” :,:
Banks“1hcnarkctswcrcrca||y,rca||ydiccy” ,o+
JP Morgan’s federally assisted acquisition of Bear Stearns averted catastrophe—for
thetimebeing.TheFederalReservehadfoundnewwaystolendcashtothefnancial
system,andsomeinvestorsandlendersbelievedtheBearepisodehadsetaprecedent
forextraordinarygovernmentintervention.Investorsbegantoworrylessaboutare-
cessionandmoreaboutinfation,asthepriceofoilcontinuedtorise(hittingalmost
·1¡¡perbarrelinJuly).Atthebeginningofioo8,thestockmarkethadfallenalmost
1,ºfromitspeakinthefallofioo,.Then,inMayioo8,theDowJonesclimbedto
1¡,o,8, within 8º of the record 1¡,1o¡ set in October ioo,. The cost of protecting
against the risk of default by fnancial institutions—refected in the prices of credit
defaultswaps—declinedfromthehighsofMarchandApril.“Inhindsight,themar-
kets were surprisingly stable and almost seemed to be neutral a month after Bear
Stearns, leading all the way up to September,” said David Wong, Morgan Stanley’s
treasurer.
1
Taking advantage of the brief respite in investor concern, the top ten
American banks and the four remaining big investment banks, anticipating losses,
raisedjustunder·1oobillionand·¡obillion,respectively,innewequitybytheend
ofJune.
Despitethisgoodnews,bankersandtheirregulatorswerehauntedbythespeedof
BearStearns’sdemise.AndtheyknewthattheotherinvestmentbankssharedBear’s
weaknesses: leverage, reliance on overnight funding, dependence on securitization
markets,andconcentrationsinilliquidmortgagesecuritiesandothertroubledassets.
Inparticular,therunonBearhadexposedthedangersoftri-partyrepoagreements
andthecounterpartyriskcausedbyderivativescontracts.
Andthewordonthestreet—despitetheassurancesofLehmanCEODickFuldat
\\itu 1u \UtU:1 z++· :¥:1i\i t ii :i tuNtiiN: z,,
anAprilshareholdermeetingthat“theworstisbehindus”
i
—wasthatBearwouldnot
betheonlyfailure.
THE FEDERAL RESERVE: “WHEN PEOPLE GOT SCARED”
Themostpressingdangerwasthepotentialfailureoftherepomarket—amarketthat
“grew very, very quickly with no single regulator having a purview of it,” former
TreasurySecretaryHenryPaulsonwouldtelltheFCIC.
¡
Marketparticipantsbelieved
thatthetri-partyrepomarketwasarelativelysafeanddurablesourceofcollateral-
ized short-term fnancing. It was on precisely this understanding that Bear had
shifted approximately ·¡o billion of its unsecured funding into repos in ioo,. But
nowitwasclearthatrepofundingcouldbejustasvulnerabletorunsaswereother
formsofshort-termfnancing.
The repo runs of ioo,, which had devastated hedge funds such as the two Bear
Stearns Asset Management funds and mortgage originators such as Countrywide,
hadseizedtheattentionofthefnancialcommunity,andtherunonBearStearnswas
similarly eye-opening. Market participants and regulators now better appreciated
howthequalityofrepocollateralhadshiftedovertimefromTreasurynotesandse-
curitiesissuedbyFannieMaeandFreddieMactohighlyratednon-GSEmortgage–
backedsecuritiesandcollateralizeddebtobligations(CDOs).
¡
Atitspeakbeforethe
crisis, this riskier collateral accounted for as much as ¡oº of the total posted.
,
In
Aprilioo,,theBankruptcyAbusePreventionandConsumerProtectionActofioo,
had dramatically expanded protections for repo lenders holding collateral, such as
mortgage-relatedsecurities,thatwasriskierthangovernmentorhighlyratedcorpo-
ratedebt.Theseprotectionsgavelendersconfdencethattheyhadclear,immediate
rights to collateral if a borrower should declare bankruptcy. Nonetheless, Jamie Di-
mon,theCEOofJPMorgan,toldtheFCIC,“Whenpeoplegotscared,theywouldn’t
fnancethenonstandardstuffatall.”
o
Tothesurpriseofbothborrowersandregulators,high-qualitycollateralwasnot
enoughtoensureaccesstotherepomarket.Repolenderscaredjustasmuchabout
thefnancialhealthoftheborrowerasaboutthequalityofthecollateral.Infact,even
forthesamecollateral,repolendersdemandeddifferenthaircutsfromdifferentbor-
rowers.
,
Despitethebankruptcyprovisionsintheioo,act,lenderswerereluctantto
riskthehassleofseizingcollateral,evengoodcollateral,fromabankruptborrower.
StevenMeierofStateStreettestifedtotheFCIC:“Iwouldsaythecounterpartiesare
afrstlineofdefense,andwedon’twanttogothroughthatuncomfortableprocessof
havingtoliquidatecollateral.”
8
WilliamDudleyoftheNewYorkFedtoldtheFCIC,
“Atthefrstsignoftrouble,theseinvestorsintri-partyrepotendtorunratherthan
takethecollateralthatthey’velentagainst. . . .Sohigh-qualitycollateralitselfisnot
sumcientwhenandifaninstitutiongetsintrouble.”
µ
Moreover, if a borrower in the repo market defaults, money market funds—fre-
quent lenders in this market—may have to seize collateral that they cannot legally
own. For example, a money market fund cannot hold long-term securities, such as
z,, ii N\Nti \i tii :i : i NQUi i¥ tu\\i : :i uN iiiui1
agencymortgage–backedsecurities.Typically,ifafundtakespossessionofsuchcol-
lateral,itliquidatesthesecuritiesimmediately,even—aswasthecaseduringthecri-
sis—into a declining market. As a result, funds simply avoided lending against
mortgage-relatedsecurities.Inthecrisis,investorsdidn’tconsidersecuredfundingto
bemuchbetterthanunsecured,accordingtoDarryllHendricks,amanagingdirector
andglobalheadofriskmethodologyatUBS,aswellastheheadofaprivate-sector
taskforceontherepomarketorganizedbytheNewYorkFed.
1o
As noted, the Fed had announced a new program, the Term Securities Lending
Facility(TSLF),ontheTuesdaybeforeBear’scollapse,butitwouldnotbeavailable
untilMarchi,.TheTSLFwouldlendatotalofupto·ioobillionofTreasurysecuri-
tiesatanyonetimetotheinvestmentbanksandotherprimarydealers—thesecuri-
tiesamliatesofthelargecommercialbanksandinvestmentbanksthattradewiththe
New York Fed, such as Citigroup, Morgan Stanley, or Merrill Lynch—for up to i8
days. The borrowers would trade highly rated securities, including debt in govern-
ment-sponsoredenterprises,inreturnforTreasuries.Theprimarydealerscouldthen
usethoseTreasuriesascollateraltoborrowcashintherepomarket.LiketheTerm
Auction Facility for commercial banks, described earlier, the TSLF would run as a
regular auction to reduce the stigma of borrowing from the Fed. However, after
Bear’s collapse, Fed omcials recognized that the situation called for a program that
couldbeupandrunningrightaway.AndtheyconcludedthattheTSLFalonewould
notbeenough.
So,theFedwouldcreateanotherprogramfrst.OntheSundayofBear’scollapse,
the Fed announced the new Primary Dealer Credit Facility—again invoking its au-
thority under 1¡(¡) of the Federal Reserve Act—to provide cash, not Treasuries, to
investmentbanksandotherprimarydealersontermsclosetothosethatdepository
institutions—banks and thrifts—received through the Fed’s discount window. The
movecame“justabout¡,minutes”toolateforBear,JimmyCayne,itsformerCEO,
toldtheFCIC.
11
Unlike the TSLF, which would offer Treasuries for i8 days, the PDCF offered
overnightcash loansinexchangeforcollateral.Ineffect,thisprogramcouldserveas
analternativetotheovernighttri-partyrepolenders,potentiallyprovidinghundreds
ofbillionsofdollarsofcredit.“SotheideaofthePDCFthenwas . . .anythingthatthe
dealercouldn’tfnance—thesecuritiesthatwereacceptableunderthediscountwin-
dow—iftheycouldn’tgetfnancinginthemarket,theycouldgetfnancingfromthe
Federal Reserve,” said Seth Carpenter, deputy associate director in the Division of
Monetary Affairs at the Federal Reserve Board. “And that way, you don’t have to
worry. And by providing that support, other lenders know that they’re going to be
abletogettheirmoneybackthenextday.”
1i
BychargingtheFederalReserve’sdiscountrateandaddingadditionalfeesforreg-
ularuse,theFederalReserveencourageddealerstousethePDCFonlyasalastre-
sort. In its frst week of operation, this program immediately provided over ·¡¡o
billionincashtoBearStearns(asbridgefnancinguntiltheJPMorgandealomcially
closed), Lehman Brothers, and the securities amliate of Citigroup, among others.
However,astheimmediatepost-Bearconcernssubsided,useofthefacilitydeclined
\\itu 1u \UtU:1 z++· :¥:1i\i t ii :i tuNtiiN: z,,
afterAprilandceasedcompletelybylateJuly.

Becausethedealersfearedthatmar-
kets would see reliance on the PDCF as an indication of severe distress, the facility
carried a stigma similar to the Fed’s discount window. “Paradoxically, while the
PDCFwascreatedtomitigatetheliquidityfightcausedbythelossofconfdencein
aninvestmentbank,useofthePDCFwasseenbothwithinLehman,andpossiblyby
the broader market, as an event that could trigger a loss of confdence,” noted the
Lehmanbankruptcyexaminer.

On May i, the Fed broadened the kinds of collateral allowed in the TSLF to in-
cludeothertriple-A-ratedasset-backedsecurities,suchasautoandcreditcardloans.
InJune,theFed’sDudleyurgedinaninternalemailthatbothprogramsbeextended
atleastthroughtheendoftheyear.“PDCFremainscriticaltothestabilityofsomeof
the[investmentbanks],”hewrote.“Amountsdon’tmatterhere,itisthefactthatthe
PDCFunderpinsthetri-partyreposystem.”
1,
OnJuly¡o,theFedextendedbothpro-
gramsthroughJanuary¡o,iooµ.
JP MORGAN: “REFUSING TO UNWIND  .  .  .
WOULD BE UNFORGIVABLE”
ThereporunonBearalsoalertedthetworepoclearingbanks—JPMorgan,themain
clearing bank for Lehman and Merrill Lynch, as it had been for Bear Stearns, and
BNYMellon,themainclearingbankforGoldmanSachsandMorganStanley—tothe
riskstheyweretaking.
Before Bear’s collapse, the market had not really understood the colossal expo-
sures that the tri-party repo market created for these clearing banks. As explained
earlier, the “unwind/rewind” mechanism could leave JP Morgan and BNY Mellon
withanenormous“intraday”exposure—aninterimexposure,butnolessrealforits
brevity. In an interview with the FCIC, Dimon said that he had not become fully
awareoftherisksstemmingfromhisbank’stri-partyrepoclearingbusinessuntilthe
Bearcrisisinioo8.
1o
Aclearingbankhadtwoconcerns:First,ifrepolendersaban-
doned an investment bank, it could be pressured into taking over the role of the
lenders.Second,andworse—iftheinvestmentbankdefaulted,itcouldbestuckwith
unwantedsecurities.“Iftheydefaultedintraday,weownthesecuritiesandwehaveto
liquidatethem.That’sahugerisktous,”Dimonexplained.
1,
Toaddressthoserisksinioo8,forthefrsttimebothJPMorganandBNYMellon
startedtodemandthatintradayloanstotri-partyrepoborrowers—mostlythelarge
investmentbanks—beovercollateralized.
TheFedincreasinglyfocusedonthesystemicriskposedbythetworepoclearing
banks.Inthechain-reactionscenariothatitenvisioned,ifeitherJPMorganorBNY
Mellonchosenottounwinditstradesonemorning,themoneyfundsandotherrepo
lenderscouldbestuckwithbillionsofdollarsinrepocollateral.Thoselenderswould
thenbeinthedimcultpositionofhavingtosellofflargeamountsofcollateralinor-
dertomeettheirowncashneeds,anactionthatinturnmightleadtowidespreadfre
salesofrepocollateralandrunsbylenders.
18
The PDCF provided overnight funding, in case money market funds and other
z,· ii N\Nti \i tii :i : i NQUi i¥ tu\\i : :i uN iiiui1
repolendersrefusedtolendastheyhadinthecaseofBearStearns,butitdidnotpro-
tectagainstclearingbanks’refusingexposuretoaninvestmentbankduringtheday.
OnJuly11,Fedomcialscirculatedaplan,ultimatelyneverimplemented,thatad-
dressedthepossibilitythatoneofthetwoclearingbankswouldbecomeunwillingor
unabletounwinditstrades.

TheplanwouldallowtheFedtoprovidetroubledin-
vestmentbanks,suchasLehmanBrothers,with·ioobillionintri-partyrepofnanc-
ing during the day—essentially covering for JP Morgan or BNY Mellon if the two
clearingbankswouldnotorcouldnotprovidethatleveloffnancing.
io
Fedomcials
made a case for the proposal in an internal memo: “Should a dealer lose the conf-
dence of its investors or clearing bank, their efforts to pull away from providing
creditcouldbedisastrousforthefrmandalsocastwidespreaddoubtaboutthein-
strumentasanearlyriskfree,liquidovernightinvestment.”
i1
ButtheNewYorkFed’snewplanshouldn’tbenecessaryaslongasthePDCFwas
theretobackuptheovernightlenders,arguedPatrickParkinson,thendeputydirec-
toroftheFederalReserveBoard’sDivisionofResearchandStatistics.“Weshouldtell
[JP Morgan] that with the PDCF in place refusing to unwind is unnecessary and
wouldbeunforgiveable,”heemailedDudleyandothers.
ii
Aweeklater,onJulyio,ParkinsonwrotetoFedGovernorKevinWarshandFed
General Counsel Scott Alvarez that JP Morgan, because of its clearing role, was
“likelytobethefrsttorealizethatthemoneyfundsandotherinvestorsthatprovide
tri-party fnancing to [Lehman Brothers] are pulling back signifcantly.” Parkinson
described the chain-reaction scenario, in which a clearing bank’s refusal to unwind
wouldleadtoawidespreadfresaleandmarketpanic.“Fearoftheseconsequencesis,
ofcourse,whywefacilitatedBear’sacquisitionbyJPMC,”hesaid.

Still,itwaspossiblethatthePDCFcouldproveinsumcienttodissuadeJPMorgan
fromrefusingtounwindLehman’srepos,Parkinsonsaid.Becausealargeportionof
Lehman’s collateral was ineligible to be funded by the PDCF, and because Lehman
couldfailduringtheday(beforethereposweresettled),JPMorganstillfacedsignif-
cant risks. Parkinson noted that even if the Fed lent as much as ·ioo billion to
Lehman,thesummightnotbeenoughtoensurethefrm’ssurvivalintheabsenceof
an acquirer: if the stigma associated with PDCF borrowing caused other funding
counterpartiestostopprovidingfundingtoLehman,thecompanywouldfail.

THE FED AND THE SEC: “WEAK LIQUIDITY POSITION”
Amongthefourremaininginvestmentbanks,onekeymeasureofliquidityriskwas
theportionoftotalliabilitiesthatthefrmsfundedthroughtherepomarket:1,ºto
ioºforLehmanandMerrillLynch,1oºto1,ºforMorganStanley,andabout1oº
forGoldmanSachs.
i,
Anothermetricwastherelianceonovernightrepo(whichma-
tureinoneday)oropenrepo(whichcanbeterminatedatanytime).Despiteefforts
amongtheinvestmentbankstoreducetheportionoftheirrepofnancingthatwas
overnightoropen,theratioofovernightandopenrepofundingtototalrepofund-
ing still exceeded ¡oº for all but Goldman Sachs. Comparing the period between
March and May to the period between July and August, Lehman’s percentage fell
\\itu 1u \UtU:1 z++· :¥:1i\i t ii :i tuNtiiN: z,,
from ¡,º to ¡oº, Merrill Lynch’s fell from ¡oº to ¡¡º, Morgan Stanley’s fell from
,oºto,,º,andGoldman’sfellfrom18ºto1oº.
io
Anothermeasureofriskwasthe
haircuts on repo loans—that is, the amount of excess collateral that lenders de-
mandedforagivenloan.Fedomcialskepttabsonthehaircutsdemandedofinvest-
ment banks, hedge funds, and other repo borrowers. As Fed analysts later noted,
“Withlendersworryingthattheycouldlosemoneyonthesecuritiestheyheldascol-
lateral, haircuts increased—doubling for some agency mortgage securities and in-
creasing signifcantly even for borrowers with high credit ratings and on relatively
safecollateralsuchasTreasurysecurities.”
i,
OnthedayofBear’sdemise,inanefforttogetabetterunderstandingofthein-
vestment banks, the New York Fed and the SEC sent teams to work on-site at
LehmanBrothers,MerrillLynch,GoldmanSachs,andMorganStanley.Accordingto
ErikSirri,directoroftheSEC’sDivisionofTradingandMarkets,theinitialroundsof
meetingscoveredthequalityofassets,funding,andcapital.
i8
Fed Chairman Ben Bernanke would testify before a House committee that the
Fed’s primary role at the investment banks in ioo8 was not as a regulator but as a
lender through the new emergency lending facilities.

Two questions guided the
Fed’sanalyses:First,waseachinvestmentbankliquid—didithaveaccesstothecash
needed to meet its commitments: Second, was it solvent—was its net equity (the
valueofassetsminusthevalueofliabilities)sumcienttocoverprobablelosses:
¡o
TheU.S.Treasuryalsodispatchedso-calledSWATteamstotheinvestmentbanks
inthespringofioo8.ThearrivalofomcialsfromtheTreasuryandtheFedcreateda
full-timeon-sitepresence—somethingtheSEChadneverhad.Historically,theSEC’s
primary concern with the investment banks had been liquidity risk, because these
frmswereentirelydependentonthecreditmarketsforfunding.
¡1
TheSECalready
requiredthesefrmstoimplementso-calledliquiditymodels,designedtoensurethat
they had sumcient cash available to sustain themselves on a stand-alone basis for a
minimum of one year without access to unsecured funding and without having to
sell a substantial amount of assets. Before the run on Bear in the repo market, the
SEC’sliquiditystressscenarios—alsoknownasstresstests—hadnottakenaccountof
the possibility that a frm would lose access to secured funding. According to the
SEC’sSirri,theSECneverthoughtthatasituationwouldarisewhereaninvestment
bankcouldn’tenterintoarepotransactionbackedbyhigh-qualitycollateralinclud-
ingTreasuries.HetoldtheFCICthatasthefnancialcrisisworsened,theSECbegan
toseeliquidityandfundingrisksasthemostcriticalfortheinvestmentbanks,and
theSECencouragedareductioninrelianceonunsecuredcommercialpaperandan
extensionofthematuritiesofrepoloans.
¡i
TheFedandtheSECcollaboratedindevelopingtwonewstressteststodetermine
theinvestmentbanks’abilitytowithstandapotentialrunorasystemwidedisruption
in the repo market. The stress scenarios, called “Bear Stearns” and “Bear Stearns
Light,” were developed jointly with the remaining investment banks. In May,
Lehman,forexample,wouldbe·8¡billionshortofcashinthemorestringentBear
Stearnsscenarioand·1,billionshortunderBearStearnsLight.
¡¡
TheFedconductedanotherliquiditystressanalysisinJune.Whileeachfrmran
z,· ii N\Nti \i tii :i : i NQUi i¥ tu\\i : :i uN iiiui1
different scenarios that matched its risk profle, the supervisors tried to maintain
comparabilitybetweenthetests.Thetestsassumedthateachfrmwouldlose1ooºof
unsecuredfundingandafractionofrepofundingthatwouldvarywiththequalityof
its collateral. The stress tests, under just one estimated scenario, concluded that
Goldman Sachs and Morgan Stanley were relatively sound. Merrill Lynch and
LehmanBrothersfailed:thetwobankscameout·iibillionand·1,billionshortof
cash,respectively;eachhadonly,8ºoftheliquidityitwouldneedunderthestress
scenario.
¡¡
TheFed’sinternalreportonthestresstestscriticizedMerrill’s“signifcantamount
of illiquid fxed income assets” and noted that “Merrill’s liquidity pool is low, a fact
[thecompany]doesnotacknowledge.”AsforLehmanBrothers,theFedconcluded
that “Lehman’s weak liquidity position is driven by its relatively large exposure to
overnight [commercial paper], combined with signifcant overnight secured [repo]
funding of less liquid assets.”
¡,
These “less liquid assets” included mortgage-related
securities—nowdevalued.Meanwhile,Lehmanranstresstestsofitsownandpassed
withbillionsin“excesscash.”
¡o
AlthoughtheSECandtheFedworkedtogetherontheliquiditystresstests,with
equalaccesstothedata,eachagencyhassaidthatformonthsduringthecrisis,the
other did not share its analyses and conclusions. For example, following Lehman’s
failure in September, the Fed told the bankruptcy examiner that the SEC had de-
clined to share two horizontal (cross-frm) reviews of the banks’ liquidity positions
andexposurestocommercialrealestate.TheSEC’sresponsewasthatthedocuments
werein“draft”formandhadnotbeenreviewedorfnalized.Addingtothetension,
theFed’son-sitepersonnelbelievedthattheSECon-sitepersonneldidnothavethe
backgroundorexpertisetoadequatelyevaluatethedata.
¡,
Thislackofcommunica-
tionwasremediedonlybyaformalmemorandumofunderstanding(MOU)togov-
ern information sharing. According to former SEC Chairman Christopher Cox,
“OnereasontheMOUwasneededwasthattheFedwasreluctanttosharesupervi-
soryinformationwiththeSEC,outofconcernthattheinvestmentbankswouldnot
beforthcomingwithinformationiftheythoughttheywouldbereferredtotheSEC
for enforcement.”
¡8
The MOU was not executed until July ioo8, more than three
monthsafterthecollapseofBearStearns.
DERIVATIVES: “EARLY STAGES OF ASSESSING
THE POTENTIAL SYSTEMIC RISK”
The Fed’s Parkinson advised colleagues in an internal August 8 email that the sys-
temicrisksoftherepoandderivativesmarketsdemandedattention:“Wehavegiven
considerablethoughttowhatmightbedonetoavoidafresaleoftri-partyrepocol-
lateral.(Thatsaid,theoptionsunderexistingauthorityarenotveryattractive—lots
ofrisktoFed/taxpayer,lotsofmoralhazard.)Westillareattheearlystagesofassess-
ingthepotentialsystemicriskfromclose-outofOTCderivativestransactionsbyan
investmentbank’scounterpartiesandidentifyingpotentialmitigants.”
¡µ
Therepomarketwashuge,butasdiscussedinearlierchapters,itwasdwarfedby
Notional Amount and Gross Market
Value of OTC Derivatives Outstanding
IN TRILLIONS OF DOLLARS, SEMIANNUAL
SOURCE: Bank for International Settlements
1999 2003 2001 2005 2007 2009
0
100
200
300
400
500
600
700
$800
0
5
10
15
20
25
30
35
$40
Gross Market Value Notional Amount
June 2010
Iigurc:õ.:
\\itu 1u \UtU:1 z++· :¥:1i\i t ii :i tuNtiiN: z,,
the global derivatives market. At the end of June ioo8, the notional amount of the
over-the-counterderivativesmarketwas·o,¡trillionandthegrossmarketvaluewas
·iotrillion(seefgure1o.1).Adequateinformationabouttherisksinthismarketwas
not available to market participants or government regulators like the Federal Re-
serve. Because the market had been deregulated by statute in iooo, market partici-
pants were not subject to reporting or disclosure requirements and no government
agencyhadoversightresponsibility.WhiletheOmceoftheComptrolleroftheCur-
rency did report information on derivatives positions from commercial banks and
bank holding companies, it did not collect such information from the large invest-
mentbanksandinsurancecompanieslikeAIG,whichwerealsomajorOTCderiva-
tivesdealers.Duringthecrisisthelackofsuchbasicinformationcreatedheightened
uncertainty.
Atthispointinthecrisis,regulatorsalsoworriedabouttheinterlockingrelation-
ships that derivatives created among the small number of large fnancial frms that
actasdealersintheOTCderivativesbusiness.Aderivativescontractcreatesacredit
relationshipbetweenparties,suchthatonepartymayhavetomakelargeandunex-
pectedpaymentstotheotherbasedonsuddenpriceorratechangesorloandefaults.
Ifapartyisunabletomakethosepaymentswhentheybecomedue,thatfailuremay
,++ ii N\Nti \i tii :i : i NQUi i¥ tu\\i : :i uN iiiui1
causesignifcantfnancialharmtoitscounterparty,whichmayhaveoffsettingobli-
gationstothirdpartiesanddependonpromptpayment.Indeed,mostOTCderiva-
tives dealers hedge their contracts with offsetting contracts; thus, if they are owed
payments on one contract, they most likely owe similar amounts on an offsetting
contract,creatingthepotentialforaseriesoflossesordefaults.Sincethesecontracts
numbered in the millions and allowed a party to have virtually unlimited leverage,
thepossibilityofsuddenlargeanddevastatinglossesinthismarketcouldposeasig-
nifcantdangertomarketparticipantsandthefnancialsystemasawhole.
TheCounterpartyRiskManagementPolicyGroup,ledbyformerNewYorkFed
President E. Gerald Corrigan and consisting of the major securities frms, had
warnedthatabackloginpaperworkconfrmingderivativestradesandmasteragree-
ments exposed frms to risk should corporate defaults occur.
¡o
With urging from
New York Fed President Timothy Geithner, by September iooo, 1¡ major market
participantshadsignifcantlyreducedthebacklogandhadendedthepracticeofas-
signingtradestothirdpartieswithoutthepriorconsentoftheircounterparties.
¡1
Largederivativespositions,andtheresultingcounterpartycreditandoperational
risks, were concentrated in a very few frms. Among U.S. bank holding companies,
the following institutions held enormous OTC derivatives positions as of June ¡o,
ioo8: ·µ¡., trillion in notional amount for JP Morgan, ·¡,., trillion for Bank of
America,·¡,.8trillionforCitigroup,·¡.1trillionforWachovia,and·¡.µtrillionfor
HSBC. Goldman Sachs and Morgan Stanley, which began to report their holdings
only after they became bank holding companies in ioo8, held ·¡,.µ and ·¡,.o tril-
lion, respectively, in notional amount of OTC derivatives in the frst quarter of
iooµ.
¡i
Inioo8,thecurrentandpotentialexposuretoderivativesatthetopfveU.S.
bankholdingcompanieswasonaveragethreetimesgreaterthanthecapitaltheyhad
onhandtomeetregulatoryrequirements.Theriskwasevenhigherattheinvestment
banks. Goldman Sachs, just after it changed its charter, had derivatives exposure
more than 1o times capital. These concentrations of positions in the hands of the
largest bank holding companies and investment banks posed risks for the fnancial
systembecauseoftheirinterconnectionswithotherfnancialinstitutions.
BroadclassesofOTCderivativesmarketsshowedstressinioo8.Bythesummer
of ioo8, outstanding amounts of some types of derivatives had begun to decline
sharply.Aswewillsee,overthecourseofthesecondhalfofioo8,theOTCderiva-
tives market would undergo an unprecedented contraction, creating serious prob-
lemsforhedgingandpricediscovery.
TheFedwasuneasyinpartbecausederivativescounterpartieshadplayedanim-
portantroleintherunonBearStearns.Thenovationsbyderivativescounterparties
to assign their positions away from Bear—and the rumored refusal by Goldman to
accept Bear as a derivatives counterparty—were still a fresh memory across Wall
Street. Chris Mewbourne, a portfolio manager at PIMCO, told the FCIC that the
ability to novate ceased to exist and this was a key event in the demise of Bear
Stearns.
¡¡
Creditderivativesinparticularwereaserioussourceofworry.Ofgreatestinterest
werethesellersofcreditdefaultswaps:themonolineinsurersandAIG,whichback-
\\itu 1u \UtU:1 z++· :¥:1i\i t ii :i tuNtiiN: ,+.
stoppedthemarketinCDOs.Inaddition,thecreditratingagencies’decisiontoissue
anegativeoutlookonthemonolineinsurershadjoltedeveryone,becausetheyguar-
anteedhundredsofbillionsofdollarsinstructuredproducts.Aswehaveseen,when
theircreditratingsweredowngraded,thevalueofall theassetstheyguaranteed,in-
cludingmunicipalbondsandothersecurities,necessarilylostsomevalueinthemar-
ket,adropthataffectedtheconservativeinstitutionalinvestorsinthosemarkets.In
thevernacularofWallStreet,thisoutcomeistheknock-oneffect;inthevernacular
ofMainStreet,thedominoeffect;inthevernacularoftheFed,systemicrisk.
BANKS: “THE MARKETS WERE REALLY, REALLY DICEY”
Bythefallofioo,,signsofstrainwerebeginningtoemergeamongthecommercial
banks. In the fourth quarter of ioo,, commercial banks’ earnings declined to a 1o-
year low, driven by write-downs on mortgage-backed securities and CDOs and by
recordprovisionsforfutureloanlosses,asborrowershadincreasingdimcultymeet-
ing their mortgage payments—and even greater dimculty was anticipated. The net
charge-offrate—theratiooffailedloanstototalloans—rosetoitshighestlevelsince
iooi,whentheeconomywascomingoutofthepost-µ/11recession.Earningscon-
tinuedtodeclineinioo8—atfrst,moreforbigbanksthansmallbanks,inpartbe-
cause of write-downs related to their investment banking–type activities, including
thepackagingofmortgage-backedsecurities,CDOs,andcollateralizedloanobliga-
tions. Declines in market values required banks to write down the value of their
holdingsofthesesecurities.Aspreviouslynoted,severalofthelargestbankshadalso
provided support to off-balance-sheet activities, such as money market funds and
commercial paper programs, bringing additional assets onto their balance sheets—
assetsthatwerelosingvaluefast.Supervisorshadbeguntodowngradetheratingsof
manysmallerbanksinresponsetotheirhighexposuresinresidentialrealestatecon-
struction, an industry that virtually went out of business as fnancing dried up in
mid-ioo,. By the end of ioo,, the FDIC had ,o banks, mainly smaller ones, on its
“problem list”; their combined assets totaled ·ii.i billion.
¡¡
(When large banks
started to be downgraded, in early ioo8, they stayed off the FDIC’s problem list, as
supervisorsrarelygivethelargestinstitutionsthelowestratings.)
¡,
Themarketfornonconformingmortgagesecuritizations(thosebackedbymort-
gagesthatdidnotmeetFannieMae’sorFreddieMac’sunderwritingormortgagesize
guidelines)hadalsovanishedinthefourthquarterofioo,.Notonlydidthesenon-
conformingloansprovehardertosell,buttheyalsoprovedlessattractivetokeepon
balance sheet, as house price forecasts looked increasingly grim. Already, house
priceshadfallenabout,ºfortheyear,dependingonthemeasure.Inthefrstquarter
ofioo8,realestateloansinthebankingsectorshowedthesmallestquarterlyincrease
since ioo¡.
¡o
IndyMac reported a i1º decline in loan production for that quarter
fromayearearlier,becauseithadstoppedmakingnonconformingloans.Washing-
ton Mutual, the largest thrift, discontinued all remaining lending through its sub-
primemortgagechannelinAprilioo8.
But those actions could not reduce the subprime and Alt-A exposure that these
,+z ii N\Nti \i tii :i : i NQUi i¥ tu\\i : :i uN iiiui1
largebanksandthriftsalready had.Andontheseassets,themarkdownscontinued
inioo8.Regulatorsbegantofocusonsolvency,urgingthebankstoraisenewcapital.
InJanuaryioo8,Citigroupsecuredatotalof·1¡billionincapitalfromKuwait,Sin-
gapore, Saudi Prince Alwaleed bin Talal, and others. In April, Washington Mutual
raised ·, billion from an investor group led by the buyout frm TPG Capital. Wa-
choviaraised·obillionincapitalattheturnoftheyearandthenanadditional·8bil-
lion in April ioo8. Despite the capital raises, though, the downgrades by banking
regulatorscontinued.
“The markets were really, really dicey during a signifcant part of this period,
startingwithAugustioo,,”RogerCole,then-directoroftheDivisionofBankingSu-
pervision and Regulation at the Federal Reserve Board, told the FCIC.
¡,
The same
wastrueforthethrifts.MichaelSolomon,amanagingdirectorinriskmanagement
manager in the Omce of Thrift Supervision (OTS), told the FCIC, “It was hard for
businesses, particularly small, midsized thrifts—to keep up with [how quickly the
ratings downgrades occurred during the crisis] and change their business models
andnotgetstuckwithoutthechairwhenthemusicstopped . . .Theygotcaught.The
ratingdowngradesstartedandbythetimethethriftwasabletodosomethingabout
it,itwastoolate . . .Businessmodels . . .can’tkeepupwithwhatwesawinioo8.”
¡8
Asthecommercialbanks’healthworsenedinioo8,examinersdowngradedeven
large institutions that had maintained favorable ratings and required several to fx
their risk management processes. These ratings downgrades and enforcement ac-
tionscamelateintheday—oftenjustasfrmswereonthevergeoffailure.Incases
that the FCIC investigated, regulators either did not identify the problems early
enoughordidnotactforcefullyenoughtocompelthenecessarychanges.
titigrou¡.“1imctocomcu¡vit/encv¡le;oook”
For Citigroup, supervisors at the New York Fed, who examined the bank holding
company,andattheOmceoftheComptrolleroftheCurrency,whooversawthena-
tional bank subsidiary, fnally downgraded the company and its main bank to “less
thansatisfactory”inAprilioo8—fvemonthsafterthefrm’sannouncementinNo-
vember ioo, of billions of dollars in write-downs related to its mortgage-related
holdings.ThesupervisorsputthecompanyundernewenforcementactionsinMay
andJune.Onlyayearearlier,boththeFedandtheOCChadupgradedthecompany,
after lifting all remaining restrictions and enforcement actions related to complex
transactionsthatithadstructuredforEnronandtotheactionsofitssubprimesub-
sidiaryCitiFinancial,discussedinanearlierchapter.“Theriskmanagementassess-
mentforioooisrefectiveofacontrolenvironmentwheretherisksfacingCitigroup
continuetobemanagedinasatisfactorymanner,”theNewYorkFed’sratingupgrade,
deliveredinitsannualinspectionreportonAprilµ,ioo,,hadnoted.“Duringiooo,
all formal restrictions and enforcement actions between the Federal Reserve and
Citigroupwerelifted.Boardandseniormanagementremainactivelyengagedinim-
provingrelevantprocesses.”
¡µ
ButthemarketdisruptionhadjoltedCitigroup’ssupervisors.InNovemberioo,,
\\itu 1u \UtU:1 z++· :¥:1i\i t ii :i tuNtiiN: ,+,
the New York Fed led a team of international supervisors, the Senior Supervisors
Group,inevaluating11ofthelargestfrmstoassesslessonslearnedfromthefnan-
cialcrisisuptothatpoint.MuchofthetoughestlanguagewasreservedforCitigroup.
“Thefrmdidnothaveanadequate,frm-wideconsolidatedunderstandingofitsrisk
factorsensitivities,”thesupervisorswroteinaninternalNovember1µmemodescrib-
ing meetings with Citigroup management. “Stress tests were not designed for this
type of extreme market event. . . . Management had believed that CDOs and lever-
agedloanswouldbesyndicated,andthatthecreditriskinsuperseniorAAACDOs
wasnegligible.”
,o
Inretrospect,Citigrouphadtwokeyproblems:alackofeffectiveenterprise-wide
managementtomonitorandcontrolrisksandalackofproperinfrastructureandin-
ternalcontrolswithrespecttothecreationofCDOs.TheOCCappearstohaveiden-
tifedsomeoftheseissuesasearlyasioo,butdidnoteffectivelyacttorectifythem.
Inparticular,theOCCassessedboththeliquidityputsandthesuper-seniortranches
aspartofitsreviewsofthebank’scompliancewiththepost-Enronenforcementac-
tion,butitdidnotexaminetherisksoftheseexposures.Asfortheissuesitdidspot,
theOCCfailedtotakeforcefulstepstorequiremandatorycorrectiveaction,andit
reliedonmanagement’sassurancesiniooothattheexecutiveswouldstrivetomeet
theOCC’sgoalsforimprovingriskmanagement.
Incontrast,documentsobtainedbytheFCICfromtheNewYorkFedgivenoin-
dicationthatitsexaminationstaffhadanyindependentknowledgeofthosetwocore
problems.AnevaluationoftheNewYorkFed’ssupervisionofCitigroup,conducted
byexaminersfromotherReserveBanks(theDecemberiooµOperationsReviewof
theNewYorkFed,whichcoveredthepreviousfouryears),concluded:
ThesupervisionprogramforCitigrouphasbeenlessthaneffective.Al-
though the dedicated supervisory team is well qualifed and generally
has sound knowledge of the organization, there have been signifcant
weaknessesintheexecutionofthesupervisoryprogram.Theteamhas
not been proactive in making changes to the regulatory ratings of the
frm, as evidenced by the double downgrades in the frm’s fnancial
componentandrelatedsubcomponentsatyear-endioo,.Additionally,
thesupervisoryprogramhaslackedtheappropriateleveloffocusonthe
frm’s risk oversight and internal audit functions. As a result, there is
currentlysignifcantworktobedoneinbothoftheseareas.Moreover,
the team has lacked a disciplined and proactive approach in assessing
andvalidatingactionstakenbythefrmtoaddresssupervisoryissues.
,1
TimothyGeithner,secretaryoftheTreasuryandformerpresidentoftheFederal
ReserveBankofNewYork,refectedontheFed’soversightofCitigroup,tellingthe
Commission,“Idonotthinkwedidenoughasaninstitutionwiththeauthoritywe
hadtohelpcontaintherisksthatultimatelyemergedinthatinstitution.”
,i
In January ioo8, an OCC review of the breakdown in the CDO business noted
that the risk in the unit had grown rapidly since iooo, after the OCC’s and Fed’s
,+, ii N\Nti \i tii :i : i NQUi i¥ tu\\i : :i uN iiiui1
lifting of supervisory agreements associated with various control problems at Citi-
group.InAprilioo8,theFedandOCCdowngradedtheiroverallratingsofthecom-
panyanditslargestbanksubsidiaryfromi(satisfactory)to¡(lessthansatisfactory),
refectingweaknessesinriskmanagementthatwerenowapparenttothesupervisors.
BothFedandOCComcialscitedtheGramm-Leach-BlileyActof1µµµasanob-
stacle that prevented each from obtaining a complete understanding of the risks
assumedbylargefnancialfrmssuchasCitigroup.Theactmadeitmoredimcult—
though not impossible—for regulators to look beyond the legal entities under their
directpurviewintootherareasofalargefrm.Citigroup,forexample,hadmanyreg-
ulatorsacrosstheworld;eventhesecuritizationbusinessesweredispersedacrosssub-
sidiarieswithdifferentsupervisors—includingthosefromtheFed,OCC,SEC,OTS,
andstateagencies.
InMayandJuneioo8,Citigroupenteredintomemorandaofunderstandingwith
boththeNewYorkFedandOCCtoresolvetheriskmanagementweaknessesthatthe
eventsofioo,hadlaidbare.Intheensuingmonths,FedandOCComcialssaid,they
were satisfed with Citigroup’s compliance with their recommendations. Indeed, in
speakingtotheFCIC,SteveManzari,theseniorrelationshipmanagerforCitigroup
attheNewYorkFedfromApriltoSeptemberioo8,complimentedCitigrouponits
assertiveness in executing its regulators’ requests: aggressively replacing manage-
ment, raising capital from investors in late ioo,, and putting in place a number of
muchneeded“internalfxes.”However,Manzariwenton,“Citiwastrappedinwhat
wasaprettyvicious . . .systemicevent,”andforregulators“itwastimetocomeup
withanewplaybook.”

\ec/ovie.“1/c6olácn\cstec¡uisitionvesemistekc”
AtWachovia,whichwassupervisedbytheOCCaswellastheOTSandtheFederal
Reserve,aioo,end-of-yearreportshowedthatcreditlossesinitssubsidiaryGolden
West’sportfolioof“Pick-a-Pay”adjustable-ratemortgages,oroptionARMs,wereex-
pectedtorisetoabout1ºoftheportfolioforioo8;iniooo,lossesinthisportfolio
had been less than o.1º. It would soon become clear that the higher estimate for
ioo8 was not high enough. The company would hike its estimate of the eventual
lossesontheportfoliotoµºbyJuneandtoiiºbySeptember.
Facing these and other growing concerns, Wachovia raised additional capital.
Then,inApril,Wachoviaannouncedalossof·¡,omillionforthefrstthreemonths
of the year. Depositors withdrew about ·1, billion in the following weeks, and
lenders reduced their exposure to the bank, shortening terms, increasing rates, and
reducing loan amounts.

By June, according to Angus McBryde, then Wachovia’s
seniorvicepresidentforTreasuryandBalanceSheetManagement,managementhad
launchedaliquiditycrisismanagementplaninanticipationofanevenmoreadverse
marketreactiontosecond-quarterlossesthatwouldbeannouncedinJuly.
,,
On June i, Wachovia’s board ousted CEO Ken Thompson after he had spent ¡i
years at the bank, 8 of them at its helm.
,o
At the end of the month, the bank an-
nouncedthatitwouldstoporiginatingGoldenWest’sPick-a-Payproductsandwould
\\itu 1u \UtU:1 z++· :¥:1i\i t ii :i tuNtiiN: ,+,
waiveallfeesandprepaymentpenaltiesassociatedwiththem.OnJulyii,Wachovia
reported an ·8.µ billion second-quarter loss. The new CEO, Robert Steel, most re-
centlyanundersecretaryofthetreasury,announcedaplantoimprovethebank’sf-
nancialcondition:raisecapital,cutthestockdividend,andlayoff1oºto1iºofthe
staff.
Theratingagenciesandsupervisorsignoredthosereassurances.Onthesameday
astheannouncement,S&Pdowngradedthebank,andtheFed,afteryearsof“satis-
factory” ratings, downgraded Wachovia to ¡, or “less than satisfactory.” The Fed
noted that ioo8 projections showed losses that could wipe out the recently raised
capital:ioo8lossesalonecouldexceed·¡billion,anamountthatcouldcauseafur-
ther ratings downgrade.
,,
The Fed directed Wachovia to reevaluate and update its
capital plans and its liquidity management. Despite having consistently rated Wa-
choviaas“satisfactory”rightuptothesummermeltdown,theFednowdeclaredthat
manyofWachovia’sproblemswere“long-terminnatureandresult[ed]fromdelayed
investmentdecisionsandadesiretohavebusinesslinesoperateautonomously.”
,8
TheFedbluntlycriticizedtheboardandseniormanagementfor“anenvironment
with inconsistent and inadequate identifcation, escalation and coverage of all risk-
takingactivities,includingdefcienciesinstresstesting”and“littleaccountabilityfor
errors.” Wachovia management had not completely understood the level of risk
across the company, particularly in certain nonbank investments, and management
had delayed fxing these known defciencies. In addition, the company’s board had
not sumciently questioned investment decisions.

Nonetheless, the Fed concluded
thatWachovia’sliquiditywascurrentlyadequateandthatthroughoutthemarketdis-
ruption,managementhadminimizedexposuretoovernightfundingmarkets.
OnAugust¡,theOCCdowngradedWachoviaBankandassesseditsoverallrisk
profleas“high.”TheOCCnotedmanyofthesameissuesastheFed,andaddedpar-
ticularlystrongremarksabouttheacquisitionofGoldenWest,identifyingthatmort-
gage portfolio and associated real estate foreclosures as the heart of Wachovia’s
problem. The OCC noted that the board had “acknowledged that the Golden West
acquisitionwasamistake.”
oo
TheOCCwrotethatthemarketwasfocusedonthecompany’sweakenedcondi-
tion and that some large fund providers had already limited their exposure to Wa-
chovia. Like the Fed, however, the OCC concluded that the bank’s liquidity was
adequate, unless events undermined market confdence.
o1
And, like the Fed, the
OCCapprovedofthenewmanagementandanew,morehands-onoversightrolefor
theboardofdirectors.
YetWachovia’sproblemswouldc