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FCIC Final Report, Part 3, Chapter 7, The Boom and Bust - The Mortgage Machine and Conclusion

FCIC Final Report, Part 3, Chapter 7, The Boom and Bust - The Mortgage Machine and Conclusion

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7

THE MORTGAGE MACHINE
CONTENTS
Foreign investors: “An irresistible proft opportunity” .........................................
Mortgages: “A good loan” ...................................................................................
Federal regulators: “Immunity from many state laws is a signifcant beneft” ....
Mortgage securities players: “Wall Street was very hungry for our product” ......
Moody’s: “Given a blank check”..........................................................................
Fannie Mae and Freddie Mac: “Less competitive in the marketplace”................
In iooa, commercial banks, thrifts, and investment banks caught up with Fannie
MaeandFreddieMacinsecuritizinghomeloans.Bvioo-,thevhadtakenthelead.
Thetwogovernment-sponsoredenterprisesmaintainedtheirmonopolvonsecuritiz-
ing prime mortgages below their loan limits, but the wave of home refnancing bv
prime borrowers spurred bv verv low, steadv interest rates petered out. Meanwhile,
WallStreetfocusedonthehigher-vieldloansthattheGSEscouldnotpurchaseand
securitize—loanstoolarge,calledjumboloans,andnonprimeloansthatdidn’tmeet
theGSEs’standards.Thenonprimeloanssoonbecamethebiggestpartofthemar-
ket—“subprime”loansforborrowerswithweakcreditand“Alt-A”loans,withcharac-
teristicsriskierthanprimeloans,toborrowerswithstrongcredit.
1
Bvioo-andiooo,WallStreetwassecuritizingone-thirdmoreloansthanFannie
and Freddie. In just two vears, private-label mortgage-backed securities had grown
morethan:oº,reaching·1.1-trillioniniooo;¬1ºweresubprimeorAlt-A.
i
Manvinvestorspreferredsecuritieshighlvratedbvtheratingagencies—orwere
encouraged or restricted bv regulations to buv them. And with vields low on other
highlvratedassets,investorshungeredforWallStreetmortgagesecuritiesbackedbv
higher-vieldmortgages—thoseloansmadetosubprimeborrowers,thosewithnon-
traditional features, those with limited or no documentation (“no-doc loans”), or
thosethatfailedinsomeotherwavtomeetstrongunderwritingstandards.
“Securitization could be seen as a factorv line,” former Citigroup CEO Charles
Prince told the FCIC. “As more and more and more of these subprime mortgages
werecreatedasrawmaterialforthesecuritizationprocess,notsurprisinglvinhind-
sight, more and more of it was of lower and lower qualitv. And at the end of that
.+z
process, the raw material going into it was actuallv bad qualitv, it was toxic qualitv,
andthatiswhatendedupcomingouttheotherendofthepipeline.WallStreetobvi-
ouslvparticipatedinthatfowofactivitv.”
:
Theoriginationandsecuritizationofthesemortgagesalsoreliedonshort-termf-
nancingfromtheshadowbankingsvstem.Unlikebanksandthriftswithaccesstode-
posits,investmentbanksreliedmoreonmonevmarketfundsandotherinvestorsfor
cash;commercialpaperandrepoloanswerethemainsources.Withhousepricesal-
readvupo1ºfrom1oo-toioo:,thisfoodofmonevandthesecuritizationappara-
tushelpedboosthomepricesanother:oºfromthebeginningofiooauntilthepeak
in April iooo—even as homeownership was falling. The biggest gains over this pe-
riodwereinthe“sandstates”:placesliketheLosAngelessuburbs(-aº),LasVegas
(:oº),andOrlando(¬iº).
FOREIGN INVESTORS:
“AN IRRESISTIBLE PROFIT OPPORTUNITY”
FromIuneioo:throughIuneiooa,theFederalReservekeptthefederalfundsrate
lowat1ºtostimulatetheeconomvfollowingtheioo1recession.Overthenexttwo
vears,asdefationfearswaned,theFedgraduallvraisedratesto-.i-ºin1¬quarter-
pointincreases.
In the view of some, the Fed simplv kept rates too low too long. Iohn Tavlor, a
Stanfordeconomistandformerundersecretarvoftreasurvforinternationalaffairs,
blamedthecrisisprimarilvonthisaction.IftheFedhadfolloweditsusualpattern,
hetoldtheFCIC,short-terminterestrateswouldhavebeenmuchhigher,discourag-
ing excessive investment in mortgages. “The boom in housing construction starts
wouldhavebeenmuchmoremild,mightnotevencallitaboom,andthebustaswell
wouldhavebeenmild,”Tavlorsaid.
a
Othersweremoreblunt:“Greenspanbailedout
the world’s largest equitv bubble with the world’s largest real estate bubble,” wrote
WilliamA.Fleckenstein,thepresidentofaSeattle-basedmonevmanagementfrm.
-
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 bv the Fed, and that short-
term and long-term rates had become de-linked. “Between 1o¬1 and iooi, the fed
funds rate and the mortgage rate moved in lock-step,” Greenspan said.
o
When the
Fedstartedtoraiseratesiniooa,omcialsexpectedmortgageratestorise,too,slow-
inggrowth.Instead,mortgageratescontinuedtofallforanothervear.Theconstruc-
tionindustrvcontinuedtobuildhouses,peakingatanannualizedrateofi.i¬million
startsinIanuarviooo—morethana:o-vearhigh.
As Greenspan told Congress in ioo-, this was a “conundrum.”
¬
One theorv
pointed to foreign monev. Developing countries were booming and—vulnerable to
fnancial problems in the past—encouraged strong saving. Investors in these coun-
tries placed their savings in apparentlv safe and high-vield 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 countrv
were unprecedented. Over six vears from iooo to iooo, U.S. Treasurv debt held bv
foreignomcialpublicentitiesrosefrom·o.otrillionto·1.a:trillion;asapercentage
ofU.S.debtheldbvthepublic,theseholdingsincreasedfrom18.iºtoi8.8º.For-
eigners also bought securities backed bv Fannie and Freddie, which, with their im-
plicit government guarantee, seemed nearlv as safe as Treasuries. As the Asian
fnancial crisis ended in 1oo8, foreign holdings of GSE securities held steadv at the
level of almost 1o vears earlier, about ·18o billion. Bv iooo—just two vears later—
foreigners owned ·:a8 billion in GSE securities; bv iooa, ·8¬- billion. “You had a
huge infow of liquiditv. A verv unique kind of situation where poor countries like
China were shipping monev to advanced countries because their fnancial svstems
were so weak that thev [were] better off shipping [monev] to countries like the
United States rather than keeping it in their own countries,” former Fed governor
FredericMishkintoldtheFCIC.“Thesvstemwasawashwithliquiditv,whichhelped
lowerlong-terminterestrates.”
o
Foreign investors sought other high-grade debt almost as safe as Treasuries and
GSEsecuritiesbutwithaslightlvhigherreturn.Thevfoundthetriple-Aassetspour-
ingfromtheWallStreetmortgagesecuritizationmachine.Asoverseasdemanddrove
uppricesforsecuritizeddebt,it“createdanirresistibleproftopportunitvfortheU.S.
fnancialsvstem:toengineer‘quasi’safedebtinstrumentsbvbundlingriskierassets
andsellingtheseniortranches,”Pierre-OlivierGourinchas,aneconomistattheUni-
versitvofCalifornia,Berkelev,toldtheFCIC.
1o
PaulKrugman,aneconomistatPrincetonUniversitv,toldtheFCIC,“It’shardto
envisageushavinghadthiscrisiswithoutconsideringinternationalmonetarvcapital
movements.TheU.S.housingbubblewasfnancedbvlargecapitalinfows.Sowere
SpanishandIrishandBalticbubbles.It’sacombinationof,inthenarrowsense,ofa
less regulated fnancial svstem and a world that was increasinglv wide open for big
internationalcapitalmovements.”
11
Itwasanoceanofmonev.
MORTGAGES: “A GOOD LOAN”
Therefnancingboomwasover,butoriginatorsstillneededmortgagestoselltothe
Street. Thev 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,mortgageproductsthatbroughthighervieldsforinvestorsbutcorrespond-
inglvgreaterrisksforborrowers.“Holdingasubprimeloanhasbecomesomethingof
ahigh-stakeswager,”theCenterforResponsibleLendingwarnediniooo.
1i
Subprime mortgages rose from 8º of mortgage originations in ioo: to ioº in
ioo-.
1:
About ¬oº of subprime borrowers used hvbrid adjustable-rate mortgages
(ARMs) such as i/i8s and :/i¬s—mortgages whose low “teaser” rate lasts for the
frst two or three vears, and then adjusts periodicallv thereafter.
1a
Prime borrowers
alsousedmorealternativemortgages.ThedollarvolumeofAlt-Asecuritizationrose
almost:-oºfromioo:toioo-.
1-
Ingeneral,theseloansmadeborrowers’monthlv
.+. ii N\Nti \i tii :i : i Nuli i¥ tu\\i : :i uN iiiui1
1ui \ui1t\ti \\tui Ni .+·
mortgagepavmentsonevermoreexpensivehomesaffordable—atleastinitiallv.Pop-
ular Alt-A products included interest-onlv mortgages and pavment-option ARMs.
Option ARMs let borrowers pick their pavment each month, including pavments
that actuallv increased the principal—anv shortfall on the interest pavment 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
monthlvpavment—perhapsdramaticallv.OptionARMsrosefromiºofmortgages
inioo:tooºiniooo.
1o
Simultaneouslv, 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:toaiºiniooa,anddownto:¬ºbviooo.

Tak-
ing their place were private-label securitizations—meaning those not issued and
guaranteedbvtheGSEs.
Inthisnewmarket,originatorscompetedfercelv;CountrvwideFinancialCorpo-
ration took the crown.
18
It was the biggest mortgage originator from iooa until the
market collapsed in ioo¬. Even after Countrvwide nearlv failed, buckling under a
mortgage portfolio with loans that its co-founder and CEO Angelo Mozilo once
called“toxic,”Mozilowoulddescribehisao-vear-oldcompanvtotheCommissionas
havinghelpedi-millionpeoplebuvhomesandpreventedsocialunrestbvextending
loanstominorities,historicallvthevictimsofdiscrimination:“Countrvwidewasone
ofthegreatestcompaniesinthehistorvofthiscountrvandprobablvmademoredif-
ferencetosocietv,totheintegritvofoursocietv,thananvcompanvinthehistorvof
America.”
1o
Lending to home buvers was onlv part of the business. Countrvwide’s
President and COO David Sambol told the Commission, as long as a loan did not
harm the companv from a fnancial or reputation standpoint, Countrvwide was “a
seller of securities to Wall Street.” Countrvwide’s essential business strategv was
“originatingwhatwassalableinthesecondarvmarket.”
io
Thecompanvsoldorsecu-
ritized8¬ºofthe·1.-trillioninmortgagesitoriginatedbetweeniooiandioo-.
Iniooa,Moziloannouncedavervaggressivegoalofgaining“marketdominance”
bvcapturing:oºoftheoriginationmarket.
i1
Hisshareatthetimewas1iº.ButCoun-
trvwidewasnotunique:Ameriquest,NewCenturv,WashingtonMutual,andothersall
pursued loans as aggressivelv. Thev competed bv originating tvpes of mortgages cre-
atedvearsbeforeasnicheproducts,butnowtransformedintoriskier,mass-marketver-
sions.“Thedefnitionofagoodloanchangedfrom‘onethatpavs’to‘onethatcouldbe
sold,’”PatriciaLindsav,formerlvafraudspecialistatNewCenturv,toldtheFCIC.
ii
/s and /s: “Adjust for the affordability”
Historicallv,i/i8sor:/i¬s,alsoknownashybrid ARMs, letcredit-impairedborrow-
ersrepairtheircredit.Duringthefrsttwoorthreevears,alowerinterestratemeant
a manageable pavment schedule and enabled borrowers to demonstrate thev could
maketimelvpavments.Eventuallvtheinterestrateswouldrisesharplv,andpavments
coulddoubleoreventriple,leavingborrowerswithfewalternatives:ifthevhades-
tablishedtheircreditworthiness,thevcouldrefnanceintoasimilarmortgageorone
with a better interest rate, often with the same lender;
i:
if unable to refnance, the
borrowerwasunlikelvtobeabletoaffordthenewhigherpavmentsandwouldhave
to sell the home and repav the mortgage. If thev could not sell or make the higher
pavments,thevwouldhavetodefault.
Butashousepricesroseafteriooo,thei/i8sand:/i¬sacquiredanewrole:help-
ingtogetpeopleintohomesortomoveuptobiggerhomes.“Ashomesgotlessand
less affordable, vou would adjust for the affordabilitv in the mortgage because vou
couldn’t reallv adjust people’s income,” Andrew Davidson, the president of Andrew
Davidson & Co. and a veteran of the mortgage markets, told the FCIC.
ia
Lenders
qualifed borrowers at low teaser rates, with little thought to what might happen
whenratesreset.HvbridARMsbecametheworkhorsesofthesubprimesecuritiza-
tionmarket.
ConsumerprotectiongroupssuchastheLeadershipConferenceonCivilRights
railed against i/i8s and :/i¬s, which, thev said, neither rehabilitated credit nor
turnedrentersintoowners.DavidBerenbaumfromtheNationalCommunitvRein-
vestment Coalition testifed to Congress in the summer of ioo¬: “The industrv has
foodedthemarketwithexoticmortgagelendingsuchasi/i8and:/i¬ARMs.These
exoticsubprimemortgagesoverwhelmborrowerswheninterestratesshootupafter
anintroductorvtimeperiod.”
i-
Totheircritics,thevweresimplvawavforlendersto
stripequitvfromlow-incomeborrowers.Theloanscamewithbigfeesthatgotrolled
intothemortgage,increasingthechancesthatthemortgagecouldbelargerthanthe
home’svalueattheresetdate.Iftheborrowercouldnotrefnance,thelenderwould
foreclose—andthenownthehomeinarisingrealestatemarket.
Option ARMs: “Our most profitable mortgage loan”
Whenthevwereoriginallvintroducedinthe1o8os,optionARMswerenicheprod-
ucts,too,butbviooathevtoobecameloansofchoicebecausetheirpavmentswere
lowerthanmoretraditionalmortgages.Duringthehousingboom,manvborrowers
repeatedlvmadeonlvtheminimumpavmentsrequired,addingtotheprincipalbal-
anceoftheirloanevervmonth.
An earlv seller of option ARMs was Golden West Savings, an Oakland, Califor-
nia–basedthriftfoundedin1oioandacquiredin1oo:bvMarionandHerbertSan-
dler. In 1o¬-, the Sandlers merged Golden West with World Savings; Golden West
FinancialCorp.,theparentcompanv,operatedbranchesunderthenameWorldSav-
ings Bank. The thrift issued about ·i¬a billion in option ARMs between 1o81 and
ioo-.
io
Unlikeothermortgagecompanies,GoldenWestheldontothem.
Sandler told the FCIC that Golden West’s option ARMs—marketed as “Pick-a-
Pav”loans—hadthelowestlossesintheindustrvforthatproduct.Eveninioo-—the
lastvearpriortoitsacquisitionbvWachovia—whenitsportfoliowasalmostentirelv
inoptionARMs,GoldenWest’slosseswerelowbvindustrvstandards.Sandlerattrib-
utedGoldenWest’sperformancetoitsdiligenceinrunningsimulationsaboutwhat
.+( ii N\Nti \i tii :i : i Nuli i¥ tu\\i : :i uN iiiui1
would happen to its loans under various scenarios—for example, if interest rates
wentupordownorifhousepricesdropped-º,even1oº.“Foraquarterofacen-
turv, it worked exactlv as the simulations showed that it would,” Sandler said. “And
wehaveneverbeenabletoidentifvasingleloanthatwasdelinquentbecauseofthe
structureoftheloan,muchlessalossorforeclosure.”

ButafterWachoviaacquired
GoldenWestinioooandthehousingmarketsoured,charge-offsonthePick-a-Pav
portfoliowouldsuddenlvjumpfromo.oaºtoi.ooºbvSeptemberioo8.Andfore-
closureswouldclimb.
Earlv in the decade, banks and thrifts such as Countrvwide and Washington
Mutual increased their origination of option ARM loans, changing the product in
wavsthatmadepavmentshocksmorelikelv.AtGoldenWest,after1ovears,orifthe
principal balance grew to 1i-º of its original size, the Pick-a-Pav mortgage would
recastintoanewfxed-ratemortgage.AtCountrvwideandWashingtonMutual,the
newloanswouldrecastinaslittleasfvevears,orwhenthebalancehitjust11oºof
the original size. Thev 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 pavment could rise more sharplv, more quicklv, and with less
cushion.
In iooi, Washington Mutual was the second-largest mortgage originator, just
ahead of Countrvwide. It had offered the option ARM since 1o8o, and in ioo:, as
citedbvtheSenatePermanentSubcommitteeonInvestigations,theoriginatorcon-
ductedastudv“toexplorewhatWashingtonMutualcoulddotoincreasesalesofOp-
tionARMs,ourmostproftablemortgageloan.”
i8
Afocusgroupmadeclearthatfew
customerswererequestingoptionARMsandthat“thisisnotaproductthatsellsit-
self.”
io
Thestudvfound“thebestsellingpointfortheOptionArm”wastoshowcon-
sumers“howmuchlowertheirmonthlvpavmentwouldbebvchoosingtheOption
Arm versus a fxed-rate loan.”
:o
The studv also revealed that manv 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 iooa, when thev 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.
:a
MorethanhalfwereinCalifornia.
:-
Countrvwide’soptionARMbusinesspeakedat·1a.-billioninoriginationsinthe
secondquarterofioo-,abouti-ºofallitsloansoriginatedthatquarter.
:o
Butithad
to relax underwriting standards to get there. In Iulv iooa, Countrvwide decided it
would lend up to ooº of a home’s appraised value, up from 8oº, and reduced the
minimumcreditscoretoaslowasoio.

Inearlvioo-,Countrvwideeasedstandards
again,increasingtheallowablecombinedloan-to-valueratio(includingsecondliens)
too-º.
:8
1ui \ui1t\ti \\tui Ni .+,
The risk in these loans was growing. From ioo: to ioo-, the average loan-to-
valueratioroseaboutaº,thecombinedloan-to-valueratioroseaboutoº,anddebt-
to-incomeratioshadrisenfrom:aºto:8º:borrowerswerepledgingmoreoftheir
incometotheirmortgagepavments.Moreover,o8ºofthesetwooriginators’option
ARMshadlowdocumentationinioo-.
:o
Thepercentageoftheseloansmadetoin-
vestors and speculators—that is, borrowers with no plans to use the home as their
primarvresidence—alsorose.
Thesechangesworriedthelendersevenasthevcontinuedtomaketheloans.In
SeptemberiooaandAugustioo-,Moziloemailedtoseniormanagementthatthese
loanscouldbring“fnancialandreputationalcatastrophe.”
ao
Countrvwideshouldnot
marketthemtoinvestors,heinsisted.“Pavoptionloansbeingusedbvinvestorsisa
purecommercialspec[ulation]loanandnotthetraditionalhomeloanthatwehave
successfullvmanagedthroughoutourhistorv,”MozilowrotetoCarlosGarcia,CEO
ofCountrvwideBank.Speculativeinvestors“shouldgotoChaseorWellsnotus.Itis
alsoimportantforvouandvourteamtounderstandfrommvpointofviewthatthere
isnothingintrinsicallvwrongwithpavoptionsloansthemselves,theproblemisthe
qualitvofborrowerswhoarebeingofferedtheproductandtheabusebvthirdpartv
originators. . . . [I]f vou are unable to fnd sumcient product then slow down the
growthoftheBankforthetimebeing.”
a1
However, Countrvwide’s growth did not slow. Nor did the volume of option
ARMsretainedonitsbalancesheet,increasingfrom·-billioniniooato·iobillion
in ioo- and peaking in iooo at ·:: billion.
ai
Finding these loans verv proftable,
through iooo, WaMu also retained option ARMs—more than ·oo billion with the
bulkfromCalifornia,followedbvFlorida.
a:
Butintheend,theseloanswouldcause
signifcantlossesduringthecrisis.
Mentioning Countrvwide and WaMu as tough, “in our face” competitors, Iohn
Stumpf, the CEO, chairman, and president of Wells Fargo, recalled Wells’s decision
not to write option ARMs, even as it originated manv other high-risk mortgages.
Thesewere“harddecisionstomakeatthetime,”hesaid,noting“wedidloserevenue,
andwedidlosevolume.”
aa
Across the market, the volume of option ARMs had risen nearlv fourfold from
ioo: to iooo, from approximatelv ·o- billion to ·i-- billion. Bv then, WaMu and
Countrvwide had plentv of evidence that more borrowers were making onlv the
minimum pavments and that their mortgages were negativelv amortizing—which
meant their equitv was being eaten awav. The percentage of Countrvwide’s option
ARMsthatwerenegativelvamortizinggrewfromjust1ºiniooato-:ºinioo-and
thentomorethanooºbvioo¬.
a-
AtWaMu,itwasiºinioo:,i8ºiniooa,and8iº
inioo¬.
ao
Declinesinhousepricesaddedtoborrowers’problems:anvequitvremain-
ingafterthenegativeamortizationwouldsimplvbeeroded.Increasinglv,borrowers
wouldowemoreontheirmortgagesthantheirhomeswereworthonthemarket,giv-
ingthemanincentivetowalkawavfrombothhomeandmortgage.
Kevin Stein, from the California Reinvestment Coalition, testifed to the FCIC
that option ARMs were sold inappropriatelv: “Nowhere was this dvnamic more
clearlv on displav than in the summer of iooo when the Federal Reserve convened
.+· ii N\Nti \i tii :i : i Nuli i¥ tu\\i : :i uN iiiui1
HOEPA(HomeOwnershipandEquitvProtectionAct)hearingsinSanFrancisco.At
the hearing, consumers testifed to being sold option ARM loans in their primarv
non-Englishlanguage,onlvtobepressuredtosignEnglish-onlvdocumentswithsig-
nifcantlvworseterms.Someconsumerstestifedtobeingunabletomakeeventheir
initial pavments because thev had been lied to so completelv bv 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-pav loans forcing them to pav
into—pav loans that thev could never pav off. Prevalent among these clients are
seniors, people of color, people with disabilities, and limited English speakers and
seniorswhoareAfricanAmericanandLatino.”
a8
Underwriting standards: “We’re going to have to hold our nose”
Anothershiftwouldhaveseriousconsequences.Fordecades,thedownpavmentfor
aprimemortgagehadbeenioº(inotherwords,theloan-to-valueratio(LTV)had
been 8oº). As prices continued to rise, fnding the cash to put ioº down became
harder,andfromioooon,lendersbeganacceptingsmallerdownpavments.
There had alwavs been a place for borrowers with down pavments below ioº.
Tvpicallv,lendersrequiredsuchborrowertopurchaseprivatemortgageinsurancefor
amonthlvfee.Ifamortgageendedinforeclosure,themortgageinsurancecompanv
would make the lender whole. Worried about defaults, the GSEs would not buv or
guarantee mortgages with down pavments below ioº unless the borrower bought
theinsurance.Unluckilvformanvhomeowners,forthehousingindustrv,andforthe
fnancial svstem, lenders devised a wav to get rid of these monthlv fees that had
added to the cost of homeownership: lower down pavments that did not require
insurance.
Lendershadlatitudeinsettingdownpavments.In1oo1,Congressorderedfederal
regulators to prescribe standards for real estate lending that would applv to banks
andthrifts.Thegoalwasto“curtailabusiverealestatelendingpracticesinorderto
reducerisktothedepositinsurancefundsandenhancethesafetvandsoundnessof
insureddepositorvinstitutions.”
ao
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,reducelendingfexibilitv,impedeeconomicgrowth,
andcauseotherundesirableconsequences.”
-1
In1ooo,regulatorsrevisitedtheissue,ashighLTVlendingwasincreasing.Thev
tightened reporting requirements and limited a bank’s total holdings of loans with
LTVsaboveooºthatlackedmortgageinsuranceorsomeotherprotection;thevalso
remindedthebanksandthriftsthatthevshouldestablishinternalguidelinestoman-
agetheriskoftheseloans.
-i
High LTV lending soon became even more common, thanks to the so-called
1ui \ui1t\ti \\tui Ni .++
piggvback mortgage. The lender offered a frst mortgage for perhaps 8oº of the
home’svalueandasecondmortgageforanother1oºorevenioº.Borrowersliked
thesebecausetheirmonthlvpavmentswereoftencheaperthanatraditionalmort-
gageplustherequiredmortgageinsurance,andtheinterestpavmentsweretaxde-
ductible. Lenders liked them because the smaller frst mortgage—even without
mortgageinsurance—couldpotentiallvbesoldtotheGSEs.
At the same time, the piggvbacks added risks. A borrower with a higher com-
binedLTVhadlessequitvinthehome.Inarisingmarket,shouldpavmentsbecome
unmanageable,theborrowercouldalwavssellthehomeandcomeoutahead.How-
ever, should the pavments become unmanageable in a falling market, the borrower
mightowemorethanthehomewasworth.Piggvbackloans—whichoftenrequired
nothingdown—guaranteedthatmanvborrowerswouldendupwithnegativeequitv
ifhousepricesfell,especiallviftheappraisalhadoverstatedtheinitialvalue.
But piggvback lending helped address a signifcant challenge for companies like
NewCenturv,whichwerebigplaversinthemarketformortgages.Meetinginvestor
demandrequiredfndingnewborrowers,andhomebuverswithoutdownpavments
were a relativelv untapped source. Yet among borrowers with mortgages originated
iniooa,bvSeptemberioo-thosewithpiggvbackswerefourtimesaslikelvasother
mortgage holders to be oo or more davs delinquent. When senior management at
New Centurv heard these numbers, the head of the Secondarv Marketing Depart-
mentaskedfor“thoughtsonwhattodowiththis . . .prettvcompelling”information.
Nonetheless,NewCenturvincreasedmortgageswithpiggvbacksto:-ºofloanpro-
ductionbvtheendofioo-,upfromonlvoºinioo:.
-:
Thevwerenotalone.Across
securitized subprime mortgages, the average combined LTV rose from ¬oº to 8oº
betweenioo1andiooo.
-a
Anotherwavtogetpeopleintomortgages—andquicklv—wastorequirelessin-
formationoftheborrower.“Statedincome”or“low-documentation”(orsometimes
“no-documentation”)loanshademergedvearsearlierforpeoplewithfuctuatingor
hard-to-verifv incomes, such as the self-emploved, 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 unnecessarv. He alreadv had a good idea how
muchmonevteachers,accountants,andengineersmade—andifhedidn’t,hecould
easilvfndout.Allheneededwastoverifvthathisborrowersworkedwherethevsaid
thevdid.Ifheguessedwrong,theloan-to-valueratiostillprotectedhisinvestment.
--
Aroundioo-,however,low-andno-documentationloanstookonanentirelvdif-
ferentcharacter.Nonprimelendersnowboastedthevcouldofferborrowersthecon-
venience of quicker decisions and not having to provide tons of paperwork. In
return, thev charged a higher interest rate. The idea caught on: from iooo to ioo¬,
low-andno-docloansskvrocketedfromlessthaniºtoroughlvoºofalloutstand-
ingloans.
-o
AmongAlt-Asecuritizations,8oºofloansissuediniooohadlimitedor
no documentation.

As William Black, a former banking regulator, testifed before
the FCIC, the mortgage industrv’s own fraud specialists described stated income
..+ ii N\Nti \i tii :i : i Nuli i¥ tu\\i : :i uN iiiui1
loansas“anopen‘invitationtofraud’thatjustifedtheindustrvterm‘liar’sloans.’”
-8
Speakingoflendinguptoioo-atCitigroup,RichardBowen,aveteranbankerinthe
consumer lending group, told the FCIC, “A decision was made that ‘We’re going to
havetoholdournoseandstartbuvingthestatedproductifwewanttostavinbusi-
ness.’”
-o
Iamie Dimon, the CEO of IP Morgan, told the Commission, “In mortgage
underwriting,somehowwejustmissed,vouknow,thathomepricesdon’tgoupfor-
everandthatit’snotsumcienttohavestatedincome.”
oo
Intheend,companiesinsubprimeandAlt-Amortgageshad,inessence,placed
alltheirchipsonblack:thevwerebettingthathomepriceswouldneverstoprising.
Thiswastheonlvscenariothatwouldkeepthemortgagemachinehumming.Theev-
idence is present in our case studv mortgage-backed securitv, CMLTI iooo-NCi,
whoseloanshavemanvofthecharacteristicsjustdescribed.
Thea,aooloansbundledinthisdealwereadjustable-rateandfxed-rateresiden-
tialmortgagesoriginatedbvNewCenturv.Thevhadanaverageprincipalbalanceof
·i1o,-:o—justunderthemedianhomepriceof·ii1,oooiniooo.
o1
Thevastmajor-
itvhada:o-vearmaturitv,andmorethanooºwereoriginatedinMav,Iune,andIulv
iooo,justafternationalhomepriceshadpeaked.Morethanooºwerereportedlvfor
primarvresidences,witha:ºforhomepurchasesanda8ºforcash-outrefnancings.
Theloanswerefromall-ostatesandtheDistrictofColumbia,butmorethanaffth
camefromCaliforniaandmorethanatenthfromFlorida.
oi
About8oºoftheloanswereARMs,andmostofthesewerei/i8sor:/i¬s.Ina
twist,manvofthesehvbridARMshadother“affordabilitvfeatures”aswell.Forex-
ample,morethanioºoftheARMswereinterest-onlv—duringthefrsttwoorthree
vears,notonlvwouldborrowerspavalowerfxedrate,thevwouldnothavetopav
anvprincipal.Inaddition,morethanaoºoftheARMswere“i/i8hvbridballoon”
loans, in which the principal would amortize over ao vears—lowering the monthlv
pavmentsevenfurther,butasaresultleavingtheborrowerwithafnalprincipalpav-
mentattheendofthe:o-vearterm.
Thegreatmajoritvofthepoolwassecuredbvfrstmortgages;ofthese,::ºhada
piggvback mortgage on the same propertv. As a result, more than one-third of the
mortgages in this deal had a combined loan-to-value ratio between o-º and 1ooº.
Raisingtheriskabitmore,aiºofthemortgageswereno-docloans.Therestwere
“full-doc,”althoughtheirdocumentationwasfullerinsomecasesthaninothers.
o:
In
sum,theloansbundledinthisdealmirroredthemarket:complexproductswithhigh
LTVsandlittledocumentation.Andevenasmanvwarnedofthistoxicmix,thereg-
ulatorswerenotonthesamepage.
FEDERAL REGULATORS: “IMMUNITY FROM
MANY STATE LAWS IS A SIGNIFICANT BENEFIT”
Forvears,somestateshadtriedtoregulatethemortgagebusiness,especiallvtoclamp
downonthepredatorvmortgagesproliferatinginthesubprimemarket.Thenational
thriftsandbanksandtheirfederalregulators—theOmceofThriftSupervision(OTS)
andtheOmceoftheComptrolleroftheCurrencv(OCC),respectivelv—resistedthe
1ui \ui1t\ti \\tui Ni ...
states’effortstoregulatethosenationalbanksandthrifts.Thecompaniesclaimedthat
withoutoneuniformsetofrules,thevcouldnoteasilvdobusinessacrossthecountrv,
andtheregulatorsagreed.InAugustioo:,asthemarketforriskiersubprimeandAlt-
Aloansgrew,andaslenderspiledonmoreriskwithsmallerdownpavments,reduced
documentation requirements, interest-onlv loans, and pavment-option loans, the
OCC fred a salvo. The OCC proposed strong preemption rules for national banks,
nearlv identical to earlier OTS rules that empowered nationallv chartered thrifts to
disregardstateconsumerlaws.
oa
Backin1oootheOTShadissuedrulessavingfederallawpreemptedstatepreda-
torvlendinglawsforfederallvregulatedthrifts.
o-
Inioo:,theOTSreferredtothese
rules in issuing four opinion letters declaring that laws in Georgia, New York, New
Iersev,andNewMexicodidnotapplvtonationalthrifts.IntheNewMexicoopinion,
theregulatorpronouncedinvalidNewMexico’sbansonballoonpavments,negative
amortization,prepavmentpenalties,loanfipping,andlendingwithoutregardtothe
borrower’sabilitvtorepav.
TheComptrolleroftheCurrencvtookthesamelineonthenationalbanksthatit
regulated,offeringpreemptionasaninducementtouseanationalbankcharter.Ina
iooispeech,beforethefnalOCCruleswerepassed,ComptrollerIohnD.HawkeIr.
pointedto“nationalbanks’immunitvfrommanvstatelaws”as“asignifcantbeneft
ofthenationalcharter—abeneftthattheOCChasfoughthardoverthevearstopre-
serve.”
oo
Inaninterviewthatvear,Hawkeexplainedthatthepotentiallossofregula-
torvmarketsharefortheOCC“wasamatterofconcern.”

In August ioo: the OCC issued its frst preemptive order, aimed at Georgia’s
mini-HOEPAstatute,andinIanuarviooatheOCCadoptedasweepingpreemption
rule applving to all state laws that interfered with or placed conditions on national
banks’ abilitv to lend. Shortlv afterward, three large banks with combined assets of
morethan·1trillionsaidthevwouldconvertfromstatecharterstonationalcharters,
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¬.
oo
OnceOCCandOTSpreemptionwasinplace,thetwofederalagencieswerethe
onlv regulators with the power to prohibit abusive lending practices bv national
banks and thrifts and their direct subsidiaries. Comptroller Iohn Dugan, who suc-
ceeded Hawke, defended preemption, noting that “¬iº of all nonprime mortgages
were made bv lenders that were subject to state law. Well over half were made bv
mortgagelendersthatwereexclusivelvsubjecttostatelaw.”
¬o
LisaMadigan,theattor-
nevgeneralofIllinois,fippedtheargumentaround,notingthatnationalbanksand
thrifts,andtheirsubsidiaries,wereheavilvinvolvedinsubprimelending.Usingdif-
ferent data, she contended: “National banks and federal thrifts and . . . their sub-
..z ii N\Nti \i tii :i : i Nuli i¥ tu\\i : :i uN iiiui1
sidiaries . . .wereresponsibleforalmost:ipercentofsubprimemortgageloans,ao.1
percentoftheAlt-Aloans,and-1percentofthepav-optionandinterest-onlvARMs
thatweresold.”MadigantoldtheFCIC:
EvenastheFedwasdoinglittletoprotectconsumersandourfnancial
svstem from the effects of predatorv lending, the OCC and OTS were
activelvengagedinacampaigntothwartstateeffortstoavertthecom-
ingcrisis. . . .Inthewakeofthefederalregulators’pushtocurtailstate
authoritv,manvofthelargestmortgage-lendersshedtheirstatelicenses
andsoughtshelterbehindtheshieldofanationalcharter.AndIthink
that it is no coincidence that the era of expanded federal preemption
gaverisetotheworstlendingabusesinournation’shistorv.
¬1
ComptrollerHawkeofferedtheFCICadifferentinterpretation:“Whilesomecrit-
icshavesuggestedthattheOCC’sactionsonpreemptionhavebeenagrabforpower,
thefactisthattheagencvhassimplvrespondedtoincreasinglvaggressiveinitiatives
atthestateleveltocontrolthebankingactivitiesoffederallvcharteredinstitutions.”
¬i
MORTGAGE SECURITIES PLAYERS:
“WALL STREET WAS VERY HUNGRY FOR OUR PRODUCT”
Subprime and Alt-A mortgage–backed securities depended on a complex supplv
chain,largelvfundedthroughshort-termlendinginthecommercialpaperandrepo
market—whichwouldbecomecriticalasthefnancialcrisisbegantounfoldinioo¬.
TheseloanswereincreasinglvcollateralizednotbvTreasuriesandGSEsecuritiesbut
bvhighlvratedmortgagesecuritiesbackedbvincreasinglvriskvloans.Independent
mortgage originators such as Ameriquest and New Centurv—without access to de-
posits—tvpicallvreliedonfnancingtooriginatemortgagesfromwarehouselinesof
credit extended bv banks, from their own commercial paper programs, or from
monevborrowedintherepomarket.
For commercial banks such as Citigroup, warehouse lending was a multibillion-
dollarbusiness.Fromioootoio1o,Citigroupmadeavailableatanvonetimeasmuch
as·¬billioninwarehouselinesofcredittomortgageoriginators,including·o-omil-
lion to New Centurv and more than ·:.- billion to Ameriquest.
¬:
Citigroup CEO
ChuckPrincetoldtheFCIChewouldnothaveapproved,hadheknown.“Ifoundout
attheendofmvtenure,Ididnotknowitbefore,thatwehadsomewarehouselines
outtosomeoriginators.AndIthinkgettingthatclosetotheoriginationfunction—
beingthatinvolvedintheoriginationofsomeoftheseproducts—issomethingthatI
wasn’tcomfortablewithandthatIdidnotviewasconsistentwiththeprescriptionI
hadlaiddownforthecompanvnottobeinvolvedinoriginatingtheseproducts.”
¬a
Asearlvas1oo8,Moodv’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-halfofcommercialpapersoldbetween1oo¬andioo1.
1ui \ui1t\ti \\tui Ni ...
Inioo1,onlvfvemortgagecompaniesborrowedatotalof·abillionthroughas-
set-backed commercial paper; in iooo, 1o entities borrowed ·a: billion.
¬o
For in-
stance, Countrvwide launched the commercial paper programs Park Granada in
ioo:andParkSiennainiooa.
¬¬
BvMavioo¬,itwasborrowing·1:billionthrough
Park Granada and ·-.: billion through Park Sienna. These programs would house
subprimeandothermortgagesuntilthevweresold.
¬8
Commercial banks used commercial paper, in part, for regulatorv arbitrage.
When banks kept mortgages on their balance sheets, regulators required them to
hold aº in capital to protect against loss. When banks put mortgages into off-bal-
ance-sheetentitiessuchascommercialpaperprograms,therewasnocapitalcharge
(in iooa, a small charge was imposed). But to make the deals work for investors,
banks had to provide liquiditv support to these programs, for which thev earned a
fee. This liquiditv support meant that the bank would purchase, at a previouslv set
price,anvcommercialpaperthatinvestorswereunwillingtobuvwhenitcameupfor
renewal.Duringthefnancialcrisisthesepromiseshadtobekept,eventuallvputting
substantialpressureonbanks’balancesheets.
When the Financial Accounting Standards Board, the private group that estab-
lishes standards for fnancial reports, responded to the Enron scandal bv making it
harderforcompaniestogetoff-balance-sheettreatmentfortheseprograms,thefa-
vorable capital rules were in jeopardv. The asset-backed commercial paper market
stalled.BanksprotestedthattheirprogramsdifferedfromthepracticesatEnronand
shouldbeexcludedfromthenewstandards.Inioo:,bankregulatorsrespondedbv
proposingtoletbanksremovetheseassetsfromtheirbalancesheetswhencalculat-
ing regulatorv capital. The proposal would have also introduced for the frst time a
capitalchargeamountingtoatmost1.oºoftheliquiditvsupportbanksprovidedto
theABCPprograms.However,afterstrongpushback—theAmericanSecuritization
Forum,anindustrvassociation,calledthatcharge“arbitrarv,”andStateStreetBank
complained it was “too conservative”
¬o
—regulators in iooa announced a fnal rule
settingthechargeatuptoo.8º,orhalftheamountofthefrstproposal.Growthin
thismarketresumed.
Regulatorvchanges—inthiscase,changesinthebankruptcvlaws—alsoboosted
growthintherepomarketbvtransformingthetvpesofrepocollateral.Priortoioo-,
repo lenders had clear and immediate rights to their collateral following the bor-
rower’s bankruptcv onlv if that collateral was Treasurv or GSE securities. In the
BankruptcvAbusePreventionandConsumerProtectionActofioo-,Congressex-
pandedthatprovisiontoincludemanvotherassets,includingmortgageloans,mort-
gage-backed securities, collateralized debt obligations, and certain derivatives. The
resultwasashort-termrepomarketincreasinglvreliantonhighlvratednon-agencv
mortgage-backed securities; but beginning in mid-ioo¬, when banks and investors
became skittish about the mortgage market, thev would prove to be an unstable
fundingsource(seefgure¬.1).Oncethecrisishit,these“illiquid,hard-to-valuese-
curitiesmadeupagreatershareofthetri-partvrepomarketthanmostpeoplewould
havewanted,”DarrvllHendricks,aUBSexecutiveandchairofaNewYorkFedtask
forceexaminingtherepomarketafterthecrisis,toldtheCommission.
8o
... ii N\Nti \i tii :i : i Nuli 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
monevNewCenturvneededtomakethea,aoomortgagesitwouldselltoCitigroup.
Most of the funds came through repo agreements from a set of banks—including
Morgan Stanlev (·aia million); Barclavs Capital, a division of a U.K.-based bank
(·ii1million);BankofAmerica(·1a¬million);andBearStearns(·oamillion).
81
The
fnancingwasprovidedwhenNewCenturvoriginatedthesemortgages;soforabout
twomonths,NewCenturvowedthesebanksapproximatelv·oaomillionsecuredbv
themortgages.Another·1imillioninfundingcamefromNewCenturvitself,includ-
ing·:millionthroughitsowncommercialpaperprogram.OnAugustio,iooo,Citi-
grouppaidNewCenturv·o¬omillionforthemortgages(andaccruedinterest),and
NewCenturvrepaidtherepolendersafterkeepinga·iamillion(i.-º)premium.
8i
The investors in the deal
Investorsformortgage-backedsecuritiescamefromallovertheglobe;whatmadese-
curitization work were the customized tranches catering to everv one of them.
CMLTIiooo-NCihad1otranches,whoseinvestorsareshowninfgure¬.i.Fannie
Mae bought the entire ·1-- million triple-A-rated A1 tranche, which paid a better
return than super-safe U.S. Treasuries.
8:
The other triple-A-rated tranches, worth
Broker-dealers’ use of repo borrowing rose sharply before the crisis.
SOURCE: Federal Reserve Flow of Funds Report
Repo Borrowing
IN BILLIONS OF DOLLARS
0
$1,500
1,200
900
600
300
–300
1980 1985 1990 1995 2000 2005 2010
$396
NOTE: Net borrowing by broker-dealers.
Figure .
..( ii N\Nti \i tii :i : i Nuli 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
%
Figure .
1ui \ui1t\ti \\tui Ni ..,
·-8imillion,wenttomorethanioinstitutionalinvestorsaroundtheworld,spread-
ing the risk globallv.
8a
These triple-A tranches represented ¬8º of the deal. Among
the buvers were foreign banks and funds in China, Italv, France, and Germanv; the
FederalHomeLoanBankofChicago;theKentuckvRetirementSvstems;ahospital;
andIPMorgan,whichpurchasedpartofthetrancheusingcashfromitssecurities-
lendingoperation.
8-
(Inotherwords,IPMorganlentsecuritiesheldbvitsclientsto
otherfnancialinstitutionsinexchangeforcashcollateral,andthenputthatcashto
work investing in this deal. Securities lending was a large, but ultimatelv unstable,
sourceofcashthatfowedintothismarket.)
The middle, mezzanine tranches in this deal constituted about i1º of the total
valueofthesecuritv.Iflossesroseabove1ºto:º(bvdesignthethresholdwouldin-
crease over time), investors in the residual tranches would be wiped out, and the
mezzanineinvestorswouldstarttolosemonev.Creatorsofcollateralizeddebtobliga-
tions, or CDOs—discussed in the next chapter—bought most of the mezzanine
tranchesratedbelowtriple-AandnearlvallthoseratedbelowAA.Onlvafewofthe
highest-ratedmezzaninetrancheswerenotputintoCDOs.Forexample,ChevneFi-
nanceLimitedpurchased·¬millionofthetopmezzaninetranche.Chevne—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.

Tvpicallv,investorsseekinghighreturns,suchashedgefunds,wouldbuvtheeq-
uitv tranches of mortgage-backed securities; thev would be the frst to lose if there
wereproblems.Theseinvestorsanticipatedreturnsof1-º,ioº,oreven:oº.Citi-
groupretainedpartoftheresidualor“frst-loss”tranches,sharingtherestwithCap-
markFinancialGroup.
88
“Compensated very well”
Thebusinessofstructuring,selling,anddistributingthisdeal,andthethousandslike
it, was lucrative for the banks. The mortgage originators profted when thev sold
loansforsecuritization.
8o
Someofthisproftfoweddowntoemplovees—particularlv
thosegeneratingmortgagevolume.
Part of the ·ia million premium received bv New Centurv for the deal we ana-
lvzedwenttopavthemanvemploveeswhoparticipated.“Theoriginators,theloan
omcers,accountexecutives,basicallvthesalespeople[who]werethereasonourloans
came in . . . were compensated verv well,” New Centurv’s Patricia Lindsav told the
FCIC. And volume mattered more than qualitv. She noted, “Wall Street was verv
hungrvforourproduct.Wehadourloanssoldthreemonthsinadvance,beforethev
wereevenmadeatonepoint.”
oo
Similar incentives were at work at Long Beach Mortgage, the subprime division of
Washington Mutual, which organized its iooa Incentive Plan bv volume. As WaMu
showed in a ioo¬ plan, “Home Loans Product Strategv,” the goals were also product-
specifc:todrive“growthinhighermarginproducts(OptionARM,AltA,HomeEquitv,
Subprime),” “recruit and leverage seasoned Option ARM sales force,” and “maintain a
compensationstructurethatsupportsthehighmarginproductstrategv.”
o1
Afterstructuringasecuritv,anunderwriter,oftenaninvestmentbank,marketed
and sold it to investors. The bank collected a percentage of the sale (generallv be-
tween o.iº and 1.-º) as discounts, concessions, or commissions.
oi
For a ·1 billion
deallikeCMLTIiooo-NCi,a1ºfeewouldearnCitigroup·1omillion.Inthiscase,
though, Citigroup instead kept parts of the residual tranches. Doing so could vield
largeproftsaslongasthedealperformedasexpected.
OptionsGroup,whichcompilescompensationfguresforinvestmentbanks,exam-
inedthemortgage-backedsecuritiessalesandtradingdesksat11commercialandin-
vestmentbanksfromioo-toioo¬.
o:
Itfoundthatassociateshadaverageannualbase
salariesof·o-,oooto·oo,ooofromioo-throughioo¬,butreceivedbonusesthatcould
wellexceedtheirsalaries.Onthenextrung,vicepresidentsaveragedbasesalariesand
bonusesfrom·ioo,oooto·1,1-o,ooo.Directorsaveraged·oi-,oooto·1,oi-,ooo.
oa
At
thetopwastheheadoftheunit.Forexample,iniooo,DowKim,theheadofMerrill’s
Global Markets and Investment Banking segment, received a base salarv of ·:-o,ooo
plusa·:-millionbonus,apackagesecondonlvtoMerrillLvnch’sCEO.
o-
MOODY’ S: “GIVEN A BLANK CHECK”
Theratingagencieswereessentialtothesmoothfunctioningofthemortgage-backed
securities market. Issuers needed them to approve the structure of their deals; banks
neededtheirratingstodeterminetheamountofcapitaltohold;repomarketsneeded
theirratingstodetermineloanterms;someinvestorscouldbuvonlvsecuritieswitha
triple-Arating;andtheratingagencies’judgmentwasbakedintocollateralagreements
andotherfnancialcontracts.Toexaminetheratingprocess,theCommissionfocused
onMoodv’sInvestorsService,thelargestandoldestofthethreeratingagencies.
The rating of structured fnance products such as mortgage-backed securities
made up close to half of Moodv’s rating revenues in ioo-, iooo, and ioo¬.
oo
From
ioootoioo¬,revenuesfromratingsuchfnancialinstrumentsincreasedmorethan
fourfold.

Buttheratingprocessinvolvedmanvconficts,whichwouldcomeintofo-
cusduringthecrisis.
Todoitswork,Moodv’sratedmortgage-backedsecuritiesusingmodelsbased,in
part,onperiodsofrelativelvstrongcreditperformance.Moodv’sdidnotsumcientlv
account for the deterioration in underwriting standards or a dramatic decline in
homeprices.AndMoodv’sdidnotevendevelopamodelspecifcallvtotakeintoac-
count the lavered risks of subprime securities until late iooo, after it had alreadv
ratednearlv1o,ooosubprimesecurities.
o8
“In the business forevermore”
Credit ratings have been linked to government regulations for three-quarters of a
centurv.
oo
In 1o:1, the Omce of the Comptroller of the Currencv let banks report
publiclvtradedbondswitharatingofBBBorbetteratbookvalue(thatis,theprice
..· ii N\Nti \i tii :i : i Nuli i¥ tu\\i : :i uN iiiui1
thev paid for the bonds); lower-rated bonds had to be reported at current market
prices,whichmightbelower.In1o-1,theNationalAssociationofInsuranceCom-
missionersadoptedhighercapitalrequirementsonlower-ratedbondsheldbvinsur-
ers.
1oo
But the watershed event in federal regulation occurred in 1o¬-, when the
Securities and Exchange Commission modifed its minimum capital requirements
forbroker-dealerstobasethemoncreditratingsbva“nationallvrecognizedstatisti-
calratingorganization”(NRSRO);atthetime,thatwasMoodv’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,signedinIuneiooa,althoughU.S.bankshadnotfullvimplemented
theadvancedapproachesallowedunderthoserules.
Creditratingsalsodeterminedwhetherinvestorscouldbuvcertaininvestmentsat
all. The SEC restricts monev market funds to purchasing “securities that have re-
ceivedcreditratingsfromanvtwoNRSROs . . .inoneofthetwohighestshort-term
ratingcategoriesorcomparableunratedsecurities.”
1o1
TheDepartmentofLaborre-
strictspensionfundinvestmentstosecuritiesratedAorhigher.Creditratingsaffect
evenprivatetransactions:contractsmavcontaintriggersthatrequirethepostingof
collateralorimmediaterepavment,shouldasecuritvorentitvbedowngraded.Trig-
gersplavedanimportantroleinthefnancialcrisisandhelpedcrippleAIG.
Importantlvforthemortgagemarket,theSecondarvMortgageMarketEnhance-
mentActof1o8apermittedfederal-andstate-charteredfnancialinstitutionstoin-
vestinmortgage-relatedsecuritiesifthesecuritieshadhighratingsfromatleastone
ratingagencv.“Lookatthelanguageoftheoriginalbill,”LewisRanieritoldtheFCIC.
“Itrequiresarating. . . .Itputtheminthebusinessforevermore.Itbecameoneofthe
biggest,ifnotthebiggest,business.”
1oi
AsEricKolchinskv,aformerMoodv’smanag-
ingdirector,wouldsummarizethesituation,“theratingagenciesweregivenablank
check.”
1o:
Theagenciesthemselves wereabletoavoidregulationfordecades.Beginningin
1o¬-,theSEChadtoapproveacompanv’sapplicationtobecomeanNRSRO—butif
approved,acompanvfacednofurtherregulation.Morethan:ovearslater,theSEC
gotlimitedauthoritvtooverseeNRSROsintheCreditRatingAgencvReformActof
iooo. That law, taking effect in Iune ioo¬, focused on mandatorv disclosure of the
ratingagencies’methodologies;however,thelawbarredtheSECfromregulating“the
substanceofthecreditratingsortheproceduresandmethodologies.”
1oa
Manv investors, such as some pension funds and universitv endowments, relied
oncreditratingsbecausethevhadneitheraccesstothesamedataastheratingagen-
ciesnorthecapacitvoranalvticalabilitvtoassessthesecuritiesthevwerepurchasing.
As Moodv’s former managing director Ierome Fons has acknowledged, “Subprime
[residentialmortgage–backedsecurities]andtheiroffshootsofferlittletransparencv
aroundcompositionandcharacteristicsoftheloancollateral. . . .Loan-bv-loandata,
thehighestlevelofdetail,isgenerallvnotavailabletoinvestors.”
1o-
Others,evenlarge
1ui \ui1t\ti \\tui Ni ..+
fnancialinstitutions,reliedontheratings.Still,someinvestorswhodidtheirhome-
workwereskepticaloftheseproductsdespitetheirratings.ArnoldCattani,chairman
ofMissionBankinBakersfeld,California,describeddecidingtosellthebank’shold-
ingsofmortgage-backedsecuritiesandCDOs:
Atonemeeting,whenthingsstartedgettingdimcult,mavbeiniooo,I
askedtheCFOwhatthemechanicalstepswerein . . .mortgage-backed
securities,ifaborrowerinDesMoines,Iowa,defaulted.Iknowwhatit
is if a borrower in Bakersfeld defaults, and somebodv has that mort-
gage.Butasapackagesecuritv,whathappens:Andhecouldn’tanswer
thequestion.AndItoldhimtosellthem,sellallofthem,then,because
wedidn’tunderstandit,andIdon’tknowthatwehadthecapabilitvto
understandthefnancialcomplexities;didn’twantanvpartofit.
1oo
Notablv, rating agencies were not liable for misstatements in securities registra-
tions because courts ruled that their ratings were opinions, protected bv the First
Amendment. Moodv’s standard disclaimer reads “The ratings . . . are, and must be
construedsolelvas,statementsofopinionandnotstatementsoffactorrecommen-
dationstopurchase,sell,orholdanvsecurities.”GarvWitt,aformerteammanaging
directoratMoodv’s,toldtheFCIC,“Peopleexpecttoomuchfromratings . . .invest-
mentdecisionsshouldalwavsbebasedonmuchmorethanjustarating.”
1o¬
“Everything but the elephant sitting on the table”
Theratingswereintendedtoprovideameansofcomparingrisksacrossassetclasses
andtime.Inotherwords,theriskofatriple-Aratedmortgagesecuritvwassupposed
tobesimilartotheriskofatriple-Aratedcorporatebond.
Since the mid-1ooos, Moodv’s has rated tranches of mortgage-backed securities
usingthreemodels.Thefrst,developedin1ooo,ratedresidentialmortgage–backed
securities.Inioo:,Moodv’screatedanewmodel,M:Prime,torateprime,jumbo,
and Alt-A deals. Onlv in the fall of iooo, when the housing market had alreadv
peaked,diditdevelopitsmodelforratingsubprimedeals,calledM:Subprime.
1o8
Themodelsincorporatedfrm-andsecuritv-specifcfactors,marketfactors,regu-
latorv and legal factors, and macroeconomic trends. The M: Prime model let
Moodv’sautomatemoreoftheprocess.AlthoughMoodv’sdidnotsampleorreview
individual loans, the companv used loan-level information from the issuer. Relving
on loan-to-value ratios, borrower credit scores, originator qualitv, and loan terms
and other information, the model simulated the performance of each loan in 1,i-o
scenarios,includingvariationsininterestratesandstate-levelunemplovmentaswell
as home price changes. On average, across the scenarios, home prices trended up-
wardatapproximatelvaºpervear.
1oo
Themodelputlittleweightonthepossibilitv
priceswouldfallsharplvnationwide.IavSiegel,aformerMoodv’steammanagingdi-
rectorinvolvedindevelopingthemodel,toldtheFCIC,“Theremavhavebeen[state-
level]componentsofthisrealestatedropthatthestatisticswouldhavecovered,but
.z+ ii N\Nti \i tii :i : i Nuli i¥ tu\\i : :i uN iiiui1
the:8ºnationaldrop,stavingdownoverthisshortbutmultiple-vearperiod,ismore
stressfulthanthestatisticscallfor.”Evenashousingpricesrosetounprecedentedlev-
els,Moodv’sneveradjustedthescenariostoputgreaterweightonthepossibilitvofa
decline.AccordingtoSiegel,inioo-,“Moodv’spositionwasthattherewasnota . . .
nationalhousingbubble.”
11o
Whentheinitialquantitativeanalvsiswascomplete,theleadanalvstonthedeal
convenedaratingcommitteeofotheranalvstsandmanagerstoassessitanddeter-
mine the overall ratings for the securities.
111
Siegel told the FCIC that qualitative
analvsis was also integral: “One common misperception is that Moodv’s credit rat-
ingsarederivedsolelvfromtheapplicationofamathematicalprocessormodel.This
isnotthecase. . . .Thecreditratingprocessinvolvesmuchmore—mostimportantlv,
the exercise of independent judgment bv members of the rating committee. Ulti-
matelv,ratingsaresubjectiveopinionsthatrefectthemajoritvviewofthecommit-
tee’smembers.”
11i
AsRogerStein,aMoodv’smanagingdirector,noted,“Overall,the
modelhastocontemplateeventsforwhichthereisnodata.”
11:
Afterratingsubprimedealswiththe1ooomodelforvears,inioooMoodv’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.
11a
Moodv’s
omcialstoldtheFCICthevrecognizedthatstressscenarioswerenotsumcientlvse-
vere,sothevappliedadditionalweighttothemoststressfulscenario,whichreduced
the portion of each deal rated triple-A. Stein, who helped develop the subprime
model,saidtheoutputwasmanuallv“calibrated”tobemoreconservativetoensure
predicted losses were consistent with analvsts’ “expert views.” Stein also noted
Moodv’sconcernaboutasuitablvnegativestressscenario;forexample,asonestep,
analvststookthe“singleworstcase”fromtheM:Subprimemodelsimulationsand
multiplieditbvafactorinordertoadddeterioration.
11-
Moodv’sdidnot,however,sumcientlvaccountforthedeterioratingqualitvofthe
loansbeingsecuritized.FonsdescribedthisproblemtotheFCIC:“Isatonthishigh-
levelStructuredCreditcommittee,whichvou’dthinkwouldbedealingwithsuchis-
sues[ofdecliningmortgage-underwritingstandards],andneveroncewasitraisedto
thisgrouporputonouragendathatthedeclineinqualitvthatwasgoingintopools,
theimpactpossiblvonratings,otherthings. . . .Wetalkedaboutevervthingbut,vou
know,theelephantsittingonthetable.”
11o
TorateCMLTIiooo-NCi,oursampledeal,Moodv’sfrstuseditsmodeltosimu-
latelossesinthemortgagepool.Thoseestimates,inturn,determinedhowbigthejun-
iortranchesofthedealwouldhavetobeinordertoprotecttheseniortranchesfrom
losses.Inanalvzingthedeal,theleadanalvstnoteditwassimilartoanotherCitigroup
dealofNewCenturvloansthatMoodv’shadratedearlierandrecommendedthesame
amount.
11¬
Thenthedealwastweakedtoaccountforcertainriskiertvpesofloans,in-
cluding interest-onlv mortgages.
118
For its efforts, Moodv’s was paid an estimated
·io8,ooo.
11o
(S&Palsoratedthisdealandreceived·1:-,ooo.)
1io
As we will describe later, three tranches of this deal would be downgraded less
thanavearafterissuance—partofMoodv’smassdowngradeonIulv1o,ioo¬,when
housing prices had declined bv onlv aº. In October ioo¬, the Ma–M11 tranches
1ui \ui1t\ti \\tui Ni .z.
weredowngradedandbvioo8,allthetrancheshadbeendowngraded.Ofallmort-
gage-backed securities it had rated triple-A in iooo, Moodv’s downgraded ¬:º to
junk.
1i1
Theconsequenceswouldreverberatethroughoutthefnancialsvstem.
FANNIE MAE AND FREDDIE MAC:
“LESS COMPETITIVE IN THE MARKETPLACE”
Iniooa,FannieandFreddiefacedproblemsonmultiplefronts.Thevhadviolatedac-
countingrulesandnowfacedcorrectionsandfnes.
1ii
Thevwerelosingmarketshare
to Wall Street, which was beginning to dominate the securitization market. Strug-
gling to remain dominant, thev loosened their underwriting standards, purchasing
andguaranteeingriskierloans,andincreasingtheirsecuritiespurchases.
1i:
Yettheir
regulator, the Omce of Federal Housing Enterprise Oversight (OFHEO), focused
moreonaccountingandotheroperationalissuesthanonFannie’sandFreddie’sin-
creasinginvestmentsinriskvmortgagesandsecurities.
Iniooi,Freddiechangedaccountingfrms.ThecompanvhadbeenusingArthur
Andersenformanvvears,butwhenAndersengotintotroubleintheEnrondebacle
(which put both Enron and its accountant out of business), Freddie switched to
PricewaterhouseCoopers.Thenewaccountantfoundthecompanvhadunderstated
itsearningsbv·-billionfromiooothroughthethirdquarterofiooi,inaneffortto
smooth reported earnings and promote itself as “Steadv Freddie,” a companv of
strongandsteadvgrowth.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.
1ia
In December ioo:,
FreddieagreedwithOFHEOtopava·1i-millionpenaltvandcorrectgovernance,
internal controls, accounting, and risk management. In Ianuarv iooa, OFHEO di-
rectedFreddietomaintain:oºmorethanitsminimumcapitalrequirementuntilit
reduced operational risk and could produce timelv, certifed fnancial statements.
FreddieMacwouldsettleshareholderlawsuitsfor·a1omillionandpav·-omillion
inpenaltiestotheSEC.
Fanniewasnext.InSeptemberiooa,OFHEOdiscoveredviolationsofaccounting
rulesthatcalledintoquestionpreviousflings.Iniooo,OFHEOreportedthatFannie
hadoverstatedearningsfrom1oo8throughiooibv·11billionandthatit,too,had
manipulatedaccountinginwavsinfuencedbvcompensationplans.
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-iooa.FanniesettledSECandOFHEOenforcementactionsfor
·aoo 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 probablv led to us being less aggressive or less competitive in the market-
place[than]weotherwisemighthavebeen.”
1io
.zz ii N\Nti \i tii :i : i Nuli i¥ tu\\i : :i uN iiiui1
As the scandals unfolded, subprime private label mortgage–backed securities
(PLS)issuedbvWallStreetincreasedfrom·8¬billioninioo1to·ao-billioninioo-
(showninfgure¬.:);thevalueofAlt-Amortgage–backedsecuritiesincreasedfrom
·11 billion to ·::i billion. Starting in ioo1 for Freddie and iooi for Fannie, the
GSEs—particularlvFreddie—becamebuversinthismarket.Whileprivateinvestors
alwavs bought the most, the GSEs purchased 1o.-º of the private-issued subprime
mortgage–backedsecuritiesinioo1.Thesharepeakedataoºiniooaandthenfell
back to i8º in ioo8. The share for Alt-A mortgage–backed securities was alwavs
lower.
1i¬
The GSEs almost alwavs 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—disproportionatelv from their purchases of Alt-A securities. Bv
the third quarter of io1o, total impairments on securities totaled ·ao billion at the
twocompanies—enoughtowipeoutnearlvooºoftheirpre-crisiscapital.
1i8
OFHEO knew about the GSEs’ purchases of subprime and Alt-A mortgage–
backedsecurities.Initsiooaexamination,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 alreadv seeing abuses with these
loans.
1io
Buttheregulatorconcludedthatthepurchasesofmortgage-backedsecuri-
tiesandriskiermortgageswerenota“signifcantsupervisorvconcern,”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
deemedsatisfactorv.
1:1
ThereasonsfortheGSEs’purchasesofsubprimeandAlt-Amortgage–backedse-
curities have been debated. Some observers, including Alan Greenspan, have linked
theGSEs’purchasesofprivatemortgage–backedsecuritiestotheirpushtofulflltheir
highergoalsforaffordablehousing.TheformerFedchairmanwroteinaworkingpa-
persubmittedaspartofhistestimonvtotheFCICthatwhentheGSEswerepressedto
“expand ‘affordable housing commitments,’ thev chose to meet them bv investing
heavilv in subprime securities.”
1:i
Using data provided bv Fannie Mae and Freddie
Mac, the FCIC examined how single-familv, multifamilv, and securities purchases
contributedtomeetingtheaffordablehousinggoals.Inioo:andiooa,FannieMae’s
single-andmultifamilvpurchasesalonemeteachofthegoals;inotherwords,theen-
terprisewouldhavemetitsobligationswithoutbuvingsubprimeorAlt-Amortgage–
backedsecurities.Infact,noneofFannieMae’siooapurchasesofsubprimeorAlt-A
securitieswereeversubmittedtoHUDtobecountedtowardthegoals.
Beforeioo-,-oºorlessoftheGSEs’loanpurchaseshadtosatisfvtheaffordable
housing goals. In ioo- the goals were increased above -oº; but even then, single-
andmultifamilvpurchasesalonemettheoverallgoals.
1::
Securitiespurchasesdid,in
1ui \ui1t\ti \\tui Ni .z.
.z. ii N\Nti \i tii :i : i Nuli 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-agencvmort-
gage–backedsecurities.
1:a
EstimatesbvtheFCICshowthatfromioo:throughiooo,
FreddiewouldhavemettheaffordablehousinggoalswithoutanvpurchasesofAlt-A
orsubprimesecurities,butusedthesecuritiestohelpmeetsubgoals.
1:-
RobertLevin,theformerchiefbusinessomcerofFannieMae,toldtheFCICthat
buving private-label mortgage–backed securities “was a monevmaking activitv—it
wasallpositiveeconomics. . . .[T]herewasnotrade-off[betweenmakingmonevand
hitting goals], it was a verv broad-brushed effort” that could be characterized as
“win-win-win: monev, goals, and share.”
1:o
Mark Winer, the head of Fannie’s Busi-
ness,Analvsis,andDecisionsGroup,statedthatthepurchaseoftriple-Atranchesof
mortgage-backed securities backed bv subprime loans was viewed as an attractive
opportunitvwithgoodreturns.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
Figure .
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-
allvextendedtolower-incomeborrowers,andtheregulationsprohibitedmortgages
toborrowerswithunstatedincomelevels—ahallmarkofAlt-Aloans—fromcount-
ingtowardaffordabilitvgoals.
1:8
LevintoldtheFCICthatthevbelievedthatthepur-
chaseofAlt-Asecurities“didnothaveanetpositiveeffectonFannieMae’shousing
goals.”
1:o
Instead,thevhadtobeoffsetwithmoremortgagesforlow-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,andAmericantaxpavers.
COMMISSION CONCLUSIONS ON CHAPTER 7
The Commission concludes that the monetarv policv of the Federal Reserve,
alongwithcapitalfowsfromabroad,createdconditionsinwhichahousingbub-
ble could develop. However, these conditions need not have led to a crisis. The
FederalReserveandotherregulatorsdidnottakeactionsnecessarvtoconstrain
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-
bilitv and responsibilitv throughout each level of the lending svstem. 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-
gardlessofabilitvtopav.
The nonprime mortgage securitization process created a pipeline through
whichriskvmortgageswereconvevedandsoldthroughoutthefnancialsvstem.
Thispipelinewasessentialtotheoriginationoftheburgeoningnumbersofhigh-
riskmortgages.Theoriginate-to-distributemodelunderminedresponsibilitvand
accountabilitvforthelong-termviabilitvofmortgagesandmortgage-relatedse-
curitiesandcontributedtothepoorqualitvofmortgageloans.
(continues)
.z( ii N\Nti \i tii :i : i Nuli i¥ tu\\i : :i uN iiiui1
Federalandstaterulesrequiredorencouragedfnancialfrmsandsomeinsti-
tutionalinvestorstomakeinvestmentsbasedontheratingsofcreditratingagen-
cies, leading to undue reliance on those ratings. However, the rating agencies
werenotadequatelvregulatedbvtheSecuritiesandExchangeCommissionoranv
otherregulatortoensurethequalitvandaccuracvoftheirratings.Moodv’s,the
Commission’scasestudvinthisarea,reliedonfawedandoutdatedmodelstois-
sueerroneousratingsonmortgage-relatedsecurities,failedtoperformmeaning-
fulduediligenceontheassetsunderlvingthesecurities,andcontinuedtorelvon
thosemodelsevenafteritbecameobviousthatthemodelswerewrong.
Not onlv did the federal banking supervisors fail to rein in riskv mortgage-
lendingpractices,buttheOmceoftheComptrolleroftheCurrencvandtheOf-
fceofThriftSupervisionpreemptedtheapplicabilitvofstatelawsandregulatorv
effortstonationalbanksandthrifts,thuspreventingadequateprotectionforbor-
rowersandweakeningconstraintsonthissegmentofthemortgagemarket.
(continued)

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