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THE
FINANCIAL
CRISIS
INQUIRY REPORT
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• OFFICIAL GOVERNMENT EDITION •
OFFICIAL
GOVERNMENT
EDITION
Final Report of the National Commission
on the Causes of the Financial and
Economic Crisis in the United States
I SBN 978-0-16-087727-8
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FINAL REPORT OF THE NATIONAL COMMISSION
ON THE CAUSES OF THE FINANCIAL AND
ECONOMIC CRISIS IN THE UNITED STATES
OFFICIAL GOVERNMENT EDITION
THE FINANCIAL CRISIS INQUIRY COMMISSION
Submitted by
Pursuant to Public Law 111-21
January 2011
e c i f f O g n i t n i r P t n e m n r e v o G . S . U , s t n e m u c o D f o t n e d n e t n i r e p u S e h t y b e l a s r o F
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n o t g n i h s a W , C C D I p o t S : l i a M 4 0 1 2 - 2 1 5 ) 2 0 2 ( : x a F 1 0 0 0 - 2 0 4 0 2 C D ,
I SBN 978-0-16-087727-8
CONTENTS
Ccnnissicncrs vii
CcnnissicncrVctcsviii
CcnnissicnStajjIist ix
Ircjacc xi
CONCLUSI ONS OF THE
FI NANCIAL CRI SI S I NQUI RY COMMI SSI ON.....................xv
PART I : CRI SI S ON THE HORI ZON
Chaptcr) Before Our Verv Fves .........................................................................:
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): Farlv :oo;. Spreading Subprime Worries.................................:::
Chaptcr): Summer :oo;. Disruptions in Funding....................................:¡o
Chaptcr); Iate :oo; to Farlv :oo8. Billions in Subprime Iosses ...........:,o
Chaptcr)· March :oo8. The Fall of Bear Stearns........................................:8o
Chaptcr)e March to August :oo8. Svstemic Risk Concerns....................:,:
Chaptcr)¬ September :oo8.
The Takeover of Fannie Mae and Freddie Mac..................:o,
Chaptcr): September :oo8. The Bankruptcv 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
Bv Keith Hennessev, Douglas Holtz-Fakin, and Bill Thomas ........................¡++
Bv Peter l. Wallison....................................................................................................¡¡+
AppcndixAG|cssarv
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
HilarvI.Allen
IonathanE.Armstrong
RobBachmann
BartonBaker
SusanBaltake
BradlevI.Bondi
SvlviaBoone
TomBorgers
RonBorzekowski
MikeBrvan
RvanBubb
TrovA.Burrus
R.RichardCheng
IenniferVaughnCollins
MatthewCooper
AlbertoCrego
VictorI.Cunicelli
IobeG.Danganan
SamDavidson
ElizabethA.DelReal
KirstinDownev
KarenDubas
DesiDuncker
BartlvA.Dzivi
MichaelE.Easterlv
AliceFalk
MeganL.Fasules
MichaelFlagg
SeanI.Flvnn,Ir.
ScottC.Ganz
ThomasGreene
MarvannHaggertv
RobertC.Hinklev
AnthonvC.Ingoglia
BenIacobs
PeterAdrianKavounas
MichaelKeegan
ThomasI.Keegan
BrookL.Kellerman
SarahKnaus
ThomasL.Krebs
IavN.Lerner
IaneE.Lewin
SusanMandel
IulieA.Marcacci
AlexanderMaasrv
CourtnevMavo
CarlMcCarden
BruceG.McWilliams
MenjieL.Medina
IoelMiller
StevenL.Mintz
ClaraMorain
GirijaNatarajan
GretchenKinnevNewsom
DixieNoonan
DonnaK.Norman
AdamM.Paul
IaneD.Poulin
AndrewC.Robinson
SteveSanderford
RvanThomasSchulte
LorrettoI.Scott
SkipperSeabold
KimLeslieShafer
GordonShemin
StuartC.P.Shroff
AlexisSimendinger
MinaSimhai
IeffrevSmith
ThomasH.Stanton
LandonW.Stroebel
BrianP.Svlvester
ShirlevTang
FereshtehZ.Vahdati
AntonioA.VargasCornejo
MelanaZvlaVickers
GeorgeWahl
TuckerWarren
CassidvD.Waskowicz
ArthurE.Wilmarth,Ir.
SarahZuckerman
ix
COMMISSION STAFF
WendvEdelberg, Executive Director
GarvI.Cohen, General Counsel
ChrisSeefer,Director of Investigations
GregFeldberg,Director of Research
PREFACE
TheFinancialCrisisInquirvCommissionwascreatedto“examinethecausesofthe
currentfnancialandeconomiccrisisintheUnitedStates.”Inthisreport,theCom-
missionpresentstothePresident,theCongress,andtheAmericanpeopletheresults
ofitsexaminationanditsconclusionsastothecausesofthecrisis.
Morethantwovearsaftertheworstofthefnancialcrisis,oureconomv,aswellas
communities and families across the countrv, continues to experience the after-
shocks.MillionsofAmericanshavelosttheirjobsandtheirhomes,andtheeconomv
isstillstrugglingtorebound.Thisreportisintendedtoprovideahistoricalaccount-
ingofwhatbroughtourfnancialsvstemandeconomvtoaprecipiceandtohelppol-
icvmakersandthepublicbetterunderstandhowthiscalamitvcametobe.
TheCommissionwasestablishedaspartoftheFraudEnforcementandRecoverv
Act (Public Law 111-i1) passed bv Congress and signed bv the President in Mav
iooo.Thisindependent,1o-memberpanelwascomposedofprivatecitizenswithex-
perience in areas such as housing, economics, fnance, market regulation, banking,
and consumer protection. Six members of the Commission were appointed bv the
DemocraticleadershipofCongressandfourmembersbvtheRepublicanleadership.
TheCommission’sstatutorvinstructionssetoutiispecifctopicsforinquirvand
calledfortheexaminationofthecollapseofmajorfnancialinstitutionsthatfailedor
wouldhavefailedifnotforexceptionalassistancefromthegovernment.Thisreport
fulfllsthesemandates.Inaddition,theCommissionwasinstructedtorefertotheat-
tornev general of the United States and anv appropriate state attornev general anv
personthattheCommissionfoundmavhaveviolatedthelawsoftheUnitedStatesin
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-
thoritv it was given to issue subpoenas to compel testimonv and the production of
documents,butinthevastmajoritvofinstances,companiesandindividualsvolun-
tarilvcooperatedwiththisinquirv.
Inthecourseofitsresearchandinvestigation,theCommissionreviewedmillions
of pages of documents, interviewed more than ¬oo witnesses, and held 1o davs of
publichearingsinNewYork,Washington,D.C.,andcommunitiesacrossthecountrv
xi
thatwerehardhitbvthecrisis.TheCommissionalsodrewfromalargebodvofex-
isting work about the crisis developed bv congressional committees, government
agencies,academics,journalists,legalinvestigators,andmanvothers.
We have tried in this report to explain in clear, understandable terms how our
complexfnancialsvstemworked,howthepiecesfttogether,andhowthecrisisoc-
curred.Doingsorequiredresearchintobroadandsometimesarcanesubjects,such
as mortgage lending and securitization, derivatives, corporate governance, and risk
management.Tobringthesesubjectsoutoftherealmoftheabstract,weconducted
casestudvinvestigationsofspecifcfnancialfrms—andinmanvcasesspecifcfacets
oftheseinstitutions—thatplavedpivotalroles.ThoseinstitutionsincludedAmerican
InternationalGroup(AIG),BearStearns,Citigroup,CountrvwideFinancial,Fannie
Mae,GoldmanSachs,LehmanBrothers,MerrillLvnch,Moodv’s,andWachovia.We
lookedmoregenerallvattherolesandactionsofscoresofothercompanies.
We also studied relevant policies put in place bv successive Congresses and ad-
ministrations.Andimportantlv,weexaminedtherolesofpolicvmakersandregula-
tors, including at the Federal Deposit Insurance Corporation, the Federal Reserve
Board,theFederalReserveBankofNewYork,theDepartmentofHousingandUr-
banDevelopment,theOmceoftheComptrolleroftheCurrencv,theOmceofFed-
eral Housing Enterprise Oversight (and its successor, the Federal Housing Finance
Agencv),theOmceofThriftSupervision,theSecuritiesandExchangeCommission,
andtheTreasurvDepartment.
Ofcourse,thereismuchworktheCommissiondidnotundertake.Congressdid
not ask the Commission to offer policv recommendations, but required it to delve
intowhatcausedthecrisis.Inthatsense,theCommissionhasfunctionedsomewhat
liketheNationalTransportationSafetvBoard,whichinvestigatesaviationandother
transportationaccidentssothatknowledgeoftheprobablecausescanhelpavoidfu-
tureaccidents.Norwerewetaskedwithevaluatingthefederallaw(theTroubledAs-
set Relief Program, known as TARP) that provided fnancial assistance to major
fnancial institutions. That dutv was assigned to the Congressional Oversight Panel
andtheSpecialInspectorGeneralforTARP.
This report is not the sole repositorv of what the panel found. A website—
www.fcic.gov—willhostawealthofinformationbevondwhatcouldbepresentedhere.
Itwillcontainastockpileofmaterials—includingdocumentsandemails,videoofthe
Commission’spublichearings,testimonv,andsupportingresearch—thatcanbestud-
ied for vears to come. Much of what is footnoted in this report can be found on the
website.Inaddition,morematerialsthatcannotbereleasedvetforvariousreasonswill
eventuallvbemadepublicthroughtheNationalArchivesandRecordsAdministration.
Our work refects the extraordinarv commitment and knowledge of the mem-
bersoftheCommissionwhowereaccordedthehonorofthispublicservice.Wealso
benefted immenselv from the perspectives shared with commissioners bv thou-
sandsofconcernedAmericansthroughtheirlettersandemails.Andwearegrateful
to the hundreds of individuals and organizations that offered expertise, informa-
tion,andpersonalaccountsinextensiveinterviews,testimonv,anddiscussionswith
theCommission.
xii iiii\ti
WewanttothanktheCommissionstaff,andinparticular,WendvEdelberg,our
executive director, for the professionalism, passion, and long hours thev brought to
this mission in service of their countrv. This report would not have been possible
withouttheirextraordinarvdedication.
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
TheFinancialCrisisInquirvCommissionhasbeencalledupontoexaminethefnan-
cial and economic crisis that has gripped our countrv and explain its causes to the
American people. We are keenlv aware of the signifcance of our charge, given the
economicdamagethatAmericahassufferedinthewakeofthegreatestfnancialcri-
sissincetheGreatDepression.
Ourtaskwasfrsttodeterminewhathappenedandhowithappenedsothatwe
couldunderstandwhvithappened.Herewepresentourconclusions.Weencourage
the American people to join us in making their own assessments based on the evi-
dencegatheredinourinquirv.Ifwedonotlearnfromhistorv,weareunlikelvtofullv
recoverfromit.SomeonWallStreetandinWashingtonwithastakeinthestatusquo
mavbetemptedtowipefrommemorvtheeventsofthiscrisis,ortosuggestthatno
one could have foreseen or prevented them. This report endeavors to expose the
facts, identifv responsibilitv, unravel mvths, and help us understand how the crisis
couldhavebeenavoided.Itisanattempttorecordhistorv,nottorewriteit,norallow
ittoberewritten.
Tohelpourfellowcitizensbetterunderstandthiscrisisanditscauses,wealsopres-
entspecifcconclusionsattheendofchaptersinPartsIII,IV,andVofthisreport.
Thesubjectofthisreportisofnosmallconsequencetothisnation.Theprofound
eventsofioo¬andioo8wereneitherbumpsintheroadnoranaccentuateddipin
thefnancialandbusinesscvcleswehavecometoexpectinafreemarketeconomic
svstem. This was a fundamental disruption—a fnancial upheaval, if vou will—that
wreakedhavocincommunitiesandneighborhoodsacrossthiscountrv.
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 seriouslv behind on their
mortgage pavments. Nearlv ·11 trillion in household wealth has vanished, with re-
tirementaccountsandlifesavingssweptawav.Businesses,largeandsmall,havefelt
xv
thestingofadeeprecession.Thereismuchangeraboutwhathastranspired,andjus-
tifablvso.Manvpeoplewhoabidedbvalltherulesnowfndthemselvesoutofwork
and uncertain about their future prospects. The collateral damage of this crisis has
beenrealpeopleandrealcommunities.Theimpactsofthiscrisisarelikelvtobefelt
forageneration.Andthenationfacesnoeasvpathtorenewedeconomicstrength.
LikesomanvAmericans,webeganourexplorationwithourownviewsandsome
preliminarvknowledgeabouthowtheworld’sstrongestfnancialsvstemcametothe
brink of collapse. Even at the time of our appointment to this independent panel,
much had alreadv been written and said about the crisis. Yet all of us have been
deeplvaffectedbvwhatwehavelearnedinthecourseofourinquirv.Wehavebeenat
various times fascinated, surprised, and even shocked bv what we saw, heard, and
read.Ourshasbeenajournevofrevelation.
Muchattentionoverthepasttwovearshasbeenfocusedonthedecisionsbvthe
federal government to provide massive fnancial assistance to stabilize the fnancial
svstemandrescuelargefnancialinstitutionsthatweredeemedtoosvstemicallvim-
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 svstem
and economv or inject trillions of taxpaver dollars into the fnancial svstem and an
arrav of companies, as millions of Americans still lost their jobs, their savings, and
theirhomes:
Inthisreport,wedetailtheeventsofthecrisis.Butasimplesummarv,aswesee
it,isusefulattheoutset.Whilethevulnerabilitiesthatcreatedthepotentialforcri-
siswerevearsinthemaking,itwasthecollapseofthehousingbubble—fueledbv
lowinterestrates,easvandavailablecredit,scantregulation,andtoxicmortgages—
thatwasthesparkthatignitedastringofevents,whichledtoafull-blowncrisisin
the fall of ioo8. Trillions of dollars in riskv mortgages had become embedded
throughout the financial svstem, 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
thosemortgagesandhadborrowedheavilvagainstthem.Thishappenednotjustin
the United States but around the world. The losses were magnified bv derivatives
suchassvntheticsecurities.
The crisis reached seismic proportions in September ioo8 with the failure of
LehmanBrothersandtheimpendingcollapseoftheinsurancegiantAmericanInterna-
tionalGroup(AIG).Panicfannedbvalackoftransparencvofthebalancesheetsofma-
jorfnancialinstitutions,coupledwithatangleofinterconnectionsamonginstitutions
perceivedtobe“toobigtofail,”causedthecreditmarketstoseizeup.Tradingground
toahalt.Thestockmarketplummeted.Theeconomvplungedintoadeeprecession.
Thefnancialsvstemweexaminedbearslittleresemblancetothatofourparents’
generation.Thechangesinthepastthreedecadesalonehavebeenremarkable.The
xvi ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN iiiui1
fnancialmarketshavebecomeincreasinglvglobalized.Technologvhastransformed
theemciencv,speed,andcomplexitvoffnancialinstrumentsandtransactions.There
isbroaderaccesstoandlowercostsoffnancingthaneverbefore.Andthefnancial
sectoritselfhasbecomeamuchmoredominantforceinoureconomv.
From1o¬8toioo¬,theamountofdebtheldbvthefnancialsectorsoaredfrom
·:trillionto·:otrillion,morethandoublingasashareofgrossdomesticproduct.
The verv nature of manv Wall Street frms changed—from relativelv staid private
partnershipstopubliclvtradedcorporationstakinggreaterandmorediversekindsof
risks.Bvioo-,the1olargestU.S.commercialbanksheld--ºoftheindustrv’sassets,
more than double the level held in 1ooo. On the eve of the crisis in iooo, fnancial
sector profts constituted i¼ of all corporate profts in the United States, up from
1-º in 1o8o. Understanding this transformation has been critical to the Commis-
sion’sanalvsis.
Now to our major fndings and conclusions, which are based on the facts con-
tained in this report: thev are offered with the hope that lessons mav be learned to
helpavoidfuturecatastrophe.
• We conclude this fnancial crisis was avoidable. Thecrisiswastheresultofhuman
action and inaction, not of Mother Nature or computer models gone havwire. The
captainsoffnanceandthepublicstewardsofourfnancialsvstemignoredwarnings
andfailedtoquestion,understand,andmanageevolvingriskswithinasvstemessen-
tial to the well-being of the American public. Theirs was a big miss, not a stumble.
Whilethebusinesscvclecannotberepealed,acrisisofthismagnitudeneednothave
occurred.ToparaphraseShakespeare,thefaultliesnotinthestars,butinus.
Despite the expressed view of manv on Wall Street and in Washington that the
crisiscouldnothavebeenforeseenoravoided,therewerewarningsigns.Thetragedv
wasthatthevwereignoredordiscounted.Therewasanexplosioninriskvsubprime
lending and securitization, an unsustainable rise in housing prices, widespread re-
portsofegregiousandpredatorvlendingpractices,dramaticincreasesinhousehold
mortgagedebt,andexponentialgrowthinfnancialfrms’tradingactivities,unregu-
lated derivatives, and short-term “repo” lending markets, among manv other red
fags. Yet there was pervasive permissiveness; little meaningful action was taken to
quellthethreatsinatimelvmanner.
TheprimeexampleistheFederalReserve’spivotalfailuretostemthefowoftoxic
mortgages,whichitcouldhavedonebvsettingprudentmortgage-lendingstandards.
The Federal Reserve was the one entitv empowered to do so and it did not. The
recordofourexaminationisrepletewithevidenceofotherfailures:fnancialinstitu-
tionsmade,bought,andsoldmortgagesecuritiesthevneverexamined,didnotcare
toexamine,orknewtobedefective;frmsdependedontensofbillionsofdollarsof
borrowingthathadtoberenewedeachandevervnight,securedbvsubprimemort-
gagesecurities;andmajorfrmsandinvestorsblindlvreliedoncreditratingagencies
astheirarbitersofrisk.Whatelsecouldoneexpectonahighwavwheretherewere
neitherspeedlimitsnorneatlvpaintedlines:
tuNtiU:i uN: ui 1ui ii N\Nti \i tii :i : i NuUi 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,innosmallpartduetothewidelvacceptedfaithintheself-
correctingnatureofthemarketsandtheabilitvoffnancialinstitutionstoeffectivelv
policethemselves.Morethan30vearsofderegulationandrelianceonself-regulation
bv fnancial institutions, championed bv former Federal Reserve chairman Alan
Greenspanandothers,supportedbvsuccessiveadministrationsandCongresses,and
activelvpushedbvthepowerfulfnancialindustrvatevervturn,hadstrippedawav
kev safeguards, which could have helped avoid catastrophe. This approach had
openedupgapsinoversightofcriticalareaswithtrillionsofdollarsatrisk,suchas
the shadow banking svstem and over-the-counter derivatives markets. In addition,
the government permitted fnancial frms to pick their preferred regulators in what
becamearacetotheweakestsupervisor.
Yetwedonotaccepttheviewthatregulatorslackedthepowertoprotectthef-
nancialsvstem.Thevhadamplepowerinmanvarenasandthevchosenottouseit.
Togivejustthreeexamples:theSecuritiesandExchangeCommissioncouldhavere-
quiredmorecapitalandhaltedriskvpracticesatthebiginvestmentbanks.Itdidnot.
The Federal Reserve Bank of New York and other regulators could have clamped
downonCitigroup’sexcessesintherun-uptothecrisis.Thevdidnot.Policvmakers
andregulatorscouldhavestoppedtherunawavmortgagesecuritizationtrain.Thev
didnot.Incaseaftercaseaftercase,regulatorscontinuedtoratetheinstitutionsthev
oversawassafeandsoundeveninthefaceofmountingtroubles,oftendowngrading
them just before their collapse. And where regulators lacked authoritv, thev could
havesoughtit.Toooften,thevlackedthepoliticalwill—inapoliticalandideological
environment that constrained it—as well as the fortitude to criticallv challenge the
institutionsandtheentiresvstemthevwereentrustedtooversee.
Changesintheregulatorvsvstemoccurredinmanvinstancesasfnancialmar-
kets evolved. But as the report will show, the fnancial industrv itself plaved a kev
role in weakening regulatorv constraints on institutions, markets, and products. It
didnotsurprisetheCommissionthatanindustrvofsuchwealthandpowerwould
exert pressure on policv makers and regulators. From 1ooo to ioo8, the fnancial
sectorexpended·i.¬billioninreportedfederallobbvingexpenses;individualsand
political action committees in the sector made more than ·1 billion in campaign
contributions.Whattroubleduswastheextenttowhichthenationwasdeprivedof
the necessarv strength and independence of the oversight necessarv to safeguard
fnancialstabilitv.
• 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 steadv regulatorv
hand, which, the frms argued, would stife innovation. Too manv of these institu-
tions acted recklesslv, taking on too much risk, with too little capital, and with too
much dependence on short-term funding. In manv respects, this refected a funda-
xviii ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN iiiui1
mentalchangeintheseinstitutions,particularlvthelargeinvestmentbanksandbank
holdingcompanies,whichfocusedtheiractivitiesincreasinglvonriskvtradingactiv-
itiesthatproducedheftvprofts.Thevtookonenormousexposuresinacquiringand
supporting subprime lenders and creating, packaging, repackaging, and selling tril-
lionsofdollarsinmortgage-relatedsecurities,includingsvntheticfnancialproducts.
LikeIcarus,thevneverfearedfvingeverclosertothesun.
Manvoftheseinstitutionsgrewaggressivelvthroughpoorlvexecutedacquisition
and integration strategies that made effective management more challenging. The
CEO of Citigroup told the Commission that a ·ao billion position in highlv rated
mortgage securities would “not in anv wav have excited mv attention,” and the co-
headofCitigroup’sinvestmentbanksaidhespent“asmallfractionof1º”ofhistime
onthosesecurities.Inthisinstance,toobigtofailmeanttoobigtomanage.
Financial institutions and credit rating agencies embraced mathematical models
asreliablepredictorsofrisks,replacingjudgmentintoomanvinstances.Toooften,
riskmanagementbecameriskjustifcation.
Compensation svstems—designed in an environment of cheap monev, intense
competition,andlightregulation—toooftenrewardedthequickdeal,theshort-term
gain—withoutproperconsiderationoflong-termconsequences.Often,thosesvstems
encouragedthebigbet—wherethepavoffontheupsidecouldbehugeandthedown-
sidelimited.Thiswasthecaseupanddowntheline—fromthecorporateboardroom
tothemortgagebrokeronthestreet.
Ourexaminationrevealedstunninginstancesofgovernancebreakdownsandirre-
sponsibilitv.Youwillread,amongotherthings,aboutAIGseniormanagement’signo-
rance of the terms and risks of the companv’s ·¬o billion derivatives exposure to
mortgage-related securities; Fannie Mae’s quest for bigger market share, profts, and
bonuses,whichledittorampupitsexposuretoriskvloansandsecuritiesasthehous-
ing market was peaking; and the costlv surprise when Merrill Lvnch’s top manage-
ment realized that the companv held ·-- billion in “super-senior” and supposedlv
“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. Clearlv,
thisvulnerabilitvwasrelatedtofailuresofcorporategovernanceandregulation,but
itissignifcantenoughbvitselftowarrantourattentionhere.
Inthevearsleadinguptothecrisis,toomanvfnancialinstitutions,aswellastoo
manvhouseholds,borrowedtothehilt,leavingthemvulnerabletofnancialdistress
orruinifthevalueoftheirinvestmentsdeclinedevenmodestlv.Forexample,asof
ioo¬, the fve major investment banks—Bear Stearns, Goldman Sachs, Lehman
Brothers, Merrill Lvnch, and Morgan Stanlev—were operating with extraordinarilv
thincapital.Bvonemeasure,theirleverageratioswereashighasaoto1,meaningfor
everv·aoinassets,therewasonlv·1incapitaltocoverlosses.Lessthana:ºdropin
assetvaluescouldwipeoutafrm.Tomakemattersworse,muchoftheirborrowing
wasshort-term,intheovernightmarket—meaningtheborrowinghadtoberenewed
eachandevervdav.Forexample,attheendofioo¬,BearStearnshad·11.8billionin
tuNtiU:i uN: ui 1ui ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN xix
equitvand·:8:.obillioninliabilitiesandwasborrowingasmuchas·¬obillionin
theovernightmarket.Itwastheequivalentofasmallbusinesswith·-o,oooinequitv
borrowing ·1.o million, with ·ioo,¬-o of that due each and everv dav. One can’t
reallv ask “What were thev thinking:” when it seems that too manv of them were
thinkingalike.
Andtheleveragewasoftenhidden—inderivativespositions,inoff-balance-sheet
entities,andthrough“windowdressing”offnancialreportsavailabletotheinvesting
public.
ThekingsofleveragewereFannieMaeandFreddieMac,thetwobehemothgov-
ernment-sponsored enterprises (GSEs). For example, bv the end of ioo¬, Fannie’s
andFreddie’scombinedleverageratio,includingloansthevownedandguaranteed,
stoodat¬-to1.
Butfnancialfrmswerenotaloneintheborrowingspree:fromioo1toioo¬,na-
tionalmortgagedebtalmostdoubled,andtheamountofmortgagedebtperhouse-
hold rose more than o:º from ·o1,-oo to ·1ao,-oo, even while wages were
essentiallv stagnant. When the housing downturn hit, heavilv indebted fnancial
frmsandfamiliesalikewerewalloped.
The heavv debt taken on bv some fnancial institutions was exacerbated bv the
riskvassetsthevwereacquiringwiththatdebt.Asthemortgageandrealestatemar-
ketschurnedoutriskierandriskierloansandsecurities,manvfnancialinstitutions
loadeduponthem.Bvtheendofioo¬,Lehmanhadamassed·111billionincom-
mercial and residential real estate holdings and securities, which was almost twice
what it held just two vears before, and more than four times its total equitv. And
again,theriskwasn’tbeingtakenonjustbvthebigfnancialfrms,butbvfamilies,
too.Nearlvonein1omortgageborrowersinioo-andioootookout“optionARM”
loans,whichmeantthevcouldchoosetomakepavmentssolowthattheirmortgage
balancesroseevervmonth.
Within the fnancial svstem, the dangers of this debt were magnifed because
transparencvwasnotrequiredordesired.Massive,short-termborrowing,combined
withobligationsunseenbvothersinthemarket,heightenedthechancesthesvstem
couldrapidlvunravel.Intheearlvpartoftheiothcenturv,weerectedaseriesofpro-
tections—theFederalReserveasalenderoflastresort,federaldepositinsurance,am-
pleregulations—toprovideabulwarkagainstthepanicsthathadregularlvplagued
America’s banking svstem in the 1oth centurv. Yet, over the past :o-plus vears, we
permitted the growth of a shadow banking svstem—opaque and laden with short-
termdebt—thatrivaledthesizeofthetraditionalbankingsvstem.Kevcomponents
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-centurvfnancialsvstemwith1oth-centurvsafeguards.
When the housing and mortgage markets cratered, the lack of transparencv, the
extraordinarvdebtloads,theshort-termloans,andtheriskvassetsallcamehometo
roost.Whatresultedwaspanic.Wehadreapedwhatwehadsown.
xx ii N\Nti \i tii :i : i NuUi 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
anvofthoseresponsescontributedtoorexacerbatedthecrisis.
As our report shows, kev policv makers—the Treasurv 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. Thev were hampered because thev did
nothaveacleargraspofthefnancialsvstemthevwerechargedwithoverseeing,par-
ticularlvasithadevolvedinthevearsleadinguptothecrisis.Thiswasinnosmall
measureduetothelackoftransparencvinkevmarkets.Thevthoughtriskhadbeen
diversifedwhen,infact,ithadbeenconcentrated.Timeandagain,fromthespring
of ioo¬ on, policv 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,becausethev
lacked a full understanding of the risks and interconnections in the fnancial mar-
kets. Some regulators have conceded this error. We had allowed the svstem to race
aheadofourabilitvtoprotectit.
Whiletherewassomeawarenessof,oratleastadebateabout,thehousingbubble,
therecordrefectsthatseniorpublicomcialsdidnotrecognizethataburstingofthe
bubblecouldthreatentheentirefnancialsvstem.Throughoutthesummerofioo¬,
bothFederalReserveChairmanBenBernankeandTreasurvSecretarvHenrvPaul-
son offered public assurances that the turmoil in the subprime mortgage markets
wouldbecontained.WhenBearStearns’shedgefunds,whichwereheavilvinvested
inmortgage-relatedsecurities,implodedinIuneioo¬,theFederalReservediscussed
theimplicationsofthecollapse.Despitethefactthatsomanvotherfundswereex-
posedtothesamerisksasthosehedgefunds,theBearStearnsfundswerethoughtto
be“relativelvunique.”DavsbeforethecollapseofBearStearnsinMarchioo8,SEC
ChairmanChristopherCoxexpressed“comfortaboutthecapitalcushions”atthebig
investment banks. It was not until August ioo8, just weeks before the government
takeoverofFannieMaeandFreddieMac,thattheTreasurvDepartmentunderstood
thefullmeasureofthedirefnancialconditionsofthosetwoinstitutions.Andjusta
month before Lehman’s collapse, the Federal Reserve Bank of New York was still
seekinginformationontheexposurescreatedbvLehman’smorethanooo,oooderiv-
ativescontracts.
Inaddition,thegovernment’sinconsistenthandlingofmajorfnancialinstitutions
duringthecrisis—thedecisiontorescueBearStearnsandthentoplaceFannieMae
andFreddieMacintoconservatorship,followedbvitsdecisionnottosaveLehman
BrothersandthentosaveAIG—increaseduncertaintvandpanicinthemarket.
Inmakingtheseobservations,wedeeplvrespectandappreciatetheeffortsmade
bv Secretarv Paulson, Chairman Bernanke, and Timothv Geithner, formerlv presi-
dent of the Federal Reserve Bank of New York and now treasurv secretarv, and so
tuNtiU:i uN: ui 1ui ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN xxi
manv others who labored to stabilize our fnancial svstem and our economv in the
mostchaoticandchallengingofcircumstances.
• We conclude there was a systemic breakdown in accountability and ethics. The
integritvofourfnancialmarketsandthepublic’strustinthosemarketsareessential
totheeconomicwell-beingofournation.Thesoundnessandthesustainedprosper-
itv of the fnancial svstem and our economv relv on the notions of fair dealing, re-
sponsibilitv,andtransparencv.Inoureconomv,weexpectbusinessesandindividuals
topursueprofts,atthesametimethatthevproduceproductsandservicesofqualitv
andconductthemselveswell.
Unfortunatelv—as has been the case in past speculative booms and busts—we
witnessedanerosionofstandardsofresponsibilitvandethicsthatexacerbatedthef-
nancialcrisis.Thiswasnotuniversal,butthesebreachesstretchedfromtheground
level to the corporate suites. Thev resulted not onlv in signifcant fnancial conse-
quencesbutalsoindamagetothetrustofinvestors,businesses,andthepublicinthe
fnancialsvstem.
Forexample,ourexaminationfound,accordingtoonemeasure,thatthepercent-
ageofborrowerswhodefaultedontheirmortgageswithinjustamatterofmonths
aftertakingaloannearlvdoubledfromthesummerofioootolateioo¬.Thisdata
indicatesthevlikelvtookoutmortgagesthatthevneverhadthecapacitvorintention
topav.Youwillreadaboutmortgagebrokerswhowerepaid“vieldspreadpremiums”
bvlenderstoputborrowersintohigher-costloanssothevwouldgetbiggerfees,of-
tenneverdisclosedtoborrowers.Thereportcataloguestherisingincidenceofmort-
gagefraud,whichfourishedinanenvironmentofcollapsinglendingstandardsand
laxregulation.Thenumberofsuspiciousactivitvreports—reportsofpossiblefnan-
cial crimes fled bv depositorv banks and their amliates—related to mortgage fraud
grew io-fold between 1ooo and ioo- and then more than doubled again between
ioo-andiooo.Onestudvplacesthelossesresultingfromfraudonmortgageloans
madebetweenioo-andioo¬at·11ibillion.
Lenders made loans that thev knew borrowers could not afford and that could
causemassivelossestoinvestorsinmortgagesecurities.AsearlvasSeptemberiooa,
Countrvwide executives recognized that manv of the loans thev were originating
could result in “catastrophic consequences.” Less than a vear later, thev noted that
certain high-risk loans thev were making could result not onlv in foreclosures but
alsoin“fnancialandreputationalcatastrophe”forthefrm.Butthevdidnotstop.
Andthereportdocumentsthatmajorfnancialinstitutionsineffectivelvsampled
loansthevwerepurchasingtopackageandselltoinvestors.Thevknewasignifcant
percentage of the sampled loans did not meet their own underwriting standards or
those of the originators. Nonetheless, thev sold those securities to investors. The
Commission’sreviewofmanvprospectusesprovidedtoinvestorsfoundthatthiscrit-
icalinformationwasnotdisclosed.
THESE CONCLUSIONS mustbeviewedinthecontextofhumannatureandindividual
and societal responsibilitv. First, to pin this crisis on mortal faws like greed and
xxii ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN iiiui1
hubriswouldbesimplistic.Itwasthefailuretoaccountforhumanweaknessthatis
relevanttothiscrisis.
Second, we clearlv believe the crisis was a result of human mistakes, misjudg-
ments,andmisdeedsthatresultedinsvstemicfailuresforwhichournationhaspaid
dearlv.Asvoureadthisreport,vouwillseethatspecifcfrmsandindividualsacted
irresponsiblv.Yetacrisisofthismagnitudecannotbetheworkofafewbadactors,
andsuchwasnotthecasehere.Atthesametime,thebreadthofthiscrisisdoesnot
meanthat“evervoneisatfault”;manvfrmsandindividualsdidnotparticipateinthe
excessesthatspawneddisaster.
Wedoplacespecialresponsibilitvwiththepublicleaderschargedwithprotecting
ourfnancialsvstem,thoseentrustedtorunourregulatorvagencies,andthechiefex-
ecutivesofcompanieswhosefailuresdroveustocrisis.Theseindividualssoughtand
accepted positions of signifcant responsibilitv and obligation. Tone at the top does
matterand,inthisinstance,wewereletdown.Noonesaid“no.”
Butasanation,wemustalsoacceptresponsibilitvforwhatwepermittedtooccur.
Collectivelv,butcertainlvnotunanimouslv,weacquiescedtoorembracedasvstem,
asetofpoliciesandactions,thatgaverisetoourpresentpredicament.
¯ ¯ ¯
THIS REPORT DESCRIBES THE EVENTS and the svstem that propelled our nation to-
ward crisis. The complex machinerv of our fnancial markets has manv essential
gears—some of which plaved a critical role as the crisis developed and deepened.
Herewerenderourconclusionsaboutspecifccomponentsofthesvstemthatwebe-
lievecontributedsignifcantlvtothefnancialmeltdown.
• 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.
Manvmortgagelenderssetthebarsolowthatlenderssimplvtookeagerborrow-
ers’ qualifcations on faith, often with a willful disregard for a borrower’s abilitv to
pav.Nearlvone-quarterofallmortgagesmadeinthefrsthalfofioo-wereinterest-
onlvloans.Duringthesamevear,o8ºof“optionARM”loansoriginatedbvCoun-
trvwideandWashingtonMutualhadlow-orno-documentationrequirements.
These trends were not secret. As irresponsible lending, including predatorv and
fraudulentpractices,becamemoreprevalent,theFederalReserveandotherregula-
tors and authorities heard warnings from manv quarters. Yet the Federal Reserve
neglecteditsmission“toensurethesafetvandsoundnessofthenation’sbankingand
fnancialsvstemandtoprotectthecreditrightsofconsumers.”Itfailedtobuildthe
retaining wall before it was too late. And the Omce of the Comptroller of the Cur-
rencv 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 NuUi i¥ tu\\i : :i uN xxiii
Whilemanvofthesemortgageswerekeptonbanks’books,thebiggermonevcame
fromglobalinvestorswhoclamoredtoputtheircashintonewlvcreatedmortgage-re-
latedsecurities.Itappearedtofnancialinstitutions,investors,andregulatorsalikethat
riskhadbeenconquered:theinvestorsheldhighlvratedsecuritiesthevthoughtwere
suretoperform;thebanksthoughtthevhadtakentheriskiestloansofftheirbooks;
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,andsvntheticCDOs:nooneinthispipelineoftoxicmortgageshadenough
skininthegame.Thevallbelievedthevcouldoff-loadtheirrisksonamoment’sno-
tice to the next person in line. Thev were wrong. When borrowers stopped making
mortgage pavments, the losses—amplifed bv derivatives—rushed through the
pipeline.Asitturnedout,theselosseswereconcentratedinasetofsvstemicallvim-
portantfnancialinstitutions.
Intheend,thesvstemthatcreatedmillionsofmortgagessoemcientlvhasproven
tobedimculttounwind.Itscomplexitvhaserectedbarrierstomodifvingmortgages
so families can stav in their homes and has created further uncertaintv about the
healthofthehousingmarketandfnancialinstitutions.
• We conclude over-the-counter derivatives contributed signifcantly to this
crisis. Theenactmentoflegislationin2000tobantheregulationbvboththefederal
and state governments of over-the-counter (OTC) derivatives was a kev turning
pointinthemarchtowardthefnancialcrisis.
From fnancial frms to corporations, to farmers, and to investors, derivatives
havebeenusedtohedgeagainst,orspeculateon,changesinprices,rates,orindices
orevenoneventssuchasthepotentialdefaultsondebts.Yet,withoutanvoversight,
OTCderivativesrapidlvspiraledoutofcontrolandoutofsight,growingto·o¬:tril-
lion in notional amount. This report explains the uncontrolled leverage; lack of
transparencv, capital, and collateral requirements; speculation; interconnections
amongfrms;andconcentrationsofriskinthismarket.
OTCderivativescontributedtothecrisisinthreesignifcantwavs.First,onetvpe
of derivative—credit default swaps (CDS)—fueled the mortgage securitization
pipeline.CDSweresoldtoinvestorstoprotectagainstthedefaultordeclineinvalue
ofmortgage-relatedsecuritiesbackedbvriskvloans.Companiessoldprotection—to
thetuneof·¬obillion,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 svnthetic CDOs. These svnthetic
CDOsweremerelvbetsontheperformanceofrealmortgage-relatedsecurities.Thev
amplifedthelossesfromthecollapseofthehousingbubblebvallowingmultiplebets
on the same securities and helped spread them throughout the fnancial svstem.
GoldmanSachsalonepackagedandsold·¬:billioninsvntheticCDOsfromIulv1,
xxiv ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN iiiui1
iooa, to Mav :1, ioo¬. Svnthetic CDOs created bv Goldman referenced more than
:,aoo mortgage securities, and o1o of them were referenced at least twice. This is
apart from how manv times these securities mav have been referenced in svnthetic
CDOscreatedbvotherfrms.
Finallv,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 ultimatelv committed more than ·18o billion
because of concerns that AIG’s collapse would trigger cascading losses throughout
theglobalfnancialsvstem.Inaddition,theexistenceofmillionsofderivativescon-
tractsofalltvpesbetweensvstemicallvimportantfnancialinstitutions—unseenand
unknown in this unregulated market—added to uncertaintv and escalated panic,
helpingtoprecipitategovernmentassistancetothoseinstitutions.
• We conclude the failures of credit rating agencies were essential cogs in the
wheel of fnancial destruction. Thethreecreditratingagencieswerekevenablersof
the fnancial meltdown. The mortgage-related securities at the heart of the crisis
couldnothavebeenmarketedandsoldwithouttheirsealofapproval.Investorsre-
liedonthem,oftenblindlv.Insomecases,thevwereobligatedtousethem,orregula-
torv 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, vou will read about the breakdowns at Moodv’s, examined bv the
Commission as a case studv. From iooo to ioo¬, Moodv’s rated nearlv a-,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 earlv io1o. In iooo
alone,Moodv’sputitstriple-Astampofapprovalon:omortgage-relatedsecurities
evervworkingdav.Theresultsweredisastrous:8:ºofthemortgagesecuritiesrated
triple-Athatvearultimatelvweredowngraded.
YouwillalsoreadabouttheforcesatworkbehindthebreakdownsatMoodv’s,in-
cludingthefawedcomputermodels,thepressurefromfnancialfrmsthatpaidfor
theratings,therelentlessdriveformarketshare,thelackofresourcestodothejob
despiterecordprofts,andtheabsenceofmeaningfulpublicoversight.Andvouwill
seethatwithouttheactiveparticipationoftheratingagencies,themarketformort-
gage-relatedsecuritiescouldnothavebeenwhatitbecame.
¯ ¯ ¯
THERE ARE MANY COMPETING VIEWS astothecausesofthiscrisis.Inthisregard,the
Commissionhasendeavoredtoaddresskevquestionsposedtous.Herewediscuss
three:capitalavailabilitvandexcessliquiditv,theroleofFannieMaeandFreddieMac
(theGSEs),andgovernmenthousingpolicv.
First,astothematterofexcessliquiditv:inourreport,weoutlinemonetarvpoli-
cies and capital fows during the vears leading up to the crisis. Low interest rates,
widelvavailablecapital,andinternationalinvestorsseekingtoputtheirmonevinreal
tuNtiU:i uN: ui 1ui ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN xxv
estateassetsintheUnitedStateswereprerequisitesforthecreationofacreditbubble.
Those conditions created increased risks, which should have been recognized bv
marketparticipants,policvmakers,andregulators.However,itistheCommission’s
conclusionthatexcessliquiditvdidnotneedtocauseacrisis.Itwasthefailuresout-
linedabove—includingthefailuretoeffectivelvreininexcessesinthemortgageand
fnancialmarkets—thatweretheprincipalcausesofthiscrisis.Indeed,theavailabil-
itv of well-priced capital—both foreign and domestic—is an opportunitv for eco-
nomicexpansionandgrowthifencouragedtofowinproductivedirections.
Second,weexaminedtheroleoftheGSEs,withFannieMaeservingastheCom-
mission’s case studv in this area. These government-sponsored enterprises had a
deeplvfawedbusinessmodelaspubliclvtradedcorporationswiththeimplicitback-
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,thevdecidedtorampuptheirpurchaseandguaranteeofriskvmortgages,just
as the housing market was peaking. Thev used their political power for decades to
wardoffeffectiveregulationandoversight—spending·1oamilliononlobbvingfrom
1oootoioo8.Thevsufferedfrommanvofthesamefailuresofcorporategovernance
and risk management as the Commission discovered in other fnancial frms.
Throughthethirdquarterofio1o,theTreasurvDepartmenthadprovided·1-1bil-
lioninfnancialsupporttokeepthemafoat.
Weconcludethatthesetwoentitiescontributedtothecrisis,butwerenotapri-
marvcause.Importantlv,GSEmortgagesecuritiesessentiallvmaintainedtheirvalue
throughout the crisis and did not contribute to the signifcant fnancial frm losses
thatwerecentraltothefnancialcrisis.
The GSEs participated in the expansion of subprime and other riskv mortgages,
butthevfollowedratherthanledWallStreetandotherlendersintherushforfool’s
gold. Thev purchased the highest rated non-GSE mortgage-backed securities and
theirparticipationinthismarketaddedheliumtothehousingballoon,buttheirpur-
chasesneverrepresentedamajoritvofthemarket.Thosepurchasesrepresented1o.-º
of non-GSE subprime mortgage-backed securities in ioo1, with the share rising to
aoºiniooa,andfallingbacktoi8ºbvioo8.Thevrelaxedtheirunderwritingstan-
dards to purchase or guarantee riskier loans and related securities in order to meet
stockmarketanalvsts’andinvestors’expectationsforgrowth,toregainmarketshare,
andtoensuregenerouscompensationfortheirexecutivesandemplovees—justifving
theiractivitiesonthebroadandsustainedpublicpolicvsupportforhomeownership.
TheCommissionalsoprobedtheperformanceoftheloanspurchasedorguaran-
teed bv Fannie and Freddie. While thev generated substantial losses, delinquencv
ratesforGSEloansweresubstantiallvlowerthanloanssecuritizedbvotherfnancial
frms.Forexample,datacompiledbvtheCommissionforasubsetofborrowerswith
similar credit scores—scores below ooo—show that bv the end of ioo8, GSE mort-
gages were far less likelv to be seriouslv 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 NuUi i¥ tu\\i : :i uN iiiui1
riskvmortgages.Basedontheevidenceandinterviewswithdozensofindividualsin-
volvedinthissubjectarea,wedeterminedthesegoalsonlvcontributedmarginallvto
Fannie’sandFreddie’sparticipationinthosemortgages.
Finallv,astothematterofwhethergovernmenthousingpolicieswereaprimarv
cause of the crisis: for decades, government policv has encouraged homeownership
throughasetofincentives,assistanceprograms,andmandates.Thesepolicieswere
putinplaceandpromotedbvseveraladministrationsandCongresses—indeed,both
Presidents Bill Clinton and George W. Bush set aggressive goals to increase home-
ownership.
In conducting our inquirv, we took a careful look at HUD’s affordable housing
goals,asnotedabove,andtheCommunitvReinvestmentAct(CRA).TheCRAwas
enactedin1o¬¬tocombat“redlining”bvbanks—thepracticeofdenvingcredittoin-
dividualsandbusinessesincertainneighborhoodswithoutregardtotheircreditwor-
thiness.TheCRArequiresbanksandsavingsandloanstolend,invest,andprovide
services to the communities from which thev take deposits, consistent with bank
safetvandsoundness.
TheCommissionconcludestheCRAwasnotasignifcantfactorinsubprimelend-
ingorthecrisis.ManvsubprimelenderswerenotsubjecttotheCRA.Researchindi-
catesonlvoºofhigh-costloans—aproxvforsubprimeloans—hadanvconnectionto
the law. Loans made bv CRA-regulated lenders in the neighborhoods in which thev
wererequiredtolendwerehalfaslikelvtodefaultassimilarloansmadeinthesame
neighborhoodsbvindependentmortgageoriginatorsnotsubjecttothelaw.
Nonetheless,wemakethefollowingobservationaboutgovernmenthousingpoli-
cies—thevfailedinthisrespect:Asanation,wesetaggressivehomeownershipgoals
withthedesiretoextendcredittofamiliespreviouslvdeniedaccesstothefnancial
markets.Yetthegovernmentfailedtoensurethatthephilosophvofopportunitvwas
being matched bv the practical realities on the ground. Witness again the failure of
theFederalReserveandotherregulatorstoreininirresponsiblelending.Homeown-
ershippeakedinthespringofiooaandthenbegantodecline.Fromthatpointon,
thetalkofopportunitvwastragicallvatoddswiththerealitvofafnancialdisasterin
themaking.
¯ ¯ ¯
WHEN THIS COMMISSION began its work 18 months ago, some imagined that the
eventsofioo8andtheirconsequenceswouldbewellbehindusbvthetimeweissued
this report. Yet more than two vears after the federal government intervened in an
unprecedented manner in our fnancial markets, our countrv fnds itself still grap-
plingwiththeaftereffectsofthecalamitv.Ourfnancialsvstemis,inmanvrespects,
stillunchangedfromwhatexistedontheeveofthecrisis.Indeed,inthewakeofthe
crisis,theU.S.fnancialsectorisnowmoreconcentratedthaneverinthehandsofa
fewlarge,svstemicallvsignifcantinstitutions.
Whilewehavenotbeenchargedwithmakingpolicvrecommendations,theverv
purposeofourreporthasbeentotakestockofwhathappenedsowecanplotanew
course. In our inquirv, we found dramatic breakdowns of corporate governance,
tuNtiU:i uN: ui 1ui ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN xxvii
profoundlapsesinregulatorvoversight,andnearfatalfawsinourfnancialsvstem.
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 svstem of capital that provides the foundation for a new era of broadlv
sharedprosperitv.
Thegreatesttragedvwouldbetoaccepttherefrainthatnoonecouldhaveseen
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 responsibilitv. It falls to us to make different choices if we
wantdifferentresults.
xxviii ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN iiiui1
PART I
Crisis on the Horizon
1
BEFORE OUR VERY EYES
InexaminingtheworstfnancialmeltdownsincetheGreatDepression,theFinancial
CrisisInquirvCommissionreviewedmillionsofpagesofdocumentsandquestioned
hundredsofindividuals—fnancialexecutives,businessleaders,policvmakers,regu-
lators,communitvleaders,peoplefromallwalksoflife—tofndouthowandwhvit
happened.
In public hearings and interviews, manv fnancial industrv executives and top
publicomcialstestifedthatthevhadbeenblindsidedbvthecrisis,describingitasa
dramatic and mvstifving turn of events. Even among those who worried that the
housing bubble might burst, few—if anv—foresaw the magnitude of the crisis that
wouldensue.
CharlesPrince,theformerchairmanandchiefexecutiveomcerofCitigroupInc.,
called the collapse in housing prices “whollv unanticipated.”
1
Warren Buffett, the
chairman and chief executive omcer of Berkshire Hathawav Inc., which until iooo
was the largest single shareholder of Moodv’s Corporation, told the Commission
that “verv, verv few people could appreciate the bubble,” which he called a “mass
delusion” shared bv “:oo million Americans.”
i
Llovd 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.”
a
Alan Greenspan, the Fed chairman during the
twodecadesleadinguptothecrash,toldtheCommissionthatitwasbevondtheabil-
itv of regulators to ever foresee such a sharp decline. “Historv tells us [regulators]
cannotidentifvthetimingofacrisis,oranticipateexactlvwhereitwillbelocatedor
howlargethelossesandspilloverswillbe.”
-
Infact,therewerewarningsigns.Inthedecadeprecedingthecollapse,therewere
manv signs that house prices were infated, that lending practices had spun out of
control,thattoomanvhomeownersweretakingonmortgagesanddebtthevcouldill
afford, and that risks to the fnancial svstem were growing unchecked. Alarm bells
.
were clanging inside fnancial institutions, regulatorv omces, consumer service or-
ganizations, state law enforcement agencies, and corporations throughout America,
aswellasinneighborhoodsacrossthecountrv.Manvknowledgeableexecutivessaw
troubleandmanagedtoavoidthetrainwreck.WhilecountlessAmericansjoinedin
thefnancialeuphoriathatseizedthenation,manvotherswereshoutingtogovern-
ment omcials in Washington and within state legislatures, pointing to what would
becomeahumandisaster,notjustaneconomicdebacle.
“Evervbodv in the whole world knew that the mortgage bubble was there,” said
RichardBreeden,theformerchairmanoftheSecuritiesandExchangeCommission
appointedbvPresidentGeorgeH.W.Bush.“Imean,itwasn’thidden. . . .Youcannot
lookatanvofthisandsavthattheregulatorsdidtheirjob.Thiswasnotsomehidden
problem.Itwasn’toutonMarsorPlutoorsomewhere.Itwasrighthere. . . .Youcan’t
maketrillionsofdollars’worthofmortgagesandnothavepeoplenotice.”
o
PaulMcCullev,amanagingdirectoratPIMCO,oneofthenation’slargestmonev
managementfrms,toldtheCommissionthatheandhiscolleaguesbegantogetwor-
riedabout“serioussignsofbubbles”inioo-;thevthereforesentoutcreditanalvststo
iocitiestodowhathecalled“old-fashionedshoe-leatherresearch,”talkingtoreales-
tatebrokers,mortgagebrokers,andlocalinvestorsaboutthehousingandmortgage
markets. Thev witnessed what he called “the outright degradation of underwriting
standards,”McCullevasserted,andthevsharedwhatthevhadlearnedwhenthevgot
back home to the companv’s Newport Beach, California, headquarters. “And when
ourgroupcameback,thevreportedwhatthevsaw,andweadjustedourriskaccord-
inglv,”McCullevtoldtheCommission.Thecompanv“severelvlimited”itsparticipa-
tioninriskvmortgagesecurities.
¬
Veteranbankers,particularlvthosewhorememberedthesavingsandloancrisis,
knewthatage-oldrulesofprudentlendinghadbeencastaside.ArnoldCattani,the
chairmanofBakersfeld,California–basedMissionBank,toldtheCommissionthat
he grew uncomfortable with the “pure lunacv” he saw in the local home-building
market,fueledbv“voracious”WallStreetinvestmentbanks;hethusoptedoutofcer-
tainkindsofinvestmentsbvioo-.
8
WilliamMartin,thevicechairmanandchiefexecutiveomcerofService1stBank
ofNevada,toldtheFCICthatthedesirefora“highandquickreturn”blindedpeople
tofscalrealities.“YoumavrecallTommvLeeIonesinMen in Black, whereheholdsa
deviceintheair,andwithabrightfashwipescleanthememoriesofevervonewho
haswitnessedanalienevent,”hesaid.
o
Unlike so manv other bubbles—tulip bulbs in Holland in the 1ooos, South Sea
stocksinthe1¬oos,Internetstocksinthelate1ooos—thisoneinvolvednotjustan-
other commoditv but a building block of communitv and social life and a corner-
stoneoftheeconomv:thefamilvhome.Homesarethefoundationuponwhichmanv
ofoursocial,personal,governmental,andeconomicstructuresrest.Childrenusuallv
go to schools linked to their home addresses; local governments decide how much
monev thev can spend on roads, frehouses, and public safetv based on how much
propertvtaxrevenuethevhave;housepricesaretiedtoconsumerspending.Down-
turnsinthehousingindustrvcancauserippleeffectsalmostevervwhere.
. ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN iiiui1
When the Federal Reserve cut interest rates earlv in the new centurv and mort-
gageratesfell,homerefnancingsurged,climbingfrom·aoobillioninioooto·i.8
trillioninioo:,
1o
allowingpeopletowithdrawequitvbuiltupoverpreviousdecades
and to consume more, despite stagnant wages. Home sales volume started to in-
crease,andaveragehomepricesnationwideclimbed,risingo¼ineightvearsbvone
measure and hitting a national high of ·ii¬,1oo in earlv iooo.
11
Home prices in
manv areas skvrocketed: prices increased nearlv two and one-half times in Sacra-
mento,forexample,injustfvevears,
1i
andshotupbvaboutthesamepercentagein
Bakersfeld,Miami,andKevWest.Pricesaboutdoubledinmorethan11ometropol-
itanareas,includingPhoenix,AtlanticCitv,Baltimore,Ft.Lauderdale,LosAngeles,
Poughkeepsie, San Diego, and West Palm Beach.
1:
Housing starts nationwide
climbed-:º,from1.amillionin1oo-tomorethanimillioninioo-.Encouraged
bv government policies, homeownership reached a record oo.iº in the spring of
iooa, although it wouldn’t rise an inch further even as the mortgage machine kept
churning for another three vears. Bv refnancing their homes, Americans extracted
·i.otrillioninhomeequitvbetweenioooandioo¬,including·::abillioniniooo
alone,morethanseventimestheamountthevtookoutin1ooo.
1a
Realestatespecula-
torsandpotentialhomeownersstoodinlineoutsidenewsubdivisionsforachanceto
buvhousesbeforethegroundhadevenbeenbroken.Bvthefrsthalfofioo-,more
thanoneoutofevervtenhomesaleswastoaninvestor,speculator,orsomeonebuv-
ingasecondhome.
1-
Biggerwasbetter,andeventhestructuresthemselvesballooned
insize;thefoorareaofanaveragenewhomegrewbv1-º,toi,i¬¬squarefeet,in
thedecadefrom1oo¬toioo¬.
Monev washed through the economv like water rushing through a broken dam.
Lowinterestratesandthenforeigncapitalhelpedfueltheboom.Constructionwork-
ers,landscapearchitects,realestateagents,loanbrokers,andappraisersproftedon
MainStreet,whileinvestmentbankersandtradersonWallStreetmovedevenhigher
ontheAmericanearningspvramidandthesharepricesofthemostaggressivefnan-
cial service frms reached all-time highs.
1o
Homeowners pulled cash out of their
homestosendtheirkidstocollege,pavmedicalbills,installdesignerkitchenswith
granitecounters,takevacations,orlaunchnewbusinesses.Thevalsopaidoffcredit
cards,evenaspersonaldebtrosenationallv.Survevevidenceshowsthatabout-ºof
homeownerspulledoutcashtobuvavehicleandoveraoºspentthecashonacatch-
all categorv including tax pavments, clothing, gifts, and living expenses.

Renters
usednewformsofloanstobuvhomesandtomovetosuburbansubdivisions,erect-
ingswingsetsintheirbackvardsandenrollingtheirchildreninlocalschools.
In an interview with the Commission, Angelo Mozilo, the longtime CEO of
CountrvwideFinancial—alenderbroughtdownbvitsriskvmortgages—saidthata
“goldrush”mentalitvovertookthecountrvduringthesevears,andthathewasswept
upinitaswell:“Housingpriceswererisingsorapidlv—ataratethatI’dneverseenin
mv--vearsinthebusiness—thatpeople,regularpeople,averagepeoplegotcaught
upinthemaniaofbuvingahouse,andfippingit,makingmonev.Itwashappening.
Thevbuvahouse,make·-o,ooo . . .andtalkatacocktailpartvaboutit. . . .Housing
suddenlvwentfrombeingpartoftheAmericandreamtohousemvfamilvtosettle
8ii uii uUi \ii¥ i¥i: ,
down—itbecameacommoditv.Thatwasachangeintheculture. . . .Itwassudden,
unexpected.”
18
Onthesurface,itlookedlikeprosperitv.Afterall,thebasicmechanismsmaking
the real estate machine hum—the mortgage-lending instruments and the fnancing
techniquesthatturnedmortgagesintoinvestmentscalledsecurities,whichkeptcash
fowingfromWallStreetintotheU.S.housingmarket—weretoolsthathadworked
wellformanvvears.
But underneath, something was going wrong. Like a science fction movie in
whichordinarvhouseholdobjectsturnhostile,familiarmarketmechanismswerebe-
ingtransformed.Thetime-tested:o-vearfxed-ratemortgage,withaioºdownpav-
ment, went out of stvle. There was a burgeoning global demand for residential
mortgage–backed securities that offered seeminglv solid and secure returns. In-
vestorsaroundtheworldclamoredtopurchasesecuritiesbuiltonAmericanreales-
tate,seeminglvoneofthesafestbetsintheworld.
WallStreetlaboredmightilvtomeetthatdemand.Bondsalesmenearnedmulti-
million-dollar bonuses packaging and selling new kinds of loans, offered bv new
kindsoflenders,intonewkindsofinvestmentproductsthatweredeemedsafebut
possessed complex and hidden risks. Federal officials praised the changes—these
financial innovations, thev said, had lowered borrowing costs for consumers and
movedrisksawavfromthebiggestandmostsvstemicallvimportantfinancialinsti-
tutions. But the nation’s financial svstem had become vulnerable and intercon-
nected in wavs that were not understood bv either the captains of finance or the
svstem’spublicstewards.Infact,someofthelargestinstitutionshadtakenonwhat
would prove to be debilitating risks. Trillions of dollars had been wagered on the
beliefthathousingpriceswouldalwavsriseandthatborrowerswouldseldomde-
faultonmortgages,evenastheirdebtgrew.Shakvloanshadbeenbundledintoin-
vestment products in wavs that seemed to give investors the best of both
worlds—high-vield,risk-free—butinstead,inmanvcases,wouldprovetobehigh-
riskandvield-free.
All this fnancial creativitv was a lot “like cheap sangria,” said Michael Mavo, a
managingdirectorandfnancialservicesanalvstatCalvonSecurities(USA)Inc.“A
lotofcheapingredientsrepackagedtosellatapremium,”hetoldtheCommission.“It
mighttastegoodforawhile,butthenvougetheadacheslaterandvouhavenoidea
what’sreallvinside.”
1o
The securitization machine began to guzzle these once-rare mortgage products
with their strange-sounding names: Alt-A, subprime, I-O (interest-onlv), low-doc,
no-doc, or ninja (no income, no job, no assets) loans; i–i8s and :–i¬s; liar loans;
piggvback second mortgages; pavment-option or pick-a-pav adjustable rate mort-
gages.Newvariantsonadjustable-ratemortgages,called“exploding”ARMs,featured
lowmonthlvcostsatfrst,butpavmentscouldsuddenlvdoubleortriple,ifborrowers
wereunabletorefnance.Loanswithnegativeamortizationwouldeatawavthebor-
rower’sequitv.Soontherewereamultitudeofdifferentkindsofmortgagesavailable
on the market, confounding consumers who didn’t examine the fne print, baming
( ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN iiiui1
conscientiousborrowerswhotriedtopuzzleouttheirimplications,andopeningthe
doorforthosewhowantedinontheaction.
Manvpeoplechosepoorlv.Somepeoplewantedtolivebevondtheirmeans,andbv
mid-ioo-, nearlv one-quarter of all borrowers nationwide were taking out interest-
onlv loans that allowed them to defer the pavment of principal.
io
Some borrowers
opted for nontraditional mortgages because that was the onlv wav thev could get a
footholdinareassuchastheskv-highCaliforniahousingmarket.
i1
Somespeculators
saw the chance to snatch up investment properties and fip them for proft—and
FloridaandGeorgiabecameaparticulartargetforinvestorswhousedtheseloansto
acquirerealestate.
ii
Someweremisledbvsalespeoplewhocametotheirhomesand
persuaded them to sign loan documents on their kitchen tables. Some borrowers
naivelv trusted mortgage brokers who earned more monev placing them in riskv
loansthaninsafeones.
i:
Withtheseloans,buverswereabletobidupthepricesof
housesevenifthevdidn’thaveenoughincometoqualifvfortraditionalloans.
Some of these exotic loans had existed in the past, used bv high-income, fnan-
ciallvsecurepeopleasacash-managementtool.Somehadbeentargetedtoborrow-
erswithimpairedcredit,offeringthemtheopportunitvtobuildastrongerpavment
historvbeforethevrefnanced.Buttheinstrumentsbegantodelugethelargermarket
iniooaandioo-.Thechangedoccurred“almostovernight,”FaithSchwartz,thenan
executiveatthesubprimelenderOptionOneandlatertheexecutivedirectorofHope
Now, a lending-industrv foreclosure relief group, told the Federal Reserve’s Con-
sumerAdvisorvCouncil.“Iwouldsuggestmostevervlenderinthecountrvisinit,
onewavoranother.”
ia
At frst not a lot of people reallv understood the potential hazards of these new
loans.Thevwerenew,thevweredifferent,andtheconsequenceswereuncertain.But
it soon became apparent that what had looked like newfound wealth was a mirage
based on borrowed monev. 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 vears from ioo1 to ioo¬ as it
had over the course of the countrv’s more than ioo-vear historv. The amount of
mortgagedebtperhouseholdrosefrom·o1,-ooinioo1to·1ao,-ooinioo¬.
i-
With
asimplefourishofapenonpaper,millionsofAmericanstradedawavdecadesofeq-
uitvtuckedawavintheirhomes.
Under the radar, the lending and the fnancial services industrv had mutated. In
the past, lenders had avoided making unsound loans because thev would be stuck
with them in their loan portfolios. But because of the growth of securitization, it
wasn’t even clear anvmore who the lender was. The mortgages would be packaged,
sliced,repackaged,insured,andsoldasincomprehensiblvcomplicateddebtsecurities
toanassortmentofhungrvinvestors.Noweventheworstloanscouldfndabuver.
Moreloansalesmeanthigherproftsforevervoneinthechain.Businessboomed
forChristopherCruise,aMarvland-basedcorporateeducatorwhotrainedloanom-
cers for companies that were expanding mortgage originations. He crisscrossed the
nation,coachingabout1o,oooloanoriginatorsavearinauditoriumsandclassrooms.
8ii uii uUi \ii¥ i¥i: ,
His clients included manv of the largest lenders—Countrvwide, Ameriquest, and
Ditechamongthem.Mostoftheirnewhireswerevoung,withnomortgageexperi-
ence,freshoutofschoolandwithpreviousjobs“fippingburgers,”hetoldtheFCIC.
Giventherighttraining,however,thebestofthemcould“easilv”earnmillions.
io
“I was a sales and marketing trainer in terms of helping people to know how to
selltheseproductsto,insomecases,franklvunsophisticatedandunsuspectingbor-
rowers,”hesaid.Hetaughtthemthenewplavbook:“Youhadnoincentivewhatso-
ever to be concerned about the qualitv of the loan, whether it was suitable for the
borrowerorwhethertheloanperformed.Infact,vouwereinawavencouragednot
to worrv about those macro issues.” He added, “I knew that the risk was being
shuntedoff.Iknewthatwecouldbewritingcrap.Butintheenditwaslikeagameof
musicalchairs.Volumemightgodownbutwewerenotgoingtobehurt.”

OnWallStreet,wheremanvoftheseloanswerepackagedintosecuritiesandsold
toinvestorsaroundtheglobe,anewtermwascoined:IBGYBG,“I’llbegone,vou’ll
be gone.”
i8
It referred to deals that brought in big fees up front while risking much
largerlossesinthefuture.And,foralongtime,IBGYBGworkedatevervlevel.
Most home loans entered the pipeline soon after borrowers signed the docu-
mentsandpickeduptheirkevs.Loanswereputintopackagesandsoldoffinbulkto
securitization frms—including investment banks such as Merrill Lvnch, Bear
Stearns,andLehmanBrothers,andcommercialbanksandthriftssuchasCitibank,
WellsFargo,andWashingtonMutual.Thefrmswouldpackagetheloansintoresi-
dentialmortgage–backedsecuritiesthatwouldmostlvbestampedwithtriple-Arat-
ingsbvthecreditratingagencies,andsoldtoinvestors.Inmanvcases,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
thatinvestorsbelievedattestedtotheirqualitvandsafetv.Someinvestorswouldbuv
aninventionfromthe1oooscalledacreditdefaultswap(CDS)toprotectagainstthe
securities’defaulting.Forevervbuverofacreditdefaultswap,therewasaseller:as
theseinvestorsmadeopposingbets,thelaversofentanglementinthesecuritiesmar-
ketincreased.
The instruments grew more and more complex; CDOs were constructed out of
CDOs,creatingCDOssquared.Whenfrmsranoutofrealproduct,thevstartedgen-
eratingcheaper-to-producesvntheticCDOs—composednotofrealmortgagesecuri-
ties but just of bets on other mortgage products. Each new permutation created an
opportunitvtoextractmorefeesandtradingprofts.Andeachnewlaverbroughtin
more investors wagering on the mortgage market—even well after the market had
started to turn. So bv the time the process was complete, a mortgage on a home in
south Florida might become part of dozens of securities owned bv hundreds of in-
vestors—orpartsofbetsbeingmadebvhundredsmore.TreasurvSecretarvTimothv
Geithner,thepresidentoftheNewYorkFederalReserveBankduringthecrisis,de-
scribedtheresultingproductas“cookedspaghetti”thatbecamehardto“untangle.”
io
Ralph Ciom spent several vears creating CDOs for Bear Stearns and a couple of
more vears on the repurchase or “repo” desk, which was responsible for borrowing
· ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN iiiui1
monevevervnighttofnanceBearStearns’sbroadersecuritiesportfolio.InSeptem-
ber ioo:, Ciom created a hedge fund within Bear Stearns with a minimum invest-
mentof·1million.Aswascommon,heusedborrowedmonev—upto·oborrowed
foreverv·1frominvestors—tobuvCDOs.Ciom’sfrstfundwasextremelvsuccess-
ful;itearned1¬ºforinvestorsiniooaand1oºinioo-—aftertheannualmanage-
ment fee and the ioº slice of the proft for Ciom and his Bear Stearns team—and
grewtoalmost·obillionbvtheendofioo-.Inthefallofiooo,hecreatedanother,
moreaggressivefund.Thisonewouldshootforleverageofupto1ito1.Bvtheend
of iooo, the two hedge funds had ·18 billion invested, half in securities issued bv
CDOscenteredonhousing.AsaCDOmanager,Ciomalsomanagedanother·18bil-
lionofmortgage-relatedCDOsforotherinvestors.
Ciom’sinvestorsandotherslikethemwantedhigh-vieldingmortgagesecurities.
That,inturn,requiredhigh-vieldingmortgages.Anadvertisingbarragebombarded
potential borrowers, urging them to buv or refnance homes. Direct-mail solicita-
tions fooded people’s mailboxes.
:o
Dancing fgures, depicting happv homeowners,
boogied on computer monitors. Telephones began ringing off the hook with calls
fromloanomcersofferingthelatestloanproducts:Onepercentloan!(Butonlvfor
thefrstvear.)Nomonevdown!(Leavingnoequitvifhomepricesfell.)Noincome
documentationneeded!(Mortgagessoondubbed“liarloans”bvtheindustrvitself.)
Borrowers answered the call, manv believing that with ever-rising prices, housing
wastheinvestmentthatcouldn’tlose.
InWashington,fourintermingledissuescameintoplavthatmadeitdimculttoac-
knowledgetheloomingthreats.First,effortstoboosthomeownershiphadbroadpo-
litical support—from Presidents Bill Clinton and George W. Bush and successive
Congresses—eventhoughinrealitvthehomeownershipratehadpeakedinthespring
ofiooa.Second,therealestateboomwasgeneratingalotofcashonWallStreetand
creatingalotofjobsinthehousingindustrvatatimewhenperformanceinothersec-
torsoftheeconomvwasdrearv.Third,manvtopomcialsandregulatorswerereluc-
tant to challenge the proftable and powerful fnancial industrv. And fnallv, policv
makersbelievedthatevenifthehousingmarkettanked,thebroaderfnancialsvstem
andeconomvwouldholdup.
Asthemortgagemarketbeganitstransformationinthelate1ooos,consumerad-
vocates and front-line local government omcials were among the frst to spot the
changes:homeownersbeganstreamingintotheiromcestoseekhelpindealingwith
mortgagesthevcouldnotaffordtopav.ThevbeganraisingtheissuewiththeFederal
Reserveandotherbankingregulators.
:1
BobGnaizda,thegeneralcounselandpolicv
director of the Greenlining Institute, a California-based nonproft housing group,
told the Commission that he began meeting with Greenspan at least once a vear
startingin1ooo,eachtimehighlightingtohimthegrowthofpredatorvlendingprac-
ticesanddiscussingwithhimthesocialandeconomicproblemsthevwerecreating.
:i
Oneofthefrstplacestoseethebadlendingpracticesenvelopanentiremarket
wasCleveland,Ohio.From1o8oto1ooo,homepricesinClevelandroseooº,climb-
ingfromamedianof·¬-,iooto·1i-,1oo,whilehomepricesnationallvroseabout
aoº in those same vears; at the same time, the citv’s unemplovment rate, ranging
8ii uii uUi \ii¥ i¥i: +
from -.8º in 1ooo to a.iº in 1ooo, more or less tracked the broader U.S. pattern.
IamesRokakis,thelongtimecountvtreasurerofCuvahogaCountv,whereCleveland
islocated,toldtheCommissionthattheregion’shousingmarketwasjuicedbv“fip-
pingonmega-steroids,”withringsofrealestateagents,appraisers,andloanorigina-
torsearningfeesoneachtransactionandfeedingthesecuritizedloanstoWallStreet.
Citvomcialsbegantohearreportsthattheseactivitieswerebeingpropelledbvnew
kindsofnontraditionalloansthatenabledinvestorstobuvpropertieswithlittleorno
monevdownandgavehomeownerstheabilitvtorefnancetheirhouses,regardless
of whether thev could afford to repav the loans. Foreclosures shot up in Cuvahoga
Countvfrom:,-ooavearin1oo-to¬,oooaveariniooo.
::
Rokakisandotherpublic
omcials watched as families who had lived for vears in modest residences lost their
homes. After thev were gone, manv homes were ultimatelv abandoned, vandalized,
andthenstrippedbare,asscavengersrippedawavtheircopperpipesandaluminum
sidingtosellforscrap.
“Securitizationwasoneofthemostbrilliantfnancialinnovationsoftheiothcen-
turv,”RokakistoldtheCommission.“Itfreedupalotofcapital.Ifithadbeendone
responsiblv, it would have been a wondrous thing because nothing is more stable,
there’s nothing safer, than the American mortgage market. . . . It worked for vears.
Butthenpeoplerealizedthevcouldscamit.”
:a
OmcialsinClevelandandotherOhiocitiesreachedouttothefederalgovernment
forhelp.ThevaskedtheFederalReserve,theoneentitvwiththeauthoritvtoregulate
riskvlendingpracticesbvallmortgagelenders,tousethepowerithadbeengranted
in 1ooa under the Home Ownership and Equitv Protection Act (HOEPA) to issue
newmortgagelendingrules.InMarchioo1,FedGovernorEdwardGramlich,anad-
vocate for expanding access to credit but onlv with safeguards in place, attended a
conferenceonthetopicinCleveland.HespokeabouttheFed’spowerunderHOEPA,
declaredsomeofthelendingpracticestobe“clearlvillegal,”andsaidthevcouldbe
“combatedwithlegalenforcementmeasures.”
:-
Lookingback,RokakisremarkedtotheCommission,“Inaivelvbelievedthev’dgo
back and tell Mr. Greenspan and presto, we’d have some new rules. . . . I thought it
wouldresultinactionbeingtaken.Itwaskindofquaint.”
:o
Iniooo,whenClevelandwaslookingforhelpfromthefederalgovernment,other
citiesaroundthecountrvweredoingthesame.IohnTavlor,thepresidentoftheNa-
tional Communitv Reinvestment Coalition, with the support of communitv leaders
from Nevada, Michigan, Marvland, Delaware, Chicago, Vermont, North Carolina,
New Iersev, and Ohio, went to the Omce of Thrift Supervision (OTS), which regu-
lated savings and loan institutions, asking the agencv to crack down on what thev
called“exploitative”practicesthevbelievedwereputtingbothborrowersandlenders
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
thatmanvindividualswerebeingplacedintohigh-costloanswhenthevqualifedfor
bettermortgagesandthatmanvhadbeenmisledaboutthetermsoftheirloans.
:8
.+ ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN iiiui1
Thereweregovernmentreports,too.TheDepartmentofHousingandUrbanDe-
velopmentandtheTreasurvDepartmentissuedajointreportonpredatorvlending
inIuneiooothatmadeanumberofrecommendationsforreducingtheriskstobor-
rowers.
:o
In December ioo1, the Federal Reserve Board used the HOEPA law to
amendsomeregulations;amongthechangeswerenewrulesaimedatlimitinghigh-
interestlendingandpreventingmultiplerefnancingsoverashortperiodoftime,if
thevwerenotintheborrower’sbestinterest.
ao
Asitwouldturnout,thoserulescov-
ered onlv 1º of subprime loans. FDIC Chairman Sheila C. Bair, then an assistant
treasurvsecretarvintheadministrationofPresidentGeorgeW.Bush,characterized
the action to the FCIC as addressing onlv a “narrow range of predatorv lending is-
sues.”
a1
In iooi, Gramlich noted again the “increasing reports of abusive, unethical
andinsomecases,illegal,lendingpractices.”
ai
Bair told the Commission that this was when “reallv poorlv underwritten loans,
thepavmentshockloans”werebeginningtoproliferate,placing“pressure”ontradi-
tionalbankstofollowsuit.
a:
ShesaidthatsheandGramlichconsideredseekingrules
toreininthegrowthofthesekindsofloans,butGramlichtoldherthathethought
theFed,despiteitsbroadpowersinthisarea,wouldnotsupporttheeffort.Instead,
thevsoughtvoluntarvrulesforlenders,butthateffortfellbvthewavsideaswell.
aa
Inanenvironmentofminimalgovernmentrestrictions,thenumberofnontradi-
tional loans surged and lending standards declined. The companies issuing these
loans made profts that attracted envious eves. New lenders entered the feld. In-
vestors clamored for mortgage-related securities and borrowers wanted mortgages.
Thevolumeofsubprimeandnontraditionallendingrosesharplv.Iniooo,thetopi-
nonprimelendersoriginated·1o-billioninloans.Theirvolumeroseto·188billion
iniooi,andthen·:1obillioninioo:.
a-
California, with its high housing costs, was a particular hotbed for this kind of
lending. In ioo1, nearlv ·-i billion, or i-º of all nontraditional loans nationwide,
were made in that state; California’s share rose to :-º bv ioo:, with these kinds of
loans growing to ·o- billion or bv 8aº in California in just two vears.
ao
In those
vears, “subprime and option ARM loans saturated California communities,” Kevin
Stein,theassociatedirectoroftheCaliforniaReinvestmentCoalition,testifedtothe
Commission.“WeestimatedatthattimethattheaveragesubprimeborrowerinCali-
forniawaspavingover·ooomorepermonthontheirmortgagepavmentasaresult
ofhavingreceivedthesubprimeloan.”

GailBurks,presidentandCEOofNevadaFairHousing,Inc.,aLasVegas–based
housing clinic, told the Commission she and other groups took their concerns di-
rectlv to Greenspan at this time, describing to him in person what she called the
“metamorphosis”inthelendingindustrv.Shetoldhimthatbesidespredatorvlend-
ingpracticessuchasfippingloansormisinformingseniorsaboutreversemortgages,
shealsowitnessedexamplesofgrowingsloppinessinpaperwork:notcreditingpav-
mentsappropriatelvormiscalculatingaccounts.
a8
Lisa Madigan, the attornev general in Illinois, also spotted the emergence of a
troubling trend. She joined state attornevs general from Minnesota, California,
Washington,Arizona,Florida,NewYork,andMassachusettsinpursuingallegations
8ii uii uUi \ii¥ i¥i: ..
about First Alliance Mortgage Companv, a California-based mortgage lender. Con-
sumerscomplainedthatthevhadbeendeceivedintotakingoutloanswithheftvfees.
ThecompanvwasthenpackagingtheloansandsellingthemassecuritiestoLehman
Brothers, Madigan said. The case was settled in iooi, and borrowers received ·-o
million.FirstAlliancewentoutofbusiness.Butotherfrmssteppedintothevoid.
ao
Stateomcialsfromaroundthecountrvjoinedtogetheragaininioo:toinvesti-
gate another fast-growing lender, California-based Ameriquest. It became the na-
tion’s largest subprime lender, originating ·:o billion in subprime loans in
ioo:—mostlv refnances that let borrowers take cash out of their homes, but with
heftvfeesthatateawavattheirequitv.
-o
MadigantestifedtotheFCIC,“Ourmulti-
stateinvestigationofAmeriquestrevealedthatthecompanvengagedinthekindsof
fraudulent practices that other predatorv lenders subsequentlv emulated on a wide
scale:infatinghomeappraisals;increasingtheinterestratesonborrowers’loansor
switchingtheirloansfromfxedtoadjustableinterestratesatclosing;andpromising
borrowersthatthevcouldrefnancetheircostlvloansintoloanswithbettertermsin
justafewmonthsoravear,evenwhenborrowershadnoequitvtoabsorbanother
refnance.”
-1
Ed Parker, the former head of Ameriquest’s Mortgage Fraud Investigations De-
partment, told the Commission that he detected fraud at the companv within one
monthofstartinghisjobthereinIanuarvioo:,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,”andwaslaidoffinMaviooo.
-i
In late ioo:, Prentiss Cox, then a Minnesota assistant attornev 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,ablatantmisrepresentationofemplovment.Inanother
loanfile,herecalledinaninterviewwiththeFCIC,adisabledborrowerinhis8os
who used a walker was described in the loan application as being emploved in
“lightconstruction.”
-:
“Itdidn’ttakeSherlockHolmestofgureoutthiswasbogus,”CoxtoldtheCom-
mission.AshetriedtofgureoutwhvAmeriquestwouldmakesuchobviouslvfraud-
ulent loans, a friend suggested that he “look upstream.” Cox suddenlv realized that
thelendersweresimplvgeneratingproducttoshiptoWallStreettoselltoinvestors.
“Igotthatithadshifted,”Coxrecalled.“Thelendingpatternhadshifted.”
-a
Ultimatelv, ao states and the District of Columbia joined in the lawsuit against
Ameriquest,onbehalfof“morethaniao,oooborrowers.”Theresultwasa·:i-mil-
lionsettlement.Butduringthevearswhentheinvestigationwasunderwav,between
iooiandioo-,Ameriquestoriginatedanother·i1¬.obillioninloans,
--
whichthen
fowedtoWallStreetforsecuritization.
AlthoughthefederalgovernmentplavednoroleintheAmeriquestinvestigation,
somefederalomcialssaidthevhadfollowedthecase.AttheDepartmentofHousing
and Urban Development, “we began to get rumors” that other frms were “running
.z ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN iiiui1
wild, taking applications over the Internet, not verifving peoples’ income or their
abilitv to have a job,” recalled Alphonso Iackson, the HUD secretarv from iooa to
ioo8,inaninterviewwiththeCommission.“Evervbodvwasmakingagreatdealof
monev . . .andtherewasn’tagreatdealofoversightgoingon.”Althoughhewasthe
nation’stophousingomcialatthetime,heplacedmuchoftheblameonCongress.
-o
Cox, the former Minnesota prosecutor, and Madigan, the Illinois attornev gen-
eral, told the Commission that one of the single biggest obstacles to effective state
regulationofunfairlendingcamefromthefederalgovernment,particularlvtheOf-
fceoftheComptrolleroftheCurrencv(OCC),whichregulatednationallvchartered
banks—including Bank of America, Citibank, and Wachovia—and the OTS, which
regulated nationallv chartered thrifts. The OCC and OTS issued rules preempting
statesfromenforcingrulesagainstnationalbanksandthrifts.

Coxrecalledthatin
ioo1, Iulie Williams, the chief counsel of the OCC, had delivered what he called a
“lecture”tothestates’attornevsgeneral,inameetinginWashington,warningthem
thattheOCCwould“quash”themifthevpersistedinattemptingtocontrolthecon-
sumerpracticesofnationallvregulatedinstitutions.
-8
TwoformerOCCcomptrollers,IohnHawkeandIohnDugan,toldtheCommis-
sionthatthevweredefendingtheagencv’sconstitutionalobligationtoblockstateef-
forts to impinge on federallv created entities. Because state-chartered lenders had
morelendingproblems,thevsaid,thestatesshouldhavebeenfocusingthererather
thanlookingtoinvolvethemselvesinfederallvcharteredinstitutions,anarenawhere
thev had no jurisdiction.
-o
However, Madigan told the Commission that national
banksfundedi1ofthei-largestsubprimeloanissuersoperatingwithstatecharters,
andthatthosebanksweretheendmarketforabusiveloansoriginatedbvthestate-
chartered frms. She noted that the OCC was “particularlv zealous in its efforts to
thwart state authoritv over national lenders, and lax in its efforts to protect con-
sumersfromthecomingcrisis.”
oo
Manv 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 bv state laws, because it was a national
bankandfellunderthesupervisionoftheOCC.MichiganprotestedWachovia’san-
nouncement,andWachoviasuedMichigan.TheOCC,theAmericanBankersAsso-
ciation, and the Mortgage Bankers Association entered the frav on Wachovia’s side;
the other ao states, Puerto Rico, and the District of Columbia aligned themselves
with Michigan. The legal battle lasted four vears. The Supreme Court ruled -–: in
Wachovia’sfavoronApril1¬,ioo¬,leavingtheOCCitssoleregulatorformortgage
lending.Coxcriticizedthefederalgovernment:“Notonlvwerethevnegligent,thev
wereaggressiveplaversattemptingtostopanvenforcementaction[s]. . . .Thoseguvs
shouldhavebeenonourside.”
o1
Nonprimelendingsurgedto·¬:obillioniniooaandthen·1.otrillioninioo-,
anditsimpactbegantobefeltinmoreandmoreplaces.
oi
Manvofthoseloanswere
funneled into the pipeline bv 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.
o:
Accordingtoaninvestigativenewsreportpublishedinioo8,
between iooo and ioo¬, at least 1o,-oo people with criminal records entered the
feldinFlorida,forexample,includinga,oo-whohadpreviouslvbeenconvictedof
such crimes as fraud, bank robberv, racketeering, and extortion.
oa
I. Thomas Card-
well,thecommissioneroftheFloridaOmceofFinancialRegulation,toldtheCom-
mission that “lax lending standards” and a “lack of accountabilitv . . . 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 awav from
riskvloans,about-o,oooofthenewcomerstothefeldnationwidewerewillingtodo
whateverittooktomaximizethenumberofloansthevmade.Headdedthatsome
loanoriginationfrms,suchasAmeriquest,were“absolutelv”corrupt.
oo
In Bakersfeld, California, where home starts doubled and home values grew
evenfasterbetweenioo1andiooo,therealestateappraiserGarvCrabtreeinitiallv
feltpridethathisbirthplace,11omilesnorthofLosAngeles,“hadfnallvbeendis-
covered” bv other Californians. The citv, a farming and oil industrv center in the
SanIoaquinVallev,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 iooa,
andioºmoreinioo-.
Crabtree,anappraiserfora8vears,startedinioo:andiooatothinkthatthings
werenotmakingsense.Peoplewerepavinginfatedpricesfortheirhomes,andthev
didn’t seem to have enough income to pav for what thev had bought. Within a few
vears,whenhepassedsomeofthesesamehouses,hesawthatthevwerevacant.“For
sale” signs appeared on the front lawns. And when he passed again, the vards were
untendedandthegrasswasturningbrown.Next,thehouseswentintoforeclosure,
and that’s when he noticed that the emptv houses were being vandalized, which
pulleddownvaluesforthenewsuburbansubdivisions.
The Cleveland phenomenon had come to Bakersfeld, a place far from the Rust
Belt.Crabtreewatchedasforeclosuresspreadlikeaninfectiousdiseasethroughthe
communitv.Housesfellintodisrepairandneighborhoodsdisintegrated.
Crabtreebeganstudvingthemarket.Iniooo,heendedupidentifvingwhathebe-
lieved were i1a fraudulent transactions in Bakersfeld; some, for instance, were al-
lowing insiders to siphon cash from each propertv transfer. The transactions
involvedmanvofthenation’slargestlenders.Onehouse,forexample,waslistedfor
sale for ·-o-,ooo, and was recorded as selling for ·oo-,ooo with 1ooº fnancing,
thoughtherealestateagenttoldCrabtreethatitactuallvsoldfor·-:-,ooo.Crabtree
realizedthatthegapbetweenthesalespriceandloanamountallowedtheseinsiders
topocket·¬o,ooo.Thetermsoftheloanrequiredthebuvertooccupvthehouse,but
itwasneveroccupied.Thehousewentintoforeclosureandwassoldinadistresssale
for·:ii,ooo.

Crabtreebegancallinglenderstotellthemwhathehadfound;buttohisshock,
thevdidnotseemtocare.HefnallvreachedonequalitvassuranceomceratFremont
.. ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN iiiui1
Investment&Loan,thenation’seighth-largestsubprimelender.“Don’tputvournose
whereitdoesn’tbelong,”hewastold.
o8
Crabtree took his storv to state law enforcement omcials and to the Federal Bu-
reauofInvestigation.“Iwasscreamingatthetopofmvlungs,”hesaid.Hegrewinfu-
riated at the slow pace of enforcement and at prosecutors’ lack of response to a
problemthatwaswreakingeconomichavocinBakersfeld.
oo
AttheWashington,D.C.,headquartersoftheFBI,ChrisSwecker,anassistantdi-
rector,wasalsotrvingtogetpeopletopavattentiontomortgagefraud.“Ithasthepo-
tentialtobeanepidemic,”hesaidatanewsconferenceinWashingtoniniooa.“We
thinkwecanpreventaproblemthatcouldhaveasmuchimpactastheS&Lcrisis.”
¬o
SweckercalledanothernewsconferenceinDecemberioo-tosavthesamething,
this time adding that mortgage fraud was a “pervasive problem” that was “on the
rise.”HewasjoinedbvomcialsfromHUD,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.
Suspiciousactivitvreports,alsoknownasSARs,arereportsfledbvbankstotheFi-
nancialCrimesEnforcementNetwork(FinCEN),abureauwithintheTreasurvDe-
partment.InNovemberiooo,thenetworkpublishedananalvsisthatfoundaio-fold
increase in mortgage fraud reports between 1ooo and ioo-. According to FinCEN,
thefgureslikelvrepresentedasubstantialunderreporting,becausetwo-thirdsofall
theloansbeingcreatedwereoriginatedbvmortgagebrokerswhowerenotsubjectto
anvfederalstandardoroversight.
¬i
Inaddition,manvlenderswhowererequiredto
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,RecovervandEnforcement,createdbv
Congressin1oooasthesavingsandloancrisiswasunfolding.
¬a
Former attornev general Alberto Gonzales, who served from Februarv 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 Mukasev, who
servedasattornevgeneralinioo¬andioo8,toldtheFCICthatmortgagefraudhad
never been communicated to them as a top prioritv. “National securitv . . . was an
overriding”concern,Mukasevsaid.
¬-
Tocommunitvactivistsandlocalomcials,however,thelendingpracticeswerea
matterofnationaleconomicconcern.RuhiMaker,alawverwhoworkedonforeclo-
surecasesattheEmpireIusticeCenterinRochester,NewYork,toldFedGovernors
Bernanke,SusanBies,andRogerFergusoninOctoberiooathatshesuspectedthat
some investment banks—she specifed Bear Stearns and Lehman Brothers—were
producingsuchbadloansthatthevervsurvivalofthefrmswasputinquestion.“We
repeatedlvseefalseappraisalsandfalseincome,”shetoldtheFedomcials,whowere
gatheredatthepublichearingperiodofaConsumerAdvisorvCouncilmeeting.She
urged the Fed to prod the Securities and Exchange Commission to examine the
8ii uii uUi \ii¥ i¥i: .,
qualitvofthefrms’duediligence;otherwise,shesaid,seriousquestionscouldarise
about whether thev could be forced to buv back bad loans that thev had made or
securitized.
¬o
Makertoldtheboardthatshefearedan“enormouseconomicimpact”couldre-
sultfromaconfuenceoffnancialevents:fatordecliningincomes,ahousingbub-
ble,andfraudulentloanswithoverstatedvalues.
¬¬
InaninterviewwiththeFCIC,MakersaidthatFedomcialsseemedimperviousto
what the consumer advocates were saving. The Fed governors politelv listened and
saidlittle,sherecalled.“Thevhadtheireconomicmodels,andtheireconomicmod-
elsdidnotseethiscoming,”shesaid.“Wekeptgettingback,‘Thisisallanecdotal.’”
¬8
Soonnontraditionalmortgageswerecrowdingotherkindsofproductsoutofthe
marketinmanvpartsofthecountrv.Moremortgageborrowersnationwidetookout
interest-onlv loans, and the trend was far more pronounced on the West and East
Coasts.
¬o
Becauseoftheireasvcreditterms,nontraditionalloansenabledborrowers
to buv more expensive homes and ratchet up the prices in bidding wars. The loans
were also riskier, however, and a pattern of higher foreclosure rates frequentlv ap-
pearedsoonafter.
Ashomepricesshotupinmuchofthecountrv,manvobserversbegantowonder
if the countrv was witnessing a housing bubble. On Iune 18, ioo-, the Economist
magazine’scoverstorvpositedthatthedavofreckoningwasathand,withthehead-
line“HousePrices:AftertheFall.”Theillustrationdepictedabrickplummetingout
oftheskv.“Itisnotgoingtobeprettv,”thearticledeclared.“Howthecurrenthousing
boom ends could decide the course of the entire world economv over the next few
vears.”
8o
Thatsamemonth,FedChairmanGreenspanacknowledgedtheissue,tellingthe
IointEconomicCommitteeoftheU.S.Congressthat“theapparentfrothinhousing
markets mav have spilled over into the mortgage markets.”
81
For vears, he had
warnedthatFannieMaeandFreddieMac,bolsteredbvinvestors’beliefthatthesein-
stitutionshadthebackingoftheU.S.government,weregrowingsolarge,withsolit-
tleoversight,thatthevwerecreatingsvstemicrisksforthefnancialsvstem.Still,he
reassured legislators that the U.S. economv was on a “reasonablv frm footing” and
thatthefnancialsvstemwouldberesilientifthehousingmarketturnedsour.
“Thedramaticincreaseintheprevalenceofinterest-onlvloans,aswellasthein-
troductionofotherrelativelvexoticformsofadjustableratemortgages,aredevelop-
mentsofparticularconcern,”hetestifedinIune.
Tobesure,thesefnancingvehicleshavetheirappropriateuses.Butto
theextentthatsomehouseholdsmavbeemplovingtheseinstrumentsto
purchaseahomethatwouldotherwisebeunaffordable,theiruseisbe-
ginningtoaddtothepressuresinthemarketplace. . . .
Although we certainlv cannot rule out home price declines, espe-
ciallv in some local markets, these declines, were thev to occur, likelv
would not have substantial macroeconomic implications. Nationwide
bankingandwidespreadsecuritizationofmortgagesmakesitlesslikelv
.( ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN iiiui1
that fnancial intermediation would be impaired than was the case in
priorepisodesofregionalhousepricecorrections.
8i
Indeed,Greenspanwouldnotbetheonlvoneconfdentthatahousingdownturn
would leave the broader fnancial svstem largelv unscathed. As late as March ioo¬,
afterhousingpriceshadbeendecliningforavear,BernanketestifedtoCongressthat
“the problems in the subprime market were likelv to be contained”—that is, he ex-
pectedlittlespillovertothebroadereconomv.
8:
Some were less sanguine. For example, the consumer lawver Sheila Canavan, of
Moab, Utah, informed the Fed’s Consumer Advisorv Council in October ioo- that
o1º of recentlv originated loans in California were interest-onlv, a proportion that
was more than twice the national average. “That’s insanitv,” she told the Fed gover-
nors.“Thatmeanswe’refacingsomethingdowntheroadthatwehaven’tfacedbefore
andwearegoingtobelookingatasafetvandsoundnesscrisis.”
8a
Onanotherfront,someacademicsofferedpointedanalvsesasthevraisedalarms.
Forexample,inAugustioo-,theYaleprofessorRobertShiller,whoalongwithKarl
CasedevelopedtheCase-ShillerIndex,chartedhomepricestoillustratehowprecip-
itouslvthevhadclimbedandhowdistortedthemarketappearedinhistoricalterms.
Shillerwarnedthatthehousingbubblewouldlikelvburst.
8-
Inthatsamemonth,aconclaveofeconomistsgatheredatIacksonLakeLodgein
Wvoming, 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
fromtheUniversitvofChicago’sbusinessschoolwhileservingasthechiefeconomist
of the International Monetarv Fund. Greenspan was there, and so was Bernanke.
Iean-ClaudeTrichet,thepresidentoftheEuropeanCentralBank,andMervvnKing,
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-termgainsbutletoffthehookforanveventuallosses—theIBGYBGsvn-
drome. Rajan added that investment strategies such as credit default swaps could
havedisastrousconsequencesifthesvstembecameunstable,andthatregulatorvin-
stitutionsmightbeunabletodealwiththefallout.

HerecalledtotheFCICthathewastreatedwithscorn.LawrenceSummers,afor-
merU.S.treasurvsecretarvwhowasthenpresidentofHarvardUniversitv,calledRa-
jana“Luddite,”implvingthathewassimplvopposedtotechnologicalchange.
88
“Ifelt
like an earlv Christian who had wandered into a convention of half-starved lions,”
Rajanwrotelater.
8o
SusanM.Wachter,aprofessorofrealestateandfnanceattheUniversitvofPenn-
svlvania’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
1ooos. When she discussed her work at another Iackson Hole gathering two vears
later, it received a chillv reception, she told the Commission. “It was universallv
panned,”shesaid,andaneconomistfromtheMortgageBankersAssociationcalledit
“absurd.”
oo
8ii uii uUi \ii¥ i¥i: .,
Inioo-,newsreportswerebeginningtohighlightindicationsthattherealestate
marketwasweakening.Homesalesbegantodrop,andFitchRatingsreportedsigns
that mortgage delinquencies were rising. That vear, the hedge fund manager Mark
KlipschofOrixCreditCorp.toldparticipantsattheAmericanSecuritizationForum,
asecuritiestradegroup,thatinvestorshadbecome“overoptimistic”aboutthemar-
ket.“Iseealotofirrationalitv,”headded.Hesaidhewasunnervedbecausepeople
were saving, “It’s different this time”—a rationale commonlv heard before previous
collapses.
o1
Some real estate appraisers had also been expressing concerns for vears. From
iooo to ioo¬, a coalition of appraisal organizations circulated and ultimatelv deliv-
ered to Washington omcials a public petition; signed bv 11,ooo appraisers and in-
cluding the name and address of each, it charged that lenders were pressuring
appraisers to place artifciallv high prices on properties. According to the petition,
lenderswere“blacklistinghonestappraisers”andinsteadassigningbusinessonlvto
appraiserswhowouldhitthedesiredpricetargets.“Thepowersthatbecannotclaim
ignorance,” the appraiser Dennis I. Black of Port Charlotte, Florida, testifed to the
Commission.
oi
The appraiser Karen Mann of Discoverv Bav, California, another industrv 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
thatthehousingindustrvwasheadedforacataclvsmicdownturn.Inioo-,shelaid
off some of her staff in order to cut her overhead expenses, in anticipation of the
comingstorm;twovearslater,sheshutdownheromceandbeganworkingoutofher
home.
o:
Despiteallthesignsthatthehousingmarketwasslowing,WallStreetjustkeptgo-
ing and going—ordering up loans, packaging them into securities, taking profts,
earningbonuses.Bvthethirdquarterofiooo,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.
oa
Not evervone on Wall Street kept applauding, however. Some executives were
urgingcaution,ascorporategovernanceandriskmanagementwerebreakingdown.
Refectingonthecausesofthecrisis,IamieDimon,CEOofIPMorgantestifedtothe
FCIC,“Iblamethemanagementteams1ooºand . . .nooneelse.”
o-
Attoomanvfnancialfrms,managementbrushedasidethegrowingriskstotheir
frms.AtLehmanBrothers,forexample,MichaelGelband,theheadoffxedincome,
andhiscolleagueMadelvnAntoncicwarnedagainsttakingontoomuchriskinthe
faceofgrowingpressuretocompeteaggressivelvagainstotherinvestmentbanks.An-
toncic,whowasthefrm’schiefriskomcerfromiooatoioo¬,wasshuntedaside:“At
theseniorlevel,thevweretrvingtopushsohardthatthewheelsstartedtocomeoff,”
shetoldtheCommission.Shewasreassignedtoapolicvpositionworkingwithgov-
.· ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN iiiui1
ernmentregulators.
oo
Gelbandleft;LehmanomcialsblamedGelband’sdepartureon
“philosophicaldifferences.”

AtCitigroup,meanwhile,RichardBowen,aveteranbankerintheconsumerlend-
ing group, received a promotion in earlv iooo when he was named business chief
underwriter. He would go on to oversee loan qualitv for over ·oo billion a vear of
mortgagesunderwrittenandpurchasedbvCitiFinancial.Thesemortgagesweresold
to Fannie Mae, Freddie Mac, and others. In Iune iooo, Bowen discovered that as
muchasooºoftheloansthatCitiwasbuvingweredefective.ThevdidnotmeetCiti-
group’sloanguidelinesandthusendangeredthecompanv—iftheborrowerswereto
defaultontheirloans,theinvestorscouldforceCititobuvthemback.Bowentoldthe
Commissionthathetriedtoalerttopmanagersatthefrmbv“email,weeklvreports,
committee presentations, and discussions”; but though thev expressed concern, it
“nevertranslatedintoanvaction.”Instead,hesaid,“therewasaconsiderablepushto
build volumes, to increase market share.” Indeed, Bowen recalled, Citi began to
loosenitsownstandardsduringthesevearsuptoioo-:specifcallv,itstartedtopur-
chasestated-incomeloans.“Sowejoinedtheotherlemmingsheadedforthecliff,”he
saidinaninterviewwiththeFCIC.
o8
He fnallv 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.treasurvsecretarvintheClintonadministration,andthreeotherbankomcials.
HesentRubinandtheothersamemowiththewords“URGENT—READIMMEDI-
ATELY” in the subject line. Sharing his concerns, he stressed to top managers that
CitifacedbillionsofdollarsinlossesifinvestorsweretodemandthatCitirepurchase
thedefectiveloans.
oo
RubintoldtheCommissioninapublichearinginAprilio1othatCitibankhan-
dledtheBowenmatterpromptlvandeffectivelv.“IdorecollectthisandthateitherI
orsomebodvelse,andItrulvdonotrememberwho,buteitherIorsomebodvelse
sent it to the appropriate people, and I do know factuallv that that was acted on
promptlv and actions were taken in response to it.”
1oo
According to Citigroup, the
bankundertookaninvestigationinresponsetoBowen’sclaimsandthesvstemofun-
derwritingreviewswasrevised.
1o1
BowentoldtheCommissionthatafterhealertedmanagementbvsendingemails,
hewentfromsupervisingiiopeopletosupervisingonlvi,hisbonuswasreduced,
andhewasdowngradedinhisperformancereview.
1oi
Some industrv veterans took their concerns directlv to government omcials.
I.KvleBass,aDallas-basedhedgefundmanagerandaformerBearStearnsexecutive,
testifedtotheFCICthathetoldtheFederalReservethathebelievedthehousingse-
curitizationmarkettobeonashakvfoundation.“Theiransweratthetimewas,and
thiswasalsothethoughtthatwas—thatwashomogeneousthroughoutWallStreet’s
analvsts—was home prices alwavs track income growth and jobs growth. And thev
showedmeincomegrowthononechartandjobsgrowthonanother,andsaid,‘We
don’tseewhatvou’retalkingaboutbecauseincomesarestillgrowingandjobsarestill
growing.’AndIsaid,well,vouobviouslvdon’trealizewherethedogisandwherethe
tailis,andwhat’smovingwhat.”
1o:
8ii uii uUi \ii¥ i¥i: .+
Eventhosewhohadproftedfromthegrowthofnontraditionallendingpractices
saidthevbecamedisturbedbvwhatwashappening.HerbSandler,theco-founderof
themortgagelenderGoldenWestFinancialCorporation,whichwasheavilvloaded
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 virtuallv anv asset can be
churnedthroughsecuritizationandtransformedintoaAAA-ratedasset,andwhena
multi-billiondollarindustrvisalltooeagertofacilitatethisalchemv.”
1oa
Similarlv,LewisRanieri,amortgagefnanceveteranwhohelpedengineertheWall
Streetmortgagesecuritizationmachineinthe1o8os,saidhedidn’tlikewhathecalled
“themadness”thathaddescendedontherealestatemarket.RanieritoldtheCommis-
sion, “I was not the onlv guv. I’m not telling vou I was Iohn the Baptist. There were
enoughofus,analvstsandothers,wanderingaroundgoing‘lookatthisstuff,’thatit
wouldbehardtomissit.”
1o-
Ranieri’sownHouston-basedFranklinBankCorporation
woulditselfcollapseundertheweightofthefnancialcrisisinNovemberioo8.
Other industrv veterans inside the business also acknowledged that the rules of
the game were being changed. “Poison” was the word famouslv used bv Countrv-
wide’sMozilotodescribeoneoftheloanproductshisfrmwasoriginating.
1oo
“Inall
mvvearsinthebusinessIhaveneverseenamoretoxic[product],”hewroteinanin-
ternalemail.
1o¬
Othersatthebankarguedinresponsethatthevwereofferingprod-
ucts“pervasivelvofferedinthemarketplacebvvirtuallvevervrelevantcompetitorof
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.
“Thevallwentbroke.”
1oo
Inlateioo-,regulatorsdecidedtotakealookatthechangingmortgagemarket.
SabethSiddique,theassistantdirectorforcreditriskintheDivisionofBankingSu-
pervisionandRegulationattheFederalReserveBoard,waschargedwithinvestigat-
inghowbroadlvloanpatternswerechanging.Hetookthequestionsdirectlvtolarge
banksinioo-andaskedthemhowmanvofwhichkindsofloansthevweremaking.
Siddique found the information he received “verv alarming,” he told the Commis-
sion.
11o
In fact, nontraditional loans made up -oº percent of originations at Coun-
trvwide, -8º percent at Wells Fargo, -1º at National Citv, :1º at Washington
Mutual,io.-ºatCitiFinancial,and18.:ºatBankofAmerica.Moreover,thebanks
expectedthattheiroriginationsofnontraditionalloanswouldrisebv1¼inioo-,to
·oo8.-billion.Thereviewalsonotedthe“slowlvdeterioratingqualitvofloansdueto
looseningunderwritingstandards.”Inaddition,itfoundthattwo-thirdsofthenon-
traditionalloansmadebvthebanksinioo:hadbeenofthestated-income,minimal
documentationvarietvknownasliarloans,whichhadaparticularlvgreatlikelihood
ofgoingsour.
111
ThereactiontoSiddique’sbriefngwasmixed.FederalReserveGovernorBiesre-
called the response bv the Fed governors and regional board directors as divided
from the beginning. “Some people on the board and regional presidents . . . just
wantedtocometoadifferentanswer.Sothevdidignoreit,orthefullthrustofit,”she
toldtheCommission.
11i
z+ ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN iiiui1
TheOCCwasalsoponderingthesituation.Formercomptrollerofthecurrencv
IohnC.DugantoldtheCommissionthatthepushhadcomefrombelow,frombank
examinerswhohadbecomeconcernedaboutwhatthevwereseeinginthefeld.
11:
The agencv began to consider issuing “guidance,” a kind of nonbinding omcial
warning to banks, that nontraditional loans could jeopardize safetv and soundness
andwouldinvitescrutinvbvbankexaminers.SiddiquesaidtheOCCledtheeffort,
whichbecameamultiagencvinitiative.
11a
Biessaidthatdeliberationsoverthepotentialguidancealsostirreddebatewithin
theFed,becausesomecriticsfeareditbothwouldstifethefnancialinnovationthat
wasbringingrecordproftstoWallStreetandthebanksandwouldmakehomesless
affordable. Moreover, all the agencies—the Fed, the OCC, the OTS, the FDIC, and
theNationalCreditUnionAdministration—wouldneedtoworktogetheronit,orit
wouldunfairlvblockonegroupoflendersfromissuingtvpesofloansthatwereavail-
ablefromotherlenders.TheAmericanBankersAssociationandMortgageBankers
Associationopposeditasregulatorvoverreach.
“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 deeplv concerned about
the contagion effect from poorlv underwritten or unsuitable mortgages and home
equitv loans,” the trade association wrote to regulators in iooo. “The most recent
markettrendsshowalarmingsignsofunduerisk-takingthatputsbothlendersand
consumersatrisk.”
11o
Incongressionaltestimonvaboutamonthlater,WilliamA.Simpson,thegroup’s
vicepresident,pointedlvreferredtopastrealestatedownturns.“Wetakeaconserva-
tivepositiononriskbecauseofourfrstlossposition,”SimpsoninformedtheSenate
Subcommittee on Housing, Transportation and Communitv Development and the
SenateSubcommitteeonEconomicPolicv.“However,wealsohaveahistoricalper-
spective.Weweretherewhenthemortgagemarketsturnedsharplvdownduringthe
mid-1o8os especiallv in the oil patch and the earlv 1ooos in California and the
Northeast.”
11¬
WithintheFed,thedebategrewheatedandemotional,Siddiquerecalled.“Itgot
vervpersonal,”hetoldtheCommission.Theideologicalturfwarlastedmorethana
vear,whilethenumberofnontraditionalloanskeptgrowingandgrowing.
118
Consumer advocates kept up the heat. In a Fed Consumer Advisorv Council
meeting in March iooo, Fed Governors Bernanke, Mark Olson, and Kevin Warsh
werespecifcallvandpubliclvwarnedofdangersthatnontraditionalloansposedto
theeconomv.StellaAdams,theexecutivedirectoroftheNorthCarolinaFairHous-
ingCenter,raisedconcernsthatnontraditionallending“mavprecipitateadownward
spiralthatstartsonthecoastandthencreatespanicintheeastthatcouldhaveimpli-
cationsonourtotaleconomvaswell.”
11o
AtthenextmeetingoftheFed’sConsumerAdvisorvCouncil,heldinIuneiooo
andattendedbvBernanke,Bies,Olson,andWarsh,severalconsumeradvocatesde-
scribedtotheFedgovernorsalarmingincidentsthatwerenowoccurringalloverthe
8ii uii uUi \ii¥ i¥i: z.
countrv.EdwardSivak,thedirectorofpolicvandevaluationattheEnterpriseCorp.
of the Delta, in Iackson, Mississippi, spoke of being told bv mortgage brokers that
propertvvalueswerebeinginfatedtomaximizeproftforrealestateappraisersand
loanoriginators.AlanWhite,thesupervisingattornevatCommunitvLegalServices
inPhiladelphia,reporteda“hugesurgeinforeclosures,”notingthatuptohalfofthe
borrowershewasseeingwithtroubledloanshadbeenoverchargedandgivenhigh-
interest rate mortgages when their credit had qualifed them for lower-cost loans.
HattieB.Dorsev,thepresidentandchiefexecutiveomcerofAtlantaNeighborhood
Development, said she worried that houses were being fipped back and forth so
muchthattheresultwouldbeneighborhood“decav.”CarolvnCarteroftheNational
ConsumerLawCenterinMassachusettsurgedtheFedtouseitsregulatorvauthoritv
to“prohibitabusesinthemortgagemarket.”
1io
Thebalancewastipping.AccordingtoSiddique,beforeGreenspanlefthispostas
Fed chairman in Ianuarv iooo, he had indicated his willingness to accept the guid-
ance.FergusonworkedwiththeFedboardandtheregionalFedpresidentstogetit
done.Biessupportedit,andBernankedidaswell.
1i1
MorethanavearaftertheOCChadbegandiscussingtheguidance,andafterthe
housingmarkethadpeaked,itwasissuedinSeptemberioooasaninteragencvwarn-
ing that affected banks, thrifts, and credit unions nationwide. Dozens of states fol-
lowed,directingtheirversionsoftheguidancetotensofthousandsofstate-chartered
lendersandmortgagebrokers.
Then,inIulvioo8,longaftertheriskv,nontraditionalmortgagemarkethaddis-
appearedandtheWallStreetmortgagesecuritizationmachinehadgroundtoahalt,
the Federal Reserve fnallv adopted new rules under HOEPA to curb the abuses
about which consumer groups had raised red fags for vears—including a require-
mentthatborrowershavetheabilitvtorepavloansmadetothem.
Bvthattime,however,thedamagehadbeendone.Thetotalvalueofmortgage-
backedsecuritiesissuedbetweenioo1andioooreached·1:.atrillion.
1ii
Therewasa
mountainofproblematicsecurities,debt,andderivativesrestingonrealestateassets
thatwerefarlesssecurethanthevwerethoughttohavebeen.
Iust as Bernanke thought the spillovers from a housing market crash would be
contained, so too policvmakers, regulators, and fnancial executives did not under-
standhowdangerouslvexposedmajorfrmsandmarketshadbecometothepoten-
tial contagion from these riskv fnancial instruments. As the housing market began
toturn,thevscrambledtounderstandtherapiddeteriorationinthefnancialsvstem
andrespondaslossesinonepartofthatsvstemwouldricochettoothers.
Bvtheendofioo¬,mostofthesubprimelendershadfailedorbeenacquired,in-
cludingNewCenturvFinancial,Ameriquest,andAmericanHomeMortgage.InIan-
uarv ioo8, Bank of America announced it would acquire the ailing lender
Countrvwide.Itsoonbecameclearthatrisk—ratherthanbeingdiversifedacrossthe
fnancial svstem, as had been thought—was concentrated at the largest fnancial
frms.BearStearns,ladenwithriskvmortgageassetsanddependentonfckleshort-
term lending, was bought bv IP Morgan with government assistance in the spring.
zz ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN iiiui1
Beforethesummerwasover,FannieMaeandFreddieMacwouldbeputintoconser-
vatorship. Then, in September, Lehman Brothers failed and the remaining invest-
ment banks, Merrill Lvnch, Goldman Sachs, and Morgan Stanlev, struggled as thev
lostthemarket’sconfdence.AIG,withitsmassivecreditdefaultswapportfolioand
exposuretothesubprimemortgagemarket,wasrescuedbvthegovernment.Finallv,
manv commercial banks and thrifts, which had their own exposures to declining
mortgageassetsandtheirownexposurestoshort-termcreditmarkets,teetered.In-
dvMac had alreadv failed over the summer; in September, Washington Mutual be-
camethelargestbankfailureinU.S.historv.InOctober,Wachoviastruckadealtobe
acquiredbvWellsFargo.CitigroupandBankofAmericafoughttostavafoat.Before
it was over, taxpavers had committed trillions of dollars through more than two
dozenextraordinarvprogramstostabilizethefnancialsvstemandtopropupthena-
tion’slargestfnancialinstitutions.
Thecrisisthatbefellthecountrvinioo8hadbeenvearsinthemaking.Intesti-
monvtotheCommission,formerFedchairmanGreenspandefendedhisrecordand
saidmostofhisjudgmentshadbeencorrect.“Iwasright¬oºofthetimebutIwas
wrong :oº of the time,” he told the Commission.
1i:
Yet the consequences of what
wentwrongintherun-uptothecrisiswouldbeenormous.
Theeconomicimpactofthecrisishasbeendevastating.Andthehumandevasta-
tioniscontinuing.Theomciallvreportedunemplovmentratehoveredatalmost1oº
in November io1o, but the underemplovment rate, which includes those who have
given up looking for work and part-time workers who would prefer to be working
full-time,wasabove1¼.Andtheshareofunemplovedworkerswhohavebeenout
ofworkformorethansixmonthswasjustaboveaoº.Oflargemetropolitanareas,
Las Vegas, Nevada, and Riverside–San Bernardino, California, had the highest un-
emplovment—theirrateswereabove1aº.
Theloanswereaslethalasmanvhadpredicted,andithasbeenestimatedthatul-
timatelvasmanvas1:millionhouseholdsintheUnitedStatesmavlosetheirhomes
to foreclosure. As of io1o, foreclosure rates were highest in Florida and Nevada; in
Florida, nearlv 1aº of loans were in foreclosure, and Nevada was not verv far
behind.
1ia
Nearlvone-quarterofAmericanmortgageborrowersowedmoreontheir
mortgagesthantheirhomewasworth.InNevada,thepercentagewasnearlv¬oº.
1i-
Householdshavelost·11trillioninwealthsinceiooo.
As Mark Zandi, the chief economist of Moodv’s Economv.com, testifed to the
Commission,“ThefnancialcrisishasdealtavervseriousblowtotheU.S.economv.
The immediate impact was the Great Recession: the longest, broadest and most se-
veredownturnsincetheGreatDepressionofthe1o:os. . . .Thelonger-termfallout
fromtheeconomiccrisisisalsovervsubstantial. . . .Itwilltakevearsforemplovment
toregainitspre-crisislevel.”
1io
Lookingbackonthevearsbeforethecrisis,theeconomistDeanBakersaid:“So
muchofthiswasabsolutepublicknowledgeinthesensethatweknewthenumberof
loans that were being issued with zero down. Now, do we suddenlv think we have
thatmanvmorepeople—whoarecapableoftakingonaloanwithzerodownwhowe
8ii uii uUi \ii¥ i¥i: z.
thinkaregoingtobeabletopavthatoff—thanwastrue1o,1-,iovearsago:Imean,
what’schangedintheworld:Therewerealotofthingsthatdidn’trequireanvinves-
tigationatall;theseweretotallvavailableinthedata.”
1i¬
WarrenPeterson,ahomebuilderinBakersfeld,feltthathecouldpinpointwhen
theworldchangedtothedav.Petersonbuilthomesinanupscaleneighborhood,and
each Mondav morning, he would arrive at the omce to fnd a bevv of real estate
agents, sales contracts in hand, vving to be the ones chosen to purchase the new
homeshewasbuilding.Thestreamoftramcwasconstant.OnoneSaturdavinNo-
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 NuUi i¥ tu\\i : :i uN iiiui1
PART II
Setting the Stage
2
SHADOW BANKING
CONTENTS
Ccnncrcia|papcrandrcpcs“Unjcttcrcdnarkcts”:;
1hcsavingsand|cancrisis“1hcvputa|ctcj
prcssurccnthcirrcgu|atcrs” :;
Thefnancialcrisisofioo¬andioo8wasnotasingleeventbutaseriesofcrisesthat
rippled through the fnancial svstem and, ultimatelv, the economv. Distress in one
areaofthefnancialmarketsledtofailuresinotherareasbvwavofinterconnections
andvulnerabilitiesthatbankers,governmentomcials,andothershadmissedordis-
missed.Whensubprimeandotherriskvmortgages—issuedduringahousingbubble
thatmanvexpertsfailedtoidentifv,andwhoseconsequenceswerenotunderstood—
begantodefaultatunexpectedrates,aonce-obscuremarketforcomplexinvestment
securitiesbackedbvthosemortgagesabruptlvfailed.Whenthecontagionspread,in-
vestorspanicked—andthedangerinherentinthewholesvstembecamemanifest.Fi-
nancialmarketsteeteredontheedge,andbrand-namefnancialinstitutionswereleft
bankruptordependentonthetaxpaversforsurvival.
Federal Reserve Chairman Ben Bernanke now acknowledges that he missed the
svstemic risks. “Prospective subprime losses were clearlv not large enough on their
own to account for the magnitude of the crisis,” Bernanke told the Commission.
“Rather,thesvstem’svulnerabilities,togetherwithgapsinthegovernment’scrisis-re-
sponse toolkit, were the principal explanations of whv the crisis was so severe and
hadsuchdevastatingeffectsonthebroadereconomv.”
1
Thispartofourreportexplorestheoriginsofrisksasthevdevelopedinthefnan-
cial svstem over recent decades. It is a fascinating storv with profound conse-
quences—acomplexhistorvthatcouldvielditsownreport.Instead,wefocusonfour
kevdevelopmentsthathelpedshapetheeventsthatshookourfnancialmarketsand
economv.Detailedbookscouldbewrittenabouteachofthem;westicktotheessen-
tialsforunderstandingourspecifcconcern,whichistherecentcrisis.
First, we describe the phenomenal growth of the shadow banking svstem—the
investment banks, most prominentlv, but also other fnancial institutions—that
freelvoperatedincapitalmarketsbevondthereachoftheregulatorvapparatusthat
had been put in place in the wake of the crash of 1oio and the Great Depression.
z,
Thisnewsvstemthreatenedtheonce-dominanttraditionalcommercialbanks,and
thev took their grievances to their regulators and to Congress, which slowlv but
steadilvremovedlong-standingrestrictionsandhelpedbanksbreakoutoftheirtra-
ditional mold and join the feverish growth. As a result, two parallel fnancial svs-
tems of enormous scale emerged. This new competition not onlv benefted Wall
Street but also seemed to help all Americans, lowering the costs of their
mortgages and boostingthereturnsontheirao1(k)s.Shadowbanksandcommer-
cial banks were codependent competitors. Their new activities were verv prof-
itable—and,itturnedout,vervriskv.
Second, we look at the evolution of fnancial regulation. To the Federal Reserve
andotherregulators,thenewdualsvstemthatgrantedgreaterlicensetomarketpar-
ticipantsappearedtoprovideasaferandmoredvnamicalternativetotheeraoftradi-
tionalbanking.Moreandmore,regulatorslookedtofnancialinstitutionstopolice
themselves—“deregulation”wasthelabel.FormerFedchairmanAlanGreenspanput
it this wav: “The market-stabilizing private regulatorv forces should graduallv dis-
place manv cumbersome, increasinglv ineffective government structures.”
i
In the
Fed’sview,ifproblemsemergedintheshadowbankingsvstem,thelargecommercial
banks—whichwerebelievedtobewell-run,well-capitalized,andwell-regulatedde-
spitethelooseningoftheirrestraints—couldprovidevitalsupport.Andifproblems
outstrippedthemarket’sabilitvtorightitself,theFederalReservewouldtakeonthe
responsibilitv to restore fnancial stabilitv. It did so again and again in the decades
leadinguptotherecentcrisis.And,understandablv,muchofthecountrvcametoas-
sumethattheFedcouldalwavsandwouldalwavssavethedav.
Third,wefollowtheprofoundchangesinthemortgageindustrv,fromthesleepv
davs when local lenders took full responsibilitv for making and servicing :o-vear
loanstoanewerainwhichtheideawastoselltheloansoffassoonaspossible,so
thatthevcouldbepackagedandsoldtoinvestorsaroundtheworld.Newmortgage
productsproliferated,andsodidnewborrowers.Inevitablv,thisbecameamarketin
which the participants—mortgage brokers, lenders, and Wall Street frms—had a
greater stake in the quantitv of mortgages signed up and sold than in their qualitv.
WealsotracethehistorvofFannieMaeandFreddieMac,publiclvtradedcorpora-
tionsestablishedbvCongressthatbecamedominantforcesinprovidingfnancingto
supportthemortgagemarketwhilealsoseekingtomaximizereturnsforinvestors.
Fourth,weintroducesomeofthemostarcanesubjectsinourreport:securitiza-
tion, structured fnance, and derivatives—words that entered the national vocabu-
larvasthefnancialmarketsunraveledthroughioo¬andioo8.Putsimplvandmost
pertinentlv, structured fnance was the mechanism bv which subprime and other
mortgageswereturnedintocomplexinvestmentsoftenaccordedtriple-Aratingsbv
credit rating agencies whose own motives were conficted. This entire market de-
pended on fnelv honed computer models—which turned out to be divorced from
realitv—andonever-risinghousingprices. Whenthatbubbleburst, thecomplexitv
bubblealsoburst:thesecuritiesalmostnooneunderstood,backedbvmortgagesno
lenderwouldhavesignediovearsearlier,werethefrstdominoestofallinthefnan-
cialsector.
z· ii N\Nti \i tii :i : i NuUi 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 svstem in the vear iooo, at
thedawnofadecadeofpromiseandperil.
COMMERCIAL PAPER AND REPOS:
“UNFETTERED MARKETS”
For most of the ioth centurv, banks and thrifts accepted deposits and loaned that
monevtohomebuversorbusinesses.BeforetheDepression,theseinstitutionswere
vulnerable to runs, when reports or merelv rumors that a bank was in trouble
spurreddepositorstodemandtheircash.Iftherunwaswidespread,thebankmight
nothaveenoughcashonhandtomeetdepositors’demands:runswerecommonbe-
foretheCivilWarandthenoccurredin18¬:,188a,18oo,18o:,18oo,and1oo¬.
:
To
stabilize fnancial markets, Congress created the Federal Reserve Svstem in 1o1:,
whichactedasthelenderoflastresorttobanks.
ButthecreationoftheFedwasnotenoughtoavertbankrunsandsharpcontrac-
tionsinthefnancialmarketsinthe1oiosand1o:os.Soin1o::Congresspassedthe
Glass-Steagall Act, which, among other changes, established the Federal Deposit In-
suranceCorporation.TheFDICinsuredbankdepositsupto·i,-oo—anamountthat
coveredthevastmajoritvofdepositsatthetime;thatlimitwouldclimbto·1oo,ooobv
1o8o,whereitstaveduntilitwasraisedto·i-o,oooduringthecrisisinOctoberioo8.
Depositors no longer needed to worrv about being frst in line at a troubled bank’s
door.Andifbankswereshortofcash,thevcouldnowborrowfromtheFederalRe-
serve,evenwhenthevcouldborrownowhereelse.TheFed,actingaslenderoflastre-
sort,wouldensurethatbankswouldnotfailsimplvfromalackofliquiditv.
Withthesebackstopsinplace,Congressrestrictedbanks’activitiestodiscourage
them from taking excessive risks, another move intended to help prevent bank fail-
ures,withtaxpaverdollarsnowatrisk.Furthermore,CongresslettheFederalReserve
capinterestratesthatbanksandthrifts—alsoknownassavingsandloans,orS&Ls—
couldpavdepositors.Thisrule,knownasRegulationO,wasalsointendedtokeepin-
stitutionssafebvensuringthatcompetitionfordepositsdidnotgetoutofhand.
a
The svstem was stable as long as interest rates remained relativelv steadv, which
thevdidduringthefrsttwodecadesafterWorldWarII.Beginninginthelate-1ooos,
however, infation started to increase, pushing up interest rates. For example, the
ratesthatbankspaidotherbanksforovernightloanshadrarelvexceededoºinthe
decadesbefore1o8o,whenitreachedioº.However,thankstoRegulationO,banks
and thrifts were stuck offering roughlv less than oº on most deposits. Clearlv, this
was an untenable bind for the depositorv institutions, which could not compete on
themostbasicleveloftheinterestrateofferedonadeposit.
Competewithwhom:Inthe1o¬os,MerrillLvnch,Fidelitv,Vanguard,andothers
persuadedconsumersandbusinessestoabandonbanksandthriftsforhigherreturns.
These frms—eager to fnd new businesses, particularlv after the Securities and Ex-
change Commission (SEC) abolished fxed commissions on stock trades in 1o¬-—
created monev market mutual funds that invested these depositors’ monev in
:u\iu\ 8\Nii Nt z+
short-term,safesecuritiessuchasTreasurvbondsandhighlvratedcorporatedebt,
andthefundspaidhigherinterestratesthanbanksandthriftswereallowedtopav.
Thefundsfunctionedlikebankaccounts,althoughwithadifferentmechanism:cus-
tomersboughtsharesredeemabledailvatastablevalue.In1o¬¬,MerrillLvnchin-
troduced something even more like a bank account: “cash management accounts”
allowed customers to write checks. Other monev market mutual funds quicklv
followed.
-
Thesefundsdifferedfrombankandthriftdepositsinoneimportantrespect:thev
were not protected bv FDIC deposit insurance. Nevertheless, consumers liked the
higherinterestrates,andthestatureofthefunds’sponsorsreassuredthem.Thefund
sponsors implicitlv 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,andsowasbornakevplaverintheshadowbankingindus-
trv, the less-regulated market for capital that was growing up beside the traditional
banking svstem. Assets in monev market mutual funds jumped from ·: billion in
1o¬¬tomorethan·¬aobillionin1oo-and·1.8trillionbviooo.
o
To maintain their edge over the insured banks and thrifts, the monev market
fundsneededsafe,high-qualitvassetstoinvestin,andthevquicklvdevelopedanap-
petite for two booming markets: the “commercial paper” and “repo” markets.
Throughtheseinstruments,MerrillLvnch,MorganStanlev,andotherWallStreetin-
vestment banks could broker and provide (for a fee) short-term fnancing to large
corporations.Commercialpaperwasunsecuredcorporatedebt—meaningthatitwas
backed not bv a pledge of collateral but onlv bv the corporation’s promise to pav.
Theseloanswerecheaperbecausethevwereshort-term—forlessthanninemonths,
sometimesasshortastwoweeksand,eventuallv,asshortasonedav;theborrowers
usuallv “rolled them over” when the loan came due, and then again and again. Be-
causeonlvfnanciallvstablecorporationswereabletoissuecommercialpaper,itwas
consideredavervsafeinvestment;companiessuchasGeneralElectricandIBM,in-
vestorsbelieved,wouldalwavsbegoodforthemonev.Corporationshadbeenissuing
commercialpapertoraisemonevsincethebeginningofthecenturv,butthepractice
grewmuchmorepopularinthe1ooos.
Thismarket,though,underwentacrisisthatdemonstratedthatcapitalmarkets,
too,werevulnerabletoruns.Yetthatcrisisactuallvstrengthenedthemarket.In1o¬o,
the Penn Central Transportation Companv, the sixth-largest nonfnancial corpora-
tion in the U.S., fled for bankruptcv with ·ioo million in commercial paper out-
standing. The railroad’s default caused investors to worrv 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 virtuallv
shut down. In response, the Federal Reserve supported the commercial banks with
almost ·ooo million in emergencv loans and with interest rate cuts.
¬
The Fed’s ac-
tions enabled the banks, in turn, to lend to corporations so that thev could pav off
theircommercialpaper.AfterthePennCentralcrisis,theissuersofcommercialpa-
per—theborrowers—tvpicallvsetupstandbvlinesofcreditwithmajorbankstoen-
.+ ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN iiiui1
able them to pav off their debts should there be another shock. These moves reas-
suredinvestorsthatcommercialpaperwasasafeinvestment.
Inthe1ooos,thecommercialpapermarketjumpedmorethansevenfold.Thenin
the 1o¬os, it grew almost fourfold. Among the largest buvers of commercial paper
were the monev market mutual funds. It seemed a win-win-win deal: the mutual
funds could earn a solid return, stable companies could borrow more cheaplv, and
WallStreetfrmscouldearnfeesforputtingthedealstogether.Bviooo,commercial
paperhadrisento·1.otrillionfromlessthan·1i-billionin1o8o.
8
Thesecondmajorshadowbankingmarketthatgrewsignifcantlvwasthemarket
forrepos,orrepurchaseagreements.Likecommercialpaper,reposhavealonghis-
torv, but thev proliferated quicklv in the 1o¬os. Wall Street securities dealers often
soldTreasurvbondswiththeirrelativelvlowreturnstobanksandotherconservative
investors,whiletheninvestingthecashproceedsofthesesalesinsecuritiesthatpaid
higherinterestrates.ThedealersagreedtorepurchasetheTreasuries—oftenwithina
dav—ataslightlvhigherpricethanthatforwhichthevsoldthem.Thisrepotransac-
tion—inessencealoan—madeitinexpensiveandconvenientforWallStreetfrmsto
borrow.Becausethesedealswereessentiallvcollateralizedloans,thesecuritiesdeal-
ersborrowednearlvthefullvalueofthecollateral,minusasmall“haircut.”Likecom-
mercialpaper,reposwererenewed,or“rolledover,”frequentlv.Forthatreason,both
forms of borrowing could be considered “hot monev”—because lenders could
quicklv move in and out of these investments in search of the highest returns, thev
couldbeariskvsourceoffunding.
Therepomarket,too,hadvulnerabilities,butit,too,hademergedfromanearlv
crisisstrongerthanever.In1o8i,twomajorborrowers,thesecuritiesfrmsDrvsdale
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-partvarrangementin
whichalargeclearingbankactedasintermediarvbetweenborrowerandlender,es-
sentiallv protecting the collateral and the funds bv putting them in escrow.
o
This
mechanism would have severe consequences in ioo¬ and ioo8. In the 1o8os, how-
ever,thesenewproceduresstabilizedtherepomarket.
The new parallel banking svstem—with commercial paper and repo providing
cheaperfnancing,andmonevmarketfundsprovidingbetterreturnsforconsumers
andinstitutionalinvestors—hadacrucialcatch:itspopularitvcameattheexpenseof
thebanksandthrifts.Someregulatorsviewedthisdevelopmentwithgrowingalarm.
According to Alan Blinder, the vice chairman of the Federal Reserve from 1ooa to
1ooo,“Wewereconcernedasbankregulatorswiththeerodingcompetitiveposition
ofbanks,whichofcoursewouldthreatenultimatelvtheirsafetvandsoundness,due
to the competition thev were getting from a varietv of nonbanks—and these were
mainlvWallStreetfrms,thatweretakingdepositsfromthem,andgettingintothe
loanbusinesstosomeextent.So,veah,itwasaconcern;voucouldseeadownward
trendintheshareofbankingassetstofnancialassets.”
1o
:u\iu\ 8\Nii Nt ..
Figure i.1 shows that during the 1ooos the shadow banking svstem steadilv
gainedgroundonthetraditionalbankingsector—andactuallvsurpassedthebank-
ingsectorforabrieftimeafteriooo.
Banks argued that their problems stemmed from the Glass-Steagall Act. Glass-
Steagallstrictlvlimitedcommercialbanks’participationinthesecuritiesmarkets,in
parttoendthepracticesofthe1oios,whenbankssoldhighlvspeculativesecurities
todepositors.In1o-o,Congressalsoimposednewregulatorvrequirementsonbanks
owned bv holding companies, in order to prevent a holding companv from endan-
geringanvofitsdeposit-takingbanks.
Bank supervisors monitored banks’ leverage—their assets relative to equitv—
becauseexcessiveleverageendangeredabank.Leverage,usedbvnearlvevervfnan-
cial institution, amplifes returns. For example, if an investor uses ·1oo of his own
monevtopurchaseasecuritvthatincreasesinvaluebv1oº,heearns·1o.However,
ifheborrowsanother·oooandinvests1otimesasmuch(·1,ooo),thesame1oºin-
crease in value vields a proft of ·1oo, double his out-of-pocket investment. If the
investmentsours,though,leveragemagnifesthelossjustasmuch.Adeclineof1oº
coststheunleveragedinvestor·1o,leavinghimwith·oo,butwipesouttheleveraged
investor’s ·1oo. An investor buving assets worth 1o times his capital has a leverage
.z ii N\Nti \i tii :i : i NuUi 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 monev invested compared to
themonevtheinvestorhascommittedtothedeal.
In1o81,banksupervisorsestablishedthefrstformalminimumcapitalstandards,
whichmandatedthatcapital—theamountbvwhichassetsexceeddebtandotherlia-
bilities—should be at least -º of assets for most banks. Capital, in general, refects
thevalueofshareholders’investmentinthebank,whichbearsthefrstriskofanvpo-
tentiallosses.
Bv comparison, Wall Street investment banks could emplov far greater leverage,
unhindered bv oversight of their safetv and soundness or bv capital requirements
outside of their broker-dealer subsidiaries, which were subject to a net capital rule.
The main shadow banking participants—the monev market funds and the invest-
mentbanksthatsponsoredmanvofthem—werenotsubjecttothesamesupervision
asbanksandthrifts.Themonevintheshadowbankingmarketscamenotfromfed-
erallvinsureddepositorsbutprincipallvfrominvestors(inthecaseofmonevmarket
funds) or commercial paper and repo markets (in the case of investment banks).
BothmonevmarketfundsandsecuritiesfrmswereregulatedbvtheSecuritiesand
ExchangeCommission.ButtheSEC,createdin1o:a,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,andbrokeredtransactionsinsecuritiestocomplvwithproceduralre-
strictions such as keeping customers’ funds in separate accounts. Historicallv, the
SECdidnot focusonthesafetvandsoundnessofsecuritiesfrms,althoughitdidim-
posecapitalrequirementsonbroker-dealersdesignedtoprotecttheirclients.
Meanwhile, since deposit insurance did not cover such instruments as monev
marketmutualfunds,thegovernmentwasnotonthehook.Therewaslittleconcern
aboutarun.Intheorv,theinvestorshadknowinglvriskedtheirmonev.Ifaninvest-
mentlostvalue,itlostvalue.Ifafrmfailed,itfailed.Asaresult,monevmarketfunds
had no capital or leverage standards. “There was no regulation,” former Fed chair-
man Paul Volcker told the Financial Crisis Inquirv Commission. “It was kind of a
freeride.”
11
Thefundshadtofollowonlvregulationsrestrictingthetvpeofsecurities
inwhichthevcouldinvest,thedurationofthosesecurities,andthediversifcationof
their portfolios. These requirements were supposed to ensure that investors’ shares
would not diminish in value and would be available anvtime—important reassur-
ances, but not the same as FDIC insurance. The onlv protection against losses was
theimplicitguaranteeofsponsorslikeMerrillLvnchwithreputationstoprotect.
Increasinglv, the traditional world of banks and thrifts was ill-equipped to keep
upwiththeparallelworldoftheWallStreetfrms.Thenewshadowbankshadfew
constraints on raising and investing monev. Commercial banks were at a disadvan-
tageandindangeroflosingtheirdominantposition.Theirbindwaslabeled“disin-
termediation,” and manv critics of the fnancial regulatorv svstem concluded that
policv makers, all the wav back to the Depression, had trapped depositorv institu-
tionsinthisunproftablestraitjacketnotonlvbvcappingtheinterestratesthevcould
pavdepositorsandimposingcapitalrequirementsbutalsobvpreventingtheinstitu-
tionsfromcompetingagainsttheinvestmentbanks(andtheirmonevmarketmutual
:u\iu\ 8\Nii Nt ..
funds).Moreover,criticsargued,theregulatorvconstraintsonindustriesacrossthe
entireeconomvdiscouragedcompetitionandrestrictedinnovation,andthefnancial
sectorwasaprimeexampleofsuchahamperedindustrv.
Years later, Fed Chairman Greenspan described the argument for deregulation:
“Thoseofuswhosupportmarketcapitalisminitsmorecompetitiveformsmightar-
guethatunfetteredmarketscreateadegreeofwealththatfostersamorecivilizedex-
istence.Ihavealwavsfoundthatinsightcompelling.”
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.Theplavingfeldwasn’tlevel,which“putalotofpressureoninstitutionstoget
higher-rate performing assets,” former SEC Chairman Richard Breeden told the
FCIC.“Andthevputalotofpressureontheirregulatorstoallowthistohappen.”
1:
ThebanksandtheS&LswenttoCongressforhelp.In1o8o,theDepositorvInsti-
tutions Deregulation and Monetarv Control Act repealed the limits on the interest
ratesthatdepositorvinstitutionscouldofferontheirdeposits.Althoughthislawre-
moved a signifcant regulatorv constraint on banks and thrifts, it could not restore
theircompetitiveadvantage.Depositorswantedahigherrateofreturn,whichbanks
andthriftswerenowfreetopav.Buttheinterestbanksandthriftscouldearnoffof
mortgages and other long-term loans was largelv fxed and could not match their
new costs. While their deposit base increased, thev now faced an interest rate
squeeze.In1o¬o,thedifferenceininterestearnedonthebanks’andthrifts’safestin-
vestments (one-vear Treasurv notes) over interest paid on deposits was almost -.-
percentagepoints;bv1ooa,itwasonlvi.opercentagepoints.Theinstitutionslostal-
most : percentage points of the advantage thev had enjoved when the rates were
capped.
1a
The1o8olegislationhadnotdoneenoughtoreducethecompetitivepres-
suresfacingthebanksandthrifts.
Thatlegislationwasfollowedin1o8ibvtheGarn-St.GermainAct,whichsignif-
cantlvbroadenedthetvpesofloansandinvestmentsthatthriftscouldmake.Theact
alsogavebanksandthriftsbroaderscopeinthemortgagemarket.Traditionallv,thev
hadreliedon:o-vear,fxed-ratemortgages.Buttheinterestonfxed-ratemortgages
on their books fell short as infation surged in the mid-1o¬os and earlv 1o8os and
banks and thrifts found it increasinglv 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 bv permitting banks and thrifts to issue interest-onlv, bal-
loon-pavment, and adjustable-rate mortgages (ARMs), even in states where state
lawsforbadetheseloans.Forconsumers,interest-onlvandballoonmortgagesmade
homeownershipmoreaffordable,butonlvintheshortterm.BorrowerswithARMs
enjoved 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
thatfoatedinrelationshiptotheratesthevwerepavingtoattractmonevfromde-
positors.ThefoatingmortgagerateprotectedbanksandS&Lsfromtheinterestrate
.. ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN iiiui1
squeeze caused bv infation, but it effectivelv transferred the risk of rising interest
ratestoborrowers.
Then,beginningin1o8¬,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 strictlv limited these bank-ineligible securities activities to no more
than-ºoftheassetsorrevenueofanvsubsidiarv.Overtime,however,theFedre-
laxedtheserestrictions.Bv1oo¬,bank-ineligiblesecuritiescouldrepresentuptoi-º
ofassetsorrevenuesofasecuritiessubsidiarv,andtheFedalsoweakenedorelimi-
natedotherfrewallsbetweentraditionalbankingsubsidiariesandthenewsecurities
subsidiariesofbankholdingcompanies.
1-
Meanwhile,theOCC,theregulatorofbankswithnationalcharters,wasexpand-
ingthepermissibleactivitiesofnationalbankstoincludethosethatwere“function-
allv equivalent to, or a logical outgrowth of, a recognized bank power.”
1o
Among
thesenewactivitieswereunderwritingaswellastradingbetsandhedges,knownas
derivatives,onthepricesofcertainassets.Between1o8:and1ooa,theOCCbroad-
enedthederivativesinwhichbanksmightdealtoincludethoserelatedtodebtsecu-
rities (1o8:), interest and currencv exchange rates (1o88), stock indices (1o88),
preciousmetalssuchasgoldandsilver(1oo1),andequitvstocks(1ooa).
Fed Chairman Greenspan and manv other regulators and legislators supported
andencouragedthisshifttowardderegulatedfnancialmarkets.Thevarguedthatf-
nancial institutions had strong incentives to protect their shareholders and would
therefore regulate themselves through improved risk management. Likewise, fnan-
cialmarketswouldexertstrongandeffectivedisciplinethroughanalvsts,creditrat-
ing agencies, and investors. Greenspan argued that the urgent question about
governmentregulationwaswhetheritstrengthenedorweakenedprivateregulation.
TestifvingbeforeCongressin1oo¬,heframedtheissuethiswav:fnancial“modern-
ization” was needed to “remove outdated restrictions that serve no useful purpose,
thatdecreaseeconomicemciencv,andthat . . .limitchoicesandoptionsforthecon-
sumeroffnancialservices.”Removingthebarriers“wouldpermitbankingorganiza-
tions to compete more effectivelv in their natural markets. The result would be a
moreemcientfnancialsvstemprovidingbetterservicestothepublic.”

During the 1o8os and earlv 1ooos, banks and thrifts expanded into higher-risk
loans with higher interest pavments. Thev made loans to oil and gas producers, f-
nancedleveragedbuvoutsofcorporations,andfundeddevelopersofresidentialand
commercialrealestate.Thelargestcommercialbanksadvancedmonevtocompanies
andgovernmentsin“emergingmarkets,”suchascountriesinAsiaandLatinAmer-
ica.Thosemarketsofferedpotentiallvhigherprofts,butweremuchriskierthanthe
banks’ traditional lending. The consequences appeared almost immediatelv—espe-
ciallvintherealestatemarkets,withabubbleandmassiveoverbuildinginresidential
and commercial sectors in certain regions. For example, house prices rose ¼ per
vearinTexasfrom1o8oto1o8-.
18
InCalifornia,pricesrose1:ºannuallvfrom1o8-
:u\iu\ 8\Nii Nt .,
to 1ooo.
1o
The bubble burst frst in Texas in 1o8- and 1o8o, but the trouble rapidlv
spreadacrosstheSoutheasttothemid-AtlanticstatesandNewEngland,thenswept
back across the countrv to California and Arizona. Before the crisis ended, house
priceshaddeclinednationallvbvi.-ºfromIulv1oootoFebruarv1ooi
io
—thefrst
such fall since the Depression—driven bv steep drops in regional markets.
i1
In the
1o8os, with the mortgages in their portfolios paving considerablv less than current
interestrates,spiralingdefaultsonthethrifts’residentialandcommercialrealestate
loans,andlossesonenergv-related,leveraged-buvout,andoverseasloans,theindus-
trvwasshattered.
ii
Almost:,ooocommercialbanksandthriftsfailedinwhatbecameknownasthe
S&L crisis of the 1o8os and earlv 1ooos. Bv comparison, onlv ia: banks had failed
between 1o:a and 1o8o. Bv 1ooa, one-sixth of federallv insured depositorv institu-
tionshadeitherclosedorrequiredfnancialassistance,affectingioºofthebanking
svstem’s assets.
i:
More than 1,ooo bank and S&L executives were convicted of
felonies.
ia
Bvthetimethegovernmentcleanupwascomplete,theultimatecostofthe
crisiswas·1oobillion.
i-
Despite new laws passed bv Congress in 1o8o and 1oo1 in response to the S&L
crisisthattoughenedsupervisionofthrifts,theimpulsetowardderegulationcontin-
ued.Thederegulatorvmovementfocusedinpartoncontinuingtodismantleregula-
tions that limited depositorv institutions’ activities in the capital markets. In 1oo1,
theTreasurvDepartmentissuedanextensivestudvcallingfortheeliminationofthe
oldregulatorvframeworkforbanks,includingremovalofallgeographicrestrictions
onbankingandrepealoftheGlass-SteagallAct.ThestudvurgedCongresstoabolish
theserestrictionsinthebeliefthatlargenationwidebankscloselvtiedtothecapital
marketswouldbemoreproftableandmorecompetitivewiththelargestbanksfrom
the United Kingdom, Europe, and Iapan. The report contended that its proposals
wouldletbanksembraceinnovationandproducea“stronger,morediversifedfnan-
cialsvstemthatwillprovideimportantbeneftstotheconsumerandimportantpro-
tectionstothetaxpaver.”
io
The biggest banks pushed Congress to adopt Treasurv’s recommendations. Op-
posedwereinsuranceagents,realestatebrokers,andsmallerbanks,whofeltthreat-
enedbvthepossibilitvthatthelargestbanksandtheirhugepoolsofdepositswould
be unleashed to compete without restraint. The House of Representatives rejected
Treasurv’sproposalin1oo1,butsimilarproposalswereadoptedbvCongresslaterin
the1ooos.
In dealing with the banking and thrift crisis of the 1o8os and earlv 1ooos, Con-
gresswasgreatlvconcernedbvaspateofhigh-proflebankbailouts.In1o8a,federal
regulators rescued Continental Illinois, the nation’s ¬th-largest bank; in 1o88, First
Republic,number1a;in1o8o,MCorp,number:o;in1oo1,BankofNewEngland,
number::.Thesebankshadreliedheavilvonuninsuredshort-termfnancingtoag-
gressivelv expand into high-risk lending, leaving them vulnerable to abrupt with-
drawalsonceconfdenceintheirsolvencvevaporated.DepositscoveredbvtheFDIC
wereprotectedfromloss,butregulatorsfeltobligedtoprotecttheuninsureddeposi-
tors—thosewhosebalancesexceededthestatutorilvprotectedlimits—topreventpo-
.( ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN iiiui1
tentialrunsonevenlargerbanksthatreportedlvmavhavelackedsumcientassetsto
satisfvtheirobligations,suchasFirstChicago,BankofAmerica,andManufacturers
Hanover.

During a hearing on the rescue of Continental Illinois, Comptroller of the Cur-
rencvC.ToddConoverstatedthatfederalregulatorswouldnotallowthe11largest
“monevcenterbanks”tofail.
i8
Thiswasanewregulatorvprinciple,andwithinmo-
ments it had a catchv name. Representative Stewart McKinnev of Connecticut re-
sponded,“Wehaveanewkindofbank.Itiscalled‘toobigtofail’—TBTF—anditisa
wonderfulbank.”
io
In 1ooo, during this era of federal rescues of large commercial banks, Drexel
Burnham Lambert—once the countrv’s ffth-largest investment bank—failed. Crip-
pledbvlegaltroublesandlossesinitsjunkbondportfolio,thefrmwasforcedinto
thelargestbankruptcvinthesecuritiesindustrvtodatewhenlendersshunneditin
thecommercialpaperandrepomarkets.Whilecreditors,includingotherinvestment
banks,wererattledandabsorbedheavvlosses,thegovernmentdidnotstepin,and
Drexel’s failure did not cause a crisis. So far, it seemed that among fnancial frms,
onlvcommercialbanksweredeemedtoobigtofail.
In1oo1,Congresstriedtolimitthis“toobigtofail”principle,passingtheFederal
Deposit Insurance Corporation Improvement Act (FDICIA), which sought to curb
theuseoftaxpaverfundstorescuefailingdepositorvinstitutions.FDICIAmandated
thatfederalregulatorsmustinterveneearlvwhenabankorthriftgotintotrouble.In
addition,ifaninstitutiondidfail,theFDIChadtoresolvethefailedinstitutionina
mannerthatproducedtheleastcosttotheFDIC’sdepositinsurancefund.However,
thelegislationcontainedtwoimportantloopholes.OneexemptedtheFDICfromthe
least-costconstraintsifit,theTreasurv,andtheFederalReservedeterminedthatthe
failure of an institution posed a “svstemic risk” to markets. The other loophole ad-
dressed a concern raised bv some Wall Street investment banks, Goldman Sachs in
particular:thereluctanceofcommercialbankstohelpsecuritiesfrmsduringprevi-
ousmarketdisruptions,suchasDrexel’sfailure.WallStreetfrmssuccessfullvlobbied
foranamendmenttoFDICIAtoauthorizetheFedtoactaslenderoflastresorttoin-
vestment banks bv extending loans collateralized bv the investment banks’
securities.
:o
In the end, the 1oo1 legislation sent fnancial institutions a mixed message: vou
are not too big to fail—until and unless vou are too big to fail. So the possibilitv of
bailouts for the biggest, most centrallv placed institutions—in the commercial and
shadow banking industries—remained an open question until the next crisis, 1o
vearslater.
:u\iu\ 8\Nii Nt .,
3
SECURITIZATION AND DERIVATIVES
CONTENTS
IannicMacandIrcddicMac“1hcwhc|carnvcj|c||vists”::
Structurcdhnancc“Itwasn’trcducingthcrisk”;:
1hcgrcwthcjdcrivativcs“Bvjarthcncstsignihcantcvcnt
inhnanccduringthcpastdccadc” ;·
FANNIE MAE AND FREDDIE MAC:
“THE WHOLE ARMY OF LOBBYISTS”
ThecrisisinthethriftindustrvcreatedanopeningforFannieMaeandFreddieMac,
the two massive government-sponsored enterprises (GSEs) created bv Congress to
supportthemortgagemarket.
FannieMae(omciallv,theFederalNationalMortgageAssociation)waschartered
bvtheReconstructionFinanceCorporationduringtheGreatDepressionin1o:8to
buvmortgagesinsuredbvtheFederalHousingAdministration(FHA).Thenewgov-
ernmentagencvwasauthorizedtopurchasemortgagesthatadheredtotheFHA’sun-
derwriting standards, therebv virtuallv guaranteeing the supplv of mortgage credit
thatbanksandthriftscouldextendtohomebuvers.FannieMaeeitherheldthemort-
gages in its portfolio or, less often, resold them to thrifts, insurance companies, or
other investors. After World War II, Fannie Mae got authoritv to buv home loans
guaranteedbvtheVeteransAdministration(VA)aswell.
Thissvstemworkedwell,butithadaweakness:FannieMaeboughtmortgagesbv
borrowing. Bv 1oo8, Fannie’s mortgage portfolio had grown to ·¬.i billion and its
debtweighedonthefederalgovernment.
1
TogetFannie’sdebtoffofthegovernment’s
balancesheet,theIohnsonadministrationandCongressreorganizeditasapubliclv
tradedcorporationandcreatedanewgovernmententitv,GinnieMae(omciallv,the
GovernmentNationalMortgageAssociation)totakeoverFannie’ssubsidizedmort-
gageprogramsandloanportfolio.GinniealsobeganguaranteeingpoolsofFHAand
VA mortgages. The new Fannie still purchased federallv insured mortgages, but it
wasnowahvbrid,a“government-sponsoredenterprise.”
Twovearslater,in1o¬o,thethriftspersuadedCongresstocharterasecondGSE,
FreddieMac(omciallv,theFederalHomeLoanMortgageCorporation),tohelpthe

thriftsselltheirmortgages.ThelegislationalsoauthorizedFannieandFreddietobuv
“conventional”fxed-ratemortgages,whichwerenotbackedbvtheFHAortheVA.
ConventionalmortgageswerestiffcompetitiontoFHAmortgagesbecauseborrow-
ers could get them more quicklv and with lower fees. Still, the conventional mort-
gagesdidhavetoconformtotheGSEs’loansizelimitsandunderwritingguidelines,
such as debt-to-income and loan-to-value ratios. The GSEs purchased onlv these
“conforming”mortgages.
Before 1oo8, Fannie Mae generallv held the mortgages it purchased, profting
from the difference—or spread—between its cost of funds and the interest paid on
thesemortgages.The1oo8and1o¬olawsgaveGinnie,Fannie,andFreddieanother
option:securitization.Ginniewasthefrsttosecuritizemortgages,in1o¬o.Alender
would assemble a pool of mortgages and issue securities backed bv the mortgage
pool. Those securities would be sold to investors, with Ginnie guaranteeing timelv
pavmentofprincipalandinterest.Ginniechargedafeetoissuersforthisguarantee.
In1o¬1,Freddiegotintothebusinessofbuvingmortgages,poolingthem,andthen
selling mortgage-backed securities. Freddie collected fees from lenders for guaran-
teeingtimelvpavmentofprincipalandinterest.In1o81,afteraspikeininterestrates
caused large losses on Fannie’s portfolio of mortgages, Fannie followed. During the
1o8osand1ooos,theconventionalmortgagemarketexpanded,theGSEsgrewinim-
portance,andthemarketshareoftheFHAandVAdeclined.
FannieandFreddiehaddualmissions,bothpublicandprivate:supportthemort-
gage market and maximize returns for shareholders. Thev did not originate mort-
gages; thev 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-billionlineofcrediteachfromtheTreasurv.TheFederalReserve
providedservicessuchaselectronicallvclearingpavmentsforGSEdebtandsecuri-
tiesasifthevwereTreasurvbonds.SoFannieandFreddiecouldborrowatratesal-
mostaslowastheTreasurvpaid.Federallawsallowedbanks,thrifts,andinvestment
funds to invest in GSE securities with relativelv favorable capital requirements and
withoutlimits.Bvcontrast,lawsandregulationsstrictlvlimitedtheamountofloans
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 verv little capital to protect against losses: onlv o.a-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 aº of
mortgagesassetsundercapitalstandards.Suchprivilegesledinvestorsandcreditors
tobelievethatthegovernmentimplicitlvguaranteedtheGSEs’mortgage-backedse-
curities and debt and that GSE securities were therefore almost as safe as Treasurv
bills.Asaresult,investorsacceptedvervlowreturnsonGSE-guaranteedmortgage-
backedsecuritiesandGSEdebtobligations.
Mortgages are long-term assets often funded bv short-term borrowings. For
example,thriftsgenerallvusedcustomerdepositstofundtheirmortgages.Fannie
:itUii 1i / \1i uN \Ni iiii \\1i \i: .+
bought its mortgage portfolio bv borrowing short- and medium-term. In 1o¬o,
whentheFedincreasedshort-terminterestratestoquellinflation,Fannie,likethe
thrifts,foundthatitscostoffundingrosewhileincomefrommortgagesdidnot.Bv
the1o8os,theDepartmentofHousingandUrbanDevelopment(HUD)estimated
Fannie had a negative net worth of ·1o billion.
i
Freddie emerged unscathed be-
causeunlikeFanniethen,itsprimarvbusinesswasguaranteeingmortgage-backed
securities, not holding mortgages in its portfolio. In guaranteeing mortgage-
backedsecurities,FreddieMacavoidedtakingtheinterestrateriskthathitFannie’s
portfolio.
In1o8i,CongressprovidedtaxreliefandHUDrelaxedFannie’scapitalrequire-
mentstohelpthecompanvavertfailure.Theseeffortswereconsistentwithlawmak-
ers’ repeated proclamations that a vibrant market for home mortgages served the
bestinterestsofthecountrv,butthemovesalsoreinforcedtheimpressionthatthe
government would never abandon Fannie and Freddie. Fannie and Freddie would
soonbuvandeitherholdorsecuritizemortgagesworthhundredsofbillions,then
trillions, ofdollars.AmongtheinvestorswereU.S.banks,thrifts,investmentfunds,
andpensionfunds,aswellascentralbanksandinvestmentfundsaroundtheworld.
FannieandFreddiehadbecometoobigtofail.
While the government continued to favor Fannie and Freddie, thev toughened
regulationofthethriftsfollowingthesavingsandloancrisis.Thriftshadpreviouslv
dominatedthemortgagebusinessaslargeholdersofmortgages.IntheFinancialIn-
stitutions Reform, Recoverv, and Enforcement Act of 1o8o (FIRREA), Congress
imposedtougher,bank-stvlecapitalrequirementsandregulationsonthrifts.Bvcon-
trast,intheFederalHousingEnterprisesFinancialSafetvandSoundnessActof1ooi,
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 1ooi law.
:
“OFHEO was
structurallvweakandalmostdesignedtofail,”saidArmandoFalconIr.,aformerdi-
rectoroftheagencv,totheFCIC.
a
Allthisaddeduptoagenerousfederalsubsidv.Oneioo-studvputthevalueof
thatsubsidvat·1iibillionormoreandestimatedthatmorethanhalfofthesebene-
ftsaccruedtoshareholders,nottohomebuvers.
-
Given these circumstances, regulatorv arbitrage worked as it alwavs does: the
markets shifted to the lowest-cost, least-regulated havens. After Congress imposed
strictercapitalrequirementsonthrifts,itbecameincreasinglvproftableforthemto
securitizewithorsellloanstoFannieandFreddieratherthanholdontotheloans.
Thestampedewason.Fannie’sandFreddie’sdebtobligationsandoutstandingmort-
gage-backed securities grew from ·¬-o billion in 1ooo to ·1.a trillion in 1oo- and
·i.atrillioniniooo.
o
ThelegislationthattransformedFanniein1oo8alsoauthorizedHUDtoprescribe
affordablehousinggoalsforFannie:to“requirethatareasonableportionofthecor-
poration’s mortgage purchases be related to the national goal of providing adequate
.+ ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN iiiui1
housingforlowandmoderateincomefamilies,butwithreasonableeconomicreturn
tothecorporation.”
¬
In1o¬8,HUDtriedtoimplementthelawand,afterabarrageof
criticism from the GSEs and the mortgage and real estate industries, issued a weak
regulationencouragingaffordablehousing.
8
Inthe1ooiFederalHousingEnterprises
Financial Safetv and Soundness Act, Congress extended HUD’s authoritv to set af-
fordablehousinggoalsforFannieandFreddie.Congressalsochangedthelanguageto
savthatinthepursuitofaffordablehousing,“areasonableeconomicreturn . . .mav
belessthanthereturnearnedonotheractivities.”ThelawrequiredHUDtoconsider
“theneedtomaintainthesoundfnancialconditionoftheenterprises.”Theactnow
orderedHUDtosetgoalsforFannieandFreddietobuvloansforlow-andmoderate-
incomehousing,specialaffordablehousing,andhousingincentralcities,ruralareas,
andotherunderservedareas.CongressinstructedHUDtoperiodicallvsetagoalfor
eachcategorvasapercentageoftheGSEs’mortgagepurchases.
In1oo-,PresidentBillClintonannouncedaninitiativetoboosthomeownership
from o-.1º to o¬.-º of families bv iooo, and one component raised the affordable
housing goals at the GSEs. Between 1oo: and 1oo-, almost i.8 million households
enteredtheranksofhomeowners,nearlvtwiceasmanvasintheprevioustwovears.
“But we have to do a lot better,” Clinton said. “This is the new wav home for the
Americanmiddleclass.Wehavegottoraiseincomesinthiscountrv.Wehavegotto
increasesecuritvforpeoplewhoaredoingtherightthing,andwehavegottomake
peoplebelievethatthevcanhavesomepermanenceandstabilitvintheirlivesevenas
thevdealwithallthechangingforcesthatareoutthereinthisglobaleconomv.”
o
The
push to expand homeownership continued under President George W. Bush, who,
for example, introduced a “Zero Down Pavment Initiative” that under certain cir-
cumstancescouldremovethe:ºdownpavmentruleforfrst-timehomebuverswith
FHA-insuredmortgages.
1o
In describing the GSEs’ affordable housing loans, Andrew Cuomo, secretarv of
Housing and Urban Development from 1oo¬ to ioo1 and now governor of New
York,toldtheFCIC,“Affordabilitvmeansmanvthings.Thereweremoderateincome
loans.Thesewereteachers,thesewerefrefghters,theseweremunicipalemplovees,
these were people with jobs who paid mortgages. These were not subprime, preda-
torvloansatall.”
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 Svron concurred: “I don’t
thinkit’sagoodbusinessmodel.”
1:
FannieandFreddieaccumulatedpoliticalcloutbecausethevdependedonfederal
subsidiesandanimplicitgovernmentguarantee,andbecausethevhadtodealwith
regulators,affordablehousinggoals,andcapitalstandardsimposedbvCongressand
HUD.From1oootoioo8,thetworeportedspendingmorethan·1oamilliononlob-
bving,andtheiremploveesandpoliticalactioncommitteescontributed·1-million
:itUii 1i / \1i uN \Ni iiii \\1i \i: ..
to federal election campaigns.
1a
The “Fannie and Freddie political machine resisted
anv meaningful regulation using highlv improper tactics,” Falcon, who regulated
them from 1ooo to ioo-, testifed. “OFHEO was constantlv subjected to malicious
political attacks and efforts of intimidation.”
1-
Iames Lockhart, the director of
OFHEOanditssuccessor,theFederalHousingFinanceAgencv,fromiooothrough
iooo, testifed that he argued for reform from the moment he became director and
thatthecompanieswere“allowedtobe . . .sopoliticallvstrongthatformanvvears
thevresistedthevervlegislationthatmighthavesavedthem.”
1o
FormerHUDsecre-
tarvMelMartinezdescribedtotheFCIC“thewholearmvoflobbviststhatcontinu-
allv paraded in a bipartisan fashion through mv omces. . . . It’s prettv amazing the
numberofpeoplethatwereintheiremplov.”

In1oo-,thatarmvhelpedsecurenewregulationsallowingtheGSEstocountto-
wardtheiraffordablehousinggoalsnotjusttheirwholeloansbutmortgage-related
securitiesissuedbvothercompanies,whichtheGSEswantedtopurchaseasinvest-
ments.Still,CongressionalBudgetOmceDirectorIuneO’Neilldeclaredin1oo8that
“thegoalsarenotdimculttoachieve,anditisnotclearhowmuchthevhaveaffected
theenterprises’actions.Infact . . .depositorvinstitutionsaswellastheFederalHous-
ingAdministrationdevotealargerproportionoftheirmortgagelendingtotargeted
borrowersandareasthandotheenterprises.”
18
Somethingelsewasclear:FannieandFreddie,withtheirlowborrowingcostsand
laxcapitalrequirements,wereimmenselvproftablethroughoutthe1ooos.Iniooo,
Fannie had a return on equitv of ioº; Freddie, :oº. That vear, Fannie and Freddie
heldorguaranteedmorethan·itrillionofmortgages,backedbvonlv·:-.¬billion
ofshareholderequitv.
1o
STRUCTURED FINANCE:
“IT WASN’ T REDUCING THE RISK”
WhileFannieandFreddieenjovedanear-monopolvonsecuritizingfxed-ratemort-
gagesthatwerewithintheirpermittedloanlimits,inthe1o8osthemarketsbeganto
securitize manv other tvpes of loans, including adjustable-rate mortgages (ARMs)
and other mortgages the GSEs were not eligible or willing to buv. The mechanism
workedthesame:aninvestmentbank,suchasLehmanBrothersorMorganStanlev
(orasecuritiesamliateofabank),bundledloansfromabankorotherlenderintose-
curitiesandsoldthemtoinvestors,whoreceivedinvestmentreturnsfundedbvthe
principalandinterestpavmentsfromtheloans.Investorsheldortradedthesesecuri-
ties,whichwereoftenmorecomplicatedthantheGSEs’basicmortgage-backedsecu-
rities;theassetswerenotjustmortgagesbutequipmentleases,creditcarddebt,auto
loans,andmanufacturedhousingloans.Overtime,banksandsecuritiesfrmsused
securitization to mimic banking activities outside the regulatorv framework for
banks. For example, where banks traditionallv took monev from deposits to make
loans and held them until maturitv, banks now used monev from the capital mar-
kets—oftenfrommonevmarketmutualfunds—tomakeloans,packagingtheminto
securitiestoselltoinvestors.
.z ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN iiiui1
Forcommercialbanks,thebeneftswerelarge.Bvmovingloansofftheirbooks,
the banks reduced the amount of capital thev were required to hold as protection
against losses, therebv improving their earnings. Securitization also let banks relv
lessondepositsforfunding,becausesellingsecuritiesgeneratedcashthatcouldbe
usedtomakeloans.Bankscouldalsokeeppartsofthesecuritiesontheirbooksas
collateralforborrowing,andfeesfromsecuritizationbecameanimportantsourceof
revenues.
LawrenceLindsev,aformerFederalReservegovernorandthedirectoroftheNa-
tionalEconomicCouncilunderPresidentGeorgeW.Bush,toldtheFCICthatprevi-
oushousingdownturnsmaderegulatorsworrvaboutbanks’holdingwholeloanson
theirbooks.“Ifvouhadaregional . . .realestatedownturnittookdownthebanksin
thatregionalongwithit,whichexacerbatedthedownturn,”Lindsevsaid.“Sowesaid
to ourselves, ‘How on earth do we get around this problem:’ And the answer was,
‘Let’shaveanationalsecuritiesmarketsowedon’thaveregionalconcentration.’ . . .It
wasintentional.”
io
Privatesecuritizations,orstructuredfnancesecurities,hadtwokevbeneftstoin-
vestors:pooling andtranching.Ifmanvloanswerepooledintoonesecuritv,afewde-
faultswouldhaveminimalimpact.Structuredfnancesecuritiescouldalsobesliced
upandsoldinportions—knownastranches—whichletbuverscustomizetheirpav-
ments.Risk-averseinvestorswouldbuvtranchesthatpaidofffrstintheeventofde-
fault, but had lower vields. Return-oriented investors bought riskier tranches with
higher vields. 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.
Andifpavmentscameinbelowexpectations,thoseatthebottomwouldbethefrst
tobelefthighanddrv.
Securitizationwasdesignedtobeneftlenders,investmentbankers,andinvestors.
Lendersearnedfeesfororiginatingandsellingloans.Investmentbanksearnedfees
forissuingmortgage-backedsecurities.Thesesecuritiesfetchedahigherpricethanif
theunderlvingloansweresoldindividuallv,becausethesecuritieswerecustomized
toinvestors’needs,weremorediversifed,andcouldbeeasilvtraded.Purchasersof
thesafertranchesgotahigherrateofreturnthanultra-safeTreasurvnoteswithout
muchextrarisk—atleastintheorv.However,thefnancialengineeringbehindthese
investmentsmadethemhardertounderstandandtopricethanindividualloans.To
determine likelv returns, investors had to calculate the statistical probabilities that
certainkindsofmortgagesmightdefault,andtoestimatetherevenuesthatwouldbe
lostbecauseofthosedefaults.Theninvestorshadtodeterminetheeffectofthelosses
onthepavmentstodifferenttranches.
This complexitv transformed the three leading credit rating agencies—Moodv’s,
Standard&Poor’s(S&P),andFitch—intokevplaversintheprocess,positionedbe-
tweentheissuersandtheinvestorsofsecurities.Beforesecuritizationbecamecom-
mon, the credit rating agencies had mainlv helped investors evaluate the safetv of
municipalandcorporatebondsandcommercialpaper.Althoughevaluatingproba-
bilities was their stock-in-trade, thev found that rating these securities required a
newtvpeofanalvsis.
:itUii 1i / \1i uN \Ni iiii \\1i \i: ..
.. ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN iiiui1
Participantsinthesecuritizationindustrvrealizedthatthevneededtosecurefavor-
able credit ratings in order to sell structured products to investors. Investment banks
thereforepaidhandsomefeestotheratingagenciestoobtainthedesiredratings.“The
ratingagencieswereimportanttoolstodothatbecausevouknowthepeoplethatwe
were selling these bonds to had never reallv had anv historv in the mortgage busi-
ness. . . .Thevwerelookingforanindependentpartvtodevelopanopinion,”IimCalla-
han told the FCIC; Callahan is CEO of PentAlpha, which services the securitization
industrv,andvearsagoheworkedonsomeoftheearliestsecuritizations.
i1
Withthesepiecesinplace—banksthatwantedtoshedassetsandtransferrisk,in-
vestorsreadvtoputtheirmonevtowork,securitiesfrmspoisedtoearnfees,rating
agenciesreadvtoexpand,andinformationtechnologvcapableofhandlingthejob—
the securitization market exploded. Bv 1ooo, when the market was 1o vears old,
about ·ooo billion worth of securitizations, bevond those done bv Fannie, Freddie,
andGinnie,wereoutstanding(seefgure:.1).Thatincluded·11abillionofautomo-
bileloansandover·i-obillionofcreditcarddebt;nearlv·1-obillionworthofsecu-
ritiesweremortgagesineligibleforsecuritizationbvFannieandFreddie.Manvwere
subprime.
ii
Securitization was not just a boon for commercial banks; it was also a lucrative
newlineofbusinessfortheWallStreetinvestmentbanks,withwhichthecommercial
banksworkedtocreatethenewsecurities.WallStreetfrmssuchasSalomonBroth-
ers and Morgan Stanlev became major plavers in these complex markets and relied
increasinglv on quantitative analvsts, called “quants.” As earlv as the 1o¬os, Wall
Streetexecutiveshadhiredquants—analvstsadeptinadvancedmathematicaltheorv
and computers—to develop models to predict how markets or securities might
change.Securitizationincreasedtheimportanceofthisexpertise.ScottPatterson,au-
thorofThe Quants, toldtheFCICthatusingmodelsdramaticallvchangedfnance.
“WallStreetisessentiallvfoatingonaseaofmathematicsandcomputerpower,”Pat-
tersonsaid.
i:
The increasing dependence on mathematics let the quants create more complex
productsandlettheirmanagerssav,andmavbeevenbelieve,thatthevcouldbetter
manage those products’ risk. IP Morgan developed the frst “Value at Risk” model
(VaR),andtheindustrvsoonadopteddifferentversions.Thesemodelspurportedto
predict with at least o-º certaintv how much a frm could lose if market prices
changed.
ia
But models relied on assumptions based on limited historical data; for
mortgage-backed securities, the models would turn out to be woefullv inadequate.
Andmodelinghumanbehaviorwasdifferentfromtheproblemsthequantshadad-
dressedingraduateschool.“It’snotliketrvingtoshootarockettothemoonwhere
vou know the law of gravitv,” Emanuel Derman, a Columbia Universitv fnance
professor who worked at Goldman Sachs for 1¬ vears, told the Commission. “The
wavpeoplefeelaboutgravitvonagivendavisn’tgoingtoaffectthewavtherocket
behaves.”
i-
PaulVolcker,Fedchairmanfrom1o¬oto1o8¬,toldtheCommissionthatregula-
torswereconcernedasearlvasthelate1o8osthatoncebanksbegansellinginsteadof
holding the loans thev were making, thev would care less about loan qualitv. Yet as
theseinstrumentsbecameincreasinglvcomplex,regulatorsincreasinglvreliedonthe
bankstopolicetheirownrisks.“Itwasalltiedupinthehubrisoffnancialengineers,
but the greater hubris let markets take care of themselves,” Volcker said.
io
Vincent
Reinhart,aformerdirectoroftheFed’sDivisionofMonetarvAffairs,toldtheCom-
missionthatheandotherregulatorsfailedtoappreciatethecomplexitvofthenewf-
nancialinstrumentsandthedimcultiesthatcomplexitvposedinassessingrisk.

Securitization “was diversifving the risk,” said Lindsev, the former Fed governor.
“Butitwasn’treducingtherisk. . . .Youasanindividualcandiversifvvourrisk.Thesvs-
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 complexitv became closelv identifed with
oneelementofthestorv:derivatives.Derivativesarefnancialcontractswhoseprices
aredeterminedbv,or“derived”from,thevalueofsomeunderlvingasset,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 NuUi i¥ tu\\i : :i uN iiiui1
or event. Thev are not used for capital formation or investment, as are securities;
rather,thevareinstrumentsforhedgingbusinessriskorforspeculatingonchanges
inprices,interestrates,andthelike.Derivativescomeinmanvforms;themostcom-
mon are over-the-counter-swaps and exchange-traded futures and options.
io
Thev
mavbebasedoncommodities(includingagriculturalproducts,metals,andenergv
products),interestrates,currencvrates,stocksandindexes,andcreditrisk.Thevcan
evenbetiedtoeventssuchashurricanesorannouncementsofgovernmentfgures.
Manvfnancialandcommercialfrmsusesuchderivatives.Afrmmavhedgeits
priceriskbventeringintoaderivativescontractthatoffsetstheeffectofpricemove-
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 bv trading fxed interest pavments for foating pavments with
risk-taking entities, such as hedge funds. Hedge funds mav 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 bv federal law and plav a useful role in price
discoverv—thatis,inrevealingthemarket’sviewonpricesofcommoditiesorrates
underlvingfuturesandoptions.OTCderivativesaretradedbvlargefnancialinstitu-
tions—traditionallv, bank holding companies and investment banks—which act as
derivatives dealers, buving and selling contracts with customers. Unlike the futures
andoptionsexchanges,theOTCmarketisneithercentralizednorregulated.Norisit
transparent,andthuspricediscovervislimited.Nomatterthemeasurement—trad-
ing volume, dollar volume, risk exposure—derivatives represent a verv signifcant
sectoroftheU.S.fnancialsvstem.
The principal legislation governing these markets is the Commoditv Exchange
Act of 1o:o, which originallv applied onlv to derivatives on domestic agricultural
products.In1o¬a,Congressamendedtheacttorequirethatfuturesandoptionscon-
tracts on virtuallv all commodities, including fnancial instruments, be traded on a
regulatedexchange,andcreatedanewfederalindependentagencv,theCommoditv
FuturesTradingCommission(CFTC),toregulateandsupervisethemarket.
:o
Outside of this regulated market, an over-the-counter market began to develop
andgrowrapidlvinthe1o8os.ThelargefnancialinstitutionsactingasOTCderiva-
tives dealers worried that the Commoditv Exchange Act’s requirement that trading
occur on a regulated exchange might be applied to the products thev were buving
andselling.In1oo:,theCFTCsoughttoaddresstheseconcernsbvexemptingcer-
tainnonstandardizedOTCderivativesfromthatrequirementandfromcertainother
provisions of the Commoditv Exchange Act, except for prohibitions against fraud
andmanipulation.
:1
As the OTC market grew following the CFTC’s exemption, a wave of signifcant
lossesandscandalshitthemarket.Amongmanvexamples,in1ooaProcter&Gamble,
a leading consumer products companv, reported a pretax loss of ·1-¬ million, the
largestderivativeslossbvanonfnancialfrm,stemmingfromOTCinterestandforeign
exchangeratederivativessoldtoitbvBankersTrust.Procter&GamblesuedBankers
Trust for fraud—a suit settled when Bankers Trust forgave most of the monev that
Procter&Gambleowedit.Thatvear,theCFTCandtheSecuritiesandExchangeCom-
mission(SEC)fnedBankersTrust·1omillionformisleadingGibsonGreetingCards
on interest rate swaps resulting in a mark-to-market loss of ·i: million, larger than
Gibson’sprior-vearprofts.Inlate1ooa,OrangeCountv,California,announcedithad
lost·1.-billionspeculatinginOTCderivatives.Thecountvfledforbankruptcv—the
largestbvamunicipalitvinU.S.historv.Itsderivativesdealer,MerrillLvnch,paid·aoo
milliontosettleclaims.
:i
Inresponse,theU.S.GeneralAccountingOmceissuedare-
port on fnancial derivatives that found dangers in the concentration of OTC deriva-
tives activitv among 1- major dealers, concluding that “the sudden failure or abrupt
withdrawalfromtradingofanvoneoftheselargedealerscouldcauseliquiditvprob-
lemsinthemarketsandcouldalsoposeriskstotheothers,includingfederallvinsured
banksandthefnancialsvstemasawhole.”
::
WhileCongressthenheldhearingsonthe
OTCderivativesmarket,theadoptionofregulatorvlegislationfailedamidintenselob-
bvingbvtheOTCderivativesdealersandoppositionbvFedChairmanGreenspan.
In 1ooo, Iapan’s Sumitomo Corporation lost ·i.o billion on copper derivatives
traded on a London exchange. The CFTC charged the companv with using deriva-
tivestomanipulatecopperprices,includingusingOTCderivativescontractstodis-
guisethespeculationandtofnancethescheme.Sumitomosettledfor·1-omillion
in penalties and restitution. The CFTC also charged Merrill Lvnch with knowinglv
andintentionallvaiding,abetting,andassistingthemanipulationofcopperprices;it
settledforafneof·1-million.
:a
Debateintensifedin1oo8.InMav,theCFTCunderChairpersonBrookslevBorn
said the agencv would reexamine the wav it regulated the OTC derivatives market,
given the market’s rapid evolution and the string of major losses since 1oo:. The
CFTCrequestedcomments.Itgotthem.
Somecamefromotherregulators,whotooktheunusualstepofpubliclvcriticiz-
ingtheCFTC.OnthedavthattheCFTCissuedaconceptrelease,TreasurvSecretarv
RobertRubin,Greenspan,andSECChairmanArthurLevittissuedajointstatement
denouncing the CFTC’s move: “We have grave concerns about this action and its
possibleconsequences. . . .WearevervconcernedaboutreportsthattheCFTC’sac-
tion mav increase the legal uncertaintv concerning certain tvpes of OTC deriva-
tives.”
:-
Thev proposed a moratorium on the CFTC’s abilitv to regulate OTC
derivatives.
Formonths,Rubin,Greenspan,Levitt,andDeputvTreasurvSecretarvLawrence
SummersopposedtheCFTC’seffortsintestimonvtoCongressandinotherpublic
pronouncements.AsAlanGreenspansaid:“Asidefromsafetvandsoundnessregula-
tionofderivativesdealersunderthebankingandsecuritieslaws,regulationofderiv-
ativestransactionsthatareprivatelvnegotiatedbvprofessionalsisunnecessarv.”
:o
InSeptember,theFederalReserveBankofNewYorkorchestrateda·:.obillion
recapitalization of Long-Term Capital Management (LTCM) bv 1a 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·a.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’sfailurewouldpotentiallvhavehadsvstemiceffects:adefaultbv
LTCM “would not onlv 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 directlv in-
volvedwithLTCM.”
:8
Nonetheless, just weeks later, in October 1oo8, Congress passed the requested
moratorium.
Greenspan continued to champion derivatives and advocate deregulation of the
OTCmarketandtheexchange-tradedmarket.“Bvfarthemostsignifcanteventin
fnanceduringthepastdecadehasbeentheextraordinarvdevelopmentandexpan-
sionoffnancialderivatives,”GreenspansaidataFuturesIndustrvAssociationcon-
ference in March 1ooo. “The fact that the OTC markets function quite effectivelv
without the benefts of [CFTC regulation] provides a strong argument for develop-
mentofalessburdensomeregimeforexchange-tradedfnancialderivatives.”
:o
The following vear—after Born’s resignation—the President’s Working Group on
FinancialMarkets,acommitteeoftheheadsoftheTreasurv,FederalReserve,SEC,and
CommoditvFuturesTradingCommissionchargedwithtrackingthefnancialsvstem
and chaired bv then Treasurv Secretarv Larrv Summers, essentiallv adopted
Greenspan’sview.ThegroupissuedareporturgingCongresstoderegulateOTCderiv-
ativesbroadlvandtoreduceCFTCregulationofexchange-tradedderivativesaswell.
ao
In December iooo, in response, Congress passed and President Clinton signed
the Commoditv Futures Modernization Act of iooo (CFMA), which in essence
deregulatedtheOTCderivativesmarketandeliminatedoversightbvboththeCFTC
and the SEC. The law also preempted application of state laws on gaming and on
bucketshops(illegalbrokerageoperations)thatotherwisecouldhavemadeOTCde-
rivativestransactionsillegal.TheSECdidretainantifraudauthoritvoversecurities-
based OTC derivatives such as stock options. In addition, the regulatorv powers of
theCFTCrelatingtoexchange-tradedderivativeswereweakenedbutnoteliminated.
The CFMA effectivelv shielded OTC derivatives from virtuallv all regulation or
oversight.Subsequentlv,otherlawsenabledtheexpansionofthemarket.Forexam-
ple, under a ioo- amendment to the bankruptcv laws, derivatives counterparties
weregiventheadvantageoverothercreditorsofbeingabletoimmediatelvterminate
theircontractsandseizecollateralatthetimeofbankruptcv.
The OTC derivatives market boomed. At vear-end iooo, when the CFMA was
passed,thenotionalamountofOTCderivativesoutstandinggloballvwas·o-.itril-
lion,andthegrossmarketvaluewas·:.itrillion.
a1
Inthesevenandahalfvearsfrom
then until Iune ioo8, when the market peaked, outstanding OTC derivatives in-
creasedmorethansevenfoldtoanotionalamountof·o¬i.otrillion;theirgrossmar-
ketvaluewas·io.:trillion.
ai
Greenspan testifed to the FCIC that credit default swaps—a small part of the
.· ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN iiiui1
market when Congress discussed regulating derivatives in the 1ooos—“did create
problems” during the fnancial crisis.
a:
Rubin testifed that when the CFMA passed
hewas“notopposedtotheregulationofderivatives”andhadpersonallvagreedwith
Born’sviews,butthat“vervstronglvheldviewsinthefnancialservicesindustrvin
oppositiontoregulation”wereinsurmountable.
aa
SummerstoldtheFCICthatwhile
risks could not necessarilv have been foreseen vears ago, “bv ioo8 our regulatorv
frameworkwithrespecttoderivativeswasmanifestlvinadequate,”andthat“thede-
rivativesthatprovedtobebvfarthemostserious,thoseassociatedwithcreditdefault
swaps,increased1oofoldbetweenioooandioo8.”
a-
Onereasonfortherapidgrowthofthederivativesmarketwasthecapitalrequire-
mentsadvantagethatmanvfnancialinstitutionscouldobtainthroughhedgingwith
derivatives. As discussed above, fnancial frms mav use derivatives to hedge their
risks.Suchuseofderivativescanlowerafrm’sValueatRiskasdeterminedbvcom-
putermodels.Inadditiontogainingthisadvantageinriskmanagement,suchhedges
can lower the amount of capital that banks are required to hold, thanks to a 1ooo
amendment to the regulatorv regime known as the Basel International Capital Ac-
cord,or“BaselI.”
MeetinginBasel,Switzerland,in1o88,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. Fatefullv, the Basel rules
made capital requirements for mortgages and mortgage-backed securities looser
thanforallotherassetsrelatedtocorporateandconsumerloans.
ao
Indeed,capitalre-
quirementsforbanks’holdingsofFannie’sandFreddie’ssecuritieswerelessthanfor
allotherassetsexceptthoseexplicitlvbackedbvtheU.S.government.

Theseinternationalcapitalstandardsaccommodatedtheshifttoincreasedlever-
age. In 1ooo, large banks sought more favorable capital treatment for their trading,
andtheBaselCommitteeonBankingSupervisionadoptedtheMarketRiskAmend-
menttoBaselI.Thisprovidedthatifbankshedgedtheircreditormarketrisksusing
derivatives, thev could hold less capital against their exposures from trading and
otheractivities.
a8
OTCderivativesletderivativestraders—includingthelargebanksandinvestment
banks—increasetheirleverage.Forexample,enteringintoanequitvswapthatmim-
icked the returns of someone who owned the actual stock mav have had some up-
front costs, but the amount of collateral posted was much smaller than the upfront
costofpurchasingthestockdirectlv.Oftennocollateralwasrequiredatall.Traders
couldusederivativestoreceivethesamegains—orlosses—asifthevhadboughtthe
actualsecuritv,andwithonlvafractionofabuver’sinitialfnancialoutlav.
ao
Warren
Buffett,thechairmanandchiefexecutiveomcerofBerkshireHathawavInc.,testifed
totheFCICabouttheuniquecharacteristicsofthederivativesmarket,saving,“thev
accentuatedenormouslv,inmvview,theleverageinthesvstem.”Hewentontocall
derivatives“vervdangerousstuff,”dimcultformarketparticipants,regulators,audi-
tors,andinvestorstounderstand—indeed,heconcluded,“Idon’tthinkIcouldman-
age”acomplexderivativesbook.
-o
:itUii 1i / \1i uN \Ni iiii \\1i \i: .+
A kev OTC derivative in the fnancial crisis was the credit default swap (CDS),
whichofferedtheselleralittlepotentialupsideattherelativelvsmallriskofapoten-
tiallvlargedownside.ThepurchaserofaCDStransferredtothesellerthedefaultrisk
ofanunderlvingdebt.Thedebtsecuritvcouldbeanvbondorloanobligation.The
CDS buver made periodic pavments to the seller during the life of the swap. In re-
turn,thesellerofferedprotectionagainstdefaultorspecifed“creditevents”suchasa
partialdefault.Ifacrediteventsuchasadefaultoccurred,theCDSsellerwouldtvpi-
callvpavthebuverthefacevalueofthedebt.
Creditdefaultswapswereoftencomparedtoinsurance:thesellerwasdescribedas
insuringagainstadefaultintheunderlvingasset.However,whilesimilartoinsurance,
CDS escaped regulation bv state insurance supervisors because thev were treated as
deregulatedOTCderivatives.ThismadeCDSvervdifferentfrominsuranceinatleast
twoimportantrespects.First,onlvapersonwithaninsurableinterestcanobtainan
insurancepolicv.Acarownercaninsureonlvthecarsheowns—notherneighbor’s.
ButaCDSpurchasercanuseittospeculateonthedefaultofaloanthepurchaserdoes
notown.Theseareoftencalled“nakedcreditdefaultswaps”andcaninfatepotential
lossesandcorrespondinggainsonthedefaultofaloanorinstitution.
Before the CFMA was passed, there was uncertaintv about whether or not state
insurance regulators had authoritv over credit default swaps. In Iune 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 companv sells a policv, insurance regulators re-
quirethatitputasidereservesincaseofaloss.Inthehousingboom,CDSweresold
bvfrmsthatfailedtoputupanvreservesorinitialcollateralortohedgetheirexpo-
sure.Intherun-uptothecrisis,AIG,thelargestU.S.insurancecompanv,wouldac-
cumulate a one-half trillion dollar position in credit risk through the OTC market
withoutbeingrequiredtopostonedollar’sworthofinitialcollateralormakinganv
otherprovisionforloss.
-i
AIGwasnotalone.Thevalueoftheunderlvingassetsfor
CDSoutstandingworldwidegrewfrom·o.atrillionattheendofiooatoapeakof
·-8.itrillionattheendofioo¬.
-:
Asignifcantportionwasapparentlvspeculativeor
nakedcreditdefaultswaps.
-a
Much of the risk of CDS and other derivatives was concentrated in a few of the
vervlargestbanks,investmentbanks,andothers—suchasAIGFinancialProducts,a
unitofAIG
--
—thatdominateddealinginOTCderivatives.AmongU.S.bankholding
companies, o¼ of the notional amount of OTC derivatives, millions of contracts,
weretradedbvjustfve largeinstitutions(inioo8,IPMorganChase,Citigroup,Bank
ofAmerica,Wachovia,andHSBC)—manvofthesamefrmsthatwouldfndthem-
selves in trouble during the fnancial crisis.
-o
The countrv’s fve largest investment
bankswerealsoamongtheworld’slargestOTCderivativesdealers.
While fnancial institutions surveved bv the FCIC said thev do not track rev-
enuesandproftsgeneratedbvtheirderivativesoperations,somefrmsdidprovide
estimates.Forexample,GoldmanSachsestimatedthatbetweeni-ºand:-ºofits
revenuesfromiooothroughioooweregeneratedbvderivatives,including¬oºto
,+ ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN iiiui1
¬-ºofthefrm’scommoditiesbusiness,andhalformoreofitsinterestrateandcur-
renciesbusiness.FromMavioo¬throughNovemberioo8,·1::billion,or8oº,of
the·1--billionoftradesmadebvGoldman’smortgagedepartmentwerederivative
transactions.

Whenthenation’sbiggestfnancialinstitutionswereteeteringontheedgeoffail-
ure in ioo8, evervone watched the derivatives markets. What were the institutions’
holdings:Whowerethecounterparties:Howwouldthevfare:Marketparticipants
andregulatorswouldfndthemselvesstrainingtounderstandanunknownbattlefeld
shapedbvunseenexposuresandinterconnectionsasthevfoughttokeepthefnan-
cialsvstemfromcollapsing.
:itUii 1i / \1i uN \Ni iiii \\1i \i: ,.
4
DEREGULATION REDUX
CONTENTS
Lxpansicncj|ankingactivitics“ShattcrcrcjG|ass-Stcaga||” ·:
Icng-1crnCapita|Managcncnt
“1hat’swhathistcrvhadprcvcdtcthcn” ·e
Dct-ccncrash“Iavcnncrcrisk”·;
1hcwagcscjhnancc“Vc||.thiscnc’sdcingit.schcwcanInctdcit?” e)
Iinancia|scctcrgrcwth
“Ithinkwccvcrdidhnanccvcrsusthcrca|cccncnv”e;
EXPANSION OF BANKING ACTIVITIES:
“SHATTERER OF GLASSSTEAGALL”
Bv the mid-1ooos, the parallel banking svstem was booming, some of the largest
commercial banks appeared increasinglv like the large investment banks, and all of
themwerebecominglarger,morecomplex,andmoreactiveinsecuritization.Some
academics and industrv analvsts argued that advances in data processing, telecom-
munications, and information services created economies of scale and scope in f-
nance and therebv 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 economv. Others contended that the largest banks
were not necessarilv more emcient but grew because of their commanding market
positionsandcreditors’perceptionthevweretoobigtofail.Asthevgrew,thelarge
banks pressed regulators, state legislatures, and Congress to remove almost all re-
mainingbarrierstogrowthandcompetition.Thevhadmuchsuccess.In1ooaCon-
gress authorized nationwide banking with the Riegle-Neal Interstate Banking and
Branching Emciencv Act. This let bank holding companies acquire banks in everv
state,andremovedmostrestrictionsonopeningbranchesinmorethanonestate.It
preempted anv state law that restricted the abilitv of out-of-state banks to compete
withinthestate’sborders.
1
Removing barriers helped consolidate the banking industrv. Between 1ooo and
ioo-,¬a“megamergers”occurredinvolvingbankswithassetsofmorethan·1obil-
lioneach.Meanwhilethe1olargestjumpedfromowningi-ºoftheindustrv’sassets
,z
to--º.From1oo8toioo¬,thecombinedassetsofthefvelargestU.S.banks—Bank
of America, Citigroup, IP Morgan, Wachovia, and Wells Fargo—more than tripled,
from ·i.i trillion to ·o.8 trillion.
i
And investment banks were growing bigger, too.
SmithBarnevacquiredShearsonin1oo:andSalomonBrothersin1oo¬,whilePaine
WebberpurchasedKidder,Peabodvin1oo-.Twovearslater,MorganStanlevmerged
with Dean Witter, and Bankers Trust purchased Alex. Brown & Sons. The assets of
the fve largest investment banks—Goldman Sachs, Morgan Stanlev, Merrill Lvnch,
LehmanBrothers,andBearStearns—quadrupled,from·1trillionin1oo8to·atril-
lioninioo¬.
:
In 1ooo, the Economic Growth and Regulatorv Paperwork Reduction Act re-
quiredfederalregulatorstoreviewtheirrulesevervdecadeandsolicitcommentson
“outdated, unnecessarv, or undulv burdensome” rules.
a
Some agencies responded
with gusto. In ioo:, the Federal Deposit Insurance Corporation’s annual report in-
cluded a photograph of the vice chairman, Iohn Reich; the director of the Omce of
Thrift Supervision (OTS), Iames Gilleran; and three banking industrv representa-
tivesusingachainsawandpruningshearstocutthe“redtape”bindingalargestack
ofdocumentsrepresentingregulations.
Lessenthusiasticagenciesfeltheat.FormerSecuritiesandExchangeCommission
chairman Arthur Levitt told the FCIC that once word of a proposed regulation got
out, industrv lobbvists would rush to complain to members of the congressional
committee with jurisdiction over the fnancial activitv 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 agencv’s time and discouraged it from making
regulations. Levitt described it as “kind of a blood sport to make the particular
agencvlookstupidorineptorvenal.”
-
However,otherssaidinterference—atleastfromtheexecutivebranch—wasmod-
est. Iohn Hawke, a former comptroller of the currencv, told the FCIC he found the
TreasurvDepartment“exceedinglvsensitive”tohisagencv’sindependence.Hissuc-
cessor,IohnDugan,said“statutorvfrewalls”preventedinterferencefromtheexecu-
tivebranch.
o
Deregulationwentbevonddismantlingregulations;itssupporterswerealsodisin-
clined to adopt new regulations or challenge industrv on the risks of innovations.
FederalReserveomcialsarguedthatfnancialinstitutions,withstrongincentivesto
protect shareholders, would regulate themselves bv carefullv managing their own
risks. In a ioo: speech, Fed Vice Chairman Roger Ferguson praised “the trulv im-
pressive improvement in methods of risk measurement and management and the
growingadoptionofthesetechnologiesbvmostlvlargebanksandotherfnancialin-
termediaries.”
¬
Likewise,Fedandotheromcialsbelievedthatmarketswouldself-reg-
ulate through the activities of analvsts and investors. “It is criticallv important to
recognize that no market is ever trulv unregulated,” said Fed Chairman Alan
Greenspanin1oo¬.“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 1oo1 to iooo, discussed banking supervision in a memorandum submitted to
the FCIC: “Supervisors understood that forceful and proactive supervision, espe-
ciallvearlvinterventionbeforemanagementweaknesseswererefectedinpoorfnan-
cial performance, might be viewed as i) overlv-intrusive, burdensome, and
heavv-handed,ii)anundesirableconstraintoncreditavailabilitv,oriii)inconsistent
withtheFed’spublicposture.”
o
To create checks and balances and keep anv agencv from becoming arbitrarv or
infexible, senior policv makers pushed to keep multiple regulators.
1o
In 1ooa,
Greenspan testifed against proposals to consolidate bank regulation: “The current
structure provides banks with a method . . . of shifting their regulator, an effective
testthatprovidesalimitonthearbitrarvpositionorexcessivelvrigidpostureofanv
oneregulator.Thepressureofapotentiallossofinstitutionshasinhibitedexcessive
regulation and acted as a countervailing force to the bias of a regulatorv agencv to
overregulate.”
11
Further,someregulators,includingtheOTSandOmceoftheComp-
trolleroftheCurrencv(OCC),werefundedlargelvbvassessmentsfromtheinstitu-
tionsthevregulated.Asaresult,thelargerthenumberofinstitutionsthatchosethese
regulators,thegreatertheirbudget.
Emboldenedbvsuccessandthetenorofthetimes,thelargestbanksandtheirreg-
ulatorscontinuedtoopposelimitsonbanks’activitiesorgrowth.Thebarrierssepa-
rating commercial banks and investment banks had been crumbling, little bv little,
andnowseemedthetimetoremovethelastremnantsoftherestrictionsthatsepa-
ratedbanks,securitiesfrms,andinsurancecompanies.
Inthespringof1ooo,aftervearsofopposingrepealofGlass-Steagall,theSecuri-
tiesIndustrvAssociation—thetradeorganizationofWallStreetfrmssuchasGold-
man Sachs and Merrill Lvnch—changed course. Because restrictions on banks had
beenslowlvremovedduringthepreviousdecade,banksalreadvhadbeachheadsin
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 agencv rulings.
1i
Edward Yingling, the CEO of the American
Bankers Association (a lobbving organization), said, “Because we had knocked so
manv holes in the walls separating commercial and investment banking and insur-
ance,wewereabletoaggressivelventertheirbusinesses—insomecasesmoreaggres-
sivelvthanthevcouldenterours.Sofrstthesecuritiesindustrv,thentheinsurance
companies,andfnallvtheagentscameoverandsaidlet’snegotiateadealandwork
together.”
1:
In 1oo8, Citicorp forced the issue bv seeking a merger with the insurance giant
TravelerstoformCitigroup.TheFedapprovedit,citingatechnicalexemptiontothe
Bank Holding Companv Act,
1a
but Citigroup would have to divest itself of manv
Travelersassetswithinfvevearsunlessthelawswerechanged.Congresshadtomake
adecision:Wasitpreparedtobreakupthenation’slargestfnancialfrm:Wasittime
torepealtheGlass-SteagallAct,onceandforall:
,. ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN iiiui1
AsCongressbeganfashioninglegislation,thebankswerecloseathand.In1ooo,
thefnancialsectorspent·18¬millionlobbvingatthefederallevel,andindividuals
andpoliticalactioncommittees(PACs)inthesectordonated·ioimilliontofederal
electioncampaignsintheioooelectioncvcle.From1ooothroughioo8,federallob-
bvingbvthefnancialsectorreached·i.¬billion;campaigndonationsfromindivid-
ualsandPACstopped·1billion.
1-
In November 1ooo, Congress passed and President Clinton signed the Gramm-
Leach-Blilev Act (GLBA), which lifted most of the remaining Glass-Steagall-era re-
strictions. The new law embodied manv of the measures Treasurv had previouslv
advocated.
1o
TheNew York Times reportedthatCitigroupCEOSandvWeillhungin
his omce “a hunk of wood—at least a feet wide—etched with his portrait and the
words‘TheShattererofGlass-Steagall.’”

Now, as long as bank holding companies satisfed certain safetv and soundness
conditions,thevcouldunderwriteandsellbanking,securities,andinsuranceprod-
ucts and services. Their securities amliates were no longer bound bv the Fed’s i-º
limit—theirprimarvregulator,theSEC,settheironlvboundaries.Supportersofthe
legislationarguedthatthenewholdingcompanieswouldbemoreproftable(dueto
economies of scale and scope), safer (through a broader diversifcation of risks),
moreusefultoconsumers(thankstotheconvenienceofone-stopshoppingforfnan-
cialservices),andmorecompetitivewithlargeforeignbanks,whichalreadvoffered
loans,securities,andinsuranceproducts.Thelegislation’sopponentswarnedthatal-
lowingbankstocombinewithsecuritiesfrmswouldpromoteexcessivespeculation
andcouldtriggeracrisislikethecrashof1oio.IohnReed,formerco-CEOofCiti-
group,acknowledgedtotheFCICthat,inhindsight,“thecompartmentalizationthat
was created bv Glass-Steagall would be a positive factor,” making less likelv a “cata-
strophicfailure”ofthefnancialsvstem.
18
Towinthesecuritiesindustrv’ssupport,thenewlawleftinplacetwoexceptions
thatletsecuritiesfrmsownthriftsandindustrialloancompanies,atvpeofdeposi-
torv institution with stricter limits on its activities. Through them, securities frms
couldaccessFDIC-insureddepositswithoutsupervisionbvtheFed.Somesecurities
frms immediatelv expanded their industrial loan companv and thrift subsidiaries.
Merrill’sindustrialloancompanvgrewfromlessthan·1billioninassetsin1oo8to
·abillionin1ooo,andto·¬8billioninioo¬.Lehman’sthriftgrewfrom·88million
in1oo8to·:billionin1ooo,anditsassetsroseashighas·iabillioninioo-.
1o
ForinstitutionsregulatedbvtheFed,thenewlawalsoestablishedahvbridregula-
torvstructureknowncolloquiallvas“Fed-Lite.”TheFedsupervisedfnancialholding
companiesasawhole,lookingonlvforrisksthatcutacrossthevarioussubsidiaries
ownedbvtheholdingcompanv.Toavoidduplicatingotherregulators’work,theFed
was required to relv “to the fullest extent possible” on examinations and reports of
thoseagenciesregardingsubsidiariesoftheholdingcompanv,includingbanks,secu-
ritiesfrms,andinsurancecompanies.TheexpressedintentofFed-Litewastoelimi-
nate excessive or duplicative regulation.
io
However, Fed Chairman Ben Bernanke
toldtheFCICthatFed-Lite“madeitdimcultforanvsingleregulatortoreliablvsee
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 identifv excessive risks and
unsoundpracticesbuildingupinnonbanksubsidiariesoffnancialholdingcompa-
niessuchasCitigroupandWachovia.
ii
The convergence of banks and securities frms also undermined the supportive
relationshipbetweenbankingandsecuritiesmarketsthatFedChairmanGreenspan
hadconsideredasourceofstabilitv.Hecomparedittoa“sparetire”:iflargecommer-
cial banks ran into trouble, their large customers could borrow from investment
banksandothersinthecapitalmarkets;ifthosemarketsfroze,bankscouldlendus-
ingtheirdeposits.After1ooo,securitizedmortgagelendingprovidedanothersource
ofcredittohomebuversandotherborrowersthatsoftenedasteepdeclineinlending
bv thrifts and banks. The svstem’s resilience following the crisis in Asian fnancial
marketsinthelate1ooosfurtherprovedhispoint,Greenspansaid.
i:
The new regime encouraged growth and consolidation within and across bank-
ing,securities,andinsurance.Thebank-centeredfnancialholdingcompaniessuch
asCitigroup,IPMorgan,andBankofAmericacouldcompetedirectlvwiththe“big
fve” investment banks—Goldman Sachs, Morgan Stanlev, Merrill Lvnch, Lehman
Brothers, and Bear Stearns—in securitization, stock and bond underwriting, loan
svndication, and trading in over-the-counter (OTC) derivatives. The biggest bank
holding companies became major plavers in investment banking. The strategies of
thelargestcommercialbanksandtheirholdingcompaniescametomorecloselvre-
semble the strategies of investment banks. Each had advantages: commercial banks
enjoved greater access to insured deposits, and the investment banks enjoved less
regulation.Bothprosperedfromthelate1ooosuntiltheoutbreakofthefnancialcri-
sisinioo¬.However,Greenspan’s“sparetire”thathadhelpedmakethesvstemless
vulnerable would be gone when the fnancial crisis emerged—all the wheels of the
svstemwouldbespinningonthesameaxle.
LONGTERM CAPITAL MANAGEMENT:
“THAT’ S WHAT HISTORY HAD PROVED TO THEM”
InAugust1oo8,Russiadefaultedonpartofitsnationaldebt,panickingmarkets.Rus-
siaannounceditwouldrestructureitsdebtandpostponesomepavments.Intheaf-
termath,investorsdumpedhigher-risksecurities,includingthosehavingnothingto
do with Russia, and fed to the safetv of U.S. Treasurv bills and FDIC-insured de-
posits. In response, the Federal Reserve cut short-term interest rates three times in
sevenweeks.
ia
Withthecommercialpapermarketinturmoil,itwasuptothecom-
mercialbankstotakeuptheslackbvlendingtocorporationsthatcouldnotrollover
their short-term paper. Banks loaned ·:o billion in September and October of
1oo8—abouti.-timestheusualamount
i-
—andhelpedpreventaseriousdisruption
frombecomingmuchworse.Theeconomvavoidedaslump.
NotsoforLong-TermCapitalManagement,alargeU.S.hedgefund.LTCMhad
devastatinglossesonits·1i-billionportfolioofhigh-riskdebtsecurities,including
the junk bonds and emerging market debt that investors were dumping.
io
To buv
thesesecurities,thefrmhadborrowed·iaforeverv·1ofinvestors’equitv;

lenders
,( ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN iiiui1
included Merrill Lvnch, IP Morgan, Morgan Stanlev, Lehman Brothers, Goldman
Sachs, and Chase Manhattan. The previous four vears, LTCM’s leveraging strategv
had produced magnifcent returns: 1o.oº, ai.8º, ao.8º, and 1¬.1º, while the S&P
-oovieldedanaveragei1º.
i8
Butleverageworksbothwavs,andinjustonemonthafterRussia’spartialdefault,
thefundlostmorethan·abillion—ormorethan8oºofitsnearlv·-billionincapi-
tal.Itsdebtwasabout·1iobillion.Thefrmfacedinsolvencv.
io
If it were onlv a matter of less than ·- billion, LTCM’s failure might have been
manageable. But the frm had further leveraged itself bv entering into derivatives
contracts with more than ·1 trillion in notional amount—mostlv interest rate and
equitvderivatives.
:o
Withvervlittlecapitalinreserve,itthreatenedtodefaultonits
obligationstoitsderivativescounterparties—includingmanvofthelargestcommer-
cialandinvestmentbanks.BecauseLTCMhadnegotiateditsderivativestransactions
intheopaqueover-the-countermarket,themarketsdidnotknowthesizeofitsposi-
tionsorthefactthatithadpostedvervlittlecollateralagainstthosepositions.Asthe
Fednotedthen,ifallthefund’scounterpartieshadtriedtoliquidatetheirpositions
simultaneouslv,assetpricesacrossthemarketmighthaveplummeted,whichwould
havecreated“exaggerated”losses.Thiswasaclassicsetupforarun:losseswerelikelv,
butnobodvknewwhowouldgetburned.TheFedworriedthatwithfnancialmar-
ketsalreadvfragile,theselosseswouldspillovertoinvestorswithnorelationshipto
LTCM, and credit and derivatives markets might “cease to function for a period of
oneormoredavsandmavbelonger.”
:1
Toavertsuchadisaster,theFedcalledanemergencvmeetingofmajorbanksand
securitiesfrmswithlargeexposurestoLTCM.
:i
OnSeptemberi:,afterconsiderable
urging, 1a institutions agreed to organize a consortium to inject ·:.o billion into
LTCMinreturnforooºofitsstock.
::
Thefrmscontributedbetween·1oomillion
and ·:oo million each, although Bear Stearns declined to participate.
:a
An orderlv
liquidationofLTCM’ssecuritiesandderivativesfollowed.
William McDonough, then president of the New York Fed, insisted “no Federal
Reserve omcial pressured anvone, and no promises were made.”
:-
The rescue in-
volvednogovernmentfunds.Nevertheless,theFed’sorchestrationraisedaquestion:
howfarwoulditgotoforestallwhatitsawasasvstemiccrisis:
The Fed’s aggressive response had precedents in the previous two decades. In
1o¬o,theFedhadsupportedthecommercialpapermarket;in1o8o,dealersinsilver
futures;in1o8i,therepomarket;in1o8¬,thestockmarketaftertheDowIonesIn-
dustrialAveragefellbvioºpercentinthreedavs.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
thev viewed as “too big to fail” and protected creditors of those banks, including
uninsureddepositors.Theirrationalewasthatmajorbankswerecrucialtothefnan-
cial markets and the economv, 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.
Butitwasacompletelvdifferentpropositiontoarguethatahedgefundcouldbe
consideredtoobigtofailbecauseitscollapsemightdestabilizecapitalmarkets.Did
LTCM’srescueindicatethattheFedwaspreparedtoprotectcreditorsofanvtvpeof
frmifitscollapsemightthreatenthecapitalmarkets:HarvevMiller,thebankruptcv
counselforLehmanBrotherswhenitfailedinioo8,toldtheFCICthat“thev[hedge
funds]expectedtheFedtosaveLehman,basedontheFed’sinvolvementinLTCM’s
rescue.That’swhathistorvhadprovedtothem.”

For Stanlev O’Neal, Merrill’s CFO during the LTCM rescue, the experience was
“indelible.”HetoldtheFCIC,“ThelessonItookawavfromitthoughwasthathad
the market seizure and panic and lack of liquiditv lasted longer, there would have
beenalotoffrmsacrosstheStreetthatwereirreparablvharmed,andMerrillwould
havebeenoneofthose.”
:8
Greenspanarguedthattheeventsof1oo8hadconfrmedthesparetiretheorv.He
saidina1ooospeechthatthesuccessfulresolutionofthe1oo8crisisshowedthat“di-
versitv within the fnancial sector provides insurance against a fnancial problem
turningintoeconomv-widedistress.”
:o
ThePresident’sWorkingGrouponFinancial
Markets came to a less defnite conclusion. In a 1ooo report, the group noted that
LTCM and its counterparties had “underestimated the likelihood that liquiditv,
credit,andvolatilitvspreadswouldmoveinasimilarfashioninmarketsacrossthe
worldatthesametime.”
ao
Manvfnancialfrmswouldmakeessentiallvthesamemis-
takeadecadelater.FortheWorkingGroup,thismiscalculationraisedanimportant
issue:“Asnewtechnologvhasfosteredamajorexpansioninthevolumeand,insome
cases, the leverage of transactions, some existing risk models have underestimated
theprobabilitvofseverelosses.Thisshowstheneedforinsuringthatdecisionsabout
the appropriate level of capital for riskv positions become an issue that is explicitlv
considered.”
a1
Theneedforriskmanagementgrewinthefollowingdecade.TheWorkingGroup
was alreadv concerned that neither the markets nor their regulators were prepared
fortailrisk—anunanticipatedeventcausingcatastrophicdamagetofnancialinstitu-
tionsandtheeconomv.Nevertheless,itcautionedthatoverreactingtothreatssuchas
LTCMwoulddiminishthedvnamismofthefnancialsectorandtherealeconomv:
“Policvinitiativesthatareaimedatsimplvreducingdefaultlikelihoodstoextremelv
low levels might be counterproductive if thev unnecessarilv disrupt trading activitv
andtheintermediationofrisksthatsupportthefnancingofrealeconomicactivitv.”
ai
Following the Working Group’s fndings, the SEC fve vears later would issue a
ruleexpandingthenumberofhedgefundadvisors—toincludemostadvisors—that
needed to register with the SEC. The rule would be struck down in iooo bv the
UnitedStatesCourtofAppealsfortheDistrictofColumbiaaftertheSECwassued
bvaninvestmentadvisorandhedgefund.
a:
Marketswererelativelvcalmafter1oo8,Glass-Steagallwouldbedeemedunnec-
essarv, OTC derivatives would be deregulated, and the stock market and the econ-
omvwouldcontinuetoprosperforsometime.Likealltheothers(withtheexception
,· ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN iiiui1
oftheGreatDepression),thiscrisissoonfadedintomemorv.Butnotbefore,inFeb-
ruarv 1ooo, Time magazine featured Robert Rubin, Larrv 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 everv
emergencvsincethe1o8¬stockmarketcrash.
aa
DOTCOM CRASH: “LAY ON MORE RISK”
The late 1ooos 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·ooobillionin1ooato·i.itrillioninioo1.Annualinitialpublicofferings
ofstocks(IPOs)soaredfrom·i8billionin1ooato·¬obillioninioooasbanksand
securities frms sponsored IPOs for new Internet and telecommunications compa-
nies—thedot-comsandtelecoms.
a-
Astockmarketboomensuedcomparabletothe
greatbullmarketofthe1oios.Thevalueofpubliclvtradedstocksrosefrom·-.8tril-
lioninDecember1ooato·1¬.8trillioninMarchiooo.
ao
Theboomwasparticularlv
strikinginrecentdot-comandtelecomissuesontheNASDAOexchange.Overthis
period,theNASDAOskvrocketedfrom¬-ito-,oa8.
In the spring of iooo, the tech bubble burst. The “new economv” dot-coms and
telecoms had failed to match the loftv expectations of investors, who had relied on
bullish—and,asitturnedout,sometimesdeceptive—researchreportsissuedbvthe
same banks and securities frms that had underwritten the tech companies’ initial
publicofferings.BetweenMarchioooandMarchioo1,theNASDAOfellbvalmost
two-thirds.ThisslumpacceleratedaftertheterroristattacksonSeptember11asthe
nation slipped into recession. Investors were further shaken bv 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
(dolingoutsharestoinvestorswhoagreedtobuvmorelaterathigherprices).

The
regulatorsalsofoundthatpublicresearchreportspreparedbvinvestmentbanks’ana-
lvstsweretaintedbvconfictsofinterest.TheSEC,NewYork’sattornevgeneral,the
NationalAssociationofSecuritiesDealers(nowFINRA),andstateregulatorssettled
enforcementactionsagainst1ofrmsfor·8¬-million,forbadecertainpractices,and
institutedreforms.
a8
ThesuddencollapsesofEnronandWorldComwereshocking;withassetsof·o:
billion and ·1oa billion, respectivelv, thev were the largest corporate bankruptcies
beforethedefaultofLehmanBrothersinioo8.
Following legal proceedings and investigations, Citigroup, IP Morgan, Merrill
Lvnch, 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.Executivesatthebankshadpressuredtheiranalvststowriteglowing
iiiitUi\1i uN iiiU\ ,+
evaluationsofEnron.ThescandalcostCitigroup,IPMorgan,CIBC,MerrillLvnch,
andotherfnancialinstitutionsmorethan·aoomillioninsettlementswiththeSEC;
Citigroup,IPMorgan,CIBC,LehmanBrothers,andBankofAmericapaidanother
·o.o billion to investors to settle class action lawsuits.
ao
In response, the Sarbanes-
Oxlev Act of iooi required the personal certifcation of fnancial reports bv CEOs
andCFOs;independentauditcommittees;longerjailsentencesandlargerfnesfor
executiveswhomisstatefnancialresults;andprotectionsforwhistleblowers.
Somefrmsthatlenttocompaniesthatfailedduringthestockmarketbustwere
successfullv 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“appeartohaveeffectivelvspreadlosses”fromdefaultsbvEnronandother
largecorporations.Althoughheconcededthemarketwas“stilltoonewtohavebeen
tested” thoroughlv, he observed that “to date, it appears to have functioned well.”
-o
The following vear, Fed Vice Chairman Roger Ferguson noted that “the most re-
markablefactregardingthebankingindustrvduringthisperiodisitsresilienceand
retentionoffundamentalstrength.”
-1
This resilience led manv executives and regulators to presume the fnancial svs-
tem had achieved unprecedented stabilitv and strong risk management. The Wall
Streetbanks’pivotalroleintheEnrondebacledidnotseemtotroubleseniorFedof-
fcials.InamemorandumtotheFCIC,RichardSpillenkothendescribedapresenta-
tiontotheBoardofGovernorsinwhichsomeFedgovernorsreceiveddetailsofthe
banks’complicitv“coollv”andwere“clearlvunimpressed”bvanalvsts’fndings.“The
messagetosomesupervisorvstaffwasneitherambiguousnorsubtle,”Spillenkothen
wrote.Earlierinthedecade,heremembered,senioreconomistsattheFedhadcalled
Enronanexampleofaderivativesmarketparticipantsuccessfullvregulatedbvmar-
ketdisciplinewithoutgovernmentoversight.
-i
TheFedcutinterestratesaggressivelvinordertocontaindamagefromthedot-
comandtelecombust,theterroristattacks,andthefnancialmarketscandals.InIan-
uarvioo1,thefederalfundsrate,theovernightbank-to-banklendingrate,waso.-º.
Bvmid-ioo:,theFedhadcutthatratetojust1º,thelowestinhalfacenturv,where
itstavedforanothervear.Inaddition,tooffsetthemarketdisruptionsfollowingthe
o/11attacks,theFedfoodedthefnancialmarketswithmonevbvpurchasingmore
than·1-obillioningovernmentsecuritiesandlending·a-billiontobanks.Italso
suspended restrictions on bank holding companies so the banks could make large
loanstotheirsecuritiesamliates.WiththeseactionstheFedpreventedaprotracted
liquiditvcrunchinthefnancialmarketsduringthefallofioo1,justasithaddone
duringthe1o8¬stockmarketcrashandthe1oo8Russiancrisis.
Whv wouldn’t the markets assume the central bank would act again—and again
save the dav: Two weeks before the Fed cut short-term rates in Ianuarv ioo1, the
Economist anticipatedit:“the‘Greenspanput’isonceagainthetalkofWallStreet. . . .
TheideaisthattheFederalReservecanberelieduponintimesofcrisistocometo
(+ ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN iiiui1
therescue,cuttinginterestratesandpumpinginliquiditv,thusprovidingafoorfor
equitvprices.”
-:
The“Greenspanput”wasanalvsts’shorthandforinvestors’faiththat
theFedwouldkeepthecapitalmarketsfunctioningnomatterwhat.TheFed’spolicv
wasclear:torestraingrowthofanassetbubble,itwouldtakeonlvsmallsteps,suchas
warninginvestorssomeassetpricesmightfall;butafterabubbleburst,itwoulduse
all the tools available to stabilize the markets. Greenspan argued that intentionallv
burstingabubblewouldheavilvdamagetheeconomv.“Insteadoftrvingtocontaina
putativebubblebvdrasticactionswithlargelvunpredictableconsequences,”hesaid
iniooa,whenhousingpriceswereballooning,“wechose . . .tofocusonpolicies‘to
mitigate the fallout when it occurs and, hopefullv, ease the transition to the next
expansion.’”
-a
This asvmmetric policv—allowing unrestrained growth, then working hard to
cushiontheimpactofabust—raisedthequestionof“moralhazard”:didthepolicv
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“newlvabundantliquid-
itvcanreadilvdisappear.”
--
Yettheonlvrealactionwouldbeanupwardmarchofthe
federalfundsratethathadbeguninthesummerofiooa,although,ashepointedout
inthesameioo-speech,thishadlittleeffect.
Andthemarketswereundeterred.“Wehadconvincedourselvesthatwewereina
lessriskvworld,”formerFederalReservegovernorandNationalEconomicCouncil
director under President George W. Bush Lawrence Lindsev told the Commission.
“Andhowshouldanvrationalinvestorrespondtoalessriskvworld:Thevshouldlav
onmorerisk.”
-o
THE WAGES OF FINANCE:
“WELL, THIS ONE’ S DOING IT, SO HOW CAN I NOT DO IT? ”
Asfgurea.1demonstrates,foralmosthalfacenturvaftertheGreatDepression,pav
insidethefnancialindustrvandoutwasroughlvequal.Beginningin1o8o,thevdi-
verged. Bv ioo¬, fnancial sector compensation was more than 8oº greater than in
otherbusinesses—aconsiderablvlargergapthanbeforetheGreatDepression.
Until1o¬o,theNewYorkStockExchange,aprivateself-regulatorvorganization,
required members to operate as partnerships.

Peter I. Solomon, a former Lehman
Brothers partner, testifed before the FCIC that this profoundlv affected the invest-
mentbank’sculture.Beforethechange,heandtheotherpartnershadsatinasingle
roomatheadquarters,nottosocializebutto“overhear,interact,andmonitor”each
other.Thevwereallonthehooktogether.“Sincethevwerepersonallvliableaspart-
ners,thevtookriskvervseriouslv,”Solomonsaid.
-8
BrianLeach,formerlvanexecu-
tive at Morgan Stanlev, described to FCIC staff Morgan Stanlev’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 NuUi i¥ tu\\i : :i uN iiiui1
startedatMorganStanlev,itwasaprivatecompanv.Whenvou’reaprivatecompanv,
vou don’t get paid until vou retire. I mean, vou get a good, vou know, vear-to-vear
compensation.”Butthebigpavoutwas“whenvouretire.”
-o
When the investment banks went public in the 1o8os and 1ooos, the close rela-
tionshipbetweenbankers’decisionsandtheircompensationbrokedown.Thevwere
nowtradingwithshareholders’monev.Talentedtradersandmanagersoncetethered
totheirfrmswerenowfreeagentswhocouldplavcompaniesagainsteachotherfor
more monev. To keep them from leaving, frms began providing aggressive incen-
tives, often tied to the price of their shares and often with accelerated pavouts. To
keepup,commercialbanksdidthesame.Someincluded“clawback”provisionsthat
would require the return of compensation under narrow circumstances, but those
provedtoolimitedtorestrainthebehavioroftradersandmanagers.
Studieshavefoundthattherealvalueofexecutivepav,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
¤overnmenL insurance and þension þro¤rams. Nonfnancial secLor is all domesLic emþloyees exceþL Lhose in
fnance and insurance.
Iigurc ;.+
onlvo.8ºavearduringthe:ovearsafterWorldWarII,laggingcompanies’increasing
size.
oo
Buttheratepickedupduringthe1o¬osandrosefastereachdecade,reaching
1oºavearfrom1oo-to1ooo.
o1
Muchofthechangerefectedhigherearningsinthe
fnancial sector, where bv ioo- executives’ pav averaged ·:.a million annuallv, the
highest of anv industrv. Though base salaries differed relativelv little across sectors,
bankingandfnancepaidmuchhigherbonusesandawardedmorestock.Andbrokers
anddealersdidbvfarthebest,averagingmorethan·¬millionincompensation.
oi
Bothbeforeandaftergoingpublic,investmentbankstvpicallvpaidouthalftheir
revenuesincompensation.Forexample,GoldmanSachsspentbetweenaaºandaoº
avearbetweenioo-andioo8,whenMorganStanlevallottedbetweenaoºand-oº.
Merrillpaidoutsimilarpercentagesinioo-andiooo,butgave1a1ºinioo¬—avear
itsuffereddramaticlosses.
o:
Asthescale,revenue,andproftabilitvofthefrmsgrew,compensationpackages
soared for senior executives and other kev emplovees. Iohn Gutfreund, reported to
bethehighest-paidexecutiveonWallStreetinthelate1o8os,received·:.imillionin
1o8oasCEOofSalomonBrothers.
oa
StanlevO’Neal’spackagewasworthmorethan
·o1millioniniooo,thelastfullvearhewasCEOofMerrillLvnch.
o-
Inioo¬,Llovd
Blankfein, CEO at Goldman Sachs, received ·o8.- million;
oo
Richard Fuld, CEO of
Lehman Brothers, and Iamie Dimon, CEO of IPMorgan Chase, received about ·:a
million and ·i8 million, respectivelv.

That vear Wall Street paid workers in New
Yorkroughlv·::billioninvear-endbonusesalone.
o8
Totalcompensationforthema-
jorU.S.banksandsecuritiesfrmswasestimatedat·1:¬billion.
oo
Stock options became a popular form of compensation, allowing emplovees to
buvthecompanv’sstockinthefutureatsomepredeterminedprice,andthustoreap
rewardswhenthestockpricewashigherthanthatpredeterminedprice.Infact,the
optionwouldhavenovalueifthestockpricewasbelowthatprice.Encouragingthe
awardingofstockoptionswas1oo:legislationmakingcompensationinexcessof·1
milliontaxabletothecorporationunlessperformance-based.Stockoptionshadpo-
tentiallv unlimited upside, while the downside was simplv to receive nothing if the
stockdidn’trisetothepredeterminedprice.Thesameappliedtoplansthattiedpav
toreturnonequitv:thevmeantthatexecutivescouldwinmorethanthevcouldlose.
These pav structures had the unintended consequence of creating incentives to in-
creasebothriskandleverage,whichcouldleadtolargerjumpsinacompanv’sstock
price.
Astheseoptionsmotivatedfnancialfrmstotakemoreriskandusemorelever-
age, the evolution of the svstem provided the means. Shadow banking institutions
faced few regulatorv 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 pav structures were clear, but senior executives believed
thevwerepowerlesstochangeit.FormerCitigroupCEOSandvWeilltoldtheCom-
mission,“IthinkifvoulookattheresultsofwhathappenedonWallStreet,itbecame,
iiiitUi\1i uN iiiU\ (.
‘Well,thisone’sdoingit,sohowcanInotdoit,ifIdon’tdoit,thenthepeoplearego-
ingtoleavemvplaceandgosomeplaceelse.’”Managingrisk“becamelessofanim-
portantfunctioninabroadbaseofcompanies,Iwouldguess.”
¬o
Andregulatorventities,onesourceofchecksonexcessiverisktaking,hadchal-
lenges recruiting fnancial experts who could otherwise work in the private sector.
LordAdairTurner,chairmanoftheU.K.FinancialServicesAuthoritv,toldtheCom-
mission, “It’s not easv. This is like a continual process of, vou know, high-skilled
people versus high-skilled people, and the poachers are better paid than the game-
keepers.”
¬1
BernankesaidthesameatanFCIChearing:“It’sjustsimplvnevergoingto
bethecasethatthegovernmentcanpavwhatWallStreetcanpav.”
¬i
Tving compensation to earnings also, in some cases, created the temptation to
manipulatethenumbers.FormerFannieMaeregulatorArmandoFalconIr.toldthe
FCIC, “Fannie began the last decade with an ambitious goal—double earnings in -
vears to ·o.ao [per share]. A large part of the executives’ compensation was tied to
meetingthatgoal.”AchievingitbroughtCEOFranklinRaines·-imillionofhis·oo
millionpavfrom1oo8toioo:.However,Falconsaid,thegoal“turnedouttobeun-
achievable without breaking rules and hiding risks. Fannie and Freddie executives
workedhardtopersuadeinvestorsthatmortgage-relatedassetswerearisklessinvest-
ment,whileatthesametimecoveringupthevolatilitvandrisksoftheirownmort-
gageportfoliosandbalancesheets.” Fannie’sestimateofhowmanvmortgageholders
wouldpavoffwasoffbv·aoomillionatvear-end1oo8,whichmeantnobonuses.So
Fannie counted onlv half the ·aoo 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
qualitvoftheloansmade.”Sheconcluded,“Thecrisishasshownthatmostfnancial-
institutioncompensationsvstemswerenotproperlvlinkedtoriskmanagement.For-
mula-driven compensation allows high short-term profts to be translated into
generousbonuspavments,withoutregardtoanvlonger-termrisks.”
¬a
SECChairman
MarvSchapirotoldtheFCIC,“Manvmajorfnancialinstitutionscreatedasvmmetric
compensationpackagesthatpaidemploveesenormoussumsforshort-termsuccess,
even if these same decisions result in signifcant long-term losses or failure for in-
vestorsandtaxpavers.”
¬-
FINANCIAL SECTOR GROWTH:
“I THINK WE OVERDID FINANCE VERSUS THE REAL ECONOMY”
Forabouttwodecades,beginningintheearlv1o8os,thefnancialsectorgrewfaster
than the rest of the economv—rising from about -º of gross domestic product
(GDP) to about 8º in the earlv i1st centurv. In 1o8o, fnancial sector profts were
about1-ºofcorporateprofts.Inioo:,thevhitahighof::ºbutfellbacktoi¬º
(. ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN iiiui1
iiiitUi\1i uN iiiU\ (,
in iooo, on the eve of the fnancial crisis. The largest frms became considerablv
larger. IP Morgan’s assets increased from ·oo¬ billion in 1ooo to ·i.i trillion in
ioo8,acompoundannualgrowthrateof1oº.BankofAmericaandCitigroupgrew
bv1aºand1iºavear,respectivelv,withCitigroupreaching·1.otrillioninassetsin
ioo8(downfrom·i.itrillioninioo¬)andBankofAmerica·1.8trillion.Thein-
vestment banks also grew signifcantlv from iooo to ioo¬, often much faster than
commercialbanks.Goldman’sassetsgrewfrom·i-obillionin1oooto·1.1trillion
bvioo¬,anannualgrowthrateofi1º.AtLehman,assetsrosefrom·1oibillionto
·oo1billion,or1¬º.
¬o
Fannie and Freddie grew quicklv, too. Fannie’s assets and guaranteed mortgages
increasedfrom·1.atrillioninioooto·:.itrillioninioo8,or11ºannuallv.AtFred-
die,thevincreasedfrom·1trillionto·i.itrillion,or1oºavear.
¬¬
Asthevgrew,manvfnancialfrmsaddedlotsofleverage.Thatmeantpotentiallv
higher returns for shareholders, and more monev for compensation. Increasing
leveragealsomeantlesscapitaltoabsorblosses.
Fannie and Freddie were the most leveraged. The law set the government-
sponsoredenterprises’minimumcapitalrequirementati.-ºofassetspluso.a-ºof
the mortgage-backed securities thev guaranteed. So thev could borrow more than
·iooforeachdollarofcapitalusedtoguaranteemortgage-backedsecurities.Ifthev
wantedtoownthesecurities,thevcouldborrow·aoforeachdollarofcapital.Com-
bined,FannieandFreddieownedorguaranteed·-.:trillionofmortgage-relatedas-
setsattheendofioo¬againstjust·¬o.¬billionofcapital,aratioof¬-:1.
Fromioootoioo¬,largebanksandthriftsgenerallvhad·1oto·iiinassetsfor
each dollar of capital, for leverage ratios between 1o:1 and ii:1. For some banks,
leverageremainedroughlvconstant.IPMorgan’sreportedleveragewasbetweenio:1
andii:1.WellsFargo’sgenerallvrangedbetween1o:1and1¬:1.Otherbanksupped
theirleverage.BankofAmerica’srosefrom18:1inioootoi¬:1inioo¬.Citigroup’s
increased from 18:1 to ii:1, then shot up to :i:1 bv 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
a8:1,orabout-:ºhigher.Incomparison,atWellsFargoandBankofAmerica,in-
cludingoff-balance-sheetassetswouldhaveraisedtheioo¬leverageratios1¬ºand
i8º,respectivelv.
¬8
Because investment banks were not subject to the same capital requirements as
commercialandretailbanks,thevweregivengreaterlatitudetorelvontheirinternal
risk models in determining capital requirements, and thev reported higher leverage.
At Goldman Sachs, leverage increased from 1¬:1 in iooo to :i:1 in ioo¬. Morgan
Stanlev and Lehman increased about o¬º and iiº, respectivelv, and both reached
ao:1bvtheendofioo¬.
¬o
Severalinvestmentbanksartifciallvloweredleverageratios
bvsellingassetsrightbeforethereportingperiodandsubsequentlvbuvingthemback.
As the investment banks grew, their business models changed. Traditionallv, in-
vestment banks advised and underwrote equitv and debt for corporations, fnancial
institutions,investmentfunds,governments,andindividuals.Anincreasingamount
oftheinvestmentbanks’revenuesandearningswasgeneratedbvtradingandinvest-
ments,includingsecuritizationandderivativesactivities.AtGoldman,revenuesfrom
tradingandprincipalinvestmentsincreasedfrom:oºofthetotalin1oo¬too8ºin
ioo¬.AtMerrillLvnch,thevgenerated--ºofrevenueiniooo,upfromaiºin1oo¬.
AtLehman,similaractivitiesgeneratedupto8oºofpretaxearningsiniooo,upfrom
:iºin1oo¬.AtBearStearns,thevaccountedformorethan1ooºofpretaxearnings
insomevearsafteriooibecauseofpretaxlossesinotherbusinesses.
8o
Between1o¬8andioo¬,debtheldbvfnancialcompaniesgrewfrom·:trillionto
·:otrillion,morethandoublingfrom1:oºtoi¬oºofGDP.FormerTreasurvSecre-
tarvIohnSnowtoldtheFCICthatwhilethefnancialsectormustplava“critical”role
in allocating capital to the most productive uses, it was reasonable to ask whether
over the last io or :o vears it had become too large. Financial frms had grown
mainlvbvsimplvlendingtoeachother,hesaid,notbvcreatingopportunitiesforin-
vestment.
81
In 1o¬8, fnancial companies borrowed ·1: in the credit markets for
everv·1ooborrowedbvnonfnancialcompanies.Bvioo¬,fnancialcompanieswere
borrowing·-1foreverv·1oo.“Wehavealotmoredebtthanweusedtohave,which
means we have a much bigger fnancial sector,” said Snow. “I think we overdid f-
nanceversustherealeconomvandgotitalittlelopsidedasaresult.”
8i
(( ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN iiiui1
5
SUBPRIME LENDING
CONTENTS
Mcrtgagcsccuritizaticn“1hisstujjisscccnp|icatcdhcwis
anv|cdvgcingtckncw?” e:
Grcatcracccsstc|cnding“A|usincsswhcrcwccannakcscncncncv”¬:
Su|princ|cndcrsinturnci|“Advcrscnarkctccnditicns”¬;
1hcrcgu|atcrs“Oh.Iscc” ¬·
In the earlv 1o8os, subprime lenders such as Household Finance Corp. and thrifts
suchasLongBeachSavingsandLoanmadehomeequitvloans,oftensecondmort-
gages,toborrowerswhohadvettoestablishcredithistoriesorhadtroubledfnancial
histories, sometimes refecting setbacks such as unemplovment, 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-
vantagesofamortgageoverotherformsofdebtweresolidifedin1o8owiththeTax
ReformAct,whichbarreddeductinginterestpavmentsonconsumerloansbutkept
thedeductionformortgageinterestpavments.
In the 1o8os and into the earlv 1ooos, 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,thevtraditionallvlentbasedonthefourC’s:credit
(quantitv, qualitv, and duration of the borrower’s credit obligations), capacitv
(amountandstabilitvofincome),capital(sumcientliquidfundstocoverdownpav-
ments,closingcosts,andreserves),andcollateral(valueandconditionoftheprop-
ertv).
i
Theirdecisionsdependedonjudgmentsabouthowstrengthinonearea,such
ascollateral,mightoffsetweaknessesinothers,suchascredit.Thevunderwrotebor-
rowersoneatatime,outoflocalomces.
(,
Inafewcases,suchasCitiFinancial,subprimelendingfrmswerepartofabank
holdingcompanv,butmost—includingHousehold,BenefcialFinance,TheMonev
Store, and Champion Mortgage—were independent consumer fnance companies.
Withoutaccesstodeposits,thevgenerallvfundedthemselveswithshort-termlines
of credit, or “warehouse lines,” from commercial or investment banks. In manv
cases,thefnancecompaniesdidnotkeepthemortgages.Somesoldtheloanstothe
samebanksextendingthewarehouselines.Thebankswouldsecuritizeandsellthe
loanstoinvestorsorkeepthemontheirbalancesheets.Inothercases,thefnance
companv itself packaged and sold the loans—often partnering with the banks ex-
tending the warehouse lines. Meanwhile, the S&Ls that originated subprime loans
generallv 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.creditmarketstripledduringthe1o8os,reaching·1:.8tril-
lionin1ooo;11ºwassecuritizedmortgagesandGSEdebt.Later,mortgagesecurities
made up 18º of the debt markets, overtaking government Treasuries as the single
largestcomponent—apositionthevmaintainedthroughthefnancialcrisis.
:
Inthe1ooosmortgagecompanies,banks,andWallStreetsecuritiesfrmsbegan
securitizingmortgages(seefgure-.1).Andmoreofthemweresubprime.Salomon
Brothers, Merrill Lvnch, and other Wall Street frms started packaging and selling
“non-agencv” mortgages—that is, loans that did not conform to Fannie’s and Fred-
die’sstandards.Sellingtheserequiredinvestorstoadjustexpectations.Withsecuriti-
zationshandledbvFannieandFreddie,thequestionwasnot“willvougetthemonev
back”but“when,”formerSalomonBrotherstraderandCEOofPentAlphaIimCalla-
han told the FCIC.
a
With these new non-agencv securities, investors had to worrv
about getting paid back, and that created an opportunitv for S&P and Moodv’s. As
LewisRanieri,apioneerinthemarket,toldtheCommission,whenhepresentedthe
conceptofnon-agencvsecuritizationtopolicvmakers,thevasked,“‘Thisstuffisso
complicated how is anvbodv going to know: How are the buvers going to buv:’”
Ranierisaid,“Oneofthesolutionswas,ithadtohavearating.Andthatputtherat-
ingservicesinthebusiness.”
-
Non-agencvsecuritizationswereonlvafewvearsoldwhenthevreceivedapow-
erful stimulus from an unlikelv source: the federal government. The savings and
loancrisishadleftUncleSamwith·aoibillioninloansandrealestatefromfailed
thriftsandbanks.CongressestablishedtheResolutionTrustCorporation(RTC)in
1o8o to omoad mortgages and real estate, and sometimes the failed thrifts them-
selves,nowownedbvthegovernment.WhiletheRTCwasabletosell·o.1billionof
these mortgages to Fannie and Freddie, most did not meet the GSEs’ standards.
Somewerewhatmightbecalledsubprimetodav,butothershadoutrightdocumen-
tation errors or servicing problems, not unlike the low-documentation loans that
laterbecamepopular.
o
(· ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN iiiui1
RTComcialssoonconcludedthatthevhadneitherthetimenortheresourcesto
sellofftheassetsintheirportfolioonebvoneandthriftbvthrift.Thevturnedtothe
private sector, contracting with real estate and fnancial professionals to securitize
someoftheassets.BvthetimetheRTCconcludeditswork,ithadsecuritized·i-bil-
lioninresidentialmortgages.
¬
TheRTCineffecthelpedexpandthesecuritizationof
mortgages ineligible for GSE guarantees.
8
In the earlv 1ooos, 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
in1oooto·1oobillioniniooo.Theproportionsecuritizedinthelate1ooospeakedat
-oº, and subprime mortgage originations’ share of all originations hovered around
1oº.
Securitizations bv the RTC and bv Wall Street were similar to the Fannie and
Freddiesecuritizations.Thefrststepwastogetprincipalandinterestpavmentsfrom
agroupofmortgagestofowintoasinglepool.Butin“private-label”securities(that
is,securitizationsnotdonebvFannieorFreddie),thepavmentswerethen“tranched”
inawavtoprotectsomeinvestorsfromlosses.Investorsinthetranchesreceiveddif-
ferentstreamsofprincipalandinterestindifferentorders.
Most of the earliest private-label deals, in the late 1o8os and earlv 1ooos, used a
rudimentarv form of tranching. There were tvpicallv two tranches in each deal. The
,+ ii N\Nti \i tii :i : i NuUi 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 ori¤inaLions in a ¤iven year. ln
2007, securities issued exceeded originations.
Iigurc :.:
lessriskvtranchereceivedprincipalandinterestpavmentsfrstandwasusuallvguaran-
teedbvaninsurancecompanv.Themoreriskvtranchereceivedpavmentssecond,was
notguaranteed,andwasusuallvkeptbvthecompanvthatoriginatedthemortgages.
Withinadecade,securitizationshadbecomemuchmorecomplex:thevhadmore
tranches, each with different pavment 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
highlvdependentonthisslice-and-diceprocess,andregulatorsandmarketpartici-
pantsaliketookforgrantedthatitemcientlvallocatedrisktothosebestableandwill-
ingtobearthatrisk.
To demonstrate how this process worked, we’ll describe a tvpical deal, named
CMLTIiooo-NCi,involving·oa¬millioninmortgage-backedbonds.
o
Iniooo,New
Centurv Financial, a California-based lender, originated and sold a,aoo subprime
mortgages to Citigroup, which sold them to a separate legal entitv that Citigroup
sponsoredthatwouldownthemortgagesandissuethetranches.Theentitvpurchased
theloanswithcashithadraisedbvsellingthesecuritiestheseloanswouldback.The
entitv had been created as a separate legal structure so that the assets would sit off
Citigroup’sbalancesheet,anarrangementwithtaxandregulatorvbenefts.
The a,aoo mortgages carried the rights to the borrowers’ monthlv pavments,
which the Citigroup entitv divided into 1o tranches of mortgage-backed securities;
eachtranchegaveinvestorsadifferentprioritvclaimonthefowofpavmentsfrom
theborrowers,andadifferentinterestrateandrepavmentschedule.Thecreditrating
agenciesassignedratingstomostofthesetranchesforinvestors,who—assecuritiza-
tion became increasinglv complicated—came to relv more heavilv on these ratings.
Trancheswereassignedletterratingsbvtheratingagenciesbasedontheirriskiness.
Inthisreport,ratingsaregenerallvpresentedinS&P’sclassifcationsvstem,whichas-
signsratingssuchas“AAA”(thehighestratingforthesafestinvestments,referredto
hereastriple-A),“AA”(lesssafethanAAA),“A,”“BBB,”and“BB,”andfurtherdistin-
guishesratingswith“+”and“–.”Anvthingratedbelow“BBB-”isconsidered“junk.”
Moodv’susesasimilarsvsteminwhich“Aaa”ishighest,followedbv“Aa,”“A,”“Baa,”
“Ba,” and so forth. For example, an S&P rating of BBB would correspond to a
Moodv’sratingofBaa.InthisCitigroupdeal,thefourseniortranches—thesafest—
wereratedtriple-Abvtheagencies.
Belowtheseniortranchesandnextinlineforpavmentswereeleven“mezzanine”
tranches—so named because thev sat between the riskiest and the safest tranches.
Thesewereriskierthantheseniortranchesand,becausethevpaidoffmoreslowlv,
carriedahigherriskthatanincreaseininterestrateswouldmakethelocked-ininter-
est pavments less valuable. As a result, thev paid a correspondinglv higher interest
rate.ThreeofthesetranchesintheCitigroupdealwereratedAA,threewereA,three
wereBBB(thelowestinvestment-graderating),andtwowereBB,orjunk.
Thelasttobepaidwasthemostjuniortranche,calledthe“equitv,”“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 anv
:U8iii \i iiNii Nt ,.
defaultsofthemortgagesinthepool.Commensuratewiththishighrisk,itprovided
thehighestvields(seefgure-.:).IntheCitigroupdeal,aswascommon,thispieceof
the deal was not rated at all. Citigroup and a hedge fund each held half the equitv
tranche.
1o
Whileinvestorsinthelower-ratedtranchesreceivedhigherinterestratesbecause
thevknewtherewasariskofloss,investorsinthetriple-Atranchesdidnotexpect
pavments from the mortgages to stop. This expectation of safetv was important, so
thefrmsstructuringsecuritiesfocusedonachievinghighratings.Inthestructureof
thisCitigroupdeal,whichwastvpical,·¬:¬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-1ooos, standardized data
with loan-level information on mortgage performance became more widelv avail-
able.Lendersunderwrotemortgagesusingcreditscores,suchastheFICOscore,de-
velopedbvFairIsaacCorporation.In1ooa,FreddieMacrolledoutLoanProspector,
anautomatedsvstemformortgageunderwritingforusebvlenders,andFannieMae
releaseditsownsvstem,DesktopUnderwriter,twomonthslater.Thedavsoflabori-
ous, slow, and manual underwriting of individual mortgage applicants were over,
loweringcostandbroadeningaccesstomortgages.
Thisnewprocesswasbasedonquantitativeexpectations:Giventheborrower,the
home,andthemortgagecharacteristics,whatwastheprobabilitvpavmentswouldbe
on time: What was the probabilitv that borrowers would prepav their loans, either
becausethevsoldtheirhomesorrefnancedatlowerinterestrates:
In the 1ooos, technologv also affected implementation of the Communitv Rein-
vestment Act (CRA). Congress enacted the CRA in 1o¬¬ to ensure that banks and
thriftsservedtheircommunities,inresponsetoconcernsthatbanksandthriftswere
refusingtolendincertainneighborhoodswithoutregardtothecreditworthinessof
individualsandbusinessesinthoseneighborhoods(apracticeknownasredlining).
11
TheCRAcalledonbanksandthriftstoinvest,lend,andserviceareaswherethev
took in deposits, so long as these activities didn’t impair their own fnancial safetv
andsoundness.ItdirectedregulatorstoconsiderCRAperformancewheneverabank
orthriftappliedforregulatorvapprovalformergers,toopennewbranches,ortoen-
gageinnewbusinesses.
1i
TheCRAencouragedbankstolendtoborrowerstowhomthevmavhaveprevi-
ouslvdeniedcredit.Whiletheseborrowersoftenhadlower-than-averageincome,a
1oo¬ studv indicated that loans made under the CRA performed consistentlv with
the rest of the banks’ portfolios, suggesting CRA lending was not riskier than the
banks’ other lending.
1:
“There is little or no evidence that banks’ safetv and sound-
nesshavebeencompromisedbvsuchlending,andbankersoftenreportsoundbusi-
nessopportunities,”FederalReserveChairmanAlanGreenspansaidofCRAlending
in1oo8.
1a
,z ii N\Nti \i tii :i : i NuUi 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 :.:
In1oo:,PresidentBillClintonaskedregulatorstoimprovebanks’CRAperform-
ancewhilerespondingtoindustrvcomplaintsthattheregulatorvreviewprocessfor
compliancewastooburdensomeandtoosubjective.In1oo-,theFed,OmceofThrift
Supervision (OTS), Omce of the Comptroller of the Currencv (OCC), and Federal
DepositInsuranceCorporation(FDIC)issuedregulationsthatshiftedtheregulatorv
focus from the efforts that banks made to complv with the CRA to their actual re-
sults.Regulatorsandcommunitvadvocatescouldnowpointtoobjective,observable
numbersthatmeasuredbanks’compliancewiththelaw.
FormercomptrollerIohnDugantoldFCICstaffthattheimpactoftheCRAhad
beenlasting,becauseitencouragedbankstolendtopeoplewhointhepastmightnot
havehadaccesstocredit.Hesaid,“Thereisatremendousamountofinvestmentthat
goesonininnercitiesandotherplacestobuildthingsthatarequiteimpressive. . . .
Andthebankersconverselvsav,‘Thisisproventobeabusinesswherewecanmake
some monev; not a lot, but when vou factor that in plus the good will that we get
fromit,itkindofworks.’”
1-
LawrenceLindsev,aformerFedgovernorwhowasresponsiblefortheFed’sDivi-
sion of Consumer and Communitv Affairs, which oversees CRA enforcement, told
the FCIC that improved enforcement had given the banks an incentive to invest in
technologv that would make lending to lower-income borrowers proftable bv such
means as creating credit scoring models customized to the market. Shadow banks
not covered bv 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 basicallv got a cvcle going which particularlv the shadow banking
industrvcould,usingrecenthistoricdata,showthedefaultratesonthistvpeoflend-
ingwereverv,vervlow,”hesaid.
1o
Indeed,defaultrateswerelowduringtheprosper-
ous1ooos,andregulators,bankers,andlendersintheshadowbankingsvstemtook
noteofthissuccess.
SUBPRIME LENDERS IN TURMOIL:
“ADVERSE MARKET CONDITIONS”
Amongnonbankmortgageoriginators,thelate1oooswereaturningpoint.During
themarketdisruptioncausedbvtheRussiandebtcrisisandtheLong-TermCapital
Managementcollapse,themarketssawa“fighttoqualitv”—thatis,asteepfallinde-
mandamonginvestorsforriskvassets,includingsubprimesecuritizations.Therate
ofsubprimemortgagesecuritizationdroppedfrom--.1ºin1oo8to:¬.aºin1ooo.
Meanwhile,subprimeoriginatorssawtheinterestrateatwhichthevcouldborrowin
creditmarketsskvrocket.Thevwerecaughtinasqueeze:borrowingcostsincreased
at the verv moment that their revenue stream dried up.

And some were caught
holdingtranchesofsubprimesecuritiesthatturnedouttobeworthfarlessthanthe
valuethevhadbeenassigned.
Mortgagelendersthatdependedonliquiditvandshort-termfundinghadimme-
diateproblems.Forexample,SouthernPacifcFunding(SFC),anOregon-basedsub-
prime lender that securitized its loans, reported relativelv positive second-quarter
,. ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN iiiui1
resultsinAugust1oo8.Then,inSeptember,SFCnotifedinvestorsabout“recentad-
versemarketconditions”inthesecuritiesmarketsandexpressedconcernabout“the
continued viabilitv of securitization in the foreseeable future.”
18
A week later, SFC
fled for bankruptcv protection. Several other nonbank subprime lenders that were
alsodependentonshort-termfnancingfromthecapitalmarketsalsofledforbank-
ruptcvin1oo8and1ooo.InthetwovearsfollowingtheRussiandefaultcrisis,8ofthe
top 1o subprime lenders declared bankruptcv, ceased operations, or sold out to
strongerfrms.
1o
When these frms were sold, their buvers would frequentlv absorb large losses.
FirstUnion,alargeregionalbankheadquarteredinNorthCarolina,incurredcharges
of almost ·1.¬ billion after it bought The Monev Store. First Union eventuallv shut
downorsoldoffmostofTheMonevStore’soperations.
Conseco,aleadinginsurancecompanv,purchasedGreenTreeFinancial,another
subprime lender. Disruptions in the securitization markets, as well as unexpected
mortgagedefaults,eventuallvdroveConsecointobankruptcvinDecemberiooi.At
thetime,thiswasthethird-largestbankruptcvinU.S.historv(afterWorldComand
Enron).
Accounting misrepresentations would also bring down subprime lenders. Kev-
stone, a small national bank in West Virginia that made and securitized subprime
mortgageloans,failedin1ooo.Inthesecuritizationprocess—aswascommonprac-
ticeinthe1ooos—Kevstoneretainedtheriskiest“frst-loss”residualtranchesforits
ownaccount.Theseholdingsfarexceededthebank’scapital.ButKevstoneassigned
themgrosslvinfatedvalues.TheOCCclosedthebankinSeptember1ooo,afterdis-
covering “fraud committed bv 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 Kevstone, it too failed after having kept and overvalued the
frst-losstranchesonitsbalancesheet.
Manv of the lenders that survived or were bought in the 1ooos reemerged in
otherforms.LongBeachwastheancestorofAmeriquestandLongBeachMortgage
(whichwasinturnpurchasedbvWashingtonMutual),twoofthemoreaggressive
lendersduringthefrstdecadeofthenewcenturv.AssociatesFirstwassoldtoCiti-
group, and Household bought Benefcial Mortgage before it was itself acquired bv
HSBCinioo:.
Withthesubprimemarketdisrupted,subprimeoriginationstotaled·1oobillion
iniooo,downfrom·1:-billiontwovearsearlier.
i1
Overthenextfewvears,however,
subprimelendingandsecuritizationwouldmorethanrebound.
THE REGULATORS: “OH, I SEE”
During the 1ooos, various federal agencies had taken increasing notice of abusive
subprimelendingpractices.Buttheregulatorvsvstemwasnotwellequippedtore-
spondconsistentlv—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 authoritv, one entitv was unquestionablv authorized bv
Congress to write strong and consistent rules regulating mortgages for all tvpes of
lenders:theFederalReserve,throughtheTruthinLendingActof1oo8.In1ooo,the
FedadoptedRegulationZforthepurposeofimplementingtheact.ButwhileRegu-
lationZappliedtoalllenders,itsenforcementwasdividedamongAmerica’smanvf-
nancialregulators.
Onestickingpointwasthesupervisionofnonbanksubsidiariessuchassubprime
lenders. The Fed had the legal mandate to supervise bank holding companies, in-
cluding the authoritv to supervise their nonbank subsidiaries. The Federal Trade
CommissionwasgivenexplicitauthoritvbvCongresstoenforcetheconsumerpro-
tections embodied in the Truth in Lending Act with respect to these nonbank
lenders. Although the FTC brought some enforcement actions against mortgage
companies, Henrv Cisneros, a former secretarv of the Department of Housing and
UrbanDevelopment(HUD),worriedthatitsbudgetandstaffwerenotcommensu-
ratewithitsmandatetosupervisetheselenders.“WecouldhavehadtheFTCoversee
mortgagecontracts,”CisnerostoldtheCommission.“ButtheFTCisuptotheirneck
inworktodavwithwhatthev’vegot.Thevdon’thavethestafftogooutandsearch
outmortgageproblems.”
i:
Glenn Lonev, deputv director of the Fed’s Consumer and Communitv Affairs
Division from 1oo8 to io1o, told the FCIC that ever since he joined the agencv in
1o¬-,Fedomcialshadbeendebatingwhetherthev—inadditiontotheFTC—should
enforcerulesfornonbanklenders.ButthevworriedaboutwhethertheFedwouldbe
steppingoncongressionalprerogativesbvassumingenforcementresponsibilitiesthat
legislationhaddelegatedtotheFTC.“Anumberofgovernorscameinandsaid,‘You
meantosavwedon’tlookatthese:’”Lonevsaid.“Andthenwetriedtoexplainitto
them,andthev’dsav,‘Oh,Isee.’”
ia
TheFederalReservewouldnotexertitsauthoritv
inthisarea,norothersthatcameunderitspurviewin1ooa,withanvrealforceuntil
afterthehousingbubbleburst.
The1ooalegislationthatgavetheFednewresponsibilitieswastheHomeOwner-
shipandEquitvProtectionAct(HOEPA),passedbvCongressandsignedbvPresi-
dent Clinton to address growing concerns about abusive and predatorv mortgage
lendingpracticesthatespeciallvaffectedlow-incomeborrowers.HOEPAspecifcallv
noted that certain communities were “being victimized . . . bv second mortgage
lenders, home improvement contractors, and fnance companies who peddle high-
rate,high-feehomeequitvloanstocash-poorhomeowners.”
i-
Forexample,aSenate
report highlighted the case of a ¬i-vear-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 monthlv pavments on the mortgage exceeded her
income.
io
HOEPAprohibitedabusivepracticesrelatingtocertainhigh-costrefnancemort-
gageloans,includingprepavmentpenalties,negativeamortization,andballoonpav-
,( ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN iiiui1
mentswithatermoflessthanfvevears.Thelegislationalsoprohibitedlendersfrom
makinghigh-costrefnanceloansbasedonthecollateralvalueofthepropertvalone
and “without regard to the consumers’ repavment abilitv, including the consumers’
currentandexpectedincome,currentobligations,andemplovment.”

However,onlv
asmallpercentageofmortgageswereinitiallvsubjecttotheHOEPArestrictions,be-
cause the interest rate and fee levels for triggering HOEPA’s coverage were set too
hightocatchmostsubprimeloans.
i8
Evenso,HOEPAspecifcallvdirectedtheFedto
actmorebroadlvto“prohibitactsorpracticesinconnectionwith[mortgageloans]
that[theBoard]fndstobeunfair,deceptiveordesignedtoevadetheprovisionsof
this[act].”
io
InIune1oo¬,twovearsafterHOEPAtookeffect,theFedheldthefrstsetofpub-
lichearingsrequiredundertheact.ThevenueswereLosAngeles,Atlanta,andWash-
ington,D.C.Consumeradvocatesreportedabusesbvhomeequitvlenders.Areport
summarizingthehearings,jointlvissuedwiththeDepartmentofHousingandUrban
Development and released in Iulv 1oo8, said that mortgage lenders acknowledged
thatsomeabusesexisted,blamedsomeoftheseonmortgagebrokers,andsuggested
that the increasing securitization of subprime mortgages was likelv to limit the op-
portunitvforwidespreadabuses.Thereportstated,“Creditorsthatpackageandse-
curitize their home equitv loans must complv with a series of representations and
warranties. These include creditors’ representations that thev have complied with
strictunderwritingguidelinesconcerningtheborrower’sabilitvtorepavtheloan.”
:o
But in the vears to come, these representations and warranties would prove to be
inaccurate.
Still,theFedcontinuednot topressitsprerogatives.InIanuarv1oo8,itformalized
itslong-standingpolicvof“notroutinelvconductingconsumercomplianceexamina-
tionsofnonbanksubsidiariesofbankholdingcompanies,”
:1
adecisionthatwouldbe
criticizedbvaNovember1oooGeneralAccountingOmcereportforcreatinga“lack
of regulatorv oversight.”
:i
The Iulv 1oo8 report also made recommendations on
mortgagereform.
::
Whilepreparingdraftrecommendationsforthereport,Fedstaff
wrotetotheFed’sCommitteeonConsumerandCommunitvAffairsthat“giventhe
Board’straditionalreluctancetosupportsubstantivelimitationsonmarketbehavior,
the draft report discusses various options but does not advocate anv particular ap-
proachtoaddressingtheseproblems.”
:a
Intheend,althoughthetwoagenciesdidnotagreeonthefullsetofrecommen-
dations addressing predatorv lending, both the Fed and HUD supported legislative
bansonballoonpavmentsandadvancecollectionoflump-suminsurancepremiums,
strongerenforcementofcurrentlaws,andnonregulatorvstrategiessuchascommu-
nitvoutreacheffortsandconsumereducationandcounseling.ButCongressdidnot
actontheserecommendations.
The Fed-Lite provisions under the Gramm-Leach-Blilev Act amrmed the Fed’s
hands-off approach to the regulation of mortgage lending. Even so, the shakeup in
the subprime industrv in the late 1ooos had drawn regulators’ attention to at least
someoftherisksassociatedwiththislending.Forthatreason,theFederalReserve,
FDIC, OCC, and OTS jointlv issued subprime lending guidance on March 1, 1ooo.
:U8iii \i iiNii Nt ,,
Thisguidanceappliedonlvtoregulatedbanksandthrifts,andevenforthemitwould
notbebindingbutmerelvlaidoutthecriteriaunderlvingregulators’bankexamina-
tions.Itexplainedthat“recentturmoilintheequitvandasset-backedsecuritiesmar-
kethascausedsomenon-banksubprimespecialiststoexitthemarket,thuscreating
increasedopportunitiesforfnancialinstitutionstoenter,orexpandtheirparticipa-
tionin,thesubprimelendingbusiness.”
:-
Theagenciesthenidentifedkevfeaturesofsubprimelendingprogramsandthe
need for increased capital, risk management, and board and senior management
oversight.Thevfurthernotedconcernsaboutvariousaccountingissues,notablvthe
valuation of anv residual tranches held bv 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
predatorvpricing. . . .Anadequatecompliancemanagementprogrammustidentifv,
monitor and control the consumer protection hazards associated with subprime
lending.”
:o
Inspringiooo,inresponsetogrowingcomplaintsaboutlendingpractices,andat
the urging of members of Congress, HUD Secretarv Andrew Cuomo and Treasurv
Secretarv Lawrence Summers convened the joint National Predatorv Lending Task
Force. It included members of consumer advocacv groups; industrv trade associa-
tionsrepresentingmortgagelenders,brokers,andappraisers;localandstateomcials;
and academics. As the Fed had done three vears earlier, this new entitv took to the
feld, conducting hearings in Atlanta, Los Angeles, New York, Baltimore, and
Chicago.Thetaskforcefound“patterns”ofabusivepractices,reporting“substantial
evidenceoftoo-frequentabusesinthesubprimelendingmarket.”Ouestionableprac-
tices included loan fipping (repeated refnancing of borrowers’ loans in a short
time),highfeesandprepavmentpenaltiesthatresultedinborrowers’losingtheeq-
uitvintheirhomes,andoutrightfraudandabuseinvolvingdeceptiveorhigh-pres-
suresalestactics.Thereportcitedtestimonvregardingincidentsofforgedsignatures,
falsifcationofincomesandappraisals,illegitimatefees,andbait-and-switchtactics.
The investigation confrmed that subprime lenders often preved on the elderlv, mi-
norities,andborrowerswithlowerincomesandlesseducation,frequentlvtargeting
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 testimonv to the FCIC, representatives of the National Consumer
LawCenter(NCLC),NevadaFairHousingCenter,Inc.,andCaliforniaReinvestment
CoalitioneachsaidthevhadcontactedCongressandthefourbankregulatorvagen-
cies multiple times about their concerns over unfair and deceptive lending prac-
tices.
:8
“Itwasapparentonthegroundasearlvas’ooor’o8 . . .thatthemarketfor
low-income consumers was being fooded with inappropriate products,” Diane
ThompsonoftheNCLCtoldtheCommission.
:o
TheHUD-Treasurvtaskforcerecommendedasetofreformsaimedatprotecting
,· ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN iiiui1
borrowersfromthemostegregiouspracticesinthemortgagemarket,includingbet-
ter disclosure, improved fnancial literacv, strengthened enforcement, and new leg-
islativeprotections.However,thereportalsorecognizedthedownsideofrestricting
the lending practices that offered manv borrowers with less-than-prime credit a
chanceathomeownership.Itwasadilemma.GarvGensler,whoworkedonthere-
portasaseniorTreasurvomcialandiscurrentlvthechairmanoftheCommoditvFu-
turesTradingCommission,toldtheFCICthatthereport’srecommendations“lasted
on Capitol Hill a verv short time. . . . There wasn’t much appetite or mood to take
theserecommendations.”
ao
But problems persisted, and others would take up the cause. Through the earlv
vears of the new decade, “the reallv poorlv underwritten loans, the pavment shock
loans” continued to proliferate outside the traditional banking sector, said FDIC
ChairmanSheilaBair,whoservedatTreasurvastheassistantsecretarvforfnancial
institutionsfromioo1toiooi.IntestimonvtotheCommission,sheobservedthat
these poor-qualitv 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 clearlv created competitive pressures on
banks. . . .Ithinknippingthisinthebudinioooandioo1withsome
strong consumer rules applving across the board that just simplv said
vou’vegottodocumentacustomer’sincometomakesurethevcanre-
pavtheloan,vou’vegottomakesuretheincomeissumcienttopavthe
loanswhentheinterestrateresets,justsimpleruleslikethat . . .could
havedonealottostopthis.
a1
AfterBairwasnominatedtoherpositionatTreasurv,andwhenshewasmaking
the rounds on Capitol Hill, Senator Paul Sarbanes, chairman of the Committee on
Banking,Housing,andUrbanAffairs,toldheraboutlendingproblemsinBaltimore,
whereforeclosureswereontherise.HeaskedBairtoreadtheHUD-Treasurvreport
on predatorv lending, and she became interested in the issue. Sarbanes introduced
legislationtoremedvtheproblem,butitfacedsignifcantresistancefromthemort-
gageindustrvandwithinCongress,BairtoldtheCommission.Bairdecidedtotrvto
gettheindustrvtoadoptasetof“bestpractices”thatwouldincludeavoluntarvban
onmortgagesthatstripborrowersoftheirequitv,andwouldofferborrowerstheop-
portunitvtoavoidprepavmentpenaltiesbvagreeinginsteadtopavahigherinterest
rate.ShereachedouttoEdwardGramlich,agovernorattheFedwhosharedhercon-
cerns, to enlist his help in getting companies to abide bv these rules. Bair said that
Gramlichdidn’ttalkoutofschoolbutmadeitcleartoherthattheFedavenuewasn’t
goingtohappen.
ai
Similarlv,SandraBraunstein,thedirectoroftheDivisionofCon-
sumer and Communitv Affairs at the Fed, said that Gramlich told the staff that
Greenspanwasnotinterestedinincreasedregulation.
a:
When Bair and Gramlich approached a number of lenders about the voluntarv
:U8iii \i iiNii Nt ,+
program, Bair said some originators appeared willing to participate. But the Wall
Streetfrmsthatsecuritizedtheloansresisted,savingthatthevwereconcernedabout
possible liabilitv if thev did not adhere to the proposed best practices, she recalled.
Theeffortdied.
aa
Ofcourse,evenastheseinitiativeswentnowhere,themarketdidnotstandstill.
Subprime mortgages were proliferating rapidlv, becoming mainstream products.
Originations were increasing, and products were changing. Bv 1ooo, three of everv
foursubprimemortgageswasafrstmortgage,andofthose8iºwereusedforref-
nancingratherthanahomepurchase.Fiftv-ninepercentofthoserefnancingswere
cash-outs,
a-
helping to fuel consumer spending while whittling awav homeowners’
equitv.
·+ ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN iiiui1
PART III
The Boom and Bust
6
CREDIT EXPANSION
CONTENTS
Hcusing“Apcwcrju|sta|i|izingjcrcc” :;
Su|princ|cans“Buvcrswi||pavahighprcniun” ::
Citigrcup“Invitcdrcgu|atcrvscrutinv” ;:
Icdcra|ru|cs“Intcndcdtccur|unjaircra|usivc|cnding” ;:
Statcs“Icng-standingpcsiticn”;e
Ccnnunitv-|cndingp|cdgcs“Vhatwcdcisrcamrncurintcnticn” ;¬
Bankcapita|standards“Ar|itragc” ;;
Bv the end of iooo, the economv had grown :o straight quarters. Federal Reserve
ChairmanAlanGreenspanarguedthefnancialsvstemhadachievedunprecedented
resilience.Largefnancialcompanieswere—oratleasttomanvobserversatthetime,
appeared to be—proftable, diversifed, and, executives and regulators agreed, pro-
tectedfromcatastrophebvsophisticatednewtechniquesofmanagingrisk.
Thehousingmarketwasalsostrong.Between1oo-andiooo,pricesroseatanan-
nualrateof-.iº;overthenextfvevears,theratewouldhit11.-º.
1
Lowerinterest
ratesformortgageborrowerswerepartlvthereason,aswasgreateraccesstomort-
gagecreditforhouseholdswhohadtraditionallvbeenleftout—includingsubprime
borrowers.Lowerinterestratesandbroaderaccesstocreditwereavailableforother
tvpesofborrowing,too,suchascreditcardsandautoloans.
Increasedaccesstocreditmeantamorestable,securelifeforthosewhomanaged
their fnances prudentlv. It meant families could borrow during temporarv income
drops, pav for unexpected expenses, or buv major appliances and cars. It allowed
otherfamiliestoborrowandspendbevondtheirmeans.Mostofall,itmeantashot
athomeownership,withallitsbenefts;andforsome,anopportunitvtospeculatein
therealestatemarket.
Ashomepricesrose,homeownerswithgreaterequitvfeltmorefnanciallvsecure
and,partlvasaresult,savedlessandless.Manvotherswentonestepfurther,borrow-
ing against the equitv. The effect was unprecedented debt: between ioo1 and ioo¬,
mortgagedebtnationallvnearlvdoubled.Householddebtrosefrom8oºofdispos-
ablepersonalincomein1oo:toalmost1:oºbvmid-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
againaftermanvofthemajorsubprimelendersfailedorwerepurchasedin1oo8and
1ooo.Afterward,thebiggestbanksmovedin.Iniooo,Citigroup,with·8oobillionin
assets, paid ·:1 billion for Associates First Capital, the second-biggest subprime
lender. Still, subprime lending remained onlv a niche, just o.-º of new mortgages
iniooo.
i
Subprime lending risks and questionable practices remained a concern. Yet the
Federal Reserve did not aggressivelv emplov the unique authoritv granted it bv the
Home Ownership and Equitv Protection Act (HOEPA). Although in iooa the Fed
fnedCitigroup·¬omillionforlendingviolations,itonlvminimallvrevisedtherules
for a narrow set of high-cost mortgages.
:
Following losses bv several banks in sub-
primesecuritization,theFedandotherregulatorsrevisedcapitalstandards.
HOUSING: “A POWERFUL STABILIZING FORCE”
Bvthebeginningofioo1,theeconomvwasslowing,eventhoughunemplovmentre-
mained at a :o-vear low of aº. To stimulate borrowing and spending, the Federal
Reserve’sFederalOpenMarketCommitteeloweredshort-terminterestratesaggres-
sivelv. On Ianuarv :, ioo1, in a rare conference call between scheduled meetings,
it cut the benchmark federal funds rate—at which banks lend to each other
overnight—bv a half percentage point, rather than the more tvpical quarter point.
Laterthatmonth,thecommitteecuttherateanotherhalfpoint,anditcontinuedcut-
tingthroughoutthevear—11timesinall—to1.¬-º,thelowestinaovears.
In the end, the recession of ioo1 was relativelv mild, lasting onlv eight months,
fromMarchtoNovember,andgrossdomesticproduct,orGDP—themostcommon
gauge of the economv—dropped bv onlv o.:º. Some policv makers concluded that
perhaps,witheffectivemonetarvpolicv,theeconomvhadreachedtheso-calledend
of the business cvcle, 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 earlv in iooa. “Whether the dominant
cause of the Great Moderation is structural change, improved monetarv policv, or
simplv good luck is an important question about which no consensus has vet
formed.”
a
Withtherecessionoverandmortgageratesatao-vearlows,housingkickedinto
high gear—again. The nation would lose more than :ao,ooo nonfarm jobs in iooi
but make small gains in construction. In states where bubbles soon appeared, con-
struction picked up quicklv. California ended iooi with a total of onlv i,:oo more
jobs,butwithi1,1oonewconstructionjobs.InFlorida,1aºofnetjobgrowthwasin
construction.Inioo:,buildersstartedmorethan1.8millionsingle-familvdwellings,
arateunseensincethelate1o¬os.Fromiooitoioo-,residentialconstructioncon-
tributed three times more to the economv than it had contributed on average since
1ooo.
·. ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN iiiui1
Butelsewheretheeconomvremainedsluggish,andemplovmentgainswerefrus-
tratinglvsmall.Expertsbegantalkingabouta“joblessrecoverv”—moreproduction
without a corresponding increase in emplovment. For those with jobs, wages stag-
nated.Betweeniooiandioo-,weeklvprivatenonfarm,nonsupervisorvwagesactu-
allv fell bv 1º after adjusting for infation. Faced with these challenges, the Fed
shiftedperspective,nowconsideringthepossibilitvthatconsumerpricescouldfall,
aneventthathadworsenedtheGreatDepressionsevendecadesearlier.Whilecon-
cerned,theFedbelieveddefationwouldbeavoided.Inawidelvquotediooispeech,
Bernankesaidthechancesofdefationwere“extremelvsmall”fortworeasons.First,
the economv’s natural resilience: “Despite the adverse shocks of the past vear, our
bankingsvstemremainshealthvandwell-regulated,andfrmandhouseholdbalance
sheetsareforthemostpartingoodshape.”Second,theFedwouldnotallowit.“Iam
confdent that the Fed would take whatever means necessarv to prevent signifcant
defationintheUnitedStates. . . .[T]heU.S.governmenthasatechnologv,calleda
printingpress(or,todav,itselectronicequivalent),thatallowsittoproduceasmanv
U.S.dollarsasitwishesatessentiallvnocost.”
-
The Fed’s monetarv policv kept short-term interest rates low. During ioo:, the
strongestU.S.companiescouldborrowforoodavsinthecommercialpapermarket
atanaverage1.1º,comparedwitho.:ºjustthreevearsearlier;ratesonthree-month
Treasurvbillsdroppedbelow1ºinmid-ioo:fromoºiniooo.
o
Low rates cut the cost of homeownership: interest rates for the tvpical :o-vear
fxed-ratemortgagetraditionallvmovedwiththeovernightfedfundsrate,andfrom
ioootoioo:,thisrelationshipheld(seefgureo.1).Bvioo:,creditworthvhomebuv-
ers could get fxed-rate mortgages for -.iº, : percentage points lower than three
vears earlier. The savings were immediate and large. For a home bought at the me-
dianpriceof·18o,ooo,withaioºdownpavment,themonthlvmortgagepavment
wouldbe·i8olessthaniniooo.Ortoturntheperspectivearound—asmanvpeople
did—forthesamemonthlvpavmentof·1,o¬¬,ahomeownercouldmoveupfroma
·18o,ooohometoa·ia-,oooone.
¬
An adjustable-rate mortgage (ARM) gave buvers even lower initial pavments or
madealargerhouseaffordable—unlessinterestratesrose.Inioo1,justaºofprime
borrowerswithnewmortgageschoseARMs;inioo:,1oºdid.Iniooa,thepropor-
tionrosetoi1º.
8
Amongsubprimeborrowers,alreadvheavvusersofARMs,itrose
fromaroundooºto¬oº.
o
Aspeoplejumpedintothehousingmarket,pricesrose,andinhotmarketsthev
reallvtookoff(seefgureo.i).InFlorida,averagehomepricesgaineda.1ºannuallv
from1oo-toioooandthen11.1ºannuallvfromioootoioo:.InCalifornia,those
numbers were even higher: o.1º and 1:.oº. In California, a house bought for
·ioo,oooin1oo-wasworth·a-a,ai8ninevearslater.However,soaringpriceswere
not necessarilv the norm. In Washington State, prices continued to appreciate, but
moreslowlv:-.oºannuallvfrom1oo-toiooo,-.-ºannuallvfromioootoioo:.In
Ohio,thenumberswerea.:ºand:.oº.
1o
Nationwide,homepricesroseo.8ºannu-
allv from iooo to ioo:—historicallv high, but well under the fastest-growing
markets.
tiiii 1 i\i\N:i uN ·,
Homeownershipincreasedsteadilv,peakingatoo.iºofhouseholdsiniooa.
11
Be-
causesomanvfamilieswerebeneftingfromhigherhomevalues,householdwealth
rosetonearlvsixtimesincome,upfromfvetimesafewvearsearlier.Thetop1oºof
households bv net worth, of whom ooº owned their homes, saw the value of their
primarvresidencesrisebetweenioo1andiooafrom·:¬i,8ooto·a-o,ooo(adjusted
forinfation),anincreaseofmorethan·¬¬,ooo.Mediannetworthforallhouseholds
inthetop1oº,afteraccountingforotherhousingvalueandassets,aswellasalllia-
bilities,was·1.amillioniniooa.Homeownershipratesforthebottomi-ºofhouse-
holdstickedupfrom1aºto1-ºbetweenioo1andiooa;themedianvalueoftheir
primarvresidencesrosefrom·-i,¬ooto·o-,ooo,anincreaseofmorethan·1i,ooo.
Mediannetworthforhouseholdsinthebottomi-ºwas·1,¬ooiniooa.
1i
Historicallv,everv·1,oooincreaseinhousingwealthboostedconsumerspending
bv an estimated ·-o a vear.
1:
But economists debated whether the wealth increases
wouldaffectspendingmorethaninpastvears,becausesomanvhomeownersatso
manv levels of wealth saw increases and because it was easier and cheaper to tap
homeequitv.
Higherhomepricesandlowmortgageratesbroughtawaveofrefnancingtothe
prime mortgage market. In ioo: alone, lenders refnanced over 1- million mort-
gages,morethanoneinfour—anunprecedentedlevel.
1a
Manvhomeownerstookout
cash while cutting their interest rates. From ioo1 through ioo:, cash-out refnanc-
·( ii N\Nti \i tii :i : i NuUi 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 ·ai¬ billion; homeowners accessed an-
other ·a:o billion via home equitv loans.
1-
Some were tvpical second liens; others
wereanewerinvention,thehomeequitvlineofcredit.Theseoperatedmuchlikea
creditcard,lettingtheborrowerborrowandrepavasneeded,oftenwiththeconven-
ienceofanactualplasticcard.
AccordingtotheFed’siooaSurvevofConsumerFinances,a-.oºofhomeowners
whotappedtheirequitvusedthatmonevforexpensessuchasmedicalbills,taxes,elec-
tronics,andvacations,ortoconsolidatedebt;another:1.oºuseditforhomeimprove-
ments;andtherestpurchasedmorerealestate,cars,investments,clothing,orjewelrv.
A Congressional Budget Omce paper from ioo¬ reported on the recent historv:
“Ashousingpricessurgedinthelate1ooosandearlviooos,consumersboostedtheir
spendingfasterthantheirincomerose.Thatwasrefectedinasharpdropintheper-
sonal savings rate.”
1o
Between 1oo8 and ioo-, increased consumer spending ac-
countedforbetweeno¬ºand1o8ºofGDPgrowthinanvvear—risingabove1ooº
invearswhenspendinggrowthoffsetdeclineselsewhereintheeconomv.Meanwhile,
thepersonalsavingratedroppedfrom-.iºto1.aº.Somecomponentsofspending
grewremarkablvfast:homefurnishingsandotherhouseholddurables,recreational
goods and vehicles, spending at restaurants, and health care. Overall consumer
spending grew faster than the economv, and in some vears it grew faster than real
disposableincome.
Nonetheless, the economv looked stable. Bv 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.Withnewfnancialproductslikethehomeequitvlineofcredit,households
couldborrowagainsttheirhomestocompensateforinvestmentlossesorunemplov-
ment.Defation,againstwhichtheFedhadstruckpreemptivelv,didnotmaterialize.
AtacongressionalhearinginNovemberiooi,Greenspanacknowledged—atleast
implicitlv—thatafterthedot-combubbleburst,theFedcutinterestratesinpartto
promotehousing.GreenspanarguedthattheFed’slow-interest-ratepolicvhadstim-
ulated the economv bv encouraging home sales and housing starts with “mortgage
interestratesthatareatlowsnotseenindecades.”AsGreenspanexplained,“Mort-
gage markets have also been a powerful stabilizing force over the past two vears of
economic distress bv facilitating the extraction of some of the equitv that home-
ownershadbuiltup.”

InFebruarviooa,hereiteratedhispoint,referringto“alarge
extractionofcashfromhomeequitv.”
18
SUBPRIME LOANS:  “BUYERS WILL PAY A HIGH PREMIUM”
Thesubprimemarketroaredbackfromitsshakeoutinthelate1ooos.Thevalueof
subprimeloansoriginatedalmostdoubledfromioo1throughioo:,to·:1obillion.
Iniooo,-iºoftheseweresecuritized;inioo:,o:º.
1o
Lowinterestratesspurredthis
boom, which would have long-term repercussions, but so did increasinglv wide-
spread computerized credit scores, the growing statistical historv on subprime bor-
rowers,andthescaleofthefrmsenteringthemarket.
Subprimewasdominatedbvanarrowingfeldofever-largerfrms;themarginal
plaversfromthepastdecadehadmergedorvanished.Bvioo:,thetopi-subprime
lendersmadeo:ºofallsubprimeloans,upfroma¬ºin1ooo.
io
Therewerenowthreemainkindsofcompaniesinthesubprimeoriginationand
securitizationbusiness:commercialbanksandthrifts,WallStreetinvestmentbanks,
and independent mortgage lenders. Some of the biggest banks and thrifts—Citi-
group,NationalCitvBank,HSBC,andWashingtonMutual—spentbillionsonboost-
ingsubprimelendingbvcreatingnewunits,acquiringfrms,orofferingfnancingto
other mortgage originators. Almost alwavs, these operations were sequestered in
nonbanksubsidiaries,leavingtheminaregulatorvno-man’s-land.
Whenitcametosubprimelending,nowitwasWallStreetinvestmentbanksthat
worriedaboutcompetitionposedbvthelargestcommercialbanksandthrifts.For-
merLehmanpresidentBartMcDadetoldtheFCICthatthebankshadgainedtheir
ownsecuritizationskillsanddidn’tneedtheinvestmentbankstostructureanddis-
tribute.
i1
So the investment banks moved into mortgage origination to guarantee a
supplvofloansthevcouldsecuritizeandselltothegrowinglegionsofinvestors.For
example,LehmanBrothers,thefourth-largestinvestmentbank,purchasedsixdiffer-
ent domestic lenders between 1oo8 and iooa, including BNC and Aurora.
ii
Bear
Stearns, the ffth-largest, ramped up its subprime lending arm and eventuallv ac-
quired three subprime originators in the United States, including Encore. In iooo,
MerrillLvnchacquiredFirstFranklin,andMorganStanlevboughtSaxonCapital;in
ioo¬,GoldmanSachsuppeditsstakeinSenderraFunding,asmallsubprimelender.
Meanwhile,severalindependentmortgagecompaniestookstepstoboostgrowth.
·· ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN iiiui1
New Centurv and Ameriquest were especiallv aggressive. New Centurv’s “Focus
iooo” plan concentrated on “originating loans with characteristics for which whole
loanbuverswillpavahighpremium.”
i:
Those“wholeloanbuvers”werethefrmson
Wall Street that purchased loans and, most often, bundled them into mortgage-
backedsecurities.Thevwereeagercustomers.Inioo:,NewCenturvsold·io.8bil-
lioninwholeloans,upfrom·:.1billionthreevearsbefore,
ia
launchingthefrmfrom
tenthtosecondplaceamongsubprimeoriginators.Three-quarterswenttotwosecu-
ritizing frms—Morgan Stanlev and Credit Suisse—but New Centurv reassured its
investorsthattherewere“manvmoreprospectivebuvers.”
i-
Ameriquest, in particular, pursued volume. According to the companv’s public
statements,itpaiditsaccountexecutiveslesspermortgagethanthecompetition,but
it encouraged them to make up the difference bv underwriting more loans. “Our
peoplemakemorevolumeperemploveethantherestoftheindustrv,”AseemMital,
CEOofAmeriquest,saidinioo-.Thecompanvcutcostselsewhereintheorigina-
tionprocess,too.Thebackomceforthefrm’sretaildivisionoperatedinassemblv-
line fashion, Mital told a reporter for American Banker; the work was divided into
specialized tasks, including data entrv, underwriting, customer service, account
management, and funding. Ameriquest used its savings to undercut bv as much as
o.--ºwhatcompetingoriginatorschargedsecuritizingfrms,accordingtoanindus-
trv analvst’s estimate. Between iooo and ioo:, Ameriquest loan origination rose
from an estimated ·a billion to ·:o billion annuallv. That vaulted the frm from
eleventhtofrstplaceamongsubprimeoriginators.“Thevareclearlvtheaggressor,”
CountrvwideCEOAngeloMozilotoldhisinvestorsinioo-.
io
Bvioo-,Countrvwide
wasthirdonthelist.
Thesubprimeplaversfolloweddiversestrategies.LehmanandCountrvwidepur-
sued a “verticallv integrated” model, involving them in everv link of the mortgage
chain:originatingandfundingtheloans,packagingthemintosecurities,andfnallv
selling the securities to investors. Others concentrated on niches: New Centurv, for
example,mainlvoriginatedmortgagesforimmediatesaletootherfrmsinthechain.
When originators made loans to hold through maturitv—an approach known as
originate-to-hold—thevhadaclearincentivetounderwritecarefullvandconsiderthe
risks. However, when thev originated mortgages to sell, for securitization or other-
wise—known as originate-to-distribute—thev no longer risked losses if the loan de-
faulted. As long as thev made accurate representations and warranties, the onlv 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.FannieandFreddiehadbeenbuvingprime,conformingmortgagessincethe
1o¬os,protectedbvstrictunderwritingstandards.Butsomesawthatthemodelnow
hadproblems.“Ifvoulookathowmanvpeopleareplaving,fromtherealestateagent
all the wav through to the guv who is issuing the securitv and the underwriter and
theunderwritinggroupandblah,blah,blah,thennobodvinthisentirechainisre-
sponsibletoanvbodv,”LewisRanieri,anearlvleaderinsecuritization,toldtheFCIC,
tiiii 1 i\i\N:i uN ·+
nottheoutcomeheandotherinvestmentbankershadexpected.“Noneofuswrote
andsaid,‘Oh,bvthewav,vouhavetoberesponsibleforvouractions,’”Ranierisaid.
“Itwasprettvself-evident.”

Thestartingpointformanvmortgageswasamortgagebroker.Theseindepend-
entbrokers,withaccesstoavarietvoflenders,workedwithborrowerstocomplete
theapplicationprocess.Usingbrokersallowedmorerapidexpansion,withnoneed
to build branches; lowered costs, with no need for full-time salespeople; and ex-
tendedgeographicreach.
For brokers, compensation generallv 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,manvborrowersmistakenlvbe-
lievedthemortgagebrokersactedinborrowers’bestinterest.
i8
Onecommonfeepaid
bvthelendertothebrokerwasthe“vieldspreadpremium”:onhigher-interestloans,
thelendingbankwouldpavthebrokerahigherpremium,givingtheincentivetosign
theborrowertothehighestpossiblerate.“Ifthebrokerdecideshe’sgoingtotrvand
makemoremonevontheloan,thenhe’sgoingtoraisetherate,”saidIavIeffries,afor-
mersalesmanagerforFremontInvestment&Loan,totheCommission.“We’vegota
higherrateloan,we’repavingthebrokerforthatvieldspreadpremium.”
io
In theorv, borrowers are the frst defense against abusive lending. Bv shopping
around,thevshouldrealize,forexample,ifabrokeristrvingtosellthemahigher-
pricedloanortoplacetheminasubprimeloanwhenthevwouldqualifvforaless-
expensiveprimeloan.Butmanvborrowersdonotunderstandthemostbasicaspects
oftheirmortgage.AstudvbvtwoFederalReserveeconomistsestimatedatleast:8º
ofborrowerswithadjustable-ratemortgagesdidnotunderstandhowmuchtheirin-
terest rates could reset at one time, and more than half underestimated how high
theirratescouldreachoverthevears.
:o
Thesamelackofawarenessextendedtoother
terms of the loan—for example, the level of documentation provided to the lender.
“Most borrowers didn’t even realize that thev were getting a no-doc loan,” said
MichaelCalhoun,presidentoftheCenterforResponsibleLending.“Thev’dcomein
withtheirW-iandendupwithano-docloansimplvbecausethebrokerwasgetting
paidmoreandthelenderwasgettingpaidmoreandtherewasextravieldleftoverfor
WallStreetbecausetheloancarriedahigherinterestrate.”
:1
Andborrowerswithlessaccesstocreditareparticularlvillequippedtochallenge
themoreexperiencedpersonacrossthedesk.“Whilemanv[consumers]believethev
areprettvgoodatdealingwithdav-to-davfnancialmatters,inactualitvthevengage
in fnancial behaviors that generate expenses and fees: overdrawing checking ac-
counts,makinglatecreditcardpavments,orexceedinglimitsoncreditcardcharges,”
AnnamariaLusardi,aprofessorofeconomicsatDartmouthCollege,toldtheFCIC.
“Comparingtermsoffnancialcontractsandshoppingaroundbeforemakingfnan-
cialdecisionsarenotatallcommonamongthepopulation.”
:i
Recall our case studv securitization deal discussed earlier—in which New Cen-
turv sold a,aoo mortgages to Citigroup, which then sold them to the securitization
trust, which then bundled them into 1o tranches for sale to investors. Out of those
a,aoo mortgages, brokers originated :,aoo on behalf of New Centurv. For each, the
++ ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN iiiui1
brokers received an average fee from the borrowers of ·:,¬-o, or 1.81º of the loan
amount.Ontopofthat,thebrokersalsoreceivedvieldspreadpremiumsfromNew
Centurvfor1,¬aaoftheseloans,averaging·i,-8-each.Intotal,thebrokersreceived
morethan·1¬.-millioninfeesforthe:,aooloans.
::
Criticsarguedthatwiththismuchmonevatstake,mortgagebrokershadevervin-
centivetoseek“thehighestcombinationoffeesandmortgageinterestratesthemarket
will bear.”
:a
Herb Sandler, the founder and CEO of the thrift Golden West Financial
Corporation,toldtheFCICthatbrokerswerethe“whoresoftheworld.”
:-
Asthehous-
ingandmortgagemarketboomed,sodidthebrokers.WholesaleAccess,whichtracks
the mortgage industrv, reported that from iooo to ioo:, the number of brokerage
frmsrosefromabout:o,oooto-o,ooo.Iniooo,brokersoriginated--ºofloans;in
ioo:,thevpeakedato8º.
:o
IPMorganCEOIamieDimontestifedtotheFCICthat
hisfrmeventuallvendeditsbroker-originatedbusinessinioooafterdiscoveringthe
loanshadmorethantwicethelossesoftheloansthatIPMorganitselforiginated.

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
savsisactuallvworthonlv·1¬-,ooo.Inthiscase,abankwon’tlendaborrower,sav,
·18o,oootobuvthehome.Thedealdies.Sureenough,appraisersbeganfeelingpres-
sure.Oneioo:survevfoundthat--ºoftheappraisershadfeltpressedtoinfatethe
value of homes; bv iooo, this had climbed to ooº. The pressure came most fre-
quentlvfromthemortgagebrokers,butappraisersreporteditfromrealestateagents,
lenders,andinmanvcasesborrowersthemselves.Mostoften,refusaltoraisetheap-
praisal meant losing the client.
:8
Dennis I. Black, president of the Florida appraisal
andbrokerageservicesfrmD.I.Black&Co.andanappraiserwithiavears’experi-
ence,heldcontinuingeducationsessionsalloverthecountrvfortheNationalAssoci-
ationofIndependentFeeAppraisers.Heheardcomplaintsfromtheappraisersthat
thevhadbeenpressuredtoignoremissingkitchens,damagedwalls,andinoperable
mechanicalsvstems.BlacktoldtheFCIC,“ThestorvIhaveheardmostoftenisthe
client saving he could not use the appraisal because the value was [not] what thev
needed.”
:o
Theclientwouldhiresomebodvelse.
Changes in regulations reinforced the trend toward laxer appraisal standards, as
Karen Mann, a Sacramento appraiser with :o vears’ experience, explained in testi-
monv to the FCIC. In 1ooa, the Federal Reserve, Omce of the Comptroller of the
Currencv, Omce of Thrift Supervision, and Federal Deposit Insurance Corporation
loosened the appraisal requirements for the lenders thev regulated bv 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.”
ao
TheBakersfeldappraiserGarvCrab-
treetoldtheFCICthatCalifornia’sOmceofRealEstateAppraisershadeightinvesti-
gatorstosupervisei1,oooappraisers.
a1
tiiii 1 i\i\N:i uN +.
In ioo-, the four bank regulators issued new guidance to strengthen appraisals.
Thev recommended that an originator’s loan production staff not select appraisers.
That led Washington Mutual to use an “appraisal management companv,” First
American Corporation, to choose appraisers. Nevertheless, in ioo¬ the New York
StateattornevgeneralsuedFirstAmerican:relvingoninternalcompanvdocuments,
thecomplaintallegedthecorporationimproperlvletWashingtonMutual’sloanpro-
duction staff “hand-pick appraisers who bring in appraisal values high enough to
permit WaMu’s loans to close, and improperlv permit[ted] WaMu to pressure . . .
appraiserstochangeappraisalvaluesthataretoolowtopermitloanstoclose.”
ai
CITIGROUP:  “INVITED REGULATORY SCRUTINY”
Assubprimeoriginationsgrew,Citigroupdecidedtoexpand,withtroublingconse-
quences. Barelv a vear after the Gramm-Leach-Blilev Act validated its 1oo8 merger
withTravelers,Citigroupmadeitsnextbigmove.InSeptemberiooo,itpaid·:1bil-
lionforAssociatesFirst,thenthesecond-largestsubprimelenderinthecountrv(af-
terHouseholdFinance.).Suchamergerwouldusuallvhaverequiredapprovalfrom
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,aprovisiontuckedawavinGramm-Leach-BlilevkepttheFedoutof
themix.TheOCC,FDIC,andNewYorkStatebankingregulatorsreviewedthedeal.
Consumergroupsfoughtit,citingalongrecordofallegedlendingabusesbvAssoci-
ates First, including high prepavment penalties, excessive fees, and other opaque
charges in loan documents—all targeting unsophisticated borrowers who tvpicallv
could not evaluate the forms. “It’s simplv unacceptable to have the largest bank in
America take over the icon of predatorv lending,” said Martin Eakes, founder of a
nonproftcommunitvlenderinNorthCarolina.
a:
Advocates for the merger argued that a large bank under a rigorous regulator
could reform the companv, and Citigroup promised to take strong actions. Regula-
torsapprovedthemergerinNovemberiooo,andbvthenextsummerCitigrouphad
startedsuspendingmortgagepurchasesfromclosetotwo-thirdsofthebrokersand
half the banks that had sold loans to Associates First. “We were aware that brokers
wereattheheartofthatpublicdiscussionandwereattheheartofalotofthe[con-
troversial]cases,”saidPamFlahertv,aCitigroupseniorvicepresidentforcommunitv
relationsandoutreach.
aa
ThemergerexposedCitigrouptoenhancedregulatorvscrutinv.Inioo1,theFed-
eralTradeCommission,whichregulatesindependentmortgagecompanies’compli-
ancewithconsumerprotectionlaws,launchedaninvestigationintoAssociatesFirst’s
premerger business and found that the companv had pressured borrowers to ref-
nanceintoexpensivemortgagesandtobuvexpensivemortgageinsurance.Iniooi,
Citigroupreachedarecord·i1-millioncivilsettlementwiththeFTCoverAssoci-
ates’“svstematicandwidespreaddeceptiveandabusivelendingpractices.”
a-
Inioo1,theNewYorkFedusedtheoccasionofCitigroup’snextproposedacqui-
sition—EuropeanAmericanBankonLongIsland,NewYork—tolaunchitsownin-
+z ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN iiiui1
vestigationofCitiFinancial,whichnowcontainedAssociatesFirst.“Themannerin
which [Citigroup] approached that transaction invited regulatorv scrutinv,” former
Fed Governor Mark Olson told the FCIC. “Thev bought a passel of problems for
themselvesanditwasatleastatwo-vear[issue].”
ao
TheFedeventuallvaccusedCiti-
Financialofconvertingunsecuredpersonalloans(usuallvforborrowersinfnancial
trouble)intohomeequitvloanswithoutproperlvassessingtheborrower’sabilitvto
repav.Reviewinglendingpracticesfromioooandioo1,theFedalsoaccusedtheunit
ofsellingcreditinsurancetoborrowerswithoutcheckingifthevwouldqualifvfora
mortgagewithoutit.Fortheseviolationsandforimpedingitsinvestigation,theFed
in iooa assessed ·¬o million in penalties. The companv said it expected to pav an-
other·:omillioninrestitutiontoborrowers.

FEDERAL RULES:
“INTENDED TO CURB UNFAIR OR ABUSIVE LENDING”
As Citigroup was buving Associates First in iooo, the Federal Reserve revisited the
rulesprotectingborrowersfrompredatorvconduct.Itconducteditssecondroundof
hearings on the Home Ownership and Equitv Protection Act (HOEPA), and subse-
quentlvthestaffofferedtworeformproposals.Thefrstwouldhaveeffectivelvbarred
lendersfromgrantinganvmortgage—notjustthelimitedsetofhigh-costloansdefned
bvHOEPA—solelvonthevalueofthecollateralandwithoutregardtotheborrower’s
abilitvtorepav.Forhigh-costloans,thelenderwouldhavetoverifvanddocumentthe
borrower’sincomeanddebt;forotherloans,thedocumentationstandardwasweaker,
asthelendercouldrelvontheborrower’spavmenthistorvandthelike.Thestaffmemo
explainedthiswouldmainlv“affectlenderswhomakeno-documentationloans.”The
secondproposaladdressedpracticessuchasdeceptiveadvertisements,misrepresenting
loanterms, andhavingconsumerssignblankdocuments—actsthatinvolvefraud,de-
ception,ormisrepresentations.
a8
Despite evidence of predatorv tactics from their own hearings and from the re-
centlvreleasedHUD-Treasurvreport,Fedomcialsremaineddividedonhowaggres-
sivelvtostrengthenborrowerprotections.Thevgrappledwiththesametrade-offthat
theHUD-Treasurvreporthadrecentlvnoted.“Wewanttoencouragethegrowthin
thesubprimelendingmarket,”FedGovernorEdwardGramlichremarkedattheFi-
nancialServicesRoundtableinearlviooa.“Butwealsodon’twanttoencouragethe
abuses;indeed,wewanttodowhatwecantostoptheseabuses.”
ao
FedGeneralCoun-
selScottAlvareztoldtheFCIC,“Therewasconcernthatifvouputoutabroadrule,
vouwouldstopthingsthatwerenotunfairanddeceptivebecausevouweretrvingto
get at the bad practices and vou just couldn’t think of all of the details vou would
need.Andifvoudidthinkofallofthedetails,vou’dendupwritingarulethatpeople
couldgetaroundverveasilv.”
-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 necessarilv be regarded as improper,” he
said,“andonthecontrarvfacilitatedthenationalpolicvofmakinghomeownership
tiiii 1 i\i\N:i uN +.
morebroadlvavailable.”
-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 svstem to rein in
predatorvlenders.FromiooototheendofGreenspan’stenureiniooo,theFedre-
ferredtotheIusticeDepartmentonlvthreeinstitutionsforfairlendingviolationsre-
lated to mortgages: First American Bank, in Carpentersville, Illinois; Desert
Communitv Bank, in Victorville, California; and the New York branch of Société
Générale,alargeFrenchbank.
Fedomcialsrejectedthestaffproposals.Aftersomewrangling,inDecemberioo1
the Fed did modifv HOEPA, but onlv at the margins. Explaining its actions, the
boardhighlightedcompromise:“Thefnalruleisintendedtocurbunfairorabusive
lendingpracticeswithoutundulvinterferingwiththefowofcredit,creatingunnec-
essarvcreditorburden,ornarrowingconsumers’optionsinlegitimatetransactions.”
Thestatusquowouldchangelittle.Fedeconomistshadestimatedthepercentageof
subprimeloanscoveredbvHOEPAwouldincreasefromoºtoasmuchas:8ºun-
der the new regulations.
-:
But lenders changed the terms of mortgages to avoid the
newrules’revisedinterestrateandfeetriggers.Bvlateioo-,itwasclearthatthenew
regulationswouldendupcoveringonlvabout1ºofsubprimeloans.
-a
Nevertheless,
refecting on the Federal Reserve’s efforts, Greenspan contended in an FCIC inter-
viewthattheFedhaddevelopedasetofrulesthathavehelduptothisdav.
--
Thiswasamissedopportunitv,savsFDICChairmanSheilaBair,whodescribed
the “one bullet” that might have prevented the fnancial crisis: “I absolutelv would
have been over at the Fed writing rules, prescribing mortgage lending standards
acrosstheboardforevervbodv,bankandnonbank,thatvoucannotmakeamortgage
unlessvouhavedocumentedincomethattheborrowercanrepavtheloan.”
-o
The Fed held back on enforcement and supervision, too. While discussing
HOEPArulechangesiniooo,thestaffoftheFed’sDivisionofConsumerandCom-
munitv 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 bv the Federal Trade Commission, while the
banksandthriftswereoverseenbvtheirprimarvregulators.Astheholdingcompanv
regulator,theFedhadtheauthoritvtoexaminenonbanksubsidiariesfor“compliance
withthe[BankHoldingCompanvAct]oranvotherFederallawthattheBoardhas
specifcjurisdictiontoenforce”;however,theconsumerprotectionlawsdidnotex-
plicitlvgivetheFedenforcementauthoritvinthisarea.
-8
The Fed resisted routine examinations of these companies, and despite the sup-
portofFedGovernorGramlich,theinitiativestalled.SandraBraunstein,thenastaff
memberintheFed’sConsumerandCommunitvAffairsDivisionandnowitsdirec-
tor,toldtheFCICthatGreenspanandotheromcialswereconcernedthatroutinelv
examiningthenonbanksubsidiariescouldcreateanunevenplavingfeldbecausethe
subsidiarieshadtocompetewiththeindependentmortgagecompanies,overwhich
+. ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN iiiui1
theFedhadnosupervisorvauthoritv(althoughtheFed’sHOEPArulesappliedtoall
lenders).
-o
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;ifvouexamineanorganizationincom-
pletelv, it tends to put a sign in their window that it was examined bv the Fed, and
partialsupervisionisdangerousbecauseitcreatesaGoodHousekeepingstamp.
oo
Butifresourcesweretheissue,theFedchairmancouldhavearguedformore.The
FeddrawsincomefrominterestontheTreasurvbondsitowns,soitdidnothaveto
askCongressforappropriations.Itwasalwavsmindful,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
suchoversightwouldextendFedauthoritvtofrms(suchasindependentmortgage
companies) whose lending practices were not subject to routine supervision, the
changewouldrequirecongressionallegislation“andmightantagonizethestates.”But
withoutsuchoversight,themortgagebusinesswas“likeacitvwithamurderlaw,but
nocopsonthebeat.”
oi
Inaninterviewinioo¬,GramlichtoldtheWall Street Journal
thatheprivatelvurgedGreenspantoclampdownonpredatorvlending.Greenspan
demurredand,lackingsupportontheboard,Gramlichbackedawav.Gramlichtold
theJournal, “Hewasopposedtoit,soIdidnotreallvpursueit.”
o:
(Gramlichdiedin
ioo8ofleukemia,atageo8.)
The Fed’s failure to stop predatorv practices infuriated consumer advocates and
somemembersofCongress.Criticschargedthataccountsofabuseswerebrushedoff
as anecdotal. Patricia McCov, a law professor at the Universitv of Connecticut who
servedontheFed’sConsumerAdvisorvCouncilbetweeniooiandiooa,wasfamil-
iar with the Fed’s reaction to stories of individual consumers. “That is classic Fed
mindset,” said McCov. “If vou cannot prove that it is a broad-based problem that
threatens svstemic consequences, then vou will be dismissed.” It frustrated Margot
SaundersoftheNationalConsumerLawCenter:“IstoodupataFedmeetinginioo-
andsaid,‘Howmanvanecdotesmakesitreal: . . .Howmanvtens[of]thousandsof
anecdoteswillittaketoconvincevouthatthisisatrend:’”
oa
The Fed’s reluctance to take action trumped the iooo HUD-Treasurv report and
reportsissuedbvtheGeneralAccountingOmcein1oooandiooa.
o-
TheFeddidnot
begin routinelv examining subprime subsidiaries until a pilot program in Iulv ioo¬,
undernewchairmanBenBernanke.
oo
TheFeddidnotissuenewrulesunderHOEPA
untilIulvioo8,avearafterthesubprimemarkethadshutdown.Theserulesbanned
deceptive practices in a much broader categorv of “higher-priced mortgage loans”;
moreover,thevprohibitedmakingthoseloanswithoutregardtotheborrower’sabilitv
tiiii 1 i\i\N:i uN +,
topav,andrequiredcompaniestoverifvincomeandassets.

Theruleswouldnottake
effectuntilOctober1,iooo,whichwastoolittle,toolate.
Lookingback,FedGeneralCounselAlvarezsaidhisinstitutionsuccumbedtothe
climate of the times. He told the FCIC, “The mind-set was that there should be no
regulation;themarketshouldtakecareofpolicing,unlesstherealreadvisanidenti-
fedproblem. . . .Wewereinthereactivemodebecausethat’swhatthemind-setwas
ofthe‘oosandtheearlviooos.”Thestronghousingmarketalsoreassuredpeople.Al-
varez noted the long historv of low mortgage default rates and the desire to help
peoplewhotraditionallvhadfewdealingswithbanksbecomehomeowners.
o8
STATES: “LONGSTANDING POSITION”
As the Fed balked, manv states proceeded on their own, enacting “mini-HOEPA”
laws and undertaking vigorous enforcement. Thev would face opposition from two
federalregulators,theOCCandtheOTS.
In 1ooo, North Carolina led the wav, establishing a fee trigger of -º: that is, for
the most part anv mortgage with points and fees at origination of more than -º of
theloanqualifedas“high-costmortgage”subjecttostateregulations.Thiswascon-
siderablvlowerthanthe8ºsetbvtheFed’sioo1HOEPAregulations.Otherprovi-
sions addressed an even broader class of loans, banning prepavment penalties for
mortgageloansunder·1-o,oooandprohibitingrepeatedrefnancing,knownasloan
“fipping.”
oo
These rules did not applv to federallv chartered thrifts. In 1ooo, the Omce of
ThriftSupervisionreassertedits“long-standingposition”thatitsregulations“occupv
theentirefeldoflendingregulationforfederalsavingsassociations,leavingnoroom
for state regulation.” Exempting states from “a hodgepodge of conficting and over-
lappingstatelendingrequirements,”theOTSsaid,wouldletthriftsdeliver“low-cost
credittothepublicfreefromundueregulatorvduplicationandburden.”Meanwhile,
“the elaborate network of federal borrower-protection statutes” would protect
consumers.
¬o
Nevertheless, other states copied North Carolina’s tactic. State attornevs general
launched thousands of enforcement actions, including more than :,ooo in iooo
alone.
¬1
Bv ioo¬, io states and the District of Columbia would pass some form of
anti-predatorv lending legislation. In some cases, two or more states teamed up to
producelargesettlements:iniooi,forexample,asuitbvIllinois,Massachusetts,and
Minnesotarecoveredmorethan·-omillionfromFirstAllianceMortgageCompanv,
eventhoughthefrmhadfledforbankruptcv.Alsothatvear,HouseholdFinance—
later acquired bv HSBC—was ordered to pav ·a8a million in penalties and restitu-
tion to consumers. In iooo, a coalition of ao states and the District of Columbia
settledwithAmeriquestfor·:i-millionandrequiredthecompanvtofollowrestric-
tionsonitslendingpractices.
Aswewillsee,however,theseeffortswouldbeseverelvhinderedwithrespectto
nationalbankswhentheOCCiniooaomciallvjoinedtheOTSinconstrainingstates
+( ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN iiiui1
fromtakingsuchactions.“Thefederalregulators’refusaltoreform[predatorv]prac-
ticesandproductsservedasanimplicitendorsementoftheirlegalitv,”IllinoisAttor-
nevGeneralLisaMadigantestifedtotheCommission.
¬i
COMMUNITYLENDING PLEDGES:
“WHAT WE DO IS REAFFIRM OUR INTENTION”
WhileconsumergroupsunsuccessfullvlobbiedtheFedformoreprotectionagainst
predatorvlenders,thevalsolobbiedthebankstoinvestinandloantolow-andmod-
erate-income communities. The resulting promises were sometimes called “CRA
commitments”or“communitvdevelopment”commitments.Thesepledgeswerenot
required under law, including the Communitv Reinvestment Act of 1o¬¬; in fact,
thevwereoftenoutsidethescopeoftheCRA.Forexample,thevfrequentlvinvolved
lendingtoindividualswhoseincomesexceededthosecoveredbvtheCRA,lending
ingeographicareasnotcoveredbvtheCRA,orlendingtominorities,onwhichthe
CRA is silent. The banks would either sign agreements with communitv groups or
elseunilaterallvpledgetolendtoandinvestinspecifccommunitiesorpopulations.
Banks often made these commitments when courting public opinion during the
mergermaniaattheturnofthei1stcenturv.Oneofthemostnotablepromiseswas
madebvCitigroupsoonafteritsmergerwithTravelersin1oo8:a·11-billionlending
and investment commitment, some of which would include mortgages. Later, Citi-
groupmadea·1iobillioncommitmentwhenitacquiredCaliforniaFederalBankin
iooi.WhenmergingwithFleetBostonFinancialCorporationiniooa,BankofAmer-
icaannounceditslargestcommitmenttodate:·¬-obillionover1ovears.Chasean-
nounced commitments of ·18.1 billion and ·8oo billion, respectivelv, in its mergers
with Chemical Bank and Bank One. The National Communitv Reinvestment Coali-
tion, an advocacv group, eventuallv tallied more than ·a.- trillion in commitments
from1o¬¬toioo¬;mortgagelendingmadeupasignifcantportionofthem.
¬:
Although banks touted these commitments in press releases, the NCRC savs it
and other communitv groups could not verifv this lending happened.
¬a
The FCIC
sentaseriesofrequeststoBankofAmerica,IPMorgan,Citigroup,andWellsFargo,
the nation’s four largest banks, regarding their “CRA and communitv lending com-
mitments.” In response, the banks indicated thev had fulflled most promises. Ac-
cordingtothedocumentsprovided,thevalueofcommitmentstocommunitvgroups
was much smaller than the larger unilateral pledges bv the banks. Further, the
pledgesgenerallvcoveredbroadercategoriesthandidtheCRA,includingmortgages
to minoritv borrowers and to borrowers with up-to-median income. For example,
onlviiºofthemortgagesmadeunderIPMorgan’s·8oobillion“communitvdevel-
opment initiative” would have fallen under the CRA.
¬-
Bank of America, which
would count all low- and moderate-income and minoritv lending as satisfving its
pledges,statedthatjustoverhalfwerelikelvtomeetCRArequirements.
Manvoftheseloanswerenotvervriskv.Thisisnotsurprising,becausesuchbroad
defnitionsnecessarilvincludedloanstoborrowerswithstrongcredithistories—low
tiiii 1 i\i\N:i uN +,
incomeandweakorsubprimecreditarenotthesame.Infact,Citigroup’siooipledge
of ·8o billion in mortgage lending “consisted of entirelv prime loans” to low- and
moderate-income households, low- and moderate-income neighborhoods, and mi-
noritvborrowers.Theseloansperformedwell.
¬o
IPMorgan’slargestcommitmenttoa
communitv group was to the Chicago CRA Coalition: ·1i billion in loans over 11
vears.Ofloansissuedbetweeniooaandiooo,fewerthan-ºhavebeenoo-or-more-
davsdelinquent,evenasoflateio1o.
¬¬
Wachoviamade·1ibillioninmortgageloans
betweeniooaandiooounderits·1oobillioninunilateralpledges:onlvabout¬.:º
wereevermorethanoodavsdelinquentoverthelifeoftheloan,comparedwithan
estimatednationalaverageof1aº.
¬8
Thebetterperformancewaspartlvtheresultof
Wachovia’s lending concentration in the relativelv stable Southeast, and partlv a re-
fectionofthecreditprofleofmanvoftheseborrowers.
DuringtheearlvvearsoftheCRA,theFederalReserveBoard,whenconsidering
whethertoapprovemergers,gavesomeweighttocommitmentsmadetoregulators.
This changed in Februarv 1o8o, when the board denied Continental Bank’s applica-
tiontomergewithGrandCanvonStateBank,savingthebank’scommitmenttoim-
provecommunitvservicecouldnotoffsetitspoorlendingrecord.
¬o
InApril1o8o,the
FDIC,OCC,andFederalHomeLoanBankBoard(theprecursoroftheOTS)joined
theFedinannouncingthatcommitmentstoregulatorsaboutlendingwouldbecon-
sideredonlvwhenaddressing“specifcproblemsinanotherwisesatisfactorvrecord.”
8o
Internal documents, and its public statements, show the Fed never considered
pledgestocommunitvgroupsinevaluatingmergersandacquisitions,nordiditen-
force them. As Glenn Lonev, a former Fed omcial, told Commission staff, “At the
vervbeginning,[we]saidwe’renotgoingtobeinaposturewheretheFed’sgoingto
besortofcoercingbanksintomakingdealswith . . .communitvgroupssothatthev
cangettheirapplicationsthrough.”
81
Infact,therulesimplementingthe1oo-changestotheCRAmadeitclearthatthe
FederalReservewouldnotconsiderpromisestothirdpartiesorenforceprioragree-
ments with those parties. The rules state “an institution’s record of fulflling these
tvpesofagreements[withthirdparties]isnotanappropriateCRAperformancecri-
terion.”
8i
Still,thebankshighlightedpastactsandassurancesforthefuture.In1oo8,
for example, when NationsBank said it was merging with BankAmerica, it also an-
nounceda1o-vear,·:-obillioninitiativethatincludedpledgesof·11-billionforaf-
fordablehousing,·:obillionforconsumerlending,·18obillionforsmallbusinesses,
and·i-and·1obillionforeconomicandcommunitvdevelopment,respectivelv.
Thismergerwasperhapsthemostcontroversialofitstimebecauseofthesizeof
thetwobanks.TheFedheldfourpublichearingsandreceivedmorethan1,ooocom-
ments.Supporterstoutedthecommunitvinvestmentcommitment,whileopponents
decried its lack of specifcitv. 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 NuUi i¥ tu\\i : :i uN iiiui1
communitv, including [low- and moderate-income] areas, with or without private
agreements.”
8:
Initspublicorderapprovingthemerger,theFederalReservementionedthecom-
mitmentbutthenwentontostatethat“anapplicantmustdemonstrateasatisfactorv
recordofperformanceundertheCRAwithoutrelianceonplansorcommitmentsfor
futureaction. . . .TheBoardbelievesthattheCRAplan—whethermadeasaplanor
as an enforceable commitment—has no relevance in this case without the demon-
stratedrecordofperformanceofthecompaniesinvolved.”
8a
Sowerethesecommitmentsameaningfulstep,oronlvagesture:LlovdBrown,a
managingdirectoratCitigroup,toldtheFCICthatmostofthecommitmentswould
havebeenfulflledinthenormalcourseofbusiness.
8-
Speakingoftheioo¬merger
withCountrvwide,AndrewPlepler,headofGlobalCorporateSocialResponsibilitv
at Bank of America, told the FCIC: “At a time of mergers, there is a lot of concern,
sometimes,thatoneplusonewillnotequaltwointheevesofcommunitieswherethe
acquiredbankhasbeeninvesting. . . .So,whatwedoisreamrmourintentiontocon-
tinue to lend and invest so that the communities where we live and work will con-
tinue to economicallv thrive.” He explained further that the pledge amount was
arrivedatbvworking“closelvwithourbusinesspartners”whoprojectcurrentlevels
ofbusinessactivitvthatqualifestowardcommunitvlendinggoalsintothefutureto
assurethecommunitvthatpastlendingandinvestingpracticeswillcontinue.
8o
Inessence,bankspromisedtokeepdoingwhatthevhadbeendoing,andcommu-
nitvgroupshadtheassurancethatthevwould.
BANK CAPITAL STANDARDS:  “ARBITRAGE”
Although the Federal Reserve had decided against stronger protections for con-
sumers,itinternalizedthelessonsof1oo8and1ooo,whenthefrstgenerationofsub-
prime lenders put themselves at serious risk; some, such as Kevstone Bank and
Superior Bank, collapsed when the values of the subprime securitized assets thev
heldprovedtobeinfated.Inresponse,theFederalReserveandotherregulatorsre-
workedthecapitalrequirementsonsecuritizationbvbanksandthrifts.
InOctoberioo1,thevintroducedthe“RecourseRule”governinghowmuchcapi-
talabankneededtoholdagainstsecuritizedassets.Ifabankretainedaninterestina
residualtrancheofamortgagesecuritv,asKevstone,Superior,andothershaddone,
it would have to keep a dollar in capital for everv dollar of residual interest. That
seemed to make sense, since the bank, in this instance, would be the frst to take
lossesontheloansinthepool.Undertheoldrules,banksheldonlv8ºincapitalto
protectagainstlossesonresidualinterestsandanvotherexposuresthevretainedin
securitizations; Kevstone and others had been allowed to seriouslv understate their
risksandtonotholdsumcientcapital.Ironicallv,becausethenewrulemadethecap-
italchargeonresidualinterests1ooº,itincreasedbanks’incentivetoselltheresidual
interests in securitizations—so that thev 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.
Thecapitalrequirementwouldbedirectlvlinkedtotheratingagencies’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-backedsecuritiesrequiredholdingonlv·1.ooincapital(thesameasforsecuri-
tiesbackedbvgovernment-sponsoredenterprises).Butthesameamountinvestedin
anvthingwithaBBratingrequired·1oincapital,or1otimesmore.
Bankscouldreducethecapitalthevwererequiredtoholdforapoolofmortgages
simplvbvsecuritizingthem,ratherthanholdingthemontheirbooksaswholeloans.
Ifabankkept·1ooinmortgagesonitsbooks,itmighthavetosetasideabout·-,in-
cluding ·a in capital against unexpected losses and ·1 in reserves against expected
losses.Butifthebankcreateda·1oomortgage-backedsecuritv,soldthatsecuritvin
tranches, and then bought all the tranches, the capital requirement would be about
·a.1o.

“Regulatorvcapitalarbitragedoesplavaroleinbankdecisionmaking,”said
DavidIones,aFedeconomistwhowroteanarticleaboutthesubjectiniooo,inan
FCICinterview.But“itis nottheonlvthingthatmatters.”
88
Andafnalcomparison:underbankregulatorvcapitalstandards,a·1ootriple-A
corporatebondrequired·8incapital—fvetimesasmuchasthetriple-Amortgage-
backedsecuritv.Unlikethecorporatebond,itwasultimatelvbackedbvrealestate.
The new requirements put the rating agencies in the driver’s seat. How much
capitalabankhelddependedinpartontheratingsofthesecuritiesitheld.Tving
capitalstandardstotheviewsofratingagencieswouldcomeinforcriticismafter
the crisis began. It was “a dangerous crutch,” former Treasurv Secretarv Henrv
PaulsontestifiedtotheCommission.
8o
However,theFed’sIonesnoteditwasbetter
than the alternative—“to let the banks rate their own exposures.” That alternative
“wouldbeterrible,”hesaid,notingthatbankshadbeencomingtotheFedandar-
guingforlowercapitalrequirementsonthegroundsthattheratingagencieswere
tooconservative.
oo
Meanwhile, banks and regulators were not prepared for signifcant losses on
triple-Amortgage-backedsecurities,whichwere,afterall,supposedtobeamongthe
safestinvestments.Norwerethevpreparedforratingsdowngradesduetoexpected
losses,whichwouldrequirebankstopostmorecapital.Andweredowngradestooc-
cur at the moment the banks wanted to sell their securities to raise capital, there
wouldbenobuvers.Allthesethingswouldoccurwithinafewvears.
.++ ii N\Nti \i tii :i : i NuUi 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 riskv mort-
gages. Unsustainable, toxic loans polluted the fnancial svstem and fueled the
housingbubble.
Subprimelendingwassupportedinsignifcantwavsbvmajorfnancialinsti-
tutions. Some frms, such as Citigroup, Lehman Brothers, and Morgan Stanlev,
acquiredsubprimelenders.Inaddition,majorfnancialinstitutionsfacilitatedthe
growthinsubprimemortgage–lendingcompanieswithlinesofcredit,securitiza-
tion,purchaseguaranteesandothermechanisms.
Regulators failed to rein in riskv home mortgage lending. In particular, the
Federal Reserve failed to meet its statutorv obligation to establish and maintain
prudentmortgagelendingstandardsandtoprotectagainstpredatorvlending.
7
THE MORTGAGE MACHINE
CONTENTS
Icrcigninvcstcrs“Anirrcsisti||cprchtcppcrtunitv” )o:
Mcrtgagcs“Agccd|can” )o;
Icdcra|rcgu|atcrs“Innunitvjrcnnanvstatc|awsisasignihcant|cncht” )))
Mcrtgagcsccuriticsp|avcrs“Va||Strcctwasvcrvhungrvjcrcurprcduct” )):
Mccdv’s“Givcna||ankchcck”)):
IannicMacandIrcddicMac“Icssccnpctitivcinthcnarkctp|acc”)::
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 NuUi 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
a/aosená./a:s.“\ájustjort/cejjoráeoilitv”
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.
0jtion\kMs.“0urmostjrojiteolcmortgegcloen”
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 NuUi 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 NuUi 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
Inácrvritingstenáerás.“\c’rcgoingto/evcto/oláournosc”
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 NuUi 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 NuUi 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 NuUi 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
1/cinvcstorsint/cácel
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.
Iigurc ;.+
..( ii N\Nti \i tii :i : i NuUi 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 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
“(omjcnsetcávcrvvcll”
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
“Int/cousincssjorcvcrmorc”
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 NuUi 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¬
“Ivcrvt/ingoutt/cclcj/entsittingont/cteolc”
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 NuUi 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 NuUi 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 NuUi 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
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-
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 NuUi 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)
8
THE CDO MACHINE
CONTENTS
CDOs“Vccrcatcdthcinvcstcr” ):;
BcarStcarns’shcdgcjunds“Itjuncticncdhncupunti|cncdav
it;ustdidn’tjuncticn”):;
Citigrcup’s|iquiditvputs“Apctcntia|ccnüictcjintcrcst” ):¬
AIG“Gc|dcngccscjcrthccntircStrcct” ):;
Gc|dnanSachs“Mu|tip|icdthccjjcctscjthccc||apscinsu|princ”);:
Mccdv’s“Achicvcdthrcughscnca|chcnv” );e
SLC“It’sgcingtc|canawju||v|igncss”)·o
Inthefrstdecadeofthei1stcenturv,apreviouslvobscurefnancialproductcalledthe
collateralizeddebtobligation,orCDO,transformedthemortgagemarketbvcreatinga
newsourceofdemandforthelower-ratedtranchesofmortgage-backedsecurities.¯
Despitetheirrelativelvhighreturns,tranchesratedotherthantriple-Acouldbe
hard to sell. If borrowers were delinquent or defaulted, investors in these tranches
wereoutofluckbecauseofwherethevsatinthepavmentswaterfall.
WallStreetcameupwithasolution:inthewordsofonebanker,thev“createdthe
investor.”
1
Thatis,thevbuiltnewsecuritiesthatwouldbuvthetranchesthathadbe-
comehardertosell.Bankerswouldtakethoselowinvestment-gradetranches,largelv
ratedBBBorA,frommanvmortgage-backedsecuritiesandrepackagethemintothe
new securities—CDOs. Approximatelv 8oº of these CDO tranches would be rated
triple-A despite the fact that thev generallv comprised the lower-rated tranches of
mortgage-backedsecurities.CDOsecuritieswouldbesoldwiththeirownwaterfalls,
with the risk-averse investors, again, paid frst and the risk-seeking investors paid
last.Asthevdidinthecaseofmortgage-backedsecurities,theratingagenciesgave
theirhighest,triple-Aratingstothesecuritiesatthetop(seefgure8.1).
Still,itwasnotobviousthatapoolofmortgage-backedsecuritiesratedBBBcould
betransformedintoanewsecuritvthatismostlvratedtriple-A.Butmathmadeitso.
.z,
¯Throughoutthisbook,unlessotherwisenoted,weusetheterm“CDOs”torefertocashCDOsbacked
bvasset-backedsecurities(suchasmortgage-backedsecurities),alsoknownasABSCDOs.
The securities frms argued—and the rating agencies agreed—that if thev pooled
manvBBB-ratedmortgage-backedsecurities,thevwouldcreateadditionaldiversif-
cation benefts. The rating agencies believed that those diversifcation benefts were
signifcant—thatifonesecuritvwentbad,thesecondhadonlvavervsmallchanceof
goingbadatthesametime.Andaslongaslosseswerelimited,onlvthoseinvestorsat
thebottomwouldlosemonev.Thevwouldabsorbtheblow,andtheotherinvestors
wouldcontinuetogetpaid.
Relvingonthatlogic,theCDOmachinegobbleduptheBBBandotherlower-rated
.z· ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN iiiui1 .z· ii N\Nti \i tii :i : i NuUi 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,growingfromabitplavertoamulti-hundred-
billion-dollar industrv. Between ioo: and ioo¬, as house prices rose i¬º nationallv
and ·a trillion in mortgage-backed securities were created, Wall Street issued nearlv
·¬oo billion in CDOs that included mortgage-backed securities as collateral.
i
With
readvbuversfortheirownproduct,mortgagesecuritizerscontinuedtodemandloans
fortheirpools,andhundredsofbillionsofdollarsfoodedthemortgageworld.Inef-
fect,theCDObecametheenginethatpoweredthemortgagesupplvchain.“Thereisa
machinegoing,”ScottEichel,aseniormanagingdirectoratBearStearns,toldafnan-
cialjournalistinMavioo-.“Thereisalotofbrainpowertokeepthisgoing.”
:
Evervone 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
provedtragicallvwrong.Themortgage-backedsecuritiesturnedouttobehighlvcor-
related—meaning thev performed similarlv. Across the countrv, in regions where
subprimeandAlt-Amortgageswereheavilvconcentrated,borrowerswoulddefault
in large numbers. This was not how it was supposed to work. Losses in one region
weresupposedtobeoffsetbvsuccessfulloansinanotherregion.Intheend,CDOs
turnedouttobesomeofthemostill-fatedassetsinthefnancialcrisis.Thegreatest
losseswouldbeexperiencedbvbigCDOarrangerssuchasCitigroup,MerrillLvnch,
andUBS,andbvfnancialguarantorssuchasAIG,Ambac,andMBIA.Theseplavers
hadbelievedtheirownmodelsandretainedexposuretowhatwereunderstoodtobe
the least riskv tranches of the CDOs: those rated triple-A or even “super-senior,”
whichwereassumedtobesaferthantriple-A-ratedtranches.
“ThewholeconceptofABSCDOshadbeenanabomination,”PatrickParkinson,
currentlv the head of banking supervision and regulation at the Federal Reserve
Board,toldtheFCIC.
a
CDOS: “WE CREATED THE INVESTOR”
Michael Milken’s Drexel Burnham Lambert assembled the frst rated collateralized
debt obligation in 1o8¬ out of different companies’ junk bonds. The strategv made
sense—pooling manv bonds reduced investors’ exposure to the failure of anv one
bond, and putting the securities into tranches enabled investors to pick their pre-
ferredlevelofriskandreturn.
ForthemanagerswhocreatedCDOs,thekevtoproftabilitvoftheCDOwasthefee
and the spread—the difference between the interest that the CDO received on the
bondsorloansthatitheldandtheinterestthattheCDOpaidtoinvestors.Throughout
the1ooos,CDOmanagersgenerallvpurchasedcorporateandemergingmarketbonds
and bank loans. When the liquiditv crisis of 1oo8 drove up returns on asset-backed
1ui tiu \\tui Ni .z+
securities,PrudentialSecuritiessawanopportunitvandlaunchedaseriesofCDOsthat
combineddifferentkindsofasset-backedsecuritiesintooneCDO.These“multisector”
or“ABS”securitieswerebackedbvmortgages,mobilehomeloans,aircraftleases,mu-
tual fund fees, and other asset classes with predictable income streams. The diversitv
wassupposedtoprovidevetanotherlaverofsafetvforinvestors.
MultisectorCDOswentthroughatoughpatchwhensomeoftheasset-backedse-
curitiesinwhichthevinvestedstartedtoperformpoorlviniooi—particularlvthose
backedbvmobilehomeloans(afterborrowersdefaultedinlargenumbers),aircraft
leases(aftero/11),andmutualfundfees(afterthedot-combust).
-
Theacceptedwis-
domamongmanvinvestmentbanks,investors,andratingagencieswasthatthewide
range of assets had actuallv contributed to the problem; according to this view, the
assetmanagerswhoselectedtheportfolioscouldnotbeexpertsinsectorsasdiverse
asaircraftleasesandmutualfunds.
So the CDO industrv turned to nonprime mortgage–backed securities, which
CDO managers believed thev understood, which seemed to have a record of good
performance,andwhichpaidrelativelvhighreturnsforwhatwasconsideredasafe
investment.“Evervonelookedatthesectorandsaid,theCDOconstructworks,but
we just need to fnd more stable collateral,” said Wing Chau, who ran two frms,
MaximGroupandHardingAdvisorv,thatmanagedCDOsmostlvunderwrittenbv
Merrill Lvnch. “And the industrv looked at residential mortgage–backed securities,
Alt-A,subprime,andnon-agencvmortgages,andsawtherelativestabilitv.”
o
CDOs quicklv became ubiquitous in the mortgage business.
¬
Investors liked the
combination of apparent safetv and strong returns, and investment bankers liked
havinganewsourceofdemandforthelowertranchesofmortgage-backedsecurities
and other asset-backed securities that thev created. “We told vou these [BBB-rated
securities]wereagreatdeal,andpricedatgreatspreads,butnobodvsteppedup,”the
Credit Suisse banker Ioe Donovan told a Phoenix conference of securitization
bankersinFebruarviooi.“Sowecreatedtheinvestor.”
8
Bviooa,creatorsofCDOswerethedominantbuversoftheBBB-ratedtranches
of mortgage-backed securities, and their bids signifcantlv infuenced prices in the
market for these securities. Bv ioo-, thev were buving “virtuallv all” of the BBB
tranches.
o
Iust as mortgage-backed securities provided the cash to originate mort-
gages,nowCDOswouldprovidethecashtofundmortgage-backedsecurities.Also
bviooa,mortgage-backedsecuritiesaccountedformorethanhalfofthecollateralin
CDOs, up from :-º in iooi.
1o
Sales of these CDOs more than doubled everv vear,
jumpingfrom·:obillioninioo:to·ii-billioniniooo.
11
Fillingthispipelinewould
requirehundredsofbillionsofdollarsofsubprimeandAlt-Amortgages.
“Itveselotojcjjort”
FivekevtvpesofplaverswereinvolvedintheconstructionofCDOs:securitiesfrms,
CDOmanagers,ratingagencies,investors,andfnancialguarantors.Eachtookvarv-
ingdegreesofriskand,foratime,proftedhandsomelv.
SecuritiesfrmsunderwrotetheCDOs:thatis,thevapprovedtheselectionofcol-
..+ ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN iiiui1 ..+ ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN iiiui1
lateral, structured the notes into tranches, and were responsible for selling them to
investors. Three frms—Merrill Lvnch, Goldman Sachs, and the securities arm of
Citigroup—accounted for more than :oº of CDOs structured from iooa 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.”
1:
The underwriters’ focus was on generating fees and structuring deals that thev
couldsell.Underwritingdidentailrisks,however.Thesecuritiesfrmhadtoholdthe
assets, such as the BBB-rated tranches of mortgage-backed securities, during the
ramp-upperiod—sixtoninemonthswhenthefrmwasaccumulatingthemortgage-
backedsecuritiesfortheCDOs.Tvpicallv,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.
1a
Chris Ricciardi, formerlv head of the CDO desk at Merrill Lvnch, likewise
told the FCIC that he did not track the performance of CDOs after underwriting
them.
1-
Moreover,Lamontsaiditwasnothisjobtodecidewhethertheratingagen-
cies’modelshadthecorrectunderlvingassumptions.That“wasnotwhatwebrought
tothetable,”hesaid.
1o
Inmanvcases,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 mav have
looked small—sometimes measured in tenths of a percentage point—but the
amounts were far from trivial. For CDOs that focused on the relativelv senior
tranches of mortgage-backed securities, annual manager fees tended to be in the
rangeof·ooo,oootoamilliondollarspervearfora·1billiondollardeal.ForCDOs
that focused on the more junior tranches, which were often smaller, fees would be
·¬-o,ooo to ·1.- million per vear for a ·-oo million deal.

As managers did more
deals,thevgeneratedmorefeeswithoutmuchadditionalcost.“You’dhearstatements
like, ‘Evervbodv and his uncle now wants to be a CDO manager,’” Mark Adelson,
thenastructuredfnanceanalvstatNomuraSecuritiesandcurrentlvchiefcreditom-
cer at S&P, told the FCIC. “That was an observation voiced repeatedlv at several of
the industrv conferences around those times—the enormous proliferation of CDO
managers— . . .becauseitwasvervlucrative.”
18
CDOmanagersindustrv-wideearned
atleast·1.-billioninmanagementfeesbetweenioo:andioo¬.
1o
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 manv investors, the
1ui tiu \\tui Ni ...
triple-A rating made those products appropriate investments. Rating agencv fees
were tvpicallv between ·i-o,ooo and ·-oo,ooo for CDOs.
io
For most deals, at least
tworatingagencieswouldprovideratingsandreceivethosefees—althoughtheviews
tendedtobeinsvnc.
TheCDOinvestors,likeinvestorsinmortgage-backedsecurities, focusedondif-
ferenttranchesbasedontheirpreferenceforriskandreturn.CDOunderwriterssuch
as Citigroup, Merrill Lvnch, and UBS often retained the super-senior triple-A
tranchesforreasonswewillseelater.Thevalsosoldthemtocommercialpaperpro-
grams that invested in CDOs and other highlv rated assets. Hedge funds often
boughttheequitvtranches.
i1
Eventuallv,otherCDOsbecamethemostimportantclassofinvestorforthemez-
zaninetranchesofCDOs.Bvioo-,CDOunderwritersweresellingmostofthemez-
zanine tranches—including those rated A—and, especiallv, those rated BBB, the
lowest and riskiest investment-grade rating—to other CDO managers, to be pack-
agedintootherCDOs.
ii
ItwascommonforCDOstobestructuredwith-ºor1-º
oftheircashinvestedinotherCDOs;CDOswithasmuchas8oºto1ooºoftheir
cashinvestedinotherCDOsweretvpicallvknownas“CDOssquared.”
Finallv, the issuers of over-the-counter derivatives called credit default swaps,
most notablv AIG, plaved a central role bv issuing swaps to investors in CDO
tranches,promisingtoreimbursethemforanvlossesonthetranchesinexchangefor
a stream of premium-like pavments. This credit default swap protection made the
CDOsmuchmoreattractivetopotentialinvestorsbecausethevappearedtobevirtu-
allvriskfree,butitcreatedhugeexposuresforthecreditdefaultswapissuersifsignif-
icantlossesdidoccur.
ProftfromthecreationofCDOs,asiscustomarvonWallStreet,wasrefectedin
emploveebonuses.And,asdemandforalltvpesoffnancialproductssoaredduring
the liquiditv boom at the beginning of the i1st centurv, pretax proft for the fve
largest investment banks doubled between ioo: and iooo, from ·io billion to ·a:
billion;totalcompensationattheseinvestmentbanksfortheiremploveesacrossthe
worldrosefrom·:abillionto·o1billion.
i:
Apartofthegrowthcouldbecreditedto
mortgage-backed securities, CDOs, and various derivatives, and thus emplovees in
those areas could be expected to be compensated accordinglv. “Credit derivatives
tradersaswellasmortgageandasset-backedsecuritiessalespeopleshouldespeciallv
enjovbonusseason,”afrmthatcompilescompensationfguresforinvestmentbanks
reportedinioo-.
ia
To see in more detail how the CDO pipeline worked, we revisit our illustrative
Citigroup mortgage-backed securitv, CMLTI iooo-NCi. Earlier, we described how
mostofthebelow-triple-AbondsissuedinthisdealwentintoCDOs.OnesuchCDO
wasKlerosRealEstateFundingIII,whichwasunderwrittenbvUBS,aSwissbank.
i-
The CDO manager was Strategos Capital Management, a subsidiarv of Cohen &
Companv;thatinvestmentcompanvwasheadedbvChrisRicciardi,whohadearlier
builtMerrill’sCDObusiness.
io
KlerosIII,launchediniooo,purchasedandheld·o.o
millioninsecuritiesfromtheA-ratedM-trancheofCitigroup’ssecuritv,alongwith
18¬juniortranchesofothermortgage-backedsecurities.Intotal,itowned·o¬-mil-
..z ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN iiiui1 ..z ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN iiiui1
lion of mortgage-related securities, of which a-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.AswastvpicalforthistvpeofCDOatthetime,roughlv88ºof
theKlerosIIIbondsweretriple-A-rated.Atleasthalfofthebelow-triple-Atranches
issuedbvKlerosIIIwentintootherCDOs.

“Mot/cr’smilktot/c . . .merkct”
ThegrowthofCDOshadimportantimpactsonthemortgagemarketitself.CDOman-
agerswhowereeagertoexpandtheassetsthatthevweremanaging—onwhichtheirin-
comewasbased—werewillingtopavhighpricestoaccumulateBBB-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 1ooos. These securities were
tvpicallvprotectedfromlossesbvbondinsurers,whohadanalvzedthedealsaswell.
Beginninginthelate1ooos,mortgage-backedsecuritiesthatwerestructuredwithsix
or more tranches and other features to protect the triple-A investors became more
common,replacingtheearlierstructuresthathadreliedonbondinsurancetopro-
tect investors. Bv iooa, the earlier forms of mortgage-backed securities had essen-
tiallv vanished, leaving the market increasinglv to the multitranche structures and
theirCDOinvestors.
Thiswasacriticaldevelopment,giventhatthefocusofCDOmanagersdiffered
fromthatoftraditionalinvestors.“TheCDOmanagerandtheCDOinvestorarenot
thesamekindoffolks[asthemonolinebondinsurers],whojustbackedawav,”Adel-
son said. “Thev’re mostlv not mortgage professionals, not real estate professionals.
Thevarederivativesfolks.”
i8
Indeed,Chau,theCDOmanager,portravedhisjobascreatingstructuresthatrat-
ingagencieswouldapproveandinvestorswouldbuv,andmakingsurethemortgage-
backedsecuritiesthathebought“metindustrvstandards.”Hesaidthathereliedon
the rating agencies. “Unfortunatelv, 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 stabilitv
wassosolidandthatitwassoconsistent.Imean,theratingagenciesdidavervgood
jobofmakingevervthingconsistent.”
io
CDOproductionwaseffectivelvonautopilot.
“Mortgage traders speak lovinglv of ‘the CDO bid.’ It is mother’s milk to the . . .
market,”IamesGrant,amarketcommentator,wroteiniooo.“Withoutit,feweras-
set-backedstructurescouldbebuilt,andthosethatwerewouldhavetomeetamuch
more conservative standard of design. The resulting pangs of credit withdrawal
wouldcertainlvbefeltintheresidentialreal-estatemarket.”
:o
UBS’sGlobalCDOGroupagreed,notingthatCDOs“havenowbecomebulliesin
theirrespectivecollateralmarkets.”Bvpromotinganincreaseinboththevolumeand
the price of mortgage-backed securities, bids from CDOs had “an impact on the
overallU.S.economvthatgoeswellbevondtheCDOmarket.”
:1
Withoutthedemand
for mortgage-backed securities from CDOs, lenders would have been able to sell
1ui tiu \\tui Ni ...
fewermortgages,andthusthevwouldhavehadlessreasontopushsohardtomake
theloansinthefrstplace.
“Icvcregcisin/crcntin(u0s”
Themortgagepipelinealsointroducedleverageatevervstep.Mostfnancialinstitu-
tions thrive on leverage—that is, on investing borrowed monev. Leverage increases
proftsingoodtimes,butalsoincreaseslossesinbadtimes.Themortgageitselfcre-
atesleverage—particularlvwhentheloanisofthelowdownpavment,highloan-to-
value ratio varietv. Mortgage-backed securities and CDOs created further leverage
becausethevwerefnancedwithdebt.AndtheCDOswereoftenpurchasedascollat-
eralbvthosecreatingother CDOswithvetanotherroundofdebt.SvntheticCDOs
consistingofcreditdefaultswaps,describedbelow,amplifedtheleverage.TheCDO,
backedbvsecuritiesthatwerethemselvesbackedbvmortgages,createdleverageon
leverage,asDanSparks,mortgagedepartmentheadatGoldmanSachs,explainedto
the FCIC.
:i
“People were looking for other forms of leverage. . . . You could either
take leverage individuallv, as an institution, or vou could take leverage within the
structure,”Citigroup’sDomingueztoldtheFCIC.
::
Even the investor that bought the CDOs could use leverage. Structured invest-
mentvehicles—atvpeofcommercialpaperprogramthatinvestedmostlvintriple-A-
rated securities—were leveraged an average of just under 1a-to-1: in other words,
theseSIVswouldhold·1ainassetsforevervdollarofcapital.
:a
Theassetswouldbe
fnanced with debt. Hedge funds, which were common purchasers, were also often
highlvleveragedintherepomarket,aswewillsee.Butitwouldbecomeclearduring
thecrisisthatsomeofthehighestleveragewascreatedbvcompaniessuchasMerrill,
Citigroup,andAIGwhenthevretainedorpurchasedthetriple-Aandsuper-senior
tranchesofCDOswithlittleornocapitalbacking.
Thus,iniooa,whenthehomeownershipratewaspeaking,andwhennewmort-
gageswereincreasinglvbeingdrivenbvserialrefnancings,bvinvestorsandspecula-
tors, and bv second home purchases, the value of trillions of dollars of securities
rested on just two things: the abilitv of millions of homeowners to make the pav-
mentsontheirsubprimeandAlt-Amortgagesandthestabilitvofthemarketvalueof
homeswhosemortgageswerethebasisofthesecurities.Thosedangerswereunder-
stood all along bv 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
iooa.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-
mentbusinessin1o8-whenitestablishedBearStearnsAssetManagement(BSAM).
... ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN iiiui1 ... ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN iiiui1
Assetmanagementbroughtinsteadvfeeincome,allowedbankstooffernewprod-
uctstocustomersandrequiredlittlecapital.
BSAMplavedaprominentroleintheCDObusinessasbothaCDOmanagerand
a hedge fund that invested in mortgage-backed securities and CDOs. At BSAM, bv
theendofioooRalphCiomwasmanaging11CDOswith·18.:billioninassetsand
i hedge funds with ·18 billion in assets.
:o
Although Bear Stearns owned BSAM,
Bear’smanagementexercisedlittlesupervisionoveritsbusiness.

Theeventualfail-
ureofCiom’stwolargemortgage-focusedhedgefundswouldbeanimportantevent
inioo¬,earlvinthefnancialcrisis.
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 mostlv mortgage-backed
securities or CDOs, and used leverage to enhance their returns. The target was for
ooºofassetstoberatedeitherAAAorAA.AsCiomtoldtheFCIC,“Thethesisbe-
hind the fund was that the structured credit markets offered vield over and above
whattheirratingssuggestedthevshouldoffer.”
:8
Ciomtargetedaleverageratioof1o
to 1 for the frst High-Grade fund. For Enhanced Leverage, Ciom upped the ante,
toutingtheEnhancedLeveragefundas“aleveredversionofthe[HighGrade]fund”
thattargetedleverageof1ito1.
:o
Attheendofiooo,theHigh-Gradefundcontained
·8.obillioninassets(using·o.obillionofhishedgefundinvestors’monevand·¬.¬
billion in borrowed monev). The Enhanced Leverage Fund had ·o.a billion (using
·o.obillionfrominvestorsand·8.-billioninborrowedmonev).
ao
BSAM fnanced these asset purchases bv borrowing in the repo markets, which
wastvpicalforhedgefunds.AsurvevconductedbvtheFCICidentifedatleast·i¬-
billionofrepoborrowingasofIuneioo8bvtheapproximatelv1¬ohedgefundsthat
responded.Therespondentsinvestedatleast·a-billioninmortgage-backedsecuri-
ties or CDOs as of Iune ioo¬.
a1
The abilitv to borrow using the AAA and AA
tranchesofCDOsasrepocollateralfacilitateddemandforthosesecurities.
Butrepoborrowingcarriedrisks:itcreatedsignificantleverageandithadtobe
renewedfrequentlv.Forexample,aninvestorbuvingastockonmargin—meaning
withborrowedmonev—mighthavetoputup-ocentsonthedollar,withtheother
-o cents loaned bv his or her stockbroker, for a leverage ratio of i to 1. A home-
ownerbuvingahousemightmakea1oºdownpavmentandtakeoutamortgage
fortherest,aleverageratioof1oto1.Bvcontrast,repolendingallowedaninvestor
tobuvasecuritvformuchlessoutofpocket—inthecaseofaTreasurvsecuritv,an
investor mav have to put in onlv o.i-º, borrowing oo.¬-º from a securities firm
(aoo to 1). In the case of a mortgage-backed securitv, an investor might pav -º
(ioto1).
ai
Withthisamountofleverage,a-ºchangeinthevalueofthatmortgage-backed
securitvcandoubletheinvestor’smonev—orlosealloftheinitialinvestment.
Anotherinherentfallacvinthestructurewastheassumptionthattheunderlving
collateralcouldbesoldeasilv.Butwhenitcametosellingthemintimesofdistress,
private-labelmortgage-backedsecuritieswouldprovetobevervdifferentfromU.S.
Treasuries.
1ui tiu \\tui Ni ..,
The short-term nature of repo monev also makes it inherentlv riskv and unreli-
able:fundingthatisofferedatcertaintermstodavcouldbegonetomorrow.Ciom’s
funds,forexample,tooktheriskthatitsrepolenderswoulddecidenottoextend,or
“roll,”therepolinesonanvgivendav.Yetmoreandmore,repolenderswereloaning
monev to funds like Ciom’s, rolling the debt nightlv, and not worrving verv much
abouttherealqualitvofthecollateral.
The frms loaning monev to Ciom’s hedge funds were often also selling them
mortgage-relatedsecurities,andthehedgefundspledgedthosesamesecuritiestose-
curetheloans.
a:
Ifthemarketvalueofthecollateralfell,therepolenderscouldand
woulddemandmorecollateralfromthehedgefundtobacktherepoloan.Thisdv-
namicwouldplavapivotalroleinthefateofmanvhedgefundsinioo¬—mostspec-
tacularlvinthecaseofCiom’sfunds.“Therepomarket,Imeanitfunctionedfneup
untilonedavitjustdidn’tfunction,”CiomtoldtheFCIC.Uptothatpoint,hishedge
fundscouldbuvbillionsofdollarsofCDOsonborrowedmonevbecauseofthemar-
ket’sbullishnessaboutmortgageassets,hesaid.“Itbecame . . .amoreandmoreac-
ceptable asset class, [with] more traders, more repo lenders, more investors
obviouslv.[Ithada]muchbroaderfootprintdomesticallvaswellasinternationallv.
Sothemarketjustreallvexploded.”
aa
BSAMtouteditsCDOholdingstoinvestors,tellingthemthatCDOswereamar-
ketopportunitvbecausethevwerecomplexandthereforeundervaluedinthegeneral
marketplace.Inioo:,thiswasapromisingmarketwithseeminglvmanageablerisks.
Ciom and his team not onlv bought CDOs, thev 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 pav off his repo lenders, and at the same time he
wouldacquiretheequitvtrancheofanewCDO.
a-
Because Ciom managed these newlv created CDOs that selected collateral from
hisownhedgefunds,
ao
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-marketpricesforasecuritv,that
wouldadvantagethehedgefundinvestorsanddisadvantagetheCDOinvestors.
BSAM’sfagshipCDOs—dubbedKlioI,II,andIII—werecreatedinrapidsucces-
sion over iooa and ioo-, with Citigroup as their underwriter. All three deals were
mainlv composed of mortgage- and asset-backed securities that BSAM alreadv
owned,andBSAMretainedtheequitvpositioninallthree;allthreewereprimarilv
funded with asset-backed commercial paper.
a8
Tvpical for the industrv at the time,
theexpectedreturnfortheCDOmanager,whowasmanagingassetsandholdingthe
equitvtranche,wasbetween1-ºandi:ºannuallv,assumingnodefaultsontheun-
derlving collateral.
ao
Thanks to the combination of mortgage-backed securities,
..( ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN iiiui1 ..( ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN iiiui1
CDOs,andleverage,Ciom’sfundsearnedhealthvreturnsforatime:theHigh-Grade
fundhadreturnsof1¬ºiniooa,1oºinioo-,andoºinioooafterfees.
-o
Ciomand
Tanninmademillionsbeforethehedgefundscollapsedinioo¬.Ciomwasrewarded
with total compensation worth more than ·a1 million from ioo- to ioo¬. In ioo¬,
thevearthetwohedgefundsfledforbankruptcv,Ciommademorethan·1¬.omil-
lionintotalcompensation.MattTannin,hisleadmanager,wasawardedcompensa-
tionofmorethan·-.omillionfromioo-toioo¬.
-1
Bothmanagersinvestedsomeof
their own monev 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
returnswouldamplifvlossesandquicklvputhistwohedgefundsoutofbusiness.
CITIGROUP’ S LIQUIDITY PUTS:
“A POTENTIAL CONFLICT OF INTEREST”
Bv the middle of the decade, Citigroup was a market leader in selling CDOs, often
usingitsdepositor-basedcommercialbanktoprovideliquiditvsupport.Formuchof
this period, the companv was in various tvpes of trouble with its regulators, and
then-CEO Charles Prince told the FCIC that dealing with those troubles took up
morethanhalfhistime.
-:
Afterpavingthe·¬omillionfnerelatedtosubprimemort-
gagelending,Citigroupagaingotintotrouble,chargedwithhelpingEnron—before
that companv fled for bankruptcv in ioo1—use structured fnance transactions to
manipulate its fnancial statements. In Iulv ioo:, Citigroup agreed to pav the SEC
·1io million to settle these allegations and also agreed, under formal enforcement
actions bv the Federal Reserve and Omce of the Comptroller of the Currencv, to
overhaulitsriskmanagementpractices.
-a
BvMarchioo-,theFedhadseenenough:itbannedCitigroupfrommakinganv
moremajoracquisitionsuntilitimproveditsgovernanceandlegalcompliance.Ac-
cordingtoPrince,hehadalreadvdecidedtoturn“thecompanv’sfocusfromanac-
quisition-drivenstrategvtomoreofabalancedstrategvinvolvingorganicgrowth.”
--
RobertRubin,aformertreasurvsecretarvandformerGoldmanSachsco-CEOwho
wasatthattimechairmanoftheExecutiveCommitteeofCitigroup’sboardofdirec-
tors, recommended that Citigroup increase its risk taking—assuming, he told the
FCIC,thatthefrmmanagedthoserisksproperlv.
-o
Citigroup’sinvestmentbanksubsidiarvwasanaturalareaforgrowthaftertheFed
and then Congress had done awav with restrictions on activities that could be pur-
suedbvinvestmentbanksamliatedwithcommercialbanks.Oneopportunitvamong
manvwastheCDObusiness,whichwasjustthentakingoffamidtheboomingmort-
gagemarket.
In ioo:, Citi’s CDO desk was a tinv unit in the companv’s investment banking
arm, “eight guvs and a Bloomberg” terminal, in the words of Nestor Dominguez,
thenco-headofthedesk.

Nevertheless,thistinvoperationunderthecommandof
1ui tiu \\tui Ni ..,
ThomasMaheras,co-CEOoftheinvestmentbank,hadbecomealeaderinthenas-
cent market for CDOs, creating more than ·18 billion in ioo: and iooa—close to
one-ffthofthemarketinthosevears.
TheeightguvshadpickeduponanovelstructurepioneeredbvGoldmanSachs
andWestLB,aGermanbank.Insteadofissuingthetriple-AtranchesoftheCDOsas
long-term debt, Citigroup structured them as short-term asset-backed commercial
paper.
-8
Of course, using commercial paper introduced liquiditv risk (not present
when the tranches were sold as long-term debt), because the CDO would have to
reissuethepapertoinvestorsregularlv—usuallvwithindavsorweeks—forthelifeof
the CDO. But asset-backed commercial paper was a cheap form of funding at the
time,andithadalargebaseofpotentialinvestors,particularlvamongmonevmarket
mutual funds. To mitigate the liquiditv risk and to ensure that the rating agencies
would give it their top ratings, Citibank (Citigroup’s national bank subsidiarv) pro-
vided assurances to investors, in the form of liquiditv puts. In selling the liquiditv
put,foranongoingfeethebankwouldbeonthehooktostepinandbuvthecom-
mercialpaperiftherewerenobuverswhenitmaturedorifthecostoffundingrose
bvapredeterminedamount.
-o
TheCDOteamatCitigrouphadjumpedintothemarketinIulvioo:witha·1.-
billionCDOnamedGrenadierFundingthatincludeda·1.:billiontranchebackedbv
a liquiditv put from Citibank.
oo
Over the next three vears, Citi would write liquiditv
putson·i-billionofcommercialpaperissuedbvCDOs,
o1
morethananvothercom-
panv.BSAM’sthreeKlioCDOs,whichCitigrouphadunderwritten,accountedforjust
over·1obillionofthistotal,
oi
alargenumberthatwouldnotbodewellforthebank.
But initiallv, this “strategic initiative,” as Dominguez called it, was verv proftable for
Citigroup.TheCDOdeskearnedroughlv1ºofthetotaldealvalueinstructuringfees
forCitigroup’sinvestmentbankingarm,orabout·1omillionfora·1billiondeal.In
addition,Citigroupwouldgenerallvchargebuverso.1oºtoo.ioºinpremiumsannu-
allvfortheliquiditvputs.
o:
Inotherwords,foratvpical·1billiondeal,Citibankwould
receive·1to·imillionannuallvontheliquiditvputsalone—practicallvfreemonev,it
seemed,becausethetradingdeskbelievedthattheseputswouldneverbetriggered.
oa
Ineffect,theliquiditvputwasvetanotherhighlvleveragedbet:acontingentlia-
bilitvthatwouldbetriggeredinsomecircumstances.Priortotheiooachangeinthe
capital rules regarding liquiditv puts (discussed earlier), Citigroup did not have to
hold anv capital against such contingencies. Rather, it was permitted to use its own
risk models to determine the appropriate capital charge. But Citigroup’s fnancial
modelsestimatedonlvaremotepossibilitvthattheputswouldbetriggered.Follow-
ingtheiooarulechange,Citibankwasrequiredtoholdo.1oºincapitalagainstthe
amountofcommercialpapersupportedbvtheliquiditvput,or·1.omillionfora·1
billionliquiditvput.Givena·1to·imillionannualfeefortheput,theannualreturn
onthatcapitalcouldstillexceed1ooº.Nodoubtaboutit,DomingueztoldtheFCIC,
the triple-A or similar ratings, the multiple fees, and the low capital requirements
madetheliquiditvputs“amuchbettertrade”forCiti’sbalancesheet.
o-
Theeventsof
ioo¬wouldrevealthefallacvofthoseassumptionsandcatapulttheentire·i-billion
..· ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN iiiui1 ..· ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN iiiui1
incommercialpaperstraightontothebank’sbalancesheet,requiringittocomeup
with·i-billionincashaswellasmorecapitaltosatisfvbankregulators.
TheliquiditvputswereapprovedbvCitigroup’sCapitalMarketsApprovalCom-
mittee, which was charged with reviewing all new fnancial products.
oo
Deeming
themtobelowrisk,thecompanvbaseditsopinionsonthecreditriskoftheunderlv-
ing collateral, but failed to consider the liquiditv risk posed bv a general market
disruption.

The OCC, the supervisor of Citigroup’s largest commercial bank sub-
sidiarv,wasawarethatthebankhadissuedtheliquiditvputs.
o8
However,thetermsof
the OCC’s post-Enron enforcement action focused onlv on whether Citibank had a
processinplacetoreviewtheproduct,andnotontherisksoftheputstoCitibank’s
balancesheet.
oo
Besides Citigroup, onlv a few large fnancial institutions, such as AIG Financial
Products, BNP, WestLB of Germanv, and Société Générale of France, wrote signif-
cant amounts of liquiditv puts on commercial paper issued bv 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 whv other market participants were not writing liquiditv puts,
Dominguez stated that Société Générale and BNP were big plavers in that market.
“Youneededtobeabankwithastrongbalancesheet,accesstocollateral,andexist-
ingrelationshipswithcollateralmanagers,”hesaid.
¬i
TheCDOdeskstoppedwritingliquiditvputsinearlviooo,
¬:
whenitreachedits
internal limits. Citibank’s treasurv function had set a ·i: billion cap on liquiditv
puts;
¬a
itgrantedonefnalexception,bringingthetotalto·i-billion.
¬-
Riskmanage-
menthadalsoseta·i-billionrisklimitontop-ratedasset-backedsecurities,which
included the liquiditv 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 buv the commercial paper protected bv the liquiditv
putswhenitcamedue,therebvcreatinga·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:
“Thereisapotentialconfictofinterestinpricingtheliquiditvputcheep[sic]sothat
moreCDOequitiescanbesoldandmorestructuringfeetobegenerated.”
¬¬
There-
sultwouldbelossessoseverethatthevwouldhelpbringthehugefnancialconglom-
eratetothebrinkoffailure,aswewillsee.
AIG: “GOLDEN GOOSE FOR THE ENTIRE STREET”
In iooa, American International Group was the largest insurance companv in the
worldasmeasuredbvstockmarketvalue:amassiveconglomeratewith·8-obillion
inassets,11o,oooemploveesin1:ocountries,andii:subsidiaries.
But to Wall Street, AIG’s most valuable asset was its credit rating: that it was
awardedthehighestpossiblerating—AaabvMoodv’ssince1o8o,AAAbvS&Psince
1ui tiu \\tui Ni ..+
1o8:—wascrucial,becausethesesterlingratingsletitborrowcheaplvanddeplovthe
monev in lucrative investments. Onlv six private-sector companies in the United
Statesinearlvio1ocarriedthoseratings.
¬8
Startingin1oo8,AIGFinancialProducts,aConnecticut-basedunitwithmajorop-
erationsinLondon,fguredoutanewwavtomakemonevfromthoseratings.Relving
ontheguaranteeofitsparent,AIG,AIGFinancialProductsbecameamajorover-the-
counter derivatives dealer, eventuallv having a portfolio of ·i.¬ trillion in notional
amount.Amongotherderivativesactivities,theunitissuedcreditdefaultswapsguar-
anteeingdebtobligationsheldbvfnancialinstitutionsandotherinvestors.Inexchange
forastreamofpremium-likepavments,AIGFinancialProductsagreedtoreimburse
the investor in such a debt obligation in the event of anv default. The credit default
swap (CDS) is often compared to insurance, but when an insurance companv sells a
policv,regulationsrequirethatitsetasideareserveincaseofaloss.Becausecreditde-
faultswapswerenotregulatedinsurancecontracts,nosuchrequirementwasapplica-
ble. In this case, the unit predicted with oo.8-º confdence that there would be no
realized economiclossonthesupposedlvsafestportionsoftheCDOsonwhichthev
wrote CDS protection, and failed to make anv provisions whatsoever for declines in
value—orunrealizedlosses—adecisionthatwouldprovefataltoAIGinioo8.
¬o
AIGFinancialProductshadahugebusinesssellingCDStoEuropeanbanksona
varietvoffnancialassets,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 therebv hold less capital against its assets. Purchasing
creditdefaultswapsfromAIGcouldreducetheamountofregulatorvcapitalthatthe
bank needed to hold against an asset from 8º to 1.oº.
8o
Bv ioo-, AIG had written
·1o¬ billion in CDS for such regulatorv capital benefts; most were with European
banksforavarietvofassettvpes.Thattotalwouldriseto·:¬obillionbvioo¬.
81
ThesameadvantagescouldbeenjovedbvbanksintheUnitedStates,whereregu-
lators had introduced similar capital standards for banks’ holdings of mortgage-
backedsecuritiesandotherinvestmentsundertheRecourseRuleinioo1.Soacredit
defaultswapwithAIGcouldalsolowerAmericanbanks’capitalrequirements.
Iniooaandioo-,AIGsoldprotectiononsuper-seniorCDOtranchesvaluedat
·-abillion,upfromjust·ibillioninioo:.
8i
InaninterviewwiththeFCIC,oneAIG
executivedescribedAIGFinancialProducts’principalswapsalesman,AlanFrost,as
“thegoldengoosefortheentireStreet.”
8:
AIG’sbiggestcustomerinthisbusinesswasalwavsGoldmanSachs,consistentlva
leadingCDOunderwriter.AIGalsowrotebillionsofdollarsofprotectionforMerrill
Lvnch,SociétéGénérale,andotherfrms.AIG“lookedliketheperfectcustomerfor
this,”CraigBroderick,Goldman’schiefriskomcer,toldtheFCIC.“Thevreallvticked
all the boxes. Thev were among the highest-rated [corporations] around. Thev had
what appeared to be unquestioned expertise. Thev had tremendous fnancial
strength.Thevhadhuge,appropriateinterestinthisspace,backedbvalonghistorv
oftradinginit.”
8a
..+ ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN iiiui1 ..+ ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN iiiui1
AIGalsobestowedtheimprimaturofitspristinecreditratingoncommercialpa-
per programs bv providing liquiditv puts, similar to the ones that Citigroup’s bank
wroteformanvofitsowndeals,guaranteeingitwouldbuvcommercialpaperifno
oneelsewantedit.Itenteredthisbusinessiniooi;bvioo-,ithadwrittenmorethan
·o billion of liquiditv puts on commercial paper issued bv CDOs. AIG also wrote
morethan·¬billioninCDStoprotectSociétéGénéraleagainsttherisksonliquiditv
putsthattheFrenchbankitselfwroteoncommercialpaperissuedbvCDOs.
8-
“What
wewouldalwavstrvtodoistostructureatransactionwherethetransactionwasvir-
tuallvriskless,andgetpaidasmallpremium,”GenePark,whowasamanagingdirec-
toratAIGFinancialProducts,toldtheFCIC.“Andwe’reoneofthefewguvswhocan
dothat.Becauseifvouthinkaboutit,noonewantstobuvdisasterprotectionfrom
someonewhoisnotgoingtobearound. . . .ThatwasAIGFP’ssalespitchtotheStreet
ortobanks.”
8o
AIG’s business of offering credit protection on assets of manv sorts, including
mortgage-backedsecuritiesandCDOs,grewfrom·iobillioniniooito·i11billion
inioo-and·-::billioninioo¬.

ThisbusinesswasasmallpartoftheAIGFinan-
cial Services business unit, which included AIG Financial Products; AIG Financial
Servicesgeneratedoperatingincomeof·a.abillioninioo-,orioºofAIG’stotal.
AIGdidnotpostanvcollateralwhenitwrotethesecontracts;butunlikemono-
lineinsurers,AIGFinancialProductsagreedtopostcollateralifthevalueoftheun-
derlving 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 paving 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
notionalamountoftheswappervear
88
—andthemanagersgottheirbonuses.Inthe
caseoftheLondonsubsidiarvthatrantheoperation,thebonuspoolwas:oºofnew
earnings.
8o
FinancialProductsCEOIosephI.Cassanomadetheallocationsattheend
ofthevear.
oo
Betweeniooiandioo¬,theleastamountCassanopaidhimselfinavear
was·:8million.Inthelatervears,hiscompensationwassometimesdoublethatof
theparentcompanv’sCEO.
o1
In the spring of ioo-, disaster struck: AIG lost its triple-A rating when auditors
discovered that it had manipulated earnings. Bv November ioo-, the companv had
reduced its reported earnings over the fve-vear period bv ·:.o billion.
oi
The board
forced out Maurice “Hank” Greenberg, who had been CEO for :8 vears. New York
AttornevGeneralEliotSpitzerpreparedtobringfraudchargesagainsthim.
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.”
o:
Butthatdidn’thappen.Instead,AIGFinancialProd-
ucts wrote another ·:o billion in credit default swaps on super-senior tranches of
1ui tiu \\tui Ni ...
CDOsinioo-.
oa
Thecompanvwouldn’tmakethedecisiontostopwritingthesecon-
tractsuntiliooo.
o-
GOLDMAN SACHS: “MULTIPLIED THE EFFECTS
OF THE COLLAPSE IN SUBPRIME”
HenrvPaulson,theCEOofGoldmanSachsfrom1ooountilhebecamesecretarvof
theTreasurviniooo,testifedtotheFCICthatbvthetimehebecamesecretarvmanv
bad loans alreadv had been issued—“most of the toothpaste was out of the tube”—
andthat“therereallvwasn’ttheproperregulatorvapparatustodealwithit.”
oo
Paul-
sonprovidedexamples:“Subprimemortgageswentfromaccountingfor-percentof
totalmortgagesin1ooatoiopercentbviooo. . . .Securitizationseparatedorigina-
tors from the risk of the products thev originated.” The result, Paulson observed,
“was a housing bubble that eventuallv burst in far more spectacular fashion than
mostpreviousbubbles.”

UnderPaulson’sleadership,GoldmanSachshadplavedacentralroleinthecre-
ation and sale of mortgage securities. From iooa through iooo, the companv pro-
vided billions of dollars in loans to mortgage lenders; most went to the subprime
lendersAmeriquest,LongBeach,Fremont,NewCenturv,andCountrvwidethrough
warehouselinesofcredit,oftenintheformofrepos.
o8
Duringthesameperiod,Gold-
man acquired ·-: billion of loans from these and other subprime loan originators,
whichitsecuritizedandsoldtoinvestors.
oo
Fromiooatoiooo,Goldmanissued:18
mortgagesecuritizationstotaling·18abillion(aboutaquarterweresubprime),and
o: CDOs totaling ·:i billion; Goldman also issued ii svnthetic or hvbrid CDOs
withafacevalueof·:-billionbetweeniooaandIuneiooo.
1oo
SvntheticCDOswerecomplexpapertransactionsinvolvingcreditdefaultswaps.
Unlike the traditional cash CDO, svnthetic CDOs contained no actual tranches of
mortgage-backed securities, or even tranches of other CDOs. Instead, thev simplv
referencedthesemortgagesecuritiesandthuswerebetsonwhetherborrowerswould
pav 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 bv the CDO; “unfunded” long investors, who entered into swaps with the
CDO, making monev if the reference securities performed; and “short” investors,
whoboughtcreditdefaultswapsonthereferencesecurities,makingmonevifthese-
curitiesfailed.Whilefundedinvestorsreceivedinterestifthereferencesecuritiesper-
formed, thev could lose all of their investment if the reference securities defaulted.
Unfunded investors, which were highest in the pavment waterfall, received pre-
mium-likepavmentsfromtheCDOaslongasthereferencesecuritiesperformedbut
wouldhavetopavifthereferencesecuritiesdeterioratedbevondacertainpointand
iftheCDOdidnothavesumcientfundstopavtheshortinvestors.Shortinvestors,
often hedge funds, bought the credit default swaps from the CDOs and paid those
premiums.HvbridCDOswereacombinationoftraditionalandsvntheticCDOs.
FirmslikeGoldmanfoundsvntheticCDOscheaperandeasiertocreatethantra-
..z ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN iiiui1 ..z ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN iiiui1
ditionalCDOsatthesametimeasthesupplvofmortgageswasbeginningtodrvup.
Because there were no mortgage assets to collect and fnance, creating svnthetic
CDOstookafractionofthetime.Thevalsowereeasiertocustomize,becauseCDO
managers and underwriters could reference anv mortgage-backed securitv—thev
were not limited to the universe of securities available for them to buv. Figure 8.i
providesanexampleofhowsuchadealworked.
Iniooa,GoldmanlauncheditsfrstmajorsvntheticCDO,Abacusiooa-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
·1o- million to purchase mezzanine tranches of the deal.
1o1
These investors would
receivescheduledprincipalandinterestpavmentsifthereferencedassetsperformed.
If the referenced assets did not perform, Goldman, as the short investor, would re-
ceive the ·1o- 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,bettingthatthevwouldfail.
Theunfundedinvestors—TCWandGSCPartners(assetmanagementfrmsthat
managedbothhedgefundsandCDOs)—didnotputupanvmonevupfront;thevre-
ceived annual premiums from the CDO in return for the promise that thev would
pav the CDO if the reference securities failed and the CDO did not have enough
fundstopavtheshortinvestors.
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 vear later, it transferred the
unfundedlongpositionbvbuvingcreditprotectionfromAIG,inreturnforanan-
nualpavmentof·i.imillion.
1oa
Asaresult,bvioo-,AIGwaseffectivelvthelargest
unfundedinvestorinthesuper-seniortranchesoftheAbacusdeal.
Alltold,longinvestorsinAbacusiooa-1stoodtoreceivemillionsofdollarsifthe
reference securities performed (just as a bond investor makes monev when a bond
performs).Ontheotherhand,Goldmanstoodtogainnearlv·ibillioniftheassets
failed.
In the end, Goldman, the short investor in the Abacus iooa-1 CDO, has received
about·o:omillionwhilethelonginvestorshavelostjustaboutalloftheirinvestments.
In April ioo8, GSC paid Goldman ·¬.: million as a result of CDS protection sold bv
GSCtoGoldmanonthefrstandsecondlosstranches.InIuneiooo,Goldmanreceived
·8oomillionfromAIGFinancialProductsasaresultoftheCDSprotectionithadpur-
chasedagainstthesuper-seniortranche.Thesamemonthitreceived·i:millionfrom
TCWasaresultoftheCDSpurchasedagainstthejuniormezzaninetranches,and·:o
millionfromIKBbecauseoftheCDSitpurchasedagainsttheCtranche.InAprilio1o,
IKB paid Goldman another ·ao million as a result of the CDS against the B tranche.
1ui tiu \\tui Ni ...
... ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN iiiui1 ... ii N\Nti \i tii :i : i NuUi 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.:
ThroughMavio1o,Goldmanreceived·iamillionfromIKB,Wachovia,andTCWasa
resultofthecreditdefaultswapsagainsttheAtranche.Aswascommon,someofthe
tranches of Abacus iooa-1 found their wav into other funds and CDOs; for example,
TCWputtranchesofAbacusiooa-1intothreeofitsownCDOs.
Intotal,betweenIulv1,iooa,andMav:1,ioo¬,Goldmanpackagedandsolda¬
svnthetic 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
Goldmanwouldearnproftsfromshortingmanvof
these deals; on others, it would proft bv facilitating the transaction between the
buverandthesellerofcreditdefaultswapprotection.
Aswewillsee,thesenewinstrumentswouldvieldsubstantialproftsforinvestors
thatheldashortpositioninthesvntheticCDOs—thatis,investorsbettingthatthe
housing boom was a bubble about to burst. Thev also would multiplv losses when
housing prices collapsed. When borrowers defaulted on their mortgages, the in-
vestors expecting cash from the mortgage pavments lost. And investors betting on
these mortgage-backed securities via svnthetic CDOs also lost (while those betting
againstthemortgageswouldgain).
1o¬
Asaresult,thelossesfromthehousingcollapse
weremultipliedexponentiallv.
Toseethisplavout,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. Svn-
thetic CDOs signifcantlv increased the demand for such bets. For example, there
wereabout·1imillionworthofbondsintheMo(BBB-rated)tranche—oneofthe
mezzanine tranches of the securitv. Svnthetic CDOs such as Auriga, Volans, and
NeptuneCDOIVallcontainedcreditdefaultswapsinwhichtheMotranchewasref-
erenced. As long as the Mo bonds performed, investors betting that the tranche
would fail (short investors) would make regular pavments into the CDO, which
wouldbepaidouttootherinvestorsbankingonittosucceed(longinvestors).Ifthe
Mobondsdefaulted,thenthelonginvestorswouldmakelargepavmentstotheshort
investors.Thatisthebet—andthereweremorethan·-omillioninsuchbetsinearlv
ioo¬ on the Mo tranche of this deal. Thus, on the basis of the performance of ·1i
millioninbonds,morethan·oomillioncouldpotentiallvchangehands.Goldman’s
Sparks put it succinctlv to the FCIC: if there’s a problem with a product, svnthetics
increasetheimpact.
1o8
TheamplifcationoftheMotranchewasnotunique.A·1-milliontrancheofthe
GlacierFundingCDOiooo-aA,ratedA,wasreferencedin·8-millionworthofsvn-
thetic CDOs. A ·i8 million tranche of the Soundview Home Equitv Loan Trust
iooo-EO1,alsoratedA,wasreferencedin·¬omillionworthofsvntheticCDOs.A
·1: million tranche of the Soundview Home Equitv Loan Trust iooo-EO1, rated
BBB,wasreferencedin·aomillionworthofsvntheticCDOs.
1oo
Intotal,svntheticCDOscreatedbvGoldmanreferenced:,ao8mortgagesecurities,
some of them multiple times. For example, o1o securities were referenced twice. In-
deed,onesinglemortgage-backedsecuritvwasreferencedinninedifferentsvnthetic
1ui tiu \\tui Ni ..,
CDOscreatedbvGoldmanSachs.
11o
Becauseofsuchdeals,whenthehousingbubble
burst,billionsofdollarschangedhands.
AlthoughGoldmanexecutivesagreedthatsvntheticCDOswere“bets”thatmag-
nifed overall risk, thev also maintained that their creation had “social utilitv” be-
cause it added liquiditv to the market and enabled investors to customize the
exposures thev wanted in their portfolios.
111
In testimonv before the Commission,
Goldman’sPresidentandChiefOperatingOmcerGarvCohnargued:“Thisisnodif-
ferentthanthetensofthousandsofswapswrittenevervdavontheU.S.dollarversus
anothercurrencv.Or,moreimportantlv,onU.S.Treasuries . . .Thisisthewavthat
thefnancialmarketswork.”
11i
Others,however,criticizedthesedeals.PatrickParkinson,thecurrentdirectorof
the Division of Banking Supervision and Regulation at the Federal Reserve Board,
noted that svnthetic CDOs “multiplied the effects of the collapse in subprime.”
11:
Otherobserverswereevenharsherintheirassessment.“Idon’tthinkthevhavesocial
value,”MichaelGreenberger,aprofessorattheUniversitvofMarvlandSchoolofLaw
and former director of the Division of Trading and Markets at the Commoditv Fu-
turesTradingCommission,toldtheFCIC.Hecharacterizedthecreditdefaultswap
marketasa“casino.”Andhetestifedthat“theconceptoflawfulbettingofbillionsof
dollars on the question of whether a homeowner would default on a mortgage that
wasnotownedbveitherpartv,hashadaprofoundeffectontheAmericanpublicand
taxpavers.”
11a
MOODY’ S: “ACHIEVED THROUGH SOME ALCHEMY”
ThemachinechurningoutCDOswouldnothaveworkedwithoutthestampofap-
proval given to these deals bv the three leading rating agencies: Moodv’s, S&P, and
Fitch. Investors often relied on the rating agencies’ views rather than conduct their
owncreditanalvsis.Moodv’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-
InratingbothsvntheticandcashCDOs,Moodv’sfacedtwokevchallenges:frst,
estimatingtheprobabilitvofdefaultforthemortgage-backedsecuritiespurchasedbv
theCDO(oritssvntheticequivalent)and,second,gaugingthecorrelationbetween
those defaults—that is, the likelihood that the securities would default at the same
time.
11o
Imaginefippingacointoseehowmanvtimesitcomesupheads.Eachfipis
unrelated to the others; that is, the fips are uncorrelated. Now, imagine a loaf of
slicedbread.Whenthereisonemoldvslice,therearelikelvothermoldvslices.The
freshnessofeachsliceishighlvcorrelatedwiththatoftheotherslices.Asinvestors
now understand, the mortgage-backed securities in CDOs were less like coins than
likeslicesofbread.
To estimate the probabilitv of default, Moodv’s relied almost exclusivelv on its
ownratingsofthemortgage-backedsecuritiespurchasedbvtheCDOs.
11¬
Atnotime
didtheagencies“lookthrough”thesecuritiestotheunderlvingsubprimemortgages.
“Wetooktheratingthathadalreadvbeenassignedbvthe[mortgage-backedsecuri-
..( ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN iiiui1 ..( ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN iiiui1
ties] group,” Garv Witt, formerlv one of Moodv’s team managing directors for the
CDOunit,toldtheFCIC.ThisapproachwouldleadtoproblemsforMoodv’s—and
for investors. Witt testifed that the underlving collateral “just completelv disinte-
gratedbelowusandwedidn’treactandweshouldhave. . . .Wehadtobelookingfor
aproblem.Andweweren’tlooking.”
118
To determine the likelihood that anv given securitv in the CDO would default,
Moodv’spluggedinassumptionsbasedonthoseoriginalratings.Thiswasnosimple
task.Meanwhile,iftheinitialratingsturnedout—owingtopoorunderwriting,fraud,
oranvothercause—topoorlvrefectthequalitvofthemortgagesinthebonds,the
error was blindlv compounded when mortgage-backed securities were packaged
intoCDOs.
Evenmoredimcultwastheestimationofthedefaultcorrelationbetweenthese-
curitiesintheportfolio—alwavstrickv,butparticularlvsointhecaseofCDOscon-
sisting of subprime and Alt-A mortgage-backed securities that had onlv a short
performancehistorv.Sothefrmexplicitlvreliedonthejudgmentofitsanalvsts.“In
theabsenceofmeaningfuldefaultdata,itisimpossibletodevelopempiricaldefault
correlation measures based on actual observations of defaults,” Moodv’s acknowl-
edgedinoneearlvexplanationofitsprocess.
11o
InplainerEnglish,Wittsaid,Moodv’sdidn’thaveagoodmodelonwhichtoesti-
matecorrelationsbetweenmortgage-backedsecurities—sothev“madethemup.”He
recalled, “Thev went to the analvst in each of the groups and thev said, ‘Well, vou
know,howrelateddovouthinkthesetvpesof[mortgage-backedsecurities]are:’”
1io
ThisproblemwouldbecomemoreseriouswiththeriseofCDOsinthemiddleofthe
decade.WittfeltstronglvthatMoodv’sneededtoupdateitsCDOratingmodeltoex-
plicitlv address the increasing concentration of riskv mortgage-related securities in
thecollateralunderlvingCDOs.
1i1
Heundertooktwoinitiativestoaddressthisissue.
First, in mid-iooa, he developed a new rating methodologv that directlv incorpo-
ratedcorrelationintothemodel.However,thetechniquehedevisedwasnotapplied
toCDOratingsforanothervear.
1ii
Second,heproposedaresearchinitiativeinearlv
ioo- to “look through” a few CDO deals at the level of the underlving mortgage-
backedsecuritiesandtoseeif“theassumptionsthatwe’remakingforAAACDOsare
consistent . . . with the correlation assumptions that we’re making for AAA [mort-
gage-backedsecurities].”AlthoughWittreceivedapprovalfromhissuperiorsforthis
investigation,contractualdisagreementspreventedhimfrombuvingthesoftwarehe
neededtoconductthelook-throughanalvsis.
1i:
InIuneioo-,Moodv’supdateditsapproachforestimatingdefaultcorrelation,but
itbasedthenewmodelontrendsfromthepreviousiovears,aperiodwhenhousing
priceswererisingandmortgagedelinquencieswerevervlow—andaperiodinwhich
nontraditionalmortgageproductshadbeenavervsmallniche.Then,Moodv’smod-
ifedthisoptimisticsetof“empirical”assumptionswithadhocadjustmentsbasedon
factors such as region, vear of origination, and servicer. For example, if two mort-
gage-backed securities were issued in the same region—sav, Southern California—
Moodv’s boosted the correlation; if thev shared a common mortgage servicer,
Moodv’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,Moodv’sestimatedthattwomort-
gage-backedsecuritieswouldbelesscloselvcorrelatedthantwosecuritiesbackedbv
otherconsumercreditassets,suchascreditcardorautoloans.
1ia
The other major rating agencies followed a similar approach.
1i-
Academics, in-
cluding some who worked at regulatorv agencies, cautioned investors that assump-
tion-heavv CDO credit ratings could be dangerous. “The complexitv of structured
fnancetransactionsmavleadtosituationswhereinvestorstendtorelvmoreheavilv
onratingsthanforothertvpesofratedsecurities.Onthisbasis,thetransformationof
riskinvolvedinstructuredfnancegivesrisetoanumberofquestionswithimportant
potentialimplications.Onesuchquestioniswhethertranchedinstrumentsmightre-
sultinunanticipatedconcentrationsofriskininstitutions’portfolios,”areportfrom
theBankforInternationalSettlements,aninternationalfnancialorganizationspon-
soredbvtheworld’sregulatorsandcentralbanks,warnedinIuneioo-.
1io
CDOmanagersandunderwritersreliedontheratingstopromotethebonds.For
each new CDO, thev created marketing material, including a pitch book that in-
vestorsusedtodecidewhethertosubscribetoanewCDO.Eachbookdescribedthe
tvpesofassetsthatwouldmakeuptheportfoliowithoutprovidingdetails.
1i¬
With-
outexception,evervpitchbookexaminedbvtheFCICstaffcitedananalvsisfromei-
therMoodv’sorS&Pthatcontrastedthehistorical“stabilitv”ofthesenewproducts’
ratings with the stabilitv of corporate bonds. Statistics that made this case included
thefactthatbetween1o8:andiooo,oiºofthesenewproductsdidnotexperience
anv rating changes over a twelve-month period while onlv ¬8º of corporate bonds
maintainedtheirratings.Overalongertimeperiod,however,structuredfnancerat-
ings were not so stable. Between 1o8: and iooo, onlv -oº of triple-A-rated struc-
turedfnancesecuritiesretainedtheiroriginalratingafterfvevears.
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.
AsKvleBassofDallas-basedHavmanCapitalAdvisorstestifedbeforetheHouse
Financial Services Committee, CDOs that purchased lower-rated tranches of mort-
gage-backed securities “are arcane structured fnance products that were designed
specifcallvtomakedangerous,lowlvratedtranchesofsubprimedebtdeceptivelvat-
tractivetoinvestors.Thiswasachievedthroughsomealchemvandsomenegligence
in adapting unrealistic correlation assumptions on behalf of the ratings agencies.
Thev convinced investors that 8oº of a collection of toxic subprime tranches were
theratingsequivalentofU.S.Governmentbonds.”
1io
Whenhousingpricesstartedtofallnationwideanddefaultsincreased,itturned
out that the mortgage-backed securities were in fact much more highlv correlated
thantheratingagencieshadestimated—thatis,thevstoppedperformingatroughlv
thesametime.TheselossesledtomassivedowngradesintheratingsoftheCDOs.
Inioo¬,ioºofU.S.CDOsecuritieswouldbedowngraded.Inioo8,o1ºwould.
1:o
..· ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN iiiui1 ..· ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN iiiui1
Inlateioo8,Moodv’swouldthrowoutitskevCDOassumptionsandreplacethem
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 kev mistakes.
First,thevassumedthatsecuritizerscouldcreatesaferfnancialproductsbvdiversi-
fvingamongmanvmortgage-backedsecurities,wheninfactthesesecuritiesweren’t
that different to begin with. “There were a lot of things [the credit rating agencies]
didwrong,”FederalReserveChairmanBenBernanketoldtheFCIC.“Thevdidnot
takeintoaccounttheappropriatecorrelationbetween[and]acrossthecategoriesof
mortgages.”
1:i
Second,theagenciesbasedtheirCDOratingsonratingsthevthemselveshadas-
signedontheunderlvingcollateral.“ThedangerwithCDOsiswhenthevarebased
on structured fnance ratings,” Ann Rutledge, a structured fnance expert, told the
FCIC.“Ratingsarenotpredictiveoffuturedefaults;thevonlvdescribearatingsman-
agementprocess,andameanandstaticexpectationofsecuritvloss.”
1::
Ofcourse,ratingCDOswasaproftablebusinessfortheratingagencies.Includ-
ing all tvpes of CDOs—not just those that were mortgage-related—Moodv’s rated
iiodealsiniooa,:o:inioo-,¬aoiniooo,and¬1¬inioo¬;thevalueofthosedeals
rosefrom·oobillioniniooato·1oibillioninioo-,·::¬billioniniooo,and·:io
billion in ioo¬.
1:a
The reported revenues of Moodv’s Investors Service from struc-
turedproducts—whichincludedmortgage-backedsecuritiesandCDOs—grewfrom
·1oomillioniniooo,or::ºofMoodv’sCorporation’srevenues,to·88¬millionin
iooo or aaº of overall corporate revenue. The rating of asset-backed CDOs alone
contributed more than 1oº of the revenue from structured fnance.
1:-
The boom
vears of structured fnance coincided with a companv-wide surge in revenue and
profts. From iooo to iooo, the corporation’s revenues surged from ·ooi million to
·ibillionanditsproftmarginclimbedfromioºto:¬º.
YettheincreaseintheCDOgroup’sworkloadandrevenuewasnotparalleledbva
stamng increase. “We were under-resourced, vou know, we were alwavs plaving
catch-up,”Wittsaid.
1:o
Moodv’s“pennv-pinching”and“stingv”managementwasre-
luctanttopavupforexperiencedemplovees.“Theproblemofrecruitingandretain-
inggoodstaffwasinsoluble.Investmentbanksoftenhiredawavourbestpeople.As
far as I can remember, we were never allocated funds to make counter offers,” Witt
said.“Wehadalmostnoabilitvtodomeaningfulresearch.”
1:¬
EricKolchinskv,afor-
merteammanagingdirectoratMoodv’s,toldtheFCICthatfromiooatoiooo,the
increaseinthenumberofdealsratedwas“huge . . .butourpersonneldidnotgoup
accordinglv.”Bviooo,Kolchinskvrecalled,“Mvroleasateamleaderwascrisisman-
agement.Eachdealwasacrisis.”
1:8
Whenpersonnelworkedtocreateanewmethod-
ologv,Wittsaid,“Wehadtokindofdoitinoursparetime.”
1:o
TheagenciesworkedcloselvwithCDOunderwritersandmanagersaseachnew
CDO was devised. And the rating agencies now relied for a substantial amount of
theirrevenuesonasmallnumberofplavers.CitigroupandMerrillaloneaccounted
formorethan·1aobillionofCDOdealsbetweenioo-andioo¬.
1ao
Theratingsagencies’correlationassumptionshadadirectandcriticalimpacton
1ui tiu \\tui Ni ..+
howCDOswerestructured:assumptionsofalowercorrelationmadepossiblelarger
easv-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,bvincreasingthesizeoftheseniortranches.More-
over,becauseissuerscouldchoosewhichratingagenciestodobusinesswith,andbe-
cause the agencies depended on the issuers for their revenues, rating agencies felt
pressuredtogivefavorableratingssothatthevmightremaincompetitive.
Thepressureonratingagencvemploveeswasalsointenseasaresultofthehigh
turnover—a revolving door that often left raters dealing with their old colleagues,
thistimeasclients.InherinterviewwithFCICstaff,YuriYoshizawa,aMoodv’steam
managing director for U.S. derivatives in ioo-, was presented with an organization
chartfromIulvioo-.Sheidentifed1:outof-1analvsts—abouti-ºofthestaff—
whohadleftMoodv’stoworkforinvestmentorcommercialbanks.
1a1
Brian Clarkson, who oversaw the structured fnance group before becoming the
presidentofMoodv’sInvestorsService,explainedtoFCICinvestigatorsthatretaining
emploveeswasalwavsachallenge,forthesimplereasonthatthebankspaidmore.As
aprecaution,Moodv’semploveeswereprohibitedfromratingdealsbvabankoris-
suerwhilethevwereinterviewingforajobwiththatparticularinstitution,butthere-
sponsibilitvfornotifvingmanagementoftheinterviewrestedontheemplovee.After
leaving Moodv’s, former emplovees were barred from interacting with Moodv’s on
the same series of deals thev had rated while in its emplov, but there were no bans
againstworkingonother dealswithMoodv’s.
1ai
SEC: “IT’ S GOING TO BE AN AWFULLY BIG MESS”
The fve major U.S. investment banks expanded their involvement in the mortgage
andmortgagesecuritiesindustriesintheearlvi1stcenturvwithlittleformalgovern-
ment regulation bevond their broker-dealer subsidiaries. In iooi, the European
UniontoldU.S.fnancialfrmsthattocontinuetodobusinessinEurope,thevwould
needa“consolidated”supervisorbviooa—thatis,oneregulatorthathadresponsibil-
itvfortheholdingcompanv.TheU.S.commercialbanksalreadvmetthatcriterion—
their consolidated supervisor was the Federal Reserve—and the Omce of Thrift
Supervision’soversightofAIGwouldlateralsosatisfvtheEuropeans.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 agencv would thev prefer as
theirregulator:
Bviooa,thecombinedassetsatthefvefrmstotaled·i.-trillion,morethanhalf
ofthe·a.¬trillionofassetsheldbvthefvelargestU.S.bankholdingcompanies.Inthe
next three vears the investment banks’ assets would grow to ·a.: trillion. Goldman
Sachswasthelargest,followedbvMorganStanlevandMerrill,thenLehmanandBear.
These large, diverse international frms had transformed their business models over
thevears.FortheirrevenuesthevreliedincreasinglvontradingandOTCderivatives
.,+ ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN iiiui1 .,+ ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN iiiui1
dealing, investments, securitization, and similar activities on top of their traditional
investmentbankingfunctions.RecallthatatBearStearns,tradingandinvestmentsac-
countedformorethan1ooºofpretaxearningsinsomevearsafteriooi.
The investment banks also owned depositorv institutions through which thev
couldprovideFDIC-insuredaccountstotheirbrokeragecustomers;thedepositspro-
videdcheapbutlimitedfunding.Thesedepositoriestooktheformofathrift(super-
visedbvtheOTS)oranindustrialloancompanv(supervisedbvtheFederalDeposit
Insurance Corporation and a state supervisor). Merrill and Lehman, which had
amongthelargestofthesesubsidiaries,usedthemtofnancetheirmortgageorigina-
tionactivities.
Theinvestmentbanks’possessionofdepositorvsubsidiariessuggestedtwoobvi-
ous choices when thev found themselves in need of a consolidated supervisor. If a
frm chartered its depositorv as a commercial bank, the Fed would be its holding
companv supervisor; if as a thrift, the OTS would do the job. But the investment
bankscameupwithathirdoption.ThevlobbiedtheSECtodeviseasvstemofregu-
lation that would satisfv the terms of the European directive and keep them from
Europeanoversight
1a:
—andtheSECwaswillingtostepin,althoughitshistoricalfo-
cuswasoninvestorprotection.
InNovemberioo:,almostavearaftertheEuropeansmadetheirannouncement,
theSECsuggestedthecreationoftheConsolidatedSupervisedEntitv(CSE)program
tooverseetheholdingcompaniesofinvestmentbanksandalltheirsubsidiaries.The
CSE program was open onlv to investment banks that had large U.S. broker-dealer
subsidiariesalreadvsubjecttoSECregulation.However,thiswastheSEC’sfrstforav
into supervising frms for safetv and soundness. The SEC did not have express leg-
islative authoritv to require the investment banks to submit to consolidated regula-
tion, so it proposed that the CSE program be voluntarv; the SEC crafted the new
program out of its authoritv to make rules for the broker-dealer subsidiaries of in-
vestmentbanks.Theprogramwouldapplvtobroker-dealersthatvolunteeredtobe
subject to consolidated supervision under the CSE program, or those that alreadv
weresubjecttosupervisionbvtheFedattheholdingcompanvlevel,suchasIPMor-
ganandCitigroup.TheCSEprogramwouldintroducealimitedformofsupervision
bv SEC examiners. CSE frms were allowed to use a new methodologv to calculate
the regulatorv capital that thev were holding against their securities portfolios—a
methodologvbasedonthevolatilitvofmarketprices.Thismethodologv,referredto
asthe“alternativenetcapitalrule,”wouldbesimilartothestandards—basedonthe
1oooMarketRiskAmendmenttotheBaselrules—thatlargecommercialbanksand
bankholdingcompaniesusedfortheirsecuritiesportfolios.
Thetraditionalnetcapitalrulethathadgovernedbroker-dealerssince1o¬-had
required straightforward calculations based on asset classes and credit ratings, a
bright-lineapproachthatgavefrmslittlediscretionincalculatingtheircapital.The
newruleswouldallowtheinvestmentbankstocreatetheirownproprietarvValueat
Risk(VaR)modelstocalculatetheirregulatorvcapital—thatis,thecapitaleachfrm
wouldhavetoholdtoprotectitscustomers’assetsshoulditexperiencelossesonits
1ui tiu \\tui Ni .,.
securities and derivatives. All in all, the SEC estimated that the proposed new re-
lianceonproprietarvVaRmodelswouldallowbroker-dealerstoreduceaveragecap-
ital charges bv aoº. The frms would be required to give the SEC an earlv-warning
notice if their tentative net capital (net capital minus hard-to-sell assets) fell below
·-billionatanvtime.
Meanwhile,theOTSwasalreadvsupervisingthethriftsownedbvseveralsecuri-
ties frms and argued that it therefore was the natural supervisor of their holding
companies. In a letter to the SEC, the OTS was harshlv critical of the agencv’s pro-
posal,whichitsaidhad“thepotentialtoduplicateorconfictwithOTS’ssupervisorv
responsibilities” over savings and loan holding companies that would also be CSEs.
TheOTSarguedthattheSECwasinterferingwiththeintentionsofCongress,which,
intheGramm-Leach-BlilevAct,“carefullvkepttheresponsibilitvforsupervisionof
the holding companv itself with the OTS or the Federal Reserve Board, depending
uponwhethertheholdingcompanvwasa[thriftholdingcompanv]orabankhold-
ing companv. This was in recognition of the expertise developed over the vears bv
theseregulatorsinevaluatingtherisksposedtodepositorvinstitutionsandthefed-
eral deposit insurance funds bv depositorv institution holding companies and their
amliates.” The OTS declared: “We believe that the SEC’s proposed assertion of au-
thoritvover[savingsandloanholdingcompanies]isunfoundedandcouldposesig-
nifcant risks to these entities, their insured deposit institution subsidiaries and the
federaldepositinsurancefunds.”
1aa
Incontrast,theresponsefromthefnancialservicesindustrvtotheSECproposal
was overwhelminglv positive, particularlv with regard to the alternative net capital
computation. Lehman Brothers, for example, wrote that it “applauds and supports
theCommission.”IPMorganwassupportiveofwhatitsawasanimprovementover
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,”thecompanvwrote.DeutscheBankfoundittobe“agreatstridetowardscon-
sistencvwithmoderncomprehensiveriskmanagementpractices.”
1a-
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 iooa meeting, SEC commissioners voted to adopt the CSE program
andthenewnetcapitalcalculationsthatwentalongwithit.Overthefollowingvear
and a half, the fve largest investment banks volunteered for this supervision, al-
thoughMerrill’sandLehman’sthriftscontinuedtobesupervisedbvtheOTS.Several
frmsdelavedentrvtotheprograminordertodevelopsvstemsthatcouldmeasure
theirexposurestomarketpricemovements.
HarvevGoldschmid,SECcommissionerfromiooitoioo-,toldFCICstaffthat
beforetheCSEprogramwascreated,SECstaffmemberswereconcernedabouthow
littleauthoritvthevhadovertheWallStreetfrms,includingtheirhedgefundsand
overseassubsidiaries.OncetheCSEprogramwasinplace,theSEChad“theauthor-
itvtolookatevervthing.”
1ao
SECcommissionersdiscussedatthetimetherisksthev
weretakingbvallowingfrmstoreducetheircapital.“Ifanvthinggoeswrongit’sgo-
.,z ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN iiiui1 .,z ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN iiiui1
ingtobeanawfullvbigmess,”Goldschmidsaidataiooameeting.“Dowefeelsecure
ifthesedropsincapitalandotherthings[occur]wereallvwillhaveinvestorprotec-
tion:”Inresponse,AnnetteNazareth,theSEComcialwhowouldbeinchargeofthe
program,assuredthecommissionersthatherdivisionwasuptothechallenge.
1a¬
ThenewprogramwashousedprimarilvintheSEC’sOmceofPrudentialSupervi-
sionandRiskAnalvsis,anomcewithastaffof1oto1iwithintheDivisionofMarket
Regulation.
1a8
Inthebeginning,itwassupportedbvtheSEC’smuchlargerexamina-
tion staff; bv ioo8 the staff dedicated to the CSE program had grown to ia.
1ao
Still,
onlv1o“monitors”wereresponsibleforthefveinvestmentbanks;:monitorswere
assignedtoeachfrm,withsomeoverlap.
1-o
TheCSEprogramwasbasedonthebanksupervisionmodel,buttheSECdidnot
trv to do exactlv 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; bv
comparison,theOCCaloneassignedmorethanooexaminersfull-timeatCitibank.
According to Erik Sirri, the SEC’s former director of trading and markets, the CSE
program was intended to focus mainlv on liquiditv because, unlike a commercial
bank, a securities frm traditionallv 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’svstemsandrecordsand
verifedthatthefrmshadinstitutedcontrolprocesses.
TheCSEprogramwastroubledfromthestart.TheSECconductedanexamfor
eachinvestmentbankwhenitenteredtheprogram.TheresultofBearStearns’sen-
tranceexam,inioo-,showedseveraldefciencies.Forexample,examinerswerecon-
cerned that there were no frmwide VaR limits and that contingencv funding plans
reliedonoverlvoptimisticstressscenarios.
1-:
Inaddition,theSECwasawareofthe
frm’s concentration of mortgage securities and its high leverage. Nonetheless, the
SECdidnotaskBeartochangeitsassetbalance,decreaseitsleverage,orincreaseits
cash liquiditv pool—all actions well within its prerogative, according to SEC
omcials.
1-a
Then,becausetheCSEprogramwaspreoccupiedwithitsownstaffreor-
ganization,Beardidnothaveitsnextannualexam,duringwhichtheSECwassup-
posedtobeon-site.TheSECdidmeetmonthlvwithallCSEfrms,includingBear,
1--
and it did conduct occasional targeted examinations across frms. In iooo, the SEC
worriedthatBearwastooreliantonunsecuredcommercialpaperfunding,andBear
reduceditsexposuretounsecuredcommercialpaperandincreaseditsrelianceonse-
cured repo lending.
1-o
Unfortunatelv, tens of billions of dollars of that repo lending
wasovernightfundingthatcoulddisappearwithnowarning.Ironicallv,inthesec-
ondweekofMarchioo8,whenthefrmwentintoitsfour-davdeathspiral,theSEC
wason-siteconductingitsfrstCSEexamsinceBear’sentranceexammorethantwo
vearsearlier.
1-¬
Leverageattheinvestmentbanksincreasedfromiooatoioo¬,growththatsome
criticshaveblamedontheSEC’schangeinthenetcapitalrules.Goldschmidtoldthe
FCICthattheincreasewasowedto“awildcapitaltimeandthefrmsbeingirrespon-
sible.”
1-8
In fact, leverage had been higher at the fve investment banks in the late
1ooos, then dropped before increasing over the life of the CSE program—a historv
1ui tiu \\tui Ni .,.
thatsuggeststhattheprogramwasnotsolelvresponsibleforthechanges.
1-o
Iniooo,
SirrinotedthatundertheCSEprogramtheinvestmentbanks’netcapitallevels“re-
mainedrelativelvstable . . .and,insomecases,increasedsignifcantlv”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. . . .
TheSEChasthepracticalabilitvtodoalotifitusesitspower.”
1o1
Overall,theCSEprogramwaswidelvviewedasafailure.Fromiooauntilthef-
nancial crisis, all fve investment banks continued their spectacular growth, relving
heavilv on short-term funding. Former SEC chairman Christopher Cox called the
CSE supervisorv program “fundamentallv fawed from the beginning.”
1oi
Marv
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 Lvnch), or converted to bank holding
companies to be supervised bv the Federal Reserve (Goldman Sachs and Morgan
Stanlev).
For the Fed, there would be a certain ironv in that last development concerning
Goldman and Morgan Stanlev. Fed omcials had seen their agencv’s regulatorv
purviewshrinkingoverthecourseofthedecade,asIPMorganswitchedthecharter
ofitsbankingsubsidiarvtotheOCC
1oa
andastheOTSandSECpromotedtheiral-
ternatives for consolidated supervision. “The OTS and SEC were verv aggressive in
trvingtopromotethemselvesasaregulatorinthatenvironmentandwantedtobethe
consolidated supervisor . . . to meet the requirements in Europe for a consolidated
supervisor,”saidMarkOlson,aFedgovernorfromioo1toiooo.“Therewasalotof
competitivenessamongtheregulators.”
1o-
InIanuarvioo8,Fedstaffhadpreparedan
internalstudvtofndoutwhvnoneoftheinvestmentbankshadchosentheFedasits
consolidatedsupervisor.Thestaffinterviewedfvefrmsthatalreadvweresupervised
bv the Fed and four that had chosen the SEC. According to the report, the biggest
reasonfrmsoptednottobesupervisedbvtheFedwasthe“comprehensiveness”of
theFed’ssupervisorvapproach,“particularlvwhencomparedtoalternativessuchas
Omce of Thrift Supervision (OTS) or Securities & Exchange Commission (SEC)
holdingcompanvsupervision.”
1oo
.,. ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN iiiui1 .,. ii N\Nti \i tii :i : i NuUi 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 plaved an important role in doing
so, including CDOs squared, credit default swaps, svnthetic CDOs, and asset-
backedcommercialpaperprogramsthatinvestedinmortgage-backedsecurities
andCDOs.Manvoftheseriskvassetsendeduponthebalancesheetsofsvstemi-
callvimportantinstitutionsandcontributedtotheirfailureornearfailureinthe
fnancialcrisis.
Creditdefaultswaps,soldtoprovideprotectionagainstdefaulttopurchasers
ofthetop-ratedtranchesofCDOs,facilitatedthesaleofthosetranchesbvcon-
vincinginvestorsoftheirlowrisk,butgreatlvincreasedtheexposureofthesellers
ofthecreditdefaultswapprotectiontothehousingbubble’scollapse.
SvntheticCDOs,whichconsistedinwholeorinpartofcreditdefaultswaps,
enabledsecuritizationtocontinueandexpandevenasthemortgagemarketdried
upandprovidedspeculatorswithameansofbettingonthehousingmarket.Bv
laveringoncorrelatedrisk,thevspreadandamplifedexposuretolosseswhenthe
housingmarketcollapsed.
The high ratings erroneouslv given CDOs bv 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
corporategovernanceatMoodv’s,whichdidnotensurethequalitvofitsratings
ontensofthousandsofmortgage-backedsecuritiesandCDOs.
The Securities and Exchange Commission’s poor oversight of the fve largest
investmentbanksfailedtorestricttheirriskvactivitiesanddidnotrequirethem
toholdadequatecapitalandliquiditvfortheiractivities,contributingtothefail-
ureorneedforgovernmentbailoutsofallfveofthesupervisedinvestmentbanks
duringthefnancialcrisis.
9
ALL IN
CONTENTS
1hc|u|||c“Acrcdit-induccd|ccn”)·¬
Mcrtgagcjraud“Crinc-jaci|itativccnvircnncnts” )eo
Disc|csurcandducdi|igcncc“Aqua|itvccntrc|issucinthcjactcrv” )e·
Rcgu|atcrs“Markctswi||a|wavssc|j-ccrrcct”)¬o
Icvcragcd|cansandccnncrcia|rca|cstatc
“Ycu’vcgcttcgctupanddancc” )¬;
IchnanIrcn“ncving”tc“stcragc” )¬e
IannicMacandIrcddicMac“1wcstarkchciccs”)¬:
Inioo:,theBakersfeld,California,homebuilderWarrenPetersonwaspavingaslit-
tleas·:-,ooofora1o,ooo-square-footlot,aboutthesizeofthreetenniscourts.The
nextvearthecostmorethantripledto·1io,ooo,asrealestateboomed.Overthepre-
viousquartercenturv,Petersonhadbuiltbetween:and1ocustomandsemi-custom
homesavear.Forawhile,hewasbuildingasmanvas:o.Andthencamethecrash.
“I have built exactlv one new home since late ioo-,” he told the FCIC fve vears
later.
1
In ioo:, the average price was ·1--,ooo for a new house in Bakersfeld, at the
southernendofCalifornia’sagriculturalcenter,theSanIoaquinVallev.Thatjumped
toalmost·:oo,ooobvIuneiooo.
i
“Bviooa,monevseemedtobecominginvervfast
and from evervwhere,” said Llovd Plank, a Bakersfeld real estate broker. “Thev
wouldpurchaseahouseinBakersfeld,keepitforashortperiodandresellit.Some-
timesthevwouldfipthehousewhileitwasstillinescrow,andwouldstillmakeioº
to:oº.”
:
Nationallv, housing prices jumped 1-iº between 1oo¬ and their peak in iooo,
a
more than in anv decade since at least 1oio.
-
It would be catastrophicallv downhill
fromthere—vetthemortgagemachinekeptchurningwellintoioo¬,apparentlvin-
differenttothefactthathousingpriceswerestartingtofallandlendingstandardsto
deteriorate. Newspaper stories highlighted the weakness in the housing market—
evensuggestingthiswasabubblethatcouldburstanvtime.Checkswereinplace,but
.,(
thevwerefailing.Loanpurchasersandsecuritizersignoredtheirownduediligence
onwhatthevwerebuving.TheFederalReserveandtheotherregulatorsincreasinglv
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 increasinglv ap-
pearedtobeacreditbubble:Manventerprises,suchasLehmanBrothersandFannie
Mae,pusheddeeper.
Allalongtheassemblvline,fromtheoriginationofthemortgagestothecreation
andmarketingofthemortgage-backedsecuritiesandcollateralizeddebtobligations
(CDOs), manv understood and the regulators at least suspected that everv cog was
reliantonthemortgagesthemselves,whichwouldnotperformasadvertised.
THE BUBBLE: “A CREDITINDUCED BOOM”
Irvine, California–based New Centurv—once the nation’s second-largest subprime
lender—ignored earlv warnings that its own loan qualitv was deteriorating and
strippedpowerfromtworisk-controldepartmentsthathadnotedtheevidence.Ina
Iuneiooapresentation,theOualitvAssurancestaffreportedthevhadfoundsevere
underwriting errors, including evidence of predatorv lending, legal and state viola-
tions,andcreditissues,ini-ºoftheloansthevauditedinNovemberandDecember
ioo:. In iooa, 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
vear,theInternalAuditdepartmentidentifednumerousdefcienciesinloanfles;out
ofninereviewsitconductedinioo-,itgavethecompanv’sloanproductiondepart-
ment“unsatisfactorv”ratingsseventimes.PatrickFlanagan,presidentofNewCen-
turv’s mortgage-originating subsidiarv, cut the department’s budget, saving in a
memo that the “group was out of control and tries to dictate business practices in-
steadofaudit.”
o
This happened as the companv struggled with increasing requests that it buv
backsouredloansfrominvestors.BvDecemberiooo,almost1¼ofitsloanswere
goingintodefaultwithinthefrstthreemonthsafterorigination.“NewCenturvhad
abrazenobsessionwithincreasingloanoriginations,withoutdueregardtotherisks
associated with that business strategv,” New Centurv’s bankruptcv examiner
reported.
¬
In September ioo-—seven months before the housing market peaked—thou-
sandsoforiginators,securitizers,andinvestorsmetattheABSEastioo-conference
inBocaRaton,Florida,toplavgolf,dodeals,andtalkaboutthemarket.Theasset-
backedsecuritvbusinesswasstillgood,buteventhemostoptimisticcouldreadthe
signs.Panelistshadthreeconcerns:Werehousingpricesoverheated,orjustdrivenbv
“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, especiallv California, had dramaticallv larger spikes—and subsequent de-
clines—than did the nation. If there was a bubble, perhaps, as Fed Chairman Alan
Greenspansaid,itwasonlvincertainregions.Hetoldacongressionalcommitteein
Iune ioo- that growth in nonprime mortgages was helping to push home prices in
somemarketstounsustainablelevels,“althougha‘bubble’inhomepricesforthena-
tionasawholedoesnotappearlikelv.”
o
Globallv,pricesjumpedinmanvcountriesaroundtheworldduringtheiooos.As
Christopher Maver, an economist from Columbia Business School, noted to the
Commission, “What reallv sticks out is how unremarkable the United States house
price experience is relative to our European peers.”
1o
From 1oo¬ to ioo¬, price in-
creases in the United Kingdom and Spain were above those in the United States,
whilepriceincreasesinIrelandandFrancewerejustbelow.InanInternationalMon-
etarvFundstudvfromiooo,morethanonehalfofthei1developedcountriesana-
lvzed had greater home price appreciation than the United States from late ioo1
through the third quarter of iooo, and vet some of these countries did not suffer
sharppricedeclines.
11
Notablv,Canadahadstronghomepriceincreasesfollowedbv
amodestandtemporarvdeclineiniooo.ResearchersattheFederalReserveBankof
Cleveland attributed Canada’s experience to tighter lending standards than in the
UnitedStatesaswellasregulatorvandstructuraldifferencesinthefnancialsvstem.
1i
Other countries, such as the United Kingdom, Ireland, and Spain, saw steep house
pricedeclines.
Americaneconomistsandpolicvmakersstruggledtoexplainthehousepricein-
creases.Thegoodnewswastheeconomvwasgrowingandunemplovmentwaslow.
But,aFederalReservestudvinMavioo-presentedevidencethatthecostofowning
ratherthanrentingwasmuchhigherthanhadbeenthecasehistoricallv:homeprices
hadrisenfromiotimestheannualcostofrentingtoi-times.
1:
Insomecities,the
change was particularlv dramatic. From 1oo¬ to iooo, the ratio of house prices to
rentsroseinLosAngeles,Miami,andNewYorkCitvbv1a¬º,1i1º,ando8º,re-
spectivelv.
1a
Iniooo,theNationalAssociationofRealtors’affordabilitvindex—which
measureswhetheratvpicalfamilvcouldqualifvforamortgageonatvpicalhome—
hadreachedarecordlow.
1-
Butthatwasbasedonthecostofatraditionalmortgage
withaioºdownpavment,
1o
whichwasnolongerrequired.Perhapssuchmeasures
werenolongerrelevant,whenAmericanscouldmakelowerdownpavmentsandob-
tainloanssuchaspavment-optionadjustable-ratemortgagesandinterest-onlvmort-
gages,withreducedinitialmortgagepavments.Orperhapsbuvingahomecontinued
tomakefnancialsense,givenhomeowners’expectationsoffurtherpricegains.
During a Iune 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 NuUi i¥ tu\\i : :i uN iiiui1
mortgagerisksandthehousingmarket.Membersandstaffhaddimcultvdevelop-
ing a consensus on whether housing prices were overvalued and “it was hard for
manv FOMC participants . . . to ascribe substantial conviction to the proposition
that overvaluation in the housing market posed the major svstemic risks that we
now know it did,” according to a letter from Fed Chairman Ben Bernanke to the
FCIC. “The national mortgage svstem might bend but will likelv not break,” and
“neither borrowers nor lenders appeared particularlv shakv,” one presentation ar-
gued, according to the letter. In discussions about nontraditional mortgage prod-
ucts, the argument was made that “interest-onlv mortgages are not an especiallv
sinisterdevelopment,”andtheirrisks“couldbecushionedbvlargedownpavments.”
Thepresentationalsonotedthatwhileloan-to-valueratioswererisingonaportion
ofinterest-onlvloans,theratiosformostremainedaround8oº.Anotherpresenta-
tionsuggestedthathousingmarketactivitvcouldbetheresultof“solidfundamen-
tals.” Yet another presentation concluded that the impact of changes in household
wealthonspendingwouldbe“perhapsonlvhalfaslargeasthatofthe1ooosstock
bubble.” Most FOMC participants agreed “the probabilitv of spillovers to fnancial
institutionsseemedmoderate.”

As one recent studv argues, manv economists were “agnostics” on housing, un-
willingtorisktheirreputationsorspookmarketsbvallegingabubblewithoutfnd-
ing support in economic theorv.
18
Fed Vice Chairman Donald Kohn was one.
“Identifcation[ofabubble]isatrickvpropositionbecausenotallthefundamental
factorsdrivingassetpricesaredirectlvobservable,”Kohnsaidinaiooospeech,cit-
ingresearchbvtheEuropeanCentralBank.“Forthisreason,anvjudgmentbvacen-
tralbankthatstocksorhomesareoverpricedisinherentlvhighlvuncertain.”
1o
Butnotalleconomistshesitatedtosoundalouderalarm.“Thesituationisbegin-
ning to look like a credit-induced boom in housing that could verv well result in a
svstemicbustifcreditconditionsoreconomicconditionsshoulddeteriorate,”Federal
Deposit Insurance Corporation Chief Economist Richard Brown wrote in a March
ioo-report.“Duringthepastfvevears,theaverageU.S.homehasriseninvaluebv
-oº, while homes in the fastest-growing markets have approximatelv doubled in
value.”Whilethisincreasemighthavebeenexplainedbvstrongmarketfundamen-
tals,“thedramaticbroadeningofthehousingboominiooastronglvsuggeststhein-
fuenceofsvstemicfactors,includingthelowcostandwideavailabilitvofmortgage
credit.”
io
Acoupleofmonthslater,Fedeconomistsinaninternalmemoacknowledgedthe
possibilitv that housing prices were overvalued, but downplaved the potential im-
pacts of a downturn. Even in the face of a large price decline, thev argued, defaults
would not be widespread, given the large equitv that manv borrowers still had in
theirhomes.Structuralchangesinthemortgagemarketmadeacrisislesslikelv,and
the fnancial svstem seemed well capitalized. “Even historicallv large declines in
housepriceswouldbesmallrelativetotherecentdeclineinhouseholdwealthowing
tothestockmarket,”theeconomistsconcluded.“Fromawealth-effectsperspective,
thisseemsunlikelvtocreatesubstantialmacroeconomicproblems.”
i1
\ii i N .,+
MORTGAGE FRAUD:
“CRIMEFACILITATIVE ENVIRONMENTS”
NewCenturv—whereaoºofthemortgageswereloanswithlittleornodocumenta-
tion
ii
—was not the onlv companv that ignored concerns about poor loan qualitv.
Across the mortgage industrv, with the bubble at its peak, standards had declined,
documentation was no longer verifed, and warnings from internal audit depart-
mentsandconcernedemploveeswereignored.Theseconditionscreatedanenviron-
ment ripe for fraud. William Black, a former banking regulator who analvzed
criminalpatternsduringthesavingsandloancrisis,toldtheCommissionthatbvone
estimate,inthemid-iooos,atleast1.-millionloansannuallvcontained“somesortof
fraud,”inpartbecauseofthelargepercentageofno-docloansoriginatedthen.
i:
Fraudforhousingcanentailaborrower’slvingorintentionallvomittinginforma-
tiononaloanapplication.Fraudforprofttvpicallvinvolvesadeceptiontogainf-
nanciallv from the sale of a house. Illinois Attornev General Lisa Madigan defnes
fraud more broadlv to include lenders’ “sale of unaffordable or structurallv unfair
mortgageproductstoborrowers.”
ia
In8oºofcases,accordingtotheFBI,fraudinvolvesindustrvinsiders.
i-
Forex-
ample,propertvfippingcaninvolvebuvers,realestateagents,appraisers,andcom-
plicitclosingagents.Ina“silentsecond,”thebuver,withthecollusionofaloanomcer
andwithouttheknowledgeofthefrstmortgagelender,disguisestheexistenceofa
secondmortgagetohidethefactthatnodownpavmenthasbeenmade.“Strawbuv-
ers”allowtheirnamesandcreditscorestobeused,forafee,bvbuverswhowantto
concealtheirownership.
io
In one instance, two women in South Florida were indicted in io1o for placing
ads between iooa and ioo¬ in Haitian communitv newspapers offering assistance
withimmigrationproblems;thevwereaccusedofthenstealingtheidentitiesofhun-
dredsofpeoplewhocameforhelpandusingtheinformationtobuvproperties,take
title in their names, and resell at a proft. U.S. Attornev Wilfredo A. Ferrer told the
Commissionitwas“oneofthecruelestschemes”hehadseen.

Estimatesvarvontheextentoffraud,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 analvzed a large
sampleofallloansfromioo-toioo¬andfound1:ºcontainedliesoromissions
significantenoughtorescindtheloanordemandabuvbackifithadbeensecuri-
tized.Thefirm’sanalvsisindicatedthatabout·1trillionoftheloansmadeduring
theperiodwerefraudulent.Fulmerfurtherestimated·1oobillionworthoffraudu-
lentloansfromioo-toioo¬resultedinforeclosures,leadingtolossesof·11ibil-
lion for the holders. According to Fulmer, experts in the field—lenders’ qualitv
assurance officers, attornevs who specialize in loan loss mitigation, and white-
collarcriminologists—savthepercentageoftransactionsinvolvinglesssignificant
formsoffraud,suchasrelativelvminormisrepresentationsoffact,couldreachooº
oforiginations.
i8
Suchloanscouldstavcomfortablvundertheradar,becausemanv
borrowersmadepavmentsontime.
.(+ ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN iiiui1
Ed Parker, the head of mortgage fraud investigation at Ameriquest, the largest
subprimelenderinioo:,iooa,andioo-,toldtheFCICthatfraudulentloanswere
vervcommonatthecompanv.“Noonewaswatching.Thevolumewasupandnow
vou see the fallout behind the loan origination process,” he told the FCIC.
io
David
Gussmann,theformervicepresidentofEnterpriseManagementCapitalMarketsat
FannieMae,toldtheCommissionthatinonepackageof-osecuritizedloanshisan-
alvstsfoundonepurchaserwhohadbought1oproperties,falselvidentifvinghimself
eachtimeastheownerofonlvonepropertv,whileanotherhadboughtfveproper-
ties.
:o
Fannie Mae’s detection of fraud increased steadilv during the housing bubble
and accelerated in late iooo, according to William Brewster, the current director of
thecompanv’smortgagefraudprogram.Hesaidthat,seeingevidenceoffraud,Fan-
nie demanded that lenders such as Bank of America, Countrvwide, Citigroup, and
IPMorganChaserepurchaseabout·--omillioninmortgagesinioo8and·o-omil-
lion in iooo.
:1
“Lax or practicallv non-existent government oversight created what
criminologists have labeled ‘crime-facilitative environments,’ where crime could
thrive,”saidHenrvN.Pontell,aprofessorofcriminologvattheUniversitvofCalifor-
nia,Irvine,intestimonvtotheCommission.
:i
Theresponsibilitvtoinvestigateandprosecutemortgagefraudviolationsfallsto
local,stateandfederallawenforcementomcials.Onthefederallevel,theFederalBu-
reauofInvestigationinvestigatesandreferscasesforprosecutiontoU.S.Attornevs,
whoarepartoftheDepartmentofIustice.Casesmavalsoinvolveotheragencies,in-
cluding the U.S. Postal Inspection Service, the Department of Housing and Urban
Development,andtheInternalRevenueService.TheFBI,whichhasthebroadestju-
risdiction of anv federal law enforcement agencv, 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,omcefrom1oootoiooa.Iniooi,thatomceinvestigatedFirstBene-
fcialMortgageforsellingfraudulentloanstoFannieMae,leadingtothesuccessful
criminalprosecutionofthecompanv’sowner,IamesEdwardMcLeanIr.,andothers.
FirstBenefcialrepurchasedthemortgagesafterFanniediscoveredevidenceoffraud,
butthen—withoutanvinterferencefromFannie—resoldthemtoGinnieMae.
:a
For
not alerting Ginnie, Fannie paid ·¬.- million of restitution to the government.
McLeancametotheattentionoftheFBIafterbuvingaluxurvvachtfor·8oo,oooin
cash.
:-
SoonafterSweckerwaspromotedtoassistantFBIdirectorforinvestigations
iniooa,heturnedaspotlightonmortgagefraud.“Thepotentialimpactofmortgage
fraudisclear,”Sweckertoldacongressionalcommitteeiniooa.“Iffraudulentprac-
ticesbecomesvstemicwithinthemortgageindustrvandmortgagefraudisallowed
tobecomeunrestrained,itwillultimatelvplacefnancialinstitutionsatriskandhave
adverseeffectsonthestockmarket.”
:o
In that testimonv, Swecker pointed out the inadequacies of data regarding fraud
and recommended that Congress mandate a reporting svstem and other remedies
andrequirealllenderstoparticipate,whetherfederallvregulatedornot.Forexam-
ple, suspicious activitv reports, also known as SARs, are reports fled bv FDIC-in-
sured banks and their amliates to the Financial Crimes Enforcement Network
\ii i N .(.
(FinCEN),abureauwithintheTreasurvDepartmentthatadministersmonev-laun-
dering laws and works closelv with law enforcement to combat fnancial crimes.
SARsarefledbvfnancialinstitutionswhenthevsuspectcriminalactivitvinafnan-
cialtransaction.Butmanvmortgageoriginators,suchasAmeriquest,NewCenturv,
andOptionOne,wereoutsideFinCEN’sjurisdiction—andthustheloansthevgener-
ated,whichwerethenplacedintosecuritizedpoolsbvlargerlendersorinvestment
banks, were not subject to FinCEN review. William Black testifed to the Commis-
sion that an estimated 8oº of nonprime mortgage loans were made bv noninsured
lendersnotrequiredtofleSARs.Andasforthoseinstitutionsrequiredtodoso,he
believedhesawevidenceofunderreportinginthat,hesaid,onlvabout1oºoffeder-
allv insured mortgage lenders fled even a single criminal referral for alleged mort-
gagefraudinthefrsthalfofiooo.

Countrvwide,thenation’slargestmortgagelenderatthetime,hadabout-,oooin-
ternal referrals of potentiallv fraudulent activitv in its mortgage business in ioo-,
1o,ooo in iooo, and io,ooo in ioo¬, according to Francisco San Pedro, the former
seniorvicepresidentofspecialinvestigationsatthecompanv.
:8
Butitfledonlv8--
SARsinioo-,i,8o-iniooo,andi,oi1inioo¬.
:o
Similarlv,inexaminingBankofAmericainioo¬,itsleadbankregulator,theOf-
fceoftheComptrolleroftheCurrencv(OCC),sampled-omortgagesandfound1o
with“qualitvassurancereferrals”forsuspiciousactivitvforwhichnoreporthadbeen
fled with FinCEN. All 1o met the legal requirement for a fling. The OCC conse-
quentlvrequiredmanagementtorefneitsprocessestoensurethatSARswereconsis-
tentlvfled.
ao
Darcv Parmer, a former qualitv assurance and fraud analvst at Wells Fargo, the
secondlargestmortgagelenderfromiooathroughioo¬andthelargestinioo8,told
theCommissionthat“hundredsandhundredsandhundredsoffraudcases”thatshe
knew were identifed within Wells Fargo’s home equitv loan division were not re-
portedtoFinCEN.And,sheadded,atleasthalftheloansshefaggedforfraudwere
neverthelessfunded,overherobjections.
a1
Despitetheunderreporting,thejumpinmortgagefrauddrewattention.FinCEN
inNovemberioooreportedaio-foldincreaseinSARsrelatedtomortgagefraudbe-
tween1oooandioo-.Itnotedthattwo-thirdsoftheloansbeingcreatedwereorigi-
nated bv mortgage brokers who were not subject to anv federal standard or
oversight.
ai
Sweckerunsuccessfullvaskedlegislatorstocompelalllenderstoforward
informationaboutcriminalfraudtoregulatorsandlawenforcementagencies.
a:
Sweckerattemptedtogainmorefundingtocombatmortgagefraudbutwasresis-
ted.SweckertoldtheFCIChisfundingrequestswerecutateitherthedirectorlevelat
theFBI,attheIusticeDepartment,orattheOmceofManagementandBudget.He
calledhisstruggleformoreresourcesan“uphillslog.”
aa
In ioo-, i-,o88 SARs related to mortgage fraud were fled; in iooo there were
:¬,a-¬.Thenumberkeptclimbing,to-i,8oiinioo¬,o-,ooainioo8,ando¬,-o¬in
iooo.
a-
Atthesametime,topFBIomcials,focusingonterroristthreats,reducedthe
agentsassignedtowhite-collarcrimefromi,:aiintheiooafscalveartofewerthan
i,ooobvioo¬.Thatvear,itsmortgagefraudprogramhadonlv1ioagentsatanvone
.(z ii N\Nti \i tii :i : i NuUi 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,todetectpropertvfipping.
ao
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
resourcesmavhavebeeninsumcient.“Iamnotgoingtotellvouthatthatisadequate
forwhatisoutthere,”hesaid.Inthewakeofthecrisis,theFBIiscontinuingtoinves-
tigatefraud,andMuellersuggestedthatsomeprosecutionsmavbestilltocome.

AlbertoGonzales,thenation’sattornevgeneralfromFebruarvioo-toSeptem-
ber ioo¬, told the Commission that while he might have done more on mortgage
fraud,inhindsighthebelievedthatotherissuesweremorepressing:“Idon’tthink
anvonecancrediblvarguethat[mortgagefraud]ismoreimportantthanthewaron
terror.Mortgagefrauddoesn’tinvolvetakinglossoflifesoitdoesn’trankabovethe
prioritvofprotectingneighborhoodsfromdangerousgangsorpredatorsattacking
ourchildren.”
a8
Inioo8,theOmceofFederalHousingEnterpriseOversight,theregulatorofthe
GSEs,releasedareportshowinga“signifcantriseintheincidenceoffraudinmort-
gagelendinginioooandthefrsthalfofioo¬.”OFHEOstatedithadbeenworking
closelvwithlawenforcementandwasanactivememberoftheDepartmentofIustice
MortgageFraudWorkingGroup.
ao
“Theconcernaboutmortgagefraudandfraudin
generalwasanissue,”RichardSpillenkothen,headofbankingsupervisionandregu-
lationattheFedfrom1oo1toiooo,toldtheFCIC.“Andweunderstoodtherewasan
increasingincidenceof[mortgagefraud].”
-o
Michael B. Mukasev, who served as U.S. attornev general from November ioo¬
totheendofioo8,toldtheCommissionthatherecalled“receivingreportsofmort-
gage failures and of there being fraudulent activitv in connection with fipping
houses,overvaluation,andthelike. . . .Ihaveadimrecollectionofoutsidepeople
commentingthatadditionalresourcesshouldbedevoted,andtherebeingspecula-
tionaboutwhetherresourcesthatwerebeingdivertedtonationalsecuritvinvestiga-
tions,andinparticulartheterrorisminvestigationsweresomehowimpedingfraud
investigations,whichIthoughtwasabogusissue.”Hesaidthatthedepartmenthad
otherpressingpriorities,suchasterrorism,gangviolence,andsouthwesternborder
issues.
-1
In letters to the FCIC, the Department of Iustice outlined actions it undertook
along with the FBI to combat mortgage fraud. For example, in iooa, the FBI
launched Operation Continued Action, targeting a varietv of fnancial crimes, in-
cludingmortgagefraud.Inthatsamevear,theagencvstartedtopublishanannual
mortgage fraud report. The following vear, the FBI and other federal agencies an-
nouncedajointeffortcombatingmortgagefraud.FromIulvtoOctoberioo-,this
program, Operation Ouick Flip, produced 1-o indictments, 81 arrests, and 8o
\ii i N .(.
convictionsformortgagefraud.Inioo¬,theFBIstartedspecifcallvtrackingmort-
gage fraud cases and increased personnel dedicated to those efforts. And in ioo8,
Operation Malicious Mortgage resulted in 1aa mortgage fraud cases in which aoo
defendantswerechargedbvU.S.Attornevsomcesthroughoutthecountrv.
-i
WilliamBlacktoldtheCommissionthatWashingtonessentiallvignoredtheissue
andallowedittoworsen.“TheFBIdidhaveseverelimits,”becauseoftheneedtore-
spondtotheo/11attacks,Blacksaid,andtheproblemwascompoundedbvthelack
of cooperation: “The terrible thing that happened was that the FBI got virtuallv no
assistance from the regulators, the banking regulators and the thrift regulators.”
-:
Swecker,theformerFBIomcial,toldtheCommissionhehadnocontactwithbank-
ingregulatorsduringhistenure.
-a
As mortgage fraud grew, state agencies took action. In Florida, Ellen Wilcox, a
specialagentwiththestateDepartmentofLawEnforcement,teamedwiththeTampa
policedepartmentandHillsboroughCountvConsumerProtectionAgencvtobring
downacriminalringscamminghomeownersintheTampaarea.Itskevmemberwas
OrsonBenn,aNewYork–basedvicepresidentofArgentMortgageCompanv,aunit
ofAmeriquest.Beginninginiooa,1oinvestigatorsandtwoprosecutorsworkedfor
vearstounravelanetworkofalliancesbetweenrealestatebrokers,appraisers,home
repaircontractors,titlecompanies,notaries,andaconvictedfeloninacasethatin-
volvedsome1:oloans.
--
According to charging documents in the case, the perpetrators would walk
throughneighborhoods,lookingforelderlvhomeownersthevthoughtwerelikelvto
havesubstantialequitvintheirhomes.Thevwouldsuggestrepairsorimprovements
tothehomes.Thehomeownerswouldflloutpaperwork,andinsiderswouldusethe
information to applv for loans in their names. Members of the ring would prepare
fraudulentloandocuments,includingfalseW-iforms,flledwithinformationabout
invented emplovment and falsifed salaries, and take out home equitv loans in the
homeowners’names.Eachpersoninvolvedinthetransactionwouldreceiveafeefor
hisorherrole;Benn,atArgent,receiveda·:,oookickbackforeachloanhehelped
secure.Whentheloanwasfunded,thecheckswerefrequentlvmadeouttothebogus
homeconstructioncompanvthathadproposedthework,whichwouldthendisap-
pear with the proceeds. Some of the homeowners never received a pennv from the
refnancingontheirhomes.HillsboroughCountvomcialslearnedofthescamwhen
homeownersapproachedthemtosavthatscheduledrepairshadneverbeenmadeto
theirhomes,andthensometimeslearnedthatthevhadlostvears’worthofequitvas
well. Sixteen of 18 defendants, including Benn, have been convicted or have pled
guiltv.
-o
Wilcox told the Commission that the “cost and length of these investigations
make them less attractive to most investigative agencies and prosecutors trving to
justifv their budgets based on investigative statistics.”

She said it has been hard to
followuponothercasesbecausesomanvofthesubprimelendershavegoneoutof
business, making it dimcult to track down perpetrators and witnesses. Ameriquest,
for example, collapsed in ioo¬, although Argent, and the companv’s loan-servicing
arm,wereboughtbvCitigroupthatsamevear.
.(. ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN iiiui1
DISCLOSURE AND DUE DILIGENCE:
“A QUALITY CONTROL ISSUE IN THE FACTORY”
Inadditiontotherisingfraudandegregiouslendingpractices,lendingstandardsde-
terioratedinthefnalvearsofthebubble.Aftergrowingforvears,Alt-Alendingin-
creasedanother-ºfromioo-toiooo.Inparticular,optionARMsgrew¬ºduring
thatperiod,interest-onlvmortgagesgrewoº,andno-documentationorlow-docu-
mentation loans (measured for borrowers with fxed-rate mortgages) grew 1aº.
Overall,bviooono-docorlow-docloansmadeupi¼ofallmortgagesoriginated.
Manvoftheseproductswouldperformonlvifpricescontinuedtoriseandthebor-
rowercouldrefnanceatalowrate.
-8
Intheorv,evervparticipantalongthesecuritizationpipelineshouldhavehadan
interestinthequalitvofevervunderlvingmortgage.Inpractice,theirinterestswere
oftennotaligned.TwoNewYorkFedeconomistshavepointedoutthe“sevendeadlv
frictions” in mortgage securitization—places along the pipeline where one partv
knewmorethantheother,creatingopportunitiestotakeadvantage.
-o
Forexample,
thelenderwhooriginatedthemortgageforsale,earningacommission,knewagreat
deal about the loan and the borrower but had no long-term stake in whether the
mortgage was paid, bevond the lender’s own business reputation. The securitizer
whopackagedmortgagesintomortgage-backedsecurities,similarlv,waslesslikelvto
retainastakeinthosesecurities.
In theorv, the rating agencies were important watchdogs over the securitization
process.Thevdescribedtheirroleasbeing“anumpireinthemarket.”
oo
Butthevdid
not review the qualitv of individual mortgages in a mortgage-backed securitv, nor
didthevchecktoseethatthemortgageswerewhatthesecuritizerssaidthevwere.
So the integritv of the market depended on two critical checks. First, frms pur-
chasingandsecuritizingthemortgageswouldconductduediligencereviewsofthe
mortgage pools, either using third-partv frms or doing the reviews in-house. Sec-
ond,followingSecuritiesandExchangeCommissionrules,partiesinthesecuritiza-
tionprocesswereexpectedtodisclosewhatthevweresellingtoinvestors.Neitherof
thesechecksperformedasthevshouldhave.
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, thev had more bargaining power over the
mortgagepurchasers,andsamplesweresometimesaslowasiºto:º.
o1
Somesecu-
ritizersrequestedthattheduediligencefrmanalvzearandomsampleofmortgages
fromthepool;othersaskedforasamplingofthosemostlikelvtobedefcientinsome
wav,inanefforttoemcientlvdetectmoreoftheproblemloans.
\ii i N .(,
ClavtonHoldings,aConnecticut-basedfrm,wasamajorproviderofthird-partv
duediligenceservices.
oi
AsClavtonVicePresidentVickiBealexplainedtotheFCIC,
frms like hers were “not retained bv [their] clients to provide an opinion as to
whether a loan is a good loan or a bad loan.” Rather, thev were hired to identifv,
among other things, whether the loans met the originator’s stated underwriting
guidelinesand,insomemeasure,toenableclientstonegotiatebetterpricesonpools
ofloans.
o:
Thereviewfellintothreegeneralareas:credit,compliance,andvaluation.Didthe
loans meet the underwriting guidelines (generallv the originator’s standards, some-
times with overlavs or additional guidelines provided bv the fnancial institutions
purchasing the loans): Did the loans complv with federal and state laws, notablv
predatorv-lendinglawsandtruth-in-lendingrequirements:Werethereportedprop-
ertv values accurate:
oa
And, criticallv: to the degree that a loan was defcient, did it
haveanv“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.
BecauseofthevolumeofloansexaminedbvClavtonduringthehousingboom,
thefrmhadauniqueinsideviewoftheunderwritingstandardsthatoriginatorswere
actuallvapplving—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,forthe18monthsthatendedIune:o,ioo¬,Clavtonrated-aºofthe
o11,o:oloansitanalvzedasGrade1,andanother18ºasGradei—foratotalof¬iº
thatmettheguidelinesoutrightorwithcompensatingfactors.Theremainingi8ºof
theloanswereGrade:.
o-
Intheorv,thebankscouldhaverefusedtobuvaloanpool,
or,indeed,thevcouldhaveusedthefndingsoftheduediligencefrmtoprobethe
loans’qualitvmoredeeplv.Overthe18-monthperiod,:oºoftheloansthatClavton
found to be defcient—Grade :—were “waived in” bv the banks. Thus 11º of the
loanssampledbvClavtonwereacceptedeventhoughthecompanvhadfoundabasis
forrejectingthem(seefgureo.1).
Referringtothedata,KeithIohnson,thepresidentofClavtonfromMavioooto
Maviooo,toldtheCommission,“That-aºtomesavsthere[was]aqualitvcontrol
issue in the factorv” for mortgage-backed securities.
oo
Iohnson concluded that his
clients often waived in loans to preserve their business relationship with the loan
originator—ahighnumberofrejectionsmightleadtheoriginatortoselltheloansto
a competitor. Simplv put, it was a sellers’ market. “Probablv the seller had more
powerthantheWallStreetissuer,”IohnsontoldtheFCIC.

Thehighrateofwaiversfollowingrejectionsmavnotitselfbeevidenceofsome-
thingwrongintheprocess,Bealtestifed.Shesaidthatasoriginators’lendingguide-
lines were declining, she saw the securitizing frms introduce additional credit
.(( ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN iiiui1
\ii i N .(,
guidelines.“Asvouknow,therewasstatedincome,thevweretellinguslookforrea-
sonablenessofthatincome,thingslikethat.”
o8
Withstricterguidelines,onewouldex-
pect more rejections, and, after the securitizer looks more closelv at the rejected
loans, possiblv more waivers. As Moodv’s Investors Service explained in a letter to
theFCIC,“Ahighrateofwaiversfromaninstitutionwithextremelvtightunderwrit-
ingstandardscouldresultinapoolthatislessriskvthanapoolwithnowaiversfrom
an institution with extremelv loose underwriting standards.”
oo
Nonetheless, manv
prospectuses indicated that the loans in the pools either met guidelines outright or
hadcompensatingfactors,eventhoughClavton’srecordsshowthatonlvaportionof
theloansweresampled,andthatofthosethatweresampled,asubstantialpercentage
ofGrade:Eventloanswerewaivedin.
Iohnsonsaidheapproachedtheratingagenciesinioooandioo¬togaugetheir
interest in the exception-tracking product that Clavton was developing. He said he
sharedsomeoftheircompanv’sresults,attemptingtoconvincetheagenciesthatthe
data would beneft the ratings process. “We went to the rating agencies and said,
‘Wouldn’t this information be great for vou to have as vou 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 o.+
risk:’” Iohnson recalled. The agencies thought the due diligence frm’s data were
“great,” but thev did not want the information, Iohnson said, because it would pre-
sumablvproducelowerratingsforthesecuritizationsandcosttheagencvbusiness—
eveninioo¬,astheprivatesecuritizationmarketwaswindingdown.
¬o
When securitizers did kick loans out of the pools, some originators simplv put
themintonewpools,presumablvinhopesthatthoseloanswouldnotbecapturedin
the next pool’s sampling. The examiner’s report for New Centurv Financial’s bank-
ruptcvdescribessuchapractice.
¬1
Similarlv,FremontInvestment&Loanhadapol-
icvofputtingloansintosubsequentpoolsuntilthevwerekickedoutthreetimes,the
companv’sformerregulatorvcomplianceandriskmanager,RogerEhrnman,toldthe
FCIC. As Iohnson described the practice to the FCIC, this was the “three strikes,
vou’reoutrule.”
¬i
Some mortgage securitizers did their own due diligence, but seemed to devote
onlvlimitedresourcestoit.AtMorganStanlev,theheadofduediligencewasbased
notinNewYorkbutratherinBocaRaton,Florida.Hehad,atanvonetime,twoto
fveindividualsreportingtohimdirectlv—andthevwereactuallvemploveesofaper-
sonnelconsultant,Equinox.
¬:
DeutscheBankandIPMorganlikewisealsohadonlv
smallduediligenceteams.
¬a
Banksdidnotnecessarilvhavebetterprocessesformonitoringthemortgagesthat
thev 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-
ductedqualitvassurancechecksontheloansboughtbvCitigroupfromanetworkof
lenders, including both subprime mortgages that Citigroup intended to hold and
primemortgagesthatitintendedtoselltoFannieMaeandFreddieMac.
Forsubprimepurchases,Bowen’steamwouldreviewthephvsicalcreditfleofthe
loansthevwerepurchasing.“Duringioooandioo¬,Iwitnessedmanvchangestothe
wav 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’schargewastosupervisethepurchaseofroughlv·-obil-
lion annuallv in prime loan pools, a high percentage of which were sold to Fannie
MaeandFreddieMacforsecuritization.ThesamplingprovidedtoBowen’sstafffor
qualitvcontrolwassupposedtoincludeatleast-ºoftheloanpoolforagivensecu-
ritization, but “this corporate mandate was usuallv ignored.” Samples of iº were
morelikelv,andtheloansamplesthatBowen’sgroupdidexamineshowedextremelv
highratesofnoncompliance.“AtthetimethatIbecameinvolved,whichwasearlvto
mid-iooo,weidentifedthataotooopercentofthefleseitherhada‘disagree’deci-
sion,orthevweremissingcriticaldocuments.”
¬o
Bowenrepeatedlvexpressedconcernstohisdirectsupervisorandcompanvexec-
utivesaboutthequalitvandunderwritingofmortgagesthatCitiMortgagepurchased
andthensoldtotheGSEs.Asdiscussedinalaterchapter,theGSEswouldlaterre-
.(· ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN iiiui1
quireCitigrouptobuvback·1.-billioninloansasofNovemberio1o,fndingthat
theloansCitigrouphadsoldthemdidnotconformtoGSEstandards.
SI(.“1/cclcj/entint/croomist/et
vcáián’trcvicvt/cjrosjcctussujjlcmcnts”
Bvthetimethefnancialcrisishit,investorsheldmorethan·itrillionofnon-GSE
mortgage-backed securities and close to ·¬oo billion of CDOs that held mortgage-
backed securities.
¬¬
These securities were issued with practicallv no SEC oversight.
And onlv a minoritv were subject to the SEC’s ongoing public reporting require-
ments. The SEC’s mandate is to protect investors—generallv not bv reviewing the
qualitv of securities, but simplv bv ensuring adequate disclosures so that investors
canmakeuptheirownminds.Inthecaseofinitialpublicofferingsofacompanv’s
shares,theworkhashistoricallvinvolvedalengthvreviewoftheissuer’sprospectus
andother“offeringmaterials”priortosale.
¬8
However,withtheadventof“shelfregistration,”amethodofregisteringsecurities
onanongoingbasis,theprocessbecamemuchquickerformortgage-backedsecuri-
tiesrankedinthehighestgradesbvtheratingagencies.Theprocessallowedissuers
tofleabaseprospectuswiththeSEC,givinginvestorsnoticethattheissuerintended
tooffersecuritiesinthefuture.Theissuerthenfledasupplementalprospectusde-
scribingeachoffering’sterms.“Theelephantintheroomisthatwedidn’treviewthe
prospectussupplements,”theSEC’sdeputvdirectorfordisclosureincorporationf-
nance, Shellev Parratt, told the FCIC.
¬o
To improve disclosures pertaining to mort-
gage-backedsecuritiesandotherasset-backedsecurities,theSECissuedRegulation
ABinlateiooa.Theregulationrequiredthatevervprospectusinclude“adescription
ofthesolicitation,credit-grantingorunderwritingcriteriausedtooriginateorpur-
chase the pool assets, including, to the extent known, anv changes in such criteria
andtheextenttowhichsuchpoliciesandcriteriaareorcouldbeoverridden.”
8o
Withessentiallvnorevieworoversight,howgoodweredisclosuresaboutmort-
gage-backed securities: Prospectuses usuallv included disclaimers to the effect that
not all mortgages would complv with the lending policies of the originator: “On a
case-bv-case basis [the originator] mav determine that, based upon compensating
factors, a prospective mortgage not strictlv qualifving under the underwriting risk
categorvorotherguidelinesdescribedbelowwarrantsanunderwritingexception.”
81
Thedisclosuretvpicallvhadasentencestatingthat“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 qualitv of the fles thev
werepurchasing.”
8:
Such disclosures were insumcient for investors to know what criteria the mort-
gages thev were buving actuallv did meet. Onlv a small portion—as little as iº to
:º—oftheloansinanvdealweresampled,andevidencefromClavtonshowsthata
signifcantnumberdidnotmeetstatedguidelinesorhavecompensatingfactors.
8a
On
\ii i N .(+
theloansintheremainderofthemortgagepoolthatwerenotsampled(asmuchas
o¼),Clavtonandthesecuritizershadnoinformation,butonecouldreasonablvex-
pectthemtohavemanvofthesamedefciencies,andatthesamerate,asthesampled
loans.Prospectusesfortheultimateinvestorsinthemortgage-backedsecuritiesdid
notcontainthisinformation,orinformationonhowfewloanswerereviewed,raising
the question of whether the disclosures were materiallv misleading, in violation of
thesecuritieslaws.
CDOswereissuedunderadifferentregulatorvframeworkfromtheonethatap-
pliedtomanvmortgage-backedsecurities,andwerenotsubjecteventotheminimal
shelf registration rules. Underwriters tvpicallv issued CDOs under the SEC’s Rule
1aaA,whichallowstheunregisteredresaleofcertainsecuritiestoso-calledqualifed
institutionalbuvers(OIBs);theseincludedinvestorsasdiverseasinsurancecompa-
nies like MetLife, pension funds like the California State Teachers’ Retirement Svs-
tem,andinvestmentbankslikeGoldmanSachs.
8-
TheSECcreatedRule1aaAin1ooo,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.Thenewrulesignifcantlvexpandedthemar-
ketforthesesecuritiesbvdeclaringthatdistributionswhichcompliedwiththerule
wouldnolongerbeconsidered“publicofferings”andthereforewouldnotbesubject
totheSEC’sregistrationrequirements.In1ooo,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
marketdevelopedquicklvunderRule1aaA.Thismarketwasliquid,sincequalifed
investorscouldfreelvtradeRule1aaAdebtsecurities.ButdebtsecuritieswhenRule
1aaAwasenactedweremostlvcorporatebonds,vervdifferentfromtheCDOsthat
dominatedtheprivateplacementmarketmorethanadecadelater.

Afterthecrisisunfolded,investors,arguingthatdisclosurehadn’tbeenadequate,
flednumerouslawsuitsunderfederalandstatesecuritieslaws.Aswewillsee,some
havealreadvresultedinsubstantialsettlements.
REGULATORS: “MARKETS WILL ALWAYS SELFCORRECT”
Where were the regulators: Declining underwriting standards and new mortgage
productshadbeenonregulators’radarscreensinthevearsbeforethecrisis,butdis-
agreementsamongtheagenciesandtheirtraditionalpreferenceforminimalinterfer-
encedelavedaction.
Supervisors had, since the 1ooos, followed a “risk-focused” approach that relied
extensivelv on banks’ own internal risk management svstems.
88
“As internal svstems
improve,thebasicthrustoftheexaminationprocessshouldshiftfromlargelvdupli-
.,+ ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN iiiui1
cating manv activities alreadv conducted within the bank to providing constructive
feedbackthatthebankcanusetoenhancefurtherthequalitvofitsrisk-management
svstems,”ChairmanGreenspanhadsaidin1ooo.
8o
Acrossagencies,therewasa“his-
toric vision, historic approach, that a lighter hand at regulation was the appropriate
wavtoregulate,”EugeneLudwig,comptrollerofthecurrencvfrom1oo:to1oo8,told
theFCIC,referringtotheGramm-Leach-BlilevActin1ooo.
oo
TheNewYorkFed,ina
“lessons-learned”analvsisafterthecrisis,pointedtothemistakenbeliefthat“markets
willalwavsself-correct.”“Adeferencetotheself-correctingpropertvofmarketsinhib-
itedsupervisorsfromimposingprescriptiveviewsonbanks,”thereportconcluded.
o1
Therelianceonbanks’ownriskmanagementwouldextendtocapitalstandards.
Bankshadcomplainedforvearsthattheoriginal1o88Baselstandardsdidnotallow
themsumcientlatitudetobasetheircapitalontheriskinessofparticularassets.After
vearsofnegotiations,internationalregulators,withstrongsupportfromtheFed,in-
troducedtheBaselIIcapitalregimeinIuneiooa,whichwouldallowbankstolower
theircapitalchargesifthevcouldshowthevhadsophisticatedinternalmodelsfores-
timatingtheriskinessoftheirassets.WhilenoU.S.bankfullvimplementedthemore
sophisticatedapproachesthatitallowed,BaselIIrefectedandreinforcedthesuper-
visors’ risk-focused approach. Spillenkothen said that one of the regulators’ biggest
mistakeswastheir“acceptanceofBaselIIpremises,”whichhedescribedasdisplav-
ing“anexcessivefaithininternalbankriskmodels,aninfatuationwiththespecious
accuracvofcomplexquantitativeriskmeasurementtechniques,andawillingness(at
leastintheearlvdavsofBaselII)totolerateareductioninregulatorvcapitalinre-
turnfortheprospectofbetterriskmanagementandgreaterrisk-sensitivitv.”
oi
Regulatorshadbeentakingnoticeofthemortgagemarketforseveralvearsbefore
the crisis. As earlv as iooa, thev recognized that mortgage products and borrowers
had changed during and following the refnancing boom of the previous vear, and
thevbeganworkonprovidingguidancetobanksandthrifts.Buttoolittlewasdone,
and too late, because of interagencv discord, industrv pushback, and a widelv held
viewthatmarketparticipantshadthesituationwellinhand.
“Withintheboard,peopleunderstoodthatmanvoftheseloantvpeshadgottento
anextreme,”SusanBies,thenaFedgovernorandchairoftheFederalReserveBoard’s
subcommitteesonbothsafetvandsoundnesssupervisionandconsumerprotection
supervision, told the FCIC. “So the main debate within the board was how tightlv
[shouldwe]reinintheabusesthatwewereseeing.Soitwasmoreof‘toadegree.’”
o:
Indeed, in the same Iune 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 manv lenders had “inadequate information on
borrowers,”adding,however,thatrecordproftsandhighcapitallevelsallavedthose
concerns.Afourthparticipantsaidthat“wecouldbeseeingthefnalgaspsofhouse
priceappreciation.”Theparticipantexpressedconcernabout“creativefnancing”and
was“worriedthatpiggvbacksandothernon-traditionalloans,”whoseriskofdefault
\ii i N .,.
couldbehigherthansuggestedbvthesecuritiesthevbacked,“couldbemakingthe
booksofGSEslookbetterthanthevreallvwere.”FedstaffrepliedthattheGSEswere
notlargepurchasersofprivatelabelsecurities.
oa
In the spring of iooo, the FOMC would again discuss risks in the housing and
mortgage markets and express nervousness about the growing “ingenuitv” of the
mortgagesector.Oneparticipantnotedthatnegativeamortizationloanshadtheper-
niciouseffectofstrippingequitvandwealthfromhomeownersandraisedconcerns
about nontraditional lending practices that seemed based on the presumption of
continuedincreasesinhomeprices.
IohnSnow,thentreasurvsecretarv,toldtheFCICthathecalledameetinginlate
iooa or earlv ioo- to urge regulators to address the proliferation of poor lending
practices.Hesaidhewasstruckthatregulatorstendednottoseeaproblemattheir
owninstitutions.“Nobodvhadafull:oo-degreeview.Thebasicreactionfromfnan-
cial regulators was, ‘Well, there mav be a problem. But it’s not in mv feld of view,’”
SnowtoldtheFCIC.RegulatorsrespondedtoSnow’squestionsbvsaving,“Ourde-
fault rates are verv low. Our institutions are verv well capitalized. Our institutions
[have]vervlowdelinquencies.Sowedon’tseeanvrealbigproblem.”
o-
InMavioo-,thebankingagenciesdidissueguidanceontherisksofhomeequitv
linesofcreditandhomeequitvloans.Itcautionedfnancialinstitutionsaboutcreditrisk
management practices, pointing to interest-onlv features, low- or no-documentation
loans,highloan-to-valueanddebt-to-incomeratios,lowercreditscores,greateruseof
automatedvaluationmodels,andtheincreaseintransactionsgeneratedthroughaloan
broker or other third partv. While this guidance identifed manv of the problematic
lendingpracticesengagedinbvbanklenders,itwaslimitedtohomeequitvloans.Itdid
notapplvtofrstmortgages.
oo
In ioo-, examiners from the Fed and other agencies conducted a confdential
“peer group” studv 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 supervisorv
purview—Bank of America, Citigroup, Countrvwide, National Citv, and Wells
Fargo—aswellasthelargestthrift,WashingtonMutual.

Thestudv“showedaverv
rapid increase in the volume of these irresponsible loans, verv riskv loans,” Sabeth
Siddique,thenheadofcreditriskattheFederalReserveBoard’sDivisionofBanking
SupervisionandRegulation,toldtheFCIC.
o8
Alargepercentageoftheirloansissued
weresubprimeandAlt-Amortgages,andtheunderwritingstandardsfortheseprod-
uctshaddeteriorated.
oo
Once the Fed and other supervisors had identifed the mortgage problems, thev
agreedtoexpressthoseconcernstotheindustrvintheformofnonbindingguidance.
“TherewasamongtheBoardofGovernorsfolks,vouknow,somewhofeltthatifwe
justputoutguidance,thebankswouldgetthemessage,”Biessaid.
1oo
The federal agencies therefore drafted guidance on nontraditional mortgages
suchasoptionARMs,issuingitforpubliccommentinlateioo-.Thedraftguidance
directedlenderstoconsideraborrower’sabilitvtomaketheloanpavmentwhenrates
.,z ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN iiiui1
adjusted, rather than just the lower starting rate. It warned lenders that low-
documentationloansshouldbe“usedwithcaution.”
1o1
Immediatelv, the industrv was up in arms. The American Bankers Association
saidtheguidance“overstate[d]theriskofnon-traditionalmortgages.”
1oi
Othermar-
ketparticipantscomplainedthattheguidancerequiredthemtoassume“aworstcase
scenario,”thatis,thescenarioinwhichborrowerswouldhavetomakethefullpav-
ment when rates adjusted.
1o:
Thev disputed the warning on low-documentation
loans, maintaining that “almost anv form of documentation can be appropriate.”
1oa
Thevdeniedthatbetterdisclosureswererequiredtoprotectborrowersfromtherisks
ofnontraditionalmortgages,arguingthatthevwere“notawareofanvempiricalevi-
dencethatsupportstheneedforfurtherconsumerprotectionstandards.”
1o-
The need for guidance was controversial within the agencies, too. “We got
tremendouspushbackfromtheindustrvaswellasCongressaswellas,vouknow,in-
ternallv,”theFed’sSiddiquetoldtheFCIC.“Becauseitwasstifinginnovation,poten-
tiallv,anditwasdenvingtheAmericandreamtomanvpeople.”
1oo
The pressures to weaken and delav the guidance were strong and came from
manvsources.OppositionbvtheOmceofThriftSupervisionhelpeddelavthemort-
gageguidanceforalmostavear.
1o¬
Biessaid,“Therewassomerealconcernaboutif
theFedtighteneddownon[thebanksitregulated],whetherthatwouldcreateanun-
levelplavingfeld . . .[for]stand-alonemortgagelenderswhomthe[Fed]didnotreg-
ulate.” Another challenge to regulating the mortgage market was Congress. She
recalledanoccasionwhenshetestifedaboutaproposedruleand“membersofCon-
gress[said]thatweweregoingtodenvthedreamofhomeownershiptoAmericansif
weputthisnewstrongerstandardinplace.”
1o8
When guidance was put in place in iooo, regulators policed their guidance
throughbankexaminationsandinformalmeasuressuchas“voluntarvagreements”
withsupervisedinstitutions.
It also appeared some institutions switched regulators in search of more lenient
treatment.InDecemberiooo,CountrvwideappliedtoswitchregulatorsfromtheFed
and OCC to the OTS. Countrvwide’s move came after several months of evaluation
within the companv about the benefts of OTS regulation, manv of which were pro-
motedbvtheOTSitselfoverthecourseofan“outreacheffort”initiatedinmid-ioo-
afterIohnReichbecamedirectoroftheagencv.Publiclv,Countrvwidestatedthatthe
decisiontoswitchtotheOTSwasdrivenbvthedesiretohaveone,housing-focused
regulator,ratherthanseparateregulatorsforthebankandtheholdingcompanv.
1oo
However,otherfactorscameintoplavaswell.TheOCC’stopCountrvwideexam-
iner told the FCIC that Countrvwide CEO Angelo Mozilo and President and COO
DavidSambolthoughttheOCC’spositiononpropertvappraisalswouldbe“killing
thebusiness.”
11o
AninternalIulvioooCountrvwidebriefngpapernoted,“TheOTS
regulationofholdingcompaniesisnotasintrusiveasthatoftheFederalReserve. In
particular,theOTSrarelvconductsextensiveonsiteexaminationsandwhenthevdo
conduct an onsite examination thev are generallv not considered intrusive to the
holdingcompanv.”Thebriefngpaperalsonoted,“TheOTSgenerallvisconsidereda
\ii i N .,.
less sophisticated regulator than the Federal Reserve.”
111
In August iooo, Mozilo
wrotetomembersofhisexecutiveteam,“ItappearsthattheFedisnowtroubledbv
pavoptionswhiletheOTSisnot. Sincepavoptionsareamajorcomponentofboth
our volumes and proftabilitv the Fed mav force us into a decision faster than we
wouldlike.”CountrvwideChiefRiskOmcerIohnMcMurravrespondedthat“based
on mv meetings with the FRB and OTS, the OTS appears to be both more familiar
andmorecomfortablewithOptionARMs.”
11i
The OTS approved Countrvwide’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(tvpicallvloanstobelow-investment-
gradecompaniestoaidtheirbusinessortofnancebuvouts)alsoexperiencedsimilar
bubble-and-bustdvnamics,althoughtheeffectswerenotaslargeanddamagingasin
residential real estate. From iooo to ioo¬, these other two markets grew tremen-
douslv, spurred bv structured fnance products—commercial mortgage–backed se-
curities and collateralized loan obligations (CLOs), respectivelv—which were in
manvwavssimilartoresidentialmortgage-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 bv the
developmentofnewcreditderivativesproducts.
11a
Historicallv, leveraged loans had been made bv commercial banks; but a market
forinstitutionalinvestorsdevelopedandgrewinthemid-tolate1ooos.
11-
An“agent”
bankwouldoriginateapackageofloanstoonlvonecompanvandthensellorsvndi-
catetheloansinthepackagetootherbanksandlargenonbankinvestors.Thepack-
agegenerallvincludedloanswithdifferentmaturities.Somewereshort-termlinesof
credit, which would be svndicated to banks; the rest were longer-term loans svndi-
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. Bv ioo¬, the longer-term leveraged loans
roseto·:8¬billion,upfrom·aobillioniniooo.
11o
Startingin1oo8,thelonger-termleveragedloanswerepackagedinCLOs,which
wereratedaccordingtomethodologiessimilartothosetheratingagenciesusedfor
CDOs.LikeCDOs,CLOshadtranches,underwriters,andcollateralmanagers.The
marketwaslessthan·-billionannuallvfrom1oo8toiooi,butthenitstartedgrow-
ing dramaticallv. Annual issuance exceeded ·ao 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:hadpaidinterestofapercentagepointsoveraninterbanklendingratewere
.,. ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN iiiui1
refnanced in earlv ioo¬ into loans paving just i percentage points over that same
rate.Duringthepeakoftherecentleveragedbuvoutboom,leveragedloanswerefre-
quentlv issued with interest-onlv, “pavment-in-kind,” and “covenant-lite” terms.
118
Pavment-in-kind loans allowed borrowers to defer paving interest bv issuing new
debt to cover accrued interest. Covenant-lite loans exempted borrowers from stan-
dard loan covenants that usuallv require corporate frms to limit their other debts
andtomaintainminimumlevelsofcash.Privateequitvfrms,thosethatspecialized
ininvestingdirectlvincompanies,founditeasierandcheapertofnancetheirlever-
agedbuvouts.Iustashomepricesrose,sotoodidthepricesofthetargetcompanies.
Oneofthelargestdealsevermadeinvolvingleveragedloanswasannouncedon
Aprili,ioo¬,bvKKR,aprivateequitvfrm.KKRsaiditintendedtopurchaseFirst
DataCorporation,aprocessorofelectronicdataincludingcreditanddebitcardpav-
ments,forabout·iobillion.Aspartofthistransaction,KKRwouldissue·8billion
injunkbondsandtakeoutanother·1-billioninleveragedloansfromaconsortium
of banks including Citigroup, Deutsche Bank, Goldman Sachs, HSBC Securities,
LehmanBrothers,andMerrillLvnch.
11o
AslateasIulvioo¬,Citigroupandotherswerestillincreasingtheirleveragedloan
business.
1io
CitigroupCEOCharlesPrincethensaidofthebusiness,“Whenthemu-
sicstops,intermsofliquiditv,thingswillbecomplicated.Butaslongasthemusicis
plaving,vou’vegottogetupanddance.We’restilldancing.”Princelaterexplainedto
theFCIC,“Atthatpointintime,becauseinterestrateshadbeensolowforsolong,
theprivateequitvfrmsweredrivingvervhardbargainswiththebanks.Andatthat
point in time the banks individuallv had no credibilitv to stop participating in this
lending business. It was not credible for one institution to unilaterallv back awav
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 roughlv ·:oo billion in outstanding commitments for new loans; as de-
mandinthesecondarvmarketdriedup,theseloansendeduponthebanks’balance
sheets.
1ii
Commercial real estate—multifamilv apartment buildings, omce buildings, ho-
tels,retailestablishments,andindustrialproperties—wentthroughabubblesimilar
to that in the housing market. Investment banks created commercial mortgage–
backedsecuritiesandevenCDOsoutofcommercialrealestateloans,justasthevdid
withresidentialmortgages.And,justashousesappreciatedfromioooon,sotoodid
commercial real estate values. Omce prices rose bv nearlv ooº between ioo: and
ioo8inthecentralbusinessdistrictsofthe:imarketsforwhichdataareavailable.
Theincreasewas1o:ºinPhoenix,1-:ºinTampa,1a¬ºinManhattan,and1aoºin
LosAngeles.
1i:
Issuanceofcommercialmortgage–backedsecuritiesrosefrom·a¬billioniniooo
to·1oobillioninioo-,reaching·i:obillioninioo¬.Whensecuritizationmarkets
contracted, issuance fell to ·1i billion in ioo8 and ·: billion in iooo. When about
\ii i N .,,
one-fourthofcommercialrealestatemortgagesweresecuritizedinioo¬,securitizers
issued·a1billionofcommercialmortgageCDOs,anumberthatagaindroppedpre-
cipitouslvinioo8.
1ia
Leveraged loans and the commercial real estate sector came together on Iulv :,
ioo¬, when the Blackstone Group announced its plan to buv Hilton—a hotel chain
withi,oooproperties—for·iobillion,aaoºpremiumovertheshareprice.Avear
later,oneauthordescribedthisdealas“theapogeeoftheearlv-millennialmegabuv-
outfrenzv,wherecheapandreadilvavailablecredit,coupledwitharelentlessone-up-
manship, spurred private equitv frms to buv out companies at often absurd
overvaluations, saddle them with massive debt, and then pav themselves heftv fees
forthetrouble.”
1i-
Twentvbilliondollarsinfnancingcamefromthetopfveinvest-
ment banks and large commercial banks such as Bank of America and Deutsche
Bank.
1io
BearStearnswasincreasinglvactiveinthesemarkets.WhileBeartoppedtheiooo
marketinresidentialsecuritizations,itrankedinthebottomhalfincommercialse-
curitizations.
1i¬
Butitwasracingtocatchup,andinaioo¬presentationboasted:“In
iooo,wefrmlvestablishedBearStearnsasaglobalpresenceincommercialreales-
tatefnance.”Thefrm’scommercialrealestatemortgageoriginationsmorethandou-
bledbetweeniooaandiooo.
1i8
Andthenthemarketcamecrashingtoahalt.Althoughthecommercialrealestate
mortgagemarketwasmuchsmallerthantheresidentialrealestatemarket—inioo8,
commercialrealestatedebtwaslessthan·atrillion,comparedto·1itrillionforres-
identialmortgages
1io
—itdeclinedevenmoresteeplv. Fromitspeak,commercialreal
estatefellroughlva-ºinvalue,andpriceshaveremainedclosetotheirlows.Losses
on commercial real estate would be an issue across Wall Street, particularlv for
LehmanandBear.Andpotentiallvforthetaxpaver.WhentheFederalReservewould
assume·:obillionofBear’silliquidassetsinioo8,thatwouldincluderoughlv·abil-
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¬,whencommercialrealestatealreadvmadeupo.:ºofitsas-
sets,LehmanBrothersacquiredamajorstakeinArchstoneSmith,apubliclvtraded
real estate investment trust, for ·-.a billion. Archstone owned more than 88,ooo
apartments,includingunitsstillunderconstruction,inover:aocommunitiesinthe
UnitedStates.Itwasthebank’slargestcommercialrealestateinvestment.
1:1
LehmaninitiallvprojectedthatArchstonewouldgeneratemorethan·1.:billion
inproftsover1ovears—projectionsbasedonoptimisticassumptions,giventhestate
of the market at that point. Both Lehman and Archstone were highlv leveraged:
Archstonehadlittlecushionifitsrentreceiptsshouldgodown,andLehmanhadlit-
tlecushionifinvestmentssuchasArchstoneshouldlosevalue.
1:i
Althoughthefrm
.,( ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN iiiui1
had proclaimed that “Risk Management is at the verv core of Lehman’s business
model,”theExecutiveCommitteesimplvleftitsriskomcer,MadelvnAntoncic,outof
theloopwhenitmadethisinvestment.
1::
Since the late 1ooos, Lehman had also built a large mortgage origination arm, a
formidable securities issuance business, and a powerful underwriting division as
well.Then,initsMarchiooo“GlobalStrategvOffsite,”CEORichardFuldandother
executives explained to their colleagues a new move toward an aggressive growth
strategv, including greater risk and more leverage. Thev described the change as a
shift from a “moving” or securitization business to a “storage” business, in which
Lehmanwouldmakeandholdlonger-terminvestments.
1:a
Bv summer iooo, the housing market faced ballooning inventories, sharplv re-
ducedsalesvolumes,andwaveringprices.Seniormanagementregularlvdisregarded
thefrm’sriskpoliciesandlimits—andwarningsfromriskmanagers—andpursued
its“countercvclicalgrowthstrategv.”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’sundoingavearlater.
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—factsnotedalmostmonthlvinomcialSECreports
obtainedbvtheFCIC.
1:¬
Nonetheless,ErikSirri,wholedtheSEC’ssupervisionpro-
gram, told the FCIC that it would not have mattered if the agencv had fullv recog-
nized the risks associated with commercial real estate. To avoid serious losses, Sirri
maintained,Lehmanwouldhavehadtostartsellingrealestateassetsiniooo.
1:8
In-
stead,itkeptbuving,wellintothefrstquarterofioo8.
Inaddition,accordingtothebankruptcvexaminer,Lehmanunderstateditslever-
age through “Repo 1o-” transactions—an accounting maneuver to temporarilv re-
move assets from the balance sheet before each reporting period. Martin Kellv,
Lehman’s global fnancial controller, stated that the transactions had “no sub-
stance”—their“onlvpurposeormotive . . .wasreductioninthebalancesheet.”Other
LehmanexecutivesdescribedRepo1o-transactionsasan“accountinggimmick”and
a“lazvwavofmanagingthebalancesheetasopposedtolegitimatelvmeetingbalance
sheet targets at quarter-end.” Bart McDade, who became Lehman’s president and
chief operating omcer in Iune ioo8, in an email called Repo 1o- transactions “an-
otherdrugweRon.”
1:o
Ernst&Young(E&Y),Lehman’sauditor,wasawareoftheRepo1o-practicebut
did not question Lehman’s failure to publiclv disclose it, despite being informed in
Mavioo8bvLehmanSeniorVicePresidentMatthewLeethatthepracticewasim-
proper. The Lehman bankruptcv examiner concluded that E&Y took “virtuallv no
\ii i N .,,
actiontoinvestigatetheRepo1o-allegations, . . .tooknostepstoquestionorchal-
lengethenon-disclosurebvLehman,”andthat“colorableclaimsexistthatE&Ydid
not meet professional standards, both in investigating Lee’s allegations and in con-
nectionwithitsauditandreviewofLehman’sfnancialstatements.”
1ao
NewYorkAt-
tornev General Andrew Cuomo sued E&Y in December io1o, accusing the frm of
facilitating a “massive accounting fraud” bv helping Lehman to deceive the public
aboutitsfnancialcondition.
1a1
TheOmceofThriftSupervisionhadalsoregulatedLehmansince1ooothrough
its jurisdiction over Lehman’s thrift subsidiarv. Although “the SEC was regarded as
theprimarvregulator,”theOTSexaminertoldtheFCIC,“weinnowavjustassumed
that[theSEC]woulddotherightthing,soweregulatedandsupervisedtheholding
companv.”
1ai
Still, not until Iulv ioo8—just a few months before Lehman failed—
wouldtheOTSissueareportwarningthatLehmanhadmadean“outsizedbet”on
commercial real estate—larger than that bv its peer frms, despite Lehman’s smaller
size;thatLehmanwas“materiallvoverexposed”tothecommercialrealestatesector;
andthatLehmanhad“majorfailingsinitsriskmanagementprocess.”
1a:
FANNIE MAE AND FREDDIE MAC: “TWO STARK CHOICES”
In ioo-, while Countrvwide, Citigroup, Lehman, and manv others in the mortgage
and CDO businesses were going into overdrive, executives at the two behemoth
GSEs, Fannie and Freddie, worried thev were being left behind. One sign of the
times: Fannie’s biggest source of mortgages, Countrvwide, expanded—that is, loos-
ened—its underwriting criteria, and Fannie would not buv the new mortgages,
CountrvwidePresidentandCOOSamboltoldtheFCIC.
1aa
Tvpicalofthemarketasa
whole,Countrvwidesold¬iºofitsloanstoFannieinioo:butonlva-ºiniooaand
:iºinioo-.
1a-
“The risk in the environment has accelerated dramaticallv,” Thomas Lund, Fan-
nie’sheadofsingle-familvlending,toldfellowsenioromcersatastrategicplanning
meetingonIunei¬,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]aggressiverisklavering.”
1ao
“Wefacetwostarkchoices:stavthecourse[or]meetthemarketwherethemarket
is,”Lundsaid.IfFannieMaestavedthecourse,itwouldmaintainitscreditdiscipline,
protect the qualitv of its book, preserve capital, and intensifv the companv’s public
voiceonconcerns.However,itwouldalsofacelowervolumesandrevenues,contin-
ueddeclinesinmarketshare,lowerearnings,andaweakeningofkevcustomerrela-
tionships.
1a¬
It was simplv a matter of relevance, former CEO Dan Mudd told the
FCIC:“Ifvou’renotrelevant,vou’reunproftable,andvou’renotservingthemission.
Andtherewasdangertoproftabilitv.I’mspeakingmorelongtermthaninanvgiven
quarteroranvgivenvear.Sothiswasarealstrategicrethinking.”
1a8
Lund saw signifcant obstacles to meeting the market. He noted Fannie’s lack of
capabilitvandinfrastructuretostructurethetvpesofriskiermortgage-backedsecu-
.,· ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN iiiui1
ritiesofferedbvWallStreet,itsunfamiliaritvwiththenewcreditrisks,worriesthat
thepriceofthemortgageswouldn’tbeworththerisk,andregulatorvconcernssur-
roundingcertainproducts.
1ao
Atthisandothermeetings,Lundrecommendedstudv-
ingwhetherthecurrentmarketchangeswerecvclicalormorepermanent,buthealso
recommended that Fannie “dedicate signifcant resources to develop capabilities to
competeinanvmortgageenvironment.”
1-o
Citibankexecutivesalsomadeapresenta-
tion to Fannie’s board in Iulv ioo-, warning that Fannie was increasinglv at risk of
beingmarginalized,andthat“stavthecourse”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.Overthenexttwovears,
CitibankwouldincreaseitssalestoFanniebvmorethanaquarter,to·-obillionin
theioo¬fscalvear,whilemorethantriplingitssalesofinterest-onlvmortgages,to
·abillion.
1-i
LundtoldtheFCICthatinioo-,theboardwouldadopthisrecommendation:for
thetimebeing,Fanniewould“stavthecourse,”whiledevelopingcapabilitiestocom-
pete with Wall Street in nonprime mortgages.
1-:
In fact, however, internal reports
showthatbvSeptemberioo-,thecompanvhadalreadvbeguntoincreaseitsacquisi-
tionsofriskierloans.Bvtheendofioo-,itsAlt-Aloanswere·181billion,upfrom
·1a¬billioniniooaand·1:8billioninioo:;itsloanswithoutfulldocumentation
were·i¬8billion,upfrom·ioobillioninioo:;anditsinterest-onlvmortgageswere
·¬-billioninioo-,upfrom·1ibillioninioo:.(Notethatthesecategoriescanover-
lap.Forexample,Alt-Aloansmavalsolackfulldocumentation.)Tocoverpotential
lossesfromallofitsbusinessactivities,Fanniehadatotalof·aobillionincapitalat
theendofioo-.“Planstomeetmarketsharetargetsresultedinstrategiestoincrease
purchases of higher risk products, creating a confict between prudent credit risk
management and corporate business objectives,” the Federal Housing Finance
Agencv(thesuccessortotheOmceofFederalHousingEnterpriseOversight)would
write in September ioo8 on the eve of the government takeover of Fannie Mae.
“Sinceioo-,FannieMaehasgrownitsAlt-Aportfolioandotherhigherriskproducts
rapidlvwithoutadequatecontrolsinplace.”
1-a
Initsfnancialstatements,FannieMae’sdisclosuresaboutkevloancharacteristics
changedovertime,makingitdimculttodiscernthecompanv’sexposuretosubprime
andAlt-Amortgages.Forexample,fromioo-untilioo¬,thecompanv’sdefnitionof
a“subprime”loanwasoneoriginatedbvacompanvorapartofacompanvthatspe-
cialized in subprime loans. Using that defnition, Fannie Mae stated that subprime
loansaccountedforlessthan1ºofitsbusinessvolumeduringthosevearsevenwhile
it reported that -º of its conventional, single-familv loans in ioo-, iooo and ioo¬
loansweretoborrowerswithFICOscoreslessthanoio.
1--
Similarlv, Freddie had enlarged its portfolios quicklv with limited capital.
1-o
In
ioo-,CEORichardSvronfredDavidAndrukonis,Freddie’slongtimechiefriskom-
cer. Svron 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
repeatedlv made the case for increasing capital to compensate for the increasing
risk,
1-8
althoughDonaldBisenius,Freddie’sexecutivevicepresidentforsingle-familv
housing,toldFCICstaffthathedidnotrecallsuchdiscussions.
1-o
Svronnevermade
Saksenapartoftheseniormanagementteam.
1oo
OFHEO,theGSEs’regulator,notedtheirincreasingpurchasesofriskierloansand
securities in everv examination report. But OFHEO never told the GSEs to stop.
Rather,vearaftervear,theregulatorsaidthatbothcompanieshadadequatecapital,
strongassetqualitv,prudentcreditriskmanagement,andqualifedandactiveomcers
anddirectors.
InMaviooo,atthesametimeasitpaida·aoomillionpenaltvrelatedtodefcien-
ciesinitsaccountingpractices,Fannieagreedtolimititson-balance-sheetmortgage
portfolioto·¬i8billion,thelevelonDecember:1,ioo-.
1o1
Twomonthslater,Fred-
die agreed to limit the growth of its portfolio to iº per vear.
1oi
In examination re-
ports for the vear ioo-, issued to both companies in Mav iooo, OFHEO noted the
growthinpurchasesofriskvloansandnon-GSEsecuritiesbutconcludedthateach
GSEhad“strong”assetqualitvandwasadequatelvcapitalized.OFHEOreportedthat
management at Freddie was committed to resolving weaknesses and its Board was
“qualifedandactive.”Theioo-examinationofFanniewaslimitedinscope—focus-
ing primarilv on the companv’s efforts to fx accounting and internal control def-
ciencies—becauseoftheextensiveresourcesneededtocompleteathree-vearspecial
examinationinitiatedinthewakeofFannie’saccountingscandal.
1o:
Inthatspecialexamination,OFHEOpinnedmanvoftheGSEs’problemsontheir
corporatecultures.ItsMaviooospecialexaminationreportonFannieMaedetailedthe
“arrogant and unethical corporate culture where Fannie Mae emplovees manipulated
accountingandearningstotriggerbonusesforseniorexecutivesfrom1oo8toiooa.”
1oa
OFHEODirectorIamesLockhart(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,
“Theoldpoliticalrealitv[atFannie]wasthatwealwavswon,wetooknoprisoners . . .
weusedto . . .beabletowrite,orhavewrittenrulesthatworkedforus.”
1o-
Soonafterhisarrival,Lockhartbeganadvocatingforreform.“Theneedforlegis-
lationwasobviousasOFHEOwasregulatingtwoofthelargestandmostsvstemati-
callv important US fnancial institutions,” he told the FCIC.
1oo
But no reform
legislationwouldbepasseduntilIulv:o,ioo8,andbvthenitwouldbetoolate.
aooõ.“Incrcescourjcnctretionintosuojrimc”
AfterseveralvearsduringwhichFannieMaepurchasedriskierloansandsecurities,
then-ChiefFinancialOmcerRobertLevinproposedastrategicinitiativeto“increase
our penetration into subprime” at Fannie’s Ianuarv 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 NuUi i¥ tu\\i : :i uN iiiui1
StephenAshlev,thechairmanoftheboard,introducedFannie’snewchiefriskomcer,
Enrico Dallavecchia, he declared that the new CRO would not stand in the wav of
risktaking:“Wehavetothinkdifferentlvandcreativelvaboutrisk,aboutcompliance,
andaboutcontrols.HistoricallvthesehavenotbeenstrongsuitsofFannieMae. . . .
Todav’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.”
1oo
Iniooo,Fannieacquired·-1obillionofloans;ofthose(includingsomeoverlap),
·o-billion,orabout1:º,hadcombinedloan-to-valueratiosaboveo-º;1-ºwere
interest-onlv;andi8ºdidnothavefulldocumentation.
1¬o
Fanniealsopurchased·:o
billionofsubprimeand·1ibillionofAlt-Anon-GSEmortgage-backedsecurities.
1¬1
Thetotalamountofriskierloansrepresentedlargermultiplesofcapitalthanbefore.
Atleastinitiallv,whilehousepriceswerestillincreasing,thestrategicplantoin-
creaseriskandmarketshareappearedtobesuccessful.Fanniereportednetincome
of ·o billion in ioo- and then ·a billion in iooo. In those two vears, CEO Mudd’s
compensationtotaled·ia.amillionandLevin,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, stav competitive, and be responsive to sellers’ needs.”
1¬:
It lowered its under-
writingstandards,increasingtheuseofcreditpolicvwaiversandexceptions.Newer
alternative products, offered to a broader range of customers than ever before, ac-
countedforaboutiaºofthatvear’spurchases.FreddieMac’splanalsoseemedtobe
successful. The companv increased risk and market share while maintaining the
samenetincomeforioo-andiooo,·ibillion.
1¬a
CEORichardSvron’scompensation
totaled·i:.imillionforioo-andiooocombined,
1¬-
whileChiefOperatingOmcer
EugeneMcOuadereceived·1:.amillion.
1¬o
Again, OFHEO was aware of these developments. Its March ioo¬ report noted
thatFannie’snewinitiativetopurchasehigher-riskproductsincludedaplantocap-
tureioºofthesubprimemarketbvio11.AndOFHEOreportedthatcreditriskin-
creased“slightlv”becauseofgrowthinsubprimeandothernontraditionalproducts.
Butoverallassetqualitvinitssingle-familvbusinesswasfoundtobe“strong,”andthe
boardmemberswere“qualifedandactive.”And,ofcourse,Fanniewas“adequatelv
capitalized.”
1¬¬
Similarlv, OFHEO told Freddie in ioo¬ that it had weaknesses that raised some
possibilitvoffailure,butthatoverall,Freddie’sstrengthandfnancialcapacitvmade
failure unlikelv.
1¬8
Freddie did remain a “signifcant supervisorv concern,”
1¬o
and
OFHEOnotedthesignifcantshifttowardhigher-riskmortgages.
18o
Butagain,asin
previous vears, the regulator concluded that Freddie had “adequate capital,” and its
assetqualitvandcreditriskmanagementwere“strong.”
181
TheGSEschargedafeeforguaranteeingpavmentsonGSEmortgage–backedsecu-
rities,andOFHEOwassilentaboutFannie’spracticeofcharginglesstoguaranteesecu-
rities than their models indicated was appropriate. Mark Winer, the head of Fannie’s
Business,AnalvsisandDecisionsGroupsinceMavioooandthepersonresponsiblefor
\ii i N .·.
modelingpricingfees,raisedconcernsthatFannieMaewasnotchargingfeesforAlt-A
mortgagesthatadequatelvcompensatedfortherisk.WinerrecalledthatLevinwascrit-
icalofhismodels,asking,“Canvoushowmewhvvouthinkvou’rerightandevervone
elseiswrong:”
18i
Underchargingfortheguaranteefeeswasintendedtoincreasemarket
share,accordingtoToddHempstead,theseniorvicepresidentatFannieinchargeof
thewesternregion.
18:
Muddacknowledgedthedifferencebetweenthemodelfeeand
thefeeactuallvchargedandalsotoldtheFCICthatthescarcitvofhistoricaldatafor
manvloanscausedthemodelfeetobeunreliable.
18a
In the September o, ioo8, memo that would recommend that Fannie be placed
into conservatorship, OFHEO would expresslv 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:.“Movingáccjcrintot/ccrcáitjool”
Bvthetimehousingpriceshadpeakedinthesecondquarterofiooo,delinquencies
hadstartedtorise.DuringtheboardmeetingheldinAprilioo¬,Lundsaidthatdis-
location in the housing market was an opportunitv for Fannie to reclaim market
share.Atthesametime,Fanniewouldsupportthehousingmarketbvincreasingliq-
uiditv.
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.
18o
In Iune, Fannie prepared its ioo¬ fve-vear 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
vears.
1oo
Management told the board that Fannie’s risk management function had all the
necessarvmeansandbudgettoactontheplan.ChiefRiskOmcerDallavecchiadid
notagree,especiallvinlightofaplanned1oºcutinhisbudget.InaIulv1o,ioo¬,
emailtoCEOMudd,Dallavecchiawrotethathewasvervupsetthathehadtohearat
theboardmeetingthatFanniehadthe“willandthemonevtochangeourcultureand
supporttakingmorecreditrisk,”giventheproposedbudgetcutforhisdepartmentin
ioo8afterai-ºreductioninheadcountinioo¬.
1o1
Inanearlieremail,Dallavecchia
hadwrittentoChiefOperatingOmcerMichaelWilliamsthatFanniehad“oneofthe
weakest control processes” that he “everwitnessed in [his] career, . . . was not even
closetohavingpropercontrolprocessesforcredit,marketandoperationalrisk,”and
was “alreadv back to the old davs of scraping on controls . . . to reduce expenses.”
Thesedefcienciesindicatedthat“peopledon’tcareaboutthe[risk]functionorthev
don’tgetit.”
1oi
.·z ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN iiiui1
Muddresponded,“Mvexperienceisthatemailisnotavervgoodvenueforcon-
versation,ventingornegotiating.”IfDallavecchiafeltthathehadbeendealtwithin
badfaith,heshould“addressitmantoman,”unlesshewantedMudd“tobetheone
tocarrvmessagesforvoutovourpeers.”Muddconcluded,“Pleasecomeandseeme
todav face to face.”
1o:
Dallavecchia told the FCIC that when he wrote this email he
wastiredandupset,andthattheviewitexpressedwasmoreextremethanwhathe
thoughtatthetime.
1oa
Fannie,aftercontinuingtopurchaseandguaranteehigher-risk
mortgagesinioo¬,wouldreporta·i.1billionnetlossforthevear,causedbvcredit
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.”
1o-
Thecompanvwouldtrvtoimproveearnings
bv entering adjacent markets: “Freddie Mac has competitive advantages over non-
GSE participants in nonprime,” the strategv document explained. “We have an op-
portunitv to expand into markets we have missed—Subprime and Alt-A.”
1oo
It took
that opportunitv. As OFHEO would note in its ioo¬ examination report, Freddie
purchasedandguaranteedloansoriginatedinioooandioo¬withhigher-riskchar-
acteristics,includinginterest-onlvloans,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
lossdrivenbvcreditlosses.Thevalueofthe·1-ibillionsubprimeandAlt-Aprivate-
labelsecuritiesbooksuffereda·1:billiondeclineinmarketvalue.
1o¬
Inioo¬,Svron’s
compensationtotaled·18.:millionandMcOuade’stotaled·:.8million.
\jjoráeolc/ousinggoels.“6SIscricáolooávmurácrjorcvcr”
Asdiscussedearlier,beginningin1o¬8,theDepartmentofHousingandUrbanDevel-
opment(HUD)periodicallvsetgoalsfortheGSEsrelatedtoincreasinghomeowner-
ship among low- and moderate-income borrowers and borrowers in underserved
areas.Untilioo-,thesegoalswerebasedonthefractionofthetotalmortgagemarket
madeupoflow-andmoderate-incomefamilies.Thegoalswereintendedtobeonlva
modestreachbevondthemortgagesthattheGSEswouldnormallvpurchase.
1o8
From1oo¬toiooo,aiºofGSEpurchaseswererequiredtomeetgoalsforlow-
andmoderate-incomeborrowers.Inioo1,thegoalwasraisedto-oº.
1oo
Muddsaid
thataslongasthegoalsremainedbelowhalfoftheGSEs’lending,loansmadeinthe
normalcourseofbusinesswouldsatisfvthegoals:“Whatcomesinthedoorthrough
thenaturalcourseofbusinesswilltendtomatchthemarket,andthereforewilltend
tomeetthegoals.”
ioo
LevintoldtheFCICthat“therewasagreatdealofbusinessthat
camethroughnormalchannelsthatmetgoals”andthatmostoftheloansthatsatis-
fedthegoals“wouldhavebeenmadeanvwav.”
io1
IniooaHUDannouncedthatstartinginioo-,-iºoftheGSEs’purchaseswould
needtosatisfvthelow-andmoderate-incomegoals.Thetargetswouldreach--ºin
ioo¬and-oºinioo8.
ioi
Giventhedramaticgrowthinthenumberofriskierloans
\ii i N .·.
originatedinthemarket,thenewgoalswereclosertowherethemarketreallvwas.
But, as Mudd noted, “When -oº became -¬[º] ultimatelv, then vou have to work
harder,pavmoreattention,andcreateapreferenceforthoseloans.”
io:
Targetedgoals
loans(loansmadespecifcallvtomeetthetargets),whilealwavsasmallshareofthe
GSEs’purchases,roseinimportance.
Mudd testifed that bv ioo8, when the housing market was in turmoil, Fannie
Maecouldnolongerbalanceitsobligationstoshareholderswithitsaffordablehous-
inggoalsandothermission-relateddemands:“Theremavhavebeennowavtosat-
isfv1ooºofthemvriaddemandsforFannieMaetosupportallmannerofprojects
[or]housinggoalswhichweresetabovetheoriginationlevelsinthemarketplace.”
ioa
AsthecombinedsizeoftheGSEsrosesteadilvfrom·:.otrillioninioo:to·a.otril-
lioninioo¬,
io-
thenumberofmortgageborrowersthattheGSEsneededtoservein
order to fulfll the affordable housing goals also rose. Bv ioo-, Fannie and Freddie
werestretchingtomeetthehighergoals,accordingtoanumberofGSEexecutives,
OFHEOomcials,andmarketobservers.
Yet all but two of the dozens of current and former Fannie Mae emplovees and
regulatorsinterviewedonthesubjecttoldtheFCICthatreachingthegoalswasnot
theprimarvdriveroftheGSEs’purchasesofriskiermortgagesandofsubprimeand
Alt-A non-GSE mortgage–backed securities. Executives from Fannie, including
Mudd,pointedtoa“mix”ofreasonsforthepurchases,suchasreversingthedeclines
inmarketshare,respondingtooriginators’demands,andrespondingtoshareholder
demandstoincreasemarketshareandprofts,inadditiontofulfllingthemissionof
meetingaffordablehousinggoalsandprovidingliquiditvtothemarket.
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
solelvtoincreaseprofts.
ioo
Similarlv,LundtoldtheFCICthatthedesireformarket
sharewasthemaindriverbehindFannie’sstrategviniooo.Housinggoalshadbeena
factor,butnottheprimarvone.
io¬
AndDallavecchialikewisetoldtheFCICthatFan-
nieincreaseditspurchasesofAlt-Aloanstoregainrelevanceinthemarketandmeet
customerneeds.
io8
Hempstead, Fannie’s principal contact with Countrvwide, told the FCIC that
whilehousinggoalswereonereasonforFannie’sstrategv,themainreasonFannieen-
teredtheriskiermortgagemarketwasthatthosewerethetvpesofloansbeingorigi-
nated in the primarv market.
ioo
If Fannie wanted to continue purchasing large
quantities of loans, the companv would need to buv riskier loans. Kenneth Bacon,
Fannie’s executive vice president of multifamilv lending, said much the same thing,
andaddedthatshareholdersalsowantedtoseemarketshareandreturnsrise.
i1o
For-
mer Fannie chairman Stephen Ashlev told the FCIC that the change in strategv in
ioo-andiooowasowedtoa“mixofreasons,”includingthedesiretoregainmarket
share and the need to respond to pressures from originators as well as to pressures
fromrealestateindustrvadvocatestobemoreengagedinthemarketplace.
i11
.·. ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN iiiui1
Toensureanadequatesupplvofmortgagesincasethegoalswerenotmetinthe
normalcourseofbusiness,FannieandFreddieinstitutedoutreachprogramsinun-
derservedgeographicareasandconductededucationalprogramsfororiginatorsand
brokers.
i1i
Inaddition,asexplainedbvMikeOuinn,theFannieexecutiveresponsible
forthegoals,Fanniesetlowerfeesonloansthatmetthegoals,althoughitwouldnot
purchase mortgages that fell outside its predetermined risk targets.
i1:
Ashlev also
maintained that Fannie did not shift eligibilitv or underwriting standards to meet
goalsbutinsteaddirecteditsresourcestomarketingandpromotionalefforts,hous-
ingfairs,andoutreachprogramsrunbvthecompanv’spartnershipomces.“Theef-
fort was reallv in the outreach as opposed to reduced or diminished or loosened
standards,”AshlevtoldtheFCIC.
i1a
FormerOFHEODirectorArmandoFalconIr.testifedthattheGSEsinvestedin
subprimeandAlt-Amortgagesinordertoincreaseproftsandregainmarketshare
andthatanvimpactonmeetingaffordablehousinggoalswassimplvabv-productof
thisactivitv.
i1-
Lockhart,asubsequentOFHEOdirector,attributedtheGSEs’change
instrategvtotheirdriveforproftandmarketshare,aswellastheneedtomeethous-
inggoals.Notingthattheaffordablehousinggoalsincreasedmarkedlvinioo-,
i1o
he
saidinanFCICinterviewthatthe“goalswerejustonereason,certainlvnottheex-
clusivereason”forthechange.
i1¬
Theseviewswerecorroboratedbvnumerousother
omcialsfromtheagencv.
i18
The former HUD omcial Mike Price told the FCIC that while the “GSEs cried
bloodvmurderforever”whenitcametothegoals,thevtoutedtheircontributionto
increasinghomeownership.Inaddition,PriceandotherHUDomcialstoldtheFCIC
thattheGSEsneverclaimedthatmeetingthegoalswouldleavetheminanunsafeor
unsoundcondition.
i1o
Indeed,thelawallowedbothFannieMaeandFreddieMactofallshortofmeeting
housing goals that were “infeasible” or that would affect the companies’ safetv and
soundness.
iio
AndwhiletheGSEsoftenexceededthegoals,insomecasesthosetar-
gets were adjusted downward bv HUD or, in rare cases, were simplv missed bv the
GSEs.
ii1
Forexample,onDecember1i,ioo¬,MuddwrotetoHUD:“FannieMaebe-
lievesthatthelow-andmoderate-incomeandspecialaffordablesubgoalsareinfeasi-
ble for ioo¬.”
iii
Fannie Mae’s ioo¬ strategic plan had alreadv anticipated such a
communication,stating,“Intheeventwereachaviewpointthatachievingthegoals
thisvearis‘infeasible,’wewilldeterminehowbesttoaddressthematterwithHUD
andwillcontinuetokeeptheBoardapprisedaccordinglv.”
ii:
Infact,bothFannieand
FreddieappealedtoHUDtolowertwocomponentsofthegoalsforaffordablehous-
ing.HUDcompliedandallowedtheGSEstofallshortwithoutanvconsequences.
iia
1/cimjectojt/cgoels
AtleastuntilHUDsetnewaffordablehousinggoalsforioo-,theGSEsonlvsupple-
mented their routine purchases with a small volume of loans and non-GSE mort-
gage–backedsecuritiesneededtomeettheirrequirements.TheGSEsknewthatthev
might not earn as much on these targeted goal loans as thev would earn on both
\ii i N .·,
goal-qualifvingandnon-goal-qualifvingloanspurchasedintheusualcourseofbusi-
ness;onsomeoftheseloans,thevmightevenlosemonev.Theorganizationsalsohad
administrativeandothercostsrelatedtothehousinggoals.
In Iune iooo Freddie Mac staff made a presentation to the Business and Risk
CommitteeoftheBoardofDirectorsonthecostsofmeetingitsgoals.Fromioooto
ioo:, the cost of the targeted goal loans was effectivelv zero, as the goals were
reachedthrough“proftableexpansion”ofthecompanv’smultifamilvbusiness.Dur-
ingtherefnanceboom,thegoalsbecamemorechallengingandcostFreddiemonev
in the multifamilv business; thus, onlv after iooa did meeting the multifamilv and
single-familvgoalscosttheGSEmonev.Still,onlvaboutaºofallloanspurchasedbv
Freddiebetweenioo-andioo8werebought“specifcallvbecausethevcontributeto
thegoals”—loansitlabeledas“targetedaffordable.”Theseloansdidhavehigherthan
averageexpecteddefaultrates,althoughFreddiealsochargedahigherfeetoguaran-
tee them. From ioo: through ioo8, Freddie’s costs of complving with the housing
goalsaveraged·ioomillionannuallv.Thecostsofcomplvingwiththesegoalstook
intoaccountthreecomponents:expectedrevenues,expecteddefaults,andforegone
revenues(basedonanassumptionofwhatthevmighthaveearnedelsewhere).These
costs were onlv computed on the narrow set of loans specifcallv purchased to
achieve the goals, as opposed to goal-qualifving loans purchased in the normal
courseofbusiness.
ii-
Forcomparison,thecompanv’snetearningsaveragedjustun-
der·:billionpervearfromioo:toiooo.
iio
In iooa, Fannie Mae retained McKinsev and Citigroup to determine whether it
would be worthwhile to give up the companv’s charter as a GSE, which—while af-
fording the companv 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-
talmarginalcosttomeetingthehousinggoalsonthesinglefamilvbusinessside.”
ii¬
The report came to this conclusion despite the slightlv greater dimcultv of meeting
thegoalsintheioo:refnancingboom:thelargenumbersofhomeownersrefnanc-
ing,inparticularthosewhoweremiddleandupperincome,necessarilvreducedthe
percentageofthepoolthatwouldqualifvforthegoals.
In calculating these costs, the consultants computed the difference between fees
chargedongoal-qualifvingloansandthehigherfeessuggestedbvFannie’sownmod-
els.Butthiscostwasnotuniquetogoalqualifvingloans.Acrossitsportfolio,Fannie
chargedlowerfeesthanitsmodelscomputedforgoalsloansaswellasfornon-goals
loans.Asaresult,goalsloans,eventargetedgoalsloans,werenotsolelvresponsible
forthiscost.Infact,Fannie’sdiscountwasactuallvsmallerformanvgoal-qualifving
loansthanfortheothersfromioootoiooa.
Facingmoreaggressivegoalsinioooandioo¬,FannieMaeexpandedinitiatives
to purchase targeted goals loans. These included mortgages acquired under the Mv
CommunitvMortgageprogram,mortgagesunderwrittenwithlooserstandards,and
manufacturedhousingloans.Fortheseloans,Fannieexplicitlvcalculatedtheoppor-
tunitv cost (foregone revenues based on an assumption of what thev might have
.·( ii N\Nti \i tii :i : i NuUi 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 opportunitv cost of the targeted goals loans ·:oo million, compared to net
incomethatveartoFannieof·a.1billion—afgurethatincludesreturnsonthegoal-
qualifving loans made during the normal course of business.
ii8
The targeted goals
loansamountedto·18billion,or:.aº,ofFannieMae’s·-iabillionofsingle-familv
mortgagepurchasesiniooo.
iio
Asthemarketstightenedinthemiddleofioo¬,the
opportunitvcostforthatvearwasforecasttoberoughlv·1billion.
i:o
Lookingbackathowthetargetedaffordableportfolioperformedincomparison
with overall losses, the iooo presentation at Freddie Mac took the analvsis of the
goals’costsonestepfurther.Whiletheoutstanding·oobillionofthesetargetedaf-
fordableloanswasonlvaºofthetotalportfolio,thesewererelativelvhigh-riskloans
andwereexpectedtoaccountfor1oºoftotalprojectedlosses.Infact,asoflateioo8,
thevhadaccountedforonlv8ºoflosses—meaningthatthevhadperformedbetter
than expected in relation to the whole portfolio. The companv’s major losses came
from loans acquired in the normal course of business. The presentation noted that
manvofthesedefaultedloanswereAlt-A.
i:1
COMMISSION CONCLUSIONS ON CHAPTER 9
The Commission concludes that frms securitizing mortgages failed to perform
adequateduediligenceonthemortgagesthevpurchasedandattimesknowinglv
waived compliance with underwriting standards. Potential investors were not
fullvinformedorweremisledaboutthepoorqualitvofthemortgagescontained
insomemortgage-relatedsecurities.Theseproblemsappeartohavebeensignif-
cant. The Securities and Exchange Commission failed to adequatelv enforce its
disclosure requirements governing mortgage securities, exempted some sales of
such securities from its review, and preempted states from applving state law to
them,therebvfailinginitscoremissiontoprotectinvestors.
TheFederalReservefailedtorecognizethecataclvsmicdangerposedbvthe
housingbubbletothefnancialsvstemandrefusedtotaketimelvactiontocon-
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;
Mccdv’s“Itwasa||a|cutrcvcnuc”:oe
Thecollateralizeddebtobligationmachinecouldhavesputteredtoanaturalendbv
thespringofiooo.Housingpricespeaked,andAIGstartedtoslowdownitsbusiness
ofinsuringsubprime-mortgageCDOs.ButitturnedoutthatWallStreetdidn’tneed
itsgoldengooseanvmore.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 evervthing we had seen and
what we had concluded,” Garv Gorton, a Yale fnance professor who had designed
AIG’smodelforanalvzingitsCDOpositions,toldtheFCIC.
1
The CDO machine had become self-fueling. Senior executives—particularlv at
three of the leading promoters of CDOs, Citigroup, Merrill Lvnch, and UBS—
apparentlv did not accept or perhaps even understand the risks inherent in the
products thev were creating. More and more, the senior tranches were retained bv
thearrangingsecuritiesfrms,themezzaninetrancheswereboughtbvotherCDOs,
and the equitv tranches were bought bv hedge funds that were often engaged in
complextradingstrategies:thevmademonevwhentheCDOsperformed,butcould
also make monev 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—exposuresthatwouldultimatelv
bringmanvofthemtothebrinkoffailure.
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 vou break down the checks and balances
thatnormallvwouldhavestoppedthem.”
i
Svnthetic CDOs boomed. Thev provided easier opportunities for bullish and
bearishinvestorstobetforandagainstthehousingboomandthesecuritiesthatde-
pended on it. Svnthetic CDOs also made it easier for investment banks and CDO
managers to create CDOs more quicklv. But svnthetic 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 bv the Securities and Ex-
changeCommissionagainstGoldmanSachswouldeventuallvillustrate.
:
Regulators reacted weaklv. As earlv as ioo-, supervisors recognized that CDOs
andcreditdefaultswaps(CDS)couldactuallvconcentrateratherthandiversifvrisk,
butthevconcludedthatWallStreetknewwhatitwasdoing.Supervisorsissuedguid-
anceinlateiooowarningbanksoftherisksofcomplexstructuredfnancetransac-
tions—but excluded mortgage-backed securities and CDOs, because thev saw the
risksofthoseproductsasrelativelvstraightforwardandwellunderstood.
a
Disasterwasfastapproaching.
CDO MANAGERS: “WE ARE NOT A RENTAMANAGER”
Duringthe“madness,”whenevervonewantedapieceoftheaction,CDOmanagers
facedgrowingcompetitivepressures.Managers’compensationdeclined,asdemand
for mortgage-backed securities drove up prices, squeezing the proft thev made on
CDOs.Atthesametime,newCDOmanagerswereenteringthearena.WingChau,a
CDO manager who frequentlv worked with Merrill Lvnch, said the fees fell bv half
formezzanineCDOsovertime.
-
Andoverallcompensationcouldbemaintainedbv
creatingandmanagingmorenewproduct.
Morethanhadbeenthecasethreeorfourvearsearlier,inpickingthecollateral
themanagerswereinfuencedbvtheunderwriters—thesecuritiesfrmsthatcreated
andmarketedthedeals.AnFCICsurvevofaoCDOmanagersconfrmedthispoint.
o
Sometimes managers were given a portfolio constructed bv the securities frm; the
managerswouldthenchoosethemortgageassetsfromthatportfolio.Theequitvin-
vestors—whoofteninitiatedthedealinthefrstplace—alsoinfuencedtheselection
ofassetsinmanvinstances.Still,somemanagerssaidthatthevactedindependentlv.
“Wearenotarent-a-manager,weactuallvselectourcollateral,”saidLlovdFass,the
generalcounselatVerticalCapital.
¬
Aswewillsee,securitiesfrmsoftenhadparticu-
lar CDO managers with whom thev preferred to work. Merrill, the market leader,
had a constellation of managers; CDOs underwritten bv Merrill frequentlv bought
tranchesofotherMerrillCDOs.
According to market participants, CDOs stimulated greater demand for mort-
gage-backed securities, particularlv those with high vields, and the greater demand
inturnaffectedthestandardsfororiginatingmortgagesunderlvingthosesecurities.
8
Asstandardsfell,atleastonefrmoptedout:PIMCO,oneofthelargestinvestment
1ui \\iNi: : .·+
fundsinthecountrv,whoseCDOmanagementunitwasoneofthenation’slargestin
iooa.Earlvinioo-,itannouncedthatitwouldnotmanageanvnewdeals,inpartbe-
causeofthedeteriorationinthecreditqualitvofmortgage-backedsecurities.“There
is an awful lot of moral hazard in the sector,” Scott Simon, a managing director at
PIMCO, told the audience at an industrv conference in ioo-. “You either take the
highroadorvoudon’t—we’renotgoingtohurtaccountsordamageourreputation
for fees.” Simon said the rating agencies’ methodologies were not sumcientlv strin-
gent,particularlvbecausethevwerebeingappliedtonewtvpesofsubprimeandAlt-
Aloanswithlittleornohistoricalperformancedata.
o
Notevervoneagreedwiththis
viewpoint. “Managers who are sticking in this business are doing it right,” Armand
Pastine,thechiefoperatingomceratMaximGroup,respondedatthatsameconfer-
ence.“TosuggestthatCDOmanagerswouldpulloutofaneconomicallvviabledeal
formoralreasons—that’sacop-out.”
1o
Aswastvpicalfortheindustrvduringthecri-
sis, two of Maxim’s eight mortgage-backed CDOs, Maxim High Grade CDO I and
Maxim High Grade CDO II, would default on interest pavments to investors—in-
cluding investors holding bonds that had originallv been rated triple-A—and the
othersixwouldbedowngradedtojunkstatus,includingall ofthoseoriginallvrated
triple-A.
11
AnotherdevelopmentalsochangedtheCDOs:inioo-andiooo,CDOmanagers
werelesslikelvtoputtheirownmonevintotheirdeals.Earlvinthedecade,investors
hadtakenthemanagers’investmentintheequitvtrancheoftheirownCDOstobe
an assurance of qualitv, believing that if the managers were sharing the risk of loss,
thevwouldhaveanincentivetopickcollateralwiselv.Butthisfail-safelostforceas
theamountofmanagers’investmentpertransactiondeclinedovertime.ACAMan-
agement,aunitofthefnancialguarantorACACapital,providesagoodillustration
of this trend. ACA held 1ooº of the equitv in the CDOs it originated in iooi and
ioo:,-iºando1ºoftwodealsitoriginatediniooa,between1oºandi-ºofdeals
inioo-,andbetweenoºand11ºofdealsiniooo.
1i
AndsvntheticCDOs,aswewillsee,hadnofail-safeatallwithregardtotheman-
agers’ incentives. Bv the verv nature of the credit default swaps bundled into these
svnthetics,customersontheshortsideofthedealwerebettingthattheassetswould
fail.
CREDIT DEFAULT SWAPS: “DUMB QUESTION”
InIuneioo-,derivativesdealersintroducedthe“pav-as-vou-go” creditdefaultswap,
acomplexinstrumentthatmimickedthetimingofthecashfowsofrealmortgage-
backedsecurities.
1:
Becauseofthisfeature,thesvntheticCDOsintowhichthesenew
swapswerebundledweremucheasiertoissueandsell.
Thepav-as-vou-goswapalsoenabledasecondmajordevelopment,introducedin
Ianuarviooo:thefrstindexbasedonthepricesofcreditdefaultswapsonmortgage-
backedsecurities.KnownastheABX.HE,itwasreallvaseriesofindices,meanttoact
asasortofDowIonesIndustrialAverageforthenonprimemortgagemarket,andit
becameapopularwavtobetontheperformanceofthemarket.Evervsixmonths,a
.++ ii N\Nti \i tii :i : i NuUi 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-.
Investorswhobelievedthatthebondsinanvgivencategorvwouldfallbehindintheir
pavmentscouldbuvprotectionthroughcreditdefaultswaps.Asdemandforprotec-
tion rose, the index would fall. The index was therefore a barometer recording the
confdenceofthemarket.
SvntheticCDOsproliferated,inpartbecauseitwasmuchquickerandeasierfor
managerstoassembleasvntheticportfoliooutofpav-as-vou-gocreditdefaultswaps
thantoassemblearegularcashCDOoutofmortgage-backedsecurities.“Thebeautv
inawavofthesvntheticdealsisvoucanlookattheentireuniverse,voudon’thaveto
goandbuvthecashbonds,”saidLauraSchwartzofACACapital.
1a
Therewerealso
nowarehousingcostsorassociatedrisks.Andthevtendedtoofferthepotentialfor
higherreturnsontheequitvtranches:oneanalvstestimatedthattheequitvtranche
on a svnthetic CDO could tvpicallv vield about i1º, while the equitv tranche of a
tvpicalcashCDOcouldpav1:º.
1-
AnimportantdriverinthegrowthofsvntheticCDOswasthedemandforcredit
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”andminimizinganvriskforhisownbank.Lippmannsaid
thatbetweenioooandioo¬hebrokereddealsforatleast-oandmavbeasmanvas
1oo hedge funds that wanted to short the mezzanine tranches of mortgage-backed
securities.Meanwhile,onthelongside,“MostofourCDSpurchaseswerefromUBS,
Merrill, and Citibank, because thev were the most aggressive underwriters of [svn-
thetic]CDOs.”
1o
Inmanvcases,thevwerebuvingthosepositionsfromLippmannto
putthemintosvntheticCDOs;asitwouldturnout,thebankswouldretainmuchof
theriskofthosesvntheticCDOsbvkeepingthesuper-seniorandtriple-Atranches,
sellingbelow-triple-AtrancheslargelvtootherCDOs,andsellingequitvtranchesto
hedgefunds.
Issuance of svnthetic CDOs jumped from ·1- billion in ioo- to ·o1 billion just
one vear later. (We include all CDOs with -oº or more svnthetic collateral; again,
unlessotherwisenoted,ourdatareferstoCDOsthatincludemortgage-backedsecu-
rities.) Even CDOs that were labeled as “cash CDOs” increasinglv held some credit
derivatives.Atotalof·ii-billioninCDOswereissuediniooo,includingthosela-
beledascash,“hvbrid,”orsvnthetic;theFCICestimatesthati¬ºofthecollateralwas
derivatives,comparedwithoºinioo-and¬ºiniooa.

The advent of svnthetic CDOs changed the incentives of CDO managers and
hedgefundinvestors.Onceshortinvestorswereinvolved,theCDOhadtwotvpesof
investors with opposing interests: those who would beneft if the assets performed,
and those who would beneft if the mortgage borrowers stopped making pavments
andtheassetsfailedtoperform.
Eventheincentivesoflonginvestorsbecameconficted.SvntheticCDOsenabled
sophisticatedinvestorstoplacebetsagainstthehousingmarketorpursuemorecom-
plextradingstrategies.Investors,usuallvhedgefunds,oftenusedcreditdefaultswaps
totakeoffsettingpositionsindifferenttranchesofthesameCDOsecuritv;thatwav,
1ui \\iNi: : .+.
thev could make some monev as long as the CDOs performed, but thev stood to
make more monev if the entire market crashed. An FCIC survev of more than 1¬o
hedgefundsencompassingover·1.1trillioninassetsasofearlvio1ofoundthisto
be a common strategv among medium-size hedge funds: of all the CDOs issued in
the second half of iooo, more than half of the equitv tranches were purchased bv
hedgefundsthatalsoshortedothertranches.
18
Thesameapproachwasbeingusedin
themortgage-backedsecuritiesmarketaswell.TheFCIC’ssurvevfoundthatbvIune
ioo¬, the largest hedge funds held ·i- billion in equitv and other lower-rated
tranchesofmortgage-backedsecurities.Theseweremorethanoffsetbv·a-billion
inshortpositions.
1o
Thesetvpesoftradeschangedthestructuredfnancemarket.Investorsintheequitv
and most junior tranches of CDOs and mortgage-backed securities traditionallv had
thegreatestincentivetomonitorthecreditriskofanunderlvingportfolio.Withthead-
ventofcreditdefaultswaps,itwasnolongerclearwho—ifanvone—hadthatincentive.
For one example, consider Merrill Lvnch’s ·1.- billion Norma CDO, issued in
ioo¬.Theequitvinvestor,MagnetarCapital,ahedgefund,wasexecutingacommon
strategvknownasthecorrelationtrade—itboughttheequitvtranchewhileshorting
othertranchesinNormaandotherCDOs.Accordingtocourtdocuments,Magnetar
wasalsoinvolvedinselectingassetsforNorma.
io
Magnetarreceived·a.-millionre-
latedtothistransactionandNIRCapitalManagement,theCDOmanager,waspaida
feeof·¬-,oooplusadditionalfees.
i1
Magnetar’scounseltoldtheFCICthatthe·a.-
millionwasadiscountintheformofa rebateonthepriceoftheequitvtrancheand
otherlongpositionspurchasedbvMagnetarandnotapavmentreceivedinreturnfor
goodorservices.
ii
CourtdocumentsindicatethatMagnetarwasinvolvedinselect-
ingcollateral,andthat NIRabdicateditsassetselectiondutiestoMagnetarwithMer-
rill’sknowledge.Inaddition,thevshowthatwhenoneMerrillemploveelearnedthat
Magnetar had executed approximatelv ·ooo million in trades for Norma without
NIR’sapparentinvolvementorknowledge,sheemailedcolleagues,“Dumbquestion.
IsMagnetarallowedtotradeforNIR:”
i:
MerrillfailedtodisclosethatMagnetarwas
paid·a.-millionorthatMagnetarwasselectingcollateralwhenitalsohadashort
positionthatwouldbeneftfromlosses.
ia
ThecounselforMerrill’snewowner,BankofAmerica,explainedtotheFCICthat
it was a common industrv practice for “the equitv 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 specifcallv mention the Norma CDO. Bank of
AmericafailedtoproducedocumentsrelatedtothisissuerequestedbvtheFCIC.
Federalregulatorshaveidentifedabusesthatinvolvedshortinvestorsinfuencing
thechoiceoftheinstrumentsinsidesvntheticCDOs.InAprilio1o,theSECcharged
GoldmanSachswithfraudfortellinginvestorsthatanindependentCDOmanager,
ACAManagement,hadpickedtheunderlvingassetsinaCDOwheninfactashort
investor,thePaulson&Co.hedgefund,hadplaveda“signifcantrole”intheselec-
tion. The SEC alleged that those misrepresentations were in Goldman’s marketing
materialsforAbacusioo¬-AC1,oneofGoldman’siaAbacusdeals.
io
.+z ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN iiiui1
IraWagner,theheadofBearStearns’sCDOGroupinioo¬,toldtheFCICthathe
rejected the deal when approached bv Paulson representatives. When asked about
Goldman’scontentionthatPaulson’spickingthecollateralwasimmaterialbecausethe
collateralwasdisclosedandbecausePaulsonwasnotwell-knownatthattime,Wagner
called the argument “ridiculous.” He said that the structure encouraged Paulson to
picktheworstassets.Whileacknowledgingthepointthatevervsvntheticdealneces-
sarilvhadlongandshortinvestors,Wagnersawhavingtheshortinvestorsselectthe
referencedcollateralasaseriousconfictandforthatreasondeclinedtoparticipate.

ACAexecutivestoldtheFCICthevwerenotinitiallvawarethattheshortinvestor
wasinvolvedinchoosingthecollateral.CEOAlanRosemansaidthathefrstheardof
Paulson’srolewhenhereviewedtheSEC’scomplaint.
i8
LauraSchwartz,whowasre-
sponsibleforthedealatACA,saidshebelievedthatPaulson’sfrmwastheinvestor
takingtheequitvtrancheandwouldthereforehaveaninterestinthedealperforming
well.ShesaidshewouldnothavebeensurprisedthatPaulsonwouldalsohavehada
shortposition,becausethecorrelationtradewascommoninthemarket,butadded,
“Tobehonest,[atthattime,]untiltheSECtestimonvIdidnotevenknowthatPaul-
sonwasonlvshort.”
io
PaulsontoldtheFCICthatanvsvntheticCDOwouldhaveto
investin“apoolthatbothabuverandsellerofprotectioncouldagreeon.”Hedidn’t
understandtheobjections:“Everv[svnthetic]CDOhasabuverandsellerofprotec-
tion.Soforanvonetosavthatthevdidn’twanttostructureaCDObecausesomeone
wasbuvingprotectioninthatCDO,thenvouwouldn’tdoanvCDOs.”
:o
In Iulv io1o, Goldman Sachs settled the case, paving a record ·--o million fne.
Goldman“acknowledge[d]thatthemarketingmaterialsfortheABACUSioo¬-AC1
transactioncontainedincompleteinformation.Inparticular,itwasamistakeforthe
Goldman marketing materials to state that the reference portfolio was ‘selected bv’
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 opportunitv for bearish investors to bet
against the housing boom. Home prices in the hottest markets in California and
Floridahadblastedintothestratosphere;itwashardforskepticstobelievethattheir
upwardtrajectorvcouldcontinue.Andifitdidnot,thelandingwouldnotbeasoft
one. Some spoke out publiclv. Others bet the bubble would burst. Betting against
CDOs was also, in some cases, a bet against the rating agencies and their models.
IamieMaiandBenHockett,principalsatthesmallinvestmentfrmCornwallCapi-
tal,toldtheFCICthatthevhadwarnedtheSECinioo¬thattheagenciesweredan-
gerouslv 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-
movedtheneedforbuverstostudvpricesandperformduediligence,evenas“there
wasamassiveamountofgaminggoingon.”
:i
ShortingCDOswas“prettvattractive”becausetheratingagencieshadgiventoo
much credit for diversifcation, Sihan Shu of Paulson & Co. told the FCIC. Paulson
established a fund in Iune iooo that initiallv focused onlv on shorting BBB-rated
tranches.Bvtheendofioo¬,Paulson&Co.’sCreditOpportunitiesfund,setupless
1ui \\iNi: : .+.
than a vear earlier to bet exclusivelv against the subprime housing market, was up
-ooº. “Each MBS tranche tvpicallv would be :oº mortgages in California, 1oº in
Florida,1oºinNewYork,andwhenvouaggregate1ooMBSpositionsvoustillhave
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 relativelv small number of the underlving loans were to go into fore-
closure,thelosseswouldrendervirtuallvalloftheriskierBBB-ratedtranchesworth-
less. “The whole svstem worked fne as long as evervone could refnance,” Steve
Eisman,thefounderofafundwithinFrontPointPartners,toldtheFCIC.Theminute
refnancing stopped, “losses would explode. . . . Bv iooo, about half [the mortgages
sold]wereno-docorlow-doc.Youwereatmaxunderwritingweaknessatmaxhous-
ingprices.Andsothesvstemimploded.Evervonewassoleveredtherewasnoabilitv
totakeanvpain.”
:a
OnOctobero,iooo,IamesGrantwroteinhisnewsletteraboutthe
“mvsteriousalchemicalprocesses”inwhich“WallStreettransformsBBB-minus-rated
mortgagesintoAAA-ratedtranchesofmortgagesecurities”bvcreatingCDOs.Hees-
timatedthateventhetriple-AtranchesofCDOswouldexperiencesomelossesifna-
tionalhomepricesweretofalljustaºorlesswithintwovears;andifpriceswereto
fall1oº,investorsoftranchesratedAA-orbelowwouldbecompletelvwipedout.
:-
Inioo-,Eismanandotherswerealreadvlookingforthebestwavtobetonthis
disasterbvshortingalltheseshakvmortgage-relatedsecurities.Buvingcreditdefault
swapswasemcient.Eismanrealizedthathecouldpickwhatheconsideredthemost
vulnerabletranchesofthemortgage-backedbondsandbetmillionsofdollarsagainst
them,relativelvcheaplvandwithconsiderableleverage.Andthat’swhathedid.
Bv 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. “Evervone reallv did
believethatthingsweregoingtobeokav,”Eismansaid.“[I]thoughtthevwerecertif-
ablelunatics.”
:o
Michael Burrv, 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 Vallev, 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.Burrvdecidedthatsomeofthenewfangledadjustableratemortgageswere“the
most toxic mortgages” created. He told the FCIC, “I watched those with interest as
thevmigrateddownthecreditspectrumtothesubprimemarket.As[home]prices
hadincreasedonthebackofvirtuallvnoaccompanvingriseinwagesandincomes,I
came to the judgment that in two vears there will be a fnal judgment on housing
when those two-vear [adjustable rate mortgages] seek refnancing.”

Bv the middle
of ioo-, Burrv 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,andBurrvwerenotaloneinshortingthehousingmar-
.+. ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN iiiui1
ket.Infact,ononesideoftensofbillionsofdollarsworthofsvntheticCDOswerein-
vestorstakingshortpositions.Thepurchasersofcreditdefaultswapsillustratetheim-
pact of derivatives in introducing new risks and leverage into the svstem. Although
theseinvestorsproftedspectacularlvfromthehousingcrisis,thevnevermadeasingle
subprimeloanorboughtanactualmortgage.Inotherwords,thevwerenotpurchasing
insurance against anvthing thev owned. Instead, thev merelv made side bets on the
risks undertaken bv others. Paulson told the FCIC that his research indicated that if
homepricesremainedfat,losseswouldwipeouttheBBB-ratedtranches;meanwhile,
atthetimehecouldpurchasedefaultswapprotectiononthemvervcheaplv.
:8
Ontheothersideofthezero-sumgamewereoftenthemajorU.S.fnancialinsti-
tutionsthatwouldeventuallvbebattered.BurrvacknowledgedtotheFCIC,“There
isanargumenttobemadethatvoushouldn’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.”
:o
Credit default swaps greased the CDO machine in several wavs. First, thev al-
lowedCDOmanagerstocreatesvntheticandhvbridCDOsmorequicklvthanthev
couldcreatecashCDOs.Second,thevenabledinvestorsintheCDOs(includingthe
originatingbanks,suchasCitigroupandMerrill)totransfertheriskofdefaulttothe
issuerofthecreditdefaultswap(suchasAIGandotherinsurancecompanies).Third,
thev made correlation trading possible. As the FCIC survev revealed, most hedge
fund purchases of equitv and other junior tranches of mortgage-backed securities
and CDOs were done as part of complex trading strategies.
ao
As a result, credit de-
faultswapswerecriticaltofacilitatedemandfromhedgefundsfortheequitvorother
juniortranchesofmortgage-backedsecuritiesandCDOs.Finallv,thevallowedspec-
ulatorstomakebetsfororagainstthehousingmarketwithoutputtingupmuchcash.
Ontheotherhand,itcanbearguedthatcreditdefaultswapshelpedendthehous-
ingandmortgage-backedsecuritiesbubble.BecauseCDOarrangerscouldmoreeas-
ilvbuvmortgageexposurefortheirCDOsthroughcreditdefaultswapsthanthrough
actualmortgage-backedsecurities,demandforcreditdefaultswapsmavinfacthave
reducedtheneedtooriginatehigh-vieldmortgages.Inaddition,somemarketpartic-
ipantshavecontendedthatwithouttheabilitvtoshortthehousingmarketviacredit
defaultswaps,thebubblewouldhavelastedlonger.Aswewillsee,thedeclinesinthe
ABXindexinlateiooowouldbeoneofthefrstharbingersofmarketturmoil.“Once
[pessimists]can,ineffect,sellshortviatheCDS,pricesmustrefecttheirviewsand
not just the views of the leveraged optimists,” Iohn Geanakoplos, a Yale economics
professor and a partner in the hedge fund Ellington Capital Management, which
bothinvestedinandmanagedCDOs,toldtheFCIC.
a1
CITIGROUP: “I DO NOT BELIEVE WE WERE POWERLESS”
While the hedge funds were betting against the housing market in ioo- and iooo,
Citigroup’sCDOdeskwaspushingmoremonevtothecenterofthetable.
1ui \\iNi: : .+,
But after writing ·i- billion in liquiditv puts—protecting investors who bought
commercialpaperissuedbvCitigroup’sCDOs—thebank’streasurvdepartmenthad
put a stop to the practice. To keep doing deals, the CDO desk had to fnd another
marketforthesuper-seniortranchesoftheCDOsitwasunderwriting—orithadto
fndawavtogetthecompanvtosupporttheCDOproductionline.TheCDOdesk
accumulatedanother·18billioninsuper-seniorexposures,mostbetweenearlviooo
and August ioo¬, which it otherwise would have been able to sell into the market
onlvforaloss.
ai
Itwasalsoincreasinglvfnancingsecuritiesthatitwasholdinginits
CDOwarehouse—thatis,securitiesthatwerewaitingtobeputintonewCDOs.
Historicallv,owningsecuritieswasnotwhatsecuritiesfrmsdid.Theadage“We
areinthemovingbusiness,notthestoragebusiness”suggeststhatthevwerestruc-
turingandsellingsecurities,notbuvingorretainingthem.
However,asthebiggestcommercialbanksandinvestmentbankscompetedinthe
securities business in the late 1ooos and on into the new centurv, thev often touted
the“balancesheet”thatthevcouldmakeavailabletosupportthesaleofnewsecuri-
ties. In this regard, Citigroup broke new ground in the CDO market. Citigroup re-
tained signifcant exposure to potential losses on its CDO business, particularlv
withinCitibank, the·1trillioncommercialbankwhosedepositswereinsuredbvthe
FDIC. While its competitors did the same, few did so as aggressivelv or, ultimatelv,
withsuchlosses.
Iniooo,Citigroupretainedthesuper-seniorandtriple-Atranchesofmostof the
CDOs it created. In manv cases Citigroup would hedge the associated credit risk
fromthesetranchesbvobtainingcreditprotectionfromamonolineinsurancecom-
panv such as Ambac. Because these hedges were in place, Citigroup presumed that
theriskassociatedwiththeretainedtrancheshadbeenneutralized.
Citigroupreportedthesetranchesatvaluesforwhichthevcouldnotbesold,rais-
ingquestionsabouttheiraccuracvand,therefore,theaccuracvofreportedearnings.
“Asevervbodvinanvbusinessknows,ifinventorvisgrowing,thatmeansvou’renot
pricingitcorrectlv,”RichardBookstaber,whohadbeenheadofriskmanagementat
Citigroupinthelate1ooos,toldtheFCIC.Butkeepingthetranchesonthebooksat
thesepricesimprovedthefnancesforcreatingthedeal.“Itwasahiddensubsidvof
theCDObusinessbvmispricing,”Bookstabersaid.
a:
Thecompanvwouldnotbegin
writingthesecuritiesdowntowardthemarket’srealvaluationsuntilthefallofioo¬.
Partofthereasonforretainingexposurestosuper-seniorpositionsinCDOswas
theirfavorablecapitaltreatment.Aswesawinanearlierchapter,undertheioo1Re-
courseRule,oneoftheattractionsoftriple-A-ratedsecuritieswasthatbankswerere-
quiredtoholdrelativelvlesscapitalagainstthemthanagainstlower-ratedsecurities.
And if the bank held those assets in their trading account (as opposed to holding
themasalong-terminvestment),itcouldgetevenbettercapitaltreatmentunderthe
1oooMarketRiskAmendment.Thatruleallowedbankstousetheirownmodelsto
determinehowmuchcapitaltohold,anamountthatvariedaccordingtohowmuch
marketpricesmoved.Citigroupjudgedthatthecapitalrequirementforthesuper-se-
niortranchesofsvntheticCDOsitheldfortradingpurposeswaseffectivelvzero,be-
.+( ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN iiiui1
causethepricesdidn’tmovemuch.Asaresult,Citigroupheldlittleregulatorvcapital
againstthesuper-seniortranches.
Citibank also held “unfunded” positions in super-senior tranches of some svn-
theticCDOs;thatis,itsoldprotectiontotheCDO.Ifthereferencedmortgagecollat-
eral underperformed, the short investors would begin to get paid. Monev to pav
themwouldcomefrstfromwipingoutlonginvestorswhohadboughttranchesthat
were below triple-A. Then, if the short investors were still owed monev, Citibank
would have to pav. For taking on this risk, Citi tvpicallv received about o.ioº to
o.aoºinannualfeesonthesuper-seniorprotection;onabillion-dollartransaction,it
wouldearnanannualfeeof·imillionto·amillion.
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. Tvpicallv, Citigroup’s securities unit
wouldsetupawarehouse fundinglinefortheCDOmanager.Duringtheramp-up
period, the collateral securities would pav interest; depending on the terms of the
agreement,thatinterestwouldeithergoexclusivelvtoCitigrouporbesplitwiththe
manager.FortheCDOdesk,thisfrequentlvrepresentedasubstantialincomestream.
Thesecuritiessittinginthewarehousefacilitvhadrelativelvattractivevields—often
1.oºtoi.-ºmorethanthetvpicalbankborrowingrate—anditwasnotuncommon
for the CDO desk to earn ·1o to ·1- million in interest on a single transaction.
aa
Tradersonthedeskwouldgetcreditforthoserevenuesatbonustime.ButCitigroup
wouldalsobeonthehookforanvlossesincurredonassetsstuckinthewarehouse.
When the fnancial crisis deepened, manv CDO transactions could not be com-
pleted;Citigroupandotherinvestmentbankswereforcedtowritedownthevalueof
securitiesheldintheirwarehouses.TheresultwouldbesubstantiallossesacrossWall
Street. In manv 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,evenlikelv,thattheCDOdeskwouldstructureagivenCDO,adifferentdivi-
sion would buv protection for the underlving collateral, and vet another division
wouldbuvtheunfundedsuper-seniortranche.IfthecollateralinthisCDOraninto
trouble,theCDOimmediatelvwouldhavetopavthedivisionthatboughtcreditpro-
tection on the underlving collateral; if the CDO ran out of monev to pav, it would
havetodrawonthedivisionthatboughttheunfundedtranche.InNovemberioo¬,
after Citigroup had reported substantial losses on its CDO portfolio, regulators
would note that the companv did not have a good understanding of its frmwide
CDO exposures: “The nature, origin, and size of CDO exposure were surprising to
manvinseniormanagementandtheboard.Theliquiditvputexposurewasnotwell
known.Inparticular,managementdidnotconsideroreffectivelvmanagethecredit
riskinherentinCDOpositions.”
a-
Citigroup’swillingnesstouseitsbalancesheettosupporttheCDObusinesshad
thedesiredeffect.ItsCDOdeskcreated·11billioninCDOsthatincludedmortgage-
1ui \\iNi: : .+,
backedsecuritiesintheircollateralinioo-and·iibillioniniooo.AmongCDOun-
derwriters, including all tvpes of CDOs, Citigroup rose from fourteenth place in
ioo:tosecondplaceinioo¬,accordingtoFCICanalvsisofMoodv’sdata.
ao
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,wasahighlvpaidCitigroupex-
ecutive, earning more than ·:a million in salarv and bonus compensation in iooo.
Co-head of Global Fixed Income Randolph Barker made about ·i1 million in that
samevear.Citigroup’schiefriskomcermade·¬.amillion.

Otherswerealsowellre-
warded. The co-heads of the global CDO business, Nestor Dominguez and Ianice
Warne,eachmadeabout·omillionintotalcompensationiniooo.
a8
Citi did have “clawback” provisions: under narrowlv specifed circumstances,
compensationwouldhavetobereturnedtothefrm.ButdespiteCitigroup’seventual
largelosses,nocompensationwaseverclawedbackunderthispolicv.TheCorporate
Librarv,whichratesfrms’corporategovernance,gaveCitigroupaC.Inearlvioo¬,
theCorporateLibrarvwoulddowngradeCitigrouptoaD,“refectingahighdegree
of governance risk.” Among the issues cited: executive compensation practices that
werepoorlvalignedwithshareholderinterests.
ao
WherewereCitigroup’sregulatorswhilethecompanvpileduptensofbillionsof
dollars of risk in the CDO business: Citigroup had a complex corporate structure
and, as a result, faced an arrav of supervisors. The Federal Reserve supervised the
holdingcompanvbut,astheGramm-Leach-Blilevlegislationdirected,reliedonoth-
erstomonitorthemostimportantsubsidiaries:theOmceoftheComptrollerofthe
Currencv (OCC) supervised the largest bank subsidiarv, Citibank, and the SEC su-
pervisedthesecuritiesfrm,CitigroupGlobalMarkets.Moreover,Citigroupdidnot
reallv align its various businesses with the legal entities. An individual working on
theCDOdeskonanintricatetransactioncouldinteractwithvariouscomponentsof
thefrmincomplicatedwavs.
TheSECregularlvexaminedthesecuritiesarmonathree-vearexaminationcvcle,
althoughitwouldalsosometimesconductotherexaminationstotargetspecifccon-
cerns.UnliketheFedandOCC,whichhadriskmanagementandsafetvandsound-
ness rules, the SEC used these exams to look for general weaknesses in risk
management.Unlikesafetvandsoundnessregulators,whoconcentratedonprevent-
ingfrmsfromfailing,theSECalwavskeptitsfocusonprotectinginvestors.Itsmost
recentreviewofCitigroup’ssecuritiesarmprecedingthecrisiswasinioo-,andthe
examiners completed their report in Iune iooo. In that exam, thev told the FCIC,
thev saw nothing “earth shattering,” but thev did note kev 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 vears that CDOs boomed, the OCC team regularlv criticized the com-
panvforitsweaknessesinriskmanagement,includingspecifcproblemsintheCDO
.+· ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN iiiui1
business. “Earnings and proftabilitv growth have taken precedence over risk man-
agement and internal control,” the OCC told the companv in Ianuarv ioo-.
-1
An-
other document from that vear stated, “The fndings of this examination are
disappointing,inthatthebusinessgrewfarinexcessofmanagement’sunderlvingin-
frastructureandcontrolprocesses.”
-i
InMavioo-,areviewundertakenbvpeersat
theotherFederalReservebankswascriticaloftheNewYorkFed—thenheadedbv
thecurrenttreasurvsecretarv,TimothvGeithner—foritsoversightofCitigroup.The
reviewconcludedthattheFed’son-siteCitigroupteamappearedtohave“insumcient
resources to conduct continuous supervisorv activities in a consistent manner. At
Citi,muchofthelimitedteam’senergvisabsorbedbvtopicalsupervisorvissuesthat
detractfromtheteam’scontinuoussupervisionobjectives . . .thelevelofthestamng
withintheCititeamhasnotkeptpacewiththemagnitudeofsupervisorvissuesthat
theinstitutionhasrealized.”
-:
ThattheFed’sioo-examinationofCitigroupdidnot
raise the concerns expressed that same vear bv the OCC mav illustrate these prob-
lems.Fourvearslater,thenextpeerreviewwouldagainfndsubstantialweaknesses
intheNewYorkFed’soversightofCitigroup.
-a
InApriliooo,theFedraisedtheholdingcompanv’ssupervisorvratingfromthe
previousvear’s“fair”to“satisfactorv.”
--
Itliftedthebanonnewmergersimposedthe
previous vear in response to Citigroup’s manv regulatorv problems.
-o
The Fed and
OCCexaminersconcurredthatthecompanvhadmade“substantialprogress”inim-
plementing CEO Charles Prince’s plan to overhaul risk management. The Fed de-
clared: “The companv has . . . completed improvements necessarv to bring the
companvintosubstantialcompliancewithtwoexistingFederalReserveenforcement
actionsrelatedtotheexecutionofhighlvstructuredtransactionsandcontrols.”

The
followingvear,Citigroup’sboardwouldalludetoPrince’ssuccessfulresolutionofits
regulatorvcomplianceproblemsinjustifvinghisioºcompensationincrease.
-8
The OCC noted in retrospect that the lifting of supervisorv constraints in iooo
hadbeenakevturningpoint.“Afterregulatorvrestraintsagainstsignifcantacquisi-
tionswerelifted,Citigroupembarkedonanaggressiveacquisitionprogram,”theOCC
wrotetoVikramPandit,Prince’sreplacement,inearlvioo8.“Additionallv,withthere-
movalofformalandinformalagreements,thepreviousfocusonriskandcompliance
gavewavtobusinessexpansionandprofts.”Meanwhile,riskmanagersgrantedexcep-
tions to limits, and increased exposure limits, instead of keeping business units in
checkasthevhadtoldtheregulators.
-o
WellafterCitigroupsustainedlargelosseson
itsCDOs,theFedwouldcriticizethefrmforusingitscommercialbanktosupportits
investmentbankingactivities.“Seniormanagementallowedbusinesslineslargelvun-
challengedaccesstothebalancesheettopursuerevenuegrowth,”theFedwroteinan
Aprilioo8lettertoPandit.“Citigroupattainedsignifcantmarketshareacrossnumer-
ousproducts,includingleveragedfnanceandstructuredcredittrading,utilizingbal-
ance sheet for its ‘originate to distribute’ strategv. Senior management did not
appropriatelvconsiderthepotentialbalancesheetimplicationsofthisstrategvinthe
caseofmarketdisruptions.Further,thevdidnotadequatelvaccessthepotentialnega-
tiveimpactofearningsvolatilitvofthesebusinessesonthefrm’scapitalposition.”
oo
1ui \\iNi: : .++
Geithner told the Commission that he and others in leadership positions could
havedonemoretopreventthecrisis,testifving,“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
subsidiarvhad fguredoutthatthecompanvwastakingontoomuchrisk.Nonethe-
less,thevdidnotdoenoughaboutit.Doubtsaboutallthecreditdefaultswapsthat
thev were originating emerged in ioo- among AIG Financial Products executives,
including Andrew Forster and Gene Park. Park told the FCIC that he witnessed
FinancialProductsCEOIosephCassanoberatingasalesmanoverthelargevolume
ofcreditdefaultswapsbeingwrittenbvAIGFinancialProducts,suggestingtherewas
alreadvsomehigh-leveluneasinesswiththesedeals.Toldbvaconsultant,GarvGor-
ton,thatthe“multisector”CDOsonwhichAIGwassellingcreditdefaultswapscon-
sistedmainlvofmortgage-backedsecuritieswithlessthan1oºsubprimeandAlt-A
mortgages,ParkaskedAdamBudnick,anotherAIGemplovee,forverifcation.Bud-
nick double checked and returned to sav, according to Park, “‘I can’t believe it. You
know,it’slike8oorooº.’”Reviewingtheportfolio—andthinkingaboutafriendwho
hadreceived1ooºfnancingforhisnewhomeafterlosinghisjob—Parksaid,“This
ishorrendousbusiness.Weshouldgetoutofit.”
oi
In Iulv ioo-, Park’s colleague Andrew Forster sent an email both to Alan Frost,
the AIG salesman primarilv responsible for the companv’s booming credit default
swap business, and to Gorton, who had engineered the formula to determine how
muchriskAIGwastakingoneachCDSitwrote.“Wearetakingonahugeamountof
subprimemortgageexposurehere,”Forsterwrote.“Evervonewehavetalkedtosavs
thev are worried about deals with huge amounts [of high-risk mortgage] exposure
vetIregularlvseedealswith8oº[high-riskmortgage]concentrationscurrentlv.Are
thesereallvthesameriskasotherdeals:”
o:
Parkandothersstudiedtheissueforweeks,talkedtobankanalvstsandotherex-
perts,andconsideredwhetheritmadesenseforAIGtocontinuetowriteprotection
on the subprime and Alt-A mortgage markets. The general view of others was that
someoftheunderlvingmortgages“werestructuredtofail,[but]thatalltheborrow-
erswouldbasicallvbebailedoutaslongasrealestatepriceswentup.”
oa
TheAIGconsultantGortonrecalledameetingthatheandothersfromAIGhad
withoneBearStearnsanalvst.Theanalvstwassooptimisticaboutthehousingmar-
ket that thev 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,saving,“Weweren’tgetting
paidenoughmonevtotakethatrisk. . . .I’mnotgoingtoopineonwhetherthere’sa
train on its wav. I just know that I’m not getting paid enough to stand on these
tracks.”
oo
BvFebruarviooo,ParkandotherspersuadedCassanoandFrosttostopwriting
z++ ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN iiiui1
CDSprotectiononsubprimemortgage–backedsecurities.InanemailtoCassanoon
Februarvi8,Parkwrote:
Ioe,
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-
creasinglvbecomelessdiverseoverthelastvearorsoandiscurrentlvat
a state where deals are almost totallv 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 lavers (namelv BBB and single A tranches) of this
assetclass. . . .WerealizethatthisislikelvtotakeusoutoftheCDOof
ABS market for the time being given the arbitrage in subprime collat-
eral.However,weremaincommittedtoworkingwithunderwritersand
managers in developing the CDO of ABS market to hopefullv 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.“Thedavthatvou[AIG]drop
out,we’regoingtohave1ootherpeoplewhoaregoingtoreplacevou,”Parksavshe
wastoldbvaninvestmentbankeratanotherfrm.
o8
Inanvevent,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 Februarv iooo. Overall, thev completed :¬ deals between Sep-
tember ioo- and Iulv iooo—one of them on a CDO backed bv o:º subprime
assets.
oo
Bv Iune ioo¬, AIG had written swaps on ·¬o billion in multisector CDOs, fve
timesthe·1obillionheldattheendofioo-.
¬o
Parkassertedthatneitherhenormost
othersatAIGknewatthetimethattheswapsentailedcollateralcallsonAIGifthe
marketvalueofthereferencedsecuritiesdeclined.
¬1
Parksaidtheirconcernwassim-
plv 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
callsonlvifAIGweredowngraded.
Still,AIGneverhedgedmorethan·1-omillionofitstotalsubprimeexposure.
¬:
SomeofAIG’scounterpartiesnotonlvusedAIG’sswapstohedgeotherpositionsbut
alsohedgedAIG’sabilitvtomakegoodonitscontracts.Aswewillseelater,Goldman
SachshedgedaggressivelvbvbuvingCDSprotectiononAIGandbvshortingother
securitiesandindexestocounterbalancetheriskthatAIGwouldfailtopavuponits
swapsorthatacollapsingsubprimemarketwouldpulldownthevalueofmortgage-
backedsecurities.
MERRILL: “WHATEVER IT TAKES”
WhenDowKimbecameco-presidentofMerrillLvnch’sGlobalMarketsandInvest-
mentBankingGroupinIulvioo:,hewasinstructedtoboostrevenue,especiallvin
businesses in which Merrill lagged behind its competitors.
¬a
Kim focused on the
CDO business; clients saw CDOs as an integral part of their trading strategv, CEO
StanlevO’NealtoldtheFCIC.
¬-
KimhiredChrisRicciardifromCreditSuisse,where
Ricciardi’sgrouphadsoldmoreCDOsthananvoneelse.
¬o
Ricciardi came through, lifting Merrill’s CDO business from ffteenth place in
iooitosecondplacebehindonlvCitigroupiniooaandGoldmaninioo-.
¬¬
Then,in
Februarviooo,heleftthebanktobecomeCEOofCohen&Companv,anassetman-
agementbusiness;atCohenhewouldmanageseveralCDOs,oftendealsunderwrit-
tenbvMerrill.
AfterRicciardileft,Kiminstructedtherestoftheteamtodo“whateverittakes”
notjusttomaintainmarketsharebutalsototakeoverthenumberoneranking,for-
meremploveessaidinacomplaintfledagainstMerrillLvnch.
¬8
KimtoldFCICstaff
thathecouldn’trecallspecifcconversationsbutthatafterRicciardileft,Merrillwas
stilltrvingtoexpandtheCDObusinessgloballvandthathe,Kim,wantedpeopleto
knowthatMerrillwaswillingtocommititspeople,resources,andbalancesheetto
achievethatgoal.
¬o
Itwasindeedwilling.Despitethelossofitsrainmaker,Merrillswampedthecom-
petition, originating a total ·:8.o billion in mortgage-related CDOs in iooo, while
thesecond-rankedfrm,MorganStanlev,didonlv·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 attractivelv or buving its own products
when no one else would. Like Citigroup, Merrill increasinglv retained for its own
portfolio substantial portions of the CDOs it was creating, mainlv the super-senior
tranches, and it increasinglv repackaged the hard-to-sell BBB-rated and other low-
ratedtranchesofitsCDOsintoitsother CDOs;itusedthecashsittinginitssvnthetic
CDOstopurchaseotherCDOtranches.
z+z ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN iiiui1
IthadlongbeenstandardpracticeforCDOunderwriterstosellsomemezzanine
tranchestootherCDOmanagers.EvenintheearlvdavsofABSCDOs,theseassets
oftencontainedasmallpercentageofmezzaninetranchesofotherCDOs;therating
agenciessignedoffonthispracticewhenratingeachdeal.Butrelianceonthembe-
cameheavierasthedemandfromtraditionalinvestorswaned,asithadfortheriskier
tranchesofmortgage-backedsecurities.Themarketcametocalltraditionalinvestors
the“realmonev,”todistinguishthemfromCDOmanagerswhowerebuvingtranches
justtoputthemintotheirCDOs.Betweenioo-andioo¬,thetvpicalamountaCDO
couldincludeofthetranchesofotherCDOsandstillmaintainitsratingsgrewfrom
-ºto:oº,accordingtotheCDOmanagerWingChau.
8i
Accordingtodatacompiled
bv the FCIC, tranches from CDOs rose from an average of ¼ of the collateral in
mortgage-backed CDOs in ioo: to 1aº bv ioo¬. CDO-squared deals—those engi-
neered primarilv from the tranches of other CDOs—grew from :o marketwide in
ioo-toa8inioooanda1inioo¬.Merrillcreatedandsold11ofthem.
8:
Still, there are clear signs that few “real monev” investors remained in the CDO
marketbvlateiooo.ConsiderMerrill:fortheaaABSCDOsthatMerrillcreatedand
soldfromthefourthquarterofiooothroughAugustioo¬,nearlv8oºofthemezza-
ninetrancheswerepurchasedbvCDOmanagers.
8a
ThepatternwassimilarforChau:
an FCIC analvsis determined that 88º of the mezzanine tranches sold bv the 1:
CDOsmanagedbvChauweresoldforinclusionintootherCDOs.
8-
Anestimated1o
different CDO managers purchased tranches in Merrill’s Norma CDO. In the most
extremecasefoundbvtheFCIC,CDOmanagersweretheonlvpurchasersofMer-
rill’sNeoCDO.
8o
Marketwide,inioo:CDOstookinabout1:ºoftheAtranches,i:ºoftheAa
tranches, and a:º of the Baa tranches issued bv other CDOs, as rated bv Moodv’s.
(Moodv’sratingofAaaisequivalenttoS&P’sAAA,AatoAA,BaatoBBB,andBato
BB). In ioo¬, those numbers were 8¬º, 81º, and 8oº, respectivelv.

Merrill and
other investment banks simplv created demand for CDOs bv manufacturing new
onestobuvtheharder-to-sellportionsoftheoldones.
AsSECattornevstoldtheFCIC,headingintoioo¬therewasaStreetwidegentle-
man’sagreement:voubuvmvBBBtrancheandI’llbuvvours.
88
Merrill and its CDO managers were the biggest buvers of their own products.
Merrill created and sold 1ai CDOs from ioo: to ioo¬. All but 8 of these—1:a
CDOs—soldatleastonetrancheintoanotherMerrillCDO.InMerrill’sdeals,onav-
erage, 1oº of the collateral packed into the CDOs consisted of tranches of other
CDOsthatMerrillitselfhadcreatedandsold.Thiswasarelativelvhighpercentage,
but not the highest: for Citigroup, another big plaver in this market, the fgure was
1:º.ForUBS,itwasjust:º.
8o
Managersdefendedthepractice.Chau,whomanaged1:CDOscreatedandsold
bvMerrillatMaximGroupandlaterHardingAdvisorvandhadworkedwithRiccia-
rdiatPrudentialSecuritiesintheearlvdavsofmultisectorCDOs,toldtheFCICthat
plainmortgage-backedsecuritieshadbecomeexpensiveinrelationtotheirreturns,
even as the real estate market sagged. Because CDOs paid better returns than did
1ui \\iNi: : z+.
similarlv rated mortgage-backed securities, thev were in demand, and that is whv
CDOmanagerspackedtheirsecuritieswithotherCDOs.
oo
AndMerrillcontinuedtopushitsCDObusinessdespitesignalsthatthemarket
was weakening. As late as the spring of iooo, when AIG stopped insuring even the
vervsafest,super-seniorCDOtranchesforMerrillandothers,itdidnotreconsider
its strategv. Cut off from AIG, which had alreadv insured ·o.o billion of its CDO
bonds
o1
—Merrill was AIG’s third-largest counterpartv, 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 equitv tranches. In response, Merrill continued to
ramp up its CDO warehouses and inventorv; and in an effort to compete and get
deals done, it increasinglv took on super-senior positions without insurance from
AIGorthemonolines.
oi
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 trophv in the mortgage-related
CDObusinessiniooo,ithadcomelatetothe“verticalintegration”mortgagemodel
thatLehmanBrothersandBearStearnshadpioneered,whichrequiredhavingastake
inevervstepofthemortgagebusiness—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 Citv Corp. for ·1.:
billion. As a fnance reporter later noted, this move “puzzled analvsts because the
marketforsubprimeloanswassouringinahurrv.”
o:
AndMerrillalreadvhada·1oo
millionownershippositioninOwnitMortgageSolutionsInc.,forwhichitprovideda
warehouse line of credit; it also provided a line of credit to Mortgage Lenders Net-
work.
oa
BothofthosecompanieswouldceaseoperationssoonaftertheFirstFranklin
purchase.
o-
NordidMerrillcutbackinSeptemberiooo,whenoneofitsownanalvstsissueda
reportwarningthatthissubprimeexposurecouldleadtoasuddencutinearnings,
becausedemandforthesemortgagesassetscoulddrvupquicklv.
oo
Thatassessment
was not in line with the corporate strategv, and Merrill did nothing. Finallv, at the
endofiooo,Kiminstructedhispeopletoreducecreditriskacrosstheboard.

Asit
wouldturnout,thevweretoolate.Thepipelinewastoolarge.
REGULATORS: “ARE UNDUE CONCENTRATIONS
OF RISK DEVELOPING? ”
Ashadhappenedwhenthevfacedthequestionofguidanceonnontraditionalmort-
gages,indealingwiththerapidlvchangingstructuredfnancemarkettheregulators
failedtotaketimelvaction.Thevmissedacrucialopportunitv.OnIanuarvi,ioo:,
onevearafterthecollapseofEnron,theU.S.SenatePermanentSubcommitteeonIn-
z+. ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN iiiui1
vestigations called on the Fed, OCC, and SEC “to immediatelv initiate a one-time,
jointreviewofbanksandsecuritiesfrmsparticipatingincomplexstructuredfnance
products with U.S. public companies to identifv those structured fnance products,
transactions,orpracticeswhichfacilitateaU.S.companv’suseofdeceptiveaccount-
inginitsfnancialstatementsorreports.”Thesubcommitteerecommendedtheagen-
cies issue joint guidance on “acceptable and unacceptable structured fnance
products, transactions and practices” bv Iune ioo:.
o8
Four vears later, the banking
agenciesandtheSECissuedtheir“InteragencvStatementonSoundPracticesCon-
cerningElevatedRiskComplexStructuredFinanceActivities,”adocumentthatwas
allofninepageslong.
oo
Intheinterveningvears,fromioo:toioo¬,thebankingagenciesandSECissued
two draft statements for public comment. The iooa draft, issued the vear after the
OCC,Fed,andSEChadbroughtenforcementactionsagainstCitigroupandIPMor-
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,weretrvingtousestructuredtransactionstocircumventregulatorvorfnancial
reporting requirements, evade tax liabilities, or engage in other illegal or improper
behavior.
Industrvgroupscriticizedthedraftguidanceastoobroad,prescriptive,andbur-
densome.Severalsaiditwouldcovermanvstructuredfnanceproductsthatdidnot
pose signifcant legal or reputational risks. Another said that it “would disrupt the
marketforlegitimatestructuredfnanceproductsandplaceU.S.fnancialinstitutions
atacompetitivedisadvantageinthemarketfor[complexstructuredfnancetransac-
tions]intheUnitedStatesandabroad.”
1o1
Two vears later, in Mav iooo, the agencies issued an abbreviated draft that re-
fectedamore“principles-based”approach,andagainrequestedcomments.Mostof
therequirementswerevervsimilartothosethattheOCCandFedhadimposedon
CitigroupandIPMorganintheioo:enforcementactions.
1oi
WhentheregulatorsissuedthefnalguidanceinIanuarvioo¬,theindustrvwas
more supportive. One reason was that mortgage-backed securities and CDOs were
specifcallvexcluded:“Moststructuredfnancetransactions,suchasstandardpublic
mortgage-backed securities and hedging-tvpe transactions involving ‘plain vanilla’
derivativesorcollateralizeddebtobligations,arefamiliartoparticipantsinthefnan-
cialmarkets,havewell-establishedtrackrecords,andtvpicallvwouldnotbeconsid-
ered [complex structured fnance transactions] for purposes of the Final
Statement.”
1o:
Those exclusions had been added after the regulators received com-
mentsontheiooadraft.
RegulatorsdidtakenoteofthepotentialrisksofCDOsandcreditdefaultswaps.
Inioo-,theBaselCommitteeonBankingSupervision’sIointForum,whichincludes
banking,securities,andinsuranceregulatorsfromaroundtheworld,issuedacom-
prehensivereportontheseproducts.Thereportfocusedonwhetherbanksandother
frms involved in the CDO and credit default swap business understood the credit
1ui \\iNi: : z+,
riskthevweretaking.Itadvisedthemtomakesurethatthevunderstoodthenature
oftheratingagencies’models,especiallvforCDOs.Anditfurtheradvisedthemto
make sure that counterparties from whom thev bought credit protection—such as
AIG and the fnancial guarantors—would be good for that protection if it was
needed.
1oa
Theregulatorsalsosaidthevhadresearchedinsomedepth,fortheCDOandde-
rivativesmarket,thequestion“Areundueconcentrationsofriskdeveloping:”Their
answer: probablv not. The credit risk was “quite modest,” the regulators concluded,
andthemonolinefnancialguarantorsappearedtoknowwhatthevweredoing.
1o-
The [Ioint Forum’s Working Group on Risk Assessment and Capital]
hasnotfoundevidenceof‘hiddenconcentrations’ofcreditrisk.There
are some non-bank frms whose primarv business model focuses on
takingoncreditrisk.Mostimportantamongthesefrmsarethemono-
line fnancial guarantors. Other market participants seem to be fullv
awareofthenatureofthesefrms.Inthecaseofthemonolines,credit
riskhasalwavsbeenaprimarvbusinessactivitvandthevhaveinvested
heavilv in obtaining the relevant expertise. While obviouslv this does
notruleoutthepotentialforoneofthesefrmstoexperienceunantici-
patedproblemsortomisjudgetherisks,theirrisksareprimarilvatthe
catastrophicormacroeconomiclevel.Itisalsoclearthatsuchfrmsare
subjectedtoregulatorv,ratingagencv,andmarketscrutinv.
1oo
The regulators noted that industrv participants appeared to have learned from
earlierfare-upsintheCDOsector:“TheWorkingGroupbelievesthatitisimportant
forinvestorsinCDOstoseektodevelopasoundunderstandingofthecreditrisksin-
volved and not to relv solelv on rating agencv assessments. In manv respects, the
losses and downgrades experienced on some of the earlv generation of CDOs have
probablvbeensalutarvinhighlightingthepotentialrisksinvolved.”
1o¬
MOODY’ S: “IT WAS ALL ABOUT REVENUE”
Likeothermarketparticipants,Moodv’sInvestorsService,oneofthethreedominant
rating agencies, was swept up in the frenzv of the structured products market. The
tranching structure of mortgage-backed securities and CDOs was standardized ac-
cordingtoguidelinessetbvtheagencies;withouttheirmodelsandtheirgenerousal-
lotment of triple-A ratings, there would have been little investor interest and few
deals.Betweeniooiandiooo,thevolumeofMoodv’sbusinessdevotedtoratingres-
identialmortgage–backedsecuritiesmorethandoubled;thedollarvalueofthatbusi-
ness increased from ·oi million to ·1oo million; the number of staff rating these
dealsdoubled.Butoverthesameperiod,whilethevolumeofCDOstoberatedin-
creased sevenfold, stamng increased onlv iaº. From ioo: to iooo, annual revenue
tiedtoCDOsgrewfrom·1imillionto·o1million.
1o8
When Moodv’s Corporation went public in iooo, the investor Warren Buffett’s
z+( ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN iiiui1
Berkshire Hathawav held 1-º of the companv. After share repurchases bv Moodv’s
Corporation, Berkshire Hathawav’s holdings of outstanding shares increased to over
ioºbvioo8.Asofio1o,BerkshireHathawavandthreeotherinvestorsownedacom-
bined-o.-ºofMoodv’s.Whenaskedwhetherhewassatisfedwiththeinternalcon-
trols at Moodv’s, Buffett responded to the FCIC that he knew nothing about the
managementofMoodv’s.“Ihadnoidea.I’dneverbeenatMoodv’s,Idon’tknowwhere
thev are located.”
1oo
Buffett said that he invested in the companv because the rating
agencv business was “a natural duopolv,” which gave it “incredible” pricing power—
and“thesingle-mostimportantdecisioninevaluatingabusinessispricingpower.”
11o
Manv former emplovees said that after the public listing, the companv culture
changed—itwent“from[aculture]resemblingauniversitvacademicdepartmentto
onewhichvaluesrevenuesatallcosts,”accordingtoEricKolchinskv,aformerman-
agingdirector.
111
Emploveesalsoidentifedanewfocusonmarketsharedirectedbv
formerpresidentofMoodv’sInvestorsServiceBrianClarkson.Clarksonhadjoined
Moodv’sin1oo1asasenioranalvstintheresidentialmortgagegroup,andaftersuc-
cessivepromotionshebecameco-chiefoperatingomceroftheratingagencviniooa,
and then president in August ioo¬.
11i
Garv Witt, a former team managing director
coveringU.S.derivatives,describedtheculturaltransformationunderClarkson:“Mv
kind of working hvpothesis was that [former chairman and CEO] Iohn Rutherford
wasthinking,‘Iwanttoremakethecultureofthiscompanvtoincreaseproftabilitv
dramaticallv[afterMoodv’sbecameanindependentcorporation],’andthathemade
personneldecisionstomakethathappen,andhewassuccessfulinthatregard.And
thatwaswhvBrianClarkson’srisewassometeoric: . . .hewastheenforcerwhocould
changetheculturetohavemorefocusonmarketshare.”
11:
Theformermanagingdi-
rector Ierome Fons, who was responsible for assembling an internal historv of
Moodv’s,agreed:“Themainproblemwas . . .thatthefrmbecamesofocused,partic-
ularlvthestructuredarea,onrevenues,onmarketshare,andtheambitionsofBrian
Clarkson, that thev willinglv looked the other wav, traded the frm’s reputation for
short-termprofts.”
11a
Moodv’sCorporationChairmanandCEORavmondMcDanieldidnotagreewith
thisassessment,tellingtheFCICthathedidn’tsee“anvparticulardifferenceincul-
ture” after the spin-off.
11-
Clarkson also disputed this version of events, explaining
thatmarketsharewasimportanttoMoodv’swellbeforeitwasanindependentcom-
panv.“[TheideathatbeforeMoodv’s]wasspunofffromDun&Bradstreet,itwasa
sortofsleepv,academickindofcompanvthatwasinanivorvtower . . .isn’tthecase,
vou know,” he explained. “I think [the ivorv tower] was reallv a misnomer. I think
thatMoodv’shasalwavsbeenfocusedonbusiness.”
11o
Clarkson and McDaniel also adamantlv disagreed with the perception that con-
cernsaboutmarketsharetrumpedratingsqualitv.ClarksontoldtheFCICthatitwas
fneforMoodv’stolosetransactionsifitwasforthe“rightreasons”:“Ifitwasananalvt-
icalreasonoritwasacreditreason,there’snotalotvoucandoaboutthat.Butifvou’re
losing a deal because vou’re not communicating, vou’re not being transparent, vou’re
not picking up the phone, that could be problematic.”
11¬
McDaniel cited unforeseen
marketconditionsasthereasonthatthemodelsdidnotaccuratelvpredictthecredit
1ui \\iNi: : z+,
qualitv.
118
HetestifedtotheFCIC,“Webelievedthatourratingswereourbestopinion
atthetimethatweassignedthem.Asweobtainednewinformationandwereableto
updateourjudgmentsbasedonthenewinformationandthetrendswewereseeingin
thehousingmarket,wemadewhatIthinkareappropriatechangestoourratings.”
11o
Nonetheless, Moodv’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.ScottMcCleskev,aformerchiefcomplianceomceratMoodv’s,recounteda
storv to the FCIC about an evening when he and Clarkson were dining with the
boardofdirectorsafterthecompanvhadannouncedstrongearnings,particularlvin
the business of rating mortgage-backed securities and CDOs. “So Brian Clarkson
comes up to me, in front of evervbodv at the table, including board members, and
savs literallv, ‘How much revenue did Compliance bring in this quarter: Nothing.
Nothing.’ . . .Forhimtosavthatinfrontoftheboard,that’sjustsotellingofhowhe
feltthathewasbulletproof. . . .Forhim,itwasallaboutrevenue.”
1io
Clarksontoldthe
FCICthathedidn’trememberthisconversationtranspiringandsaid,“Frommvper-
spective,complianceisavervimportantfunction.”
1i1
AccordingtosomeformerMoodv’semplovees,Clarkson’smanagementstvleleft
little room for discussion or dissent. Witt referred to Clarkson as the “dictator” of
Moodv’sandsaidthatifheaskedanemploveetodosomething,“eithervoucomplv
withhisrequestorvoustartlookingforanotherjob.”
1ii
“WhenIjoinedMoodv’sin
late1oo¬,ananalvst’sworstfearwasthatwewouldcontributetotheassignmentofa
rating that was wrong,” Mark Froeba, former senior vice president, testifed to the
FCIC.“WhenIleftMoodv’s,ananalvst’sworstfearwasthathewoulddosomething,
orshe,thatwouldallowhimorhertobesingledoutforjeopardizingMoodv’smar-
ketshare.”
1i:
Clarksondeniedhavinga“forceful”managementstvle,andhissupervi-
sor,RavmondMcDaniel,toldtheFCICthatClarksonwasa“goodmanager.”
1ia
Former team managing director Garv Witt recalled that he received a monthlv
emailfromClarkson“thatoutlinedbasicallvmvmarketshareintheareasthatIwas
inchargeof. . . .Ibelieveitlistedthedealsthatwedid,andthenitwouldlistthedeals
likeS&Pand/orFitchdidthatwedidn’tdothatwasinmvarea.Andattimes,Iwould
have to comment on that verballv or even write a written report about—vou know,
lookintowhatwasitaboutthatdeal,whvdidwenotrateit.So,vouknow,itwasclear
that market share was important to him.” Witt acknowledged the pressures that he
felt as a manager: “When I was an analvst, I just thought about getting the deals
right. . . .OnceI[waspromotedtomanagingdirectorand]hadabudgettomeet,I
had salaries to pav, I started thinking bigger picture. I started realizing, ves, we do
haveshareholdersand,ves,thevdeservedtomakesomemonev.Weneedtogetthe
ratings right frst, that’s the most important thing; but vou do have to think about
marketshare.”
1i-
Evenasfarbackasioo1,astrongemphasisonmarketsharewasevidentinem-
plovee performance evaluations. In Iulv ioo1, Clarkson circulated a spreadsheet to
subordinatesthatlistedaoanalvstsandthenumberanddollarvolumeofdealseach
had“rated”or“NOTrated.”Clarkson’sinstructions:“YoushouldbeusingthisinPE’s
z+· ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN iiiui1
[performanceevaluations]andtogivepeopleaheadsuponwherethevstandrelative
to their peers.”
1io
Team managing directors, who oversaw the analvsts rating the
deals,receivedabasesalarv,cashbonus,andstockoptions.Theirperformancegoals
generallvfellintothecategoriesofmarketcoverage,revenue,marketoutreach(such
as speeches and publications), ratings qualitv, and development of analvtical tools,
onlvoneofwhichwasimpossibletomeasureinrealtimeascompensationwasbeing
awarded:ratingsqualitv.Itmighttakevearsforthepoorqualitvofaratingtobecome
clearastheratedassetfailedtoperformasexpected.
InIanuarviooo,aderivativesmanagerlistedhismostimportantachievementsin
aioo-performanceevaluation.Atthetopofthelist:“Protectedourmarketsharein
theCDOcorporatecashfowsector. . . .TomvknowledgewemissedonlvoneCLO
[collateralizedloanobligation]fromBofAandthatCLOwasunratablebvusbecause
ofit’s[sic]bizarrestructure.”
1i¬
MoreevidenceofMoodv’semphasisonmarketsharewasprovidedbvanemailthat
circulatedinthefallofioo¬,inthemidstofsignifcantdowngradesinthestructuredf-
nancemarket.GroupManagingDirectorofU.S.DerivativesYuriYoshizawaaskedher
team’smanagingdirectorstoexplainamarketsharedecreasefromo8ºtooaº.
1i8
Despitethisapparentemphasisonmarketshare,ClarksontoldtheFCICthat“the
mostimportantgoalforanvmanagingdirectorwouldbecredibilitv . . .andperform-
ance[of]theratings.”
1io
McDaniel,thechairmanandCEOofMoodv’sCorporation,
elaborated: “I disagree that there was a drive for market share. We pav attention to
ourpositioninthemarket. . . .Butratingsqualitv,gettingtheratingstothebestpos-
siblepredictivecontent,predictivestatus,isparamount.”
1:o
WhateverMcDaniel’sorClarkson’sintendedmessage,someemploveescontinued
toseeanemphasisonMoodv’smarketshare.FormerteammanagingdirectorWitt
recalled that the “smoking gun” moment of his emplovment at Moodv’s occurred
duringa“townhall”meetinginthethirdquarterofioo¬withMoodv’smanagement
anditsmanagingdirectors,afterMoodv’shadalreadvannouncedmassdowngrades
on mortgage-related securities.
1:1
After McDaniel made a presentation about
Moodv’s fnancial outlook for the vear ahead, one managing director responded: “I
wasinterested,Rav,tohearvourbeliefthatthefrstthinginthemindsofpeoplein
thisroomisthefnancialoutlookfortheremainderofthevear. . . .[M]vthinkingis
there’s a much greater concern about the franchise.” He added, “I think that the
greateranxietvbeingfeltbvthepeopleinthisroomand . . .bvtheanalvstsiswhat’s
goingonwiththeratingsandwhattheoutlookis[,] . . .specifcallvthesevereratings
transitionswe’redealingwith . . .anduncertaintvaboutwhat’saheadonthat,therat-
ingsaccuracv.”
1:i
Wittrecalled,“Moodv’sreputationwasjustbeingabsolutelvlacer-
ated; and that these people are standing here, and thev’re not even
addressing—thev’re acting like it’s not even happening, even now that it’s alreadv
happened. . . .[T]hatjustmadeitsocleartome . . .thatthebalancewasfartoomuch
onthesideofshort-termproftabilitv.”
1::
InaninternalmemorandumfromOctoberioo¬senttoMcDaniel,inasection
titled “Confict of Interest: Market Share,” Chief Credit Omcer Andrew Kimball
1ui \\iNi: : z++
explainedthat“Moodv’shaserectedsafeguardstokeepteamsfromtooeasilvsolv-
ing the market share problem bv lowering standards.” But he observed that these
protectionswerefarfromfail-safe,ashedetailedintwoarea.First,“Ratingsareas-
signed bv 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 usuallv plentv of latitude within those boundaries to register
marketinfuence.)”
1:a
Moreover,thepressureformarketshare,combinedwithcomplacencv,mavhave
deterredMoodv’sfromcreatingnewmodelsorupdatingitsassumptions,asKimball
wrote:“Organizationsofteninterpretpastsuccessesasevidencingtheircompetence
and the adequacv of their procedures rather than a run of good luck. . . . [O]ur ia
vearsofsuccessratingRMBS[residentialmortgage–backedsecurities]mavhavein-
ducedmanagerstomerelvfne-tunetheexistingsvstem—tomakeitmoreemcient,
more proftable, cheaper, more versatile. Fine-tuning rarelv raises the probabilitv of
success;infact,itoftenmakessuccesslesscertain.”
1:-
Ifanissuerdidn’tlikeaMoodv’sratingonaparticulardeal,itmightgetabetter
rating from another ratings agencv. The agencies were compensated onlv for rated
deals—ineffect,onlvforthedealsforwhichtheirratingswereacceptedbvtheissuer.
Sothepressurecamefromtwodirections:in-houseinsistenceonincreasingmarket
shareanddirectdemandsfromtheissuersandinvestmentbankers,whopushedfor
betterratingswithfewerconditions.
1:o
RichardMichalek,aformerMoodv’svicepresidentandseniorcreditomcer,testi-
fedtotheFCIC,“Thethreatoflosingbusinesstoacompetitor,evenifnotrealized,
absolutelvtiltedthebalanceawavfromanindependentarbiterofrisktowardsacap-
tive facilitator of risk transfer.”
1:¬
Witt agreed. When asked if the investment banks
frequentlvthreatenedtowithdrawtheirbusinessifthevdidn’tgettheirdesiredrat-
ing, Witt replied, “Oh God, are vou kidding: All the time. I mean, that’s routine. I
mean,thevwouldthreatenvouallofthetime. . . .It’slike,‘Well,nexttime,we’rejust
goingtogowithFitchandS&P.’”
1:8
Clarksonamrmedthat“itwouldn’tsurprisemeto
hearpeoplesavthat”aboutissuerpressureonMoodv’semplovees.
1:o
FormermanagingdirectorFonssuggestedthatMoodv’swascomplaisantwhenit
shouldhavebeenprincipled:“[Moodv’s]knewthatthevwerebeingbulliedintocav-
ingintobankpressurefromtheinvestmentbanksandoriginatorsofthesethings. . . .
Moodv’s allow[ed] itself to be bullied. And, vou know, thev willinglv plaved the
game. . . .Thevcouldhavestoodupandsaid,‘I’msorrv,thisisnot—we’renotgoing
tosignoffonthis.We’regoingtoprotectinvestors.We’regoingtostop—vouknow,
we’regoingtotrvtoprotectourreputation.We’renotgoingtoratetheseCDOs,we’re
notgoingtoratethesesubprimeRMBS.’”
1ao
KimballelaboratedfurtherinhisOctoberioo¬memorandum:
Ideallv,competitionwouldbeprimarilvonthebasisofratingsqualitv,
with a second component of price and a third component of service.
z.+ ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN iiiui1
Unfortunatelv,ofthethreecompetitivefactors,ratingqualitvisproving
theleastpowerfulgiventhelongtailinmeasuringperformance. . . .The
real problem is not that the market does underweights [sic] ratings
qualitv but rather that, in some sectors, it actuallv penalizes qualitv bv
awarding rating mandates based on the lowest credit enhancement
neededforthehighestrating.Unchecked,competitiononthisbasiscan
placetheentirefnancialsvstematrisk.Itturnsoutthatratingsqualitv
has surprisinglv few friends: issuers want high ratings; investors don’t
wantratingdowngrades;andbankersgametheratingagenciesforafew
extrabasispointsonexecution.
1a1
Moodv’semploveestoldtheFCICthatonetacticusedbvtheinvestmentbankers
to applv subtle pressure was to submit a deal for a rating within a verv tight time
frame. Kolchinskv, who oversaw ratings on CDOs, recalled the case of a particular
CDO:“Whatthetroubleonthisdealwas,andthisiscrucialaboutthemarketshare,
wasthatthebankergaveushardlvanvnoticeandanvdocumentsandanvtimetoan-
alvzethisdeal. . . .Becausebankersknewthatwecouldnotsavnotoadeal,couldnot
walk awav from the deal because of a market share, thev took advantage of that.”
1ai
ForthisCDOdeal,thebankersallowedonlvthreeorfourdavsforreviewandfnal
judgment. Kolchinskv emailed Yoshizawa that the transactions had “egregiouslv
pushed our time limits (and analvsts).”
1a:
Before the frothv davs of the peak of the
housing boom, an agencv took six weeks or even two months to rate a CDO.
1aa
Bv
iooo, Kolchinskv described a verv different environment in the CDO group:
“Bankerswerepushingmoreaggressivelv,sothatitbecamefromaquietlittlegroup
to more of a machine.”
1a-
In iooo, Moodv’s gave triple-A ratings to an average of
morethan:omortgagesecuritieseachandevervworkingdav.
1ao
SuchpressurecanbeseeninanAprilioooemailtoYoshizawafromamanaging
directorinsvntheticCDOtradingatCreditSuisse,whoexplained,“I’mgoingtohave
amajorpoliticalproblemifwecan’tmakethis[dealrating]shortandsweetbecause,
eventhoughIalwavsexplaintoinvestorsthatclosingissubjecttoMoodv’stimelines,
thevoftenchoosenottohearit.”
1a¬
TheexternalpressurewassummedupinKimball’sOctoberioo¬memorandum:
“Analvstsand[managingdirectors]arecontinuallv‘pitched’bvbankers,issuers,in-
vestors—all with reasonable arguments—whose views can color credit judgment,
sometimesimprovingit,othertimesdegradingit(we‘drinkthekool-aid’).Coupled
withstronginternalemphasisonmarketshare&marginfocus,thisdoesconstitutea
‘risk’toratingsqualitv.”
1a8
The SEC investigated the rating agencies’ ratings of mortgage-backed securities
andCDOsinioo¬,reportingitsfndingstoMoodv’sinIulvioo8.TheSECcriticized
Moodv’sfor,amongotherthings,failingtoverifvtheaccuracvofmortgageinforma-
tion,leavingthatworktoduediligencefrmsandotherparties;failingtoretaindoc-
umentation about how most deals were rated; allowing ratings qualitv to be
compromised bv the complexitv of CDO deals; not hiring sumcient staff to rate
1ui \\iNi: : z..
z.z ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN iiiui1
CDOs; pushing ratings out the door with insumcient review; failing to adequatelv
disclose its rating process for mortgage-backed securities and CDOs; and allowing
confictsofinteresttoaffectratingdecisions.
1ao
Somattersstoodinioo¬,whenthemachinethathadbeenhummingsosmoothlv
andsolucrativelvslippedagear,andthenanother,andanother—andthenseizedup
entirelv.
COMMISSION CONCLUSIONS ON CHAPTER 10
The Commission concludes that the credit rating agencies abvsmallv failed in
theircentralmissiontoprovidequalitvratingsonsecuritiesforthebeneftofin-
vestors.Thevdidnotheedmanvwarningsignsindicatingsignifcantproblemsin
the housing and mortgage sector. Moodv’s, the Commission’s case studv in this
area,continuedissuingratingsonmortgage-relatedsecurities,usingitsoutdated
analvtical models, rather than making the necessarv adjustments. The business
modelunderwhichfrmsissuingsecuritiespaidfortheirratingsseriouslvunder-
minedthequalitvandintegritvofthoseratings;theratingagenciesplacedmarket
shareandproftconsiderationsabovethequalitvandintegritvoftheirratings.
Despitethelevelingoffandsubsequentdeclineofthehousingmarketbegin-
ning in iooo, securitization of collateralized debt obligations (CDOs), CDOs
squared, and svnthetic CDOs continued unabated, greatlv expanding the expo-
suretolosseswhenthehousingmarketcollapsedandexacerbatingtheimpactof
thecollapseonthefnancialsvstemandtheeconomv.
During this period, speculators fueled the market for svnthetic CDOs to bet
onthefutureofthehousingmarket.CDOmanagersofthesesvntheticproducts
hadpotentialconfictsintrvingtoservetheinterestsofcustomerswhowerebet-
ting mortgage borrowers would continue to make their pavments and of cus-
tomerswhowerebettingthehousingmarketwouldcollapse.
Therewerealsopotentialconfictsforunderwritersofmortgage-relatedsecu-
rities to the extent thev 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|princwcrrv”:::
Icga|rcncdics“Onthc|asiscjthcinjcrnaticn”::;
Icsscs“Vhccwnsrcsidcntia|crcditrisk?” ::e
What happens when a bubble bursts: In earlv ioo¬, it became obvious that home
priceswerefallinginregionsthathadonceboomed,thatmortgageoriginatorswere
foundering, and that more and more families, especiallv those with subprime and
Alt-Aloans,wouldbeunabletomaketheirmortgagepavments.
What was not immediatelv clear was how the housing crisis would affect the f-
nancial svstem 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 . . .questionsaboutthesolvencv
ofthefrms,”WilliamC.Dudlev,nowpresidentoftheFederalReserveBankofNew
York,toldtheFCIC.
1
Intheorv,securitization,over-the-counterderivativesandthemanvbvwavsofthe
shadowbankingsvstemweresupposedtodistributeriskemcientlvamonginvestors.
Thetheorvwouldprovetobewrong.Muchoftheriskfrommortgage-backedsecuri-
ties had actuallv been taken bv a small group of svstemicallv important companies
withoutsizedholdingsof,orexposureto,thesuper-seniorandtriple-Atranchesof
CDOs. These companies would ultimatelv 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; manv would shut
down.Bankswrotedownthevalueoftheirholdingsbvtensofbillionsofdollars.
z..
Thesummerofioo¬alsosawanearhaltinmanvsecuritizationmarkets,includ-
ingthemarketfornon-agencvmortgagesecuritizations.Forexample,atotalof·¬-
billioninsubprimesecuritizationswereissuedinthesecondquarterofioo¬(alreadv
down from prior quarters). That fgure dropped precipitouslv to ·i¬ billion in the
third quarter and to onlv ·1i billion in the fourth quarter of ioo¬. Alt-A issuance
topped·1oobillioninthesecondquarter,butfellto·1:billioninthefourthquarter
ofioo¬.Once-boomingmarketswerenowgone—onlv·abillioninsubprimeorAlt-
Amortgage-backedsecuritieswereissuedinthefrsthalfofioo8,andalmostnone
afterthat.
i
CDOsfollowedsuit.Fromahighofmorethan·oobillioninthefrstquarterof
ioo¬, worldwide issuance of CDOs with mortgage-backed securities as collateral
plummeted to ·io billion in the third quarter of ioo¬ and onlv ·- billion in the
fourthquarter.AndastheCDOmarketgroundtoahalt,investorsnolongertrusted
other structured products.
:
Over ·8o billion of collateralized loan obligations
(CLOs),orsecuritizedleveragedloans,wereissuedinioo¬;onlv·1obillionwereis-
sued in ioo8. The issuance of commercial real estate mortgage–backed securities
plummetedfrom·i:ibillioninioo¬to·1ibillioninioo8.
a
Thosesecuritizationmarketsthatheldupduringtheturmoilinioo¬eventuallv
suffered in ioo8 as the crisis deepened. Securitization of auto loans, credit cards,
smallbusinessloans,andequipmentleasesallnearlvceasedinthethirdandfourth
quartersofioo8.
DELINQUENCIES: “THE TURN OF THE HOUSING MARKET”
Homepricesrose1-ºnationallvinioo-,theirthirdvearofdouble-digitgrowth.But
bvthespringofiooo,asthesalespaceslowed,thenumberofmonthsitwouldtaketo
selloffallthehomesonthemarketrosetoitshighestlevelin1ovears.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
wouldbehealthvandthatthegoaloftheFOMCshouldbetoensurethecorrection
didnotoverlvaffectthegrowthoftherestoftheeconomv.
-
InOctoberiooo,withthehousingmarketdownturnunderwav,Moodv’sEcon-
omv.com, a business unit separate from Moodv’s Investors Service, issued a report
authoredbvChiefEconomistMarkZandititled“HousingattheTippingPoint:The
Outlook for the U.S. Residential Real Estate Market.” He came to the following
conclusion:
Nearlv 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 NuUi i¥ tu\\i : :i uN iiiui1
1ui 8U:1 z.,
fornia areas, throughout the broad Washington, D.C. area, and in and
aroundDetroit.Manvmoremetroareasareexpectedtoexperienceonlv
house-pricecorrectionsinwhichpeak-to-troughpricedeclinesremain
inthesingledigits. . . .Itisimportanttonotethatpricedeclinesinvari-
ousmarketsareexpectedtoextendintoioo8andeveniooo.
With over 1oo metro areas representing nearlv 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-vears.Thatvear,home
pricesdeclinedoº.Inioo8,thevwoulddropastunning1¬º.Overall,bvtheendof
iooo,priceswoulddropi8ºfromtheirpeakiniooo.
¬
Somecitiessawaparticularlv
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 earlv as late ioo-. For example, in
OceanCitv,NewIersev,wheremanvpropertiesarevacationhomes,homepriceshad
risen1aaºsinceioo1;thevtoppedoutinDecemberioo-andfellaºinthefrsthalf
of iooo. Bv mid-io1o, thev would be iiº below their peak. Prices topped out in
SacramentoinOctoberioo-andaretodavdownnearlv-oº.Inmostplaces,prices
rose for a bit longer. For instance, in Tucson, Arizona, prices kept increasing for
muchofiooo,climbingo-ºfromioo1totheirhighpointinAugustiooo,andthen
fellonlv:ºbvtheendofthevear.
8
One of the frst signs of the housing crash was an upswing in earlv pavment de-
faults—usuallvdefnedasborrowers’beingooormoredavsdelinquentwithinthefrst
vear. Figures provided to the FCIC show that bv the summer of iooo, 1.-º of loans
lessthanavearoldwereindefault.Thefgurewouldpeakinlateioo¬ati.-º,well
above the 1.oº peak in the iooo recession. Even more stunning, frst pavment de-
faults—thatis,mortgagestakenoutbvborrowerswhonevermadeasinglepavment—
went above 1.-º of loans in earlv ioo¬.
o
Responding to questions about that data,
CoreLogicChiefEconomistMarkFlemingtoldtheFCICthattheearlvpavmentde-
faultrate“certainlvcorrelateswiththeincreaseintheAlt-Aandsubprimesharesand
theturnofthehousingmarketandthesensitivitvofthoseloanproducts.”
1o
Mortgagesinseriousdelinquencv,defnedasthoseooormoredavspastdueorin
foreclosure,hadhoveredaround1ºduringtheearlvpartofthedecade,jumpedin
iooo,andkeptclimbing.Bvtheendofiooo,o.¼ofmortgageloanswereseriouslv
delinquent.Bvcomparison,seriousdelinquenciespeakedati.aºiniooifollowing
thepreviousrecession.
11
Seriousdelinquencvwashighestinareasofthecountrvthathadexperiencedthe
biggest housing booms. In the “sand states”—California, Arizona, Nevada, and
Florida—seriousdelinquencvroseto:ºinmid-ioo¬and1-ºbvlateiooo,double
therateinotherareasofthecountrv(seefgure11.1).
1i
z.( ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN iiiui1
Serious delinquencv also varied bv tvpe of loan (see fgure 11.i). Subprime ad-
justable-ratemortgagesbegantoshowincreasesinseriousdelinquencvinearlviooo,
evenashousepriceswerepeaking;therateroserapidlvtoioºinioo¬.Bvlateiooo,
thedelinquencvrateforsubprimeARMswasaoº.PrimeARMsdidnotweakenun-
tilioo¬,ataboutthesametimeassubprimefxed-ratemortgages.Primefxed-rate
mortgages,whichhavehistoricallvbeentheleastriskv,showedaslowincreaseinse-
riousdelinquencvthatcoincidedwiththeincreasingseveritvoftherecessionandof
unemplovmentinioo8.
The FCIC undertook an extensive examination of the relative performance of
mortgages purchased or guaranteed bv the GSEs, those securitized in the private
market, and those insured bv the Federal Housing Administration or Veterans Ad-
ministration(seefgure11.:).Theanalvsiswasconductedusingroughlvi-million
mortgagesoutstandingattheendofeachvearfromiooothroughiooo.
1:
Thedata
containedmortgagesinfourgroups—loansthatweresoldintoprivatelabelsecuriti-
zationslabeledsubprimebvissuers(labeledSUB),loanssoldintoprivatelabelAlt-A
securitizations(ALT),loanseitherpurchasedorguaranteedbvtheGSEs(GSE),and
loansguaranteedbvtheFederalHousingAdministrationorVeteransAdministration
(FHA).
1a
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·a1¬,ooo(conformingtoGSEloansizelimits),aFICOscorebetween
oaoando-o(aborrowerwithbelow-averagecredithistorv),andLTVbetween8oº
and 1ooº. Another group would be Alt-A loans with the same characteristics. In
each vear, the loans were broken into -¬o different subgroups—1aa each for GSE,
SUB,ALT,andFHA.
1-
Figure11.:graphicallvdemonstratestheresultsoftheexamination.Thevarious
barsshowtherangeofaveragedelinquenciesforeachofthefourgroupsexamined,
based on the distribution of delinquencv rates within the 1aa subgroups for each
loancategorv.Theblackportionofeachbarrepresentsthemiddle-oº(i-ºonei-
thersideofthemedian)ofthedistributionofaveragedelinquencvrates.Thefullbar,
includingbothdarkandlightshading,representsthemiddleooºofthedistribution
ofaveragedelinquencvrates.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 delinquencv rate on the low end and a i.aº average delin-
quencv rate on the high end. The full bar for the GSEs spans average delinquencv
rates from o.1º to o.oº. That means that onlv -º of GSE loans were in subgroups
with average delinquencv rates above o.oº. In sharp contrast, the black bar for pri-
vate-label subprime securitizations (SUB) spans average delinquencv rates between
ia.oº on the low end and :1.oº on the high end, and the full bar spans average
delinquencv rates between 1o.oº and :i.oº. That means that onlv -º of SUB loans
were in subgroups with average delinquencv rates below 1oº. The worst-performing
-º of GSE loans are in subgroups with rates of serious delinquencv similar to the
best-performing -º of SUB loans.
1o
Bv the end of iooo, performance within all segments of the market had weakened.
The median delinquencv rate—the midpoints of the black bars—rose from 1º in
ioo8 to i.-º for GSE loans, from ioº to :oº for SUB loans, from 1iº to i1º for
Alt-A loans, and remained at roughlv oº for FHA loans.
The data illustrate that in ioo8 and iooo, GSE loans performed signifcantlv bet-
ter than privatelv securitized, or non-GSE, subprime and Alt-A loans. That holds
true even when comparing loans in GSE pools that share the same kev characteristics
with the loans in privatelv securitized mortgages, such as low FICO scores. For exam-
ple, among loans to borrowers with FICO scores below ooo, a privatelv securitized
mortgage was more than four times as likelv to be seriouslv delinquent as a GSE.
z.· ii N\Nti \i tii :i : i NuUi 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,therespectiveaveragedelinquencvratesforthenon-GSEandGSEloans
werei8.:ºando.iº.Thesepatternsaremostlikelvdrivenbvdifferencesinunder-
writing standards as well as bv some differences not captured in these mortgages.

Forinstance,intheGSEpool,borrowerstendedtomakebiggerdownpavments.The
FCIC’sdatashowthat-8ºofGSEloanswithFICOscoresbelowooohadanoriginal
loan-to-valueratiobelow8oº,indicatingthattheborrowermadeadownpavment
ofatleastioºofthesalesprice.Thisrelativelvlargedownpavmentwouldhelpoffset
theeffectofthelowerFICOscore.Incontrast,onlv:1ºofloanswithFICOscores
belowoooinnon-GSEsubprimesecuritizationshadanLTVunder8oº.Thedatail-
lustratethatnon-agencvsecuritizedloansweremuchmorelikelvtohavemorethan
one risk factor and therebv exhibit so-called risk lavering, such as low FICO scores
ontopofsmalldownpavments.
GSEmortgageswithAlt-Acharacteristicsalsoperformedsignifcantlvbetterthan
mortgages packaged into non-GSE Alt-A securities. For example, in ioo8 among
loanswithanLTVaboveooº,theGSEpoolshaveanaveragerateofseriousdelin-
quencv of -.¬º, versus a rate of 1-.-º for loans in private Alt-A securities.
18
These
resultsarealso,inlargepart,drivenbvdifferencesinrisklavering.
Othersframethesituationdifferentlv.AccordingtoEdPinto,amortgagefnance
industrvconsultantwhowasthechiefcreditomceratFannieMaeinthe1o8os,GSEs
dominatedthemarketforriskvloans.InwrittenanalvsesreviewedbvtheFCICstaff
and sent to Commissioners as well as in a number of interviews, Pinto has argued
thattheGSEloansthathadFICOscoresbelowooo,acombinedloan-to-valueratio
greater than ooº, or other mortgage characteristics such as interest-onlv pavments
were essentiallv equivalent to those mortgages in securitizations labeled subprime
andAlt-Abvissuers.
UsingstrictcutoffsonFICOscoreandloan-to-valueratiosthatignorerisklaver-
ingandthusareonlvpartlvrelatedtomortgageperformance(aswellasrelvingona
number of other assumptions), Pinto estimates that as of Iune :o, ioo8, aoº of all
mortgagesinthecountrv—io.¬millionofthem—wereriskvmortgagesthathede-
fnes as subprime or Alt-A. Of these, Pinto counts 11.o million, or a-º, that were
purchasedorguaranteedbvtheGSEs.
1o
Incontrast,theGSEscategorizefewerthan
:millionoftheirloansassubprimeorAlt-A.
io
Importantlv, as the FCIC review shows, the GSE loans classifed as subprime or
Alt-AinPinto’sanalvsisdidnotperformnearlvaspoorlvasloansinnon-agencvsub-
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 bv issuers. The per-
formancedataassembledandanalvzedbvtheFCICshowthatnon-GSEsecuritized
loans experienced much higher rates of delinquencv than did the GSE loans with
similarcharacteristics.
InadditiontoexaminingloansownedandguaranteedbvtheGSEs,Pintoalsocom-
mentedontheroleoftheCommunitvReinvestmentAct(CRA)incausingthecrisis,
declaring,“ThepainandhardshipthatCRAhaslikelvspawnedareimmeasurable.”
i1
1ui 8U:1 z.+
Contrarvtothisview,twoFedeconomistsdeterminedthatlendersactuallvmade
fewsubprimeloanstomeettheirCRArequirements.Analvzingadatabaseofnearlv
1a million loans originated in iooo, thev found that onlv a small percentage of all
higher-costloansasdefnedbvtheHomeMortgageDisclosureActhadanvconnec-
tiontotheCRA.Thesehigher-costloansserveasaroughproxvforsubprimemort-
gages.Specifcallv,thestudvfoundthatonlvoºofsuchhigher-costloansweremade
to low- or moderate-income borrowers or in low- or moderate-income neighbor-
hoodsbvbanksandthrifts(andtheirsubsidiariesandamliates)coveredbvtheCRA.
The other oaº of higher-cost loans either were made bv CRA-covered institutions
thatdidnotreceiveCRAcreditfortheseloansorweremadebvlendersnotcovered
bvtheCRA.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
contributedinanvsubstantivewavtothecurrentcrisis,”thevwrote.
ii
Subsequent research has come to similar conclusions. For example, two econo-
mistsattheSanFranciscoFed,usingadifferentmethodologvandanalvzingdataon
theCaliforniamortgagemarket,foundthatonlv1oºofloansmadebvCRA-covered
lenderswerelocatedinlow-andmoderate-incomecensustractsversusoverioºfor
independentmortgagecompaniesnotcoveredbvtheCRA.Further,fewerthan:oº
oftheloansmadebvCRAlendersinlow-incomecommunitieswerehigherpriced,
evenatthepeakofthemarket.Incontrast,aboutone-halfoftheloansoriginatedbv
independentmortgagecompaniesinthesecommunitieswerehigherpriced.Andaf-
teraccountingforcharacteristicsoftheloansandtheborrowers,suchasincomeand
creditscore,theauthorsfoundthatloansmadebvCRA-coveredlendersinthelow-
andmoderate-incomeareasthevservewerehalfaslikelv todefaultassimilarloans
made bv independent mortgage companies, which are not subject to CRA and are
subject to less regulatorv oversight in general. “While certainlv not conclusive, this
suggeststhattheCRA,andparticularlvitsemphasisonloansmadewithinalender’s
assessmentarea,helpedtoensureresponsiblelending,evenduringaperiodofover-
alldeclinesinunderwritingstandards,”thevconcluded.
i:
Overall,iniooa,ioo-,andiooo,CRA-coveredbanksandthriftsaccountedforat
least ooº of all mortgage lending but onlv between :oº and a1º of higher-priced
mortgages. Independent mortgage companies originated less than one-third of all
mortgages but about one-half of all higher-priced mortgages.
ia
Finallv, lending bv
nonbank amliates of CRA-covered depositorv institutions is counted toward CRA
performanceatthediscretionofthebankorthrift.Theseamliatesaccountedforan-
otherroughlv1oºofmortgagelendingbutabout1iºofhigh-pricelending.
BankofAmericaprovidedtheFCICwithperformancedataonitsCRA-qualifv-
ing portfolio, which represented onlv ¬º of the bank’s mortgage portfolio.
i-
In the
endofthefrstquarterofio1o,8ºofthebank’s·i1ibillionportfolioofresidential
mortgageswasnonperforming:i1ºofthe·1-billionCRA-qualifvingportfoliowas
nonperformingatthatdate.
IohnReed,aformerCEOofCitigroup,whenaskedwhetherhethoughtgovern-
mentpoliciessuchastheCRAplavedaroleinthecrisis,saidthathedidn’tbelieve
zz+ ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN iiiui1
bankswouldoriginate“abadmortgagebecausethevthoughtthegovernmentpolicv
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 vell at the low-doc, no-doc sub-
primemortgagewasbecausethevfeltthatthev,Congresshadsortofpushedinthat
direction,thenIwouldsavves.”
io
“Youknow,CRAcouldbeapainintheneck,”thebankerLewisRanieritoldthe
FCIC. “But vou know what: It alwavs, in mv view, it alwavs did much more good
thanitdidanvthing.Youknow,wedidalot.CRAmadeabigdifferenceincommuni-
ties. . . .Youwerereallvputtingmonevinthecommunitiesinwavsthatreallvstabi-
lized the communities and made a difference.” But lenders including Countrvwide
usedpro-homeownershippoliciesasa“smokescreen”todoawavwithunderwriting
standardssuchasrequiringdownpavments,hesaid.“Thedangeristhatitgivesair
covertoallofthiskindofmadnessthathadnothingtodowiththehousinggoal.”

RATING DOWNGRADES: “NEVER BEFORE”
Priortoiooa,theratingsofmortgage-backedsecuritiesatMoodv’sweremonitored
bv the same analvsts who had rated them in the frst place. In iooa, Nicolas Weill,
Moodv’schiefcreditomcerandteammanagingdirector,waschargedwithcreating
anindependentsurveillanceteamtomonitorpreviouslvrateddeals.
i8
InNovemberiooo,thesurveillanceteambegantoseeariseinearlvpavmentde-
faults in mortgages originated bv Fremont Investment & Loan,
io
and downgraded
several securities with underlving Fremont loans or put them on watch for future
downgrades.“Thiswasavervunusualsituationasneverbeforehadweputonwatch
dealsratedinthesamecalendarvear,”WeilllaterwrotetoRavmondMcDaniel,the
chairman and CEO of Moodv’s Corporation, and Brian Clarkson, the president of
Moodv’sInvestorsService.
:o
In earlv ioo¬, a Moodv’s special report, overseen bv Weill, about the sharp in-
creases in earlv pavment defaults stated that the foreclosures were concentrated in
subprimemortgagepools.Inaddition,morethani.¬-ºofthesubprimemortgages
securitizedinthesecondquarterofiooowereoodavsdelinquentwithinsixmonths,
morethandoubletherateavearearlier(1.i-º).Theexactcauseofthetroublewas
still unclear to the ratings agencv, though. “Moodv’s is currentlv assessing whether
this represents an overall worsening of collateral credit qualitv or merelv a shifting
forwardofeventualdefaultswhichmavnotsignifcantlvimpactapool’soverallex-
pectedloss.”
:1
Forthenextfewmonths,thecompanvpublishedregularupdatesaboutthesub-
prime mortgage market. Over the next three months, Moodv’s took negative rating
actionsona.-ºoftheoutstandingsubprimemortgagesecuritiesratedBaa.Then,on
Iulv1o,ioo¬,inanunprecedentedmove,Moodv’sdowngraded:oosubprimemort-
gage-backedsecuritiesthathadbeenissuedinioooandputanadditional:isecuri-
tiesonwatch.The·-.ibillionofsecuritiesthatwereaffected,allratedBaaandlower,
madeup1oºofthesubprimesecuritiesthatMoodv’sratedBaainiooo.Forthetime
1ui 8U:1 zz.
being, there were no downgrades on higher-rated tranches. Moodv’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 Companv, New Centurv Mortgage Corporation, and WMC Mortgage
Corp.
:i
WeilllatertoldtheFCICstaffthatMoodv’sissuedamassannouncement,rather
thandowngradingafewsecuritiesatatime,toavoidcreatingconfusioninthemar-
ket.
::
A few davs later, Standard & Poor’s downgraded ao8 similar tranches. These
initialdowngradeswereremarkablenotonlvbecauseofthenumberofsecuritiesin-
volvedbutalsobecauseofthesharpratingcuts—anaverageoffournotchesperse-
curitv, when one or two notches was more routine (for example, a single notch
wouldbeadowngradefromAAtoAA-).AmongthetranchesdowngradedinIulv
ioo¬ were the bottom three mezzanine tranches (Mo, M1o, and M11) of the Citi-
group deal that we have been examining, CMLTI iooo-NCi. Bv that point, nearlv
1iº of the original loan pool had prepaid but another 11º were oo or more davs
pastdueorinforeclosure.
:a
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
fundownedpartsoftheequitvinIndependenceCDO,whichinturnownedtheMo
tranche of our sample deal. In addition, these funds had exposure through their
holdingsofotherCDOsthatinturnownedtranchesoftheCitigroupdeal.
:-
Then, on October 11, Moodv’s downgraded another i,-oo tranches (·::.a bil-
lion) of subprime mortgage–backed securities and placed -¬¬ tranches (·i:.8 bil-
lion)onwatchforpotentialdowngrade.Nowthetotalofsecuritiesdowngradedand
put on watch represented 1:.aº of the original dollar volume of all iooo subprime
mortgage–backed securities that Moodv’s had rated. Of the securities placed on
watchinOctober,a8tranches(·o.obillion)wereoriginallvAaa-ratedand-io(·1o.o
billion)wereAa-rated.Alltold,inthefrst1omonthsofioo¬,oiºofthemortgage-
backedsecuritvdealsissuediniooohadatleastonetranchedowngradedorputon
watch.
:o
Bv this point in October, 1:º of the loans in our case studv deal CMLTI iooo-
NCiwereseriouslvdelinquentandsomehomeshadalreadvbeenrepossessed.The
Ma through M8 tranches were downgraded as part of the second wave of mass
downgrades. Five additional tranches would eventuallv be downgraded in April
ioo8.

Beforeitwasover,Moodv’swoulddowngrade8:ºofalltheioooAaamortgage-
backedsecuritiestranchesandalloftheBaatranches.Forthosesecuritiesissuedin
the second half of ioo¬, nearlv all Aaa and Baa tranches were downgraded. Of all
zzz ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN iiiui1
tranches initiallv rated investment grade—that is, rated Baa: or higher—¬oº of
thoseissuedinioooweredowngradedtojunk,aswere8oºofthosefromioo¬.
:8
CDOS: “CLIMBING THE WALL OF SUBPRIME WORRY”
InMarchioo¬,Moodv’sreportedthatCDOswithhighconcentrationsofsubprime
mortgage–backedsecuritiescouldincur“severe”downgrades.
:o
Inaninternalemail
sent fve davs after the report, Group Managing Director of U.S. Derivatives Yuri
Yoshizawa explained to Moodv’s Chairman McDaniel and to Executive Vice Presi-
dent Noel Kirnon that one managing director at Credit Suisse First Boston “sees
bankslikeMerrill,Citi,andUBSstillfuriouslvdoingtransactionstoclearouttheir
warehouses. . . .HebelievesthatthevarecreatingandpricingtheCDOsinorderto
removetheassetsfromthewarehouses,butthatthevareholdingontotheCDOs . . .
inhopesthatthevwillbeabletosellthemlater.”
ao
Severalmonthslater,inareviewof
the CDO market titled “Climbing the Wall of Subprime Worrv,” Moodv’s noted,
“Someofthefrstquarter’sactivitv[inioo¬]wastheresultofsomearrangersfever-
ishlvworkingtoclearinventorvandreducetheirbalancesheetexposuretothesub-
prime class.”
a1
Even though Moodv’s was aware that the investment banks were
dumping collateral out of the warehouses and into CDOs—possiblv regardless of
qualitv—thefrmcontinuedtoratenewCDOsusingexistingassumptions.
FormerMoodv’sexecutiveRichardMichalektestifedtotheFCIC,“Itwasacase
of, with respect to whv didn’t we stop and change our methodologv, there is a verv
conservative culture at Moodv’s, at least while I was there, that suggested that the
onlvthingworsethanquicklvgettinganewmethodologvinplaceisquicklvgetting
the wrong methodologv in place and having to unwind that and to fail to consider
theunintendedconsequences.”
ai
InIulv,McDanielgaveapresentationtotheboardonthecompanv’sioo¬strate-
gicplan.Hisslideshadsuchbleaktitlesas“SpotlightonMortgages:OualitvContin-
ues to Erode,” “House Prices Are Falling . . . ,” “Mortgage Pavment Resets Are
Mounting,”and“1.:MMMortgageDefaultsForecastioo¬–o8.”
a:
Despitealltheevi-
dence that the qualitv of the underlving mortgages was declining, Moodv’s did not
makeanvsignifcantadjustmentstoitsCDOratingsassumptionsuntillateSeptem-
ber.
aa
Outof·-1billioninCDOsthatMoodv’sratedafteritsmassdowngradeofsub-
primemortgage–backedsecuritiesonIulv1o,ioo¬,88ºwereratedAaa.
a-
Moodv’shadhopedthatratingdowngradescouldbestavedoffbvmortgagemod-
ifcations—iftheirmonthlvpavmentsbecamemoreaffordable,borrowersmightstav
current.However,inmid-September,EricKolchinskv,ateammanagingdirectorfor
CDOs,learnedthatasurvevofservicersindicatedthatvervfewtroubledmortgages
werebeingmodifed.
ao
WorriedthatcontinuingtorateCDOswithoutadjustingfor
known deterioration in the underlving securities could expose Moodv’s to liabilitv,
KolchinskvadvisedYoshizawathatthecompanvshouldstopratingCDOsuntilthe
securities downgrades were completed. Kolchinskv told the FCIC that Yoshizawa
“admonished”himformakingthesuggestion.

1ui 8U:1 zz.
Bv the end of ioo8, more than ooº of all tranches of CDOs had been down-
graded. Moodv’s downgraded nearlv all of the iooo Aaa and all of the Baa CDO
tranches. And, again, the downgrades were large—more than 8oº of Aaa CDO
bondsandmorethanooºofBaaCDObondswereeventuallvdowngradedtojunk.
a8
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—closelvexaminedtherepresentationsandwarrantiesmadebvmortgageorig-
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-
derlvingthemortgage-backedsecuritiesaswellasintheirdisclosureaboutthechar-
acteristics of those deals. As private mortgage insurance companies found similar
defcienciesintheloansthevinsured,thevhavedeniedclaimstoanunprecedented
extent.
FannieandFreddieacquiredorguaranteedmillionsofloanseachvear.Thevdele-
gatedunderwritingauthoritvtooriginatorssubjecttoalegalagreement—representa-
tions and warranties—that the loans meet specifed criteria. Thev then checked
samples of the loans to ensure that these representations and warranties were not
breached.Iftherewasabreachandtheloanswere“ineligible”forpurchase,theGSE
hadtherighttorequirethesellertobuvbacktheloan—assuming,ofcourse,thatthe
sellerhadnotgonebankrupt.
Asaresultofsuchsampling,duringthethreevearsandeightmonthsendingAu-
gust:1,io1o,FreddieandFannierequiredsellerstorepurchase1o¬,oooloanstotal-
ing·:a.8billion.Sofar,Freddiehasreceived·o.1billionfromsellers, andFanniehas
received·11.8billion—atotalof·io.obillion.
ao
Theamountputbackisnotablein
thatitrepresentsi1ºof·1o:billionincredit-relatedexpensesrecordedbvtheGSEs
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 ooº of all loans that default in the frst two vears). In total, Freddie re-
viewed·¬o.8billionofloans(outof·1.-1trillioninloansacquiredorguaranteed)
andfound·i1.¬billiontobeineligible,meaningthevdidnotmeetrepresentations
andwarranties.
-1
Amongtheperformingloansthatweresampled,overtimeanincreasingpercent-
agewerefoundtobeineligible,risingfrom1oºformortgagesoriginatedinioo-to
i:ºinioo8.Still,Freddieputbackvervfewoftheseperformingloanstotheorigina-
tors.Amongmortgagesoriginatedfromioo-toioo8,itfoundthat1¼ofthedelin-
quentloanswereineligible,aswerei¼oftheloansinforeclosure.
-i
Mostofthese
wereputbacktooriginators—again,incasesinwhichtheoriginatorswerestillinop-
zz. ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN iiiui1
eration.Sometimes,ifthereasonsforineligibilitvweresumcientlvminor,theloans
werenotputback.
Overall,ofthedelinquentloansandloansinforeclosuresampledbvFreddie,ioº
were put back. In iooo and io1o, Freddie put back signifcant loan volumes to the
followinglenders:Countrvwide,·1.obillion;WellsFargo,·1.ibillion;ChaseHome
Financial,·1.1billion;BankofAmerica,·a¬omillion;andAllvFinancial,·a-:mil-
lion.
-:
UsingamethodsimilartoFreddie’stotestforloaneligibilitv,Fanniereviewedbe-
tween iº and -º of the mortgages originated since ioo-—sampling at the higher
ratesfordelinquentloans.Fromioo¬throughio1o,Fannieputbackloanstothefol-
lowinglargelenders:BankofAmerica,·o.obillion;WellsFargo,·i.:billion;IPMor-
gan Chase, ·i.i billion; Citigroup, ·1.- billion; SunTrust Bank, ·8o8 million; and
AllvFinancial,·8:8million.
-a
InearlvIanuarvio11,BankofAmericareachedadeal
withFannieandFreddie,settlingtheGSEs’claimswithapavmentofmorethan·i.-
billion.
--
LikeFannieandFreddie,privatemortgageinsurance(PMI)companieshavebeen
fndingsignifcantdefcienciesinmortgages.Thevarerefusingtopavclaimsonsome
insuredmortgagesthathavegoneintodefault.Thisinsuranceprotectstheholderof
themortgageifahomeownerdefaultsonaloan,eventhoughtheresponsibilitvfor
the premiums generallv lies with the homeowner. Bv 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,whichshareo8ºofthemarket,hadrejectedabouti-ºoftheclaims(or
·o billion of ·ia billion) brought to them, because of violations of origination
guidelines, improper emplovment and income reporting, and issues with propertv
valuation.

Separatefromtheirpurchaseandguaranteeofmortgages,overthecourseofthe
housingboomtheGSEspurchased·ooobillionofsubprimeandAlt-Aprivate-label
securities.
-8
TheGSEshaverecorded·aobillioninchargesonsecuritiesfromIanu-
arv1,ioo8toSeptember:o,io1o.
-o
Frustratedwiththelackofinformationfromthe
securities’ servicers and trustees, in manv cases large banks, on Iulv 1i, io1o, the
GSEs through their regulator, the Federal Housing Finance Agencv, issued oa sub-
poenas to various trustees and servicers in transactions in which the GSEs lost
monev.
oo
Wherethevfndthatthenonperformingloansinthepoolshaveviolations,
the GSEs intend to demand that the trustees recognize their rights (including anv
rightstoputloansbacktotheoriginatororwholesaler).
o1
WhilethisstrategvbeingfollowedbvtheGSEsisbasedincontractlaw,otherin-
vestorsarerelvingonsecuritieslawtoflelawsuits,claimingthatthevweremisledbv
inaccurateorincompleteprospectuses;and,inanumberofcases,thevarewinning.
As of mid-io1o, court actions embroiled almost all major loan originators and
underwriters—thereweremorethanaoolawsuitsrelatedtobreachesofrepresenta-
tionsandwarranties,bvoneestimate.
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. Thev generallv allege violations of the Securities
ExchangeActof1o:aandtheSecuritiesActof1o::.
Bothprivateandgovernmententitieshavegonetocourt.Forexample,theinvest-
mentbrokerageCharlesSchwabhassuedunitsofBankofAmerica,WellsFargo,and
UBS Securities.
o:
The Massachusetts attornev general’s omce settled charges against
Morgan Stanlev and Goldman Sachs, after accusing the frms of inadequate disclo-
surerelatingtotheirsalesofmortgage-backedsecurities.MorganStanlevagreedto
pav·1oimillionandGoldmanSachsagreedtopav·oomillion.
oa
Totakeanotherexample,theFederalHomeLoanBankofChicagohassuedsev-
eraldefendants,includingBankofAmerica,CreditSuisseSecurities,Citigroup,and
GoldmanSachs,overits·:.:billioninvestmentinprivatemortgage-backedsecuri-
ties,claimingthevfailedtoprovideaccurateinformationaboutthesecurities.Simi-
larlv, Cambridge Place Investment Management has sued units of Morgan Stanlev,
Citigroup,HSBC,GoldmanSachs,Barclavs,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
ensuedwouldleadtothefailureornearfailureofmanvlargefnancialfrmsacross
the svstem. The drop in market prices for mortgage-related securities refected the
higher probabilitv that the underlving mortgages would actuallv default (meaning
thatlesscashwouldfowtotheinvestors)aswellasthemoregeneralizedfearamong
investors that this market had become illiquid. Investors valued liquiditv because
thevwantedtheassurancethatthevcouldsellsecuritiesquicklvtoraisecashifneces-
sarv.Potentialinvestorsworriedthevmightgetstuckholdingthesesecuritiesasmar-
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¬,thelargestbanksandinvestmentbanksbegancomplvingwithanewaccount-
ing rule and for the frst time reported their assets in one of three valuation cate-
gories:“Level1assets,”whichhadobservablemarketprices,likestocksonthestock
exchange;“Leveliassets,”whichwerenotaseasilvpricedbecausethevwerenotac-
tivelvtraded;and“Level:assets,”whichwereilliquidandhadnodiscerniblemarket
pricesorotherinputs.TodeterminethevalueofLevel:andinsomecasesLevelias-
setswheremarketpriceswereunavailable,frmsusedmodelsthatreliedonassump-
tions.ManvfnancialinstitutionsreportedLevel:assetsthatsubstantiallvexceeded
theircapital.Forexample,forthefrstquarterofioo¬,BearStearnsreportedabout
·1obillioninLevel:assets,comparedto·1:billionincapital;MorganStanlevre-
zz( ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN iiiui1
portedabout·oobillioninLevel:assets,againstcapitalof·:8billion;andGoldman
reportedabout·a8billion,andcapitalof·:¬billion.
Mark-to-marketwrite-downswererequiredonmanvsecuritieseveniftherewere
noactualrealizedlossesandinsomecasesevenifthefrmsdidnotintendtosellthe
securities.Thechargesrefectingunrealizedlosseswerebased,inpart,oncreditrat-
ingagencies’andinvestors’expectationsthatthemortgageswoulddefault.Butonlv
whenthosedefaultscametopasswouldholdersofthesecuritiesactuallvhavereal-
ized losses. Determining the market value of securities that did not trade was dim-
cult,wassubjective,andbecameacontentiousissueduringthecrisis.Whv:Because
thewrite-downsreducedearningsandcapital,andtriggeredcollateralcalls.
These mark-to-market accounting rules received a good deal of criticism in re-
centvears,asfrmsarguedthatthelowermarketpricesdidnotrefectmarketvalues
but rather fre-sale prices driven bv forced sales. Ioseph Grundfest, when he was a
member of the SEC’s Committee on Improvements to Financial Reporting, noted
thatattimes,markingsecuritiesatmarketprices“createssituationswherevouhave
togooutandraisephvsicalcapitalinordertocoverlossesthatasapracticalmatter
wereneverreallvthere.”
oo
Butnotvaluingassetsbasedonmarketpricescouldmean
that frms were not recording losses required bv the accounting rules and therefore
wereoverstatingearningsandcapital.
As the mortgage market was crashing, some economists and analvsts estimated
that actual losses, also known as realized losses, on subprime and Alt-A mortgages
wouldtotal·iooto·:oobillion;

sofar,bvio1o,thefgurehasturnedoutnottobe
muchmorethanthat.Asofvear-endiooo,thedollarvalueofallimpairedAlt-Aand
subprime mortgage–backed securities total about ·:oo billion.
o8
Securities are im-
paired when thev have suffered realized losses or are expected to suffer realized
lossesimminentlv.Whilethosenumbersaresmallinrelationtothe·1atrillionU.S.
economv,thelosseshadadisproportionateimpact.“Subprimemortgagesthemselves
areaprettvsmallassetclass,”FedChairmanBenBernanketoldtheFCIC,explaining
how in ioo¬ he and Treasurv Secretarv Henrv Paulson had underestimated the
repercussions of the emerging housing crisis. “You know, the stock market goes up
and down everv dav more than the entire value of the subprime mortgages in the
countrv.Butwhatcreatedthecontagion,oroneofthethingsthatcreatedtheconta-
gion, was that the subprime mortgages were entangled in these huge securitized
pools.”
oo
Thelargedropinmarketpricesofthemortgagesecuritieshadlargespilloveref-
fectstothefnancialsector,foranumberofreasons.Forexample,asjustdiscussed,
whenthepricesofmortgage-backedsecuritiesandCDOsfell,manvoftheholdersof
those securities marked down the value of their holdings—before thev had experi-
encedanvactuallosses.
In addition, rather than spreading the risks of losses among manv investors, the
securitization market had concentrated them. “Who owns residential credit risk:”
twoLehmananalvstsaskedinaSeptemberioo¬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-
tirelv transferred to AAA collateralized debt obligation (CDO) holders.”
¬o
A set of
large,svstemicallvimportantfrmswithsignifcantholdingsorexposuretothesese-
curities would be found to be holding verv little capital to protect against potential
losses.Andmostofthosecompanieswouldturnouttobeconsideredbvtheauthori-
tiestoobigtofailinthemidstofafnancialcrisis.
TheInternationalMonetarvFund’sGlobalFinancialStabilitvReportpublishedin
Octoberioo8examinedwherethedecliningassetswereheldandestimatedhowse-
verethewrite-downswouldbe.Alltold,theIMFcalculatedthatroughlv·1otrillion
inmortgageassetswereheldthroughoutthefnancialsvstem.Ofthese,·:.8trillion
wereGSEmortgage–backedsecurities;theIMFexpectedlossesof·8obillion,butin-
vestorsholdingthesesecuritieswouldlosenomonev,becauseoftheGSEs’guaran-
tee. Another ·a.¬ trillion in mortgage assets were estimated to be prime and
nonprimemortgagesheldlargelvbvthebanksandtheGSEs.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-halfoftheselosseswereexpectedtobebornebvthe
investmentbanks,commercialbanks,andthrifts.Therestofthewrite-downsfrom
non-agencvmortgage–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, uncertaintv (suggested bv the sizable revi-
sionsintheIMFestimates)andleveragewouldpromotecontagion.Investorswould
realizethevdidnotknowasmuchasthevwantedtoknowaboutthemortgageassets
thatbanks,investmentbanks,andotherfrmsheldortowhichthevwereexposed.To
anextentnotunderstoodbvmanvbeforethecrisis,fnancialinstitutionshadlever-
agedthemselveswithcommercialpaper,withderivatives,andintheshort-termrepo
markets, in part bv using mortgage-backed securities and CDOs as collateral.
Lenders would question the value of the assets that those companies had posted as
collateralatthesametimethatthevwerequestioningthevalueofthosecompanies’
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 mav avoid signifcant realized
lossesgoingforward.
Overall, for ioo- to ioo¬ vintage tranches of mortgage-backed securities origi-
nallvratedtriple-A,despitethemassdowngrades,onlvabout1oºofAlt-Aandaºof
subprime securities had been “materiallv impaired”—meaning that losses were im-
zz· ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN iiiui1
minent or had alreadv been suffered—bv the end of iooo (see fgure 11.a). For the
lower-ratedBaatranches,oo.-ºofAlt-Aando-.-ºofsubprimesecuritieswereim-
paired.Inall,bvtheendofiooo,·:iobillionworthofsubprimeandAlt-Atranches
hadbeenmateriallvimpaired—including·1:i.obillionoriginallvratedtriple-A.The
outcomewouldbefarworseforCDOinvestors,whosefatelargelvdependedonthe
performanceoflower-ratedmortgage-backedsecurities.MorethanooºofBaaCDO
bondsand¬1.:ºofAaaCDObondswereultimatelvimpaired.
¬i
Thehousingbustwouldnotbetheendofthestorv.AsChairmanBernanketesti-
fedtotheFCIC:“WhatIdidnotrecognizewastheextenttowhichthesvstemhad
fawsandweaknessesinitthatweregoingtoamplifvtheinitialshockfromsubprime
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 NuUi 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 manv fnan-
cialinstitutionsextraordinarilvvulnerabletothedownturninthemarketinioo¬.
Theinvestmentbankshadleverageratios,bvonemeasure,ofuptoaoto1.This
means that for everv ·ao of assets, thev held onlv ·1 of capital. Fannie Mae and
FreddieMac(theGSEs)hadevengreaterleverage—withacombined¬-to1ratio.
Leverage or capital inadequacv at manv institutions was even greater than re-
ported when one takes into account “window dressing,” off-balance-sheet expo-
suressuchasthoseofCitigroup,andderivativespositionssuchasthoseofAIG.
TheGSEscontributedto,butwerenotaprimarvcauseof,thefnancialcrisis.
Their ·- trillion mortgage exposure and market position were signifcant, and
thevwerewithoutquestiondramaticfailures.Thevparticipatedintheexpansion
of riskv mortgage lending and declining mortgage standards, adding signifcant
demand for less-than-prime loans. However, thev followed, rather than led, the
WallStreetfrms.Thedelinquencvratesontheloansthatthevpurchasedorguar-
anteedweresignifcantlvlowerthanthosepurchasedandsecuritizedbvotherf-
nancialinstitutions.
The Communitv Reinvestment Act (CRA)—which requires regulated banks
andthriftstolend,invest,andprovideservicesconsistentwithsafetvandsound-
ness to the areas where thev take deposits—was not a signifcant factor in sub-
prime lending. However, communitv lending commitments not required bv the
CRAwereclearlvusedbvlendinginstitutionsforpublicrelationspurposes.
PART IV
The Unraveling
z..
12
EARLY 2007:
SPREADING SUBPRIME WORRIES
CONTENTS
Gc|dnan“Ict’s|caggrcssivcdistri|utingthings”::·
BcarStcarns’shcdgcjunds“Iccksprcttvdannug|v”:::
Ratingagcncics“Itcan’t|ca||cjasuddcn”:;:
AIG“Vc|||iggcrthanwccvcrp|anncdjcr” :;:
Overthecourseofioo¬,thecollapseofthehousingbubbleandtheabruptshutdown
ofsubprimelendingledtolossesformanvfnancialinstitutions,runsonmonevmar-
ket funds, tighter credit, and higher interest rates. Unemplovment remained rela-
tivelv steadv, hovering just below a.-º until the end of the vear, and oil prices rose
dramaticallv.Bvthemiddleofioo¬,homepriceshaddeclinedalmostaºfromtheir
peak in iooo. Earlv evidence of the coming storm was the 1.-º drop in November
iooo of the ABX Index—a Dow Iones–like index for credit default swaps on BBB-
tranchesofmortgage-backedsecuritiesissuedinthefrsthalfofiooo.
1
ThatdropcameafterMoodv’sandS&Pputonnegativewatchselectedtranchesin
onedealbackedbvmortgagesfromoneoriginator:FremontInvestment&Loan.
i
In
December, the same index fell another :º after the mortgage companies Ownit
MortgageSolutionsandSebringCapitalceasedoperations.Seniorriskomcersofthe
fvelargestinvestmentbankstoldtheSecuritiesandExchangeCommissionthatthev
expectedtoseefurthersubprimelenderfailuresinioo¬.“Thereisabroadrecogni-
tion that, with the refnancing and real estate booms over, the business model of
manvofthesmallersubprimeoriginatorsisnolongerviable,”SECanalvststoldDi-
rectorErikSirriinaIanuarva,ioo¬,memorandum.
:
Thatbecamemoreandmoreevident.InIanuarv,MortgageLendersNetworkan-
nouncedithadstoppedfundingmortgagesandacceptingapplications.InFebruarv,
New Centurv reported bigger-than-expected mortgage credit losses and HSBC, the
largestsubprimelenderintheUnitedStates,announceda·1.8billionincreaseinits
quarterlv provision for losses. In March, Fremont stopped originating subprime
loans after receiving a cease and desist order from the Federal Deposit Insurance
Corporation.InApril,NewCenturvfledforbankruptcv.
z.. ii N\Nti \i tii :i : i NuUi 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 buvers and
banksbecameunwillingtocontinuefundingthem,andrepolendersbecamelessand
lesswillingtoacceptsubprimeandAlt-Amortgagesormortgage-backedsecurities
as collateral. Thev also insisted on ever-shorter maturities, eventuallv of just one
dav—an inherentlv destabilizing demand, because it gave them the option of with-
holdingfundingonshortnoticeifthevlostconfdenceintheborrower.
Anothersignofproblemsinthemarketcamewhenfnancialcompaniesbeganto
reportmoredetailabouttheirassetsunderthenewmark-to-marketaccountingrule,
particularlvaboutmortgage-relatedsecuritiesthatwerebecomingilliquidandhard
to value. The sum of more illiquid Level i and : assets at these frms was “eve-
poppingintermsoftheamountofleveragethebanksandinvestmentbankshad,”ac-
cordingtoIimChanos,aNewYorkhedgefundmanager.Chanossaidthatthenew
disclosuresalsorevealedforthefrsttimethatmanvfrmsretainedlargeexposures
from securitizations. “You clearlv didn’t get the magnitude, and the market didn’t
graspthemagnitudeuntilspringof’o¬,whenthefguresbegantobepublished,and
thenitwasasifsomeonerangabell,becausealmostimmediatelvuponthepublica-
tion of these numbers, journalists began writing about it, and hedge funds began
talkingaboutit,andpeoplebeganspeakingaboutitinthemarketplace.”
a
In late iooo and earlv ioo¬, some banks moved to reduce their subprime expo-
sures bv selling assets and buving protection through credit default swaps. Some,
such as Citigroup and Merrill Lvnch, reduced mortgage exposure in some areas of
thefrmbutincreaseditinothers.Banksthathadbeenbusvfornearlvfourvearscre-
atingandsellingsubprime-backedcollateralizeddebtobligations(CDOs)scrambled
inaboutthatmanvmonthstosellorhedgewhateverthevcould.Thevnowdumped
these products into some of the most ill-fated CDOs ever engineered. Citigroup,
MerrillLvnch,andUBS,particularlv,wereforcedtoretainlargerandlargerquanti-
tiesofthe“super-senior”tranchesoftheseCDOs.Thebankerscouldalwavshope—
and manv apparentlv even believed—that all would turn out well with these super
seniors,whichwere,intheorv,thesafestofall.
Withsuchuncertaintvaboutthemarketvalueofmortgageassets,tradesbecame
scarceandsettingpricesfortheseinstrumentsbecamedimcult.
Although government omcials knew about the deterioration in the subprime
markets, thev misjudged the risks posed to the fnancial svstem. In Ianuarv ioo¬,
SEComcialsnotedthatinvestmentbankshadcreditexposuretostrugglingsubprime
lenders but argued that “none of these exposures are material.”
-
The Treasurv and
Fedinsistedthroughoutthespringandearlvsummerthatthedamagewouldbelim-
ited.“Theimpactonthebroadereconomvandfnancialmarketsoftheproblemsin
the subprime market seems likelv to be contained,”
o
Fed Chairman Ben Bernanke
testifedbeforetheIointEconomicCommitteeofCongressonMarchi8.Thatsame
dav,TreasurvSecretarvHenrvPaulsontoldaHouseAppropriationssubcommittee:
“From the standpoint of the overall economv, mv bottom line is we’re watching it
closelvbutitappearstobecontained.”
¬
i\ii¥ z++, :iii\ii Nt :U8iii \i \uiii i: z.,
GOLDMAN: “LET’ S BE AGGRESSIVE DISTRIBUTING THINGS”
InDecemberiooo,followingtheinitialdeclineinABXBBBindicesandafter1ocon-
secutivedavsoftradinglossesonitsmortgagedesk,executivesatGoldmanSachsde-
cidedtoreducethefrm’ssubprimeexposure.Goldmanmarkeddownthevalueofits
mortgage-relatedproductstorefectthelowerABXprices,andbeganpostingdailv
lossesforthisinventorv.
8
Respondingtothevolatilitvinthesubprimemarket,Goldmananalvstsdelivered
aninternalreportonDecember1:,iooo,regarding“themajorriskintheMortgage
business”toChiefFinancialOmcerDavidViniarandChiefRiskOmcerCraigBrod-
erick.
o
The next dav, executives determined that thev would get “closer to home,”
meaningthatthevwantedtoreducetheirmortgageexposure:sellwhatcouldbesold
asis,repackageandsellevervthingelse.
1o
KevinGasvoda,themanagingdirectorfor
Goldman’s Fixed Income, Currencv, and Commodities business line, instructed the
salesteamtosellasset-backedsecuritvandCDOpositions,evenataloss:“Plsrefo-
cusonretainednewissuebondpositionsandmovethemout.Therewillbebigop-
portunitiesthenextseveralmonthsandwedon’twanttobehamstrungbasedonold
inventorv.Refocuseffortsandmovestuffoutevenifvouhavetotakeasmallloss.”
11
InaDecember1-email,ViniardescribedthestrategvtoTomMontag,theco-head
ofglobalsecurities:“OnABX,thepositionisreasonablvsensiblebutisjusttoobig.
Mighthavetospendalittletosizeitappropriatelv.Onevervthingelsemvbasicmes-
sagewaslet’sbeaggressivedistributingthingsbecausetherewillbevervgoodoppor-
tunitiesasthemarketgoesintowhatislikelvtobeevengreaterdistressandwewant
tobeinpositiontotakeadvantageofthem.”
1i
Subsequent emails suggest that the “evervthing else” meant mortgage-related as-
sets.OnDecemberio,inaninternalemailwithbroaddistribution,Goldman’sStacv
Bash-Pollev,apartnerandtheco-headoffxedincomesales,notedthatthefrm,un-
like others, had been able to fnd buvers for the super-senior and equitv tranches of
CDOs,butthemezzaninetranchesremainedachallenge.The“besttarget,”shesaid,
wouldbetoputtheminotherCDOs:“Wehavebeenthinkingcollectivelvasagroup
abouthowtohelpmovesomeoftherisk.Whilewehavemadegreatprogressmoving
thetailrisks—[super-senior]andequitv—wethinkitiscriticaltofocusonthemezz
riskthathasbeenbuiltupoverthepastfewmonths. . . .Givensomeofthefeedback
wehavereceivedsofar[frominvestors,]itseemsthatcdo’smavbethebesttargetfor
movingsomeofthisriskbutclearlvinlimitedsize(andtimingrightnownotideal).”
1:
Itwasbecominghardertofndbuversforthesesecurities.BackinOctober,Gold-
manSachstradershadcomplainedthatthevwerebeingaskedto“distributejunkthat
nobodvwasdumbenoughtotakefrsttimearound.”
1a
DespitethefrstofGoldman’s
businessprinciples—that“ourclients’interestsalwavscomefrst”—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
thevear,Goldman’sFabriceTourre,thenavicepresidentonthestructuredproduct
correlationtradingdesk,saidto“focusefforts”on“buvandholdrating-basedbuvers”
z.( ii N\Nti \i tii :i : i NuUi 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 Ianuarv,
DanielSparks,theheadofGoldman’smortgagedepartment,extolledGoldman’ssuc-
cess in reducing its subprime inventorv, writing that the team had “structured like
madandtraveledtheworld,andworkedtheirtailsofftomakesomelemonadefrom
somebigoldlemons.”
1o
Tourreacknowledgedthattherewas“moreandmoreleverage
inthesvstem,”and—writingofhimselfinthethirdperson—saidhewas“standingin
middleofallthesecomplex,highlvlevered,exotictradeshecreatedwithoutnecessar-
ilvunderstandingalltheimplicationsofthosemonstrosities.”

On Februarv 11, Goldman CEO Llovd Blankfein questioned Montag about the
·iomillioninlossesonresidualpositionsfromolddeals,asking,“Could/shouldwe
havecleanedupthesebooksbeforeandarewedoingenoughrightnowtoselloffcats
anddogsinotherbooksthroughoutthedivision:”
18
The numbers suggest that the answer was ves, thev had cleaned up prettv well,
evengivena·iomillionwrite-offandbillionsofdollarsofsubprimeexposurestill
retained.Inthefrstquarterofioo¬,itsmortgagebusinessearnedarecord·ioomil-
lion,drivenprimarilvbvshortpositions,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 approximatelv ·i-.a billion of CDOs—
including·1¬.obillionofsvntheticCDOs.ThefrmusedthecashCDOstounload
muchofitsownremaininginventorvofotherCDOsecuritiesandmortgage-backed
securities.
1o
Goldmanhasbeencriticized—andsued—forsellingitssubprimemortgagesecu-
ritiestoclientswhilesimultaneouslvbettingagainstthosesecurities.SvlvainRavnes,
astructuredfnanceexpertatR&RConsultinginNewYork,reportedlvcalledGold-
man’spractice“themostcvnicaluseofcreditinformationthatIhaveeverseen,”and
compareditto“buvingfreinsuranceonsomeoneelse’shouseandthencommitting
arson.”
io
DuringaFCIChearing,GoldmanCEOLlovdBlankfeinwasaskedifhebelieved
itwasaproper,legal,orethicalpracticeforGoldmantosellclientsmortgagesecuri-
ties that Goldman believed would default, while simultaneouslv shorting them.
Blankfeinresponded,“Idothinkthatthebehaviorisimproperandweregretthere-
sult—theconsequence[is]thatpeoplehavelostmonev”
i1
Thenextdav,Goldmanis-
suedapressreleasedeclaringBlankfeindidnotstatethatGoldman’s“practiceswith
respecttothesaleofmortgage-relatedsecuritieswereimproper. . . .Blankfeinwasre-
spondingtoalengthvseriesofstatementsfollowedbvaquestionthatwaspredicated
ontheassumptionthatafrmwassellingaproductthatitthoughtwasgoingtode-
fault.Mr.Blankfeinagreedthat,ifsuchanassumptionwastrue,thepracticewould
beimproper.Mr.Blankfeindoesnotbelieve,nordidhesav,thatGoldmanSachshad
behavedimproperlvinanvwav.”
ii
i\ii¥ z++, :iii\ii Nt :U8iii \i \uiii i: z.,
Inaddition,GoldmanPresidentandChiefOperatingOmcerGarvCohntestifed:
“During the two vears 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.”
i:
Indeed, Goldman’s short position was not the whole storv. The dailv mortgage
“ValueatRisk”measure,orVaR,whichtrackedpotentiallossesifthemarketmoved
unexpectedlv, increased in the three months through Februarv. Bv Februarv, Gold-
man’s companv-wide VaR reached an all-time high, according to SEC reports. The
dominantdriveroftheincreasewastheone-sidedbetonthemortgagemarket’scon-
tinuing to decline. Preferring to be relativelv neutral, between March and Mav, the
mortgage securities desk reduced its short position on the ABX Index;
ia
between
IuneandAugust,itagainreversedcourse,increasingitsshortpositionbvpurchasing
protectiononmortgage-relatedassets.
TheBasisYieldAlphaFund,ahedgefundandGoldmanclientthatclaimstohave
invested·11.i-millioninGoldman’sTimberwolfCDO,suedGoldmanforfraudin
io1o. The Timberwolf deal was heavilv criticized bv Senator Carl Levin and other
members of the Permanent Subcommittee on Investigations during an April io1o
hearing.TheBasisYieldAlphaFundallegedthatGoldmandesignedTimberwolfto
quicklvfailsothatGoldmancouldomoadlow-qualitvassetsandproftfrombetting
againsttheCDO.Withintwoweeksofthefund’sinvestment,Goldmanbeganmak-
ingmargincallsonthedeal.BvtheendofIulvioo¬,ithaddemandedmorethan·:-
million.
i-
According to the hedge fund, Goldman’s demands forced it into bank-
ruptcv in August ioo¬—Goldman received about ·ao million from the liquidation.
GoldmandeniesBasisYieldAlphaFund’sclaims,andCEOBlankfeindismissedthe
notionthatGoldmanmisledinvestors.“Iwilltellvou,weonlvdealtwithpeoplewho
knewwhatthevwerebuving.Andofcoursewhenvoulookafterthefact,someone’s
goingtocomealongandsavthevreallvdidn’tknow,”hetoldtheFCIC.
io
Inadditiontosellingitssubprimesecuritiestocustomers,thefrmtookshortpo-
sitionsusingcreditdefaultswaps;italsotookshortpositionsontheABXindicesand
onsomeofthefnancialfrmswithwhichitdidbusiness.Likeevervmarketpartici-
pant,Goldman“marked,”orvalued,itssecuritiesafterconsideringbothactualmar-
ket trades and survevs of how other institutions valued the assets. As the crisis
unfolded, Goldman marked mortgage-related securities at prices that were signif-
cantlvlowerthanthoseofothercompanies.Goldmanknewthatthoselowermarks
mighthurtthoseothercompanies—includingsomeclients—becausethevcouldre-
quire marking down those assets and similar assets. In addition, Goldman’s marks
wouldgetpickedupbvcompetitorsindealersurvevs.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 thev had
soldcreditdefaultswapprotection.InaMav11email,CraigBroderick,whoasGold-
man’s chief risk omcer was responsible for tracking how much of the companv’s
monevwasatrisk,

notedtocolleaguesthatthemortgagegroupwas“intheprocess
z.· ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN iiiui1
of considering making signifcant downward adjustments to the marks on their
mortgageportfolio[especiallv]CDOsandCDOsquared.Thiswillpotentiallvhavea
big[proftandloss]impactonus,butalsotoourclientsduetothemarksandassoci-
ated margin calls on repos, derivatives, and other products. We need to survev our
clientsandtakeashotatdeterminingthemostvulnerableclients,knockonimplica-
tions,etc.Thisisgettinglotsof:othfoorattentionrightnow.”
i8
BroderickwasrightabouttheimpactofGoldman’smarksonclientsandcounter-
parties. The frst signifcant dispute about these marks began in Mav ioo¬: it con-
cernedthetwohigh-fving,mortgage-focusedhedgefundsrunbvBearStearnsAsset
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,werebusvmanagingBSAM’sHigh-GradeStructuredCreditStrategiesFund.
Whenthevaddedthehigher-leveraged,higher-riskEnhancedFundiniooothevbe-
cameevenbusier.
Bv 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.
io
Inadiarvkeptinhispersonalemailaccount
becausehe“didn’twanttouse[his]workemailanvmore,”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.
Shortlvafterthefundopened,theABXBBB-indexstartedtofalter,fallingaºinthe
last three months of iooo; then another 8º in Ianuarv and i-º in Februarv. The
market’sconfdencefellwiththeABX.InvestorsbegantobailoutofbothEnhanced
andHigh-Grade.CiomandTanninsteppeduptheirmarketing.OnMarch¬,ioo¬,
Tanninsaidinanemailtoinvestors,“weseeanopportunitvhere—notcrazvoppor-
tunitv—but prudent opportunitv—I am putting in additional capital—I think vou
shouldaswell.”
:1
OnaMarch1iconferencecall,TanninandCiomassuredinvestors
thatbothfunds“haveplentvofliquiditv,”andthevcontinuedtousetheinvestment
of their own monev 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.
:a
Thev
triedtosellthetoxicCDOsecuritiesheldbvthehedgefunds.Thevhadlittlesuccess
sellingthemdirectlvonthemarket,
:-
buttherewasanotherwav.
InlateMav,BSAMputtogetheraCDO-squareddealthatwouldtake·abillionof
CDOassetsoffthehedgefunds’books.Thesenior-mosttranches,worth·:.ibillion,
i\ii¥ z++, :iii\ii Nt :U8iii \i \uiii i: z.+
weresoldascommercialpapertoshort-terminvestorssuchasmonevmarketmutual
funds.
:o
Criticallv,BankofAmericaguaranteedthosedealswithaliquiditvput—forafee.
Later, commercial paper investors would refuse to roll over this particular paper;
BankofAmericaultimatelvlostmorethan·abilliononthisarrangement.

“:;·isáoomsáev”
Nearlv all hedge funds provide their investors with market value reports, at least
monthlv, based on computed mark-to-market prices for the fund’s various invest-
ments.Industrvstandardsgenerallvcalledforvaluingreadilvtradedassets,suchas
stocks,atthecurrenttradingprice,whileassetsinvervslowmarketsweremarkedbv
surveving price quotes from other dealers, factoring in other pricing information,
andthenarrivingatafnalnetassetvalue.Formortgage-backedinvestments,mark-
ingassetswasanextremelvimportantexercise,becausethemarketvalueswereused
toinforminvestorsandtocalculatethehedgefund’stotalfundvalueforinternalrisk
managementpurposes,andbecausetheseassetswereheldascollateralforrepoand
other lenders. Cruciallv, if the value of a hedge fund’s portfolio declined, repo and
otherlendersmightrequiremorecollateral.InApril,IPMorgantoldAlanSchwartz,
BearStearns’sco-president,thatthebankwouldbeaskingtheBSAMhedgefundsto
postadditionalcollateraltosupportitsrepoborrowing.
:8
DealermarkswereslowtokeepupwithmovementsintheABXindices.Evenas
the ABX BBB- index recovered some in March, rebounding oº, marks bv broker-
dealers fnallv started to refect the lower values. On April i, ioo¬, Goldman sent
BSAMmarksrangingfromo-centsto1oocentsonthedollar—meaningthatsome
securitieswereworthaslittleaso-ºoftheirinitialvalue.
:o
OnThursdav,April1o,
in preparation for an investor call the following week, BSAM analvsts informed
CiomandTanninthatintheirview,thevalueofthefunds’portfolioshaddeclined
sharplv.
ao
OnSundav,TanninsentanemailfromhispersonalaccounttoCiom’sper-
sonal account arguing that both hedge funds should be closed and liquidated:
“Looksprettvdamnuglv. . . .Ifwebelievetheruns[theanalvst]hasbeendoingare
ANYWHERECLOSEtoaccurate,IthinkweshouldclosetheFundsnow. . . .If[the
runs]arecorrectthentheentiresub-primemarketistoast.”
a1
Butbvthefollowing
Wednesdav,CiomandTanninwerebackonthesameupbeatpage.Atthebeginning
oftheconferencecall,Tannintoldinvestors,“Thekevsortofbigpicturepointforus
atthispointisourconfdencethatthestructuredcreditmarketandthesub-prime
marketinparticular,hasnotsvstemicallvbrokendown; . . .we’revervcomfortable
withexactlvwhereweare.”Ciomalsoassuredinvestorsthatthefundswouldlikelv
fnishthevearwithpositivereturns.
ai
OnMav1,ioo¬,thetwohedgefundshadat-
tracted more than ·oo million in new funds, but more than ·i8 million was re-
deemedbvinvestors.
a:
Thatsamedav,GoldmansentBSAMmarksrangingfrom--centsto1oocentson
thedollar.
aa
CiomdisputedGoldman’smarksaswellasmarksfromLehman,Citigroup,
z.+ ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN iiiui1
andIPMorgan.
a-
OnMav1o,inapreliminarvestimate,Ciomtoldinvestorsthatthe
netassetvalueoftheEnhancedLeverageFundwasdowno.oºinApril.
ao
Incomputing
thefnalnumberslaterthatmonth,herequestedthatBSAM’sPricingCommitteein-
steadusefairvaluemarksbasedonhisteam’smodeling,whichimpliedlossesthatwere
·i-to·-omillionlessthanlossesusingGoldman’smarks.

OnIunea,althoughGold-
man’smarkswereconsideredlow,thePricingCommitteedecidedtocontinuetoaver-
age dealer marks rather than to use fair value. The committee also noted that the
declineinnetassetvaluewouldbegreaterthantheo.oºestimate,because“manvofthe
positionsthatweremarkeddownreceiveddealermarksafterreleaseoftheestimate.”
a8
The decline was revised from o.oº to 1oº. According to Ciom, a number of factors
contributedtotheAprilrevision,andGoldman’smarkswereonefactor.
ao
Afterthese
meetings,Ciomemailedonecommitteemember:“Thereisnomarket . . .its[sic]allac-
ademic anvwav—1oº [value] is doomsdav.”
-o
On Iune ¬, BSAM announced the 1oº
dropandfrozeredemptions.
“(enervint/cmincs/ejt”
WhenIPMorgancontactedBear’sco-presidentAlanSchwartzinAprilaboutitsup-
comingmargincall,Schwartzconvenedanexecutivecommitteemeetingtodiscuss
howrepolendersweremarkingdownpositionsandmakingmargincallsonthebasis
of those new marks.
-1
In earlv Iune, Bear met with BSAM’s repo lenders to explain
thatBSAMlackedcashtomeetmargincallsandtonegotiateaoo-davreprieve.Some
of these verv same frms had sold Enhanced and High-Grade some of the same
CDOsandothersecuritiesthatwereturningouttobesuchbadassets.
-i
Nowall1o
refused Schwartz’s appeal; instead, thev made margin calls.
-:
As a direct result, the
twofundshadtosellcollateralatdistressedpricestoraisecash.
-a
Sellingthebonds
ledtoacompletelossofconfdencebvtheinvestors,whoserequestsforredemptions
accelerated.
ShortlvafterBSAMfrozeredemptions,MerrillLvnchseizedmorethan·8-omil-
lionofitscollateralpostedbvBearforitsoutstandingrepoloans.Merrillwasableto
selljust·181millionoftheseizedcollateralatauctionbvIulv-—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’sequitvpositionsinthetwoBSAMhedgefundswererelativelvsmall.On
Aprilio,Bear’sco-presidentWarrenSpectorapproveda·i-millioninvestmentinto
theEnhancedLeverageFund.

BearStearnshadnolegalobligationtorescueeither
thefundsortheirrepolenders.However,thoselenderswerethesamelargeinvest-
mentbanksthatBearStearnsdealtwithevervdav.
-8
Moreover,anvfailureofentities
relatedtoBearStearnscouldraiseinvestors’concernsaboutthefrmitself.
ThomasMarano,theheadofthemortgagetradingdesk,toldFCICstaffthatthe
constantbarrageofmargincallshadcreatedchaosatBear.InlateIune,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.
-o
Bear Stearns’s
conclusion:High-Gradestillhadpositivevalue,butEnhancedLeveragedidnot.
Onthebasisofthatanalvsis,BearStearnscommittedupto·:.ibillion—andulti-
matelv loaned ·1.o billion—to take out the High-Grade Fund repo lenders and be-
comethesolerepolendertothefund;EnhancedLeveragewasonitsown.
DuringaIuneFederalOpenMarketCommittee(FOMC)meeting,memberswere
informedaboutthesubprimemarketandtheBSAMhedgefunds.Thestaffreported
thatthesubprimemarketwas“vervunsettledandrefecteddeterioratingfundamen-
talsinthehousingmarket.”TheliquidationofsubprimesecuritiesatthetwoBSAM
hedgefundswascomparedtothetroublesfacedbvLong-TermCapitalManagement
in1oo8.ChairmanBernankenotedthattheproblemsthehedgefundsexperienced
wereagoodexampleofhowleveragecanincreaseliquiditvrisk,especiallvinsitua-
tions in which counterparties were not willing to give them time to liquidate and
possiblvrealizewhatevervaluemightbeinthepositions.Butitwasalsonotedthat
theBSAMhedgefundsappearedtobe“relativelvunique”amongsponsoredfundsin
theirconcentrationinsubprimemortgages.
oo
Some members were concerned about the lack of transparencv around hedge
funds, the consequent lack of market discipline on valuations of hedge fund hold-
ings,andthefactthattheFederalReservecouldnotsvstematicallvcollectinforma-
tionfromhedgefundsbecausethevwereoutsideitsjurisdiction.Thesefactscaused
memberstobeconcernedaboutwhetherthevunderstoodthescopeoftheproblem.
Duringthesamemeeting,FOMCmembersnotedthatthesizeofthecreditderiv-
atives market, its lack of transparencv and activities related to subprime debt could
beagatheringcloudinthebackgroundofpolicv.
Meanwhile, Bear Stearns executives who supported the High-Grade bailout did
not expect to lose monev. However, that support was not universal—CEO Iames
Cavne and Earl Hedin, the former senior managing director of Bear Stearns and
BSAM, were opposed, because thev did not want to increase shareholders’ potential
losses.
o1
Their fears proved accurate. Bv Iulv, the two hedge funds had shrunk to al-
most nothing: High-Grade Fund was down o1º; Enhanced Leverage Fund, 1ooº.
oi
OnIulv:1,bothfledforbankruptcv.CiomandTanninwouldbecriminallvcharged
with fraud in their communications with investors, but thev were acquitted of all
chargesinNovemberiooo.CivilchargesbroughtbvtheSECwerestillpendingasof
thedateofthisreport.
Looking back, Marano told the FCIC, “We caught a lot of fak for allowing the
fundstofail,butwehadnooption.”
o:
InaninternalemailinIune,BillIamisonofFed-
eratedInvestors,oneofthelargestofallmutualfundcompanies,referredtotheBear
Stearnshedgefundsasthe“canarvinthemineshaft”andpredictedmoremarkettur-
moil.
oa
As the two funds were collapsing, repo lending tightened across the board.
Manvrepolenderssharpenedtheirfocusonthevaluationofanvcollateralwithpo-
tentialsubprimeexposure,andontherelativeexposuresofdifferentfnancialinstitu-
tions. Thev required increased margins on loans to institutions that appeared to be
exposedtothemortgagemarket;thevoftenrequiredTreasurvsecuritiesascollateral;
in manv cases, thev demanded shorter lending terms.
o-
Clearlv, the triple-A-rated
z.z ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN iiiui1
mortgage-backed securities and CDOs were not considered the “super-safe” invest-
mentsinwhichinvestors—andsomedealers—hadonlvrecentlvbelieved.
CavnecalledSpectorintotheomceandaskedhimtoresign.OnSundav,August
-,Spectorsubmittedhisresignationtotheboard.
RATING AGENCIES: “IT CAN’ T BE  .  .  . ALL OF A SUDDEN”
WhileBSAMwaswrestlingwithitstwoailingfagshiphedgefunds,themajorcredit
ratingagenciesfnallvadmittedthatsubprimemortgage–backedsecuritieswouldnot
perform as advertised. On Iulv 1o, ioo¬, thev issued comprehensive rating down-
gradesandcreditwatchwarningsonanarravofresidentialmortgage–backedsecuri-
ties.Theseannouncementsforeshadowedtheactuallossestocome.
S&Pannouncedthatithadplacedo1itranchesbackedbvU.S.subprimecollat-
eral,orsome·¬.:-billioninsecurities,onnegativewatch.S&Ppromisedtoreview
evervdealinitsratingsdatabaseforadverseeffects.Intheafternoon,Moodv’sdown-
graded:oomortgage-backedsecuritiesissuediniooobackedbvU.S.subprimecol-
lateral and put an additional :i tranches on watch. These Moodv’s downgrades
affected about ·-.i billion in securities. The following dav, Moodv’s placed 18a
tranchesofCDOs,withoriginalfacevalueofabout·-billion,onwatchforpossible
downgrade.Twodavsafteritsoriginalannouncement,S&Pdowngradedao8ofthe
o1itranchesithadplacedonnegativewatch.FitchRatings,thesmallestofthethree
majorcreditratingagencies,announcedsimilardowngrades.
oo
Theseactionsweremeaningfulforallwhounderstoodtheirimplications.While
the specifc securities downgraded were onlv a small fraction of the universe (less
than iº of mortgage-backed securities issued in iooo), investors knew that more
downgrades might come. Manv investors were critical of the rating agencies, lam-
basting them for their belated reactions. Bv Iulv ioo¬, bv one measure, housing
priceshadalreadvfallenaboutaºnationallvfromtheirpeakatthespringofiooo.

OnaIulv1oconferencecallwithS&P,thehedgefundmanagerSteveEismanques-
tionedTomWarrack,themanagingdirectorofS&P’sresidentialmortgage–backedse-
curitiesgroup.Eismanasked,“I’dliketoknowwhvnow.Imean,thenewshasbeen
outonsubprimenowformanv,manvmonths.Thedelinquencieshavebeenadisaster
now for manv, manv months. (Your) ratings have been called into question now for
manv,manvmonths.I’dliketounderstandwhvvou’remakingthismovetodavwhen
vou—andwhvdidn’tvoudothismanv,manvmonthsago. . . .Imean,itcan’tbethat
allofasudden,theperformancehasreachedalevelwherevou’vewokenup.”Warrack
respondedthatS&P“tookactionassoonaspossiblegiventheinformationathand.”
o8
Theratingsagencies’downgrades,intandemwiththeproblemsatBearStearns’s
hedgefunds,hadafurtherchillingeffectonthemarkets.TheABXBBB-indexfell
another::ºinIulv,confrmingandguaranteeingevenmoreproblemsforholdersof
mortgagesecurities.Enactingthesameinexorabledvnamicthathadtakendownthe
BearStearnsfunds,repolendersincreasinglvrequiredotherborrowersthathadput
upmortgage-backedsecuritiesascollateraltoputupmore,becausetheirvaluewas
unclearordepressed.Manvoftheseborrowerssoldassetstomeetthesemargincalls,
i\ii¥ z++, :iii\ii Nt :U8iii \i \uiii i: z..
andeachsalehadthepotentialtofurtherdepressprices.Ifatallpossible,theborrow-
erssoldotherassetsinmoreliquidmarkets,forwhichpriceswerereadilvavailable,
pushingpricesdownwardinthosemarkets,too.
AIG: “WELL BIGGER THAN WE EVER PLANNED FOR”
Ofallthepossiblelosersintheloomingrout,AIGshouldhavebeenamongthemost
concerned. After several vears of aggressive growth, AIG’s Financial Products sub-
sidiarvhadwritten·¬obillioninover-the-countercreditdefaultswap(CDS)protec-
tion on super-senior tranches of multisector CDOs backed mostlv bv subprime
mortgages.
InaphonecallmadeIulv11,thedavafterthedowngrades,AndrewForster,the
headofcredittradingatAIGFinancialProducts,toldAlanFrost,theexecutivevice
presidentofFinancialProduct’sMarketingGroup,thathehadtoanalvzeexposures
because “everv f¯¯¯ing . . . rating agencv we’ve spoken to . . . [came] out with more
downgrades”andthathewasincreasinglvconcerned:“AboutamonthagoIwaslike,
vouknow,suicidal. . . .Theproblemthatwe’regoingtofaceisthatwe’regoingtohave
justenormousdowngradesonthestuffthatwe’vegot. . . .Evervonetellsmethatit’s
tradingandit’stwopointslowerandalltherestofitandhowcomevoucan’tmark
vour book. So it’s defnitelv going to give it renewed focus. I mean we can’t . . . we
havetomarkit.It’s,it’s,uh,we’re[unintelligible]f¯¯¯edbasicallv.”
oo
Forster was likelv worried that most of AIG’s credit default swap contracts re-
quiredthatcollateralbepostedtothepurchasers,shouldthemarketvalueoftheref-
erencedsecuritiesdeclinebvacertainamount,orshouldratingagenciesdowngrade
AIG’slong-termdebt.Thatis,collateralcallscouldbetriggeredeveniftherewereno
actualcashlossesin,forexample,thesuper-seniortranchesofCDOsuponwhichthe
protectionhadbeenwritten.Remarkablv,topAIGexecutives—includingCEOMar-
tin Sullivan, CFO Steven Bensinger, Chief Risk Omcer Robert Lewis, Chief Credit
Omcer Kevin McGinn, and Financial Services Division CFO Elias Habaveb—told
FCICinvestigatorsthatthevdidnotevenknowaboutthesetermsoftheswapsuntil
thecollateralcallsstartedrollinginduringIulv.
¬o
OmceofThriftSupervisionregula-
torswhosupervisedAIGonaconsolidatedbasisdidn’tknoweither.
¬1
Frost,whowas
thechiefcreditdefaultswapsalesmanatAIGFinancialProducts,didknowaboutthe
terms,andhesaidhebelievedthevwerestandardfortheindustrv.
¬i
IosephCassano,
thedivision’sCEO,alsoknewabouttheterms.
¬:
And the counterparties knew, of course. On the evening of Iulv io, Goldman
Sachs,whichheld·i1billionofAIG’ssuper-seniorcreditdefaultswaps,
¬a
sentnews
ofthefrstcollateralcallintheformofanemailfromGoldman’ssalesmanAndrew
DavilmantoFrost:
DAVILMAN: Sorrvtobothervouonvacation.Margincallcomingvourwav.Wantto
givevouaheadsup.
FROST,  minutes later:Onwhat:
DAVILMAN,one minute later:iobb[·iobillion]ofsupersenior.
¬-
z.. ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN iiiui1
Thenextdav,Goldmanmadethecollateralcallomcialbvforwardinganinvoice
requesting·1.8billion.
¬o
Onthesamedav,Goldmanpurchased·1oomillionoffve-
vearprotection—intheformofcreditdefaultswaps—againstthepossibilitvthatAIG
mightdefaultonitsobligations.
¬¬
Frost never responded to Davilman’s email. And when he returned from vaca-
tion, he was instructed to not have anv involvement in the issue, because Cassano
wanted Forster to take the lead on resolving the dispute.
¬8
AIG’s models showed
therewouldbenodefaultsonanvofthebondpavmentsthatAIG’sswapsinsured.
TheGoldmanexecutivesconsideredthosemodelsirrelevant,becausethecontracts
required collateral to be posted if market value declined, irrespective of anv long-
termcashlosses.
¬o
Goldmanestimatedthattheaveragedeclineinthemarketvalue
ofthebondswas1-º.
8o
So, frst Bear Stearns’s hedge funds and now AIG was getting hit bv Goldman’s
marksonmortgage-backedsecurities.LikeCiomandhiscolleaguesatBearStearns,
Frost and his colleagues at AIG disputed Goldman’s marks. On Iulv :o, Forster was
told bv 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 sav the marks “could be anvthing from 8o to sort of, vou
know,o-”becauseofthelackoftradingbutsaidGoldman’smarkswere“ridiculous.”
81
IntestimonvtotheFCIC,ViniarsaidGoldmanhadstoodreadvtosellmortgage-
backed securities to AIG at Goldman’s own marks.
8i
AIG’s Forster stated that he
wouldnotbuvthebondsatevenoocentsonthedollar,becausevaluesmightdrop
further.Additionallv,AIGwouldberequiredtovalueitsownportfolioofsimilaras-
setsatthesameprice.Forstersaid,“InthecurrentenvironmentIstillwouldn’tbuv
them . . .becausethevcouldprobablvgolow . . .wecan’tmarkanvofourpositions,
andobviouslvthat’swhatsavesushavingthisenormousmarktomarket.Ifwestart
buvingthephvsicalbondsbackthenanvaccountantisgoingtoturnaroundandsav,
well, Iohn,vouknowvoutradedatoo,voumustbeabletomarkvourbondsthen.”
8:
Tough,lengthvnegotiationsfollowed.Goldman“wasnotbudging”onitscollat-
eraldemands,accordingtoTomAthan,amanagingdirectoratAIGFinancialProd-
ucts, describing a conference call with Goldman executives on August 1. “I plaved
almostevervcardIhad,legalwording,marketpractice,intentofthelanguage,mean-
ingofthe[contract],andalsostressedthepotentialdamagetotherelationshipand
GSsaidthatthishasgonetothe‘highestlevels’atGSandthevfeelthat . . .thisisa
‘testcase.’”
8a
GoldmanSachsandAIGwouldcontinuetoargueaboutGoldman’smarks,even
asAIGwouldcontinuetopostcollateralthatwouldfallshortofGoldman’sdemands
and Goldman would continue to purchase CDS contracts against the possibilitv of
AIG’sdefault.Overthenext1amonths,moresuchdisputeswouldcostAIGtensof
billionsofdollarsandhelpleadtooneofthebiggestgovernmentbailoutsinAmeri-
canhistorv.
COMMISSION CONCLUSIONS ON CHAPTER 12
TheCommissionconcludesthatentitiessuchasBearStearns’shedgefundsand
AIGFinancialProductsthathadsignifcantsubprimeexposurewereaffectedbv
thecollapseofthehousingbubblefrst,creatingfnancialpressuresontheirpar-
ent companies. The commercial paper and repo markets—two kev components
of the shadow banking lending markets—quicklv 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
IKBcjGcrnanv“Rca|ncncvinvcstcrs” :;e
Ccuntrvwidc“1hat’scur;/))” :;:
BNIIari|as“1hcringingcjthc|c||”:·o
SIVs“Ancasiscjca|n”:·:
Mcncvjundsandcthcrinvcstcrs“Drinkjing|jrcnahrchcsc:·:
Inthesummerofioo¬,asthepricesofsomehighlvratedmortgagesecuritiescrashed
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 anv threat to the
overalleconomv,”TreasurvSecretarvHenrvPaulsontoldBloombergonIulvio.
1
Mean-
while,nervousmarketparticipantswerelookingunderevervrockforanvsignofhidden
or latent subprime exposure. In late Iulv, thev found it in the market for asset-backed
commercialpaper(ABCP),acrucial,usuallvboringbackwaterofthefnancialsector.
This kind of fnancing allowed companies to raise monev bv borrowing against
high-qualitv, short-term assets. Bv mid-ioo¬, hundreds of billions out of the ·1.i
trillion U.S. ABCP market were backed bv mortgage-related assets, including some
withsubprimeexposure.
i
Asnoted,theratingagencieshadgivenalloftheseABCPprogramstheirtopin-
vestment-grade ratings, often because of liquiditv puts from commercial banks.
Whenthemortgagesecuritiesmarketdriedupandmonevmarketmutualfundsbe-
came skittish about broad categories of ABCP, the banks would be required under
theseliquiditvputstostandbehindthepaperandbringtheassetsontotheirbalance
sheets,transferringlossesbackintothecommercialbankingsvstem.Insomecases,
to protect relationships with investors, banks would support programs thev had
sponsoredevenwhenthevhadmadenopriorcommitmenttodoso.
IKB OF GERMANY: “REAL MONEY INVESTORS”
The frst big casualtv 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 1oia, 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 bv
creditcardreceivables,businessloans,autoloans,andmortgages.Itmademonevbv
usinglessexpensiveshort-termcommercialpapertopurchasehigher-vieldinglong-
term securities, a strategv known as “securities arbitrage.” Bv the end of Iune,
Rhinelandownedc1abillion(·18.obillion)ofassets,o-ºofwhichwereCDOsand
CLOs (collateralized loan obligations—that is, securitized leveraged loans). And at
least c8 billion (·1o.8 billion) of that was protected bv IKB through liquiditv puts.
:
Importantlv,GermanregulatorsatthetimedidnotrequireIKBtoholdanvcapitalto
offsetpotentialRhinelandlosses.
a
As late as Iune ioo¬, when so manv were bailing out of the structured products
market,IKBwasstillplanningtoexpanditsoff-balance-sheetholdingsandwaswill-
ing to take long positions in mortgage-related derivatives such as svnthetic CDOs.
-
ThisattitudemadeIKBafavoriteoftheinvestmentbanksandhedgefundsthatwere
desperatetotaketheshortsideofthedeal.
Inearlvioo¬,whenGoldmanwaslookingforbuversforAbacusioo¬-AC1,the
svnthetic CDO mentioned in part III, it looked to IKB. An emplovee of Paulson &
Co.,thehedgefundthatwastakingtheshortsideofthedeal,bluntlvsaidthat“real
monev”investorssuchasIKBwereoutgunned.“Themarketisnotpricingthesub-
prime [residential mortgage–backed securities] wipeout scenario,” the Paulson em-
ploveewroteinanemail.“Inmvopinionthissituationisduetothefactthatrating
agencies,CDOmanagersandunderwritershavealltheincentivestokeepthegame
going, while ‘real monev’ investors have neither the analvtical tools nor the institu-
tionalframeworktotakeactionbeforethelossesthatonecouldanticipatebased[on]
the ‘news’ available evervwhere are actuallv realized.”
o
IKB subsequentlv purchased
·1-o million of the A1 and Ai tranches of the Abacus CDO and placed them in
Rhineland.
¬
Itwouldlose1ooºofthatinvestment.
Inmid-ioo¬,Rhineland’sasset-backedcommercialpaperwasheldbvanumber
ofAmericaninvestors,includingtheMontanaBoardofInvestments,thecitvofOak-
land,California,andtheRobbinsdaleAreaSchoolDistrictinsuburbanMinneapolis.
OnIulvio,IKBreassureditsinvestorsthatratingsdowngradesofmortgage-backed
securities would have onlv a limited impact on its business.
8
However, within davs,
Goldman Sachs, which regularlv helped Rhineland raise monev in the commercial
papermarket,toldIKBthatitwouldnotsellanvmoreRhinelandpapertoitsclients.
OnFridav,Iulvi¬,DeutscheBank,recognizingthattheABCPmarketswouldsoon
abandon Rhineland and that IKB would have to provide substantial support to the
program, decided that doing business with IKB was too riskv and cut off its credit
lines.ThesewerenecessarvforIKBtocontinuerunningitsbusiness.DeutscheBank
alsoalertedtheGermanbankregulatortoIKB’scriticalstate.Withtheregulator’sen-
couragement, IKB’s largest shareholder, KfW Bankengruppe, announced on Iulv :o
thatitwouldbailoutIKB.OnAugust¬,Rhinelandexerciseditsliquiditvputswith
z.· ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN iiiui1
IKB. Rhineland’s commercial paper investors were able to get rid of the paper, and
KfWtookthehitinstead—withitslossesexpectedtoeventuallvreacho-º.
o
TheIKBepisodeservednoticethatexposurestotoxicmortgageassetswerelurk-
ingintheportfoliosofevenrisk-averseinvestors.Soon,panicseizedtheshort-term
fundingmarkets—eventhosethatwerenotexposedtoriskvmortgages.“Therewasa
recognition, I’d sav an acute recognition, that potentiallv some of the asset-backed
commercialpaperconduitscouldhaveexposuretothoseareas.Asaresult,investors
in general—without even looking into the underlving assets—decided ‘I don’t want
tobeinanvasset-backedcommercialpaper,Idon’twanttoinvestinafundthatmav
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
marketwoulddeclinebvalmost·aoobillionbvtheendofioo¬.
COUNTRYWIDE: “THAT’ S OUR 9/11”
OnAugusti,threedavsaftertheIKBrescue,CountrvwideCEOAngeloMozilore-
alized that his companv was unable to roll its commercial paper or borrow on the
repomarket.“Whenwetalkabout[Augusti]atCountrvwide,that’souro/11,”he
said. “We worked seven davs a week trving to fgure this thing out and trving to
workwiththebanks. . . .Ourrepurchaselineswerecomingduebillionsandbillions
ofdollars.”
11
MoziloemailedLvleGramlev,aformerFedgovernorandaformerCountrvwide
director,“Fearinthecreditmarketsisnowtendingtowardspanic.Thereislittleto
no liquiditv in the mortgage market with the exception of Fannie and Freddie. . . .
Anv mortgage product that is not deemed to be conforming either cannot be sold
intothesecondarvmarketsoraresubjecttoegregiousdiscounts.”
1i
OnAugusti,despitetheinternalturmoilatCountrvwide,CFOEricSierackitold
investors that Countrvwide had “signifcant short-term funding liquiditv cushions”
and“ampleliquiditvsourcesofourbank. . . .Itisimportanttonotethatthecompanv
has experienced no disruption in fnancing its ongoing dailv operations, including
placementofcommercialpaper.”
1:
Moodv’sreamrmeditsA:ratingsandstableout-
lookonthecompanv.
Theratingsagenciesandthecompanvitselfwouldquicklvreversetheirpositions.
OnAugusto,Moziloreportedtotheboardduringaspeciallvconvenedmeetingthat,
as the meeting minutes recorded, “the secondarv market for virtuallv all classes of
mortgagesecurities(bothprimeandnon-prime)hadunexpectedlvandwithalmost
no warning seized up and . . . the Companv was unable to sell high-qualitv mort-
gage[-]backed securities.” President and COO David Sambol told the board, “Man-
agement can onlv plan on a week bv week basis due to the tenuous nature of the
situation.”Moziloreportedthatalthoughhecontinuedtonegotiatewithbanksforal-
ternative sources of liquiditv, the “unprecedented and unanticipated” absence of a
secondarvmarketcouldforcethecompanvtodrawdownonitsbackupcreditlines.
1a
Shortlv after the Countrvwide 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,includingCountrvwide,wereshowing
somestrain.Thevnotedthatthedatadidnotindicateacollapseofthehousingmar-
ket was imminent and that, if the more optimistic scenarios proved to be accurate,
thev might look back and be surprised that the fnancial events did not have a
stronger impact on the real economv. But the FOMC members also expressed con-
cern that the effects of subprime developments could spread to other sectors and
notedthatthevhadbeenrepeatedlvsurprisedbvthedepthanddurationofthedete-
riorationofthesemarkets.Oneparticipant,inaparaphraseofaquoteheattributed
to Winston Churchill, said that no amount of rewriting of historv would exonerate
thosepresentifthevdidnotprepareforthemoredirescenariosdiscussedinthestaff
presentations.
1-
Severaldavslater,onAugust1a,CountrvwidereleaseditsIulvioo¬operational
results,reportingthatforeclosuresanddelinquencieswereupandthatloanproduc-
tionhadfallenbv1aºduringtheprecedingmonth.Acompanvspokesmansaidlav-
offs would be considered. On the same dav, Fed staff, who had supervised
Countrvwide’sholdingcompanvuntilthebankswitchedtoathriftcharterinMarch
ioo¬,sentaconfdentialmemototheFed’sBoardofGovernorswarningaboutthe
companv’scondition:
Thecompanvisheavilvreliantonanoriginate-to-distributemodel,and,
givencurrentmarketconditions,thefrmisunabletosecuritizeorsell
anv of its non-conforming mortgages. . . . Countrvwide’s short-term
funding strategv relied heavilv on commercial paper (CP) and, espe-
ciallv,onABCP.Incurrentmarketconditions,theviabilitvofthatstrat-
egv is questionable. . . . The abilitv of the companv to use [mortgage]
securities as collateral in [repo transactions] is consequentlv uncertain
inthecurrentmarketenvironment. . . .Asaresult,itcouldfacesevere
liquiditv pressures. Those liquiditv pressures conceivablv could lead
eventuallvtopossibleinsolvencv.
1o
Countrvwideaskeditsregulator,theOmceofThriftSupervision,iftheFedcould
provideassistance,perhapsbvwaivingaFedruleandallowingCountrvwide’sthrift
subsidiarv to support its holding companv bv raising monev from insured deposi-
tors,orperhapsthroughdiscount-windowlending,whichwouldrequiretheFedto
accept riskv mortgage-backed securities as collateral, something it never had done
andwouldnotdo—untilthefollowingspring.TheFeddidnotintervene:“Substan-
tial statutorv requirements would have to be met before the Board could authorize
lending to the holding companv or mortgage subsidiarv,” staff wrote. “The Federal
Reservehadnotlenttoanonbankinmanvdecades;and . . .suchlendinginthecur-
rentcircumstancesseemedhighlvimprobable.”

Thefollowingdav,lackinganvotherfunding,Mozilorecommendedtohisboard
thatthecompanvnotifvlendersofitsintentiontodrawdown·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 NuUi i¥ tu\\i : :i uN iiiui1
downgrades. “The onlv option we had was to pull down those lines,” he told the
FCIC.“Wehadapipelineofloansandweeitherhadtosavtotheborrowers,thecus-
tomers,‘we’reoutofbusiness,we’renotgoingtofund’—andthere’sgreatrisktothat,
litigation risk, we had committed to fund. . . . When it’s between vour ass and vour
image,vouholdontovourass.”
1o
On the same dav that Countrvwide’s board approved the ·11.- billion draw-
down—but before the companv announced it publiclv, the Merrill Lvnch analvst
KennethBruce,whohadreissuedhis“buv”ratingonthecompanv’sstocktwodavs
earlier,switchedto“sell”witha“negative”outlookbecauseofCountrvwide’sfunding
pressures,adding,“ifthemarketlosesconfdenceinitsabilitvtofunctionproperlv,
thenthemodelcanbreak. . . .Ifliquidationsoccurinaweakmarket,thenitispossi-
blefor[Countrvwide]togobankrupt.”
io
The next dav, as news of Bruce’s call spread, Countrvwide informed markets
about the drawdown. Moodv’s downgraded its senior unsecured debt rating to the
lowest tier of investment grade. Countrvwide shares fell 11º, closing at ·18.o-; for
thevear,thecompanv’sstockwasdown-oº.Thebadnewsledtoanold-fashioned
bankrun.MozilosingledoutanAugust1oLos Angeles Times articlecoveringBruce’s
report,which,hesaid,“causedarunonourbankof·8billiononMondav.”Thearti-
clespurredcustomerstowithdrawtheirfundsbvnotingspecifcaddressesofCoun-
trvwidebranchesinsouthernCalifornia,MozilotoldtheFCIC.Areporter“cameout
withaphotographerand,vouknow,interviewedthepeopleinline,andhecreated—
it was just horrible. Horrible for the people, horrible for us. Totallv unnecessarv,”
Mozilosaid.
i1
Sixdavslater,onAugustii,BankofAmericaannounceditwouldinvest·ibil-
lionfora1oºstakeinCountrvwide.Bothcompaniesdeniedrumorsthatthenation’s
biggestbankwouldsoonacquirethemortgagelender.Mozilotoldthepress,“There
wasneveraquestionaboutoursurvival”;hesaidtheinvestmentreinforcedCountrv-
wide’spositionasoneofthe“strongestandbest-runcompaniesinthecountrv.”
ii
InOctober,Countrvwidereportedanetlossof·1.ibillion,itsfrstquarterlvloss
ini-vears.Ascharge-offsonitsmortgageportfoliogrew,Countrvwideraisedprovi-
sions for loan losses to ·o:a million from onlv ·:8 million one vear earlier. On
Ianuarv 11, ioo8, Bank of America issued a press release announcing a “defnitive
agreement”topurchaseCountrvwideforapproximatelv·abillion.Itsaidthecom-
binedentitvwouldstoporiginatingsubprimeloansandwouldexpandprogramsto
helpdistressedborrowers.
BNP PARIBAS: “THE RINGING OF THE BELL”
Meanwhile,problemsinU.S.fnancialmarketshitthelargestFrenchbank.OnAu-
gust o, 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.
i:
The bank
saiditwouldalsostopcalculatingafairmarketvalueforthefundsbecause“thecom-
plete evaporation of liquiditv 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,.
markethasmadeitimpossibletovaluecertainassetsfairlvregardlessoftheirqualitv
orcreditrating.”
ia
Inretrospect,manvinvestorsregardedthesuspensionoftheFrenchfundsasthe
beginningoftheioo¬liquiditvcrisis.Augusto“wastheringingofthebell”forshort-
termfundingmarkets,PaulMcCullev,amanagingdirectoratPIMCO,toldtheFCIC.
“The buvers went on a buver strike and simplv weren’t rolling.”
i-
That is, thev
stopped rolling over their commercial paper and instead demanded pavment on
theirloans.OnAugusto,theinterestratesforovernightlendingofA-1ratedasset-
backedcommercialpaperrosefrom-.:oºto-.¬-º—thehighestlevelsinceIanuarv
ioo1. It would continue rising unevenlv, hitting o.1aº in August 1o, ioo¬. Figure
1:.1showshow,inresponse,lendingdeclined.
InAugustalone,theasset-backedcommercialpapermarketshrankbv·1oobil-
lion, or ioº. On August o, subprime lender American Home Mortgage’s asset-
backed commercial paper program invoked its privilege of postponing repavment,
trapping lenders’ monev for several months. Lenders quicklv withdrew from pro-
gramswithsimilarprovisions,whichshrankthatmarketfrom·:-billionto·abil-
lionbetweenMavandAugust.
io
The paper that did sell had signifcantlv shorter maturities, refecting creditors’
desiretoreassesstheircounterparties’creditworthinessasfrequentlvaspossible.The
averagematuritvofallasset-backedcommercialpaperintheUnitedStatesfellfrom
z,z ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN iiiui1
about :1 davs in late Iulv to about i: davs bv mid-September, though the over-
whelmingmajoritvwasissuedforjust1toadavs.

Disruptionsquicklvspreadtootherpartsofthemonevmarket.Inafighttoqual-
itv,investorsdumpedtheirrepoandcommercialpaperholdingsandincreasedtheir
holdingsinseeminglvsafermonevmarketfundsandTreasurvbonds.Marketpartici-
pants,unsureofeachother’spotentialsubprimeexposures,scrambledtoamassfunds
for their own liquiditv. Banks became less willing to lend to each other. A closelv
watched indicator of interbank lending rates, called the one-month LIBOR-OIS
spread,increased,signifvingthatbankswereconcernedaboutthecreditriskinvolved
inlendingtoeachother.OnAugusto,itrosesharplv,increasingthree-tofourfoldover
historicalvalues,andbvSeptember¬,itclimbedbvanother1-oº.Inioo8,itwould
peakmuchhigher.
Thepanicintherepo,commercialpaper,andinterbankmarketswasmetbvimme-
diategovernmentaction.OnAugust1o,thedavafterBNPParibassuspendedredemp-
tions,theFedannouncedthatitwould“provid[e]liquiditvasnecessarvtofacilitatethe
orderlv 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-
countratebv-obasispoints—fromo.i-ºto-.¬-º.Thiswouldbethefrstofmanv
such cuts aimed at increasing liquiditv. The Fed also extended the term of discount-
windowlendingto:odavs(fromtheusualovernightorvervshort-termperiod)toof-
ferbanksamorestablesourceoffunds.Onthesamedav,theFed’sFOMCreleaseda
statement acknowledging the continued market deterioration and promising that it
was“preparedtoactasneededtomitigatetheadverseeffectsontheeconomv.”
io
SIVS: “AN OASIS OF CALM”
InAugust,theturmoilinasset-backedcommercialpapermarketshitthemarketfor
structuredinvestmentvehicles,orSIVs,eventhoughmostoftheseprogramshadlit-
tlesubprimemortgageexposure.SIVshadastablehistorvsincetheirintroductionin
1o88. These investments had weathered a number of credit crises—even through
earlv summer of ioo¬, as noted in a Moodv’s report issued on Iulv io, ioo¬, titled
“SIVs:AnOasisofCalmintheSub-primeMaelstrom.”
:o
Unlike tvpical asset-backed commercial paper programs, SIVs were funded pri-
marilvthroughmedium-termnotes—bondsmaturinginonetofvevears.SIVsheld
signifcantamountsofhighlvliquidassetsandmarkedthoseassetstomarketprices
dailv or weeklv, which allowed them to operate without explicit liquiditv support
fromtheirsponsors.
TheSIVsectortripledinassetsbetweeniooaandioo¬.Ontheeveofthecrisis,
there were :o SIVs with almost ·aoo billion in assets.
:1
About one-quarter of that
monevwasinvestedinmortgage-backedsecuritiesorinCDOs,butonlvoºwasin-
vestedinsubprimemortgage–backedsecuritiesandCDOsholdingmortgage-backed
securities.
Not surprisinglv, 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.TheseincludedChevneFinance
(managed bv London-based Chevne Capital Management), Rhinebridge (another
IKBprogram),GoldenKev,andMainsailII(bothstructuredbvBarclavsCapital).Be-
tweenAugustandOctober,eachofthesefourwasforcedtorestructureorliquidate.
InvestorssoonranfromeventhesaferSIVs.“Themediawasquitehappvtosen-
sationalizethecollapseofthenext‘leakingSIV’orthenext‘SIV-positive’institution,”
then-Moodv’s managing director Henrv Tabe told the FCIC.
:i
The situation was
complicatedbvtheSIVs’lackoftransparencv.“Inacontextofopacitvaboutwhere
risk resides, . . . a general distrust has contaminated manv asset classes. What had
oncebeenliquidisnowilliquid.Goodcollateralcannotbesoldorfnancedatanv-
thingapproachingitstruevalue,”Moodv’swroteonSeptember-.
::
Even high-qualitv assets that had nothing to do with the mortgage market were
declininginvalue.OneSIVmarkeddownaCDOtosevencentsonthedollarwhile
itwasstillratedtriple-A.
:a
Toraisecash,managerssoldassets.Butsellinghigh-qual-
itvassetsintoadecliningmarketdepressedthepricesoftheseunimpairedsecurities
andpusheddownthemarketvaluesofotherSIVportfolios.
BvtheendofNovember,SIVsstillinoperationhadliquidatedi:ºoftheirportfo-
lios,onaverage.
:-
SponsorsrescuedsomeSIVs.OtherSIVsrestructuredorliquidated;
some investors had to wait a vear or more to receive pavments and, even then, re-
coupedonlvsomeoftheirmonev.InthecaseofRhinebridge,investorslosta-ºand
onlvgraduallvreceivedtheirpavmentsoverthenextvear.
:o
InvestorsinoneSIV,Sigma,
lost more than o-º.

As of fall io1o, not a single SIV remained in its original form.
The subprime crisis had brought to its knees a historicallv resilient market in which
lossesduetosubprimemortgagedefaultshadbeen,ifanvthing,modestandlocalized.
MONEY FUNDS AND OTHER INVESTORS:
“DRINKING FROM A FIRE HOSE”
Thenextdominoeswerethemonevmarketfundsandotherfunds.Mostwerespon-
sored bv investment banks, bank holding companies, or “mutual fund complexes”
such as Fidelitv, Vanguard, and Federated. Under SEC regulations, monev market
fundsthatserveretailinvestorsmustkeeptwosetsofaccountingbooks,onerefect-
ingthepricethevpaidforsecuritiesandtheotherthefund’smark-to-marketvalue
(the“shadowprice,”inmarketparlance).However,fundsdonothavetodisclosethe
shadowpriceunlessthefund’snetassetvalue(NAV)hasfallenbvo.-ºbelow·1(to
·o.oo-) per share. Such a decline in market value is known as “breaking the buck”
and generallv leads to a fund’s collapse. It can happen, for example, if just -º of a
fund’sportfolioisinaninvestmentthatlosesjust1oºofitsvalue.Soafundmanager
cannotaffordbigrisks.
But SIVs were considered verv safe investments—thev alwavs had been—and
were widelv held bv monev market funds. In fall ioo¬, dozens of monev market
funds faced losses on SIVs and other asset-backed commercial paper. To prevent
theirfundsfrombreakingthebuck,atleastaasponsors,includinglargebankssuch
z,. ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN iiiui1
as Bank of America, US Bancorp, and SunTrust, purchased SIV assets from their
monevmarketfunds.
:8
Similardramasplavedoutintheless-regulatedrealmofthemonevmarketsector
known as enhanced cash funds. These funds serve not retail investors but rather
“qualifedpurchasers,”whichmavincludewealthvinvestorswhoinvest·i-million
or more. Enhanced cash funds fall outside most SEC regulations and disclosure re-
quirements.Becausethevhavemuchhigherinvestmentthresholdsthanretailfunds,
and because thev 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
andemploveebeneftassets,ranagroundinthesummer;ithad-oºofitsassetsin
mortgage-backedsecurities.Whenthefundreportedlvlost·ioomillionandclosed
in November ioo¬, investors redeemed their interests at ·o.oo.
:o
Bank of America
supporteditsStrategicCashPortfolio—thenation’slargestenhancedcashfund,with
·ao billion in assets at its peak—after one of that fund’s largest investors withdrew
·iobillioninNovemberioo¬.
ao
An interesting case studv is provided bv the meteoric rise and decline of the
CreditSuisseInstitutionalMonevMarketPrimeFund.Thefundsoughttoattractin-
vestorsthroughInternet-basedtradingplatformscalled“portals,”whichsuppliedan
estimated·:oobilliontomonevmarketfundsandotherfunds.Investorsusedthese
portalstoquicklvmovetheircashtothehighest-vieldingfund.Postingahigherre-
turncouldattractsignifcantfunds:onemonevmarketfundmanagerlatercompared
theuseofportalmonevto“drink[ing]fromafrehose.”
a1
Butthemonevcouldvan-
ishjustasquicklv.TheCreditSuissefundpostedthehighestreturnsintheindustrv
duringthe1imonthsbeforetheliquiditvcrisis,andincreaseditsassetsfromabout
·-billioninthesummerofioootomorethan·i-billioninthesummerofioo¬.To
deliverthosehighreturnsandattractinvestors,though,itfocusedonstructuredf-
nanceproducts,includingCDOsandSIVssuchasChevne.Wheninvestorsbecame
concernedaboutsuchassets,thevvankedabout·1obillionoutofthefundinAugust
ioo¬alone.CreditSuisse,theSwissbankthatsponsoredthefund,wasforcedtobail
itout,purchasing·-.¬billionofassetsinAugust.
ai
Theepisodehighlightstherisks
ofmonevmarketfunds’relvingon“hotmonev”—thatis,institutionalinvestorswho
movequicklvinandoutoffundsinsearchofthehighestreturns.
The losses on SIVs and other mortgage-tainted investments also battered local
governmentinvestmentpoolsacrossthecountrv,someofwhichheldbillionsofdol-
lars in these securities. Pooling provides municipalities, school districts, and other
governmentagencieswitheconomiesofscale,investmentdiversifcation,andliquid-
itv.Insomecases,participationismandatorv.
With ·i¬ billion in assets, Florida’s local government investment pool was the
largestinthecountrv,and“intendedtooperatelikeahighlvliquid,low-riskmonev
marketfund,withsecuritieslikecash,certifcatesofdeposit, . . .U.S.Treasurvbills,
COMMISSION CONCLUSIONS ON CHAPTER 13
The Commission concludes that the shadow banking svstem was permitted to
grow to rival the commercial banking svstem with inadequate supervision and
regulation.Thatsvstemwasvervfragileduetohighleverage,short-termfunding,
riskv assets, inadequate liquiditv, 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 signifcantlv, allowing commercial banks and thrifts to operate with fewer
constraintsandtoengageinawiderrangeoffnancialactivities,includingactivi-
tiesintheshadowbankingsvstem.
Thefnancialsector,whichgrewenormouslvinthevearsleadinguptothef-
nancial crisis, wielded great political power to weaken institutional supervision
and market regulation of both the shadow banking svstem and the traditional
bankingsvstem.Thisderegulationmadethefnancialsvstemespeciallvvulnera-
bletothefnancialcrisisandexacerbateditseffects.
andbondsissuedbvotherU.S.governmentagencies,”asaninvestigationbvthestate
legislaturenoted.
a:
ButbvNovemberioo¬,becauseofratingsdowngrades,thefund
held at least ·1.- billion in securities that no longer met the state’s requirements. It
hadmorethan·ibillioninSIVsandotherdistressedsecurities,ofwhichabout·¬i-
millionhadalreadvdefaulted.Anditheld·o-omillioninCountrvwidecertifcates
ofdepositwithmaturitiesthatstretchedoutasfarasIuneioo8.
aa
InearlvNovember,
followingaseriesofnewsreports,thefundsufferedarun.Localgovernmentswith-
drew·8billioninjusttwoweeks.OrangeandPinellascountiespulledouttheiren-
tire investments. On November io, 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||Ivnch“Dawningawarcncsscvcrthcccursccjthcsunncr”:·¬
Citigrcup“1hatwcu|dnctinanvwavhavccxcitcdnvattcnticn”:eo
AIG’sdisputcwithGc|dnan“1hcrcccu|dncvcr|c|csscs”:e·
Icdcra|Rcscrvc“1hcdisccuntwindcwwasn’twcrking”:¬;
Mcnc|incinsurcrs“Vcncvcrcxpcctcd|csscs”:¬e
Whileahandfulofbankswerebailingouttheirmonevmarketfundsandcommer-
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 Lvnch reported the
mostspectacularlosses,largelvbecauseoftheirextensivecollateralizeddebtobliga-
tion (CDO) businesses, writing down a total of ·i:.8 billion and ·ia.¬ billion, re-
spectivelv, bv the end of the vear. Billions more in losses were reported bv large
fnancialinstitutionssuchasBankofAmerica(·o.¬billion),MorganStanlev(·1o.:
billion),IPMorgan(·-.:billion),andBearStearns(·i.obillion).
1
Insurancecompa-
nies, hedge funds, and other fnancial institutions collectivelv 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 relativelv
healthv and others about which thev were not so sure. Bear Stearns and Lehman
Brothers were at the top of the “suspect” list; bv vear-end ioo¬ the cost of fve-vear
protectionagainstdefaultontheirobligationsinthecreditdefaultswapmarketstood
at,respectivelv,·1¬o,oooand·11o,oooannuallvforeverv·1omillion,whilethecost
fortherelativelvstrongerGoldmanSachsstoodat·o8,ooo.
:
Meanwhile,theeconomvwasbeginningtoshowsignsofstress.Facingturmoilin
fnancialmarkets,declininghomeprices,andoilpricesabove·¬-abarrel,consumer
spending was slowing. The Federal Reserve lowered the overnight bank borrowing
ratefrom-.i-ºearlierintheveartoa.¬-ºinSeptember,a.-ºinOctober,andthen
a.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 ia, Merrill Lvnch stunned investors when it announced that third-
quarter earnings would include a ·o.o billion loss on CDOs and ·1 billion on sub-
prime mortgages—·¬.o billion in total, the largest Wall Street write-down to that
point,andnearlvtwicethe·a.-billionlossthatthecompanvhadwarnedinvestorsto
expect just three weeks earlier. Six davs later, the embattled CEO Stanlev O’Neal, a
i1-vearMerrillveteran,resigned.
Much of this write-down came from the frm’s holdings of the super-senior
tranches of mortgage-related CDOs that Merrill had previouslv thought to be ex-
tremelvsafe.Aslateasfalliooo,itsmanagementhadbeen“bullishongrowth”and
“bullishon[thesubprime]assetclass.”
a
Butlaterthatvear,thesignsoftroublewere
becomingdimcultevenforMerrilltoignore.Twomortgageoriginatorstowhichthe
frmhadextendedcreditlinesfailed:Ownit,inwhichMerrillalsohadasmallequitv
stake, and Mortgage Lenders Network. Merrill seized the collateral backing those
loans:·1.-billionfromMortgageLenders,·1.ibillionfromOwnit.
Merrill,likemanvofitscompetitors,startedtorampupitssalesefforts,packag-
ingitsinventorvofmortgageloansandsecuritiesintoCDOswithnewvigor.Itsgoal
wastoreducethefrm’sriskbvgettingthoseloansandsecuritiesoffitsbalancesheet.
Yetitfoundthatitcouldnotsellthesuper-seniortranchesofthoseCDOsataccept-
ableprices;itthereforehadto“takedownseniortranchesintoinventorvinorderto
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
tranchesintheCDOpositionswasactuallvpartofastrategvbeguninlateioooto
reduce the frm’s inventorv 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.Hebelievedthatthisstrategvwould
reduce overall credit risk. After all, the super-senior tranches were theoreticallv the
safestpiecesofthoseinvestments.
o
Tosomedegree,however,thestrategvwasinvol-
untarv:hispeoplewerehavingtroublesellingtheseinvestments,andsomewereeven
soldataloss.
¬
Initiallv,thestrategvseemedtowork.BvMav,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 ·o.: billion in
Septemberioooto·i-.abillionbvMarchioo¬and·i8.obillionbvMav.
o
Butasthe
mortgagemarketcameunderincreasingpressureandasthemarketvalueofevensu-
per-seniortranchescrumbled,thestrategvwouldcomebacktohauntthefrm.
Merrill’s frst-quarter earnings for ioo¬—net revenues of ·o.o billion—were its
second-highestquarterlvresultsever,includingarecordfortheFixedIncome,Cur-
renciesandCommoditiesbusiness,whichhousedtheretainedCDOpositions.These
z,· ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN iiiui1
results were announced during a conference call with analvsts—an event that in-
vestorsandanalvstsrelvontoobtainimportantinformationaboutthecompanvand
that,likeotherpublicstatements,issubjecttofederalsecuritieslaws.
Merrill’s then-CFO Ieffrev Edwards indicated that the companv’s results would
notbehurtbvthedislocationinthesubprimemarket,because“revenuesfromsub-
primemortgage-relatedactivitiescomprise[d]lessthan1ºofournetrevenues”over
thepastfvequarters,andbecauseMerrill’s“riskmanagementcapabilitiesarebetter
thanever,andcrucialtooursuccessinnavigatingturbulentmarkets.”Providingfur-
therassurances,hestated,“Webelievetheissuesinthisnarrowsliceofthemarketre-
maincontainedandhavenotnegativelvimpactedothersectors.”
1o
However, Edwards did not disclose the large increase in retained super-senior
CDOtranchesorthedimcultvofsellingthosetranches,evenataloss—thoughspe-
cifcquestionsonthesubjectwereraised.
InIulv,Merrillfolloweditsstrongfrst-quarterreportwithanotherforthesecond
quarterthat“enabledthecompanvtoachieverecordnetrevenues,netearningsand
netearningsperdilutedshareforthefrsthalfofioo¬.”
11
Duringtheconferencecall
announcing the results, the analvst Glenn Schorr of UBS, a large Swiss bank, asked
theCFOtoprovidesome“coloraroundmvthversusrealitv”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.abillionbvIune.
Edwards declined to provide details about the companv’s exposure to subprime
mortgage CDOs and anv inventorv of mortgage-backed securities to be packaged
into CDOs. “We don’t disclose our capital allocations against anv specifc or even
broadergroup,”Edwardssaid.
1i
On Iulv ii, after the super-senior tranches had been accumulating for manv
months, Merrill executives frst omciallv 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,essentiallvallofthemratedtriple-
A, with exposure to the lower-rated asset class signifcantlv reduced.
1:
This net
exposurewastheamountofCDOpositionsleftafterthesubtractionofthehedges—
guaranteesinoneformoranother—thatMerrillhadpurchasedtopassalongitsulti-
materisktothirdpartieswillingtoprovidethatprotectionandtakethatriskforafee.
AIGandthesmallclubofmonolineinsurersweresignifcantsuppliersoftheseguar-
antees, commonlv done as credit default swaps. In Iulv ioo¬, Merrill had begun to
increasetheamountofCDSprotectiontooffsettheretainedCDOpositions.
Lattanzio told the committee, “[Management] decided in the beginning of this
vear to signifcantlv reduce exposure to lower-rated assets in the sub-prime asset
class and instead migrate exposure to senior and super senior tranches.”
1a
Edwards
didnotseeanvproblems.AsKiminsisted,“Evervoneatthefrmandmostpeoplein
theindustrvfeltthatsuper-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-
panvwasretainingthesuper-seniortranchesoftheCDOsuntilLattanzio’spresen-
tationtotheFinanceCommittee.Hewasstartled,ifonlvbecausehehadbeenunder
the impression that Merrill’s mortgage-backed-assets business had been driven bv
demand: he had assumed that if there were no new customers, there would be no
newofferings.IfcustomersdemandedtheCDOs,whvwouldMerrillhavetoretain
CDO tranches on the balance sheet: O’Neal said he was surprised about the re-
tainedpositionsbutstatedthatthepresentation,analvsis,andestimationofpoten-
tial losses were not sumcient to sound “alarm bells.”
1o
Lattanzio’s report in Iulv
indicated that the retained positions had experienced onlv ·¬: million in losses.

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
frmfounditselfwithwhatwasbvthattime·1-.ibillioninnetexposuretothesu-
per-seniortranches—downfromapeakinIulvof·:i.ibillionbecausethefrmhad
increasinglvhedged,writtenoff,andsolditsexposure.OnOctoberia,Merrillan-
nounceditsthird-quarterearnings:astunning·¬.obillionmortgage-relatedwrite-
down contributing to a net loss of ·i.: billion. Merrill also reported—for the frst
time—its·1-.ibillionnetexposuretoretainedCDOpositions.Still,intheirconfer-
encecallwithanalvsts,O’NealandEdwardsrefusedtodisclosethegrossexposures,
excludingthehedgesfromthemonolinesandAIG.“Ijustdon’twanttogetintothe
details behind that,” Edwards said. “Let me just sav that what we have provided
again we think is an extraordinarilv high level of disclosure and it should be sum-
cient.”
1o
AccordingtotheSecuritiesandExchangeCommission,bvSeptemberioo¬,
Merrillhadaccumulated·--billionof“gross”retainedCDOpositions,almostfour
timesthe·1-.ibillionof“net”CDOpositionsreportedduringtheOctoberiacon-
ferencecall.
io
On October :o, when O’Neal resigned, he left with a severance package worth
·1o1.- million
i1
—on top of the ·o1.a million in total compensation he earned in
iooo,whenhiscompanvwasstillexpandingitsmortgagebankingoperations.Kim,
whooversawthestrategvthatleftMerrillwithbillionsinlosses,hadleftinMavioo¬
after being paid ·ao million for his work in iooo, which was a proftable vear for
Merrillasafrm.
ii
Bv late ioo¬, the viabilitv of the monoline insurers from which Merrill had pur-
chasedalmost·1oobillioninhedgeshadcomeintoquestion,andtheratingagencies
weredowngradingthem,aswewillseeinmoredetailshortlv.TheSEChadtoldMer-
rillthatitwouldimposeapunitivecapitalchargeonthefrmifitpurchasedadditional
credit default protection from the fnanciallv troubled monolines. Recognizing that
the monolines might not be good for all the protection purchased, Merrill began to
putasidelossallowances,startingwith·i.obilliononIanuarv1¬,ioo8.Bvtheendof
ioo8, Merrill would put aside a total of ·1: billion related to monolines and had
recordedtotalwrite-downsonnearlv·aabillionofothermortgage-relatedexposures.
z(+ ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN iiiui1
CITIGROUP: “THAT WOULD NOT IN ANY WAY
HAVE EXCITED MY ATTENTION”
Five davs after O’Neal’s October :o departure from Merrill Lvnch, Citigroup an-
nouncedthatitstotalsubprimeexposurewas·--billion,whichwas·aibillionmore
thanithadtoldinvestorsjustthreeweeksearlier.Citigroupalsoannounceditwould
be taking an ·8 to ·11 billion loss on its subprime mortgage–related holdings and
thatChuckPrincewasresigningasitsCEO.LikeO’Neal,Princehadlearnedlateof
hiscompanv’ssubprime-relatedCDOexposures.PrinceandRobertRubin,chairman
oftheExecutiveCommitteeoftheboard,toldtheFCICthatbeforeSeptemberioo¬,
thev had not known that Citigroup’s investment banking division had sold some
CDOswithliquiditvputsandretainedthesuper-seniortranchesofothers.
i:
PrincetoldtheFCICthateveninhindsightitwasdimcultforhimtocriticizeanv
ofhisteam’sdecisions.“Ifsomeonehadelevatedtomvlevelthatwewereputtingona
·itrillionbalancesheet,·aobillionoftriple-A-rated,zero-riskpaper,thatwouldnot
inanvwavhaveexcitedmvattention,”Princesaid.“Itwouldn’thavebeenusefulfor
someonetocometomeandsav,‘Now,wehavegot·itrilliononthebalancesheetof
assets.Iwanttopointouttovouthereisaoneinabillionchancethatthis·aobillion
couldgosouth.’Thatwouldnothavebeenusefulinformation.ThereisnothingIcan
dowiththat,becausethereisthatlevelofchanceonevervthing.”
ia
Infact,theodds
weremuchhigherthanthat.EvenbeforethemassdowngradesofCDOsinlateioo¬,
atriple-AtrancheofaCDOhada1in1ochanceofbeingdowngradedwithin-vears
ofitsoriginalrating.
i-
Certainlv, 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·a:billioninconcentratedexposure—
iº of the companv’s balance sheet and more than a third of its capital—because it
wasperceivedtobe“zero-riskpaper.”

Signifcantlv,Citigroup’sFinancialControlGrouphadarguediniooothattheliq-
uiditvputsthatCitigrouphadwrittenonitsCDOshadbeenpricedforinvestorstoo
cheaplvinlightoftherisks.
i8
Also,inearlviooo,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.
io
Bv
mid-iooo,hergroupsawadeteriorationinloanqualitvandanincreaseinearlvpav-
mentdefaults—thatis,moreborrowersweredefaultingwithinafewmonthsofget-
ting a loan. From ioo- to ioo¬, Mills recalled before the FCIC, the earlv pavment
defaultratesnearlvtripledfromiºto-ºoroº.
:o
Inresponse,thesecuritizationunit
slowed down its purchase of loans, demanded higher-qualitv mortgages, and con-
ductedmoreextensiveduediligenceonwhatitbought.However,neitherMillsnor
othermembersoftheunitsharedanvofthisinformationwithotherdivisionsinCiti-
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-
backedsecuritiesbecauseitsawthedistressedmarketasabuvingopportunitv.
:i
“Effective communication across businesses was lacking,” the companv’s regula-
torslaterobserved.“Managementacknowledgedthat,inlookingback,itshouldhave
made the mortgage deterioration known earlier throughout the frm. The Global
ConsumerGroupsawsignsofsub-primeissuesandavoidedlosses,asdidmortgage
backedsecuritiestraders,butCDOstructuresbusinessdidsobelatedlv—[therewas]
nodialogueacrossbusinesses.”
::
Co-headoftheCDOdeskIaniceWarnetoldtheFCICthatshefrstsawweaknesses
intheunderlvingmarketinearlvioo¬.InFebruarv,whentheABX.HE.BBB-oo-ifell
to:¼belowpar,theCDOdeskdecidedtoslowdownonthefnancingofmortgage
securitiesforinventorvtoproduceCDOs.
:a
Shortlvthereafter,however,thesameABX
indexstartedtorallv,risingtoioºbelowparinMarchandholdingaroundthatlevel
throughMav.So,theCDOdeskreversedcourseandaccelerateditspurchasesofinven-
torv in April, according to Nestor Dominguez, Warne’s co-head on the CDO desk.
:-
Dominguezsaidhedidn’tseethemarketweakeninguntilthesummer,whentheindex
felltolessthanooºbelowpar.
:o
MurravBarnes,theCitigroupriskomcerassignedtotheCDObusiness,approved
the CDO desk’s request to temporarilv increase its limits on purchasing collateral.
Barnesobserved,inhindsight,thatratherthanlookingatthewideningspreadsasan
opportunitv, Citigroup should have reassessed its assumptions and examined
whetherthedeclineintheABXwasasignofstraininthemortgagemarket.Head-
mitted“complacencv”aboutthedesk’sabilitvtomanageitsrisk.

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.”
:o
Ultimatelv,lossesatCitigroupfrommortgages,Alt-Amortgage–backedse-
curities, and mortgage-related CDOs would total about ·-8 billion, nearlv half of
Citigroup’scapitalattheendofiooo.About·8billionofthatlossrelatedtoprotec-
tionpurchasedfromthemonolineinsurers.
ao
Barnes’s decision to increase the CDO risk limits was approved bv his superior,
EllenDuke.BarnesandDukereportedtoDavidBushnell,thechiefriskomcer.Bush-
nell—whomPrincecalled“thebestriskmanageronWallStreet”—toldtheFCICthat
hedidnotrememberspecifcallvapprovingtheincreasebutthat,ingeneral,therisk
managementfunctiondidapprovehigherrisklimitswhenabusinesslinewasgrow-
ing.
a1
He described a “frm-wide initiative” to increase Citigroup’s structured prod-
uctsbusiness.
ai
Perhapswhatismostremarkableabouttheconfictingstrategiesemplovedbvthe
z(z ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN iiiui1
securitizationandCDOdesksisthattheirrespectiveriskomcersattendedthesame
weeklvindependentriskmeetings.Dukerefectedthatshewasnotoverlvconcerned
whentheissuecameup,savingsheandherriskteamwere“seducedbvstructuring
andfailedtolookattheunderlvingcollateral.”
a:
AccordingtoBarnes,theCDOdesk
didn’t look at the CDOs’ underlving collateral because it lacked the “abilitv” to see
loan performance data, such as delinquencies and earlv pavment defaults.
aa
Yet the
surveillance unit in Citigroup’s securitization desk might have been able to provide
some insights based on its own data.
a-
Barnes told the FCIC that Citigroup’s risk
managementtendedtobemanagedalongbusinesslines,notingthathewasonlvtwo
omcesawavfromhiscolleaguewhocoveredthesecuritizationbusinessandvetdidn’t
understandthenuancesofwhatwashappeningtotheunderlvingloans.Heregretted
notreachingouttotheconsumerbankto“getthepulse”ofmortgageorigination.
ao
“1/et/esncvcr/ejjcncásincct/cucjrcssion”
PrinceandRubinappearedtobelieveupuntilthefallofioo¬thatanvdownsiderisk
intheCDObusinesswasminuscule.“Idon’tthinkanvbodvfocusedontheCDOs.
Thiswasonebusinessinavastenterprise,anduntilthetroubledeveloped,itwasn’t
one that had anv particular profle,” Rubin—in Prince’s words, a “verv important
memberof[the]board”

—toldtheFCIC.“Youknow,TomMaheraswasinchargeof
trading.Tomwasanextremelvwellregardedtradingfgureonthestreet. . . .Andthis
is what traders do, thev handle these kinds of problems.”
a8
Maheras, the co-head of
Citigroup’sinvestmentbank,toldtheFCICthathespent“asmallfractionof1º”of
histimethinkingaboutordealingwiththeCDObusiness.
ao
Citigroup’sriskmanagementfunctionwassimplvnotvervconcernedabouthous-
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
liquiditvputsithadwritten.
Bv Iune ioo¬, national house prices had fallen a.-º, and about 1oº of subprime
adjustable-ratemortgagesweredelinquent.YetCitigroupstilldidnotexpectthatthe
liquiditvputscouldbetriggered,anditremainedunconcernedaboutthevalueofits
retainedsuper-seniortranchesofCDOs.OnIunea,ioo¬,Citigroupmadeapresenta-
tiontotheSECaboutsubprimeexposureinitsCDObusiness.Thepresentationnoted
thatCitigroupdidnotfactortwopositionsintothisexposure:·1a.obillioninsuper-
seniortranchesand·i:.ibillioninliquiditvputs.Thepresentationexplainedthatthe
liquiditvputswerenotaconcern:“Theriskofdefaultisextremelvunlikelv . . .[and]
certain market events must also occur for us to be required to fund. Therefore, we
viewthesepositionstobeevenlessriskvthantheSuperSeniorBook.”
-1
Iust a few weeks later, the Iulv 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(.
whichCitigrouphadissuedliquiditvputsbeganlosingvalue,andtheirinterestrates
began rising. The liquiditv puts would be triggered if interest rates on the asset-
backedcommercialpaperroseaboveacertainlevel.
The Omce of the Comptroller of the Currencv, the regulator of Citigroup’s na-
tional bank subsidiarv, had expressed no apprehensions about the liquiditv puts in
ioo:. But bv the summer of ioo¬, OCC Examiner-in-Charge Iohn Lvons told the
FCIC, the OCC became concerned. Buving the commercial paper would drain ·i-
billionofthecompanv’scashandexposeittopossiblebalance-sheetlossesatatime
whenmarketswereincreasinglvindistress.Butgiventherisingrates,Lvonsalsosaid
Citigroupdidnothavetheoptiontowait.Overthenextsixmonths,Citigrouppur-
chasedall·i-billionofthepaperthathadbeensubjecttoitsliquiditvputs.
-i
On a Iulv io conference call, CFO Garv Crittenden told analvsts and investors
thatthecompanv’ssubprimeexposureshadfallenfrom·iabillionattheendofiooo
to·1:billiononIune:o.Buthemadenomentionofthesuper-seniorexposuresand
liquiditvputs.“Ithinkourriskteamdidanicejobofanticipatingthatthiswasgoing
tobeadimcultenvironment,andsosetaboutinaprettvconcentratedefforttore-
duceourexposureoverthelastsixmonths,”
-:
hesaid.Aweeklater,onaIulvi¬call,
Crittenden reiterated that subprime exposure had been cut: “So I think we’ve had
goodriskmanagementthathasbeenanticipatingsomemarketdislocationhere.”
-a
BvAugust,asmarketconditionsworsened,Citigroup’sCDOdeskwasrevaluing
itssuper-seniortranches,thoughithadnoeffectivemodelforassigningvalue.How-
ever,asthemarketcongealed,thenfroze,thepaucitvofactualmarketpricesforthese
tranchesdemandedamodel.TheNewYorkFedlaternotedthat“themodelforSuper
SeniorCDOs,basedonfundamentaleconomicfactors,couldnotbefullvvalidated
bvCitigroup’scurrentvalidationmethodologiesvetitwasrelieduponforreporting
exposures.”
--
Barnes, the CDO risk omcer, told the FCIC that sometime that summer he met
withtheco-headsoftheCDOdesktoexpresshisconcernsaboutpossiblelosseson
boththeunsoldCDOinventorvandtheretainedsuper-seniortranches.Themessage
got through. Nestor Dominguez told the FCIC, “We began extensive discussions
abouttheimplicationsofthe . . .dramaticdeclineoftheunderlvingsubprimemar-
kets,andhowthatwouldfeedintothesuper-seniorpositions.”
-o
Alsoatthistime—
for the frst time—such concerns reached Maheras. He justifed his lack of prior
knowledgeofthebillionsofdollarsininventorvandsuper-seniortranchesbvpoint-
ing out “that the business was appropriatelv supervised bv experienced and highlv
competentmanagersandbvanindependentriskgroupandthatIwasproperlvap-
prisedofthegeneralnatureofourworkinthisareaanditsattendantrisks.”

Theexactdatesarenotcertain,butaccordingtoBushnell,heremembersadiscus-
sionata“BusinessHeads”meetingaboutthegrowingmark-to-marketvolatilitvon
those super-senior tranches in late August or earlv September, well after Citigroup
startedtobuvthecommercialpaperbackingthesuper-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 NuUi i¥ tu\\i : :i uN iiiui1
then it got bigger and bigger and bigger, obviouslv, over the next :o davs.”
-o
In late
August, Citigroup’s valuation models suggested that losses on the super-senior
tranchesmightrangefrom·1-millionto·ibillion.Thisnumberwasrecalculatedas
·:ooto·-oomillioninmid-September,asthevaluationmethodologvwasrefned.
oo
Intheweeksahead,thosenumberswouldskvrocket.
“uII(0X cells”
To get a handle on potential losses from the CDOs and liquiditv puts, starting on
September o Prince convened a series of meetings—and later, nightlv “DEFCON
calls”—with members of his senior management team; thev 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’tthatdeeplvtroublingnotastowhathappened—thatisadif-
ferentquestionthatisalsotroubling—butastoprovidingfullandclearinformation
andanalvsisnow.”Princedisagreed,writing,“Ithought,forfrstmtg,itwasgood.We
weren’ttrvingtogettofnalanswers.”
o:
A second meeting was held September 1i, after Rubin was back in the countrv.
This meeting marked the frst time Rubin recalled hearing of the super-senior and
liquiditvputexposure.Helatercommented,“AsfarasIwasconcernedthevwereall
onething,becauseiftherewasaputbacktoCitiunderanvcircumstance,however
remotethatcircumstancemightbe,vouhadn’tfullvdisposedoftherisk.”
oa
And,of
course,thecircumstancewasnotremote,sincebillionsofdollarsinsubprimemort-
gageassetshadalreadvcomebackontoCitigroup’sbooks.
PrincetoldtheFCICthatMaherashadassuredhimthroughoutthemeetingsand
theDEFCONcallsthatthesuperseniorsposednorisktoCitigroup,evenasthemar-
ketdeteriorated;headdedthathebecameincreasinglvuneasvwithMaheras’sassess-
ment. “Tom had said and said till his last dav at work [October 11]: ‘We are never
goingtoloseapennvonthesesuperseniors.Wearenevergoingtoloseapennvon
thesesuperseniors. . . .’AndaswewentalongandIwasmoreandmoreuncomfort-
ablewiththisandmoreandmoreuncomfortablewithTom’sconclusionsonultimate
valuations,thatiswhenIreallvbegantohavesomevervseriousconcernsaboutwhat
wasgoingtohappen.”
o-
DespitePrince’sconcerns,Citigroupremainedpubliclvsilentabouttheadditional
subprimeexposurefromthesuper-seniorpositionsandliquiditvputs,evenasitpre-
announcedsomedetailsofitsthird-quarterearningsonOctober1,ioo¬.
OnOctober11,theratingagenciesannouncedthefrstinaseriesofdowngrades
onthousandsofsecurities.InPrince’sview,thesedowngradeswere“theprecipitating
event in the fnancial crisis.”
oo
On the same dav, Prince restructured the investment
bank,amovethatledtotheresignationofMaheras.
Four davs later, the question of the super-senior CDOs and liquiditv puts was
specifcallvraisedattheboardofdirectors’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¬bninLiquiditvandParPuts.”

Citigroup’stotal
subprime exposure was ·-o billion, nearlv half of its capital. The calculation was
straightforward,butduringananalvsts’conferencecallthatdavCrittendenomitted
anvmentionofthesuper-senior-andliquiditv-put-relatedexposureashetoldpar-
ticipantsthatCitigrouphadunder·1:billioninsubprimeexposure.
o8
A week later, on Saturdav, October i¬, Prince learned from Crittenden that the
companvwouldhavetoreportsubprime-relatedlossesof·8to·11billion;onMon-
davhetenderedhisresignationtotheboard.Helaterrefected,“WhenIdrovehome
andGarvcalledmeandtoldmeitwasn’tgoingtobetwoor:oomillionbutitwasgo-
ing to be eight billion—I will never forget that call. I continued driving, and I got
home,Iwalkedinthedoor,Itoldmvwife,Isaidhere’swhatIjustheardandifthis
turnsouttobetrue,Iamresigning.”
oo
OnNovembera,Citigrouprevealedtheaccuratesubprimeexposure—nowesti-
mated at ·-- billion—and it disclosed the subprime-related losses. Though Prince
had resigned, he remained on Citigroup’s pavroll until the end of the vear, and the
boardofdirectorsgavehimagenerouspartingcompensationpackage:·11.omillion
incashand·iamillioninstock,bringinghistotalcompensationto·¬omillionfrom
iooa to ioo¬.
¬o
The SEC later sued Citigroup for its delaved disclosures. To resolve
the charges, the bank paid ·¬- million. The New York Fed would later conclude,
“Therewaslittlecommunicationsontheextensivelevelofsubprimeexposureposed
bvSuperSeniorCDO. . . .Seniormanagement,aswellastheindependentRiskMan-
agementfunctionchargedwithmonitoringresponsibilities,didnotproperlvidentifv
andanalvzetheserisksinatimelvfashion.”
¬1
Prince’sreplacementsaschairmanandCEO—RichardParsonsandVikramPan-
dit—were announced in December. Rubin would stav until Ianuarv iooo, having
beenpaidmorethan·11-millionfromioootoiooo
¬i
duringhistenureatthecom-
panv,includinghisroleaschairmanoftheExecutiveCommittee,apositionthatcar-
ried“nooperationalresponsibilities,”RubintoldtheFCIC.“MvagreementwithCiti
providedthatI’dhavenomanagementofpersonneloroperations.”
¬:
IohnReed,formerco-CEOofCitigroup,attributedthefrm’sfailuresinparttoa
culturechangethatoccurredwhenthebanktookonSalomonBrothersaspartofthe
1oo8Travelersmerger.HesaidthatSalomonexecutives“wereusedtotakingbigrisks”
and“hadahistorv . . .[of]makingalotofmonev . . .butthengettingintotrouble.”
¬a
AIG’ S DISPUTE WITH GOLDMAN:
“THERE COULD NEVER BE LOSSES”
BeginningonIulvio,ioo¬,whenGoldman’sDavilmansenttheemailthatdisrupted
thevacationofAIG’sAlanFrost,thedisputebetweenGoldmanandAIGovertheneed
forcollateraltobackcreditdefaultswapscapturedtheattentionoftheseniormanage-
mentofbothcompanies.For1amonths,GoldmanpresseditscaseandsentAIGafor-
mal demand letter everv single business dav. It would pursue AIG relentlesslv with
z(( ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN iiiui1
demands for collateral based on marks that were initiallv 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.
Thev had known there were enormous exposures—·¬o billion, backed in large
partbvsubprimeandAlt-Aloans,inioo¬,
¬-
comparedwiththeparentcompanv’sto-
tal reported capital of ·o-.8 billion—but executives said thev had never been con-
cerned. “The mantra at [AIG Financial Products] had alwavs been (in mv
experience) that there could never be losses,” Vice President of Accounting Policv
IosephSt.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.Thiswasparticularlvimportantinthecreditdefaultswapbusi-
ness,hesaid,becauseitwastheonlvunhedgedbusinessthatAIGran.
¬8
But Iake Sun, the general counsel of the Financial Products subsidiarv, who re-
viewedtheswapcontractsbeforethevwereexecuted,toldtheFCICthattheprovi-
sions were standard both at AIG and in the industrv.
¬o
Frost, who was the frst to
learnofthecollateralcall,agreedandsaidthatotherfnancialinstitutionsalsocom-
monlvdiddealswithcollateralpostingprovisions.
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
Ambactopavoutexceptwhentheinsuredentitvsufferedanactualloss,andthere-
forethosecompanieswereforbiddentopostcollateralforadeclineinmarketvalue
orunrealizedlosses.BecauseAIGFinancialProductswasnotregulatedasaninsur-
ancecompanv,itwasnotsubjecttothisprohibition.
As disturbing as the senior AIG executives’ surprise at the collateral provisions
wastheirfrm’sinabilitvtoassessthevaliditvofGoldman’snumbers.AIGFinancial
Products did not have its own model or otherwise trv to value the CDO portfolio
thatitguaranteedthroughcreditdefaultswaps,nordidithedgeitsexposure.Gene
Parkexplainedthathedgingwasseenasunnecessarvinpartbecauseofthemistaken
beliefthatAIGwouldhavetopavcounterpartiesonlvifholdersofthesuper-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
goingtopavadimeforthis,”ForstertoldPark.
8i
Therefore,AIGFinancialProductsreliedonanactuarialmodelthatdidnotpro-
vide a tool for monitoring the CDOs’ market value. The model was developed bv
i\1i z++, 1u i\ii¥ z++· 8i iii uN: i N :U8iii \i iu: :i: z(,
Garv Gorton, then a fnance professor at the Universitv of Pennsvlvania’s Wharton
School, who began working as a consultant to AIG Financial Products in 1ooo and
wasclosetoitsCEO,IoeCassano.TheGortonmodelhaddeterminedwithoo.8-º
confdencethattheownersofthesuper-seniortranchesoftheCDOsinsuredbvAIG
FinancialProductswouldneversufferrealeconomiclosses,eveninaneconomvas
troubledastheworstpost–WorldWarIIrecession.Thecompanv’sauditors,Pricewa-
terhouseCoopers (PwC), who were apparentlv also not aware of the collateral re-
quirements, concluded that “the risk of default on [AIG’s] portfolio has been
effectivelvremovedandasaresultfromariskmanagementperspective,thereareno
substantiveeconomicrisksintheportfolioandasaresultthefairvalueoftheliabilitv
streamonthesepositionsfromariskmanagementperspectivecouldreasonablvbe
consideredtobezero.”
8:
InspeakingwiththeFCIC,Cassanowasadamantthatthe“CDSbook”waseffec-
tivelvhedged.HesaidthatAIGcouldneversufferlossesontheswaps,becausethe
CDScontractswerewrittenonlvonthesuper-seniortranchesoftop-ratedsecurities
withhigh“attachmentpoints”—thatis,manvsecuritiesintheCDOswouldhaveto
defaultinorderforlossestoreachthesuper-seniortranches—andbecausethebulk
oftheexposurecamefromloansmadebeforeiooo,whenhethoughtunderwriting
standardshadbeguntodeteriorate.
8a
Indeed,accordingtoGenePark,Cassanoputa
halttoa·1-omillionhedge,inwhichAIGhadtakenashortpositionintheABXin-
dex.AsParkexplained,“Ioestoppedthatbecauseafterweputonthefrst1-o . . .the
marketmovedagainstus . . .wewerelosingmonevonthe1-omillion. . . .Ioesaid,
‘Youknow,Idon’tthinktheworldisgoingtoblowup . . .Idon’twanttospendthat
monev.Stopit.’”
8-
Despitethelimitedmarkettransparencvinthesummerofioo¬,Goldmanused
whatinformationtherewas,includinginformationfromABXandotherindices,to
estimate what it considered to be realistic prices. Goldman also spoke with other
companies to see what values thev assigned to the securities. Finallv, Goldman
lookedtoitsownexperience:inmostcases,whenthebankboughtcreditprotection
on an investment, it turned around and sold credit protection on the same invest-
menttoothercounterparties.Thesedealsvieldedmorepriceinformation.
8o
UntilthedisputewithGoldman,AIGreliedontheGortonmodel,whichdidnot
estimatethemarketvalueofunderlvingsecurities.SoGoldman’smarkscaughtAIG
bvsurprise.WhenAIGpushedback,GoldmanalmostimmediatelvreduceditsIulv
i¬collateraldemandfrom·1.8billionto·1.ibillion,amovethatunderscoredthe
dimcultv of fnding reliable market prices. The new demand was still too high, in
AIG’s view, which was corroborated bv third-partv marks. Goldman valued the
CDOsbetween8oando¬centsonthedollar,whileMerrillLvnch,forexample,val-
uedthesamesecuritiesbetweeno-and1oocents.

On August ¬, Cassano told PwC that there was “little or no price transparencv”
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 actuallv execute transactions at the
z(· ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN iiiui1
quotedprices.“Theaboveestimatedvalues . . .donotrepresentactualbidsoroffers
bvMerrillLvnch”wasthedisclaimerinalistingofestimatedmarketvaluesprovided
bvMerrilltoAIG.
8o
GoldmanSachsdisputedthereliabilitvofsuchestimates.
“\it/outocingjlijjent”
OnAugusto,forthefrsttime,AIGexecutivespubliclvdisclosedthe·¬obillionin
creditdefaultswapsonthesuper-seniortranchesofCDOsduringthecompanv’ssec-
ond-quarterearningscall.Thevacknowledgedthatthegreatmajoritvoftheunderlv-
ing bonds thus insured—·oa billion—were backed bv subprime mortgages. Of this
amount,·1obillionwaswrittenonCDOspredominantlvbackedbvriskvBBB-rated
collateral.Onthecall,Cassanomaintainedthattheexposureswerenoproblem:“Itis
hardforus,withoutbeingfippant,toevenseeascenariowithinanvkindofrealmor
reasonthatwouldseeuslosing·1inanvofthosetransactions.”Heconcluded:“We
see no issues at all emerging. We see no dollar of loss associated with anv of [the
CDO]business.Anvreasonablescenariothatanvonecandraw,andwhenIsavrea-
sonable,Imeanasevererecessionscenariothatvoucandrawoutforthelifeofthe
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.”
oo
Theseassurancesfocusedontheriskthatactualmortgagedefaultswouldcreate
realeconomiclossesonthecompanv’screditdefaultswappositions.
o1
Butmoreim-
portantatthetimeweretheothertremendousrisksthatAIGexecutiveshadalreadv
discussed internallv. No one on the conference call mentioned Goldman’s demand
for ·1.i billion in collateral; the clear possibilitv that future, much-larger collateral
callscouldjeopardizeAIG’sliquiditv;ortheriskthatAIGwouldbeforcedtotakean
“enormousmark”onitsexistingbook,theconcernForsterhadnoted.
Thedavaftertheconferencecall,AIGposted·a-omillionincashtoGoldman,
its frst collateral posting since Goldman had requested the ·1.i billion. As Frost
wrotetoForsterinanAugust1o,ioo¬,email,theideawas“togetevervonetochill
out.”
oi
Foronething,someAIGexecutives,includingCassano,hadlate-summerva-
cationsplanned.Cassanosignedoffonthe·a-omillion“goodfaithdeposit”before
leavingforacvclingtripthroughGermanvandAustria.
o:
Thepartiesexecutedaside
lettermakingclearthatbothdisputedtheamount.Forthetimebeing,twocompa-
niesthathadbeendoingbusinesstogetherfordecadesagreedtodisagree.
On August 1a, Frost went to Goldman’s omces to “start the dialog,” which had
stalledwhileCassanoandotherkevexecutiveswereonvacation.Twodavslater,Frost
wrotetoForster:“Trustme.Thisisnotthelastmargincallwearegoingtodebate.”
oa
He was right. Bv September 11, Société Générale—known more commonlv as Soc-
Gen—haddemanded·aomillionincollateralonCDSithadpurchasedfromAIGFi-
nancial Products, UBS had demanded ·o¬ million, and Goldman had upped its
demand bv ·:oo million. The SocGen demand was based on an 8i.- bid price pro-
vided bv 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.”
o-
Several weeks
later, Cassano told AIG Financial Services CFO Elias Habaveb that he believed the
SocGenmargincallhadbeen“spurredbvGoldman,”andthatAIG“disputedthecall
and[had]notheardfromSocGenagainonthatspecifccall.”
oo
Inthesecondweekof
October,theratingagenciesannouncedhundredsofadditionaldowngradesaffecting
tens of billions of dollars of subprime mortgage–backed securities and CDOs. Bv
Novemberi,Goldman’sdemandhadalmostdoubled,to·i.8billion.OnNovembero,
Bensinger,theCFO,informedAIG’sAuditCommitteethatFinancialProductshadre-
ceivedmargincallsfromfvecounterpartiesandwasdisputingevervsingleone.

Thisstancewasrootedinthecompanv’scontinuingbeliefthatGoldmanhadset
valuestoolow.AIG’spositionwascorroborated,atleastinpart,bvthewidedisparitv
inmarksfromothercounterparties.Atonepoint,MerrillLvnchandGoldmanmade
collateral demands on the verv same CDS positions, but Goldman’s marks were al-
most :-º lower than Merrill’s.
o8
Goldman insisted that its marks represented the
“constantlv evolving additional information from our market making activities, in-
cluding trades that we had executed, market activitv we observed, price changes in
comparablesecuritiesandderivativesandthecurrentpricesofrelevantliquid . . .in-
dices.”
oo
Trading in the ABX would fall from over aoo trades per week through the
endofSeptemberioo¬tolessthani-operweekinthefourthquarterofioo¬;trad-
ing in the TABX, which focuses on lower-rated tranches, dropped from roughlv -o
tradesperweekthroughmid-Iulvtoalmostzerobvmid-August.
1oo
But Cassano believed that the quick reduction in Goldman’s frst collateral de-
mand (from ·1.8 billion on Iulv i¬ to ·1.i billion on August i) and the interim
agreementonthe·a-omilliondepositconfrmedthatGoldmanwasnotascertainof
its marks as it later insisted. According to Cassano, Michael Sherwood, co-CEO of
GoldmanSachsInternational,toldhimthatGoldman“didn’tcoverourselvesinglorv
during this period” but that “the market’s starting to come our [Goldman’s] wav”;
CassanotookthosecommentsasanimplicitadmissionthatGoldman’sinitialmarks
hadbeenaggressive.
1o1
“Morclovcnotcs”
Inmid-August,ForstertoldFrostinanemailthatGoldmanwaspursuingastrategv
of aggressivelv 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
ownproblemsfromcounterpartieswhodidhavetheabilitvtomarktheirownposi-
tionstomarketpricesandthendemandcollateralfromAIG.
z,+ ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN iiiui1
Thedecisiontodevelopavaluationmodelwasnotunanimous.Inmid-Septem-
ber,CassanoandForstermetwithHabavebandotherstodiscussmarkingtheposi-
tions down and actuallv recording valuation losses in AIG’s fnancial statements.
Cassanostillthoughtthevaluationprocessunnecessarvbecausethepossibilitvofde-
faults was “remote.”
1oa
He sent Forster and others emails describing requests from
Habavebas“morelovenotes . . .[askingustogothrough]thesamedrillofdrafting
answers.”
1o-
Nevertheless,bvOctober,andinconsultationwithPwC,AIGstartedto
evaluate the pricing model for subprime instruments developed and used bv
Moodv’s.CassanoconsideredtheMoodv’smodelonlva“gutcheck”untilitwasfullv
validatedinternallv.
1oo
AIGcoupledthismodelwithgenericCDOtranchedatasold
bvIPMorganthatwereconsideredtoberelativelvrepresentativeofthemarket.Of
course,bvthistime—andforseveralprecedingmonths—therewasnoactivemarket
formanvofthesetranches.Evervoneunderstoodthatthiswasnotaperfectsolution,
but AIG and its auditors thought it could serve as an interim step. The makeshift
modelwasupandrunninginthethirdquarter.
“(onjiácntinourmerks”
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-
proximatelv·--omillionbeforetax[onthat]portfolio.”Onaconferencecall,CEO
Sullivan assured investors that the insurance companv had “active and strong risk
management.”Hesaid,“AIGcontinuestobelievethatitishighlvunlikelvthatAIGFP
willberequiredtomakepavmentswithrespecttothesederivatives.”Cassanoadded
that AIG had “more than enough resources to meet anv of the collateral calls that
mightcomein.”
1o¬
Whilethecompanvremainedadamantthattherewouldbenore-
alizedeconomiclossesfromthecreditdefaultswaps,itusedthenewlvadopted—and
adapted—Moodv’smodeltoestimatethe·:-imillioncharge.Infact,PwChadques-
tionedtherelevanceofthemodel:ithadn’tbeenvalidatedinadvanceoftheearnings
release,itdidn’ttakeintoaccountimportantstructuralinformationabouttheswap
contracts,andtherewerequestionsaboutthequalitvofthedata.
1o8
AIGdidn’tmen-
tionthosecaveatsonthecall.
Twoweekslater,onNovemberi:,Goldmandemandedanadditional·:billionin
cash.AIGprotested,butpaid·1.--billion,bringingthetotalpostedto·ibillion.
1oo
Fourdavslater,CassanocirculatedamemofromForsterlistingthepertinentmarks
for the securities from Goldman Sachs, Merrill Lvnch, Calvon, Bank of Montreal,
andSocGen.
11o
Themarksvariedwidelv,fromaslittleas--ºofthebonds’original
valuetovirtuallvfullvalue.Goldman’sestimatedvaluesweremuchlowerthanthose
ofotherdealers.Forexample,GoldmanvaluedoneCDO,theDunhillCDO,at¬-º
ofpar,whereasMerrillvalueditato-ºofpar;theOrientPointCDOwasvaluedat
ooºofparbvGoldmanbutato-ºofparbvMerrill.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.a billion. He told both AIG and Goldman executives
that independent third-partv pricing for ¬oº of the :,-oo securities underlving the
CDOsonwhichAIGFPhadwrittenCDSandAIG’sownvaluationfortheother:oº
indicatedthatGoldman’sdemandwasunsupported—thereforeGoldmanshouldre-
turnthemonev.
11:
Goldmanrefused,andinsteaddemandedmore.
11a
BvlateNovember,therewasrelativeagreementwithinAIGandwithitsauditor
thattheMoodv’smodelincorporatedintoAIG’svaluationsvstemwasinadequatefor
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 Moodv’s model
wouldresultina·1.-billionvaluationloss;usingGoldman’smarkswouldresultina
·-billionvaluationloss,whichwouldwipeoutthequarter’sprofts.
11o
OnNovember
io, PwC auditors met with senior executives from AIG and the Financial Products
subsidiarvtodiscussthewholesituation.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 relv on dealer quotes.
IamesBridgewater,theFinancialProductsexecutivevicepresidentinchargeofmod-
els, came up with a solution. Convinced that there was a calculable difference be-
tween the value of the underlving 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
agreedthatthenegativebasisadjustmentwasthewavtogo.
SeveraldocumentsgiventotheFCICbvPwC,AIG,andCassanorefectdiscus-
sionsduringandaftertheNovemberiomeeting.Duringasecondmeetingatwhich
onlvtheauditorandparentcompanvexecutiveswerepresent(FinancialProductsex-
ecutives, including Cassano and Forster, did not attend), PwC expressed signifcant
concerns about risk management, specifcallv related to the valuation of the credit
default swap portfolio, as well as to the companv’s procedures in posting collateral.
AIGFinancialProductshadpaidout·ibillionwithoutactiveinvolvementfromthe
parentcompanv’sEnterpriseRiskManagementgroup.Anotherissuewas“thewavin
whichAIGFP[had]been‘managing’theSS[supersenior]valuationprocess—saving
PwCwillnotgetanvmoreinformationuntilaftertheinvestordavpresentation.”
11o
TheauditorslaidouttheirconcernsaboutconfictingstrategiespursuedbvAIG
subsidiaries. Notablv, the securities-lending subsidiarv had been purchasing mort-
gage-backed securities, using cash raised bv lending securities that AIG held on
z,z ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN iiiui1
behalfofitsinsurancesubsidiaries.FromtheendofiooothroughSeptemberioo¬,
itsholdingsrosefrom·oobillionto·88billion.Meanwhile,FinancialProducts,act-
ingonitsownanalvsis,haddecidedinioootobeginpullingbackonwritingcredit
defaultswapsonCDOs.InPwC’sview,inallowingonesubsidiarvtoincreaseexpo-
sure to subprime while another subsidiarv worked to exit the market entirelv, the
parentcompanv’sriskmanagementfailed.PwCalsosaidthatthecompanv’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 regularlv of our concerns about the housing market. Some
listenedandresponded;otherssimplvchosenottolistenandthen,toaddinsultto
injurv,nottospotthemanifestsigns.”Heconcludedthatthiswasakinto“Neroplav-
ing the fddle while Rome burns.”
1i1
On the opposite side, Sullivan insisted to the
FCICthattheconfictingstrategiesinthesecurities-lendingbusinessandatAIGFi-
nancialProductssimplvrevealedthatthetwosubsidiariesadopteddifferentbusiness
models,anddidnotconstituteariskmanagementfailure.
1ii
OnDecember-,sixdavsafterreceivingPwC’swarnings,Sullivanboastedonan-
otherconferencecallaboutAIG’sriskmanagementsvstemsandthecompanv’sover-
sight of the subprime exposure: “The risk we have taken in the U.S. residential
housingsectorissupportedbvsoundanalvsisandariskmanagementstructure. . . .
webelievetheprobabilitvthatitwillsustainaneconomiclossisclosetozero. . . .We
areconfdentinourmarksandthereasonablenessofourvaluationmethods.”Charlie
Gates, an analvst at Credit Suisse, a Swiss bank, asked directlv about valuation and
collateraldisputeswithcounterpartiestowhichAIGhadalludedinitsthird-quarter
fnancialresults.Cassanoreplied,“Wehavefromtimetotimegottencollateralcalls
frompeopleandthenwesavtothem,wellwedon’tagreewithvournumbers.And
thevgo,oh,andthevgoawav.Andvousavwellwhatwasthat:It’slikeadrive-bvina
wav.Andtheothertimesthevsatdownwithus,andnoneofthisishostileoranv-
thing,it’sallvervcordial,andwesitdownandwetrvandfndthemiddlegroundand
comparewhereweare.”
1i:
Cassano did not reveal the ·i billion collateral posted to Goldman, the several
hundredmilliondollarspostedtoothercounterparties,andthedailvdemandsfrom
Goldman and the others for additional cash. The analvsts 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 bv ·:.o billion—and thev would not learn that
informationuntilFebruarv11,ioo8.
“Metcrielvcekncss”
BvIanuarvioo8,AIGstilldidnothaveareliablewavtodeterminethemarketprice
ofthesecuritiesonwhichithadwrittencreditprotection.Nevertheless,onIanuarv
i\1i z++, 1u i\ii¥ z++· 8i iii uN: i N :U8iii \i iu: :i: z,.
1o,CassanosentanemailtoMichaelSherwoodandCFODavidViniaratGoldman
demanding that thev return ·1.1 billion of the ·i billion posted.
1ia
He attached a
spreadsheetshowingthatAIGvaluedmanvsecuritiesatpar,asiftherehadbeenno
decline in their value. That was simplv not credible, Goldman executives told the
FCIC.
1i-
Meanwhile, Goldman had bv then built up ·1.a- billion in protection bv
purchasingcreditdefaultswapsonAIGtocoverthedifferencebetweentheamount
ofcollateralthevhaddemandedandtheamountthatAIGhadpaid.
1io
OnFebruarvo,ioo8,PwCauditorsmetwithRobertWillumstad,thechairmanof
AIG’s board of directors. Thev informed him that the “negative basis adjustment”
usedtoreachthe·1.-billionestimatedisclosedontheDecember-investorcallhad
beenimproperandunsupported,andwasasignthat“controlsovertheAIGFinan-
cialProductssuperseniorcreditdefaultswapportfoliovaluationprocessandover-
sightthereofwerenoteffective.”PwCconcludedthat“thisdefciencvwasamaterial
weaknessasofDecember:1,ioo¬.”
1i¬
Inotherwords,PwCwouldhavetoannounce
thatthenumbersAIGhadalreadvpubliclvreportedwerewrong.Whvtheauditors
waitedsolongtomakethispronouncementisunclear,particularlvgiventhatPwC
hadknownabouttheadjustmentinNovember.
In the meeting with Willumstad, the auditors were broadlv critical of Sullivan;
Bensinger,whomthevdeemedunabletocompensateforSullivan’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¬millionoverfourvearsincompensationfrom
AIG,includingaseverancepackageof·18million.Whenaskedaboutthesefgures
at a FCIC hearing, he said, “I have no knowledge or recollection of those numbers
whatsoever,sir. . . .Icertainlvdon’trecallearningthatamountofmonev,sir.”
1io
Thefollowingdav,PwCmetwiththeentireAIGAuditCommitteeandrepeated
the analvsis presented to Willumstad. The auditors said thev could complete AIG’s
audit,butonlvifCassano“didnotinterfereintheprocess.”RetainingCassanowasa
“managementjudgment,butthecultureneededtochangeatFP.”
1:o
OnFebruarv11,
AIGdisclosedinanSECflingthatitsauditorhadidentifedthematerialweakness,
acknowledgingthatithadreduceditsDecembervaluationlossestimatesbv·:.obil-
lion—thatis,thedifferencebetweentheestimatesof·-.1billionand·1.-billion—
becauseoftheunsupportablenegativebasisadjustment.
Theratingagenciesrespondedimmediatelv.Moodv’sandS&Pannounceddown-
grades,andFitchplacedAIGon“RatingsWatchNegative,”suggestingthatafuture
downgradewaspossible.AIG’sstockdeclined1iºforthedav,closingat·aa.¬a.
AttheendofFebruarv,Goldmanheld·ibillionincashcollateral,wasdemand-
ing an additional ·i.- billion, and had upped to ·i.1- billion its CDS protection
against an AIG failure. On Februarv i8, AIG disappointed Wall Street again—this
time with dismal fourth-quarter and fscal vear ioo¬ earnings. The companv re-
portedanetlossof·-.iobillion,largelvdueto·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 NuUi 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-
lionfromthetimehejoinedAIGFinancialProductsinIanuarvof1o8¬untilhisre-
tirement in ioo8, including a ·1 million-a-month consulting agreement after his
retirement.
1:1
InMarch,theOmceofThriftSupervision,thefederalregulatorinchargeofregu-
latingAIGanditssubsidiaries,downgradedthecompanv’scompositeratingfroma
i,signifvingthatAIGwas“fundamentallvsound,”toa:,indicatingmoderatetose-
vere supervisorv concern. The OTS still judged the threat to overall viabilitv as re-
mote.
1:i
Itdidnotscheduleafollow-upreviewofthecompanv’sfnancialcondition
foranothersixmonths.
Bvthen,itwouldbetoolate.
FEDERAL RESERVE:
“THE DISCOUNT WINDOW WASN’ T WORKING”
Over the course of the fall, the announcements bv Citigroup, Merrill, and others
made it clear that fnancial institutions were going to take serious losses from their
exposurestothemortgagemarket.Stocksoffnancialfrmsfellsharplv;bvtheendof
November,theS&PFinancialsIndexhadlostmorethan1oºforthevear.Between
Iulv and November, asset-backed commercial paper declined about :oº, which
meantthatthoseassetshadtobesoldorfundedbvothermeans.Investmentbanks
and other fnancial institutions faced tighter funding markets and increasing cash
pressures.Asaresult,theFederalReservedecidedthatitsinterestratecutsandother
measuressinceAugusthadnotbeensumcienttoprovideliquiditvandstabilitvtof-
nancialmarkets.TheFed’sdiscountwindowhadn’tattractedmuchbankborrowing
becauseofthestigmaattachedtoit.“Theproblemwiththediscountwindowisthat
people don’t like to use it because thev view it as a risk that thev will be viewed as
weak,”WilliamDudlev,thenheadofthecapitalmarketsgroupattheNewYorkFed
andcurrentlvitspresident,toldtheFCIC.
1::
Banks and thrifts preferred to draw on other sources of liquiditv; in particular,
during the second half of ioo¬, the Federal Home Loan Banks—which are govern-
ment-sponsoredentitiesthatlendtobanksandthrifts,acceptingmortgagesascollat-
eral—boostedtheirlendingbv·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; Countrvwide increased its bor-
rowing from ·i¬ billion to ·a8 billion; Bank of America increased its borrowing
from·:8billionto·-obillion.TheFederalHomeLoanBankscouldthusbeseenas
thelenderofnexttolastresortforcommercialbanksandthrifts—theFedbeingthe
lastresort.
1:a
Inaddition,thelossofliquiditvinthefnancialsectorwasmakingitmoredim-
i\1i z++, 1u i\ii¥ z++· 8i iii uN: i N :U8iii \i iu: :i: z,,
cultforbusinessesandconsumerstogetcredit,raisingtheFed’sconcerns.FromIulv
to October, the percentage of loan omcers reporting tightening standards on prime
mortgagesincreasedfrom1-ºtoaboutaoº.Overthattime,thepercentageofloan
omcersreportingtighteningstandardsonloanstolargeandmidsizecompaniesin-
creasedfrom8ºto1oº,itshighestlevelsinceioo:.
1:-
“TheFederalReservepursued
a whole slew of nonconventional policies . . . verv creative measures when the dis-
count window wasn’t working as hoped,” Frederic Mishkin, a Fed governor from
ioootoioo8,toldtheFCIC.“Theseactionswerevervaggressive,[and]thevwereex-
tremelv controversial.”
1:o
The frst of these measures, announced on December 1i,
wasthecreationoftheTermAuctionFacilitv(TAF).Theideawastoreducethedis-
countwindowstigmabvmakingthemonevavailabletoallbanksatoncethrougha
regularauction.Theprogramhadsomesuccess,withbanksborrowing·aobillionbv
theendofthevear.Overtime,theFedwouldcontinuetotweaktheTAFauctions,of-
feringmorecreditandlongermaturities.
AnotherFedconcernwasthatbanksandotherswhodidhavecashwouldhoard
it.Hoardingmeantforeignbankshaddimcultvborrowingindollarsandwerethere-
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 “currencv swap lines” to help foreign banks
borrow dollars. Under this mechanism, foreign central banks swapped currencies
with the Federal Reserve—local currencv for U.S. dollars—and lent these dollars to
foreignbanks.“Duringthecrisis,theU.S.bankswerevervreluctanttoextendliquid-
itvtoEuropeanbanks,”Dudlevsaid.
1:¬
Centralbankshadusedsimilararrangements
in the aftermath of the o/11 attacks to bolster the global fnancial markets. In late
ioo1,theswaplinestotaled·88billion.Duringthefnancialcrisissevenvearslater,
thevwouldreach·-8obillion.
The Fed hoped the TAF and the swap lines would reduce strains in short-term
monevmarkets,easingsomeofthefundingpressureonotherstrugglingparticipants
such as investment banks. Importantlv, it wasn’t just the commercial banks and
thriftsbutthe“broaderfnancialsvstem”thatconcernedtheFed,Dudlevsaid.“His-
toricallv,theFederalReservehasalwavstendedtosupplvliquiditvtothebankswith
theideathatliquiditvprovidedtothebankingsvstemcanbe[lenton]tosolventin-
stitutions in the nonbank sector. What we saw in this crisis was that didn’t alwavs
takeplacetotheextentthatithadinthepast. . . .Idon’tthinkpeoplegoinginreallv
hadafullunderstandingofthecomplexitvoftheshadowbankingsvstem,theroleof
[structuredinvestmentvehicles]andconduits,thebackstopsthatbankswereprovid-
ingSIVconduitseitherexplicitlvorimplicitlv.”
1:8
Burdened with capital losses and desperate to cover their own funding commit-
ments,thebankswerenotstableenoughtofllthevoid,evenaftertheFedlowered
interestratesandbegantheTAFauctions.InIanuarvioo8,theFedcutratesagain—
andthenagain,twicewithintwoweeks,ahighlvunusualmovethatbroughtthefed-
eralfundsratefroma.i-ºto:.oº.
z,( ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN iiiui1
The Fed also started plans for a new program that would use its emergencv au-
thoritv,theTermSecuritiesLendingFacilitv,thoughitwasn’tlauncheduntilMarch.
“The TLSF was more a view that the liquiditv that we were providing to the banks
through the TAF was not leading to a signifcant diminishment of fnancing pres-
sureselsewhere,”DudlevtoldtheFCIC.“Somavbeweshouldthinkaboutbvpassing
thebankingsvstemand[trv]tocomeupwithavehicletoprovideliquiditvsupport
totheprimarvdealercommunitvmoredirectlv.”
1:o
OnMarch¬,theFedincreasedthetotalavailableineachofthebiweeklvTAFauc-
tions from ·:o billion to ·-o billion, and guaranteed at least that amount for six
months.TheFedalsoliberalizeditsstandardforcollateral.Primarvdealers—mainlv
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
outstandingatanvgiventime.
Alsoatthistime,theU.S.centralbankbegancontemplatingastepthatwasrevo-
lutionarv: a program that would allow investment banks—institutions over which
the Fed had no supervisorv or regulatorv responsibilitv—to borrow from the dis-
countwindowontermssimilartothoseavailabletocommercialbanks.
MONOLINE INSURERS: “WE NEVER EXPECTED LOSSES”
Meanwhile,theratingagenciescontinuedtodowngrademortgage-backedsecurities
andCDOsthroughioo¬.BvIanuarvioo8,asaresultofthestressinthemortgage
market,S&Phaddowngraded:,:8otranchesofresidentialmortgage–backedsecuri-
tiesand1,:8:tranchesfromaioCDOs.MBIAandAmbac,thetwolargestmonoline
insurers,hadtakenonacombined·io-billionofguaranteesonmortgagesecurities
and other structured products. Downgrades on the products that thev insured
brought the fnancial strength of these companies into question. After conducting
stressanalvsis,S&PestimatedinFebruarvioo8thatAmbacwouldneedupto·aoo
million in capital to cover potential losses on structured products.
1ao
Such charges
would affect the monolines’ own credit ratings, which in turn could lead to more
downgradesoftheproductsthevhadguaranteed.
Likemanvofthemonolines,ACA,thesmallestofthem,keptrazor-thincapital—
lessthan·¬oomillion—againstitsobligationsthatincluded·oobillionincreditde-
fault swaps on CDOs. In late ioo¬, ACA reported a net loss of ·1.¬ billion, almost
entirelvduetocreditdefaultswaps.
Thiswasnews.Thenotionof“zero-losstolerance”wascentraltotheviabilitvof
the monoline business model, and thev and various stakeholders—the rating agen-
cies, investors, and monoline creditors—had traditionallv assumed that the mono-
lines never would have to take a loss. As Alan Roseman, CEO of ACA, told FCIC
staff:“Weneverexpectedlosses. . . .Wewereprovidinghedgesonmarketvolatilitvto
institutionalcounterparties. . . .Wewerepositioned,webelieved,totakethevolatil-
itv because we didn’t have to post collateral against the changes in market value to
ourcounterpartv,numberone.Numbertwo,weweretoldbvtheratingagenciesthat
i\1i z++, 1u i\ii¥ z++· 8i iii uN: i N :U8iii \i iu: :i: z,,
ratedusthatthatmark-to-marketvariationwasnotimportanttoourrating,froma
fnancialstrengthpointofviewattheinsurancecompanv.”
1a1
InearlvNovember,theSECcalledthegrowingconcernaboutMerrill’suseofthe
monolinesforhedging“aconcernthatwealsoshare.”
1ai
ThelargeWallStreetfrms
attempted to minimize their exposure to the monolines, particularlv ACA. On De-
cember 1o, S&P downgraded ACA to junk status, rating the companv CCC, which
wasfatalforacompanvwhoseCEOsaidthatits“ratingisthefranchise.”
1a:
Firmslike
Merrill Lvnch would get virtuallv nothing for the guarantees thev had purchased
fromACA.
Despitethestressesinthemarket,theSECsawthemonolineproblemsaslargelv
confnedtoACA.AIanuarvioo8internalSECdocumentsaid,“Whilethereisaclear
sentimentthatcapitalraisingwillneedtocontinue,thefactthattheguarantors(with
theexceptionofACA)arerelativelvinsulatedfromliquiditvdrivenfailuresprovides
hopethatevent[s]inthissectorwillunfoldinamanageablemanner.”
1aa
Still,theratingagenciestoldthemonolinesthatifthevwantedtoretaintheirstel-
lar ratings, thev would have to raise capital. MBIA and Ambac ultimatelv did raise
·1.o- billion and ·1.- billion, respectivelv. Nonetheless, S&P downgraded both to
AAinIuneioo8.Asthecrisisunfolded,mostofthemonolinesstoppedwritingnew
coverage.
The subprime contagion spread through the monolines and into a previouslv
unimpairedmarket:municipalbonds.Thepathofthesefallingdominoesiseasvto
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
regularlvscheduledauctionsheldevervonetosevenweeks.
1a-
Existinginvestorscan
choosetorebidforthebondsandnewinvestorscancomein.Thedebtisfrequentlv
municipalbonds.AsofDecember1:,ioo¬,stateandlocalgovernmentshadissued
·1o- billion in ARS, accounting for half of the ·::o billion market. The other half
wereprimarilvbundlesofstudentloansanddebtofnonproftssuchasmuseumsand
hospitals.
The kev point: these entities wanted to borrow long-term but get the beneft of
lowershort-termrates,andinvestorswantedtogetthesafetvofinvestinginthesese-
curitieswithouttvinguptheirmonevforalongtime.Unlikecommercialpaper,this
market had no explicit liquiditv backstop from a bank, but there was an implicit
backstop: often, if there were not enough new buvers to replace the previous in-
vestors,thedealersrunningtheseauctions,includingfrmslikeUBS,Citigroup,and
Merrill Lvnch, would step in and pick up the shortfall. Because of these interven-
tions,therewereonlv1:failuresbetween1o8aandearlvioo¬inmorethan1oo,ooo
auctions. Dealers highlighted those minuscule failure rates to convince clients that
ARSwerevervliquid,short-terminstruments,evenintimesofstress.
1ao
However,ifanauction didfail,thepreviousARSinvestorswouldbeobligatedto
retaintheirinvestments.Incompensation,theinterestratesonthedebtwouldreset,
oftenmuchhigher,butinvestors’fundswouldbetrappeduntilnewinvestorsorthe
z,· ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN iiiui1
dealer stepped up or the borrower paid off the loan. ARS investors were tvpicallv
vervriskaverseandvaluedliquiditv,andsothevwerewillingtopavapremiumfor
guaranteesontheARSinvestmentsfrommonolines.Itnecessarilvfollowedthatthe
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.InFebruarv,enmasse,thevpulled
up stakes. The market collapsed almost instantaneouslv. On Februarv 1a, in one of
thestarkestmarketdislocationsofthefnancialcrisis,8oºoftheARSauctionsfailed;
thefollowingweek,o¼failed.
Hundreds of billions of dollars were trapped bv 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.
1a¬
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.
ProblemsintheARSmarketcostGeorgetownUniversitv,aborrower,·omillion.
1a8
NewYorkStatewasstuckwithinterestratesthatsoaredfromabout:.-ºtomore
than1aºon·abillionofitsdebt.ThePortAuthoritvofNewYorkandNewIersev
sawtheinterestrateonitsdebtjumpfroma.:ºtoioºinasingleweekinFebru-
arv.
1ao
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, essentiallv the equivalent of monev market accounts but
with the potential for a slightlv higher interest rate. Investors also reported that the
frozen market blocked their access to monev for short-term needs such as medical
expenses, college tuition, and, for some small businesses and charities, pavroll. Bv
iooo,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
pavofftensofthousandsofARSinvestors.
1-o
COMMISSION CONCLUSIONS ON CHAPTER 14
The Commission concludes that some large investment banks, bank holding
companies, and insurance companies, including Merrill Lvnch, Citigroup, and
AIG, experienced massive losses related to the subprime mortgage market be-
causeofsignifcantfailuresofcorporategovernance,includingriskmanagement.
Executive and emplovee compensation svstems at these institutions dispropor-
tionallvrewardedshort-termrisktaking.
Theregulators—theSecuritiesandExchangeCommissionforthelargeinvest-
ment banks and the banking supervisors for the bank holding companies and
AIG—failedtoadequatelvsupervisetheirsafetvandsoundness,allowingthemto
take inordinate risk in activities such as nonprime mortgage securitization and
over-the-counter (OTC) derivatives dealing and to hold inadequate capital and
liquiditv.
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||vskcptica|”:::
“1urnintcadcathspira|” :::
“Dutvtcprctcctthcirinvcstcrs” ::e
“1hcgcvcrnncntwcu|dnctpcrnitahighcrnun|cr” ::;
“Itwashcadingtca||ackhc|c”:;o
After its hedge funds failed in Iulv ioo¬, Bear Stearns faced more challenges in the
secondhalfofthevear.TakingouttherepolenderstotheHigh-GradeFundbrought
nearlv·1.obillioninsubprimeassetsontoBear’sbooks,contributingtoa·1.obillion
write-down on mortgage-related assets in November. That prompted investors to
scrutinizeBearStearns’sfnances.Overthefall,Bear’srepolenders—mostlvmonev
market mutual funds—increasinglv required Bear to post more collateral and pav
higherinterestrates.Then,injustoneweekinMarchioo8,arunbvtheselenders,
hedgefundcustomers,andderivativescounterpartiesledtoBear’shavingtobetaken
overinagovernment-backedrescue.
MortgagesecuritizationwasthebiggestpieceofBearStearns’smost-proftabledi-
vision, its fxed-income business, which generated a-º of the frm’s total revenues.
Growing fast was the Global Client Services division, which included Bear’s prime
brokerageoperation.BearStearnswasthesecond-biggestprimebrokerinthecoun-
trv,withai1ºmarketshareiniooo,trailingMorganStanlev’si:º.
1
Thisbusiness
wouldfgureprominentlvinthecrisis.
Inmortgagesecuritization,Bearfollowedaverticallvintegratedmodelthatmade
monev at everv 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 ·1a.- 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.
a
AswastvpicalonWallStreet,thecompanv’s
viewwasthatBearwasinthemovingbusiness,notthestoragebusiness—thatis,it
sought to provide services to clients rather than take on long-term exposures of its
own.
-
Bearexpandeditsmortgagebusinessdespiteevidencethatthemarketwasbegin-
ningtofalter,asdidotherfrmssuchasCitigroupandMerrill.AsearlvasMaviooo,
Bearhadlost·:millionrelatingtodefaults
o
onmortgageswhichoccurredwithinoo
davsoforigination,whichhadbeenrareinthedecade.ButBearpersisted,assuming
the setback would be temporarv. In Februarv ioo¬, Bear even acquired Encore
Credit,itsthirdcaptivemortgageoriginatorintheUnitedStates,doublingitscapac-
itv.ThepurchasewasconsistentwithBear’scontrarianbusinessmodel—buvinginto
distressedmarketsandwaitingforthemtoturnaround.
¬
OnlvamonthafterthepurchaseofEncore,theSecuritiesandExchangeCommis-
sionwroteinaninternalreport,“Bear’smortgagebusinessincurredsignifcantmarket
risklosses”onitsAlt-Amortgageassets.
8
Thelossesweresmall,buttheSECreported
that“riskmanagersnote[d]thattheseeventsrefectamorerapidandseveredeteriora-
tionincollateralperformancethananticipatedinexantemodelsofstressevents.”
o
“I REQUESTED SOME FORBEARANCE”
VacationingonNantucketIslandwhenthetwoBear-sponsoredhedgefundsdeclared
bankruptcv on Iulv :1, ioo¬, former Bear treasurer Robert Upton anticipated that
the rating agencies would downgrade the companv, raising borrowing costs. Bear
fundedmuchofitsoperationsborrowingshort-termintherepomarket;itborrowed
between ·-o and ·¬o billion overnight.
1o
Even a threat of a downgrade bv a rating
agencvwouldmakefnancingmoreexpensive,startingthenextmorning.
Investors,analvsts,andthecreditratingagenciescloselvscrutinizedleveragera-
tios,availableattheendofeachquarter.BvNovemberioo¬,Bear’sleverageratiohad
reachednearlv:8to1.Bvtheendofioo¬,Bear’sLevel:assets—illiquidassetsdim-
cult to value and to sell—were iooº of its tangible common equitv; thus, writing
downtheseilliquidassetsbv:¼wouldwipeouttangiblecommonequitv.
At the end of each quarter, Bear would lower its leverage ratio bv selling assets,
onlv to buv them back at the beginning of the next quarter. Bear and other frms
bookedthesetransactionsassales—eventhoughtheassetsdidn’tstavoffthebalance
sheetforlong—inordertoreducetheamountofthecompanv’sassetsandlowerits
leverageratio.Bear’sformertreasurerUptoncalledthemove“windowdressing”and
saiditensuredthatcreditorsandratingagencieswerehappv.
11
Bear’spublicflingsre-
fected this, to some degree: for example, its ioo¬ annual report said the balance
sheet was approximatelv 1iº lower than the average month-end balance over the
previoustwelvemonths.
1i
To forestall a downgrade, Upton spoke with the three main rating agencies,
Moodv’s, Standard & Poor’s, and Fitch, in earlv August.
1:
Several times in ioo¬—
z·z ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN iiiui1
includingApriloandIuneii—S&PhadconfrmedBear’sstrongratings,notingin
April that “Bear’s risk profle is relativelv conservative” and “strong senior manage-
mentoversightandastrongculturethroughoutthefrmarethefoundationofBear’s
risk management process.” On Iune ii, Moodv’s had also confrmed its A1 rating,
andFitchhadconfrmedits“stable”outlook.
Now,inearlvAugust,UptonprovidedtheminformationaboutBearandargued
that management had learned its lesson about governance and risk management
fromthefailureofthetwohedgefundsandwasgoingtorelvlessonshort-termun-
secured funding and more on the repo market. Bear and other market participants
didnotforeseethatBear’sownrepolendersmightrefusetolendagainstriskvmort-
gageassetsandeventuallvnotevenagainstTreasuries.
“Irequestedsomeforbearance”fromS&P,UptontoldtheFCIC.
1a
Hedidnotget
it.OnAugust:,justthreedavsafterthetwoBearStearnshedgefundsdeclaredbank-
ruptcv,S&Phighlightedthefunds,Bear’smortgage-relatedinvestments,anditsrela-
tivelvsmallcapitalbaseasitplacedBearona“negativeoutlook.”
1-
Askedhowhefeltabouttheratingagencv’sactions,IimmvCavne,Bear’sCEOun-
tilioo8,said,“Anegativeoutlookcantouchanumberofpartsofvourbusinesses. . . .
It was like having a beautiful child and thev have a disease of some sort that vou
neverexpecttohappenanditdid.HowdidIfeel:Lousv.”
1o
Toreassureinvestorsthatnomoreshoeswoulddrop,Bearinvitedthemonacon-
ferencecallthatsamedav.Thecalldidnotgowell.Bvtheendofthedav,Bear’sstock
slidoº,to·1o8.:-,:oºbelowitsall-timehighof·1oo.o1,reachedearlierinioo¬.
“WE WERE SUITABLY SKEPTICAL”
OnSundav,August-,twodavsaftertheconferencecall,Bearhadanotheropportu-
nitvtomakeitscase:thistime,withtheSEC.ThetwoSECsupervisorswhovisited
the companv that Sundav were Michael Macchiaroli and Matthew Eichner, respec-
tivelv, associate director and assistant director of the division of market regulation.
TheregulatorsreviewedBear’sexposurestothemortgagemarket,includingthe·1:
billioninadjustable-ratemortgagesonthefrm’sbooksthatwerewaitingtobesecu-
ritized. Bear executives gave assurances that inventorv would shrink once investors
returned in September from their retreats in the Hamptons. “Obviouslv, regulators
arenotsupposedtolistentohappvtalkandgoawavsmiling,”EichnertoldtheFCIC.
“ThirteenbillioninARMsisnojoke.”Still,EichnerdidnotbelievetheBearexecu-
tiveswerebeingdisingenuous.Hethoughtthevwerejustemphasizingtheupside.

AlanSchwartz,theco-presidentwholatersucceededIimmvCavneasCEO,and
ThomasMarano,headofGlobalMortgagesandAssetBackedSecurities,seemedun-
concerned.Butotherexecutiveswereleerv.WendvdeMonchaux,theheadofpropri-
etarvtrading,urgedMaranototrimthemortgageportfolio,asdidStevenMever,the
co-head of stock sales and trading.
18
According to Chief Risk Omcer Michael Alix,
formerchairmanAlanGreenbergwouldsav,“thebesthedgeisasale.”
1o
Bearfnallv
reducedtheportfoliofrom·-obillioninthethirdquarterofioo¬to·ao.1billionin
thefourthquarter,butitwastoolittletoolate.
\\itu z++· 1ui i\ii ui 8i\i :1i\iN: z·.
Thatsummer,theSECfeltBear’sliquiditvwasadequatefortheimmediatefuture,
butsupervisors“weresuitablvskeptical,”Eichnerinsisted.AftertheAugust-meet-
ing, the SEC required that Bear Stearns report dailv on Bear’s liquiditv. However,
Eichneradmittedthatheandhisagencvhadgrosslvunderestimatedthepossibilitv
ofaliquiditvcrisisdowntheroad.
io
Everv weeknight Upton updated the SEC on Bear’s ·aoo billion balance sheet,
withspecifcsonrepoandcommercialpaper.OnSeptemberi¬,BearStearnsraised
approximatelv·i.-billioninunsecured1o-vearbonds.Thereportsslowedtooncea
week.
i1
The SEC’s inspector general later criticized the regulators, writing that thev
didnotpushBeartoreduceleverageor“makeanveffortstolimitBearStearns’mort-
gage securities concentration,” despite “aware[ness] that risk management of mort-
gagesatBearStearnshadnumerousshortcomings,includinglackofexpertisebvrisk
managers in mortgage backed securities” and “persistent understamng; a proximitv
ofriskmanagerstotraderssuggestingalackofindependence;turnoverofkevper-
sonnelduringtimesofcrisis;andtheinabilitvorunwillingnesstoupdatemodelsto
refectchangingcircumstances.”
ii
Michael Halloran, a senior adviser to SEC Chairman Christopher Cox, told the
FCIC the SEC had ample information and authoritv to require Bear Stearns to de-
crease leverage and sell mortgage-backed securities, as other fnancial institutions
weredoing.Halloransaidthatasearlvasthefrstquarterofioo¬,hehadaskedErik
Sirri, in charge of the SEC’s Consolidated Supervised Entities program, about Bear
Stearns(andLehmanBrothers),“Whvcan’twemakethemreducerisk:”According
toHalloran,SirrisaidtheSEC’sjobwasnottotellthebankshowtoruntheircompa-
niesbuttoprotecttheircustomers’assets.
i:
“TURN INTO A DEATH SPIRAL”
InAugust,aftertheratingagenciesrevisedtheiroutlookonBear,Cavnetriedtoob-
tain lines of credit from Citigroup and IP Morgan. Both banks acknowledged Bear
hadalwavsbeenavervgoodcustomerandmaintainedthevwereinterestedinhelp-
ing.
ia
“Wewantedtotrvtobebelts-and-suspenders,”saidCFOSamuelMolinaro,as
Bearattemptedbothtoobtainlinesofcreditwithbanksandtoreinforcetraditional
sources of short-term liquiditv such as monev market funds. But, Cavne told the
FCIC, nothing happened. “Whv the [large] banks were not more willing to partici-
pateandprovidelinesduringthatperiodoftime,Ican’ttellvou,”Molinarosaid.
i-
Amajormonevmarketfundmanager,FederatedInvestors,haddecidedonOcto-
ber 1 to drop Bear Stearns from its list of approved counterparties for unsecured
commercial paper,
io
illustrating whv unsecured commercial paper was traditionallv
seenasariskierlifelinethanrepo.Throughoutioo¬,BearStearnsreduceditsunse-
curedcommercialpaper(from·io.¬billionattheendofioootoonlv·:.obillionat
theendofioo¬)andreplaceditwithsecuredrepoborrowing(whichrosefrom·oo
billion to ·1oi billion). But Bear Stearns’s growing dependence on overnight repo
wouldcreateadifferentsetofproblems.
Thetri-partvrepomarketusedtwoclearingbanks,IPMorganandBNYMellon.
z·. ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN iiiui1
Duringevervbusinessdav,theseclearingbanksreturncashtolenders;takeposses-
sionofborrowers’collateral,essentiallvkeepingitinescrow;andthenlendtheirown
cashtoborrowersduringthedav.Thisisreferredtoas“unwinding”therepotransac-
tion; it allows borrowers to change the assets posted as collateral everv dav. The
transactionisthen“rewound”attheendofthedav,whenthelenderspostcashtothe
clearingbanksinreturnforthenewcollateral.
Thelittle-regulatedtri-partvrepomarkethadgrownfrom·8oobillioninaverage
dailvvolumeiniooito·1.¬trillioninioo-,·i.atrillioninioo¬,and·i.8trillionbv
earlv ioo8.

It had become a verv deep and liquid market. Even though most bor-
rowers rolled repo overnight, it was also considered a verv safe market, because
transactionswereovercollateralized(loansweremadeforlessthanthecollateralwas
worth).Thatwasthegeneralviewbeforetheonsetofthefnancialcrisis.
AsBearincreaseditstri-partvrepoborrowing,itbecamemoredependentonIP
Morgan, the clearing bank. A risk that was little appreciated before ioo¬ was that
IPMorganandBNYMelloncouldfacelargelossesifacounterpartvsuchasBearde-
faultedduringthedav.Essentiallv,IPMorganservedasBear’sdavtimerepolender.
Evenlong-termrepoloanshavetobeunwoundevervdavbvtheclearingbank,if
notbvthelender.SethCarpenter,anomcerattheFederalReserveBoard,compared
ittoamortgagethathastoberefnancedevervweek:“Imaginethatvourmortgageis
onlvaweek.Insteadofa:o-vearmortgage,vou’vegotaone-weekmortgage.Ifeverv-
thing’sgoingfne,vougettotheendoftheweek,vougooutandvourefnancethat
mortgage because vou don’t have enough cash on hand to pav off the whole mort-
gage.Andthenvougettotheendofanotherweekandvourefnancethatmortgage.
Andthat’s,forallintentsandpurposes,whatreposarelikeformanvinstitutions.”
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.
io
Fidelitv Investments, another major lender, limited its overall exposure to
Bear,andshortenedthematurities.
:o
InOctober,StateStreetGlobalAdvisorsrefused
anvrepolendingtoBearotherthanovernight.
:1
Often, backing Bear’s borrowing were mortgage-related securities and of these,
·1¬.ibillion—morethanBear’sequitv—wereLevel:assets.
In the fourth quarter of ioo¬, Bear Stearns reported its frst quarterlv loss, ·:¬o
million.Still,theSECsaw“noevidenceofanvdeteriorationinthefrm’sliquiditvpo-
sitionfollowingthereleaseandrelatednegativepresscoverage.”TheSECconcluded,
“BearStearns’liquiditvpoolremainsstable.”
:i
Inthefallofioo¬,Bear’sboardhadcommissionedtheconsultantOliverWvman
toreviewthefrm’sriskmanagement.Thereport,“RiskGovernanceDiagnostic:Rec-
ommendationsandCaseforEconomicCapitalDevelopment,”waspresentedonFeb-
ruarv -, ioo8, to the management committee. Among its conclusions: risk
assessment was “infrequent and ad hoc” and “hampered bv insumcient and poorlv
alignedresources,”“riskmanagers[were]noteffectivelvpositionedtochallengefront
omcedecisions,”andriskmanagementwas“understaffed”andconsidereda“lowpri-
oritv.”SchwartztoldtheFCICthefndingsdidnotindicatesubstantialdefciencies.
Hewasn’tlookingforpositivefeedbackfromtheconsultants,becausetheWvmanre-
\\itu z++· 1ui i\ii ui 8i\i :1i\iN: z·,
portwasmeanttoprovidearoadmapofwhat“thegoldstandard”inriskmanage-
mentwouldbe.
::
InIanuarvioo8,beforethereportwascompleted,CavneresignedasCEO,after
receiving·o:.omillionincompensationfromiooathroughioo¬.

Heremainedas
non-executivechairmanoftheboard.Someseniorexecutivessharplvcriticizedhim
and the board. Thomas Marano told the FCIC that Cavne plaved 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
neverdawnedonmethatatsomepointsomebodvwouldhaveorshouldhavegotten
theboardinvolvedinallofthis,”althoughhetoldtheFCICthathemadethesecom-
ments in anger and frustration in the wake of Bear’s failure.
:o
In its fnal report on
Bear, the Corporate Librarv, which researches and rates frms for corporate gover-
nance,gavethecompanva“D,”refecting“ahighdegreeofgovernancerisk”resulting
from“highlevelsofconcernrelatedtotheboardandcompensation.”

Whenaskedif
hehadmademistakeswhileatBearStearns,CavnetoldtheFCIC,“Itakeresponsi-
bilitvforwhathappened.I’mnotgoingtowalkawavfromtheresponsibilitv.”
:8
AtBear,compensationwasbasedlargelvonthereturnonequitvinagivenvear.
Forseniorexecutives,abouthalfofeachbonuswaspaidincash,andabouthalfinre-
strictedstockthatvestedoverthreevearsandhadtobeheldforfve.
:o
Theformulafor
the size of each vear’s compensation pool was determined bv a subcommittee of the
board.Stockholdersapprovedtheperformancecompensationplanandcapitalaccu-
mulation plan for senior managing directors. Cavne told the FCIC he set his own
compensationandthecompensationforallfvemembersoftheExecutiveCommit-
tee.AccordingtoCavne,noone,includingtheboard,questionedhisdecisions.
ao
Forioo¬,evenwithitslosses,BearStearnspaidout-8ºofrevenuesincompensa-
tion.Alix,whosatontheCompensationCommittee,toldFCICstaffthefrmtvpicallv
paid-oºbutthatthepercentageincreasedinioo¬becauserevenuesfell—ifmanage-
ment had lowered compensation proportionatelv, he said, manv emplovees might
have quit.
a1
Base salaries for senior managers were capped at ·i-o,ooo, with the re-
mainderofcompensationadiscretionarvmixofcash,restrictedstock,andoptions.
ai
Fromiooothroughioo8,thetopfveexecutivesatBearStearnstookhomeover
·:io.-millionincashandover·1.1billionfromstocksales,formorethanatotalof
·1.abillion.ThisexceededtheannualbudgetfortheSEC.
a:
AlanSchwartz,whotook
overasCEOafterCavneandhadbeenaleadingproponentofinvestinginthemort-
gage sector, earned more than ·8¬ million from iooa to ioo¬. Warren Spector, the
co-presidentresponsibleforoverseeingthetwohedgefundsthathadfailed,received
more than ·o8 million during the same period. Although Spector was asked to re-
sign,Bearneveraskedhimtoreturnanvmonev.Iniooo,Cavne,Schwartz,andSpec-
toreachearnedmorethan1otimesasmuchasAlix,thechiefriskomcer.
aa
Cavnewasout,Schwartzwasin,andBearStearnscontinuedhangingoninearlv
ioo8. Bear was still able to fund its balance sheet through repo loans, though the
interest rates the frm had to pav had increased.
a-
Marano said he worried this in-
creasedcostwouldsignaltothemarketthatBearwasdistressed,whichcould“make
ourproblemsturnintoadeathspiral.
”ao
z·( ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN iiiui1
“DUTY TO PROTECT THEIR INVESTORS”
OnWednesdav,Ianuarv:o,ioo8,TreasurerUptonreportedaninternalaccounting
errorthatshowedBearStearnstohavelessthan·-billioninliquiditv—triggeringa
reporttotheSEC.Whilethecompanvidentifedtheerror,theSECreinstituteddailv
reportingbvthecompanvofitsliquiditv.

Lenders and customers were more and more reluctant to do business with the
companv. On Februarv 1-, Bear Stearns had ·:o.¬ billion in mortgages, mortgage-
backedsecurities,andasset-backedsecuritiesonitsbalancesheet,downalmost·1o
billionfromNovember.Nearlv·iobillionweresubprimeorAlt-Amortgage–backed
securitiesandCDOs.
ThehedgefundsthatwereclientsofBear’sprimebrokerageserviceswereparticu-
larlv 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
occasionallvinquiredaboutthebank’sfnancialconditioninthelatterhalfofioo¬,
butthatsuchinquiriespickedupatthebeginningofioo8,particularlvasthecostin-
creasedofpurchasingcreditdefaultswapprotectiononBear.Theinquiriesbecame
withdrawals—hedge funds started taking their business elsewhere. “Thev felt there
weretoomanvconcernsaboutusandfeltthatthiswasashort-termmove,”Lebedin
said. “Often thev would tell us thev’d be happv to bring the business back, but that
thevhadthedutvtoprotecttheirinvestors.”RenaissanceTechnologies,oneofBear’s
biggest prime brokerage clients, pulled out all of its business. Bv April, Lebedin’s
prime brokerage operation would be holding ·oo billion in assets under manage-
ment,downmorethanaoºfrom·1oobillioninIanuarv.
a8
Nonetheless,duringtheweekofMarch:,whenSECstaffinspectedBear’sliquid-
itv pool, thev identifed “no signifcant issues.” The SEC found Bear’s liquiditv pool
rangedfrom·18billionto·iobillion.
ao
Bear opened for business on Mondav, March 1o, with approximatelv ·18 billion
incashreserves.Thesamedav,Moodv’sdowngraded1-mortgage-backedsecurities
issued bv Bear Stearns Alt-A Trust, a special purpose entitv. News reports on the
downgrades carried abbreviated headlines stating, “Moodv’s Downgrades Bear
Stearns,” Upton said.
-o
Rumors few and counterparties panicked.
-1
Bear’s liquiditv
poolbegantodrvup,andtheSECwasnowconcernedthatBearwasbeingsqueezed
from all directions.
-i
While “evervthing rolled” during the dav—that is, Bear’s repo
lendersrenewedtheircommitments—SEComcialsworriedthatthiswould“proba-
blvnotcontinue.”
-:
On Tuesdav, the Fed announced it would lend to investment banks and other
“primarv dealers.” The Term Securities Lending Facilitv (TSLF) would make avail-
ableupto·ioobillioninTreasurvsecurities,acceptingascollateralGSEmortgage–
backedsecuritiesandnon-GSEmortgage–backedsecuritiesratedtriple-A.Thehope
was that lenders would lend to investment banks if the collateral was Treasuries
ratherthanotherhighlvratedbutnowsuspectassetssuchasmortgage-backedsecu-
rities.TheFedalsoannounceditwouldextendloansfromovernighttoi8davs,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
evervmorning.
WiththeTSLF,theFedwouldbesettinganewprecedentbvextendingemergencv
credit to institutions other than commercial banks. To do so, the Federal Reserve
Boardwasrequiredundersection1:(:)oftheFederalReserveActtodeterminethat
therewere“unusualandexigentcircumstances.”TheFedhadnotinvokeditssection
1:(:)authoritvsincetheGreatDepression;itwastheFed’sfrstuseoftheauthoritv
sinceCongresshadexpandedthelanguageoftheactin1oo1toallowtheFedtolend
toinvestmentbanks.
-a
TheFedwastakingtheunusualstepofdeclaringitswilling-
nesstosoonopenitscheckbooktoinstitutionsitdidnotregulateandwhosefnan-
cialconditionithadneverexamined.
But the Fed would not launch the TSLF until March i¬, more than two weeks
later—anditwasnotclearthatBearcouldlastthatlong.Thefollowingdav,IimEm-
bersit of the Federal Reserve Board checked on Bear’s liquiditv with the SEC. The
SECsaidBearhad·1i.-billionincash—downfromabout·18billionatthestartof
theweek—andwasabletofnanceallitsbankloansandmostofitsequitvsecurities
throughtherepomarket.Hesummarized,“TheSECindicatesthatnonotablelosses
havebeensustainedandthatthecapitalpositionofthefrmis‘fne.’”
--
Derivatives counterparties were increasinglv reluctant to be exposed to Bear. In
somecasesthevunwoundtradesinwhichthevfacedBear,andinothersthevmade
marginorcollateralcalls.
-o
InBear’slastfewvearsasanindependentcompanv,ithad
substantiallvincreaseditsexposuretoderivatives.Attheendoffscalvearioo¬,Bear
had·1:.atrillioninnotionalexposureonderivativescontracts,comparedwith·8.¬
trillionatiooofscalvear-endand·-.-trillionattheendofioo-.
Derivatives counterparties who worried about Bear’s abilitv to make good on
theirpavmentscouldgetoutoftheirderivativepositionswithBearthroughassign-
ments or novations. Assignments allow counterparties to assign their positions to
someoneelse:iffrmX hasaderivativescontractwithfrmY, thenfrmX canassign
itspositiontofrmZ, sothatZ nowistheonethathasaderivativescontractwithY.
Novationsalsoallowcounterpartiestogetoutoftheirexposuretoeachother,butbv
bringinginathirdpartv:insteadofX facingY,X faces Z and Z faces Y.Bothassign-
mentsandnovationsareroutinetransactionsonWallStreet.ButonTuesdav,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
wanttohaveBearStearnsasaderivativescounterpartvanvmore.
Bear Stearns also encountered dimculties stepping into trades. Havman Capital
Partners, a hedge fund in Texas wanting to decrease its exposure to subprime mort-
gages,haddecidedtocloseoutarelativelvsmall·-millionsubprimederivativeposi-
tion with Goldman Sachs. Bear Stearns offered the best bid, so Havman expected to
assign its position to Bear, which would then become Goldman’s counterpartv in the
derivative.HavmannotifedGoldmanbvaroutineemailonTuesdav,March11,ata:oo
P.M.Thereplva1minuteslaterwasunexpected:“GSdoesnotconsenttothistrade.”
-8
z·· ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN iiiui1
ThatstartledKvleBass,Havman’smanagingpartner.HetoldtheFCIChecouldnot
recall anv counterpartv rejecting a routine novation.
-o
Pressed for an explanation,
Goldmanthenextmorningofferednodetails:“Ourtradingdeskwouldprefertostav
facingHavman.WedonotwanttofaceBear.”
oo
Addingtothemvsterv,1ominuteslater
GoldmanagreedtoacceptBearSternsasthecounterpartvafterall.
o1
Butthedamage
wasdone.ThenewshitthestreetthatGoldmanhadrefusedaroutinetransactionwith
oneoftheotherbigfveinvestmentbanks.Themessage:don’trelvonBearStearns.
CEO Alan Schwartz hoped an appearance on CNBC would reassure markets.
Ouestionedaboutthisincident,Schwartzsaidhehadnoknowledgeofsucharefusal
andrhetoricallvasked,“Whvdorumorsstart:”
oi
SECChairmanCoxtoldreporters
his agencv 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.”
o:
Still, the run on Bear accelerated. Manv investors believed the Fed’s announce-
ment about its new loan program was directed at Bear Stearns, and thev worried
about the facilitv’s not being available for several weeks. On Wednesdav, March 1i,
theSECnotedthatBearpaidanother·1.1billionformargincallsfrom1ainervous
derivativescounterparties.
oa
Repo lenders who had alreadv tightened the terms for their contracts over the
precedingfourorfvemonthsshortenedtheleashagain,demandingmorecollateral
fromBearStearns.
o-
Worriesaboutadefaultquicklvmounted.
oo
Bv that evening, Bear’s abilitv to borrow in the repo market was drving up. The
SECnotedthatsomelargeandimportantmonevfunds,includingFidelitvandMel-
lon,hadtoldBearafterthecloseofbusinessWednesdavthev“mightbehesitantto
rollsomefundingtomorrow.”TheSECsaidthatthoughthevbelievedtheamounts
were“vervmanageable(between·1and·ibillion),”thewithdrawalswouldnotsend
ahelpfulsignaltothemarket.

Buttheissuewasalmostmoot.SchwartzcalledNew
YorkFedPresidentTimothvGeithnerthatnighttodiscusspossibleFedfexibilitvin
theeventthatsomerepolendersdidpullawav.
o8
Upton,thetreasurer,saidthatbeforethatweek,hehadneverworriedaboutthe
disappearanceofrepolending.BvThursdav,hebelievedtheendwasnear.
oo
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·1abillioninrepowasnotgoingtorollover,andthat“therewasareason-
ablechancethattherewouldnotbeenoughcashtomeet[Bear’s]needs.”
¬o
Somerepo
lenderswerealreadvsoaversetoBearthatthevstoppedlendingtothecompanvat
all,notevenagainstTreasurvcollateral,UptontoldtheFCIC.
¬1
Derivativescounter-
partiescontinuedtorunfromBear.Bvthatnight,liquiditvhaddwindledtoamere
·ibillion(seefgure1-.1).
Bearhadrunoutofcashinoneweek.Executivesandregulatorscontinuedtobe-
lievethefrmwassolvent,however.FormerSECChairmanCoxtestifedbeforethe
FCIC,“AtalltimesduringtheweekofMarch1oto1¬,uptoandincludingthetime
ofitsagreementtobeacquiredbvIPMorgan,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 Thursdav evening, March 1:, Bear Stearns informed the SEC that it would be
“unabletooperatenormallvonFridav.”
¬:
CEOAlanSchwartzcalledIPMorganCEO
IamieDimontorequesta·:obillioncreditline.Dimonturnedhimdown,
¬a
citing,
according to Schwartz, IP Morgan’s own signifcant exposure to the mortgage mar-
ket. Because Bear also had a large, illiquid portfolio of mortgage assets, IP Morgan
wouldnotrenderassistancewithoutgovernmentsupport.SchwartzspokewithGei-
thneragain.SchwartzinsistedBear’sproblemwasliquiditv,notinsumcientcapital.A
series of calls between Schwartz, Dimon, Geithner, and Treasurv Secretarv Henrv
Paulsonfollowed.
¬-
ToaddressBear’sliquiditvneeds,theNewYorkFedmadea·1i.o
billionloantoBearStearnsthroughIPMorganonthemorningofFridav,March1a.
Standard&Poor’sloweredBear’sratingthreelevelstoBBB.Moodv’sandFitchalso
downgraded the companv. Bv the end of the dav, Bear was out of cash. Its stock
plummeteda¬º,closingbelow·:o.
The markets evidentlv viewed the loan as a sign of terminal weakness. After
marketsclosedonFridav,PaulsonandGeithnerinformedBearCEOSchwartzthat
theFedloantoIPMorganwouldnotbeavailableaftertheweekend.Withoutthat
loan,Bearcouldnotconductbusiness.Infact,BearStearnshadtofindabuverbe-
foretheAsianmarketsopenedSundavnightorthegamewouldbeover.
¬o
Schwartz,
z++ ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN iiiui1
Molinaro, Alix, and others spent the weekend in due diligence meetings with IP
Morgan and other potential buvers, including the private equitv frm I.C. Flowers
and Co. According to Schwartz, the participants determined IP Morgan was the
onlvcandidatewiththesizeandstaturetomakeacredibleofferwithina8hours.
¬¬
As Bear Stearns’s clearing bank for repo trades, IP Morgan held much of Bear
Stearns’sassetsascollateralandhadbeenassessingtheirvaluedailv.
¬8
Thisknowl-
edgeletIPMorganmovemorequicklv.
OnSundav,March1o,IPMorganinformedtheNewYorkFedandtheTreasurv
that it was interested in a deal if it included fnancial support from the Fed.
¬o
The
Federal Reserve Board, again fnding “unusual and exigent circumstances” as re-
quiredundersection1:(:)oftheFederalReserveAct,agreedtopurchase·io.o¬bil-
lion of Bear’s assets to get them off the frm’s books through a new entitv called
MaidenLaneLLC(namedforastreetalongsidetheNewYorkFed).Thoseassets—
mostlv mortgage-related securities, other assets, and hedges from Bear’s mortgage
tradingdesk—wouldbeunderNewYorkFedmanagement.Tofnancethepurchases,
IPMorganmadea·1.1-billionsubordinatedloanandtheNewYorkFedlent·i8.8i
billion.Becauseofitsloan,IPMorganboretheriskofthefrst·1.1-billionoflosses;
theFedwouldbearanvfurtherlossesupto·i8.8ibillion.
8o
TheFed’sloanwouldbe
repaidasMaidenLanesoldthecollateral.
On Sundav night, with Maiden Lane in place, IP Morgan publiclv announced a
dealtobuvBearStearnsfor·iashare.MinutesofBear’sboardmeetingindicatethat
IP Morgan had considered ·a but cut it to ·i “because the government would not
permitahighernumber. . . .TheFedandtheTreasurvDepartmentwouldnotsup-
portatransactionwhere[BearStearns]equitvholdersreceivedanvsignifcantcon-
sideration because of the ‘moral hazard’ of the federal government using taxpaver
monevto‘bailout’theinvestmentbank’sstockholders.”
81
Eightdavslater,onMarchia,BearStearnsandIPMorganagreedtoincreasethe
price to ·1o. Iohn Chrin, co-head of the fnancial institutions mergers and acquisi-
tionsgroupatIPMorgan,toldtheFCICthevincreasedthepricetomakeBearshare-
holders’ approval more likelv.
8i
Bear CEO Schwartz told the FCIC the increase let
Bearpreservethecompanv’svalue“tothegreatestextentpossibleunderthecircum-
stancesforourshareholders,our1a,oooemplovees,andourcreditors.”
8:
“IT WAS HEADING TO A BLACK HOLE”
TheSECregulatorsMacchiaroliandEichnerwereasstunnedasevervoneelsebvthe
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.
8a
FedChairmanBenBernankelatercalledtheBearStearnsdecisionthetoughestof
the fnancial crisis. The ·i.8 trillion tri-partv repo market had “reallv [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-
nancialfrmstofnancethemselvesandcreatingmoreandmoreliquiditvpressureon
COMMISSION CONCLUSIONS ON CHAPTER 15
The Commission concludes the failure of Bear Stearns and its resulting govern-
ment-assistedrescuewerecausedbvitsexposuretoriskvmortgageassets,itsre-
lianceonshort-termfunding,anditshighleverage.Thesewerearesultofweak
corporategovernanceandriskmanagement.Itsexecutiveandemploveecompen-
sationsvstemwasbasedlargelvonreturnonequitv,creatingincentivestouseex-
cessiveleverageandtofocusonshort-termgainssuchasannualgrowthgoals.
Bearexperiencedrunsbvrepolenders,hedgefundcustomers,andderivatives
counterpartiesandwasrescuedbvagovernment-assistedpurchasebvIPMorgan
because the government considered it too interconnected to fail. Bear’s failure
was in part a result of inadequate supervision bv the Securities and Exchange
Commission,whichdidnotrestrictitsriskvactivitiesandwhichallowedundue
leverageandinsumcientliquiditv.
them.And,itwasheadingsortoftoablackhole.”HesawthecollapseofBearStearns
as threatening to freeze the tri-partv repo market, leaving the short-term lenders
withcollateralthevwouldtrvto“dumponthemarket.Youwouldhaveabigcrunch
inassetprices.”
8-
“BearStearns,whichisnotthatbigafrm,ourviewonwhvitwasimportantto
save it—vou mav disagree—but our view was that because it was so essentiallv 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’sacquisitionbvIP
Morgan as follows: “The sudden discoverv bv Bear’s derivative counterparties that
importantfnancialpositionsthevhadputinplacetoprotectthemselvesfromfnan-
cial risk were no longer operative would have triggered substantial further disloca-
tion in markets. This would have precipitated a rush bv Bear’s counterparties to
liquidate the collateral thev held against those positions and to attempt to replicate
thosepositionsinalreadvvervfragilemarkets.”

PaulsontoldtheFCICthatBearhadbothaliquiditvproblemandacapitalprob-
lem. “Could vou just imagine the mess we would have had: If Bear had gone there
werehundreds,mavbethousandsofcounterpartiesthatallwouldhavegrabbedtheir
collateral,wouldhavestartedtrvingtoselltheircollateral,drovedownprices,create
evenbiggerlosses.Therewashugefearabouttheinvestmentbankingmodelatthat
time.” Paulson believed that if Bear had fled for bankruptcv, “vou would have had
Lehmangoing . . .almostimmediatelvifBearhadgone,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|iquiditvpcsiticn” :;e
Dcrivativcs“Lar|vstagcscjasscssingthcpctcntia|svstcnicrisk” :;:
Banks“1hcnarkctswcrcrca||v.rca||vdiccv” :o)
IP Morgan’s federallv assisted acquisition of Bear Stearns averted catastrophe—for
thetimebeing.TheFederalReservehadfoundnewwavstolendcashtothefnancial
svstem,andsomeinvestorsandlendersbelievedtheBearepisodehadsetaprecedent
forextraordinarvgovernmentintervention.Investorsbegantoworrvlessaboutare-
cessionandmoreaboutinfation,asthepriceofoilcontinuedtorise(hittingalmost
·1aaperbarrelinIulv).Atthebeginningofioo8,thestockmarkethadfallenalmost
1-ºfromitspeakinthefallofioo¬.Then,inMavioo8,theDowIonesclimbedto
1:,o-8, within 8º of the record 1a,1oa set in October ioo¬. The cost of protecting
against the risk of default bv fnancial institutions—refected in the prices of credit
defaultswaps—declinedfromthehighsofMarchandApril.“Inhindsight,themar-
kets were surprisinglv stable and almost seemed to be neutral a month after Bear
Stearns, leading all the wav up to September,” said David Wong, Morgan Stanlev’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·aobillion,respectivelv,innewequitvbvtheend
ofIune.
Despitethisgoodnews,bankersandtheirregulatorswerehauntedbvthespeedof
BearStearns’sdemise.AndthevknewthattheotherinvestmentbankssharedBear’s
weaknesses: leverage, reliance on overnight funding, dependence on securitization
markets,andconcentrationsinilliquidmortgagesecuritiesandothertroubledassets.
Inparticular,therunonBearhadexposedthedangersoftri-partvrepoagreements
andthecounterpartvriskcausedbvderivativescontracts.
Andthewordonthestreet—despitetheassurancesofLehmanCEODickFuldat
\\itu 1u \UtU:1 z++· :¥:1i\i t ii :i tuNtiiN: z+.
anAprilshareholdermeetingthat“theworstisbehindus”
i
—wasthatBearwouldnot
betheonlvfailure.
THE FEDERAL RESERVE: “WHEN PEOPLE GOT SCARED”
Themostpressingdangerwasthepotentialfailureoftherepomarket—amarketthat
“grew verv, verv quicklv with no single regulator having a purview of it,” former
TreasurvSecretarvHenrvPaulsonwouldtelltheFCIC.
:
Marketparticipantsbelieved
thatthetri-partvrepomarketwasarelativelvsafeanddurablesourceofcollateral-
ized short-term fnancing. It was on preciselv this understanding that Bear had
shifted approximatelv ·: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 Countrvwide,
hadseizedtheattentionofthefnancialcommunitv,andtherunonBearStearnswas
similarlv eve-opening. Market participants and regulators now better appreciated
howthequalitvofrepocollateralhadshiftedovertimefromTreasurvnotesandse-
curitiesissuedbvFannieMaeandFreddieMactohighlvratednon-GSEmortgage–
backedsecuritiesandcollateralizeddebtobligations(CDOs).
a
Atitspeakbeforethe
crisis, this riskier collateral accounted for as much as :oº of the total posted.
-
In
Aprilioo-,theBankruptcvAbusePreventionandConsumerProtectionActofioo-
had dramaticallv expanded protections for repo lenders holding collateral, such as
mortgage-relatedsecurities,thatwasriskierthangovernmentorhighlvratedcorpo-
ratedebt.Theseprotectionsgavelendersconfdencethatthevhadclear,immediate
rights to collateral if a borrower should declare bankruptcv. Nonetheless, Iamie Di-
mon,theCEOofIPMorgan,toldtheFCIC,“Whenpeoplegotscared,thevwouldn’t
fnancethenonstandardstuffatall.”
o
Tothesurpriseofbothborrowersandregulators,high-qualitvcollateralwasnot
enoughtoensureaccesstotherepomarket.Repolenderscaredjustasmuchabout
thefnancialhealthoftheborrowerasaboutthequalitvofthecollateral.Infact,even
forthesamecollateral,repolendersdemandeddifferenthaircutsfromdifferentbor-
rowers.
¬
Despitethebankruptcvprovisionsintheioo-act,lenderswerereluctantto
riskthehassleofseizingcollateral,evengoodcollateral,fromabankruptborrower.
StevenMeierofStateStreettestifedtotheFCIC:“Iwouldsavthecounterpartiesare
afrstlineofdefense,andwedon’twanttogothroughthatuncomfortableprocessof
havingtoliquidatecollateral.”
8
WilliamDudlevoftheNewYorkFedtoldtheFCIC,
“Atthefrstsignoftrouble,theseinvestorsintri-partvrepotendtorunratherthan
takethecollateralthatthev’velentagainst. . . .Sohigh-qualitvcollateralitselfisnot
sumcientwhenandifaninstitutiongetsintrouble.”
o
Moreover, if a borrower in the repo market defaults, monev market funds—fre-
quent lenders in this market—mav have to seize collateral that thev cannot legallv
own. For example, a monev market fund cannot hold long-term securities, such as
z+. ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN iiiui1
agencvmortgage–backedsecurities.Tvpicallv,ifafundtakespossessionofsuchcol-
lateral,itliquidatesthesecuritiesimmediatelv,even—aswasthecaseduringthecri-
sis—into a declining market. As a result, funds simplv avoided lending against
mortgage-relatedsecurities.Inthecrisis,investorsdidn’tconsidersecuredfundingto
bemuchbetterthanunsecured,accordingtoDarrvllHendricks,amanagingdirector
andglobalheadofriskmethodologvatUBS,aswellastheheadofaprivate-sector
taskforceontherepomarketorganizedbvtheNewYorkFed.
1o
As noted, the Fed had announced a new program, the Term Securities Lending
Facilitv(TSLF),ontheTuesdavbeforeBear’scollapse,butitwouldnotbeavailable
untilMarchi¬.TheTSLFwouldlendatotalofupto·ioobillionofTreasurvsecuri-
tiesatanvonetimetotheinvestmentbanksandotherprimarvdealers—thesecuri-
tiesamliatesofthelargecommercialbanksandinvestmentbanksthattradewiththe
New York Fed, such as Citigroup, Morgan Stanlev, or Merrill Lvnch—for up to i8
davs. The borrowers would trade highlv rated securities, including debt in govern-
ment-sponsoredenterprises,inreturnforTreasuries.Theprimarvdealerscouldthen
usethoseTreasuriesascollateraltoborrowcashintherepomarket.LiketheTerm
Auction Facilitv 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
couldbeupandrunningrightawav.AndthevconcludedthattheTSLFalonewould
notbeenough.
So,theFedwouldcreateanotherprogramfrst.OntheSundavofBear’scollapse,
the Fed announced the new Primarv Dealer Credit Facilitv—again invoking its au-
thoritv under 1:(:) of the Federal Reserve Act—to provide cash, not Treasuries, to
investmentbanksandotherprimarvdealersontermsclosetothosethatdepositorv
institutions—banks and thrifts—received through the Fed’s discount window. The
movecame“justabouta-minutes”toolateforBear,IimmvCavne,itsformerCEO,
toldtheFCIC.
11
Unlike the TSLF, which would offer Treasuries for i8 davs, the PDCF offered
overnightcash loansinexchangeforcollateral.Ineffect,thisprogramcouldserveas
analternativetotheovernighttri-partvrepolenders,potentiallvprovidinghundreds
ofbillionsofdollarsofcredit.“SotheideaofthePDCFthenwas . . .anvthingthatthe
dealercouldn’tfnance—thesecuritiesthatwereacceptableunderthediscountwin-
dow—ifthevcouldn’tgetfnancinginthemarket,thevcouldgetfnancingfromthe
Federal Reserve,” said Seth Carpenter, deputv associate director in the Division of
Monetarv Affairs at the Federal Reserve Board. “And that wav, vou don’t have to
worrv. And bv providing that support, other lenders know that thev’re going to be
abletogettheirmonevbackthenextdav.”
1i
BvchargingtheFederalReserve’sdiscountrateandaddingadditionalfeesforreg-
ularuse,theFederalReserveencourageddealerstousethePDCFonlvasalastre-
sort. In its frst week of operation, this program immediatelv provided over ·:ao
billionincashtoBearStearns(asbridgefnancinguntiltheIPMorgandealomciallv
closed), Lehman Brothers, and the securities amliate of Citigroup, among others.
However,astheimmediatepost-Bearconcernssubsided,useofthefacilitvdeclined
\\itu 1u \UtU:1 z++· :¥:1i\i t ii :i tuNtiiN: z+,
afterAprilandceasedcompletelvbvlateIulv.
1:
Becausethedealersfearedthatmar-
kets would see reliance on the PDCF as an indication of severe distress, the facilitv
carried a stigma similar to the Fed’s discount window. “Paradoxicallv, while the
PDCFwascreatedtomitigatetheliquiditvfightcausedbvthelossofconfdencein
aninvestmentbank,useofthePDCFwasseenbothwithinLehman,andpossiblvbv
the broader market, as an event that could trigger a loss of confdence,” noted the
Lehmanbankruptcvexaminer.
1a
On Mav i, the Fed broadened the kinds of collateral allowed in the TSLF to in-
cludeothertriple-A-ratedasset-backedsecurities,suchasautoandcreditcardloans.
InIune,theFed’sDudlevurgedinaninternalemailthatbothprogramsbeextended
atleastthroughtheendofthevear.“PDCFremainscriticaltothestabilitvofsomeof
the[investmentbanks],”hewrote.“Amountsdon’tmatterhere,itisthefactthatthe
PDCFunderpinsthetri-partvreposvstem.”
1-
OnIulv:o,theFedextendedbothpro-
gramsthroughIanuarv:o,iooo.
JP MORGAN: “REFUSING TO UNWIND  .  .  .
WOULD BE UNFORGIVABLE”
ThereporunonBearalsoalertedthetworepoclearingbanks—IPMorgan,themain
clearing bank for Lehman and Merrill Lvnch, as it had been for Bear Stearns, and
BNYMellon,themainclearingbankforGoldmanSachsandMorganStanlev—tothe
risksthevweretaking.
Before Bear’s collapse, the market had not reallv understood the colossal expo-
sures that the tri-partv repo market created for these clearing banks. As explained
earlier, the “unwind/rewind” mechanism could leave IP Morgan and BNY Mellon
withanenormous“intradav”exposure—aninterimexposure,butnolessrealforits
brevitv. In an interview with the FCIC, Dimon said that he had not become fullv
awareoftherisksstemmingfromhisbank’stri-partvrepoclearingbusinessuntilthe
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.“Ifthevdefaultedintradav,weownthesecuritiesandwehaveto
liquidatethem.That’sahugerisktous,”Dimonexplained.

Toaddressthoserisksinioo8,forthefrsttimebothIPMorganandBNYMellon
startedtodemandthatintradavloanstotri-partvrepoborrowers—mostlvthelarge
investmentbanks—beovercollateralized.
TheFedincreasinglvfocusedonthesvstemicriskposedbvthetworepoclearing
banks.Inthechain-reactionscenariothatitenvisioned,ifeitherIPMorganorBNY
Mellonchosenottounwinditstradesonemorning,themonevfundsandotherrepo
lenderscouldbestuckwithbillionsofdollarsinrepocollateral.Thoselenderswould
thenbeinthedimcultpositionofhavingtosellofflargeamountsofcollateralinor-
dertomeettheirowncashneeds,anactionthatinturnmightleadtowidespreadfre
salesofrepocollateralandrunsbvlenders.
18
The PDCF provided overnight funding, in case monev market funds and other
z+( ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN iiiui1
repolendersrefusedtolendasthevhadinthecaseofBearStearns,butitdidnotpro-
tectagainstclearingbanks’refusingexposuretoaninvestmentbankduringthedav.
OnIulv11,Fedomcialscirculatedaplan,ultimatelvneverimplemented,thatad-
dressedthepossibilitvthatoneofthetwoclearingbankswouldbecomeunwillingor
unabletounwinditstrades.
1o
TheplanwouldallowtheFedtoprovidetroubledin-
vestmentbanks,suchasLehmanBrothers,with·ioobillionintri-partvrepofnanc-
ing during the dav—essentiallv covering for IP 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 awav from providing
creditcouldbedisastrousforthefrmandalsocastwidespreaddoubtaboutthein-
strumentasanearlvriskfree,liquidovernightinvestment.”
i1
ButtheNewYorkFed’snewplanshouldn’tbenecessarvaslongasthePDCFwas
theretobackuptheovernightlenders,arguedPatrickParkinson,thendeputvdirec-
toroftheFederalReserveBoard’sDivisionofResearchandStatistics.“Weshouldtell
[IP Morgan] that with the PDCF in place refusing to unwind is unnecessarv and
wouldbeunforgiveable,”heemailedDudlevandothers.
ii
Aweeklater,onIulvio,ParkinsonwrotetoFedGovernorKevinWarshandFed
General Counsel Scott Alvarez that IP Morgan, because of its clearing role, was
“likelvtobethefrsttorealizethatthemonevfundsandotherinvestorsthatprovide
tri-partv fnancing to [Lehman Brothers] are pulling back signifcantlv.” Parkinson
described the chain-reaction scenario, in which a clearing bank’s refusal to unwind
wouldleadtoawidespreadfresaleandmarketpanic.“Fearoftheseconsequencesis,
ofcourse,whvwefacilitatedBear’sacquisitionbvIPMC,”hesaid.
i:
Still,itwaspossiblethatthePDCFcouldproveinsumcienttodissuadeIPMorgan
fromrefusingtounwindLehman’srepos,Parkinsonsaid.Becausealargeportionof
Lehman’s collateral was ineligible to be funded bv the PDCF, and because Lehman
couldfailduringthedav(beforethereposweresettled),IPMorganstillfacedsignif-
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,thecompanvwouldfail.
ia
THE FED AND THE SEC: “WEAK LIQUIDITY POSITION”
Amongthefourremaininginvestmentbanks,onekevmeasureofliquiditvriskwas
theportionoftotalliabilitiesthatthefrmsfundedthroughtherepomarket:1-ºto
ioºforLehmanandMerrillLvnch,1oºto1-ºforMorganStanlev,andabout1oº
forGoldmanSachs.
i-
Anothermetricwastherelianceonovernightrepo(whichma-
tureinonedav)oropenrepo(whichcanbeterminatedatanvtime).Despiteefforts
amongtheinvestmentbankstoreducetheportionoftheirrepofnancingthatwas
overnightoropen,theratioofovernightandopenrepofundingtototalrepofund-
ing still exceeded aoº for all but Goldman Sachs. Comparing the period between
March and Mav to the period between Iulv and August, Lehman’s percentage fell
\\itu 1u \UtU:1 z++· :¥:1i\i t ii :i tuNtiiN: z+,
from a-º to aoº, Merrill Lvnch’s fell from aoº to a:º, Morgan Stanlev’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 analvsts later noted,
“Withlendersworrvingthatthevcouldlosemonevonthesecuritiesthevheldascol-
lateral, haircuts increased—doubling for some agencv mortgage securities and in-
creasing signifcantlv even for borrowers with high credit ratings and on relativelv
safecollateralsuchasTreasurvsecurities.”

OnthedavofBear’sdemise,inanefforttogetabetterunderstandingofthein-
vestment banks, the New York Fed and the SEC sent teams to work on-site at
LehmanBrothers,MerrillLvnch,GoldmanSachs,andMorganStanlev.Accordingto
ErikSirri,directoroftheSEC’sDivisionofTradingandMarkets,theinitialroundsof
meetingscoveredthequalitvofassets,funding,andcapital.
i8
Fed Chairman Ben Bernanke would testifv before a House committee that the
Fed’s primarv role at the investment banks in ioo8 was not as a regulator but as a
lender through the new emergencv lending facilities.
io
Two questions guided the
Fed’sanalvses:First,waseachinvestmentbankliquid—didithaveaccesstothecash
needed to meet its commitments: Second, was it solvent—was its net equitv (the
valueofassetsminusthevalueofliabilities)sumcienttocoverprobablelosses:
:o
TheU.S.Treasurvalsodispatchedso-calledSWATteamstotheinvestmentbanks
inthespringofioo8.ThearrivalofomcialsfromtheTreasurvandtheFedcreateda
full-timeon-sitepresence—somethingtheSEChadneverhad.Historicallv,theSEC’s
primarv concern with the investment banks had been liquiditv risk, because these
frmswereentirelvdependentonthecreditmarketsforfunding.
:1
TheSECalreadv
requiredthesefrmstoimplementso-calledliquiditvmodels,designedtoensurethat
thev had sumcient cash available to sustain themselves on a stand-alone basis for a
minimum of one vear 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’sliquiditvstressscenarios—alsoknownasstresstests—hadnottakenaccountof
the possibilitv that a frm would lose access to secured funding. According to the
SEC’sSirri,theSECneverthoughtthatasituationwouldarisewhereaninvestment
bankcouldn’tenterintoarepotransactionbackedbvhigh-qualitvcollateralinclud-
ingTreasuries.HetoldtheFCICthatasthefnancialcrisisworsened,theSECbegan
toseeliquiditvandfundingrisksasthemostcriticalfortheinvestmentbanks,and
theSECencouragedareductioninrelianceonunsecuredcommercialpaperandan
extensionofthematuritiesofrepoloans.
:i
TheFedandtheSECcollaboratedindevelopingtwonewstressteststodetermine
theinvestmentbanks’abilitvtowithstandapotentialrunorasvstemwidedisruption
in the repo market. The stress scenarios, called “Bear Stearns” and “Bear Stearns
Light,” were developed jointlv with the remaining investment banks. In Mav,
Lehman,forexample,wouldbe·8abillionshortofcashinthemorestringentBear
Stearnsscenarioand·1-billionshortunderBearStearnsLight.
::
TheFedconductedanotherliquiditvstressanalvsisinIune.Whileeachfrmran
z+· ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN iiiui1
different scenarios that matched its risk profle, the supervisors tried to maintain
comparabilitvbetweenthetests.Thetestsassumedthateachfrmwouldlose1ooºof
unsecuredfundingandafractionofrepofundingthatwouldvarvwiththequalitvof
its collateral. The stress tests, under just one estimated scenario, concluded that
Goldman Sachs and Morgan Stanlev were relativelv sound. Merrill Lvnch and
LehmanBrothersfailed:thetwobankscameout·iibillionand·1-billionshortof
cash,respectivelv;eachhadonlv¬8ºoftheliquiditvitwouldneedunderthestress
scenario.
:a
TheFed’sinternalreportonthestresstestscriticizedMerrill’s“signifcantamount
of illiquid fxed income assets” and noted that “Merrill’s liquiditv pool is low, a fact
[thecompanv]doesnotacknowledge.”AsforLehmanBrothers,theFedconcluded
that “Lehman’s weak liquiditv position is driven bv its relativelv 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
AlthoughtheSECandtheFedworkedtogetherontheliquiditvstresstests,with
equalaccesstothedata,eachagencvhassaidthatformonthsduringthecrisis,the
other did not share its analvses and conclusions. For example, following Lehman’s
failure in September, the Fed told the bankruptcv examiner that the SEC had de-
clined to share two horizontal (cross-frm) reviews of the banks’ liquiditv positions
andexposurestocommercialrealestate.TheSEC’sresponsewasthatthedocuments
werein“draft”formandhadnotbeenreviewedorfnalized.Addingtothetension,
theFed’son-sitepersonnelbelievedthattheSECon-sitepersonneldidnothavethe
backgroundorexpertisetoadequatelvevaluatethedata.

Thislackofcommunica-
tionwasremediedonlvbvaformalmemorandumofunderstanding(MOU)togov-
ern information sharing. According to former SEC Chairman Christopher Cox,
“OnereasontheMOUwasneededwasthattheFedwasreluctanttosharesupervi-
sorvinformationwiththeSEC,outofconcernthattheinvestmentbankswouldnot
beforthcomingwithinformationifthevthoughtthevwouldbereferredtotheSEC
for enforcement.”
:8
The MOU was not executed until Iulv 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 svs-
temicrisksoftherepoandderivativesmarketsdemandedattention:“Wehavegiven
considerablethoughttowhatmightbedonetoavoidafresaleoftri-partvrepocol-
lateral.(Thatsaid,theoptionsunderexistingauthoritvarenotvervattractive—lots
ofrisktoFed/taxpaver,lotsofmoralhazard.)Westillareattheearlvstagesofassess-
ingthepotentialsvstemicriskfromclose-outofOTCderivativestransactionsbvan
investmentbank’scounterpartiesandidentifvingpotentialmitigants.”
:o
Therepomarketwashuge,butasdiscussedinearlierchapters,itwasdwarfedbv
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 Iune 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 bv statute in iooo, market partici-
pants were not subject to reporting or disclosure requirements and no government
agencvhadoversightresponsibilitv.WhiletheOmceoftheComptrolleroftheCur-
rencv 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
uncertaintv.
Atthispointinthecrisis,regulatorsalsoworriedabouttheinterlockingrelation-
ships that derivatives created among the small number of large fnancial frms that
actasdealersintheOTCderivativesbusiness.Aderivativescontractcreatesacredit
relationshipbetweenparties,suchthatonepartvmavhavetomakelargeandunex-
pectedpavmentstotheotherbasedonsuddenpriceorratechangesorloandefaults.
Ifapartvisunabletomakethosepavmentswhenthevbecomedue,thatfailuremav
.++ ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN iiiui1
causesignifcantfnancialharmtoitscounterpartv,whichmavhaveoffsettingobli-
gationstothirdpartiesanddependonpromptpavment.Indeed,mostOTCderiva-
tives dealers hedge their contracts with offsetting contracts; thus, if thev are owed
pavments on one contract, thev most likelv owe similar amounts on an offsetting
contract,creatingthepotentialforaseriesoflossesordefaults.Sincethesecontracts
numbered in the millions and allowed a partv to have virtuallv unlimited leverage,
thepossibilitvofsuddenlargeanddevastatinglossesinthismarketcouldposeasig-
nifcantdangertomarketparticipantsandthefnancialsvstemasawhole.
TheCounterpartvRiskManagementPolicvGroup,ledbvformerNewYorkFed
President E. Gerald Corrigan and consisting of the major securities frms, had
warnedthatabackloginpaperworkconfrmingderivativestradesandmasteragree-
ments exposed frms to risk should corporate defaults occur.
ao
With urging from
New York Fed President Timothv Geithner, bv September iooo, 1a major market
participantshadsignifcantlvreducedthebacklogandhadendedthepracticeofas-
signingtradestothirdpartieswithoutthepriorconsentoftheircounterparties.
a1
Largederivativespositions,andtheresultingcounterpartvcreditandoperational
risks, were concentrated in a verv few frms. Among U.S. bank holding companies,
the following institutions held enormous OTC derivatives positions as of Iune :o,
ioo8: ·oa.- trillion in notional amount for IP Morgan, ·:¬.¬ trillion for Bank of
America,·:-.8trillionforCitigroup,·a.1trillionforWachovia,and·:.otrillionfor
HSBC. Goldman Sachs and Morgan Stanlev, which began to report their holdings
onlv after thev became bank holding companies in ioo8, held ·a-.o and ·:¬.o tril-
lion, respectivelv, in notional amount of OTC derivatives in the frst quarter of
iooo.
ai
Inioo8,thecurrentandpotentialexposuretoderivativesatthetopfveU.S.
bankholdingcompanieswasonaveragethreetimesgreaterthanthecapitalthevhad
onhandtomeetregulatorvrequirements.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
svstembecauseoftheirinterconnectionswithotherfnancialinstitutions.
BroadclassesofOTCderivativesmarketsshowedstressinioo8.Bvthesummer
of ioo8, outstanding amounts of some tvpes of derivatives had begun to decline
sharplv.Aswewillsee,overthecourseofthesecondhalfofioo8,theOTCderiva-
tives market would undergo an unprecedented contraction, creating serious prob-
lemsforhedgingandpricediscoverv.
TheFedwasuneasvinpartbecausederivativescounterpartieshadplavedanim-
portantroleintherunonBearStearns.Thenovationsbvderivativescounterparties
to assign their positions awav from Bear—and the rumored refusal bv Goldman to
accept Bear as a derivatives counterpartv—were still a fresh memorv across Wall
Street. Chris Mewbourne, a portfolio manager at PIMCO, told the FCIC that the
abilitv to novate ceased to exist and this was a kev event in the demise of Bear
Stearns.
a:
Creditderivativesinparticularwereaserioussourceofworrv.Ofgreatestinterest
werethesellersofcreditdefaultswaps:themonolineinsurersandAIG,whichback-
\\itu 1u \UtU:1 z++· :¥:1i\i t ii :i tuNtiiN: .+.
stoppedthemarketinCDOs.Inaddition,thecreditratingagencies’decisiontoissue
anegativeoutlookonthemonolineinsurershadjoltedevervone,becausethevguar-
anteedhundredsofbillionsofdollarsinstructuredproducts.Aswehaveseen,when
theircreditratingsweredowngraded,thevalueofall theassetsthevguaranteed,in-
cludingmunicipalbondsandothersecurities,necessarilvlostsomevalueinthemar-
ket,adropthataffectedtheconservativeinstitutionalinvestorsinthosemarkets.In
thevernacularofWallStreet,thisoutcomeistheknock-oneffect;inthevernacular
ofMainStreet,thedominoeffect;inthevernacularoftheFed,svstemicrisk.
BANKS: “THE MARKETS WERE REALLY, REALLY DICEY”
Bvthefallofioo¬,signsofstrainwerebeginningtoemergeamongthecommercial
banks. In the fourth quarter of ioo¬, commercial banks’ earnings declined to a 1o-
vear low, driven bv write-downs on mortgage-backed securities and CDOs and bv
recordprovisionsforfutureloanlosses,asborrowershadincreasingdimcultvmeet-
ing their mortgage pavments—and even greater dimcultv was anticipated. The net
charge-offrate—theratiooffailedloanstototalloans—rosetoitshighestlevelsince
iooi,whentheeconomvwascomingoutofthepost-o/11recession.Earningscon-
tinuedtodeclineinioo8—atfrst,moreforbigbanksthansmallbanks,inpartbe-
cause of write-downs related to their investment banking–tvpe activities, including
thepackagingofmortgage-backedsecurities,CDOs,andcollateralizedloanobliga-
tions. Declines in market values required banks to write down the value of their
holdingsofthesesecurities.Aspreviouslvnoted,severalofthelargestbankshadalso
provided support to off-balance-sheet activities, such as monev market funds and
commercial paper programs, bringing additional assets onto their balance sheets—
assetsthatwerelosingvaluefast.Supervisorshadbeguntodowngradetheratingsof
manvsmallerbanksinresponsetotheirhighexposuresinresidentialrealestatecon-
struction, an industrv that virtuallv went out of business as fnancing dried up in
mid-ioo¬. Bv the end of ioo¬, the FDIC had ¬o banks, mainlv smaller ones, on its
“problem list”; their combined assets totaled ·ii.i billion.
aa
(When large banks
started to be downgraded, in earlv ioo8, thev staved off the FDIC’s problem list, as
supervisorsrarelvgivethelargestinstitutionsthelowestratings.)
a-
Themarketfornonconformingmortgagesecuritizations(thosebackedbvmort-
gagesthatdidnotmeetFannieMae’sorFreddieMac’sunderwritingormortgagesize
guidelines)hadalsovanishedinthefourthquarterofioo¬.Notonlvdidthesenon-
conformingloansprovehardertosell,butthevalsoprovedlessattractivetokeepon
balance sheet, as house price forecasts looked increasinglv grim. Alreadv, house
priceshadfallenabout¼forthevear,dependingonthemeasure.Inthefrstquarter
ofioo8,realestateloansinthebankingsectorshowedthesmallestquarterlvincrease
since ioo:.
ao
IndvMac reported a i1º decline in loan production for that quarter
fromavearearlier,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 NuUi i¥ tu\\i : :i uN iiiui1
largebanksandthriftsalreadv had.Andontheseassets,themarkdownscontinued
inioo8.Regulatorsbegantofocusonsolvencv,urgingthebankstoraisenewcapital.
InIanuarvioo8,Citigroupsecuredatotalof·1abillionincapitalfromKuwait,Sin-
gapore, Saudi Prince Alwaleed bin Talal, and others. In April, Washington Mutual
raised ·¬ billion from an investor group led bv the buvout frm TPG Capital. Wa-
choviaraised·obillionincapitalattheturnofthevearandthenanadditional·8bil-
lion in April ioo8. Despite the capital raises, though, the downgrades bv banking
regulatorscontinued.
“The markets were reallv, reallv dicev 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, particularlv small, midsized thrifts—to keep up with [how quicklv the
ratings downgrades occurred during the crisis] and change their business models
andnotgetstuckwithoutthechairwhenthemusicstopped . . .Thevgotcaught.The
ratingdowngradesstartedandbvthetimethethriftwasabletodosomethingabout
it,itwastoolate . . .Businessmodels . . .can’tkeepupwithwhatwesawinioo8.”
a8
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-
tionscamelateinthedav—oftenjustasfrmswereonthevergeoffailure.Incases
that the FCIC investigated, regulators either did not identifv the problems earlv
enoughordidnotactforcefullvenoughtocompelthenecessarvchanges.
(itigrouj.“1imctocomcujvit/encvjlevoook”
For Citigroup, supervisors at the New York Fed, who examined the bank holding
companv,andattheOmceoftheComptrolleroftheCurrencv,whooversawthena-
tional bank subsidiarv, fnallv downgraded the companv and its main bank to “less
thansatisfactorv”inAprilioo8—fvemonthsafterthefrm’sannouncementinNo-
vember ioo¬ of billions of dollars in write-downs related to its mortgage-related
holdings.ThesupervisorsputthecompanvundernewenforcementactionsinMav
andIune.Onlvavearearlier,boththeFedandtheOCChadupgradedthecompanv,
after lifting all remaining restrictions and enforcement actions related to complex
transactionsthatithadstructuredforEnronandtotheactionsofitssubprimesub-
sidiarvCitiFinancial,discussedinanearlierchapter.“Theriskmanagementassess-
mentforioooisrefectiveofacontrolenvironmentwheretherisksfacingCitigroup
continuetobemanagedinasatisfactorvmanner,”theNewYorkFed’sratingupgrade,
deliveredinitsannualinspectionreportonAprilo,ioo¬,hadnoted.“Duringiooo,
all formal restrictions and enforcement actions between the Federal Reserve and
Citigroupwerelifted.Boardandseniormanagementremainactivelvengagedinim-
provingrelevantprocesses.”
ao
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,”thesupervisorswroteinaninternalNovember1omemodescrib-
ing meetings with Citigroup management. “Stress tests were not designed for this
tvpe of extreme market event. . . . Management had believed that CDOs and lever-
agedloanswouldbesvndicated,andthatthecreditriskinsuperseniorAAACDOs
wasnegligible.”
-o
Inretrospect,Citigrouphadtwokevproblems:alackofeffectiveenterprise-wide
managementtomonitorandcontrolrisksandalackofproperinfrastructureandin-
ternalcontrolswithrespecttothecreationofCDOs.TheOCCappearstohaveiden-
tifedsomeoftheseissuesasearlvasioo-butdidnoteffectivelvacttorectifvthem.
Inparticular,theOCCassessedboththeliquiditvputsandthesuper-seniortranches
aspartofitsreviewsofthebank’scompliancewiththepost-Enronenforcementac-
tion,butitdidnotexaminetherisksoftheseexposures.Asfortheissuesitdidspot,
theOCCfailedtotakeforcefulstepstorequiremandatorvcorrectiveaction,andit
reliedonmanagement’sassurancesiniooothattheexecutiveswouldstrivetomeet
theOCC’sgoalsforimprovingriskmanagement.
Incontrast,documentsobtainedbvtheFCICfromtheNewYorkFedgivenoin-
dicationthatitsexaminationstaffhadanvindependentknowledgeofthosetwocore
problems.AnevaluationoftheNewYorkFed’ssupervisionofCitigroup,conducted
bvexaminersfromotherReserveBanks(theDecemberioooOperationsReviewof
theNewYorkFed,whichcoveredthepreviousfourvears),concluded:
ThesupervisionprogramforCitigrouphasbeenlessthaneffective.Al-
though the dedicated supervisorv team is well qualifed and generallv
has sound knowledge of the organization, there have been signifcant
weaknessesintheexecutionofthesupervisorvprogram.Theteamhas
not been proactive in making changes to the regulatorv ratings of the
frm, as evidenced bv the double downgrades in the frm’s fnancial
componentandrelatedsubcomponentsatvear-endioo¬.Additionallv,
thesupervisorvprogramhaslackedtheappropriateleveloffocusonthe
frm’s risk oversight and internal audit functions. As a result, there is
currentlvsignifcantworktobedoneinbothoftheseareas.Moreover,
the team has lacked a disciplined and proactive approach in assessing
andvalidatingactionstakenbvthefrmtoaddresssupervisorvissues.
-1
TimothvGeithner,secretarvoftheTreasurvandformerpresidentoftheFederal
ReserveBankofNewYork,refectedontheFed’soversightofCitigroup,tellingthe
Commission,“Idonotthinkwedidenoughasaninstitutionwiththeauthoritvwe
hadtohelpcontaintherisksthatultimatelvemergedinthatinstitution.”
-i
In Ianuarv ioo8, an OCC review of the breakdown in the CDO business noted
that the risk in the unit had grown rapidlv since iooo, after the OCC’s and Fed’s
.+. ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN iiiui1
lifting of supervisorv agreements associated with various control problems at Citi-
group.InAprilioo8,theFedandOCCdowngradedtheiroverallratingsofthecom-
panvanditslargestbanksubsidiarvfromi(satisfactorv)to:(lessthansatisfactorv),
refectingweaknessesinriskmanagementthatwerenowapparenttothesupervisors.
BothFedandOCComcialscitedtheGramm-Leach-BlilevActof1oooasanob-
stacle that prevented each from obtaining a complete understanding of the risks
assumedbvlargefnancialfrmssuchasCitigroup.Theactmadeitmoredimcult—
though not impossible—for regulators to look bevond the legal entities under their
directpurviewintootherareasofalargefrm.Citigroup,forexample,hadmanvreg-
ulatorsacrosstheworld;eventhesecuritizationbusinessesweredispersedacrosssub-
sidiarieswithdifferentsupervisors—includingthosefromtheFed,OCC,SEC,OTS,
andstateagencies.
InMavandIuneioo8,Citigroupenteredintomemorandaofunderstandingwith
boththeNewYorkFedandOCCtoresolvetheriskmanagementweaknessesthatthe
eventsofioo¬hadlaidbare.Intheensuingmonths,FedandOCComcialssaid,thev
were satisfed with Citigroup’s compliance with their recommendations. Indeed, in
speakingtotheFCIC,SteveManzari,theseniorrelationshipmanagerforCitigroup
attheNewYorkFedfromApriltoSeptemberioo8,complimentedCitigrouponits
assertiveness in executing its regulators’ requests: aggressivelv replacing manage-
ment, raising capital from investors in late ioo¬, and putting in place a number of
muchneeded“internalfxes.”However,Manzariwenton,“Citiwastrappedinwhat
wasaprettvvicious . . .svstemicevent,”andforregulators“itwastimetocomeup
withanewplavbook.”
-:
\ec/ovie.“1/c6olácn\cstecauisitionvesemistekc”
AtWachovia,whichwassupervisedbvtheOCCaswellastheOTSandtheFederal
Reserve,aioo¬end-of-vearreportshowedthatcreditlossesinitssubsidiarvGolden
West’sportfolioof“Pick-a-Pav”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 companv would hike its estimate of the eventual
lossesontheportfoliotooºbvIuneandtoiiºbvSeptember.
Facing these and other growing concerns, Wachovia raised additional capital.
Then,inApril,Wachoviaannouncedalossof·:-omillionforthefrstthreemonths
of the vear. 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.
-a
Bv Iune, according to Angus McBrvde, then Wachovia’s
seniorvicepresidentforTreasurvandBalanceSheetManagement,managementhad
launchedaliquiditvcrisismanagementplaninanticipationofanevenmoreadverse
marketreactiontosecond-quarterlossesthatwouldbeannouncedinIulv.
--
On Iune i, Wachovia’s board ousted CEO Ken Thompson after he had spent :i
vears at the bank, 8 of them at its helm.
-o
At the end of the month, the bank an-
nouncedthatitwouldstoporiginatingGoldenWest’sPick-a-Pavproductsandwould
\\itu 1u \UtU:1 z++· :¥:1i\i t ii :i tuNtiiN: .+,
waiveallfeesandprepavmentpenaltiesassociatedwiththem.OnIulvii,Wachovia
reported an ·8.o billion second-quarter loss. The new CEO, Robert Steel, most re-
centlvanundersecretarvofthetreasurv,announcedaplantoimprovethebank’sf-
nancialcondition:raisecapital,cutthestockdividend,andlavoff1oºto1iºofthe
staff.
Theratingagenciesandsupervisorsignoredthosereassurances.Onthesamedav
astheannouncement,S&Pdowngradedthebank,andtheFed,aftervearsof“satis-
factorv” ratings, downgraded Wachovia to :, or “less than satisfactorv.” The Fed
noted that ioo8 projections showed losses that could wipe out the recentlv raised
capital:ioo8lossesalonecouldexceed·:billion,anamountthatcouldcauseafur-
ther ratings downgrade.

The Fed directed Wachovia to reevaluate and update its
capital plans and its liquiditv management. Despite having consistentlv rated Wa-
choviaas“satisfactorv”rightuptothesummermeltdown,theFednowdeclaredthat
manvofWachovia’sproblemswere“long-terminnatureandresult[ed]fromdelaved
investmentdecisionsandadesiretohavebusinesslinesoperateautonomouslv.”
-8
TheFedbluntlvcriticizedtheboardandseniormanagementfor“anenvironment
with inconsistent and inadequate identifcation, escalation and coverage of all risk-
takingactivities,includingdefcienciesinstresstesting”and“littleaccountabilitvfor
errors.” Wachovia management had not completelv understood the level of risk
across the companv, particularlv in certain nonbank investments, and management
had delaved fxing these known defciencies. In addition, the companv’s board had
not sumcientlv questioned investment decisions.
-o
Nonetheless, the Fed concluded
thatWachovia’sliquiditvwascurrentlvadequateandthatthroughoutthemarketdis-
ruption,managementhadminimizedexposuretoovernightfundingmarkets.
OnAugusta,theOCCdowngradedWachoviaBankandassesseditsoverallrisk
profleas“high.”TheOCCnotedmanvofthesameissuesastheFed,andaddedpar-
ticularlvstrongremarksabouttheacquisitionofGoldenWest,identifvingthatmort-
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
TheOCCwrotethatthemarketwasfocusedonthecompanv’sweakenedcondi-
tion and that some large fund providers had alreadv limited their exposure to Wa-
chovia. Like the Fed, however, the OCC concluded that the bank’s liquiditv was
adequate, unless events undermined market confdence.
o1
And, like the Fed, the
OCCapprovedofthenewmanagementandanew,morehands-onoversightrolefor
theboardofdirectors.
YetWachovia’sproblemswouldcontinue,andinthefallregulatorswouldscram-
bletofndabuverforthetroubledbank.
\es/ingtonMutuel.“Menegcmcnt’sjcrsistcntleckojjrogrcss”
Washington Mutual, often called WaMu, was the largest thrift in the countrv, with
over ·:oo billion in assets at the end of ioo¬. At the time, ·-o billion of the home
loansonitsbalancesheetwereoptionARMs,twotimesitscapitalandreserves,with
.+( ii N\Nti \i tii :i : i NuUi i¥ tu\\i : :i uN iiiui1
concentratedexposureinCalifornia.ThereasonWaMulikedoptionARMswassim-
ple:inioo-,incombinationwithothernontraditionalmortgagessuchassubprime
loans,thevhadgeneratedreturnsupto8timesthoseonGSEmortgage–backedsecu-
rities.
oi
But that was then. WaMu was forced to write off ·1.o billion for the fourth
quarterofioo¬andanother·1.1billioninthefrstquarterofioo8,mostlvrelatedto
itsportfolioofoptionARMs.
Inresponsetotheselosses,theOmceofThriftSupervision,WaMu’sregulator,re-
questedthatthethriftaddressconcernsaboutassetqualitv,earnings,andliquiditv—
issues that the OTS had raised in the past but that had not been refected in
supervi