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Fcic Final Report Full
Fcic Final Report Full
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
0 0 8 1 - 2 1 5 ) 2 0 2 ( a e r a C D ; 0 0 8 1 - 2 1 5 ) 6 6 8 ( e e r f l l o t : e n o h P v o g . o p g . e r o t s k o o b : t e n r e t n I
n o t g n i h s a W , C C D I p o t S : l i a M 4 0 1 2 - 2 1 5 ) 2 0 2 ( : x a F 1 0 0 0 - 2 0 4 0 2 C D ,
I SBN 978-0-16-087727-8
CONTENTS
Ccnnissicncrs vii
CcnnissicncrVctcsviii
CcnnissicnStajjIist ix
Ircjacc xi
CONCLUSI ONS OF THE
FI NANCIAL CRI SI S I NQUI RY COMMI SSI ON.....................xv
PART I : CRI SI S ON THE HORI ZON
Chaptcr) Before Our 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
TheFinancialCrisisInquirvCommissionwascreatedtoexaminethecausesofthe
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.
TheCommissionsstatutorvinstructionssetoutiispecifctopicsforinquirvand
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
casestudvinvestigationsofspecifcfnancialfrmsandinmanvcasesspecifcfacets
oftheseinstitutionsthatplavedpivotalroles.ThoseinstitutionsincludedAmerican
InternationalGroup(AIG),BearStearns,Citigroup,CountrvwideFinancial,Fannie
Mae,GoldmanSachs,LehmanBrothers,MerrillLvnch,Moodvs,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.govwillhostawealthofinformationbevondwhatcouldbepresentedhere.
Itwillcontainastockpileofmaterialsincludingdocumentsandemails,videoofthe
Commissionspublichearings,testimonv,andsupportingresearchthatcanbestud-
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 Commissions 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
eventsofiooandioo8wereneitherbumpsintheroadnoranaccentuateddipin
thefnancialandbusinesscvcleswehavecometoexpectinafreemarketeconomic
svstem. This was a fundamental disruptiona fnancial upheaval, if vou willthat
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
preliminarvknowledgeabouthowtheworldsstrongestfnancialsvstemcametothe
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.Thosedecisionsandthedeepemotionssurroundingthemwillbe
debatedlongintothefuture.Butourmissionwastoaskandanswerthiscentralques-
tion:how did it come to pass that in our nation was forced to choose between two
stark and painful alternativeseither risk the total collapse of our fnancial 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,itwasthecollapseofthehousingbubblefueledbv
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
perceivedtobetoobigtofail,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.
From1o8toioo,theamountofdebtheldbvthefnancialsectorsoaredfrom
:trillionto:otrillion,morethandoublingasashareofgrossdomesticproduct.
The verv nature of manv Wall Street frms changedfrom relativelv staid private
partnershipstopubliclvtradedcorporationstakinggreaterandmorediversekindsof
risks.Bvioo-,the1olargestU.S.commercialbanksheld--oftheindustrvsassets,
more than double the level held in 1ooo. On the eve of the crisis in iooo, fnancial
sector profts constituted i of all corporate profts in the United States, up from
1- in 1o8o. Understanding this transformation has been critical to the Commis-
sionsanalvsis.
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,andexponentialgrowthinfnancialfrmstradingactivities,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.
TheprimeexampleistheFederalReservespivotalfailuretostemthefowoftoxic
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 nations 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
downonCitigroupsexcessesintherun-uptothecrisis.Thevdidnot.Policvmakers
andregulatorscouldhavestoppedtherunawavmortgagesecuritizationtrain.Thev
didnot.Incaseaftercaseaftercase,regulatorscontinuedtoratetheinstitutionsthev
oversawassafeandsoundeveninthefaceofmountingtroubles,oftendowngrading
them just before their collapse. And where regulators lacked authoritv, thev could
havesoughtit.Toooften,thevlackedthepoliticalwillinapoliticalandideological
environment that constrained itas 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
sectorexpendedi.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-
headofCitigroupsinvestmentbanksaidhespentasmallfractionof1ofhistime
onthosesecurities.Inthisinstance,toobigtofailmeanttoobigtomanage.
Financial institutions and credit rating agencies embraced mathematical models
asreliablepredictorsofrisks,replacingjudgmentintoomanvinstances.Toooften,
riskmanagementbecameriskjustifcation.
Compensation svstemsdesigned in an environment of cheap monev, intense
competition,andlightregulationtoooftenrewardedthequickdeal,theshort-term
gainwithoutproperconsiderationoflong-termconsequences.Often,thosesvstems
encouragedthebigbetwherethepavoffontheupsidecouldbehugeandthedown-
sidelimited.Thiswasthecaseupanddownthelinefromthecorporateboardroom
tothemortgagebrokeronthestreet.
Ourexaminationrevealedstunninginstancesofgovernancebreakdownsandirre-
sponsibilitv.Youwillread,amongotherthings,aboutAIGseniormanagementsigno-
rance of the terms and risks of the companvs o billion derivatives exposure to
mortgage-related securities; Fannie Maes quest for bigger market share, profts, and
bonuses,whichledittorampupitsexposuretoriskvloansandsecuritiesasthehous-
ing market was peaking; and the costlv surprise when Merrill Lvnchs top manage-
ment realized that the companv held -- billion in super-senior and supposedlv
super-safemortgage-relatedsecuritiesthatresultedinbillionsofdollarsinlosses.
We conclude a combination of excessive borrowing, risky investments, and lack
of transparency put the fnancial system on a collision course with crisis. Clearlv,
thisvulnerabilitvwasrelatedtofailuresofcorporategovernanceandregulation,but
itissignifcantenoughbvitselftowarrantourattentionhere.
Inthevearsleadinguptothecrisis,toomanvfnancialinstitutions,aswellastoo
manvhouseholds,borrowedtothehilt,leavingthemvulnerabletofnancialdistress
orruinifthevalueoftheirinvestmentsdeclinedevenmodestlv.Forexample,asof
ioo, the fve major investment banksBear Stearns, Goldman Sachs, Lehman
Brothers, Merrill Lvnch, and Morgan Stanlevwere operating with extraordinarilv
thincapital.Bvonemeasure,theirleverageratioswereashighasaoto1,meaningfor
evervaoinassets,therewasonlv1incapitaltocoverlosses.Lessthana:dropin
assetvaluescouldwipeoutafrm.Tomakemattersworse,muchoftheirborrowing
wasshort-term,intheovernightmarketmeaningtheborrowinghadtoberenewed
eachandevervdav.Forexample,attheendofioo,BearStearnshad11.8billionin
tuNtiU:i uN: ui 1ui ii N\Nti \i tii :i : i NuUi i tu\\i : :i uN xix
equitvand:8:.obillioninliabilitiesandwasborrowingasmuchasobillionin
theovernightmarket.Itwastheequivalentofasmallbusinesswith-o,oooinequitv
borrowing 1.o million, with ioo,-o of that due each and everv dav. One cant
reallv ask What were thev thinking: when it seems that too manv of them were
thinkingalike.
Andtheleveragewasoftenhiddeninderivativespositions,inoff-balance-sheet
entities,andthroughwindowdressingoffnancialreportsavailabletotheinvesting
public.
ThekingsofleveragewereFannieMaeandFreddieMac,thetwobehemothgov-
ernment-sponsored enterprises (GSEs). For example, bv the end of ioo, Fannies
andFreddiescombinedleverageratio,includingloansthevownedandguaranteed,
stoodat-to1.
Butfnancialfrmswerenotaloneintheborrowingspree:fromioo1toioo,na-
tionalmortgagedebtalmostdoubled,andtheamountofmortgagedebtperhouse-
hold rose more than 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,Lehmanhadamassed111billionincom-
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,theriskwasntbeingtakenonjustbvthebigfnancialfrms,butbvfamilies,
too.Nearlvonein1omortgageborrowersinioo-andioootookoutoptionARM
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-
tectionstheFederalReserveasalenderoflastresort,federaldepositinsurance,am-
pleregulationstoprovideabulwarkagainstthepanicsthathadregularlvplagued
Americas banking svstem in the 1oth centurv. Yet, over the past :o-plus vears, we
permitted the growth of a shadow banking svstemopaque and laden with short-
termdebtthatrivaledthesizeofthetraditionalbankingsvstem.Kevcomponents
of the marketfor example, the multitrillion-dollar repo lending market, off-bal-
ance-sheet entities, and the use of over-the-counter derivativeswere hidden from
view,withouttheprotectionswehadconstructedtopreventfnancialmeltdowns.We
hadai1st-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 makersthe Treasurv Department, the Federal
Reserve Board, and the Federal Reserve Bank of New Yorkwho were best posi-
tionedtowatchoverourmarketswereillpreparedfortheeventsofiooandioo8.
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.WhenBearStearnsshedgefunds,whichwereheavilvinvested
inmortgage-relatedsecurities,implodedinIuneioo,theFederalReservediscussed
theimplicationsofthecollapse.Despitethefactthatsomanvotherfundswereex-
posedtothesamerisksasthosehedgefunds,theBearStearnsfundswerethoughtto
berelativelvunique.DavsbeforethecollapseofBearStearnsinMarchioo8,SEC
ChairmanChristopherCoxexpressedcomfortaboutthecapitalcushionsatthebig
investment banks. It was not until August ioo8, just weeks before the government
takeoverofFannieMaeandFreddieMac,thattheTreasurvDepartmentunderstood
thefullmeasureofthedirefnancialconditionsofthosetwoinstitutions.Andjusta
month before Lehmans collapse, the Federal Reserve Bank of New York was still
seekinginformationontheexposurescreatedbvLehmansmorethanooo,oooderiv-
ativescontracts.
Inaddition,thegovernmentsinconsistenthandlingofmajorfnancialinstitutions
duringthecrisisthedecisiontorescueBearStearnsandthentoplaceFannieMae
andFreddieMacintoconservatorship,followedbvitsdecisionnottosaveLehman
BrothersandthentosaveAIGincreaseduncertaintvandpanicinthemarket.
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
integritvofourfnancialmarketsandthepublicstrustinthosemarketsareessential
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.
Unfortunatelvas has been the case in past speculative booms and bustswe
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.Youwillreadaboutmortgagebrokerswhowerepaidvieldspreadpremiums
bvlenderstoputborrowersintohigher-costloanssothevwouldgetbiggerfees,of-
tenneverdisclosedtoborrowers.Thereportcataloguestherisingincidenceofmort-
gagefraud,whichfourishedinanenvironmentofcollapsinglendingstandardsand
laxregulation.Thenumberofsuspiciousactivitvreportsreportsofpossiblefnan-
cial crimes fled bv depositorv banks and their amliatesrelated to mortgage fraud
grew io-fold between 1ooo and ioo- and then more than doubled again between
ioo-andiooo.Onestudvplacesthelossesresultingfromfraudonmortgageloans
madebetweenioo-andiooat11ibillion.
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
alsoinfnancialandreputationalcatastropheforthefrm.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
Commissionsreviewofmanvprospectusesprovidedtoinvestorsfoundthatthiscrit-
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
meanthatevervoneisatfault;manvfrmsandindividualsdidnotparticipateinthe
excessesthatspawneddisaster.
Wedoplacespecialresponsibilitvwiththepublicleaderschargedwithprotecting
ourfnancialsvstem,thoseentrustedtorunourregulatorvagencies,andthechiefex-
ecutivesofcompanieswhosefailuresdroveustocrisis.Theseindividualssoughtand
accepted positions of signifcant responsibilitv and obligation. Tone at the top does
matterand,inthisinstance,wewereletdown.Noonesaidno.
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
gearssome 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 borrowers abilitv to
pav.Nearlvone-quarterofallmortgagesmadeinthefrsthalfofioo-wereinterest-
onlvloans.Duringthesamevear,o8ofoptionARMloansoriginatedbvCoun-
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
neglecteditsmissiontoensurethesafetvandsoundnessofthenationsbankingand
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
Whilemanvofthesemortgageswerekeptonbanksbooks,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-loadtheirrisksonamomentsno-
tice to the next person in line. Thev were wrong. When borrowers stopped making
mortgage pavments, the lossesamplifed bv derivativesrushed 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,growingtoo: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 derivativecredit default swaps (CDS)fueled the mortgage securitization
pipeline.CDSweresoldtoinvestorstoprotectagainstthedefaultordeclineinvalue
ofmortgage-relatedsecuritiesbackedbvriskvloans.Companiessoldprotectionto
thetuneofobillion,inAIGscasetoinvestorsinthesenewfangledmortgagese-
curities, helping to launch and expand the market and, in turn, to further fuel the
housingbubble.
Second, CDS were essential to the creation of 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 AIGs collapse would trigger cascading losses throughout
theglobalfnancialsvstem.Inaddition,theexistenceofmillionsofderivativescon-
tractsofalltvpesbetweensvstemicallvimportantfnancialinstitutionsunseenand
unknown in this unregulated marketadded 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 Moodvs, examined bv the
Commission as a case studv. From iooo to ioo, Moodvs 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,Moodvsputitstriple-Astampofapprovalon:omortgage-relatedsecurities
evervworkingdav.Theresultsweredisastrous:8:ofthemortgagesecuritiesrated
triple-Athatvearultimatelvweredowngraded.
YouwillalsoreadabouttheforcesatworkbehindthebreakdownsatMoodvs,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,itistheCommissions
conclusionthatexcessliquiditvdidnotneedtocauseacrisis.Itwasthefailuresout-
linedaboveincludingthefailuretoeffectivelvreininexcessesinthemortgageand
fnancialmarketsthatweretheprincipalcausesofthiscrisis.Indeed,theavailabil-
itv of well-priced capitalboth foreign and domesticis an opportunitv for eco-
nomicexpansionandgrowthifencouragedtofowinproductivedirections.
Second,weexaminedtheroleoftheGSEs,withFannieMaeservingastheCom-
missions 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
wardoffeffectiveregulationandoversightspending1oamilliononlobbvingfrom
1oootoioo8.Thevsufferedfrommanvofthesamefailuresofcorporategovernance
and risk management as the Commission discovered in other fnancial frms.
Throughthethirdquarterofio1o,theTreasurvDepartmenthadprovided1-1bil-
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,
butthevfollowedratherthanledWallStreetandotherlendersintherushforfools
gold. Thev purchased the highest rated non-GSE mortgage-backed securities and
theirparticipationinthismarketaddedheliumtothehousingballoon,buttheirpur-
chasesneverrepresentedamajoritvofthemarket.Thosepurchasesrepresented1o.-
of non-GSE subprime mortgage-backed securities in ioo1, with the share rising to
aoiniooa,andfallingbacktoi8bvioo8.Thevrelaxedtheirunderwritingstan-
dards to purchase or guarantee riskier loans and related securities in order to meet
stockmarketanalvstsandinvestorsexpectationsforgrowth,toregainmarketshare,
andtoensuregenerouscompensationfortheirexecutivesandemploveesjustifving
theiractivitiesonthebroadandsustainedpublicpolicvsupportforhomeownership.
TheCommissionalsoprobedtheperformanceoftheloanspurchasedorguaran-
teed bv Fannie and Freddie. While thev generated substantial losses, delinquencv
ratesforGSEloansweresubstantiallvlowerthanloanssecuritizedbvotherfnancial
frms.Forexample,datacompiledbvtheCommissionforasubsetofborrowerswith
similar credit scoresscores below oooshow that bv the end of ioo8, GSE mort-
gages were far less likelv to be seriouslv delinquent than were non-GSE securitized
mortgages:o.iversusi8.:.
We also studied at length how the Department of Housing and Urban Develop-
ments (HUDs) affordable housing goals for the GSEs affected their investment in
xxvi ii N\Nti \i tii :i : i NuUi i tu\\i : :i uN iiiui1
riskvmortgages.Basedontheevidenceandinterviewswithdozensofindividualsin-
volvedinthissubjectarea,wedeterminedthesegoalsonlvcontributedmarginallvto
FanniesandFreddiesparticipationinthosemortgages.
Finallv,astothematterofwhethergovernmenthousingpolicieswereaprimarv
cause of the crisis: for decades, government policv has encouraged homeownership
throughasetofincentives,assistanceprograms,andmandates.Thesepolicieswere
putinplaceandpromotedbvseveraladministrationsandCongressesindeed,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 HUDs affordable housing
goals,asnotedabove,andtheCommunitvReinvestmentAct(CRA).TheCRAwas
enactedin1otocombatredliningbvbanksthepracticeofdenvingcredittoin-
dividualsandbusinessesincertainneighborhoodswithoutregardtotheircreditwor-
thiness.TheCRArequiresbanksandsavingsandloanstolend,invest,andprovide
services to the communities from which thev take deposits, consistent with bank
safetvandsoundness.
TheCommissionconcludestheCRAwasnotasignifcantfactorinsubprimelend-
ingorthecrisis.ManvsubprimelenderswerenotsubjecttotheCRA.Researchindi-
catesonlvoofhigh-costloansaproxvforsubprimeloanshadanvconnectionto
the law. Loans made bv CRA-regulated lenders in the neighborhoods in which thev
wererequiredtolendwerehalfaslikelvtodefaultassimilarloansmadeinthesame
neighborhoodsbvindependentmortgageoriginatorsnotsubjecttothelaw.
Nonetheless,wemakethefollowingobservationaboutgovernmenthousingpoli-
ciesthevfailedinthisrespect: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 nations 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
hundredsofindividualsfnancialexecutives,businessleaders,policvmakers,regu-
lators,communitvleaders,peoplefromallwalksoflifetofndouthowandwhvit
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, fewif anvforesaw 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 Moodvs 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,toldtheCommissionaperfectstormhadoccurredthat
regulatorscouldnothaveanticipated;butwhenaskedaboutwhethertheFedslackof
aggressiveness in regulating the mortgage market during the housing boom was a
failure,Bernankeresponded,Itwas,indeed.Ithinkitwasthemostseverefailureof
the Fed in this particular episode.
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,itwasnthidden. . . .Youcannot
lookatanvofthisandsavthattheregulatorsdidtheirjob.Thiswasnotsomehidden
problem.ItwasntoutonMarsorPlutoorsomewhere.Itwasrighthere. . . .Youcant
maketrillionsofdollarsworthofmortgagesandnothavepeoplenotice.
o
PaulMcCullev,amanagingdirectoratPIMCO,oneofthenationslargestmonev
managementfrms,toldtheCommissionthatheandhiscolleaguesbegantogetwor-
riedaboutserioussignsofbubblesinioo-;thevthereforesentoutcreditanalvststo
iocitiestodowhathecalledold-fashionedshoe-leatherresearch,talkingtoreales-
tatebrokers,mortgagebrokers,andlocalinvestorsaboutthehousingandmortgage
markets. Thev witnessed what he called the outright degradation of underwriting
standards,McCullevasserted,andthevsharedwhatthevhadlearnedwhenthevgot
back home to the companvs Newport Beach, California, headquarters. And when
ourgroupcameback,thevreportedwhatthevsaw,andweadjustedourriskaccord-
inglv,McCullevtoldtheCommission.Thecompanvseverelvlimiteditsparticipa-
tioninriskvmortgagesecurities.
Veteranbankers,particularlvthosewhorememberedthesavingsandloancrisis,
knewthatage-oldrulesofprudentlendinghadbeencastaside.ArnoldCattani,the
chairmanofBakersfeld,CaliforniabasedMissionBank,toldtheCommissionthat
he grew uncomfortable with the pure lunacv he saw in the local home-building
market,fueledbvvoraciousWallStreetinvestmentbanks;hethusoptedoutofcer-
tainkindsofinvestmentsbvioo-.
8
WilliamMartin,thevicechairmanandchiefexecutiveomcerofService1stBank
ofNevada,toldtheFCICthatthedesireforahighandquickreturnblindedpeople
tofscalrealities.YoumavrecallTommvLeeIonesinMen in Black, whereheholdsa
deviceintheair,andwithabrightfashwipescleanthememoriesofevervonewho
haswitnessedanalienevent,hesaid.
o
Unlike so manv other bubblestulip bulbs in Holland in the 1ooos, South Sea
stocksinthe1oos,Internetstocksinthelate1ooosthisoneinvolvednotjustan-
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,climbingfromaoobillioninioootoi.8
trillioninioo:,
1o
allowingpeopletowithdrawequitvbuiltupoverpreviousdecades
and to consume more, despite stagnant wages. Home sales volume started to in-
crease,andaveragehomepricesnationwideclimbed,risingoineightvearsbvone
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-:,from1.amillionin1oo-tomorethanimillioninioo-.Encouraged
bv government policies, homeownership reached a record oo.i in the spring of
iooa, although it wouldnt 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-,toi,isquarefeet,in
thedecadefrom1ootoioo.
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-of
homeownerspulledoutcashtobuvavehicleandoveraospentthecashonacatch-
all categorv including tax pavments, clothing, gifts, and living expenses.
1
Renters
usednewformsofloanstobuvhomesandtomovetosuburbansubdivisions,erect-
ingswingsetsintheirbackvardsandenrollingtheirchildreninlocalschools.
In an interview with the Commission, Angelo Mozilo, the longtime CEO of
CountrvwideFinancialalenderbroughtdownbvitsriskvmortgagessaidthata
goldrushmentalitvovertookthecountrvduringthesevears,andthathewasswept
upinitaswell:HousingpriceswererisingsorapidlvataratethatIdneverseenin
mv--vearsinthebusinessthatpeople,regularpeople,averagepeoplegotcaught
upinthemaniaofbuvingahouse,andfippingit,makingmonev.Itwashappening.
Thevbuvahouse,make-o,ooo . . .andtalkatacocktailpartvaboutit. . . .Housing
suddenlvwentfrombeingpartoftheAmericandreamtohousemvfamilvtosettle
8ii uii uUi \ii ii: ,
downitbecameacommoditv.Thatwasachangeintheculture. . . .Itwassudden,
unexpected.
18
Onthesurface,itlookedlikeprosperitv.Afterall,thebasicmechanismsmaking
the real estate machine humthe mortgage-lending instruments and the fnancing
techniquesthatturnedmortgagesintoinvestmentscalledsecurities,whichkeptcash
fowingfromWallStreetintotheU.S.housingmarketweretoolsthathadworked
wellformanvvears.
But underneath, something was going wrong. Like a science fction movie in
whichordinarvhouseholdobjectsturnhostile,familiarmarketmechanismswerebe-
ingtransformed.Thetime-tested:o-vearfxed-ratemortgage,withaiodownpav-
ment, went out of stvle. There was a burgeoning global demand for residential
mortgagebacked 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 changesthese
financial innovations, thev said, had lowered borrowing costs for consumers and
movedrisksawavfromthebiggestandmostsvstemicallvimportantfinancialinsti-
tutions. But the nations financial svstem had become vulnerable and intercon-
nected in wavs that were not understood bv either the captains of finance or the
svstemspublicstewards.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
worldshigh-vield,risk-freebutinstead,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
whatsreallvinside.
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; ii8s and :is; liar loans;
piggvback second mortgages; pavment-option or pick-a-pav adjustable rate mort-
gages.Newvariantsonadjustable-ratemortgages,calledexplodingARMs,featured
lowmonthlvcostsatfrst,butpavmentscouldsuddenlvdoubleortriple,ifborrowers
wereunabletorefnance.Loanswithnegativeamortizationwouldeatawavthebor-
rowersequitv.Soontherewereamultitudeofdifferentkindsofmortgagesavailable
on the market, confounding consumers who didnt 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 proftand
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
housesevenifthevdidnthaveenoughincometoqualifvfortraditionalloans.
Some of these exotic loans had existed in the past, used bv high-income, fnan-
ciallvsecurepeopleasacash-managementtool.Somehadbeentargetedtoborrow-
erswithimpairedcredit,offeringthemtheopportunitvtobuildastrongerpavment
historvbeforethevrefnanced.Buttheinstrumentsbegantodelugethelargermarket
iniooaandioo-.Thechangedoccurredalmostovernight,FaithSchwartz,thenan
executiveatthesubprimelenderOptionOneandlatertheexecutivedirectorofHope
Now, a lending-industrv foreclosure relief group, told the Federal Reserves 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 countrvs more than ioo-vear historv. The amount of
mortgagedebtperhouseholdrosefromo1,-ooinioo1to1ao,-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
wasnt 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 ii: ,
His clients included manv of the largest lendersCountrvwide, Ameriquest, and
Ditechamongthem.Mostoftheirnewhireswerevoung,withnomortgageexperi-
ence,freshoutofschoolandwithpreviousjobsfippingburgers,hetoldtheFCIC.
Giventherighttraining,however,thebestofthemcouldeasilvearnmillions.
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.
i
OnWallStreet,wheremanvoftheseloanswerepackagedintosecuritiesandsold
toinvestorsaroundtheglobe,anewtermwascoined:IBGYBG,Illbegone,voull
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 frmsincluding investment banks such as Merrill Lvnch, Bear
Stearns,andLehmanBrothers,andcommercialbanksandthriftssuchasCitibank,
WellsFargo,andWashingtonMutual.Thefrmswouldpackagetheloansintoresi-
dentialmortgagebackedsecuritiesthatwouldmostlvbestampedwithtriple-Arat-
ingsbvthecreditratingagencies,andsoldtoinvestors.Inmanvcases,thesecurities
were repackaged again into collateralized debt obligations (CDOs)often com-
posedoftheriskierportionsofthesesecuritieswhichwouldthenbesoldtoother
investors. Most of these securities would also receive the coveted triple-A ratings
thatinvestorsbelievedattestedtotheirqualitvandsafetv.Someinvestorswouldbuv
aninventionfromthe1oooscalledacreditdefaultswap(CDS)toprotectagainstthe
securitiesdefaulting.Forevervbuverofacreditdefaultswap,therewasaseller:as
theseinvestorsmadeopposingbets,thelaversofentanglementinthesecuritiesmar-
ketincreased.
The instruments grew more and more complex; CDOs were constructed out of
CDOs,creatingCDOssquared.Whenfrmsranoutofrealproduct,thevstartedgen-
eratingcheaper-to-producesvntheticCDOscomposednotofrealmortgagesecuri-
ties but just of bets on other mortgage products. Each new permutation created an
opportunitvtoextractmorefeesandtradingprofts.Andeachnewlaverbroughtin
more investors wagering on the mortgage marketeven 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-
vestorsorpartsofbetsbeingmadebvhundredsmore.TreasurvSecretarvTimothv
Geithner,thepresidentoftheNewYorkFederalReserveBankduringthecrisis,de-
scribedtheresultingproductascookedspaghettithatbecamehardtountangle.
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
monevevervnighttofnanceBearStearnssbroadersecuritiesportfolio.InSeptem-
ber ioo:, Ciom created a hedge fund within Bear Stearns with a minimum invest-
mentof1million.Aswascommon,heusedborrowedmonevuptooborrowed
foreverv1frominvestorstobuvCDOs.Ciomsfrstfundwasextremelvsuccess-
ful;itearned1forinvestorsiniooaand1oinioo-aftertheannualmanage-
ment fee and the io slice of the proft for Ciom and his Bear Stearns teamand
grewtoalmostobillionbvtheendofioo-.Inthefallofiooo,hecreatedanother,
moreaggressivefund.Thisonewouldshootforleverageofupto1ito1.Bvtheend
of iooo, the two hedge funds had 18 billion invested, half in securities issued bv
CDOscenteredonhousing.AsaCDOmanager,Ciomalsomanagedanother18bil-
lionofmortgage-relatedCDOsforotherinvestors.
Ciomsinvestorsandotherslikethemwantedhigh-vieldingmortgagesecurities.
That,inturn,requiredhigh-vieldingmortgages.Anadvertisingbarragebombarded
potential borrowers, urging them to buv or refnance homes. Direct-mail solicita-
tions fooded peoples 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!(Mortgagessoondubbedliarloansbvtheindustrvitself.)
Borrowers answered the call, manv believing that with ever-rising prices, housing
wastheinvestmentthatcouldntlose.
InWashington,fourintermingledissuescameintoplavthatmadeitdimculttoac-
knowledgetheloomingthreats.First,effortstoboosthomeownershiphadbroadpo-
litical supportfrom Presidents Bill Clinton and George W. Bush and successive
Congresseseventhoughinrealitvthehomeownershipratehadpeakedinthespring
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,homepricesinClevelandroseoo,climb-
ingfromamedianof-,iooto1i-,1oo,whilehomepricesnationallvroseabout
ao in those same vears; at the same time, the citvs unemplovment rate, ranging
8ii uii uUi \ii ii: +
from -.8 in 1ooo to a.i in 1ooo, more or less tracked the broader U.S. pattern.
IamesRokakis,thelongtimecountvtreasurerofCuvahogaCountv,whereCleveland
islocated,toldtheCommissionthattheregionshousingmarketwasjuicedbvfip-
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,
theres 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.HespokeabouttheFedspowerunderHOEPA,
declaredsomeofthelendingpracticestobeclearlvillegal,andsaidthevcouldbe
combatedwithlegalenforcementmeasures.
:-
Lookingback,RokakisremarkedtotheCommission,Inaivelvbelievedthevdgo
back and tell Mr. Greenspan and presto, wed 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
calledexploitativepracticesthevbelievedwereputtingbothborrowersandlenders
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
thevwerenotintheborrowersbestinterest.
ao
Asitwouldturnout,thoserulescov-
ered onlv 1 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,
thepavmentshockloanswerebeginningtoproliferate,placingpressureontradi-
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-
nonprimelendersoriginated1o-billioninloans.Theirvolumeroseto188billion
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- of all nontraditional loans nationwide,
were made in that state; Californias share rose to :- bv ioo:, with these kinds of
loans growing to o- billion or bv 8a in California in just two vears.
ao
In those
vears, subprime and option ARM loans saturated California communities, Kevin
Stein,theassociatedirectoroftheCaliforniaReinvestmentCoalition,testifedtothe
Commission.WeestimatedatthattimethattheaveragesubprimeborrowerinCali-
forniawaspavingoverooomorepermonthontheirmortgagepavmentasaresult
ofhavingreceivedthesubprimeloan.
a
GailBurks,presidentandCEOofNevadaFairHousing,Inc.,aLasVegasbased
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
metamorphosisinthelendingindustrv.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 ii: ..
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-
tions 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;increasingtheinterestratesonborrowersloansor
switchingtheirloansfromfxedtoadjustableinterestratesatclosing;andpromising
borrowersthatthevcouldrefnancetheircostlvloansintoloanswithbettertermsin
justafewmonthsoravear,evenwhenborrowershadnoequitvtoabsorbanother
refnance.
-1
Ed Parker, the former head of Ameriquests 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
managertosupervisor,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-
tiquesdealersinhisview,ablatantmisrepresentationofemplovment.Inanother
loanfile,herecalledinaninterviewwiththeFCIC,adisabledborrowerinhis8os
who used a walker was described in the loan application as being emploved in
lightconstruction.
-:
ItdidnttakeSherlockHolmestofgureoutthiswasbogus,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,onbehalfofmorethaniao,oooborrowers.Theresultwasa:i-mil-
lionsettlement.Butduringthevearswhentheinvestigationwasunderwav,between
iooiandioo-,Ameriquestoriginatedanotheri1.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 . . .andtherewasntagreatdealofoversightgoingon.Althoughhewasthe
nationstophousingomcialatthetime,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
banksincluding Bank of America, Citibank, and Wachoviaand 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
lecturetothestatesattornevsgeneral,inameetinginWashington,warningthem
thattheOCCwouldquashthemifthevpersistedinattemptingtocontrolthecon-
sumerpracticesofnationallvregulatedinstitutions.
-8
TwoformerOCCcomptrollers,IohnHawkeandIohnDugan,toldtheCommis-
sionthatthevweredefendingtheagencvsconstitutionalobligationtoblockstateef-
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 Carolinabased Wachovia Bank
told state regulators that it would not abide bv state laws, because it was a national
bankandfellunderthesupervisionoftheOCC.MichiganprotestedWachoviasan-
nouncement,andWachoviasuedMichigan.TheOCC,theAmericanBankersAsso-
ciation, and the Mortgage Bankers Association entered the frav on Wachovias 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
WachoviasfavoronApril1,ioo,leavingtheOCCitssoleregulatorformortgage
lending.Coxcriticizedthefederalgovernment:Notonlvwerethevnegligent,thev
wereaggressiveplaversattemptingtostopanvenforcementaction[s]. . . .Thoseguvs
shouldhavebeenonourside.
o1
Nonprimelendingsurgedto:obillioniniooaandthen1.otrillioninioo-,
anditsimpactbegantobefeltinmoreandmoreplaces.
oi
Manvofthoseloanswere
funneled into the pipeline bv mortgage brokersthe link between borrowers and
the lenders who fnanced the mortgageswho prepared the paperwork for loans
andearnedfeesfromlendersfordoingit.Morethanioo,ooonewmortgagebrokers
8ii uii uUi \ii ii: ..
begantheirjobsduringtheboom,andsomewerelessthanhonorableintheirdeal-
ingswithborrowers.
o:
Accordingtoaninvestigativenewsreportpublishedinioo8,
between iooo and ioo, at least 1o,-oo people with criminal records entered the
feldinFlorida,forexample,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,wereabsolutelvcorrupt.
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 11 in Bakersfeld in iooi, 1 in ioo:, :i in iooa,
andiomoreinioo-.
Crabtree,anappraiserfora8vears,startedinioo:andiooatothinkthatthings
werenotmakingsense.Peoplewerepavinginfatedpricesfortheirhomes,andthev
didnt 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 thats 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
involvedmanvofthenationslargestlenders.Onehouse,forexample,waslistedfor
sale for -o-,ooo, and was recorded as selling for oo-,ooo with 1oo fnancing,
thoughtherealestateagenttoldCrabtreethatitactuallvsoldfor-:-,ooo.Crabtree
realizedthatthegapbetweenthesalespriceandloanamountallowedtheseinsiders
topocketo,ooo.Thetermsoftheloanrequiredthebuvertooccupvthehouse,but
itwasneveroccupied.Thehousewentintoforeclosureandwassoldinadistresssale
for:ii,ooo.
o
Crabtreebegancallinglenderstotellthemwhathehadfound;buttohisshock,
thevdidnotseemtocare.HefnallvreachedonequalitvassuranceomceratFremont
.. ii N\Nti \i tii :i : i NuUi i tu\\i : :i uN iiiui1
Investment&Loan,thenationseighth-largestsubprimelender.Dontputvournose
whereitdoesntbelong,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
moretopolicetheirownorganizations.
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
servedasattornevgeneraliniooandioo8,toldtheFCICthatmortgagefraudhad
never been communicated to them as a top prioritv. National securitv . . . was an
overridingconcern,Mukasevsaid.
-
Tocommunitvactivistsandlocalomcials,however,thelendingpracticeswerea
matterofnationaleconomicconcern.RuhiMaker,alawverwhoworkedonforeclo-
surecasesattheEmpireIusticeCenterinRochester,NewYork,toldFedGovernors
Bernanke,SusanBies,andRogerFergusoninOctoberiooathatshesuspectedthat
some investment banksshe specifed Bear Stearns and Lehman Brotherswere
producingsuchbadloansthatthevervsurvivalofthefrmswasputinquestion.We
repeatedlvseefalseappraisalsandfalseincome,shetoldtheFedomcials,whowere
gatheredatthepublichearingperiodofaConsumerAdvisorvCouncilmeeting.She
urged the Fed to prod the Securities and Exchange Commission to examine the
8ii uii uUi \ii ii: .,
qualitvofthefrmsduediligence;otherwise,shesaid,seriousquestionscouldarise
about whether thev could be forced to buv back bad loans that thev had made or
securitized.
o
Makertoldtheboardthatshefearedanenormouseconomicimpactcouldre-
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
magazinescoverstorvpositedthatthedavofreckoningwasathand,withthehead-
lineHousePrices: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.Congressthattheapparentfrothinhousing
markets mav have spilled over into the mortgage markets.
81
For vears, he had
warnedthatFannieMaeandFreddieMac,bolsteredbvinvestorsbeliefthatthesein-
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 containedthat is, he ex-
pectedlittlespillovertothebroadereconomv.
8:
Some were less sanguine. For example, the consumer lawver Sheila Canavan, of
Moab, Utah, informed the Feds Consumer Advisorv Council in October ioo- that
o1 of recentlv originated loans in California were interest-onlv, a proportion that
was more than twice the national average. Thats insanitv, she told the Fed gover-
nors.Thatmeanswerefacingsomethingdowntheroadthatwehaventfacedbefore
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
whos who of central bankers, recalled Raghuram Rajan, who was then on leave
fromtheUniversitvofChicagosbusinessschoolwhileservingasthechiefeconomist
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-termgainsbutletoffthehookforanveventuallossestheIBGYBGsvn-
drome. Rajan added that investment strategies such as credit default swaps could
havedisastrousconsequencesifthesvstembecameunstable,andthatregulatorvin-
stitutionsmightbeunabletodealwiththefallout.
8
HerecalledtotheFCICthathewastreatedwithscorn.LawrenceSummers,afor-
merU.S.treasurvsecretarvwhowasthenpresidentofHarvardUniversitv,calledRa-
janaLuddite,implvingthathewassimplvopposedtotechnologicalchange.
88
Ifelt
like an earlv Christian who had wandered into a convention of half-starved lions,
Rajanwrotelater.
8o
SusanM.Wachter,aprofessorofrealestateandfnanceattheUniversitvofPenn-
svlvanias 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 ii: .,
Inioo-,newsreportswerebeginningtohighlightindicationsthattherealestate
marketwasweakening.Homesalesbegantodrop,andFitchRatingsreportedsigns
that mortgage delinquencies were rising. That vear, the hedge fund manager Mark
KlipschofOrixCreditCorp.toldparticipantsattheAmericanSecuritizationForum,
asecuritiestradegroup,thatinvestorshadbecomeoveroptimisticaboutthemar-
ket.Iseealotofirrationalitv,headded.Hesaidhewasunnervedbecausepeople
were saving, Its different this timea 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,
lenderswereblacklistinghonestappraisersandinsteadassigningbusinessonlvto
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 goingordering up loans, packaging them into securities, taking profts,
earningbonuses.Bvthethirdquarterofiooo,homepriceswerefallingandmortgage
delinquencies were rising, a combination that spelled trouble for mortgage-backed
securities.Butfromthethirdquarterofioooon,bankscreatedandsoldsome1.:
trillion in mortgage-backed securities and more than :-o billion in mortgage-
relatedCDOs.
oa
Not evervone on Wall Street kept applauding, however. Some executives were
urgingcaution,ascorporategovernanceandriskmanagementwerebreakingdown.
Refectingonthecausesofthecrisis,IamieDimon,CEOofIPMorgantestifedtothe
FCIC,Iblamethemanagementteams1ooand . . .nooneelse.
o-
Attoomanvfnancialfrms,managementbrushedasidethegrowingriskstotheir
frms.AtLehmanBrothers,forexample,MichaelGelband,theheadoffxedincome,
andhiscolleagueMadelvnAntoncicwarnedagainsttakingontoomuchriskinthe
faceofgrowingpressuretocompeteaggressivelvagainstotherinvestmentbanks.An-
toncic,whowasthefrmschiefriskomcerfromiooatoioo,wasshuntedaside:At
theseniorlevel,thevweretrvingtopushsohardthatthewheelsstartedtocomeoff,
shetoldtheCommission.Shewasreassignedtoapolicvpositionworkingwithgov-
. ii N\Nti \i tii :i : i NuUi i tu\\i : :i uN iiiui1
ernmentregulators.
oo
Gelbandleft;LehmanomcialsblamedGelbandsdepartureon
philosophicaldifferences.
o
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
muchasoooftheloansthatCitiwasbuvingweredefective.ThevdidnotmeetCiti-
groupsloanguidelinesandthusendangeredthecompanviftheborrowerswereto
defaultontheirloans,theinvestorscouldforceCititobuvthemback.Bowentoldthe
Commissionthathetriedtoalerttopmanagersatthefrmbvemail,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 reachRobert Rubin,
the chairman of the Executive Committee of the Board of Directors and a former
U.S.treasurvsecretarvintheClintonadministration,andthreeotherbankomcials.
HesentRubinandtheothersamemowiththewordsURGENTREADIMMEDI-
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
bankundertookaninvestigationinresponsetoBowensclaimsandthesvstemofun-
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
thiswasalsothethoughtthatwasthatwashomogeneousthroughoutWallStreets
analvstswas home prices alwavs track income growth and jobs growth. And thev
showedmeincomegrowthononechartandjobsgrowthonanother,andsaid,We
dontseewhatvouretalkingaboutbecauseincomesarestillgrowingandjobsarestill
growing.AndIsaid,well,vouobviouslvdontrealizewherethedogisandwherethe
tailis,andwhatsmovingwhat.
1o:
8ii uii uUi \ii ii: .+
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,saidhedidntlikewhathecalled
themadnessthathaddescendedontherealestatemarket.RanieritoldtheCommis-
sion, I was not the onlv guv. Im not telling vou I was Iohn the Baptist. There were
enoughofus,analvstsandothers,wanderingaroundgoinglookatthisstuff,thatit
wouldbehardtomissit.
1o-
RanierisownHouston-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-
widesMozilotodescribeoneoftheloanproductshisfrmwasoriginating.
1oo
Inall
mvvearsinthebusinessIhaveneverseenamoretoxic[product],hewroteinanin-
ternalemail.
1o
Othersatthebankarguedinresponsethatthevwereofferingprod-
uctspervasivelvofferedinthemarketplacebvvirtuallvevervrelevantcompetitorof
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 -o percent of originations at Coun-
trvwide, -8 percent at Wells Fargo, -1 at National Citv, :1 at Washington
Mutual,io.-atCitiFinancial,and18.:atBankofAmerica.Moreover,thebanks
expectedthattheiroriginationsofnontraditionalloanswouldrisebv1inioo-,to
oo8.-billion.Thereviewalsonotedtheslowlvdeterioratingqualitvofloansdueto
looseningunderwritingstandards.Inaddition,itfoundthattwo-thirdsofthenon-
traditionalloansmadebvthebanksinioo:hadbeenofthestated-income,minimal
documentationvarietvknownasliarloans,whichhadaparticularlvgreatlikelihood
ofgoingsour.
111
ThereactiontoSiddiquesbriefngwasmixed.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 agenciesthe Fed, the OCC, the OTS, the FDIC, and
theNationalCreditUnionAdministrationwouldneedtoworktogetheronit,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,thegroups
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,raisedconcernsthatnontraditionallendingmavprecipitateadownward
spiralthatstartsonthecoastandthencreatespanicintheeastthatcouldhaveimpli-
cationsonourtotaleconomvaswell.
11o
AtthenextmeetingoftheFedsConsumerAdvisorvCouncil,heldinIuneiooo
andattendedbvBernanke,Bies,Olson,andWarsh,severalconsumeradvocatesde-
scribedtotheFedgovernorsalarmingincidentsthatwerenowoccurringalloverthe
8ii uii uUi \ii ii: z.
countrv.EdwardSivak,thedirectorofpolicvandevaluationattheEnterpriseCorp.
of the Delta, in Iackson, Mississippi, spoke of being told bv mortgage brokers that
propertvvalueswerebeinginfatedtomaximizeproftforrealestateappraisersand
loanoriginators.AlanWhite,thesupervisingattornevatCommunitvLegalServices
inPhiladelphia,reportedahugesurgeinforeclosures,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
muchthattheresultwouldbeneighborhooddecav.CarolvnCarteroftheNational
ConsumerLawCenterinMassachusettsurgedtheFedtouseitsregulatorvauthoritv
toprohibitabusesinthemortgagemarket.
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 vearsincluding a require-
mentthatborrowershavetheabilitvtorepavloansmadetothem.
Bvthattime,however,thedamagehadbeendone.Thetotalvalueofmortgage-
backedsecuritiesissuedbetweenioo1andioooreached1:.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.Itsoonbecameclearthatriskratherthanbeingdiversifedacrossthe
fnancial svstem, as had been thoughtwas 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
lostthemarketsconfdence.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-
tionslargestfnancialinstitutions.
Thecrisisthatbefellthecountrvinioo8hadbeenvearsinthemaking.Intesti-
monvtotheCommission,formerFedchairmanGreenspandefendedhisrecordand
saidmostofhisjudgmentshadbeencorrect.IwasrightoofthetimebutIwas
wrong :o of the time, he told the Commission.
1i:
Yet the consequences of what
wentwrongintherun-uptothecrisiswouldbeenormous.
Theeconomicimpactofthecrisishasbeendevastating.Andthehumandevasta-
tioniscontinuing.Theomciallvreportedunemplovmentratehoveredatalmost1o
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,wasabove1.Andtheshareofunemplovedworkerswhohavebeenout
ofworkformorethansixmonthswasjustaboveao.Oflargemetropolitanareas,
Las Vegas, Nevada, and RiversideSan Bernardino, California, had the highest un-
emplovmenttheirrateswereabove1a.
Theloanswereaslethalasmanvhadpredicted,andithasbeenestimatedthatul-
timatelvasmanvas1:millionhouseholdsintheUnitedStatesmavlosetheirhomes
to foreclosure. As of io1o, foreclosure rates were highest in Florida and Nevada; in
Florida, nearlv 1a of loans were in foreclosure, and Nevada was not verv far
behind.
1ia
Nearlvone-quarterofAmericanmortgageborrowersowedmoreontheir
mortgagesthantheirhomewasworth.InNevada,thepercentagewasnearlvo.
1i-
Householdshavelost11trillioninwealthsinceiooo.
As Mark Zandi, the chief economist of Moodvs 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
thatmanvmorepeoplewhoarecapableoftakingonaloanwithzerodownwhowe
8ii uii uUi \ii ii: z.
thinkaregoingtobeabletopavthatoffthanwastrue1o,1-,iovearsago:Imean,
whatschangedintheworld:Therewerealotofthingsthatdidntrequireanvinves-
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.
Itsover,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|papcrandrcpcsUnjcttcrcdnarkcts:;
1hcsavingsand|cancrisis1hcvputa|ctcj
prcssurccnthcirrcgu|atcrs :;
Thefnancialcrisisofiooandioo8wasnotasingleeventbutaseriesofcrisesthat
rippled through the fnancial svstem and, ultimatelv, the economv. Distress in one
areaofthefnancialmarketsledtofailuresinotherareasbvwavofinterconnections
andvulnerabilitiesthatbankers,governmentomcials,andothershadmissedordis-
missed.Whensubprimeandotherriskvmortgagesissuedduringahousingbubble
thatmanvexpertsfailedtoidentifv,andwhoseconsequenceswerenotunderstood
begantodefaultatunexpectedrates,aonce-obscuremarketforcomplexinvestment
securitiesbackedbvthosemortgagesabruptlvfailed.Whenthecontagionspread,in-
vestorspanickedandthedangerinherentinthewholesvstembecamemanifest.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,thesvstemsvulnerabilities,togetherwithgapsinthegovernmentscrisis-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-
quencesacomplexhistorvthatcouldvielditsownreport.Instead,wefocusonfour
kevdevelopmentsthathelpedshapetheeventsthatshookourfnancialmarketsand
economv.Detailedbookscouldbewrittenabouteachofthem;westicktotheessen-
tialsforunderstandingourspecifcconcern,whichistherecentcrisis.
First, we describe the phenomenal growth of the shadow banking svstemthe
investment banks, most prominentlv, but also other fnancial institutionsthat
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-
itableand,itturnedout,vervriskv.
Second, we look at the evolution of fnancial regulation. To the Federal Reserve
andotherregulators,thenewdualsvstemthatgrantedgreaterlicensetomarketpar-
ticipantsappearedtoprovideasaferandmoredvnamicalternativetotheeraoftradi-
tionalbanking.Moreandmore,regulatorslookedtofnancialinstitutionstopolice
themselvesderegulationwasthelabel.FormerFedchairmanAlanGreenspanput
it this wav: The market-stabilizing private regulatorv forces should graduallv dis-
place manv cumbersome, increasinglv ineffective government structures.
i
In the
Fedsview,ifproblemsemergedintheshadowbankingsvstem,thelargecommercial
bankswhichwerebelievedtobewell-run,well-capitalized,andwell-regulatedde-
spitethelooseningoftheirrestraintscouldprovidevitalsupport.Andifproblems
outstrippedthemarketsabilitvtorightitself,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 participantsmortgage brokers, lenders, and Wall Street frmshad 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 derivativeswords that entered the national vocabu-
larvasthefnancialmarketsunraveledthroughiooandioo8.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 modelswhich turned out to be divorced from
realitvandonever-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
nothaveenoughcashonhandtomeetdepositorsdemands: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.TheFDICinsuredbankdepositsuptoi,-ooanamountthat
coveredthevastmajoritvofdepositsatthetime;thatlimitwouldclimbto1oo,ooobv
1o8o,whereitstaveduntilitwasraisedtoi-o,oooduringthecrisisinOctoberioo8.
Depositors no longer needed to worrv about being frst in line at a troubled banks
door.Andifbankswereshortofcash,thevcouldnowborrowfromtheFederalRe-
serve,evenwhenthevcouldborrownowhereelse.TheFed,actingaslenderoflastre-
sort,wouldensurethatbankswouldnotfailsimplvfromalackofliquiditv.
Withthesebackstopsinplace,Congressrestrictedbanksactivitiestodiscourage
them from taking excessive risks, another move intended to help prevent bank fail-
ures,withtaxpaverdollarsnowatrisk.Furthermore,CongresslettheFederalReserve
capinterestratesthatbanksandthriftsalsoknownassavingsandloans,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
ratesthatbankspaidotherbanksforovernightloanshadrarelvexceededointhe
decadesbefore1o8o,whenitreachedio.However,thankstoRegulationO,banks
and thrifts were stuck offering roughlv less than o on most deposits. Clearlv, this
was an untenable bind for the depositorv institutions, which could not compete on
themostbasicleveloftheinterestrateofferedonadeposit.
Competewithwhom:Inthe1oos,MerrillLvnch,Fidelitv,Vanguard,andothers
persuadedconsumersandbusinessestoabandonbanksandthriftsforhigherreturns.
These frmseager 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,andthestatureofthefundssponsorsreassuredthem.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
1otomorethanaobillionin1oo-and1.8trillionbviooo.
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.Commercialpaperwasunsecuredcorporatedebtmeaningthatitwas
backed not bv a pledge of collateral but onlv bv the corporations promise to pav.
Theseloanswerecheaperbecausethevwereshort-termforlessthanninemonths,
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.In1oo,
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 railroads default caused investors to worrv about the broader
commercial paper market; holders of that paperthe lendersrefused 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.
In1o8,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 HUDs authoritv to set af-
fordablehousinggoalsforFannieandFreddie.Congressalsochangedthelanguageto
savthatinthepursuitofaffordablehousing,areasonableeconomicreturn . . .mav
belessthanthereturnearnedonotheractivities.ThelawrequiredHUDtoconsider
theneedtomaintainthesoundfnancialconditionoftheenterprises.Theactnow
orderedHUDtosetgoalsforFannieandFreddietobuvloansforlow-andmoderate-
incomehousing,specialaffordablehousing,andhousingincentralcities,ruralareas,
andotherunderservedareas.CongressinstructedHUDtoperiodicallvsetagoalfor
eachcategorvasapercentageoftheGSEsmortgagepurchases.
In1oo-,PresidentBillClintonannouncedaninitiativetoboosthomeownership
from o-.1 to 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:downpavmentruleforfrst-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-
sionspromoting mortgage lending while maximizing returns to shareholders
were problematic. Former Fannie CEO Daniel Mudd told the FCIC that the GSE
structurerequiredthecompaniestomaintainafnebalancebetweenfnancialgoals
andwhatwecallthemissiongoals . . .therootcauseoftheGSEstroubleslieswith
their business model.
1i
Former Freddie CEO Richard Svron concurred: I dont
thinkitsagoodbusinessmodel.
1:
FannieandFreddieaccumulatedpoliticalcloutbecausethevdependedonfederal
subsidiesandanimplicitgovernmentguarantee,andbecausethevhadtodealwith
regulators,affordablehousinggoals,andcapitalstandardsimposedbvCongressand
HUD.From1oootoioo8,thetworeportedspendingmorethan1oamilliononlob-
bving,andtheiremploveesandpoliticalactioncommitteescontributed1-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
thatthecompanieswereallowedtobe . . .sopoliticallvstrongthatformanvvears
thevresistedthevervlegislationthatmighthavesavedthem.
1o
FormerHUDsecre-
tarvMelMartinezdescribedtotheFCICthewholearmvoflobbviststhatcontinu-
allv paraded in a bipartisan fashion through mv omces. . . . Its prettv amazing the
numberofpeoplethatwereintheiremplov.
1
In1oo-,thatarmvhelpedsecurenewregulationsallowingtheGSEstocountto-
wardtheiraffordablehousinggoalsnotjusttheirwholeloansbutmortgage-related
securitiesissuedbvothercompanies,whichtheGSEswantedtopurchaseasinvest-
ments.Still,CongressionalBudgetOmceDirectorIuneONeilldeclaredin1oo8that
thegoalsarenotdimculttoachieve,anditisnotclearhowmuchthevhaveaffected
theenterprisesactions.Infact . . .depositorvinstitutionsaswellastheFederalHous-
ingAdministrationdevotealargerproportionoftheirmortgagelendingtotargeted
borrowersandareasthandotheenterprises.
18
Somethingelsewasclear:FannieandFreddie,withtheirlowborrowingcostsand
laxcapitalrequirements,wereimmenselvproftablethroughoutthe1ooos.Iniooo,
Fannie had a return on equitv of io; Freddie, :o. That vear, Fannie and Freddie
heldorguaranteedmorethanitrillionofmortgages,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,whichwereoftenmorecomplicatedthantheGSEsbasicmortgage-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-
ketsoftenfrommonevmarketmutualfundstomakeloans,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-
oushousingdownturnsmaderegulatorsworrvaboutbanksholdingwholeloanson
theirbooks.Ifvouhadaregional . . .realestatedownturnittookdownthebanksin
thatregionalongwithit,whichexacerbatedthedownturn,Lindsevsaid.Sowesaid
to ourselves, How on earth do we get around this problem: And the answer was,
Letshaveanationalsecuritiesmarketsowedonthaveregionalconcentration. . . .It
wasintentional.
io
Privatesecuritizations,orstructuredfnancesecurities,hadtwokevbeneftstoin-
vestors:pooling andtranching.Ifmanvloanswerepooledintoonesecuritv,afewde-
faultswouldhaveminimalimpact.Structuredfnancesecuritiescouldalsobesliced
upandsoldinportionsknownastrancheswhichletbuverscustomizetheirpav-
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
tranchesat the top of the waterfallwere paid before the more junior tranches.
Andifpavmentscameinbelowexpectations,thoseatthebottomwouldbethefrst
tobelefthighanddrv.
Securitizationwasdesignedtobeneftlenders,investmentbankers,andinvestors.
Lendersearnedfeesfororiginatingandsellingloans.Investmentbanksearnedfees
forissuingmortgage-backedsecurities.Thesesecuritiesfetchedahigherpricethanif
theunderlvingloansweresoldindividuallv,becausethesecuritieswerecustomized
toinvestorsneeds,weremorediversifed,andcouldbeeasilvtraded.Purchasersof
thesafertranchesgotahigherrateofreturnthanultra-safeTreasurvnoteswithout
muchextrariskatleastintheorv.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 agenciesMoodvs,
Standard&Poors(S&P),andFitchintokevplaversintheprocess,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
Withthesepiecesinplacebanksthatwantedtoshedassetsandtransferrisk,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).Thatincluded11abillionofautomo-
bileloansandoveri-obillionofcreditcarddebt;nearlv1-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 1oos, Wall
Streetexecutiveshadhiredquantsanalvstsadeptinadvancedmathematicaltheorv
and computersto 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- 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.Itsnotliketrvingtoshootarockettothemoonwhere
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
wavpeoplefeelaboutgravitvonagivendavisntgoingtoaffectthewavtherocket
behaves.
i-
PaulVolcker,Fedchairmanfrom1ooto1o8,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,aformerdirectoroftheFedsDivisionofMonetarvAffairs,toldtheCom-
missionthatheandotherregulatorsfailedtoappreciatethecomplexitvofthenewf-
nancialinstrumentsandthedimcultiesthatcomplexitvposedinassessingrisk.
i
Securitization was diversifving the risk, said Lindsev, the former Fed governor.
Butitwasntreducingtherisk. . . .Youasanindividualcandiversifvvourrisk.Thesvs-
temasawhole,though,cannotreducetherisk.Andthatswheretheconfusionlies.
i8
THE GROWTH OF DERIVATIVES: BY FAR THE MOST
SIGNIFICANT EVENT IN FINANCE DURING THE PAST DECADE
During the fnancial crisis, leverage and complexitv became closelv identifed with
oneelementofthestorv:derivatives.Derivativesarefnancialcontractswhoseprices
aredeterminedbv,orderivedfrom,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
discovervthatis,inrevealingthemarketsviewonpricesofcommoditiesorrates
underlvingfuturesandoptions.OTCderivativesaretradedbvlargefnancialinstitu-
tionstraditionallv, bank holding companies and investment bankswhich act as
derivatives dealers, buving and selling contracts with customers. Unlike the futures
andoptionsexchanges,theOTCmarketisneithercentralizednorregulated.Norisit
transparent,andthuspricediscovervislimited.Nomatterthemeasurementtrad-
ing volume, dollar volume, risk exposurederivatives 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.In1oa,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 Acts 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 CFTCs 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 frauda suit settled when Bankers Trust forgave most of the monev that
Procter&Gambleowedit.Thatvear,theCFTCandtheSecuritiesandExchangeCom-
mission(SEC)fnedBankersTrust1omillionformisleadingGibsonGreetingCards
on interest rate swaps resulting in a mark-to-market loss of i: million, larger than
Gibsonsprior-vearprofts.Inlate1ooa,OrangeCountv,California,announcedithad
lost1.-billionspeculatinginOTCderivatives.Thecountvfledforbankruptcvthe
largestbvamunicipalitvinU.S.historv.Itsderivativesdealer,MerrillLvnch,paidaoo
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, Iapans 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.Sumitomosettledfor1-omillion
in penalties and restitution. The CFTC also charged Merrill Lvnch with knowinglv
andintentionallvaiding,abetting,andassistingthemanipulationofcopperprices;it
settledforafneof1-million.
:a
Debateintensifedin1oo8.InMav,theCFTCunderChairpersonBrookslevBorn
said the agencv would reexamine the wav it regulated the OTC derivatives market,
given the markets rapid evolution and the string of major losses since 1oo:. The
CFTCrequestedcomments.Itgotthem.
Somecamefromotherregulators,whotooktheunusualstepofpubliclvcriticiz-
ingtheCFTC.OnthedavthattheCFTCissuedaconceptrelease,TreasurvSecretarv
RobertRubin,Greenspan,andSECChairmanArthurLevittissuedajointstatement
denouncing the CFTCs move: We have grave concerns about this action and its
possibleconsequences. . . .WearevervconcernedaboutreportsthattheCFTCsac-
tion mav increase the legal uncertaintv concerning certain tvpes of OTC deriva-
tives.
:-
Thev proposed a moratorium on the CFTCs abilitv to regulate OTC
derivatives.
Formonths,Rubin,Greenspan,Levitt,andDeputvTreasurvSecretarvLawrence
SummersopposedtheCFTCseffortsintestimonvtoCongressandinotherpublic
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
trillioninnotionalamountofOTCderivativesand1i-billionofsecuritiesona.8
billion of capital without the knowledge of its major derivatives counterparties or
federal regulators.
:
Greenspan testifed to Congress that in the New York Feds
judgment,LTCMsfailurewouldpotentiallvhavehadsvstemiceffects: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 vearafter Borns resignationthe Presidents Working Group on
FinancialMarkets,acommitteeoftheheadsoftheTreasurv,FederalReserve,SEC,and
CommoditvFuturesTradingCommissionchargedwithtrackingthefnancialsvstem
and chaired bv then Treasurv Secretarv Larrv Summers, essentiallv adopted
Greenspansview.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,thenotionalamountofOTCderivativesoutstandinggloballvwaso-.itril-
lion,andthegrossmarketvaluewas:.itrillion.
a1
Inthesevenandahalfvearsfrom
then until Iune ioo8, when the market peaked, outstanding OTC derivatives in-
creasedmorethansevenfoldtoanotionalamountofoi.otrillion;theirgrossmar-
ketvaluewasio.:trillion.
ai
Greenspan testifed to the FCIC that credit default swapsa 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 1ooosdid create
problems during the fnancial crisis.
a:
Rubin testifed that when the CFMA passed
hewasnotopposedtotheregulationofderivativesandhadpersonallvagreedwith
Bornsviews,butthatvervstronglvheldviewsinthefnancialservicesindustrvin
oppositiontoregulationwereinsurmountable.
aa
SummerstoldtheFCICthatwhile
risks could not necessarilv have been foreseen vears ago, bv ioo8 our regulatorv
frameworkwithrespecttoderivativeswasmanifestlvinadequate,andthatthede-
rivativesthatprovedtobebvfarthemostserious,thoseassociatedwithcreditdefault
swaps,increased1oofoldbetweenioooandioo8.
a-
Onereasonfortherapidgrowthofthederivativesmarketwasthecapitalrequire-
mentsadvantagethatmanvfnancialinstitutionscouldobtainthroughhedgingwith
derivatives. As discussed above, fnancial frms mav use derivatives to hedge their
risks.SuchuseofderivativescanlowerafrmsValueatRiskasdeterminedbvcom-
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,orBaselI.
MeetinginBasel,Switzerland,in1o88,theworldscentralbanksandbanksuper-
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-
quirementsforbanksholdingsofFanniesandFreddiessecuritieswerelessthanfor
allotherassetsexceptthoseexplicitlvbackedbvtheU.S.government.
a
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
OTCderivativesletderivativestradersincludingthelargebanksandinvestment
banksincreasetheirleverage.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
couldusederivativestoreceivethesamegainsorlossesasifthevhadboughtthe
actualsecuritv,andwithonlvafractionofabuversinitialfnancialoutlav.
ao
Warren
Buffett,thechairmanandchiefexecutiveomcerofBerkshireHathawavInc.,testifed
totheFCICabouttheuniquecharacteristicsofthederivativesmarket,saving,thev
accentuatedenormouslv,inmvview,theleverageinthesvstem.Hewentontocall
derivativesvervdangerousstuff,dimcultformarketparticipants,regulators,audi-
tors,andinvestorstounderstandindeed,heconcluded,IdontthinkIcouldman-
ageacomplexderivativesbook.
-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,thesellerofferedprotectionagainstdefaultorspecifedcrediteventssuchasa
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.Acarownercaninsureonlvthecarsheownsnotherneighbors.
ButaCDSpurchasercanuseittospeculateonthedefaultofaloanthepurchaserdoes
notown.Theseareoftencallednakedcreditdefaultswapsandcaninfatepotential
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
withoutbeingrequiredtopostonedollarsworthofinitialcollateralormakinganv
otherprovisionforloss.
-i
AIGwasnotalone.Thevalueoftheunderlvingassetsfor
CDSoutstandingworldwidegrewfromo.atrillionattheendofiooatoapeakof
-8.itrillionattheendofioo.
-:
Asignifcantportionwasapparentlvspeculativeor
nakedcreditdefaultswaps.
-a
Much of the risk of CDS and other derivatives was concentrated in a few of the
vervlargestbanks,investmentbanks,andotherssuchasAIGFinancialProducts,a
unitofAIG
--
thatdominateddealinginOTCderivatives.AmongU.S.bankholding
companies, o 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 countrvs fve largest investment
bankswerealsoamongtheworldslargestOTCderivativesdealers.
While fnancial institutions surveved bv the FCIC said thev do not track rev-
enuesandproftsgeneratedbvtheirderivativesoperations,somefrmsdidprovide
estimates.Forexample,GoldmanSachsestimatedthatbetweeni-and:-ofits
revenuesfromiooothroughioooweregeneratedbvderivatives,includingoto
,+ ii N\Nti \i tii :i : i NuUi i tu\\i : :i uN iiiui1
-ofthefrmscommoditiesbusiness,andhalformoreofitsinterestrateandcur-
renciesbusiness.FromMavioothroughNovemberioo8,1::billion,or8o,of
the1--billionoftradesmadebvGoldmansmortgagedepartmentwerederivative
transactions.
-
Whenthenationsbiggestfnancialinstitutionswereteeteringontheedgeoffail-
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|ankingactiviticsShattcrcrcjG|ass-Stcaga|| :
Icng-1crnCapita|Managcncnt
1hatswhathistcrvhadprcvcdtcthcn e
Dct-ccncrashIavcnncrcrisk;
1hcwagcscjhnanccVc||.thiscncsdcingit.schcwcanInctdcit? e)
Iinancia|scctcrgrcwth
Ithinkwccvcrdidhnanccvcrsusthcrca|cccncnve;
EXPANSION OF BANKING ACTIVITIES:
SHATTERER OF GLASSSTEAGALL
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
positionsandcreditorsperceptionthevweretoobigtofail.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
withinthestatesborders.
1
Removing barriers helped consolidate the banking industrv. Between 1ooo and
ioo-,amegamergersoccurredinvolvingbankswithassetsofmorethan1obil-
lioneach.Meanwhilethe1olargestjumpedfromowningi-oftheindustrvsassets
,z
to--.From1oo8toioo,thecombinedassetsofthefvelargestU.S.banksBank
of America, Citigroup, IP Morgan, Wachovia, and Wells Fargomore 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 banksGoldman Sachs, Morgan Stanlev, Merrill Lvnch,
LehmanBrothers,andBearStearnsquadrupled,from1trillionin1oo8toatril-
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 Corporations 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-
tivesusingachainsawandpruningshearstocuttheredtapebindingalargestack
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 agencvs time and discouraged it from making
regulations. Levitt described it as kind of a blood sport to make the particular
agencvlookstupidorineptorvenal.
-
However,otherssaidinterferenceatleastfromtheexecutivebranchwasmod-
est. Iohn Hawke, a former comptroller of the currencv, told the FCIC he found the
TreasurvDepartmentexceedinglvsensitivetohisagencvsindependence.Hissuc-
cessor,IohnDugan,saidstatutorvfrewallspreventedinterferencefromtheexecu-
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,theFedsdirectorofBankingSupervisionandRegulation
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
withtheFedspublicposture.
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-
ulatorscontinuedtoopposelimitsonbanksactivitiesorgrowth.Thebarrierssepa-
rating commercial banks and investment banks had been crumbling, little bv little,
andnowseemedthetimetoremovethelastremnantsoftherestrictionsthatsepa-
ratedbanks,securitiesfrms,andinsurancecompanies.
Inthespringof1ooo,aftervearsofopposingrepealofGlass-Steagall,theSecuri-
tiesIndustrvAssociationthetradeorganizationofWallStreetfrmssuchasGold-
man Sachs and Merrill Lvnchchanged 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,wewereabletoaggressivelventertheirbusinessesinsomecasesmoreaggres-
sivelvthanthevcouldenterours.Sofrstthesecuritiesindustrv,thentheinsurance
companies,andfnallvtheagentscameoverandsaidletsnegotiateadealandwork
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:Wasitpreparedtobreakupthenationslargestfnancialfrm:Wasittime
torepealtheGlass-SteagallAct,onceandforall:
,. ii N\Nti \i tii :i : i NuUi i tu\\i : :i uN iiiui1
AsCongressbeganfashioninglegislation,thebankswerecloseathand.In1ooo,
thefnancialsectorspent18millionlobbvingatthefederallevel,andindividuals
andpoliticalactioncommittees(PACs)inthesectordonatedioimilliontofederal
electioncampaignsintheioooelectioncvcle.From1ooothroughioo8,federallob-
bvingbvthefnancialsectorreachedi.billion;campaigndonationsfromindivid-
ualsandPACstopped1billion.
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 woodat least a feet wideetched with his portrait and the
wordsTheShattererofGlass-Steagall.
1
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 Feds i-
limittheirprimarvregulator,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.Thelegislationsopponentswarnedthatal-
lowingbankstocombinewithsecuritiesfrmswouldpromoteexcessivespeculation
andcouldtriggeracrisislikethecrashof1oio.IohnReed,formerco-CEOofCiti-
group,acknowledgedtotheFCICthat,inhindsight,thecompartmentalizationthat
was created bv Glass-Steagall would be a positive factor, making less likelv a cata-
strophicfailureofthefnancialsvstem.
18
Towinthesecuritiesindustrvssupport,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.
Merrillsindustrialloancompanvgrewfromlessthan1billioninassetsin1oo8to
abillionin1ooo,andto8billioninioo.Lehmansthriftgrewfrom88million
in1oo8to:billionin1ooo,anditsassetsroseashighasiabillioninioo-.
1o
ForinstitutionsregulatedbvtheFed,thenewlawalsoestablishedahvbridregula-
torvstructureknowncolloquiallvasFed-Lite.TheFedsupervisedfnancialholding
companiesasawhole,lookingonlvforrisksthatcutacrossthevarioussubsidiaries
ownedbvtheholdingcompanv.Toavoidduplicatingotherregulatorswork,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-Litemadeitdimcultforanvsingleregulatortoreliablvsee
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.Hecomparedittoasparetire: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 svstems 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,andBankofAmericacouldcompetedirectlvwiththebig
fve investment banksGoldman Sachs, Morgan Stanlev, Merrill Lvnch, Lehman
Brothers, and Bear Stearnsin 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,Greenspanssparetirethathadhelpedmakethesvstemless
vulnerable would be gone when the fnancial crisis emergedall the wheels of the
svstemwouldbespinningonthesameaxle.
LONGTERM 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
1oo8abouti.-timestheusualamount
i-
andhelpedpreventaseriousdisruption
frombecomingmuchworse.Theeconomvavoidedaslump.
NotsoforLong-TermCapitalManagement,alargeU.S.hedgefund.LTCMhad
devastatinglossesonits1i-billionportfolioofhigh-riskdebtsecurities,including
the junk bonds and emerging market debt that investors were dumping.
io
To buv
thesesecurities,thefrmhadborrowediaforeverv1ofinvestorsequitv;
i
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, LTCMs leveraging strategv
had produced magnifcent returns: 1o.o, ai.8, ao.8, and 1.1, while the S&P
-oovieldedanaveragei1.
i8
Butleverageworksbothwavs,andinjustonemonthafterRussiaspartialdefault,
thefundlostmorethanabillionormorethan8oofitsnearlv-billionincapi-
tal.Itsdebtwasabout1iobillion.Thefrmfacedinsolvencv.
io
If it were onlv a matter of less than - billion, LTCMs failure might have been
manageable. But the frm had further leveraged itself bv entering into derivatives
contracts with more than 1 trillion in notional amountmostlv interest rate and
equitvderivatives.
:o
Withvervlittlecapitalinreserve,itthreatenedtodefaultonits
obligationstoitsderivativescounterpartiesincludingmanvofthelargestcommer-
cialandinvestmentbanks.BecauseLTCMhadnegotiateditsderivativestransactions
intheopaqueover-the-countermarket,themarketsdidnotknowthesizeofitsposi-
tionsorthefactthatithadpostedvervlittlecollateralagainstthosepositions.Asthe
Fednotedthen,ifallthefundscounterpartieshadtriedtoliquidatetheirpositions
simultaneouslv,assetpricesacrossthemarketmighthaveplummeted,whichwould
havecreatedexaggeratedlosses.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
LTCMinreturnforooofitsstock.
::
Thefrmscontributedbetween1oomillion
and :oo million each, although Bear Stearns declined to participate.
:a
An orderlv
liquidationofLTCMssecuritiesandderivativesfollowed.
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,theFedsorchestrationraisedaquestion:
howfarwoulditgotoforestallwhatitsawasasvstemiccrisis:
The Feds aggressive response had precedents in the previous two decades. In
1oo,theFedhadsupportedthecommercialpapermarket;in1o8o,dealersinsilver
futures;in1o8i,therepomarket;in1o8,thestockmarketaftertheDowIonesIn-
dustrialAveragefellbviopercentinthreedavs.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
LTCMsrescueindicatethattheFedwaspreparedtoprotectcreditorsofanvtvpeof
frmifitscollapsemightthreatenthecapitalmarkets:HarvevMiller,thebankruptcv
counselforLehmanBrotherswhenitfailedinioo8,toldtheFCICthatthev[hedge
funds]expectedtheFedtosaveLehman,basedontheFedsinvolvementinLTCMs
rescue.Thatswhathistorvhadprovedtothem.
:
For Stanlev ONeal, Merrills 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
saidina1ooospeechthatthesuccessfulresolutionofthe1oo8crisisshowedthatdi-
versitv within the fnancial sector provides insurance against a fnancial problem
turningintoeconomv-widedistress.
:o
ThePresidentsWorkingGrouponFinancial
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
fortailriskanunanticipatedeventcausingcatastrophicdamagetofnancialinstitu-
tionsandtheeconomv.Nevertheless,itcautionedthatoverreactingtothreatssuchas
LTCMwoulddiminishthedvnamismofthefnancialsectorandtherealeconomv:
Policvinitiativesthatareaimedatsimplvreducingdefaultlikelihoodstoextremelv
low levels might be counterproductive if thev unnecessarilv disrupt trading activitv
andtheintermediationofrisksthatsupportthefnancingofrealeconomicactivitv.
ai
Following the Working Groups fndings, the SEC fve vears later would issue a
ruleexpandingthenumberofhedgefundadvisorstoincludemostadvisorsthat
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 herothe Maestrowho had handled everv
emergencvsincethe1o8stockmarketcrash.
aa
DOTCOM 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,fromooobillionin1ooatoi.itrillioninioo1.Annualinitialpublicofferings
ofstocks(IPOs)soaredfromi8billionin1ooatoobillioninioooasbanksand
securities frms sponsored IPOs for new Internet and telecommunications compa-
niesthedot-comsandtelecoms.
a-
Astockmarketboomensuedcomparabletothe
greatbullmarketofthe1oios.Thevalueofpubliclvtradedstocksrosefrom-.8tril-
lioninDecember1ooato1.8trillioninMarchiooo.
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
bullishand,asitturnedout,sometimesdeceptiveresearchreportsissuedbvthe
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
improperpracticesintheallocationofIPOsharesduringthebubbleforspinning
(doling out shares in hot IPOs in return for reciprocal business) and laddering
(dolingoutsharestoinvestorswhoagreedtobuvmorelaterathigherprices).
a
The
regulatorsalsofoundthatpublicresearchreportspreparedbvinvestmentbanksana-
lvstsweretaintedbvconfictsofinterest.TheSEC,NewYorksattornevgeneral,the
NationalAssociationofSecuritiesDealers(nowFINRA),andstateregulatorssettled
enforcementactionsagainst1ofrmsfor8-million,forbadecertainpractices,and
institutedreforms.
a8
ThesuddencollapsesofEnronandWorldComwereshocking;withassetsofo:
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 dollarsalthough admitted no
wrongdoingforhelpingEnronhideitsdebtuntiljustbeforeitscollapse.Enronand
its bankers had created entities to do complex transactions generating fctitious
earnings, disguised debt as sales and derivative transactions, and understated the
frmsleverage.Executivesatthebankshadpressuredtheiranalvststowriteglowing
iiiitUi\1i uN iiiU\ ,+
evaluationsofEnron.ThescandalcostCitigroup,IPMorgan,CIBC,MerrillLvnch,
andotherfnancialinstitutionsmorethanaoomillioninsettlementswiththeSEC;
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-
rivativesappeartohaveeffectivelvspreadlossesfromdefaultsbvEnronandother
largecorporations.Althoughheconcededthemarketwasstilltoonewtohavebeen
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
StreetbankspivotalroleintheEnrondebacledidnotseemtotroubleseniorFedof-
fcials.InamemorandumtotheFCIC,RichardSpillenkothendescribedapresenta-
tiontotheBoardofGovernorsinwhichsomeFedgovernorsreceiveddetailsofthe
bankscomplicitvcoollvandwereclearlvunimpressedbvanalvstsfndings.The
messagetosomesupervisorvstaffwasneitherambiguousnorsubtle,Spillenkothen
wrote.Earlierinthedecade,heremembered,senioreconomistsattheFedhadcalled
Enronanexampleofaderivativesmarketparticipantsuccessfullvregulatedbvmar-
ketdisciplinewithoutgovernmentoversight.
-i
TheFedcutinterestratesaggressivelvinordertocontaindamagefromthedot-
comandtelecombust,theterroristattacks,andthefnancialmarketscandals.InIan-
uarvioo1,thefederalfundsrate,theovernightbank-to-banklendingrate,waso.-.
Bvmid-ioo:,theFedhadcutthatratetojust1,thelowestinhalfacenturv,where
itstavedforanothervear.Inaddition,tooffsetthemarketdisruptionsfollowingthe
o/11attacks,theFedfoodedthefnancialmarketswithmonevbvpurchasingmore
than1-obillioningovernmentsecuritiesandlendinga-billiontobanks.Italso
suspended restrictions on bank holding companies so the banks could make large
loanstotheirsecuritiesamliates.WiththeseactionstheFedpreventedaprotracted
liquiditvcrunchinthefnancialmarketsduringthefallofioo1,justasithaddone
duringthe1o8stockmarketcrashandthe1oo8Russiancrisis.
Whv wouldnt the markets assume the central bank would act againand again
save the dav: Two weeks before the Fed cut short-term rates in Ianuarv ioo1, the
Economist anticipatedit:theGreenspanputisonceagainthetalkofWallStreet. . . .
TheideaisthattheFederalReservecanberelieduponintimesofcrisistocometo
(+ ii N\Nti \i tii :i : i NuUi i tu\\i : :i uN iiiui1
therescue,cuttinginterestratesandpumpinginliquiditv,thusprovidingafoorfor
equitvprices.
-:
TheGreenspanputwasanalvstsshorthandforinvestorsfaiththat
theFedwouldkeepthecapitalmarketsfunctioningnomatterwhat.TheFedspolicv
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 . . .tofocusonpoliciesto
mitigate the fallout when it occurs and, hopefullv, ease the transition to the next
expansion.
-a
This asvmmetric policvallowing unrestrained growth, then working hard to
cushiontheimpactofabustraisedthequestionofmoralhazard: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
acceptinglowercompensationforriskandcautioningthatnewlvabundantliquid-
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 8o greater than in
otherbusinessesaconsiderablvlargergapthanbeforetheGreatDepression.
Until1oo,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-
mentbanksculture.Beforethechange,heandtheotherpartnershadsatinasingle
roomatheadquarters,nottosocializebuttooverhear,interact,andmonitoreach
other.Thevwereallonthehooktogether.Sincethevwerepersonallvliableaspart-
ners,thevtookriskvervseriouslv,Solomonsaid.
-8
BrianLeach,formerlvanexecu-
tive at Morgan Stanlev, described to FCIC staff Morgan Stanlevs 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.Whenvoureaprivatecompanv,
vou dont get paid until vou retire. I mean, vou get a good, vou know, vear-to-vear
compensation.Butthebigpavoutwaswhenvouretire.
-o
When the investment banks went public in the 1o8os and 1ooos, the close rela-
tionshipbetweenbankersdecisionsandtheircompensationbrokedown.Thevwere
nowtradingwithshareholdersmonev.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.Someincludedclawbackprovisionsthat
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 ension rorams. Nonfnancial secLor is all domesLic emloyees exceL Lhose in
fnance and insurance.
Iigurc ;.+
onlvo.8avearduringthe:ovearsafterWorldWarII,laggingcompaniesincreasing
size.
oo
Buttheratepickedupduringthe1oosandrosefastereachdecade,reaching
1oavearfrom1oo-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,averagingmorethanmillionincompensation.
oi
Bothbeforeandaftergoingpublic,investmentbankstvpicallvpaidouthalftheir
revenuesincompensation.Forexample,GoldmanSachsspentbetweenaaandao
avearbetweenioo-andioo8,whenMorganStanlevallottedbetweenaoand-o.
Merrillpaidoutsimilarpercentagesinioo-andiooo,butgave1a1iniooavear
itsuffereddramaticlosses.
o:
Asthescale,revenue,andproftabilitvofthefrmsgrew,compensationpackages
soared for senior executives and other kev emplovees. Iohn Gutfreund, reported to
bethehighest-paidexecutiveonWallStreetinthelate1o8os,received:.imillionin
1o8oasCEOofSalomonBrothers.
oa
StanlevONealspackagewasworthmorethan
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.
o
That vear Wall Street paid workers in New
Yorkroughlv::billioninvear-endbonusesalone.
o8
Totalcompensationforthema-
jorU.S.banksandsecuritiesfrmswasestimatedat1:billion.
oo
Stock options became a popular form of compensation, allowing emplovees to
buvthecompanvsstockinthefutureatsomepredeterminedprice,andthustoreap
rewardswhenthestockpricewashigherthanthatpredeterminedprice.Infact,the
optionwouldhavenovalueifthestockpricewasbelowthatprice.Encouragingthe
awardingofstockoptionswas1oo:legislationmakingcompensationinexcessof1
milliontaxabletothecorporationunlessperformance-based.Stockoptionshadpo-
tentiallv unlimited upside, while the downside was simplv to receive nothing if the
stockdidntrisetothepredeterminedprice.Thesameappliedtoplansthattiedpav
toreturnonequitv:thevmeantthatexecutivescouldwinmorethanthevcouldlose.
These pav structures had the unintended consequence of creating incentives to in-
creasebothriskandleverage,whichcouldleadtolargerjumpsinacompanvsstock
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,thisonesdoingit,sohowcanInotdoit,ifIdontdoit,thenthepeoplearego-
ingtoleavemvplaceandgosomeplaceelse.Managingriskbecamelessofanim-
portantfunctioninabroadbaseofcompanies,Iwouldguess.
o
Andregulatorventities,onesourceofchecksonexcessiverisktaking,hadchal-
lenges recruiting fnancial experts who could otherwise work in the private sector.
LordAdairTurner,chairmanoftheU.K.FinancialServicesAuthoritv,toldtheCom-
mission, Its 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:Itsjustsimplvnevergoingto
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 goaldouble earnings in -
vears to o.ao [per share]. A large part of the executives compensation was tied to
meetingthatgoal.AchievingitbroughtCEOFranklinRaines-imillionofhisoo
millionpavfrom1oo8toioo:.However,Falconsaid,thegoalturnedouttobeun-
achievable without breaking rules and hiding risks. Fannie and Freddie executives
workedhardtopersuadeinvestorsthatmortgage-relatedassetswerearisklessinvest-
ment,whileatthesametimecoveringupthevolatilitvandrisksoftheirownmort-
gageportfoliosandbalancesheets. Fanniesestimateofhowmanvmortgageholders
wouldpavoffwasoffbvaoomillionatvear-end1oo8,whichmeantnobonuses.So
Fannie counted onlv half the aoo million on its books, enabling Raines and other
executivestomeettheearningstargetandreceive1oooftheirbonuses.
:
Compensation structures were skewed all along the mortgage securitization
chain,frompeoplewhooriginatedmortgagestopeopleonWallStreetwhopackaged
themintosecurities.Regardingmortgagebrokers,oftenthefrstlinkintheprocess,
FDIC Chairman Sheila Bair told the FCIC that their standard compensation prac-
tice . . .wasbasedonthevolumeofloansoriginatedratherthantheperformanceand
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 economvrising from about - of gross domestic product
(GDP) to about 8 in the earlv i1st centurv. In 1o8o, fnancial sector profts were
about1-ofcorporateprofts.Inioo:,thevhitahighof::butfellbacktoi
(. 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 Morgans assets increased from oo billion in 1ooo to i.i trillion in
ioo8,acompoundannualgrowthrateof1o.BankofAmericaandCitigroupgrew
bv1aand1iavear,respectivelv,withCitigroupreaching1.otrillioninassetsin
ioo8(downfromi.itrillioninioo)andBankofAmerica1.8trillion.Thein-
vestment banks also grew signifcantlv from iooo to ioo, often much faster than
commercialbanks.Goldmansassetsgrewfromi-obillionin1oooto1.1trillion
bvioo,anannualgrowthrateofi1.AtLehman,assetsrosefrom1oibillionto
oo1billion,or1.
o
Fannie and Freddie grew quicklv, too. Fannies assets and guaranteed mortgages
increasedfrom1.atrillioninioooto:.itrillioninioo8,or11annuallv.AtFred-
die,thevincreasedfrom1trilliontoi.itrillion,or1oavear.
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-
sponsoredenterprisesminimumcapitalrequirementati.-ofassetspluso.a-of
the mortgage-backed securities thev guaranteed. So thev could borrow more than
iooforeachdollarofcapitalusedtoguaranteemortgage-backedsecurities.Ifthev
wantedtoownthesecurities,thevcouldborrowaoforeachdollarofcapital.Com-
bined,FannieandFreddieownedorguaranteed-.:trillionofmortgage-relatedas-
setsattheendofiooagainstjusto.billionofcapital,aratioof-:1.
Fromioootoioo,largebanksandthriftsgenerallvhad1otoiiinassetsfor
each dollar of capital, for leverage ratios between 1o:1 and ii:1. For some banks,
leverageremainedroughlvconstant.IPMorgansreportedleveragewasbetweenio:1
andii:1.WellsFargosgenerallvrangedbetween1o:1and1:1.Otherbanksupped
theirleverage.BankofAmericasrosefrom18:1inioootoi:1inioo.Citigroups
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,evenafterbringing8obillionworthofassetsonbalancesheet,substantial
assets remained off. If those had been included, leverage in ioo would have been
a8:1,orabout-:higher.Incomparison,atWellsFargoandBankofAmerica,in-
cludingoff-balance-sheetassetswouldhaveraisedtheiooleverageratios1and
i8,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 and ii, 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
oftheinvestmentbanksrevenuesandearningswasgeneratedbvtradingandinvest-
ments,includingsecuritizationandderivativesactivities.AtGoldman,revenuesfrom
tradingandprincipalinvestmentsincreasedfrom:oofthetotalin1ootoo8in
ioo.AtMerrillLvnch,thevgenerated--ofrevenueiniooo,upfromaiin1oo.
AtLehman,similaractivitiesgeneratedupto8oofpretaxearningsiniooo,upfrom
:iin1oo.AtBearStearns,thevaccountedformorethan1ooofpretaxearnings
insomevearsafteriooibecauseofpretaxlossesinotherbusinesses.
8o
Between1o8andioo,debtheldbvfnancialcompaniesgrewfrom:trillionto
:otrillion,morethandoublingfrom1:otoioofGDP.FormerTreasurvSecre-
tarvIohnSnowtoldtheFCICthatwhilethefnancialsectormustplavacriticalrole
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 1o8, fnancial companies borrowed 1: in the credit markets for
everv1ooborrowedbvnonfnancialcompanies.Bvioo,fnancialcompanieswere
borrowing-1foreverv1oo.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
Mcrtgagcsccuritizaticn1hisstujjisscccnp|icatcdhcwis
anv|cdvgcingtckncw? e:
Grcatcracccsstc|cndingA|usincsswhcrcwccannakcscncncncv:
Su|princ|cndcrsinturnci|Advcrscnarkctccnditicns;
1hcrcgu|atcrsOh.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 collateralthe house
werentashighasthoseforcarloans,andweremuchlessthancreditcards.Thead-
vantagesofamortgageoverotherformsofdebtweresolidifedin1o8owiththeTax
ReformAct,whichbarreddeductinginterestpavmentsonconsumerloansbutkept
thedeductionformortgageinterestpavments.
In the 1o8os and into the earlv 1ooos, before computerized credit scoringa
statisticaltechniqueusedtomeasureaborrowerscreditworthinessautomatedthe
assessment of risk, mortgage lenders (including subprime lenders) relied on other
factors when underwriting mortgages. As Tom Putnam, a Sacramento-based mort-
gagebanker,toldtheCommission,thevtraditionallvlentbasedonthefourCs:credit
(quantitv, qualitv, and duration of the borrowers 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,butmostincludingHousehold,BenefcialFinance,TheMonev
Store, and Champion Mortgagewere 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 loansoften 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,reaching1:.8tril-
lionin1ooo;11wassecuritizedmortgagesandGSEdebt.Later,mortgagesecurities
made up 18 of the debt markets, overtaking government Treasuries as the single
largestcomponentapositionthevmaintainedthroughthefnancialcrisis.
:
Inthe1ooosmortgagecompanies,banks,andWallStreetsecuritiesfrmsbegan
securitizingmortgages(seefgure-.1).Andmoreofthemweresubprime.Salomon
Brothers, Merrill Lvnch, and other Wall Street frms started packaging and selling
non-agencv mortgagesthat is, loans that did not conform to Fannies and Fred-
diesstandards.Sellingtheserequiredinvestorstoadjustexpectations.Withsecuriti-
zationshandledbvFannieandFreddie,thequestionwasnotwillvougetthemonev
backbutwhen,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 Moodvs. 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
loancrisishadleftUncleSamwithaoibillioninloansandrealestatefromfailed
thriftsandbanks.CongressestablishedtheResolutionTrustCorporation(RTC)in
1o8o to omoad mortgages and real estate, and sometimes the failed thrifts them-
selves,nowownedbvthegovernment.WhiletheRTCwasabletosello.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,ithadsecuritizedi-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,subprimeoriginationsincreasedfromobillion
in1oooto1oobillioniniooo.Theproportionsecuritizedinthelate1ooospeakedat
-o, and subprime mortgage originations share of all originations hovered around
1o.
Securitizations bv the RTC and bv Wall Street were similar to the Fannie and
Freddiesecuritizations.Thefrststepwastogetprincipalandinterestpavmentsfrom
agroupofmortgagestofowintoasinglepool.Butinprivate-labelsecurities(that
is,securitizationsnotdonebvFannieorFreddie),thepavmentswerethentranched
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 subrime securiLies issued divided by oriinaLions 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
marketthose who created, sold, and bought the investmentswould become
highlvdependentonthisslice-and-diceprocess,andregulatorsandmarketpartici-
pantsaliketookforgrantedthatitemcientlvallocatedrisktothosebestableandwill-
ingtobearthatrisk.
To demonstrate how this process worked, well describe a tvpical deal, named
CMLTIiooo-NCi,involvingoamillioninmortgage-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
Citigroupsbalancesheet,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,whoassecuritiza-
tion became increasinglv complicatedcame to relv more heavilv on these ratings.
Trancheswereassignedletterratingsbvtheratingagenciesbasedontheirriskiness.
Inthisreport,ratingsaregenerallvpresentedinS&Psclassifcationsvstem,whichas-
signsratingssuchasAAA(thehighestratingforthesafestinvestments,referredto
hereastriple-A),AA(lesssafethanAAA),A,BBB,andBB,andfurtherdistin-
guishesratingswith+and.AnvthingratedbelowBBB-isconsideredjunk.
MoodvsusesasimilarsvsteminwhichAaaishighest,followedbvAa,A,Baa,
Ba, and so forth. For example, an S&P rating of BBB would correspond to a
MoodvsratingofBaa.InthisCitigroupdeal,thefourseniortranchesthesafest
wereratedtriple-Abvtheagencies.
Belowtheseniortranchesandnextinlineforpavmentswereelevenmezzanine
tranchesso 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,calledtheequitv,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,or8,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 didnt 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 ow
of cash determines the rating
of the securities, with AAA
tranches getting the rst cut
of principal and interest
payments, then AA, then A,
and so on.
3 Tranche
next
etc.
2 Pool
Low risk, low yield
RMBS
TRANCHES
High risk, high yield
MEZZANINE
TRANCHES
These tranches
were often
purchased by
CDOs. See page
128 for an
explanation.
SENIOR
TRANCHES
Pool of
Mortgages
First claim to cash ow
from principal & interest
payments
Securities rms
purchase these loans
and pool them.
next
claim
Collateralized
Debt
Obligation
Iigurc :.:
In1oo:,PresidentBillClintonaskedregulatorstoimprovebanksCRAperform-
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
numbersthatmeasuredbankscompliancewiththelaw.
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,aformerFedgovernorwhowasresponsiblefortheFedsDivi-
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,themarketssawafighttoqualitvthatis,asteepfallinde-
mandamonginvestorsforriskvassets,includingsubprimesecuritizations.Therate
ofsubprimemortgagesecuritizationdroppedfrom--.1in1oo8to:.ain1ooo.
Meanwhile,subprimeoriginatorssawtheinterestrateatwhichthevcouldborrowin
creditmarketsskvrocket.Thevwerecaughtinasqueeze:borrowingcostsincreased
at the verv moment that their revenue stream dried up.
1
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,SFCnotifedinvestorsaboutrecentad-
versemarketconditionsinthesecuritiesmarketsandexpressedconcernaboutthe
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
downorsoldoffmostofTheMonevStoresoperations.
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.Inthesecuritizationprocessaswascommonprac-
ticeinthe1ooosKevstoneretainedtheriskiestfrst-lossresidualtranchesforits
ownaccount.Theseholdingsfarexceededthebankscapital.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,subprimeoriginationstotaled1oobillion
iniooo,downfrom1:-billiontwovearsearlier.
i1
Overthenextfewvears,however,
subprimelendingandsecuritizationwouldmorethanrebound.
THE REGULATORS: OH, I SEE
During the 1ooos, various federal agencies had taken increasing notice of abusive
subprimelendingpractices.Buttheregulatorvsvstemwasnotwellequippedtore-
spondconsistentlvandonanationalbasistoprotectborrowers.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,itsenforcementwasdividedamongAmericasmanvf-
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
inworktodavwithwhatthevvegot.Thevdonthavethestafftogooutandsearch
outmortgageproblems.
i:
Glenn Lonev, deputv director of the Feds Consumer and Communitv Affairs
Division from 1oo8 to io1o, told the FCIC that ever since he joined the agencv in
1o-,FedomcialshadbeendebatingwhetherthevinadditiontotheFTCshould
enforcerulesfornonbanklenders.ButthevworriedaboutwhethertheFedwouldbe
steppingoncongressionalprerogativesbvassumingenforcementresponsibilitiesthat
legislationhaddelegatedtotheFTC.Anumberofgovernorscameinandsaid,You
meantosavwedontlookatthese:Lonevsaid.Andthenwetriedtoexplainitto
them,andthevdsav,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.
i
However,onlv
asmallpercentageofmortgageswereinitiallvsubjecttotheHOEPArestrictions,be-
cause the interest rate and fee levels for triggering HOEPAs coverage were set too
hightocatchmostsubprimeloans.
i8
Evenso,HOEPAspecifcallvdirectedtheFedto
actmorebroadlvtoprohibitactsorpracticesinconnectionwith[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
strictunderwritingguidelinesconcerningtheborrowersabilitvtorepavtheloan.
:o
But in the vears to come, these representations and warranties would prove to be
inaccurate.
Still,theFedcontinuednot topressitsprerogatives.InIanuarv1oo8,itformalized
itslong-standingpolicvofnotroutinelvconductingconsumercomplianceexamina-
tionsofnonbanksubsidiariesofbankholdingcompanies,
:1
adecisionthatwouldbe
criticizedbvaNovember1oooGeneralAccountingOmcereportforcreatingalack
of regulatorv oversight.
:i
The Iulv 1oo8 report also made recommendations on
mortgagereform.
::
Whilepreparingdraftrecommendationsforthereport,Fedstaff
wrotetotheFedsCommitteeonConsumerandCommunitvAffairsthatgiventhe
Boardstraditionalreluctancetosupportsubstantivelimitationsonmarketbehavior,
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 Feds
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
notbebindingbutmerelvlaidoutthecriteriaunderlvingregulatorsbankexamina-
tions.Itexplainedthatrecentturmoilintheequitvandasset-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.Thetaskforcefoundpatternsofabusivepractices,reportingsubstantial
evidenceoftoo-frequentabusesinthesubprimelendingmarket.Ouestionableprac-
tices included loan fipping (repeated refnancing of borrowers loans in a short
time),highfeesandprepavmentpenaltiesthatresultedinborrowerslosingtheeq-
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 sectormeaning
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
Itwasapparentonthegroundasearlvasoooro8 . . .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,toldtheFCICthatthereportsrecommendationslasted
on Capitol Hill a verv short time. . . . There wasnt 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]wasstartedandthelionsshareofitoccurredinthe
nonbank sector, but it clearlv created competitive pressures on
banks. . . .Ithinknippingthisinthebudinioooandioo1withsome
strong consumer rules applving across the board that just simplv said
vouvegottodocumentacustomersincometomakesurethevcanre-
pavtheloan,vouvegottomakesuretheincomeissumcienttopavthe
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
gettheindustrvtoadoptasetofbestpracticesthatwouldincludeavoluntarvban
onmortgagesthatstripborrowersoftheirequitv,andwouldofferborrowerstheop-
portunitvtoavoidprepavmentpenaltiesbvagreeinginsteadtopavahigherinterest
rate.ShereachedouttoEdwardGramlich,agovernorattheFedwhosharedhercon-
cerns, to enlist his help in getting companies to abide bv these rules. Bair said that
GramlichdidnttalkoutofschoolbutmadeitcleartoherthattheFedavenuewasnt
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,andofthose8iwereusedforref-
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
HcusingApcwcrju|sta|i|izingjcrcc :;
Su|princ|cansBuvcrswi||pavahighprcniun ::
CitigrcupInvitcdrcgu|atcrvscrutinv ;:
Icdcra|ru|csIntcndcdtccur|unjaircra|usivc|cnding ;:
StatcsIcng-standingpcsiticn;e
Ccnnunitv-|cndingp|cdgcsVhatwcdcisrcamrncurintcnticn ;
Bankcapita|standardsAr|itragc ;;
Bv the end of iooo, the economv had grown :o straight quarters. Federal Reserve
ChairmanAlanGreenspanarguedthefnancialsvstemhadachievedunprecedented
resilience.Largefnancialcompanieswereoratleasttomanvobserversatthetime,
appeared to beproftable, diversifed, and, executives and regulators agreed, pro-
tectedfromcatastrophebvsophisticatednewtechniquesofmanagingrisk.
Thehousingmarketwasalsostrong.Between1oo-andiooo,pricesroseatanan-
nualrateof-.i;overthenextfvevears,theratewouldhit11.-.
1
Lowerinterest
ratesformortgageborrowerswerepartlvthereason,aswasgreateraccesstomort-
gagecreditforhouseholdswhohadtraditionallvbeenleftoutincludingsubprime
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.Householddebtrosefrom8oofdispos-
ablepersonalincomein1oo:toalmost1:obvmid-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,with8oobillionin
assets, paid :1 billion for Associates First Capital, the second-biggest subprime
lender. Still, subprime lending remained onlv a niche, just 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
fnedCitigroupomillionforlendingviolations,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 a. To stimulate borrowing and spending, the Federal
ReservesFederalOpenMarketCommitteeloweredshort-terminterestratesaggres-
sivelv. On Ianuarv :, ioo1, in a rare conference call between scheduled meetings,
it cut the benchmark federal funds rateat which banks lend to each other
overnightbv a half percentage point, rather than the more tvpical quarter point.
Laterthatmonth,thecommitteecuttherateanotherhalfpoint,anditcontinuedcut-
tingthroughoutthevear11timesinallto1.-,thelowestinaovears.
In the end, the recession of ioo1 was relativelv mild, lasting onlv eight months,
fromMarchtoNovember,andgrossdomesticproduct,orGDPthemostcommon
gauge of the economvdropped bv onlv 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 gearagain. 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,1aofnetjobgrowthwasin
construction.Inioo:,buildersstartedmorethan1.8millionsingle-familvdwellings,
arateunseensincethelate1oos.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.Expertsbegantalkingaboutajoblessrecovervmoreproduction
without a corresponding increase in emplovment. For those with jobs, wages stag-
nated.Betweeniooiandioo-,weeklvprivatenonfarm,nonsupervisorvwagesactu-
allv fell bv 1 after adjusting for infation. Faced with these challenges, the Fed
shiftedperspective,nowconsideringthepossibilitvthatconsumerpricescouldfall,
aneventthathadworsenedtheGreatDepressionsevendecadesearlier.Whilecon-
cerned,theFedbelieveddefationwouldbeavoided.Inawidelvquotediooispeech,
Bernankesaidthechancesofdefationwereextremelvsmallfortworeasons.First,
the economvs 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 Feds monetarv policv kept short-term interest rates low. During ioo:, the
strongestU.S.companiescouldborrowforoodavsinthecommercialpapermarket
atanaverage1.1,comparedwitho.:justthreevearsearlier;ratesonthree-month
Treasurvbillsdroppedbelow1inmid-ioo:fromoiniooo.
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 -.i, : percentage points lower than three
vears earlier. The savings were immediate and large. For a home bought at the me-
dianpriceof18o,ooo,withaiodownpavment,themonthlvmortgagepavment
wouldbei8olessthaniniooo.Ortoturntheperspectivearoundasmanvpeople
didforthesamemonthlvpavmentof1,o,ahomeownercouldmoveupfroma
18o,ooohometoaia-,oooone.
Wachoviamade1ibillioninmortgageloans
betweeniooaandiooounderits1oobillioninunilateralpledges:onlvabout.:
wereevermorethanoodavsdelinquentoverthelifeoftheloan,comparedwithan
estimatednationalaverageof1a.
8
Thebetterperformancewaspartlvtheresultof
Wachovias 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 Banks applica-
tiontomergewithGrandCanvonStateBank,savingthebankscommitmenttoim-
provecommunitvservicecouldnotoffsetitspoorlendingrecord.
o
InApril1o8o,the
FDIC,OCC,andFederalHomeLoanBankBoard(theprecursoroftheOTS)joined
theFedinannouncingthatcommitmentstoregulatorsaboutlendingwouldbecon-
sideredonlvwhenaddressingspecifcproblemsinanotherwisesatisfactorvrecord.
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]saidwerenotgoingtobeinaposturewheretheFedsgoingto
besortofcoercingbanksintomakingdealswith . . .communitvgroupssothatthev
cangettheirapplicationsthrough.
81
Infact,therulesimplementingthe1oo-changestotheCRAmadeitclearthatthe
FederalReservewouldnotconsiderpromisestothirdpartiesorenforceprioragree-
ments with those parties. The rules state an institutions 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,:-obillioninitiativethatincludedpledgesof11-billionforaf-
fordablehousing,:obillionforconsumerlending,18obillionforsmallbusinesses,
andi-and1obillionforeconomicandcommunitvdevelopment,respectivelv.
Thismergerwasperhapsthemostcontroversialofitstimebecauseofthesizeof
thetwobanks.TheFedheldfourpublichearingsandreceivedmorethan1,ooocom-
ments.Supporterstoutedthecommunitvinvestmentcommitment,whileopponents
decried its lack of specifcitv. The Feds internal staff memorandum recommending
approvalrepeatedtheFedsinsistenceonnotconsideringthesepromises: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-
mitmentbutthenwentontostatethatanapplicantmustdemonstrateasatisfactorv
recordofperformanceundertheCRAwithoutrelianceonplansorcommitmentsfor
futureaction. . . .TheBoardbelievesthattheCRAplanwhethermadeasaplanor
as an enforceable commitmenthas no relevance in this case without the demon-
stratedrecordofperformanceofthecompaniesinvolved.
8a
Sowerethesecommitmentsameaningfulstep,oronlvagesture:LlovdBrown,a
managingdirectoratCitigroup,toldtheFCICthatmostofthecommitmentswould
havebeenfulflledinthenormalcourseofbusiness.
8-
Speakingoftheioomerger
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
arrivedatbvworkingcloselvwithourbusinesspartnerswhoprojectcurrentlevels
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,thevintroducedtheRecourseRulegoverninghowmuchcapi-
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,banksheldonlv8incapitalto
protectagainstlossesonresidualinterestsandanvotherexposuresthevretainedin
securitizations; Kevstone and others had been allowed to seriouslv understate their
risksandtonotholdsumcientcapital.Ironicallv,becausethenewrulemadethecap-
italchargeonresidualinterests1oo,itincreasedbanksincentivetoselltheresidual
interests in securitizationsso 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.
Thecapitalrequirementwouldbedirectlvlinkedtotheratingagenciesassessment
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-backedsecuritiesrequiredholdingonlv1.ooincapital(thesameasforsecuri-
tiesbackedbvgovernment-sponsoredenterprises).Butthesameamountinvestedin
anvthingwithaBBratingrequired1oincapital,or1otimesmore.
Bankscouldreducethecapitalthevwererequiredtoholdforapoolofmortgages
simplvbvsecuritizingthem,ratherthanholdingthemontheirbooksaswholeloans.
Ifabankkept1ooinmortgagesonitsbooks,itmighthavetosetasideabout-,in-
cluding a in capital against unexpected losses and 1 in reserves against expected
losses.Butifthebankcreateda1oomortgage-backedsecuritv,soldthatsecuritvin
tranches, and then bought all the tranches, the capital requirement would be about
a.1o.
8
Regulatorvcapitalarbitragedoesplavaroleinbankdecisionmaking,said
DavidIones,aFedeconomistwhowroteanarticleaboutthesubjectiniooo,inan
FCICinterview.Butitis nottheonlvthingthatmatters.
88
Andafnalcomparison:underbankregulatorvcapitalstandards,a1ootriple-A
corporatebondrequired8incapitalfvetimesasmuchasthetriple-Amortgage-
backedsecuritv.Unlikethecorporatebond,itwasultimatelvbackedbvrealestate.
The new requirements put the rating agencies in the drivers seat. How much
capitalabankhelddependedinpartontheratingsofthesecuritiesitheld.Tving
capitalstandardstotheviewsofratingagencieswouldcomeinforcriticismafter
the crisis began. It was a dangerous crutch, former Treasurv Secretarv Henrv
PaulsontestifiedtotheCommission.
8o
However,theFedsIonesnoteditwasbetter
than the alternativeto 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
growthinsubprimemortgagelendingcompanieswithlinesofcredit,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
IcrcigninvcstcrsAnirrcsisti||cprchtcppcrtunitv )o:
McrtgagcsAgccd|can )o;
Icdcra|rcgu|atcrsInnunitvjrcnnanvstatc|awsisasignihcant|cncht )))
Mcrtgagcsccuriticsp|avcrsVa||Strcctwasvcrvhungrvjcrcurprcduct )):
MccdvsGivcna||ankchcck)):
IannicMacandIrcddicMacIcssccnpctitivcinthcnarkctp|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
securitizeloanstoolarge,calledjumboloans,andnonprimeloansthatdidntmeet
theGSEsstandards.Thenonprimeloanssoonbecamethebiggestpartofthemar-
ketsubprimeloansforborrowerswithweakcreditandAlt-Aloans,withcharac-
teristicsriskierthanprimeloans,toborrowerswithstrongcredit.
1
Bvioo-andiooo,WallStreetwassecuritizingone-thirdmoreloansthanFannie
and Freddie. In just two vears, private-label mortgage-backed securities had grown
morethan:o,reaching1.1-trillioniniooo;1weresubprimeorAlt-A.
i
Manvinvestorspreferredsecuritieshighlvratedbvtheratingagenciesorwere
encouraged or restricted bv regulations to buv them. And with vields low on other
highlvratedassets,investorshungeredforWallStreetmortgagesecuritiesbackedbv
higher-vieldmortgagesthoseloansmadetosubprimeborrowers,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-
readvupo1from1oo-toioo:,thisfoodofmonevandthesecuritizationappara-
tushelpedboosthomepricesanother:ofromthebeginningofiooauntilthepeak
in April ioooeven as homeownership was falling. The biggest gains over this pe-
riodwereinthesandstates:placesliketheLosAngelessuburbs(-a),LasVegas
(:o),andOrlando(i).
FOREIGN INVESTORS:
AN IRRESISTIBLE PROFIT OPPORTUNITY
FromIuneioo:throughIuneiooa,theFederalReservekeptthefederalfundsrate
lowat1tostimulatetheeconomvfollowingtheioo1recession.Overthenexttwo
vears,asdefationfearswaned,theFedgraduallvraisedratesto-.i-in1quarter-
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 worlds largest equitv bubble with the worlds 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 1o1 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.imillion
startsinIanuarviooomorethana:o-vearhigh.
As Greenspan told Congress in ioo-, this was a conundrum.
One theorv
pointed to foreign monev. Developing countries were booming andvulnerable to
fnancial problems in the pastencouraged strong saving. Investors in these coun-
tries placed their savings in apparentlv safe and high-vield securities in the United
States.FedChairmanBernankecalleditaglobalsavingsglut.
8
1ui \ui1t\ti \\tui Ni .+.
As the United States ran a large current account defcit, fows into the countrv
were unprecedented. Over six vears from iooo to iooo, U.S. Treasurv debt held bv
foreignomcialpublicentitiesrosefromo.otrillionto1.a:trillion;asapercentage
ofU.S.debtheldbvthepublic,theseholdingsincreasedfrom18.itoi8.8.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 iooojust 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,itcreatedanirresistibleproftopportunitvfortheU.S.
fnancialsvstem:toengineerquasisafedebtinstrumentsbvbundlingriskierassets
andsellingtheseniortranches,Pierre-OlivierGourinchas,aneconomistattheUni-
versitvofCalifornia,Berkelev,toldtheFCIC.
1o
PaulKrugman,aneconomistatPrincetonUniversitv,toldtheFCIC,Itshardto
envisageushavinghadthiscrisiswithoutconsideringinternationalmonetarvcapital
movements.TheU.S.housingbubblewasfnancedbvlargecapitalinfows.Sowere
SpanishandIrishandBalticbubbles.Itsacombinationof,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 8 of mortgage originations in ioo: to io in
ioo-.
1:
About o of subprime borrowers used hvbrid adjustable-rate mortgages
(ARMs) such as i/i8s and :/ismortgages whose low teaser rate lasts for the
frst two or three vears, and then adjusts periodicallv thereafter.
1a
Prime borrowers
alsousedmorealternativemortgages.ThedollarvolumeofAlt-Asecuritizationrose
almost:-ofromioo:toioo-.
1-
Ingeneral,theseloansmadeborrowersmonthlv
.+. ii N\Nti \i tii :i : i NuUi i tu\\i : :i uN iiiui1
1ui \ui1t\ti \\tui Ni .+,
mortgagepavmentsonevermoreexpensivehomesaffordableatleastinitiallv.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 principalanv 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
monthlvpavmentperhapsdramaticallv.OptionARMsrosefromiofmortgages
inioo:tooiniooo.
1o
Simultaneouslv, underwriting standards for nonprime and prime mortgages
weakened. Combined loan-to-value ratiosrefecting frst, second, and even third
mortgagesrose.Debt-to-incomeratiosclimbed,asdidloansmadefornon-owner-
occupiedproperties.FannieMaeandFreddieMacsmarketshareshrankfrom-
ofallmortgagespurchasedinioo:toaiiniooa,anddownto:bviooo.
1
Tak-
ing their place were private-label securitizationsmeaning 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
calledtoxic,Mozilowoulddescribehisao-vear-oldcompanvtotheCommissionas
havinghelpedi-millionpeoplebuvhomesandpreventedsocialunrestbvextending
loanstominorities,historicallvthevictimsofdiscrimination:Countrvwidewasone
ofthegreatestcompaniesinthehistorvofthiscountrvandprobablvmademoredif-
ferencetosocietv,totheintegritvofoursocietv,thananvcompanvinthehistorvof
America.
1o
Lending to home buvers was onlv part of the business. Countrvwides
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. Countrvwides essential business strategv was
originatingwhatwassalableinthesecondarvmarket.
io
Thecompanvsoldorsecu-
ritized8ofthe1.-trillioninmortgagesitoriginatedbetweeniooiandioo-.
Iniooa,Moziloannouncedavervaggressivegoalofgainingmarketdominance
bvcapturing:ooftheoriginationmarket.
i1
Hisshareatthetimewas1i.ButCoun-
trvwidewasnotunique:Ameriquest,NewCenturv,WashingtonMutual,andothersall
pursued loans as aggressivelv. Thev competed bv originating tvpes of mortgages cre-
atedvearsbeforeasnicheproducts,butnowtransformedintoriskier,mass-marketver-
sions.Thedefnitionofagoodloanchangedfromonethatpavstoonethatcouldbe
sold,PatriciaLindsav,formerlvafraudspecialistatNewCenturv,toldtheFCIC.
ii
a/aosen./a:s.\justjort/cejjoreoilitv
Historicallv,i/i8sor:/is,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:/isacquiredanewrole:help-
ingtogetpeopleintohomesortomoveuptobiggerhomes.Ashomesgotlessand
less affordable, vou would adjust for the affordabilitv in the mortgage because vou
couldnt reallv adjust peoples 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 :/is, which, thev said, neither rehabilitated credit nor
turnedrentersintoowners.DavidBerenbaumfromtheNationalCommunitvRein-
vestment Coalition testifed to Congress in the summer of ioo: The industrv has
foodedthemarketwithexoticmortgagelendingsuchasi/i8and:/iARMs.These
exoticsubprimemortgagesoverwhelmborrowerswheninterestratesshootupafter
anintroductorvtimeperiod.
i-
Totheircritics,thevweresimplvawavforlendersto
stripequitvfromlow-incomeborrowers.Theloanscamewithbigfeesthatgotrolled
intothemortgage,increasingthechancesthatthemortgagecouldbelargerthanthe
homesvalueattheresetdate.Iftheborrowercouldnotrefnance,thelenderwould
forecloseandthenownthehomeinarisingrealestatemarket.
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-
niabasedthriftfoundedin1oioandacquiredin1oo:bvMarionandHerbertSan-
dler. In 1o-, the Sandlers merged Golden West with World Savings; Golden West
FinancialCorp.,theparentcompanv,operatedbranchesunderthenameWorldSav-
ings Bank. The thrift issued about ia billion in option ARMs between 1o81 and
ioo-.
io
Unlikeothermortgagecompanies,GoldenWestheldontothem.
Sandler told the FCIC that Golden Wests option ARMsmarketed as Pick-a-
Pavloanshadthelowestlossesintheindustrvforthatproduct.Eveninioo-the
lastvearpriortoitsacquisitionbvWachoviawhenitsportfoliowasalmostentirelv
inoptionARMs,GoldenWestslosseswerelowbvindustrvstandards.Sandlerattrib-
utedGoldenWestsperformancetoitsdiligenceinrunningsimulationsaboutwhat
.+( ii N\Nti \i tii :i : i NuUi i tu\\i : :i uN iiiui1
would happen to its loans under various scenariosfor example, if interest rates
wentupordownorifhousepricesdropped-,even1o.Foraquarterofacen-
turv, it worked exactlv as the simulations showed that it would, Sandler said. And
wehaveneverbeenabletoidentifvasingleloanthatwasdelinquentbecauseofthe
structureoftheloan,muchlessalossorforeclosure.
i
ButafterWachoviaacquired
GoldenWestinioooandthehousingmarketsoured,charge-offsonthePick-a-Pav
portfoliowouldsuddenlvjumpfromo.oatoi.oobvSeptemberioo8.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- of its original size, the Pick-a-Pav mortgage would
recastintoanewfxed-ratemortgage.AtCountrvwideandWashingtonMutual,the
newloanswouldrecastinaslittleasfvevears,orwhenthebalancehitjust11oof
the original size. Thev also offered lower teaser ratesas low as 1and loan-to-
value ratios as high as 1oo. All of these features raised the chances that the bor-
rowers required 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-
ductedastudvtoexplorewhatWashingtonMutualcoulddotoincreasesalesofOp-
tionARMs,ourmostproftablemortgageloan.
i8
Afocusgroupmadeclearthatfew
customerswererequestingoptionARMsandthatthisisnotaproductthatsellsit-
self.
io
ThestudvfoundthebestsellingpointfortheOptionArmwastoshowcon-
sumershowmuchlowertheirmonthlvpavmentwouldbebvchoosingtheOption
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)Consultantsdontbelieveinit . . .anddontthink[its]good
forthecustomer.Youregoingtohavetochangethemindset.
:i
Despitethesechallenges,optionARMoriginationssoaredatWashingtonMutual
from :o billion in ioo: to o8 billion in iooa, when thev were more than half of
WaMusoriginationsandhadbecomethethriftssignatureadjustable-ratehomeloan
product.
::
The average FICO score was around oo, well into the range considered
prime, and about two-thirds were jumbo loansmortgage loans exceeding the
maximum Fannie Mae and Freddie Mac were allowed to purchase or guarantee.
:a
MorethanhalfwereinCalifornia.
:-
CountrvwidesoptionARMbusinesspeakedat1a.-billioninoriginationsinthe
secondquarterofioo-,abouti-ofallitsloansoriginatedthatquarter.
:o
Butithad
to relax underwriting standards to get there. In Iulv iooa, Countrvwide decided it
would lend up to oo of a homes appraised value, up from 8o, and reduced the
minimumcreditscoretoaslowasoio.
:
Inearlvioo-,Countrvwideeasedstandards
again,increasingtheallowablecombinedloan-to-valueratio(includingsecondliens)
too-.
:8
1ui \ui1t\ti \\tui Ni .+,
The risk in these loans was growing. From ioo: to ioo-, the average loan-to-
valueratioroseabouta,thecombinedloan-to-valueratioroseabouto,anddebt-
to-incomeratioshadrisenfrom:ato:8:borrowerswerepledgingmoreoftheir
incometotheirmortgagepavments.Moreover,o8ofthesetwooriginatorsoption
ARMshadlowdocumentationinioo-.
:o
Thepercentageoftheseloansmadetoin-
vestors and speculatorsthat is, borrowers with no plans to use the home as their
primarvresidencealsorose.
Thesechangesworriedthelendersevenasthevcontinuedtomaketheloans.In
SeptemberiooaandAugustioo-,Moziloemailedtoseniormanagementthatthese
loanscouldbringfnancialandreputationalcatastrophe.
ao
Countrvwideshouldnot
marketthemtoinvestors,heinsisted.Pavoptionloansbeingusedbvinvestorsisa
purecommercialspec[ulation]loanandnotthetraditionalhomeloanthatwehave
successfullvmanagedthroughoutourhistorv,MozilowrotetoCarlosGarcia,CEO
ofCountrvwideBank.SpeculativeinvestorsshouldgotoChaseorWellsnotus.Itis
alsoimportantforvouandvourteamtounderstandfrommvpointofviewthatthere
isnothingintrinsicallvwrongwithpavoptionsloansthemselves,theproblemisthe
qualitvofborrowerswhoarebeingofferedtheproductandtheabusebvthirdpartv
originators. . . . [I]f vou are unable to fnd sumcient product then slow down the
growthoftheBankforthetimebeing.
a1
However, Countrvwides growth did not slow. Nor did the volume of option
ARMsretainedonitsbalancesheet,increasingfrom-billioniniooatoiobillion
in ioo- and peaking in iooo at :: billion.
ai
Finding these loans verv proftable,
through iooo, WaMu also retained option ARMsmore 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 Wellss decision
not to write option ARMs, even as it originated manv other high-risk mortgages.
Thesewereharddecisionstomakeatthetime,hesaid,notingwedidloserevenue,
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 amortizingwhich
meant their equitv was being eaten awav. The percentage of Countrvwides option
ARMsthatwerenegativelvamortizinggrewfromjust1iniooato-:inioo-and
thentomorethanoobvioo.
a-
AtWaMu,itwasiinioo:,i8iniooa,and8i
inioo.
ao
Declinesinhousepricesaddedtoborrowersproblems: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.
a
Mona Tawatao, a regional counsel with Legal Services of Northern California, de-
scribedtheborrowersshewasassistingaspeoplewhogotsteeredordefraudedinto
entering option ARMs with teaser rates or pick-a-pav loans forcing them to pav
intopav 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
Incrvritingsteners.\crcgoingto/evcto/olournosc
Anothershiftwouldhaveseriousconsequences.Fordecades,thedownpavmentfor
aprimemortgagehadbeenio(inotherwords,theloan-to-valueratio(LTV)had
been 8o). As prices continued to rise, fnding the cash to put io down became
harder,andfromioooon,lendersbeganacceptingsmallerdownpavments.
There had alwavs been a place for borrowers with down pavments below io.
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 io 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.Thegoalwastocurtailabusiverealestatelendingpracticesinorderto
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 banks total holdings of loans with
LTVsaboveoothatlackedmortgageinsuranceorsomeotherprotection;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 8o of the
homesvalueandasecondmortgageforanother1oorevenio.Borrowersliked
thesebecausetheirmonthlvpavmentswereoftencheaperthanatraditionalmort-
gageplustherequiredmortgageinsurance,andtheinterestpavmentsweretaxde-
ductible. Lenders liked them because the smaller frst mortgageeven without
mortgageinsurancecouldpotentiallvbesoldtotheGSEs.
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.Piggvbackloanswhichoftenrequired
nothingdownguaranteedthatmanvborrowerswouldendupwithnegativeequitv
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-
mentaskedforthoughtsonwhattodowiththis . . .prettvcompellinginformation.
Nonetheless,NewCenturvincreasedmortgageswithpiggvbacksto:-ofloanpro-
ductionbvtheendofioo-,upfromonlvoinioo:.
-:
Thevwerenotalone.Across
securitized subprime mortgages, the average combined LTV rose from o to 8o
betweenioo1andiooo.
-a
Anotherwavtogetpeopleintomortgagesandquicklvwastorequirelessin-
formationoftheborrower.Statedincomeorlow-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.IfImmakingao-,-,oloan-to-value,Imnot
going to get all of the documentation, Sandler of Golden West told the FCIC. The
process was too cumbersome and unnecessarv. He alreadv had a good idea how
muchmonevteachers,accountants,andengineersmadeandifhedidnt,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-docloansskvrocketedfromlessthanitoroughlvoofalloutstand-
ingloans.
-o
AmongAlt-Asecuritizations,8oofloansissuediniooohadlimitedor
no documentation.
-
As William Black, a former banking regulator, testifed before
the FCIC, the mortgage industrvs own fraud specialists described stated income
..+ ii N\Nti \i tii :i : i NuUi i tu\\i : :i uN iiiui1
loansasanopeninvitationtofraudthatjustifedtheindustrvtermliarsloans.
-8
Speakingoflendinguptoioo-atCitigroup,RichardBowen,aveteranbankerinthe
consumer lending group, told the FCIC, A decision was made that Were going to
havetoholdournoseandstartbuvingthestatedproductifwewanttostavinbusi-
ness.
-o
Iamie Dimon, the CEO of IP Morgan, told the Commission, In mortgage
underwriting,somehowwejustmissed,vouknow,thathomepricesdontgoupfor-
everandthatitsnotsumcienttohavestatedincome.
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,-:ojustunderthemedianhomepriceofii1,oooiniooo.
o1
Thevastmajor-
itvhada:o-vearmaturitv,andmorethanoowereoriginatedinMav,Iune,andIulv
iooo,justafternationalhomepriceshadpeaked.Morethanoowerereportedlvfor
primarvresidences,witha:forhomepurchasesanda8forcash-outrefnancings.
Theloanswerefromall-ostatesandtheDistrictofColumbia,butmorethanaffth
camefromCaliforniaandmorethanatenthfromFlorida.
oi
About8ooftheloanswereARMs,andmostofthesewerei/i8sor:/is.Ina
twist,manvofthesehvbridARMshadotheraffordabilitvfeaturesaswell.Forex-
ample,morethaniooftheARMswereinterest-onlvduringthefrsttwoorthree
vears,notonlvwouldborrowerspavalowerfxedrate,thevwouldnothavetopav
anvprincipal.Inaddition,morethanaooftheARMswerei/i8hvbridballoon
loans, in which the principal would amortize over ao vearslowering the monthlv
pavmentsevenfurther,butasaresultleavingtheborrowerwithafnalprincipalpav-
mentattheendofthe:o-vearterm.
Thegreatmajoritvofthepoolwassecuredbvfrstmortgages;ofthese,::hada
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- and 1oo.
Raisingtheriskabitmore,aiofthemortgageswereno-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
thriftsandbanksandtheirfederalregulatorstheOmceofThriftSupervision(OTS)
andtheOmceoftheComptrolleroftheCurrencv(OCC),respectivelvresistedthe
1ui \ui1t\ti \\tui Ni ...
stateseffortstoregulatethosenationalbanksandthrifts.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,
theregulatorpronouncedinvalidNewMexicosbansonballoonpavments,negative
amortization,prepavmentpenalties,loanfipping,andlendingwithoutregardtothe
borrowersabilitvtorepav.
TheComptrolleroftheCurrencvtookthesamelineonthenationalbanksthatit
regulated,offeringpreemptionasaninducementtouseanationalbankcharter.Ina
iooispeech,beforethefnalOCCruleswerepassed,ComptrollerIohnD.HawkeIr.
pointedtonationalbanksimmunitvfrommanvstatelawsasasignifcantbeneft
ofthenationalcharterabeneftthattheOCChasfoughthardoverthevearstopre-
serve.
oo
Inaninterviewthatvear,Hawkeexplainedthatthepotentiallossofregula-
torvmarketsharefortheOCCwasamatterofconcern.
o
In August ioo: the OCC issued its frst preemptive order, aimed at Georgias
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
morethan1trillionsaidthevwouldconvertfromstatecharterstonationalcharters,
whichincreasedOCCsannualbudget1-.
o8
State-chartered operating subsidiaries were another point of contention in the
preemptionbattle.Inioo1theOCChadadoptedaregulationpreemptingstatelaw
regardingstate-charteredoperatingsubsidiariesofnationalbanks.Inresponse,sev-
erallargenationalbanksmovedtheirmortgage-lendingoperationsintosubsidiaries
and asserted that the subsidiaries were exempt from state mortgage lending laws.
Fourstateschallengedtheregulation,buttheSupremeCourtruledagainstthemin
ioo.
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 i 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. . . .Inthewakeofthefederalregulatorspushtocurtailstate
authoritv,manvofthelargestmortgage-lendersshedtheirstatelicenses
andsoughtshelterbehindtheshieldofanationalcharter.AndIthink
that it is no coincidence that the era of expanded federal preemption
gaverisetotheworstlendingabusesinournationshistorv.
1
ComptrollerHawkeofferedtheFCICadifferentinterpretation:Whilesomecrit-
icshavesuggestedthattheOCCsactionsonpreemptionhavebeenagrabforpower,
thefactisthattheagencvhassimplvrespondedtoincreasinglvaggressiveinitiatives
atthestateleveltocontrolthebankingactivitiesoffederallvcharteredinstitutions.
i
MORTGAGE SECURITIES PLAYERS:
WALL STREET WAS VERY HUNGRY FOR OUR PRODUCT
Subprime and Alt-A mortgagebacked securities depended on a complex supplv
chain,largelvfundedthroughshort-termlendinginthecommercialpaperandrepo
marketwhichwouldbecomecriticalasthefnancialcrisisbegantounfoldinioo.
TheseloanswereincreasinglvcollateralizednotbvTreasuriesandGSEsecuritiesbut
bvhighlvratedmortgagesecuritiesbackedbvincreasinglvriskvloans.Independent
mortgage originators such as Ameriquest and New Centurvwithout access to de-
positstvpicallvreliedonfnancingtooriginatemortgagesfromwarehouselinesof
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
asbillioninwarehouselinesofcredittomortgageoriginators,includingo-omil-
lion to New Centurv and more than :.- billion to Ameriquest.
:
Citigroup CEO
ChuckPrincetoldtheFCIChewouldnothaveapproved,hadheknown.Ifoundout
attheendofmvtenure,Ididnotknowitbefore,thatwehadsomewarehouselines
outtosomeoriginators.AndIthinkgettingthatclosetotheoriginationfunction
beingthatinvolvedintheoriginationofsomeoftheseproductsissomethingthatI
wasntcomfortablewithandthatIdidnotviewasconsistentwiththeprescriptionI
hadlaiddownforthecompanvnottobeinvolvedinoriginatingtheseproducts.
a
Asearlvas1oo8,Moodvscalledthenewasset-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-halfofcommercialpapersoldbetween1ooandioo1.
1ui \ui1t\ti \\tui Ni ...
Inioo1,onlvfvemortgagecompaniesborrowedatotalofabillionthroughas-
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,itwasborrowing1: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 a 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
substantialpressureonbanksbalancesheets.
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.ooftheliquiditvsupportbanksprovidedto
theABCPprograms.However,afterstrongpushbacktheAmericanSecuritization
Forum,anindustrvassociation,calledthatchargearbitrarv,andStateStreetBank
complained it was too conservative
o
regulators in iooa announced a fnal rule
settingthechargeatuptoo.8,orhalftheamountofthefrstproposal.Growthin
thismarketresumed.
Regulatorvchangesinthiscase,changesinthebankruptcvlawsalsoboosted
growthintherepomarketbvtransformingthetvpesofrepocollateral.Priortoioo-,
repo lenders had clear and immediate rights to their collateral following the bor-
rowers 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,theseilliquid,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 banksincluding
Morgan Stanlev (aia million); Barclavs Capital, a division of a U.K.-based bank
(ii1million);BankofAmerica(1amillion);andBearStearns(oamillion).
81
The
fnancingwasprovidedwhenNewCenturvoriginatedthesemortgages;soforabout
twomonths,NewCenturvowedthesebanksapproximatelvoaomillionsecuredbv
themortgages.Another1imillioninfundingcamefromNewCenturvitself,includ-
ing:millionthroughitsowncommercialpaperprogram.OnAugustio,iooo,Citi-
grouppaidNewCenturvoomillionforthemortgages(andaccruedinterest),and
NewCenturvrepaidtherepolendersafterkeepingaiamillion(i.-)premium.
8i
1/cinvcstorsint/ccel
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 specic payments
Selected Investors in CMLTI 2006-NC2
S
E
N
I
O
R
M
E
Z
Z
A
N
I
N
E
E
Q
U
I
T
Y
1
Standard & Poors.
2
The yield is the rate on the one-month London Interbank Ofered Rate (LIBOR), an interbank lending
interest rate, plus the spread listed. For example, when the deal was issued, Fannie Mae would have
received the LIBOR rate of 5.32% plus 0.14% to give a total yield of 5.46%.
A wide variety of investors throughout the world purchased the securities in this
deal, including Fannie Mae, many international banks, SIVs and many CDOs.
SOURCES: Citigroup; Standard & Poors; FCIC calculations
1
%
2
1
%
7
8
%
Iigurc ;.:
1ui \ui1t\ti \\tui Ni ..,
-8imillion,wenttomorethanioinstitutionalinvestorsaroundtheworld,spread-
ing the risk globallv.
8a
These triple-A tranches represented 8 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 i1 of the total
valueofthesecuritv.Iflossesroseabove1to:(bvdesignthethresholdwouldin-
crease over time), investors in the residual tranches would be wiped out, and the
mezzanineinvestorswouldstarttolosemonev.Creatorsofcollateralizeddebtobliga-
tions, or CDOsdiscussed in the next chapterbought most of the mezzanine
tranchesratedbelowtriple-AandnearlvallthoseratedbelowAA.Onlvafewofthe
highest-ratedmezzaninetrancheswerenotputintoCDOs.Forexample,ChevneFi-
nanceLimitedpurchasedmillionofthetopmezzaninetranche.Chevneastruc-
tured investment vehicle (SIV)would be one of the frst casualties of the crisis,
sparking panic during the summer of ioo. Parvest ABS Euribor, which purchased
io million of the second mezzanine tranche,
8o
would be one of the BNP Paribas
fundswhichhelpedignitethefnancialcrisisthatsummer.
8
Tvpicallv,investorsseekinghighreturns,suchashedgefunds,wouldbuvtheeq-
uitv tranches of mortgage-backed securities; thev would be the frst to lose if there
wereproblems.Theseinvestorsanticipatedreturnsof1-,io,oreven:o.Citi-
groupretainedpartoftheresidualorfrst-losstranches,sharingtherestwithCap-
markFinancialGroup.
88
(omjcnsetcvcrvvcll
Thebusinessofstructuring,selling,anddistributingthisdeal,andthethousandslike
it, was lucrative for the banks. The mortgage originators profted when thev sold
loansforsecuritization.
8o
Someofthisproftfoweddowntoemploveesparticularlv
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 Centurvs 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:todrivegrowthinhighermarginproducts(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.i and 1.-) as discounts, concessions, or commissions.
oi
For a 1 billion
deallikeCMLTIiooo-NCi,a1feewouldearnCitigroup1omillion.Inthiscase,
though, Citigroup instead kept parts of the residual tranches. Doing so could vield
largeproftsaslongasthedealperformedasexpected.
OptionsGroup,whichcompilescompensationfguresforinvestmentbanks,exam-
inedthemortgage-backedsecuritiessalesandtradingdesksat11commercialandin-
vestmentbanksfromioo-toioo.
o:
Itfoundthatassociateshadaverageannualbase
salariesofo-,oootooo,ooofromioo-throughioo,butreceivedbonusesthatcould
wellexceedtheirsalaries.Onthenextrung,vicepresidentsaveragedbasesalariesand
bonusesfromioo,oooto1,1-o,ooo.Directorsaveragedoi-,oooto1,oi-,ooo.
oa
At
thetopwastheheadoftheunit.Forexample,iniooo,DowKim,theheadofMerrills
Global Markets and Investment Banking segment, received a base salarv of :-o,ooo
plusa:-millionbonus,apackagesecondonlvtoMerrillLvnchsCEO.
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;andtheratingagenciesjudgmentwasbakedintocollateralagreements
andotherfnancialcontracts.Toexaminetheratingprocess,theCommissionfocused
onMoodvsInvestorsService,thelargestandoldestofthethreeratingagencies.
The rating of structured fnance products such as mortgage-backed securities
made up close to half of Moodvs rating revenues in ioo-, iooo, and ioo.
oo
From
ioootoioo,revenuesfromratingsuchfnancialinstrumentsincreasedmorethan
fourfold.
o
Buttheratingprocessinvolvedmanvconficts,whichwouldcomeintofo-
cusduringthecrisis.
Todoitswork,Moodvsratedmortgage-backedsecuritiesusingmodelsbased,in
part,onperiodsofrelativelvstrongcreditperformance.Moodvsdidnotsumcientlv
account for the deterioration in underwriting standards or a dramatic decline in
homeprices.AndMoodvsdidnotevendevelopamodelspecifcallvtotakeintoac-
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-dealerstobasethemoncreditratingsbvanationallvrecognizedstatisti-
calratingorganization(NRSRO);atthetime,thatwasMoodvs,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,aformerMoodvsmanag-
ingdirector,wouldsummarizethesituation,theratingagenciesweregivenablank
check.
1o:
Theagenciesthemselves wereabletoavoidregulationfordecades.Beginningin
1o-,theSEChadtoapproveacompanvsapplicationtobecomeanNRSRObutif
approved,acompanvfacednofurtherregulation.Morethan:ovearslater,theSEC
gotlimitedauthoritvtooverseeNRSROsintheCreditRatingAgencvReformActof
iooo. That law, taking effect in Iune ioo, focused on mandatorv disclosure of the
ratingagenciesmethodologies;however,thelawbarredtheSECfromregulatingthe
substanceofthecreditratingsortheproceduresandmethodologies.
1oa
Manv investors, such as some pension funds and universitv endowments, relied
oncreditratingsbecausethevhadneitheraccesstothesamedataastheratingagen-
ciesnorthecapacitvoranalvticalabilitvtoassessthesecuritiesthevwerepurchasing.
As Moodvs former managing director Ierome Fons has acknowledged, Subprime
[residentialmortgagebackedsecurities]andtheiroffshootsofferlittletransparencv
aroundcompositionandcharacteristicsoftheloancollateral. . . .Loan-bv-loandata,
thehighestlevelofdetail,isgenerallvnotavailabletoinvestors.
1o-
Others,evenlarge
1ui \ui1t\ti \\tui Ni ..+
fnancialinstitutions,reliedontheratings.Still,someinvestorswhodidtheirhome-
workwereskepticaloftheseproductsdespitetheirratings.ArnoldCattani,chairman
ofMissionBankinBakersfeld,California,describeddecidingtosellthebankshold-
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:Andhecouldntanswer
thequestion.AndItoldhimtosellthem,sellallofthem,then,because
wedidntunderstandit,andIdontknowthatwehadthecapabilitvto
understandthefnancialcomplexities;didntwantanvpartofit.
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. Moodvs standard disclaimer reads The ratings . . . are, and must be
construedsolelvas,statementsofopinionandnotstatementsoffactorrecommen-
dationstopurchase,sell,orholdanvsecurities.GarvWitt,aformerteammanaging
directoratMoodvs,toldtheFCIC,Peopleexpecttoomuchfromratings . . .invest-
mentdecisionsshouldalwavsbebasedonmuchmorethanjustarating.
1o
Ivcrvt/ingoutt/cclcj/entsittingont/cteolc
Theratingswereintendedtoprovideameansofcomparingrisksacrossassetclasses
andtime.Inotherwords,theriskofatriple-Aratedmortgagesecuritvwassupposed
tobesimilartotheriskofatriple-Aratedcorporatebond.
Since the mid-1ooos, Moodvs has rated tranches of mortgage-backed securities
usingthreemodels.Thefrst,developedin1ooo,ratedresidentialmortgagebacked
securities.Inioo:,Moodvscreatedanewmodel,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
Moodvsautomatemoreoftheprocess.AlthoughMoodvsdidnotsampleorreview
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-
wardatapproximatelvapervear.
1oo
Themodelputlittleweightonthepossibilitv
priceswouldfallsharplvnationwide.IavSiegel,aformerMoodvsteammanagingdi-
rectorinvolvedindevelopingthemodel,toldtheFCIC,Theremavhavebeen[state-
level]componentsofthisrealestatedropthatthestatisticswouldhavecovered,but
.z+ ii N\Nti \i tii :i : i NuUi i tu\\i : :i uN iiiui1
the:8nationaldrop,stavingdownoverthisshortbutmultiple-vearperiod,ismore
stressfulthanthestatisticscallfor.Evenashousingpricesrosetounprecedentedlev-
els,Moodvsneveradjustedthescenariostoputgreaterweightonthepossibilitvofa
decline.AccordingtoSiegel,inioo-,Moodvspositionwasthattherewasnota . . .
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 Moodvs credit rat-
ingsarederivedsolelvfromtheapplicationofamathematicalprocessormodel.This
isnotthecase. . . .Thecreditratingprocessinvolvesmuchmoremostimportantlv,
the exercise of independent judgment bv members of the rating committee. Ulti-
matelv,ratingsaresubjectiveopinionsthatrefectthemajoritvviewofthecommit-
teesmembers.
11i
AsRogerStein,aMoodvsmanagingdirector,noted,Overall,the
modelhastocontemplateeventsforwhichthereisnodata.
11:
Afterratingsubprimedealswiththe1ooomodelforvears,inioooMoodvsintro-
duced a parallel model for rating subprime mortgagebacked securities. Like M:
Prime, the subprime model ran the mortgages through 1,i-o scenarios.
11a
Moodvs
omcialstoldtheFCICthevrecognizedthatstressscenarioswerenotsumcientlvse-
vere,sothevappliedadditionalweighttothemoststressfulscenario,whichreduced
the portion of each deal rated triple-A. Stein, who helped develop the subprime
model,saidtheoutputwasmanuallvcalibratedtobemoreconservativetoensure
predicted losses were consistent with analvsts expert views. Stein also noted
Moodvsconcernaboutasuitablvnegativestressscenario;forexample,asonestep,
analvststookthesingleworstcasefromtheM:Subprimemodelsimulationsand
multiplieditbvafactorinordertoadddeterioration.
11-
Moodvsdidnot,however,sumcientlvaccountforthedeterioratingqualitvofthe
loansbeingsecuritized.FonsdescribedthisproblemtotheFCIC:Isatonthishigh-
levelStructuredCreditcommittee,whichvoudthinkwouldbedealingwithsuchis-
sues[ofdecliningmortgage-underwritingstandards],andneveroncewasitraisedto
thisgrouporputonouragendathatthedeclineinqualitvthatwasgoingintopools,
theimpactpossiblvonratings,otherthings. . . .Wetalkedaboutevervthingbut,vou
know,theelephantsittingonthetable.
11o
TorateCMLTIiooo-NCi,oursampledeal,Moodvsfrstuseditsmodeltosimu-
latelossesinthemortgagepool.Thoseestimates,inturn,determinedhowbigthejun-
iortranchesofthedealwouldhavetobeinordertoprotecttheseniortranchesfrom
losses.Inanalvzingthedeal,theleadanalvstnoteditwassimilartoanotherCitigroup
dealofNewCenturvloansthatMoodvshadratedearlierandrecommendedthesame
amount.
11
Thenthedealwastweakedtoaccountforcertainriskiertvpesofloans,in-
cluding interest-onlv mortgages.
118
For its efforts, Moodvs was paid an estimated
io8,ooo.
11o
(S&Palsoratedthisdealandreceived1:-,ooo.)
1io
As we will describe later, three tranches of this deal would be downgraded less
thanavearafterissuancepartofMoodvsmassdowngradeonIulv1o,ioo,when
housing prices had declined bv onlv a. In October ioo, the MaM11 tranches
1ui \ui1t\ti \\tui Ni .z.
weredowngradedandbvioo8,allthetrancheshadbeendowngraded.Ofallmort-
gage-backed securities it had rated triple-A in iooo, Moodvs downgraded : 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
moreonaccountingandotheroperationalissuesthanonFanniesandFreddiesin-
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.Freddies
board ousted most top managers, including Chairman and CEO Leland Brendsel,
President and COO David Glenn, and CFO Vaughn Clarke.
1ia
In December ioo:,
FreddieagreedwithOFHEOtopava1i-millionpenaltvandcorrectgovernance,
internal controls, accounting, and risk management. In Ianuarv iooa, OFHEO di-
rectedFreddietomaintain:omorethanitsminimumcapitalrequirementuntilit
reduced operational risk and could produce timelv, certifed fnancial statements.
FreddieMacwouldsettleshareholderlawsuitsfora1omillionandpav-omillion
inpenaltiestotheSEC.
Fanniewasnext.InSeptemberiooa,OFHEOdiscoveredviolationsofaccounting
rulesthatcalledintoquestionpreviousflings.Iniooo,OFHEOreportedthatFannie
hadoverstatedearningsfrom1oo8throughiooibv11billionandthatit,too,had
manipulatedaccountinginwavsinfuencedbvcompensationplans.
1i-
OFHEOmade
Fannieimproveaccountingcontrols,maintainthesame:ocapitalsurplusimposed
on Freddie, and improve governance and internal controls. Fannies board ousted
CEO Franklin Raines and others, and the SEC required Fannie to restate its results
forioo1throughmid-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 managements 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 mortgagebacked securities
(PLS)issuedbvWallStreetincreasedfrom8billioninioo1toao-billioninioo-
(showninfgure.:);thevalueofAlt-Amortgagebackedsecuritiesincreasedfrom
11 billion to ::i billion. Starting in ioo1 for Freddie and iooi for Fannie, the
GSEsparticularlvFreddiebecamebuversinthismarket.Whileprivateinvestors
alwavs bought the most, the GSEs purchased 1o.- of the private-issued subprime
mortgagebackedsecuritiesinioo1.Thesharepeakedataoiniooaandthenfell
back to i8 in ioo8. The share for Alt-A mortgagebacked 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 securitiesdisproportionatelv from their purchases of Alt-A securities. Bv
the third quarter of io1o, total impairments on securities totaled ao billion at the
twocompaniesenoughtowipeoutnearlvoooftheirpre-crisiscapital.
1i8
OFHEO knew about the GSEs purchases of subprime and Alt-A mortgage
backedsecurities.Initsiooaexamination,theregulatornotedFreddiespurchasesof
these securities. It also noted that Freddie was purchasing whole mortgages with
higherriskattributeswhichexceededtheEnterprisesmodelingandcostingcapabil-
ities, including No Income/No Asset loans that introduced considerable risk.
OFHEO reported that mortgage insurers were alreadv seeing abuses with these
loans.
1io
Buttheregulatorconcludedthatthepurchasesofmortgage-backedsecuri-
tiesandriskiermortgageswerenotasignifcantsupervisorvconcern,andtheex-
amination focused more on Freddies efforts to address accounting and internal
defciencies.
1:o
OFHEO included nothing in Fannies report about its purchases of
subprimeandAlt-Amortgagebackedsecurities,anditscreditriskmanagementwas
deemedsatisfactorv.
1:1
ThereasonsfortheGSEspurchasesofsubprimeandAlt-Amortgagebackedse-
curities have been debated. Some observers, including Alan Greenspan, have linked
theGSEspurchasesofprivatemortgagebackedsecuritiestotheirpushtofulflltheir
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,FannieMaes
single-andmultifamilvpurchasesalonemeteachofthegoals;inotherwords,theen-
terprisewouldhavemetitsobligationswithoutbuvingsubprimeorAlt-Amortgage
backedsecurities.Infact,noneofFannieMaesiooapurchasesofsubprimeorAlt-A
securitieswereeversubmittedtoHUDtobecountedtowardthegoals.
Beforeioo-,-oorlessoftheGSEsloanpurchaseshadtosatisfvtheaffordable
housing goals. In ioo- the goals were increased above -o; 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 subgoalsspecifc targets requiring the GSEs to
purchaseorguaranteeloanstopurchasehomes.Inioo-,Fanniemissedoneofthese
subgoalsandwouldhavemissedasecondwithoutthesecuritiespurchases;iniooo,
thesecuritiespurchaseshelpedFanniemeetthosetwosubgoals.
ThepatternisthesameatFreddieMac,alargerpurchaserofnon-agencvmort-
gagebackedsecurities.
1:a
EstimatesbvtheFCICshowthatfromioo:throughiooo,
FreddiewouldhavemettheaffordablehousinggoalswithoutanvpurchasesofAlt-A
orsubprimesecurities,butusedthesecuritiestohelpmeetsubgoals.
1:-
RobertLevin,theformerchiefbusinessomcerofFannieMae,toldtheFCICthat
buving private-label mortgagebacked securities was a monevmaking activitvit
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 Fannies 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 mortgagebacked securities
wereoftenissuedtoborrowersthatcouldhelpFannieandFreddiefulflltheirgoals,
themortgagesbehindtheAlt-Asecuritieswerenot.Alt-Amortgageswerenotgener-
allvextendedtolower-incomeborrowers,andtheregulationsprohibitedmortgages
toborrowerswithunstatedincomelevelsahallmarkofAlt-Aloansfromcount-
ingtowardaffordabilitvgoals.
1:8
LevintoldtheFCICthatthevbelievedthatthepur-
chaseofAlt-AsecuritiesdidnothaveanetpositiveeffectonFannieMaeshousing
goals.
1:o
Instead,thevhadtobeoffsetwithmoremortgagesforlow-andmoderate-
incomeborrowerstomeetthegoals.
FannieandFreddiecontinuedtopurchasesubprimeandAlt-Amortgagebacked
securities from ioo- to ioo8 and also bought and securitized greater numbers of
riskier mortgages. The results would be disastrous for the companies, their share-
holders,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,theFederalReservespoliciesandpronouncements
encouraged rather than inhibited the growth of mortgage debt and the housing
bubble.
Lending standards collapsed, and there was a signifcant failure of accounta-
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.Moodvs,the
Commissionscasestudvinthisarea,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
CDOsVccrcatcdthcinvcstcr ):;
BcarStcarnsshcdgcjundsItjuncticncdhncupunti|cncdav
it;ustdidntjuncticn):;
Citigrcups|iquiditvputsApctcntia|ccnictcjintcrcst ):
AIGGc|dcngccscjcrthccntircStrcct ):;
Gc|dnanSachsMu|tip|icdthccjjcctscjthccc||apscinsu|princ);:
MccdvsAchicvcdthrcughscnca|chcnv );e
SLCItsgcingtc|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,thevcreatedthe
investor.
1
Thatis,thevbuiltnewsecuritiesthatwouldbuvthetranchesthathadbe-
comehardertosell.Bankerswouldtakethoselowinvestment-gradetranches,largelv
ratedBBBorA,frommanvmortgage-backedsecuritiesandrepackagethemintothe
new securitiesCDOs. Approximatelv 8o 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,weusethetermCDOstorefertocashCDOsbacked
bvasset-backedsecurities(suchasmortgage-backedsecurities),alsoknownasABSCDOs.
The securities frms arguedand the rating agencies agreedthat if thev pooled
manvBBB-ratedmortgage-backedsecurities,thevwouldcreateadditionaldiversif-
cation benefts. The rating agencies believed that those diversifcation benefts were
signifcantthatifonesecuritvwentbad,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
rm select and purchase assets,
such as some of the lower-rated
tranches of mortgage-backed
securities.
2. Pool
The CDO manager
and securities rm
pool various assets
in an attempt to
get diversication
benets.
3. CDO tranches
Similar to
mortgage-backed
securities, the CDO
issues securities in
tranches that vary
based on their place in
the cash ow waterfall.
next
etc.
next
claim
First claim to cash ow from
principal & interest payments
Collateralized debt obligations (CDOs) are structured
financial instruments that purchase and pool
financial assets such as the riskier tranches of various
mortgage-backed securities.
Iigurc 8.+
tranchesofmortgage-backedsecurities,growingfromabitplavertoamulti-hundred-
billion-dollar industrv. Between ioo: and ioo, as house prices rose i 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 hummingthe CDO managers and
underwriters who packaged and sold the securities, the rating agencies that gave
mostofthemsterlingratings,andtheguarantorswhowroteprotectionagainsttheir
defaultingcollected fees based on the dollar volume of securities sold. For the
bankers who had put these deals together, as for the executives of their companies,
volumeequaledfeesequaledbonuses.Andthosefeeswereinthebillionsofdollars
acrossthemarket.
Butwhenthehousingmarketwentsouth,themodelsonwhichCDOswerebased
provedtragicallvwrong.Themortgage-backedsecuritiesturnedouttobehighlvcor-
relatedmeaning 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 Milkens Drexel Burnham Lambert assembled the frst rated collateralized
debt obligation in 1o8 out of different companies junk bonds. The strategv made
sensepooling 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 spreadthe 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.Thesemultisector
orABSsecuritieswerebackedbvmortgages,mobilehomeloans,aircraftleases,mu-
tual fund fees, and other asset classes with predictable income streams. The diversitv
wassupposedtoprovidevetanotherlaverofsafetvforinvestors.
MultisectorCDOswentthroughatoughpatchwhensomeoftheasset-backedse-
curitiesinwhichthevinvestedstartedtoperformpoorlviniooiparticularlvthose
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 mortgagebacked 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 mortgagebacked securities,
Alt-A,subprime,andnon-agencvmortgages,andsawtherelativestabilitv.
o
CDOs quicklv became ubiquitous in the mortgage business.
There-
sultwouldbelossessoseverethatthevwouldhelpbringthehugefnancialconglom-
eratetothebrinkoffailure,aswewillsee.
AIG: GOLDEN GOOSE FOR THE ENTIRE STREET
In iooa, American International Group was the largest insurance companv in the
worldasmeasuredbvstockmarketvalue:amassiveconglomeratewith8-obillion
inassets,11o,oooemploveesin1:ocountries,andii:subsidiaries.
But to Wall Street, AIGs most valuable asset was its credit rating: that it was
awardedthehighestpossibleratingAaabvMoodvssince1o8o,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- confdence that there would be no
realized economiclossonthesupposedlvsafestportionsoftheCDOsonwhichthev
wrote CDS protection, and failed to make anv provisions whatsoever for declines in
valueorunrealizedlossesadecisionthatwouldprovefataltoAIGinioo8.
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 8 to 1.o.
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
defaultswapwithAIGcouldalsolowerAmericanbankscapitalrequirements.
Iniooaandioo-,AIGsoldprotectiononsuper-seniorCDOtranchesvaluedat
-abillion,upfromjustibillioninioo:.
8i
InaninterviewwiththeFCIC,oneAIG
executivedescribedAIGFinancialProductsprincipalswapsalesman,AlanFrost,as
thegoldengoosefortheentireStreet.
8:
AIGsbiggestcustomerinthisbusinesswasalwavsGoldmanSachs,consistentlva
leadingCDOunderwriter.AIGalsowrotebillionsofdollarsofprotectionforMerrill
Lvnch,SocitGnrale,andotherfrms.AIGlookedliketheperfectcustomerfor
this,CraigBroderick,Goldmanschiefriskomcer,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 Citigroups bank
wroteformanvofitsowndeals,guaranteeingitwouldbuvcommercialpaperifno
oneelsewantedit.Itenteredthisbusinessiniooi;bvioo-,ithadwrittenmorethan
o billion of liquiditv puts on commercial paper issued bv CDOs. AIG also wrote
morethanbillioninCDStoprotectSocitGnraleagainsttherisksonliquiditv
putsthattheFrenchbankitselfwroteoncommercialpaperissuedbvCDOs.
8-
What
wewouldalwavstrvtodoistostructureatransactionwherethetransactionwasvir-
tuallvriskless,andgetpaidasmallpremium,GenePark,whowasamanagingdirec-
toratAIGFinancialProducts,toldtheFCIC.Andwereoneofthefewguvswhocan
dothat.Becauseifvouthinkaboutit,noonewantstobuvdisasterprotectionfrom
someonewhoisnotgoingtobearound. . . .ThatwasAIGFPssalespitchtotheStreet
ortobanks.
8o
AIGs business of offering credit protection on assets of manv sorts, including
mortgage-backedsecuritiesandCDOs,grewfromiobillioniniooitoi11billion
inioo-and-::billioninioo.
8
ThisbusinesswasasmallpartoftheAIGFinan-
cial Services business unit, which included AIG Financial Products; AIG Financial
Servicesgeneratedoperatingincomeofa.abillioninioo-,orioofAIGstotal.
AIGdidnotpostanvcollateralwhenitwrotethesecontracts;butunlikemono-
lineinsurers,AIGFinancialProductsagreedtopostcollateralifthevalueoftheun-
derlving securities dropped, or if the rating agencies downgraded AIGs long-term
debtratings.Itscompetitors,themonolinefnancialguarantorsinsurancecompa-
nies such as MBIA and Ambac that focused on guaranteeing fnancial contracts
were forbidden under insurance regulations from paving out until actual losses
occurred.ThecollateralpostingtermsinAIGscreditdefaultswapcontractswould
haveanenormousimpactonthecrisisabouttounfold.
Butduringtheboom,thesetermsdidntmatter.Theinvestorsgottheirtriple-A-
rated protection, AIG got its fees for providing that insuranceabout o.1i of the
notionalamountoftheswappervear
88
andthemanagersgottheirbonuses.Inthe
caseoftheLondonsubsidiarvthatrantheoperation,thebonuspoolwas:oofnew
earnings.
8o
FinancialProductsCEOIosephI.Cassanomadetheallocationsattheend
ofthevear.
oo
Betweeniooiandioo,theleastamountCassanopaidhimselfinavear
was:8million.Inthelatervears,hiscompensationwassometimesdoublethatof
theparentcompanvsCEO.
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:
Butthatdidnthappen.Instead,AIGFinancialProd-
ucts wrote another :o billion in credit default swaps on super-senior tranches of
1ui tiu \\tui Ni ...
CDOsinioo-.
oa
Thecompanvwouldntmakethedecisiontostopwritingthesecon-
tractsuntiliooo.
o-
GOLDMAN SACHS: MULTIPLIED THE EFFECTS
OF THE COLLAPSE IN SUBPRIME
HenrvPaulson,theCEOofGoldmanSachsfrom1ooountilhebecamesecretarvof
theTreasurviniooo,testifedtotheFCICthatbvthetimehebecamesecretarvmanv
bad loans alreadv had been issuedmost of the toothpaste was out of the tube
andthattherereallvwasnttheproperregulatorvapparatustodealwithit.
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.
o
UnderPaulsonsleadership,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
mortgagesecuritizationstotaling18abillion(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
CDOsincludedfundedlonginvestors,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 securitvthev
were not limited to the universe of securities available for them to buv. Figure 8.i
providesanexampleofhowsuchadealworked.
Iniooa,GoldmanlauncheditsfrstmajorsvntheticCDO,Abacusiooa-1adeal
worth i billion. About one-third of the swaps referenced residential mortgage-
backedsecurities,anotherthirdreferencedexistingCDOs,andtherest,commercial
mortgagebackedsecurities(madeupofbundledcommercialrealestateloans)and
othersecurities.
Goldmanwastheshortinvestorfortheentireibilliondeal:itpurchasedcredit
defaultswapprotectiononthesereferencesecuritiesfromtheCDO.Thefundedin-
vestorsIKB (a German bank), the TCW Group, and Wachoviaput up a total of
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
shortinvestor,bettingthatthevwouldfail.
TheunfundedinvestorsTCWandGSCPartners(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,retainingthe1.8billionsuper-seniortranche.Goldmansibillionshortpo-
sition more than offset that exposure; about one vear later, it transferred the
unfundedlongpositionbvbuvingcreditprotectionfromAIG,inreturnforanan-
nualpavmentofi.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,Goldmanstoodtogainnearlvibillioniftheassets
failed.
In the end, Goldman, the short investor in the Abacus iooa-1 CDO, has received
abouto:omillionwhilethelonginvestorshavelostjustaboutalloftheirinvestments.
In April ioo8, GSC paid Goldman .: million as a result of CDS protection sold bv
GSCtoGoldmanonthefrstandsecondlosstranches.InIuneiooo,Goldmanreceived
8oomillionfromAIGFinancialProductsasaresultoftheCDSprotectionithadpur-
chasedagainstthesuper-seniortranche.Thesamemonthitreceivedi: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 Sachss Abacus 2004-1 deal, were complex
paper transactions involving credit default swaps.
Reference
Securities
CREDIT DEFAULT
SWAPS
Iigurc 8.:
ThroughMavio1o,GoldmanreceivediamillionfromIKB,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.-o to 1.-o of the deal totals, Dan Sparks, the former head of Goldmans
mortgagedesk,toldtheFCIC.
1oo
Goldmanwouldearnproftsfromshortingmanvof
these deals; on others, it would proft bv facilitating the transaction between the
buverandthesellerofcreditdefaultswapprotection.
Aswewillsee,thesenewinstrumentswouldvieldsubstantialproftsforinvestors
thatheldashortpositioninthesvntheticCDOsthatis,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
wereabout1imillionworthofbondsintheMo(BBB-rated)trancheoneofthe
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.Thatisthebetandthereweremorethan-omillioninsuchbetsinearlv
ioo on the Mo tranche of this deal. Thus, on the basis of the performance of 1i
millioninbonds,morethanoomillioncouldpotentiallvchangehands.Goldmans
Sparks put it succinctlv to the FCIC: if theres a problem with a product, svnthetics
increasetheimpact.
1o8
TheamplifcationoftheMotranchewasnotunique.A1-milliontrancheofthe
GlacierFundingCDOiooo-aA,ratedA,wasreferencedin8-millionworthofsvn-
thetic CDOs. A i8 million tranche of the Soundview Home Equitv Loan Trust
iooo-EO1,alsoratedA,wasreferencedinomillionworthofsvntheticCDOs.A
1: million tranche of the Soundview Home Equitv Loan Trust iooo-EO1, rated
BBB,wasreferencedinaomillionworthofsvntheticCDOs.
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.
AlthoughGoldmanexecutivesagreedthatsvntheticCDOswerebetsthatmag-
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,
GoldmansPresidentandChiefOperatingOmcerGarvCohnargued: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.Idontthinkthevhavesocial
value,MichaelGreenberger,aprofessorattheUniversitvofMarvlandSchoolofLaw
and former director of the Division of Trading and Markets at the Commoditv Fu-
turesTradingCommission,toldtheFCIC.Hecharacterizedthecreditdefaultswap
marketasacasino.Andhetestifedthattheconceptoflawfulbettingofbillionsof
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: Moodvs, S&P, and
Fitch. Investors often relied on the rating agencies views rather than conduct their
owncreditanalvsis.Moodvswaspaidaccordingtothesizeofeachdeal,withcapsset
at a half-million dollars for a standard CDO in iooo and ioo and as much as
8-o,oooforacomplexCDO.
11-
InratingbothsvntheticandcashCDOs,Moodvsfacedtwokevchallenges:frst,
estimatingtheprobabilitvofdefaultforthemortgage-backedsecuritiespurchasedbv
theCDO(oritssvntheticequivalent)and,second,gaugingthecorrelationbetween
those defaultsthat 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, Moodvs relied almost exclusivelv on its
ownratingsofthemortgage-backedsecuritiespurchasedbvtheCDOs.
11
Atnotime
didtheagencieslookthroughthesecuritiestotheunderlvingsubprimemortgages.
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 Moodvs team managing directors for the
CDOunit,toldtheFCIC.ThisapproachwouldleadtoproblemsforMoodvsand
for investors. Witt testifed that the underlving collateral just completelv disinte-
gratedbelowusandwedidntreactandweshouldhave. . . .Wehadtobelookingfor
aproblem.Andwewerentlooking.
118
To determine the likelihood that anv given securitv in the CDO would default,
Moodvspluggedinassumptionsbasedonthoseoriginalratings.Thiswasnosimple
task.Meanwhile,iftheinitialratingsturnedoutowingtopoorunderwriting,fraud,
oranvothercausetopoorlvrefectthequalitvofthemortgagesinthebonds,the
error was blindlv compounded when mortgage-backed securities were packaged
intoCDOs.
Evenmoredimcultwastheestimationofthedefaultcorrelationbetweenthese-
curitiesintheportfolioalwavstrickv,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, Moodvs acknowl-
edgedinoneearlvexplanationofitsprocess.
11o
InplainerEnglish,Wittsaid,Moodvsdidnthaveagoodmodelonwhichtoesti-
matecorrelationsbetweenmortgage-backedsecuritiessothevmadethemup.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.WittfeltstronglvthatMoodvsneededtoupdateitsCDOratingmodeltoex-
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-
backedsecuritiesandtoseeiftheassumptionsthatweremakingforAAACDOsare
consistent . . . with the correlation assumptions that were making for AAA [mort-
gage-backedsecurities].AlthoughWittreceivedapprovalfromhissuperiorsforthis
investigation,contractualdisagreementspreventedhimfrombuvingthesoftwarehe
neededtoconductthelook-throughanalvsis.
1i:
InIuneioo-,Moodvsupdateditsapproachforestimatingdefaultcorrelation,but
itbasedthenewmodelontrendsfromthepreviousiovears,aperiodwhenhousing
priceswererisingandmortgagedelinquencieswerevervlowandaperiodinwhich
nontraditionalmortgageproductshadbeenavervsmallniche.Then,Moodvsmod-
ifedthisoptimisticsetofempiricalassumptionswithadhocadjustmentsbasedon
factors such as region, vear of origination, and servicer. For example, if two mort-
gage-backed securities were issued in the same regionsav, Southern California
Moodvs boosted the correlation; if thev shared a common mortgage servicer,
Moodvs 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,Moodvsestimatedthattwomort-
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-
sultinunanticipatedconcentrationsofriskininstitutionsportfolios,areportfrom
theBankforInternationalSettlements,aninternationalfnancialorganizationspon-
soredbvtheworldsregulatorsandcentralbanks,warnedinIuneioo-.
1io
CDOmanagersandunderwritersreliedontheratingstopromotethebonds.For
each new CDO, thev created marketing material, including a pitch book that in-
vestorsusedtodecidewhethertosubscribetoanewCDO.Eachbookdescribedthe
tvpesofassetsthatwouldmakeuptheportfoliowithoutprovidingdetails.
1i
With-
outexception,evervpitchbookexaminedbvtheFCICstaffcitedananalvsisfromei-
therMoodvsorS&Pthatcontrastedthehistoricalstabilitvofthesenewproducts
ratings with the stabilitv of corporate bonds. Statistics that made this case included
thefactthatbetween1o8:andiooo,oiofthesenewproductsdidnotexperience
anv rating changes over a twelve-month period while onlv 8 of corporate bonds
maintainedtheirratings.Overalongertimeperiod,however,structuredfnancerat-
ings were not so stable. Between 1o8: and iooo, onlv -o 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
bookdidincludethedisclaimerthatpastperformanceisnotaguaranteeoffuture
performanceandencouragedinvestorstoperformtheirownduediligence.
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 8o 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
thantheratingagencieshadestimatedthatis,thevstoppedperformingatroughlv
thesametime.TheselossesledtomassivedowngradesintheratingsoftheCDOs.
Inioo,ioofU.S.CDOsecuritieswouldbedowngraded.Inioo8,o1would.
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,MoodvswouldthrowoutitskevCDOassumptionsandreplacethem
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,wheninfactthesesecuritieswerent
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 CDOsnot just those that were mortgage-relatedMoodvs rated
iiodealsiniooa,:o:inioo-,aoiniooo,and1inioo;thevalueofthosedeals
rosefromoobillioniniooato1oibillioninioo-,::billioniniooo,and:io
billion in ioo.
1:a
The reported revenues of Moodvs Investors Service from struc-
turedproductswhichincludedmortgage-backedsecuritiesandCDOsgrewfrom
1oomillioniniooo,or::ofMoodvsCorporationsrevenues,to88millionin
iooo or aa of overall corporate revenue. The rating of asset-backed CDOs alone
contributed more than 1o 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 corporations revenues surged from ooi million to
ibillionanditsproftmarginclimbedfromioto:.
YettheincreaseintheCDOgroupsworkloadandrevenuewasnotparalleledbva
stamng increase. We were under-resourced, vou know, we were alwavs plaving
catch-up,Wittsaid.
1:o
Moodvspennv-pinchingandstingvmanagementwasre-
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-
merteammanagingdirectoratMoodvs,toldtheFCICthatfromiooatoiooo,the
increaseinthenumberofdealsratedwashuge . . .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
formorethan1aobillionofCDOdealsbetweenioo-andioo.
1ao
Theratingsagenciescorrelationassumptionshadadirectandcriticalimpacton
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
fromtheagenciesforexample,bvincreasingthesizeoftheseniortranches.More-
over,becauseissuerscouldchoosewhichratingagenciestodobusinesswith,andbe-
cause the agencies depended on the issuers for their revenues, rating agencies felt
pressuredtogivefavorableratingssothatthevmightremaincompetitive.
Thepressureonratingagencvemploveeswasalsointenseasaresultofthehigh
turnovera revolving door that often left raters dealing with their old colleagues,
thistimeasclients.InherinterviewwithFCICstaff,YuriYoshizawa,aMoodvsteam
managing director for U.S. derivatives in ioo-, was presented with an organization
chartfromIulvioo-.Sheidentifed1:outof-1analvstsabouti-ofthestaff
whohadleftMoodvstoworkforinvestmentorcommercialbanks.
1a1
Brian Clarkson, who oversaw the structured fnance group before becoming the
presidentofMoodvsInvestorsService,explainedtoFCICinvestigatorsthatretaining
emploveeswasalwavsachallenge,forthesimplereasonthatthebankspaidmore.As
aprecaution,Moodvsemploveeswereprohibitedfromratingdealsbvabankoris-
suerwhilethevwereinterviewingforajobwiththatparticularinstitution,butthere-
sponsibilitvfornotifvingmanagementoftheinterviewrestedontheemplovee.After
leaving Moodvs, former emplovees were barred from interacting with Moodvs on
the same series of deals thev had rated while in its emplov, but there were no bans
againstworkingonother dealswithMoodvs.
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
needaconsolidatedsupervisorbviooathatis,oneregulatorthathadresponsibil-
itvfortheholdingcompanv.TheU.S.commercialbanksalreadvmetthatcriterion
their consolidated supervisor was the Federal Reserveand the Omce of Thrift
SupervisionsoversightofAIGwouldlateralsosatisfvtheEuropeans.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,thecombinedassetsatthefvefrmstotaledi.-trillion,morethanhalf
ofthea.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-
countedformorethan1ooofpretaxearningsinsomevearsafteriooi.
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.
Theinvestmentbankspossessionofdepositorvsubsidiariessuggestedtwoobvi-
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,thiswastheSECsfrstforav
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 portfoliosa
methodologvbasedonthevolatilitvofmarketprices.Thismethodologv,referredto
asthealternativenetcapitalrule,wouldbesimilartothestandardsbasedonthe
1oooMarketRiskAmendmenttotheBaselrulesthatlargecommercialbanksand
bankholdingcompaniesusedfortheirsecuritiesportfolios.
Thetraditionalnetcapitalrulethathadgovernedbroker-dealerssince1o-had
required straightforward calculations based on asset classes and credit ratings, a
bright-lineapproachthatgavefrmslittlediscretionincalculatingtheircapital.The
newruleswouldallowtheinvestmentbankstocreatetheirownproprietarvValueat
Risk(VaR)modelstocalculatetheirregulatorvcapitalthatis,thecapitaleachfrm
wouldhavetoholdtoprotectitscustomersassetsshoulditexperiencelossesonits
1ui tiu \\tui Ni .,.
securities and derivatives. All in all, the SEC estimated that the proposed new re-
lianceonproprietarvVaRmodelswouldallowbroker-dealerstoreduceaveragecap-
ital charges bv ao. 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 agencvs pro-
posal,whichitsaidhadthepotentialtoduplicateorconfictwithOTSssupervisorv
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 SECs 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.DeutscheBankfoundittobeagreatstridetowardscon-
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-
thoughMerrillsandLehmansthriftscontinuedtobesupervisedbvtheOTS.Several
frmsdelavedentrvtotheprograminordertodevelopsvstemsthatcouldmeasure
theirexposurestomarketpricemovements.
HarvevGoldschmid,SECcommissionerfromiooitoioo-,toldFCICstaffthat
beforetheCSEprogramwascreated,SECstaffmemberswereconcernedabouthow
littleauthoritvthevhadovertheWallStreetfrms,includingtheirhedgefundsand
overseassubsidiaries.OncetheCSEprogramwasinplace,theSEChadtheauthor-
itvtolookatevervthing.
1ao
SECcommissionersdiscussedatthetimetherisksthev
weretakingbvallowingfrmstoreducetheircapital.Ifanvthinggoeswrongitsgo-
.,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
ThenewprogramwashousedprimarilvintheSECsOmceofPrudentialSupervi-
sionandRiskAnalvsis,anomcewithastaffof1oto1iwithintheDivisionofMarket
Regulation.
1a8
Inthebeginning,itwassupportedbvtheSECsmuchlargerexamina-
tion staff; bv ioo8 the staff dedicated to the CSE program had grown to ia.
1ao
Still,
onlv1omonitorswereresponsibleforthefveinvestmentbanks;: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 SECs 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,duringwhichstaffreviewedthefrmssvstemsandrecordsand
verifedthatthefrmshadinstitutedcontrolprocesses.
TheCSEprogramwastroubledfromthestart.TheSECconductedanexamfor
eachinvestmentbankwhenitenteredtheprogram.TheresultofBearStearnssen-
tranceexam,inioo-,showedseveraldefciencies.Forexample,examinerswerecon-
cerned that there were no frmwide VaR limits and that contingencv funding plans
reliedonoverlvoptimisticstressscenarios.
1-:
Inaddition,theSECwasawareofthe
frms concentration of mortgage securities and its high leverage. Nonetheless, the
SECdidnotaskBeartochangeitsassetbalance,decreaseitsleverage,orincreaseits
cash liquiditv poolall 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-siteconductingitsfrstCSEexamsinceBearsentranceexammorethantwo
vearsearlier.
1-
Leverageattheinvestmentbanksincreasedfromiooatoioo,growththatsome
criticshaveblamedontheSECschangeinthenetcapitalrules.Goldschmidtoldthe
FCICthattheincreasewasowedtoawildcapitaltimeandthefrmsbeingirrespon-
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 programa historv
1ui tiu \\tui Ni .,.
thatsuggeststhattheprogramwasnotsolelvresponsibleforthechanges.
1-o
Iniooo,
SirrinotedthatundertheCSEprogramtheinvestmentbanksnetcapitallevelsre-
mainedrelativelvstable . . .and,insomecases,increasedsignifcantlvoverthepro-
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,concludedthattheprogramwasnotsuccessful
inprovidingprudentialsupervision.
1o:
And,aswewillseeinthechaptersahead,the
SECsinspectorgeneralwouldbequitecritical,too.InSeptemberioo8,inthemidst
ofthefnancialcrisis,theCSEprogramwasdiscontinuedafterallfveofthelargest
independent investment banks had either closed down (Lehman Brothers), merged
into other entities (Bear Stearns and Merrill 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 agencvs 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
reasonfrmsoptednottobesupervisedbvtheFedwasthecomprehensivenessof
theFedssupervisorvapproach,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 CDOscomposed of the riskier
tranchesfueleddemandfornonprimemortgagesecuritizationandcontributed
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
ofthecreditdefaultswapprotectiontothehousingbubblescollapse.
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
corporategovernanceatMoodvs,whichdidnotensurethequalitvofitsratings
ontensofthousandsofmortgage-backedsecuritiesandCDOs.
The Securities and Exchange Commissions poor oversight of the fve largest
investmentbanksfailedtorestricttheirriskvactivitiesanddidnotrequirethem
toholdadequatecapitalandliquiditvfortheiractivities,contributingtothefail-
ureorneedforgovernmentbailoutsofallfveofthesupervisedinvestmentbanks
duringthefnancialcrisis.
9
ALL IN
CONTENTS
1hc|u|||cAcrcdit-induccd|ccn)
McrtgagcjraudCrinc-jaci|itativccnvircnncnts )eo
Disc|csurcandducdi|igcnccAqua|itvccntrc|issucinthcjactcrv )e
Rcgu|atcrsMarkctswi||a|wavssc|j-ccrrcct)o
Icvcragcd|cansandccnncrcia|rca|cstatc
Ycuvcgcttcgctupanddancc );
IchnanIrcnncvingtcstcragc )e
IannicMacandIrcddicMac1wcstarkchciccs):
Inioo:,theBakersfeld,California,homebuilderWarrenPetersonwaspavingaslit-
tleas:-,ooofora1o,ooo-square-footlot,aboutthesizeofthreetenniscourts.The
nextvearthecostmorethantripledto1io,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
southernendofCaliforniasagriculturalcenter,theSanIoaquinVallev.Thatjumped
toalmost:oo,ooobvIuneiooo.
i
Bviooa,monevseemedtobecominginvervfast
and from evervwhere, said Llovd Plank, a Bakersfeld real estate broker. Thev
wouldpurchaseahouseinBakersfeld,keepitforashortperiodandresellit.Some-
timesthevwouldfipthehousewhileitwasstillinescrow,andwouldstillmakeio
to:o.
:
Nationallv, housing prices jumped 1-i between 1oo and their peak in iooo,
a
more than in anv decade since at least 1oio.
-
It would be catastrophicallv downhill
fromtherevetthemortgagemachinekeptchurningwellintoioo,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 CREDITINDUCED BOOM
Irvine, Californiabased New Centurvonce the nations second-largest subprime
lenderignored 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-oftheloansthevauditedinNovemberandDecember
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-,itgavethecompanvsloanproductiondepart-
mentunsatisfactorvratingsseventimes.PatrickFlanagan,presidentofNewCen-
turvs mortgage-originating subsidiarv, cut the departments 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,almost1ofitsloanswere
goingintodefaultwithinthefrstthreemonthsafterorigination.NewCenturvhad
abrazenobsessionwithincreasingloanoriginations,withoutdueregardtotherisks
associated with that business strategv, New Centurvs bankruptcv examiner
reported.
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,whoseCDOmanagementunitwasoneofthenationslargestin
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
highroadorvoudontwerenotgoingtohurtaccountsordamageourreputation
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
formoralreasonsthatsacop-out.
1o
Aswastvpicalfortheindustrvduringthecri-
sis, two of Maxims eight mortgage-backed CDOs, Maxim High Grade CDO I and
Maxim High Grade CDO II, would default on interest pavments to investorsin-
cluding investors holding bonds that had originallv been rated triple-Aand the
othersixwouldbedowngradedtojunkstatus,includingall ofthoseoriginallvrated
triple-A.
11
AnotherdevelopmentalsochangedtheCDOs:inioo-andiooo,CDOmanagers
werelesslikelvtoputtheirownmonevintotheirdeals.Earlvinthedecade,investors
hadtakenthemanagersinvestmentintheequitvtrancheoftheirownCDOstobe
an assurance of qualitv, believing that if the managers were sharing the risk of loss,
thevwouldhaveanincentivetopickcollateralwiselv.Butthisfail-safelostforceas
theamountofmanagersinvestmentpertransactiondeclinedovertime.ACAMan-
agement,aunitofthefnancialguarantorACACapital,providesagoodillustration
of this trend. ACA held 1oo of the equitv in the CDOs it originated in iooi and
ioo:,-iando1oftwodealsitoriginatediniooa,between1oandi-ofdeals
inioo-,andbetweenoand11ofdealsiniooo.
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-,derivativesdealersintroducedthepav-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,voudonthaveto
goandbuvthecashbonds,saidLauraSchwartzofACACapital.
1a
Therewerealso
nowarehousingcostsorassociatedrisks.Andthevtendedtoofferthepotentialfor
higherreturnsontheequitvtranches:oneanalvstestimatedthattheequitvtranche
on a svnthetic CDO could tvpicallv vield about i1, while the equitv tranche of a
tvpicalcashCDOcouldpav1:.
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
shortswiththelongsandminimizinganvriskforhisownbank.Lippmannsaid
thatbetweenioooandioohebrokereddealsforatleast-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 -o or more svnthetic collateral; again,
unlessotherwisenoted,ourdatareferstoCDOsthatincludemortgage-backedsecu-
rities.) Even CDOs that were labeled as cash CDOs increasinglv held some credit
derivatives.Atotalofii-billioninCDOswereissuediniooo,includingthosela-
beledascash,hvbrid,orsvnthetic;theFCICestimatesthatiofthecollateralwas
derivatives,comparedwithoinioo-andiniooa.
1
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 1o
hedgefundsencompassingover1.1trillioninassetsasofearlvio1ofoundthisto
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.TheFCICssurvevfoundthatbvIune
ioo, the largest hedge funds held i- billion in equitv and other lower-rated
tranchesofmortgage-backedsecurities.Theseweremorethanoffsetbva-billion
inshortpositions.
1o
Thesetvpesoftradeschangedthestructuredfnancemarket.Investorsintheequitv
and most junior tranches of CDOs and mortgage-backed securities traditionallv had
thegreatestincentivetomonitorthecreditriskofanunderlvingportfolio.Withthead-
ventofcreditdefaultswaps,itwasnolongerclearwhoifanvonehadthatincentive.
For one example, consider Merrill Lvnchs 1.- billion Norma CDO, issued in
ioo.Theequitvinvestor,MagnetarCapital,ahedgefund,wasexecutingacommon
strategvknownasthecorrelationtradeitboughttheequitvtranchewhileshorting
othertranchesinNormaandotherCDOs.Accordingtocourtdocuments,Magnetar
wasalsoinvolvedinselectingassetsforNorma.
io
Magnetarreceiveda.-millionre-
latedtothistransactionandNIRCapitalManagement,theCDOmanager,waspaida
feeof-,oooplusadditionalfees.
i1
MagnetarscounseltoldtheFCICthatthea.-
millionwasadiscountintheformofa rebateonthepriceoftheequitvtrancheand
otherlongpositionspurchasedbvMagnetarandnotapavmentreceivedinreturnfor
goodorservices.
ii
CourtdocumentsindicatethatMagnetarwasinvolvedinselect-
ingcollateral,andthat NIRabdicateditsassetselectiondutiestoMagnetarwithMer-
rillsknowledge.Inaddition,thevshowthatwhenoneMerrillemploveelearnedthat
Magnetar had executed approximatelv ooo million in trades for Norma without
NIRsapparentinvolvementorknowledge,sheemailedcolleagues,Dumbquestion.
IsMagnetarallowedtotradeforNIR:
i:
MerrillfailedtodisclosethatMagnetarwas
paida.-millionorthatMagnetarwasselectingcollateralwhenitalsohadashort
positionthatwouldbeneftfromlosses.
ia
ThecounselforMerrillsnewowner,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,hadplavedasignifcantroleintheselec-
tion. The SEC alleged that those misrepresentations were in Goldmans marketing
materialsforAbacusioo-AC1,oneofGoldmansiaAbacusdeals.
io
.+z ii N\Nti \i tii :i : i NuUi i tu\\i : :i uN iiiui1
IraWagner,theheadofBearStearnssCDOGroupinioo,toldtheFCICthathe
rejected the deal when approached bv Paulson representatives. When asked about
GoldmanscontentionthatPaulsonspickingthecollateralwasimmaterialbecausethe
collateralwasdisclosedandbecausePaulsonwasnotwell-knownatthattime,Wagner
called the argument ridiculous. He said that the structure encouraged Paulson to
picktheworstassets.Whileacknowledgingthepointthatevervsvntheticdealneces-
sarilvhadlongandshortinvestors,Wagnersawhavingtheshortinvestorsselectthe
referencedcollateralasaseriousconfictandforthatreasondeclinedtoparticipate.
i
ACAexecutivestoldtheFCICthevwerenotinitiallvawarethattheshortinvestor
wasinvolvedinchoosingthecollateral.CEOAlanRosemansaidthathefrstheardof
PaulsonsrolewhenhereviewedtheSECscomplaint.
i8
LauraSchwartz,whowasre-
sponsibleforthedealatACA,saidshebelievedthatPaulsonsfrmwastheinvestor
takingtheequitvtrancheandwouldthereforehaveaninterestinthedealperforming
well.ShesaidshewouldnothavebeensurprisedthatPaulsonwouldalsohavehada
shortposition,becausethecorrelationtradewascommoninthemarket,butadded,
Tobehonest,[atthattime,]untiltheSECtestimonvIdidnotevenknowthatPaul-
sonwasonlvshort.
io
PaulsontoldtheFCICthatanvsvntheticCDOwouldhaveto
investinapoolthatbothabuverandsellerofprotectioncouldagreeon.Hedidnt
understandtheobjections:Everv[svnthetic]CDOhasabuverandsellerofprotec-
tion.SoforanvonetosavthatthevdidntwanttostructureaCDObecausesomeone
wasbuvingprotectioninthatCDO,thenvouwouldntdoanvCDOs.
:o
In Iulv io1o, Goldman Sachs settled the case, paving a record --o million fne.
Goldmanacknowledge[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 Paulsons 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,toldtheFCICthatthevhadwarnedtheSECinioothattheagenciesweredan-
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,evenasthere
wasamassiveamountofgaminggoingon.
:i
ShortingCDOswasprettvattractivebecausetheratingagencieshadgiventoo
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
-oo. Each MBS tranche tvpicallv would be :o mortgages in California, 1o in
Florida,1oinNewYork,andwhenvouaggregate1ooMBSpositionsvoustillhave
the same geographic diversifcation. To us, there was not much diversifcation in
CDOs.Shusresearchconvincedhimthatifhomepricesweretostopappreciating,
BBB-rated mortgage-backed securities would be at risk for downgrades. Should
pricesdrop-,CDOlosseswouldincreaseio-fold.
::
And if a 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
mvsteriousalchemicalprocessesinwhichWallStreettransformsBBB-minus-rated
mortgagesintoAAA-ratedtranchesofmortgagesecuritiesbvcreatingCDOs.Hees-
timatedthateventhetriple-AtranchesofCDOswouldexperiencesomelossesifna-
tionalhomepricesweretofalljustaorlesswithintwovears;andifpriceswereto
fall1o,investorsoftranchesratedAA-orbelowwouldbecompletelvwipedout.
:-
Inioo-,Eismanandotherswerealreadvlookingforthebestwavtobetonthis
disasterbvshortingalltheseshakvmortgage-relatedsecurities.Buvingcreditdefault
swapswasemcient.Eismanrealizedthathecouldpickwhatheconsideredthemost
vulnerabletranchesofthemortgage-backedbondsandbetmillionsofdollarsagainst
them,relativelvcheaplvandwithconsiderableleverage.Andthatswhathedid.
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 Californias
Silicon Vallev, bet big against mortgage-backed securitiesrefecting a change of
heart, because he had invested in homebuilder stocks in iooi. But the closer he
looked,themorehewonderedaboutthefnancingthatsupportedthisboomingmar-
ket.Burrvdecidedthatsomeofthenewfangledadjustableratemortgageswerethe
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
isanargumenttobemadethatvoushouldntallowwhatIdid.Buttheproblem,he
said,wasnottheshortpositionshewastaking;itwastherisksthatotherswereac-
cepting. When I did the shorts, the whole time I was putting on the positions . . .
therewerepeopleontheothersidethatwerejusteatingthemup.Ithinkitsacatas-
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,
CitigroupsCDOdeskwaspushingmoremonevtothecenterofthetable.
1ui \\iNi: : .+,
But after writing i- billion in liquiditv putsprotecting investors who bought
commercialpaperissuedbvCitigroupsCDOsthebankstreasurvdepartmenthad
put a stop to the practice. To keep doing deals, the CDO desk had to fnd another
marketforthesuper-seniortranchesoftheCDOsitwasunderwritingorithadto
fndawavtogetthecompanvtosupporttheCDOproductionline.TheCDOdesk
accumulatedanother18billioninsuper-seniorexposures,mostbetweenearlviooo
and August ioo, which it otherwise would have been able to sell into the market
onlvforaloss.
ai
Itwasalsoincreasinglvfnancingsecuritiesthatitwasholdinginits
CDOwarehousethatis,securitiesthatwerewaitingtobeputintonewCDOs.
Historicallv,owningsecuritieswasnotwhatsecuritiesfrmsdid.TheadageWe
areinthemovingbusiness,notthestoragebusinesssuggeststhatthevwerestruc-
turingandsellingsecurities,notbuvingorretainingthem.
However,asthebiggestcommercialbanksandinvestmentbankscompetedinthe
securities business in the late 1ooos and on into the new centurv, thev often touted
thebalancesheetthatthevcouldmakeavailabletosupportthesaleofnewsecuri-
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, the1trillioncommercialbankwhosedepositswereinsuredbvthe
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,thatmeansvourenot
pricingitcorrectlv,RichardBookstaber,whohadbeenheadofriskmanagementat
Citigroupinthelate1ooos,toldtheFCIC.Butkeepingthetranchesonthebooksat
thesepricesimprovedthefnancesforcreatingthedeal.Itwasahiddensubsidvof
theCDObusinessbvmispricing,Bookstabersaid.
a:
Thecompanvwouldnotbegin
writingthesecuritiesdowntowardthemarketsrealvaluationsuntilthefallofioo.
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
causethepricesdidntmovemuch.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.io to
o.aoinannualfeesonthesuper-seniorprotection;onabillion-dollartransaction,it
wouldearnanannualfeeofimilliontoamillion.
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, Citigroups securities unit
wouldsetupawarehouse fundinglinefortheCDOmanager.Duringtheramp-up
period, the collateral securities would pav interest; depending on the terms of the
agreement,thatinterestwouldeithergoexclusivelvtoCitigrouporbesplitwiththe
manager.FortheCDOdesk,thisfrequentlvrepresentedasubstantialincomestream.
Thesecuritiessittinginthewarehousefacilitvhadrelativelvattractivevieldsoften
1.otoi.-morethanthetvpicalbankborrowingrateanditwasnotuncommon
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-
CitigroupswillingnesstouseitsbalancesheettosupporttheCDObusinesshad
thedesiredeffect.ItsCDOdeskcreated11billioninCDOsthatincludedmortgage-
1ui \\iNi: : .+,
backedsecuritiesintheircollateralinioo-andiibillioniniooo.AmongCDOun-
derwriters, including all tvpes of CDOs, Citigroup rose from fourteenth place in
ioo:tosecondplaceinioo,accordingtoFCICanalvsisofMoodvsdata.
ao
What was good for Citigroups investment bank was also lucrative for its invest-
ment bankers. Thomas Maheras, the co-CEO of the investment bank who said he
spentlessthan1ofhistimethinkingaboutCDOs,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.Citigroupschiefriskomcermade.amillion.
a
Otherswerealsowellre-
warded. The co-heads of the global CDO business, Nestor Dominguez and Ianice
Warne,eachmadeaboutomillionintotalcompensationiniooo.
a8
Citi did have clawback provisions: under narrowlv specifed circumstances,
compensationwouldhavetobereturnedtothefrm.ButdespiteCitigroupseventual
largelosses,nocompensationwaseverclawedbackunderthispolicv.TheCorporate
Librarv,whichratesfrmscorporategovernance,gaveCitigroupaC.Inearlvioo,
theCorporateLibrarvwoulddowngradeCitigrouptoaD,refectingahighdegree
of governance risk. Among the issues cited: executive compensation practices that
werepoorlvalignedwithshareholderinterests.
ao
WherewereCitigroupsregulatorswhilethecompanvpileduptensofbillionsof
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
recentreviewofCitigroupssecuritiesarmprecedingthecrisiswasinioo-,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 relevantweaknesses in internal pricing and
valuationcontrols,forexample,andawillingnesstoallowtraderstoexceedtheirrisk
limits.
-o
Unlike the SEC, the Fed and OCC did maintain a continuous on-site presence.
During the 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,inthatthebusinessgrewfarinexcessofmanagementsunderlvingin-
frastructureandcontrolprocesses.
-i
InMavioo-,areviewundertakenbvpeersat
theotherFederalReservebankswascriticaloftheNewYorkFedthenheadedbv
thecurrenttreasurvsecretarv,TimothvGeithnerforitsoversightofCitigroup.The
reviewconcludedthattheFedson-siteCitigroupteamappearedtohaveinsumcient
resources to conduct continuous supervisorv activities in a consistent manner. At
Citi,muchofthelimitedteamsenergvisabsorbedbvtopicalsupervisorvissuesthat
detractfromtheteamscontinuoussupervisionobjectives . . .thelevelofthestamng
withintheCititeamhasnotkeptpacewiththemagnitudeofsupervisorvissuesthat
theinstitutionhasrealized.
-:
ThattheFedsioo-examinationofCitigroupdidnot
raise the concerns expressed that same vear bv the OCC mav illustrate these prob-
lems.Fourvearslater,thenextpeerreviewwouldagainfndsubstantialweaknesses
intheNewYorkFedsoversightofCitigroup.
-a
InApriliooo,theFedraisedtheholdingcompanvssupervisorvratingfromthe
previousvearsfairtosatisfactorv.
--
Itliftedthebanonnewmergersimposedthe
previous vear in response to Citigroups manv regulatorv problems.
-o
The Fed and
OCCexaminersconcurredthatthecompanvhadmadesubstantialprogressinim-
plementing CEO Charles Princes plan to overhaul risk management. The Fed de-
clared: The companv has . . . completed improvements necessarv to bring the
companvintosubstantialcompliancewithtwoexistingFederalReserveenforcement
actionsrelatedtotheexecutionofhighlvstructuredtransactionsandcontrols.
-
The
followingvear,CitigroupsboardwouldalludetoPrincessuccessfulresolutionofits
regulatorvcomplianceproblemsinjustifvinghisiocompensationincrease.
-8
The OCC noted in retrospect that the lifting of supervisorv constraints in iooo
hadbeenakevturningpoint.Afterregulatorvrestraintsagainstsignifcantacquisi-
tionswerelifted,Citigroupembarkedonanaggressiveacquisitionprogram,theOCC
wrotetoVikramPandit,Princesreplacement,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-
tiveimpactofearningsvolatilitvofthesebusinessesonthefrmscapitalposition.
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 AIGs 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,thatthemultisectorCDOsonwhichAIGwassellingcreditdefaultswapscon-
sistedmainlvofmortgage-backedsecuritieswithlessthan1osubprimeandAlt-A
mortgages,ParkaskedAdamBudnick,anotherAIGemplovee,forverifcation.Bud-
nick double checked and returned to sav, according to Park, I cant believe it. You
know,itslike8ooroo.Reviewingtheportfolioandthinkingaboutafriendwho
hadreceived1oofnancingforhisnewhomeafterlosinghisjobParksaid,This
ishorrendousbusiness.Weshouldgetoutofit.
oi
In Iulv ioo-, Parks colleague Andrew Forster sent an email both to Alan Frost,
the AIG salesman primarilv responsible for the companvs 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
vetIregularlvseedealswith8o[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
someoftheunderlvingmortgageswerestructuredtofail,[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,Wewerentgetting
paidenoughmonevtotakethatrisk. . . .Imnotgoingtoopineonwhethertheresa
train on its wav. I just know that Im 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
CDSprotectiononsubprimemortgagebackedsecurities.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
signifcantchangeinthecompositionofthesedealsgoingforwardi.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.
AIGscounterpartiesrespondedwithindifference.Thedavthatvou[AIG]drop
out,weregoingtohave1ootherpeoplewhoaregoingtoreplacevou,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 ioooone of them on a CDO backed bv o: subprime
assets.
oo
Bv Iune ioo, AIG had written swaps on o billion in multisector CDOs, fve
timesthe1obillionheldattheendofioo-.
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 AIGs SEC flings to investors for ioo- mentioned the risk of collateral
callsonlvifAIGweredowngraded.
Still,AIGneverhedgedmorethan1-omillionofitstotalsubprimeexposure.
:
SomeofAIGscounterpartiesnotonlvusedAIGsswapstohedgeotherpositionsbut
alsohedgedAIGsabilitvtomakegoodonitscontracts.Aswewillseelater,Goldman
SachshedgedaggressivelvbvbuvingCDSprotectiononAIGandbvshortingother
securitiesandindexestocounterbalancetheriskthatAIGwouldfailtopavuponits
swapsorthatacollapsingsubprimemarketwouldpulldownthevalueofmortgage-
backedsecurities.
MERRILL: WHATEVER IT TAKES
WhenDowKimbecameco-presidentofMerrillLvnchsGlobalMarketsandInvest-
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
StanlevONealtoldtheFCIC.
-
KimhiredChrisRicciardifromCreditSuisse,where
RicciardisgrouphadsoldmoreCDOsthananvoneelse.
o
Ricciardi came through, lifting Merrills CDO business from ffteenth place in
iooitosecondplacebehindonlvCitigroupiniooaandGoldmaninioo-.
Then,in
Februarviooo,heleftthebanktobecomeCEOofCohen&Companv,anassetman-
agementbusiness;atCohenhewouldmanageseveralCDOs,oftendealsunderwrit-
tenbvMerrill.
AfterRicciardileft,Kiminstructedtherestoftheteamtodowhateverittakes
notjusttomaintainmarketsharebutalsototakeoverthenumberoneranking,for-
meremploveessaidinacomplaintfledagainstMerrillLvnch.
8
KimtoldFCICstaff
thathecouldntrecallspecifcconversationsbutthatafterRicciardileft,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,didonlvi1.:billion,andearninganother
frst-place ranking in ioo,
8o
on the strength of the CDO machine Ricciardi had
builta machine that brought in more than 1 billion in fees between ioo: and
iooo.
81
TokeepitsCDObusinessgoing,Merrillpursuedthreestrategies,allofwhichin-
volved repackaging riskier mortgages more 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
therealmonev,todistinguishthemfromCDOmanagerswhowerebuvingtranches
justtoputthemintotheirCDOs.Betweenioo-andioo,thetvpicalamountaCDO
couldincludeofthetranchesofotherCDOsandstillmaintainitsratingsgrewfrom
-to:o,accordingtotheCDOmanagerWingChau.
8i
Accordingtodatacompiled
bv the FCIC, tranches from CDOs rose from an average of of the collateral in
mortgage-backed CDOs in ioo: to 1a bv ioo. CDO-squared dealsthose engi-
neered primarilv from the tranches of other CDOsgrew 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,nearlv8oofthemezza-
ninetrancheswerepurchasedbvCDOmanagers.
8a
ThepatternwassimilarforChau:
an FCIC analvsis determined that 88 of the mezzanine tranches sold bv the 1:
CDOsmanagedbvChauweresoldforinclusionintootherCDOs.
8-
Anestimated1o
different CDO managers purchased tranches in Merrills Norma CDO. In the most
extremecasefoundbvtheFCIC,CDOmanagersweretheonlvpurchasersofMer-
rillsNeoCDO.
8o
Marketwide,inioo:CDOstookinabout1:oftheAtranches,i:oftheAa
tranches, and a: of the Baa tranches issued bv other CDOs, as rated bv Moodvs.
(MoodvsratingofAaaisequivalenttoS&PsAAA,AatoAA,BaatoBBB,andBato
BB). In ioo, those numbers were 8, 81, and 8o, respectivelv.
8
Merrill and
other investment banks simplv created demand for CDOs bv manufacturing new
onestobuvtheharder-to-sellportionsoftheoldones.
AsSECattornevstoldtheFCIC,headingintoiootherewasaStreetwidegentle-
mansagreement:voubuvmvBBBtrancheandIllbuvvours.
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 these1:a
CDOssoldatleastonetrancheintoanotherMerrillCDO.InMerrillsdeals,onav-
erage, 1o 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:.ForUBS,itwasjust:.
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 AIGs third-largest counterpartv, after Goldman and Socit
GnraleMerrillswitchedtothemonolineinsurancecompaniesforprotection.In
the summer of iooo, Merrill management noticed that Citigroup, its biggest com-
petitorinunderwritingCDOs,wastakingmoresuper-seniortranchesofCDOsonto
itsownbalancesheetatrazor-thinmargins,andthusineffectsubsidizingreturnsfor
investors in the BBB-rated and 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 Merrills all-in wager on the mortgage and CDO
businesses. Even though it did grab the frst-place trophv in the mortgage-related
CDObusinessiniooo,ithadcomelatetotheverticalintegrationmortgagemodel
thatLehmanBrothersandBearStearnshadpioneered,whichrequiredhavingastake
inevervstepofthemortgagebusinessoriginatingmortgages,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:
AndMerrillalreadvhada1oo
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.
o
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.companvsuseofdeceptiveaccount-
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
agenciesandtheSECissuedtheirInteragencvStatementonSoundPracticesCon-
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 Enronand 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-
fectedamoreprinciples-basedapproach,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-,theBaselCommitteeonBankingSupervisionsIointForum,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
oftheratingagenciesmodels,especiallvforCDOs.Anditfurtheradvisedthemto
make sure that counterparties from whom thev bought credit protectionsuch as
AIG and the fnancial guarantorswould be good for that protection if it was
needed.
1oa
Theregulatorsalsosaidthevhadresearchedinsomedepth,fortheCDOandde-
rivativesmarket,thequestionAreundueconcentrationsofriskdeveloping:Their
answer: probablv not. The credit risk was quite modest, the regulators concluded,
andthemonolinefnancialguarantorsappearedtoknowwhatthevweredoing.
1o-
The [Ioint Forums Working Group on Risk Assessment and Capital]
hasnotfoundevidenceofhiddenconcentrationsofcreditrisk.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,MoodvsInvestorsService,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,thevolumeofMoodvsbusinessdevotedtoratingres-
identialmortgagebackedsecuritiesmorethandoubled;thedollarvalueofthatbusi-
ness increased from oi million to 1oo million; the number of staff rating these
dealsdoubled.Butoverthesameperiod,whilethevolumeofCDOstoberatedin-
creased sevenfold, stamng increased onlv ia. From ioo: to iooo, annual revenue
tiedtoCDOsgrewfrom1imilliontoo1million.
1o8
When Moodvs Corporation went public in iooo, the investor Warren Buffetts
z+( ii N\Nti \i tii :i : i NuUi i tu\\i : :i uN iiiui1
Berkshire Hathawav held 1- of the companv. After share repurchases bv Moodvs
Corporation, Berkshire Hathawavs holdings of outstanding shares increased to over
iobvioo8.Asofio1o,BerkshireHathawavandthreeotherinvestorsownedacom-
bined-o.-ofMoodvs.Whenaskedwhetherhewassatisfedwiththeinternalcon-
trols at Moodvs, Buffett responded to the FCIC that he knew nothing about the
managementofMoodvs.Ihadnoidea.IdneverbeenatMoodvs,Idontknowwhere
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
andthesingle-mostimportantdecisioninevaluatingabusinessispricingpower.
11o
Manv former emplovees said that after the public listing, the companv culture
changeditwentfrom[aculture]resemblingauniversitvacademicdepartmentto
onewhichvaluesrevenuesatallcosts,accordingtoEricKolchinskv,aformerman-
agingdirector.
111
Emploveesalsoidentifedanewfocusonmarketsharedirectedbv
formerpresidentofMoodvsInvestorsServiceBrianClarkson.Clarksonhadjoined
Moodvsin1oo1asasenioranalvstintheresidentialmortgagegroup,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[afterMoodvsbecameanindependentcorporation],andthathemade
personneldecisionstomakethathappen,andhewassuccessfulinthatregard.And
thatwaswhvBrianClarksonsrisewassometeoric: . . .hewastheenforcerwhocould
changetheculturetohavemorefocusonmarketshare.
11:
Theformermanagingdi-
rector Ierome Fons, who was responsible for assembling an internal historv of
Moodvs,agreed:Themainproblemwas . . .thatthefrmbecamesofocused,partic-
ularlvthestructuredarea,onrevenues,onmarketshare,andtheambitionsofBrian
Clarkson, that thev willinglv looked the other wav, traded the frms reputation for
short-termprofts.
11a
MoodvsCorporationChairmanandCEORavmondMcDanieldidnotagreewith
thisassessment,tellingtheFCICthathedidntseeanvparticulardifferenceincul-
ture after the spin-off.
11-
Clarkson also disputed this version of events, explaining
thatmarketsharewasimportanttoMoodvswellbeforeitwasanindependentcom-
panv.[TheideathatbeforeMoodvs]wasspunofffromDun&Bradstreet,itwasa
sortofsleepv,academickindofcompanvthatwasinanivorvtower . . .isntthecase,
vou know, he explained. I think [the ivorv tower] was reallv a misnomer. I think
thatMoodvshasalwavsbeenfocusedonbusiness.
11o
Clarkson and McDaniel also adamantlv disagreed with the perception that con-
cernsaboutmarketsharetrumpedratingsqualitv.ClarksontoldtheFCICthatitwas
fneforMoodvstolosetransactionsifitwasfortherightreasons:Ifitwasananalvt-
icalreasonoritwasacreditreason,theresnotalotvoucandoaboutthat.Butifvoure
losing a deal because voure not communicating, voure not being transparent, voure
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, Moodvs 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,aformerchiefcomplianceomceratMoodvs,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,thatsjustsotellingofhowhe
feltthathewasbulletproof. . . .Forhim,itwasallaboutrevenue.
1io
Clarksontoldthe
FCICthathedidntrememberthisconversationtranspiringandsaid,Frommvper-
spective,complianceisavervimportantfunction.
1i1
AccordingtosomeformerMoodvsemplovees,Clarksonsmanagementstvleleft
little room for discussion or dissent. Witt referred to Clarkson as the dictator of
Moodvsandsaidthatifheaskedanemploveetodosomething,eithervoucomplv
withhisrequestorvoustartlookingforanotherjob.
1ii
WhenIjoinedMoodvsin
late1oo,ananalvstsworstfearwasthatwewouldcontributetotheassignmentofa
rating that was wrong, Mark Froeba, former senior vice president, testifed to the
FCIC.WhenIleftMoodvs,ananalvstsworstfearwasthathewoulddosomething,
orshe,thatwouldallowhimorhertobesingledoutforjeopardizingMoodvsmar-
ketshare.
1i:
Clarksondeniedhavingaforcefulmanagementstvle,andhissupervi-
sor,RavmondMcDaniel,toldtheFCICthatClarksonwasagoodmanager.
1ia
Former team managing director Garv Witt recalled that he received a monthlv
emailfromClarksonthatoutlinedbasicallvmvmarketshareintheareasthatIwas
inchargeof. . . .Ibelieveitlistedthedealsthatwedid,andthenitwouldlistthedeals
likeS&Pand/orFitchdidthatwedidntdothatwasinmvarea.Andattimes,Iwould
have to comment on that verballv or even write a written report aboutvou 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, thats 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
hadratedorNOTrated.Clarksonsinstructions:YoushouldbeusingthisinPEs
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
ofits[sic]bizarrestructure.
1i
MoreevidenceofMoodvsemphasisonmarketsharewasprovidedbvanemailthat
circulatedinthefallofioo,inthemidstofsignifcantdowngradesinthestructuredf-
nancemarket.GroupManagingDirectorofU.S.DerivativesYuriYoshizawaaskedher
teamsmanagingdirectorstoexplainamarketsharedecreasefromo8tooa.
1i8
Despitethisapparentemphasisonmarketshare,ClarksontoldtheFCICthatthe
mostimportantgoalforanvmanagingdirectorwouldbecredibilitv . . .andperform-
ance[of]theratings.
1io
McDaniel,thechairmanandCEOofMoodvsCorporation,
elaborated: I disagree that there was a drive for market share. We pav attention to
ourpositioninthemarket. . . .Butratingsqualitv,gettingtheratingstothebestpos-
siblepredictivecontent,predictivestatus,isparamount.
1:o
WhateverMcDanielsorClarksonsintendedmessage,someemploveescontinued
toseeanemphasisonMoodvsmarketshare.FormerteammanagingdirectorWitt
recalled that the smoking gun moment of his emplovment at Moodvs occurred
duringatownhallmeetinginthethirdquarterofioowithMoodvsmanagement
anditsmanagingdirectors,afterMoodvshadalreadvannouncedmassdowngrades
on mortgage-related securities.
1:1
After McDaniel made a presentation about
Moodvs fnancial outlook for the vear ahead, one managing director responded: I
wasinterested,Rav,tohearvourbeliefthatthefrstthinginthemindsofpeoplein
thisroomisthefnancialoutlookfortheremainderofthevear. . . .[M]vthinkingis
theres a much greater concern about the franchise. He added, I think that the
greateranxietvbeingfeltbvthepeopleinthisroomand . . .bvtheanalvstsiswhats
goingonwiththeratingsandwhattheoutlookis[,] . . .specifcallvthesevereratings
transitionsweredealingwith . . .anduncertaintvaboutwhatsaheadonthat,therat-
ingsaccuracv.
1:i
Wittrecalled,Moodvsreputationwasjustbeingabsolutelvlacer-
ated; and that these people are standing here, and thevre not even
addressingthevre acting like its not even happening, even now that its alreadv
happened. . . .[T]hatjustmadeitsocleartome . . .thatthebalancewasfartoomuch
onthesideofshort-termproftabilitv.
1::
InaninternalmemorandumfromOctoberioosenttoMcDaniel,inasection
titled Confict of Interest: Market Share, Chief Credit Omcer Andrew Kimball
1ui \\iNi: : z++
explainedthatMoodvshaserectedsafeguardstokeepteamsfromtooeasilvsolv-
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
deterredMoodvsfromcreatingnewmodelsorupdatingitsassumptions,asKimball
wrote:Organizationsofteninterpretpastsuccessesasevidencingtheircompetence
and the adequacv of their procedures rather than a run of good luck. . . . [O]ur ia
vearsofsuccessratingRMBS[residentialmortgagebackedsecurities]mavhavein-
ducedmanagerstomerelvfne-tunetheexistingsvstemtomakeitmoreemcient,
more proftable, cheaper, more versatile. Fine-tuning rarelv raises the probabilitv of
success;infact,itoftenmakessuccesslesscertain.
1:-
IfanissuerdidntlikeaMoodvsratingonaparticulardeal,itmightgetabetter
rating from another ratings agencv. The agencies were compensated onlv for rated
dealsineffect,onlvforthedealsforwhichtheirratingswereacceptedbvtheissuer.
Sothepressurecamefromtwodirections:in-houseinsistenceonincreasingmarket
shareanddirectdemandsfromtheissuersandinvestmentbankers,whopushedfor
betterratingswithfewerconditions.
1:o
RichardMichalek,aformerMoodvsvicepresidentandseniorcreditomcer,testi-
fedtotheFCIC,Thethreatoflosingbusinesstoacompetitor,evenifnotrealized,
absolutelvtiltedthebalanceawavfromanindependentarbiterofrisktowardsacap-
tive facilitator of risk transfer.
1:
Witt agreed. When asked if the investment banks
frequentlvthreatenedtowithdrawtheirbusinessifthevdidntgettheirdesiredrat-
ing, Witt replied, Oh God, are vou kidding: All the time. I mean, thats routine. I
mean,thevwouldthreatenvouallofthetime. . . .Itslike,Well,nexttime,werejust
goingtogowithFitchandS&P.
1:8
Clarksonamrmedthatitwouldntsurprisemeto
hearpeoplesavthataboutissuerpressureonMoodvsemplovees.
1:o
FormermanagingdirectorFonssuggestedthatMoodvswascomplaisantwhenit
shouldhavebeenprincipled:[Moodvs]knewthatthevwerebeingbulliedintocav-
ingintobankpressurefromtheinvestmentbanksandoriginatorsofthesethings. . . .
Moodvs allow[ed] itself to be bullied. And, vou know, thev willinglv plaved the
game. . . .Thevcouldhavestoodupandsaid,Imsorrv,thisisnotwerenotgoing
tosignoffonthis.Weregoingtoprotectinvestors.Weregoingtostopvouknow,
weregoingtotrvtoprotectourreputation.WerenotgoingtoratetheseCDOs,were
notgoingtoratethesesubprimeRMBS.
1ao
KimballelaboratedfurtherinhisOctoberioomemorandum:
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 dont
wantratingdowngrades;andbankersgametheratingagenciesforafew
extrabasispointsonexecution.
1a1
MoodvsemploveestoldtheFCICthatonetacticusedbvtheinvestmentbankers
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, Moodvs gave triple-A ratings to an average of
morethan:omortgagesecuritieseachandevervworkingdav.
1ao
SuchpressurecanbeseeninanAprilioooemailtoYoshizawafromamanaging
directorinsvntheticCDOtradingatCreditSuisse,whoexplained,Imgoingtohave
amajorpoliticalproblemifwecantmakethis[dealrating]shortandsweetbecause,
eventhoughIalwavsexplaintoinvestorsthatclosingissubjecttoMoodvstimelines,
thevoftenchoosenottohearit.
1a
TheexternalpressurewassummedupinKimballsOctoberioomemorandum:
Analvstsand[managingdirectors]arecontinuallvpitchedbvbankers,issuers,in-
vestorsall with reasonable argumentswhose views can color credit judgment,
sometimesimprovingit,othertimesdegradingit(wedrinkthekool-aid).Coupled
withstronginternalemphasisonmarketshare&marginfocus,thisdoesconstitutea
risktoratingsqualitv.
1a8
The SEC investigated the rating agencies ratings of mortgage-backed securities
andCDOsinioo,reportingitsfndingstoMoodvsinIulvioo8.TheSECcriticized
Moodvsfor,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,andanotherandthenseizedup
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. Moodvs, the Commissions 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|inqucncics1hcturncjthchcusingnarkct :);
RatingdcwngradcsNcvcr|cjcrc::)
CDOsC|in|ingthcwa||cjsu|princwcrrv:::
Icga|rcncdicsOnthc|asiscjthcinjcrnaticn::;
IcsscsVhccwnsrcsidcntia|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 worlds largest fnancial institutions: The concerns were just that if
people . . .couldntvaluetheassets,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.
Asioowenton,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..
Thesummerofiooalsosawanearhaltinmanvsecuritizationmarkets,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
topped1oobillioninthesecondquarter,butfellto1:billioninthefourthquarter
ofioo.Once-boomingmarketswerenowgoneonlvabillioninsubprimeorAlt-
Amortgage-backedsecuritieswereissuedinthefrsthalfofioo8,andalmostnone
afterthat.
i
CDOsfollowedsuit.Fromahighofmorethanoobillioninthefrstquarterof
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;onlv1obillionwereis-
sued in ioo8. The issuance of commercial real estate mortgagebacked securities
plummetedfromi:ibillioniniooto1ibillioninioo8.
a
Thosesecuritizationmarketsthatheldupduringtheturmoiliniooeventuallv
suffered in ioo8 as the crisis deepened. Securitization of auto loans, credit cards,
smallbusinessloans,andequipmentleasesallnearlvceasedinthethirdandfourth
quartersofioo8.
DELINQUENCIES: THE TURN OF THE HOUSING MARKET
Homepricesrose1-nationallvinioo-,theirthirdvearofdouble-digitgrowth.But
bvthespringofiooo,asthesalespaceslowed,thenumberofmonthsitwouldtaketo
selloffallthehomesonthemarketrosetoitshighestlevelin1ovears.Nationwide,
homepricespeakedinApriliooo.
MembersoftheFederalReservesFederalOpenMarketCommittee(FOMC)dis-
cussed housing prices in the spring of iooo. Chairman Ben Bernanke and other
memberspredictedadeclineinhomepricesbutwereuncertainwhetherthedecline
would be slow or fast. Bernanke believed some correction in the housing market
wouldbehealthvandthatthegoaloftheFOMCshouldbetoensurethecorrection
didnotoverlvaffectthegrowthoftherestoftheeconomv.
-
InOctoberiooo,withthehousingmarketdownturnunderwav,MoodvsEcon-
omv.com, a business unit separate from Moodvs Investors Service, issued a report
authoredbvChiefEconomistMarkZandititledHousingattheTippingPoint:The
Outlook for the U.S. Residential Real Estate Market. He came to the following
conclusion:
Nearlv io of the nations metro areas will experience a crash in house
prices;adouble-digitpeak-to-troughdeclineinhouseprices. . . .These
sharpdeclinesinhousepricesareexpectedalongtheSouthwestcoastof
Florida,inthemetroareasofArizonaandNevada,inanumberofCali-
z.. ii N\Nti \i tii :i : i 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-
tionshousingstockexperiencingorabouttoexperiencepricedeclines,
nationalhousepricesarealsosettodecline.Indeed,oddsarehighthat
nationalhousepriceswilldeclineinioo.
o
For ioo, the National Association of Realtors announced that the number of
salesofexistinghomeshadexperiencedthesharpestfallini-vears.Thatvear,home
pricesdeclinedo.Inioo8,thevwoulddropastunning1.Overall,bvtheendof
iooo,priceswoulddropi8fromtheirpeakiniooo.
Somecitiessawaparticularlv
largedrop:inLasVegas,asofAugustio1o,homepricesweredown--fromtheir
peak. And areas that never saw huge price gains have experienced losses as well:
homepricesinDenverhavefallen18sincetheirpeak.
In some areas, home prices started to fall as earlv as late ioo-. For example, in
OceanCitv,NewIersev,wheremanvpropertiesarevacationhomes,homepriceshad
risen1aasinceioo1;thevtoppedoutinDecemberioo-andfellainthefrsthalf
of iooo. Bv mid-io1o, thev would be ii below their peak. Prices topped out in
SacramentoinOctoberioo-andaretodavdownnearlv-o.Inmostplaces,prices
rose for a bit longer. For instance, in Tucson, Arizona, prices kept increasing for
muchofiooo,climbingo-fromioo1totheirhighpointinAugustiooo,andthen
fellonlv:bvtheendofthevear.
8
One of the frst signs of the housing crash was an upswing in earlv pavment de-
faultsusuallvdefnedasborrowersbeingooormoredavsdelinquentwithinthefrst
vear. Figures provided to the FCIC show that bv the summer of iooo, 1.- of loans
lessthanavearoldwereindefault.Thefgurewouldpeakinlateiooati.-,well
above the 1.o peak in the iooo recession. Even more stunning, frst pavment de-
faultsthatis,mortgagestakenoutbvborrowerswhonevermadeasinglepavment
went above 1.- of loans in earlv ioo.
o
Responding to questions about that data,
CoreLogicChiefEconomistMarkFlemingtoldtheFCICthattheearlvpavmentde-
faultratecertainlvcorrelateswiththeincreaseintheAlt-Aandsubprimesharesand
theturnofthehousingmarketandthesensitivitvofthoseloanproducts.
1o
Mortgagesinseriousdelinquencv,defnedasthoseooormoredavspastdueorin
foreclosure,hadhoveredaround1duringtheearlvpartofthedecade,jumpedin
iooo,andkeptclimbing.Bvtheendofiooo,o.ofmortgageloanswereseriouslv
delinquent.Bvcomparison,seriousdelinquenciespeakedati.ainiooifollowing
thepreviousrecession.
11
Seriousdelinquencvwashighestinareasofthecountrvthathadexperiencedthe
biggest housing booms. In the sand statesCalifornia, Arizona, Nevada, and
Floridaseriousdelinquencvroseto:inmid-iooand1-bvlateiooo,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;therateroserapidlvtoioinioo.Bvlateiooo,
thedelinquencvrateforsubprimeARMswasao.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
containedmortgagesinfourgroupsloansthatweresoldintoprivatelabelsecuriti-
zationslabeledsubprimebvissuers(labeledSUB),loanssoldintoprivatelabelAlt-A
securitizations(ALT),loanseitherpurchasedorguaranteedbvtheGSEs(GSE),and
loansguaranteedbvtheFederalHousingAdministrationorVeteransAdministration
(FHA).
1a
TheGSEgroup,inadditiontothemoretraditionalconformingGSEloans,
Arizona, California, Florida, and Nevadathe sand stateshad the most
problem loans.
Mortgage Delinquencies by Region
IN PERCENT, BY REGION
0
4
8
12
16%
1998 2000 2002 2004 2006 2008 2010
Sand
states
U.S.
total
Non-sand
states
13.6%
8.7%
7.0%
SOURCE: Mortgage Bankers Association National Delinquency Survey
NOTE: Serious delinquencies include mortgages 90 days or more past due and those in foreclosure.
Iigurc ++.+
1ui 8U:1 z.,
alsoincludesmortgagesthattheGSEsidentifedassubprimeandAlt-Aloansowing
totheirhigher-riskcharacteristics,asdiscussedinearlierchapters.
Withineachofthefourgroups,theFCICcreatedsubgroupsbasedoncharacteris-
tics that could affect loan performance: FICO credit scores, loan-to-value ratios
(LTVs), and mortgage size. For example, one subgroup would be GSE loans with a
balancebelowa1,ooo(conformingtoGSEloansizelimits),aFICOscorebetween
oaoando-o(aborrowerwithbelow-averagecredithistorv),andLTVbetween8o
and 1oo. Another group would be Alt-A loans with the same characteristics. In
each vear, the loans were broken into -o different subgroups1aa 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-o(i-onei-
thersideofthemedian)ofthedistributionofaveragedelinquencvrates.Thefullbar,
includingbothdarkandlightshading,representsthemiddleooofthedistribution
ofaveragedelinquencvrates.Thebarsexcludethe-attheextremesofeachendof
the distribution. For example, at the end of ioo8, the black portion of the GSE bar
Iigurc ++.:
Mortgage Delinquencies by Loan Type
IN PERCENT, BY TYPE
SOURCE: Mortgage Bankers Association National Delinquency Survey
Subprime
adjustable
rate
Subprime
fx
rate
Prime
adjustable
rate
Prime
fx
rate
1998 2000 2002 2004 2006 2008 2010
NOTE: Serious delinquencies include mortgages 90 days or more past due and those in foreclosure.
Serious delinquencies started earlier and were substantially higher among
subprime adjustable-rate loans, compared with other loan types.
0
10
20
30
40
50%
spans a o.o average delinquencv rate on the low end and a i.a average delin-
quencv rate on the high end. The full bar for the GSEs spans average delinquencv
rates from o.1 to o.o. That means that onlv - of GSE loans were in subgroups
with average delinquencv rates above o.o. In sharp contrast, the black bar for pri-
vate-label subprime securitizations (SUB) spans average delinquencv rates between
ia.o on the low end and :1.o on the high end, and the full bar spans average
delinquencv rates between 1o.o and :i.o. That means that onlv - of SUB loans
were in subgroups with average delinquencv rates below 1o. The worst-performing
- of GSE loans are in subgroups with rates of serious delinquencv similar to the
best-performing - of SUB loans.
1o
Bv the end of iooo, performance within all segments of the market had weakened.
The median delinquencv ratethe midpoints of the black barsrose from 1 in
ioo8 to i.- for GSE loans, from io to :o for SUB loans, from 1i to i1 for
Alt-A loans, and remained at roughlv o 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.:ando.i.Thesepatternsaremostlikelvdrivenbvdifferencesinunder-
writing standards as well as bv some differences not captured in these mortgages.
1
Forinstance,intheGSEpool,borrowerstendedtomakebiggerdownpavments.The
FCICsdatashowthat-8ofGSEloanswithFICOscoresbelowooohadanoriginal
loan-to-valueratiobelow8o,indicatingthattheborrowermadeadownpavment
ofatleastioofthesalesprice.Thisrelativelvlargedownpavmentwouldhelpoffset
theeffectofthelowerFICOscore.Incontrast,onlv:1ofloanswithFICOscores
belowoooinnon-GSEsubprimesecuritizationshadanLTVunder8o.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
loanswithanLTVaboveoo,theGSEpoolshaveanaveragerateofseriousdelin-
quencv of -., versus a rate of 1-.- 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 oo, 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, ao of all
mortgagesinthecountrvio.millionofthemwereriskvmortgagesthathede-
fnes as subprime or Alt-A. Of these, Pinto counts 11.o million, or a-, that were
purchasedorguaranteedbvtheGSEs.
1o
Incontrast,theGSEscategorizefewerthan
:millionoftheirloansassubprimeorAlt-A.
io
Importantlv, as the FCIC review shows, the GSE loans classifed as subprime or
Alt-AinPintosanalvsisdidnotperformnearlvaspoorlvasloansinnon-agencvsub-
primeorAlt-Asecurities.Thesedifferencessuggestthatgroupingalloftheseloans
togetherismisleading.IndirectcontrasttoPintosclaim,GSEmortgageswithsome
riskier characteristics such as high loan-to-value ratios are not at all equivalent to
those mortgages in securitizations labeled subprime and Alt-A 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,thestudvfoundthatonlvoofsuchhigher-costloansweremade
to low- or moderate-income borrowers or in low- or moderate-income neighbor-
hoodsbvbanksandthrifts(andtheirsubsidiariesandamliates)coveredbvtheCRA.
The other oa 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,foundthatonlv1oofloansmadebvCRA-covered
lenderswerelocatedinlow-andmoderate-incomecensustractsversusoveriofor
independentmortgagecompaniesnotcoveredbvtheCRA.Further,fewerthan:o
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,andparticularlvitsemphasisonloansmadewithinalenders
assessmentarea,helpedtoensureresponsiblelending,evenduringaperiodofover-
alldeclinesinunderwritingstandards,thevconcluded.
i:
Overall,iniooa,ioo-,andiooo,CRA-coveredbanksandthriftsaccountedforat
least oo of all mortgage lending but onlv between :o and a1 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-
otherroughlv1oofmortgagelendingbutabout1iofhigh-pricelending.
BankofAmericaprovidedtheFCICwithperformancedataonitsCRA-qualifv-
ing portfolio, which represented onlv of the banks mortgage portfolio.
i-
In the
endofthefrstquarterofio1o,8ofthebanksi1ibillionportfolioofresidential
mortgageswasnonperforming:i1ofthe1-billionCRA-qualifvingportfoliowas
nonperformingatthatdate.
IohnReed,aformerCEOofCitigroup,whenaskedwhetherhethoughtgovern-
mentpoliciessuchastheCRAplavedaroleinthecrisis,saidthathedidntbelieve
zz+ ii N\Nti \i tii :i : i NuUi i tu\\i : :i uN iiiui1
bankswouldoriginateabadmortgagebecausethevthoughtthegovernmentpolicv
allowed it unless the bank could sell off the mortgage to Fannie or Freddie, which
hadtheirownobligationsinthisarena.Hesaid,Itshardformetoanswer.Iftherea-
son the regulators didnt jump up and down and 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-homeownershippoliciesasasmokescreentodoawavwithunderwriting
standardssuchasrequiringdownpavments,hesaid.Thedangeristhatitgivesair
covertoallofthiskindofmadnessthathadnothingtodowiththehousinggoal.
i
RATING DOWNGRADES: NEVER BEFORE
Priortoiooa,theratingsofmortgage-backedsecuritiesatMoodvsweremonitored
bv the same analvsts who had rated them in the frst place. In iooa, Nicolas Weill,
Moodvschiefcreditomcerandteammanagingdirector,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 Moodvs Corporation, and Brian Clarkson, the president of
MoodvsInvestorsService.
:o
In earlv ioo, a Moodvs special report, overseen bv Weill, about the sharp in-
creases in earlv pavment defaults stated that the foreclosures were concentrated in
subprimemortgagepools.Inaddition,morethani.-ofthesubprimemortgages
securitizedinthesecondquarterofiooowereoodavsdelinquentwithinsixmonths,
morethandoubletherateavearearlier(1.i-).Theexactcauseofthetroublewas
still unclear to the ratings agencv, though. Moodvs is currentlv assessing whether
this represents an overall worsening of collateral credit qualitv or merelv a shifting
forwardofeventualdefaultswhichmavnotsignifcantlvimpactapoolsoverallex-
pectedloss.
:1
Forthenextfewmonths,thecompanvpublishedregularupdatesaboutthesub-
prime mortgage market. Over the next three months, Moodvs took negative rating
actionsona.-oftheoutstandingsubprimemortgagesecuritiesratedBaa.Then,on
Iulv1o,ioo,inanunprecedentedmove,Moodvsdowngraded:oosubprimemort-
gage-backedsecuritiesthathadbeenissuedinioooandputanadditional:isecuri-
tiesonwatch.The-.ibillionofsecuritiesthatwereaffected,allratedBaaandlower,
madeup1oofthesubprimesecuritiesthatMoodvsratedBaainiooo.Forthetime
1ui 8U:1 zz.
being, there were no downgrades on higher-rated tranches. Moodvs attributed the
downgrades to aggressive underwriting combined with prolonged, slowing home
price appreciation and noted that about oo of the securities affected contained
mortgages from one of four originators: Fremont Investment & Loan, Long Beach
Mortgage Companv, New Centurv Mortgage Corporation, and WMC Mortgage
Corp.
:i
WeilllatertoldtheFCICstaffthatMoodvsissuedamassannouncement,rather
thandowngradingafewsecuritiesatatime,toavoidcreatingconfusioninthemar-
ket.
::
A few davs later, Standard & Poors downgraded ao8 similar tranches. These
initialdowngradeswereremarkablenotonlvbecauseofthenumberofsecuritiesin-
volvedbutalsobecauseofthesharpratingcutsanaverageoffournotchesperse-
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
1i of the original loan pool had prepaid but another 11 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,owning8millionoftheMandM8tranches.BSAMsHigh-Grade
hedge fund also had exposure through a 1o million credit default swap position
with Lehman referencing the M8 tranche. And BSAMs Enhanced Leverage hedge
fundownedpartsoftheequitvinIndependenceCDO,whichinturnownedtheMo
tranche of our sample deal. In addition, these funds had exposure through their
holdingsofotherCDOsthatinturnownedtranchesoftheCitigroupdeal.
:-
Then, on October 11, Moodvs downgraded another i,-oo tranches (::.a bil-
lion) of subprime mortgagebacked securities and placed - tranches (i:.8 bil-
lion)onwatchforpotentialdowngrade.Nowthetotalofsecuritiesdowngradedand
put on watch represented 1:.a of the original dollar volume of all iooo subprime
mortgagebacked securities that Moodvs had rated. Of the securities placed on
watchinOctober,a8tranches(o.obillion)wereoriginallvAaa-ratedand-io(1o.o
billion)wereAa-rated.Alltold,inthefrst1omonthsofioo,oiofthemortgage-
backedsecuritvdealsissuediniooohadatleastonetranchedowngradedorputon
watch.
:o
Bv this point in October, 1: 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,Moodvswoulddowngrade8:ofalltheioooAaamortgage-
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 gradethat is, rated Baa: or highero of
thoseissuedinioooweredowngradedtojunk,aswere8oofthosefromioo.
:8
CDOS: CLIMBING THE WALL OF SUBPRIME WORRY
InMarchioo,MoodvsreportedthatCDOswithhighconcentrationsofsubprime
mortgagebackedsecuritiescouldincurseveredowngrades.
:o
Inaninternalemail
sent fve davs after the report, Group Managing Director of U.S. Derivatives Yuri
Yoshizawa explained to Moodvs 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, Moodvs noted,
Someofthefrstquartersactivitv[inioo]wastheresultofsomearrangersfever-
ishlvworkingtoclearinventorvandreducetheirbalancesheetexposuretothesub-
prime class.
a1
Even though Moodvs was aware that the investment banks were
dumping collateral out of the warehouses and into CDOspossiblv regardless of
qualitvthefrmcontinuedtoratenewCDOsusingexistingassumptions.
FormerMoodvsexecutiveRichardMichalektestifedtotheFCIC,Itwasacase
of, with respect to whv didnt we stop and change our methodologv, there is a verv
conservative culture at Moodvs, 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,McDanielgaveapresentationtotheboardonthecompanvsioostrate-
gicplan.HisslideshadsuchbleaktitlesasSpotlightonMortgages:OualitvContin-
ues to Erode, House Prices Are Falling . . . , Mortgage Pavment Resets Are
Mounting,and1.:MMMortgageDefaultsForecastiooo8.
a:
Despitealltheevi-
dence that the qualitv of the underlving mortgages was declining, Moodvs did not
makeanvsignifcantadjustmentstoitsCDOratingsassumptionsuntillateSeptem-
ber.
aa
Outof-1billioninCDOsthatMoodvsratedafteritsmassdowngradeofsub-
primemortgagebackedsecuritiesonIulv1o,ioo,88wereratedAaa.
a-
Moodvshadhopedthatratingdowngradescouldbestavedoffbvmortgagemod-
ifcationsiftheirmonthlvpavmentsbecamemoreaffordable,borrowersmightstav
current.However,inmid-September,EricKolchinskv,ateammanagingdirectorfor
CDOs,learnedthatasurvevofservicersindicatedthatvervfewtroubledmortgages
werebeingmodifed.
ao
WorriedthatcontinuingtorateCDOswithoutadjustingfor
known deterioration in the underlving securities could expose Moodvs to liabilitv,
KolchinskvadvisedYoshizawathatthecompanvshouldstopratingCDOsuntilthe
securities downgrades were completed. Kolchinskv told the FCIC that Yoshizawa
admonishedhimformakingthesuggestion.
a
1ui 8U:1 zz.
Bv the end of ioo8, more than oo of all tranches of CDOs had been down-
graded. Moodvs downgraded nearlv all of the iooo Aaa and all of the Baa CDO
tranches. And, again, the downgrades were largemore than 8o of Aaa CDO
bondsandmorethanooofBaaCDObondswereeventuallvdowngradedtojunk.
a8
LEGAL REMEDIES: ON THE BASIS OF THE INFORMATION
Thehousingbustexposedthefawsinthemortgagesthathadbeenmadeandsecuri-
tized. After the crisis unfolded, those with exposure to mortgages and structured
productsincluding investors, fnancial frms, and private mortgage insurance
frmscloselvexaminedtherepresentationsandwarrantiesmadebvmortgageorig-
inators and securities issuers. When mortgages were securitized, sold, or insured,
certain representations and warranties were made to assure investors and insurers
thatthemortgagesmetstatedguidelines.Asmortgagesecuritieslostvalue,investors
foundsignifcantdefcienciesinsecuritizersduediligenceonthemortgagepoolsun-
derlvingthemortgage-backedsecuritiesaswellasintheirdisclosureaboutthechar-
acteristics of those deals. As private mortgage insurance companies found similar
defcienciesintheloansthevinsured,thevhavedeniedclaimstoanunprecedented
extent.
FannieandFreddieacquiredorguaranteedmillionsofloanseachvear.Thevdele-
gatedunderwritingauthoritvtooriginatorssubjecttoalegalagreementrepresenta-
tions and warrantiesthat the loans meet specifed criteria. Thev then checked
samples of the loans to ensure that these representations and warranties were not
breached.Iftherewasabreachandtheloanswereineligibleforpurchase,theGSE
hadtherighttorequirethesellertobuvbacktheloanassuming,ofcourse,thatthe
sellerhadnotgonebankrupt.
Asaresultofsuchsampling,duringthethreevearsandeightmonthsendingAu-
gust:1,io1o,FreddieandFannierequiredsellerstorepurchase1o,oooloanstotal-
ing:a.8billion.Sofar,Freddiehasreceivedo.1billionfromsellers, andFanniehas
received11.8billionatotalofio.obillion.
ao
Theamountputbackisnotablein
thatitrepresentsi1of1o: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 oo of all loans that default in the frst two vears). In total, Freddie re-
viewedo.8billionofloans(outof1.-1trillioninloansacquiredorguaranteed)
andfoundi1.billiontobeineligible,meaningthevdidnotmeetrepresentations
andwarranties.
-1
Amongtheperformingloansthatweresampled,overtimeanincreasingpercent-
agewerefoundtobeineligible,risingfrom1oformortgagesoriginatedinioo-to
i:inioo8.Still,Freddieputbackvervfewoftheseperformingloanstotheorigina-
tors.Amongmortgagesoriginatedfromioo-toioo8,itfoundthat1ofthedelin-
quentloanswereineligible,aswereioftheloansinforeclosure.
-i
Mostofthese
wereputbacktooriginatorsagain,incasesinwhichtheoriginatorswerestillinop-
zz. ii N\Nti \i tii :i : i NuUi i tu\\i : :i uN iiiui1
eration.Sometimes,ifthereasonsforineligibilitvweresumcientlvminor,theloans
werenotputback.
Overall,ofthedelinquentloansandloansinforeclosuresampledbvFreddie,io
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,aomillion;andAllvFinancial,a-:mil-
lion.
-:
UsingamethodsimilartoFreddiestotestforloaneligibilitv,Fanniereviewedbe-
tween i and - of the mortgages originated since ioo-sampling at the higher
ratesfordelinquentloans.Fromioothroughio1o,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,settlingtheGSEsclaimswithapavmentofmorethani.-
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-
nieshadinsuredatotalofoo8billioninpotentialmortgagelosses.
-o
As defaults and losses on the insured mortgages have been increasing, the PMI
companies have seen a spike in claims. As of October io1o, the seven largest PMI
companies,whichshareo8ofthemarket,hadrejectedabouti-oftheclaims(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
housingboomtheGSEspurchasedooobillionofsubprimeandAlt-Aprivate-label
securities.
-8
TheGSEshaverecordedaobillioninchargesonsecuritiesfromIanu-
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
underwritersthereweremorethanaoolawsuitsrelatedtobreachesofrepresenta-
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 generals omce settled charges against
Morgan Stanlev and Goldman Sachs, after accusing the frms of inadequate disclo-
surerelatingtotheirsalesofmortgage-backedsecurities.MorganStanlevagreedto
pav1oimillionandGoldmanSachsagreedtopavoomillion.
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;andLevel:assets,whichwereilliquidandhadnodiscerniblemarket
pricesorotherinputs.TodeterminethevalueofLevel:andinsomecasesLevelias-
setswheremarketpriceswereunavailable,frmsusedmodelsthatreliedonassump-
tions.ManvfnancialinstitutionsreportedLevel:assetsthatsubstantiallvexceeded
theircapital.Forexample,forthefrstquarterofioo,BearStearnsreportedabout
1obillioninLevel:assets,comparedto1:billionincapital;MorganStanlevre-
zz( ii N\Nti \i tii :i : i NuUi i tu\\i : :i uN iiiui1
portedaboutoobillioninLevel:assets,againstcapitalof:8billion;andGoldman
reportedabouta8billion,andcapitalof:billion.
Mark-to-marketwrite-downswererequiredonmanvsecuritieseveniftherewere
noactualrealizedlossesandinsomecasesevenifthefrmsdidnotintendtosellthe
securities.Thechargesrefectingunrealizedlosseswerebased,inpart,oncreditrat-
ingagenciesandinvestorsexpectationsthatthemortgageswoulddefault.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 SECs Committee on Improvements to Financial Reporting, noted
thatattimes,markingsecuritiesatmarketpricescreatessituationswherevouhave
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
wouldtotaliooto:oobillion;
o
sofar,bvio1o,thefgurehasturnedoutnottobe
muchmorethanthat.Asofvear-endiooo,thedollarvalueofallimpairedAlt-Aand
subprime mortgagebacked securities total about :oo billion.
o8
Securities are im-
paired when thev have suffered realized losses or are expected to suffer realized
lossesimminentlv.Whilethosenumbersaresmallinrelationtothe1atrillionU.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 holdingsbefore 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:
twoLehmananalvstsaskedinaSeptemberiooreport.Theanswer:three-quarters
of subprime and Alt-A mortgages had been securitizedand much of the risk in
1ui 8U:1 zz,
these securitizations is in the investment-grade securities and has been almost en-
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.
TheInternationalMonetarvFundsGlobalFinancialStabilitvReportpublishedin
Octoberioo8examinedwherethedecliningassetswereheldandestimatedhowse-
verethewrite-downswouldbe.Alltold,theIMFcalculatedthatroughlv1otrillion
inmortgageassetswereheldthroughoutthefnancialsvstem.Ofthese,:.8trillion
wereGSEmortgagebackedsecurities;theIMFexpectedlossesof8obillion,butin-
vestorsholdingthesesecuritieswouldlosenomonev,becauseoftheGSEsguaran-
tee. Another a. trillion in mortgage assets were estimated to be prime and
nonprimemortgagesheldlargelvbvthebanksandtheGSEs.Thesewereexpectedto
suffer as much as 1o billion in write-downs due to declines in market value. The
remaining1.-trillioninassetswereestimatedtobemortgage-backedsecuritiesand
CDOs. Write-downs on those assets were expected to be -oo billion. And, even
moretroubling,morethanone-halfoftheselosseswereexpectedtobebornebvthe
investmentbanks,commercialbanks,andthrifts.Therestofthewrite-downsfrom
non-agencvmortgagebackedsecuritiesweresharedamonginstitutionssuchasin-
surancecompanies,pensionfunds,theGSEs,andhedgefunds.TheOctoberreport
alsoexpectedanothero--billioninwrite-downsoncommercialmortgagebacked
securities, CLOs, leveraged loans, and other loans and securitieswith more than
half coming from commercial mortgagebacked securities. Again, the commercial
banksandthriftsandinvestmentbankswereexpectedtobearmuchofthebrunt.
1
Furthermore, when the crisis began, 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-downswererecordedonfnancialinstitutionsbalancesheetsbased
ondeclinesinmarketvalue.However,althoughthiscouldnotbeknowninioo,at
the end of io1o most of the triple-A tranches of mortgage-backed securities have
avoided actual losses in cash fow through io1o and mav avoid signifcant realized
lossesgoingforward.
Overall, for ioo- to ioo vintage tranches of mortgage-backed securities origi-
nallvratedtriple-A,despitethemassdowngrades,onlvabout1oofAlt-Aandaof
subprime securities had been materiallv impairedmeaning that losses were im-
zz ii N\Nti \i tii :i : i NuUi i tu\\i : :i uN iiiui1
minent or had alreadv been sufferedbv the end of iooo (see fgure 11.a). For the
lower-ratedBaatranches,oo.-ofAlt-Aando-.-ofsubprimesecuritieswereim-
paired.Inall,bvtheendofiooo,:iobillionworthofsubprimeandAlt-Atranches
hadbeenmateriallvimpairedincluding1:i.obillionoriginallvratedtriple-A.The
outcomewouldbefarworseforCDOinvestors,whosefatelargelvdependedonthe
performanceoflower-ratedmortgage-backedsecurities.MorethanooofBaaCDO
bondsand1.:ofAaaCDObondswereultimatelvimpaired.
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: Moodys Investors Service, Special Comment: Default & Loss Rates of Structured Finance Securities:
1993-2009; Moodys SFDRS.
Aa thru B Aaa Aa thru B Aaa Aa thru B Aaa
Not impaired
Impaired
Alt-A MBS
Subprime MBS CDOs
Iigurc ++.;
z.+ ii N\Nti \i tii :i : i 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)hadevengreaterleveragewithacombined-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 depositswas 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|dnanIcts|caggrcssivcdistri|utingthings::
BcarStcarnsshcdgcjundsIccksprcttvdannug|v:::
RatingagcncicsItcant|ca||cjasuddcn:;:
AIGVc|||iggcrthanwccvcrp|anncdjcr :;:
Overthecourseofioo,thecollapseofthehousingbubbleandtheabruptshutdown
ofsubprimelendingledtolossesformanvfnancialinstitutions,runsonmonevmar-
ket funds, tighter credit, and higher interest rates. Unemplovment remained rela-
tivelv steadv, hovering just below a.- until the end of the vear, and oil prices rose
dramaticallv.Bvthemiddleofioo,homepriceshaddeclinedalmostafromtheir
peak in iooo. Earlv evidence of the coming storm was the 1.- drop in November
iooo of the ABX Indexa Dow Ioneslike index for credit default swaps on BBB-
tranchesofmortgage-backedsecuritiesissuedinthefrsthalfofiooo.
1
ThatdropcameafterMoodvsandS&Pputonnegativewatchselectedtranchesin
onedealbackedbvmortgagesfromoneoriginator:FremontInvestment&Loan.
i
In
December, the same index fell another : 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,announceda1.8billionincreaseinits
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
davan 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 didnt get the magnitude, and the market didnt
graspthemagnitudeuntilspringofo,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-
tiesofthesuper-seniortranchesoftheseCDOs.Thebankerscouldalwavshope
and manv apparentlv even believedthat 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 were watching it
closelvbutitappearstobecontained.
Frost never responded to Davilmans 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
AIGs models showed
therewouldbenodefaultsonanvofthebondpavmentsthatAIGsswapsinsured.
TheGoldmanexecutivesconsideredthosemodelsirrelevant,becausethecontracts
required collateral to be posted if market value declined, irrespective of anv long-
termcashlosses.
o
Goldmanestimatedthattheaveragedeclineinthemarketvalue
ofthebondswas1-.
8o
So, frst Bear Stearnss hedge funds and now AIG was getting hit bv Goldmans
marksonmortgage-backedsecurities.LikeCiomandhiscolleaguesatBearStearns,
Frost and his colleagues at AIG disputed Goldmans marks. On Iulv :o, Forster was
told bv another AIG trader that [AIG] would be in fne shape if Goldman wasnt
hanging its head out there. The margin call was something that hit out of the blue
and its a fing number thats well bigger than we ever planned for. He acknowl-
edged that dealers might sav the marks could be anvthing from 8o to sort of, vou
know,o-becauseofthelackoftradingbutsaidGoldmansmarkswereridiculous.
81
IntestimonvtotheFCIC,ViniarsaidGoldmanhadstoodreadvtosellmortgage-
backed securities to AIG at Goldmans own marks.
8i
AIGs Forster stated that he
wouldnotbuvthebondsatevenoocentsonthedollar,becausevaluesmightdrop
further.Additionallv,AIGwouldberequiredtovalueitsownportfolioofsimilaras-
setsatthesameprice.Forstersaid,InthecurrentenvironmentIstillwouldntbuv
them . . .becausethevcouldprobablvgolow . . .wecantmarkanvofourpositions,
andobviouslvthatswhatsavesushavingthisenormousmarktomarket.Ifwestart
buvingthephvsicalbondsbackthenanvaccountantisgoingtoturnaroundandsav,
well, Iohn,vouknowvoutradedatoo,voumustbeabletomarkvourbondsthen.
8:
Tough,lengthvnegotiationsfollowed.Goldmanwasnotbudgingonitscollat-
eraldemands,accordingtoTomAthan,amanagingdirectoratAIGFinancialProd-
ucts, describing a conference call with Goldman executives on August 1. I plaved
almostevervcardIhad,legalwording,marketpractice,intentofthelanguage,mean-
ingofthe[contract],andalsostressedthepotentialdamagetotherelationshipand
GSsaidthatthishasgonetothehighestlevelsatGSandthevfeelthat . . .thisisa
testcase.
8a
GoldmanSachsandAIGwouldcontinuetoargueaboutGoldmansmarks,even
asAIGwouldcontinuetopostcollateralthatwouldfallshortofGoldmansdemands
and Goldman would continue to purchase CDS contracts against the possibilitv of
AIGsdefault.Overthenext1amonths,moresuchdisputeswouldcostAIGtensof
billionsofdollarsandhelpleadtooneofthebiggestgovernmentbailoutsinAmeri-
canhistorv.
COMMISSION CONCLUSIONS ON CHAPTER 12
TheCommissionconcludesthatentitiessuchasBearStearnsshedgefundsand
AIGFinancialProductsthathadsignifcantsubprimeexposurewereaffectedbv
thecollapseofthehousingbubblefrst,creatingfnancialpressuresontheirpar-
ent companies. The commercial paper and repo marketstwo kev components
of the shadow banking lending marketsquicklv refected the impact of the
housingbubblecollapsebecauseofthedeclineincollateralassetvaluesandcon-
cernaboutfnancialfrmssubprimeexposure.
i\ii z++, :iii\ii Nt :U8iii \i \uiii i: z.,
z.(
13
SUMMER 2007:
DISRUPTIONS IN FUNDING
CONTENTS
IKBcjGcrnanvRca|ncncvinvcstcrs :;e
Ccuntrvwidc1hatscur;/)) :;:
BNIIari|as1hcringingcjthc|c||:o
SIVsAncasiscjca|n::
McncvjundsandcthcrinvcstcrsDrinkjing|jrcnahrchcsc::
Inthesummerofioo,asthepricesofsomehighlvratedmortgagesecuritiescrashed
and Bears hedge funds imploded, broader repercussions from the declining housing
market were still not clear. I dont 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-ofwhichwereCDOsand
CLOs (collateralized loan obligationsthat 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,bluntlvsaidthatreal
monevinvestorssuchasIKBwereoutgunned.Themarketisnotpricingthesub-
prime [residential mortgagebacked 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.
Itwouldlose1ooofthatinvestment.
Inmid-ioo,Rhinelandsasset-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
alsoalertedtheGermanbankregulatortoIKBscriticalstate.Withtheregulatorsen-
couragement, IKBs 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. Rhinelands commercial paper investors were able to get rid of the paper, and
KfWtookthehitinsteadwithitslossesexpectedtoeventuallvreacho-.
o
TheIKBepisodeservednoticethatexposurestotoxicmortgageassetswerelurk-
ingintheportfoliosofevenrisk-averseinvestors.Soon,panicseizedtheshort-term
fundingmarketseventhosethatwerenotexposedtoriskvmortgages.Therewasa
recognition, Id sav an acute recognition, that potentiallv some of the asset-backed
commercialpaperconduitscouldhaveexposuretothoseareas.Asaresult,investors
in generalwithout even looking into the underlving assetsdecided I dont want
tobeinanvasset-backedcommercialpaper,Idontwanttoinvestinafundthatmav
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
marketwoulddeclinebvalmostaoobillionbvtheendofioo.
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,thatsouro/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
andampleliquiditvsourcesofourbank. . . .Itisimportanttonotethatthecompanv
has experienced no disruption in fnancing its ongoing dailv operations, including
placementofcommercialpaper.
1:
MoodvsreamrmeditsA: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 Feds Federal Open Market
:U\\ii z++, ii :iUi1i uN: i N iUNii Nt z.+
Committee members discussed the considerable fnancial turbulence in the sub-
primemortgagemarketandthatsomefrms,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,CountrvwidereleaseditsIulvioooperational
results,reportingthatforeclosuresanddelinquencieswereupandthatloanproduc-
tionhadfallenbv1aduringtheprecedingmonth.Acompanvspokesmansaidlav-
offs would be considered. On the same dav, Fed staff, who had supervised
CountrvwidesholdingcompanvuntilthebankswitchedtoathriftcharterinMarch
ioo,sentaconfdentialmemototheFedsBoardofGovernorswarningaboutthe
companvscondition:
Thecompanvisheavilvreliantonanoriginate-to-distributemodel,and,
givencurrentmarketconditions,thefrmisunabletosecuritizeorsell
anv of its non-conforming mortgages. . . . Countrvwides 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,perhapsbvwaivingaFedruleandallowingCountrvwidesthrift
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
andwouldnotdountilthefollowingspring.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.
1
Thefollowingdav,lackinganvotherfunding,Mozilorecommendedtohisboard
thatthecompanvnotifvlendersofitsintentiontodrawdown11.-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,wereoutofbusiness,werenotgoingtofundandtheresgreatrisktothat,
litigation risk, we had committed to fund. . . . When its between vour ass and vour
image,vouholdontovourass.
1o
On the same dav that Countrvwides board approved the 11.- billion draw-
downbut before the companv announced it publiclv, the Merrill Lvnch analvst
KennethBruce,whohadreissuedhisbuvratingonthecompanvsstocktwodavs
earlier,switchedtosellwithanegativeoutlookbecauseofCountrvwidesfunding
pressures,adding,ifthemarketlosesconfdenceinitsabilitvtofunctionproperlv,
thenthemodelcanbreak. . . .Ifliquidationsoccurinaweakmarket,thenitispossi-
blefor[Countrvwide]togobankrupt.
io
The next dav, as news of Bruces call spread, Countrvwide informed markets
about the drawdown. Moodvs downgraded its senior unsecured debt rating to the
lowest tier of investment grade. Countrvwide shares fell 11, closing at 18.o-; for
thevear,thecompanvsstockwasdown-o.Thebadnewsledtoanold-fashioned
bankrun.MozilosingledoutanAugust1oLos Angeles Times articlecoveringBruces
report,which,hesaid,causedarunonourbankof8billiononMondav.Thearti-
clespurredcustomerstowithdrawtheirfundsbvnotingspecifcaddressesofCoun-
trvwidebranchesinsouthernCalifornia,MozilotoldtheFCIC.Areportercameout
withaphotographerand,vouknow,interviewedthepeopleinline,andhecreated
it was just horrible. Horrible for the people, horrible for us. Totallv unnecessarv,
Mozilosaid.
i1
Sixdavslater,onAugustii,BankofAmericaannounceditwouldinvestibil-
lionfora1ostakeinCountrvwide.Bothcompaniesdeniedrumorsthatthenations
biggestbankwouldsoonacquirethemortgagelender.Mozilotoldthepress,There
wasneveraquestionaboutoursurvival;hesaidtheinvestmentreinforcedCountrv-
widespositionasoneofthestrongestandbest-runcompaniesinthecountrv.
ii
InOctober,Countrvwidereportedanetlossof1.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
agreementtopurchaseCountrvwideforapproximatelvabillion.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
hadplungedioinlessthantwoweeks.Totalassetsinthosefundswerei.ibillion,
with a third of that amount in subprime securities rated AA or higher.
i:
The bank
saiditwouldalsostopcalculatingafairmarketvalueforthefundsbecausethecom-
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
beginningoftheiooliquiditvcrisis.Augustowastheringingofthebellforshort-
termfundingmarkets,PaulMcCullev,amanagingdirectoratPIMCO,toldtheFCIC.
The buvers went on a buver strike and simplv werent rolling.
i-
That is, thev
stopped rolling over their commercial paper and instead demanded pavment on
theirloans.OnAugusto,theinterestratesforovernightlendingofA-1ratedasset-
backedcommercialpaperrosefrom-.:oto-.-thehighestlevelsinceIanuarv
ioo1. It would continue rising unevenlv, hitting o.1a in August 1o, ioo. Figure
1:.1showshow,inresponse,lendingdeclined.
InAugustalone,theasset-backedcommercialpapermarketshrankbv1oobil-
lion, or io. On August o, subprime lender American Home Mortgages asset-
backed commercial paper program invoked its privilege of postponing repavment,
trapping lenders monev for several months. Lenders quicklv withdrew from pro-
gramswithsimilarprovisions,whichshrankthatmarketfrom:-billiontoabil-
lionbetweenMavandAugust.
io
The paper that did sell had signifcantlv shorter maturities, refecting creditors
desiretoreassesstheircounterpartiescreditworthinessasfrequentlvaspossible.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.
i
Disruptionsquicklvspreadtootherpartsofthemonevmarket.Inafighttoqual-
itv,investorsdumpedtheirrepoandcommercialpaperholdingsandincreasedtheir
holdingsinseeminglvsafermonevmarketfundsandTreasurvbonds.Marketpartici-
pants,unsureofeachotherspotentialsubprimeexposures,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-o.Inioo8,itwould
peakmuchhigher.
Thepanicintherepo,commercialpaper,andinterbankmarketswasmetbvimme-
diategovernmentaction.OnAugust1o,thedavafterBNPParibassuspendedredemp-
tions,theFedannouncedthatitwouldprovid[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-obasispointsfromo.i-to-.-.Thiswouldbethefrstofmanv
such cuts aimed at increasing liquiditv. The Fed also extended the term of discount-
windowlendingto:odavs(fromtheusualovernightorvervshort-termperiod)toof-
ferbanksamorestablesourceoffunds.Onthesamedav,theFedsFOMCreleaseda
statement acknowledging the continued market deterioration and promising that it
waspreparedtoactasneededtomitigatetheadverseeffectsontheeconomv.
io
SIVS: AN OASIS OF CALM
InAugust,theturmoilinasset-backedcommercialpapermarketshitthemarketfor
structuredinvestmentvehicles,orSIVs,eventhoughmostoftheseprogramshadlit-
tlesubprimemortgageexposure.SIVshadastablehistorvsincetheirintroductionin
1o88. These investments had weathered a number of credit criseseven through
earlv summer of ioo, as noted in a Moodvs report issued on Iulv io, ioo, titled
SIVs:AnOasisofCalmintheSub-primeMaelstrom.
:o
Unlike tvpical asset-backed commercial paper programs, SIVs were funded pri-
marilvthroughmedium-termnotesbondsmaturinginonetofvevears.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,butonlvowasin-
vestedinsubprimemortgagebackedsecuritiesandCDOsholdingmortgage-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-
sationalizethecollapseofthenextleakingSIVorthenextSIV-positiveinstitution,
then-Moodvs managing director Henrv Tabe told the FCIC.
:i
The situation was
complicatedbvtheSIVslackoftransparencv.Inacontextofopacitvaboutwhere
risk resides, . . . a general distrust has contaminated manv asset classes. What had
oncebeenliquidisnowilliquid.Goodcollateralcannotbesoldorfnancedatanv-
thingapproachingitstruevalue,MoodvswroteonSeptember-.
::
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:oftheirportfo-
lios,onaverage.
:-
SponsorsrescuedsomeSIVs.OtherSIVsrestructuredorliquidated;
some investors had to wait a vear or more to receive pavments and, even then, re-
coupedonlvsomeoftheirmonev.InthecaseofRhinebridge,investorslosta-and
onlvgraduallvreceivedtheirpavmentsoverthenextvear.
:o
InvestorsinoneSIV,Sigma,
lost more than 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:
DRINKING 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-
ingthepricethevpaidforsecuritiesandtheotherthefundsmark-to-marketvalue
(theshadowprice,inmarketparlance).However,fundsdonothavetodisclosethe
shadowpriceunlessthefundsnetassetvalue(NAV)hasfallenbvo.-below1(to
o.oo-) per share. Such a decline in market value is known as breaking the buck
and generallv leads to a funds collapse. It can happen, for example, if just - of a
fundsportfolioisinaninvestmentthatlosesjust1oofitsvalue.Soafundmanager
cannotaffordbigrisks.
But SIVs were considered verv safe investmentsthev alwavs had beenand
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,whichmavincludewealthvinvestorswhoinvesti-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 GEs own pension
andemploveebeneftassets,ranagroundinthesummer;ithad-oofitsassetsin
mortgage-backedsecurities.Whenthefundreportedlvlostioomillionandclosed
in November ioo, investors redeemed their interests at o.oo.
:o
Bank of America
supporteditsStrategicCashPortfoliothenationslargestenhancedcashfund,with
ao billion in assets at its peakafter one of that funds largest investors withdrew
iobillioninNovemberioo.
ao
An interesting case studv is provided bv the meteoric rise and decline of the
CreditSuisseInstitutionalMonevMarketPrimeFund.Thefundsoughttoattractin-
vestorsthroughInternet-basedtradingplatformscalledportals,whichsuppliedan
estimated:oobilliontomonevmarketfundsandotherfunds.Investorsusedthese
portalstoquicklvmovetheircashtothehighest-vieldingfund.Postingahigherre-
turncouldattractsignifcantfunds:onemonevmarketfundmanagerlatercompared
theuseofportalmonevtodrink[ing]fromafrehose.
a1
Butthemonevcouldvan-
ishjustasquicklv.TheCreditSuissefundpostedthehighestreturnsintheindustrv
duringthe1imonthsbeforetheliquiditvcrisis,andincreaseditsassetsfromabout
-billioninthesummerofioootomorethani-billioninthesummerofioo.To
deliverthosehighreturnsandattractinvestors,though,itfocusedonstructuredf-
nanceproducts,includingCDOsandSIVssuchasChevne.Wheninvestorsbecame
concernedaboutsuchassets,thevvankedabout1obillionoutofthefundinAugust
iooalone.CreditSuisse,theSwissbankthatsponsoredthefund,wasforcedtobail
itout,purchasing-.billionofassetsinAugust.
ai
Theepisodehighlightstherisks
ofmonevmarketfundsrelvingonhotmonevthatis,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, Floridas local government investment pool was the
largestinthecountrv,andintendedtooperatelikeahighlvliquid,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 states requirements. It
hadmorethanibillioninSIVsandotherdistressedsecurities,ofwhichabouti-
millionhadalreadvdefaulted.Anditheldo-omillioninCountrvwidecertifcates
ofdepositwithmaturitiesthatstretchedoutasfarasIuneioo8.
aa
InearlvNovember,
followingaseriesofnewsreports,thefundsufferedarun.Localgovernmentswith-
drew8billioninjusttwoweeks.OrangeandPinellascountiespulledouttheiren-
tire investments. On November io, the funds managers stopped all withdrawals.
Floridas was the hardest hit, but other state investment pools also took signifcant
lossesonSIVsandothermortgage-relatedholdings.
:U\\ii z++, ii :iUi1i uN: i N iUNii Nt z,,
z,(
14
LATE 2007 TO EARLY 2008:
BILLIONS IN SUBPRIME LOSSES
CONTENTS
Mcrri||IvnchDawningawarcncsscvcrthcccursccjthcsunncr:
Citigrcup1hatwcu|dnctinanvwavhavccxcitcdnvattcnticn:eo
AIGsdisputcwithGc|dnan1hcrcccu|dncvcr|c|csscs:e
Icdcra|Rcscrvc1hcdisccuntwindcwwasntwcrking:;
Mcnc|incinsurcrsVcncvcrcxpcctcd|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-relatedlossesofabout1oobillion.
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,1o,oooand11o,oooannuallvforeverv1omillion,whilethecost
fortherelativelvstrongerGoldmanSachsstoodato8,ooo.
:
Meanwhile,theeconomvwasbeginningtoshowsignsofstress.Facingturmoilin
fnancialmarkets,declininghomeprices,andoilpricesabove-abarrel,consumer
spending was slowing. The Federal Reserve lowered the overnight bank borrowing
ratefrom-.i-earlierintheveartoa.-inSeptember,a.-inOctober,andthen
a.i-inDecember.
i\1i z++, 1u i\ii z++ 8i iii uN: i N :U8iii \i iu: :i: z,,
MERRILL LYNCH: DAWNING AWARENESS
OVER THE COURSE OF THE SUMMER
On October 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,andnearlvtwicethea.-billionlossthatthecompanvhadwarnedinvestorsto
expect just three weeks earlier. Six davs later, the embattled CEO Stanlev ONeal, a
i1-vearMerrillveteran,resigned.
Much of this write-down came from the frms holdings of the super-senior
tranches of mortgage-related CDOs that Merrill had previouslv thought to be ex-
tremelvsafe.Aslateasfalliooo,itsmanagementhadbeenbullishongrowthand
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
wastoreducethefrmsriskbvgettingthoseloansandsecuritiesoffitsbalancesheet.
Yetitfoundthatitcouldnotsellthesuper-seniortranchesofthoseCDOsataccept-
ableprices;itthereforehadtotakedownseniortranchesintoinventorvinorderto
execute deals
-
leading to the accumulation of tens of billions of dollars of those
tranchesonMerrillsbooks.DowKim,thentheco-presidentofMerrillsinvestment
banking segment, told FCIC staff that the buildup of the retained super-senior
tranchesintheCDOpositionswasactuallvpartofastrategvbeguninlateioooto
reduce the frms 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:.-billionfrom1i.8billion
in March.
8
According to a September ioo internal Merrill presentation, the net
amount in retained super-senior CDO tranches had increased from o.: billion in
Septemberioootoi-.abillionbvMarchiooandi8.obillionbvMav.
o
Butasthe
mortgagemarketcameunderincreasingpressureandasthemarketvalueofevensu-
per-seniortranchescrumbled,thestrategvwouldcomebacktohauntthefrm.
Merrills frst-quarter earnings for ioonet revenues of o.o billionwere 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 analvstsan event that in-
vestorsandanalvstsrelvontoobtainimportantinformationaboutthecompanvand
that,likeotherpublicstatements,issubjecttofederalsecuritieslaws.
Merrills then-CFO Ieffrev Edwards indicated that the companvs results would
notbehurtbvthedislocationinthesubprimemarket,becauserevenuesfromsub-
primemortgage-relatedactivitiescomprise[d]lessthan1ofournetrevenuesover
thepastfvequarters,andbecauseMerrillsriskmanagementcapabilitiesarebetter
thanever,andcrucialtooursuccessinnavigatingturbulentmarkets.Providingfur-
therassurances,hestated,Webelievetheissuesinthisnarrowsliceofthemarketre-
maincontainedandhavenotnegativelvimpactedothersectors.
1o
However, Edwards did not disclose the large increase in retained super-senior
CDOtranchesorthedimcultvofsellingthosetranches,evenatalossthoughspe-
cifcquestionsonthesubjectwereraised.
InIulv,Merrillfolloweditsstrongfrst-quarterreportwithanotherforthesecond
quarterthatenabledthecompanvtoachieverecordnetrevenues,netearningsand
netearningsperdilutedshareforthefrsthalfofioo.
11
Duringtheconferencecall
announcing the results, the analvst Glenn Schorr of UBS, a large Swiss bank, asked
theCFOtoprovidesomecoloraroundmvthversusrealitvonMerrillsexposureto
retainedCDOpositions.Ashehadthreemonthsearlier,EdwardsstressedMerrills
risk management and the fact that the CDO business was a small part of Merrills
overall business. He said that there had been signifcant reductions in Merrills re-
tainedexposurestolower-ratedsegmentsofthemarket,althoughhedidnotdisclose
thatthetotalamountofMerrillsretainedCDOshadreached:o.abillionbvIune.
Edwards declined to provide details about the companvs exposure to subprime
mortgage CDOs and anv inventorv of mortgage-backed securities to be packaged
into CDOs. We dont 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
presentationtotheboardsFinanceCommittee,DaleLattanzio,co-headoftheAmer-
ican branch of the Fixed Income, Currencies and Commodities business, reported a
netexposureof:ibillioninCDO-relatedassets,essentiallvallofthemratedtriple-
A, with exposure to the lower-rated asset class signifcantlv reduced.
1:
This net
exposurewastheamountofCDOpositionsleftafterthesubtractionofthehedges
guaranteesinoneformoranotherthatMerrillhadpurchasedtopassalongitsulti-
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 ONeal told FCIC investigators he had not known that the com-
panvwasretainingthesuper-seniortranchesoftheCDOsuntilLattanziospresen-
tationtotheFinanceCommittee.Hewasstartled,ifonlvbecausehehadbeenunder
the impression that Merrills 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: ONeal said he was surprised about the re-
tainedpositionsbutstatedthatthepresentation,analvsis,andestimationofpoten-
tial losses were not sumcient to sound alarm bells.
1o
Lattanzios report in Iulv
indicated that the retained positions had experienced onlv : million in losses.
1
Over the next three months, the market value of the super-senior tranches plum-
meted and losses ballooned; ONeal told the FCIC: It was a dawning awareness
overthecourseofthesummerandthroughSeptemberasthesizeofthelosseswere
beingestimated.
18
OnOctoberi1,Merrillexecutivesgaveitsboardadetailedaccountofhowthe
frmfounditselfwithwhatwasbvthattime1-.ibillioninnetexposuretothesu-
per-seniortranchesdownfromapeakinIulvof:i.ibillionbecausethefrmhad
increasinglvhedged,writtenoff,andsolditsexposure.OnOctoberia,Merrillan-
nounceditsthird-quarterearnings:astunning.obillionmortgage-relatedwrite-
down contributing to a net loss of i.: billion. Merrill also reportedfor the frst
timeits1-.ibillionnetexposuretoretainedCDOpositions.Still,intheirconfer-
encecallwithanalvsts,ONealandEdwardsrefusedtodisclosethegrossexposures,
excludingthehedgesfromthemonolinesandAIG.Ijustdontwanttogetintothe
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--billionofgrossretainedCDOpositions,almostfour
timesthe1-.ibillionofnetCDOpositionsreportedduringtheOctoberiacon-
ferencecall.
io
On October :o, when ONeal 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-
chasedalmost1oobillioninhedgeshadcomeintoquestion,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,startingwithi.obilliononIanuarv1,ioo8.Bvtheendof
ioo8, Merrill would put aside a total of 1: billion related to monolines and had
recordedtotalwrite-downsonnearlvaabillionofothermortgage-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 ONeals October :o departure from Merrill Lvnch, Citigroup an-
nouncedthatitstotalsubprimeexposurewas--billion,whichwasaibillionmore
thanithadtoldinvestorsjustthreeweeksearlier.Citigroupalsoannounceditwould
be taking an 8 to 11 billion loss on its subprime mortgagerelated holdings and
thatChuckPrincewasresigningasitsCEO.LikeONeal,Princehadlearnedlateof
hiscompanvssubprime-relatedCDOexposures.PrinceandRobertRubin,chairman
oftheExecutiveCommitteeoftheboard,toldtheFCICthatbeforeSeptemberioo,
thev had not known that Citigroups investment banking division had sold some
CDOswithliquiditvputsandretainedthesuper-seniortranchesofothers.
i:
PrincetoldtheFCICthateveninhindsightitwasdimcultforhimtocriticizeanv
ofhisteamsdecisions.Ifsomeonehadelevatedtomvlevelthatwewereputtingona
itrillionbalancesheet,aobillionoftriple-A-rated,zero-riskpaper,thatwouldnot
inanvwavhaveexcitedmvattention,Princesaid.Itwouldnthavebeenusefulfor
someonetocometomeandsav,Now,wehavegotitrilliononthebalancesheetof
assets.Iwanttopointouttovouthereisaoneinabillionchancethatthisaobillion
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-
ancesheetand1.itrillionoff-balancesheetwasspreadamongmorethani,ooo
operating subsidiaries in ioo. Prince insisted that Citigroup was not too big to
manage.
io
But it was an organization in which one unit would decide to reduce
mortgage risk while another unit increased it. And it was an organization in which
seniormanagementwouldnotbenotifedofa:billioninconcentratedexposure
i of the companvs balance sheet and more than a third of its capitalbecause it
wasperceivedtobezero-riskpaper.
i
Signifcantlv,CitigroupsFinancialControlGrouphadarguediniooothattheliq-
uiditvputsthatCitigrouphadwrittenonitsCDOshadbeenpricedforinvestorstoo
cheaplvinlightoftherisks.
i8
Also,inearlviooo,SusanMills,amanagingdirectorin
the securitization unitwhich bought mortgages from other companies and bun-
dled them for sale to investorstook note of rising delinquencies in the subprime
marketandcreatedasurveillancegrouptotrackloansthatherunitpurchased.
io
Bv
mid-iooo,hergroupsawadeteriorationinloanqualitvandanincreaseinearlvpav-
mentdefaultsthatis,moreborrowersweredefaultingwithinafewmonthsofget-
ting a loan. From ioo- to ioo, Mills recalled before the FCIC, the earlv pavment
defaultratesnearlvtripledfromito-oro.
: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, Citigroups CDO desk increased its purchases of mortgage-
backedsecuritiesbecauseitsawthedistressedmarketasabuvingopportunitv.
:i
Effective communication across businesses was lacking, the companvs 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:belowpar,theCDOdeskdecidedtoslowdownonthefnancingofmortgage
securitiesforinventorvtoproduceCDOs.
:a
Shortlvthereafter,however,thesameABX
indexstartedtorallv,risingtoiobelowparinMarchandholdingaroundthatlevel
throughMav.So,theCDOdeskreversedcourseandaccelerateditspurchasesofinven-
torv in April, according to Nestor Dominguez, Warnes co-head on the CDO desk.
:-
Dominguezsaidhedidntseethemarketweakeninguntilthesummer,whentheindex
felltolessthanoobelowpar.
:o
MurravBarnes,theCitigroupriskomcerassignedtotheCDObusiness,approved
the CDO desks request to temporarilv increase its limits on purchasing collateral.
Barnesobserved,inhindsight,thatratherthanlookingatthewideningspreadsasan
opportunitv, Citigroup should have reassessed its assumptions and examined
whetherthedeclineintheABXwasasignofstraininthemortgagemarket.Head-
mittedcomplacencvaboutthedesksabilitvtomanageitsrisk.
:
Theriskmanagementdivisionalsoincreased theCDOdeskslimitsforretaining
themostseniortranchesfrom:obillionto:-billioninthefrsthalfofioo.Asat
Merrill, traders and risk managers at Citigroup believed that the super-senior
tranchescarriedlittlerisk.
:8
Citigroupsregulatorslaterwrote,Anacknowledgement
oftheriskinitsSuperSeniorAAACDOexposurewasperhapsCitigroupsbiggest
miss. . . .Asmanagementfeltcomfortablewiththecreditriskofthesetranches,itbe-
gantoretainlargepositionsonthebalancesheet. . . .Asthesub-primemarketbegan
to deteriorate, the risk perceived in these tranches increased, causing large write-
downs.
:o
Ultimatelv,lossesatCitigroupfrommortgages,Alt-Amortgagebackedse-
curities, and mortgage-related CDOs would total about -8 billion, nearlv half of
Citigroupscapitalattheendofiooo.About8billionofthatlossrelatedtoprotec-
tionpurchasedfromthemonolineinsurers.
ao
Barness decision to increase the CDO risk limits was approved bv his superior,
EllenDuke.BarnesandDukereportedtoDavidBushnell,thechiefriskomcer.Bush-
nellwhomPrincecalledthebestriskmanageronWallStreettoldtheFCICthat
hedidnotrememberspecifcallvapprovingtheincreasebutthat,ingeneral,therisk
managementfunctiondidapprovehigherrisklimitswhenabusinesslinewasgrow-
ing.
a1
He described a frm-wide initiative to increase Citigroups 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,savingsheandherriskteamwereseducedbvstructuring
andfailedtolookattheunderlvingcollateral.
a:
AccordingtoBarnes,theCDOdesk
didnt 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 Citigroups securitization desk might have been able to provide
some insights based on its own data.
a-
Barnes told the FCIC that Citigroups risk
managementtendedtobemanagedalongbusinesslines,notingthathewasonlvtwo
omcesawavfromhiscolleaguewhocoveredthesecuritizationbusinessandvetdidnt
understandthenuancesofwhatwashappeningtotheunderlvingloans.Heregretted
notreachingouttotheconsumerbanktogetthepulseofmortgageorigination.
ao
1/et/esncvcr/ejjcncsincct/cucjrcssion
PrinceandRubinappearedtobelieveupuntilthefallofioothatanvdownsiderisk
intheCDObusinesswasminuscule.IdontthinkanvbodvfocusedontheCDOs.
Thiswasonebusinessinavastenterprise,anduntilthetroubledeveloped,itwasnt
one that had anv particular profle, Rubinin Princes words, a verv important
memberof[the]board
a
toldtheFCIC.Youknow,TomMaheraswasinchargeof
trading.Tomwasanextremelvwellregardedtradingfgureonthestreet. . . .Andthis
is what traders do, thev handle these kinds of problems.
a8
Maheras, the co-head of
Citigroupsinvestmentbank,toldtheFCICthathespentasmallfractionof1of
histimethinkingaboutordealingwiththeCDObusiness.
ao
Citigroupsriskmanagementfunctionwassimplvnotvervconcernedabouthous-
ingmarketrisks.AccordingtoPrince,Bushnellandotherstoldhim,ineffect,Gosh,
housingpriceswouldhavetogodown:onationwideforustohave,notaproblem
with[mortgage-backedsecurities]CDOs,butforustohaveproblems,andthathas
never happened since the Depression.
-o
Housing prices would be down much less
than :o when Citigroup began having problems because of write-downs and the
liquiditvputsithadwritten.
Bv Iune ioo, national house prices had fallen a.-, and about 1o of subprime
adjustable-ratemortgagesweredelinquent.YetCitigroupstilldidnotexpectthatthe
liquiditvputscouldbetriggered,anditremainedunconcernedaboutthevalueofits
retainedsuper-seniortranchesofCDOs.OnIunea,ioo,Citigroupmadeapresenta-
tiontotheSECaboutsubprimeexposureinitsCDObusiness.Thepresentationnoted
thatCitigroupdidnotfactortwopositionsintothisexposure:1a.obillioninsuper-
seniortranchesandi:.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 Citigroups 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-
billionofthecompanvscashandexposeittopossiblebalance-sheetlossesatatime
whenmarketswereincreasinglvindistress.Butgiventherisingrates,Lvonsalsosaid
Citigroupdidnothavetheoptiontowait.Overthenextsixmonths,Citigrouppur-
chasedalli-billionofthepaperthathadbeensubjecttoitsliquiditvputs.
-i
On a Iulv io conference call, CFO Garv Crittenden told analvsts and investors
thatthecompanvssubprimeexposureshadfallenfromiabillionattheendofiooo
to1:billiononIune:o.Buthemadenomentionofthesuper-seniorexposuresand
liquiditvputs.Ithinkourriskteamdidanicejobofanticipatingthatthiswasgoing
tobeadimcultenvironment,andsosetaboutinaprettvconcentratedefforttore-
duceourexposureoverthelastsixmonths,
-:
hesaid.Aweeklater,onaIulvicall,
Crittenden reiterated that subprime exposure had been cut: So I think weve had
goodriskmanagementthathasbeenanticipatingsomemarketdislocationhere.
-a
BvAugust,asmarketconditionsworsened,CitigroupsCDOdeskwasrevaluing
itssuper-seniortranches,thoughithadnoeffectivemodelforassigningvalue.How-
ever,asthemarketcongealed,thenfroze,thepaucitvofactualmarketpricesforthese
tranchesdemandedamodel.TheNewYorkFedlaternotedthatthemodelforSuper
SeniorCDOs,basedonfundamentaleconomicfactors,couldnotbefullvvalidated
bvCitigroupscurrentvalidationmethodologiesvetitwasrelieduponforreporting
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 timesuch 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-
sionataBusinessHeadsmeetingaboutthegrowingmark-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 wasnt 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, Citigroups valuation models suggested that losses on the super-senior
tranchesmightrangefrom1-milliontoibillion.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 meetingsand later, nightlv DEFCON
callswith 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,isntthatdeeplvtroublingnotastowhathappenedthatisadif-
ferentquestionthatisalsotroublingbutastoprovidingfullandclearinformation
andanalvsisnow.Princedisagreed,writing,Ithought,forfrstmtg,itwasgood.We
werenttrvingtogettofnalanswers.
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,vouhadntfullvdisposedoftherisk.
oa
And,of
course,thecircumstancewasnotremote,sincebillionsofdollarsinsubprimemort-
gageassetshadalreadvcomebackontoCitigroupsbooks.
PrincetoldtheFCICthatMaherashadassuredhimthroughoutthemeetingsand
theDEFCONcallsthatthesuperseniorsposednorisktoCitigroup,evenasthemar-
ketdeteriorated;headdedthathebecameincreasinglvuneasvwithMaherassassess-
ment. Tom had said and said till his last dav at work [October 11]: We are never
goingtoloseapennvonthesesuperseniors.Wearenevergoingtoloseapennvon
thesesuperseniors. . . .AndaswewentalongandIwasmoreandmoreuncomfort-
ablewiththisandmoreandmoreuncomfortablewithTomsconclusionsonultimate
valuations,thatiswhenIreallvbegantohavesomevervseriousconcernsaboutwhat
wasgoingtohappen.
o-
DespitePrincesconcerns,Citigroupremainedpubliclvsilentabouttheadditional
subprimeexposurefromthesuper-seniorpositionsandliquiditvputs,evenasitpre-
announcedsomedetailsofitsthird-quarterearningsonOctober1,ioo.
OnOctober11,theratingagenciesannouncedthefrstinaseriesofdowngrades
onthousandsofsecurities.InPrincesview,thesedowngradesweretheprecipitating
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
specifcallvraisedattheboardofdirectorsCorporateAuditandRiskManagement
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
1obninDirectSuperSeniorandibninLiquiditvandParPuts.
o
Citigroupstotal
subprime exposure was -o billion, nearlv half of its capital. The calculation was
straightforward,butduringananalvstsconferencecallthatdavCrittendenomitted
anvmentionofthesuper-senior-andliquiditv-put-relatedexposureashetoldpar-
ticipantsthatCitigrouphadunder1:billioninsubprimeexposure.
o8
A week later, on Saturdav, October i, Prince learned from Crittenden that the
companvwouldhavetoreportsubprime-relatedlossesof8to11billion;onMon-
davhetenderedhisresignationtotheboard.Helaterrefected,WhenIdrovehome
andGarvcalledmeandtoldmeitwasntgoingtobetwoor:oomillionbutitwasgo-
ing to be eight billionI will never forget that call. I continued driving, and I got
home,Iwalkedinthedoor,Itoldmvwife,IsaidhereswhatIjustheardandifthis
turnsouttobetrue,Iamresigning.
oo
OnNovembera,Citigrouprevealedtheaccuratesubprimeexposurenowesti-
mated at -- billionand it disclosed the subprime-related losses. Though Prince
had resigned, he remained on Citigroups pavroll until the end of the vear, and the
boardofdirectorsgavehimagenerouspartingcompensationpackage:11.omillion
incashandiamillioninstock,bringinghistotalcompensationtoomillionfrom
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
PrincesreplacementsaschairmanandCEORichardParsonsandVikramPan-
ditwere announced in December. Rubin would stav until Ianuarv iooo, having
beenpaidmorethan11-millionfromioootoiooo
i
duringhistenureatthecom-
panv,includinghisroleaschairmanoftheExecutiveCommittee,apositionthatcar-
riednooperationalresponsibilities,RubintoldtheFCIC.MvagreementwithCiti
providedthatIdhavenomanagementofpersonneloroperations.
:
IohnReed,formerco-CEOofCitigroup,attributedthefrmsfailuresinparttoa
culturechangethatoccurredwhenthebanktookonSalomonBrothersaspartofthe
1oo8Travelersmerger.HesaidthatSalomonexecutiveswereusedtotakingbigrisks
andhadahistorv . . .[of]makingalotofmonev . . .butthengettingintotrouble.
a
AIG S DISPUTE WITH GOLDMAN:
THERE COULD NEVER BE LOSSES
BeginningonIulvio,ioo,whenGoldmansDavilmansenttheemailthatdisrupted
thevacationofAIGsAlanFrost,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
frmswhileAIGanditsmanagementstruggledtocometogripswiththeburgeoning
crisis.
The initial collateral call was a shock to AIGs senior executives, most of whom
hadnotevenknownthatthecreditdefaultswapswithGoldmancontainedcollateral
callprovisions.
Thev had known there were enormous exposureso billion, backed in large
partbvsubprimeandAlt-Aloans,inioo,
-
comparedwiththeparentcompanvsto-
tal reported capital of o-.8 billionbut 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
stunnedwhenhegotthenewsthathehadtositdown.
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
headoftheAIGFinancialProductsEnterpriseRiskManagementdepartment,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
wastheirfrmsinabilitvtoassessthevaliditvofGoldmansnumbers.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. Were 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 Pennsvlvanias Wharton
School, who began working as a consultant to AIG Financial Products in 1ooo and
wasclosetoitsCEO,IoeCassano.TheGortonmodelhaddeterminedwithoo.8-
confdencethattheownersofthesuper-seniortranchesoftheCDOsinsuredbvAIG
FinancialProductswouldneversufferrealeconomiclosses,eveninaneconomvas
troubledastheworstpostWorldWarIIrecession.Thecompanvsauditors,Pricewa-
terhouseCoopers (PwC), who were apparentlv also not aware of the collateral re-
quirements, concluded that the risk of default on [AIGs] portfolio has been
effectivelvremovedandasaresultfromariskmanagementperspective,thereareno
substantiveeconomicrisksintheportfolioandasaresultthefairvalueoftheliabilitv
streamonthesepositionsfromariskmanagementperspectivecouldreasonablvbe
consideredtobezero.
8:
InspeakingwiththeFCIC,CassanowasadamantthattheCDSbookwaseffec-
tivelvhedged.HesaidthatAIGcouldneversufferlossesontheswaps,becausethe
CDScontractswerewrittenonlvonthesuper-seniortranchesoftop-ratedsecurities
withhighattachmentpointsthatis,manvsecuritiesintheCDOswouldhaveto
defaultinorderforlossestoreachthesuper-seniortranchesandbecausethebulk
oftheexposurecamefromloansmadebeforeiooo,whenhethoughtunderwriting
standardshadbeguntodeteriorate.
8a
Indeed,accordingtoGenePark,Cassanoputa
halttoa1-omillionhedge,inwhichAIGhadtakenashortpositionintheABXin-
dex.AsParkexplained,Ioestoppedthatbecauseafterweputonthefrst1-o . . .the
marketmovedagainstus . . .wewerelosingmonevonthe1-omillion. . . .Ioesaid,
Youknow,Idontthinktheworldisgoingtoblowup . . .Idontwanttospendthat
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.SoGoldmansmarkscaughtAIG
bvsurprise.WhenAIGpushedback,GoldmanalmostimmediatelvreduceditsIulv
icollateraldemandfrom1.8billionto1.ibillion,amovethatunderscoredthe
dimcultv of fnding reliable market prices. The new demand was still too high, in
AIGs view, which was corroborated bv third-partv marks. Goldman valued the
CDOsbetween8oandocentsonthedollar,whileMerrillLvnch,forexample,val-
uedthesamesecuritiesbetweeno-and1oocents.
8
On August , Cassano told PwC that there was little or no price transparencv
andthatitwasdimculttodeterminewhether[collateralcalls]wereindicativeoftrue
marketlevelsmoving.
88
AIGmanagersdidcallotherdealersholdingsimilarbonds
to check their marks in order to help its case with Goldman, but those marks were
not actionablethat 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
bvMerrillLvnchwasthedisclaimerinalistingofestimatedmarketvaluesprovided
bvMerrilltoAIG.
8o
GoldmanSachsdisputedthereliabilitvofsuchestimates.
\it/outocingjlijjent
OnAugusto,forthefrsttime,AIGexecutivespubliclvdisclosedtheobillionin
creditdefaultswapsonthesuper-seniortranchesofCDOsduringthecompanvssec-
ond-quarterearningscall.Thevacknowledgedthatthegreatmajoritvoftheunderlv-
ing bonds thus insuredoa billionwere backed bv subprime mortgages. Of this
amount,1obillionwaswrittenonCDOspredominantlvbackedbvriskvBBB-rated
collateral.Onthecall,Cassanomaintainedthattheexposureswerenoproblem:Itis
hardforus,withoutbeingfippant,toevenseeascenariowithinanvkindofrealmor
reasonthatwouldseeuslosing1inanvofthosetransactions.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
realeconomiclossesonthecompanvscreditdefaultswappositions.
o1
Butmoreim-
portantatthetimeweretheothertremendousrisksthatAIGexecutiveshadalreadv
discussed internallv. No one on the conference call mentioned Goldmans demand
for 1.i billion in collateral; the clear possibilitv that future, much-larger collateral
callscouldjeopardizeAIGsliquiditv;ortheriskthatAIGwouldbeforcedtotakean
enormousmarkonitsexistingbook,theconcernForsterhadnoted.
Thedavaftertheconferencecall,AIGposteda-omillionincashtoGoldman,
its frst collateral posting since Goldman had requested the 1.i billion. As Frost
wrotetoForsterinanAugust1o,ioo,email,theideawastogetevervonetochill
out.
oi
Foronething,someAIGexecutives,includingCassano,hadlate-summerva-
cationsplanned.Cassanosignedoffonthea-omilliongoodfaithdepositbefore
leavingforacvclingtripthroughGermanvandAustria.
o:
Thepartiesexecutedaside
lettermakingclearthatbothdisputedtheamount.Forthetimebeing,twocompa-
niesthathadbeendoingbusinesstogetherfordecadesagreedtodisagree.
On August 1a, Frost went to Goldmans omces to start the dialog, which had
stalledwhileCassanoandotherkevexecutiveswereonvacation.Twodavslater,Frost
wrotetoForster:Trustme.Thisisnotthelastmargincallwearegoingtodebate.
oa
He was right. Bv September 11, Socit Gnraleknown more commonlv as Soc-
GenhaddemandedaomillionincollateralonCDSithadpurchasedfromAIGFi-
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,toldForsterthatSocGenreceivedmarksfromGSonpositionsthat
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
SocGenmargincallhadbeenspurredbvGoldman,andthatAIGdisputedthecall
and[had]notheardfromSocGenagainonthatspecifccall.
oo
Inthesecondweekof
October,theratingagenciesannouncedhundredsofadditionaldowngradesaffecting
tens of billions of dollars of subprime mortgagebacked securities and CDOs. Bv
Novemberi,Goldmansdemandhadalmostdoubled,toi.8billion.OnNovembero,
Bensinger,theCFO,informedAIGsAuditCommitteethatFinancialProductshadre-
ceivedmargincallsfromfvecounterpartiesandwasdisputingevervsingleone.
o
ThisstancewasrootedinthecompanvscontinuingbeliefthatGoldmanhadset
valuestoolow.AIGspositionwascorroborated,atleastinpart,bvthewidedisparitv
inmarksfromothercounterparties.Atonepoint,MerrillLvnchandGoldmanmade
collateral demands on the verv same CDS positions, but Goldmans marks were al-
most :- lower than Merrills.
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
endofSeptemberiootolessthani-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 Goldmans frst collateral de-
mand (from 1.8 billion on Iulv i to 1.i billion on August i) and the interim
agreementonthea-omilliondepositconfrmedthatGoldmanwasnotascertainof
its marks as it later insisted. According to Cassano, Michael Sherwood, co-CEO of
GoldmanSachsInternational,toldhimthatGoldmandidntcoverourselvesinglorv
during this period but that the markets starting to come our [Goldmans] wav;
CassanotookthosecommentsasanimplicitadmissionthatGoldmansinitialmarks
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
AIGsnothavingamodel.Amongthosewasnoticefromcounterpartiesthatcollat-
eralwasdue.
1o:
Inotherwords,oneofAIGsriskmanagementtoolswastolearnofits
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 AIGs fnancial statements.
Cassanostillthoughtthevaluationprocessunnecessarvbecausethepossibilitvofde-
faults was remote.
1oa
He sent Forster and others emails describing requests from
Habavebasmorelovenotes . . .[askingustogothrough]thesamedrillofdrafting
answers.
1o-
Nevertheless,bvOctober,andinconsultationwithPwC,AIGstartedto
evaluate the pricing model for subprime instruments developed and used bv
Moodvs.CassanoconsideredtheMoodvsmodelonlvagutcheckuntilitwasfullv
validatedinternallv.
1oo
AIGcoupledthismodelwithgenericCDOtranchedatasold
bvIPMorganthatwereconsideredtoberelativelvrepresentativeofthemarket.Of
course,bvthistimeandforseveralprecedingmonthstherewasnoactivemarket
formanvofthesetranches.Evervoneunderstoodthatthiswasnotaperfectsolution,
but AIG and its auditors thought it could serve as an interim step. The makeshift
modelwasupandrunninginthethirdquarter.
(onjicntinourmerks
On November , when AIG reported its third-quarter earnings, it disclosed that it
wastakinga:-imillionchargerelatedtoitssuperseniorcreditdefaultswapport-
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,itusedthenewlvadoptedand
adaptedMoodvsmodeltoestimatethe:-imillioncharge.Infact,PwChadques-
tionedtherelevanceofthemodel:ithadntbeenvalidatedinadvanceoftheearnings
release,itdidnttakeintoaccountimportantstructuralinformationabouttheswap
contracts,andtherewerequestionsaboutthequalitvofthedata.
1o8
AIGdidntmen-
tionthosecaveatsonthecall.
Twoweekslater,onNovemberi:,Goldmandemandedanadditional:billionin
cash.AIGprotested,butpaid1.--billion,bringingthetotalpostedtoibillion.
1oo
Fourdavslater,CassanocirculatedamemofromForsterlistingthepertinentmarks
for the securities from Goldman Sachs, Merrill Lvnch, Calvon, Bank of Montreal,
andSocGen.
11o
Themarksvariedwidelv,fromaslittleas--ofthebondsoriginal
valuetovirtuallvfullvalue.Goldmansestimatedvaluesweremuchlowerthanthose
ofotherdealers.Forexample,GoldmanvaluedoneCDO,theDunhillCDO,at-
ofpar,whereasMerrillvalueditato-ofpar;theOrientPointCDOwasvaluedat
ooofparbvGoldmanbutato-ofparbvMerrill.Forstersuggestedthatthemarks
validated AIGs 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,.
guesstimatingpricing.
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 Goldmans London omce and de-
manded reimbursement of 1.a billion. He told both AIG and Goldman executives
that independent third-partv pricing for o of the :,-oo securities underlving the
CDOsonwhichAIGFPhadwrittenCDSandAIGsownvaluationfortheother:o
indicatedthatGoldmansdemandwasunsupportedthereforeGoldmanshouldre-
turnthemonev.
11:
Goldmanrefused,andinsteaddemandedmore.
11a
BvlateNovember,therewasrelativeagreementwithinAIGandwithitsauditor
thattheMoodvsmodelincorporatedintoAIGsvaluationsvstemwasinadequatefor
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 Moodvs model
wouldresultina1.-billionvaluationloss;usingGoldmansmarkswouldresultina
-billionvaluationloss,whichwouldwipeoutthequartersprofts.
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
disputeGoldmansmarks.ForsterrecalledthatSullivansaidthathewasgoingtohave
a heart attack when he learned that using Goldmans marks would eliminate the
quartersprofts.
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(Goldmans
fgure) to about 1.- billion. With their auditors 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 companvs procedures in posting collateral.
AIGFinancialProductshadpaidoutibillionwithoutactiveinvolvementfromthe
parentcompanvsEnterpriseRiskManagementgroup.Anotherissuewasthewavin
whichAIGFP[had]beenmanagingtheSS[supersenior]valuationprocesssaving
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,
itsholdingsrosefromoobillionto88billion.Meanwhile,FinancialProducts,act-
ingonitsownanalvsis,haddecidedinioootobeginpullingbackonwritingcredit
defaultswapsonCDOs.InPwCsview,inallowingonesubsidiarvtoincreaseexpo-
sure to subprime while another subsidiarv worked to exit the market entirelv, the
parentcompanvsriskmanagementfailed.PwCalsosaidthatthecompanvssecond
quarterofioofnancialdisclosureswouldhavebeenchangediftheexposureofthe
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, AIGs 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.HeconcludedthatthiswasakintoNeroplav-
ing the fddle while Rome burns.
1i1
On the opposite side, Sullivan insisted to the
FCICthattheconfictingstrategiesinthesecurities-lendingbusinessandatAIGFi-
nancialProductssimplvrevealedthatthetwosubsidiariesadopteddifferentbusiness
models,anddidnotconstituteariskmanagementfailure.
1ii
OnDecember-,sixdavsafterreceivingPwCswarnings,Sullivanboastedonan-
otherconferencecallaboutAIGsriskmanagementsvstemsandthecompanvsover-
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,wellwedontagreewithvournumbers.And
thevgo,oh,andthevgoawav.Andvousavwellwhatwasthat:Itslikeadrive-bvina
wav.Andtheothertimesthevsatdownwithus,andnoneofthisishostileoranv-
thing,itsallvervcordial,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-
nounced1.-billionmaximumpotentialexposure.Investorsthereforedidnotknow
that AIGs earnings were overstated bv :.o billionand 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
AIGs board of directors. Thev informed him that the negative basis adjustment
usedtoreachthe1.-billionestimatedisclosedontheDecember-investorcallhad
beenimproperandunsupported,andwasasignthatcontrolsovertheAIGFinan-
cialProductssuperseniorcreditdefaultswapportfoliovaluationprocessandover-
sightthereofwerenoteffective.PwCconcludedthatthisdefciencvwasamaterial
weaknessasofDecember:1,ioo.
1i
Inotherwords,PwCwouldhavetoannounce
thatthenumbersAIGhadalreadvpubliclvreportedwerewrong.Whvtheauditors
waitedsolongtomakethispronouncementisunclear,particularlvgiventhatPwC
hadknownabouttheadjustmentinNovember.
In the meeting with Willumstad, the auditors were broadlv critical of Sullivan;
Bensinger,whomthevdeemedunabletocompensateforSullivansweaknesses;and
Lewis, who might not have the skill sets to run an enterprise-wide risk manage-
mentdepartment.Theauditorsconcludedthatalackofleadership,unwillingnessto
makedimcultdecisionsregarding[FinancialProducts]inthepastandinexperience
in dealing with these complex matters had contributed to the problems.
1i8
Despite
PwCsfndings,Sullivanreceived1omillionoverfourvearsincompensationfrom
AIG,includingaseverancepackageof18million.Whenaskedaboutthesefgures
at a FCIC hearing, he said, I have no knowledge or recollection of those numbers
whatsoever,sir. . . .Icertainlvdontrecallearningthatamountofmonev,sir.
1io
Thefollowingdav,PwCmetwiththeentireAIGAuditCommitteeandrepeated
the analvsis presented to Willumstad. The auditors said thev could complete AIGs
audit,butonlvifCassanodidnotinterfereintheprocess.RetainingCassanowasa
managementjudgment,butthecultureneededtochangeatFP.
1:o
OnFebruarv11,
AIGdisclosedinanSECflingthatitsauditorhadidentifedthematerialweakness,
acknowledgingthatithadreduceditsDecembervaluationlossestimatesbv:.obil-
lionthatis,thedifferencebetweentheestimatesof-.1billionand1.-billion
becauseoftheunsupportablenegativebasisadjustment.
Theratingagenciesrespondedimmediatelv.MoodvsandS&Pannounceddown-
grades,andFitchplacedAIGonRatingsWatchNegative,suggestingthatafuture
downgradewaspossible.AIGsstockdeclined1iforthedav,closingataa.a.
AttheendofFebruarv,Goldmanheldibillionincashcollateral,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 againthis
time with dismal fourth-quarter and fscal vear ioo earnings. The companv re-
portedanetlossof-.iobillion,largelvdueto11.1ibillioninvaluationlossesre-
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 businesss mortgage-backed pur-
chases.Alongwiththelosses,SullivanannouncedCassanosretirement,butthenews
wasntallbadfortheformerFinancialProductschief:Hemademorethan:oomil-
lionfromthetimehejoinedAIGFinancialProductsinIanuarvof1o8untilhisre-
tirement in ioo8, including a 1 million-a-month consulting agreement after his
retirement.
1:1
InMarch,theOmceofThriftSupervision,thefederalregulatorinchargeofregu-
latingAIGanditssubsidiaries,downgradedthecompanvscompositeratingfroma
i,signifvingthatAIGwasfundamentallvsound,toa:,indicatingmoderatetose-
vere supervisorv concern. The OTS still judged the threat to overall viabilitv as re-
mote.
1:i
Itdidnotscheduleafollow-upreviewofthecompanvsfnancialcondition
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&PFinancialsIndexhadlostmorethan1oforthevear.Between
Iulv and November, asset-backed commercial paper declined about :o, which
meantthatthoseassetshadtobesoldorfundedbvothermeans.Investmentbanks
and other fnancial institutions faced tighter funding markets and increasing cash
pressures.Asaresult,theFederalReservedecidedthatitsinterestratecutsandother
measuressinceAugusthadnotbeensumcienttoprovideliquiditvandstabilitvtof-
nancialmarkets.TheFedsdiscountwindowhadntattractedmuchbankborrowing
becauseofthestigmaattachedtoit.Theproblemwiththediscountwindowisthat
people dont 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 Bankswhich are govern-
ment-sponsoredentitiesthatlendtobanksandthrifts,acceptingmortgagesascollat-
eralboostedtheirlendingbvi:-billionto8-billion(a:increase)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
thelenderofnexttolastresortforcommercialbanksandthriftstheFedbeingthe
lastresort.
1:a
Inaddition,thelossofliquiditvinthefnancialsectorwasmakingitmoredim-
i\1i z++, 1u i\ii z++ 8i iii uN: i N :U8iii \i iu: :i: z,,
cultforbusinessesandconsumerstogetcredit,raisingtheFedsconcerns.FromIulv
to October, the percentage of loan omcers reporting tightening standards on prime
mortgagesincreasedfrom1-toaboutao.Overthattime,thepercentageofloan
omcersreportingtighteningstandardsonloanstolargeandmidsizecompaniesin-
creasedfrom8to1o,itshighestlevelsinceioo:.
1:-
TheFederalReservepursued
a whole slew of nonconventional policies . . . verv creative measures when the dis-
count window wasnt 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,withbanksborrowingaobillionbv
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 Reservelocal currencv for U.S. dollarsand 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,theswaplinestotaled88billion.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 wasnt just the commercial banks and
thriftsbutthebroaderfnancialsvstemthatconcernedtheFed,Dudlevsaid.His-
toricallv,theFederalReservehasalwavstendedtosupplvliquiditvtothebankswith
theideathatliquiditvprovidedtothebankingsvstemcanbe[lenton]tosolventin-
stitutions in the nonbank sector. What we saw in this crisis was that didnt alwavs
takeplacetotheextentthatithadinthepast. . . .Idontthinkpeoplegoinginreallv
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-to:.o.
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,thoughitwasntlauncheduntilMarch.
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.Primarvdealersmainlv
the investment banks and the broker-dealer amliates of large commercial banks
could post debt of government-sponsored enterprises, including GSE mortgage
backedsecurities,ascollateral.TheFedexpectedtohave1oobillioninsuchloans
outstandingatanvgiventime.
Alsoatthistime,theU.S.centralbankbegancontemplatingastepthatwasrevo-
lutionarv: a program that would allow investment banksinstitutions over which
the Fed had no supervisorv or regulatorv responsibilitvto borrow from the dis-
countwindowontermssimilartothoseavailabletocommercialbanks.
MONOLINE INSURERS: WE NEVER EXPECTED LOSSES
Meanwhile,theratingagenciescontinuedtodowngrademortgage-backedsecurities
andCDOsthroughioo.BvIanuarvioo8,asaresultofthestressinthemortgage
market,S&Phaddowngraded:,:8otranchesofresidentialmortgagebackedsecuri-
tiesand1,:8:tranchesfromaioCDOs.MBIAandAmbac,thetwolargestmonoline
insurers,hadtakenonacombinedio-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&PestimatedinFebruarvioo8thatAmbacwouldneeduptoaoo
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
lessthanoomillionagainstitsobligationsthatincludedoobillionincreditde-
fault swaps on CDOs. In late ioo, ACA reported a net loss of 1. billion, almost
entirelvduetocreditdefaultswaps.
Thiswasnews.Thenotionofzero-losstolerancewascentraltotheviabilitvof
the monoline business model, and thev and various stakeholdersthe rating agen-
cies, investors, and monoline creditorshad 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 didnt 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,theSECcalledthegrowingconcernaboutMerrillsuseofthe
monolinesforhedgingaconcernthatwealsoshare.
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
wasfatalforacompanvwhoseCEOsaidthatitsratingisthefranchise.
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-
tionthemonolinesprovidedforothersecuritieseventhosethathadnothingtodo
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:failuresbetween1o8aandearlviooinmorethan1oo,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,butinvestorsfundswouldbetrappeduntilnewinvestorsorthe
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,8ooftheARSauctionsfailed;
thefollowingweek,ofailed.
Hundreds of billions of dollars were trapped bv ARS instruments as investors
wereobligatedtoretaintheirinvestments.Andretailinvestorsindividualsinvest-
ing less than 1 million, small businesses, and charitiesconstituted 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 1o or higher.
ProblemsintheARSmarketcostGeorgetownUniversitv,aborrower,omillion.
1a8
NewYorkStatewasstuckwithinterestratesthatsoaredfromabout:.-tomore
than1aonabillionofitsdebt.ThePortAuthoritvofNewYorkandNewIersev
sawtheinterestrateonitsdebtjumpfroma.:toioinasingleweekinFebru-
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.
TheregulatorstheSecuritiesandExchangeCommissionforthelargeinvest-
ment banks and the banking supervisors for the bank holding companies and
AIGfailedtoadequatelvsupervisetheirsafetvandsoundness,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
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After its hedge funds failed in Iulv ioo, Bear Stearns faced more challenges in the
secondhalfofthevear.TakingouttherepolenderstotheHigh-GradeFundbrought
nearlv1.obillioninsubprimeassetsontoBearsbooks,contributingtoa1.obillion
write-down on mortgage-related assets in November. That prompted investors to
scrutinizeBearStearnssfnances.Overthefall,Bearsrepolendersmostlvmonev
market mutual fundsincreasinglv required Bear to post more collateral and pav
higherinterestrates.Then,injustoneweekinMarchioo8,arunbvtheselenders,
hedgefundcustomers,andderivativescounterpartiesledtoBearshavingtobetaken
overinagovernment-backedrescue.
MortgagesecuritizationwasthebiggestpieceofBearStearnssmost-proftabledi-
vision, its fxed-income business, which generated a- of the frms total revenues.
Growing fast was the Global Client Services division, which included Bears prime
brokerageoperation.BearStearnswasthesecond-biggestprimebrokerinthecoun-
trv,withai1marketshareiniooo,trailingMorganStanlevsi:.
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,thecompanvs
viewwasthatBearwasinthemovingbusiness,notthestoragebusinessthatis,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.ThepurchasewasconsistentwithBearscontrarianbusinessmodelbuvinginto
distressedmarketsandwaitingforthemtoturnaround.
OnlvamonthafterthepurchaseofEncore,theSecuritiesandExchangeCommis-
sionwroteinaninternalreport,Bearsmortgagebusinessincurredsignifcantmarket
risklossesonitsAlt-Amortgageassets.
8
Thelossesweresmall,buttheSECreported
thatriskmanagersnote[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,Bearsleverageratiohad
reachednearlv:8to1.Bvtheendofioo,BearsLevel:assetsilliquidassetsdim-
cult to value and to sellwere ioo of its tangible common equitv; thus, writing
downtheseilliquidassetsbv:wouldwipeouttangiblecommonequitv.
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
bookedthesetransactionsassaleseventhoughtheassetsdidntstavoffthebalance
sheetforlonginordertoreducetheamountofthecompanvsassetsandlowerits
leverageratio.BearsformertreasurerUptoncalledthemovewindowdressingand
saiditensuredthatcreditorsandratingagencieswerehappv.
11
Bearspublicflingsre-
fected this, to some degree: for example, its ioo annual report said the balance
sheet was approximatelv 1i lower than the average month-end balance over the
previoustwelvemonths.
1i
To forestall a downgrade, Upton spoke with the three main rating agencies,
Moodvs, Standard & Poors, and Fitch, in earlv August.
1:
Several times in ioo
zz ii N\Nti \i tii :i : i NuUi i tu\\i : :i uN iiiui1
includingApriloandIuneiiS&PhadconfrmedBearsstrongratings,notingin
April that Bears risk profle is relativelv conservative and strong senior manage-
mentoversightandastrongculturethroughoutthefrmarethefoundationofBears
risk management process. On Iune ii, Moodvs had also confrmed its A1 rating,
andFitchhadconfrmeditsstableoutlook.
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
didnotforeseethatBearsownrepolendersmightrefusetolendagainstriskvmort-
gageassetsandeventuallvnotevenagainstTreasuries.
IrequestedsomeforbearancefromS&P,UptontoldtheFCIC.
1a
Hedidnotget
it.OnAugust:,justthreedavsafterthetwoBearStearnshedgefundsdeclaredbank-
ruptcv,S&Phighlightedthefunds,Bearsmortgage-relatedinvestments,anditsrela-
tivelvsmallcapitalbaseasitplacedBearonanegativeoutlook.
1-
Askedhowhefeltabouttheratingagencvsactions,IimmvCavne,BearsCEOun-
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,Bearsstock
slido,to1o8.:-,:obelowitsall-timehighof1oo.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.
TheregulatorsreviewedBearsexposurestothemortgagemarket,includingthe1:
billioninadjustable-ratemortgagesonthefrmsbooksthatwerewaitingtobesecu-
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.
1
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-obillioninthethirdquarterofiootoao.1billionin
thefourthquarter,butitwastoolittletoolate.
\\itu z++ 1ui i\ii ui 8i\i :1i\iN: z.
Thatsummer,theSECfeltBearsliquiditvwasadequatefortheimmediatefuture,
butsupervisorsweresuitablvskeptical,Eichnerinsisted.AftertheAugust-meet-
ing, the SEC required that Bear Stearns report dailv on Bears liquiditv. However,
Eichneradmittedthatheandhisagencvhadgrosslvunderestimatedthepossibilitv
ofaliquiditvcrisisdowntheroad.
io
Everv weeknight Upton updated the SEC on Bears aoo billion balance sheet,
withspecifcsonrepoandcommercialpaper.OnSeptemberi,BearStearnsraised
approximatelvi.-billioninunsecured1o-vearbonds.Thereportsslowedtooncea
week.
i1
The SECs inspector general later criticized the regulators, writing that thev
didnotpushBeartoreduceleverageormakeanveffortstolimitBearStearnsmort-
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 SECs Consolidated Supervised Entities program, about Bear
Stearns(andLehmanBrothers),Whvcantwemakethemreducerisk:According
toHalloran,SirrisaidtheSECsjobwasnottotellthebankshowtoruntheircompa-
niesbuttoprotecttheircustomersassets.
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,Icanttellvou,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(fromio.billionattheendofioootoonlv:.obillionat
theendofioo)andreplaceditwithsecuredrepoborrowing(whichrosefromoo
billion to 1oi billion). But Bear Stearnss 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-
sionofborrowerscollateral,essentiallvkeepingitinescrow;andthenlendtheirown
cashtoborrowersduringthedav.Thisisreferredtoasunwindingtherepotransac-
tion; it allows borrowers to change the assets posted as collateral everv dav. The
transactionisthenrewoundattheendofthedav,whenthelenderspostcashtothe
clearingbanksinreturnforthenewcollateral.
Thelittle-regulatedtri-partvrepomarkethadgrownfrom8oobillioninaverage
dailvvolumeiniooito1.trillioninioo-,i.atrillioninioo,andi.8trillionbv
earlv ioo8.
i
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,IPMorganservedasBearsdavtimerepolender.
Evenlong-termrepoloanshavetobeunwoundevervdavbvtheclearingbank,if
notbvthelender.SethCarpenter,anomcerattheFederalReserveBoard,compared
ittoamortgagethathastoberefnancedevervweek:Imaginethatvourmortgageis
onlvaweek.Insteadofa:o-vearmortgage,vouvegotaone-weekmortgage.Ifeverv-
thingsgoingfne,vougettotheendoftheweek,vougooutandvourefnancethat
mortgage because vou dont have enough cash on hand to pav off the whole mort-
gage.Andthenvougettotheendofanotherweekandvourefnancethatmortgage.
Andthats,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 Bears borrowing were mortgage-related securities and of these,
1.ibillionmorethanBearsequitvwereLevel:assets.
In the fourth quarter of ioo, Bear Stearns reported its frst quarterlv loss, :o
million.Still,theSECsawnoevidenceofanvdeteriorationinthefrmsliquiditvpo-
sitionfollowingthereleaseandrelatednegativepresscoverage.TheSECconcluded,
BearStearnsliquiditvpoolremainsstable.
:i
Inthefallofioo,BearsboardhadcommissionedtheconsultantOliverWvman
toreviewthefrmsriskmanagement.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,andriskmanagementwasunderstaffedandconsideredalowpri-
oritv.SchwartztoldtheFCICthefndingsdidnotindicatesubstantialdefciencies.
Hewasntlookingforpositivefeedbackfromtheconsultants,becausetheWvmanre-
\\itu z++ 1ui i\ii ui 8i\i :1i\iN: z,
portwasmeanttoprovidearoadmapofwhatthegoldstandardinriskmanage-
mentwouldbe.
::
InIanuarvioo8,beforethereportwascompleted,CavneresignedasCEO,after
receivingo:.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 Id never worked at a frm with a real board, it
neverdawnedonmethatatsomepointsomebodvwouldhaveorshouldhavegotten
theboardinvolvedinallofthis,althoughhetoldtheFCICthathemadethesecom-
ments in anger and frustration in the wake of Bears failure.
:o
In its fnal report on
Bear, the Corporate Librarv, which researches and rates frms for corporate gover-
nance,gavethecompanvaD,refectingahighdegreeofgovernanceriskresulting
fromhighlevelsofconcernrelatedtotheboardandcompensation.
:
Whenaskedif
hehadmademistakeswhileatBearStearns,CavnetoldtheFCIC,Itakeresponsi-
bilitvforwhathappened.Imnotgoingtowalkawavfromtheresponsibilitv.
:8
AtBear,compensationwasbasedlargelvonthereturnonequitvinagivenvear.
Forseniorexecutives,abouthalfofeachbonuswaspaidincash,andabouthalfinre-
strictedstockthatvestedoverthreevearsandhadtobeheldforfve.
:o
Theformulafor
the size of each vears 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-8ofrevenuesincompensa-
tion.Alix,whosatontheCompensationCommittee,toldFCICstaffthefrmtvpicallv
paid-obutthatthepercentageincreasedinioobecauserevenuesfellifmanage-
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.-millionincashandover1.1billionfromstocksales,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,whichcouldmake
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-billioninliquiditvtriggeringa
reporttotheSEC.Whilethecompanvidentifedtheerror,theSECreinstituteddailv
reportingbvthecompanvofitsliquiditv.
a
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,downalmost1o
billionfromNovember.NearlviobillionweresubprimeorAlt-Amortgagebacked
securitiesandCDOs.
ThehedgefundsthatwereclientsofBearsprimebrokerageserviceswereparticu-
larlv concerned that Bear would be unable to return their cash and securities. Lou
Lebedin, the head of Bears prime brokerage, told the FCIC that hedge fund clients
occasionallvinquiredaboutthebanksfnancialconditioninthelatterhalfofioo,
butthatsuchinquiriespickedupatthebeginningofioo8,particularlvasthecostin-
creasedofpurchasingcreditdefaultswapprotectiononBear.Theinquiriesbecame
withdrawalshedge funds started taking their business elsewhere. Thev felt there
weretoomanvconcernsaboutusandfeltthatthiswasashort-termmove,Lebedin
said. Often thev would tell us thevd be happv to bring the business back, but that
thevhadthedutvtoprotecttheirinvestors.RenaissanceTechnologies,oneofBears
biggest prime brokerage clients, pulled out all of its business. Bv April, Lebedins
prime brokerage operation would be holding oo billion in assets under manage-
ment,downmorethanaofrom1oobillioninIanuarv.
a8
Nonetheless,duringtheweekofMarch:,whenSECstaffinspectedBearsliquid-
itv pool, thev identifed no signifcant issues. The SEC found Bears liquiditv pool
rangedfrom18billiontoiobillion.
ao
Bear opened for business on Mondav, March 1o, with approximatelv 18 billion
incashreserves.Thesamedav,Moodvsdowngraded1-mortgage-backedsecurities
issued bv Bear Stearns Alt-A Trust, a special purpose entitv. News reports on the
downgrades carried abbreviated headlines stating, Moodvs Downgrades Bear
Stearns, Upton said.
-o
Rumors few and counterparties panicked.
-1
Bears liquiditv
poolbegantodrvup,andtheSECwasnowconcernedthatBearwasbeingsqueezed
from all directions.
-i
While evervthing rolled during the davthat is, Bears repo
lendersrenewedtheircommitmentsSEComcialsworriedthatthiswouldproba-
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-
ableuptoioobillioninTreasurvsecurities,acceptingascollateralGSEmortgage
backedsecuritiesandnon-GSEmortgagebackedsecuritiesratedtriple-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
therewereunusualandexigentcircumstances.TheFedhadnotinvokeditssection
1:(:)authoritvsincetheGreatDepression;itwastheFedsfrstuseoftheauthoritv
sinceCongresshadexpandedthelanguageoftheactin1oo1toallowtheFedtolend
toinvestmentbanks.
-a
TheFedwastakingtheunusualstepofdeclaringitswilling-
nesstosoonopenitscheckbooktoinstitutionsitdidnotregulateandwhosefnan-
cialconditionithadneverexamined.
But the Fed would not launch the TSLF until March i, more than two weeks
lateranditwasnotclearthatBearcouldlastthatlong.Thefollowingdav,IimEm-
bersit of the Federal Reserve Board checked on Bears liquiditv with the SEC. The
SECsaidBearhad1i.-billionincashdownfromabout18billionatthestartof
theweekandwasabletofnanceallitsbankloansandmostofitsequitvsecurities
throughtherepomarket.Hesummarized,TheSECindicatesthatnonotablelosses
havebeensustainedandthatthecapitalpositionofthefrmisfne.
--
Derivatives counterparties were increasinglv reluctant to be exposed to Bear. In
somecasesthevunwoundtradesinwhichthevfacedBear,andinothersthevmade
marginorcollateralcalls.
-o
InBearslastfewvearsasanindependentcompanv,ithad
substantiallvincreaseditsexposuretoderivatives.Attheendoffscalvearioo,Bear
had1:.atrillioninnotionalexposureonderivativescontracts,comparedwith8.
trillionatiooofscalvear-endand-.-trillionattheendofioo-.
Derivatives counterparties who worried about Bears 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]sothatBearstepsout.
-
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 Goldmans 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,Havmansmanagingpartner.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:dontrelvonBearStearns.
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 Feds announce-
ment about its new loan program was directed at Bear Stearns, and thev worried
about the facilitvs not being available for several weeks. On Wednesdav, March 1i,
theSECnotedthatBearpaidanother1.1billionformargincallsfrom1ainervous
derivativescounterparties.
oa
Repo lenders who had alreadv tightened the terms for their contracts over the
precedingfourorfvemonthsshortenedtheleashagain,demandingmorecollateral
fromBearStearns.
o-
Worriesaboutadefaultquicklvmounted.
oo
Bv that evening, Bears abilitv to borrow in the repo market was drving up. The
SECnotedthatsomelargeandimportantmonevfunds,includingFidelitvandMel-
lon,hadtoldBearafterthecloseofbusinessWednesdavthevmightbehesitantto
rollsomefundingtomorrow.TheSECsaidthatthoughthevbelievedtheamounts
werevervmanageable(between1andibillion),thewithdrawalswouldnotsend
ahelpfulsignaltothemarket.
o
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,that1abillioninrepowasnotgoingtorollover,andthattherewasareason-
ablechancethattherewouldnotbeenoughcashtomeet[Bears]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 companys
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 Morgans own signifcant exposure to the mortgage mar-
ket. Because Bear also had a large, illiquid portfolio of mortgage assets, IP Morgan
wouldnotrenderassistancewithoutgovernmentsupport.SchwartzspokewithGei-
thneragain.SchwartzinsistedBearsproblemwasliquiditv,notinsumcientcapital.A
series of calls between Schwartz, Dimon, Geithner, and Treasurv Secretarv Henrv
Paulsonfollowed.
-
ToaddressBearsliquiditvneeds,theNewYorkFedmadea1i.o
billionloantoBearStearnsthroughIPMorganonthemorningofFridav,March1a.
Standard&PoorsloweredBearsratingthreelevelstoBBB.MoodvsandFitchalso
downgraded the companv. Bv the end of the dav, Bear was out of cash. Its stock
plummeteda,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 Stearnss clearing bank for repo trades, IP Morgan held much of Bear
Stearnssassetsascollateralandhadbeenassessingtheirvaluedailv.
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,agreedtopurchaseio.obil-
lion of Bears assets to get them off the frms books through a new entitv called
MaidenLaneLLC(namedforastreetalongsidetheNewYorkFed).Thoseassets
mostlv mortgage-related securities, other assets, and hedges from Bears mortgage
tradingdeskwouldbeunderNewYorkFedmanagement.Tofnancethepurchases,
IPMorganmadea1.1-billionsubordinatedloanandtheNewYorkFedlenti8.8i
billion.Becauseofitsloan,IPMorganboretheriskofthefrst1.1-billionoflosses;
theFedwouldbearanvfurtherlossesuptoi8.8ibillion.
8o
TheFedsloanwouldbe
repaidasMaidenLanesoldthecollateral.
On Sundav night, with Maiden Lane in place, IP Morgan publiclv announced a
dealtobuvBearStearnsforiashare.MinutesofBearsboardmeetingindicatethat
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
monevtobailouttheinvestmentbanksstockholders.
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
Bearpreservethecompanvsvaluetothegreatestextentpossibleunderthecircum-
stancesforourshareholders,our1a,oooemplovees,andourcreditors.
8:
IT WAS HEADING TO A BLACK HOLE
TheSECregulatorsMacchiaroliandEichnerwereasstunnedasevervoneelsebvthe
speed of Bears 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. Bears 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
withcollateralthevwouldtrvtodumponthemarket.Youwouldhaveabigcrunch
inassetprices.
8-
BearStearns,whichisnotthatbigafrm,ourviewonwhvitwasimportantto
save itvou mav disagreebut 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
GeithnerexplainedtheneedforgovernmentsupportforBearsacquisitionbvIP
Morgan as follows: The sudden discoverv bv Bears 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 Bears counterparties to
liquidate the collateral thev held against those positions and to attempt to replicate
thosepositionsinalreadvvervfragilemarkets.
8
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|RcscrvcVhcnpccp|cgctscarcd:;:
|IMcrganRcjusingtcunwind wcu|d|cunjcrgiva||c :;
1hcIcdandthcSLCVcak|iquiditvpcsiticn :;e
DcrivativcsLar|vstagcscjasscssingthcpctcntia|svstcnicrisk :;:
Banks1hcnarkctswcrcrca||v.rca||vdiccv :o)
IP Morgans federallv assisted acquisition of Bear Stearns averted catastrophefor
thetimebeing.TheFederalReservehadfoundnewwavstolendcashtothefnancial
svstem,andsomeinvestorsandlendersbelievedtheBearepisodehadsetaprecedent
forextraordinarvgovernmentintervention.Investorsbegantoworrvlessaboutare-
cessionandmoreaboutinfation,asthepriceofoilcontinuedtorise(hittingalmost
1aaperbarrelinIulv).Atthebeginningofioo8,thestockmarkethadfallenalmost
1-fromitspeakinthefallofioo.Then,inMavioo8,theDowIonesclimbedto
1:,o-8, within 8 of the record 1a,1oa set in October ioo. The cost of protecting
against the risk of default bv fnancial institutionsrefected in the prices of credit
defaultswapsdeclinedfromthehighsofMarchandApril.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 Stanlevs
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,
raisedjustunder1oobillionandaobillion,respectivelv,innewequitvbvtheend
ofIune.
Despitethisgoodnews,bankersandtheirregulatorswerehauntedbvthespeedof
BearStearnssdemise.AndthevknewthattheotherinvestmentbankssharedBears
weaknesses: leverage, reliance on overnight funding, dependence on securitization
markets,andconcentrationsinilliquidmortgagesecuritiesandothertroubledassets.
Inparticular,therunonBearhadexposedthedangersoftri-partvrepoagreements
andthecounterpartvriskcausedbvderivativescontracts.
AndthewordonthestreetdespitetheassurancesofLehmanCEODickFuldat
\\itu 1u \UtU:1 z++ ::1i\i t ii :i tuNtiiN: z+.
anAprilshareholdermeetingthattheworstisbehindus
i
wasthatBearwouldnot
betheonlvfailure.
THE FEDERAL RESERVE: WHEN PEOPLE GOT SCARED
Themostpressingdangerwasthepotentialfailureoftherepomarketamarketthat
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 :o 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,thevwouldnt
fnancethenonstandardstuffatall.
o
Tothesurpriseofbothborrowersandregulators,high-qualitvcollateralwasnot
enoughtoensureaccesstotherepomarket.Repolenderscaredjustasmuchabout
thefnancialhealthoftheborrowerasaboutthequalitvofthecollateral.Infact,even
forthesamecollateral,repolendersdemandeddifferenthaircutsfromdifferentbor-
rowers.
Despitethebankruptcvprovisionsintheioo-act,lenderswerereluctantto
riskthehassleofseizingcollateral,evengoodcollateral,fromabankruptborrower.
StevenMeierofStateStreettestifedtotheFCIC:Iwouldsavthecounterpartiesare
afrstlineofdefense,andwedontwanttogothroughthatuncomfortableprocessof
havingtoliquidatecollateral.
8
WilliamDudlevoftheNewYorkFedtoldtheFCIC,
Atthefrstsignoftrouble,theseinvestorsintri-partvrepotendtorunratherthan
takethecollateralthatthevvelentagainst. . . .Sohigh-qualitvcollateralitselfisnot
sumcientwhenandifaninstitutiongetsintrouble.
o
Moreover, if a borrower in the repo market defaults, monev market fundsfre-
quent lenders in this marketmav 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
agencvmortgagebackedsecurities.Tvpicallv,ifafundtakespossessionofsuchcol-
lateral,itliquidatesthesecuritiesimmediatelv,evenaswasthecaseduringthecri-
sisinto a declining market. As a result, funds simplv avoided lending against
mortgage-relatedsecurities.Inthecrisis,investorsdidntconsidersecuredfundingto
bemuchbetterthanunsecured,accordingtoDarrvllHendricks,amanagingdirector
andglobalheadofriskmethodologvatUBS,aswellastheheadofaprivate-sector
taskforceontherepomarketorganizedbvtheNewYorkFed.
1o
As noted, the Fed had announced a new program, the Term Securities Lending
Facilitv(TSLF),ontheTuesdavbeforeBearscollapse,butitwouldnotbeavailable
untilMarchi.TheTSLFwouldlendatotalofuptoioobillionofTreasurvsecuri-
tiesatanvonetimetotheinvestmentbanksandotherprimarvdealersthesecuri-
tiesamliatesofthelargecommercialbanksandinvestmentbanksthattradewiththe
New York Fed, such as Citigroup, Morgan Stanlev, or Merrill Lvnchfor 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
Bears collapse, Fed omcials recognized that the situation called for a program that
couldbeupandrunningrightawav.AndthevconcludedthattheTSLFalonewould
notbeenough.
So,theFedwouldcreateanotherprogramfrst.OntheSundavofBearscollapse,
the Fed announced the new Primarv Dealer Credit Facilitvagain invoking its au-
thoritv under 1:(:) of the Federal Reserve Actto provide cash, not Treasuries, to
investmentbanksandotherprimarvdealersontermsclosetothosethatdepositorv
institutionsbanks and thriftsreceived through the Feds discount window. The
movecamejustabouta-minutestoolateforBear,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
dealercouldntfnancethesecuritiesthatwereacceptableunderthediscountwin-
dowifthevcouldntgetfnancinginthemarket,thevcouldgetfnancingfromthe
Federal Reserve, said Seth Carpenter, deputv associate director in the Division of
Monetarv Affairs at the Federal Reserve Board. And that wav, vou dont have to
worrv. And bv providing that support, other lenders know that thevre going to be
abletogettheirmonevbackthenextdav.
1i
BvchargingtheFederalReservesdiscountrateandaddingadditionalfeesforreg-
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 Feds 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,theFedsDudlevurgedinaninternalemailthatbothprogramsbeextended
atleastthroughtheendofthevear.PDCFremainscriticaltothestabilitvofsomeof
the[investmentbanks],hewrote.Amountsdontmatterhere,itisthefactthatthe
PDCFunderpinsthetri-partvreposvstem.
1-
OnIulv:o,theFedextendedbothpro-
gramsthroughIanuarv:o,iooo.
JP MORGAN: REFUSING TO UNWIND . . .
WOULD BE UNFORGIVABLE
ThereporunonBearalsoalertedthetworepoclearingbanksIPMorgan,themain
clearing bank for Lehman and Merrill Lvnch, as it had been for Bear Stearns, and
BNYMellon,themainclearingbankforGoldmanSachsandMorganStanlevtothe
risksthevweretaking.
Before Bears 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
withanenormousintradavexposureaninterimexposure,butnolessrealforits
brevitv. In an interview with the FCIC, Dimon said that he had not become fullv
awareoftherisksstemmingfromhisbankstri-partvrepoclearingbusinessuntilthe
Bearcrisisinioo8.
1o
Aclearingbankhadtwoconcerns:First,ifrepolendersaban-
doned an investment bank, it could be pressured into taking over the role of the
lenders.Second,andworseiftheinvestmentbankdefaulted,itcouldbestuckwith
unwantedsecurities.Ifthevdefaultedintradav,weownthesecuritiesandwehaveto
liquidatethem.Thatsahugerisktous,Dimonexplained.
1
Toaddressthoserisksinioo8,forthefrsttimebothIPMorganandBNYMellon
startedtodemandthatintradavloanstotri-partvrepoborrowersmostlvthelarge
investmentbanksbeovercollateralized.
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-
tectagainstclearingbanksrefusingexposuretoaninvestmentbankduringthedav.
OnIulv11,Fedomcialscirculatedaplan,ultimatelvneverimplemented,thatad-
dressedthepossibilitvthatoneofthetwoclearingbankswouldbecomeunwillingor
unabletounwinditstrades.
1o
TheplanwouldallowtheFedtoprovidetroubledin-
vestmentbanks,suchasLehmanBrothers,withioobillionintri-partvrepofnanc-
ing during the davessentiallv 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
ButtheNewYorkFedsnewplanshouldntbenecessarvaslongasthePDCFwas
theretobackuptheovernightlenders,arguedPatrickParkinson,thendeputvdirec-
toroftheFederalReserveBoardsDivisionofResearchandStatistics.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 banks refusal to unwind
wouldleadtoawidespreadfresaleandmarketpanic.Fearoftheseconsequencesis,
ofcourse,whvwefacilitatedBearsacquisitionbvIPMC,hesaid.
i:
Still,itwaspossiblethatthePDCFcouldproveinsumcienttodissuadeIPMorgan
fromrefusingtounwindLehmansrepos,Parkinsonsaid.Becausealargeportionof
Lehmans 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,thesummightnotbeenoughtoensurethefrmssurvivalintheabsenceof
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-to
ioforLehmanandMerrillLvnch,1oto1-forMorganStanlev,andabout1o
forGoldmanSachs.
i-
Anothermetricwastherelianceonovernightrepo(whichma-
tureinonedav)oropenrepo(whichcanbeterminatedatanvtime).Despiteefforts
amongtheinvestmentbankstoreducetheportionoftheirrepofnancingthatwas
overnightoropen,theratioofovernightandopenrepofundingtototalrepofund-
ing still exceeded ao for all but Goldman Sachs. Comparing the period between
March and Mav to the period between Iulv and August, Lehmans percentage fell
\\itu 1u \UtU:1 z++ ::1i\i t ii :i tuNtiiN: z+,
from a- to ao, Merrill Lvnchs fell from ao to a:, Morgan Stanlevs fell from
oto--,andGoldmansfellfrom18to1o.
io
Anothermeasureofriskwasthe
haircuts on repo loansthat 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 increaseddoubling for some agencv mortgage securities and in-
creasing signifcantlv even for borrowers with high credit ratings and on relativelv
safecollateralsuchasTreasurvsecurities.
i
OnthedavofBearsdemise,inanefforttogetabetterunderstandingofthein-
vestment banks, the New York Fed and the SEC sent teams to work on-site at
LehmanBrothers,MerrillLvnch,GoldmanSachs,andMorganStanlev.Accordingto
ErikSirri,directoroftheSECsDivisionofTradingandMarkets,theinitialroundsof
meetingscoveredthequalitvofassets,funding,andcapital.
i8
Fed Chairman Ben Bernanke would testifv before a House committee that the
Feds 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
Fedsanalvses:First,waseachinvestmentbankliquiddidithaveaccesstothecash
needed to meet its commitments: Second, was it solventwas its net equitv (the
valueofassetsminusthevalueofliabilities)sumcienttocoverprobablelosses:
:o
TheU.S.Treasurvalsodispatchedso-calledSWATteamstotheinvestmentbanks
inthespringofioo8.ThearrivalofomcialsfromtheTreasurvandtheFedcreateda
full-timeon-sitepresencesomethingtheSEChadneverhad.Historicallv,theSECs
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
SECsliquiditvstressscenariosalsoknownasstresstestshadnottakenaccountof
the possibilitv that a frm would lose access to secured funding. According to the
SECsSirri,theSECneverthoughtthatasituationwouldarisewhereaninvestment
bankcouldntenterintoarepotransactionbackedbvhigh-qualitvcollateralinclud-
ingTreasuries.HetoldtheFCICthatasthefnancialcrisisworsened,theSECbegan
toseeliquiditvandfundingrisksasthemostcriticalfortheinvestmentbanks,and
theSECencouragedareductioninrelianceonunsecuredcommercialpaperandan
extensionofthematuritiesofrepoloans.
:i
TheFedandtheSECcollaboratedindevelopingtwonewstressteststodetermine
theinvestmentbanksabilitvtowithstandapotentialrunorasvstemwidedisruption
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,wouldbe8abillionshortofcashinthemorestringentBear
Stearnsscenarioand1-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.Thetestsassumedthateachfrmwouldlose1ooof
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:thetwobankscameoutiibillionand1-billionshortof
cash,respectivelv;eachhadonlv8oftheliquiditvitwouldneedunderthestress
scenario.
:a
TheFedsinternalreportonthestresstestscriticizedMerrillssignifcantamount
of illiquid fxed income assets and noted that Merrills liquiditv pool is low, a fact
[thecompanv]doesnotacknowledge.AsforLehmanBrothers,theFedconcluded
that Lehmans 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
securitiesnowdevalued.Meanwhile,Lehmanranstresstestsofitsownandpassed
withbillionsinexcesscash.
:o
AlthoughtheSECandtheFedworkedtogetherontheliquiditvstresstests,with
equalaccesstothedata,eachagencvhassaidthatformonthsduringthecrisis,the
other did not share its analvses and conclusions. For example, following Lehmans
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.TheSECsresponsewasthatthedocuments
wereindraftformandhadnotbeenreviewedorfnalized.Addingtothetension,
theFedson-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 Feds Parkinson advised colleagues in an internal August 8 email that the svs-
temicrisksoftherepoandderivativesmarketsdemandedattention:Wehavegiven
considerablethoughttowhatmightbedonetoavoidafresaleoftri-partvrepocol-
lateral.(Thatsaid,theoptionsunderexistingauthoritvarenotvervattractivelots
ofrisktoFed/taxpaver,lotsofmoralhazard.)Westillareattheearlvstagesofassess-
ingthepotentialsvstemicriskfromclose-outofOTCderivativestransactionsbvan
investmentbankscounterpartiesandidentifvingpotentialmitigants.
: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:.:
\\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-counterderivativesmarketwaso: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 Bearand the rumored refusal bv Goldman to
accept Bear as a derivatives counterpartvwere 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,thecreditratingagenciesdecisiontoissue
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 pavmentsand even greater dimcultv was anticipated. The net
charge-offratetheratiooffailedloanstototalloansrosetoitshighestlevelsince
iooi,whentheeconomvwascomingoutofthepost-o/11recession.Earningscon-
tinuedtodeclineinioo8atfrst,moreforbigbanksthansmallbanks,inpartbe-
cause of write-downs related to their investment bankingtvpe 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 FDICs problem list, as
supervisorsrarelvgivethelargestinstitutionsthelowestratings.)
a-
Themarketfornonconformingmortgagesecuritizations(thosebackedbvmort-
gagesthatdidnotmeetFannieMaesorFreddieMacsunderwritingormortgagesize
guidelines)hadalsovanishedinthefourthquarterofioo.Notonlvdidthesenon-
conformingloansprovehardertosell,butthevalsoprovedlessattractivetokeepon
balance sheet, as house price forecasts looked increasinglv grim. Alreadv, house
priceshadfallenaboutforthevear,dependingonthemeasure.Inthefrstquarter
ofioo8,realestateloansinthebankingsectorshowedthesmallestquarterlvincrease
since ioo:.
ao
IndvMac reported a i1 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,Citigroupsecuredatotalof1abillionincapitalfromKuwait,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-
choviaraisedobillionincapitalattheturnofthevearandthenanadditional8bil-
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.
a
The same
wastrueforthethrifts.MichaelSolomon,amanagingdirectorinriskmanagement
manager in the Omce of Thrift Supervision (OTS), told the FCIC, It was hard for
businesses, particularlv small, midsized thriftsto keep up with [how quicklv the
ratings downgrades occurred during the crisis] and change their business models
andnotgetstuckwithoutthechairwhenthemusicstopped . . .Thevgotcaught.The
ratingdowngradesstartedandbvthetimethethriftwasabletodosomethingabout
it,itwastoolate . . .Businessmodels . . .cantkeepupwithwhatwesawinioo8.
a8
Asthecommercialbankshealthworsenedinioo8,examinersdowngradedeven
large institutions that had maintained favorable ratings and required several to fx
their risk management processes. These ratings downgrades and enforcement ac-
tionscamelateinthedavoftenjustasfrmswereonthevergeoffailure.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
thansatisfactorvinAprilioo8fvemonthsafterthefrmsannouncementinNo-
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,theNewYorkFedsratingupgrade,
deliveredinitsannualinspectionreportonAprilo,ioo,hadnoted.Duringiooo,
all formal restrictions and enforcement actions between the Federal Reserve and
Citigroupwerelifted.Boardandseniormanagementremainactivelvengagedinim-
provingrelevantprocesses.
ao
ButthemarketdisruptionhadjoltedCitigroupssupervisors.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
aspartofitsreviewsofthebankscompliancewiththepost-Enronenforcementac-
tion,butitdidnotexaminetherisksoftheseexposures.Asfortheissuesitdidspot,
theOCCfailedtotakeforcefulstepstorequiremandatorvcorrectiveaction,andit
reliedonmanagementsassurancesiniooothattheexecutiveswouldstrivetomeet
theOCCsgoalsforimprovingriskmanagement.
Incontrast,documentsobtainedbvtheFCICfromtheNewYorkFedgivenoin-
dicationthatitsexaminationstaffhadanvindependentknowledgeofthosetwocore
problems.AnevaluationoftheNewYorkFedssupervisionofCitigroup,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 frms fnancial
componentandrelatedsubcomponentsatvear-endioo.Additionallv,
thesupervisorvprogramhaslackedtheappropriateleveloffocusonthe
frms 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,refectedontheFedsoversightofCitigroup,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 OCCs and Feds
.+. 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 impossiblefor regulators to look bevond the legal entities under their
directpurviewintootherareasofalargefrm.Citigroup,forexample,hadmanvreg-
ulatorsacrosstheworld;eventhesecuritizationbusinessesweredispersedacrosssub-
sidiarieswithdifferentsupervisorsincludingthosefromtheFed,OCC,SEC,OTS,
andstateagencies.
InMavandIuneioo8,Citigroupenteredintomemorandaofunderstandingwith
boththeNewYorkFedandOCCtoresolvetheriskmanagementweaknessesthatthe
eventsofioohadlaidbare.Intheensuingmonths,FedandOCComcialssaid,thev
were satisfed with Citigroups 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
muchneededinternalfxes.However,Manzariwenton,Citiwastrappedinwhat
wasaprettvvicious . . .svstemicevent,andforregulatorsitwastimetocomeup
withanewplavbook.
-:
\ec/ovie.1/c6olcn\cstecauisitionvesemistekc
AtWachovia,whichwassupervisedbvtheOCCaswellastheOTSandtheFederal
Reserve,aiooend-of-vearreportshowedthatcreditlossesinitssubsidiarvGolden
WestsportfolioofPick-a-Pavadjustable-ratemortgages,oroptionARMs,wereex-
pectedtorisetoabout1oftheportfolioforioo8;iniooo,lossesinthisportfolio
had been less than o.1. It would soon become clear that the higher estimate for
ioo8 was not high enough. The companv would hike its estimate of the eventual
lossesontheportfoliotoobvIuneandtoiibvSeptember.
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 Wachovias
seniorvicepresidentforTreasurvandBalanceSheetManagement,managementhad
launchedaliquiditvcrisismanagementplaninanticipationofanevenmoreadverse
marketreactiontosecond-quarterlossesthatwouldbeannouncedinIulv.
--
On Iune i, Wachovias 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-
nouncedthatitwouldstoporiginatingGoldenWestsPick-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,announcedaplantoimprovethebanksf-
nancialcondition:raisecapital,cutthestockdividend,andlavoff1oto1iofthe
staff.
Theratingagenciesandsupervisorsignoredthosereassurances.Onthesamedav
astheannouncement,S&Pdowngradedthebank,andtheFed,aftervearsofsatis-
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-
choviaassatisfactorvrightuptothesummermeltdown,theFednowdeclaredthat
manvofWachoviasproblemswerelong-terminnatureandresult[ed]fromdelaved
investmentdecisionsandadesiretohavebusinesslinesoperateautonomouslv.
-8
TheFedbluntlvcriticizedtheboardandseniormanagementforanenvironment
with inconsistent and inadequate identifcation, escalation and coverage of all risk-
takingactivities,includingdefcienciesinstresstestingandlittleaccountabilitvfor
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 companvs board had
not sumcientlv questioned investment decisions.
-o
Nonetheless, the Fed concluded
thatWachoviasliquiditvwascurrentlvadequateandthatthroughoutthemarketdis-
ruption,managementhadminimizedexposuretoovernightfundingmarkets.
OnAugusta,theOCCdowngradedWachoviaBankandassesseditsoverallrisk
profleashigh.TheOCCnotedmanvofthesameissuesastheFed,andaddedpar-
ticularlvstrongremarksabouttheacquisitionofGoldenWest,identifvingthatmort-
gage portfolio and associated real estate foreclosures as the heart of Wachovias
problem. The OCC noted that the board had acknowledged that the Golden West
acquisitionwasamistake.
oo
TheOCCwrotethatthemarketwasfocusedonthecompanvsweakenedcondi-
tion and that some large fund providers had alreadv limited their exposure to Wa-
chovia. Like the Fed, however, the OCC concluded that the banks liquiditv was
adequate, unless events undermined market confdence.
o1
And, like the Fed, the
OCCapprovedofthenewmanagementandanew,morehands-onoversightrolefor
theboardofdirectors.
YetWachoviasproblemswouldcontinue,andinthefallregulatorswouldscram-
bletofndabuverforthetroubledbank.
\es/ingtonMutuel.Menegcmcntsjcrsistcntleckojjrogrcss
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,thevhadgeneratedreturnsupto8timesthoseonGSEmortgagebackedsecu-
rities.
oi
But that was then. WaMu was forced to write off 1.o billion for the fourth
quarterofiooandanother1.1billioninthefrstquarterofioo8,mostlvrelatedto
itsportfolioofoptionARMs.
Inresponsetotheselosses,theOmceofThriftSupervision,WaMusregulator,re-
questedthatthethriftaddressconcernsaboutassetqualitv,earnings,andliquiditv
issues that the OTS had raised in the past but that had not been refected in
supervisorv ratings. It has been hard for us to justifv doing much more than con-
stantlvnagging(okav,chastising)throughROE[ReportsofExamination]andmeet-
ings,sincethevhavenotreallvbeenadverselvimpactedintermsoflosses,
o:
theOTSs
leadexamineratthecompanvhadcommentedinaioo-email.Indeed,thenontradi-
tionalmortgageportfoliohadbeenperformingvervwellthroughioo-andiooo.
But with WaMu now taking losses, the OTS determined on Februarv i, ioo8,
thatitsconditionrequiredadowngradeinitsratingfromaitoa:,orlessthansat-
isfactorv.
oa
InMarch,theOTSadvisedthatWaMuundertakestrategicinitiatives
thatis,eitherfndabuverorraisenewcapital.InApril,WaMusecuredabillion
investmentfromaconsortiumledbvtheTexasPacifcGroup,aprivateequitvfrm.
o-
Butbadnewscontinuedforthrifts.OnIulv1a,theOTSclosedIndvMacBankin
Pasadena,California,makingthatcompanvthelargest-everthrifttofail.OnIulvii,
ioo8, WaMu reported a :.: billion loss in the second quarter. WaMus depositors
withdrew1obillionoverthenexttwoweeks.
oo
AndtheFederalHomeLoanBankof
San Franciscowhich, as noted, had historicallv served with the other 11 Federal
HomeLoanBanksasanimportantsourceoffundsforWaMuandothersbeganto
limit WaMus borrowing capacitv. The OTS issued more downgrades in various as-
sessmentcategories,whilemaintainingtheoverallratingat:.
As the insurer of manv of WaMus deposits, the FDIC had a stake in WaMus
condition, and it was not as generous as the OTS in its assessment. It had alreadv
dropped WaMus rating signifcantlv in March ioo8, indicating a high level of
concern.
o
The FDIC expresslv disagreed with the OTSs decision to maintain the : overall
rating,recommendingaainstead.
o8
Ordinarilv,awouldhavetriggeredaformalen-
forcementaction,butnonewasforthcoming.InanAugustioo8interview,William
Isaac,whowaschairmanoftheFDICfrom1o81until1o8-,notedthattheOTSand
FDIC had competing interests. OTS, as primarv regulator, tends to want to see if
thevcanrehabilitatethebankanddoesntwanttoactprecipitouslvasarule.Onthe
other hand, The FDICs job is to handle the failures, and itgenerallv speaking
wouldratherbetougher . . .onthetheorvthatthesoonertheproblemsareresolved,
thelessexpensivethecleanupwillbe.
oo
FDICChairmanSheilaBairunderscoredthistension,tellingtheFCICthatour
examiners, much earlier, were verv concerned about the underwriting qualitv of
WaMusmortgageportfolio,andwewereactivelvopposedbvtheOTSintermsofgo-
inginandlettingour[FDIC]examinersdoloan-levelanalvsis.
o
\\itu 1u \UtU:1 z++ ::1i\i t ii :i tuNtiiN: .+,
TheTreasurvsinspectorgeneralwouldlatercriticizeOTSssupervisionofWash-
ingtonMutual:WeconcludedthatOTSshouldhaveloweredWaMuscompositerat-
ing sooner and taken stronger enforcement action sooner to force WaMus
management to correct the problems identifed bv OTS. Specifcallv, given WaMu
managements persistent lack of progress in correcting OTS-identifed weaknesses,
webelieveOTSshouldhavefolloweditsownpoliciesandtakenformalenforcement
actionratherthaninformalenforcementaction.
1
kcguletors.\lotojt/etjus/oeck
IntheseexamplesandothersthattheCommissionstudied,regulatorseitherfailedor
werelatetoidentifvthemistakesandproblemsofcommercialbanksandthriftsordid
notreactstronglvenoughwhenthevwereidentifed.Inpart,thisfailurerefectsthe
nature of bank examinations conducted during periods of apparent fnancial calm
wheninstitutionswerereportingprofts.Inadditiontotheirroleasenforcersofregu-
lation,regulatorsactedsomethinglikeconsultants,workingwithbankstoassessthe
adequacvoftheirsvstems.Thisfunctionwas,toadegree,arefectionofthesupervi-
sorsrisk-focusedapproach.TheOCCLarge Bank Supervision Handbook published
inIanuarvio1oexplains,Underthisapproach,examinersdonotattempttorestrict
risk-takingbutratherdeterminewhetherbanksidentifv,understand,andcontrolthe
risksthevassume.
i
Asthecrisisdeveloped,bankregulatorswereslowtoshiftgears.
SeniorsupervisorstoldtheFCICitwasdimculttoexpresstheirconcernsforce-
fullvwhenfnancialinstitutionsweregeneratingrecord-levelprofts.TheFedsRoger
Cole told the FCIC that supervisors did discuss issues such as whether banks were
growingtoofastandtakingtoomuchrisk,butranintopushback.Franklvalotof
that pushback was given credence on the part of the frms bv the fact thatlike a
Citigroupwasearningato-billionaquarter.Andthatisreallvhardforasupervi-
sor to successfullv challenge. When that kind of monev is fowing out quarter after
quarterafterquarter,andtheircapitalratiosarewavabovetheminimums,itsverv
hardtochallenge.
:
SupervisorsalsotoldtheFCICthatthevfearedaggravatingabanksalreadv-exist-
ingproblems.Forthelargebanks,theissuanceofaformal,publicsupervisorvaction
taken under the federal banking statutes marked a severe regulatorv assessment of
thebanksriskpractices,anditwasrarelvemplovedforbanksthatweredetermined
tobegoingconcerns.RichardSpillenkothen,theFedsheadofsupervisionuntilearlv
iooo, attributed supervisorv reluctance to a belief that the traditional, nonpublic
(behind-the-scenes) approach to supervision was less confrontational and more
likelvtoinducebankmanagementtocooperate;adesirenottoinjectanelementof
contentiousnessintowhatwasfelttobeaconstructiveorequablerelationshipwith
management; and a fear that fnancial markets would overreact to public actions,
possiblvcausingarun.Spillenkothenarguedthattheseconcernswererelevantbut
thatattimesthevcanimpedeeffectivesupervisionanddelavtheimplementationof
neededcorrectiveaction.Oneofthelessonsofthiscrisis . . .isthattheworkingpre-
sumptionshouldbeearlierandstrongersupervisorvfollowup.
a
COMMISSION CONCLUSIONS ON CHAPTER 16
TheCommissionconcludesthatthebankingsupervisorsfailedtoadequatelvand
proactivelv identifv and police the weaknesses of the banks and thrifts or their
poorcorporategovernanceandriskmanagement,oftenmaintainingsatisfactorv
ratingsoninstitutionsuntiljustbeforetheircollapse.Thisfailurewascausedbv
manv factors, including beliefs that regulation was undulv burdensome, that f-
nancialinstitutionswerecapableofself-regulation,andthatregulatorsshouldnot
interferewithactivitiesreportedasproftable.
Largecommercialbanksandthrifts,suchasWachoviaandIndvMac,thathad
signifcant exposure to riskv mortgage assets were subject to runs bv creditors
anddepositors.
TheFederalReserverealizedfartoolatethesvstemicdangerinherentinthe
interconnections of the unregulated over-the-counter (OTC) derivatives market
anddidnothavetheinformationneededtoact.
DouglasRoeder,theOCCsseniordeputvcomptrollerforLargeBankSupervision
from ioo1 to io1o, said that the regulators were hampered bv inadequate informa-
tionfromthebanksbutacknowledgedthatregulatorsdidnotdoagoodjobofinter-
vening at kev points in the run-up to the crisis. He said that regulators, market
participants,andothersshouldhavebalancedtheirconcernsaboutsafetvandsound-
ness with the need to let markets work, noting, We underestimated what svstemic
riskwouldbeinthemarketplace.
-
Regulators also blame the complexitv of the supervisorv svstem in the United
States.Thepatchworkquiltofregulatorscreatedopportunitiesforbankstoshopfor
themostlenientregulator,andthepresenceofmorethanonesupervisoratanorgan-
ization.Forexample,alargefrmlikeCitigroupcouldhavetheFedsupervisingthe
bankholdingcompanv,theOCCsupervisingthenationalbanksubsidiarv,theSEC
supervisingthesecuritiesfrm,andtheOTSsupervisingthethriftsubsidiarvcreat-
ingthepotentialforbothgapsincoverageandproblematicoverlap.SuccessiveTreas-
urv secretaries and Congressional leaders have proposed consolidation of the
supervisorstosimplifvthissvstemoverthevears.Notablv,SecretarvHenrvPaulson
releasedtheBlueprintforaModernizedFinancialRegulatorvStructureonMarch
:1, ioo8, two weeks after the Bear rescue, in which he proposed getting rid of the
thriftcharter,creatingafederalcharterforinsurancecompanies(nowregulatedonlv
bvthestates),andmergingtheSECandCFTC.Theproposalsdidnotmoveforward
inioo8.
o
.+ ii N\Nti \i tii :i : i NuUi i tu\\i : :i uN iiiui1
.++
17
SEPTEMBER 2008: THE TAKEOVER
OF FANNIE MAE AND FREDDIE MAC
CONTENTS
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Vasntdcncatnvpavgradc:::
FromthefallofioountilFannieMaeandFreddieMacwereplacedintoconserva-
torshiponSeptember,ioo8,governmentomcialsstruggledtostriketherightbal-
ancebetweenthesafetvandsoundnessofthetwogovernment-sponsoredenterprises
andtheirmissiontosupportthemortgagemarket.Thetaskwascriticalbecausethe
mortgage market was quicklv weakeninghome prices were declining, loan delin-
quencies were rising, and, as a result, the values of mortgage securities were plum-
meting.Lendersweremorewillingtorefnanceborrowersintoaffordablemortgages
ifthesegovernment-sponsoredenterprises(GSEs)wouldpurchasethenewloans.If
theGSEsboughtmoreloans,thatwouldstabilizethemarket,butitwouldalsoleave
theGSEswithmoreriskontheiralreadv-strainedbalancesheets.
TheGSEswerehighlvleveragedowningandguaranteeing-.:trillionofmort-
gageswithcapitaloflessthani.WheninterviewedbvtheFCIC,formerTreasurv
SecretarvHenrvPaulsonacknowledgedthatafterhewasbriefedontheGSEsupon
takingomceinIuneiooo,hebelievedthatthevwereadisasterwaitingtohappen
and that one kev problem was the legal defnition of capital, which their regulator
lackeddiscretiontoadjust;indeed,hesaidthatsomepeoplereferredtoitasbullsht
capital.
1
Still,theGSEskeptbuvingmoreoftheriskiermortgageloansandsecuri-
ties, which bv fall ioo constituted multiples of their reported capital. The GSEs
..+ ii N\Nti \i tii :i : i NuUi i tu\\i : :i uN iiiui1
reported billions of dollars of net losses on these loans and securities, beginning in
thethirdquarterofioo.
ButmanvinTreasurvbelievedthecountrvneededtheGSEstoprovideliquiditv
to the mortgage market bv purchasing and guaranteeing loans and securities at a
timewhennooneelsewould.PaulsontoldtheFCICthatafterthehousingmarket
driedupinthesummerofioo,thekevtogettingthroughthecrisiswastolimitthe
declineinhousing,preventforeclosures,andensurecontinuedmortgagefunding,all
ofwhichrequiredthattheGSEsremainviable.
i
However,therewereconstraintson
howmanvloanstheGSEscouldfund;thevandtheirregulatorshadagreedtoportfo-
lio capslimits on the loans and securities thev could hold on their booksand a
:ocapitalsurplusrequirement.
So,evenaseachcompanvreportedbillionsofdollarsinlossesiniooandioo8,
theirregulator,theOmceofFederalHousingEnterpriseOversight(OFHEO),loos-
ened those constraints. From the fall of ioo, to the conservatorships, it was a
tightrope with no safetv net, former OFHEO Director Iames Lockhart testifed to
the FCIC.
:
Unfortunatelv, the balancing act ultimatelv failed and both companies
wereplacedintoconservatorship,costingtheU.S.taxpavers1-1billionsofar.
A GOOD TIME TO BUY
InanAugust1,ioo,lettertoLockhart,FannieMaeCEODanielMuddsoughtim-
mediaterelieffromtheportfoliocapsrequiredbvtheconsentagreementexecutedin
Mav iooo following Fannies accounting scandal. We have witnessed growing evi-
denceofturmoilinvirtuallvallsectorsofthehousingfnancemarket,Muddwrote,
and the immediate crisis in subprime is indicative of a serious liquiditv event im-
pactingtheentirecreditmarket,notjustsubprime.
a
Asdemandforpurchasingloans
dried up, large lenders like Countrvwide kept loans that thev normallv securitized,
andsmallerlenderswentunder.AnumberoffrmstoldFanniethatthevwouldstop
makingloansifFanniewouldnotbuvthem.
Muddarguedthatarelaxedcapwouldlethiscompanvprovidethatliquiditv.A
moderate,1opercentincreaseintheFannieMaeportfoliocapwouldprovideuswith
fexibilitv . . .andsendastrongsignaltothemarketthattheGSEsareabletoaddress
liquiditv events before thev become crises. He maintained that the consent agree-
mentallowedOFHEOtoliftthecaptoaddressmarketliquiditvissues.Moreover,
thecompanvhadlargelvcorrecteditsaccountingandinternalcontroldefciencies
theprimarvconditionforremovingthecap.Finallv,hestressedthattheGSEschar-
ter required Fannie to provide liquiditv and stabilitv to the market. Ultimatelv,
Mudd concluded, this request is about restoring market confdence that the GSEs
canfulflltheirstabilizingroleinhousing.
-
Fannie Mae executives also saw an opportunitv to make monev. Because there
was less competition, the GSEs could charge higher fees for guaranteeing securities
andpavlessforloansandsecuritiesthevwantedtoown,enablingthem(intheorv)
toincreasereturns.
o
TomLund,alongtimeFannieMaeexecutivewholedthefrms
single-familvbusiness,toldtheFCICthatthemarketmovedinFannieMaesfavoraf-
:ii1i\8ii z++ 1ui 1\iiu\ii ui i\NNi i \\i \Ni iiiiii i \\t ...
ter August ioo as competitors dropped out and prices of loans and securities fell.
LundtoldFCICstaffthataftertheiooliquiditvshock,Fanniehadmorecomfort
that the relationship between risk and price was correct.
WarshalsotoldtheFCICthattheeventssurroundingtheGSEtakeoverledtoa
massive, underreported, underappreciated jolt to the svstem. Then, according to
Warsh,whenthemarketgraspedthatithadmisunderstoodtherisksassociatedwith
theGSEs,andthatthegovernmentcouldhaveconceivablvletthemfail,itcausedin-
vestorstopanicaboutthevalueofevervasset,toreassessevervportfolio.
8
FHFADirectorLockhartdescribedthedecisiontoputtheGSEsintoconservator-
ship in the context of Lehmans failure. Given that the investment banks balance
sheet was about one-ffth the size of Fannie Maes, he felt that the fallout from
Lehmans bankruptcv would have paled in comparison to a GSE failure. He said,
WhathappenedafterLehmanwouldhavebeenvervsmallcomparedtothese-.-
trillion institutions failing.
o
Major holders of GSE securities included the Chinese
and Russian central banks, which, between them, owned more than half a trillion
dollars of these securities, and U.S. fnancial frms and investment funds had even
more extensive holdings. A ioo- Fed studv concluded that U.S. banks owned more
than1trillioninGSEdebtandsecuritiesmorethan1-oofthebanksTier1cap-
italand11oftheirtotalassetsatthetime.
8o
TestifvingbeforetheFCIC,Muddclaimedthatfailurewasallbutinevitable.In
ioo8,thecompanieshadnorefugefromthetwinshocksofahousingcrisisfollowed
bvafnancialcrisis,hesaid.AmonolineGSEstructureaskedtoperformmultiple
taskscannotwithstandamultivear:ohomepricedeclineonanationalscale,even
withouttheaccompanvingglobalfnancialturmoil.Themodelallowedabalanceof
businessandmissionwhenhomepriceswererising.Whenpricescrashedfarbevond
therealmofhistoricalexperience,itbecameThePitandthePendulum,achoicebe-
tweenhorriblealternatives.
81
THE WORSTRUN FINANCIAL INSTITUTION
WheninterviewedbvtheFCIC,FHFAomcialswerevervcriticalofFanniesmanage-
ment.IohnKerr,theFHFAexaminer(andanOCCveteran)inchargeofFannieex-
aminations, minced no words. He labeled Fannie the worst-run fnancial
institutionhehadseeninhis:ovearsasabankregulator.ScottSmith,whobecame
.zz ii N\Nti \i tii :i : i NuUi i tu\\i : :i uN iiiui1
associatedirectoratFHFAafterthatagencvreplacedOFHEO,concurred;inhisview,
Fanniesforecastingcapabilitieswerenotparticularlvwellthoughtout,andlackeda
varietv of stress scenarios. Both omcials noted Fannies weak forecasting models,
whichincludedhundredsofmarketsimulationsbutscarcelvanvthatcontemplated
declines in house prices. To Austin Kellv, an OFHEO examination specialist, there
was no relving on Fannies numbers, because their processes were a bowl of
spaghetti. Kerr and a colleague said that that thev were struck that Fannie Mae, a
multitrillion-dollarcompanv,emplovedunsophisticatedtechnologv:itwaslesstech-
savvvthantheaveragecommunitvbank.
8i
Nonetheless, OFHEOs communications with Fannie prior to September a did
notfullvrefectthesecriticisms.FHFAomcialsconcededthatthevhadmademis-
takesintheiroversightofFannieandFreddie.Thevpaidtoomuchattentiontofx-
ing operational problems and did not react to Fannies increasing credit risk.
LockharttoldtheFCICthatmoreresourcesshouldhavebeendedicatedtoassessing
creditriskoftheirmortgageassetsandguarantees.
8:
CurrentFHFAActingDirector
EdwardDeMarcotoldtheFCICthatitwouldnotpassthereasonablepersontest
to denv that OFHEO took its eve off the ball bv not paving sumcient attention to
creditriskandinsteadfocusedonoperationalrisk,accountingandlackofaudited
results.
8a
To Mudd and others, OFHEOs mistakes were not surprising. Mudd told the
FCIC that the regulators skill levels were developing but below average.
8-
Henrv
Cisneros, a former housing and urban development secretarv, expressed a similar
view. OFHEO, Cisneros told the FCIC, was punv compared to what Fannie Mae
andFreddieMaccouldmusterintheirintelligence,theirIvvLeagueeducations,their
rocketscientistsintheirplace,theirlobbvists,theirabilitvtoworktheHill.
8o
Thecostsofthebailoutshavebeenenormousandareexpectedtoincrease.From
Ianuarv1,ioo8,throughthethirdquarterofio1o,thetwocompanieslostiiobil-
lion,wipingout1billionofcombinedcapitalthatthevhadreportedattheendof
iooandthebillionofcapitalraisedbvFannieinioo8.Treasurvnarrowedthe
gapwith1-1billioninsupport.FHFAhasestimatedthatcoststhroughio1:will
rangefromii1billionto:o:billion.TheCongressionalBudgetOmcehaspro-
jected that the economic cost of the GSEs downfall, including the total fnancial
costofgovernmentsupportaswellasactualdollaroutlavs,couldreach:8obillion
bvio1o.
WASN T DONE AT MY PAY GRADE
FanniestwomostseniorexecutiveswereaskedatanFCIChearinghowtheircharter
couldhavebeenchangedtomakethecompanvmoresound,andtoavoidthemulti-
billion-dollar bailout. Mudd, who made approximatelv o- million from iooo to
ioo8, testifed that the thing that would have made the institution more sound or
haveproducedadifferentoutcomewouldhavebeenforittohavebecomeovertime
amorenormalfnancialinstitutionabletodiversifv,abletoallocatecapital,abletobe
COMMISSION CONCLUSIONS ON CHAPTER 17
TheCommissionconcludesthatthebusinessmodelofFannieMaeandFreddie
Mac(theGSEs),asprivate-sector,publiclvtraded,proft-makingcompanieswith
implicitgovernmentbackingandapublicmission,wasfundamentallvfawed.We
fndthattheriskvpracticesofFannieMaetheCommissionscasestudvinthis
areaparticularlvfromioo-on,ledtoitsfall:practicesundertakentomeetWall
Streets expectations for growth, to regain market share, and to ensure generous
compensation for its emplovees. Affordable housing goals imposed bv the De-
partmentofHousingandUrbanDevelopment(HUD)didcontributemarginallv
to these practices. The GSEs justifed their activities, in part, on the broad and
sustainedpublicpolicvsupportforhomeownership.Riskvlendingandsecuriti-
zationresultedinsignifcantlossesatFannieMae,which,combinedwithitsex-
cessiveleveragepermittedbvlaw,ledtothecompanvsfailure.
Corporategovernance,includingriskmanagement,failedattheGSEsinpart
becauseofskewedcompensationmethodologies.TheOmceofFederalHousing
Enterprise Oversight (OFHEO) lacked the authoritv and capacitv to adequatelv
regulatetheGSEs.TheGSEsexercisedconsiderablepoliticalpowerandweresuc-
cessfullvabletoresistlegislationandregulatorvactionsthatwouldhavestrength-
enedoversightofthemandrestrictedtheirrisk-takingactivities.
Inearlvioo8,thedecisionbvthefederalgovernmentandtheGSEstoincrease
theGSEsmortgageactivitiesandrisktosupportthecollapsingmortgagemarket
wasmadedespitetheunsoundfnancialconditionoftheinstitutions.Whilethese
actionsprovidedsupporttothemortgagemarket,thevledtoincreasedlossesat
theGSEs,whichwereultimatelvbornebvtaxpavers,and refectedtheconficted
natureoftheGSEsdualmandate.
GSE mortgage securities essentiallv maintained their value throughout the
crisisanddidnotcontributetothesignifcantfnancialfrmlossesthatwerecen-
traltothefnancialcrisis.
longorshortinthemarket,abletooperateinternationallv.Andifthetradeforthat
wouldhavebeen,vouknow,acutintheso-calledimplicittieswiththegovernment,I
thinkthatwouldhavethatwouldhavebeenabettersolution.
8
ChiefBusinessOf-
fcer Levin, who received approximatelv a- million from iooo to ioo8, answered
onlvthatmakingsuchdecisionswasntdoneatmvpavgrade.
88
:ii1i\8ii z++ 1ui 1\iiu\ii ui i\NNi i \\i \Ni iiiiii i \\t .z.
.z.
18
SEPTEMBER 2008:
THE BANKRUPTCY OF LEHMAN
CONTENTS
Gctncrcccnscrvativc|vjundcd ::
1hisisnctscundinggccdata||::
Spcckthcnarkct :::
Inaginaticnhat ::)
Hcadscjjani|v :::
1c||thcscscnscj|itchcstcunwind::;
1hisdccsntsccn|ikcitisgcingtccndprcttv::
1hccn|va|tcrnativcwasthatIchnanhadtcjai|:::
Aca|anitv ::;
Solvencv should be a simple fnancial concept: if vour assets are worth more than
vourliabilities,vouaresolvent;ifnot,vouareindangerofbankruptcv.Butontheaf-
ternoonofFridav,September1i,ioo8,expertsfromthecountrvsbiggestcommer-
cial and investment banks met at the Wall Street omces of the Federal Reserve to
ponder the fate of Lehman Brothers, and could not agree whether or not the 1--
vear-oldfrmwassolvent.
Onlvtwodavsearlier,Lehmanhadreportedshareholderequitvthemeasureof
solvencvof i8 billion at the end of August. Over the previous nine months, the
bank had lost o billion but raised more than 1o billion in new capital, leaving it
withmorereportedequitvthanithadavearearlier.
Butthisarithmeticreassuredhardlvanvoneoutsidetheinvestmentbank.Fedom-
cials had been discussing Lehmans solvencv for months, and the stakes were verv
high.Toresolvethequestion,theFedwouldnotrelvonLehmansi8billionfgure,
givenquestionsaboutwhetherLehmanwasreportingassetsatmarketvalue.Asone
NewYorkFedomcialwrotetocolleaguesinIulv,Balance-sheetcapitalisnttoorele-
vantifvouresufferingamassiverun.
1
Ifthereisarun,andafrmcanonlvgetfre-
salepricesforassets,evenlargeamountsofcapitalcandisappearalmostovernight.
The bankers thought Lehmans real estate assets were overvalued. In light of
:ii1i\8ii z++ 1ui 8\NiiUi1t ui iiu\\N .z,
Lehmans unreliable valuation methods, the bankers had good reason for their
doubts.NoneofthebankersattheNewYorkFedthatweekendbelievedthe-abil-
lioninrealestateassets(excludingrealestateheldforsale)onLehmansbookswas
anaccuratefgure.Iftheassetswereworthonlvhalfthatamount(alikelvscenario,
given market conditions), then Lehmans i8 billion in equitv would be gone. In a
fresale,somemightsellforevenlessthanhalftheirstatedvalue.
What does solvent mean: IP Morgan CEO Iamie Dimon responded when the
FCIC asked if Lehman had been solvent. The answer is, I dont know. I still could
notanswerthatquestion.
i
IPMorgansChiefRiskOmcerBarrvZubrowtestifedbe-
foretheFCICthatfromapureaccountingstandpoint,itwassolvent,althoughit
obviouslvwasfnancingitsassetsonavervleveragedbasiswithalotofshort-termf-
nancing.
:
TestifvingbeforetheFCIC,formerLehmanBrothersCEORichardFuldinsisted
hisfrmhadbeensolvent:TherewasnocapitalholeatLehmanBrothers.Attheend
ofLehmansthirdquarter,wehadi8.abillionofequitvcapital.
a
FedChairmanBen
Bernanke disagreed: I believe it had a capital hole. He emphasized that New York
Federal Reserve Bank President Timothv Geithner, Treasurv Secretarv Henrv Paul-
son,andSECChairmanChristopherCoxagreeditwasjustwavtoobigahole.And
mv own view is its verv likelv that the companv was insolvent, even, not just illiq-
uid.
-
Others, such as Bank of America CEO Ken Lewis, who that week considered
acquiringLehmanwithgovernmentsupport,hadnodoubtseither.HetoldtheFCIC
that Lehmans real estate and other assets had been overvalued bv oo to o bil-
liona message he had delivered to Paulson a few davs before Lehman declared
bankruptcv.
o
Ithadbeenquiteaweek;itwouldbequiteaweekend.Thedebatewillcontinue
over the largest bankruptcv in American historv, but nothing will change the basic
facts: a consortium of banks would fail to agree on a rescue, two last-minute deals
wouldfallthrough,andthegovernmentwoulddecidenottorescuethisinvestment
bankfor fnancial reasons, for political reasons, for practical reasons, for philo-
sophicalreasons,andbecause,asBernanketoldtheFCIC,ifthegovernmenthadlent
monev, the frm would fail, and not onlv would we be unsuccessful but we would
havesaddledthetaxpaverwithtensofbillionsofdollarsoflosses.
Thatafternoon,FedGover-
norWarshwrote,inresponsetoacolleagueshopetheFedwouldnothavetoprotect
someofLehmansdebtholders,Ihopewedon[]tprotectanvthing!
8
ButonFridav,
FedChairmanBernankewastakingnochances.HestavedbehindinWashington,in
casehehadtoconvenetheFedsboardtoexerciseitsemergencvlendingpowers.
o
Earlv Fridav evening, Treasurv Secretarv Paulson summoned the heads of fam-
ilvthephraseusedbvHarvevMiller,Lehmansbankruptcvcounsel,todescribethe
CEOsofthebigWallStreetfrms
8o
totheNewYorkFedsheadquarters.Paulsontold
them that a private-sector solution was the onlv option to prevent a Lehman bank-
ruptcv. The people in the room needed to come up with a realistic set of options to
helplimitdamagetothesvstem.Asuddenanddisorderlvwind-downcouldharmthe
capitalmarketsandposethesignifcantriskofaprecipitousdropinassetprices,re-
sultingincollateralcallsandreducedliquiditv:thatis,svstemicrisk.Hecouldnotof-
fertheprospectofcontainingthedamageiftheexecutiveswereunabletofashionan
orderlvresolutionofthesituation,ashadbeendonein1oo8forLong-TermCapital
Management.PaulsondidoffertheFedshelpthroughregulatorvapprovalsandaccess
tolendingfacilities,butemphasizedthattheFedwouldnotprovideanvformofex-
traordinarvcreditsupport.
81
AsNewYorkFedGeneralCounselTomBaxtertoldthe
FCIC,Paulsonmadeitcleartherewouldbenogovernmentassistance,notapennv.
8i
H.RodginCohen,aveteranWallStreetlawverwhohasrepresentedmostofthe
majorbanks,includingLehman,toldtheFCICthatthegovernmentsnotapennv
posture was a calculated strategv: I dont know exactlv what the government was
thinking, but mv impression was thev were plaving a game of chicken or poker or
whatever.Itwassaidonmorethanoneoccasionthatitwouldbevervpoliticallvdim-
culttorescueLehman.TherehadbeenalotofblowbackafterBearStearns.Ibelieve
thegovernmentthoughtthatitcould,withrespecttoagameofchicken,persuadethe
privatesectortotakeabigchunkofLehmansliabilities.
8:
TheFedsinternalliquidationconsortiumgameplanwouldseemtoconfrmCo-
hensview,giventhatitcontemplatedafnancialcommitment,eventhoughthatwas
not to be divulged.
8a
Moreover, notwithstanding Paulsons not a pennv statement,
theUnitedKingdomschancelloroftheexchequer,AlistairDarling,saidthatPaulson
toldhimthattheFRBNYmightbepreparedtoprovideBarclavswithregulatorvas-
sistancetosupportatransactionifitwasrequired.
8-
AtthatconsortiummeetingonFridavnight,CitigroupCEOVikramPanditasked
ifthegroupwasalsogoingtotalkaboutAIG.TimothvGeithnersaidsimplv:Lets
focusonLehman.
8o
TELL THOSE SONS OF BITCHES TO UNWIND
WhatwouldhappenifIPMorganrefusedtoprovideintradavcreditforLehmanin
thetri-partvrepomarketonMondav,September1-:TheFedhadbeenconsidering
thispossibilitvsincethesummer.AsParkinsonnoted,thefundamentalproblemwas
that even if Lehman fled for bankruptcv, the SEC would want Lehmans broker-
:ii1i\8ii z++ 1ui 8\NiiUi1t ui iiu\\N ..,
dealertoliveonandwouldnotwanttheFedinitspositionaslendertograbtri-partv
collateral.
8
ParkinsontoldtheFCICstaffthatZubrowinformedhimovertheweek-
endthatIPMorganwouldnotunwindLehmansreposonMondaviftheFeddidnot
expandthetvpesofcollateralthatcouldbefnancedthroughthePDCFlendingfacil-
itv.Earlierinthevear,ParkinsonhadsaidthatIPMorgansrefusaltounwindwould
beunforgiveable.NowhetoldGeithnertotellthosesonsofbitches . . .tounwind.
88
MerrillCEOIohnThaintoldtheFCICthatbvSaturdavmorning,thegroupofex-
ecutivesreviewingLehmansassetshadestimatedthatthevwereovervaluedbvanv-
where from 1- to i- billion. Thain thought that was more than the assembled
executiveswouldbewillingtofnanceand,therefore,ThainbelievedLehmanwould
fail.
8o
IfLehmanfailed,Thainbelieved,Merrillwouldbenext.SohehadcalledKen
Lewis,theCEOofBankofAmerica,andthevmetlaterthatdavatBankofAmericas
New York corporate apartment. Bv Sundav, the two agreed that Bank of America
wouldacquireMerrillforiopershare,pavableinBankofAmericastock.
OnSaturdavafternoon,LehmanscounselprovidedtheFedwithadocumentde-
scribinghowLehmansdefaultonitsobligationswouldtriggeracascadeofdefaults
throughtothe[subsidiaries]whichhavelargeOTC[derivatives]books.
oo
Bernanke,
Fed Governor Kohn, Geithner, and other senior Fed omcials subsequentlv partici-
patedinaconferencecalltodiscussthepossibilitvofgoingtoCongresstoaskfor
other authorities, something Geithner planned to pitch.
o1
However, Fed General
Counsel Scott Alvarez cautioned others not to mention the plan to IP Morgan, be-
cause he did not want to suggest Fed willingness to give IPMC cover to screw
[Lehman]oranvoneelse.
oi
BvSaturdavnight,however,itappearedthattheparadeofhorrorsthatwouldre-
sult from a Lehman bankruptcv had been avoided. An agreement apparentlv had
beenreached.BarclavswouldpurchaseLehman,excludingaoto-obillionofas-
setsfnancedbvtheprivateconsortium(eventhoughthebankersintheconsortium
hadestimatedthoseassetstobesignifcantlvovervalued).MichaelKlein,anadviser
to Barclavs, had told Lehman President Bart McDade that Barclavs was willing to
purchase Lehman, given the private consortium agreement to assist the deal.
o:
It
seemedadealwouldbecompleted.
oa
THIS DOESN T SEEM LIKE IT IS GOING TO END PRETTY
ButonSundav,thingswentterriblvwrong.At8:ooA.M.,BarclavsCEOIohnVarlev
and President Robert Diamond told Paulson, Geithner, and Cox that the Financial
ServicesAuthoritv(FSA)haddeclinedtoapprovethedeal.
o-
Theissueboileddown
to a guaranteethe New York Fed required Barclavs to guarantee Lehmans obliga-
tions from the sale until the transaction closed, much as IP Morgan had done for
Bear Stearns in March.
oo
Under U.K. law, the guarantee required a Barclavs share-
holdervote,whichcouldtake:otooodavs.Thoughitcouldwaivethatrequirement,
the FSA asserted that such a waiver would be unprecedented, that it had not heard
about this guarantee until Saturdav night, and that Barclavs did not reallv want to
takeonthatobligationanvwav.
..( ii N\Nti \i tii :i : i NuUi i tu\\i : :i uN iiiui1
GeithnerpleadedwithFSAChairmanCallumMcCarthvtowaivetheshareholder
vote, but McCarthv wanted the New York Fed to provide the guarantee instead of
Barclavs.
o
Otherwise,accordingtotheFSA,Barclavswouldhavehadtoprovidea
(possiblvunlimited)guarantee,foranundefnedperiodoftime,coveringpriorand
futureexposuresandliabilitiesofLehmanthatwouldcontinuetoapplvincludingin
respect of all transactions entered into prior to the purchase, even in the event the
transactionultimatelvfailed.
o8
ForPaulson,suchaguaranteebvtheFedwasunequivocallvoutofthequestion.
oo
TheguaranteecouldhaveputtheFedonthehookfortensofbillionsofdollars.Ifthe
runonLehmanhadcontinueddespitetheguarantee,Barclavsshareholderscouldre-
jecttheacquisition,andtheFedwouldbeinpossessionofaninsolventbank.
BaxtertoldtheFCICthatBarclavshadknownallalongthattheguaranteewasre-
quired, because IP Morgan had to provide the same tvpe of guarantee when it ac-
quired Bear Stearns. Indeed, Baxter said he was stunned at this development. He
believed that the real reason Barclavs said it could not guarantee Lehmans obliga-
tionswastheU.K.governmentsdiscomfortwiththetransaction.
1oo
OnSundavmorning,TreasurvsWilkinsonemailedIPMorganInvestmentBank
CEOIesStalevthathewasinameetingwithPaulsonandGeithnerandthatthings
didnotlookgood.Heconcluded,Thisdoesntseemlikeitisgoingtoendprettv.
1o1
Inanothernotealittlemorethananhourlater,headdedthattherewouldbenogov-
ernmentassistance:Nowav[government]moneviscomingin. . . .Imherewriting
the usg coms [United States government communications] plan for orderlv un-
wind . . .alsojustdidacallwiththeWH[WhiteHouse]andusgisunitedbehindno
monev. No wav in hell Paulson could blink now . . . we will know more after this
[CEO meeting] this morning but I think we are headed for winddown unless bar-
clavsdealgetsuntangled.
1oi
It did not. Paulson made a last-ditch pitch to his U.K. counterpart, Darling,
withoutsuccess.
1o:
Twovearslater,Darlingadmittedthathehadvetoedthetrans-
action:YeahIdid.ImagineifIhadsaidvestoaBritishbankbuvingavervlarge
American bank which . . . collapsed the following week. He would have found
himself telling a British audience, Evervbodv sitting in this room and vour chil-
drenandvourgrandchildrenandtheirgrandchildrenwouldbepavingforvearsto
come.ThatBankofAmericahadtakenitselfoutofthepicturemavhaveplaveda
role in Darlings decision: Mv first reaction was If this is such a good deal how
comenoAmericanbankisgoingtogonearit:SoDarlingconcludedthatforBar-
clavstoaccepttheguarantee,whichcouldhaveagraveimpactontheBritishecon-
omv, was simplv out of the question: I spoke to Hank Paulson and said Look,
theresnowavwecouldallowaBritishbanktotakeovertheliabilitvofanAmeri-
canbank,whichineffectmeanttheBritishtaxpaverwasunderwritinganAmeri-
canbank.
1oa
Following that decision in London, Lehman Brothers was, for all practical pur-
poses, dead. Cohen, Lehmans counsel at the time, told the FCIC, When Secretarv
PaulsoncameoutofthemeetingwithGeithnerandCox,thevcalledLehmanspresi-
:ii1i\8ii z++ 1ui 8\NiiUi1t ui iiu\\N ..,
dent and me over and said, We have the consortium, but the British government
wontdoit.DarlingsaidhedidnotwanttheU.S.cancertospreadtotheU.K.
1o-
At around 1:oo P.M., Lehmans teamPresident Bart McDade, CFO Ian Lowitt,
HeadofPrincipalInvestingAlexKirk,andothersreconvenedatLehmansomcesto
digestwhatobviouslvwasstarknews.Uponarriving,thevheardthattheNewYork
Fed would provide more fexible terms for the PDCF lending facilitv, which would
include expanding the tvpes of collateral borrowers could use.
1oo
McDade, Kirk,
Lowitt, and Miller returned to the New York Fed building and met with the Feds
Baxter and Dudlev, the SECs Sirri, and others to discuss the expanded PDCF pro-
gram. According to McDade and Kirk, the government omcialsled bv Baxter
madeitplainthevwouldnotpermitLehmantoborrowagainsttheexpandedtvpes
of collateral, as other frms could. The sentiment was clear but the reasons were
vague,McDadetoldtheFCIC.HesaidtherefusaltoallowLehmantoprovidetheex-
pandedtvpesofcollateralmadethedifferenceinLehmansbeingabletoobtainthe
fundingneededtoopenforbusinessonMondav.
1o
BaxterexplainedtotheFCIC,however,thatLehmansbroker-dealeramliatenot
the holding companvcould borrow against the expanded tvpes of collateral.
1o8
A
New York Fed email written at i:1- P.M. on that Sundav, September 1a, stated that
LehmanscounselwasinformedoftheexpansionofPDCF-eligiblecollateralbutthat
suchcollateralwouldnotbeavailabletothebroker-dealerifitfledforbankruptcv.
1oo
The minutes of Lehmans September 1a board meeting show that the Fed rejected
Lehmans request for an even broader range of collateral to be eligible for PDCF f-
nancingandpreferredthatLehmansholdingcompanvbutnotthebroker-dealer
fle for bankruptcv and that the broker-dealer be wound down in an orderlv
fashion.
11o
InaletterdatedSeptember1a,theNewYorkFedinformedLehmanSen-
iorVicePresidentRobertGuglielmothatthebroker-dealercouldfnanceexpanded
tvpesofcollateralwiththePDCF,butthatletterwasnotsentuntili:iaA.M.onSep-
tember 1-after Lehman had fled for bankruptcv.
111
The Lehman broker-dealer
borrowediotoi8billionfromthePDCFeachdavoverthenextthreedavs.
11i
AsKirkrecountedtotheFCIC,duringthatSundavmeetingattheNewYorkFed,
government omcials stepped out for an hour and came back to ask: Are vou plan-
ningonflingbankruptcvtonight:
11:
AsurprisedMillerrepliedthatnooneinthe
roomwasauthorizedtoflethecompanv,onlvtheBoardcould . . .andtheBoardhad
tobecalledtoameetingandhaveavote. . . .Therewouldbesomelagintermsof
havingtoputallthepaperstogethertoactuallvfleit.Therewasapracticalissuethat
voucouldnt . . .getitdonequicklv.
11a
Unmoved,governmentomcialsexplainedthat
directorsofLehmansU.K.subsidiarvLBIEwouldbepersonallvliableifthevdid
notfleforbankruptcvbvtheopeningofbusinessMondav.AsKirkrecalled,Thev
thentolduswewouldlikevoutofletonight. . . .Itstherightthingtodo,because
theres something else which we cant tell vou that will happen this evening. We
would like both events to happen tonight before the opening of trading Mondav
morning.
11-
The second event would turn out to be the announcement of Bank of
AmericasacquisitionofMerrillLvnch.
.. ii N\Nti \i tii :i : i NuUi i tu\\i : :i uN iiiui1
THE ONLY ALTERNATIVE WAS THAT LEHMAN HAD TO FAIL
Miller insisted that there had to be an alternative, because fling for bankruptcv
would be Armageddon.
11o
Lehman had prepared a presentation arguing that a
Lehmanbankruptcvwouldbecatastrophic.Itwouldtakeatleastfvevearstoresolve,
cost8to1obillion,andcausemajordisruptionsintheUnitedStatesandabroad.
11
Baxter told the FCIC, I knew that the consequences were going to be bad; that
wasntanissue.Lehmanwasindenialatthatpointintime.Therewasnowavthevbe-
lievedthatthisstorvendswithaLehmanbankruptcv . . .thevkeptthinkingthatthev
weregoingtobebailedoutbvthetaxpaveroftheUnitedStates.AndImnottrvingto
convincevouthatthatbeliefwasacrazvbeliefbecausethevhadseenthathappenin
theBearcase.Baxtersmission,however,wastotrvtogetthemtounderstandthat
thev werent going to be rescued, and then focus on what their real options were,
whichweredriftintoMondavmorningwithnothingdoneandthenhavechaosbreak
out,oralternativelvfle.Heconcluded,Frommvpointofview,frstthingwastocon-
vinceHarvevthatitwasfarbettertoflethantogointoMondavandhavecomplete
pandemonium break out. And then he had to have discussions with the Lehman
Boardbecausethevhadafduciarvdutvtoresolvewhatwasinthebestinterestsofthe
companvanditsshareholdersandotherstakeholders.
118
TheonlvalternativewasthatLehmanhadtofail,MillertestifedtotheFCIC.
11o
He stated that Baxter provided no further details on the governments plan for the
falloutfrombankruptcv,butassuredhimthatthesituationwasundercontrol.Then,
Miller told the FCIC, Baxter told the Lehman delegation to leave the Fed omces.
Thevbasicallvthrewusout,Millersaid.Millerrememberedtellinghiscolleagues
asthevleftthebuilding,Idontthinkthevlikeus.
Millercontinued:
Wewentbacktotheheadquarters,anditwaspandemoniumupthere
itwaslikeascenefrom[the1oaoflm]Its a Wonderful Life withtherun
on the savings and loan crisis. . . . [A]ll of paparazzi running around.
Therewasaguvthere . . .inasortofaNorsegoduniformwithahelmet
andapicketsignsavingDownwithWallStreet. . . .Therewerehun-
dredsofemploveesgoinginandout. . . .BartMcDadewasreportingto
the board what had happened. Most of the board members were
stunned. Henrv Kaufman, in particular, was asking How could this
happeninAmerica:
1io
The group informed the board that the Barclavs deal had fallen apart. The gov-
ernmenthadinstructedtheboardtofleforbankruptcv.SECsCoxcalled.WithTom
Baxteralsoontheline,Coxtoldtheboardthatthesituationwasseriousandrequired
action.TheboardaskedCoxifhewasdirectingthemtofleforbankruptcv.Coxand
Baxter conferred for a few minutes, and then answered that the decision was the
boardstomake.TheboardagainaskedifCoxandBaxterweretellingthemtoflefor
bankruptcv.CoxandBaxterconferredagain,thenrepliedthatthevbelievedthegov-
:ii1i\8ii z++ 1ui 8\NiiUi1t ui iiu\\N ..+
ernmentspositionhadbeenmadeperfectlvclearatthemeetingattheFedearlierin
thedav.
1i1
Followingthatcall,McDadeadvisedtheboardthatLehmanwouldbeunableto
obtain funding without government assistance. The board voted to fle for bank-
ruptcv.Thecompanvfledat1:a-A.M.onMondavmorning.
1ii
A CALAMITY
Fed Chairman Bernanke told the FCIC that government omcials understood a
Lehmanbankruptcvwouldbecatastrophic:
Weneverhadanvdoubtaboutthat.Itwasgoingtohavehugeimpacts
onfundingmarkets.Itwouldcreateahugelossofconfdenceinother
fnancialfrms.ItwouldcreatepressureonMerrillandMorganStanlev,
if not Goldman, which it eventuallv did. It would probablv bring the
short-termmonevmarketsintocrisis,whichwedidntfullvanticipate;
but,ofcourse,intheenditdidbringthecommercialpapermarketand
themonevmarketmutualfundsunderpressure.Sotherewasneveranv
doubt in our minds that it would be a calamitv, catastrophe, and that,
vouknow,weshoulddoevervthingwecouldtosaveit.
1i:
Whats the connection between Lehman Brothers and General Motors: he
askedrhetoricallv.LehmanBrothersfailuremeantthatcommercialpaperthatthev
used to fnance went bad. Bernanke noted that monev market funds, in particular
onenamedtheReservePrimarvFund,heldLehmanspaperandsufferedlosses.He
explainedthatthismeanttherewasaruninthemonevmarketmutualfunds,which
meant the commercial paper market spiked, which [created] problems for General
Motors.
1ia
As the fnancial industrv came under stress, Paulson told the FCIC, investors
pulledbackfromthemarket,andwhenLehmancollapsed,evenmajorindustrialcor-
porationsfounditdimculttoselltheirpaper.Theresultingliquiditvcrunchshowed
that frms had overlv relied on this short term funding and had failed to anticipate
howrestrictedthecommercialpapermarketcouldbecomeintimesofstress.
1i-
HarvevMillertestifedtotheFCICthatthebankruptcvofLehmanwasacatalvst
forsvstemicconsequencesthroughouttheworld.Itfosteredanegativereactionthat
endangeredtheviabilitvofthefnancialsvstem.Asaresultoffailedexpectationsof
the fnancial markets and others, a major loss of confdence in the fnancial svstem
occurred.
1io
OnthedavthatLehmanfledforbankruptcv,theDowplummetedmorethan-oo
points;oobillioninvaluefromretirementplans,governmentpensionfunds,and
otherinvestmentportfoliosdisappeared.
1i
AsforLehmanitself,thebankruptcvaffectedabout8,ooosubsidiariesandamliates
withooobillioninassetsandliabilities,thefrmsmorethan1oo,ooocreditors,and
about io,ooo emplovees. Its failure triggered default clauses in derivatives contracts,
..+ ii N\Nti \i tii :i : i NuUi i tu\\i : :i uN iiiui1
allowingitscounterpartiestohavetheoptionofseizingitscollateralandterminating
thecontracts.Aftertheparentcompanvfled,about8oinsolvencvproceedingsofits
subsidiaries in 18 foreign countries followed. In the main bankruptcv proceeding,
about oo,ooo claimsexceeding 8: billionhave been fled against Lehman as of
September io1o. Miller told the FCIC that Lehmans bankruptcv represents the
largest, most complex, multi-faceted and far-reaching bankruptcv case ever fled in
theUnitedStates.Thecostsofthebankruptcvadministrationareapproaching1bil-
lion;asofthiswriting,theproceedingisexpectedtolastatleastanothertwovears.
1i8
InhistestimonvbeforetheFCIC,Bernankeadmittedthattheconsiderationsbe-
hindthegovernmentsdecisiontoallowLehmantofailwerebothlegalandpractical.
Fromalegalstandpoint,Bernankeexplained,Wearenotallowedtolendwithouta
reasonableexpectationofrepavment.Theloanhastobesecuredtothesatisfactionof
theReserveBank.Remember,thiswasbeforeTARP.Wehadnoabilitvtoinjectcapi-
talortomakeguarantees.
1io
ASundavafternoonemailfromBernanketoFedGov-
ernor Warsh indicated that more than 1i billion in capital assistance would have
beenneededtopreventLehmansfailure.IncaseIamasked:Howmuchcapitalin-
jectionwouldhavebeenneededtokeepLEHaliveasagoingconcern:Igather1iB
orsofromtheprivateguvstogetherwithFedliquiditvsupportwasnotenough.
1:o
InMarch,theFedhadprovidedaloantofacilitateIPMorganspurchaseofBear
Stearns, invoking its authoritv under section 1:(:) of the Federal Reserve Act. But,
even with this authoritv, practical considerations were in plav. Bernanke explained
thatLehmanhadinsumcientcollateralandtheFed,haditacted,wouldhavelentinto
arun:OnSundavnightofthatweekend,whatwastoldtomewasthatandIhave
everv reason to believewas that there was a run proceeding on Lehman, that is
peoplewereessentiallvdemandingliquiditvfromLehman;thatLehmandidnothave
enoughcollateraltoallowtheFedtolenditenoughtomeetthatrun.Thus,Ifwe
lentthemonevtoLehman,allthatwouldhappenwouldbethattherun[onLehman]
wouldsucceed,becauseitwouldntbeabletomeetthedemands,thefrmwouldfail,
andnotonlvwouldwebeunsuccessfulbutwewould[have]saddledthe[t]axpaver
withtensofbillionsofdollarsoflosses.
1:1
TheFedhadnochoicebuttostandbvas
Lehmanwentunder,Bernankeinsisted.
AsBernankeacknowledgedtotheFCIC,however,hisexplanationfornotprovid-
ing assistance to Lehman was not the explanation he offered davs after the bank-
ruptcvat that time, he said that he believed the market was prepared for the
event.
1:i
OnSeptemberi:,ioo8,hetestifed:ThefailureofLehmanposedrisks.But
thetroublesatLehmanhadbeenwellknownforsometime,andinvestorsclearlvrec-
ognizedas evidenced, for example, bv the high cost of insuring Lehmans debt in
themarketforcreditdefaultswapsthatthefailureofthefrmwasasignifcantpos-
sibilitv.Thus,wejudgedthatinvestorsandcounterpartieshadhadtimetotakepre-
cautionarv measures.
1::
In addition, though the Federal Reserve subsequentlv
assertedthatitdidnothavethelegalabilitvtosaveLehmanbecausethefrmdidnot
have sumcient collateral to secure a loan from the Fed under section 1:(:), the au-
thoritvtolendunderthatprovisionisvervbroad.Itrequiresnotthatloansbefullv
secured but rather that thev be secured to the satisfaction of the Federal Reserve
:ii1i\8ii z++ 1ui 8\NiiUi1t ui iiu\\N ...
bank.
1:a
Indeed,inMarchiooo,FederalReserveGeneralCounselScottAlvarezcon-
cluded that requiring loans under 1:(:) to be fullv secured would undermine the
vervpurposeofsection1:(:),whichwastomakecreditavailableinunusualandex-
igentcircumstancestohelprestoreeconomicactivitv.
1:-
ToCEOFuldandothers,theFedsemergencvlendingpowersundersection1:(:)
providedapermissiblevehicletoobtaingovernmentsupport.AlthoughFedomcials
discussedanddismissedmanvideasinthechaoticdavsleadinguptothebankruptcv,
the Fed did not furnish to the FCIC anv written analvsis to illustrate that Lehman
lacked sumcient collateral to secure a loan under 1:(:). Fuld asserted to the FCIC
thatinfact,Lehmanhadadequatefnanceablecollateral. . . .[O]nSeptember1i,the
Fridav night preceding Lehmans bankruptcv fling, Lehman fnanced itself and did
notneedaccesstotheFedsdiscountwindow. . . .WhatLehmanneededonthatSun-
dav night was a liquiditv bridge. We had the capital. Along with its excess available
collateral, Lehman also could have used whole businesses as collateralsuch as its
Neuberger Berman subsidiarvas did AIG some two davs later. Fuld also rejected
assertionsaboutLehmanscapitalhole.HetoldtheFCIC,AsofAugust:1,ioo8,two
weekspriortothebankruptcvfling,Lehmanhad . . .io.billioninequitvcapital.
Positiveequitvofio.billionisvervdifferentfromthenegative:ooroobillion
holesclaimedbvsome.Moreover,FuldmaintainedthatLehmanwouldhavebeen
savedifithadbeengrantedbankholdingcompanvstatusaswereGoldmanSachs
andMorganStanlevtheweekafterLehmansbankruptcv.
1:o
TheFedchairmandeniedanvbiasagainstLehmanBrothers.Inhisview,theonlv
realresolutionshortofbankruptcvhadbeentofndabuver.Bernankesaid:When
thepotentialbuverswereunabletocarrvthroughinthecaseofBankofAmerica,
becausethevchangedtheirmindsanddecidedthevwantedtobuvMerrillinstead;in
the case of Barclavs, [because thev withdrew] . . . we essentiallv had no choice and
hadtoletitfail.
1:
DuringtheSeptember1o,ioo8,meetingoftheFedsFederalOpenMarketCom-
mittee, some members stated that the government should not have prevented
Lehmans failure because doing so would onlv strengthen the perception that some
frms were too big to fail and erode market discipline. Thev noted that letting
Lehmanfailwastheonlvwavtoprovidecredibilitvtotheassertionthatnofrmwas
toobigtofailandonememberstatedthatthemarketwasbeginningtoplavthe
Treasurv and Federal Reserve. Other meeting participants believed that the disor-
derlvfailureofakevfrmcouldhaveabroadanddisruptiveeffectonfnancialmar-
kets and the economv, but that the appropriate solution was capital injections, a
power the Federal Reserve did not have. Bernankes view was that onlv a fscal and
perhaps regulatorv response could address the potential for wide-scale failure of f-
nancialinstitutions.
1:8
MerrillsThainmadeitthroughtheLehmanweekendbvnegotiatingalifesaving
acquisitionbvBankofAmerica,formerlvLehmanspotentialsuitor.Thainblamed
thefailuretobailoutLehmanonpoliticiansandregulatorswhofearedthepolitical
consequencesofrescuingthefirm.Therewasatremendousamountofcriticismof
what was done with Bear Stearns so that IP Morgan would buv them, Thain told
..z ii N\Nti \i tii :i : i NuUi i tu\\i : :i uN iiiui1
theFCIC.TherewasacriticismofbailingoutWallStreet.Itwasacombinationof
politicalunwillingnesstobailoutWallStreetandabeliefthatthereneededtobea
reinforcementofmoralhazard.Therewasneveradiscussionaboutthelegalabilitv
oftheFedtodothis.Henoted,Therewasneverdiscussiontothebestofmvrec-
ollectionthatthevcouldnt[bailoutLehman].Itwasonlvthatthevwouldnt.
1:o
Thain also told the FCIC that in his opinion, allowing Lehman to go bankrupt
was the single biggest mistake of the whole fnancial crisis. He wished that he and
theotherWallStreetexecutiveshadtriedhardertoconvincePaulsonandGeithner
topreventLehmansfailure:AsIthinkaboutwhatIwoulddodifferentlvafterthat
weekend . . .istrvtograbthemandshakethemthatthevcantletthishappen. . . .
Thevwerenotvervmuchinthemoodtolisten.Thevwerenotwillingtolistentothe
ideathattherehadtobegovernmentsupport. . . .Thegroupofusshouldhavejust
grabbedthemandshakenthemandsaid,Look,vouguvscouldnotdothis.Butwe
didnt,andthevwerenotwillingtoentertainthatdiscussion.
1ao
FCIC staff asked Thain if he and the other executives explicitlv said to Paulson,
Geithner,oranvoneelse,Youcantletthishappen.Thainreplied,Wedidntdoit
stronglv enough. We said to them, Look, this is going to be bad. But it wasnt like,
No . . .vouhave tohelp.
1a1
Anotherprominentmemberofthatselectgroup,IPMorgansDimon,hadadif-
ferentview.HetoldtheFCIC,Ididntthinkitwassobad.Ihatetosavthat. . . .ButI
[thought]itwasalmostthesameifonMondavmorningthegovernmenthadsaved
Lehman. . . .Youstillwouldhaveterriblethingshappen. . . .AIGwasgoingtohave
theirproblemsthathadnothingtodowithLehman.Youwerestillgoingtohavethe
runs on the other banks and vou were going to have absolute fear and panic in the
globalmarkets.WhetherLehmanitselfgotsavedornot . . .thecrisiswouldhaveun-
foldedalongadifferentpath,butitprobablvwouldhaveunfolded.
1ai
FedGeneralCounselAlvarezandNewYorkFedGeneralCounselBaxtertoldthe
FCICthattherewouldhavebeenquestionseitherwav.AsBaxterputit,Ithinkthat
if the Federal Reserve had lent to Lehman that Mondav in a wav that some people
thinkwithout adequate collateral and without other securitv to ensure repav-
mentthishearingandotherhearingswouldhaveonlvbeenabouthowwewasted
thetaxpaversmonev.
1a:
COMMISSION CONCLUSIONS ON CHAPTER 18
The Commission concludes the fnancial crisis reached cataclvsmic proportions
withthecollapseofLehmanBrothers.
Lehmanscollapsedemonstratedweaknessesthatalsocontributedtothefailures
or near failures of the other four large investment banks: inadequate regulatorv
oversight, riskv trading activities (including securitization and over-the-counter
(OTC) derivatives dealing), enormous leverage, and reliance on short-term fund-
ing. While investment banks tended to be initiallv more vulnerable, commercial
bankssufferedfrommanvofthesameweaknesses,includingtheirinvolvementin
theshadowbankingsvstem,andultimatelvmanvsufferedmajorlosses,requiring
governmentrescue.
Lehman,likeotherlargeOTCderivativesdealers,experiencedrunsonitsde-
rivatives operations that plaved a role in its failure. Its massive derivatives posi-
tions greatlv complicated its bankruptcv, and the impact of its bankruptcv
throughinterconnectionswithderivativescounterpartiesandotherfnancialin-
stitutionscontributedsignifcantlvtotheseveritvanddepthofthefnancialcrisis.
Lehmans failure resulted in part from signifcant problems in its corporate
governance,includingriskmanagement,exacerbatedbvcompensationtoitsex-
ecutivesandtradersthatwasbasedpredominantlvonshort-termprofts.
Federal government omcials decided not to rescue Lehman for a varietv of
reasons,includingthelackofaprivatefrmwillingandabletoacquireit,uncer-
taintvaboutLehmanspotentiallosses,concernsaboutmoralhazardandpolitical
reaction,anderroneousassumptionsthatLehmansfailurewouldhaveamanage-
ableimpactonthefnancial svstembecausemarketparticipantshadanticipated
it.Afterthefact,thevjustifedtheirdecisionbvstatingthattheFederalReserve
didnothavelegalauthoritvtorescueLehman.
TheinconsistencvoffederalgovernmentdecisionsinnotrescuingLehmanaf-
terhavingrescuedBearStearnsandtheGSEs,andimmediatelvbeforerescuing
AIG,addedtouncertaintvandpanicinthefnancialmarkets.
:ii1i\8ii z++ 1ui 8\NiiUi1t ui iiu\\N ...
...
19
SEPTEMBER 2008:
THE BAILOUT OF AIG
CONTENTS
Currcnt|iquiditvpcsiticnisprccaricus :;
Spi||cvcrcjjcct :;
Iikcagnatcnanc|cphant :o
Ninebilliondollarsisalotofmonev,butasAIGexecutivesandtheboardexamined
theirbalancesheetandponderedthemarketsinthesecondweekofSeptemberioo8,
thevwerealmostcertainobillionincashcouldnotkeepthecompanvalivethrough
the next week.
1
The AIG corporate empire held more than 1 trillion in assets, but
most of the liquid assets, including cash, were held bv regulated insurance sub-
sidiaries whose regulators did not allow the cash to fow freelv up to the holding
companv, much less out to troubled subsidiaries such as AIG Financial Products.
i
The companvs liabilities, especiallv those due in the near future, were much larger
thantheobilliononhand.
OnFridav,September1i,ioo8,AIGwasfacingchallengesonanumberoffronts.
It had to fund 1.a billion of its own commercial paper on that dav
:
because tradi-
tional investorsfor example, monev market fundsno longer wanted even short-
termunsecuredexposuretoAIG;andthecompanvhadanother:.ibillioncoming
duethefollowingweek.
a
Onanotherfront,therepolenderswhohadthecomfort
of holding collateral for their loans to AIG (o. billion in mostlv overnight fund-
ing)
-
werenonethelessbecomingskittishabouttheperceivedweaknessofthecom-
panvandthelowqualitvofmostofitscollateral:mortgage-relatedsecurities.
o
On a third front, AIG had alreadv put up billions of dollars in collateral to its
creditdefaultswapcounterparties.BvIuneofioo8,counterpartiesweredemanding
1-. billion, and AIG had posted 1:.i billion. Bv September 1i, the calls had
soared to i:.a billion, and AIG had paid 18.o billion.o billion to Goldman
aloneand it looked verv likelv that AIG would need to post billions more in the
near future.
That dav, S&P and Moodvs both warned of potential coming down-
grades to AIGs credit rating, which, if thev happened, would lead to an estimated
1obillioninnewcollateralcalls.
8
Adowngradewouldalsotriggerliquiditvputsthat
:ii1i\8ii z++ 1ui 8\i iuU1 ui \i t ..,
AIGhadwrittenoncommercialpaper,requiringAIGtocomeupwithanotherato
-billion.
o
Finallv, AIG was increasinglv strained bv its securities lending business. As a
lender of securities, AIG received cash from borrowers, tvpicallv equal to between
1ooand1oiofthemarketvalueofthesecuritiesthevlent.Asborrowersbegan
questioningAIGsstabilitv,thecompanvhadtoacceptbelow-markettermssome-
timesacceptingcashequaltoonlvooofthevalueofthesecurities.
1o
Furthermore,
AIGhadinvestedthiscashinmortgage-relatedassets,whosevaluehadfallen.Since
Septemberioo,stateregulatorshadworkedwithAIGtoreduceexposuresofthese-
curitieslendingprogramtomortgage-relatedassets,accordingtotestimonvbvEric
Dinallo, the former superintendent of the New York State Insurance Department
(NYSID).
11
Still, bv the end of Iune ioo8, AIG had invested - billion in cash in
mortgage-relatedsecurities,whichhaddeclinedinvalueto-o.-billion.BvlateAu-
gustioo8,theparentcompanvhadtoprovide:.:billiontoitsstrugglingsecurities
lending subsidiarv, and counterparties were demanding ia billion to offset the
shortfallbetweenthecashcollateralprovidedandthediminishedvalueofthesecuri-
ties.
1i
AccordingtoDinallo,thecollateralcalldisputesbetweenAIGanditscreditde-
fault swap counterparties hindered an orderlv wind down of the securities lending
business,andinfactaccelerateddemandsfromsecuritieslendingcounterparties.
1:
ThatFridav,AIGsboarddispatchedateamledbvViceChairmanIacobFrenkel
tomeetwithtopomcialsattheFederalReserveBankofNewYork.
1a
Elsewherein
thebuilding,TreasurvSecretarvHenrvPaulsonandNewYorkFedPresidentTimo-
thvGeithnerweretellingWallStreetbankersthatthevhadtheweekendtodevisea
solutiontopreventLehmansbankruptcvwithoutgovernmentassistance.Nowcame
thisemergencvmeetingregardinganotherbeleagueredAmericaninstitution.Bot-
tomline,theNewYorkFedlaterreportedofthatmeeting,[AIGs]Treasureresti-
mates that parent and [Financial Products] have -1o davs before thev are out of
liquiditv.
1-
AIGposedasimplequestion:howcoulditobtainanemergencvloanunderthe
Federal Reserves 1:(:) authoritv: Without a solution, there was no wav this con-
glomerate,despitemorethan1 trillion inassets,wouldsurviveanotherweek.
CURRENT LIQUIDITY POSITION IS PRECARIOUS
AIGsvisittotheNewYorkFedmavhavebeenanemergencv,butitshouldnothave
beenasurprise.WiththePrimarvDealerCreditFacilitv(PDCF),theFedhadeffec-
tivelvopeneditsdiscountwindowtraditionallvavailableonlvtodepositorvinstitu-
tionsto investment banks that qualifed as primarv dealers; AIG did not qualifv.
Butoverthesummer,NewYorkFedomcialshadbeguntoconsiderprovidingemer-
gencv collateralized funding to even more large institutions that were svstemicallv
important.Thatledtheregulatorstolookcloselvattwotrillion-dollarholdingcom-
panies, AIG and GE Capital. Both were large participants in the commercial paper
market:AIGwithiobillioninoutstandingpaper,GECapitalwithoobillion.
1o
In
..( ii N\Nti \i tii :i : i NuUi i tu\\i : :i uN iiiui1
August,theNewYorkFedsetupateamtostudvthetwocompaniesfundingandliq-
uiditvrisk.
OnAugust11,NewYorkFedomcialsmetwithOmceofThriftSupervision(OTS)
regulators to discuss AIG.
1
The OTS said that it was generallv comfortable with
[the]frmscurrentliquiditv . . .[and]confdentthatthefrmcouldaccessthecapital
marketswithnoproblemifithadto.
18
TheNewYorkFeddidnotagree.OnAugust
1a,ioo8,KevinCoffev,ananalvstfromtheFinancialSectorPolicvandAnalvsisunit,
wrotethatdespiteraisingiobillionearlierinthevear,AIGisunderincreasingcap-
ital and liquiditv pressure and appears to need to raise substantial longer term
fundstoaddresstheimpactofdeterioratingassetvaluesonitscapitalandavailable
liquiditvaswellastoaddresscertainasset/liabilitvfundingmismatches.
1o
Coffev listed six concerns: (1) AIGs signifcant losses on investments, primarilv
becauseofsecuritieslendingactivities;(i)io.-billioninmark-to-marketlosseson
AIGFinancialProductscreditdefaultswapbookandrelatedmargincalls,forwhich
AIG had posted 1o.- billion in collateral bv mid-August; (:) signifcant near-term
liabilities; (a) commitments to purchase collateralized debt obligations due to out-
standing liquiditv puts; (-) ratings-based triggers in derivative contracts that could
causesignifcantadditionalcollateralcallsifAIGweredowngraded;and(o)limited
standbv credit facilities to manage sudden cash needs. He noted Moodvs and S&P
had highlighted worries about earnings, capital, and liquiditv following AIGs ioo8
second-quarterearnings.TheagencieswarnedthevwoulddowngradeAIGifitdid
notaddresstheseissues.
io
Four davs later, Goldman Sachs issued a report to clients that echoed much of
Coffevsinternalanalvsis.Thereport,DontBuvAIG:PotentialDowngrades,Capi-
talRaiseontheHorizon,warnedthatweforeseeoiobillionineconomiclosses
from[AIGscreditdefaultswap]book,whichcouldresultinlargercashoutlavs . . .
resulting in a signifcant shift in the risk qualitv of AIGs assets. . . . Put simplv, we
haveseenthiscreditoverhangstorvbeforewithanotherstockinourcoverageuni-
verse,andforeseeoutcomessimilarinnaturebutonamuchlargerscale.
i1
Goldman
appeared to be referring to Bear Stearns. Ira Selig, a manager at the New York Fed,
emailedtheGoldmanreporttoCoffevandothers.Thebottomline:largescalecash
outfows and posting of collateral could substantiallv weaken AIGs balance sheet,
themanagerwrote.
ii
On September i, the New York Feds Danielle Vicente noted the situation had
worsened:AIGscurrentliquiditvpositionisprecariousandassetliabilitvmanage-
mentappearsinadequategiventhesubstantialoffbalancesheetliquiditvneeds.Liq-
uidating an 8:- billion securities portfolio to cover liabilities would mean
substantiallossesandpotentiallvaffectprices,shewrote.BorrowingagainstAIGs
securities through the Feds PDCF might allow AIG to unwind its positions calmlv
while satisfving immediate cash needs, but Vicente questioned whether the PDCF
wasnecessarvforthesurvivalofthefrm.
i:
Arguablv,however,AIGsvolatilefund-
ingsourcesmadethefrmvulnerabletoruns.Off-balance-sheetcommitmentsin-
cludingcollateralcalls,contractterminations,andliquiditvputscouldbeashighas
:ii1i\8ii z++ 1ui 8\i iuU1 ui \i t ..,
::billionifAIGwasdowngraded.YetAIGhadonlvabillionofrevolvingcredit
facilitiesinadditiontothe1ito1:billionofcashithadonhandatthetime.
ia
TheratingagencieswaitedtoseehowAIGwouldaddressitsliquiditvandcapital
needs.AnalvstsworriedaboutthelossesinAIGscreditdefaultswapsandinvestment
portfolios,aboutratingagencvactions,andaboutsubsequentimpactsoncapital.In-
deed,GoldmansAugust18reportonAIGconcludedthatthefrmitselfandtherat-
ingagencieswereindenialaboutimpendinglosses.
i-
BvearlvSeptember,managementwasnolongerindenial.AttheFridav,Septem-
ber1i,meetingattheNewYorkFed,AIGexecutivesreportedthatthecompanvwas
facing serious liquiditv issues that threaten[ed] its survival viabilitv and that a
downgrade,possiblvafteraratingagencvmeetingSeptember1-,wouldtriggerbil-
lions of dollars in collateral calls, liquiditv puts, and other liquiditv needs.
io
AIGs
stockhadfallensignifcantlv(shareshitanintradavlowof11.aoFridav,downfrom
a1.--closethedavbefore)andcreditdefaultswapspreadshadreached1adur-
ing the dav,
i
indicating that protection on 1o million of AIG debt would cost ap-
proximatelv 1.a million per vear. AIG reported it was having problems with its
commercial paper, able to roll onlv 1.1 billion of the i.- billion that matured on
September1i.
i8
Inaddition,somebankswerepullingawavandevenrefusingtopro-
vide repo funding.
io
Assets were illiquid, their values had declined, borrowing was
restricted,andraisingcapitalwasnotviable.
SPILLOVER EFFECT
TheNewYorkFedknewthatafailureofAIGwouldhavedramatic,far-reachingcon-
sequences. Bv the evening of September 1i, after the meeting with AIG executives,
that possibilitv looked increasinglv realistic. Havlev Boeskv of the New York Fed
emailedWilliamDudlevandothers.Morepanicfrom[hedgefunds].Nowfocusis
onAIG,shewrote.IamhearingworsethanLEH.Evervbankanddealerhasexpo-
suretothem.
:o
Shortlv before midnight, New York Fed Assistant Vice President Alejandro La-
TorreemailedGeithner,Dudlev,andothersenioromcialsaboutAIG:Thekevtake-
awavisthatthevarepotentiallvfacingasevererunontheirliquiditvoverthecourse
ofthenextseveral(approx.1o)davsifthevaredowngraded. . . .Theirriskexposures
areconcentratedamongthe1ilargestinternationalbanks(bothU.S.andEuropean)
acrossawidearravofproducttvpes(banklines,derivatives,securitieslending,etc.)
meaning[there]couldbesignifcantcounterpartvlossestothosefrmsintheevent
ofAIGsfailure.
:1
NewYorkFedomcialsmetonSaturdavmorning,andgatheredadditionalinfor-
mation about AIGs fnancial condition, but according to New York Fed General
CounselTomBaxter,itseemedclearthattheprivatesectorsolutionwouldmaterial-
izeforAIG.
:i
Indeed,ChristopherFlowers,headofI.C.Flowers&Co.,aprivateeq-
uitv frm, had spoken to AIG CEO Robert Willumstad the prior Thursdav, and the
twohadcalledWarrenBuffetttodiscussapossibledeal.WillumstadtoldtheFCIC
.. ii N\Nti \i tii :i : i NuUi i tu\\i : :i uN iiiui1
that he was in contact with about a dozen private equitv frms over the weekend.
::
AIG executives also worked with then-Superintendent Eric Dinallo to help craft a
dealthatwouldhaveallowedAIGsregulatedsubsidiariestoessentiallvlendmonev
totheparentcompanv.FedomcialsreportedtoAIGexecutivesduringaconference
callonSaturdavthatthevshouldnotbeparticularlvoptimistic[aboutfnancialas-
sistance],giventhehurtles[sic]andhistorvof[theFeds]1:-:lending[authoritv].
:a
AndbvtheendofthedavonSaturdav,AIGappearedtotheFedtobepursuingpri-
vate-sector leads. It was clear from the conversation that Flowers [is] activelv in-
volvedinworkingwithevervthing(AIG,regulators,bankers,etc)inputtingtogether
boththetermsheetwithAIG,andprovidinganalvsistoNYSIDonliquiditvprofle
oftheparentcompanv,PatriciaMosser,aseniorvicepresidentattheNewYorkFed,
wrotetoLaTorreandothers.
:-
OnSundavmorning,September1a,AdamAshcraftoftheNewYorkFedcircu-
latedamemo,CommentonPossible1:-:LendingtoAIG,discussingtheeffectofa
fre sale bv AIG on asset markets.
:o
In an accompanving email, Ashcraft wrote that
thethreatbvAIGtosellassetswasaclearattempttoscarepolicvmakersintogiv-
ing[AIG]accesstothediscountwindow,andavoidmakingotherwisehardbutvi-
able options: sell or hedge the CDO risk (little to no impact on capital), sell
subsidiaries,orraisecapital.
:
Beforeai::oP.M.meeting,LaTorresentananalvsis,Prosandconsoflendingto
AIG,tocolleagues.Theprosincludedavoidingamessvcollapseanddislocationsin
marketssuchascommercialpaper.IfAIGcollapsed,itcouldhaveaspillovereffect
on other frms involved in similar activities (e.g. GE Finance) and would lead to
18B increase in European bank capital requirements. In other words, European
banksthathadloweredcreditriskand,asaresult,loweredcapitalrequirements
bv buving credit default swaps from AIG would lose that protection if AIG failed.
AIGsbankruptcvwouldalsoaffectothercompaniesbecauseofitsnon-trivialexotic
derivatives book, a i. trillion over-the-counter derivatives portfolio of which 1
trillion was concentrated in 1i large counterparties. The memo also noted that an
AIG failure could cause dislocations in CDS market [that] . . . could leave dealer
bookssignifcantlvunbalanced.
:8
The cons of a bailout included a chilling effect on private-sector solutions
thoughttobeunderwav;thepossibilitvthataFedloanwouldbeinsumcienttokeep
AIG afoat, undermining emcacv of 1:-: lending as a policv tool; an increase in
moral hazard; the perception that it would be incoherent to lend to AIG and not
Lehman; the possibilitv of assets being insumcient to cover the potential liquiditv
hole. LaTorre concluded, Without punitive terms, lending [to AIG] could reward
poorriskmanagement,whichincludedAIGsunwillingnesstosellorhedgesomeof
itsCDOrisk.
:o
Theprivate-sectorsolutionsLaTorrereferredtohadhitawall,however.BvSundav
afternoon,FlowershadbeensummarilvdismissedbvAIGsboard.Flowerstoldthe
FCIC that under his proposal, his frm and Allianz, the giant insurance companv,
wouldhaveeachinvested-billioninexchangeforthestockofAIGsubsidiaries.With
:ii1i\8ii z++ 1ui 8\i iuU1 ui \i t ..+
approvalfromtheNYSID,thesubsidiarieswouldupstreamiobilliontotheparent
companv,andtheparentcompanvwouldgetaccesstobridgefnancingfromtheFed.
Then,AllianzwouldtakecontrolofAIGalmostimmediatelv.Flowerssaidthathewas
surprisedbvAIGsunwillingnesstonegotiate.Imnotsavingitwouldhaveworkedor
thatitwasperfectaswritten,butitwasastoundingtomethatgivenwhathappened,
nobodvbotheredtocheckthis[deal]out,hesaid.
ao
WillumstadreferredtotheFlowers
dealasaso-calledofferhedidnotconsiderittobeaseriouseffort,andsoitwas
dismissedimmediatelv.WithrespecttotheotherpotentialinvestorsAIGspokewith
overtheweekend,Willumstadsaidthatnegotiationswereunsuccessfulbecauseeverv
potential deal would have required government assistancesomething Willumstad
hadbeenassuredbvthehighestlevelswouldnotbeforthcoming.
a1
On Mondav morningafter Lehman had declared bankruptcv, and with no pri-
vate-sectorsolutiononthehorizontheFedinitiatedanefforttohaveIPMorganand
GoldmanSachsassembleasvndicateofbankstolendabout-billiontokeepAIG
afoat.
ai
In the afternoon, the rating agencies announced their assessments, which
were even worse than expected. All three rating agencies announced downgrades of
AIG:S&PbvthreenotchestoA-,andMoodvsandFitchbvtwonotchestoAiandA,
respectivelv. The downgrades triggered an additional 1: billion in cash collateral
callsonAIGFinancialProductscreditdefaultswaps.GoldmanSachsalonerequested
i.1billion.
a:
Demandshit:ibillion,andAIGspavoutsincreasedto1o.-billion.
aa
The companvs stock plummeted o1 to a.o from the closing price of 1i.1a the
previousFridavafractionofitsall-timehighof1a-.8a.
Thesvndicateofbanksdidnotagreeonadeal,despitetheexpectationsofFedof-
fcials. Once Lehman fled [for bankruptcv] on the morning of the 1-th, evervone
decidedthat,wevegottoprotectourownbalancesheet,andthebanksthatwerego-
ing to provide the - billion decided that thev were not going to, Baxter told the
FCIC.
a-
SarahDahlgren,aseniorNewYorkFedomcial,agreedwithBaxter.Lehmans
bankruptcvwastheendoftheprivate-sectorsolution,shetoldtheCommission.
ao
Afterthemarketsclosed,AIGinformedtheNewYorkFeditwasunabletoaccess
the short-term commercial paper market.
a
Regulators spent the next several hours
preparingforalate-nightteleconferencewithGeithner.TheLeadpoint,according
toanemailcirculatedtotheFedsAIGmonitoringgroup,wasthatthesize,name,
franchiseandmarketpresence(wholesaleandretail)[ofAIG]raisequestionsabout
potential worldwide contagion, should this franchise become impaired.
a8
Late that
night,forthesecondtimesincethebeginningofthecrisis,theFederalReserveBoard
invoked section 1:(:) of the Federal Reserve Act to bail out a companv. As it had
done for Bear Stearns, the New York Fed, with the support of the Treasurv, would
rescueabrand-namefnancialinstitution.
TheFederalOpenMarketCommitteewasbriefedaboutAIG.Membersweretold
thatAIGfacedaliquiditvcrisisbutthatitwasuncleariftherewerealsosolvencvis-
sues. In addition, the staff noted that monev market funds had even broader expo-
sure to AIG than to Lehman and that the parent companv could run out of monev
quitesoon,evenwithindavs.
ao
.,+ ii N\Nti \i tii :i : i NuUi i tu\\i : :i uN iiiui1
OnTuesdavmorning,theFedputanumberonthetable:itwouldloan8-billion
sothatAIGcouldmeetitsimmediateobligations.Thecollateralwouldbetheassets
oftheparentcompanvanditsprimarvnonregulatedsubsidiaries,plusthestockofal-
mostalltheregulatedinsurancesubsidiaries.TheFedstatedthatadisorderlvfailure
ofAIGcouldaddtoalreadvsignifcantlevelsoffnancialmarketfragilitvandleadto
substantiallv higher borrowing costs, reduced household wealth, and materiallv
weakereconomicperformance.
-o
BvWednesdav,ashareofAIGsoldforaslittleas
1.oo.Thepreviouseightvearsproftsofoobillionwouldbedwarfedbvtheoo.:
billionlossforthisonevear,ioo8.
But8-billionwouldsoonproveinsumcient.Treasurvaddedao.1billionunder
its Troubled Asset Relief Program (TARP).
-1
Ultimatelv, according to the Congres-
sionalOversightPanel,taxpaverfundscommittedtoAIGreached18ibillion.The
panelfaultedthegovernmentfordecidingtobailoutAIGtoohastilv:WithAIG,the
FederalReserveandTreasurvbrokenewground.ThevputtheU.S.taxpaveronthe
lineforthefullcostandfullriskofrescuingafailingcompanv.
-i
TheTreasurvDe-
partmentdefendeditsdecision,savingthatthepanelreportoverlooksthebasicfact
that the global economv was on the brink of collapse and there were onlv hours in
whichtomakecriticaldecisions.
-:
LIKE A GNAT ON AN ELEPHANT
TheOmceofThriftSupervisionhasacknowledgedfailuresinitsoversightofAIG.In
aMarch18,iooo,congressionalhearing,ActingDirectorScottPolakofftestifedthat
supervisors failed to recognize the extent of liquiditv risk of the Financial Products
subsidiarvs credit default swap portfolio.
-a
Iohn Reich, a former OTS director, told
the FCIC that as late as September ioo8, he had no clueno ideawhat [AIGs]
CDSliabilitvwas.
--
According to Mike Finn, the director for the OTSs northeast region, the OTSs
authoritv to regulate holding companies was intended to ensure the safetv and
soundnessoftheFDIC-insuredsubsidiarvofAIGandnottofocusonthepotential
impact on AIG of an uninsured subsidiarv like AIG Financial Products.
-o
Finn ig-
nored the OTSs responsibilities under the European Unions Financial Conglomer-
ates Directive (FCD)responsibilities the OTS had activelv sought. The directive
required foreign companies doing business in Europe to have the equivalent of a
consolidatedsupervisorintheirhomecountrv.Startinginiooa,theOTSworked
topersuadetheEuropeanUnionthatitwascapableofservingasAIGshomecoun-
trvconsolidatedsupervisor.
-
Inioo-theagencvwrote:AIGanditssubsidiariesare
subjecttoconsolidatedsupervisionbvOTS. . . .Aspartofitssupervision,OTSwill
conductcontinuouson-sitereviewsofAIGanditssubsidiaries.
-8
YetevenReichtold
FCIC staff that he did not understand his agencvs responsibilities under the FCD.
TheformerdirectorsaidhewasneversurewhatauthoritvtheOTShadoverAIGFi-
nancialProducts,whichhesaidhadslippedthrougharegulatorvgap.
-o
:ii1i\8ii z++ 1ui 8\i iuU1 ui \i t .,.
FurtherunderminingtheOTSsclaimthatitlackedauthoritvoverAIGFinancial
Productsareitsownactions:theOTSdidinfactexaminethesubsidiarv,albeitmuch
too late to matter. OTS examiners argued thev got little cooperation from Ioseph
Cassano, the head of the subsidiarv. Ioseph Gonzales, the examiner in charge from
ApriliooatoNovemberiooo,toldFCICstaff,Ioverheardoneemploveesavingthat
IoeCassanofeltthat[theOTSwas]overreachingourscopebvgoingintoFP.
oo
TheOTSdidnotlookcarefullvatthecreditdefaultswapportfolioguaranteedbv
the parent companveven though AIG did describe the nature of its super-senior
portfolioinitsannualreportsatthattime,includingthedollaramountoftotalcredit
defaultswapsthatithadwritten.GonzalessaidthattheOTSdidnotknowaboutthe
CDSduringtheiooao-period.
o1
AfteralimitedreviewinIulviooconducteda
week before Goldman sent AIG Financial Products its frst demand for collateral
theOTSconcludedthattheriskintheCDSbookwastoosmalltobemeasuredand
decidedtoputoffamoredetailedreviewuntilioo8.
oi
Theagencvsstatedreasonwas
itslimitedtimeandstaffresources.
o:
In Februarv ioo8, AIG reported billions of dollars in losses and material weak-
nessesinthewavitvaluedcreditdefaultswappositions.YettheOTSdidnotinitiate
anin-depthreviewofthecreditdefaultswapsuntilSeptemberioo8tendavsbefore
AIGwenttotheFedseekingarescuecompletingthereviewonOctober1,more
thanamonthafterAIGfailed.Itwas,formerOTSdirectorofConglomerateOpera-
tionsBradWaringadmitted,inhindsight,abadchoice.
oa
ReichtoldtheFCICthatbeforeioo8,AIGhadnotbeenagreatconcern.Healso
acknowledgedthattheOTShadneverfullvunderstoodtheFinancialProductsunit,
andthuscouldntregulateit.Atthesimplestlevel, . . .anorganizationlikeOTScan-
notsuperviseAIG,GE,MerrillLvnch,andentitiesthathaveworldwideomces. . . .I
wouldbethefrsttosavthatforanorganizationlikeOTStopretendthatithastotal
responsibilitvoverAIGandallofitssubsidiaries . . .itslikeagnatonanelephant
theresnowav.ReichsaidthatfortheOTStothinkitcouldregulateAIGwastotallv
impracticalandunrealistic. . . .Ithinkwethoughtwecouldgrowintothatresponsi-
bilitv. . . .ButIthinkthatwassortofpieintheskvdreaming.
o-
Geithneragreed,andtoldReichsobluntlv.ReichtoldtheFCICaboutaphonecall
fromGeithneraftertherescue.AboutallIcanrememberisthefoullanguagethatI
heard on the other end of the line, Reich said. He recalled Geithner telling him.
Youguvshavehandedmeabagofsht.Ijustlistened.
oo
COMMISSION CONCLUSIONS ON CHAPTER 19
TheCommissionconcludesAIGfailedandwasrescuedbvthegovernmentprima-
rilvbecauseitsenormoussalesofcreditdefaultswapsweremadewithoutputting
up initial collateral, setting aside capital reserves, or hedging its exposurea pro-
foundfailureincorporategovernance,particularlvitsriskmanagementpractices.
AIGs failure was possible because of the sweeping deregulation of over-the-
counter(OTC)derivatives,includingcreditdefaultswaps,whicheffectivelvelim-
inatedfederalandstateregulationoftheseproducts,includingcapitalandmargin
requirementsthatwouldhavelessenedthelikelihoodofAIGsfailure.TheOTC
derivativesmarketslackoftransparencvandofeffectivepricediscovervexacer-
batedthecollateraldisputesofAIGandGoldmanSachsandsimilardisputesbe-
tween other derivatives counterparties. AIG engaged in regulatorv arbitrage bv
setting up a major business in this unregulated product, locating much of the
business in London, and selecting a weak federal regulator, the Omce of Thrift
Supervision(OTS).
TheOTSfailedtoeffectivelvexerciseitsauthoritvoverAIGanditsamliates:it
lackedthecapabilitvtosuperviseaninstitutionofthesizeandcomplexitvofAIG,
didnotrecognizetherisksinherentinAIGssalesofcreditdefaultswaps,anddid
not understand its responsibilitv to oversee the entire companv, including AIG
FinancialProducts.Furthermore,becauseofthederegulationofOTCderivatives,
state insurance supervisors were barred from regulating AIGs sale of credit de-
faultswapseventhoughthevweresimilarineffecttoinsurancecontracts.Ifthev
had been regulated as insurance contracts, AIG would have been required to
maintain adequate capital reserves, would not have been able to enter into con-
tractsrequiringthepostingofcollateral,andwouldnothavebeenabletoprovide
defaultprotectiontospeculators;thusAIGwouldhavebeenpreventedfromact-
inginsuchariskvmanner.
AIG was so interconnected with manv large commercial banks, investment
banks,andotherfnancialinstitutionsthroughcounterpartvcreditrelationships
oncreditdefaultswapsandotheractivitiessuchassecuritieslendingthatitspo-
tentialfailurecreatedsvstemicrisk.ThegovernmentconcludedAIGwastoobig
tofailandcommittedmorethan18obilliontoitsrescue.Withoutthebailout,
AIGs default and collapse could have brought down its counterparties, causing
cascadinglossesandcollapsesthroughoutthefnancialsvstem.
.,z ii N\Nti \i tii :i : i NuUi i tu\\i : :i uN iiiui1
.,.
20
CRISIS AND PANIC
CONTENTS
McncvnarkctjundsDca|crswcrcntcvcnpickingupthcirphcncs :e
McrganStan|cvNcwwcrcthcncxtin|inc:eo
Ovcr-thc-ccuntcrdcrivativcsAgrindingha|t :e:
VashingtcnMutua|Itsvcurs:e
VachcviaAtthcjrcntcndcjthcdcninccsascthcrdcninccsjc||:ee
1ARICcnprchcnsivcapprcach :)
AIGVcnccdcdtcstcpthcsuckingchcstwcundinthispaticnt:e
CitigrcupIctthcwcr|dkncwwcwi||nctpu||aIchnan:;
BankcjAncricaAshctgunwcdding :::
September 1-, ioo8the date of the bankruptcv of Lehman Brothers and the
takeoverofMerrillLvnch,followedwithiniahoursbvtherescueofAIGmarked
the beginning of the worst market disruption in postwar American historv and an
extraordinarv rush to the safest possible investments. Creditors and investors sus-
pectedthatmanvotherlargefnancialinstitutionswereontheedgeoffailure,andthe
Lehmanbankruptcvseemedtoprovethatatleastsomeofthemwouldnothaveac-
cesstothefederalgovernmentssafetvnet.
IohnMack,CEOofMorganStanlevduringthecrisis,toldtheFCIC,Intheimme-
diatewakeofLehmansfailureonSeptember1-,MorganStanlevandsimilarinstitu-
tionsexperiencedaclassicrunonthebank,asinvestorslostconfdenceinfnancial
institutionsandtheentireinvestmentbankingbusinessmodelcameundersiege.
1
The markets were verv bad, the volatilitv, the illiquiditv, some things couldnt
tradeatall,Imeancompletelvlocked,themarketswereinterribleshape,IPMorgan
CEOIamieDimonrecalledtotheFCIC.Hethoughtthecountrvcouldfaceioun-
emplovment.Wecouldhavesurviveditinmvopinion,butitwouldhavebeenterri-
ble. I would have stopped lending, marketing, investing . . . and probablv laid off
io,ooopeople.AndIwouldhavedoneitinthreeweeks.Yougetcompaniesstarting
totakeactionslikethat,thatswhataGreatDepressionis.
i
TreasurvSecretarvTimothvGeithnertoldtheFCIC,Youhadpeoplestartingto
taketheirdepositsoutofverv,vervstrongbanks,longwavremovedindistanceand
.,. ii N\Nti \i tii :i : i NuUi i tu\\i : :i uN iiiui1
riskandbusinessfromtheguvsonWallStreetthatwereattheepicenteroftheprob-
lem.Andthatisagoodmeasure,classicmeasureofincipientpanic.
:
Inaninterview
inDecemberiooo,Geithnersaidthatnoneof[thebiggestbanks]wouldhavesur-
vivedasituationinwhichwehadletthatfretrvtoburnitselfout.
a
Fed Chairman Ben Bernanke told the FCIC, As a scholar of the Great Depres-
sion,IhonestlvbelievethatSeptemberandOctoberofioo8wastheworstfnancial
crisisinglobalhistorv,includingtheGreatDepression.Ifvoulookatthefrmsthat
came under pressure in that period . . . onlv one . . . was not at serious risk of fail-
ure. . . .Sooutofmavbethe1:,1:ofthemostimportantfnancialinstitutionsinthe
UnitedStates,1iwereatriskoffailurewithinaperiodofaweekortwo.
-
As it had on the weekend of Bears demise, the Federal Reserve announced new
measuresonSundav,September1a,tomakemorecashavailabletoinvestmentbanks
andotherfrms.Yetagain,itlowereditsstandardsregardingthequalitvofthecollateral
thatinvestmentbanksandotherprimarvdealerscouldusewhileborrowingunderthe
twoprogramstosupportrepolending,thePrimarvDealerCreditFacilitv(PDCF)and
theTermSecuritiesLendingFacilitv(TSLF).
o
And,providingatemporarvexceptionto
itsrules,itallowedtheinvestmentbanksandotherfnancialcompaniestoborrowcash
from their insured depositorv amliates. The investment banks drew liberallv on the
Feds lending programs. Bv the end of September, Morgan Stanlev was getting bv on
oo.1billionofFed-providedlifesupport;Goldmanwasreceiving:1.-billion.
But the new measures did not quell the market panic. Among the frst to be di-
rectlv affected were the monev market funds and other institutions that held
Lehmansabillioninunsecuredcommercialpaperandmadeloanstothecompanv
through the tri-partv repo market. Investors pulled out of funds with known expo-
sure to that jeopardv, including the Reserve Management Companvs Reserve Pri-
marvFundandWachoviasEvergreenInvestments.
Other parties with direct connections to Lehman included the hedge funds, in-
vestment banks, and investors who were on the other side of Lehmans more than
ooo,ooo over-the-counter derivatives contracts. For example, Deutsche Bank, IP
Morgan,andUBStogetherhadmorethan1-o,ooooutstandingtradeswithLehman
asofMavioo8.TheLehmanbankruptcvcausedimmediateproblemsfortheseOTC
derivatives counterparties. Thev had the right under U.S. bankruptcv law to termi-
natetheirderivativescontractswithLehmanuponitsbankruptcv,andtotheextent
thatLehmanowedthemmonevonthecontractsthevcouldseizeanvLehmancollat-
eralthatthevheld.However,anvadditionalamountowedtothemhadtobeclaimed
inthebankruptcvproceeding.IfthevhadpostedcollateralwithLehman,thevwould
havetomakeaclaimforthereturnofthatcollateral,anddisputesovervaluationof
thecontractswouldstillhavetoberesolved.Theseproceedingswoulddelavpavment
andmostlikelvresultinlosses.Moreover,anvhedgesthatrestedonthesecontracts
werenowgone,increasingrisk.
8
InvestorsalsopulledoutoffundsthatdidnothavedirectLehmanexposure.The
managers of these funds, in turn, pulled 1o- billion out of the commercial paper
market in September and shifted billions of dollars of repo loans to safer collateral,
puttingfurtherpressureoninvestmentbanksandotherfnancecompaniesthatde-
As concerns about the health of bank counterparties spread, lending banks
demanded higher interest rates to compensate for the risk. The one-month LIBOR-
OIS spread measures the part of the interest rates banks paid other banks that is due
to this credit risk. Strains in the interbank lending markets appeared just after the
crisis began in 2007 and then peaked during the fall of 2008.
Cost of Interbank Lending
IN PERCENT, DAILY
SOURCE: Bloomberg
1
0
2
3
4%
2005 2006 2007 2009 2008
NOTE: Chart shows the spread between the one-month London Interbank Offered Rate (LIBOR) and the
overnight index swap rate (OIS), both closely watched interest rates.
Iigurcao.:
tii :i : \Ni i\Ni t .,,
pended on those markets.
o
When the commercial paper market died, the biggest
corporationsinAmericathoughtthevwerefnished,HarvevMiller,thebankruptcv
attornevfortheLehmanestate,toldtheFCIC.
1o
Investors and uninsured depositors vanked tens of billions of dollars out of banks
whose real estate exposures might be debilitating (Washington Mutual, Wachovia) in
favorofthosewhoserealestateexposuresappearedmanageable(WellsFargo,IPMor-
gan).Hedgefundswithdrewtensofbillionsofdollarsofassetsheldincustodvatthere-
maininginvestmentbanks(GoldmanSachs,MorganStanlev,andevenMerrillLvnch,
asthejust-announcedBankofAmericaacquisitionwouldntcloseforanotherthreeand
ahalfmonths)infavoroflargecommercialbankswithprimebrokeragebusinesses(IP
Morgan, Credit Suisse, Deutsche Bank), because the commercial banks had more di-
versesourcesofliquiditvthantheinvestmentbanksaswellaslargebasesofinsuredde-
posits.IPMorganandBNYMellon,thetri-partvrepoclearingbanks,clampeddown
ontheirintradavexposures,demandingmorecollateralthaneverfromtheremaining
investment banks and other primarv dealers. Manv banks refused to lend to one an-
other;thecostofinterbanklendingrosetounprecedentedlevels(seefgureio.1).
.,( ii N\Nti \i tii :i : i NuUi i tu\\i : :i uN iiiui1
OnMondav,September1-,theDowIonesIndustrialAveragefellmorethan-oo
points, or a, the largest single-dav point drop since the o/11 terrorist attacks.
ThesedropswouldbeexceededonSeptemberiothedavthattheHouseofRepre-
sentatives initiallv voted against the oo billion Troubled Asset Relief Program
(TARP)proposaltoprovideextraordinarvsupporttofnancialmarketsandfrms
whentheDowIonesfellandfnancialstocksfell1o.Forthemonth,theS&P
-oo would lose 88o billion of its value, a decline of othe worst month since
Septemberiooi.
Andspecifcinstitutionswouldtakedirecthits.
MONEY MARKET FUNDS:
DEALERS WEREN T EVEN PICKING UP THEIR PHONES
WhenLehmandeclaredbankruptcv,theReservePrimarvFundhad8-millionin-
vestedinLehmanscommercialpaper.ThePrimarvFundwastheworldsfrstmonev
market mutual fund, established in 1o1 bv Reserve Management Companv. The
fundhadtraditionallvinvestedinconservativeassetssuchasgovernmentsecurities
andbankcertifcatesofdepositandhadforvearsenjovedMoodvsandS&Pshighest
ratingsforsafetvandliquiditv.
In March iooo, the fund had advised investors that it had slightlv underper-
formeditsrivals,owingtoamoreconservativeandriskaversemannerofinvest-
ingfor example, the Reserve Funds do not invest in commercial paper.
11
But
immediatelvafterpublishingthisstatement,itquietlvbutdramaticallvchangedthat
strategv.Within18months,commercialpapergrewfromzerotoone-halfofReserve
Primarvsassets.ThehighervieldsattractednewinvestorsandtheReservePrimarv
Fund was the fastest-growing monev market fund complex in the United States in
iooo,ioo,andioo8doublinginthefrsteightmonthsofioo8alone.
1i
Earlierinioo8,PrimarvFundsmanagershadloanedBearStearnsmonevinthe
repomarketuptotwodavsbeforeBearsnear-collapse,pullingitsmonevonlvafter
Bear CEO Alan Schwartz appeared on CNBC in the companvs fnal davs, Primarv
FundPortfolioManagerMichaelLucianotoldtheFCIC.Butafterthegovernment-
assisted rescue of Bear, Luciano, like manv other professional investors, said he as-
sumedthatthefederalgovernmentwouldsimilarlvsavethedavifLehmanoroneof
theotherinvestmentbanks,whichweremuchlargerandposedgreaterapparentsvs-
temicrisks,ranintotrouble.Thesefrms,Lucianosaid,weretoobigtofail.
1:
On September 1-, when Lehman declared bankruptcv, the Primarv Funds
Lehman holdings amounted to 1.i of the funds total assets of oi.a billion. That
morning,thefundwasfoodedwithredemptionrequeststotaling1o.8billion.State
Street, the funds custodian bank, initiallv helped the fund meet those requests,
largelvthroughanexistingoverdraftfacilitv,butstoppeddoingsoat1o:1oA.M.With
nomeanstoborrow,PrimarvFundrepresentativesreportedlvdescribedStateStreets
actionasthekissofdeathforthePrimarvFund.
1a
Despitepublicassurancesfrom
thefundsinvestmentadvisors,BruceBentSr.andBruceBentII,thatthefundwas
tii :i : \Ni i\Ni t .,,
committedtomaintaininga1.oonetassetvalue,investorsrequestedanadditional
iobillionlateronMondavandTuesdav,September1o.
1-
Meanwhile,onMondav,thefundsboardhaddeterminedthattheLehmanpaper
wasworth8ocentsonthedollar.Thatappraisalhadquicklvprovedoptimistic.After
themarketclosedTuesdav,ReserveManagementpubliclvannouncedthatthevalue
of its Lehman paper was zero, effective a:ooPM New York time todav. As a result,
the fund broke the buck.
1o
Four davs later, the fund sought SEC permission to om-
ciallvsuspendredemptions.
Otherfundssufferingsimilarlosseswereproppedupbvtheirsponsors.OnMon-
dav, Wachovias asset management unit, Evergreen Investments, announced that it
would support three Evergreen mutual funds that held about -ao million in
Lehman paper. On Wednesdav, BNY Mellon announced support for various funds
that held Lehman paper, including the ii billion Institutional Cash Reserves fund
andfourofitstrademarkDrevfusfunds. BNYMellonwouldtakeanafter-taxcharge
ofai-millionbecauseofthisdecision.Overthenexttwovears,oimonevmarket
funds:obasedintheUnitedStates,ioinEurope
1
wouldreceivesuchassistance
tokeeptheirfundsfrombreakingthebuck.
After the Primarv Fund broke the buck, the run took an ominous turn: it even
slammedmonevmarketfundswithnodirectLehmanexposure.Thislackofexpo-
sure was generallv known, since the SEC requires these funds to report details on
theirinvestmentsatleastquarterlv.Investorspulledoutsimplvbecausethevfeared
thattheirfellowinvestorswouldrunfrst.Itwasoverwhelminglvclearthatwewere
staringintotheabvssthattherewasntabottomtothisastheoutfowspickedup
steamonWednesdavandThursdav,FedeconomistPatrickMcCabetoldtheFCIC.
The overwhelming sense was that this was a catastrophe that we were watching
unfold.
18
We were reallv cognizant of the fact that there werent backstops in the svstem
thatwereresilientatthattime,theFedsMichaelPalumbosaid.Liquiditvcrises,bv
theirnature,invokerapid,emergentepisodesthatswhatthevare.Bvtheirnature,
thevspreadvervquicklv.
1o
An earlv and signifcant casualtv was Putnam Investments 1i billion Prime
Monev Market Fund, which was hit on Wednesdav with a wave of redemption re-
quests.Thefund,unabletoliquidateassetsquicklvenough,haltedredemptions.One
weeklater,itwassoldtoFederatedInvestors.
Within a week, investors in prime monev market fundsfunds that invested in
highlv rated securitieswithdrew :ao billion; within three weeks, thev withdrew
another8-billion.Thatmonevwasmostlvheadedforotherfundsthatboughtonlv
Treasuriesandagencvsecurities;indeed,itwasmoremonevthanthosefundscould
invest, and thev had to turn people awav
io
(see fgure io.i). As a result of the un-
precedented demand for Treasuries, the vield on four-week Treasuries fell close to
o,levelsnotseensinceWorldWarII.
Monevmarketmutualfundsneedingcashtohonorredemptionssoldtheirnow
illiquid investments. Unfortunatelv, there was little market to speak of. We heard
In a flight to safety, investors shifted from prime money market funds to
money market funds investing in Treasury and agency securities.
Investments in Money Market Funds
IN TRILLIONS OF DOLLARS, DAILY
SOURCE: Crane Data
0
.5
1
1.5
$2
SEPT. OCT. AUG. 2008
Prime
Treasury and
government
Iigurcao.a
., ii N\Nti \i tii :i : i NuUi i tu\\i : :i uN iiiui1
anecdotallvthatthedealerswerentevenpickinguptheirphones. Thefundshadto
getridoftheirpaper;thevdidnthaveanvonetogiveitto,McCabesaid.
i1
And holding unsecured commercial paper from anv large fnancial institution
was now simplv out of the question: fund managers wanted no part of the next
Lehman.AnFCICsurvevofthelargestmonevmarketfundsfoundthatmanvwere
unwillingtopurchasecommercialpaperfromfnancialfrmsduringtheweekafter
Lehman. Of the respondents, the fve with the most drastic reduction in fnancial
commercial paper cut their holdings bv half, from -8 billion to io billion.
ii
This
ledtounprecedentedincreasesintheratesoncommercialpaper,creatingproblems
for borrowers, particularlv for fnancial companies, such as GE Capital, CIT, and
AmericanExpress,aswellasfornonfnancialcorporationsthatusedcommercialpa-
per to pav their immediate expenses such as pavroll and inventories. The cost of
commercialpaperborrowingspikedinmid-September,dramaticallvsurpassingthe
previoushighsinioo(seefgureio.:).
You had a broad-based run on commercial paper markets, Geithner told the
FCIC.Andsovoufacedtheprospectofsomeofthelargestcompaniesintheworld
andtheUnitedStateslosingthecapacitvtofundandaccessthosecommercialpaper
markets.
i:
Threedecadesofeasvborrowingforthosewithtop-ratedcreditinaverv
liquidmarkethaddisappearedalmostovernight.Thepanicthreatenedtodisruptthe
pavmentssvstemthroughwhichfnancialinstitutionstransfertrillionsofdollarsin
During the crisis, the cost of borrowing for lower-rated nonfinancial firms spiked.
Cost of Short-Term Borrowing
IN PERCENT, DAILY
N0TE. Shown is Lhe sread beLween Lhe raLe aid by secondLier raLed nonfnancial comanies
(A?/P?) LhaL borrowed by issuin 80day commercial aer and Lhe raLe aid on similar aer by
Lhe besLraLed comanies.
S0uPCE. Federal Peserve Board of Covernors
0
1
2
3
4
5
6
7%
2007 2009 2008
Iigurcao..
tii :i : \Ni i\Ni t .,+
cashandassetsevervdavanduponwhichconsumersrelvforexample,tousetheir
creditcardsanddebitcards.Atthatpoint,voudontneedtomapoutwhichparticu-
larmechanismitsnotrelevantanvmoreitsbecomesvstemicandendemicandit
needstobestopped,Palumbosaid.
ia
The government responded with two new lending programs on Fridav, Septem-
ber 1o. Treasurv would guarantee the 1 net asset value of eligible monev market
funds,forafeepaidbvthefunds.
i-
AndtheFedwouldprovideloanstobankstopur-
chase high-qualitv-asset-backed commercial paper from monev market funds.
io
In
itsfrsttwoweeks,thisprogramloanedbanks1-obillion,althoughusagedeclined
overtheensuingmonths.Thetwoprogramsimmediatelvslowedtherunonmonev
marketfunds.
Withthefnancialsectorindisarrav,theSECimposedatemporarvbanonshort-
sellingonthestocksofabout8oobanks,insurancecompanies,andsecuritiesfrms.
Thisaction,takenonSeptember18,followedanearliertemporarvbanputinplace
overthesummeronnakedshort-sellingthatis,shortingastockwithoutarranging
todeliverittothebuverof1ofnancialstocksinordertoprotectthemfromun-
lawfulmanipulation.
Meanwhile,TreasurvSecretarvHenrvPaulsonandothersenioromcialshadde-
cided thev needed a more svstematic approach to dealing with troubled frms and
troubledmarkets.PaulsonstartedseekingauthoritvfromCongressforTARP.One
.(+ ii N\Nti \i tii :i : i NuUi i tu\\i : :i uN iiiui1
thingthatwasconstantaboutthecrisisisthatwewerealwavsbehind.Itwasalwavs
morphingandmanifestingitselfinwavswedidntexpect,NeelKashkari,thenassis-
tantsecretarvofthetreasurv,toldtheFCIC.Soweknewwedgetoneshotatthisau-
thoritv and it was important that we provided ourselves maximum frepower and
maximum fexibilitv. We specifcallv designed the authoritv to allow us basicallv to
dowhateverweneededtodo.Kashkarispentthenexttwoweeksbasicallvlivingon
CapitolHill.
i
Asdiscussedbelow,theprogramwasatoughsell.
MORGAN STANLEY: NOW WE RE THE NEXT IN LINE
Investorsscrutinizedthetworemaininglarge,independentinvestmentbanksafter
thefailureofLehmanandtheannouncedacquisitionofMerrill.EspeciallvMorgan
Stanlev. On Mondav, September 1-, the annual cost of protecting 1o million in
Morgan Stanlev debt through credit default swaps jumped to o8i,ooofrom
:o:,oooonFridavaboutdoublethecostforGoldman.Assoonaswecomeinon
Mondav, were in the eve of the storm with Merrill gone and Lehman gone, Iohn
Mack,thenMorganStanlevsCEO,saidtotheFCIC.Helateradded,Nowwerethe
nextinline.
i8
MorganStanlevomcialshadsomereasonforconfdence.OnthepreviousFridav,
the companvs liquiditv pool was more than 1:o billionGoldmans was 1io
billion
io
and, like Goldman, it had passed the regulators liquiditv stress tests
months earlier. But the earlv market indicators were mixed. David Wong, Morgan
Stanlevstreasurer,heardearlvfromhisLondonomcethatseveralEuropeanbanks
were not accepting Morgan Stanlev as a counterpartv on derivatives trades.
:o
He
calledthosebanksandthevagreedtokeeptheirtradeswithMorganStanlev,atleast
forthetimebeing.ButWongwellknewthatrumorsaboutderivativescounterpar-
tiesfeeingthroughnovationshadcontributedtothedemiseofBearandLehman.
Repo lenders, primarilv monev market funds, likewise did not panic immediatelv.
OnMondav,onlvafewofthemrequestedslightlvmorecollateral.
:1
But the relative stabilitv was feeting. Morgan Stanlev immediatelv became the
targetofahedgefundrun.Beforethefnancialcrisis,ithadtvpicallvbeenprimebro-
kers like Morgan Stanlev who were worried about their exposures to hedge fund
clients.Nowtheroleswerereversed.TheLehmanepisodehadrevealedthatbecause
primebrokerswereabletoreuseclientsassetstoraisecashfortheirownactivities,
clientsassetscouldbefrozenorlostinbankruptcvproceedings.
:i
Toprotectthemselves,hedgefundspulledbillionsofdollarsincashandotheras-
setsoutofMorganStanlev,Merrill,andGoldmaninfavorofprimebrokersinbank
holding companies, such as IP Morgan; big foreign banks, such as Deutsche Bank
and Credit Suisse; and custodian banks, such as BNY Mellon and Northern Trust,
whichthevbelievedweresaferandmoretransparent.FundmanagerstoldtheFCIC
thatsomeprimebrokerstookaggressivemeasurestopreventhedgefundcustomers
fromdemandingtheirassets.Forexample,Most[hedgefunds]requestcashmove-
ment from [prime brokers] primarilv through a fax, the hedge fund manager
IonathanWoodtoldtheFCIC.Whattendstohappeninvervstressfultimesisthose
tii :i : \Ni i\Ni t .(.
faxestendtogetlost.Imnotsurethatsjustcoincidental . . .thatwascollateralfor
whatever lending [prime brokers] had against vou and thev didnt want to give it
[awav].
::
Soon, hedge funds would suffer unprecedented runs bv their own investors. Ac-
cordingtoanFCICsurvevofhedgefundsthatsurvived,investorredemptionrequests
averagedioofclientfundsinthefourthquarterofioo8.
:a
Thispummeledthemar-
kets.Monevinvestedinhedgefundstotaledi.itrillion,globallv,attheendofioo,
:-
butbecauseofleverage,theirmarketimpactwasseveraltimeslarger.Widespreadre-
demptions forced hedge funds to sell extraordinarv amounts of assets, further de-
pressingmarketprices.Manvhedgefundswouldhaltredemptionsorcollapse.
On Mondav, hedge funds requested about 1o billion from Morgan Stanlev.
:o
Then,onTuesdavmorning,MorganStanlevannouncedaproftof1.abillionforthe
three months ended August :1, ioo8, about the same as that period a vear earlier.
Mackhaddecidedtoreleasethegoodnewsadavearlv,butthismovehadbackfred.
Onehedgefundmanagersaidtomeafterthefact . . .thathethoughtpreannounc-
ingearningsadavearlvwasasignofweakness.SoIguessitwas,becausepeoplecer-
tainlv continued to short our stock or sell our stockI dont know if thev were
shortingitbutthevwerecertainlvsellingit,MacktoldtheFCIC.
:
Wongsaid,We
weremanagingourfunding . . .butreallvtherewereotherthingsthatwerehappen-
ingasaresultoftheLehmanbankruptcvthatwerebeginningtoaffect,reallvripple
throughandaffectsomeofourclients,ourmoresophisticatedclients.
:8
The hedge fund run became a :i billion torrent on Wednesdav,
:o
the dav after
AIGwasbailedoutandthedavthatmanvofoursophisticatedclientsstartedtoliq-
uefv, as Wong put it.
ao
Manv of the hedge funds now sought to exercise their con-
tractual capabilitv to borrow more from Morgan Stanlevs prime brokerage without
needing to post collateral. Morgan Stanlev borrowed 1: billion from the Feds
PDCFonTuesdav,ibilliononWednesdav,and:-.:billiononFridav.
ThesedevelopmentstriggeredtheeventthatFedpolicvmakershadworriedabout
over the summer: an increase in collateral calls bv the two tri-partv repo clearing
banks,IPMorganandBNYMellon.AshadhappenedduringtheBearepisode,the
two clearing banks became concerned about their intradav exposures to Morgan
Stanlev,Merrill,andGoldman.OnSundavoftheLehmanweekend,theFedhadlow-
ered the bar on the collateral that it would take for overnight lending through the
PDCF.ButthePDCFwasnotdesignedtotaketheplaceoftheintradav fundingpro-
videdbvIPMorganandBNYMellon,andneitherofthemwantedtoacceptfortheir
intradavloansthelower-qualitvcollateralthattheFedwasacceptingforitsovernight
loans. Thev would not make those loans to the three investment banks without re-
quiringbiggerhaircuts,whichtranslatedintorequestsformorecollateral.
Bigintradavissuesattheclearingbanks,theSECsMattEichnerinformedNew
YorkFedcolleaguesinanearlvWednesdavemail.Thevdontwantexposureandare
askingforcash/securities. . . .Lotsofdesklevelnoisearound[MorganStanlev]and
[MerrillLvnch]andtakingthename.Notprettv.
a1
TakingthenameisWallStreetparlanceforacceptingacounterpartvonatrade.
On Thursdav, BNY Mellon requested : billion in collateral from Morgan Stanlev.
.(z ii N\Nti \i tii :i : i NuUi i tu\\i : :i uN iiiui1
AndNewYorkFedomcialsreportedthatIPMorganwasthinkingaboutrequesting
i.8billionontopofai.ibillionondeposit.
ai
AccordingtoaFedexamineratCiti-
group, a banker from that frm had said that Morgan [Stanlev] is the deer in the
headlightsandhavingsignifcantstressinEurope.ItslookinglikeLehmandidafew
weeksago.
a:
CommercialpapermarketsalsoseizedupforMorganStanlev.FromFridav,Sep-
tember1i,totheendofSeptember,theamountofthefrmsoutstandingcommercial
paperhadfallennearlvao,andithadrolledoveronlviomillion.Bvcomparison,
onaverageMorganStanlevrolledoveraboutiaomillionevervdavinthelasttwo
weeksofAugust.
aa
On Saturdav, Morgan Stanlev executives briefed the New York Fed on the situa-
tion.Bvthistime,thefrmhadatotalof:-.:billioninPDCFfundingand:i.-bil-
lion in TSLF funding from the Fed.
a-
Morgan Stanlevs liquiditv pool had dropped
from1:obillionto--billioninoneweek.Repolendershadpulledout:1billion
andhedgefundshadtaken8obillionoutofMorganStanlevsprimebrokerage.That
runhadvastlvexceededthecompanvsmostseverescenarioinstresstestsadminis-
teredonlvonemonthearlier.
ao
During the week, Goldman Sachs had encountered a similar run. Its liquiditv
pool had fallen from about 1io billion on the previous Fridav to - billion on
Thursdav. At the end of the week, its Fed borrowing totaled - billion from the
PDCF and 1:.- billion from the TSLF. Llovd Blankfein, Goldmans CEO, told the
FCIC,
We had tremendous liquiditv through the period. But there were svs-
temiceventsgoingon,andwewerevervnervous.Ifvouareaskingme
whatwouldhavehappenedbutfortheconsiderablegovernmentinter-
vention, I would sav we were init was a more nervous position than
wewouldhavewanted[tobe]in.Weneveranticipatedthegovernment
help.Wewerentrelvingonthosemechanisms. . . .Ifeltgoodaboutit,
butweweregoingtobedevervnightwithmoreriskthananvresponsi-
blemanagershouldwanttohave,eitherforourbusinessorforthesvs-
temasawholerisk,notcertaintv.
a
BernanketoldtheFCICthattheFedbelievedtherunonGoldmanthatweekcould
leadtoitsfailure:[LikeIPMorgan,]GoldmanSachsIwouldsavalsoprotectedthem-
selvesquitewellonthewhole.Thevhadalotofcapital,alotofliquiditv.Butbeingin
theinvestmentbankingcategorvratherthanthecommercialbankingcategorv,when
thathugefundingcrisishitalltheinvestmentbanks,evenGoldmanSachs,wethought
there was a real chance that thev would go under.
a8
Although it did not keep pace
withMorganStanlevsuseoftheFedsfacilities,GoldmanSachswouldcontinuetoac-
cesstheFedsfacilities,increasingitsPDCFborrowingtoahighofiabillioninOc-
toberanditsTSLFborrowingtoahighofa:.-billioninDecember.
On Sundav, September i1, both Morgan Stanlev and Goldman Sachs applied to
theFedtobecomebankholdingcompanies.Inmv:o-vearhistorv,[Goldmanand
tii :i : \Ni i\Ni t .(.
Morgan Stanlev] had consistentlv opposed Federal Reserve supervision[but after
Lehman,]thosefranchisessawthatthevwerenextunlessthevdidsomethingdrastic.
That drastic thing was to become bank holding companies, Tom Baxter, the New
YorkFedsgeneralcounsel,toldtheFCIC.
ao
TheFed,intandemwiththeDepartment
ofIustice,approvedthetwoapplicationswithextraordinarvspeed,waivingthestan-
dard fve-dav antitrust waiting period.
-o
Morgan Stanlev instantlv converted its :o
billion industrial loan companv into a national bank, subject to supervision bv the
Omce of the Comptroller of the Currencv (OCC), and Goldman converted its io
billionindustrialloancompanvintoastate-charteredbankthatwasamemberofthe
FederalReserveSvstem,subjecttosupervisionbvtheFedandNewYorkState.The
Fedwouldbegintosupervisethetwonewbankholdingcompanies.
Thetwocompaniesgainedtheimmediatebeneftofemergencvaccesstothedis-
countwindowfortermsofuptooodavs.
-1
But,moreimportant,Ithinkthebiggest
beneftisitwouldshowvouthatvoureimportanttothesvstemandtheFedwould
notmakevouaholdingcompanvifthevthoughtinavervshortperiodoftimevoud
beoutofbusiness,MacktoldtheFCIC.Itsendsasignalthatthesetwofrmsarego-
ingtosurvive.
-i
In a show of confdence, Warren Buffett invested - billion in Goldman Sachs,
and Mitsubishi UFI invested o billion in Morgan Stanlev. Mack said he had been
waiting all weekend for confrmation of Mitsubishis investment when, late Sundav
afternoon,hereceivedacallfromBernanke,Geithner,andPaulson.Basicallvthev
said thev wanted me to sell the frm, Mack told the FCIC. Less than an hour later,
Mitsubishicalledtoconfrmitsinvestmentandtheregulatorsbackedoff.
-:
Despitetheweekendannouncements,however,therunonMorganStanlevcon-
tinued.Overthecourseofaweek,adecreasingnumberofpeople[were]willingto
donewrepos,Wongsaid.Thevjustcouldntlendanvmore.
-a
BvtheendofSeptember,MorganStanlevsliquiditvpoolwouldbe--billion.
--
ButMorganStanlevsliquiditvdependedcriticallvonborrowingfromtwoFedpro-
grams,oobillionfromthePDCFand:obillionfromtheTSLF.GoldmanSachss
liquiditv pool had recovered to about 8o billion, backed bv 1o.- billion from the
PDCFand1-billionfromtheTSLF.
OVERTHECOUNTER DERIVATIVES: A GRINDING HALT
Tradingintheover-the-counterderivativesmarketshadbeendecliningasinvestors
grewmoreconcernedaboutcounterpartvriskandashedgefundsandothermarket
participants reduced their positions or exited. Activitv in manv of these markets
slowedtoacrawl;insomecases,therewasnomarketatallnotradeswhatsoever.A
sharpandunprecedentedcontractionofthemarketoccurred.
-o
TheOTCderivativesmarketscametoagrindinghalt,jeopardizingtheviabilitv
ofevervparticipantregardlessoftheirdirectexposuretosubprimemortgage-backed
securities,thehedgefundmanagerMichaelMasterstoldtheFCIC.
-
Furthermore,
when the OTC derivatives markets collapsed, participants reacted bv liquidating
theirpositionsinotherassetsthoseswapsweredesignedtohedge.Thismarketwas
.(. ii N\Nti \i tii :i : i NuUi i tu\\i : :i uN iiiui1
unregulatedandlargelvopaque,withnopublicreportingrequirementsandlittleor
nopricediscoverv.WiththeLehmanbankruptcv,participantsinthemarketbecame
concernedabouttheexposuresandcreditworthinessoftheircounterpartiesandthe
valueoftheircontracts.Thatuncertainlvcausedanabruptretreatfromthemarket.
Badlvhitwasthemarketforderivativesbasedonnonprimemortgages.Firmshad
come to relv on the prices of derivatives contracts refected in the ABX indices to
value their nonprime mortgage assets. The ABX.HE.BBB- oo-i, whose decline in
ioohadbeenanearlvbellwetherforthemarketcrisis,hadbeentradingaround-
centsonthedollarsinceMav.Buttradingonthisindexhadbecomesothin,falling
fromanaverageofaboutotransactionsperweekfromIanuarviootoSeptember
ioo8 to fewer than : transactions per week in October ioo8, that index values
werentinformative.
-8
So,whatwasavalidpricefortheseassets:Pricediscovervwas
aguessinggame,evenmorethanithadbeenundernormalmarketconditions.
ThecontractionoftheOTCderivativesmarkethadimplicationsbevondthevalu-
ation of mortgage securities. Derivatives had been used to manage all manner of
risktheriskthatcurrencvexchangerateswouldfuctuate,theriskthatinterestrates
wouldchange,theriskthatassetpriceswouldmove.Emcientlvmanagingtheserisks
inderivativesmarketsrequiredliquiditvsothatpositionscouldbeadjusteddailvand
atlittlecost.Butinthefallofioo8,evervonewantedtoreduceexposuretoevervone
else.Therewasarushfortheexitsasparticipantsworkedtogetoutofexistingtrades.
And because evervone was worried about the risk inherent in the next trade, there
often was no next tradeand volume fell further. The result was a vicious circle of
justifablecautionandinaction.
Meanwhile, in the absence of a liquid derivatives market and emcient price dis-
coverv,evervfrmsriskmanagementbecamemoreexpensiveanddimcult.Theusual
hedgingmechanismswereimpaired.Aninvestorthatwantedtotradeatalosstoget
outofalosingpositionmightnotfndabuver,andthosethatneededhedgeswould
fndthemmoreexpensiveorunavailable.
Several measures revealed the lack of liquiditv in derivatives markets. First, the
number of outstanding contracts in a broad range of OTC derivatives sharplv de-
clined. Since its deregulation bv federal statute in December iooo, this market had
increasedmorethansevenfold.FromIune:o,ioo8totheendofthevear,however,
outstanding notional amounts of OTC derivatives fell bv more than 1o. This de-
clinedefedhistoricalprecedent.Itwasthefrstsignifcantcontractioninthemarket
overasix-monthperiodsincetheBankforInternationalSettlementsbegankeeping
statisticsin1oo8.
-o
Moreover,itoccurredduringaperiodofgreatvolatilitvinthef-
nancialmarkets.Atsuchatime,frmsusuallvturntothederivativesmarkettohedge
theirincreasedrisksbutnowthevfedthemarket.
Thelackofliquiditvinderivativesmarketswasalsosignaledbvthehigherprices
charged bv OTC derivatives dealers to enter into contracts. Dealers bear additional
risks when markets are illiquid, and thev pass the cost of those risks on to market
participants.Thecostisevidentintheincreasedbid-askspreadthedifferencebe-
tweenthepriceatwhichdealerswerewillingtobuvcontracts(thebidprice)andthe
priceatwhichthevwerewillingtosellthem(theaskprice).Asmarketsbecameless
tii :i : \Ni i\Ni t .(,
liquid during the crisis, dealers worried that thev might be saddled with unwanted
exposure. As a result, thev began charging more to sell contracts (raising their ask
price), and the spread rose. In addition, thev offered less to buv contracts (lowered
their bid price), because thev feared involvement with uncreditworthv counterpar-
ties. The increase in the spread in these contracts meant that the cost to a frm of
hedging its exposure to the potential default of a loan or of another frm also in-
creased.Thecostofriskmanagementrosejustwhentherisksthemselveshadrisen.
Meanwhile,outstandingcreditderivativescontractedbva8betweenDecember
ioo, when thev reached their height of -8.i trillion in notional amount, and the
latestfguresasofIuneio1o,whenthevhadfallento:o.:trillion.
oo
In sum, the sharp contraction in the OTC derivatives market in the fall of ioo8
greatlvdiminishedtheabilitvofinstitutionstoenterorunwindtheircontractsorto
effectivelvhedgetheirbusinessrisksatatimewhenuncertaintvinthefnancialsvs-
temmaderiskmanagementatopprioritv.
WASHINGTON MUTUAL: IT S YOURS
In the eight davs after Lehmans bankruptcv, depositors pulled 1o. billion out of
WashingtonMutual,whichnowfacedimminentcollapse.WaMuhadbeenthesubject
ofconcernforsometimebecauseofitspoormortgage-underwritingstandardsandits
exposurestopavment-optionadjustable-ratemortgages(ARMs).Moodvshaddown-
gradedWaMusseniorunsecureddebttoBaa:,thelowest-tierinvestment-graderat-
ing, in Iulv, and then to junk status on September 11, citing WAMUs reduced
fnancialfexibilitv,deterioratingassetqualitv,andexpectedfranchiseerosion.
o1
TheOmceofThriftSupervision(OTS)determinedthatthethriftlikelvcouldnot
pavitsobligationsandmeetitsoperatingliquiditvneeds.
oi
Thegovernmentseized
thebankonThursdav,Septemberi-,ioo8,appointingtheFederalDepositInsurance
Corporationasreceiver;manvunsecuredcreditorssufferedlosses.Withassetsof:o
billionasofIune:o,ioo8,WaMuthusbecamethelargestinsureddepositorvinstitu-
tioninU.S.historvtofailbiggerthanIndvMac,biggerthananvbankorthriftfailure
inthe1o8osand1ooos.IPMorganpaid1.obilliontoacquireWaMusbankingoper-
ationsfromtheFDIConthesamedav;onthenextdav,WaMusparentcompanv(now
minusthethrift)fledforChapter11bankruptcvprotection.
FDIComcialstoldtheFCICthatthevhadknowninadvanceofWaMustroublesand
thushadtimetoarrangethetransactionwithIPMorgan.IPMorganCEOIamieDimon
saidthathisbankwasalreadvexaminingWaMusassetsforpurchasewhenFDICChair-
man Sheila Bair called him and asked, Would vou be prepared to bid on WaMu: I
saidveswewould,DimontoldtheFCIC.Shecalledmeupliterallvthenextdavand
saidIts vours. . . . I thought there was another bidder, bv the wav, the whole time,
otherwiseIwouldhavebidadollarnot[1.obillion],butwewantedtowin.
o:
TheFDICinsurancefundcameoutoftheWaMubankruptcvwhole.Sodidthe
uninsured depositors, and (of course) the insured depositors. But the FDIC never
contemplatedusingFDICfundstoprotectunsecuredcreditors,whichitcouldhave
donebvinvokingthesvstemicriskexceptionundertheFDICImprovementActof
.(( ii N\Nti \i tii :i : i NuUi i tu\\i : :i uN iiiui1
1oo1.(RecallthatFDICIArequiredthatfailingbanksbedismantledattheleastcost
totheFDICunlesstheFDIC,theFed,andTreasurvagreethataparticularcompanvs
collapseposesarisktotheentirefnancialsvstem;ithadnotbeentestedin1vears.)
Lossesamongthosecreditorscreatedpanicamongtheunsecuredcreditorsofother
struggling banks, particularlv Wachoviawith serious consequences. Nevertheless,
FDICChairmanBairstoodbehindthedecision.Iabsolutelvdothinkthatwasthe
rightdecision,shetoldtheFCIC.WaMuwasnotawell-runinstitution.Shechar-
acterizedtheresolutionofWaMuassuccessful.
oa
TheFDICsdecisionwouldbehotlvdebated.FedGeneralCounselScottAlvarez
toldtheFCICthatheagreedwithBairthatthereshouldnothavebeenintervention
inWaMu.
o-
ButTreasurvomcialsfeltdifferentlv:Weweresavingthatsgreat,wecan
all be tough, and we can be so tough that we plunge the fnancial svstem into the
Great Depression, Treasurvs Neel Kashkari told the FCIC. And so, I think, in mv
judgmentthatwasamistake. . . .[A]tthattime,theeconomvwasinsuchaperilous
state,itwaslikeplavingwithfre.
oo
WACHOVIA: AT THE FRONT END OF
THE DOMINOES AS OTHER DOMINOES FELL
Wachovia, having bought Golden West, was the largest holder of pavment-option
ARMs,thesameproductthathadhelpedbringdownWaMuandCountrvwide.Con-
cerns about Wachoviathen the fourth-largest bank holding companvhad also
been escalating for some time. On September o, the Merrill analvst Ed Najarian
downgradedthecompanvsstocktounderperform,pointingtoweaknessinitsop-
tion ARM and commercial loan portfolios. On September 11, Wachovia executives
metFedomcialstoaskforanexemptionfromrulesthatlimitedholdingcompanies
useofinsureddepositstomeettheirliquiditvneeds.TheFeddidnotaccede;staffbe-
lieved that Wachovias cash position was strong and that the requested relief was a
wantratherthananeed.
o
ButthevchangedtheirmindsaftertheLehmanbankruptcv,immediatelvlaunch-
ingdailvconferencecallstodiscussliquiditvwithWachoviamanagement.Depositor
outfows increased. On September 1o, the Fed supported the companvs request to
useinsureddepositstoprovideliquiditvtotheholdingcompanv.OnSeptemberio,a
Saturdav, Wells Fargo Chairman Richard M. Kovacevich told Robert Steel, Wa-
choviasCEOandrecentlvaTreasurvundersecretarv,thatWellsmightbeinterested
in acquiring the besieged bank, and the two agreed to speak later in the week. The
samedav,FedGovernorKevinWarshsuggestedthatSteelalsotalktoGoldman.Asa
formervicechairmanofGoldman,Steelcouldeasilvapproachthefrm,buttheensu-
ingconversationswereshort;Goldmanwasnotinterested.
o8
Throughout the following week, it became increasinglv clear that Wachovia
neededtomergewithastrongerfnancialinstitution.Then,WaMusfailureonSep-
temberi-raisedcreditorconcernaboutthehealthofWachovia,theFedsAlvarez
toldtheFCIC.ThedavafterthefailureofWaMu,WachoviaBankdepositorsacceler-
atedthewithdrawalofsignifcantamountsfromtheiraccounts,Alvarezsaid.Inad-
tii :i : \Ni i\Ni t .(,
dition, wholesale funds providers withdrew liquiditv support from Wachovia. It ap-
pearedlikelvthatWachoviawouldsoonbecomeunabletofunditsoperations.
oo
Steel
said, As the dav progressed, some liquiditv pressure intensifed as fnancial institu-
tionsbegandecliningtoconductnormalfnancingtransactionswithWachovia.
o
David Wilson, the Omce of the Comptroller of the Currencvs lead examiner at
Wachovia,agreed.ThewholeworldchangedforWachoviaafterWaMusfailure,he
said.
1
TheFDICsBairhadaslightlvdifferentview.WaMusfailurewaspracticallva
nonevent, she told the FCIC. It was below the fold if it was even on the front
page . . .barelvablipgivenevervthingelsethatwasgoingon.
i
TherunonWachoviaBank,thecountrvsfourth-largestcommercialbank,wasa
silentrunbvuninsureddepositorsandunsecuredcreditorssittinginfrontoftheir
computers,ratherthanbvdepositorsstandinginlinesoutsidebankdoors.
:
Bvnoon
on Fridav, September io, creditors were refusing to roll over the banks short-term
funding, including commercial paper and brokered certifcates of deposit.
a
The
FDICsIohnCorstontestifedthatWachovialost-.billionofdepositsand1.1bil-
lionofcommercialpaperandreposthatdav.
-
BvtheendofthedavonFridav,WachoviatoldtheFedthatworriedcreditorshad
askedittorepavroughlvhalfofitslong-termdebt-obilliontooobillion.
o
Wa-
choviadidnothavetopavallthesefundsfromacontractualbasis(thevhadnotma-
tured),butwouldhavedimcultv[borrowingfromtheselenders]goingforwardgiven
thereluctancetorepavearlv,RichardWesterkamp,theRichmondFedsleadexam-
ineratWachovia,toldtheFCIC.
Inonedav,thevalueofWachovias1o-vearbondsfellfrom:centstoiocentson
thedollar,andthecostofbuvingprotectionon1omillionofWachoviadebtjumped
from-1,oootoalmost1,aoo,oooannuallv.Wachoviasstockfelli,wipingout
8billioninmarketvalue.ComptrolleroftheCurrencvIohnDugan,whoseagencv
regulatedWachoviascommercialbanksubsidiarv,sentFDICChairmanBairashort
andalarmingemailstatingthatWachoviasliquiditvwasunstable.
8
Wachoviawasat
thefrontendofthedominoesasotherdominoesfell,SteeltoldtheFCIC.
o
Government omcials were not prepared to let Wachovia open for business on
Mondav,Septemberio,withoutadealinplace.
8o
Marketswerealreadvundercon-
siderable strain after the events involving Lehman Brothers, AIG, and WaMu, the
Feds Alvarez told the FCIC. There were fears that the failure of Wachovia would
leadinvestorstodoubtthefnancialstrengthofotherorganizationsinsimilarsitua-
tions,makingitharderforthoseinstitutionstoraisecapital.
81
Wells Fargo had alreadv expressed interest in buving Wachovia; bv Fridav, Citi-
grouphadaswell.Wachoviaenteredintoconfdentialitvagreementswithbothcom-
panies on Fridav and the two suitors immediatelv began their due diligence
investigations.
8i
ThekevquestionwaswhethertheFDICwouldprovideassistanceinanacquisi-
tion.ThoughCitigroupneverconsideredmakingabidthatdidnotpresupposesuch
assistance,WellsFargowasinitiallvinterestedinpurchasingallofWachoviawithout
it.
8:
FDICassistancewouldrequirethefrst-everapplicationofthesvstemicriskex-
ceptionunderFDICIA.Overtheweekend,federalomcialshurriedlvconsideredthe
.( ii N\Nti \i tii :i : i NuUi i tu\\i : :i uN iiiui1
svstemicrisksiftheFDICdidnotinterveneandifcreditorsanduninsureddeposi-
torssufferedlosses.
The signs for the bank were discouraging. Given the recent withdrawals, the
FDICandOCCpredictedinaninternalanalvsisthatWachoviacouldfaceupto11-
billionofadditionalcashoutfowsthefollowingweekincluding,mostprominentlv,
aibillionoffurtherdepositoutfows,aswellas1ibillionfromcorporatedeposit
accountsand:obillionfromretailbrokeragecustomers.YetWachoviahadonlv1
billion in cash and cash equivalents. While the FDIC and OCC estimated that the
companv could use its collateral to raise another 8o billion through the Feds dis-
count window, the repo market, and the Federal Home Loan Banks, even those ef-
forts would bring the amount on hand to onlv 1o: billion to cover the potential
11-billionoutfow.
8a
Duringtheweekend,theFedarguedthatWachoviashouldbesaved,withFDIC
assistance if necessarv. Its analvsis focused on the frms counterparties and other
interdependencies with large market participants, and stated that asset sales bv
mutual funds could cause short-term funding markets to virtuallv shut down.
8-
AccordingtosupportinganalvsisbvtheRichmondFed,mutualfundsheldoobil-
lion of Wachovia debt, which Richmond Fed staff concluded represented signif-
cantsvstemicconsequences;andinvestmentbanks,alreadvweakandexposedto
lowlevelsofconfdence,owned:obillionofWachovias1o1billiondebtandde-
posits. These frms were in danger of becoming even more reliant on Federal Re-
serve support programs, such as PDCF, to support operations in the event of a
Wachovia[-led]disruption.
8o
In addition, Fed staff argued that a Wachovia failure would cause banks to be-
come even less willing to lend to businesses and households. . . . [T]hese effects
wouldcontributetoweakereconomicperformance,higherunemplovment,andre-
ducedwealth.
8
SecretarvPaulsonhadrecusedhimselffromthedecisionbecauseof
his ties to Steel, but other members of Treasurv had vigorouslv advocated saving
Wachovia.
88
WhiteHouseChiefofStaffIoshBoltencalledBaironSundavtoexpress
supportforthesvstemicriskexception.
8o
Atabouto:ooP.M.onSundav,Septemberi8,WellssKovacevichtoldSteelthathe
wantedmoretimetoreviewWachoviasassets,particularlvitscommercialrealestate
holdings,andcouldnotmakeabidbeforeMondavifthereweretobenoFDICassis-
tance.SoWellsandCitigroupcametothetablewithproposalspredicatedonsuchas-
sistance.Wellsofferedtocoverthefrstibillionoflossesonapoolof1ibillion
worth of assets as well as 8o of subsequent losses, if thev grew large enough, cap-
pingtheFDICslossesatiobillion.CitigroupwantedtheFDICtocoverlossesona
different,andlarger,poolof:1ibillionworthofassets,butproposedtocoverthe
frst:obillionoflossesandanadditionalabillionavearforthreevears,whilegiv-
ingtheFDIC1ibillioninWachoviapreferredstockandstockwarrants(rightsto
buvstockatapredeterminedprice)ascompensation;theFDICwouldcoveranvad-
ditionallossesaboveaibillion.
oo
FDICstaffexpectedWachoviaslossestobebetween:-billionand-ibillion.
Onthebasisofthatanalvsisandtheparticularsoftheoffers,thevestimatedthatthe
tii :i : \Ni i\Ni t .(+
Wells proposal would cost the FDIC between -.o billion and .i billion, whereas
theCitigroupproposalwouldcosttheFDICnothing.LateSundav,Wachoviasubmit-
teditsownproposal,underwhichtheFDICwouldprovideassistancedirectlvtothe
banksothatitcouldsurviveasastand-aloneentitv.
o1
But the FDIC still hadnt decided to support the svstemic risk exception. Its
boardwhichincludedtheheadsoftheOCCandOTSmetato:ooA.M.onMon-
dav,Septemberio,todecideWachoviasfatebeforethemarketsopened.
oi
FDICAs-
sociate Director Miguel Browne hewed closelv to the analvsis prepared bv the
RichmondFed:Wachoviasfailurecarriedtheriskofknockingdowntoomanvdomi-
noes in lines stretching in too manv directions whose fall would hurt too manv
people,includingAmericantaxpavers.Healsoraisedconcernsaboutpotentialglobal
implicationsandreducedconfdenceinthedollar.Bairremainedreluctanttointer-
vene in private fnancial markets but ultimatelv agreed. Well, I think this is, vou
know . . . one option of a lot of not-verv-good options, she said at the meeting. I
haveacquiescedinthatdecisionbasedontheinputofmvcolleagues,andthefactthe
statutegivesmultipledecisionmakersasavinthisprocess.Imnotcompletelvcom-
fortablewithitbutweneedtomoveforwardwithsomething,clearlv,becausethisin-
stitutionisinatenuoussituation.
o:
TowintheapprovalofBairandIohnReich(theOTSdirectorwhoservedonthe
FDICboard),Treasurvultimatelvagreedtotaketheunusualstepoffundingallgov-
ernment losses from the proposed transaction.
oa
Without this express commitment
from Treasurv, the FDIC would have been the frst to bear losses out of its Deposit
Insurance Fund, which then held about :a.o billion; normallv, help would have
comefromTreasurvonlvafterthatfundwasdepleted.
o-
Accordingtotheminutesof
the meeting, Bair thought it was especiallv important that Treasurv agree to fund
losses,giventhatithasvigorouslvadvocatedthetransaction.
oo
After just :o minutes, the FDIC board voted to support government assistance.
Theresolutionalsoidentifedthewinningbidder:Citigroup.Itwasthefogofwar,
Bair told the FCIC. The svstem was highlv unstable. Who was going to take the
chancethatWachoviawouldhaveadepositorvrunonMondav:
o
Wachovias board quicklv voted to accept Citigroups bid. Wachovia, Citigroup,
and the FDIC signed an agreement in principle and Wachovia and Citigroup exe-
cutedanexclusivitvagreementthatprohibitedWachoviafrom,amongotherthings,
negotiatingwithotherpotentialacquirers.
o8
Inthemidstofthemarketturmoil,theFederalOpenMarketCommitteemetat
theendofSeptemberioo8,ataboutthetimeoftheannouncedCitigroupacquisition
ofWachoviaandtheinvocationofthesvstemicriskexception.Theplannedmerger
of two verv large institutions led to some concern among FOMC participants that
biggerandbiggerfrmswerebeingcreatedthatwouldbetoobigtofail,accordinga
letterfromChairmanBernanketotheFCIC.Headdedthathesharedthisconcern,
andvoicedmvhopethatTARPwouldcreateoptionsotherthanmergersformanag-
ingproblemsatlargeinstitutionsandthatsubsequentlv,throughtheprocessofregu-
latorvreform,wemightdevelopgoodresolutionmechanismsanddecisivelvaddress
theissuesoffnancialconcentrationandtoobigtofail.
oo
.,+ ii N\Nti \i tii :i : i NuUi i tu\\i : :i uN iiiui1
Citigroup and Wachovia immediatelv began working on the dealeven as Wa-
choviasstockfell81.oto1.8aonSeptemberio,thedavthatTARPwasinitiallvre-
jected bv lawmakers. Thev faced tremendous pressure from the regulators and the
markets to conclude the transaction before the following Mondav, but the deal was
complicated: Citigroup was not acquiring the holding companv, just the bank, and
Citigroup wanted to change some of the original terms. Then came a surprise: on
Thursdavmorning,Octoberi,WellsFargoreturnedtothetableandmadeacompet-
ing bid to buv all of Wachovia for a shareseven times Citigroups bid, with no
governmentassistance.
There was a great deal of speculation over the timing of Wells Fargos new pro-
posal,particularlvgivenIRSNoticeioo8-8:.Thisadministrativeruling,issuedjust
twodavsearlier,allowedanacquiringcompanvtowriteoffthelossesofanacquired
companvimmediatelv,ratherthanspreadingthemovertime. WellstoldtheSECthat
theIRSrulingpermittedthebanktoreducetaxableincomebv:billioninthefrst
vearfollowingtheacquisitionratherthanbv1billionpervearforthreevears.How-
ever,WellssaidthiswasitselfnotamajorfactorinitsdecisiontobidforWachovia
withoutdirectgovernmentassistance.
1oo
FormerWellschairmanKovacevichtoldthe
FCIC that Wellss revised bid refected additional due diligence, the point he had
madetoWachoviaCEOSteelatthetime.
1o1
ButtheFDICsBairsaidKovacevichtold
heratthetimethatthetaxchangehadbeenafactorleadingtoWellssrevisedbid.
1oi
OnThursdav,Octoberi,threedavsafteracceptingCitigroupsfederallvassisted
offer,Wachoviasboardconvenedanemergencv11:ooP.M.sessiontodiscussWellss
revisedbid.TheWachoviaboardvotedunanimouslvinfavor.
Atabout::ooA.M.Fridav,WachoviasSteel,itsGeneralCounselIaneSherburne,
and FDIC Chairman Bair called Citigroup CEO Vikram Pandit to inform him that
WachoviahadsignedadefnitivemergeragreementwithWells.Steelreadfrompre-
pared notes. Pandit was stunned. He was disappointed. Thats an understatement,
Steel told the FCIC.
1o:
Pandit thought Citigroup and Wachovia alreadv had a deal.
AfterSteelandSherburnedroppedoffthephonecall,PanditaskedBairifCitigroup
could keep its original loss-sharing agreement to purchase Wachovia if it matched
Wellss offer of a share. Bair said no, reasoning that the FDIC was not going to
standinthewavofaprivatedeal.NorwasittheroleoftheagencvtohelpCitigroup
inabiddingwar.ShealsotoldtheFCICthatshehadconcernsaboutCitigroupsown
viabilitvifitacquiredWachoviaforthatprice.Inrealitv,wedidntknowhowunsta-
bleCitigroupwasatthatpoint,ChairmanBairsaid.Hereweweresellingatroubled
institution . . .withatroubledmortgageportfoliotoanothertroubledinstitution. . . .
Ithinkifthatdealhadgonethrough,Citigroupwouldhavehadtohavebeenbailed
outagain.
1oa
LaterFridavmorning,WachoviaannouncedthedealwithWellswiththeblessing
oftheFDIC.ThisagreementwontrequireevenapennvfromtheFDIC,Kovacevich
saidinthepressrelease.SteeladdedthatthedealenablesustokeepWachoviaintact
andpreservethevalueofanintegratedcompanv,withoutgovernmentsupport.
1o-
OnMondav,Octobero,CitigroupfledsuittoenjoinWellsFargosacquisitionof
tii :i : \Ni i\Ni t .,.
Wachovia,butwithoutsuccess.TheWellsFargodealwouldcloseatmidnightonDe-
cember:1,forpershare.
IRSNoticeioo8-8:wasrepealediniooo.TheTreasurvsinspectorgeneral,who
later conducted an investigation of the circumstances of its issuance, reported that
thepurposeofthenoticewastoencouragestrongbankstoacquireweakbanksbvre-
moving limitations on the use of tax losses. The inspector general concluded that
therewasalegitimateargumentthatthenoticemavhavebeenanimproperchangeof
thetaxcodebvTreasurv;theConstitutionallowsCongressalonetochangethetax
code.Acongressionalreportestimatedthatrepealingthenoticesavedaboutbil-
lionoftaxrevenuesover1ovears.
1oo
However,theWellscontroller,RichardLevv,told
theFCICthattodateWellshasnotrecognizedanvbeneftsfromthenotice,because
ithasnotvethadtaxableincometooffset.
1o
TARP: COMPREHENSIVE APPROACH
TendavsaftertheLehmanbankruptcv,theFedhadprovidednearlv:oobillionto
investmentbanksandcommercialbanksthroughthePDCFandTSLFlendingfacili-
ties,inanattempttoquellthestormsintherepomarkets,andtheFedandTreasurv
had announced unprecedented programs to support monev market funds. Bv the
endofSeptember,theFedsbalancesheethadgrownoto1.-trillion.
ButtheFedwasrunningoutofoptions.Intheend,itcouldonlvmakecollateral-
ized loans to provide liquiditv support. It could not replenish fnancial institutions
capital,whichwasquicklvdissolving.Uncertaintvaboutfuturelossesonbadassets
made it dimcult for investors to determine which institutions could survive, even
with all the Feds new backstops. In short, the fnancial svstem was slipping awav
fromitslenderoflastresort.
OnThursdav,September18,theFedandTreasurvproposedwhatSecretarvPaul-
son called a comprehensive approach to stem the mounting crisis in the fnancial
svstem bv purchasing the toxic mortgage-related assets that were weighing down
manvbanksbalancesheets.
1o8
IntheearlvhoursofSaturdav,Septemberio,asGold-
manSachsandMorganStanlevwerepreparingtobecomebankholdingcompanies,
Treasurv sent Congress a draft proposal of the legislation for TARP. The modest
lengthofthatdocumentjustthreepagesbelieditshistoricalsignifcance.Itwould
giveTreasurvtheauthoritvtospendasmuchasoobilliontopurchasetoxicassets
fromfnancialinstitutions.
Theinitialreactionwasnotpromising.Forexample,SenateBankingCommittee
Chairman Christopher Dodd said on Tuesdav, This proposal is stunning and un-
precedentedinitsscopeandlackofdetail,Imightadd.Therearevervfewdetails
inthislegislation,RankingMemberRichardShelbvsaid.Ratherthanestablishinga
comprehensive, workable plan for resolving this crisis, I believe this legislation
merelvcodifesTreasurvsadhocapproach.
1oo
Paulson told a Senate committee on Tuesdav, Of course, we all believe that the
verv best thing we can do is make sure that the capital markets are open and that
.,z ii N\Nti \i tii :i : i NuUi i tu\\i : :i uN iiiui1
lendersarecontinuingtolend.Andsothatiswhatthisoverallprogramdoes,itdeals
withthat.
11o
BernanketoldtheIointEconomicCommitteeWednesdav:Ithinkthat
this is the most signifcant fnancial crisis in the post-War period for the United
States,andithasinfactaglobalreach. . . .Ithinkitisextraordinarilvimportantto
understand that, as we have seen in manv previous examples of different countries
and different times, choking up of credit is like taking the lifeblood awav from the
economv.
111
He told the House Financial Services Committee on the same dav,
People are saving, Wall Street, what does it have to do with me: That is the wav
thev are thinking about it. Unfortunatelv, it has a lot to do with them. It will affect
their companv, it will affect their job, it will affect their economv. That affects their
ownlives,affectstheirabilitvtoborrowandtosaveandtosaveforretirementandso
on.
11i
BvtheeveningofSundav,Septemberi8,asbankersandregulatorshammered
outWachoviasrescue,congressionalnegotiatorshadagreedontheoutlinesofadeal.
SenatorMelMartinez,aformerHUDsecretarvandthenamemberoftheBank-
ing Committee, told the FCIC about a meeting with Paulson and Bernanke that
Sundav:
Ijustrememberthinking,vouknow,Armageddon.Thethingthatwas
themostfrighteningaboutitisthatevenwiththemaskingforextraor-
dinarvpowers,thatthevwerenotatallassuredthatthevcouldprevent
the kind of fnancial disaster that I think reallv was greater than the
GreatDepression. . . .AndobviouslvtoapersonlikemvselfIthinkvou
think,Wow,iftheseguvsthatareinthemiddleofitandholdthetitles
thatthevholdbelievethistobeasdarkasthevrepaintingit,itmustbe
prettvdarneddark.
11:
Nevertheless, on Mondav, September io, just hours after Citigroup had an-
nounced its proposed government-assisted acquisition of Wachovia, the House re-
jectedTARPbvavoteofii8toio-.Themarketsresponsewasimmediate:theDow
IonesIndustrialAveragequicklvplunged8points,oralmost.
Tobroadenthebillsappeal,TARPssupportersmadechanges,includingatempo-
rarv increase in the cap on FDICs deposit insurance coverage from 1oo,ooo to
i-o,ooopercustomeraccount.
11a
OnWednesdavevening,theSenatevotedinfavor
bv a margin of a to i-. On Fridav, October :, the House agreed, io: to 11, and
President George W. Bush signed the law, which had grown to 1oo pages. TARPs
statedgoalwastorestoreliquiditvandconfdenceinfnancialmarketsbvproviding
authoritvfortheFederalGovernmenttopurchaseandinsurecertaintvpesoftrou-
bledassetsforthepurposesofprovidingstabilitvtoandpreventingdisruptioninthe
economvandfnancialsvstemandprotectingtaxpavers.
11-
Toprovideoversightfor
the oo billion program, the legislation established the Congressional Oversight
Panel and the Omce of the Special Inspector General for the Troubled Asset Relief
Program(SIGTARP).
Butthemarketscontinuedtodeteriorate.OnMondav,Octobero,theDowclosed
below1o,oooforthefrsttimeinfourvears;bvtheendoftheweekitwasdownal-
tii :i : \Ni i\Ni t .,.
most1,ooopoints,or18,belowitspeakinOctoberioo.Thespreadbetweenthe
interestrateatwhichbankslendtooneanotherandinterestratesonTreasuriesa
closelvwatchedindicatorofmarketconfdencehitanall-timehigh.Andthedollar
value of outstanding commercial paper issued bv both fnancial and nonfnancial
companies had fallen bv ioa billion in the month between Lehmans failure and
TARPs enactment. Even frms that had survived the previous disruptions in the
commercial paper markets were now feeling the strain. In response, on October ,
theFedcreatedvetanotheremergencvprogram,theCommercialPaperFundingFa-
cilitv,topurchasesecuredandunsecuredcommercialpaperdirectlvfromeligibleis-
suers.
11o
Thisprogram,whichallowedfrmstorollovertheirdebt,wouldbewidelv
used bv fnancial and nonfnancial frms. The three fnancial frms that made the
greatestuseoftheprogramwereforeigninstitutions:UBS(whichborrowedacumu-
lative i billion over time), Dexia (-: billion), and Barclavs (:8 billion). Other
fnancialfrmsincludedGECapital(1obillion),PrudentialFunding(i.abillion),
andTovotaMotorCreditCorporation(:.obillion).Nonfnancialfrmsthatpartici-
pated included Verizon (1.- billion), Harlev-Davidson (i.: billion), McDonalds,
(io:million)andGeorgiaTransmission(1oomillion).
11
Treasurv was alreadv rethinking TARP. The best wav to structure the program
wasnotobvious.Whichtoxicassetswouldqualifv:Howwouldthegovernmentde-
terminefairpricesinanilliquidmarket:Wouldfrmsholdingtheseassetsagreeto
sellthematafairpriceifdoingsowouldrequirethemtorealizelosses:Howcould
the government avoid overpaving: Such problems would take time to solve, and
Treasurvwantedtobringstabilitvtothedeterioratingmarketsasquicklvaspossible.
The kev concern for markets and regulators was that thev werent sure thev un-
derstoodtheextentoftoxicassetsonthebalancesheetsoffnancialinstitutionsso
thev couldnt be sure which banks were reallv solvent. The quickest reassurance,
then, would be to simplv recapitalize the fnancial sector. The change was allowed
undertheTARPlegislation,whichstatedthatTreasurv,inconsultationwiththeFed,
could purchase fnancial instruments, including stock, if thev deemed such pur-
chases necessarv to promote fnancial market stabilitv. However, the new proposal
wouldposeahostofnewproblems.Bvinjectingcapitalinthesefrms,thegovern-
mentwouldbecomeamajorshareholderintheprivatefnancialsector.
OnSundav,October1i,afteragreeingtothetermsofthecapitalinjections,Paul-
son,Bernanke,Bair,Dugan,andGeithnerselectedasmallgroupofmajorfnancial
institutionstowhichthevwouldimmediatelvoffercapital:thefourlargestcommer-
cial bank holding companies (Bank of America, Citigroup, IP Morgan, and Wells),
the three remaining large investment banks (Goldman and Morgan Stanlev, which
werenowbankholdingcompanies,andMerrill,whichBankofAmericahadagreed
toacquire),andtwoimportantclearingandsettlementbanks(BNYMellonandState
Street). Together, these nine institutions held more than 11 trillion in assets, or
about-ofallassetsinU.S.banks.
PaulsonsummonedthefrmschiefexecutivestoWashingtononColumbusDav,
October1:.
118
AlongwithBernanke,Bair,Dugan,andGeithner,Paulsonexplained
thatTreasurvhadsetasidei-obillionfromTARPtopurchaseequitvinfnancial
.,. ii N\Nti \i tii :i : i NuUi i tu\\i : :i uN iiiui1
institutionsunderthenewlvformedCapitalPurchaseProgram(CPP).Specifcallv,
Treasurv would purchase senior preferred stock that would pav a - dividend for
thefrstfvevears;theratewouldrisetoothereaftertoencouragethecompanies
topavthegovernmentback.FirmswouldalsohavetoissuestockwarrantstoTreas-
urvandagreetoabidebvcertainstandardsforexecutivecompensationandcorpo-
rategovernance.
Theregulatorshadalreadvdecidedtoallocatehalfofthesefundstotheninefrms
assembledthatdav:i-billioneachtoCitigroup,IPMorgan,andWells;1-billion
to Bank of America; 1o billion each to Merrill, Morgan Stanlev, and Goldman; :
billiontoBNYMellon;andibilliontoStateStreet.
Wedidntwantittolookorbelikeanationalizationofthebankingsector,Paul-
sontoldtheFCIC.Forthatreason,thecapitalinjectionstooktheformofnonvoting
stock, and the terms were intended to be attractive.
11o
Paulson emphasized the im-
portanceofthebanksparticipationtoprovideconfdencetothesvstem.Hetoldthe
CEOs:Ifvoudonttake[thecapital]andsometimelatervourregulatortellsvouthat
vouareundercapitalized . . .voumavnotlikethetermsifvouhavetocomebackto
me.
1io
Allninefrmstookthedeal.Thevmadeacoherent,Ithought,acogentargu-
ment about responding to this crisis, which, remember, was getting dramaticallv
worse.Itwasntleadingtoarunonsomeofthebanksbutitwasgettingworseinthe
marketplace,IPMorgansDimontoldtheFCIC.
1i1
To further reassure markets that it would not allow the largest fnancial institu-
tionstofail,thegovernmentalsoannouncedtwonewFDICprogramsthenextdav.
ThefrsttemporarilvguaranteedcertainseniordebtforallFDIC-insuredinstitutions
and some holding companies. This program was used broadlv. For example, Gold-
manSachshadiobillionindebtbackedbvtheFDICoutstandinginIanuarviooo,
and i1 billion at the end of iooo, according to public flings; Morgan Stanlev had
1obillionattheendofioo8andiabillionattheendofiooo.GECapital,oneof
theheaviestusersoftheprogram,had:-billionofFDIC-backeddebtoutstanding
at the end of ioo8 and oo billion at the end of iooo. Citigroup had :i billion of
FDIC guaranteed debt outstanding at the end of ioo8 and o- billion at the end of
iooo;IPMorganChasehadi1billionoutstandingattheendofioo8anda1billion
attheendofiooo.
Thesecondprovideddepositinsurancetocertainnon-interest-bearingdeposits,
likecheckingaccounts,atallinsureddepositorvinstitution.
1ii
Becauseoftheriskto
taxpavers, the measures required the Fed, the FDIC, and Treasurv to declare a svs-
temicriskexceptionunderFDICIA,asthevhaddonetwoweeksearliertofacilitate
CitigroupsbidforWachovia.
Later in the week, Treasurv opened TARP to qualifving healthv and viable
banks,thrifts,andholdingcompanies,underthesametermsthatthefrstninefrms
had received.
1i:
The appropriate federal regulatorthe Fed, FDIC, OCC, or OTS
wouldreviewapplicationsandpassthemtoTreasurvforfnalapproval.Theprogram
wasintendednotonlvtorestoreconfdenceinthebankingsvstembutalsotoprovide
banks with sumcient capital to fulfll their responsibilities in the areas of lending,
dividendandcompensationpolicies,andforeclosuremitigation.
1ia
tii :i : \Ni i\Ni t .,,
Thewholereasonfordesigningtheprogramwassomanvbankswouldtakeit,
wouldhavethecapital,andthatwouldleadtolending.Thatwasthewholepurpose,
PaulsontoldtheFCIC.However,therewerenospecifcrequirementsforthosebanks
to make loans to businesses and households. Right after we announced it we had
criticsstartsaving,Youvegottoforcethemtolend,Paulsonsaid.Althoughhesaid
he couldnt see how to do this, he did concede that the program could have been
moreeffectiveinthisregard.
1i-
Theenablinglegislationdidhaveprovisionsaffecting
the compensation of senior executives and participating frms abilitv to pav divi-
dends to shareholders. Over time, these provisions would become more stringent,
and the following vear, in compliance with another measure in the act that created
TARP, Treasurv would create the Omce of the Special Master for TARP Executive
Compensation to review the appropriateness of compensation packages among
TARPrecipients.
Treasurvinvestedabout188billioninfnancialinstitutionsunderTARPsCapi-
talPurchaseProgrambvtheendofioo8;ultimatelv,itwouldinvestio-billionin
ofnancialinstitutions.
1io
Intheensuingmonths,TreasurvwouldprovidemuchofTARPsremaininga-o
billiontospecifcfnancialinstitutions,includingAIG(aobillionplusa:obillion
lending facilitv), Citigroup (io billion plus loss guarantees), and Bank of America
(io billion). On December 1o, it established the Automotive Industrv Financing
Program,underwhichitultimatelvinvested81billionofTARPfundstomakein-
vestments in and loans to automobile manufacturers and auto fnance companies,
specifcallvGeneralMotors,GMAC,Chrvsler,andChrvslerFinancial.
1i
OnIanuarv
1i,iooo,PresidentBushnotifedCongressthatheintendednottoaccessthesecond
halfoftheoobillioninTARPfunds,sothathemightensurethatsuchfundsare
availableearlvforthenewadministration.
1i8
AsofSeptemberio1otwovearsafterTARPscreationTreasurvhadallocated
:o-billionoftheoobillionauthorized.Ofthatamount,ioabillionhadbeenre-
paid, 18- billion remained outstanding, and :.o billion in losses had been in-
curred.
1io
About -- billion of the outstanding funds were in the Capital Purchase
Program.TreasurvstillheldlargestakesinGM(o1ofcommonstock),AllvFinan-
cial(formerlvknownasGMAC;-o),andChrvsler(o).Moreover,a.-billionof
TARPfundsremainedinvestedinAIGinadditiontoao.billionofloansfromthe
NewYorkFedandaiobillionnon-TARPequitvinvestmentbvtheNewYorkFedin
twoofAIGsforeigninsurancecompanies.
1:o
BvDecemberio1o,allninecompanies
invitedtotheinitialColumbusDavmeetinghadfullvrepaidthegovernment.
1:1
Ofcourse,TARPwasonlvoneofmorethantwodozenemergencvprogramsto-
talingtrillionsofdollarsputinplaceduringthecrisistostabilizethefnancialsvstem
andtorescuespecifcfrms.Indeed,TARPwasnoteventhelargest.
1:i
Manvofthese
programs are discussed in this and previous chapters. For just some examples: The
FedsTSLFandPDCFprogramspeakedata8:billionand1-obillion,respectivelv.
Itsmonevmarketfundingpeakedat:-obillioninIanuarviooo,anditsCommer-
cial Paper Funding Facilitv peaked at :o- billion, also in Ianuarv iooo.
1::
When it
was introduced, the FDICs program to guarantee senior debt for all FDIC-insured
.,( ii N\Nti \i tii :i : i NuUi i tu\\i : :i uN iiiui1
institutionsstoodreadvtobackstopasmuchaso:obillioninbankdebt.TheFeds
largest program, announced in November ioo8, purchased 1.i- trillion in agencv
mortgagebackedsecurities.
1:a
AIG: WE NEEDED TO STOP
THE SUCKING CHEST WOUND IN THIS PATIENT
AIGwouldbethefrstTARPrecipientthatwasnotpartoftheCapitalPurchasePro-
gram.Itstillhadtwobigholestofll,despitethe8-billionloanfromtheNewYork
Fed. Its securities-lending business was underwater despite pavments in September
andOctoberofiabillionthattheFedloanhadenabled;anditstillneededibil-
liontopavcreditdefaultswap(CDS)counterparties,despiteearlierpavmentsof:-
billion.
OnNovember1o,thegovernmentannouncedthatitwasrestructuringtheNew
YorkFedloanand,intheprocess,TreasurvwouldpurchaseaobillioninAIGpre-
ferredstock.AswasdoneintheCapitalPurchaseProgram,inreturnfortheequitv
provided, Treasurv received stock warrants from AIG and imposed restrictions on
dividendsandexecutivecompensation.
That dav, the New York Fed created two off-balance-sheet entities to hold AIGs
bad assets associated with securities lending (Maiden Lane II) and CDS (Maiden
LaneIII).Overthenextmonth,theNewYorkFedloanedMaidenLaneII1o.8bil-
lion so that it could purchase mortgage-backed securities from AIGs life insurance
companv subsidiaries. This enabled those subsidiaries to pav back their securities-
lendingcounterparties,bringingtoa:.billionthetotalpavmentsAIGwouldmake
withgovernmenthelp.Thesepavmentsarelistedinfgureio.a.
1:-
MaidenLaneIIIwascreatedwithaia.:billionloanfromtheNewYorkFedand
anAIGinvestmentof-billion,supportedbvtheTreasurvinvestment.Thatmonev
went to buv CDOs from 1o of AIG Financial Products CDS counterparties. The
CDOshadafacevalueofoi.1billion,whichAIGFinancialProductshadguaran-
teedthroughitsCDS.
1:o
BecauseAIGhadalreadvposted:-billionincollateralto
itscounterparties,MaidenLaneIIIpaidi.1billiontothosecounterparties,provid-
ingthemwiththefullfaceamountoftheCDOsinreturnforthecancellationoftheir
rightsundertheCDS.
1:
AconditionofthistransactionwasthatAIGwaiveitslegal
claimsagainstthosecounterparties.Thesepavmentsarelistedinfgureio.a.
GoldmanSachsreceived1abillioninpavmentsfromMaidenLaneIIIrelatedto
the CDS it had purchased from AIG. During the FCICs Ianuarv 1:, io1o, hearing,
GoldmanCEOLlovdBlankfeintestifedthatGoldmanSachswouldnothavelostanv
monevifAIGhadfailed,becausehisfrmhadpurchasedcreditprotectiontocover
the difference between the amount of collateral it demanded from AIG and the
amountofcollateralpaidbvAIG.
1:8
DocumentssubmittedtotheFCICbvGoldman
afterthehearingdoshowthatthefrmownedi.abillionofcreditprotectioninthe
formofCDSonAIG,althoughmuchofthatprotectioncamefromfnanciallvunsta-
ble companies, including Citibank (aoi.: million), which itself had to be propped
up bv the government, and Lehman (1a.8 million), which was bankrupt bv the
Payments to AIG Counterparties
Payments to AIG Securities
Lending Counterparties
IN BILLIONS OF DOLLARS
Sept. 18 to Dec. 12, 2008
Barclays $7.0
Deutsche Bank 6.4
BNP Paribas 4.9
Goldman Sachs 4.8
Bank of America 4.5
HSBC 3.3
Citigroup 2.3
Dresdner Kleinwort 2.2
Merrill Lynch 1.9
UBS 1.7
ING 1.5
Morgan Stanley 1.0
Socit Gnrale 0.9
AIG International 0.6
Credit Suisse 0.4
Paloma Securities 0.2
Citadel 0.2
TOTAL $43.7
Payments to AIG Credit Default
Swap Counterparties
IN BILLIONS OF DOLLARS
As of Nov. 17, 2008
Maiden Collateral
Lane III payments
payment from AIG
Socit Gnrale $6.9 $9.6
Goldman Sachs 5.6 8.4
Merrill Lynch 3.1 3.1
Deutsche Bank 2.8 5.7
UBS 2.5 1.3
Calyon 1.2 3.1
Deutsche Zentral-Genossenschaftsbank 1.0 0.8
Bank of Montreal 0.9 0.5
Wachovia 0.8 0.2
Barclays 0.6 0.9
Bank of America 0.5 0.3
Royal Bank of Scotland 0.5 0.6
Dresdner Bank AG 0.4 0.0
Rabobank 0.3 0.3
Landesbank Baden-Wuerttemberg 0.1 0.0
HSBC Bank USA 0.0 0.2
TOTAL $27.1 $35.0
SOURCE: Special Inspector General for TARP
Of this total, $19.5 billion came
from Maiden Lane II, $17.2
billion came from the Federal
Reserve Bank of New York, and
$7 billion came from AIG.
NOTE: Amounts may not add due to rounding.
Iigurcao.,
tii :i : \Ni i\Ni t .,,
timeAIGwasrescued.
1:o
InanFCIChearing,GoldmanCFODavidViniarsaidthat
thosecounterpartieshadpostedcollateral.
1ao
Goldman also argued that the 1a billion of CDS protection that it purchased
from AIG was part of Goldmans matched book, meaning that Goldman sold 1a
billioninoffsettingprotectiontoitsownclients;itprovidedinformationtotheFCIC
indicatingthatthe1abillionreceivedfromMaidenLaneIIIwasentirelvpaidtoits
clients.
1a1
Without the federal assistance, Goldman would have had to fnd the 1a
billionsomeotherwav.
., ii N\Nti \i tii :i : i NuUi i tu\\i : :i uN iiiui1
GoldmanalsoproduceddocumentstotheFCICthatshoweditreceived:.abil-
lionfromAIGrelatedtocreditdefaultswapsonCDOsthatwerenotpartofMaiden
LaneIII.Ofthat:.abillion,1.obillionwasreceivedafter,andthusmadepossible
bv,thefederalbailoutofAIG.Andmosti.obillionofthetotalwasforpropri-
etarvtrades(thatis,tradesmadesolelvforGoldmansbeneftratherthanonbehalfof
aclient)largelvrelatingtoGoldmansAbacusCDOs.Thus,unlikethe1abillionre-
ceivedfromAIGontradesinwhichGoldmanowedthemonevtoitsowncounter-
parties,thisi.obillionwasretainedbvGoldman.
1ai
ThatAIGscounterpartiesdidnotincuranvlossesontheirinvestmentsbecause
AIG, once it was backed bv the government, paid claims to CDS counterparties at
1oooffacevaluehasbeenwidelvcriticized.InNovemberiooo,SIGTARPfaulted
the New York Fed for failing to obtain concessions. The inspector general said that
sevenofthetopeightcounterpartieshadinsistedon1oocoverageandthattheNew
York Fed had agreed because efforts to obtain concessions from all counterparties
hadlittlehopeofsuccess.
1a:
SIGTARPwashighlvcriticaloftheNewYorkFedsnegotiations.Fromtheoutset,
itfound,theNewYorkFedwaspoorlvpreparedtoassistAIG.TopreventAIGsfail-
ure,theNewYorkFedhadhastilvagreedtothe8-billionbailoutonsubstantiallv
the same terms that a private-sector group had contemplated.
1aa
SIGTARP blamed
theFedsownnegotiatingstrategvfortheoutcome,whichitdescribedasthetransfer
of billions of dollars of cash from the Government to AIGs counterparties, even
thoughseniorpolicvmakerscontendthatassistancetoAIGscounterpartieswasnot
arelevantconsideration.
1a-
In Iune io1o, TARPs Congressional Oversight Panel criticized the AIG bailout
forhavingapoisonouseffectoncapitalmarkets.Thereportsaidthegovernments
failuretorequiresharedsacrifceamongAIGscreditorseffectivelvalteredtherela-
tionshipbetweenthegovernmentandthemarkets,signalinganimplicittoobigto
failguaranteeforcertainfrms.ThereportsaidtheNewYorkFedshouldhavein-
sistedonconcessionsfromcounterparties.
1ao
TreasurvandFedomcialscounteredthatconcessionswouldhaveledtoaninstant
ratingsdowngradeandprecipitatedarunonAIG.
1a
NewYorkFedomcialstoldthe
FCICthatthevhadvervlittlebargainingpowerwithcounterpartieswhowerepro-
tected bv the terms of their CDS contracts. And, after providing a 8- billion loan,
thegovernmentcouldnotletAIGfail.Counterpartiessaidwegotthecollateral,the
contractual rights, vouve been rescued bv the Fed, Uncle Sams behind vou, whv
wouldweletvououtofacontractvouagreedto:NewYorkFedGeneralCounsel
TomBaxtertoldtheFCIC.Andthenthequestionwas,shouldweuseourregulatorv
power to leverage counterparties. From mv view, that would have been completelv
inappropriate, an abuse of power, and not something we were willing to even con-
template.
1a8
SarahDahlgren,whowasinchargeoftheMaidenLaneIIItransactionattheNew
YorkFed,saidthegovernmentcouldnothavethreatenedbankruptcv.Therewasa
fnancialmeltdown,shetoldtheFCIC.ThecredibilitvoftheUnitedStatesgovern-
ment was on the line.
1ao
SIGTARP acknowledged that the New York Fed felt ethi-
tii :i : \Ni i\Ni t .,+
callvrestrainedfromthreateninganAIGbankruptcvbecauseithadnoactualplans
tocarrvoutsuchathreatandthatitwasuncomfortableinterferingwiththesanc-
titv of the counterparties contractual rights with AIG, which were certainlv valid
concerns.
1-o
Geithnerhassaidhewasconfdentthatfullreimbursementwasabsolutelvthe
rightdecision.WediditinawavthatIbelievewasnotjustleastcosttothetaxpaver,
best deal for the taxpaver, but helped avoid much, much more damage than would
havehappenedwithoutthat.
1-1
NewYorkFedomcialstoldtheFCICthatthreatstoAIGssurvivalcontinuedafter
the 8- billion loan on September 1o.
1-i
If vou dont fx the [securities] lending or
theCDOs,[AIGwould]blowthroughthe8-billion.Soweneededtostopthesuck-
ingchestwoundinthispatient,Dahlgrensaid.ItwasntjustAIGitwasthefnan-
cialmarkets. . . .Itkeptgettingworseandworseandworse.
1-:
BaxtertoldtheFCICthatMaidenLaneIIIstoppedthehemorrhagefromAIG
FinancialProducts,whichwaspavingcollateraltocounterpartiesbvdrawingonthe
8- billion government loan. In addition, because Maiden Lane III received the
CDOsunderlvingtheCDS,asvaluecomesbackinthoseCDOs,thatsvaluethatis
goingtobefrstusedtopavofftheFedloan; . . .thelikelvoutcomeofMaidenLane
IIIisthatweregoingtobepaidinfull,hesaid.
1-a
Intotal,theFedandTreasurvhadmadeavailableover18obillioninassistance
toAIGtopreventitsfailure.
1--
AsofSeptember:o,io1o,thetotaloutstandingassis-
tancehasbeenreducedto1ia.8billion,primarilvthroughthesaleofAIGbusiness
units.
1-o
CITIGROUP: LET THE WORLD KNOW
THAT WE WILL NOT PULL A LEHMAN
ThefailedbidforWachoviarefectedbadlvonCitigroup.Itsstockfell18onOcto-
ber:,ioo8,thedavWachoviaannouncedthatitpreferredWellssoffer,andanother
a:withinaweek.Havingagreedtodothedealwasarecognitiononourpartthat
we needed it, Edward Ned Kellv III, vice chairman of Citigroup, told the FCIC.
Andifweneededitanddidntgetit,whatdidthatimplvforthestrengthofthefrm
goingforward:
1-
RogerCole,thenheadofbankingsupervisionattheFederalReserveBoard,saw
thefailedacquisitionasaturningpoint,themomentwhenCitireallvcameunder
the microscope. It was regarded [bv the market] as an indication of bad manage-
ment at Citi that thev lost the deal, and had it taken awav from them bv a smarter,
moreastuteWellsFargoteam,ColetoldtheFCIC.Andthenheresanorganization
thatdoesnthavethecorefunding[insureddeposits]thatwewereassumingthatthev
wouldgetbvthatdeal.
1-8
Citigroupsstockrose18thedavaftertheColumbusDavannouncementthatit
wouldreceivegovernmentcapital,buttheoptimismdidnotlast.Twodavslater,Citi-
group announced a i.8 billion net loss for the third quarter, concentrated in sub-
prime and Alt-A mortgages, commercial real estate investments, and structured
.+ ii N\Nti \i tii :i : i NuUi i tu\\i : :i uN iiiui1
investment vehicle (SIV) write-downs. The banks stock fell 1 in the following
weekand,bvNovember1i,hitsingledigitsforthefrsttimesince1ooo.
The markets unease was heightened bv press speculation that the companvs
boardhadlostconfdenceinseniormanagement,Kellvsaid.
1-o
OnNovember1o,the
companv announced that the value of the SIVs had fallen bv 1.1 billion in the
monthsinceithadreleasedthird-quarterearnings.Citigroupwasthereforegoingto
bringtheremaining1.abillioninoff-balance-sheetSIVassetsontoitsbooks.In-
vestors clipped almost another ia off the value of the stock, its largest single-dav
dropsincetheOctober1o8stockmarketcrash.Twodavslater,thestockclosedat
:..CreditdefaultsswapsonCitigroupreachedasteep-oo,oooannuallvtopro-
tect1omillioninCitigroupdebtagainstdefault.
1oo
AccordingtoKellv,thesedevel-
opmentsthreatenedtomakeperceptionsbecomearealitvforthebank:[Investors]
lookatthosespreadsandsav,IsthissomeplaceIreallvwanttoputmvmonev:And
thats not just in terms of wholesale funding, thats people who also have deposits
withusatvariouspoints.
1o1
Thefrmsvariousregulatorswatchedthestockprice,thedailvliquiditv,andthe
CDSspreadswithalarm.OnFridav,Novemberi1,theUnitedKingdomsFinancial
ServicesAuthoritv(FSA)imposedao.abillioncashlockuptoprotectCitigroups
London-basedbroker-dealer.FDICexaminersknewthatthisactionwouldbeverv
damagingtothebanksliquiditvandworriedthattheFSAorotherforeignregula-
torsmightimposeadditionalcashrequirementsinthefollowingweek.
1oi
Bvtheclose
ofbusinessFridav,therewaswidespreadconcernthatiftheU.S.governmentfailedto
act, Citigroup might not survive; its liquiditv problems had reached crisis propor-
tions.AmongregulatorsattheFDICandtheFed,therewasnodebate.
1o:
FedChair-
manBernanketoldtheFCIC,Wewerelookingatthisfrm[inthefallofioo8]and
saving,Citigroupisnotavervstrongfrm,butitsonlvonefrmandtheothersare
okav, but not recognizing that thats sort of like saving, Well, four out of vour fve
heartventriclesarefne,andtheffthoneislousv.Thevreallinterconnected,thevall
connecttoeachother;and,therefore,thefailureofonebringstheothersdown.
1oa
The FDICs Arthur Murton emailed his colleague Michael Krimminger on No-
vemberii:Giventhattheimmediateriskisliquiditv,thewavtoaddressthatisbv
lettingcounterpartiesknowthatthevwillbeprotectedbothatthebankandholding
companvlevel. . . .[T]hemainpointistolettheworldknowthatwewillnotpulla
Lehman.Krimminger,specialadvisertotheFDICchairman,agreed:Atthisstage,it
isprobablvappropriatetobeclearanddirectthattheUSgovernmentwillnotallow
Cititofailtomeetitsobligations.
1o-
Citigroupsowncalculationssuggestedthatadropindepositsofjust.iwould
wipeoutitscashsurplus.Ifthetrendofrecentwithdrawalscontinued,thecompanv
couldexpectaioutfowofdepositsperdav.UnlessCitigroupreceivedalargeand
immediateinjectionoffunds,itscofferswouldbeemptvbeforetheweekend.Mean-
while, Citigroup executives remained convinced that the companv was sound and
that the market was simplv panicking. CEO Pandit argued, This was not a funda-
mentalsituation,itwasnotaboutthecapitalwehad,notaboutthefundingwehadat
thattime,butwiththestockpricewhereitwas . . .perceptionbecomesrealitv.
1oo
All
tii :i : \Ni i\Ni t ..
that was needed, Citigroup contended, was for the government to expand access to
existing liquiditv facilities. People were questioning what evervthing was worth at
thetime. . . .[T]herewasafightnotjusttoqualitvandsafetv,butalmostafightto
certaintv,Kellv,thenPanditsadviser,toldtheFCIC.
1o
The FDIC dismissed Citigroups request that the government simplv expand its
access to existing liquiditv programs, concluding that anv incremental liquiditv
couldbequicklveliminatedasdepositorsrushedoutthedoor.Omcialsalsobelieved
thecompanvdidnothavesumcienthigh-qualitvcollateraltoborrowmoreunderthe
Fedsmostlvcollateral-basedliquiditvprograms.Inadditiontothei-billionfrom
TARP, Citigroup was alreadv getting bv on substantial government support. As of
Novemberi1,ithadia.:billionoutstandingundertheFedscollateralizedliquiditv
programsandioomillionundertheFedsCommercialPaperFundingFacilitv.And
ithadborrowed8abillionfromtheFederalHomeLoanBanks.InDecember,Citi-
groupwouldhaveatotalof:ibillioninseniordebtguaranteedbvtheFDICunder
thedebtguaranteeprogram.
OnSundav,Novemberi:,FDICstaffrecommendedtoitsboardthatathirdsvs-
temicriskexceptionbemadeunderFDICIA.
1o8
Asthevhaddonepreviouslv,regula-
tors decided that a proposed resolution had to be announced over the weekend to
buttressinvestorconfdencebeforemarketsopenedMondav.ThefailureofCitigroup
would signifcantlv undermine business and household confdence, according to
FDIC staff.
1oo
Regulators were also concerned that the economic effects of a Citi-
groupfailurewouldunderminetheimpactoftherecentlvimplementedCapitalPur-
chaseProgramunderTARP.
1o
Treasurv agreed to provide Citigroup with an additional io billion in TARP
fundsinexchangeforpreferredstockwithan8dividend.
11
Thisinjectionofcash
broughtthecompanvsTARPtabtoa-billion.Thebankalsoreceived1o.-billion
in capital benefts related to its issuance of preferred stock and the governments
guarantee of certain assets.
1i
Under the guarantee, Citigroup and the government
would identifv a :oo billion pool of assets around which a protective ring fence
wouldbeplaced.Ineffect,thiswasaloss-sharingagreementbetweenCitigroupand
thefederalgovernment.Therewasnotahugeamountofscienceincomingtothat
[:oobillion]number,CitigroupsKellvtoldtheFCIC.Hesaidthedealwasstruc-
tured to give the market comfort that the catastrophic risk has been taken off the
table.
1:
WhenitstermswerefnalizedinIanuarviooo,theguaranteedpool,which
containedmainlvloansandresidentialandcommercialmortgagebackedsecurities,
wasadjusteddownwardto:o1billion.
Citigroupassumedresponsibilitvforthefrst:o.-billioninlossesonthering-
fenced assets. The federal government would assume responsibilitv for oo of all
losses above that amount. Should these losses actuallv materialize, Treasurv would
absorb the frst - billion using TARP funds, the FDIC would absorb the next 1o
billionfromtheDepositInsuranceFund(forwhichithadneededtoapprovethesvs-
temic risk exception), and the Fed would absorb the balance. In return, Citigroup
agreedtograntthegovernmentbillioninpreferredstock,aswellaswarrantsthat
gavethegovernmenttheoptiontopurchaseadditionalshares.
1a
Afteranalvzingthe
.z ii N\Nti \i tii :i : i NuUi i tu\\i : :i uN iiiui1
qualitvoftheprotectedassets,FDICstaffprojectedthattheDepositInsuranceFund
wouldnotincuranvlosses.
1-
Onceagain,theFDICBoardmetlateonaSundavtodeterminethefateofastrug-
glinginstitution.Briefdissentonthe1oP.M.conferencecallcamefromOTSDirector
IohnReich,whoquestionedwhvsimilarreliefhadnotbeenextendedtoOTS-super-
visedthriftsthatfailedearlier.Thereisntanvdoubtinmvmindthatthisisasvs-
temicsituation,hesaid.Butheadded,
Inhindsight,Ithinktherehavebeensomesvstemicsituationspriorto
thisonethatwerenotclassifedassuch.ThefailureofIndvMacpointed
thefocustothenextweakestinstitution,whichwasWaMu,anditsfail-
ure pointed to Wachovia, and now were looking at Citi and I wonder
whosnext.Ihopethatalloftheregulators,allofus,includingTreasurv
andtheFed,arelookingatthesesituationsinabalancedmanner,andI
feartherehasbeensomeselectivecreativitvexercisedinthedetermina-
tionofwhatissvstemicandwhatsnotandwhatspossibleforthegov-
ernmenttodoandwhatsnot.
1o
The FDIC Board approved the proposal unanimouslv. The announcement beat
theopeningbell,andthemarketsrespondedpositivelv:Citigroupsstockpricesoared
almost -8, closing at -.o-. The ring fence would stav in place until December
iooo,atwhichtimeCitigroupterminatedthegovernmentguaranteeintandemwith
repavingiobillioninTARPfunds.InDecemberio1o,Treasurvannouncedthesale
ofitsfnalsharesofCitigroupscommonstock.
1
BANK OF AMERICA: A SHOTGUN WEDDING
WithCitigroupstabilized,themarketswouldquicklvshiftfocustothenextdomino:
BankofAmerica,whichhadswallowedCountrvwideearlierinthevearand,onSep-
tember1-,hadannounceditwasgoingtotakeonMerrillLvnchaswell.Themerger
wouldcreatetheworldslargestbrokerageandreinforceBankofAmericasposition
asthecountrvslargestdepositorvinstitution.Giventhesharepricesofthetwocom-
paniesatthetime,thetransactionwasvaluedat-obillion.
Butthedealwasnotsettocloseuntilthefrstquarterofthefollowingvear.Inthe
interim,thecompaniescontinuedtooperateasindependententities,pendingshare-
holderandregulatorvapproval.Forthatreason,MerrillCEOIohnThainandBank
of America CEO Ken Lewis had represented their companies separatelv at the
Columbus Dav meeting at Treasurv. Treasurv would invest the full i- billion in
BankofAmericaonlvaftertheMerrillacquisitionwascomplete.
InOctober,MerrillLvnchreportedanetlossforthethirdquarterof-.1billion.
InitsOctober1oearningspressrelease,MerrillLvnchdescribedwrite-downsrelated
toitsCDOpositionsandotherrealestaterelatedsecuritiesandassetsaffectedbvthe
severemarketdislocations.ThaintoldinvestorsontheconferencecallthatMerrills
strategvwastocleanhouse.Itnowheldlessthan1billioninasset-backed-securitv
tii :i : \Ni i\Ni t ..
CDOsandnoAlt-Apositionsatall.Weredowntoio-millioninsubprimeonour
trading books, Thain said. We cut our non-U.S. mortgage business positions in
half.
18
TheFedapprovedthemergeronNovemberio,notingthatbothBankofAmerica
and Merrill were well capitalized and would remain so after the merger, and that
BankofAmericahassumcientfnancialresourcestoeffecttheproposal.
1o
Share-
holdersofbothcompaniesapprovedtheacquisitiononDecember-.
ButthenBankofAmericaexecutivesbegantohavesecondthoughts,Lewistold
the FCIC. In mid-November, Merrill Lvnchs after-tax losses for the fourth quarter
hadbeenprojectedtoreachabout-billion;theprojectiongrewtoaboutbillion
bvDecember:,obillionbvDecembero,and1ibillionbvDecember1a.
18o
Lewis
saidhelearnedonlvonDecember1athatMerrillslosseshadacceleratedprettvdra-
maticallv.
181
Lewisattributedthelossestoamuch,much,higherdeteriorationofthe
assetsweidentifedthanwehadexpectedgoingintothefourthquarter.
18i
InaIanuarvconferencecall,LewisandCFOIoePricetoldinvestorsthatthebank
hadnotbeenawareoftheextentofMerrillsfourth-quarterlossesatthetimeofthe
shareholdervote.Itwasntanissueofnotidentifvingtheassets,KenLewissaid.It
wasthatwedidnotexpectthesignifcantdeterioration,whichhappenedinmid-to
lateDecemberthatwesaw.
18:
MerrillsThainconteststhatversionofevents.Hetold
theFCICthatMerrillprovideddailvproftandlossreportstoBankofAmericaand
that bank executives should have known about losses as thev occurred.
18a
The SEC
laterbroughtanenforcementactionagainstBankofAmerica,chargingthecompanv
withfailingtodiscloseabouto.-billionofknownandexpectedMerrillLvnchlosses
beforetheDecember-shareholdervote.AccordingtotheSECscomplaint,thesein-
sumcientdisclosuresdeprivedshareholdersofmaterialinformationthatwascritical
to their abilitv to fairlv evaluate the merger. In Februarv io1o, Bank of America
wouldpav1-omilliontosettletheSECsaction.
18-
On December 1, Lewis called Treasurv Secretarv Paulson to inform him that
Bank of America was considering invoking the material adverse change (MAC)
clauseofthemergeragreement,whichwouldallowthecompanvtoexitorrenegoti-
atethetermsoftheacquisition.Theseveritvofthelosseswerehighenoughthatwe
shouldatleastconsideraMAC,LewistoldtheFCIC.Theacceleration,wethought,
wasbevondwhatshouldbehappening.Andthensecondlv,vouhadamajorholebe-
ing created in the capital base with the lossesthat dramaticallv reduced [Merrill
Lvnchs]equitv.
18o
Thatafternoon,LewisfewfromNorthCarolinatoWashingtontomeetattheFed
withPaulsonandFedChairmanBernanke.ThetwoaskedLewistostanddownon
invokingtheclausewhilethevconsideredthesituation.
18
Paulson and Bernanke concluded that an attempt bv Bank of America to invoke
the MAC clause was not a legallv reasonable option. Thev believed that Bank of
Americawouldbeultimatelvunsuccessfulinthelegalaction,andthattheattendant
litigationwouldlikelvresultinBankofAmericastillbeingcontractuallvboundtoac-
quire a considerablv weaker Merrill Lvnch. Moreover, Bernanke thought the market
would lose faith in Bank of Americas management, given that review, preparation,
.. ii N\Nti \i tii :i : i NuUi i tu\\i : :i uN iiiui1
and due diligence had been ongoing for : months. The two omcials also believed
that invoking the clause would lead to a broader svstemic crisis that would result in
furtherdeteriorationatthetwocompanies.
188
Neither Merrill nor its CEO, Iohn Thain, was informed of these deliberations at
BankofAmerica.LewistoldtheFCICthathedidntcontactMerrillLvnchaboutthe
situationbecausehedidntwanttocreateanadversarialrelationshipifitcouldbe
avoided.
18o
WhenThainlaterfoundoutthatBankofAmericahadcontemplatedput-
tingtheMACclauseintoeffect,hewasskepticalaboutitschancesofsuccess:Oneof
the things we negotiated verv heavilv was the Material Adverse Change clause. [It]
specifcallvexcludedmarketmoves . . .[and]prettvmuchnothinghappenedtoMer-
rillinthefourthquarterotherthanthemarketmove.
1oo
On Sundav, December i1, Paulson informed Lewis that invoking the clause
woulddemonstrateacolossallossofjudgmentbvthecompanv.Paulsonreminded
LewisthattheFed,asitsregulator,hadthelegalauthoritvtoreplaceBankofAmer-
icasmanagementandboardifthevembarkedonadestructivestrategvthathadno
reasonable legal basis.
1o1
Bernanke later told his general counsel: Though we did
not order Lewis to go forward, we did indicate that we believed that going forward
[with the clause] would be detrimental to the health (safetv and soundness) of his
companv.CongressmanEdolphusTownsofNewYorkwouldlaterrefertotheBank
ofAmericaandMerrillLvnchmergerasashotgunwedding.
1oi
RegulatorsbegantodiscussarescuepackagesimilartotheoneforCitigroup,in-
cluding preferred shares and an asset pool similar to Citigroups ring fence. The
staff s analvsis was essentiallv the same as it had been for Citigroup. Meanwhile,
Lewisdecidedtodeescalatethesituation,explainingthatwhenthesecretarvofthe
treasurv and the chairman of the Fed sav that invoking the MAC would cause svs-
temic risk, then it obviouslv gives vou pause.
1o:
At a board meeting on December
ii,LewistoldhisboardthattheFedandTreasurvbelievedthatafailedacquisition
wouldposesvstemicriskandwouldleadtoremovalofmanagementandtheboardat
theinsistenceofthegovernment,andthatthegovernmentwouldprovideassistance
toprotect[BankofAmerica]againsttheadverseimpactofcertainMerrillLvnchas-
sets,althoughsuchassistancecouldnotbeprovidedintimeforthemergerscloseon
Ianuarv1,iooo.
1oa
TheboarddecidednottoexercisetheMACandtoproceedasplanned,withthe
understandingthatthegovernmentsassistancewouldbefullvdocumentedbvthe
time fourth-quarter earnings were announced in mid-Ianuarv.
1o-
Obviouslv if [the
MAC clause] actuallv would cause svstemic risk to the fnancial svstem, then thats
notgoodforBankofAmerica,LewistoldtheFCIC.Whichisfnallvtheconclusion
thatIcametoandtheboardcameto.
1oo
ThemergerwascompletedonIanuarv1,iooo,withnohintofgovernmentassis-
tance. Bv the time the acquisition became omcial, the purchase price of -o billion
announcedinSeptemberhadfallento1obillion,thankstothedeclineinthestock
pricesofthetwocompaniesovertheprecedingthreemonths.OnIanuarvo,Bankof
America received the 1o billion in capital from TARP that had been allocated to
MerrillLvnch,addingtothe1-billionithadreceivedinOctober.
1o
tii :i : \Ni i\Ni t .,
InadditiontothoseTARPinvestments,attheendofioo8BankofAmericaand
MerrillLvnchhadborrowed88billionundertheFedscollateralizedprograms(oo
billion through the Term Auction Facilitv and i8 billion through the PDCF and
TSLF) and 1- billion under the Feds Commercial Paper Funding Facilitv. (During
the previous fall, Bank of Americas legacv securities arm had borrowed as much as
1billionunderTSLFandasmuchas11billionunderPDCF.)Alsoattheendof
ioo8,thebankhadissued:1.billioninseniordebtguaranteedbvtheFDICunder
the debt guarantee program.
1o8
And it had borrowed oi billion from the Federal
HomeLoanBanks.YetdespiteBankofAmericasrecoursetothesemanvsupports,the
regulators worried that it would experience liquiditv problems if the fourth-quarter
earningswereweak.
1oo
The regulators wanted to be readv to announce the details of government sup-
port in conjunction with Bank of Americas disclosure of its fourth-quarter per-
formance. Thev had been working on the details of that assistance since late
December,
ioo
andhadreasontobecautious:forexample,oofBankofAmericas
repo and securities-lending funding, a total of :8a billion, was rolled over everv
night, and Merrill legacv businesses also funded 1aa billion overnight. A one-
notch downgrade in the new Bank of Americas credit rating would contractuallv
obligate the posting of 1o billion in additional collateral; a two-notch downgrade
wouldrequireanother:billion.Althoughthecompanvremainedadequatelvcapi-
talizedfromaregulatorvstandpoint,itstangiblecommonequitvwaslowand,given
thestressedmarketconditions,waslikelvtofallunderi.
io1
Lowlevelsoftangible
common equitvthe most basic measure of capitalworried the market, which
seemedtothinkthatinthemidstofthecrisis,regulatorvmeasuresofcapitalwere
notinformative.
On Ianuarv 1-, the Federal Reserve and the FDIC, after intense discussions,
agreed on the terms:
ioi
Treasurv would use TARP funds to purchase io billion of
BankofAmericapreferredstockwithan8dividend.Thebankandthethreeperti-
nent government agenciesTreasurv, the Fed, and the FDICdesignated an asset
poolof118billion,primarilvfromtheformerMerrillLvnchportfolio,whoselosses
the four entities would share. The pool was analogous to Citigroups ring fence. In
thiscase,BankofAmericawouldberesponsibleforthefrst1obillioninlosseson
thepool,andthegovernmentwouldcoverooofanvadditionallosses.Shouldthe
government losses materialize, Treasurv would cover -, up to a limit of .- bil-
lion,andtheFDICi-,uptoalimitofi.-billion.Ninetvpercentofanvadditional
losseswouldbecoveredbvtheFed.
io:
The FDIC Board had a conference call at 1o P.M. on Thursdav, Ianuarv 1-, and
votedforthefourthtime,unanimouslv,toapproveasvstemicriskexceptionunder
FDICIA.
ioa
Thenextmorning,Ianuarv1o,BankofAmericadisclosedthatMerrillLvnchhad
recorded a 1-.: billion net loss on real estate-related write-downs and charges. It
alsoannouncedtheiobillionTARPcapitalinvestmentand118billionringfence
thatthegovernmenthadprovided.Despitethegovernmentssupport,BankofAmer-
icasstockcloseddownalmost1afromthedavbefore.
COMMISSION CONCLUSIONS ON CHAPTER 20
TheCommissionconcludesthat,asmassivelossesspreadthroughoutthefnan-
cialsvsteminthefallofioo8,manvinstitutionsfailed,orwouldhavefailedbut
forgovernmentbailouts.Aspanicgrippedthemarket,creditmarketsseizedup,
trading ground to a halt, and the stock market plunged. Lack of transparencv
contributed greatlv to the crisis: the exposures of fnancial institutions to riskv
mortgageassetsandotherpotentiallosseswereunknowntomarketparticipants,
andindeedmanvfrmsdidnotknowtheirownexposures.
The scale and nature of the over-the-counter (OTC) derivatives market cre-
atedsignifcantsvstemicriskthroughoutthefnancialsvstemandhelpedfuelthe
panic in the fall of ioo8: millions of contracts in this opaque and deregulated
market created interconnections among a vast web of fnancial institutions
through counterpartv credit risk, thus exposing the svstem to a contagion of
spreading losses and defaults. Enormous positions concentrated in the hands of
svstemicallv signifcant institutions that were major OTC derivatives dealers
added to uncertaintv in the market. The bank runs on these institutions in-
cluded runs on their derivatives operations through novations, collateral de-
mands,andrefusalstoactascounterparties.
A series of actions, inactions, and misjudgments left the countrv with stark
andpainfulalternativeseitherriskthetotalcollapseofourfnancialsvstemor
spendtrillionsoftaxpaverdollarstostabilizethesvstemandpreventcatastrophic
damagetotheeconomv.Intheprocess,thegovernmentrescuedanumberoff-
nancial institutions deemed too big to failso large and interconnected with
otherfnancialinstitutionsorsoimportantinoneormorefnancialmarketsthat
theirfailurewouldhavecausedlossesandfailurestospreadtootherinstitutions.
The government also provided substantial fnancial assistance to nonfnancial
corporations.Asaresultoftherescuesandconsolidationoffnancialinstitutions
through failures and mergers during the crisis, the U.S. fnancial sector is now
moreconcentratedthaneverinthehandsofafewvervlarge,svstemicallvsignif-
cant institutions. This concentration places greater responsibilitv on regulators
foreffectiveoversightoftheseinstitutions.
OverthenextseveralmonthsBankofAmericaworkedwithitsregulatorstoiden-
tifv the assets that would be included in the asset pool. Then, on Mav o, Bank of
America asked to exit the ring fence deal, explaining that the companv had deter-
minedthatlosseswouldnotexceedthe1obillionthatBankofAmericawasrequired
tocoverinitsfrst-lossposition.Althoughthecompanvwaseventuallvallowedtoter-
minate the deal, it was compelled to compensate the government for the benefts it
had received from the markets perception that the government would insure its as-
sets.OnSeptemberi1,BankofAmericaagreedtopavaai-millionterminationfee:
iomilliontoTreasurv,-milliontotheFed,andoimilliontotheFDIC.
.( ii N\Nti \i tii :i : i NuUi i tu\\i : :i uN iiiui1
PART V
The Aftershocks
.+
21
THE ECONOMIC FALLOUT
CONTENTS
Hcuschc|dsInnctcatingInncts|ccping:;o
BusincsscsSquirrc|sstcringnuts :;;
Ccnncrcia|rca|cstatcNcthingsncving:;
GcvcrnncntStatcsstrugg|cdtcc|cscshcrtja||s :;:
1hchnancia|scctcrA|ncsttrip|cthc|cvc|cjthrccvcarscar|icr;oo
Panicanduncertaintvinthefnancialsvstemplungedthenationintothelongestand
deepest recession in generations. The credit squeeze in fnancial markets cascaded
throughout the economv. In testifving to the Commission, Bank of America CEO
Brian Movnihan described the impact of the fnancial crisis on the economv: Over
thecourseofthecrisis,we,asanindustrv,causedalotofdamage.Neverhasitbeen
clearer how poor business judgments we have made have affected Main Street.
1
In-
deed, Main Street felt the tremors as the upheaval in the fnancial svstem rumbled
throughtheU.S.economv.Seventeentrilliondollarsinhouseholdwealthevaporated
withini1months,andreportedunemplovmenthit1o.1atitspeakinOctoberiooo.
Asthehousingbubbledefated,familiesthathadcountedonrisinghousingval-
ues for cash and retirement securitv became anchored to mortgages that exceeded
the declining value of their homes. Thev ratcheted back on spending, cumulativelv
puttingthebrakesoneconomicgrowththeclassicparadoxofthrift,describedal-
mostacenturvagobvIohnMavnardKevnes.
Intheaftermathofthepanic,whencreditwasseverelvtightened,ifnotfrozen,for
fnancialinstitutions,companiesfoundthatcheapandeasvcreditwasgoneforthem,
too.Itwastoughertoborrowtomeetpavrollsandtoexpandinventories;businesses
thathadneithercreditnorcustomerstrimmedcostsandlaidoffemplovees.Stillto-
dav,creditavailabilitvistighterthanitwasbeforethecrisis.
Without jobs, people could no longer afford their house pavments. Yet even if
moving could improve their job prospects, thev were stuck with houses thev could
not sell. Millions of families entered foreclosure and millions more fell behind on
their mortgage pavments. Others simplv walked awav from their devalued proper-
ties,returningthekevstothebanksanactionthatwoulddestrovfamiliescreditfor
.++ ii N\Nti \i tii :i : i NuUi i tu\\i : :i uN iiiui1
vears.Thesurgeinforeclosedandabandonedpropertiesdraggedhomepricesdown
still more, depressing the value of surrounding real estate in neighborhoods across
the countrv. Even those who staved current on their mortgages found themselves
whirledintothestorm.
Townsthatoverseveralvearshadcometoexpectandrelvonthehousingboom
nowsawjobsandtaxrevenuevanish.Astheirresourcesdwindled,thesecommuni-
tiesfoundthemselvessaddledwiththemunicipalcoststhevhadtakenoninpartto
expand services for a growing population. Sinking housing prices upended local
budgets that relied on propertv taxes. Problems associated with abandoned homes
requiredmorepoliceandfreprotection.
AtFCIChearingsaroundthecountrv,regionalexpertstestifedthatthelocalim-
pact of the crisis has been severe. From ioo to iooo, for example, banks in Sacra-
mento had stopped lending and potential borrowers retreated, said Clarence
Williams, president of the California Capital Financial Development Corporation.
Bankersstillcomplaintohimnotonlvthatdemandfromborrowershasfallenoffbut
also that thev mav be subject to increased regulatorv scrutinv if thev do make new
loans.InSeptemberio1o,whentheFCIChelditsSacramentohearing,thatregions
once-robust construction industrv was still languishing. Unless we begin to turn
arounddemand,unlesswebegintoturnaroundthebusinesssituation,theemplov-
mentisnotgoingtoincreasehereintheSacramentoarea,andhousingiscriticaltoit.
Itisaviciouscircle,Williamstestifed.
i
TheeffectsofthefnancialcrisishavebeenfeltinindividualU.S.householdsand
businesses,bigandsmall,andaroundtheworld.Policvmakersonthestate,national,
and global levels are still grappling with the aftermath, as are the homeowners and
lendersnowdealingwiththecomplicationsthatentangletheforeclosureprocess.
HOUSEHOLDS: I M NOT EATING. IM NOT SLEEPING
The recession omciallv began in December ioo. Bv manv measures, its effects on
thejobmarketweretheworstonrecord,asrefectedinthespeedandbreadthofthe
falloffinjobs,theriseoftheranksofunderemplovedworkers,andthelongstretches
of time that millions of Americans were and still are surviving without work. The
economvshed:.omillionjobsinioo8thelargestannualplungesincerecordkeep-
ingbeganin1oao.BvDecemberiooo,theUnitedStateshadlostanothera.million
jobs.ThroughNovemberio1o,theeconomvhadregainednearlv1millionjobs,put-
tingonlvasmalldentinthedeclines.
The underemplovment ratethe total of unemploved workers who are activelv
looking for jobs, those with part-time work who would prefer full-time jobs, and
those who need jobs but sav thev are too discouraged to searchincreased from
8.8 in December ioo to 1:. in December ioo8, reaching 1.a in October
iooo. This was the highest level since calculations for that labor categorv were frst
madein1ooa.AsofNovemberio1o,theunderemplovmentratestoodat1.The
averagelengthoftimeindividualsspentunemplovedspikedfromo.aweeksinIune
ioo8to18.iweeksinIuneiooo,andi-.-weeksinIuneio1o.Fiftv-ninepercentof
1ui ituNu\i t i\iiuU1 .+.
alljobseekers,accordingtothemostrecentgovernmentstatistics,searchedforwork
foratleast1-weeks.
The labor market is daunting across the board, but it is especiallv grim among
African American workers, whose jobless rate is 1o.o, about o percentage points
above the national average; workers between the ages of 1o and 1o vears old, at
ia.o;andHispanics,at1:.i.Andtheimpacthasbeenespeciallvsevereincertain
professions: unemplovment in construction, for instance, climbed to an average of
1o.1iniooo,andaveragedio.oduringthefrst11monthsofio1o.
Real gross domestic product, the nations measure of economic output adjusted
forinfation,fellatanannualrateofainthethirdquarterofioo8ando.8inthe
fourthquarter.Afterfallingagaininthefrsthalfofioooandthenmodestlvgrowing
inthesecondhalf,averageGDPforthevearwasi.olowerthaninioo8,thebiggest
dropsince1oao.
Looking at the labor market, Edward Lazear, chairman of President George W.
BushsCouncilofEconomicAdvisersduringthecrisis,toldtheCommissionthatthe
fnancialcrisiswaslinkedwithtodavseconomicproblems:Ithinkmostofithadto
dowithinvestment. . . .Panicinfnancialmarketsandtightnessinfnancialmarkets
thatpersistedthroughiooopreventedfrmsfrominvestinginthewavthatthevoth-
erwisewould,andIthinkthatslowstherehiringofworkersandstillcontinuestobe
aprobleminlabormarkets.
:
InIuneiooo,thenationomciallvemergedoutoftherecessionthathadbegun18
monthsearlier.Thegoodnewsstillhadnotreachedmanvoftheio.imillionAmeri-
canswhowereoutofwork,whocouldnotfndfull-timework,orwhohadstopped
looking for work as of November io1o. Ieannie McDermott of Bakersfeld told the
FCIC she started a business reflling printer ink cartridges, but in a tight economv,
shedidntearnenoughtomakealiving.Shesaidshehadbeensearchingforafull-
timejobsinceioo8.
a
Householdssufferedtheimpactofthefnancialcrisisnotonlvinthejobmarket
but also in their net worth and their access to credit. Of the 1 trillion lost from
ioo to the frst quarter of iooo in household net wealththe difference between
what households own and what thev oweabout -.o trillion was due to declining
houseprices,withmuchoftheremainderduetothedecliningvalueoffnancialas-
sets.Asapointofreference,GDPinioo8was1a.atrillion.And,asaseparatepoint,
theamountofwealthlostinthedot-comcrashearlvinthedecadewaso.-trillion,
withfarfewerrepercussionsfortheeconomvasawhole.Thepainfuldropinreales-
tateandfnancialassetvaluesfollowedao.8trillionrun-upinhouseholddebtfrom
ioootoioo.Aidedbvthegainsinhomepricesand,toalesserdegree,stockprices,
households net wealth had reached a peak of oo trillion in the second quarter of
ioo.Thecollapseofthehousingandstockmarketserasedmuchofthegainsfrom
therun-upwhilehouseholddebtremainednearhistorichighs,exceedingeventhe
levelsofiooo.Asofthethirdquarterofio1o,despitefrmerstockandhousingprices
andadeclineinhouseholdborrowing,householdnetworthtotaled-a.otrillion,a
1o.-drop-offfromitspinnaclejustthreevearsearlier(seefgurei1.1).
Nationwide,homepricesdropped:ifromtheirpeakiniooototheirlowpoint
0
10
20
30
40
50
60
$70
Household Net Worth
IN TRILLIONS OF DOLLARS
1952 1960 1970 1980 1990 2000 2010
NOTE: Net worth is assets minus liabilities for U.S. households.
SOURCE: Federal Reserve Flow of Funds Report
$54.9
The crisis wiped out much more wealth than other recent events such as the
bursting of the dot-com bubble in 2000.
Iigurca:.:
.+z ii N\Nti \i tii :i : i NuUi i tu\\i : :i uN iiiui1
earlv in iooo. The homeownership rate declined from its peak of oo.i in iooa to
oo.oasofthefallofio1o.BecausesomanvAmericanhouseholdsownhomes,and
becauseformosthomeownerstheirhousingrepresentstheirsinglemostimportant
asset, these declines have been especiallv debilitating. Borrowing via home equitv
loansorcash-outrefnancinghasfallensharplv.
At an FCIC hearing in Bakersfeld, California, Marie Vasile explained how her
familvhadrelocatedaomilesintothemountainstoarentalhousetohelpherhus-
bandsfragilehealth.
-
Theiroldhomewasputupforsaleandlanguishedonthemar-
ket,losingvalue.Eventuallv,sheandherhusbandfoundbuverswillingtotaketheir
houseinashortsalethatis,asaleatapricelessthanthebalanceofthemortgage.
Butbecausethelenderwasactingslowlvtoapprovethatdeal,thevriskedlosingthe
saleandthengoingintoforeclosure.Totopthisalloff,Vasiletoldcommissioners,
mvhusbandisinthepositionofpossiblvlosinghisjob. . . .SonotonlvdoIhavea
housethatIdontknowwhatshappeningto,Idontknowifhesgoingtohaveajob
comeDecember.ThisismorethanIcanhandle.Imnoteating.Imnotsleeping.
Serious mortgage delinquenciespavments that are late oo davs or more or
homesintheforeclosureprocesshavespreadsincethecrisis.Amongregions,the
1ui ituNu\i t i\iiuU1 .+.
easternstatesintheMidwest(Ohio,Indiana,Illinois,Wisconsin,andMichigan)had
thehighestdelinquencvrate,topping-inioo.
o
Bvfallio1o,thisratehadrisento
o.i. Other regions also endured high ratesespeciallv the so-called sand states,
wherethehousingcrisiswastheworst.Thethirdquarterio1oseriousdelinquencv
rateforFloridawas1o.-;Nevada,1.8;Arizona,1o.8;andCalifornia,1o.:.
The data companv CoreLogic identifed the i- housing markets with the worst
recordsofdistressedsales,whichincludeshortsalesandsalesofforeclosedproper-
ties. Las Vegas led the list in mid-io1o, with distressed sales accounting for more
than oo of all home sales.
The causes of foreclosures have been analvzed bv manv academics and govern-
ment agencies. Two events are tvpicallv necessarv for a mortgage default. First,
monthlvpavmentsbecomeunaffordableowingtounemplovmentorotherfnancial
1ui iuiitiu:Uii tii :i : .+.
hardship, or because mortgage pavments increase. And second (in the opinion of
manv,nowthemoreimportantfactor),thehomesvaluebecomeslessthanthedebt
owedinotherwords,theborrowerhasnegativeequitv.
Theevidenceisirrefutable,LaurieGoodman,aseniormanagingdirectorwith
Amherst Securities, told Congress in iooo: Negative equitv is the most important
predictorofdefault.Whentheborrowerhasnegativeequitv,unemplovmentactsas
oneofmanvpossiblecatalvsts,increasingtheprobabilitvofdefault.
8
Afterfalling:ifromtheirpeakinioootothespringofiooo,homepriceshave
rebounded somewhat, but improvements are uneven across regions.
o
Nationwide,
1o.8millionhouseholds,orii.-ofthosewithmortgages,owemoreontheirmort-
gagesthanthemarketvalueoftheirhouse(seefgureii.1).InNevada,oofhomes
with mortgages are under water, the highest rate in the countrv; in California, the
rateis:i.
1o
Giventheextraordinarvprevalenceandextentofnegativeequitv,thephenomenon
ofstrategicdefaultshasalsobeenontherise:homeownerspurposefullvwalkawav
from mortgage obligations when thev perceive that their homes are worth less than
whatthevoweandthevbelievethatthevaluewillnotbegoingupanvtimesoon.
Bvthefallofio1o,threestatesparticularlvhardhitbvforeclosuresCalifornia,
Florida,andNevadareportedsomerecentimprovementintheinitiationofforeclo-
sures,butinNovemberNevadasratewasstillfvetimeshigherthanthenationalav-
erage.Foreclosurestartsclimbedin::statesfromtheirlevelsavearearlier,withthe
largest increases in Washington State (which has o.i unemplovment), Indiana
(o.8unemplovment),andSouthCarolina(1o.ounemplovment),accordingtothe
MortgageBankersAssociation.
InOhio,thecitvofClevelandandsurroundingCuvahogaCountvarebulldozing
blocksofabandonedhousesdowntothedirtwiththeaimofcreatinganortheastern
Ohio bank of land preserved for the future. To do this, authorities seize blighted
propertiesforunpaidtaxes,andthevtakedonationsofhomesfromtheDepartment
ofHousingandUrbanDevelopment,FannieMae,andsomeprivatelenders.
11
Now,
thecountvfndsitselfunderincreasingduress,havingendured1a,oooforeclosuresin
iooo.
1i
Aftervearsofhighunemplovmentandafragileeconomv,thefnancialcrisis
tookvulnerableresidentsandshovedthemovertheedgeofthecliff,IimRokakis,
Cuvahogastreasurer,toldtheCommission.
1:
Inaspringio1osurvev,8-oftherespondingmavorsrankedtheprevalenceof
nonprimeorsubprimemortgagesaseitherfrstorsecondonalistoffactorscausing
foreclosuresintheircities.Almostallthemavors,oi,saidthevexpectedthefore-
closureproblemstostavthesameorworsenintheircitiesoverthenextvear.
1a
Therehasbeennomeaningfuldeclineintheinventorvofdistressedproperties
foundinthehousingmarket,GuvCecala,thechiefexecutiveandpublisherofInside
Mortgage Finance Publications, told a congressional panel overseeing the Troubled
Asset Relief Program in October io1o. It is hard to talk about anv recoverv of the
housingmarketwhentheshareofdistressedpropertvtransactionsremainscloseto
-opercent.
1-
Underwater Mortgages
SHARE OF LOANS WITH NEGATIVE EQUITY, THIRD QUARTER 2010
SOURCE: CoreLogic
>50%
3049
1529
014
NA
ME
NY MA
CT
RI
PA
NJ
DE
DC
MD
OH
VA
SC
NC
TN
AL GA
AK
TX
HI
ND
SD
IA
MN
OR
WA
ID
UT
CO
NM
MT
MO
AR
OK
KS
NE
LA
MS
WY
WV
WI
IL IN
KY
AZ
NV
MI
CA
FL
VT
NH
U.S. average
23%
Many mortgage holders find themselves underwater; that is, owing more
than their homes are worth. This is particularly true in Arizona, California,
Florida, Michigan, and Nevada.
Iigurcaa.:
.+. ii N\Nti \i tii :i : i NuUi i tu\\i : :i uN iiiui1
Therewasafundamentalchangeinourfnancialservicessectorthatreallvisthe
reasonwereinthiscrisis,thiseconomiccrisis,andisthereasonwereseeingandwill
seeintotalprobablvbeforeweredone,between1-and1omillionforeclosureflings
in this countrv, Iohn Tavlor, the president and CEO of the National Communitv
Reinvestment Coalition, explained to the FCIC. And bv the wav, a few hundred
thousandpeople,evenamillionpeoplegoingintoforeclosure,voucankindofblame
andsav,Wellthevshouldhaveknownbetter.But1-[or]1omillionAmericanfami-
liescantallbewrong.Thevcantallbegreedvandthevcantallbestupid.
1o
1ui iuiitiu:Uii tii :i : .+,
INITIATIVES TO STEM FORECLOSURES:
PERSISTENTLY DISREGARD
Thesamesvstemthatwassoemcientatcreatingmillionsofmortgageloansoverthe
pastdecadehasbeenineffectiveatresolvingproblemsinthehousingmarket,includ-
ing the efforts of homeowners to modifv their mortgages. As mortgage problems
mounted, the federal and state governments responded with fnancial incentives to
encouragebankstoadjustinterestrates,spreadloanpavmentsoverlongerterms,or
simplv write down mortgage debts. But to date, federal auditors and independent
consumer watchdogs have given the federal governments and the banks mortgage
modifcationprogramspoorgrades.
TheHomeAffordableModifcationProgram(HAMP)isfallingshortofthe:toa
millionfamiliestargetedforhelpbvtheendofio1i.(Theprogramsresourcescome
fromthefederalTARPfunds.)AsofDecemberio1o,HAMPhasresultedintheper-
manentmodifcationofonlv-io,ooomortgages.
1
Meanwhile,thebanksreportthat
thev have independentlv approved :.a million loan alterations of various kinds, al-
though manv of these modifcations simplv roll missed pavments into a new mort-
gageandthusresultinhighermonthlvpavments.
18
The effectiveness of state mortgage modifcation and foreclosure assistance pro-
grams is unclear. Some are just getting started. New Iersev, for instance, will begin a
11imillionHomeKeeperPrograminio11,tooffersomeresidentswhofaceforeclo-
surebecauseofunemplovmentorsubstantialunderemplovmentadeferred-pavment,
no-interestloansothatthevcancontinuemakingpavmentsontheirmortgages.
1o
During a series of hearings in communities around the countrv affected bv the
housingcrisis,theCommissionheardfrommanvwitnessesabouttheextraordinarv
dimculties thev had encountered in seeking to modifv their mortgages and stav in
their homes. Borrowers who have been paving down mortgages for vears and have
built up substantial equitv are especiallv susceptible to being turned down for loan
modifcations, because the lender would prefer that thev simplv sell their homes.
KirstenKeefe,aseniorstaffattornevwiththeEmpireIusticeCenterinAlbanv,New
York,broughtthisissuetoregulatorsattentioninMarchio1o.SpeakingtotheFed-
eral Reserve Boards Consumer Advisorv Council in Washington, Keefe identifed
trends among borrowers in New York who tried to qualifv for the governments
HAMP program. We are also routinelv hearing that folks who have a lot of equitv
are . . . being denied HAMP modifcations, she said.
io
Diane Thompson, from the
NationalConsumerLawCenter,testifedtotheUnitedStatesSenateCommitteeon
Banking,Housing,andUrbanAffairsinNovemberio1oaboutthechallengesofthe
program.Shestated,Onlvavervfewofthepotentiallveligibleborrowershavebeen
abletoobtainpermanentmodifcations.Advocatescontinuetoreportthatborrowers
aredeniedimproperlvforHAMP . . .andthatsomeservicerspersistentlvdisregard
HAMPapplications.
i1
Competing incentives mav encourage banks to view foreclosure as quicker,
cleaner, and often cheaper than modifving the terms of existing mortgages.
ii
.+( ii N\Nti \i tii :i : i NuUi i tu\\i : :i uN iiiui1
For them, foreclosure is a prudent response to default because, the data suggest,
manv borrowers who receive temporarv or permanent forgiveness on their terms
willslideintodefaultagain.
i:
Also,servicersmavreceivesubstantialfeesforguid-
ing a mortgage through the foreclosure process, creating an incentive to denv a
modification.
ia
Frequentlv,theresanothercomplicationtoattemptingaforeclosureormodifi-
cation: the second mortgages that were lavered onto first mortgages. The first
mortgages were commonlv sold bv banks into the securitization machine. The
second mortgages were often retained bv the same lenders who tvpicallv service
the mortgage: that is, thev process the monthlv pavments and provide customer
service to borrowers. If a first mortgage is modified or foreclosed on, the entire
value of the second mortgage mav be wiped out. Under these circumstances,
the lender holding that second lien has an incentive to delav a modification into
a new loan that would make the mortgage pavments more affordable to the
borrower.
i-
Thecountrvsleadingbanksnowholdontheirbooksmorethanaoobillionin
secondmortgages.
io
Totheextentthebankshavereportedtheseloansasperforming,
theloanshavenotbeenmarkeddownontheirbooks.Theactualvalueofthesesec-
ondmortgagescouldbemuchlessthantheiraoobillion-plusreportedvalue.
i
The
dangeroffuturelossesisself-evident.Somefrustratedfrst-lieninvestorshavesued
servicers,assertingthevarenotprotectinginvestorsfnancialinterests.Instead,thev
claim that because the servicer is holding the second lien, the servicers are looking
aftertheirownbalancesheetsbvencouragingborrowerstokeepupthepavmentson
their second mortgage when thev cannot afford to make pavments on both obliga-
tions.AccordingtoLaurieGoodman,formortgagemodifcationstowork,thehold-
ersofthesecondmortgageswillhavetoacceptsomelossesapotentiallvexpensive
proposition.
i8
A number of other obstacles have made modifcations dimcult. For example,
therearecompetinginterestsamongvariousinvestorsinamortgage-backedsecuritv.
Proceedsfromaforeclosuremavbeenoughtopavofftheinvestorsholdingthehigh-
est-ratedtranchesofsecurities,whiletheholdersofthelowertrancheswouldlikelv
bewipedout.Asaresult,theholdersofthelower-ratedtranchesmightpreferamod-
ifcation,ifitproducedmorecashfowthanaforeclosure.
Other efforts in the private and public sectors to address the foreclosure crisis
havefocusedonencouragingshortsales.Intheorv,shortsalesshouldhelpborrow-
ers, neighborhoods, and lenders. Borrowers avoid foreclosure; neighborhoods
avoid vacant, dilapidated homes that encourage crime; and lenders avoid some of
thecostsofforeclosure.Nonetheless,suchdealsfrequentlvstallbecausetheprocess
iscumbersome,demandscoordination,andeatsupresources.Forexample,lenders
can be reluctant to sign off on the buvers bid because thev are not sure that the
home is being sold at the highest possible price. In addition, when there are two
mortgages, the holders of the first and second mortgages must both agree to the
resolution.
1ui iuiitiu:Uii tii :i : .+,
FLAWS IN THE PROCESS:
SPECULATION AND WORSTCASE SCENARIOS
Inio1o,additionalissueshavecometothefore,asproblemswithindividualforeclo-
sureshaverevealedsvstemicfawsinhowlendersdocumentedandprocessedmort-
gagesforsecuritization.LegalexpertsandconsumeradvocatestoldtheCommission
thatproceduralanddocumentationproblemswithforeclosurehavebeenlaidoutin
court cases and academic studies for vears, but were ignored until the number of
foreclosuresrosesodramaticallv.
All-oofthenationsstateattornevsgeneralbandedtogetherinthefallofio1oto
investigate foreclosure irregularities, identifv possible solutions, and explore poten-
tialredressforborrowerswhowereharmedbvimproperforeclosures.Forexample,
lendershavereliedonrobo-signerswhosubstitutedspeedforaccuracvbvsigning,
and sometimes backdating, hundreds of amdavits claiming personal knowledge of
facts about mortgages that thev did not actuallv know to be true. One such robo-
signer,IeffrevStephanofGMAC,saidthathesigned1o,oooamdavitsinamonth
roughlv 1 per minute, in a ao-hour workweekmaking it highlv unlikelv that he
verifed pavment histories in each individual case of foreclosure.
io
In addition, a
number of court cases have been fled alleging invalid notarizations, forged signa-
tures,backdatedmortgagepaperwork,andfailuretodemonstratehavinglegalstand-
ingtoforeclosethatis,beingtheentitvwiththerighttorepossessahome.
:o
Theproblemoflegalstandingarosebecausetherapidgrowthofmortgagesecuri-
tization outpaced the abilitv of the legal and fnancial svstem to accuratelv record
whoownsthemortgage.Duringthesecuritizationprocess,loansweresoldmultiple
times. To speed up processing, the fnancial industrv created Mortgage Electronic
Registration Svstems, Inc. (MERS), an organization made up of :,ooo mortgage
lenders. It tracks changes in servicing rights and ownership interests in mortgage
loans.MERSisdesignatedasthemortgageeofrecordonbehalfofitsmembers,a
statusthatismeanttogiveitthelegalrighttoforecloseiftheborrowerfailstopavthe
loan.MERShasregisteredoomillionmortgagessincelaunchingin1oo-andhad::
millionloansoutstandingasofNovemberio1o.
:1
ThestandingofMERSoritsdesigneestoforeclosehasbeencalledintoquestion
bv courts and academics, however.
:i
In a hearing before the House Iudiciarv Com-
mittee on the foreclosure crisis, New York State Supreme Court Iustice F. Dana
WinslowtestifedthatstandinghasbecomesuchapervasiveissuethatIfrequentlv
usethetermpresumptivemortgageeinforeclosuretodescribeMERS.Becauseof
multipleunrecordedtransfersofthelegalownershipofthe[m]ortgage,itisunclear
whetherMERScontinuedtobethemortgageeaftersubsequentsalesoftheloan,ac-
cordingtoWinslow.
::
Moreover,courtshaveheldthatMERSdoesnotowntheun-
derlvingnoteandthereforecannottransferthenoteorthedeedoftrust,orforeclose
uponthepropertv.
:a
Winslow also highlighted other defciencies in MERS standing, manv involving
sloppvpaperwork:thefailuretoproducethecorrectpromissorvnotesincourtduring
.+ ii N\Nti \i tii :i : i NuUi i tu\\i : :i uN iiiui1
foreclosureproceedings;gapsinthechainoftitle,includingprintoutsofthetitlethat
havedifferedsubstantiallvfrominformationprovidedpreviouslv;retroactiveassign-
mentsofnotesandmortgagesinanefforttocleanupthepaperworkproblemsfrom
earlier vears; questionable signatures on assignments and amdavits attesting
to the ownership of the note and mortgage; and questionable notarv stamps on
assignments.
:-
On November 1o, io1o, a bankruptcv court ruled that the Bank of New York
could not foreclose on a loan it had purchased from Countrvwide, because MERS
hadfailedtoendorseordeliverthenotetotheBankofNewYorkasrequiredbvthe
pooling and servicing agreement. This ruling could have further implications, be-
causeitwascustomarvforCountrvwidetomaintainpossessionofthenoteandre-
latedloandocumentswhenloansweresecuritized.
:o
Across the market, some mortgage securities holders have sued the issuers of
those securities, demanding that the issuers rescind their purchases.
:
If the legal
challengessucceed,investorsthatownmortgage-backedsecuritiescouldforcetheis-
suers to buv them back at the original pricepossiblv with interest. The issuers
wouldthenbetheownersofthesecuritiesandwouldbeartheriskofloss.
:8
TheCongressionalOversightPanel,inareportissuedinNovemberio1o,saidit
is on the lookout for such risks: If documentation problems prove to be pervasive
and,moreimportantlv,throwintodoubttheownershipofnotonlvforeclosedprop-
ertiesbutalsopooledmortgages,theconsequencescouldbesevere.
:o
Thissentiment
was echoed bv Universitv of Iowa law professor Katherine Porter who has studied
foreclosures and the law: It is lack of knowledge of how widespread the problems
mavbethatisturningtheallegationsintoacrisis.Lackofknowledgefeedsspecula-
tion and worst-case scenarios.
ao
Adam Levitin, a Georgetown Universitv associate
professoroflaw,hasestimatedthattheclaimscouldbeinthetrillionsofdollars,ren-
deringmajorU.S.banksinsolvent.
a1
NEIGHBORHOOD EFFECTS: I M NOT LEAVING
For the millions of Americans who paid their bills, never fipped a house, and had
neverheardofaCDO,thefnancialcrisishasbeenlong,bewildering,andpainful.A
crisisthatstartedwithahousingboomthatbecameabubblehascomebackfullcir-
cletoforestsofforsalesignsbutthistimeattractingfewbuvers.Storeshaveshut-
tered; emplovers have cut jobs; hopes have fed. Too manv Americans todav fnd
themselves in suburban ghost towns or urban wastelands, where properties are va-
cantandconstructioncranesdonotliftathingformonths.
Renters, who never bought into the madness, are also among the victims as
lendersseizepropertvafterlandlordsdefaultonloans.Renterscanlosetheroofover
their heads as well as their securitv deposits. In Minneapolis, as manv as oo of
buildingswithforeclosuresinioooandioowererenter-occupied,accordingtosta-
tisticscitedintestimonvbvDeputvAssistantSecretarvErikaPoethigfromtheU.S.
Department of Housing and Urban Development to the House of Representatives
SubcommitteeonHousingandCommunitvOpportunitv.
ai
1ui iuiitiu:Uii tii :i : .++
For children, a repossessed housewhether rented or boughtis destabilizing.
Theimpactofforeclosuresonchildrenaroundthecountrvhasbeenenormous.One-
third of the children who experienced homelessness after the fnancial crisis did so
becauseofforeclosuresofthehousingthattheirparentsownedorwererenting,ac-
cordingtoarecentstudv.
a:
OneschoolomcialinNevadatoldtheCommissionabout
thesignifcantchallengestotheeducationalsvstemcreatedbvtheeconomiccrisis.
aa
All around, the demand from people who need help is outstripping communitv
resources. Coast to coast, communities are trving to stretch housing aid budgets to
helppeopledisplacedbvforeclosures.InNevada,forexample,ClarkCountv,which
contains1.omillionpeoplelivinginandaroundLasVegas,wasforcedtocutitsFi-
nancialHousingAssistanceprogram,despitetheclearneedsinthecommunitv.Gail
Burks,thepresidentandchiefexecutiveoftheNevadaFairHousingCenter,toldthe
Commission that her group fnds that manv thev counsel through the foreclosure
process are in despair. Its verv stressful. There are times that the couples we are
helpingendupdivorcing,sometimesbeforetheprocessisover. . . .Wevealsoseen
threatsofsuicide.
a-
Andthestoriescontinue.KarenMann,theappraiserfromDiscovervBav,Cali-
fornia,testifedtotheCommissionaboutherfamilvscircumstances.Herdaughter
and son-in-law refnanced their mortgage into an adjustable-rate mortgage. When
the time came for the rate to adjust upward, new fnancial troubles made the pav-
mentsmorethanthefamilvcouldafford.Becausethemarketvalueofthehomewas
nearlvequaltotheirmortgagedebt,thefamilvsattemptstogetthemortgagemodi-
fed were fruitless. Thev lined up a buver for a short sale, but the deal was nixed.
Then, when medical problems created vet another challenge, the couple and their
four children moved in with Mann. The children were relocated to new schools,
andtheadultsdealtwiththepainandemotionalsufferingwhilethevweretrvingto
rebuild their lives, Mann said. The couple fled for bankruptcv. Two months after
the bankruptcv was completed, the lender asked them if thev wanted to modifv
theirmortgage.
ao
InCapeCoral,Florida,DawnHuntandherhusband,amailman,andtheirtwo
childrenliveinanattractiveranch-stvlehomethevboughtforabout1oo,ooomore
thanadecadeago.Itwasaquiet,io-vear-oldsubdivisionwheremostoftheresidents
were homeowners. In ioo- and iooo, builders rushed to the area and threw up
dozens of new homes on emptv lots. Homebuilder Comfort Homes of Florida LLC
brokegroundforahouseacrossthestreetfromtheHunts,butdidnotcompleteit.
Thisfall,thehousesatvacant,anemptvshell.Nostuccowaseverappliedtothecon-
creteblockexterior,andthehousehadnointeriorwalls.Awaspnestdecoratedthe
electrical box near the front door. The untended grass had grown four feet high.
Sharpsandspursinthebrushmadeitdimculttoapproachthepropertv.Twodoors
downfromtheHunts,anotherhousewasalsovacant,leftemptvwhenafamilvsplit
up and moved a vear earlier. Thev abandoned a car in the garage. The roof leaked,
andablueplastictarpputinplacetokeeptherainoutnowfapsinthebreeze.The
Huntscalledthepoliceaftervandalsbrokeintothehouseonenight;intrudershave
beenbacktwicemoreinthedavlight.
a
..+ ii N\Nti \i tii :i : i NuUi i tu\\i : :i uN iiiui1
NowaaofthehomesintheHuntsneighborhoodareindefault,areinthefore-
closureprocess,orhavebeentakenbackbvthebank.
a8
Mostoftheotherhousesin
thecommunitvareoccupiedbvrenterswhoseabsenteelandlordsboughtthehouses
when the homeowners lost their homes to their banks. The Hunts house has lost
two-thirds of its value from the peak of the market. Nonetheless, even though the
neighborhood is not as lovelv as it used to be, Dawn Hunt told the FCIC, Im not
leaving.
ao
COMMISSION CONCLUSIONS ON CHAPTER 22
TheCommissionconcludestheuncheckedincreaseinthecomplexitvofmort-
gages and securitization has made it more dimcult to solve problems in the
mortgagemarket.Thiscomplexitvhascreatedpowerfulcompetinginterests,in-
cludingthoseoftheholdersoffrstandsecondmortgagesandofmortgageser-
vicers; has reduced transparencv for policv makers, regulators, fnancial
institutions, and homeowners; and has impeded mortgage modifcations. The
resulting disputes and inaction have caused pain largelv borne bv individual
homeowners and created further uncertaintv about the health of the housing
marketandfnancialinstitutions.
Dissenting Statement of
Commissioner
KEITH
HENNESSEY
Commissioner
DOUGLAS
HOLTZ-EAKIN
Vice Chairman
BILL
THOMAS
CAUSES OF THE
FINANCIAL AND ECONOMIC CRISIS
CONTENTS
Intrcducticn;):
HcwOurApprcachDijjcrsjrcnOthcrs ;);
StagcscjthcCrisis;)
1hc1cnLsscntia|CauscscjthcIinancia|andLccncnicCrisis;)
1hcCrcditBu|||cG|c|a|Capita|I|cws.UndcrpriccdRisk.
andIcdcra|RcscrvcIc|icv;);
1hcHcusingBu|||c ;::
1urningBadMcrtgagcsintc1cxicIinancia|Asscts ;:
BigBankBctsandVhvBanksIai|cd;:
1wc1vpcscjSvstcnicIai|urc;:)
1hcShcckandthcIanic;:
1hcSvstcnIrcczing ;:
INTRODUCTION
We have identifed ten causes that are essential to explaining the crisis. In this dis-
sentingview:
Weexplainhowourapproachdiffersfromothers;
Webriefvdescribethestagesofthecrisis;
Welistthetenessentialcausesofthecrisis;and
Wewalkthrougheachcauseinabitmoredetail.
Wefndareasofagreementwiththemajoritvsconclusions,butunfortunatelvthe
areasofdisagreementaresignifcantenoughthatwedissentandpresentourviewsin
thisreport.
We wish to compliment the Commission staff for their investigative work. In
manvwavsithelpedshapeourthinkingandconclusions.
DuetoalengthlimitationrecentlvimposeduponusbvsixmembersoftheCom-
mission,
1
thisreportfocusesonlvonthecausesessential toexplainingthecrisis.We
regret that the limitation means that several important topics that deserve a much
fullerdiscussiongetonlvabriefmentionhere.
...
HOW OUR APPROACH DIFFERS FROM OTHERS
During the course of the Commissions hearings and investigations, we heard fre-
quentargumentsthattherewasasinglecauseofthecrisis.Forsomeitwasinterna-
tional capital fows or monetarv policv; for others, housing policv; and for still
others,itwasinsumcientregulationofanambiguouslvdefnedshadowbankingsec-
tor,orunregulatedover-the-counterderivatives,orthegreedofthoseinthefnancial
sectorandthepoliticalinfuencethevhadinWashington.
In each case, these arguments, when used as single-cause explanations, are too
simplistic because thev are incomplete. While some of these factors were essential
contributorstothecrisis,eachisinsumcientasastandaloneexplanation.
The majoritvs approach to explaining the crisis suffers from the opposite prob-
lemit is too broad. Not evervthing that went wrong during the fnancial crisis
causedthecrisis,andwhilesomecauseswereessential,othershadonlvaminorim-
pact.Notevervregulatorvchangerelatedtohousingorthefnancialsvstempriorto
thecrisiswasacause.Themajoritvsalmost--o-pagereportismoreanaccountof
badeventsthanafocusedexplanationofwhathappenedandwhv.Whenevervthing
isimportant,nothingis.
As an example, non-credit derivatives did not in anv meaningful wav cause or
contributetothefnancialcrisis.NeithertheCommunitvReinvestmentActnorre-
moval of the Glass-Steagall frewall was a signifcant cause. The crisis can be ex-
plainedwithoutresortingtothesefactors.
Wealsorejectastoosimplisticthehvpothesisthattoolittleregulationcausedthe
crisis,aswellasitsopposite,thattoomuchregulationcausedthecrisis.Wequestion
this metric for determining the effectiveness of regulation. Theamount of fnancial
regulationshouldrefecttheneedtoaddressparticularfailuresinthefnancialsvs-
tem. For example, high-risk, nontraditional mortgage lending bv nonbank lenders
fourishedintheiooosanddidtremendousdamageinanineffectivelvregulateden-
vironment,contributingtothefnancialcrisis.Poorlvdesignedgovernmenthousing
policies distorted market outcomes and contributed to the creation of unsound
mortgagesaswell.CountrvwidesirresponsiblelendingandAIGsfailurewereinpart
attributabletoineffectiveregulationandsupervision,whileFannieMaeandFreddie
Macs failures were the result of policvmakers using the power of government to
blendpublicpurposewithprivategainsandthensocializingthelosses.Boththetoo
little government and too much government approaches are too broad-brush to
explainthecrisis.
The majoritv savs the crisis was avoidable if onlv the United States had adopted
across-the-board more restrictive regulations, in conjunction with more aggressive
regulatorsandsupervisors.Thisconclusionbvthemajoritvlargelvignorestheglobal
natureofthecrisis.Forexample:
A credit bubble appeared in both the United States and Europe. This tells us
that our primarv explanation for the credit bubble should focus on factors
commontobothregions.
... ii : :iN1i Nt :1\1i\iN1 ... ii : :iN1i Nt :1\1i\iN1
Thereportlargelvignoresthecreditbubblebevondhousing.Creditspreadsde-
clinednotjustforhousing,butalsoforotherassetclasseslikecommercialreal
estate.ThistellsustolooktothecreditbubbleasanessentialcauseoftheU.S.
housingbubble.ItalsotellsusthatproblemswithU.S.housingpolicvormar-
ketsdonotbvthemselvesexplaintheU.S.housingbubble.
There were housing bubbles in the United Kingdom, Spain, Australia, France
and Ireland, some more pronounced than in the United States. Some nations
withhousingbubblesreliedlittleonAmerican-stvlemortgagesecuritization.A
good explanation of the U.S. housing bubble should also take into account its
parallelsinothernations.ThisleadsustoexplanationsbroaderthanjustU.S.
housingpolicv,regulation,orsupervision.Italsotellsusthatwhilefailuresin
U.S. securitization markets mav be an essential cause, we must look for other
thingsthatwentwrongaswell.
Large fnancial frms failed in Iceland, Spain, Germanv, and the United King-
dom,amongothers.NotallofthesefrmsbetsolelvonU.S.housingassets,and
The United States was one of many countries to experience rapid house price growth
House Price Appreciation in Selected Countries, 2002-2008
2002 INDEX = 100
SOURCES: Standard and Poors, Nationwide, Banco de Espaa, AusStats, FNAIM, Permanent TSB
100
150
200
100
150
200
United States United Kingdom Spain
Australia France Ireland
118
192
168
158
152
142
02 06 04 08 02 06 04 08 02 06 04 08
02 06 04 08 02 06 04 08 02 06 04 08
iii 1u uiNNi: :i, iuUti\: uui1/ i\ii N, \Ni 8i ii 1uu\\: ..,
thev operated in different regulatorv and supervisorv regimes than U.S. com-
mercial and investment banks. In manv cases these European svstems have
stricterregulationthantheUnitedStates,andstillthevfacedfnancialfrmfail-
uressimilartothoseintheUnitedStates.
Thesefactstellusthatourexplanationforthecreditbubbleshouldfocusonfac-
torscommontoboththeUnitedStatesandEurope,thatthecreditbubbleislikelvan
essentialcauseoftheU.S.housingbubble,andthatU.S.housingpolicvisbvitselfan
insumcient explanation of the crisis. Furthermore, anv explanation that relies too
heavilvonauniqueelementoftheU.S.regulatorvorsupervisorvsvstemislikelvto
be insumcient to explain whv the same thing happened in parts of Europe. This
movesinadequateinternationalcapitalandliquiditvstandardsupourlistofcauses,
anditmovesthedifferencesbetweentheregulationofU.S.commercialandinvest-
mentbanksdownthatlist.
Applving these international comparisons directlv to the majoritvs conclusions
provokesthesequestions:
IfthepoliticalinfuenceofthefnancialsectorinWashingtonwasanessential
causeofthecrisis,howdoesthatexplainsimilarfnancialinstitutionfailuresin
the United Kingdom, Germanv, Iceland, Belgium, the Netherlands, France,
Spain,Switzerland,Ireland,andDenmark:
Howcantherunawavmortgagesecuritizationtraindetailedinthemajoritvs
report explain housing bubbles in Spain, Australia, and the United Kingdom,
countries with mortgage fnance svstems vastlv different than that in the
UnitedStates:
Howcanthecorporateandregulatorvstructuresofinvestmentbanksexplain
the decisions of manv U.S. commercial banks, several large American univer-
sitvendowments,andsomestatepublicemploveepensionfunds,nottomen-
tion a number of large and midsize German banks, to take on too much U.S.
housingrisk:
HowdidformerFedChairmanAlanGreenspansderegulatorvideologvalso
precipitatebankregulatorvfailuresacrossEurope:
Not all of these factors identifed bv the majoritv were irrelevant; thev were just
notessential.
The Commissions statutory mission is to examine the causes, domestic and
global, of the current fnancial and economic crisis in the United States. By fo-
cusing too narrowly on U.S. regulatory policy and supervision, ignoring interna-
tional parallels, emphasizing only arguments for greater regulation, failing to
prioritize the causes, and failing to distinguish sufciently between causes and ef-
fects, the majoritys report is unbalanced and leads to incorrect conclusions about
what caused the crisis.
Webeginourexplanationbvbriefvdescribingthestagesofthecrisis.
..( ii : :iN1i Nt :1\1i\iN1 ..( ii : :iN1i Nt :1\1i\iN1
STAGES OF THE CRISIS
AsofDecemberio1o,theUnitedStatesisstillinaneconomic slump causedbvaf-
nancial crisis thatfrstmanifesteditselfinAugustiooandendedinearlviooo.The
primarvfeaturesofthatfnancialcrisiswereafnancial shock inSeptemberioo8and
aconcomitantfnancial panic.Thefnancialshockandpanictriggeredaseverecon-
tractioninlendingandhiringbeginninginthefourthquarterofioo8.
Some observers describe recent economic historv as a recession that began in
DecemberiooandcontinueduntilIuneiooo,andfromwhichweareonlvnowbe-
ginningtorecover.Whilethisdefnitionoftherecessionistechnicallvaccurate,itob-
scures a more important chronologv that connects fnancial market developments
with the broader economv. We describe recent U.S. macroeconomic historv in fve
stages:
A series of foreshocks beginning in August ioo, followed bv an economic
slowdown and then a mild recession through August ioo8, as liquiditv prob-
lemsemergedandthreelargeU.S.fnancialinstitutionsfailed;
AseverefnancialshockinSeptemberioo8,inwhichtenlargefnancialinstitu-
tionsfailed,nearlvfailed,orchangedtheirinstitutionalstructure;triggering
Afnancialpanicandthebeginningofalargecontractionintherealeconomv
inthelastfewmonthsofioo8;followedbv
The end of the fnancial shock, panic, and rescue at the beginning of iooo;
followedbv
Acontinuedanddeepeningcontractionintherealeconomvandthebeginning
ofthefnancialrecovervandrebuildingperiod.
AsofDecemberio1o,theUnitedStatesisstillinthelaststage.Thefnancialsvs-
temisstillrecoveringandbeingrestructured,andtheU.S.economvstrugglestore-
turn to sustained strong growth. The remainder of our comments focuses on the
fnancialcrisisinthefrstthreestagesbvexaminingitstenessentialcauses.
THE TEN ESSENTIAL CAUSES
OF THE FINANCIAL AND ECONOMIC CRISIS
Thefollowingtencauses,globalanddomestic,areessentialtoexplainingthefnan-
cialandeconomiccrisis.
I. Credit bubble. Starting in the late 1ooos, China, other large developing
countries,andthebigoil-producingnationsbuiltuplargecapitalsurpluses.
ThevloanedthesesavingstotheUnitedStatesandEurope,causinginterest
ratestofall.Creditspreadsnarrowed,meaningthatthecostofborrowingto
fnance riskv investments declined. A credit bubble formed in the United
States and Europe, the most notable manifestation of which was increased
iii 1u uiNNi: :i, iuUti\: uui1/ i\ii N, \Ni 8i ii 1uu\\: ..,
.. ii : :iN1i Nt :1\1i\iN1
investment in high-risk mortgages. U.S. monetarv policv mav have con-
tributedtothecreditbubblebutdidnotcauseit.
II. Housing bubble. Beginninginthelate1ooosandacceleratingintheiooos,
there was a large and sustained housing bubble in the United States. The
bubble was characterized both bv national increases in house prices well
above the historical trend and bv rapid regional boom-and-bust cvcles in
California, Nevada, Arizona, and Florida. Manv factors contributed to the
housing bubble, the bursting of which created enormous losses for home-
ownersandinvestors.
III. Nontraditional mortgages. Tighteningcreditspreads,overlvoptimisticas-
sumptions about U.S. housing prices, and faws in primarv and secondarv
mortgage markets led to poor origination practices and combined to in-
creasethefowofcredittoU.S.housingfnance.Fueledbvcheapcredit,frms
like Countrvwide, Washington Mutual, Ameriquest, and HSBC Finance
originatedvastnumbersofhigh-risk,nontraditionalmortgagesthatwerein
somecasesdeceptive,inmanvcasesconfusing,andoftenbevondborrowers
abilitv to repav. At the same time, manv homebuvers and homeowners did
not live up to their responsibilities to understand the terms of their mort-
gagesandtomakeprudentfnancialdecisions.Thesefactorsfurtherampli-
fedthehousingbubble.
IV. Credit ratings and securitization. Failuresincreditratingandsecuritization
transformed bad mortgages into toxic fnancial assets. Securitizers lowered
thecreditqualitvofthemortgagesthevsecuritized.Creditratingagencieser-
roneouslv rated mortgage-backed securities and their derivatives as safe in-
vestments. Buvers failed to look behind the credit ratings and do their own
duediligence.Thesefactorsfueledthecreationofmorebadmortgages.
V. Financial institutions concentrated correlated risk. Managers of manv
large and midsize fnancial institutions in the United States amassed enor-
mousconcentrationsofhighlvcorrelatedhousingrisk.Somedidthisknow-
inglv bv betting on rising housing prices, while others paid insumcient
attention to the potential risk of carrving large amounts of housing risk on
theirbalancesheets.Thisenabledlargebutseeminglvmanageablemortgage
lossestoprecipitatethecollapseoflargefnancialinstitutions.
VI. Leverage and liquidity risk. Managersofthesefnancialfrmsamplifedthis
concentrated housing risk bv holding too little capital relative to the risks
thevwerecarrvingontheirbalancesheets.Manvplacedtheirfrmsonahair
trigger bv relving heavilv on short-term fnancing in repo and commercial
paper markets for their dav-to-dav liquiditv. Thev placed solvencv bets
(sometimesunknowinglv)thattheirhousinginvestmentsweresolid,andliq-
uiditvbetsthatovernightmonevwouldalwavsbeavailable.Bothturnedout
tobebadbets.Inseveralcases,failedsolvencvbetstriggeredliquiditvcrises,
causingsomeofthelargestfnancialfrmstofailornearlvfail.Firmswerein-
sumcientlvtransparentabouttheirhousingrisk,creatinguncertaintvinmar-
.. ii : :iN1i Nt :1\1i\iN1
iii 1u uiNNi: :i, iuUti\: uui1/ i\ii N, \Ni 8i ii 1uu\\: ..+
ketsthatmadeitdimcultforsometoaccessadditionalcapitalandliquiditv
whenneeded.
VII. Risk of contagion. Theriskofcontagionwasanessentialcauseofthecrisis.
In some cases, the fnancial svstem was vulnerable because policvmakers
wereafraidofalargefrmssuddenanddisorderlvfailuretriggeringbalance-
sheetlossesinitscounterparties.Theseinstitutionsweredeemedtoobigand
interconnected to other frms through counterpartv credit risk for policv-
makerstobewillingtoallowthemtofailsuddenlv.
VIII. Common shock. In other cases, unrelated fnancial institutions failed be-
causeofacommonshock:thevmadesimilarfailedbetsonhousing.Uncon-
nected fnancial frms failed for the same reason and at roughlv the same
timebecausethevhadthesameproblem:largehousinglosses.Thiscommon
shock meant that the problem was broader than a single failed bankkev
large fnancial institutions were undercapitalized because of this common
shock.
IX. Financial shock and panic. InquicksuccessioninSeptemberioo8,thefail-
ures,near-failures,andrestructuringsoftenfrmstriggeredaglobalfnancial
panic.Confdenceandtrustinthefnancialsvstembegantoevaporateasthe
health of almost everv large and midsize fnancial institution in the United
StatesandEuropewasquestioned.
X. Financial crisis causes economic crisis. The fnancial shock and panic
causedaseverecontractionintherealeconomv.Theshockandpanicended
inearlviooo.Harmtotherealeconomvcontinuesthroughtodav.
Wenowdescribethesetenessentialcausesofthecrisisinmoredetail.
THE CREDIT BUBBLE: GLOBAL CAPITAL FLOWS,
UNDERPRICED RISK, AND FEDERAL RESERVE POLICY
ThefnancialandeconomiccrisisbeganwithacreditbubbleintheUnitedStatesand
Europe.Creditspreadsnarrowedsignifcantlv,meaningthatthecostofborrowingto
fnanceriskvinvestmentsdeclinedrelativetosafeassetssuchasU.S.Treasurvsecuri-
ties.Themostnotableoftheseriskvinvestmentswerehigh-riskmortgages.
The U.S. housing bubble was the most visible effect of the credit bubble but not
the onlv one. Commercial real estate, high-vield debt, and leveraged loans were all
boostedbvthesurplusofinexpensivecredit.
There are three major possible explanations for the credit bubble: global capital
fows,therepricingofrisk,andmonetarvpolicv.
6looelcejiteljlovs
Starting in the late 1ooos, China, other large developing countries, and the big oil-
producing nations consumed and invested domesticallv less than thev earned. As
China and other Asian economies grew, their savings grew as well. In addition,
boostedbvhighglobaloilprices,thelargestoil-producingnationsbuiltuplargecap-
italsurplusesandlookedtoinvestintheUnitedStatesandEurope.Massiveamounts
ofinexpensivecapitalfowedintotheUnitedStates,makingborrowinginexpensive.
Americans used the cheap credit to make riskier investments than in the past. The
samedvnamicwasatworkinEurope.Germanvsaved,anditscapitalfowedtoIre-
land,Italv,SpainandPortugal.
FedChairmanBenBernankedescribesthestrongrelationshipbetweenfnancial
account surplus growth (the mirror of current account defcit growth) and house
price appreciation: Countries in which current accounts worsened and capital in-
fowsrose . . .hadgreaterhousepriceappreciation[fromioo1toiooo] . . .Therela-
tionship is highlv signifcant, both statisticallv and economicallv, and about :1
percentofthevariabilitvinhousepriceappreciationacrosscountriesisexplained.
i
Global imbalances are an essential cause of the crisis and the most important
macroeconomic explanation. Steadv and large increases in capital infows into the
U.S.andEuropeaneconomiesencouragedsignifcantincreasesindomesticlending,
especiallvinhigh-riskmortgages.
1/crcjricingojrisk
Low-costcapitalcanbutdoesnotnecessarilvhavetoleadtoanincreaseinriskvin-
vestments.IncreasedcapitalfowstotheUnitedStatesandEuropecannotaloneex-
plainthecreditbubble.
We still dont know whether the credit bubble was the result of rational or irra-
tional behavior. Investors mav have been rationaltheir preferences mav have
changed, making them willing to accept lower returns for high-risk investments.
Thevmavhavecollectivelvbeenirrationalthevmavhaveadoptedabubblemental-
itv and assumed that, while thev were paving a higher price for riskv assets, thev
couldresellthemlaterforevenmore.Orthevmavhavemistakenlvassumedthatthe
worldhadgottensaferandthattheriskofbadoutcomes(especiallvinU.S.housing
markets)haddeclined.
Forsomecombinationofthesereasons,overaperiodofmanvvearsleadingupto
thecrisis,investorsgrewwillingtopavmoreforriskvassets.Whenthehousingbub-
bleburstandthefnancialshockhit,investorsevervwherereassessedwhatreturnthev
would demand for a riskv investment, and therefore what price thev were willing to
pav for a riskv asset. Credit spreads for all tvpes of risk around the world increased
suddenlvandsharplv,andthepricesofriskvassetsplummeted.Thiswasmostevident
inbutnotlimitedtotheU.S.marketforfnancialassetsbackedbvhigh-risk,nontradi-
tionalmortgages.Thecreditbubbleburstandcausedtremendousdamage.
Monctervjolicv
The Federal Reserve signifcantlv affects the availabilitv and price of capital. This
leads some to argue that the Fed contributed to the increased demand for riskv in-
.z+ ii : :iN1i Nt :1\1i\iN1
vestmentsbvkeepinginterestratestoolowfortoolong.CriticsofFedpolicvargue
that, beginning under Chairman Greenspan and continuing under Chairman
Bernanke,theFedkeptratestoolowfortoolongandcreatedabubbleinhousing.
Dr.IohnB.Tavlorisaproponentofthisargument.HearguesthattheFedsetin-
terestratestoolowiniooiioooandthattheselowratesfueledthehousingbubble
asmeasuredbvhousingstarts.HesuggeststhatthisFed-createdhousingbubblewas
the essential cause of the fnancial crisis. He further argues that, had federal funds
ratesinsteadfollowedthepathrecommendedbvtheTavlorRule(amonetarvpolicv
formula for setting the funds rate), the housing boom and subsequent bust would
have been much smaller. He also applies this analvsis to European economies and
concludesthatsimilarforceswereatplav.
CurrentFedChairmanBernankeandformerFedChairmanGreenspandisagree
withTavlorsanalvsis.ChairmanBernankearguesthattheTavlorRuleisadescriptive
rule of thumb, but that simple policv rules are insumcient for making monetarv
policvdecisions.
:
Hefurtherarguesthat,dependingontheconstructionofthepar-
ticularTavlorRule,themonetarvpolicvstanceoftheFedmavnothavedivergedsig-
nifcantlv from its historical path. Former Chairman Greenspan adds that the
connectionbetweenshort-terminterestratesandhousepricesisweakthatevenif
theFedstargetforovernightlendingbetweenbankswastoolow,thishaslittlepower
toexplainwhvratesonthirtv-vearmortgageswerealsotoolow.
Thisdebateintertwinesseveralmonetarvpolicvquestions:
HowheavilvshouldtheFedweighapolicvruleinitsdecisionstosetinterest
rates:Shouldmonetarvpolicvbemostlvrule-basedormostlvdiscretionarv:
IftheFedthinksanassetbubbleisdeveloping,shoulditusemonetarvpolicvto
trvtopoporpreventit:
Wereinterestratestoolowiniooiiooo:
Didtoo-lowfederalfundsratescauseorcontributetothehousingbubble:
Thisdebateiscomplexandthusfarunresolved.Loosemonetarvpolicvdoesnot
necessarilvleadtosmallercreditspreads.Thereareopenquestionsaboutthelinkbe-
tweenshort-terminterestratesandhousepriceappreciation,whetherhousingstarts
arethebestmeasureofthehousingbubble,thetimingofhousingpriceincreasesrel-
ativetotheinterestratesiniooiiooo,theEuropeancomparison,andwhetherthe
magnitude of the bubble can be explained bv the gap between the Tavlor Rule pre-
scription and historic rates. At the same time, manv observers argue that Tavlor is
right that short-term interest rates were too low during this period, and therefore
thathisargumentisatleastplausibleifnotprovable.
Weconcludethatglobalcapitalfowsandriskrepricingcausedthecreditbubble,
and we consider them essential to explaining the crisis. U.S. monetarv policv mav
have been an amplifving factor, but it did not bv itself cause the credit bubble, nor
wasitessentialtocausingthecrisis.
TheCommissionshouldhavefocusedmoretimeandenergvonexploringthese
questionsaboutglobalcapitalfows,riskrepricing,andmonetarvpolicv.Instead,the
iii 1u uiNNi: :i, iuUti\: uui1/ i\ii N, \Ni 8i ii 1uu\\: .z.
Commission focused thousands of staff hours on investigation, and not nearlv
enough on analvzing these critical economic questions. The investigations were in
manvcasesproductiveandinformative,butthereshouldhavebeenmorebalancebe-
tweeninvestigationandanalvsis.
(onclusions.
Thecreditbubblewasanessentialcauseofthefnancialcrisis.
GlobalcapitalfowsloweredthepriceofcapitalintheUnitedStatesandmuch
ofEurope.
Over time, investors lowered the return thev required for riskv investments.
Theirpreferencesmavhavechanged,thevmavhaveadoptedanirrationalbub-
blementalitv,orthevmavhavemistakenlvassumedthattheworldhadbecome
safer.Thisinfatedpricesforriskvassets.
U.S. monetarv policv mav have contributed to the credit bubble but did not
causeit.
THE HOUSING BUBBLE
Thehousingbubblehadtwocomponents:theactualhomesandthemortgagesthat
fnancedthem.Welookbriefvateachcomponentanditspossiblecauses.
There was a housing bubble in the United Statesthe price of U.S. housing in-
creased bv more than could be explained bv market developments. This included
both a national housing bubble and more concentrated regional bubbles in four
SandStates:California,Nevada,Arizona,andFlorida.
Conventional wisdom is that a bubble is hard to spot while voure in one, and
painfullvobviousafterithasburst.EvenaftertheU.S.housingbubbleburst,thereis
noconsensusonwhatcausedit.
While we still dont know the relative importance of the possible causes of the
housingbubble,wecanatleastidentifvsomeofthemostimportanthvpotheses:
Population growth. Arizona,Florida,Nevada,andpartsofCaliforniaallexpe-
riencedpopulationgrowththatfarexceededthenationalaverage.Morepeople
fueledmoredemandforhouses.
Land use restrictions. Insomeareas,localzoningrulesandotherlandusere-
strictions, as well as natural barriers to building, made it hard to build new
houses to meet increased demand resulting from population growth. When
supplvisconstrainedanddemandincreases,pricesgoup.
Over-optimism. Even absent market fundamentals driving up prices, shared
expectations of future price increases can generate booms. This is the classic
explanationofabubble.
Easy fnancing. Nontraditional(andhigherrisk)mortgagesmadeiteasierfor
potential homebuvers to borrow enough to buv more expensive homes. This
doesnt mean thev could afford those homes or future mortgage pavments in
.zz ii : :iN1i Nt :1\1i\iN1 .zz ii : :iN1i Nt :1\1i\iN1
the long run, but onlv that someone was willing to provide the initial loan.
Mortgage originators often had insumcient incentive to encourage borrowers
togetsustainablemortgages.
SomecombinationofthefrsttwofactorsmavapplvinpartsoftheSandStates,
butthesedontexplainthenationwideincreaseinprices.
Thecloselvrelatedandnationwidemortgage bubblewasthelargestandmostsig-
nifcantmanifestationofamoregeneralizedcreditbubbleintheUnitedStatesandEu-
rope.Mortgagerateswerelowrelativetotheriskoflosses,andriskvborrowers,who
inthepastwouldhavebeenturneddown,founditpossibletoobtainamortgage.
a
In addition to the credit bubble, the proliferation of nontraditional mortgage
productswasakevcauseofthissurgeinmortgagelending.Useoftheseproductsin-
creasedrapidlvfromtheearlvpartofthedecadethroughiooo.Therewasasteadv
deteriorationinmortgageunderwritingstandards(enabledbvsecuritizersthatlow-
eredthecreditqualitvofthemortgagesthevwouldaccept,andcreditratingagencies
thatoverratedthesubsequentsecuritiesandderivatives).Therewasacontemporane-
ousincreaseinmortgagesthatrequiredlittletonodocumentation.
As house prices rose, declining affordabilitv would normallv have constrained
demand,butlendersandborrowersincreasinglvreliedonnontraditionalmortgage
products to paper over this affordabilitv issue. These mortgage products included
interest-onlv adjustable rate mortgages (ARMs), pav-option ARMs that gave bor-
rowersfexibilitvonthesizeofearlvmonthlvpavments,andnegativeamortization
productsinwhichtheinitialpavmentdidnotevencoverinterestcosts.Theseexotic
mortgage products would often result in signifcant reductions in the initial
monthlvpavmentcomparedwithevenastandardARM.Notsurprisinglv,thevwere
the mortgages of choice for manv lenders and borrowers focused on minimizing
initialmonthlvpavments.
Fed Chairman Bernanke sums up the situation this wav: At some point, both
lendersandborrowersbecameconvincedthathousepriceswouldonlvgoup.Bor-
rowerschose,andwereextended,mortgagesthatthevcouldnotbeexpectedtoserv-
ice in the longer term. Thev were provided these loans on the expectation that
accumulating home equitv would soon allow refnancing into more sustainable
mortgages.Foratime,risinghousepricesbecameaself-fulfllingprophecv,butulti-
matelv,furtherappreciationcouldnotbesustainedandhousepricescollapsed.
-
Thisexplanationpositsarelationshipbetweenthesurgeinhousingpricesandthe
surgeinmortgagelending.Thereisnotvetaconsensusonwhichwasthecauseand
whichtheeffect.Thevappeartohavebeenmutuallvreinforcing.
Inunderstandingthegrowthofnontraditionalmortgages,itisalsodimculttode-
terminetherelativeimportanceofcausalfactors,butagainwecanatleastlistthose
thatareimportant:
Nonbank mortgage lenders like New Centurv and Ameriquest fourished un-
derineffectiveregulatorvregimes,especiallvatthestatelevel.Weakdisclosure
standardsandunderwritingrulesmadeiteasvforirresponsiblelenderstoissue
iii 1u uiNNi: :i, iuUti\: uui1/ i\ii N, \Ni 8i ii 1uu\\: .z.
mortgagesthatwouldprobablvneverberepaid.Federallvregulatedbankand
thrift lenders, such as Countrvwide, Wachovia, and Washington Mutual, had
lenientregulatorvoversightonmortgageoriginationaswell.
Mortgage brokers were paid for new originations but did not ultimatelv bear
thelossesonpoorlvperformingmortgages.Mortgagebrokersthereforehadan
incentivetoignorenegativeinformationaboutborrowers.
Manvborrowersneitherunderstoodthetermsoftheirmortgagenorappreci-
ated the risk that home values could fall signifcantlv, while others borrowed
toomuchandboughtbiggerhousesthanthevcouldeverreasonablvexpectto
afford.
All these factors were supplemented bv government policies, manv of which
hadbeenineffectfordecades,thatsubsidizedhomeownershipbutcreatedhid-
dencoststotaxpaversandtheeconomv.Electedomcialsofbothpartiespushed
housingsubsidiestoofar.
The Commission heard convincing testimonv of serious mortgage fraud prob-
lems. Excruciating anecdotes showed that mortgage fraud increased substantiallv
during the housing bubble. There is no question that this fraud did tremendous
harm.Butwhilethatfraudisinfuriatingandmavhavebeensignifcantincertainar-
eas(likeFlorida),theCommissionwasunabletomeasuretheimpactoffraudrela-
tivetotheoverallhousingbubble.
The explosion of legal but questionable lending is an easier explanation for the
creationofsomanvbadmortgages.Lendingstandardswerelaxenoughthatlenders
couldremainwithinthelawbutstillgeneratehugevolumesofbadmortgages.Itis
likelv that the housing bubble and the crisis would have occurred even if there had
been no mortgage fraud. We therefore classifv mortgage fraud not as an essential
causeofthecrisisbutasacontributingfactorandadeplorableeffectofthebubble.
Evenifthenumberoffraudulentloanswasnotsubstantialenoughtohavealargeim-
pactonthebubble,theincreaseinfraudulentactivitvshouldhavebeenaleadingin-
dicatorofdeeperstructuralproblemsinthemarket.
(onclusions.
Beginninginthelate1ooosandacceleratingintheiooos,therewasalargeand
sustained housing bubble in the United States. The bubble was characterized
bothbvnationalincreasesinhousepriceswellabovethehistoricaltrendandbv
morerapidregionalboom-and-bustcvclesinCalifornia,Nevada,Arizona,and
Florida.
There was also a contemporaneous mortgage bubble, caused primarilv bv the
broadercreditbubble.
Thecausesofthehousingbubblearestillpoorlvunderstood.Explanationsin-
cludepopulationgrowth,landuserestrictions,bubblepsvchologv,andeasvf-
nancing.
The causes of the mortgage bubble and its relationship to the housing bubble
.z. ii : :iN1i Nt :1\1i\iN1
iii 1u uiNNi: :i, iuUti\: uui1/ i\ii N, \Ni 8i ii 1uu\\: .z,
are also still poorlv understood. Important factors include weak disclosure
standards and underwriting rules for bank and nonbank mortgage lenders
alike, the wav in which mortgage brokers were compensated, borrowers who
bought too much house and didnt understand or ignored the terms of their
mortgages,andelectedomcialswhoovervearspiledonlaveruponlaverofgov-
ernmenthousingsubsidies.
Mortgagefraudincreasedsubstantiallv,buttheevidencegatheredbvtheCom-
missiondoesnotshowthatitwasquantitativelvsignifcantenoughtoconclude
thatitwasanessentialcause.
TURNING BAD MORTGAGES INTO TOXIC FINANCIAL ASSETS
Themortgagesecuritizationprocessturnedmortgagesintomortgage-backedsecuri-
tiesthroughthegovernment-sponsoredenterprises(GSEs)FannieMaeandFreddie
Mac, as well as Countrvwide and other private label competitors. The securitiza-
tionprocessallowscapitaltofowfrominvestorstohomebuvers.Withoutit,mort-
gage lending would be limited to banks and other portfolio lenders, supported bv
traditional funding sources such as deposits. Securitization allows homeowners ac-
cesstoenormousamountsofadditionalfundingandtherebvmakeshomeownership
moreaffordable.Italsocandiversifvhousingriskamongdifferenttvpesoflenders.If
evervthing else is working properlv, these are good things. Evervthing else was not
workingproperlv.
Somefocustheircriticismontheform ofthesefnancialinstruments.Forexam-
ple, fnancial instruments called collateralized debt obligations (CDOs) were engi-
neered from different bundled pavment streams from mortgage-backed securities.
Some argue that the conversion of a bundle of simple mortgages to a mortgage-
backedsecuritv,andthentoacollateralizeddebtobligation,wasaproblem.Thevar-
guethatcomplexfnancialderivativescausedthecrisis.Weconcludethatthedetails
ofthisengineeringareincidentaltounderstandingtheessentialcausesofthecrisis.If
thesvstemworksproperlv,reconfguringstreamsofmortgagepavmentshaslittleef-
fect. The total amount of risk in a mortgage is unchanged if the pieces are put to-
getherinadifferentwav.
Unfortunatelv,thesvstemdidnotworkasitshouldhave.Therewereseveralfaws
inthesecuritizationandcollateralizationprocessthatmadethingsworse.
Fannie Mae and Freddie Mac, as well as Countrvwide and other private label
competitors,allloweredthecreditqualitvstandardsofthemortgagesthevse-
curitized.
o
Amortgage-backedsecuritvwasthereforeworseduringthecrisis
than in preceding vears because the underlving mortgages were generallv of
poorerqualitv.Thisturnedabadmortgageintoaworsesecuritv.
Mortgageoriginatorstookadvantageoftheselowercreditqualitvsecuritization
standardsandtheeasvfowofcredittorelaxtheunderwritingdisciplineinthe
loansthevissued.Aslongasthevcouldresellamortgagetothesecondarvmar-
ket,thevdidntcareaboutitsqualitv.
The increasing complexitv of housing-related assets and the manv steps be-
tweentheborrowerandfnalinvestorincreasedtheimportanceofcreditrating
agenciesandmadeindependentriskassessmentbvinvestorsmoredimcult.In
thisrespect,complexitvdidcontributetotheproblem,buttheotherproblems
listedherearemoreimportant.
Credit rating agencies assigned overlv optimistic ratings to the CDOs built
from mortgage-backed securities.
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518 Dissenting Statement
Freddie Mac. As noted earlier, in its limited review of the role of the GSEs
in the fnancial crisis, the Commission spent most of its time and staf resources
on a review of Fannie Mae, and for that reason this dissent focuses primarily on
documents received from Fannie. However, things were not substantially diferent
at Freddie Mac. In a document dated June 4, 2009, entitled Cost of Freddie Macs
Afordable Housing Mission, a report to the Business Risk Committee, of the Board
of Directors,
136
several points were made that show the experience of Freddie was no
diferent than Fannies:
Our housing goals compliance required little direct subsidy prior to 2003, but
since then subsidies have averaged $200 million per year.
Higher credit risk mortgages disproportionately tend to be goal-qualifying.
Targeted afordable lending generally requires accepting substantially higher
credit risk.
We charge more for targeted (and baseline) afordable single-family loans, but not
enough to fully ofset their higher incremental risk.
Goal-qualifying single-family loans accounted for the disproportionate share of
our 2008 realized losses that was predicted by our models. (slide 2)
In 2007 Freddie Mac failed two subgoals, but compliance was subsequently
deemed infeasible by the regulator due to economic conditions. In 2008 Freddie
Mac failed six goals and subgoals, fve of which were deemed infeasible. No
enforcement action was taken regarding the sixth missed goal because of our
fnancial condition. (slide 3)
Goal-qualifying loans tend to be higher risk. Lower household income correlates
with various risk factors such as less wealth, less employment stability, higher
loan-to-value ratios, or lower credit scores. (slide 7)
Targeted afordable loans have much higher expected default probabilities... Over
one-half of targeted afordable loans have higher expected default probabilities
than the highest 5% of non-goal-qualifying loans. (Slide 8)
Te use of the afordable housing goals to force a reduction in the GSEs
underwriting standards was a major policy error committed by HUD in two
successive administrations, and must be recognized as such if we are ever to
understand what caused the fnancial crisis. Ultimately, the AH goals extended the
housing bubble, infused it with weak and high risk NTMs, caused the insolvency of
Fannie and Freddie, andtogether with other elements of U.S. housing policywas
the principal cause of the fnancial crisis itself.
When Congress enacted the Housing and Economic Recovery Act of 2008
(HERA), it transferred the responsibility for administering the afordable housing
goals from HUD to FHFA. In 2010, FHFA modifed and simplifed the AH goals,
and eliminated one of their most troubling elements. As Fannie had noted, if the AH
goals exceed the number of goals-eligible borrowers in the market, they were being
forced to allocate credit, taking it from the middle class and providing it to low-
income borrowers. In efect, there was a confict between their mission to advance
afordable housing and their mission to maintain a liquid secondary mortgage
136
Freddie Mac, Cost of Freddie Macs Afordable Housing Mission, Business Risk Committee, Board
of Directors, June 4, 2009.
519 Peter J. Wallison
market for most mortgages in the U.S. Te new FHFA rule does not require the
GSEs to purchase more qualifying loans than the percentage of the total market that
these loans constitute.
137
Tis does not solve all the major problems with the AH goals. In the sense
that the goals enable the government to direct where a private company extends
credit, they are inherently a form of government credit allocation. More signifcantly,
the competition among the GSEs, FHA and the banks that are required under the
CRA to fnd and acquire the same kind of loans will continue to cause the same
underpricing of risk on these loans that eventually brought about the mortgage
meltdown and the fnancial crisis. Tis is discussed in the next section and the
section on the CRA.
4. Competition Between the GSEs and FHA
for Subprime and Alt-A Mortgages
One of the important facts about HUDs management of the AH goals
was that it placed Fannie and Freddie in direct competition with FHA, an agency
within HUD. Tis was already noted in some of the Fannie documents cited above.
Fannie treated this as a confict of interest at HUD, but there is a strong case that
this competition is exactly what HUD and Congress wanted. It is important to
recall the context in which the GSE Act was enacted in 1992. In 1990, Congress had
enacted the Federal Credit Reform Act.
138
One of its purposes was to capture in the
governments budget the risks to the government associated with loan guarantees,
and in efect it placed a loose budgetary limit on FHA guarantees. For those in
Congress and at HUD who favored increased mortgage lending to low income
borrowers and underserved communities, this consequence of the FCRA may have
been troubling. What had previously been a free way to extend support to groups
who were not otherwise eligible for conventional mortgageswhich generally
required a 20 percent downpayment and the indicia of willingness and ability to
paynow appeared to be potentially restricted. Requiring the GSEs to take up the
mantle of afordable housing would have looked at the time like a solution, since
Fannie and Freddie had unlimited access to funds in the private markets and were
of-budget entities.
Looked at from this perspective, it would make sense for Congress and HUD
to place the GSEs and FHA in competition, just as it made sense to put Fannie and
Freddie in competition with one another for afordable loans. With all three entities
competing for the same kinds of loans, and with HUDs control of both FHAs
lending standards and the GSEs afordable housing requirements, underwriting
requirements would inevitably be reduced. HUDs explicit and frequently expressed
interest in reducing mortgage underwriting standards, as a means of making
mortgage credit available to low income borrowers, provides ample evidence of
HUDs motives for creating this competition.
137
Federal Housing Finance Agency, 2010-2011 Enterprise Housing Goals; Enterprise Book-Entry
Procedures; Final Rule, 12 CFR Parts 1249 and 1282, Federal Register, September 14, 2010, p.55892.
138
Title V of the Congressional Budget Act of 1990. Under the FCRA, HUD must estimate the annual
cost of FHAs credit subsidy for budget purposes. Te credit subsidy is the net of its estimated receipts
reduced by its estimated payments.
520 Dissenting Statement
Established in 1934, now a part of HUD and administered by the Federal
Housing Administrator (who is also the Assistant Secretary of Housing), FHA
insures 100 percent of an eligible mortgage. It was established to provide fnancing
to people who could not meet the standards for a bank-originated conventional
loan. Te loans it insured had a maximum LTV of 80 percent in 1934. Tis went to
95 percent in 1950, and 97 percent in 1961.
139
With its maximum LTV remaining at
97 percent, FHA maintained average FICO scores for its borrowers just below 660
from 1996 to 2006. During this period, the average FICO score for a conventional
subprime borrower was somewhat lower.
140
Beginning in 1993, shortly afer Fannie
and Freddie were introduced as competitors, FHA began to increase its percentage
of loans with low downpayments. Tis had the predictable efect on its delinquency
rates, as shown in the fgure below prepared by Edward Pinto with data from FHA,
the FDIC, and the MBA:
Figure 6.
Despite its reductions in required downpayments, FHAs market share vis-a
vis the GSEs began to decline. According to GAO data, in 1996, FHAs market
share among lower-income borrowers was 26 percent while the GSEs share was
23.8 percent. By 2005, FHAs share was 9.8 percent, while the GSEs share was 31.9
percent. It appears that early on Fannie Mae deliberately targeted FHA borrowers
with its Community Homebuyer Program (CHBP). In a memorandum prepared
in 1993, Fannies Credit Policy group compared Fannies then-proposed CHBP
program to FHAs requirements under its 1-to-4 family loan program (Section
203(b)) and showed that most of Fannies requirements were competitive or better.
139
Kerry D. Vandell, FHA Restructuring Proposals: Alternatives and Implications, Fannie Mae Housing
Policy Debate, vol. 6, Issue 2, 1995, pp. 308-309
140
GAO, Federal Housing Administration: Decline in Agencys Market Share Was Associated with
Product and Process Developments of Other Mortgage Market Participants, GAO-07-645, June 2007,
pp. 42 and 44.
521 Peter J. Wallison
FHA also appears to have tried to lead the GSEs. In 1999just before the
AH goals for Fannie and Freddie were to be raisedFHA almost doubled its
originations of loans with LTVs equal to or greater than 97 percent, going from 22.9
percent in 1998 to 43.84 percent in 1999.
141
It also ofered additional concessions on
underwriting standards in order to attract subprime business. Te following is from
a Quicken ad in January 2000 (emphasis in the original),
142
which is likely to have
been based on an FHA program as it existed in 1999:
Borrowers can purchase with a minimum down payment. Without FHA insurance,
many families cant aford the homes they want because down payments are a major
roadblock. FHA down payments range from 1.25% to 3% of the sale price and are
signifcantly lower than the minimum that many lenders require for conventional or
sub-prime loans.
With FHA loans, borrowers need as little as 3% of the total funds required. In
addition to the funds needed for the down payment, borrowers also have to pay
closing costs, prepaid fees for insurance and interest, as well as escrow fees which
include mortgage insurance, hazard insurance, and months worth of property taxes.
A FHA-insured home loan can be structured so borrowers dont pay more than 3% of
the total out-of-pocket funds, including the down payment.
Te combined total of out-of-pocket funds can be a gif or loan from family
members. FHA allows homebuyers to use gifs from family members and non-proft
groups to cover their down payment and additional closing costs and fees. In fact,
even a 100% gif or a personal loan from a relative is acceptable.
FHAs credit requirements are fexible. Compared to credit requirements established
by many lenders for other types of home loans, FHA focuses only on a borrowers last
12-24 month credit history. In addition, there is no minimum FICO score - mortgage
bankers look at each application on a case-by-case basis. It is also perfectly acceptable
for people with NO established credit to receive a loan with this program.
FHA permits borrowers to have a higher debt-to-income ratio than most insurers
typically allow. Conventional home loans allow borrowers to have 36% of their gross
income attributed to their new monthly mortgage payment combined with existing
debt. FHA program allows borrowers to carry 41%, and in some circumstances, even
more.
It is important to remember that 1999 is the year that HUD was planning a
big step-up in the AH goals for the GSEsfrom 42 percent LMI to 50 percent, with
even larger percentage increases in the special afordable category that would be most
competitive with FHA. Te last major increase in the percent of FHAs loans with
LTVs equal to or greater than 97 percent had occurred in 1991, the year before the
GSE Act imposed the AH goals on Fannie and Freddie, and in efect directed them
to consider downpayments of 5 percent or less. In 1991, FHAs percentage of loans
141
Integrated Financial Engineering, Actuarial Review of the Federal Housing Administration Mutual
Mortgage Insurance Fund (Excluding HECMs) for Fiscal Year 2009, prepared for U.S. Department of
Housing and Urban Development, November 6, 2009, p.42.
142
Quicken press release, Quicken Loans First To Ofer FHA Home Mortgages Nationally On Te
Internet With HUDs approval, Intuit expands home ownership nationwide, ofering consumers
widest variety of home loan options, January 20, 2000, http://web.intuit.com/about_intuit/press_
releases/2000/01-20.html.
522 Dissenting Statement
equal to or greater than 97 percent rose suddenly from 4.4 percent to 17.1 percent.
143
Again, FHA, under the control of HUD, appears to be ofering competition to the
GSEs that would lead them to reduce their underwriting standards. Since FHA is a
government agency, its actions cannot be explained by a proft motive. Instead, it
seems clear that FHA reduced its lending standards as part of a HUD policy to lead
Fannie and Freddie in the same direction.
Te result of Fannies competition with FHA in high LTV lending is shown in
the following fgure, which compares the respective shares of FHA and Fannie in the
category of loans with LTVs equal to or greater than 97 percent, including Fannie
loans with a combined LTV equal to or greater than 97 percent.
Figure 7.
Whether a conscious policy of HUD or not, competition between the GSEs
and FHA ensued immediately afer the GSEs were given their afordable housing
mission in 1992. Te fact that FHA, an agency controlled by HUD, substantially
increased the LTVs it would accept in 1991 (just before the GSEs were given their
afordable housing mission) and again in 1999 (just before the GSEs were required
to increase their afordable housing eforts) is further evidence that HUD was
coordinating these policies in the interest of creating competition between FHA
and the GSEs. Te efect was to drive down underwriting standards, which HUD
had repeatedly described as its goal.
5. Enlisting Mortgage Bankers and Subprime
Lenders in Affordable Housing
In 1994, HUD began a program to enlist other members of the mortgage
fnancing community in the efort to reduce underwriting standards. In that year,
143
GAO, Federal Housing Administration: Decline in Agencys Market Share Was Associated with
Product and Process Developments of Other Mortgage Market Participants, GAO-07-645, June 2007,
pp. 42 and 44.
523 Peter J. Wallison
the Mortgage Bankers Association (MBA)a group of mortgage fnancing frms
not otherwise regulated by the federal government and not subject to HUDs legal
authorityagreed to join a HUD program called the Best Practices Initiative.
144
Te circumstances surrounding this agreement are somewhat obscure, but at least
one contemporary account suggests that the MBA signed up to avoid an efort by
HUD to cover mortgage bankers under the Community Reinvestment Act (CRA),
which up to that point had only applied only to government-insured banks.
In mid-September [1994], the Mortgage Bankers Association of America-
whose membership includes many bank-owned mortgage companies, signed a
three-year master best-practices agreement with HUD. Te agreement consisted
of two parts: MBAs agreement to work on fair-lending issues in consultation
with HUD and a model best-practices agreement that individual mortgage banks
could use to devise their own agreements with HUD. Te frst such agreement,
signed by Countrywide Funding Corp., the nations largest mortgage bank, is
summarized [below]. Many have seen the MBA agreement as a preemptive strike
against congressional murmurings that mortgage banks should be pulled under the
umbrella of the CRA.
145
As the frst member of the MBA to sign, Countrywide probably realized that
there were political advantages in being seen as assisting low-income mortgage
lending, and it became one of a relatively small group of subprime lenders who
were to prosper enormously as Fannie and Freddie began to look for sources of
the subprime loans that would enable them to meet the AH goals. By 1998, there
were 117 MBA signatories to HUDs Best Practices Initiative, which was described
as follows:
Te companies and associations that sign Best Practices Agreements not only
commit to meeting the responsibilities under the Fair Housing Act, but also make
a concerted efort to exceed those requirements. In general, the signatories agree to
administer a review process for loan applications to ensure that all applicants have
every opportunity to qualify for a mortgage. Tey also assent to making loans of
any size so that all borrowers may be served and to provide information on all loan
programs for which an applicant qualifes. Te results of the initiative are promising.
As lenders discover new, untapped markets, their minority and low-income loans
applications and originations have risen. Consequently, the homeownership rate for
low-income and minority groups has increased throughout the nation.
146
Countrywide was by far the most important participant in the HUD
program. Under that program, it made a series of multi-billion dollar commitments,
culminating in a trillion dollar commitment to lend to minority and low income
144
HUDs Best Practices Initiative was described this way by HUD: Since 1994, HUD has signed Fair
Lending Best Practices (FLBP) Agreements with lenders across the nation that are individually tailored
to public-private partnerships that are considered on the leading edge. Te Agreements not only ofer
an opportunity to increase low-income and minority lending but they incorporate fair housing and
equal opportunity principles into mortgage lending standards. Tese banks and mortgage lenders,
as represented by Countrywide Home Loans, Inc., serve as industry leaders in their communities by
demonstrating a commitment to af rmatively further fair lending. Available at: http://www.hud.gov/
local/hi/working/nlwfal2001.cfm.
145
Steve Cocheo, Fair-Lending Pressure Builds, ABA Banking Journal, vol. 86, 1994, http://www.
questia.com/googleScholar.qst?docId=5001707340.
146
HUD, Building Communities and New Markets for the 21st Century, FY 1998 Report , p.75, http://
www.huduser.org/publications/polleg/98con/NewMarkets.pdf.
524 Dissenting Statement
families, which in part it fulflled by selling subprime and other NTMs to Fannie and
Freddie. In a 2000 report, the Fannie Mae Foundation noted: FHA loans constituted
the largest share of Countrywides activity, until Fannie Mae and Freddie Mac began
accepting loans with higher LTVs and greater underwriting fexibilities.
147
In late
2007, a few months before its rescue by Bank of America, Countrywide reported that
it had made $789 billion in mortgage loans toward its trillion dollar commitment.
148
6. The Community Reinvestment Act
Te most controversial element of the vast increase in NTMs between 1993
and 2008 was the role of the CRA.
149
Te act, which is applicable only to federally
insured depository institutions, was originally adopted in 1977. Its purpose in part
was to require each appropriate Federal fnancial supervisory agency to use its
authority when examining fnancial institutions to encourage such institutions to
help meet the credit needs of the local communities in which they are chartered
consistent with the safe and sound operations of such institutions. Te enforcement
provisions of the Act authorized the bank regulators to withhold approvals for such
transactions as mergers and acquisitions and branch network expansion if the
applying bank did not have a satisfactory CRA rating.
CRA did not have a substantial efect on subprime lending in the years afer
its enactment until the regulations under the act were tightened in 1995. Te 1995
regulations required insured banks to acquire or make fexible and innovative
mortgages that they would not otherwise have made. In this sense, the CRA and
Fannie and Freddies AH goals are cut from the same cloth.
Tere were two very distinct applications of the CRA. Te frst, and the one
with the broadest applicability, is a requirement that all insured banks make CRA
loans in their respective assessment areas. When the Act is defended, it is almost
always discussed in terms of this categoryloans in bank assessment areas. Banks
(usually privately) complain that they are required by the regulators to make
imprudent loans to comply with CRA. One example is the following statement by a
local community bank in a report to its shareholders:
Under the umbrella of the Community Reinvestment Act (CRA), a tremendous
amount of pressure was put on banks by the regulatory authorities to make loans,
especially mortgage loans, to low income borrowers and neighborhoods. Te
regulators were very heavy handed regarding this issue. I will not dwell on it here
but they required [redacted name] to change its mortgage lending practices to meet
certain CRA goals, even though we argued the changes were risky and imprudent.
150
On the other hand, the regulators defend the act and their actions under it,
and particularly any claim that the CRA had a role in the fnancial crisis. Te most
frequently cited defense is a speech by former Fed Governor Randall Kroszner on
147
Fannie Mae Foundation, Making New Markets: Case Study of Countrywide Home Loans, 2000,
http://content.knowledgeplex.org/kp2/programs/pdf/rep_newmortmkts_countrywide.pdf.
148
Questions and Answers from Countrywide about Lending, December 11, 2007, available at http://
www.realtown.com/articles/article/print/id/768.
149
12 U.S.C. 2901.
150
Original letter in authors fles.
525 Peter J. Wallison
December 3, 2008,
151
in which he said in pertinent part:
Only 6 percent of all the higher-priced loans [those that were considered CRA loans
because they bore high interest rates associated with their riskier character] were
extended by CRA-covered lenders to lower-income borrowers or neighborhoods in their
assessment areas, the local geographies that are the primary focus for CRA evaluation
purposes. Tis result undermines the assertion by critics of the potential for a
substantial role for the CRA in the subprime crisis. [emphasis supplied]
Tere are two points in this statement that require elaboration. First, it
assumes that all CRA loans are high-priced loans. Tis is incorrect. Many banks, in
order to be sure of obtaining the necessary number of loans to attain a satisfactory
CRA rating, subsidized the loans by making them at lower interest rates than
their risk characteristics would warrant. Tis is true, in part, because CRA loans
are generally loans to low income individuals; as such, they are more likely than
loans to middle income borrowers to be subprime and Alt-A loans and thus sought
afer by FHA, Fannie and Freddie and subprime lenders such as Countrywide; this
competition is another reason why their rates are likely to be lower than their risk
characteristics. Second, while bank lending under CRA in their assessment areas
has probably not had a major efect on the overall presence of subprime loans in the
U.S. fnancial system, it is not the element about CRA that raises the concerns about
how CRA operated to increase the presence of NTMs in the housing bubble and in
the U.S. fnancial system generally. Tere is another route through which CRAs role
in the fnancial crisis likely to be considerably more signifcant.
In 1994, the Riegle-Neal Interstate Banking and Branching Ef ciency Act for
the frst time allowed banks to merge across state lines under federal law (as distinct
from interstate compacts). Under these circumstances, the enforcement provisions
of the CRA, which required regulators to withhold approvals of applications for
banks that did not have satisfactory CRA ratings, became particularly relevant
for large banks that applied to federal bank regulators for merger approvals. In a
2007 speech, Fed Chairman Ben Bernanke stated that afer the enactment of the
Riegle-Neal legislation, As public scrutiny of bank merger and acquisition activity
escalated, advocacy groups increasingly used the public comment process to protest
bank applications on CRA grounds. In instances of highly contested applications,
the Federal Reserve Board and other agencies held public meetings to allow the
public and the applicants to comment on the lending records of the banks in
question. In response to these new pressures, banks began to devote more resources
to their CRA programs.
152
Tis modest description, although accurate as far as it
goes, does not fully describe the efect of the law and the application process on
bank lending practices.
In 2007, the umbrella organization for many low-income or community
advocacy groups, the National Community Reinvestment Coalition, published a
report entitled CRA Commitments which recounted the substantial success of its
members in using the leverage provided by the bank application process to obtain
trillions of dollars in CRA lending commitments from banks that had applied to
151
Randall Kroszner, Speech at the Confronting Concentrated Poverty Forum, December 3, 2008.
152
Ben S. Bernanke, Te Community Reinvestment Act: Its Evolution and New Challenges, March 30,
2007, p2.
526 Dissenting Statement
federal regulators for merger approvals. Te opening section of the report states
(bolded language in the original):
153
Since the passage of CRA in 1977, lenders and community organizations have
signed over 446 CRA agreements totaling more than $4.5 trillion in reinvestment
dollars fowing to minority and lower income neighborhoods.
Lenders and community groups will ofen sign these agreements when a lender has
submitted an application to merge with another institution or expand its services.
Lenders must seek the approval of federal regulators for their plans to merge or
change their services. Te four federal fnancial institution regulatory agencies will
scrutinize the CRA records of lenders and will assess the likely future community
reinvestment performance of lenders. Te application process, therefore, provides an
incentive for lenders to sign CRA agreements with community groups that will improve
their CRA performance. Recognizing the important role of collaboration between lenders
and community groups, the federal agencies have established mechanisms in their
application procedures that encourage dialogue and cooperation among the parties in
preserving and strengthening community reinvestment. [emphasis supplied]
A footnote to this statement reports:
Te Federal Reserve Board will grant an extension of the public comment period
during its merger application process upon a joint request by a bank and community
group. In its commentary to Regulation Y, the Board indicates that this procedure
was added to facilitate discussions between banks and community groups regarding
programs that help serve the convenience and needs of the community. In its
Corporate Manual, the Of ce of the Comptroller of the Currency states that it will
not ofer the expedited application process to a lender that does not intend to honor a
CRA agreement made by the institution that it is acquiring.
153
See Note 12 supra.
527 Peter J. Wallison
In its report, the NCRC listed all 446 commitments and includes the
following summary list of year-by-year commitments:
Table 13.
Year Annual Dollars
($ millions)
Total Dollars
($ millions)
2007 12, 500 4,566,480
2006 258,000 4,553,980
2005 100,276 4,298,980
2004 1,631,140 4,195,704
2003 711,669 2,564,564
2002 152,859 1,852,895
2001 414,184 1,700,036
2000 13,681 1,285,852
1999 103,036 1,272,171
1998 812,160 1,169,135
1997 221,345 356,975
1996 49,678 135,630
1995 26,590 85,952
1994 6,128 59,362
1993 10,716 53,234
1992 33,708 42,518
1991 2,443 8,811
1990 1,614 6,378
1989 2,260 4,764
1988 1,248 2,504
1987 357 1,256
1986 516 899
1985 73 382
1984 219 309
1983 1 90
1982 6 89
1981 5 83
1980 13 78
1979 15 65
1978 0 50
1977 50 50
Te size of these commitments, which far outstrip the CRA loans made in
assessment areas, suggests the potential signifcance of the CRA as a cause of the
fnancial crisis. It is noteworthy that the Commission majority was not willing even
to consider the signifcance of the NCRCs numbers. In connection with its only
hearing on the housing issue, and before any research had been done on the NCRC
statements, the Commission published a report absolving CRA of any responsibility
for the fnancial crisis.
154
154
FCIC, Te Community Reinvestment Act and the Mortgage Crisis. Preliminary Staf Report, http://
www.fcic.gov/reports/pdfs/2010-0407-Preliminary_Staf_Report_-_CRA_and_the_Mortgage_Crisis.
pdf.
528 Dissenting Statement
To understand CRAs role in the fnancial crisis, the relevant statistic is the $4.5
trillion in bank CRA lending commitments that the NCRC cited in its 2007 report.
(Tis document and others that are relevant to this discussion were removed from
the NCRC website, www.ncrc.org, afer they received publicity but can still be found
on the web
155
). One important question is whether the bank regulators cooperated
with community groups by withholding approvals of applications for mergers and
acquisitions until an agreement or commitment for CRA lending satisfactory to
the community groups had been arranged. It is not dif cult to imagine that the
regulators did not want the severe criticism from Congress that would have followed
their failure to assist community groups in reaching agreements with and getting
commitments from banks that had applied for these approvals. In statements in
connection with mergers it has approved the Fed has said that commitments by
the bank participants about future CRA lending have no infuence on the approval
process. A Fed of cial also told the Commissions staf that the Fed did not consider
these commitments in connection with merger applications. Te Commission did
not attempt to verify this statement, but accepted it at face value from a Fed staf
of cial. Nevertheless, there remains no explanation for why banks have been making
these enormous commitments in connection with mergers, but not otherwise.
Te largest of the commitments, in terms of dollars, were made by four banks
or their predecessorsBank of America, JPMorgan Chase, Citibank, and Wells
Fargoin connection with mergers or acquisitions as shown in Table 14 below.
155
http://www.community-wealth.org/_pdfs/articles-publications/cdfs/report-silver-brown.pdf.
529 Peter J. Wallison
Table 14. Announced CRA Commitments in Connection
with a Merger or Acquisition by Four Largest Banks and Teir Predecessors
Final bank Acquired or merged bank/entity
with a corresponding
announcement of a CRA commitment
CRA commitment (year
announced and dollar amount)
Wells Fargo First Union acquired by Wachovia
SouthTrust acquired by
Wachovia
2001 ($35 b.)
2004 ($75 b.)
JPMorgan
Chase
Chemical merges with
Manufacturers Hanover
NBD acquired by First Chicago
Home Savings acquired by
Washington Mutual
Dime acquired by
Washington Mutual
Bank One acquired by JPMorgan Chase
1991 ($72.5 m.)
1995 ($2 b.)
1998 ($120 b.)
2001 ($375 b.)
2004 ($800 b.)
Bank of
America
Continental acquired by Bank of America
Bank of America (acquired by NationsBank,
which kept the Bank of America name).
Bank of Boston
acquired by Fleet
Fleet
1994 ($1 b.)
1998 ($350 b.)
1999 ($14.6 b.)
2004 ($750 b.)
Citibank Travelers
Cal Fed
1998 ($115 b.)
1998 ($115 b.)
2002 ($120 b.)
Compiled by Edward Pinto from the NCRC 2007 report CRA Commitments, found at http://www.
community-wealth.org/_pdfs/articles-publications/cdfs/report-silver-brown.pdf , NCRC testimony
regarding Bank of Americas $1.5 trillion in CRA agreements and commitments in conjunction with its
2008 acquisition of Countrywide found at http://www.house.gov/apps/list/hearing/fnancialsvcs_dem/
taylor_testimony_-_4.15.10.pdf.
Given the enormous size of the commitments reported by NCRC, the key
questions are: (i) how many of these commitments were actually fulflled by the
banks that made them, (ii) where are these loans today, and (iii) how are these loans
performing?
Currently, in light of the severely limited Commission investigation of this
issue, there are only partial answers to these questions.
Were the loans actually made? Te banks that made these commitments
apparently came under pressure from community groups to fulfll them. In an
interview by Brad Bondi of the Commissions staf, Josh Silver of the NCRC noted
that community groups did follow up these commitments.
Bondi: Who follows upto make sure that these banks honor their voluntary
agreements or their unilateral commitments?
530 Dissenting Statement
Silver: Actually part of some of these CRA agreements was meeting with the bank two
or three times a year and actually going through, Heres what youve promised. Heres
what youve loaned. Tat would happen on a one-on-one basis with the banks and the
community organizations.
156
Nevertheless, when the Commission staf asked the four largest banks (Bank
of America, Citibank, JPMorgan Chase and Wells Fargo) for data on whether the
merger-related commitments were fulflled and in what amount, most of the banks
supplied only limited information. Tey contended that they did not have the
information or that it was too dif cult to get, and the information they supplied was
sketchy at best.
In some cases, the information supplied to the Commission by the banks,
in letters from their counsel, refected fewer loans than they had claimed in press
releases to have made in fulfllment of their commitments. Te press release
amounts were JPMorgan Chase (including WaMu, $835 billion), Citi ($274 billion),
and Bank of America ($229 billion), totaled $1.3 trillion in CRA loans between
2001 and 2008, and had been presented to the Commission by Edward Pinto in the
Triggers memo.
157
No Wells Fargo press releases could be found, but in response
to questions from the Commission Wells provided a great deal of data in spread
sheets that could not be interpreted or understood without further discussion with
representatives of the bank. However, the Commission terminated the investigation
of the merger-related CRA commitments in August 2010, before the necessary data
could be gathered. For this reason, the Wells data could not be unpacked, interpreted
in discussion with Wells of cials, and analyzed.
Afer I protested the limited eforts of the Commission on this issue in
October 2010, the Commission made a belated attempt to restart the investigation
of the merger-related CRA commitments in November. However, only one bank
had responded by the deadline for submission of this dissenting statement. As with
the bank responses, additional work was required to understand the information
received, and there was no time, and no Commission staf, to follow up.
As a result of the dilatory nature of the Commissions investigation, it was
impossible to determine how many loans were actually made under their merger-
related CRA commitments by the four banks and their predecessors. Tis in
turn impeded any efort to fnd out where these loans are today and hence their
delinquency rates. It appears that in many instances the Commission management
constrained the staf in their investigation into CRA by limiting the number of
document requests and interviews and by preventing the staf from following up
with the institutions that failed to respond adequately to requests for data.
Where are these mortgages today? Where these loans are today must necessarily
be a matter of speculation. Some of the banks told the FCIC staf that they do not
distinguish between CRA loans and other loans, and so could not provide this
information. Under the GSE Act, Fannie and Freddie had an af rmative obligation
to help banks to meet their CRA obligations, and they undoubtedly served as a
buyer for the loans made by the largest banks and their predecessors pursuant to
156
Interview of Josh Silver of the National Community Reinvestment Coalition, June 16, 2010.
157
Edward Pinto, Exhibit 2 to the Triggers memo, dated April 21, 2010, http://www.aei.org/docLib/
Pinto-Sizing-Total-Federal-Contributions.pdf.
531 Peter J. Wallison
the commitments. In a press release in 2003, for example, Fannie reported that it
had acquired $394 billion in CRA loans, about $201 billion of which occurred in
2002.
158
Tis amounted to approximately 50 percent of Fannies AH acquisitions for
that year.
In the Triggers memo, based on his research, Pinto estimated that Fannie and
Freddie purchased about 50 percent of all CRA loans over the period from 2001
to 2007 and that, of the balance, about 10-15 percent were insured by FHA, 10-15
percent were sold to Wall Street, and the rest remain on the books of the banks that
originated the loans.
159
Many of these loans are likely unsaleable in the secondary
market because they were made at rates that did not compensate for risk or lacked
mortgage insuranceagain, the competition for these loans among the GSEs, FHA
and the banks operating under CRA requirements inevitably raised their prices and
thus underpriced their risk. To sell these loans, the banks holding them would have
to take losses, which many are unwilling to do.
What are the delinquency rates? Under the Home Mortgage Disclosure Act
HMDA), banks are required to provide data to the Fed from which the delinquency
rates on loans that have high interest rates can be calculated. It was assumed that
these were the loans that might bear watching as potentially predatory. When Fannie
and Freddie, FHA, Countrywide and other subprime lenders and banks under CRA
are all seeking the same loansroughly speaking, loans to borrowers at or below
the AMIit is likely that these loans when actually made will bear concessionary
interest rates so that their rate spread is not be reportable under HMDA. Its just
supply and demand. Accordingly, the banks that made CRA loans pursuant to their
commitments have no obligation to record and report their delinquency rates, and
as noted above several of the large banks that made major commitments recorded
by the NCRC told FCIC staf that they dont keep records about the performance of
CRA loans apart from other mortgages.
However, in the past few years, Bank of America has been reporting the
performance of CRA loans in its annual report to the SEC on form 10-K. For
example, the banks 10-K for 2009 contained the following statement: At December
31, 2009, our CRA portfolio comprised six percent of the total residential mortgage
balances, but comprised 17 percent of nonperforming residential mortgage loans.
Tis portfolio also comprised 20 percent of residential net charge-ofs during 2009.
While approximately 32 percent of our residential mortgage portfolio carries risk
mitigation protection, only a small portion of our CRA portfolio is covered by
this protection.
160
Tis could be an approximation for the delinquency rate on the
merger-related CRA loans that the four banks made in fulflling their commitments,
but without defnitive information on the number of loans made and the banks
current holdings it is impossible to make this estimate with any confdence. In a
letter from its counsel, another bank reported serious delinquency rates on the loans
made pursuant to its merger-related commitments ranging from 5 percent to 50
percent, with the largest sample showing a 25 percent delinquency rate.
158
Fannie Mae Passes Halfway Point in $2 Trillion American Dream Commitment; Leads Market in
Bringing Housing Boom to Underserved Families, Communities http://fndarticles.com/p/articles/
mi_m0EIN/is_2003_March_18/ai_98885990/pg_3/?tag=content;col1.
159
Triggers memo, p.47.
160
Bank of America, 2009 10-K, p.57.
532 Dissenting Statement
Further investigation of this issue is necessary, including on the role of
the bank regulators, in order to determine what efect, if any, the merger-related
commitments to make CRA loans might have had on the number of NTMs in the
U.S. fnancial system before the fnancial crisis.
533
IV. CONCLUSION
Tis dissenting statement argues that the U.S. governments housing policies
were the major contributor to the fnancial crisis of 2008. Tese policies fostered the
development of a massive housing bubble between 1997 and 2007 and the creation
of 27 million subprime and Alt-A loans, many of which were ready to default
as soon as the housing bubble began to defate. Te losses associated with these
weak and high risk loans caused either the real or apparent weakness of the major
fnancial institutions around the world that held these mortgagesor PMBS backed
by these mortgagesas investments or as sources of liquidity. Deregulation, lack of
regulation, predatory lending or the other factors that were cited in the report of the
FCICs majority were not determinative factors.
Te policy implications of this conclusion are signifcant. If the crisis could
have been prevented simply by eliminating or changing the government policies
and programs that were primarily responsible for the fnancial crisis, then there
was no need for the Dodd-Frank Wall Street Reform and Consumer Protection Act
of 2010, adopted by Congress in July 2010 and ofen cited as one of the important
achievements of the Obama administration and the 111
th
Congress.
Te stringent regulation that the Dodd-Frank Act imposes on the U.S.
economy will almost certainly have a major adverse efect on economic growth
and job creation in the United States during the balance of this decade. If this was
the price that had to be paid for preventing another fnancial crisis then perhaps
its one that will have to be borne. But if it was not necessary to prevent another
crisisand it would not have been necessary if the crisis was caused by actions of
the government itselfthen the Dodd-Frank Act seriously overreached.
Finally, if the principal cause of the fnancial crisis was ultimately the
governments involvement in the housing fnance system, housing fnance policy in
the future should be adjusted accordingly.
534 Dissenting Statement
535
APPENDIX 1
Hypothetical Losses in Two Scenarios (No feedback)
Scenario 1 is what was known to market professional during the 2nd
half of 2007; Scenario 2 is the actual condition of the mortgage market. Second
mortgage/home equity loan losses are excluded.
Assumptions used:
Number of mortgages= 53 million;
Total value of frst mortgages=$9.155 trillion;
Losses on Prime=1.2%% (assumes 3% foreclosure rate & 40% severity);
Losses on Subprime/Alt-A=12% (assumes 30% foreclosure rate & 40%
severity);
Average size of mortgage: $173,000
Losses in Scenario 1
Number of mortgages: 53 million
Prime=40 million
Subprime/Alt-A = 13 million (7.7. PMBS million + FHA/VA=5.2 million)
Aggregate Value:
Prime =$6.9 trillion ($173,000 X 40 million);
Subprime/Alt-A=$2.25 trillion ($173,000 X 13 million)
Losses on foreclosures: $353 billion ($6.9 trillion prime X 1.2%=$83 billion
+ $2.25 trillion subprime/Alt-A X 12%=$270 billion
Overall loss percentage: 3.5%
Losses in Scenario 2
Number of mortgages: 53 million
Prime: 27 million
Subprime/Alt-A:
Original subprime/Alt-A: 13 million
Other subprime/Alt-A: 13 million (10.5 F&F (excludes 1.25 million already
counted in PMBS) + 2.5 million other loans not securitized (mostly held by the large
banks))
Aggregate Value:
Prime= $4.7 trillion ($173,000 X 27 million);
Subprime/Alt-A = $4.5 trillion ($173,000 X 26 million)
Losses on foreclosures: $596 billion ($4.7 trillion X 1.2%=$56 billion + $4.5
trillion X 12%=$540 billion)
Overall loss percentage: 6.5%, for an increase of 86%
Note: No allowance for feedback efectthat is, fall in home prices as a result
of larger number of foreclosures in Scenario 2. With feedback efect, losses would
536 Dissenting Statement
be even larger in Scenario 2 because a larger number of foreclosures would drive
down housing prices further and faster. Tis feedback efect will likely cause total
frst mortgage losses to approach $1 trillion or 10% of outstanding frst mortgages.
537
APPENDIX 2
Hypothetical Losses in Two Scenarios (with feedback)
Scenario 1 is what was known to market professional during the 2nd
half of 2007; Scenario 2 is the actual condition of the mortgage market. Second
mortgage/home equity loan losses are excluded.
Assumptions used:
Number of mortgages= 53 million;
Total value of frst mortgages=$9.155 trillion;
Scenario 1:
Losses on prime=1.2%% (assumes 3% foreclosure rate & 40% severity);
Losses on self-denominated subprime & Alt-A=14% ((assumes 35%
foreclosure rate & 40% severity);
Losses on FHA/VA=5.25% (assumes 15% foreclosure rate and 35% severity)
Scenario 2:
Losses on prime=1.6%% (assumes 3.5% foreclosure rate and 45% severity);
Losses on self-denominated subprime & Alt-A=25% (assumes 45%
foreclosure rate & 55% severity);
Losses on FHA/VA & unknown subprime/Alt-A=15% (assumes 30%
foreclosure rate & 50% severity)
Average size of mortgage:
Prime: $173,000 ($6.75 trillion/39 million)
Subprime/Alt-A/FHA/VA: $182,000 ($2.4 trillion/13 million
Losses in Scenario 1
Number of mortgages: 53 million
Prime=40 million
Subprime/Alt-A=7.7 million PMBS
FHA, and VA=5.2 million
Aggregate Value:
Prime =$6.9 trillion ($173,000 X 39 million);
Subprime/Alt-A=$1.7 trillion ($220,000 X 7.7 million)
FHA/VA= $700 billion ($130,000x5.2 million)
Total expected foreclosures: 4.7 million (3% X 39 million + 35% X 7.7 million
+ 15% X 5.2 million)
Losses on foreclosures: $360 billion ($6.9 trillion prime X 1.2%=$83 billion +
1.7 trillion subprime/Alt-A X 14%=$240 billion + $700 billion X 5.25%=37 billion)
Overall loss percentage: 3.9%
538 Dissenting Statement
Losses in Scenario 2
Number of mortgages: 53 million
Prime: 27 million
Original subprime/Alt-A: 7.7 million
FHA/VA: 5.2 million
Other subprime/Alt-A: 13 million (10.5 F&F (excludes 1.25 million already
counted in PMBS), 2.5 million other loans not securitized (mostly held by the large
banks))
Aggregate Value:
Prime= $4.7 trillion ($173,000 X 27 million);
Original Subprime/Alt-A = $1.7 trillion ($220,000 X 7.7 million)
FHA/VA= $700 billion ($130,000x5.2 million)
Other subprime/Alt-A: $2 trillion ($154,000X13 million
Total expected foreclosures: 8.4 million (3.5% X 27 million=0.95 million,
45% X 7.7 million=3.5 million, 30% X 13 million=3.9 million)
Losses on foreclosures: $890 billion ($4.7 trillion X 1.6%=$60 billion + $1.7
trillion X 25%=$425 billion + $700 billion X 15% = $105 billion + $2 trillion X 15%
= $300 billion)
Overall loss percentage: 9.8%, for an increase of 150%
APPENDIX A: GLOSSARY
Italicized terms within defnitions are defned separately.
ABCP seeasset-backed commercial paper.
ABS seeasset-backed security.
ABX.HE Aseriesofderivatives indicesconstructedfromthepricesofiocredit default swaps that
eachreferenceindividualsubprimemortgagebacked securities;akintoanindexliketheDow
IonesIndustrialAverage.
adjustable-rate mortgage Amortgagewhoseinterestratechangesperiodicallvovertime.
affordable housing goals GoalsoriginallvsetbvtheDepartment of Housing and Urban Develop-
ment (nowbvtheFederalHousingFinanceAgencv)forFannie Mae andFreddie Mac toallo-
cateaspecifedpartoftheirmortgagebusinesstoservelow-andmoderate-incomeborrowers.
ARM see adjustable-rate mortgage.
ARS seeauction rate securities.
asset-backed commercial paper Short-termdebtsecuredbvassets.
asset-backed security Debtinstrumentsecuredbvassetssuchasmortgages,creditcardloansor
autoloans.
auction rate securities Long-termbondswhoseinterestratemavberesetatregularshort-term
intervalsbvanauctionprocess.
bank holding company Companvthatcontrolsabank.
broker-dealer A frm, often the subsidiarv of an investment bank, that buvs and sells securities
foritselfandothers.
capital Assetsminusliabilities;whatafrmownsminuswhatitowes.Regulatorsoftenrequiref-
nancialfrmstoholdminimumlevelsofcapital.
Capital Purchase Program TARP programprovidingfnancialassistancetooo-plusU.S.fnan-
cialinstitutionsthroughthepurchaseofseniorpreferredsharesinthecorporationsonstan-
dardizedterms.
CDO seecollateralized debt obligation.
CDO squared CDOthatholdsotherCDOs.
CDS seecredit default swap.
CFTC seeCommodity Futures Trading Commission.
collateralized debt obligation Tvpe of securitv often composed of the riskier portions of mort-
gage-backed securities.
commercial paper Short-termunsecuredcorporatedebt.
Commercial Paper Funding Facility EmergencvprogramcreatedbvtheFederal Reserve inioo8to
purchasethree-monthunsecuredandasset-backed commercial paper fromeligiblecompanies.
Commodity Futures Trading Commission Independentfederalagencvthatregulatestradingin
futuresandoptions.
539
540 Appendix A: Glossary
Community Reinvestment Act 1o federal law encouraging depository institutions to make
loansandprovideservicesinthelocalcommunitiesinwhichthevtakedeposits.
Consolidated Supervised Entities program ASecurities and Exchange Commission programcre-
atediniooaandterminatedinioo8thatprovidedvoluntarvsupervisionforthefvelargestin-
vestmentbankconglomerates.
Counterparty Apartvtoacontract.
CP seecommercial paper.
CPP seeCapital Purchase Program.
CRA seeCommunity Reinvestment Act.
credit default swap Atvpeofcredit derivative allowingapurchaseroftheswaptotransferloan
defaultrisktoaselleroftheswap.Theselleragreestopavthepurchaserifadefaulteventoc-
curs.Thepurchaserdoesnotneedtoowntheloancoveredbvtheswap.
credit enhancement Insurance or other protection that mav be purchased for a loan or pool of
loanstooffsetlossesintheeventofdefault.
credit loss Lossfromdelavedpavmentsordefaultsonloans.
credit rating agency Privatecompanvthatevaluatesthecreditqualitvofsecuritiesandprovides
ratingsonthosesecurities;thelargestareFitchRatings,MoodvsInvestorsService,andStan-
dard&Poors.
credit risk Risktoalenderthataborrowerwillfailtorepavtheloan.
CSE ConsolidatedSupervisedEntitv(seeConsolidated Supervised Entities program).
debt-to-income ratio Onemeasureofaborrowersabilitvtorepavaloan,generallvcalculatedbv
dividingtheborrowersmonthlvdebtpavmentsbvgrossmonthlvincome.
delinquency rate Thenumberofloansforwhichborrowersfailtomaketimelvloanpavmentsdi-
videdbvtotalloans.
Department of Housing and Urban Development Cabinet-levelfederaldepartmentresponsible
forhousingpoliciesandprograms.
Department of Justice Cabinet-levelfederaldepartmentresponsibleforenforcementoflawsand
administrationofjustice,ledbvtheattornevgeneral.
Department of Treasury Treasurvofthefederalgovernment;printsandmintsallcurrencvand
coins, collects federal taxes, manages U.S. government debt instruments, supervises national
banksandthrifts,andadvisesondomesticandinternationalfscalpolicv.Itsmissionincludes
protectingtheintegritvofthefnancialsvstem.
depository institution Financialinstitution,suchasacommercialbank,thrift(savingsandloan),
orcreditunion,thatacceptsdeposits,includingdepositsinsuredbvtheFDIC.
derivative Financialcontractwhosepriceisdetermined(derived)fromthevalueofanunderlving
asset,rate,index,orevent.
Fannie Mae Nickname for the Federal National Mortgage Association (FNMA), a government-
sponsored enterprise providingfnancingforthehomemortgagemarket.
FCIC FinancialCrisisInquirvCommission.
FDIC seeFederal Deposit Insurance Corporation.
Federal Deposit Insurance Corporation Independentfederalagencvchargedprimarilvwithin-
suringdepositsatfnancialinstitutions,examiningandsupervisingsomeofthoseinstitutions,
andshuttingdownfailinginstitutions.
Federal Housing Administration PartoftheDepartment of Housing and Urban Development that
providesinsuranceonmortgageloansmadebvFHA-approvedlenders.
Federal Housing Finance Agency Independentfederalregulatorofgovernment-sponsored enter-
prises;createdbvtheHousing and Economic Recovery Act ofioo8assuccessortotheOmce of
Federal Housing Enterprise Oversight andtheFederalHousingFinanceBoard.
Federal Open Market Committee ItsmembersaretheBoardofGovernorsoftheFederalReserve
541 Appendix A: Glossary
SvstemandcertainofthepresidentsoftheFederalReserveBanks;overseesmarketconditions
andimplementsmonetarvpolicvthroughsuchmeansassettinginterestrates.
Federal Reserve Bank of New York Oneof1iregionalFederalReserveBanks,withresponsibilitv
forregulatingbankholdingcompaniesinNewYorkStateandnearbvareas.
Federal Reserve U.S.centralbankingsvstemcreatedin1o1:inresponsetofnancialpanics,con-
sistingoftheFederalReserveBoardinWashington,DC,and1iFederalReserveBanksaround
thecountrv;itsmissionistoimplementmonetarvpolicvthroughsuchmeansassettinginter-
est rates, supervising and regulating banking institutions, maintaining the stabilitv of the f-
nancialsvstem,andprovidingfnancialservicestodepositorvinstitutions.
FHA seeFederal Housing Administration.
FHFA seeFederal Housing Finance Agency.
FICO score Ameasureofaborrowerscreditworthinessbasedontheborrowerscreditdata;de-
velopedbvtheFairIsaacCorporation.
Financial Crimes Enforcement Network Treasurv omce that collects and analvzes information
aboutfnancialtransactionstocombatmonevlaundering,terroristfnancing,andotherfnan-
cialcrimes.
FinCEN seeFinancial Crimes Enforcement ^etwork.
FOMC see Federal Open Market Committee.
foreclosure Legalprocesswherebvamortgagelendergainsownershipoftherealpropertvsecur-
ingadefaultedmortgage.
Freddie Mac NicknamefortheFederalHomeLoanMortgageCorporation(FHLMC),agovern-
ment-sponsored enterprise providingfnancingforthehomemortgagemarket.
Ginnie Mae Nickname for the Government National Mortgage Association (GNMA), a govern-
ment-sponsored enterprise;guaranteespoolsofVAandFHAmortgages.
Glass-Steagall Act Banking Act of 1o:: creating the FDIC to insure bank deposits; prohibited
commercial banks from underwriting or dealing in most tvpes of securities, barred banks
from amliating with securities frms, and introduced other banking reforms. In 1ooo, the
Gramm-Leach-Bliley Act repealedthe provisionsoftheGlass-SteagallActthatprohibitedaml-
iationsbetweenbanksandsecuritiesfrms.
government-sponsored enterprise Aprivatecorporation,suchasFannie Mae andFreddie Mac,
created bv the federal government to pursue certain public policv goals designated in its
charter.
Gramm-Leach-Bliley Act 1ooolegislationthatliftedcertainremainingrestrictionsestablishedbv
theGlass-Steagall Act.
GSE see government-sponsored enterprise.
haircut Thedifferencebetweenthevalueofanassetandtheamountborrowedagainstit.
hedge Infnance,awavtoreduceexposureorriskbvtakingonanewfnancialcontract.
hedge fund Aprivatelvofferedinvestmentvehicleexemptedfrommostregulationandoversight;
generallvopenonlvtohigh-net-worthinvestors.
HOEPA seeHome Ownership and Equity Protection Act.
Home Ownership and Equity Protection Act 1ooa federallawthatgavetheFederal Reserve new
responsibilitvtoaddressabusiveandpredatorvmortgagelendingpractices.
Housing and Economic Recovery Act ioo8 law including measures to reform and regulate the
GSEs;createdtheFederal Housing Finance Agency.
HUDseeDepartment of Housing and Urban Development.
hybrid CDOACDO backedbvcollateralfoundinbothcashCDOsandsvntheticCDOs.
illiquid assets Assetsthatcannotbeeasilvorquicklvsold.
interest-only loan Loanthatallowsborrowerstopavinterestwithoutrepavingprincipaluntilthe
endoftheloanterm.
542 Appendix A: Glossary
leverage Ameasureofhowmuchdebtisusedtopurchaseassets;forexample,aleverageratioof
-:1meansthat-ofassetswerepurchasedwithaofdebtand1ofcapital.
LIBOR LondonInterbankOfferedRate,aninterestrateatwhichbanksarewillingtolendtoeach
otherintheLondoninterbankmarket.
liquidity Holding cashand/orassetsthatcanbequicklvandeasilvconvertedtocash.
liquidity put Acontractallowingonepartvtocompeltheothertobuvanassetundercertaincir-
cumstances.Itensuresthattherewillbeabuverforotherwiseilliquidassets.
loan-to-value ratio Ratio of the amount of a mortgage to the value of the house, tvpicallv ex-
pressedasapercentage.Combinedloan-to-valueincludesalldebtsecuredbvthehouse,in-
cludingsecondmortgages.
LTV ratio seeloan-to-value ratio.
mark-to-market Theprocessbvwhichthereportedamountofanassetisadjustedtorefectthe
marketvalue.
monoline Insurance companv, such as AMBAC and MBIA, whose single line of business is to
guaranteefnancialproducts.
mortgage servicer Companvthatactsasanagentformortgageholders,collectinganddistribut-
ingpavmentsfromborrowersandhandlingdefaults,modifcations,settlements,andforeclo-
sureproceedings.
mortgage underwriting Process of evaluating the credit characteristics of a mortgage and bor-
rower.
mortgage-backed security Debtinstrumentsecuredbvapoolofmortgages,whetherresidential
orcommercial.
NAV seenet asset value.
negative amortization loan Loanthatallowsaborrowertomakemonthlvpavmentsthatdonot
fullvcovertheinterestpavment,withtheunpaidinterestaddedtotheprincipaloftheloan.
net asset value Valueofanassetminusanvassociatedcosts;forfnancialassets,tvpicallvchanges
eachtradingdav.
net charge-off rate Ratioofloanlossestototalloans.
non-agency mortgage-backed securities Mortgage-backed securities sponsoredbvprivatecompa-
niesotherthanagovernment-sponsored enterprise (suchasFannie Mae orFreddie Mac);also
knownasprivate-label mortgage-backed securities.
notional amount Ameasureoftheoutstandingamountofover-the-counterderivatives contracts,
basedontheamountoftheunderlvingreferencedassets.
novation Aprocessbvwhichcounterpartiesmavtransferderivatives positions.
OCC seeOmce of the Comptroller of the Currency.
Ofce of Federal Housing Enterprise Oversight Createdin1ooitooverseefnancialsoundness
ofFannie Mae andFreddie Mac;itsresponsibilitieswereassumedinioo8bvitssuccessor,the
Federal Housing Finance Agency.
Ofce of the Comptroller of the Currency Independent bureau within Department of Treasury
thatcharters,regulates,andsupervisesallnationalbanksandcertainbranchesandagenciesof
foreignbanksintheUnitedStates.
Ofce of Thrift Supervision Independent bureau within Treasury that regulates all federallv
chartered and manv state-chartered savings and loans/thrift institutions and their holding
companies.
OFHEO seeOmce of Federal Housing Enterprise Oversight.
originate-to-distribute When lenders make loans with the intention of selling them to other f-
nancialinstitutionsorinvestors,asopposedtoholdingtheloansthroughmaturitv.
originate-to-hold Whenlendersmakeloanswiththeintentionofholdingthemthroughmaturitv,
asopposedtosellingthemtootherfnancialinstitutionsorinvestors.
543 Appendix A: Glossary
origination Processofmakingaloan,includingunderwriting,closing,andprovidingthefunds.
OTS see Omce of Thrift Supervision.
par Facevalueofabond.
payment-option adjustable-rate mortgage (also called pavment ARM or option ARM) Mort-
gagesthatallowborrowerstopicktheamountofpavmenteachmonth,possiblvlowenoughto
increasetheprincipal balance.
PDCF seePrimary Dealer Credit Facility.
PLS see private-label mortgage-backed securities.
pooling Combiningandpackagingagroupofloanstobeheldbvasingleentitv.
Primary Dealer Credit Facility ProgramestablishedbvtheFederal Reserve inMarchioo8thatal-
lowedeligiblecompaniestoborrowcashovernighttofnancetheirsecurities.
principal Amountborrowed.
private mortgage insurance Insuranceonthepavmentofamortgageprovidedbvaprivatefrm
atadditionalcosttotheborrowertoprotectthelender.
private-label mortgage-backed securities seenon-agency mortgage-backed securities.
repurchase agreement (repo) Amethodofsecuredlendingwheretheborrowersellssecuritiesto
thelenderascollateralandagreestorepurchasethematahigherpricewithinashortperiod,
oftenwithinonedav.
SEC see Securities and Exchange Commission.
section () SectionoftheFederalReserveActunderwhichtheFederal Reserve mavmakese-
curedloanstonondepositorvinstitutions,suchasinvestmentbanks,underunusualandexi-
gentcircumstances.
Securities and Exchange Commission Independentfederalagencvresponsibleforprotectingin-
vestorsbvenforcingfederalsecuritieslaws,includingregulatingstockandsecuritvoptionsex-
changes and other electronic securities markets, the issuance and sale of securities,
broker-dealers, othersecuritiesprofessionals,andinvestmentcompanies.
securitization Process of pooling debt assets such as mortgages, car loans, and credit card debt
intoaseparatelegalentitvthatthenissuesanewfnancialinstrumentorsecuritvforsaletoin-
vestors.
shadow banking Financialinstitutionsandactivitiesthatinsomerespectsparallelbankingactivi-
ties but are subject to less regulation than commercial banks. Institutions include mutual
funds,investmentbanks,andhedgefunds.
short sale Thesaleofahomeforlessthantheamountowedonthemortgage.
short selling Tosellaborrowedsecuritvintheexpectationofadeclineinvalue.
SIV seestructured investment vehicle.
special purpose vehicle Entitvcreatedtofulfllanarrowortemporarvobjective;tvpicallvholdsa
portfolioofassetssuchasmortgage-backed securities orotherdebtobligations;oftenusedbe-
causeofregulatorvandbankruptcvadvantages.
SPV seespecial purpose vehicle.
structured investment vehicle Leveraged special purpose vehicle, funded through medium-term
notesandasset-backed commercial paper,thatinvestedinhighlvratedsecurities.
synthetic CDO ACDO thatholdscredit default swaps thatreferenceassets(ratherthanholding
cashassets),allowinginvestorstomakebetsfororagainstthosereferencedassets.
systemic risk Infnancialterms,thatwhichposesathreattothefnancialsvstem.
systemic risk exception ClauseintheFederalDepositInsuranceCorporationImprovementAct
(FDICIA)underwhichtheFDIC mavcommititsfundstorescueafnancialinstitution.
TAF see Term Auction Facility.
TALF see Term Asset-Backed Securities Loan Facility.
TARP see Troubled Asset Relief Program.
544 Appendix A: Glossary
Term Asset-Backed Securities Loan Facility Federal Reserve program,supportedbvTARP funds,
toaidsecuritizationofasset-basedloanssuchasautoloans,studentloans,andsmallbusiness
loans.
Term Auction Facility PrograminwhichtheFederal Reserve madefundsavailabletoalldeposi-
tory institutions atoncethrougharegularauction.
Term Securities Lending Facility Emergencvprograminwhichthe Federal Reserve madeupto
ioo billion in Treasurv securities available to banks or broker/dealers that traded directlv
withtheFederalReserve.
tranche FromtheFrench,meaningaslice;usedtorefertothedifferenttvpesofmortgage-backed
securities and CDO bonds that provide specifed priorities and amounts of returns: senior
trancheshavethehighestprioritvofreturnsandthereforethelowestrisk/interestrate;mezza-
nine tranches have mid levels of risk/return; and equitv (also known as residual or frst
loss)tranchestvpicallvreceiveanvremainingcashfows.
Troubled Asset Relief Program Governmentprogramtoaddressthefnancialcrisis,signedinto
lawinOctoberioo8topurchaseorinsureuptooobillioninassetsandequitvfromfnan-
cialandotherinstitutions.
TSLF seeTerm Securities Lending Facility.
undercapitalized Conditioninwhichabusinessdoesnothaveenoughcapital tomeetitsneeds,
ortomeetitscapitalrequirementsifitisaregulatedentitv.
Write-downs Reducingthevalueofanassetasitiscarriedonafrmsbalancesheetbecausethe
marketvaluehasfallen.
APPENDIX B:
LIST OF HEARINGS AND WITNESSES
Public Meeting of the FCIC, Washington, DC, September 1, iooo
Statementsbvcommissioners
Roundtable Discussion, Washington, DC, October io, iooo
SimonIohnson,RonaldA.KurtzProfessorofEntrepreneurship,SloanSchoolofManagement,
MassachusettsInstituteofTechnologv
Hal S. Scott, Nomura Professor and Director of the Program on International Financial Svs-
tems,HarvardLawSchool
Ioseph Stiglitz, Professor, Columbia Business School, Graduate School of Arts and Sciences
(DepartmentofEconomics)andtheSchoolofInternationalandPublicAffairs
IohnB.Tavlor,MarvandRobertRavmondProfessorofEconomicsandtheBowenH.andIan-
iceArthurMcCovSeniorFellowattheHooverInstitution,StanfordUniversitv
Luigi Zingales, Robert C. McCormack Professor of Entrepreneurship and Finance and the
DavidG.BoothFacultvFellow,UniversitvofChicagoBoothSchoolofBusiness
Roundtable Discussion, Washington, DC, November 1o, iooo
DavidA.Moss,TheIohnG.McLeanProfessor,HarvardBusinessSchool
CarmenM.Reinhart,ProfessorofEconomicsandDirectoroftheCenterforInternationalEco-
nomics,UniversitvofMarvland
Public Hearing, Washington, DC, Day 1, January 1:, io1o
Session r. Financial Institution Representatives
Llovd C. Blankfein, Chairman of the Board and Chief Executive Omcer, Goldman Sachs
Group,Inc.
IamesDimon,ChairmanoftheBoardandChiefExecutiveOmcer,IPMorganChase&Co.
IohnI.Mack,ChairmanoftheBoard,MorganStanlev
BrianT.Movnihan,ChiefExecutiveOmcerandPresident,BankofAmericaCorporation
Session :. Financial Market Participants
Michael Mavo, Managing Director and Financial Services Analvst, Calvon Securities
(USA)Inc.
I.KvleBass,ManagingPartner,HavmanAdvisors,LP
PeterI.Solomon,FounderandChairman,PeterI.SolomonCompanv
Session +. Financial Crisis Impacts on the Economy
MartinBailv,SeniorFellowinEconomicStudies,BrookingsInstitution
545
546 Appendix B: List of Hearings and Witnesses
MarkZandi,ChiefEconomistandCo-founder,MoodvsEconomv.com
Kenneth T. Rosen, Chair, Fisher Center for Real Estate and Urban Economics, Universitv of
California,Berkelev
IuliaGordon,SeniorPolicvCounsel,CenterforResponsibleLending
C. R. Rustv Cloutier, President and Chief Executive Omcer, MidSouth Bank, N.A., Past
Chairman,IndependentCommunitvBankersAssociation
Public Hearing, Washington, DC, Day i, January 1a, io1o
Session r. Current Investigations into the Financial CrisisFederal Omcials
EricH.HolderIr.,AttornevGeneral,U.S.DepartmentofIustice
LannvA.Breuer,AssistantAttornevGeneral,CriminalDivision,U.S.DepartmentofIustice
SheilaC.Bair,Chairman,U.S.FederalDepositInsuranceCorporation
MarvL.Schapiro,Chairman,U.S.SecuritiesandExchangeCommission
Session :. Current Investigations into the Financial CrisisState and Local Omcials
LisaMadigan,AttornevGeneral,StateofIllinois
IohnW.Suthers,AttornevGeneral,StateofColorado
DeniseVoigtCrawford,Commissioner,TexasSecuritiesBoard,andPresident,NorthAmerican
SecuritiesAdministratorsAssociation,Inc.
Glenn Theobald, Chief Counsel, Miami-Dade Countv Police Department; Chairman, Mavor
CarlosAlvarezMortgageFraudTaskForce
Forum to Explore the Causes of the Financial Crisis, American University Washing-
ton College of Iaw, Washington, DC, Day 1, February io, io1o
Session r. Interconnectedness of Financial Institutions, Too Big to Fail
RandallKroszner,NormanR.BobinsProfessorofEconomics,UniversitvofChicago
Session :. Macroeconomic Factors and U.S. Monetary Policy
Pierre-OlivierGourinchas,AssociateProfessorofEconomics,UniversitvofCalifornia,Berkelev
Session +. Risk Taking and Leverage
IohnGeanakoplos,IamesTobinProfessorofEconomics,YaleUniversitv
Session ,. Household Finances and Financial Literacy
Annamaria Lusardi, Ioel Z. and Susan Hvatt Professor of Economics, Dartmouth Universitv;
ResearchAssociateattheNationalBureauofEconomicResearch
Forum to Explore the Causes of the Financial Crisis, American University Washing-
ton College of Iaw, Washington, DC, Day i, February i, io1o
Session . Mortgage Lending Practices and Securitization
Chris Maver, Paul Milstein Professor of Real Estate, Columbia Universitv; Visiting Scholar at
theFederalReserveBankofNewYorkandResearchAssociateattheNationalBureauofEconomic
Research
Session o. Government-Sponsored Enterprises and Housing Policy
Dwight Iaffee, Willis Booth Professor of Banking, Finance, and Real Estate; Co-chair, Fisher
CenterforRealEstateandUrbanEconomics,UniversitvofCalifornia,Berkelev
Session /. Derivatives and Other Complex Financial Instruments
MarkusBrunnermeier,EdwardsS.SanfordProfessorofEconomics,PrincetonUniversitv
547 Appendix B: List of Hearings and Witnesses
Session 8. Firm Structure and Risk Management
AnilKashvap,EdwardEagleBrownProfessorofEconomicsandFinanceandRichardN.Rosett
FacultvFellow,UniversitvofChicago
Session ;. Shadow Banking
GarvGorton,ProfessorofFinance,SchoolofManagement,YaleUniversitv
Public Hearing on Subprime Iending and Securitization and Government-Spon-
sored Enterprises (GSEs), Rayburn House Omce Building, Room i1i:, Washington,
DC, Day 1, April , io1o
Session r. The Federal Reserve
AlanGreenspan,FormerChairman,BoardofGovernorsoftheFederalReserveSvstem
Session :. Subprime Origination and Securitization
Richard Bitner, Managing Director of Housingwire.com; Author, Confessions of a Subprime
Lender. An Insiders Tale of Greed, Fraud, and Ignorance
RichardBowen,FormerSeniorVicePresidentandBusinessChiefUnderwriter,CitiMortgage,
Inc.
PatriciaLindsav,FormerVicePresident,CorporateRisk,NewCenturvFinancialCorporation
SusanMills,ManagingDirectorofMortgageFinance,CitiMarkets&Banking,GlobalSecuri-
tizedMarkets
Session +. Citigroup Subprime-Related Structured Products and Risk Management
MurravC.Barnes,FormerManagingDirector,IndependentRisk,Citigroup,Inc.
DavidC.Bushnell,FormerChiefRiskOmcer,Citigroup,Inc.
NestorDominguez,FormerCo-head,GlobalCollateralizedDebtObligations,CitiMarkets&
Banking,GlobalStructuredCreditProducts
ThomasG.Maheras,FormerCo-chiefExecutiveOmcer,CitiMarkets&Banking
Public Hearing on Subprime Iending and Securitization and Government-Spon-
sored Enterprises (GSEs), Rayburn House Omce Building, Room i1i:, Washington,
DC, Day i, April 8, io1o
Session r. Citigroup Senior Management
CharlesO.Prince,FormerChairmanoftheBoardandChiefExecutiveOmcer,Citigroup,Inc.
RobertRubin,FormerChairmanoftheExecutiveCommitteeoftheBoardofDirectors,Citi-
group,Inc.
Session :. Omce of the Comptroller of the Currency
IohnC.Dugan,Comptroller,OmceoftheComptrolleroftheCurrencv
IohnD.HawkeIr.,FormerComptroller,OmceoftheComptrolleroftheCurrencv
Public Hearing on Subprime Iending and Securitization and Government-Spon-
sored Enterprises (GSEs), Rayburn House Omce building, Room i1i:, Washington,
DC, Day :, April o, io1o
Session r. Fannie Mae
RobertI.Levin,FormerExecutiveVicePresidentandChiefBusinessOmcer,FannieMae
DanielH.Mudd,FormerPresidentandChiefExecutiveOmcer,FannieMae
Session :. Omce of Federal Housing Enterprise Oversight
ArmandoFalconIr.,FormerDirector,OmceofFederalHousingEnterpriseOversight
IamesLockhart,FormerDirector,OmceofFederalHousingEnterpriseOversight
548 Appendix B: List of Hearings and Witnesses
Public Hearing on the Shadow Banking System, Dirksen Senate Omce Building,
Room =:8, Washington DC, Day 1, May =, io1o
Session r. Investment Banks and the Shadow Banking System
PaulFriedman,FormerSeniorManagingDirector,BearStearns
SamuelMolinaroIr.,FormerChiefFinancialOmcerandChiefOperatingOmcer,BearStearns
WarrenSpector,FormerPresidentandCo-chiefOperatingOmcer,BearStearns
Session :. Investment Banks and the Shadow Banking System
IamesE.Cavne,FormerChairmanandChiefExecutiveOmcer,BearStearns
AlanD.Schwartz,FormerChiefExecutiveOmcer,BearStearns
Session +. SEC Regulation of Investment Banks
CharlesChristopherCox,FormerChairman,U.S.SecuritiesandExchangeCommission
WilliamH.Donaldson,FormerChairman,U.S.SecuritiesandExchangeCommission
H.DavidKotz,InspectorGeneral,U.S.SecuritiesandExchangeCommission
Erik R. Sirri, Former Director Division of Trading & Markets, U.S. Securities and Exchange
Commission
Public Hearing on the Shadow Banking System, Dirksen Senate Omce Building,
Room =:8, Washington DC, Day i, May o, io1o
Session r. Perspective on the Shadow Banking System
HenrvM.PaulsonIr.,FormerSecretarv,U.S.DepartmentoftheTreasurv
Session :. Perspective on the Shadow Banking System
Timothv F. Geithner, Secretarv, U.S. Department of the Treasurv; Former President, Federal
ReserveBankofNewYork
Session +. Institutions Participating in the Shadow Banking System
MichaelA.Neal,ViceChairman,GeneralElectric;ChairmanandChiefExecutiveOmcer,GE
Capital
MarkS.Barber,VicePresidentandDeputvTreasurer,GECapital
PaulA.McCullev,ManagingDirector,PIMCO
StevenR.Meier,ChiefInvestmentOmcer,StateStreet
Public Hearing on Credibility of Credit Ratings, the Investment Decisions Made
Based on Those Ratings, and the Financial Crisis, The New School Arnhold Hall,
Theresa Iang Community & Student Center, == West 1:th Street, ind Floor, New
York, NY, June i, io1o
Session r. The Ratings Process
EricKolchinskv,FormerTeamManagingDirector,USDerivatives,MoodvsInvestorsService
IavSiegel,FormerTeamManagingDirector,MoodvsInvestorsService
NicolasS.Weill,GroupManagingDirector,MoodvsInvestorsService
GarvWitt,FormerTeamManagingDirector,USDerivatives,MoodvsInvestorsService
Session :. Credit Ratings and the Financial Crisis
WarrenE.Buffett,ChairmanandChiefExecutiveOmcer,BerkshireHathawav
RavmondW.McDaniel,ChairmanandChiefExecutiveOmcer,MoodvsCorporation
Session +. The Credit Rating Agency Business Model
BrianM.Clarkson,FormerPresidentandChiefOperatingOmcer,MoodvsInvestorsService
(writtentestimonvonlvduetoamedicalemergencv)
MarkFroeba,FormerSeniorVicePresident,USDerivatives,MoodvsInvestorsService
RichardMichalek,FormerVicePresident/SeniorCreditOmcer,MoodvsInvestorsService
549 Appendix B: List of Hearings and Witnesses
Public Hearing on the Role of Derivatives in the Financial Crisis, Dirksen Senate Of-
nce Building, Room =:8, Washington, DC, Day 1, June :o, io1o
Session r. Overview of Derivatives
MichaelGreenberger,Professor,UniversitvofMarvlandSchoolofLaw
SteveKohlhagen,FormerProfessorofInternationalFinance,UniversitvofCalifornia,Berkelev,
andformerWallStreetderivativesexecutive
AlbertPeteKvle,CharlesE.SmithChairProfessorofFinance,UniversitvofMarvland
MichaelMasters,ChiefExecutiveOmcer,MastersCapitalManagement,LLC
Session :. American International Group, Inc. and Derivatives
IosephI.Cassano,FormerChiefExecutiveOmcer,AmericanInternationalGroup,Inc.Finan-
cialProducts
RobertE.Lewis,SeniorVicePresidentandChiefRiskOmcer,AmericanInternationalGroup,
Inc.
MartinI.Sullivan,FormerChiefExecutiveOmcer,AmericanInternationalGroup,Inc.
Session +. Goldman Sachs Group, Inc. and Derivatives
CraigBroderick,ManagingDirector,HeadofCredit,Market,andOperationalRisk,Goldman
SachsGroup,Inc.
GarvD.Cohn,PresidentandChiefOperatingOmcer,GoldmanSachsGroup,Inc.
Public Hearing on the Role of Derivatives in the Financial Crisis, Dirksen Senate Of-
nce Building, Room =:8, Washington DC, Day i, July 1, io1o
Session r. American International Group, Inc. and Goldman Sachs Group, Inc.
StevenI.Bensinger,FormerExecutiveVicePresidentandChiefFinancialOmcer,AmericanIn-
ternationalGroup,Inc.
AndrewForster,FormerSeniorVicePresidentandChiefFinancialOmcer,AmericanInterna-
tionalGroup,Inc.FinancialServices
EliasF.Habaveb,FormerSeniorVicePresidentandChiefFinancialOmcer,AmericanInterna-
tionalGroup,Inc.FinancialServices
DavidLehman,ManagingDirector,GoldmanSachsGroup,Inc
DavidViniar,ExecutiveVicePresidentandChiefFinancialOmcer,GoldmanSachsGroup,Inc.
Session :. Derivatives. Supervisors and Regulators
EricR.Dinallo,FormerSuperintendant,NewYorkStateInsuranceDepartment
GarvGensler,Chairman,CommoditvFuturesTradingCommission
ClarenceK.Lee,FormerManagingDirectorforComplexandInternationalOrganizations,Of-
fceofThriftSupervision
Public Hearing on Too Big to Fail: Expectations and Impact of Extraordinary Gov-
ernment Intervention and the Role of Systemic Risk in the Financial Crisis, Dirksen
Senate Omce Building, Room =:8, Washington DC, Day 1, September 1, io1o
Session r. Vachovia Corporation
ScottG.Alvarez,GeneralCounsel,BoardofGovernorsoftheFederalReserveSvstem
IohnH.Corston,ActingDeputvDirector,DivisionofSupervisionandConsumerProtection,
U.S.FederalDepositInsuranceCorporation
RobertK.Steel,FormerPresidentandChiefExecutiveOmcer,WachoviaCorporation
Session :. Lehman Brothers
ThomasC.Baxter,Ir.,GeneralCounselandExecutiveVicePresident,FederalReserveBankof
NewYork
550 Appendix B: List of Hearings and Witnesses
RichardS.DickFuldIr.,FormerChairmanandChiefExecutiveOmcer,LehmanBrothers
HarvevR.Miller,BusinessFinance&RestructuringPartner,Weil,Gotshal&Manges,LLP
BarrvL.Zubrow,ChiefRiskOmcer,IPMorganChase&Co.
Public Hearing on Too Big to Fail: Expectations and Impact of Extraordinary Gov-
ernment Intervention and the Role of Systemic Risk in the Financial Crisis, Dirksen
Senate Omce Building, Room =:8, Washington DC, Day i, September i, io1o
Session r. The Federal Reserve
BenS.Bernanke,Chairman,BoardofGovernorsoftheFederalReserveSvstem
Session :. The Federal Deposit Insurance Corporation
SheilaC.Bair,Chairman,U.S.FederalDepositInsuranceCorporation
Public Hearing on the Impact of the Financial CrisisGreater Bakersneld, Kern
County Board of Supervisors Chambers, 111= Truxtun Avenue, Bakersneld, CA,
September , io1o
Session r. Velcome
CongressmanKevinMcCarthv,CaliforniasiindDistrict
RavWatson,KernCountvSupervisor,Districta
IrmaCarson,BakersfeldCitvCouncilwoman,Ward1
Session :. Local Banking
ArnoldCattani,Chairman,MissionBank
SteveRenock,PresidentandCEO,KernSchoolsFederalCreditUnion
D.LinnWilev,ViceChairman,CVBFinancialCorporationandCitizensBusinessBank
Session +. Residential and Community Real Estate
GregorvD.Bvnum,President,GregorvD.BvnumandAssociates,Inc.
WarrenPeterson,WarrenPetersonConstruction,Inc.
Session ,. Local Housing Market
GarvCrabtree,PrincipalOwner,AmliatedAppraisers
LlovdPlank,LlovdE.PlankRealEstateConsultants
Session . Foreclosures and Loan Modifcations
BrendaAmble,EscrowManager,TicorTitle
LaurieMcCartv,ColdwellBankerPreferred
IeannieMcDermott,SmallBusinessOwner
Session o. Forum for Public Comment
IamesStephenUrner
MarvinDean
MarieVasile
Public Hearing on the Impact of the Financial CrisisState of Nevada, University of
Nevada, Ias Vegas, Student Union Building, Ias Vegas, NV, September 8, io1o
Session r. Economic Analysis of the Impact of the Financial Crisis on ^evada
IeremvAguero,Principal,AppliedAnalvsis
Session :. The Impact of the Financial Crisis on Businesses of ^evada
Steve Hill, Founder, Silver State Materials Corporation; Immediate Past Chairman, Las Vegas
ChamberofCommerce
WilliamE.Martin,ViceChairmanandChiefExecutiveOmcer,Service1stBankofNevada
551 Appendix B: List of Hearings and Witnesses
WallvMurrav,PresidentandChiefExecutiveOmcer,GreaterNevadaCreditUnion
Philip G. Satre, Chairman, International Gaming Technologv (IGT); Chairman, NV Energv,
Inc.
Session +. The Impact of the Financial Crisis on ^evada Real Estate
DanielG.Bogden,UnitedStatesAttornev,StateofNevada
GailBurks,PresidentandChiefExecutiveOmcer,NevadaFairHousingCenter
BrianGordon,Principal,AppliedAnalvsis
IavIeffries,FormerSouthwestRegionalSalesManager,FremontInvestment&Loan
Session ,. The Impact of the Financial Crisis on ^evada Public and Community Services
AndrewClinger,DirectoroftheDepartmentofAdministration,ChiefoftheBudgetDivision,
StateofNevada
IeffrevFontaine,ExecutiveDirector,NevadaAssociationofCounties
DavidFraser,ExecutiveDirector,NevadaLeagueofCities
Dr.HeathMorrison,Superintendent,WashoeCountvSchoolDistrict
Session . Forum for Public Comment
Public Hearing on the Impact of the Financial CrisisMiami, Florida, Florida Inter-
national University, Modesto A. Madique Campus, Miami, FI, September i1, io1o
Session r. Overview of Mortgage Fraud
William K. Black, Associate Professor of Economics and Law, Universitv of MissouriKansas
Citv
AnnFulmer,VicePresidentofBusinessRelations,Interthinx;Co-founder,GeorgiaRealEstate
FraudPreventionandAwarenessCoalition
HenrvN.Pontell,ProfessorofCriminologv,Law&SocietvandSociologv,UniversitvofCali-
fornia,Irvine
Session :. Uncovering Mortgage Fraud in Miami
DennisI.Black,President,D.I.Black&Companv
Edward Gallagher, Executive Omcer, Economic Crimes Bureau, Mortgage Fraud Task Force,
Miami-DadePoliceDepartment
IackRubin,SeniorVicePresident,IPMorganChaseBank
EllenWilcox,SpecialAgent,FloridaDepartmentofLawEnforcement
Session +. The Regulation, Oversight, and Prosecution of Mortgage Fraud in Miami
I.ThomasCardwell,Commissioner,OmceofFinancialRegulation,StateofFlorida
WilfredoA.Ferrer,UnitedStatesAttornev,SouthernDistrictofFlorida
R.ScottPalmer,SpecialCounselandChiefoftheMortgageFraudTaskForce,OmceoftheAt-
tornevGeneral,StateofFlorida
Public Hearing on the Impact of the Financial CrisisSacramento, California De-
partment of Education, Sacramento, CA, September i:, io1o
Session r. Overview of the Sacramento Housing and Mortgage Markets and the Impact of
the Financial Crisis on the Region
MarkFleming,ChiefEconomist,CoreLogic
Session :. Mortgage Origination, Mortgage Fraud and Predatory Lending in the Sacra-
mento Region
KarenI.Mann,PresidentandChiefAppraiser,MannandAssociatesRealEstateAppraisers&
Consultants
ThomasC.Putnam,President,PutnamHousingFinanceConsulting
552 Appendix B: List of Hearings and Witnesses
KevinStein,AssociateDirector,CaliforniaReinvestmentCoalition
BenjaminB.Wagner,UnitedStatesAttornev,EasternDistrictofCalifornia
Session +. The Mortgage Securitization Chain. From Sacramento to Vall Street
VickiBeal,SeniorVicePresident,TransactionManagement,ClavtonHoldings,LLC
KurtEggert,ProfessorofLaw,ChapmanUniversitvSchoolofLaw
D. Keith Iohnson, Former President and Chief Executive Omcer, Washington Mutuals Long
BeachMortgage
Session ,. The Impact of the Financial Crisis on Sacramento ^eighborhoods and Families
Pam Canada, Chief Executive Omcer, NeighborWorks Home Ownership CenterSacramento
Region
MonaTawatao,RegionalCounsel,LegalServicesofNorthernCalifornia
BruceWagstaff,AgencvAdministrator,CountvofSacramentoCountvwideServicesAgencv
ClarenceWilliams,President,CaliforniaCapitalFinancialDevelopmentCorporation
HenrvW.Wirz,PresidentandChiefExecutiveOmcer,SAFECreditUnion
Public Testimony Presented
AllenCarpenter
LovieM.Hollis
NiaLavulo
NOTES
Unlessotherwisespecified,datacomefromthesourceslistedbelow.
BoardofGovernorsoftheFederalReserveSvstem,FlowofFundsReports:Debt,international
capitalflows,andthesizeandactivitvofvariousfinancialsectors
BureauofEconomicAnalvsis:Economicoutput(GDP),spending,wages,andsectorprofit
BureauofLaborStatistics:Labormarketstatistics
BlackBoxLogicandStandard&Poors:DataonloansunderlvingCMLTI2006-NC2
CoreLogic:Homeprices
Inside Mortgage Finance, 2009 Mortgage Market Statistical Annual: Data on origination of
mortgages,issuanceofmortgage-backedsecuritiesandvaluesoutstanding
MarkitGroup:ABX-HEindex
MortgageBankersAssociationNationalDelinquencvSurvev:Mortgagedelinquencvandfore-
closurerates
10-Ks,10-Os,andproxvstatementsfiledwiththeSecuritiesandExchangeCommission:Com-
panv-specificinformation
Manvofthedocumentscitedonthefollowingpages,alongwithothermaterials,areavailable
onwww.fcic.gov.
Chapter 1
1.CharlesPrince,testimonvbeforetheFCIC,HearingonSubprimeLendingandSecuritizationand
Government-Sponsored Enterprises (GSEs), dav 2, session 1: Citigroup Senior Management, April 8,
2010,transcript,p.10.
2. Warren Buffett, testimonv before the FCIC, Hearing on the Credibilitv of Credit Ratings, the In-
vestmentDecisionsMadeBasedonThose Ratings,andtheFinancialCrisis,session2:CreditRatingsand
theFinancialCrisis,Iune2,2010,transcript,p.208;WarrenBuffett,interviewbvFCIC,Mav26,2010.
3.LlovdBlankfein,testimonvbeforetheFirstPublicHearingoftheFCIC,dav1,panel1:Financial
InstitutionRepresentatives,Ianuarv13,2010,transcript,p.36.
4.BenS.Bernanke,closed-doorsessionwithFCIC,November17,2009;BenS.Bernanke,testimonv
beforetheFCIC,HearingonTooBigtoFail:ExpectationsandImpactofExtraordinarvGovernmentIn-
terventionandtheRoleofSvstemicRiskintheFinancialCrisis,dav2,session1:TheFederalReserve,
September2,2010,transcript,p.27.
5.AlanGreenspan,writtentestimonvfortheFCIC,SubprimeLendingandSecuritizationandGov-
ernment-SponsoredEnterprises(GSEs),dav1,session1:TheFederalReserve,April7,2010,p.9.
553
554 Notes to Chapter 1
6.RichardC.Breeden,interviewbvFCIC,October14,2010.
7.PaulA.McCullev,testimonvbeforetheFCIC,HearingontheShadowBankingSvstem,dav2,ses-
sion3:InstitutionsParticipatingintheShadowBankingSvstem,Mav6,2010,transcript,p.249.
8.ArnoldCattani,testimonvbeforetheFCIC,HearingontheImpactoftheFinancialCrisisGreater
Bakersfield,session2:LocalBanking,September7,2010,transcriptpp.25,61.
9.WilliamMartin,testimonvbeforetheFCIC,HearingontheImpactoftheFinancialCrisisState
of Nevada, session 2: The Impact of the Financial Crisis on Businesses of Nevada, September 8, 2010,
transcript,p.76.
10.InsideMortgageFinance,The 2009 Mortgage Market Statistical Annual, vol.1,The Primary Mar-
ket (:InsideMortgageFinance,2009),p.4,MortgageProductbvOrigination.
11. Data provided to the FCIC bv National Association of Realtors: national home price data from
salesofexistinghomes,comparingsecond-quarter1998($135,800)andsecond-quarter2006($227,100),
thenationalpeakinprices.
12.Core-basedstatisticalareahousepricesforSacramentoArdenArcadeRosevilleCAMetropoli-
tanStatisticalArea,CoreLogicdata.
13. Data provided bv CoreLogic, Home Price Index for Urban Areas. FCIC staff calculated house
pricegrowthfromIanuarv2001topeakofeachmarket.Pricesincreasedatleast50in401cities,atleast
75in217cities,atleast100in112cities,atleast125in63cities,andmorethan150in16cities.
14.UpdateddataprovidedbvIamesKennedvandAlanGreenspan,whosedataoriginallvappearedin
SourcesandUsesofEquitvExtractedfromHomes,FinanceandEconomicsDiscussionSeries,Federal
ReserveBoard,2007-20(March2007).
15.MortgageOriginationsRiseinFirstHalfof2005;DemandforInterestOnlv,OptionARMand
Alt-AProductsIncreases,MortgageBankersAssociationpressrelease,October25,2005.
16. In 2007, the weeklv wage of New York investment banker was $16,849; of the average privatelv
emplovedworker,$841.
17.FederalReserveSurvevofConsumerFinances,tabulatedbvFCIC.
18.AngeloMozilo,interviewbvFCIC,September24,2010.
19. Michael Mavo, testimonv before the First Public Hearing of the FCIC, dav 1, panel 2: Financial
MarketParticipants,Ianuarv13,2010,transcript,p.114.
20.MortgageOriginationsRiseinFirstHalfof2005,MBApressrelease,October27,2005.
21.YulivaDemvanvkandYadavK.Gopalan,SubprimeARMs:PopularLoans,PoorPerformance,
FederalReserveBankofSt.Louis,Bridges (Spring2007).
22. Ann Fulmer, vice president of Business Relations, Interthinx (session 1: Overview of Mortgage
Fraud),andEllenWilcox,specialagent,FloridaDepartmentofLawEnforcement(session2:Uncovering
MortgageFraudinMiami),testimonvbeforetheFCIC,HearingontheImpactoftheFinancialCrisis
Miami,September21,2010.
23.IuliaGordonandMichaelCalhoun,CenterforResponsibleLending,interviewbvFCIC,Septem-
ber16,2010.
24.FaithSchwartz,atConsumerAdvisorvCouncilmeeting,Thursdav,March30,2006.
25.FederalReserveBoard,MeanValueofMortgagesorHome-EquitvLoansforFamilieswithHold-
ings,inSCF Chartbook, Iune15,2009,tablesupdatedtoFebruarv18,2010.
26.ChristopherCruise,interviewbvFCIC,August24,2010.
27.Ibid.
28.RobertKuttner,interviewbvFCIC,August5,2010.
29. Timothv Geithner, testimonv before the FCIC, Hearing on the Shadow Banking Svstem, dav 2,
session2:PerspectiveontheShadowBankingSvstem,Mav6,2010,transcript,p.146.
30.IamesRvan,chiefmarketingofficeratCitiFinancialandIohnSchachtel,executivevicepresident
ofCitiFinancial,interviewbvFCIC,Februarv3,2010.
31.ThesepointsweremadetotheFCICbvconsumeradvocates:e.g.,KevinStein,associatedirector,
CaliforniaReinvestmentCoalition,attheHearingontheImpactoftheFinancialCrisisSacramento,ses-
sion2:MortgageOrigination,MortgageFraudandPredatorvLendingintheSacramentoRegion,Septem-
ber23,2010;GailBurks,presidentandCEO,NevadaFairHousingCenter,attheHearingontheImpactof
theFinancialCrisisStateofNevada,session3:TheImpactoftheFinancialCrisisonNevadaRealEstate,
September 8, 2010. See also Federal Reserve Consumer Advisorv Council transcripts, March 25, 2004;
Iune24,2004;October28,2004;March17,2005;October27,2005;Iune22,2006;October26,2006.
555 Notes to Chapter 1
32.BobGnaizda,interviewbvFCIC,March25,2010.
33.IamesRokakis,interviewbvFCIC,November8,2010.
34.Ibid.
35. Fed Governor Edward M. Gramlich, Tackling Predatorv Lending: Regulation and Education,
remarksatClevelandStateUniversitv,Cleveland,Ohio,March23,2001.
36.Rokakis,interview.
37.IohnTavlor,chairmanandchiefexecutiveofficer,NationalCommunitvReinvestmentCoalition,
lettertoOfficeofThriftSupervision,Iulv3,2000,providedtotheFCIC.
38.Stein,testimonvbeforetheFCIC,transcript,pp.7374,71.
39.U.S.DepartmentoftheTreasurvandU.SDepartmentofHousingandUrbanDevelopment,Ioint
ReportonRecommendationstoCurbPredatorvHomeMortgageLending(Iune1,2000).
40.FederalReserveBoardpressrelease,December12,2001.
41. Sheila C. Bair, written testimonv for the FCIF, First Public Hearing of the FCIC, dav 2, panel 1:
CurrentInvestigationsintotheFinancialCrisisFederalOfficials,Ianuarv14,2010,p.11.
42. Fed Governor Edward M. Gramlich, Predatorv Lending, remarks at the Housing Bureau for
SeniorsConference,,Ianuarv18,2002.
43.SheilaC.Bair,testimonvbeforetheFCIC,FirstPublicHearingoftheFCIC,dav2,panel1:Cur-
rentInvestigationsintotheFinancialCrisisFederalOfficials,Ianuarv14,2010,transcript,p.97.
44.SheilaC.Bair,interviewbvFCIC,March29,2010.
45. 2009 Mortgage Market Statistical Annual, 1:220, Top B&C Lenders in 2000; 1.223, Top B&C
Lendersin2003.
46.Ibid.,1:237,SubprimeOriginationbvStatein2001;and1:235,SubprimeOriginationsbvState
in2003.
47.Stein,testimonvbeforetheFCIC,September23,2010,transcript,p.72.
48.GailBurks,interviewbvFCIC,August30,2010.
49.LisaMadigan,writtentestimonvfortheFCIC,FirstPublicHearingoftheFCIC,dav1,panel2:
Current Investigations into the Financial CrisisState and Local Officials, Ianuarv 14, 2010, p. 45;
HomeMortgageLendersettledPredatorvLendingCharges,FederalTradeCommissionpressrelease,
March21,2002.
50.2009 Mortgage Market Statistical Annual, 1:220,Top25B&CLendersin2003.
51.Madigan,writtentestimonvfortheFCIC,Ianuarv14,2010,pp.45.
52.EdParker,interviewbvFCIC,Mav26,2010.
53.PrentissCox,interviewbvFCIC,October15,2010.
54.Ibid.
55.2009 Mortgage Market Statistical Annual, 1:45,47,49,51.
56.AlphonsoIackson,interviewbvFCIC,October6,2010.
57.Cox,interview;Madigan,writtentestimonvfortheFCIC,Ianuarv14,2010,p.11.
58.Cox,interview.Madigan,testimonvbeforetheFCIC,Ianuarv14,2010,transcript,pp.121122.
59. Iohn D. Hawke Ir. and Iohn C. Dugan, written statements for the FCIC, Hearing on Subprime
Lending and Securitization and Government-Sponsored Enterprises (GSEs), dav 2, session 2: Office of
theComptrolleroftheCurrencv,April8,2010,pp.45andpp.48,respectivelv.
60.Madigan,writtentestimonvfortheFCIC,Ianuarv14,2010,pp.9,10.
61.Cox,interview.
62. 2009 Mortgage Market Statistical Annual, 1:4, Mortgage Originations bv Product. Nonprime =
Alt-Aandsubprimecombined.
63.MarcS.Savitt,interviewbvFCIC,November17,2010.
64. Rob Barrv, Matthew Haggman, and Iack Dolan, Ex-convicts active in mortgage fraud, Miami
Herald,Ianuarv29,2009.
65.I.ThomasCardwell,writtentestimonvfortheFCIC,HearingontheImpactoftheFinancialCri-
sisMiami, session 3: The Regulation, Oversight, and Prosecution of Mortgage Fraud in Miami, Sep-
tember21,2010,p.8.
66.Savitt,interview.
67.GarvCrabtree,writtentestimonvfortheFCIC,HearingontheImpactoftheFinancialCrisis
GreaterBakersfield,session4:LocalHousingMarket,September7,2010,p.6.
68.Ibid.
556 Notes to Chapter 1
69. Garv Crabtree, interview bv FCIC, August 18, 2010. Crabtree, written testimonv for the FCIC,
September7,2010,pp.67.
70.FBIWarnsofMortgageFraudEpidemicfromTerrvFrieden,CNNnewsreport,September17,
2004.
71. Kirstin Downev, FBI Vows to Crack Down on Mortgage Fraud; Hot Real Estate Market Drives
ReportsofSuspiciousActivitv,AgencvSavs,Vashington Post, Februarv15,2005.
72. Financial Crimes Enforcement Network, Regulatorv Policv and Programs Division, Mortgage
LoanFraud:AnIndustrvAssessmentBaseduponSuspiciousActivitvReportAnalvsis,November2006.
SeealsoFinancialCrimesEnforcementNetwork,AnnualReport:FiscalYear2008.
73.FinCENresponsetoFCICinterrogatories,October1415,2010.
74.WilliamK.Black,writtentestimonvfortheFCIC,HearingontheImpactoftheFinancialCrisis
Miami,session1:OverviewofMortgageFraud,September21,2010,p.8.
75.AlbertoGonzales,interviewbvFCIC,November1,2010;MichaelMukasev,interviewbvFCIC,
October20,2010.
76.FederalReserveConsumerAdvisorvCouncilMeeting,October28,2004,transcript,p.44.
77.Ibid.,p.45.
78.RuhiMaker,interviewbvFCIC,October25,2010.
79.KirstinDownev,ManvBuversOptforRiskvMortgages,Vashington Post, Mav28,2005.
80.AftertheFall:Soaringhousepriceshavegivenahugeboosttotheworldeconomv.Whathappens
whenthevdrop:The Economist, Iune16,2005.
81. Fed Chairman Alan Greenspan, The Economic Outlook, prepared testimonv before the Ioint
EconomicCommittee,109thCong.,1stsess.,Iune9,2005.
82.Ibid.
83. Fed Chairman Ben S. Bernanke, The Economic Outlook, prepared testimonv before the Ioint
EconomicCommittee,U.S.Congress,110thCong.,1stsess.,March28,2007.
84.SheilaCanavan,commentsduringoftheFederalReserveConsumerAdvisorvCouncilMeeting,
October27,2005,transcript,p.52.
85.DavidLeonhardt,BeWarned:Mr.BubblesWorriedAgain,^ew York Times, August21,2005.
86.RaghuramRajan,interviewbvFCIC,November22,2010.
87.Ibid.
88.Ibid.
89.RaghuramG.Rajan,Fault Lines. How Hidden Fractures Still Threaten The Vorld Economy (Prince-
ton:PrincetonUniversitvPress,2010),p.3.
90.SusanM.Wachter,interviewbvFCIC,October6,2010.
91.MarkKlipsch,quotedinBlizzardCantStopASF2005Conference,Asset Securitization Report,
Ianuarv31,2005.
92.DennisI.Black,writtentestimonvfortheFCIC,HearingontheImpactoftheFinancialCrisis
Miami,session2:UncoveringMortgageFraudinMiami,September21,2010,p.1;fortheappraiserspe-
tition,seehttp://appraiserspetition.com/.
93. Karen Mann, written testimonv for the FCIC, Hearing on the Impact of the Financial Crisis
Sacramento,session2:MortgageOrigination,MortgageFraudandPredatorvLendingintheSacramento
Region,September23,2010.
94.2009 Mortgage Market Statistical Annual, vol.2,The Secondary Market,p.13,Non-AgencvMBS
IssuancebvTvpe,andFCICstaffestimatesbasedonanalvsisofMoodvsSFDRSdata.
95.IamieDimon,testimonvbeforetheFCIC,FirstPublicHearingoftheFCIC,dav1,panel1:Finan-
cialInstitutionRepresentatives,Ianuarv13,2010,transcript,p.78.
96.MadelvnAntoncic,interviewbvFCIC,Iulv14,2010.
97. Anton R. Valukas, Report of Examiner, In re Lehman Brothers Holdings Inc., et al., Chapter 11
CaseNo.08-13555(IMP),(Bankr.S.D.N.Y.),March11,2010,1:114,withn.418.
98.RichardBowen,interviewbvFCIC,Februarv27,2010.
99. Richard Bowen, email to Robert Rubin, David Bushnell, Garv Crittenden, and Bonnie Howard,
November3,2007.
557 Notes to Chapter 1
100.RobertRubin,testimonvbeforetheFCIC,HearingonSubprimeLendingandSecuritizationand
Government-SponsoredEntities(GSEs),dav2,session1:CitigroupSeniorManagement,April8,2010,
transcript,p.30.
101.BradS.Karp,counselforCitigroup,lettertoFCIC,November1,2010,inresponsetoFCICre-
questofSeptember21,2010,forinformationregardingRichardBowensNovember3,2007,email,p.2.
102.Bowen,interview.
103.I.KvleBass,testimonvbeforetheFCIC,FirstPublicHearingoftheFCIC,dav1,panel2:Finan-
cialMarketParticipants,Ianuarv13,2010,transcript,pp.14344.
104.HerbertM.Sandler,CommentonIointANPRforProposedRevisiontotheExistingRisk-based
CapitalRule,lettertoFederalReserveBoard,OfficeoftheComptrolleroftheCurrencv,FederalDeposit
InsuranceCorporation,andOfficeofThriftSupervision,Ianuarv18,2006.
105.LewisRanieri,interviewbvFDIC,Iulv30,2010.
106.AngeloMozilo,emailtoEricSieracki,April13,2006,re:1O2006Earnings.
107.AngeloMozilo,emailtoDavidSambol,April17,2006,subject:sub-primeseconds.
108. David Sambol, email to Angelo Mozilo, April 17, 2006, re: Sub-prime seconds (cc Kurland,
McMurrav,andBartlett).
109.AngeloMozilo,emailtoDavidSambol,April17,2006,subject:re:Sub-primeseconds(ccKur-
land,McMurrav,andBartlett).
110.SabethSiddique,interviewbvFCIC,September9,2010.
111.SurvevofNontraditionalMortgages(actualtitleredacted),confidentialFederalReservedocu-
mentobtainedbvFCIC,producedNovember1,2005,pp.2,3.
112.SusanBies,interviewbvFDIC,October11,2010.
113.IohnDugan,testimonvbeforetheFCIC,HearingonSubprimeLendingandSecuritizationand
Government-SponsoredEnterprises(GSEs),dav2,session2:OfficeoftheComptrolleroftheCurrencv,
April8,2010,transcript,
114.SabethSiddique,interviewsbvFCIC,September9,2010,andOctober25,2010.
115.Bies,interview.
116.MortgageInsuranceCompaniesofAmerica,quotedinKirstinDownev,InsurersWantAction
onRiskvMortgages;FirmsWantMoreLoanRestrictions,Vashington Post,August19,2006.
117.WilliamA.Sampson,MortgageInsuranceCompaniesofAmerica,MICATestimonvonNon-
Traditional Mortgages, before the Senate Subcommittee on Housing and Transportation and the Sub-
committeeonEconomicPolicv,109thCong.,2ndsess.,September20,2006.
118.Siddique,interviews,October25,2010,andSeptember9,2010.
119.ConsumerAdvisorvCouncilMeeting,March30,2006,transcript.
120.ConsumerAdvisorvCouncilMeeting,Iune22,2006,transcript.
121.Siddique,interview,October25,2010;Bies,interview.
122. There is no central clearinghouse to calculate structured finance assets. The FCICs estimate is
based on the amount of structured finance assets rated bv Moodvs along with unrated agencv RMBS,
alongwithanestimateforstructuredfinanceassetsnotratedbvMoodvs,usingassourcesFannieMae
and Freddie Mac, Bloomberg, American CoreLogic Loan Performance, Fitch Ratings, Moodvs, S&P,
ThomsonReuters,andSIFMA.
123.AlanGreenspan,testimonvbeforetheFCIC,HearingonSubprimeLendingandSecuritization
and Government-Sponsored Enterprises (GSEs), dav 1, session 1: The Federal Reserve, April 7, 2010,
transcript,p.29.
124.MortgageBankersAssociation,NationalDelinquencvSurvev.
125. CoreLogic, Inc., August 26, 2010, news release, second quarter, 2010. Second-quarter figures
wereanimprovementfrom11.2millionresidentialproperties(24)innegativeequitvinthefirstquar-
terof2010.
126. Mark Zandi, written testimonv for the FCIC, First Public Hearing of the FCIC, dav 1, panel 3:
FinancialCrisisImpactsontheEconomv,Ianuarv13,2010,pp.14,15.
127.DeanBaker,interviewbvFCIC,August18,2010.
128. Warren Peterson, testimonv before the FCIC, Hearing on the Impact of the Financial Crisis
Greater Bakersfield, session 3: Residential and Communitv Real Estate, September 7, 2010, transcript,
pp.1067,11920,1078;WarrenPeterson,interviewbvFCIC,August24,2010.
558 Notes to Chapter 2
Chapter 2
1. Ben Bernanke, written testimonv before the FCIC, Hearing on Too Big to Fail: Expectations and
ImpactofExtraordinarvGovernmentInterventionandtheRoleofSvstemicRiskintheFinancialCrisis,
dav1,session1,September2,2010,p.2.
2.AlanGreenspan,TheEvolutionofBankinginaMarketEconomv,remarksattheAnnualConfer-
enceoftheAssociationofPrivateEnterpriseEducation,Arlington,Virginia,April12,1997.
3. Charles Calomiris and Garv Gorton, The Origins of Banking Panics: Models, Facts, and Bank
Regulation,inCalomiris,U.S. Bank Deregulation in Historical Perspective (Cambridge:CambridgeUni-
versitvPress,2000),pp.98100.PriortotheendoftheCivilWar,banksissuednotesinsteadofholding
deposits.Runsonthatsvstemoccurredin1814,1819,1837,1839,1857,and1861(ibid.,pp.9899).
4.R.AltonGilbert,RequiemforRegulationO:WhatItDidandWhvItPassedAwav,Federal Re-
serve Bank of St. Louis Review 68,no.2(Februarv1986):23.
5.FCIC,PreliminarvStaffReport:ShadowBankingandtheFinancialCrisis,Mav4,2010,pp.18
25.
6. Arthur E. Wilmarth Ir., The Transformation of the U.S. Financial Services Industrv, 19752000:
Competition,Consolidation,andIncreasedRisks,University of Illinois Law Review (2002):23940.
7.FredericS.Mishkin,AsvmmetricInformationandFinancialCrises:AHistoricalPerspective,in
Financial Markets and Financial Crises, ed. R. Glenn Hubbard (Chicago: Universitv of Chicago Press,
1991),p.99;Wilmarth,TheTransformationoftheU.S.FinancialServicesIndustrv,19752000,p.236.
8.FederalReserveBoardFlowofFundsRelease,tableL.208.AccessedDecember29,2010.
9.KennethGarbade,TheEvolutionofRepoContractingConventionsinthe1980s,Federal Reserve
Bank of ^ew York Economic Policy Review 12, no. 1 (Mav 2006): 3233, 3839 (available at
http://papers.ssrn.com/sol3/papers.cfm:abstract_id=918498). To implement monetarv policv, the Fed-
eralReserveBankofNewYorkusestherepomarket:itsetsinterestratesbvborrowingTreasuriesfrom
andlendingthemtosecuritiesfirms,manvofwhichareunitsofcommercialbanks.
10.AlanBlinder,interviewbvFCIC,September17,2010.
11.PaulVolcker,interviewbvFCIC,October11,2010.
12.FedChairmanAlanGreenspan,InternationalFinancialRiskManagement,remarksbeforethe
CouncilonForeignRelations,November19,2002.
13.RichardC.Breeden,interviewbvFCIC,October14,2010.
14. Wilmarth, The Transformation of the U.S. Financial Services Industrv, 19752000, p. 241 and
n.102.
15.Thereafter,bankswereonlvrequiredtolendoncollateralandsettermsbaseduponwhatthemar-
ketwasoffering.Thevalsocouldnotlendmorethan10oftheircapitaltoonesubsidiarvormorethan
20toallsubsidiaries.OrderApprovingApplicationstoEngageinLimitedUnderwritingandDealingin
CertainSecurities,Federal Reserve Bulletin 73,no.6(Iul.1987):473508;RevenueLimitonBank-Inel-
igibleActivitiesofSubsidiariesofBankHoldingCompaniesEngagedinUnderwritingandDealinginSe-
curities,Federal Register 61,no.251(Dec.30,1996),6875056.
16.IulieL.WilliamsandMarkP.Iacobsen,TheBusinessofBanking:LookingtotheFuture,Busi-
ness Lawyer 50(Mav1995):798.
17.FedChairmanAlanGreenspan,preparedtestimonvbeforetheHouseCommitteeonBankingand
FinancialServices,H.R. 10, the Financial Services Competitiveness Act of 1997, 105thCong.,1stsess.,Mav
22,1997.
18.FCICstaffcalculations.
19.FCICstaffcalculations.
20.FCICstaffcalculationsusingFirstAmerican/CoreLogic,NationalHPISingle-FamilvCombined
(SFC).
21.Thisdataseriesisrelativelvnew.Thoseseriesavailablebefore2009showednovear-over-vearna-
tionalhousepricedecline.FirstAmerican/CoreLogic,NationalHPISingle-FamilvCombined(SFC).
22.Forageneraloverviewofthebankingandthriftcrisisofthe1980s,seeFDIC,History of the Eight-
ies. Lessons for the Future, vol. 1, An Examination of the Banking Crises of the 1980s and Early 1990s
(Washington,DC:FederalDepositInsuranceCorporation,1997).
559 Notes to Chapter 3
23. Specificallv, between 1980 and 1994, 1,617 federallv insured banks with $302.6 billion in assets
and 1,295 savings and loans with $621 billion in assets either closed or received FDIC or FSLIC assis-
tance.SeeFederalDepositInsuranceCorp.,Managing the Crisis. The FDIC and RTC Experience, 1980
1994 (Aug.1998),pp.4,5.
24.WilliamK.Black,AssociateProfessorofEconomicsandLaw,UniversitvofMissouriKansasCitv,
written testimonv for the FCIC, Hearing on the Impact of the Financial Crisis, session 1: Overview of
MortgageFraud,September21,2010,p.4.AndseeKittvCalavita,HenrvN.Pontell,andRobertH.Till-
man,Big Money Crime. Fraud and Politics in the Savings and Loan Crisis (Berkelev:UniversitvofCalifor-
niaPress,1997),p.28.
25.FDIC,History of the Eighties. Lessons for the Future, 1:39.
26.U.S.TreasurvDepartment,ModernizingtheFinancialSvstem:RecommendationsforSafer,More
CompetitiveBanks(Februarv1991),p.55.
27.TestimonvofIohnLaWare,Governor,FederalReserveBoard,atHearingsbeforeSubcommittee
onEconomicStabilizationoftheCommitteeonBanking,Finance,andUrbanAffairsontheEconomic
Implications of the Too Big to Fail Policv, Mav 9, 1991, p. 11, http://fraser.stlouisfed.org/
publications/tbtf/issue/3954/download/61094/housetbtf1991.pdf.
FDIC,History of the Eighties. Lessons for the Future,1:251.
28.GeorgeG.Kaufman,TooBigtoFailinU.S.Banking:OuoVadis:inToo Big to Fail. Policies and
Practices in Government Bailouts, ed.BentonE.Gup(Westport,CT:Praeger,2004),p.163.
29.FCIC,PreliminarvStaffReport:Too-Big-to-FailFinancialInstitutions,August31,2010,pp.6
9.(Rep.McKinnevisquotedfromthetranscriptofthehearingbeforetheHouseCommitteeonBanking,
Housing,andUrbanAffairs).
30.Ibid.,pp.10,19.
Chapter 3
1. Federal National Mortgage Association, Federal ^ational Mortgage Association, Background and
History (1975).
2.DepartmentofHousingandUrbanDevelopment,198 Report to Congress on the Federal ^ational
Mortgage Association (1987),p.100.
3. See, e.g., Kenneth H. Bacon, Privileged Position: Fannie Mae Expected to Escape Attempt at
Tighter Regulation, Vall Street Iournal, Iune 19, 1992, and Stephen Labaton, Power of the Mortgage
Twins:FannieandFreddieGuardAutonomv,^ew York Times,November12,1991.
4.ArmandoFalconIr.,writtentestimonvfortheFCIC,HearingonSubprimeLendingandSecuritiza-
tionandGovernment-SponsoredEnterprises(GSEs),dav3,session2:OfficeofFederalHousingEnter-
priseOversight,April9,2010,p.2.
5.WavnePassmore,TheGSEImplicitSubsidvandtheValueofGovernmentAmbiguitv,FederalRe-
serveBoardStaffWorkingPaper200505.SeealsoCongressionalBudgetOffice,UpdatedEstimatesof
theSubsidiestotheHousingGSEs,April8,2004.
6.FederalHousingFinanceAgencv,Report to Congress, 2009 (2010),pp.141,158.
7.FannieMaeCharterActof1968,309(h),codifiedat12U.S.C.1723a(h).The1992FederalHous-
ing Enterprises Financial Safetv and Soundness Act repealed this provision and replaced it with more
elaborateprovisions.Currentlv,theGSEstvpicallvdefinelow-andmoderate-incomeborrowersasthose
withincomeatorbelowmedianincomeforagivenarea.
8.DepartmentofHousingandUrbanDevelopment,RegulationsImplementingtheAuthoritvofthe
Secretarv of the Department of Housing and Urban Development over the conduct of the Secondarv
marketOperationsoftheFederalNationalMortgageAssociation(FNMA),Federal Register 43,no.158
(August15,1978):36199226.
9.PresidentWilliamI.Clinton,RemarksontheNationalHomeownershipStrategv,Iune5,1995.
10.PresidentGeorgeW.Bush,PresidentsRemarkstotheNationalAssociationofHomeBuilders,
GreaterColumbusConventionCenter,Columbus,Ohio,October2,2004.
11.AndrewCuomo,interviewbvFCIC,December17,2010.
12.DanielMudd,testimonvbeforetheFCIC,HearingonSubprimeLendingandSecuritizationand
Government-SponsoredEnterprises(GSEs),dav3,session1:FannieMae,April9,2010,transcript,pp.
1819.
560 Notes to Chapter 3
13.RichardSvron,interviewbvFCIC,August31,2010.
14. Senate Lobbving Disclosure Act Database (www.senate.gov/legislative/Public_Disclosure/
LDA_reports.htm);figuresonemploveesandPACscompiledbvtheCenterforResponsivePoliticsfrom
FederalElectionsCommissiondata.
15.Falcon,writtentestimonvfortheFCIC,April9,2010,p.5.
16. Iames Lockhart, written testimonv for the FCIC, Hearing on Subprime Lending and Securitiza-
tionandGovernment-SponsoredEnterprises(GSEs),dav3,session2:OfficeofFederalHousingEnter-
priseOversight,pp.48,17(quotation).
17.SenatorMelMartinez,interviewbvFCIC,September28,2010.
18. Iune E. ONeill, remarks before the Conference on Appraising Fannie Mae and Freddie Mac,
Washington,D.C.,Mav14,1998,p.8.
19.FederalHousingFinanceAgencv,Report to Congress, 2008 (2009),tables3,4,12,and13.
20.LawrenceLindsev,interviewbvFCIC,September20,2010.
21.IimCallahan,interviewbvFCIC,October18,2010.
22.SecuritiesIndustrvandFinancialMarketsAssociation(SIFMA),USABSOutstanding.
23.ScottPatterson,interviewbvFCIC,August12,2010.
24.GillianTett,Fools Gold. How the Bold Dream of a Small Tribe at I. P. Morgan Vas Corrupted by
Vall Street Greed and Unleashed a Catastrophe (NewYork:FreePress,2009),pp.3233,49,70,115.
25.EmmanuelDerman,interviewbvFCIC,Mav12,2010.
26.Volcker,interview.
27.VincentReinhart,interviewbvFCIC,September10,2010.
28.Lindsev,interview.
29.Afuturescontractisabilateralcontractinwhichonepartv,thelongposition,iscompensatedif
thepriceorindexorrateunderlvingthecontractriseswhiletheotherpartv,theshortposition,iscom-
pensatedifitgoesdown.Anoptionscontractgrantstherightbutnottheobligationtopurchaseorsella
commoditvorfinancialinstrumentataparticularpriceinthefuture;theoptionholderderivesabenefit
ifthepricemovesinhisorherfavor.Inaswapscontract,thetwopartiesexchangestreamsofpavments
basedondifferentbenchmarks.
30.SecuritiesoptionsareregulatedbvtheSEC.
31.CommoditvFuturesTradingCommission,ExemptionforCertainSwapAgreements,FinalRule,
Federal Registrar 58(Ianuarv22,1993):5587.
32.BrookslevBorn,chairperson,CommoditvFuturesTradingCommission,ConcerningtheOver-
the-CounterDerivativesMarket,preparedtestimonvbeforetheHouseCommitteeonBankingandFi-
nancialServices,105thCong.,2ndsess.,Iulv24,1998.
33.GAO,FinancialDerivatives:ActionsNeededtoProtecttheFinancialSvstem,GGD-94-133(Re-
porttoCongressionalRequesters),Mav18,1994.
34. Commoditv Futures Trading Commission, Division of Enforcement (www.cftc.gov/anr/an-
renf98.htm).
35. Ioint Statement bv Treasurv Secretarv Robert E. Rubin, Federal Reserve Board Chairman Alan
Greenspan, and Securities and Exchange Commission Chairman Arthur Levitt, Treasurv Department
pressrelease,Mav7,1998.
36.FedChairmanAlanGreenspan,TheRegulationofOTCDerivatives,preparedtestimonvbefore
theHouseCommitteeonBankingandFinancialServices,105thCong.,2ndsess.,Iulv24,1998.
37.GAO,Long-TermCapitalManagement:RegulatorsNeedtoFocusGreaterAttentiononSvstemic
Risk, GAO/GGD-00-3 (Report to Congressional Requesters), October 1999, pp. 7, 18, 3940. The no-
tionalamountofOTCderivativescontractsisastandardmeasureusedinreportingtheoutstandingvol-
ume of such contracts. Its calculation is based on the value of the underlving instrument, commoditv,
index,orratethattheswapisbasedon.Itthereforemavbeoflimiteduseinmeasuringthepotentialex-
posureofthepartiestothecontracts.Forexample,aninterestrateswapbasedonchangesininterestrate
ona$100millionloanwouldlikelvinvolveonlvasmallpercentageofthe$100millionnotionalamount.
Ontheotherhand,pricechangesonanoilswapbasedon$100millionworthofoilcouldbeevenmore
thanthenotionalamount,dependingonthevolatilitvinoilprices.Forcreditdefaultswaps,whichare
discussedinmoredetaillaterinthisvolume,thenotionalamountisusuallvaclosemeasureofthepoten-
tialfinancialexposureoftheissuerorselleroftheswap.
561 Notes to Chapter 4
38.FedChairmanAlanGreenspan,Private-sectorRefinancingoftheLargeHedgeFund,Long-Term
CapitalManagement,preparedtestimonvbeforetheHouseCommitteeonBankingandFinancialServ-
ices,105thCong.,2ndsess.,October1,1998.
39.FedChairmanAlanGreenspan,FinancialDerivatives,remarksbeforetheFuturesIndustrvAs-
sociation,BocaRaton,Florida,March19,1999.
40.Over-the-CounterDerivativesMarketsandtheCommoditvExchangeAct,reportofthePresi-
dentsWorkingGrouponFinancialMarkets,November1999.
41.Grossmarketvalueisthecurrentpriceatwhichtheoutstandingswapscontractcanbesoldorre-
placedonthemarket.Assuch,thatamountreflectsthecurrentamountowingonacontractbutdoesnot
reflectthepossiblefutureexposureonthesegenerallvlong-terminstruments.
42.BankforInternationalSettlements,dataonsemiannualOTCderivativesstatistics.
43. Alan Greenspan, testimonv before the FCIC, Hearing on Subprime Lending and Securitization
andGovernment-SponsoredEntities(GSEs),dav1,session1:TheFederalReserve,April1,2010,tran-
script,pp.8889.
44.RobertRubin,testimonvbeforetheFCIC,FCICHearingonSubprimeLendingandSecuritization
and Government-Sponsored Entities (GSEs), dav 2, session 1: Citigroup Senior Management, April 8,
2010,transcript,pp.10810,12324.
45.LawrenceSummers,interviewbvFCIC,Mav28,2010.
46.DanielK.Tarullo,Banking on Basel. The Future of International Financial Regulation (Washington,
DC:PetersonInstituteforInternationalEconomics,2008),p.58.
47.FinalRuleAmendmenttoRegulationsHandY,Federal Reserve Bulletin 75,no.3(March1989),
16466.
48.Tarullo,Banking on Basel,pp.6164.
49.Formoreonderivatives,seeFCIC,PreliminarvStaffReport:OverviewonDerivatives,Iune29,
2010.
50.WarrenBuffett,testimonvbeforetheFCIC,HearingontheCredibilitvofCreditRatings,theIn-
vestmentDecisionsMadeBasedonThoseRatings,andtheFinancialCrisis,session2:CreditRatingsand
theFinancialCrisis,Iune2,2010,transcript,pp.312,326,325.
51.EricR.Dinallo,formersuperintendant,NewYorkStateInsuranceDepartment,writtentestimonv
fortheFCIC,HearingontheRoleofDerivativesintheFinancialCrisis,session2,Derivatives:Supervi-
sorsandRegulators,Iulv1,2010,p.7;RochelleKatz,StateofNewYorkInsuranceDepartment,letterto
BertilLundqvist,Skadden,Arps,Slate,Meagher&Flom,LLP,Iune16,2000.
52.DataprovidedbvAIGtotheFCIC,CDSnotionalbalancesatvear-end.
53.BankforInternationalSettlements,semiannualOTCderivativesstatistics.
54.DinallotestifiedthatthemarketinCDSinSeptember2008wasestimatedtobe$62trillionata
time when there was about $16 trillion of private-sector debt (written testimonv for the FDIC, Iulv 1,
2010,p.9).
55.AIGFPalsoparticipatesasadealerinawidevarietvoffinancialderivativestransactions(AIG,
2007Form10-K,p.83).AIGsnotionalderivativesoutstandingwere$2.1trillionattheendof2007,in-
cluding $1.2 trillion of interest rate swaps, $0.6 trillion of credit derivatives, $0.2 trillion of currencv
swaps,and$0.2trillionofotherderivatives(p.163).
56.FCICstaffcalculationsusingdatafromOfficeoftheComptrolleroftheCurrencv;callreports.
57.DataprovidedtotheFCICbvGoldmanSachs.
Chapter 4
1.103PublicLaw103-328,September29,1994.Beforethe1994legislation,somestateshadvoluntar-
ilvopenedthemselvesuptoout-of-statebanks.FDIC,History of the Eighties. Lessons for the Future, vol.1,
An Examination of the Banking Crises of the 1980s and Early 1990s (Washington, DC: FDIC, 1997),
p.130.
2.Thesewerethelargestbanksasof2007.SeeFCIC,PreliminarvStaffReport:Too-Big-to-FailFi-
nancialInstitutions,August31,2010,p.14.
3.DatafromSNLFinancial(www.snl.com/).
4.PublicLaw104-208,sec.2222,codifiedas12U.S.C.3311;lawineffectasofIanuarv3,2007.
5.ArthurLevitt,interviewbvFCIC,October1,2010.
562 Notes to Chapter 4
6. Iohn D. Hawke and Iohn Dugan, testimonv before the FCIC, Hearing on Subprime Lending and
SecuritizationandGovernment-SponsoredEnterprises(GSEs),dav2,session2:OfficeoftheComptrol-
leroftheCurrencv,April8,2010,transcript,pp.169,175.
7.FedViceChairmanRogerW.FergusonIr.,TheFutureofFinancialServicesRevisited,remarks
attheFutureofFinancialServicesConference,UniversitvofMassachusetts,Boston,October8,2003.
8.FedChairmanAlanGreenspan,GovernmentRegulationandDerivativeContracts,speechatthe
Financial Markets Conference of the Federal Reserve Bank of Atlanta, Coral Gables, Florida, Februarv
21,1997.
9.RichardSpillenkothen,Notesontheperformanceofprudentialsupervisioninthevearspreceding
the financial crisis bv a former director of banking supervision and regulation at the Federal Reserve
Board(1991to2006),Mav31,2010,p.28.
10.SeeU.S.DepartmentoftheTreasurv,Modernizing the Financial System(Februarv1991),pp.XIX-
5,XIX-6,6769:theexistenceoffeweragencieswouldconcentrateregulatorvpowerintheremaining
ones,raisingthedangerofarbitrarvorinflexiblebehavior. . . .Agencvpluralism,ontheotherhand,mav
be useful, since it can bring to bear on general bank supervision the different perspectives and experi-
encesofeachregulator,anditsubjectseachone,whereconsultationandcoordinationarerequired,tothe
checksandbalancesoftheothersopinion.
11. Fed Chairman Alan Greenspan, statement before the Senate Committee on Banking, Housing,
andUrbanAffairs,103rdCong.,2ndsess.,March2,1994,reprintedintheFederal Reserve Bulletin, Mav
1,1994,p.382.
12.SecuritiesIndustrvAssociationv.BoardofGovernorsoftheFederalReserveSvstem,627F.Supp.
695(D.D.C.1986);KathleenDav,ReinventingtheBank;WithDepression-EraLawabouttoBeRewrit-
ten,theFutureRemainsUnclear,Vashington Post, October31,1999.
13.EdwardYingling,quotedinTheMakingofaLaw,ABA Banking Iournal,December1999.
14.Thetwo-vearexemptioniscontainedinsection4(a)(2)oftheBankHoldingCompanvAct.The
Fedcouldhavegranteduptothreeone-vearextensionsofthatexemption.
15.FCICstaffcomputationsbasedondatafromtheCenterforResponsivePolitics.Financialsector
here includes insurance companies, commercial banks, securities and investment firms, finance and
credit companies, accountants, savings and loan institutions, credit unions, and mortgage bankers and
brokers.
16.U.S.DepartmentoftheTreasurv,Modernizing the Financial System (Februarv1991);FedChair-
man Alan Greenspan, H.R. 10, the Financial Services Competitiveness Act of 1997, testimonv before
theHouseCommitteeonBankingandFinancialServices,105thCong.,1stsess.,Mav22,1997.
17.KatrinaBrooker,CitisCreator,AlonewithHisRegrets,^ew York Times, Ianuarv2,2010.
18.IohnReed,interviewbvFCIC,March24,2010.
19.FDICInstitutionDirectorv;SNLFinancial.
20.FedGovernorLaurenceH.Mever,TheImplicationsofFinancialModernizationLegislationfor
Bank Supervision, remarks at the Svmposium on Financial Modernization Legislation, sponsored bv
WomeninHousingandFinance,Washington,D.C.,December15,1999.
21.BenS.Bernanke,writtentestimonvbeforetheFCIC,HearingonTooBigtoFail:Expectationsand
ImpactofExtraordinarvGovernmentInterventionandtheRoleofSvstemicRiskintheFinancialCrisis,
dav1,session1:TheFederalReserve,September2,2010,p.14.
22.PatriciaA.McCovetal.,SvstemicRiskthroughSecuritization:TheResultofDeregulationand
RegulatorvFailure,Connecticut Law Review 41(2009):134547,135355.
23.FedChairmanAlanGreenspan,LessonsfromtheGlobalCrises,remarksbeforetheWorldBank
Group and the International Monetarv Fund, Program of Seminars, Washington, DC, September 27,
1999.
24.DavidA.Marshall,TheCrisisof1998andtheRoleoftheCentralBank,FederalReserveBankof
Chicago, Economic Perspectives (1O2001):2.
25.Commercialandindustrialloansatallcommercialbanks,monthlv,seasonallvadjusted,fromthe
FederalReserveBoardofGovernorsH.8release;FCICstaffcalculationofaveragechangeinloansout-
standingoveranvtwoconsecutivemonthsin1997and1998.
26.FranklinR.Edwards,HedgeFundsandtheCollapseofLong-TermCapitalManagement,Iour-
nal of Economic Perspectives 13(1999):198.
563 Notes to Chapter 4
27.HedgeFunds,Leverage,andtheLessonsofLong-TermCapitalManagement,ReportofthePres-
identsWorkingGrouponFinancialMarkets,April1999,p.14.
28.Edwards,HedgeFundsandtheCollapseofLong-TermCapitalManagement,pp.200,197;and
Bloomberg.
29.Ibid.,pp.197205;RogerLowenstein,Vhen Genius Failed. The Rise and Fall of Long-Term Capital
Management (NewYork:RandomHouse,2000),pp.3654,7784,94105,12330.
30.HedgeFunds,Leverage,andtheLessonsofLong-TermCapitalManagement,pp.1112.
31.WilliamI.McDonough,presidentoftheFederalReserveBankofNewYork,statementbeforethe
HouseCommitteeonBankingandFinancialServices,105thCong.,2ndsess.,October1,1998.
32.GAO,Long-TermCapitalManagement:RegulatorsNeedtoFocusGreaterAttentiononSvstemic
Risk,GAO/GGD-00-3(ReporttoCongressionalRequesters),October1999,p.39.
33.HedgeFunds,Leverage,andtheLessonsofLong-TermCapitalManagement, pp.1314.
34.Lowenstein,Vhen Genius Failed, pp.20518.
35.McDonough,statementbeforetheHouseCommitteeonBankingandFinancialServices,October
1,1998.
36.AndrewF.Brimmer,DistinguishedLectureonEconomicsinGovernment:CentralBankingand
SvstemicRisksinCapitalMarkets,Iournal of Economic Perspectives,no.2(Spring1989)(lecturebvafor-
merFedgovernor,analvzingtheFedsmarketinterventionsin1970,1980and1987,andconcludingthat
theFedhadconsciouslvassumedastrategicroleastheultimatesourceofliquiditvintheeconomvat
large);KeithGarbade,TheEvolutionofRepoContractingConventionsinthe1980s,FederalReserve
BankofNewYorkEconomic Policy Review (Mav2006):33.
37.HarvevMiller,interviewbvFCIC,August5,2010.
38.StanlevONeal,interviewbvFCIC,September16,2010.
39.FedChairmanAlanGreenspan,Doefficientfinancialmarketsmitigatefinancialcrises:remarks
beforethe1999FinancialMarketsConferenceoftheFederalReserveBankofAtlanta,October19,1999
(www.federalreserve.gov/boarddocs/speeches/1999/19991019.htm).
40.HedgeFunds,Leverage,andtheLessonsofLong-TermCapitalManagement,p.16.
41.Ibid.
42.Ibid.
43.PhilipGoldstein,etal.v.SEC,Opinion,CaseNo.04-1434(D.C.Cir. Iune23,2006).
44.Time, Februarv15,1999;BobWoodward,Maestro. Greenspans Fed and the American Boom (New
York:Simon&Schuster,2000).
45.SIFMA(SecuritiesIndustrvandFinancialMarketsAssociation),Fact Book 2008, pp.910.
46.BoardofGovernorsoftheFederalReserveSvstem,Federal Reserve Statistical Release Z.1. Flow of
Funds Accounts of the United States, 4thOtr.1996,p.88(TableL.213,line18);4thOtr.2001,p.90(Table
L.213,line20).
47.SECChairmanWilliamH.Donaldson,TestimonvConcerningGlobalResearchAnalvstSettle-
ment,beforetheSenateCommitteeonBanking,HousingandUrbanAffairs,108thCong.,1stsess.,Mav
7,2003.
48.SEC,SECFactSheetonGlobalAnalvstResearchSettlements,April30,2003;FinancialIndustrv
Regulatorv Authoritv news release, NASD Fines Piper Iaffrav $2.4 Million for IPO Spinning, Iulv 12,
2004.
49. Arthur E. Wilmarth Ir., Conflicts of Interest and Corporate Governance Failures at Universal
BanksDuringtheStockMarketBoomofthe1990s:TheCasesofEnronandWorldCom,GeorgeWash-
ingtonUniversitvPublicLawandLegalTheorvWorkingPaper234(2007).
50.FedChairmanAlanGreenspan,InternationalFinancialRiskManagement,remarksbeforethe
CouncilonForeignRelations,Washington,DC, November19,2002.
51.Ferguson,TheFutureofFinancialServicesRevisited.
52.Spillenkothen,Notesontheperformanceofprudentialsupervisioninthevearsprecedingthefi-
nancialcrisis,p.28.
53.FirstthePut;ThentheCut:Economist, December16,2000,p.81.
564 Notes to Chapter 4
54.FedChairmanAlanGreenspan,RiskandUncertaintvinMonetarvPolicv,remarksattheMeet-
ingsoftheAmericanEconomicAssociation,SanDiego,California,Ianuarv3,2004.SeealsoFedGover-
norBenS.Bernanke,Asset-PriceBubblesandMonetarvPolicv,remarksbeforetheN.Y.Chapterofthe
NationalAssociationofBusinessEconomics,NewYork,October15,2002.
55.FedChairmanAlanGreenspan,ReflectionsonCentralBanking,remarksatasvmposiumspon-
soredbvtheFederalReserveBoardofKansasCitv,IacksonHole,Wvoming,August26,2005.
56.LawrenceLindsev,interviewbvFCIC,September20,2010.
57. The NYSE decided in 1970 to allow members to be publiclv traded. See Andrew von Norden -
flvcht, The Demise of the Professional Partnership: The Emergence and Diffusion of Publiclv-Traded
ProfessionalServiceFirms(draftpaper,FacultvofBusiness,SimonFraserUniversitv,September2006),
pp.2021.
58.PeterSolomon,writtentestimonvfortheFCIC,FirstPublicHearingofFCIC,dav1,panel2:Fi-
nancialMarketParticipants,Ianuarv13,2010,p.2.
59.BrianR.Leach,interviewbvFCIC,March4,2010,p.22.
60.IianCai,KentChernv,andToddMilbourn,CompensationandRiskIncentivesinBankingand
Finance,FederalReserveBankofClevelandEconomic Commentary (September14,2010).
61.CarolaFrvdmanandRavenE.Saks,HistoricalTrendsinExecutiveCompensation,19362005
(2007),p.3.
62.Cai,Chernv,andMilbourn,CompensationandRiskIncentivesinBankingandFinance.
63.GoldmanSachs,2006and200910-K;MorganStanlev,200810-K;MerrillLvnch,2005and2008
10-K.
64.GutfreundsPavIsCut,^ew York Times, December23,1987.
65.MerrillLvnch,2007ProxvStatement,p.38.
66.GoldmanSachs,ProxvStatementfor2008AnnualMeetingofShareholders,March7,2008,p.
16:Blankfeinreceived$600,000basesalarvanda2007vear-endbonusof$67.9million.
67. Lehman Brothers, Proxv Statement for Year-end 2007, p. 28; IP Morgan Chase, 2007 Proxv
Statement,p.16.
68.NewYorkStateOfficeoftheStateComptroller,NewYorkCitvSecuritiesIndustrvBonusPool,
Februarv23,2010.Thebonuspoolisforsecuritiesindustrv(NAICS523)emploveeswhoworkinNew
YorkCitv.
69.BanksSetforRecordPav,TopFirmsonPacetoAward$145Billionfor2009,Up18,WSIStudv
Finds,WSI.com,Ianuarv14,2010.
70.SandvWeill,interviewbvFCIC,October4,2010.
71.LordAdairTurner,interviewbvFCIC,November30,2010.
72.BenS.Bernanke,testimonvbeforetheFCIC,HearingonTooBigtoFail:ExpectationsandImpact
ofExtraordinarvGovernmentInterventionandtheRoleofSvstemicRiskintheFinancialCrisis,dav2,
session1:TheFederalReserve,September2,2010,transcript,p.111.
73. Testimonv of Armando Falcon Ir., former director Office of Federal Housing Enterprise Over-
sight, written testimonv for the FCIC, Hearing on Subprime Lending and Securitization and Govern-
ment-Sponsored Enterprises (GSEs), dav 3, session 2: Office of Federal Housing Enterprise Oversight,
April9,2010,pp.810.
74.SheilaC.Bair,writtentestimonvfortheFCIC,FirstPublicHearingoftheFCIC,dav2,panel1:
CurrentInvestigationsintotheFinancialCrisisFederalOfficials,Ianuarv14,2010,p.22.
75.MarvL.Schapiro,writtentestimonvfortheFCIC,FirstPublicHearingoftheFCIC,dav2,panel
1:CurrentInvestigationsintotheFinancialCrisisFederalOfficials,Ianuarv14,2010,p.18.
76.BloombergLLC,FinancialAnalvsisFunction,PublicFilingsforIPM,Citigroup,BankofAmerica,
GoldmanSachs,andLehmanBrothers.
77.FannieMae,SECfilings10-Kand10-O;seethe200910-K,p.70,TotalAssetsandFannieMaeMBS
heldbvThirdParties;FederalHousingFinanceAgencv,Report to Congress, 2008 (2009),pp.111,128.
78.FCICstaffcalculations.
79.SNLFinancialDatabaseandSECpublicfilings.
80.Calculatedfromproxvstatements.
81.IohnSnow,interviewbvFCIC,October7,2010.
82.Ibid.
565 Notes to Chapter 5
Chapter 5
1.GailBurks,writtentestimonvfortheFCIC,HearingontheImpactoftheFinancialCrisisStateof
Nevada,session3:TheImpactoftheFinancialCrisisonNevadaRealEstate,September8,2010,p.3.
2.TomC.Putnam,president,PutnamHousingFinanceConsulting,writtentestimonvfortheFCIC,
HearingontheImpactoftheFinancialCrisisSacramento,session2:MortgageOrigination,Mortgage
FraudandPredatorvLendingintheSacramentoRegion,September23,2010,pp.34.
3.BoardofGovernorsoftheFederalReserveSvstem, Federal Reserve Statistical Release Z.1. Flow of
Funds Accounts of the United States, releasedate,December9,2010,TableL.1:CreditMarketDebtOut-
standing,andTableL.126:IssuersofAsset-BackedSecurities(ABS)
4.IimCallahan,interviewbvFCIC,October18,2010.
5.LewisRanieri,formervicechairmanofSalomonBrothers,interviewbvFCIC,Iulv30,2010.
6. Federal Deposit Insurance Corporation, Managing the Crisis: The FDIC and RTC Experience
(August1998),pp.29,67,4078,38.
7.Ibid.,417.
8.Ibid.,pp.9,32,36,48
9.ThefiguresthroughoutthisdiscussionofCMLTI2006-NC2areFCICstaffcalculations,basedon
analvsis of loan-level data from Blackbox Inc. and Standard & Poors; Moodvs PDS database; Moodvs
CDOEMSdatabase;andCitigroup,FannieMaeTermSheet,CMLTI2006-NC2,September7,2006,pp.
1,3.SeealsoBradS.Karp,counselforCitigroup,lettertoFCIC,November4,2010,p.1,pp.23.Allrat-
ingsofitstranchesareasgivenbvStandard&Poors.
10.Technicallv,thisdealhadtwounratedtranchesbelowtheequitvtranche,alsoheldbvCitigroup
andthehedgefund.
11. Fed Chairman Ben S. Bernanke, The Communitv Reinvestment Act: Its Evolution and New
Challenges,speechattheCommunitvAffairsResearchConference,Washington,D.C.,March30,2007.
12.Ibid.
13.SeeGlennCannerandWavnePassmore,TheCommunitvReinvestmentActandtheProfitabilitv
ofMortgage-OrientedBanks,WorkingPaper,FederalReserveBoard,March3,1997.UndertheCom-
munitvReinvestmentAct,low-andmoderate-incomeborrowershaveincomethatisatmost80ofarea
medianincome.
14. Fed Chairman Alan Greenspan, Economic Development in Low- and Moderate-Income Com-
munities,speechatCommunitvForumonCommunitvReinvestmentandAccesstoCredit:Californias
Challenge,inLosAngeles,Ianuarv12,1998.
15.IohnDugan,interviewbvFCIC,March12,2010.
16.LawrenceB.Lindsev,interviewbvFCIC,September20,2010.
17. Souphala Chomsisengphet and Anthonv Pennington-Cross, The Evolution of the Subprime
MortgageMarket,Federal Reserve Bank of St. Louis Review 88,no.1(Ianuarv/Februarv2006):40
18.SouthernPacificFundingCorp,Form8-K,September14,1998
19. The top 10 list is as of 1996, according to FCIC staff calculations using data from the following
sources:InsideMortgageFinance,The 2009 Mortgage Market Statistical Annual, vol.1,The Primary Mar-
ket (Bethesda,Md.:InsideMortgageFinancePublications,2009),p.214,Top25B&CLendersin1996;
Thomas E. Folev, Alternative Financial Ratios for the Effects of Securitization: Tools for Analvsis,
MoodvsInvestorServices,September19,1997,p.5;andMoodvsInvestorService,SubprimeHomeEq-
uitvIndustrvOutlookThePartvsOver,MoodvsGlobalCreditResearch,October1998.
20. FDIC Announces Receivership of First National Bank of Kevstone, Kevstone, West Virginia,
FederalDepositInsuranceCorporationandOfficeoftheComptrolleroftheCurrencvjointpressrelease,
September1,1999.
21.FCICstaffcalculationsusingdatafromInside MBS o ABS.
22.SeeMarcSavitt,interviewbvFCIC,November17,2010.
23.HenrvCisneros,interviewbvFCIC,October13,2010.
24.GlennLonev,interviewbvFCIC,April1,2010.
25.SenateCommitteeonBanking,Housing,andUrbanAffairs,The Community Development, Credit
Enhancement, and Regulatory Improvement Act of 1993, 103rdCong.,1stsess.,October28,1993,S.Rep.
103169,p.18.
26.Ibid.,p.19.
566 Notes to Chapter 6
27.15U.S.C.1639(h)2006.
28.LoansweresubjecttoHOEPAonlvifthevhittheinterestratetriggerorfeetrigger:i.e.,ifthean-
nualpercentageratefortheloanwasmorethan10percentagepointsabovethevieldonTreasurvsecuri-
ties having a comparable maturitv or if the total charges paid bv the borrower at or before closing
exceeded $400 or 8 of the loan amount, whichever was greater. See Senate Committee on Banking,
Housing,andUrbanAffairs,S.Rep.103169,p.54.
29.Ibid.,p.24.
30.BoardofGovernorsoftheFederalReserveSvstemandDepartmentofHousingandUrbanDevel-
opment,IointReportConcerningReformtotheTruthinLendingActandtheRealEstateSettlement
ProceduresAct(Iulv1998),p.56.
31. Griffith L. Garwood, director, Division of Consumer and Communitv Affairs, Board of Gover-
norsoftheFederalReserveSvstem,TotheOfficersandManagersinChargeofConsumerAffairsEx-
aminationandConsumerComplaintPrograms,ConsumerAffairsLetterCA981,Ianuarv20,1998
32.GAO,LargeBankMergers:FairLendingReviewCouldBeEnhancedwithBetterCoordination,
GAO/GGD-0016(ReporttotheHonorableMaxineWatersandtheHonorableBernardSanders,House
ofRepresentatives),November1999,p.20.
33.FedandHUD,IointReport,pp.IXXVII.
34. Griffith L. Garwood, director, Division of Consumer and Communitv Affairs, Board of Gover-
norsoftheFederalReserveSvstem,memorandumtotheCommitteeonConsumerandCommunitvAf-
fairs,MemorandumconcerningtheBoardsReporttotheCongressontheTruthinLendingandReal
EstateSettlementProceduresActs,April8,1998,p.42.
35.BoardofGovernorsoftheFederalReserveSvstem,FederalDepositInsuranceCorporation,Office
of the Comptroller of the Currencv, and Office of Thrift Supervision, Interagencv Guidance on Sub-
primeLending(March1,1999),p.1
36.Ibid.,pp.17;quotation,p.5.
37. U.S. Department of the Treasurv and U.S. Department of Housing and Urban Development,
CurbingPredatorvHomeLending(Iune1,2000),pp.1314,12,81(quotations,2,12).
38.GailBurks,presidentandchiefexecutiveofficer,NevadaFairHousingCenter,Inc.,testimonvbe-
foretheFCIC,HearingontheImpactoftheFinancialCrisisStateofNevada,session3:TheImpactof
theFinancialCrisisonNevadaRealEstate,September8,2010,transcript,p.24243.SeealsoKevinStein,
associate director, California Reinvestment Coalition, written testimonv for the FCIC, Hearing on the
Impact of the Financial CrisisSacramento, session 2: Mortgage Origination, Mortgage Fraud and
PredatorvLendingintheSacramentoRegion,September23,2010,pp.89.Seealsohistestimonvatthe
samehearing,transcript,pp.7374.SeeDianeE.Thompson,ofcounsel,NationalConsumerLawCen-
ter, Inc., and Margot F. Saunders, of counsel, National Consumer Law Center, Inc., interview bv FCIC,
September10,2010.
39.DianeE.ThompsonandMargotF.Saunders,bothofcounsel,NationalConsumerLawCenter,in-
terviewbvFCIC,September10,2010.
40.GarvGensler,interviewbvFCIC,Mav14,2010.
41.SheilaBair,testimonvbeforetheFCIC,FirstPublicHearingoftheFCIC,dav2,panel1:Current
InvestigationsintotheFinancialCrisisFederalOfficials,Ianuarv14,2010,transcript,p.97.
42.SheilaBair,interviewbvFCIC,March29,2010.
43.SandraF.Braunstein,interviewbvFCIC,April1,2010,pp.3134.
44.Bair,interview.
45.TreasurvandHUD,CurbingPredatorvHomeLending,p.31.
Chapter 6
1.FiguresrepresentedthecompoundaveragegrowthrateandFCICstaffcalculationsfromCoreLogic
NationalHomePriceIndex,Single-FamilvCombined(SCF);CoreLogicLoanPerformanceHPIAugust
2010.
2.InsideMortgageFinance,The 2009 Mortgage Market Statistical Annual, vol.1,The Primary Market
(Bethesda,Md.:InsideMortgageFinance,2009),p.4,MortgageOriginationsbvProduct.
3.FederalReserveBoardpressrelease,Mav27,2004.
567 Notes to Chapter 6
4. Fed Governor Ben S. Bernanke, The Great Moderation, remarks at the meetings of the Eastern
Economic Association, Washington, D.C., Februarv 20, 2004. See also Olivier Blanchard and Iohn Si-
mon,TheLongandLargeDeclineinU.S.OutputVolatilitv,Brookings Papers on Economic Activity, no.
1(2001):13564.
5.FedGovernorBenS.Bernanke,Deflation:MakingSureItDoesntHappenHere,remarksbefore
theNationalEconomistsClub,Washington,D.C.,November21,2002.
6.FCICstaffcalculationsfromBoardofGovernorsoftheFederalReserveSvstem,H.15SelectedIn-
terestRaterelease,3-monthAANonfinancialCommercialPaperRate,WCPN3M(weeklv,endingFri-
dav);U.S.DepartmentofTreasurv,DailvTreasurvYieldCurveRates,1990toPresent.
7.Thisexampleassumesthatthehomeownerisabletocomeupwithalargerdownpavmenttocover
20ofthehigher-pricedhome.Here,thedifferencewouldbeabout$13,000.
8. Federal Housing Finance Agencv, Data on the Risk Characteristics and Performance of Single-
FamilvMortgagesOriginatedfrom2001through2008andFinancedintheSecondarvMarket(Septem-
ber 13, 2010), Table 2a: Share of Single-Familv Mortgages Originated from 2001 through 2008 and
AcquiredbvtheEnterprisesorFinanceswithPrivate-LabelMBSbvLoan-to-ValueRatioandBorrower
FICO Score at Origination, Adjustable-Rate Mortgages, p. 22. Prime borrowers are defined as those
whosemortgagesarefinancedbvthegovernment-sponsoredenterprises.
9.YulivaDemvanvkandOttoVanHemert,UnderstandingtheSubprimeMortgageCrisis(Decem-
ber5,2008),table1:LoanCharacteristicsatOriginationforDifferentVintages,p.7.
10. FCIC staff calculations from CoreLogic/First American, Home Price Index for Single-Familv
CombinedStateHPIdata,lastupdatedAugust2010,andCoreLogicStateHomePriceIndex,providedto
theFCICbvCoreLogic.Staffcalculationsofallannualgrowthratesarecompoundannualgrowthrates
fromIanuarvtoIanuarv.
11.U.S.CensusBureau,HousingVacanciesandHomeownership,CPS/HVS,Table14:Homeowner-
shipRatesfortheUS1965toPresent.
12. Brian K. Bucks, Arthur B. Kennickell, and Kevin B. Moore, Recent Changes in US Familv Fi-
nances:Evidencefromthe2001and2004SurvevofConsumerFinances,Federal Reserve Bulletin (2006):
Tables8Aand8B,pp.A20A23,A8.
13.CongressionalBudgetOffice,HousingWealthandConsumerSpending,BackgroundPaper,Ian-
uarv2007,p.15.
14.Mortgagesmavhavebeenrefinancedmorethanonceinthatvear.
15. FCIC staff calculations with updated data provided bv Alan Greenspan and Iames Kennedv,
whosedataoriginallvappearedinSourcesandUsesofEquitvExtractedfromHomes,FinanceandEco-
nomicsDiscussionSeries,FederalReserveBoard,2007-20(March2007).
16.CBO,HousingWealthandConsumerSpending,p.2.
17. Fed Chairman Alan Greenspan, The Economic Outlook, prepared testimonv before the Ioint
EconomicCommittee,107thCong.,2ndsess.,November13,2002.
18.FedChairmanAlanGreenspan,FederalReserveBoardsSemiannualMonetarvPolicvReportto
theCongress,preparedtestimonvbeforetheHouseCommitteeonFinancialServices,108thCong.,2nd
sess.,Februarv12,2004.
19. FCIC staff calculations from 2009 Mortgage Market Statistical Annual, 1:4, Mortgage Origina-
tionsbvProduct(totalsubprimevolume);2:13,Non-AgencvMBSIssuancebvTvpe(subprimePLS).
20.Ibid.,1:3,MortgageOriginationIndicators;220,227,MortgageOriginationsbvProduct.
21.BartMcDade,interviewbvFCIC,April16,2010.
22.PresentationtotheLehmanBoardofDirectors,March20,2007.Lehmanhadalsoacquiredthree
internationallendersduringthistimeperiod.
23.NewCenturv,199910-K,March30,2000,p.2.
24.FinalReportofMichaelI.Missal,BankruptcvCourtExaminer,inRE:NewCenturvTRSHold-
ings,Chapter11,CaseNo.07-10416(KIC),(Bankr.D.Del.),Februarv29,2008,p42.
25. New Centurv, 2000 10-K, April 2, 2001, p. 15; New Centurv, 2003 10-K, March 15, 2004, p. 13.
Rankingsfrom2009 Mortgage Market Statistical Annual, 1:220,223.
26.AseemMitalandAngeloMozilo,quotedinErickBergquist,UnderScrutinv,AmeriquestDetails
Procedures,American Banker 170,no.125(Iune30,2005):1.Volumeandrankingsfrom2009 Mortgage
Market Statistical Annual, 1:220,223.
568 Notes to Chapter 6
27.LewisRanieri,interviewbvFCIC,Iulv30,2010.
28.IamesM.LackoandIanisK.Pappalardo,TheEffectofMortgageBrokerCompensationDisclo-
suresonConsumersandCompetition:AControlledExperiment,FederalTradeCommissionBureauof
EconomicsStaffReport(Februarv2004),p.1.
29. Iav Ieffries, testimonv before the FCIC, Hearing on the Impact of the Financial CrisisState of
Nevada, session 3: The Impact of the Financial Crisis on Nevada Real Estate, September 8, 2010, tran-
script,p.177.
30. Brian Bucks and Karen Pence, Do Borrowers Know Their Mortgage Terms: Iournal of Urban
Economics 64(2008):223.
31.MichaelCalhounandIuliaGordon,interviewbvFCIC,September16,2010.
32.AnnamariaLusardi,AmericansFinancialCapabilitv,reportpreparedfortheFCIC,Februarv26,
2010,p.3.
33. FCIC staff estimates based on analvsis of Blackbox, S&P, and IP Recoverv, provided bv Antje
Berndt,BurtonHollifield,andPatrikSandas,intheirpaper,TheRoleofMortgageBrokersintheSub-
primeCrisis,April2010.
34. William C. Apgar and Allen I. Fishbein, The Changing Industrial Organization of Housing Fi-
nance and the Changing Role of Communitv-Based Organizations, working paper (Ioint Center for
HousingStudies,HarvardUniversitv,Mav2004),p.9.
35.HerbSandler,interviewbvFCIC,September22,2010.
36.WholesaleAccess,MortgageBrokers2006(August2007),pp.35,37.
37.IamieDimon,testimonvbeforetheFCIC,FirstPublicHearingoftheFCIC,panel1:FinancialIn-
stitutionRepresentatives,Ianuarv13,2010,transcript,p.13.
38.OctoberResearchCorporation,executivesummarvofthe2007 ^ational Appraisal Survey, p.4.
39.DennisI.Black,writtentestimonvfortheFCIC,HearingontheImpactoftheFinancialCrisis
Miami,session2:UncoveringMortgageFraudinMiami,September21,2010,p.8.
40.KarenI.Mann,writtentestimonvfortheFCIC,HearingontheImpactoftheFinancialCrisis
Sacramento,session2:MortgageOrigination,MortgageFraudandPredatorvLendingintheSacramento
Region,September23,2010,p.2.
41. Garv Crabtree, testimonv before the FCIC, Hearing on the Impact of the Financial Crisis
GreaterBakersfield,session4:LocalHousingMarket,September7,2010,transcript,p.172.
42. Complaint, People of the State of New York v. First American Corporation and First American
eAppraiseIT(N.Y.Sup.Ct.November1,2007),pp.3,7,8.
43. Martin Eakes, quoted in Richard A. Oppel Ir. and Patrick McGeehan, Along with a Lender, Is
CitigroupBuvingTrouble:^ew York Times,October22,2000.
44.PamFlahertv,quotedinErickBergquist,IudgingCiti,aYearLater:SubprimeReformonTrack;
CriticsUnsatisfied, American Banker, September10,2001.
45.CitigroupSettlesFTCChargesagainsttheAssociatesRecord-Setting$215MillionforSubprime
LendingVictims,FederalTradeCommissionpressrelease,September19,2002.
46.MarkOlson,interviewbvFCIC,October4,2010.
47.TimothvOBrien,FedAssessCitigroupUnit$70MillioninLoanAbuse,The ^ew York Times,
Mav28,2004.
48.FederalReserveBoardinternalstaffdocument,TheProblemofPredatorvLending,December
5,2000,pp.1013.
49. Federal Reserve Board, Morning Session of Public Hearing on Home Equitv Lending, Iulv 27,
2000,openingremarksbvGovernorGramlich,p.9.
50.ScottAlvarez,interviewbvFCIC,March23,2010.
51.AlanGreenspan,writtentestimonvfortheFCIC,HearingonSubprimeLendingandSecuritiza-
tion and Government-Sponsored Enterprises (GSEs), dav one, session 1: The Federal Reserve, April 7,
2010,p.13.
52.AlanGreenspan,quotedinDavidFaber,And Then the Roof Caved In. How Vall Streets Greed and
Stupidity Brought Capitalism to Its Knees (Hoboken,N.I.:Wilev,2009),pp.5354.
53.TruthinLending,Federal Register 66,no.245(December20,2001):65612(quotation),65608.
569 Notes to Chapter 6
54. Robert B. Averv, Glenn B. Canner, and Robert E. Cook, New Information Reported under
HMDA and Its Application in Fair Lending Enforcement, Federal Reserve Bulletin 91 (Summer 2005):
372.
55.AlanGreenspan,interviewbvFCIC,March31,2010
56. Sheila Bair, testimonv before the FCIC, Hearing on Too Big to Fail: Expectations and Impact of
ExtraordinarvGovernmentInterventionandtheRoleofSvstemicRiskintheFinancialCrisis,dav2,ses-
sion2:FederalDepositInsuranceCorporation,September2,2010,transcript,p.191.
57.DoloresSmithandGlennLonev,memorandumtoGovernorEdwardGramlich,ComplianceIn-
spectionsofNonbankSubsidiariesofBankHoldingCompanies,August31,2000.
58. GAO, Consumer Protection: Federal and State Agencies Face Challenges in Combating Preda-
torvLending,GAO04280(ReporttotheChairmanandRankingMinoritvMember,SpecialCommit-
teeonAging,U.S.Senate),Ianuarv2004,pp.5253.
59.SandraBraunstein,interviewbvFCIC,April1,2010.Transcriptpp.3233.
60.Greenspan,interview.
61.Ibid.
62.EdwardM.Gramlich,BoomsandBusts:TheCaseofSubprimeMortgages,Federal Reserve Bank
of Kansas City Economic Review (2007):109.
63.EdwardGramlich,quotedinGregIp,DidGreenspanAddtoSubprimeWoes:GramlichSavsEx-
Colleague Blocked Crackdown On Predatorv Lenders Despite Growing Concerns, Vall Street Iournal,
Iune9,2007.SeealsoEdmundL.Andrews,FedShruggedasSubprimeCrisisSpread,^ew York Times,
December18,2007.
64. Patricia McCov and Margot Saunders, quoted in Binvamin Appelbaum, Fed Held Back as Evi-
denceMountedonSubprimeLoanAbuses,Vashington Post, September27,2009.
65.GAO,LargeBankMergers:FairLendingReviewCouldbeEnhancedwithBetterCoordination,
GAO/GDD-00-16(ReporttotheHonorableMaxineWatersandHonorable BernardSanders,Houseof
Representatives),November1999;GAO,ConsumerProtection: FederalandStateAgenciesFaceChal-
lengesinCombatingPredatorvLending.
66.FederalandStateAgenciesAnnouncePilotProjecttoImproveSupervisionofSubprimeMort-
gageLenders,Iointpressrelease(FedReserveBoard,OTC,FTC,ConferenceofStateBankSupervisors,
AmericanAssociationofResidentialMortgageRegulators),Iulv17,2007.
67.TruthinLending,pp.4452223.Higher-pricedmortgageloansaredefinedinthe2008regula-
tionstoincludemortgageloanswhoseannualpercentagerateexceedstheaverageprimeofferratesfora
comparabletransaction(aspublishedbvtheFed)bvatleast1.5forfirst-lienloansor3.5forsubordi-
nate-lienloans.
68.Alvarez,interview.
69.RaphaelW.Bostic,KathleenC.Engel,PatriciaA.McCov,AnthonvPennington-Cross,andSusan
M. Wachter, State and Local Anti-Predatorv Lending Laws: The Effect of Legal Enforcement Mecha-
nisms,Iournal of Economics and Business 60(2008):4766.
70.LendingandInvestment,Federal Register 61,no.190(September30,1996):50965.
71. Ioseph A. Smith, Mortgage Market Turmoil: Causes and Consequences, testimonv before the
SenateCommitteeonBanking,Housing,andUrbanAffairs,110thCong.,1stsess.,March22,2007,p.33
(ExhibitB),usingdatafromtheMortgageAssetResearchInstitute.
72.LisaMadigan,writtentestimonvfortheFCIC,FirstPublicHearingoftheFCIC,dav2,panel2:
CurrentInvestigationsintotheFinancialCrisisStateandLocalOfficials,Ianuarv14,2010,p.12.
73.CommitmentscompiledatNationalCommunitvReinvestmentCoalition,CRACommitments
(2007).
74.IoshSilver,NCRC,interviewbvFCIC,Iune16,2010.
75.DatareferencesbasedonReginaldBrown,counselforBankofAmerica,lettertoFCIC,Iune16,
2010, p. 2; Iessica Carev, counsel for IPMorgan Chase, letter to FCIC, December 16, 2010; Brad Karp,
counselforCitigroup,lettertoFCIC,March18,2010,inresponsetoFCICrequest;WellsFargopublic
commitments19902010,dataprovidedbvWellsFargototheFCIC.
76.Karp,lettertoFCIC,March18,2010,inresponsetoFCICrequest.
77.Carev,lettertoFCIC,December16,2010,p.9;BradKarp,counselforIPMorgan,lettertoFCIC,
Mav26,2010,p.10.
570 Notes to Chapter 7
78. FCIC calculation based on Federal Housing Finance Agencv, Data on the Risk Characteristics
andPerformanceofSingle-FamilvMortgagesOriginatedin20012008andFinancedintheSecondarv
Market(August2010),Table1-C;thisreportcoversallloanspurchasedorsecuritizedbvtheGSEsorin
private-labelsecuritizations.DelinquencvdataprovidedbvWellsFargocovered81ofloans.
79.OrdersIssuedUndertheBankHoldingCompanvAct,Federal Reserve Bulletin 75,no.4(April
1989):304.
80. Statement of the Federal Financial Supervisorv Agencies Regarding the Communitv Reinvest-
mentAct,Federal Register 54(April5,1989):13742.Thisremainstheinteragencvpolicv.Communitv
Reinvestment Act: Interagencv Ouestions and Answers Regarding Communitv Reinvestment; Notice,
Federal Register 75(March11,2010):11666.
81.GlennLonev,interviewbvFCIC,April1,2010.
82.CommunitvReinvestmentActRegulationsandHomeMortgageDisclosure;FinalRules,Federal
Register 60,no.86(Mav4,1995):22155223.
83.DivisionofConsumerandCommunitvAffairs,memorandumtoBoardofGovernors,August10,
1998.
84.FederalReserveBoardpressrelease,OrderApprovingtheMergerofBankHoldingCompanies,
August17,1998,pp.6364.
85.LlovdBrown,interviewbvFCIC,Februarv5,2010.
86.AndrewPlepler,interviewbvFCIC,Iulv14,2010.
87. Assuming 75 AAA tranche ($1.20), 10 AA tranche ($0.20), 8 A tranche ($0.30), 5 BBB
tranche($0.40),and2equitvtranche($2.00).SeeGoldmanSachs,EffectiveRegulation:Part1,Avoid-
ingAnotherMeltdown,March2009,p.22.
88.DavidIones,interviewbvFCIC,October19,2010.SeeDavidIones,EmergingProblemswiththe
BaselCapitalAccord:RegulatorvCapitalArbitrageandRelatedIssues,Iournal of Banking and Finance
24,nos.12(Ianuarv2000):3558.
89.HenrvPaulson,testimonvbeforetheFCIC,HearingontheShadowBankingSvstem,dav2,ses-
sion1:PerspectiveontheShadowBankingSvstem,Mav6,2010),transcript,p.34.
90.Iones,interview.
Chapter 7
1.Forexample,anAlt-Aloanmavhavenoorlimiteddocumentationoftheborrowersincome,mav
haveahighloan-to-valueratio(LTV),ormavbeforaninvestor-ownedpropertv.
2.InsideMortgageFinance,The 2009 Mortgage Market Statistical Annual, vol.2,The Secondary Mar-
ket (Bethesda,MD:InsideMortgageFinance,2009),p.9,Mortgage&AssetSecuritiesIssuance(show-
ing Wall St. securitizing a third more than Fannie and Freddie); p. 13, Non-Agencv MBS Issuance bv
Tvpe.FCICstaffcalculationsfrom2004to2006(forgrowthinprivatelabelMBS).
3.CharlesO.Prince,interviewbvFCIC,March17,2010.
4.IohnTavlor,interviewbvFCIC,September23,2010.
5.WilliamA.FleckensteinandFrederickSheeham, Greenspans Bubbles. The Age of Ignorance at the
Federal Reserve (NewYork:McGraw-Hill,2008),p.181.
6.AlanGreenspan,TheFedDidntCausetheHousingBubble,Vall Street Iournal, March11,2009.
SeealsoBenBernanke,MonetarvPolicvandtheHousingBubble,speechattheAnnualMeetingofthe
AmericanEconomicAssociation,Atlanta,Georgia,Ianuarv3,2010.
7.AlanGreenspan,testimonvbeforetheSenateCommitteeonBanking,Housing,andUrbanAffairs,
109thCong.,1stsess.,Februarv16,2005.
8.FedChairmanBenS.Bernanke,TheGlobalSavingGlutandtheU.S.CurrentAccountDeficit,re-
marks at the Sandridge Lecture, Virginia Association of Economics, Richmond, Virginia, March 10,
2005.
9.FredericMishkin,interviewbvFCIC,October1,2010.
10. Pierre-Olivier Gourinchas, written testimonv for the FCIC, Forum to Explore the Causes of the
FinancialCrisis,dav1,session2:MacroeconomicFactorsandU.S.MonetarvPolicv,Februarv26,2010,
pp.2526..
11.PaulKrugman,interviewbvFCIC,October6,2010.
571 Notes to Chapter 7
12. Ellen Schloemer, Wei Li, Keith Ernst, and Kathleen Keest, Losing Ground: Foreclosures in the
Subprime Market and Their Cost to Homeowners, Center for Responsible Lending, December 2006,
p.22.
13.2009 Mortgage Market Statistical Annual,vol.1,The Primary Market,p.4,MortgageOriginations
bvProduct.
14.ChristopherMaver,KarenPence,andShaneM.Sherlund,TheRiseinMortgageDefaults,Iour-
nal of Economic Perspectives 23,no.1(Winter2009):Table2,AttributesforMortgagesinSubprimeand
Alt-APools,p.31.
15.2009 Mortgage Market Statistical Annual, 2:13,Non-AgencvMBSIssuancebvTvpe.
16.2009 Mortgage Market Statistical Annual,1:6,AlternativeMortgageOriginations;previousdata
extrapolatedinFCICestimatesfromGoldenWest,Form10-Kforfiscalvear2005,andFederalReserve,
ResidentialMortgageLendersPeerGroupSurvev:AnalvsisandImplicationsforFirstLienGuidance,
November30,2005.
17.InsideMortgageFinance.
18. Countrvwide, 2005 Form 10-K, p. 39; 2007 Form 10-K, p. 47 (showing the growth in Countrv-
widesoriginations).
19. Angelo Mozilo, email to Sambol and Kurland re: Sub-prime Seconds. See also Angelo Mozilo,
email to Sambol, Bartlett, and Sieracki, re: Reducing Risk, Reducing Cost, Mav 18, 2006; Angelo
Mozilo,interviewbvFCIC.September24,2010.
20.DavidSambol,interviewbvFCIC,September27,2010.
21. See Countrvwide, Investor Conference Call, Ianuarv 27, 2004, transcript, p. 5. See also Iodv
Shenn,CountrvwideAddingStafftoBoostPurchaseShare,American Banker, Ianuarv28,2004.
22.PatriciaLindsav,writtentestimonvfortheFCIC,hearingonSubprimeLendingandSecuritization
andGovernment-SponsoredEnterprises(GSEs),dav1,sess.2:SubprimeOriginationandSecuritization,
April7,2010,p.3
23.AndrewDavidson,interviewbvFCIC,October29,2020.
24.Ibid.
25.DavidBerenbaum,testimonvbeforeSenateCommitteeonBanking,SubcommitteeonHousing,
TransportationandCommunitvDevelopment,110thCong.,1stsess.,Iune26,2007.
26. Email and data attachment from former Golden West emplovee to FCIC, subject: re: Golden
WestEstimatedVolumeofAdjustableRateMortgageOriginations,December6,2010.
27.HerbertSandler,interviewbvFCIC,September22,2010.
28. Washington Mutual, Option ARM Focus GroupsPhase II, September 17, 2003; Washington
Mutual,OptionARMFocusGroupsPhaseI,August14,2003,Exhibits35and36inSenatePerma-
nentSubcommitteeonInvestigations,exhibits,Vall Street and the Financial Crisis. The Role of High Risk
Home Loans,111thCong.,2ndsess.,April13,2010(hereaftercitedasPSIDocuments),PDFpp.33051,
availableathttp://hsgac.senate.gov/public/_files/Financial_Crisis/041310Exhibits.pdf.
29.PSIDocuments,Exhibits35and36pp.33051.
30.Ibid.,pp.33051,334.
31.Ibid.,p.345.
32.Ibid.,p.346.
33.WashingtonMutual,OptionARMCreditRisk,August2006,PSIDocumentExhibit37,p.366.
34. PSI Documents Exhibit 37, p. 366, showing average FICO score of 698; p. 356; comparing con-
formingandjumbooriginations.
35.Ibid.,p.357.
36.DocumentlistingCountrvwideoriginationsbvquarterfrom2003to2007,providedbvBankof
America.
37.CountrvwideOctober2003LoanProgramGuide(depictingamaximumCLTVof80andmini-
mumFICOof680)andIulv2004LoanProgramGuide(showing90620FICO).
38.CountrvwideLoanProgramGuide,datedMarch7,2005.
39.FederalReserve,ResidentialMortgageLendersPeerGroupSurvev:AnalvsisandImplicationsfor
FirstLienGuidance,November30,2005,pp.6,8.
40.AngeloMozilo,emailtoCarlosGarcia(cc:StanKurland),Subject:BankAssets,August1,2005.
572 Notes to Chapter 7
41. Angelo Mozilo, email to Carlos Garcia (cc: Kurland), subject: re: Fw: Bank Assets, August 2,
2005.
42.Countrvwide,2005Form10-K,p.57;2007Form10-K,p.F-45.
43.SeeWashingtonMutual,2006Form10-K,p.53.
44.IohnStumpf,interviewbvFCIC,September23,2010.
45.Countrvwide,2007Form10-K,p.F-45;2005Form10-K,p.57
46.WashingtonMutual,2007Form10-K,p.57;2005Form10-K,p.55
47. Kevin Stein, testimonv before the FCIC, Sacramento Hearing on the Impact of the Financial
CrisisSanFrancisco,dav1,session2:MortgageOrigination,MortgageFraudandPredatorvLendingin
theSacramentoRegion,September23,2010,transcript,p.72.
48.MonaTawatao,inibid.,p.228.
49.RealEstateLendingStandards,Federal Register 57(December31,1992):62890.
50.Ibid.
51.OfficeoftheComptrolleroftheCurrencv,BoardofGovernorsoftheFederalDepositInsurance
Corporation,OfficeofThriftSupervision,RealEstateLendingStandards:FinalRule,SR931,Ianuarv
11,1993.
52.OfficeoftheComptrolleroftheCurrencv,BoardofGovernorsoftheFederalDepositInsurance
Corporation,OfficeofThriftSupervision,InteragencvGuidanceonHighLTVResidentialRealEstate
Lending,October8,1999.
53.FinalReportofMichaelI.Missal,BankruptcvCourtExaminer,InRE:NewCenturvTRSHold-
ings,Chapter11,CaseNo.07-10416(KIC),(Bankr.D.Del.),Februarv29,2008,pp.128,149,128.
54.YulivaDemvanvkandOttoVanHemert,UnderstandingtheSubprimeMortgageCrisis,Review
of Financial Studies, Mav2009.
55.Sandler,interview.
56.CoreLogicloanperformancedataforsubprimeandAlt-Aloans,andCoreLogictotaloutstanding
loansservicerdataprovidedtotheFCIC.
57.ChristopherMaver,KarenPence,andShaneM.Sherlund,TheRiseinMortgageDefaults,Iour-
nal of Economic Perspectives 23,no.1(Winter2009):32.
58.WilliamBlack,testimonvfortheFCIC,MiamiHearingontheImpactoftheFinancialCrisis,dav
1,session1:OverviewofMortgageFraud,September21,2010,p.27.
59.RichardBowen,interviewbvFCIC,Februarv27,2010.
60.IamieDimon,testimonvbeforetheFCIC,Ianuarv13,2010,p.60.
61.Thisparticulardealwouldbedescribedasanexcess-spreadover-collateralized-basedcrediten-
hancementstructure;seeGarvGorton,ThePanicof2007,paperpresentedattheFederalReserveBank
ofKansasCitvsIacksonHoleConference,August2008,p.23.
62.FCICstaffestimatesbasedonanalvsisofdatafromBlackBox,S&P,andBloomberg.Theprospec-
tiveloanpoolforthisdealoriginallvcontained4,507mortgages.Eightofthesehadbeendroppedfrom
thepoolbvthetimethebondswereissued.Therefore,theseestimatesmavdifferslightlvfromthosere-
portedinthedealprospectusbecausetheseestimatesarebasedonapoolof4,499loans.
63.Ibid.
64.Federal Register 69(Ianuarv7,2004):1904.TheruleswereissuedinproposedformatFederal Reg-
ister 68(August5,2003):46119.
65.SeeOTSOpinionreCaliforniaMinimumPavmentStatute,October1,2002,p.6.
66. Comptroller of the Currencv Iohn Hawke, remarks before Women in Housing and Finance,
Washington,D.C.,Februarv12,2002,attachedtoOCCNewsRelease2002-10,p.2.
67.IohnHawke,quotedinIessBravinandPaulBeckett,FriendlvWatchdog:FederalRegulatorOf-
tenHelpsBanksFightingConsumers,Vall Street Iournal, Ianuarv28,2002.
68. Oren Bar-Gill and Elizabeth Warren, Making Credit Safer, University of Pennsylvania Law Re-
view 157(2008):182-83,192-94.
69.SeeWattersv.WachoviaBankNA,550U.S.1(2007).
70.IohnDugan,testimonvbeforetheFCIC,PublicHearingonSubprimeLendingandSecuritization
andGovernment-SponsoredEnterprises(GSEs),dav2,session2:OfficeoftheComptrolleroftheCur-
rencv,April8,2010,transcript,p.150.
71.LisaMadigan,testimonvbeforetheFCIC,FirstPublicHearingoftheFCIC,dav2,panel2:Inves-
tigationsintotheFinancialCrisisStateandLocalOfficials,Ianuarv14,2010,transcript,p.104.
573 Notes to Chapter 7
72.IohnD.HawkeIr.,writtentestimonvfortheFCIC,PublicHearingonSubprimeLendingandSe-
curitizationandGovernment-SponsoredEnterprises(GSEs),dav2,session2:OfficeoftheComptroller
oftheCurrencv,April8,2010,p.6.
73.CitigroupWarehouseLinesofCreditwithMortgageOriginators,inGlobalSecuritizedMarkets,
20002010(revised),producedbvCitigroup;staffcalculations.
74.CharlesO.Prince,interviewbvFCIC,March17,2010.
75.MoodvsSpecialReport,TheABCPMarketintheThirdOuarterof1998,Februarv2,1999.
76.Moodvs2007Reviewand2008Outlook:USAsset-backedCommercialPaper,Februarv27,2008.
77.MoodvsABCPReviewsofParkGranadaandParkSienna.
78.MoodvsABCPProgramReview:ParkGranada,Iulv16,2007.
79. Letters from the American Securitization Forum (November 17, 2003) and State St. Bank
(November14,2003)totheOfficeofThriftSupervision.
80.DarrvllHendricks,interviewbvFCIC,August6,2010.
81.CitiAugust29,2006,LoanSale.
82. Correspondence between Citi and New Centurv provided to FCIC. FCIC staff estimates from
prospectusandCitigroupproductiondatedNovember4,2010.CitiAugust29,2006,LoanSale.
83.FannieMaeTermSheet.
84.Forthemorethan20institutionalinvestorsaroundtheworld,seeCitigrouplettertotheFCICre
SeniorInvestors,October14,2010.The$582millionfigureisbasedonFCICstaffestimatesthat,inturn,
werebasedonanalvsisofMoodvsPDSdatabase.
85.SeeBradS.Karp,counselforCitigroup,lettertoFCIC,aboutseniorinvestors,October14,2010,
p.2.SeealsoEricS.Goldstein,counselforIPMorganChase&Co.,lettertoFCIC,November16,2010.
86.CitigrouplettertotheFCIC,November4,2010.
87.See,e.g.,SimonKennedv,BNPSuspendsFundsAmidCredit-MarketTurmoil,August9,2007.
(www.marketwatch.com/storv/bnp-suspends-fund-valuations-amid-credit-market-turmoil).
88.SeeBradS.Karp,lettertoFCIC,aboutmezzanineinvestors,November4,2010,p.1.Theequitv
trancheswerenotofferedforpublicsalebutwereretainedbvCitigroup.
89.FCICstaffestimatesfromprospectusandCitigroupproductiondatedNovember4,2010.
90.PatriciaLindsav,interviewbvFCIC,March24,2010.
91. PSI Documents, Exhibit 59a: Long Beach Mortgage Production, Incentive Plan 2004, and Ex-
hibit60a(quotingpage2ofWaMuHomeLoansProductStrategvPowerPointpresentation).
92. Iohn M. Ouiglev, Compensation and Incentives in the Mortgage Business, Economists Voices
(TheBerkelevElectronicPress,October2008),p.2.
93. Barclavs Capital, Bear Stearns, BNP Paribas, Citigroup, Deutsche Bank, Goldman Sachs, HSBC,
IPMorgan,LehmanBrothers,MorganStanlev,andUBS.
94.Figuresareaveragetop-tierpavworldwideinmortgagesandMBSsalesandtrading.SeeOptions
Group,2005GlobalFinancialMarketOverview&CompensationReport(October2005),pp.42,52;
Options Group, 2006 Global Financial Market Overview & Compensation Report (November 2006),
pp.59,69;andOptionsGroup,2007GlobalFinancialMarketOverview&CompensationReport(No-
vember2007),pp.73,82.
95.SeeMerrillLvnch,2007ProxvStatement,p.46.
96.SeeFCICstaffanalvsisofMoodvsForm10-Ksforvears2005,2006,and2007.
97.SeeFCICstaffcalculationsbasedonMoodvsForm10-Ksforvears200307.
98.MoodvsExpandsMoodvsMortgageMetricstoIncludeSubprimeResidentialMortgages,Sep-
tember6,2006;FCICstaffestimatebasedonanalvsisofMoodvsSFDRSandPDSdatabases.
99.Theratingsfromthethreeagenciesmeasureslightlvdifferentcreditriskcharacteristics.S&Pand
Fitchbasetheirratingsontheprobabilitvthataborrowerwilldefault;Moodvsbasesitsratingsonthe
expected loss totheinvestor.Despitesuchdifferences,investorsandregulatorstendtoviewtheratingsas
roughlvequivalent.Ratingsaredividedintotwocategories:investmentgradesecuritiesareratedBBB-to
AAA,whilesecuritiesratedbelowBBB-areconsideredspeculativeandarealsoreferredtoasjunk(for
S&P;similarlevelsforMoodvsareBaatotriple-A).
100.RichardCantorandFrankPacker,TheCreditRatingIndustrv,FRB^Y Ouarterly Review (Sum-
merFall1994):6.
574 Notes to Chapter 7
101.AndrewI.Donahue,director,DivisionofInvestmentManagement,SEC,SpeechbvSECStaff:
Opening Remarks before the Commission Open Meeting, Washington, DC, Iune 25, 2008. See also
Lawrence I. White, Markets: The Credit Rating Agencies, Iournal of Economic Perspectives 24, no. 2
(Spring2010):214.
102.LewisRanieri,interviewbvFCIC,Iulv30,2010.
103.EricKolchinskv,testimonvbeforetheFCIC,HearingontheCredibilitvofCreditRatings,theIn-
vestment Decisions Made Based on Those Ratings, and the Financial Crisis, session 1: The Ratings
Process,Iune2,2010,transcript,pp.1920.
104.See15U.S.C.78o-7(c)(2).
105.IeromeS.Fons,testimonvbeforetheHouseCommitteeonOversightandGovernmentReform,
110thCong.,2ndsess.,October22,2008,p.2.
106. Arnold Cattani, testimonv before the FCIC, Hearing on the Impact of the Financial Crisis
GreaterBakersfield,session2:LocalBanking,transcript,p.60.
107.GarvWitt,testimonvbeforetheFCIC,HearingontheCredibilitvofCreditRatings,theInvest-
mentDecisionsMadeBasedonThoseRatings,andtheFinancialCrisis,session1:TheRatingsProcess,
Iune2,2010,transcript,p.41.
108. Moodvs Investors Service, Introducing Moodvs Mortgage Metrics: Subprime Iust Became
MoreTransparent,September7,2009.
109.DavidTeicher,MoodvsInvestorsService,interviewbvFCIC,Mav4,2010;MoodvsMortgage
Metrics:AModelAnalvsisofResidentialMortgagePools,April1,2003.
110.IavSiegel,interviewbvFCIC,Mav26,2010.
111.Teicher,interview.
112.IavSiegel,testimonvbeforetheFCIC,HearingontheCredibilitvofCreditRatings,theInvest-
mentDecisionsMadeBasedonThoseRatings,andtheFinancialCrisis,session1:TheRatingsProcess,
Iune2,2010,transcript,p.29.
113.RogerStein,interviewbvFCIC,Mav26,2010.
114.MoodvsInvestorsService,IntroducingMoodvsMortgageMetrics.
115.Stein,interview.
116.IeromeFons,interviewbvFCIC,April22,2010.
117.MoodvsRatingCommitteeMemorandum,August29,2006.
118.FCICstaffestimatesbasedonanalvsisofMoodvsPDSdatabase.
119.InvoicefromMoodvsInvestorsServicetoSusanMills,CitigroupGlobalMarketsInc.,October
12,2006.
120. Standard & Poors, Global New Issue Billing Form, Citigroup Mortgage Loan Trust 2006-NC2,
September28,2006.
121.FCICstaffestimatesbasedonanalvsisofMoodvsSFDRSdataasofApril2010.
122. Chris Cox, SEC chairman, prepared testimonv before the Senate Banking Committee, 109th
Cong., 2nd sess., Iune 15, 2006; Freddie Mac, Four Former Executives Settle SEC Action Relating to
Multi-BillionDollarAccountingFraud,SECpressrelease,September27,2007.
123. Iames Lockhart, director, FHFA, speech to American Securitization Forum in Las Vegas, New
Mexico,Februarv9,2009(p.2,slide4ofpresentationshowsthechart).
124.OFHEOSpecialExaminationReport,December2003.
125.In2006,OFHEOissueditsfinalReport of the Special Examination of Fannie Mae.OFHEOsaid
thatmanagementengagedinnumerousactsofmisconduct,involvingwelloveradozendifferentforms
ofaccountingmanipulationandviolationsofgenerallvacceptedaccountingprinciples.Asinthecaseof
Freddie,OFHEOsaidFanniesmanagementsoughttohitambitiousearnings-per-sharetargetsthatwere
linkedtotheirowncompensation.
126.DonaldBisenius,interviewbvFCIC,September29,2010.
127.Mortgage Market Statistical Annual 2009.
128.SeeTables5.1/5.2inFHFAConservatorshipreportforthird-quarter2010.
129.OFHEOSpecialExaminationReport,September2004,pp.910.
130.Ibid.,pp.2,10.
131.OFHEO,2005ReporttoCongress,Iune15,2005,p.15.
575 Notes to Chapter 8
132.AlanGreenspan,testimonvbeforetheFCIC,HearingonSubprimeLendingandSecuritization
and Government-Sponsored Enterprises (GSEs), dav 1, session 1: The Federal Reserve, April 7, 2010,
transcript,p.13.
133. FHFA, Mortgage Market Note: Goals of Fannie Mae and Freddie Mac in the Context of the
MortgageMarket:19962009,Februarv2010,p.22;FCICcalculations.
134.FHFA,Report to Congress, 2008 (2009),pp.116,125.
135. BlackRock Solutions, Fannie Maes Strategv and Business Model, Supplementarv Exhibits,
December2007.
136.RobertLevin,interviewbvFCIC,March17,2010.
137.MarkWiner,interviewbvFCIC,March23,2010.
138.IohnWeicher,formerFHAcommissioner,interviewbvFCIC,March11,2010.
139.LetterfromRobertLevintoFCIC,Iune17,2010,p.2.
Chapter 8
1.IoeDonovan,CreditSuisse,quotedinMichaelGregorv,TheWhatIf sinABSCDOs,Asset Secu-
ritization Report, Februarv18,2002.
2.FCICstaffcalculations,usingdatafromtheU.S.Census,datainMoodvsCDOPDSdatabase,and
data in Moodvs CDO Enhanced Monitoring Service database. The FCIC selected CDOs with at least
10oftheircollateralinvestedinmortgage-backedsecuritiesorwithothercharacteristicsthatidentified
themasABSCDOs.
3.ScottEichel,quotedinAllisonPvburn,CDOMachine:Managers,MortgageCompanies,Happv
toKeepFuelComing,Asset Securitization Report, Mav23,2005.
4.PatrickParkinson,interviewbvFCIC,March30,2010.
5.IianHu,AssessingtheCreditRiskofCDOsBackedbvStructuredFinanceSecurities:RatingAna-
lvstsChallengesandSolutions,Iournal of Structured Finance 13,no.3(2007):46.
6.WingChau,interviewbvFCIC,November11,2010.
7. CDOs that bought relativelv senior tranches of mortgage-backed securities were known as high-
grade, thosethatboughttheBBB-ratedandotherjuniortrancheswereknownasmezzanine.
8.IoeDonovan,quotedinGregorv,TheWhatIf sinABSCDOs.
9. Laurie Goodman et al., Subprime Mortgage Credit Derivatives (Hoboken, NI: Iohn Wilev, 2008),
p.315.
10.Hu,AssessingtheCreditRiskofCDOsBackedbvStructuredFinanceSecurities,p.47,Exhibit5.
11.Issuancedroppedin2007to$194billionandvirtuallvdisappearedin2008.FCICstaffestimates
basedondataprovidedbvMoodvsCDOEnhancedMonitoringSvstem(EMS).
12.FCICstaffestimatesbasedonanalvsisofMoodvsCDOEMSdatabase.
13.NestorDominguez,interviewbvFCIC,September28,2010.
14.MichaelLamont,interviewbvFCIC,September21,2010.
15.ChrisRicciardi,interviewbvFCIC,September15,2010.
16.Lamont,interview.
17.FCICstaffcalculationsusingdatainFCICCDOmanagerandunderwritersurvev.
18.MarkAdelson,interviewbvFCIC,October22,2010.
19. FCIC staff calculations. Our estimate assumes an annual management fee of 0.10 of the total
valueofthedealthatis,thelowestnormallvearnedintheindustrvappliedtothemortgage-focused
multisector CDOs in the FCIC database. It does not include other income, such as interest on equitv
tranches retained bv the managers. CDO managers responding to the FCIC survev reported manage-
mentfeesrangingfromaslowas0.10toashighas0.40.
20.SummarvofKevFeeProvisionsforCashCDOsasofIanuarv20002010,preparedbvMoodvs
fortheFCIC.
21.FCICHedgeFundSurvev.SeeFCICwebsitefordetails.
22.FCICstaffestimatesbasedonMoodvsCDOEnhancedMonitoringService.
23.BloombergLLC,FinancialAnalvstFunction;BearStearnsCompaniesInc.,Form10-K,forthefis-
calvearendedNovember30,2006,filedFebruarv13,2007,Exhibit13.
24.TheOptionsGroup,2005GlobalFinancialMarketOverview&CompensationReport,October
2005,p.16.
576 Notes to Chapter 8
25.Moodvs,KlerosRealEstateCDOIII,Ltd.,CDOEMSData,lastupdatedMav27,2008.Thefol-
lowingdiscussionofCMLTI2006-NC2reliesonFCICstaffestimatesbasedonanalvsisofMoodvsCDO
EMSdatabase.
26.Ricciardi,interview.
27.Forexample,KlerosIIItrancheswereinBuckinghamCDO,BuckinghamCDOII,andBucking-
hamCDOIII,alldealsunderwrittenbvBarclavs.
28.Adelson,interview.
29.Chau,interview.
30. Iames Grant, Up the Capital Structure (December 15, 2006), in Mr. Market Miscalculates. The
Bubble Years and Beyond (MountIackson,VA:AxiosPress,2008),186.
31.UBSGlobalCDOGroup,PresentationonProductSeries(POPS),Ianuarv2007.
32.DanSparks,interviewbvFCIC,Iune15,2010.
33.Dominguez,interview.
34.Theratioofthebookvalueofassetstoequitvrangedfrom2.5to28.3timesforallSIVs;theaver-
agewas13.6times.MoodvsInvestorsService,MoodvsSpecialReport:MoodvsUpdateonStructured
InvestmentVehicles,Ianuarv16,2008,p.13.
35.MarkKlipsch,quotedinColleenMarieOConnor,DroughtofCDOCollateralTopsConcerns,
Asset Securitization Report, October18,2004.
36. Bear Stearns Asset Management, Collateral Manager Presentation; Ralph Cioffi, interview bv
FCIC,October19,2010;BearStearnsHigh-GradeStructuredCreditStrategiesMasterFund,Ltd.,finan-
cial statements for the vear ended December 31, 2006 (total assets were $8,573,315,025); Bear Stearns
High-GradeStructuredCreditStrategiesEnhancedLeverageMasterFund,Ltd.,financialstatementsfor
thevearendedDecember31,2006(totalassetswere$9,403,235,402).
37.IamesCavne,writtentestimonvfortheFCIC,HearingontheShadowBankingSvstem,dav1,ses-
sion2:InvestmentBanksandtheShadowBankingSvstem,Mav5,2010,p.2;WarrenSpector,interview
bvFCIC,March30,2010.
38.Cioffi,interview.
39. AIMAs Illustrative Ouestionnaire for Due Diligence of Bear Stearns High Grade Structured
CreditStrategiesFund;BankofAmericapresentationtoMerrillLvnchsBoardofDirectors,BearSteams
AssetManagement:WhatWentWrong.
40.BearStearnsHigh-GradeStructuredCreditStrategiesMasterFund,Ltd.,financialstatementsfor
the vear ended December 31, 2006; Financial Statements, Bear Stearns High-Grade Structured Credit
StrategiesEnhancedLeverageMasterFund,Ltd.,financialstatementsforthevearendedDecember31,
2006;BSAMfundchartpreparedbvIPMorgan.
41.FCICstaffcalculationsusingdatafromFCICsurvevofhedgefunds.Thehedgefundsresponding
tothesurvevhadatotalof$1.2trillionininvestments.
42.IMF,Global Financial Stability Report,April2008,Table1.2,page23,TvpicalHaircutorInitial
Margin.
43.AlanSchwartz,interviewbvFCIC,April23,2010.
44.Cioffi,interview.
45.Ibid.
46.Ibid.
47.BearStearnsHigh-GradeStructuredCreditStrategies,investorpresentation,statingthatthefund
issubjecttoconflictsofinterest.BearStearnsHigh-GradeStructuredCreditStrategiesEnhancedLever-
age Fund, L.P., Preliminarv Confidential Private Placement Memorandum, August 2006. Everquest Fi-
nancialLtd.,FormS-1,p.13.
48.BearStearnsAssetManagementCollateralManager,presentation,statingthatKlioIcollateralin-
cludes 73 RMBS and ABS and 27 CDOs, Klio II collateral includes 74 RMBS and ABS and 26
CDOs,andKlioIIIcollateralincludes74RMBSandABSand26CDOs;Cioffi,interview.
49.EverquestFinancialLtd.,FormS-1,pp.9,3.
50.BearStearnsAssetManagement,CollateralManagerPresentation.
51.CioffiandTanninCompensationTable,producedbvPaul,Weiss,Rifkind,Wharton&Garrison,
LLP.
577 Notes to Chapter 8
52.MattTannin,BearStearns,emailtoBellaBorg-Brenner,StillwaterCapital,March16,2007;Greg
Ouental,BearStearns,emailtoAndrewDonnellan,BearStearns,etal.,Iune6,2007.
53.CharlesPrince,interviewbvFCIC,March17,2010.
54.RegulatorsinIapanandtheUnitedKingdomalsocamedownonthecompanvin2004and2005.
InSeptember2004,IapansFinancialServicesAgencvsuspendedCitibanksabilitvtooperatebranchesin
Iapanbecauseofthebanksparticipationinallegedillegalactivitvinthatcountrv,andinthefollowing
vear the United Kingdoms Financial Services Authoritv fined Citigroup $25 million for engaging in a
bondtradingschemelabeledDr.EvilbvCitigroupbondtraders.FinancialServicesAgencv,Govern-
mentofIapan,AdministrativeActionsonCitibank,N.A.IapanBranch,September17,2004;Financial
Services Authoritv, Final Notice to Citigroup Global Markets Limited, Iune 28, 2005
(www.fsa.gov.uk/pubs/final/cgml_28jun05.pdf); David Reillv, Moving the Market: Citigroup to Take
$25MillionHitinDr.EvilCase,Vall Street Iournal, Iune29,2005.
55.Prince,interview.
56.RobertRubin,interviewbvFCIC,March11,2010.
57.Dominguez,interviewbvFCIC,March2,2010.TheCDOdeskearnedrevenuesof$367millionin
2005.Paul,Weiss,Citigroupscounsel,lettertoFCIC,March31,2010,inretheFCICssecondandthird
supplementalrequests,ResponsetoInterrogatorvNo.21.
58. Ianice Warne, interview bv FCIC, Februarv 2, 2010; Paul, Weiss, Citigroups counsel, letter to
FCIC,March1,2010,ResponsetoInterrogatorvNo.18.
59. Paul, Weiss, Citigroups counsel, letter to FCIC, March 1, 2010, Response to Interrogatorv No.
18.
60. Moodvs Investors Service, CDOs with Short-Term Tranches: Moodvs Approach to Rating
Prime-1CDONotes,Februarv3,2006,p.11.
61.CitigroupInc.,Form10-K,forthefiscalvearendedDecember31,2007,filedFebruarv22,2008,
p.91.
62.EverquestFinancialLtd.,FormS-1,Mav9,2007,p.93.
63.Dominguez,interview,March2,2010.
64.Ibid.;Warne,interview.
65.Dominguez,interview,March2,2010.
66.Warne,interview.
67.GCIBCapitalMarketsApprovalCommittee,CoventreeCapital,LiquiditvPutOption,draftasof
December13,2002,p.4.
68.RonFrake,interviewbvFCIC,March11,2010.
69.FormalAgreementbetweentheComptrolleroftheCurrencvandCitibank,Iulv22,2003.
70.MoodvsInvestorsService,CDOswithShort-TermTranches.
71. Ibid.; Bank of America Corporation, Form 10-O for the quarterlv period ended September 30,
2007,p.19;FlovdNorris,AsBankProfitsGrew,WarningSignsWentUnheeded,^ew York Times, No-
vember16,2007.
72.Dominguez,interview,March2,2010.
73.Paul,Weiss,Citigroupscounsel,lettertoFCIC,Iune23,2010,ResponsesofNestorDominguez,
p.6.
74.OCC,SubprimeCDOValuationandOversightReviewConclusionMemorandum,Memoran-
dumfromMichaelSullivan,RAD,andRonFrake,NBE,toIohnLvons,Examiner-in-Charge,Citibank,
NA,Ianuarv17,2008,p.6,
75.Ibid.
76. Tobias Brushammar et al., memorandum to Nestor Dominguez et al., Re: Liquiditv Put Valua-
tion,October19,2006,pp.1,34;LiquiditvPutDiscussion,pt.1,producedbvCiti.
77.LiquiditvPutDiscussion,producedbvCiti.
78.DataprovidedbvMoodvstotheFCIC.
79.GarvGorton,interviewbvFCIC,Mav11,2010.
80.AIG,200810-K,p.133.Assetsareassignedariskweightingorpercentagethatisthenmultiplied
bv8capitalrequirementtodeterminetheamountofrisk-basedcapital.
81.AIG,CDSnotionalbalancesatvear-end2000through2010O1,providedtotheFCIC.
82.Thetotalwouldreach$78billionbv2007(ibid.).
578 Notes to Chapter 8
83.GenePark,interviewbvFCIC,Mav18,2010.
84.CraigBroderick,testimonvbeforetheFCIC,HearingontheRoleofDerivativesintheFinancial
Crisis,dav1,session3:GoldmanSachsGroup,Inc.andDerivatives,Iune30,2010,transcript,pp.289
90.
85. Moodvs, CDOs with Short-Term Tranches; AIG, Information Pertaining to the Multi-sector
CDSPortfolio,providedtotheFCIC.
86.Park,interview.
87.AIG,CDSnotionalbalancesatvear-end,2000through2010O1.
88.AlanFrost,interviewbvFCIC,Mav11,2010.
89.AIGFinancialProductsCorp.DeferredCompensationPlan,March18,2005,p.2.
90.IosephCassano,emailtoAllUsers,re:2007SpecialCompensationPlan,December17,2007.
91.IosephCassanocompensationhistorv,providedbvAIGtotheFCIC.
92.AIG,Form8-K,filedMav1,2005.
93.FactSheetonAIGFP,providedbvHankGreenberg,p.4.
94.AIG,CDSnotionalbalancesatvear-end.
95.GenePark,emailtoIosephCassano,re:CDOofABSApproachGoingForwardMessagetothe
DealerCommunitv,Februarv28,2006.
96.HenrvM.PaulsonIr.,testimonvbeforetheFCIC,HearingontheShadowBankingSvstem,dav2,
session1:PerspectiveontheShadowBankingSvstem,Mav6,2010,transcript,p.22.
97.HenrvM.PaulsonIr.,writtentestimonvfortheFCIC,HearingontheShadowBankingSvstem,
dav2,session1:PerspectiveontheShadowBankingSvstem,Mav6,2010,p.2.
98. Goldman Sachs, 2005 and 2006 10-K (appendix 5a to Goldmans March 8, 2010, letter to the
FCIC).
99.Appendix5ctoGoldmansMarch8,2010,lettertotheFCIC.
100.GoldmansMarch8,2010,lettertotheFCIC,p.28(subprimesecurities).
101. Protection Bought bv GS, spreadsheet provided bv Goldman Sachs to the FCIC. Specificallv,
IKB purchased $30 million of Class A notes, $40 million of Class B notes, and $30 million of Class C
notesonIune9,2004.TCWpurchased$50millionofClassAnotesinIanuarv2005,andWachoviapur-
chased$45millionofClassAnotesinMarch2005.Seeibid.,Exhibit1.
102.FCICstaffcalculationsbasedondataprovidedbvGoldmanSachs.
103.ProtectionBoughtbvGS,spreadsheet.
104.FCICcalculationsbasedondataprovidedbvGoldmanSachs.
105.FCICstaffanalvsisbasedondataprovidedbvGoldmanSachs.
106.Sparks,interview.
107.Ofcourse,intheorvthenet impactonthefinancialsvstemisnotgreater,becausethereisawin-
nerforevervloserinthederivativesmarket.
108.Sparks,interview.
109.FromGoldmanSachsdataprovidedtotheFCICinahandouttitledAmplificationandquoted
attheFCICsHearingontheRoleofDerivativesintheFinancialCrisis,dav1,session3:GoldmanSachs
Group,Inc.andDerivatives,Iune30,2010.
110.FCICstaffanalvsisbasedondataprovidedbvGoldmanSachs.
111.LlovdBlankfein,chairmanoftheboardandchiefexecutiveofficer,GoldmanSachsGroup,inter-
viewbvFCIC,Iune16,2010;Sparks,interview.
112.GarvCohn,testimonvbeforetheFCIC,HearingontheRoleofDerivativesintheFinancialCri-
sis,dav1,session3:GoldmanSachsGroup,Inc.andDerivatives,Iune30,2010,transcript,p.351.
113.Parkinson,interview.
114.MichaelGreenberger,beforetheFCIC,HearingontheRoleofDerivativesintheFinancialCri-
sis,dav1,session1:OverviewofDerivatives,Iune30,2010;oraltestimonv,transcript,p.109;writtentes-
timonv,p.16.
115. Moodvs Investors Service, Summarv of Kev Provisions for Cash CDOs as of Ianuarv 2000
2010.
116.GarvWitt,writtentestimonvfortheFCIC,HearingonCredibilitvofCreditRatings,theInvest-
ment Decisions Made Based on Those Ratings, and the Financial Crisis, dav 1, session 1: The Ratings
Process,Iune2,2010,pp.12,15.
579 Notes to Chapter 8
117.Ibid.,12.
118.GarvWitt,testimonvbeforetheFCIC,HearingonCredibilitvofCreditRatings,theInvestment
DecisionsMadeBasedonthoseRatings,andtheFinancialCrisis,dav1,session1:TheRatingsProcess,
Iune2,2010,transcript,pp.168,436.
119. Moodvs Investors Service, Moodvs Approach to Rating Multisector CDOs, September 15,
2000,p.5.
120.GarvWitt,interviewbvFCIC,April21,2010.
121.Witt,writtentestimonvfortheFCIC,Iune2,2010,p.17.
122.GarvWitt,follow-upinterviewbvFCIC,Mav13,2010.
123.Witt,interview,April21,2010.
124.Forexample,Moodvsassumedthatborrowerswithdifferentcreditratingswouldnotdefaultat
thesametime.TheagencvsplitthesecuritiesintothreesubcategoriesbasedontheaverageFICOscore
of the underlving mortgages: prime (FICO greater than 700), midprime (FICO between 700 and 625),
and subprime (FICO under 625). Creating three FICO-based subcategories rather than the traditional
two(primeandsubprime)resultedinlowercorrelationassumptions,becausemortgage-backedsecuri-
tiesindifferentsubcategorieswereassumedtobelesscorrelated.MoodvsRevisitsItsAssumptionsRe-
gardingStructuredFinanceDefault(andAsset)CorrelationsforCDOs,Iune27,2005,pp.15,5,7,9,4;
GarvWitt,interviewbvFCIC,Mav6,2010.
125. Hedi Katz, U.S. Subprime RMBS in CDOs, Fitch Special Report, April 15, 2005, p. 3; Sten
Bergman, CDO Evaluator Applies Correlation and Monte Carlo Simulation to Determine Portfolio
Oualitv,Standard&PoorsGlobalCreditPortalRatingsDirect,November13,2001,p.8.
126.IngoFenderandIanetMitchell,StructuredFinance:Complexitv,RiskandtheUseofRatings,
BIS Ouarterly Review (Iune2005):68(www.bis.org/publ/qtrpdf/r_qt0506.pdf).
127.BasedonanFCICsurvevof40CDOmanagersand11underwritersabouttheprocessofcreat-
ingandmarketingCDOs.
128. Moodvs Investors Service, Structured Finance Rating Transitions: 19832006, Ianuarv 2007,
pp.7,64.Ofstructuredfinancesecuritiesoriginallvratedtriple-Abetween1984and2006,56retained
theiroriginalrating5vearslater,5weredowngraded,and39werewithdrawn.
129.KvleBass,testimonvtotheHouseFinancialServicesCommittee,SubcommitteeonCapitalMar-
kets,Insurance,andGovernmentSponsoredEnterprises,Hearing on the Role of Credit Rating Agencies in
the Structured Finance Market, 110thCong.,1stsess.,September27,2007,p.11.
130. Structured Finance Rating Transitions: 19832008, Moodvs Credit Policv Special Comment,
March2009,p.2.
131. Moodvs Investors Service, Announcement: Moodvs Updates Its Kev Assumptions for Rating
StructuredFinanceCDOs,December11,2008.
132.BenBernanke,closed-doorsessionwithFCIC,November17,2009.
133.AnnRutledge,emailtoFCIC,November16,2010.AnnRutledgeisaprincipalinR&RConsult-
ing,acoauthorofElements of Structured Finance (Oxford:OxfordUniversitvPress,2010),andaformer
emplovee of Moodvs Investor Service. She and co-principal Svlvain Raines first spoke to the FCIC on
April12,2010.
134.FromMoodvsStructuredFinance:SpecialReport, thefollowingpage1headlines:2004U.S.
CDOReview/2005Preview:RecordActivitvLevelsDrivenbvResecuritizationCDOsandCLOs,Feb-
ruarv1,2005;2005U.S.CDOReview:LookingAheadto2006:RecordYearFollowsRecordYear,Feb-
ruarv 6, 2006; 2008 U.S. CDO Outlook and 2007 Review: Issuance Down in 2007 Triggered bv
SubprimeMortgagesMeltdown;LowerOverallIssuanceExpectedin2008,March3,2008.
135. Moodvs annual gross revenues for ABS CDO ratings was $11,730,234 in 2003, $22,210,695 in
2004, $40,332,909 in 2005, $91,285,905 in 2006, and $94,666,014 in 2007. Information provided bv
Moodvs,Mav3,2010.SeealsoMoodvsCorporation200610-K,p.66andMoodvsCorporation,2007
10-K.
136.Witt,testimonvbeforetheFCIC,Iune2,2010,transcript,p.46.
137.Witt,writtentestimonvfortheFCIC,Iune2,2010,p.11;Witt,interview,April21,2010.
138.EricKolchinskv,interviewbvFCIC,April27,2010.
139.Witt,interview,April21,2010.
140.FCICstaffestimatesbasedonanalvsisofMoodvsCDOEMSdatabase.
580 Notes to Chapter 9
141. Yuri Yoshizawa, interview bv FCIC, Mav 17, 2010. The chart was labeled Derivatives (Amer-
ica).
142.BrianClarkson,interviewbvFCIC,Mav20,2010.
143.HarvevGoldschmid,interviewbvFCIC,March24,2010;AnnetteNazareth,interviewbvFCIC,
April1,2010.
144.OfficeofThriftSupervision,lettertotheSEC,Februarv11,2004.
145.LehmanBrothers,Inc.,lettertotheSEC,March8,2004;I.P.MorganChase&Co.,lettertothe
SEC,Februarv12,2004;DeutscheBankA.G.andDeutscheBankSecs.,lettertotheSEC,Februarv18,
2004.
146.HarvevGoldschmid,interviewbvFCIC, April8,2010.
147.ClosedmeetingoftheSecuritiesandExchangeCommission,April28,2004.
148.In2005,theDivisionofMarketRegulationbecametheDivisionofTradingandMarkets.Forthe
sakeofsimplicitv,throughoutthisreportitisreferredtoastheDivisionofMarketRegulation.
149.ErikSirri,interviewbvFCIC,April1,2010.Althoughtherearemorethan1,000SECexaminers,
collectivelvthevregulatemorethan5,000broker-dealers(withmorethan750,000registeredrepresenta-
tives)aswellasothermarketparticipants.
150.MichaelMacchiaroli,interviewbvFCIC,March18,2010.
151.ThemonitorsmetwithseniorbusinessandriskmanagersateachCSEfirmevervmonthabout
generalconcernsandrisksthefirmswereseeing.Writtenreportsofthesemeetingsweregiventothedi-
rectorofmarketregulationevervmonth.Inaddition,theCSEmonitorsmetquarterlvwiththetreasurv
andfinancialcontrolfunctionsofeachCSEfirmtodiscussliquiditvandfundingissues.
152.ErikSirri,writtentestimonvfortheFCIC,HearingontheShadowBankingSvstem,dav1,ses-
sion3:SECRegulationofInvestmentBanks,Mav5,2010.
153. Internal SEC memorandum, Re: CSE Examination of Bear Stearns & Co. Inc., November 4,
2005.
154. Securities and Exchange Commission, Office of Inspector General, SECs Oversight of Bear
StearnsandRelatedEntities:TheConsolidatedSupervisedEntitvProgram,ReportNo.446-A,Septem-
ber25,2008,pp.1718.
155.MichaelMacchiaroli,interviewbvFCIC,April13,2010.
156.RobertSeabolt,emailtoIamesGiles,StevenSpurrv,andMatthewEichner,October1,2007.
157.MattEichner,interviewbvFCIC,April14,2010;SEC,OIG,SECsOversightofBearStearnsand
RelatedEntities:TheConsolidatedSupervisedEntitvProgram,p.109.
158.Goldschmid,interview.
159.GAO,FinancialMarketsRegulation:FinancialCrisisHighlightsNeedtoImproveOversightof
Leverage at Financial Institutions, GAO-09-739 (Report to Congressional Committees), Iulv 2009, pp.
3842.
160. Erik Sirri, Securities Markets and Regulatorv Reform, remarks at the National Economists
Club,Washington,D.C.,April9,2009.
161.HarvevGoldschmid,interview,April8,2010.
162. Chairman Cox Announces End of Consolidated Supervised Entities Program, SEC press re-
lease,September26,2008.
163.MarvSchapiro,testimonvbeforetheFCIC,FirstPublicHearingoftheFinancialCrisisInquirv
Commission,dav2,panel1:CurrentInvestigationsintotheFinancialCrisisFederalOfficials,Ianuarv
14,2010,transcript,p.39.
164.TheFedremainedthesupervisorofIPMorganattheholdingcompanvlevel.
165.MarkOlson,interviewbvFCIC,October4,2010.
166.FederalReserveSvstem,FinancialHoldingCompanvProject, Ianuarv25,2008,p.3.
Chapter 9
1.WarrenPeterson,writtentestimonvfortheFCIC,HearingontheImpactoftheFinancialCrisis
GreaterBakersfield,session3:ResidentialandCommunitvRealEstate,September7,2010,pp.1,3.
2.GarvCrabtree,principalowner,AffiliatedAppraisers,writtentestimonvfortheFCIC,Hearingon
theImpactoftheFinancialCrisisGreaterBakersfield,session4:LocalHousingMarket,September7,
2010,p.2.
581 Notes to Chapter 9
3.LlovdPlank,LlovdE.PlankRealEstateConsultants,writtentestimonvfortheFCIC,Hearingon
theImpactoftheFinancialCrisisGreaterBakersfield,session4:LocalHousingMarket,September7,
2010,p.2.
4. CoreLogic Single Familv Combined (SFC) Home Price Index, data accessed August 2010. FCIC
calculationofchangefromIanuarv1997toApril2006,peak.
5.ProfessorRobertShiller,HistoricalHousingdata..
6.FinalReportofMichaelI.Missal,BankruptcvCourtExaminer,InRE:NewCenturvTRSHoldings,
Chapter11,CaseNo.07-10416(KIC),(Bankr.D.Del),Februarv29,2008,pp.145,138,13940(hereafter
Missal).
7.Ibid.,p.3.
8.NomuraFixedIncomeResearch,NotesfromBocaRaton:CoveragefromSelectedSessionsofABS
East2005,September20,2005,pp.57.
9.AlanGreenspan,TheEconomicOutlook,testimonvbeforetheIointEconomicCommittee,109th
Cong.,1stsess.,Iune9,2005.
10.ChristopherMaver,writtentestimonvfortheFCIC,ForumtoExploretheCausesoftheFinancial
Crisis,dav2,session5:MortgageLendingPracticesandSecuritization,Februarv27,2010,pp.56.
11.AntonioFatas,PrakashKannan,PauRabanal,andAlasdairScott,LessonsforMonetarvPolicv
from Asset Price Fluctuations Leaving the Board, International Monetarv Fund, Vorld Economic Out-
look (Fall2009),chapter3.
12.IamesMacGee,WhvDidntCanadasHousingMarketGoBust:FederalReserveBankofCleve-
land. Economic Comment (December2,2009).
13.MorrisA.Davis,AndreasLehnert,andRobertF.Martin,TheRent-PriceRatiofortheAggregate
StockofOwner-OccupiedHousing,FederalReserveBoardWorkingPaper,Mav2005,p.2.
14.PricedatafromCoreLogicCSBAHomePriceIndex,Single-FamilvCombined.RentdataisBu-
reau of Labor Statistics, metro-level Consumer Price Index (CPI-U), Owners Equivalent Rent for Pri-
marvResidence;allindexfiguresareadjustedsothatIan.1997=1.MethodsfollowfromFederalReserve
BankofSanFranciscoEconomicLetter,HousePricesandFundamentalValue,Number200427,Oc-
tober1,2004.
15.NationalAssociationofRealtorsHousingAffordabilitvIndex,accessedfromBloombergascom-
positeIndex(HOMECOMP).Theindexbeganin1986.
16.Theindexalsoassumesthatthequalifvingratioof25,sothatthemonthlvprincipal&interest
pavmentcouldnotexceed25ofthemedianfamilvmonthlvincome.Moreaboutthemethodologvcan
befoundatNationalAssociationofRealtors,MethodologvfortheHousingAffordabilitvIndex.
17.BenBernanke,lettertoFCICChairmanPhilAngelides,December21,2010,p.2.
18.KristopherS.Gerardi,ChristopherL.Foote,andPaulS.Willen,ReasonablePeopleDidDisagree:
Optimism and Pessimism about the U.S. Housing Market Before the Crash, Federal Reserve Bank of
BostonPublicPolicvDiscussionPaperNo.10-5,August12,2010.
19. Donald L. Kohn, Monetarv Policv and Asset Prices, speech delivered at Monetarv Policv: A
IournevfromTheorvtoPractice,aEuropeanCentralBankColloquiumheldinhonorofOtmarIssing,
Frankfurt,Germanv,March16,2006.
20.RichardA.Brown,RisingRisksinHousingMarkets,memorandumtotheNationalRiskCom-
mitteeoftheFederalDepositInsuranceCorporation,March21,2005,pp.12.
21. Board of Governors, memorandum from Iosh Gallin and Andreas Lehnert to Vice Chairman
[Roger]Ferguson,TalkingPointsonHousePrices,Mav5,2005,p.3.
22.Missal,p.40.
23.WilliamBlack,testimonvbeforetheFCIC,HearingontheImpactoftheFinancialCrisisMiami,
Florida, session 1: Overview of Mortgage Fraud, September 21, 2010, transcript, p. 78; and email from
WilliamBlacktoFCIC,December12,2010.
24.ReplvofAttornevGeneralLisaMadigan(Illinois)totheFCIC,April27,2010,p.7.
25.ChrisSwecker,AssistantDirectorCriminalInvestigativeDivisionFederalBureauofInvestigation,
statementbeforetheHouseFinancialServicesSubcommitteeonHousingandCommunitvOpportunitv,
108thCong.,2ndsess.,October7,2004.
26.FloridaDepartmentofLawEnforcement,MortgageFraudAssessment,November2005.
582 Notes to Chapter 9
27. Wilfredo Ferrer, testimonv before the FCIC, Hearing on the Impact of the Financial Crisis
Miami,Florida,session3:TheRegulation,Oversight,andProsecutionofMortgageFraudinMiami,Sep-
tember21,2010,transcript,pp.18687.
28.AnnFulmer,supplementalwrittentestimonvfortheFCIC,HearingontheImpactoftheFinan-
cial CrisisMiami, Florida, session 1: Overview of Mortgage Fraud, September 21, 2010, p. 2; Fulmer,
testimonv,transcript,pp.8081.
29.EdParker,interviewbvFCIC,Mav26,2010.
30.DavidGussmann,interviewbvFCIC,March30,2010.
31.WilliamH.Brewster,interviewbvFCIC,October29,2010.
32. Henrv Pontell, written testimonv for the FCIC, Hearing on the Impact of the Financial Crisis
Miami,Florida,session1:OverviewofMortgageFraud,September21,2010,p.1.
33.DepartmentofIustice,OfficeoftheInspectorGeneral,TheInternalEffectsoftheFBIsReprior-
itization,September2004,p.1.
34.ChrisSwecker,interviewbvFCIC,March8,2010.
35.PatrickCrowlev,MortgageDailv.com,November24,2003.
36.Swecker,statementtotheHouseFinancialServicesSubcommitteeonHousingandCommunitv
Opportunitv,October7,2004.
37.WilliamBlack,writtentestimonvfortheFCIC,September21,2010,p.17.
38.FranciscoSanPedro,interviewbvFCIC,September20,2010.
39.FinCENreporttotheFCIConCountrvwideSARactivitv,19992009.
40.OCC,lettertoBankofAmerica,Iune5,2007.
41.DarcvParmer,interviewbvFCIC,Iune4,2010.
42. FinCEN, Mortgage Loan Fraud: An Industrv Assessment Based on SAR Analvsis, November
2006,pp.2,6.
43.Swecker,statementbeforetheHouseFinancialServicesSubcommitteeonHousingandCommu-
nitvOpportunitv,October7,2004.
44.Swecker,interview.
45.FinCEN,MortgageLoanFraudUpdate:SuspiciousActivitvReportFilingsfromAprilIune30,
2010,p.21.
46.DOI,letterfromAssistantAttornevGeneralRonaldWelchtotheFCIC,April28,2010,pp.1,3,
October21,2010,p.2.
47.RobertMueller,interviewbvFCIC,December14,2010.
48.AlbertoGonzales,interviewbvFCIC,November1,2010.
49.OFHEO,2007PerformanceandAccountabilitvReport,pp.13,17.
50.RichardSpillenkothen,interviewbvFCIC,March19,2010.
51.MichaelI.Mukasev,interviewbvFCIC,October20,2010.
52.DOIresponsetoFCICrequest,April16,2010; seealsoDOIresponsetoFCICrequest,April28,
2010.
53.WilliamBlack,testimonvbeforetheFCIC,September21,2010,transcript,p.38.
54.Swecker,interview.
55.EllenWilcox,specialagent,FloridaDepartmentofLawEnforcement,testimonvbeforetheFCIC,
HearingontheImpactoftheFinancialCrisisMiami,session2:UncoveringMortgageFraudinMiami,
September21,2010,transcript,p.80;Participantin$13MillionMortgageFraudSchemeConvictedbv
PolkCountvIurv,OfficeofFloridaAttornevGeneralBillMcCollumpressrelease,August28,2008.
56. Tenth Iudicial Circuit in and for Polk Countv, Florida, State of Florida vs. Scott Almeida, et al.,
OSWPNo.2005-0256-TPA;Iulv23,2007,seeparagraphs2,17,18,19,28,and32.
57.Wilcox,testimonvbeforetheFCIC,September21,2010,transcript,pp.9899.
58. Garv Gorton, The Panic of 2007, paper presented at the Federal Reserve Bank of Kansas Citv,
IacksonHoleConference,MaintainingStabilitvinaChangingFinancialSvstem,August2008.
59.AdamB.AshcraftandTilSchuermann,UnderstandingtheSecuritizationofSubprimeMortgage
Credit,FederalReserveBankofNewYorkStaffReportNo.318,March2008,pp.511.
60.RavmondMcDaniel,quotedinthetranscriptofMoodvsManagingDirectorsTownHallMeeting,
September11,2007.
583 Notes to Chapter 9
61.KeithIohnson,formerpresidentandchiefoperatingofficerofClavtonHoldings,Inc.,interview
bvFCIC,September2,2010.
62.FrankFilipps,interviewbvFCIC,August9,2010.
63. Vicki Beal, testimonv before the FCIC, Hearing on the Impact of the Financial CrisisSacra-
mento, session 3: The Mortgage Securitization Chain: From Sacramento to Wall Street, September 23,
2010,transcript,pp.155,15556.
64. Beal, testimonv before the FCIC, September 23, 2010, transcript, pp. 169, 157; see also Martha
Coaklev,MassachusettsAttornevGeneral,commentlettertotheSecuritiesandExchangeCommission
regardingproposedruleregardingasset-backedsecurities,ReleaseNo.33-9117;34-61858;FileNo.S7-
08-10,August2,2010,p.6.
65.Beal,testimonvbeforetheFCIC,September23,2010,transcript,pp.16970.
66. D. Keith Iohnson, testimonv before the FCIC, Hearing on the Impact of the Financial Crisis
Sacramento,session3:TheMortgageSecuritizationChain:FromSacramentotoWallStreet,September
23,2010,transcript,pp.18384.
67.Ibid.,p.211.
68.Beal,testimonvbeforetheFCIC,September23,2010,transcript,p.172.
69. Iohn I. Goggins, senior vice president and general counsel, Moodvs, letter to FCIC regarding
September27,2010ArticlePublishedinThe ^ew York Times MisconstruingCommissionTestimonv,
September30,2010.
70.Iohnson,testimonvbeforetheFCIC,September23,2010,transcript,p.174.
71.Missal,p.67.
72.RogerEhrnman,interviewbvFCIC,September2,2010;Iohnson,testimonvbeforetheFCIC,Sep-
tember23,2010,transcript,p.178.
73.TonvPeterson,interviewbvFCIC,October14,2010.
74.IosephSchwartz,vicepresidentinchargeofmortgageacquisitionduediligence,DeutscheBank,
interviewbvFCIC,Iulv21,2010;WilliamCollinsBuellVI,headofmortgageacquisition,IPMorgan,in-
terviewbvFCIC,September15,2010.
75.RichardM.Bowen,writtentestimonvfortheFCIC,HearingonSubprimeLendingandSecuriti-
zationandGovernment-SponsoredEnterprises(GSEs),dav1,session2:SubprimeOriginationandSe-
curitization,April7,2010,p.2.
76. Richard M. Bowen, interview bv FCIC, Februarv 27, 2010; FCIC correspondence with Richard
M.Bowen.
77. Inside Mortgage Finance, The 2009 Mortgage Market Statistical Annual, vol. 2, The Secondary
Market (Bethesda,MD:InsideMortgageFinance,2009), p.156;FCICstaffestimatebasedonanalvsisof
MoodvsCDOEMSdatabase.
78.See,forexample,IamesC.TreadwavIr.,AnOverviewofRule415andSomeThoughtsAboutthe
Future, remarks to the thirteenth annual meeting of the Securities Industrv Association, Hot Springs,
Virginia,October8,1983.
79.ShellevParrattandPaulaDubberlv,interviewbvtheFCIC,October1,2010.
80.17C.F.R.Part229.1111(a)(3),PoolAssets,revisedasofApril1,2005.
81. See Part V of complaint filed bv Cambridge Place Investment Management Inc., dated Iulv 9,
2010, in Suffolk Countv (Massachusetts) Superior Court, Cambridge Place Investment Management,
Inc.,v.MorganStanlev&Co.,Inc.,CaseNo.10-27841,p.71(hereafterCambridgeComplaint),andPart
VofcomplaintfiledbvFederalHomeLoanBankofChicago,datedOctober15,2010,inCircuitCourtof
Cook Countv, Illinois (Chancerv Division), Federal Home Loan Bank of Chicago v. Banc of America
FundingCorp.etal.,CaseNo.10CH450B3,p.173.
82.CambridgeComplaint,pp.3233,6163,7071,7576.
83.Bowen,interview.
84.D.KeithIohnson,formerpresidentandchiefoperatingofficer,ClavtonHoldings,Inc.,interview
bvFCIC,Iune8,2010.
85. A OIB was defined under Rule 144A to include entities, acting for its own account or the ac-
countsofotherqualifiedinstitutionalbuvers,thatintheaggregateownsandinvestsonadiscretionarv
basis at least $100 million in securities of issuers that are not affiliated with the entitv. See 17 C.F.R.
230.144A,PrivateResaleofSecuritiestoInstitutions.
584 Notes to Chapter 9
86.DennisVoigtCrawford,testimonvbeforetheFCIC,FirstPublicHearingoftheFCIC,dav2,ses-
sion 2: Current Investigation into the Financial CrisisState and Local Officials, Ianuarv 14, 2010,
p.112.
87.RichardBreeden,interviewbvFCIC,October14,2010.SeePublicLaw104290(Oct.11,1996);
Rule144Acontainedprovisionsthatensureditdidnotexpandtothesecuritiesmarketsinwhichretail
investorsdidparticipate.
88.FederalReserveBoard,SR9724,Risk-FocusedFrameworkforSupervisionofLargeComplexIn-
stitutions,October27,1997.
89.AlanGreenspan,TheEvolutionofBankSupervision,speechbeforetheAmericanBankersAs-
sociation,Phoenix,Arizona,October11,1999.
90.EugeneLudwig,interviewbvFCIC,September2,2010.
91.FederalReserveBankofNewYork,ReportonSvstemicRiskandSupervision,DraftofAugust5,
2009,p.2.
92.RichSpillenkothen,Notesontheperformanceofprudentialsupervisioninthevearspreceding
the financial crisis bv a former director of banking supervision and regulation at the Federal Reserve
Board(1991to2006),Mav31,2010,12.
93.SusanBies,interviewbvFCIC,October11,2010.
94.Bernanke,lettertotheFCIC,December21,2010.
95.IohnSnow,interviewbvFCIC,October7,2010.
96.OfficeoftheComptrolleroftheCurrencv,BoardofGovernorsoftheFederalDepositInsurance
Corporation, Office of Thrift Supervision, and National Credit Union Administration, Credit Risk
ManagementGuidanceforHomeEquitvLending,Mav16,2005.
97.2009 Mortgage Market Statistical Annual, 1:3;ResidentialMortgageLendersPeerGroupSurvev:
AnalvsisandImplicationsforGuidance,PowerPointpresentation,November30,2005,pp.13,3.
98.SabethSiddique,interviewbvtheFCIC,September9,2010.
99. Residential Mortgage Lenders Peer Group Survev: Analvsis and Implications for Guidance,
PowerPoint,November30,2005.
100.Bies,interview.
101.OfficeoftheComptrolleroftheCurrencv,BoardofGovernorsoftheFederalDepositInsurance
Corporation, Office of Thrift Supervision, and National Credit Union Administration, Interagencv
Guidance on Nontraditional Mortgage Products, Federal Register 70 (December 29, 2005): 77,249,
72,252,72,253.
102.PaulSmith,AmericanBankersAssociation,lettertotheFederalDepositInsuranceCorporation,
BoardofGovernorsoftheFederalReserveSvstem,OfficeofThriftSupervision,andOfficeoftheComp-
trolleroftheCurrencv,March29,2006,p.2.
103. Letter from American Financial Services Association to federal regulators 8, available at
http://www.ots.treas.gov/_files/comments/d1e85ce107ab-4acf-8db58d1747afba0a.pdf.
104. Letters to the Office of Thrift Supervision from the American Bankers Association (March 29,
2006), p. 2; the American Financial Services Association (March 28, 2006), p. 8; and Indvmac Bank
(March29,2006),p.4.
105.TheHousingPolicvCounciloftheFinancialServicesRoundtable,lettertotheOfficeofThrift
Supervision,March29,2006,p.6.
106.Siddique,interview.
107. Binvamin Appelbaum and Ellen Nakashima, Banking Regulator Plaved Advocate Over En-
forcer:AgencvLetLendersGrowOutofControl,ThenFail,Vashington Post, November23,2008.
108.Bies,interview.
109.See,e.g.CountrvwideSeekstoBecomeSavingsBank;TheMortgageLenderSavsItIsPlanning
toApplvtoConvertItsCharterSoItWillBeRegulatedbvOneFederalAgencvinsteadofTwo,Los An-
geles Times, November11,2006,basedonBloomberg,Reuters.
110.KimSherer,interviewbvFCIC,August32003.
111. Countrvwide, Briefing Paper: Meeting with Office of Thrift Supervision, Thursdav Iulv 13,
2006.
585 Notes to Chapter 9
112.AngeloMozilo,emailtoIohnMcMurrav(ccDaveSambol,CarlosGarcia),re:PavOptions,Au-
gust12,2006;IohnMcMurrav,emailtoAngeloMozilo(ccKevinBartlett,CarlosGarcia,DaveSambol,
re:PavOptions,August13,2006.
113.Thecostofborrowingisreflectedbvcreditspreads,theportionofinterestratesthatcompensate
investors for credit risk. Credit spreads are the interest rates that investors require above the so-called
risk-freeinterestrate,usuallvmeasuredintermsofTreasuriesorinterestrateswapswithsimilarcharac-
teristics.
114.CongressionalOversightPanel,CommercialRealEstateLossesandtheRisktoFinancialStabil-
itv,Februarv10,2010,pp.5860.
115.LoanSvndicationTradingAssociation,TheUSLoanMarketTodav,presentation.
116. Loan Svndication Trading Association, Financial Reform and the Leveraged Loan Market,
presentation.
117.Ibid.,LoanSvndicationTradingAssociation,ChallengesFacingCLOsandtheLoanMarket,
presentation.
118. Ibid., p. 14. SEC, Risk Management Reviews at Consolidated Supervised Entities, memoran-
dum,April26,2007.
119.MichaelFlahertvandDenaAubin,ForPrivateEquitvMarket,AllEvesonFirstData,Reuters,
September4,2007.
120. SEC, Risk Management Reviews of Consoldated Supervised Entities, memorandum, Iulv 5,
2007.
121. Charles Prince, quoted in Citigroup chief stavs bullish on buvouts, Financial Times, Iulv 9,
2007; testimonv before the FCIC, Hearing on Subprime Lending and Securitization and Government-
SponsoredEnterprises(GSEs),dav2,session1:CitigroupSeniorManagement,April8,2010,transcript,
pp.4950.
122.RobenFarzad,MatthewGoldstein,DavidHenrv,andChristopherPalmeri,NotSoSmart,Busi-
nessVeek, September3,2007.
123.IosephGvourko,UnderstandingCommercialRealEstate:IustHowDifferentfromHousingIs
It:NBERWorkingPaper14708,NationalBureauofEconomicResearch,Februarv2009,pp.23,38.
124.CREFinanceCouncil,Compendium of Statistics, November5,2010,Exhibits3,2.
125.IoeKeohane,HeartbreakHotels,Portfolio, November11,2008.
126.HiltonDebtClogsLendersBalanceSheets,CommercialMortgageAlert,Februarv20,2009.
127.TomMarano,interviewbvFCIC,April19,2010.
128.IeffMaverandTomMarano,FixedIncomeOverview,BearStearns,March29,2007,p.18.
129.Gvourko,UnderstandingCommercialRealEstate:IustHowDifferentfromHousingIsIt:p.1.
130.NewYorkFederalReserveBank,MaidenLaneLLCHoldingsasof9/30/2008.
131.AntonR.Valukas,ReportofExaminer,In re LehmanBrothersHoldingsInc.,etal.,Chapter11
CaseNo.08-13555(IMP),(Bankr.S.D.N.Y.),March11,2010,2:356(hereaftercitedasValukas).
132.Ibid.,2:35658.
133.MadelvnAntoncic,LehmanBrothersRiskManagement,August7,2007,p.5;andAntoncic,in-
terviewbvFCIC,Iulv14,2010.
134.Valukas,1:43,4;Antoncic,interview.
135.Valukas,1:4562,7980.
136. Iodv Shenn, Lehman Said to Return to Mortgage Market through Aurora Unit (Update 1),
Bloomberg, October21,2009.
137.SEC,RiskManagementReviewsofConsolidatedSupervisedEntities,memoranda,October6,
2006;December6,2007;Februarv2,2007;March30,2007;Mav31,2007;Iulv5,2007;August3,2007;
September5,2007;October5,2007.
138.ErikSirri,interviewbvFCIC,April1,2010.
139.Valukas,1:7;18nn.63,64;3:742,81522.
140.Valukas,1:8,2021.
141.ThePeopleoftheStateofNewYorkv.Ernst&YoungLLP(N.Y.Sup.Ct.filedDec.21,2010).
142.RonaldMarcus,interviewbvFCIC,Iulv23,2010.
143. See Ronald S. Marcus, OTS, Report of Examination Lehman Brothers Holdings Inc., Iulv 7,
2008,pp.12.
586 Notes to Chapter 9
144.DavidSambol,interviewbvFCIC,September27,2010.
145.SeeCountrvwideFinancialCorporation,Form10-K,Februarv29,2007,p.47.SeealsoFannie
Mae, Single-Familv Conventional Acquisition Characteristics: Overall (2007); Fannie Mae, Single
FamilvConventionalAcquisitionCharacteristics:CountrvwideFinancialCorporation(2007);Countrv-
wide,ResponsetoIune23Request:11and12:Summarv.
146.SingleFamilvGuaranteeBusiness:FacingStrategicCrossroads,Iune27,2005.
147.Ibid.
148.DanielMudd,interviewbvFCIC,March26,2010.
149.SingleFamilvGuaranteeBusiness:FacingStrategicCrossroads.
150.SingleFamilvGuarantvBusinessStrategicReviewSummarv,PowerPointpresentation,Iulv19,
2005.
151.Citigroup,ProjectPhineas:PresentationtotheBoardofDirectors,executivesummarv,Iulv18
and19,2005.
152.SingleFamilvConventionalAcquisitionCharacteristicsOverall,producedbvFannieMae.
153.TomLund,interviewbvFCIC,March4,2010.
154.ChristopherDickersontoIamesB.LockhartIII,ProposedAppointmentoftheFederalHousing
FinanceAgencvasConservatorfortheFederalNationalMortgageAssociation,memorandum,Septem-
ber6,2008,p.14
155.FannieMae,3O2008Form10-O,p.at115;FannieMae,2007Form10K,pp.12630.
156.BvDecember31,2005,Freddiereportedcapitalof$36.4 billion; $173billioninloanstoborrow-
erswithFICOscoresbelow660;$80billioninhighLTV;and$93billioninloansfornon-owner-occu-
piedhomes. FederalHomeLoanMortgageCorporation,InformationStatementandAnnualReportto
Stockholders:ForthefiscalvearendedDecember31,2007,Februarv28,2008,p.74.
157.RichardSvron,interviewbvFCIC,August31,2010.
158.AnuragSaksena,interviewbvFCIC,Iune22,2010.
159.DonaldBisenius,interviewbvFCIC,September29,2010.
160.Saksena,interview.
161.OFHEO,SECReachSettlementwithFannieMae;PenaltvImposed,OfficeofFederalHousing
EnterpriseOversightpressrelease,Mav23,2006.
162. Freddie Mac Voluntarilv Adopts Temporarv Limited Growth for Retained Portfolio, Federal
HomeLoanMortgageCorporationpressrelease,August1,2006.
163.OFHEO,ReportoftheSpecialExaminationofFannieMae,Mav2006.
164.OFHEOReport:FannieMaeFaade;FannieMaeCriticizedforEarningsManipulation,Office
ofFederalHousingEnterpriseOversightpressrelease,Mav23,2006.
165.IamesLockhart,writtentestimonvfortheFCIC,HearingonSubprimeLendingandSecuritiza-
tionandGovernment-SponsoredEnterprises(GSEs),dav3,session2:OfficeofFederalHousingEnter-
priseOversight,April9,2010,p.2.
166.Ibid.,p.1.
167.RobertI.Levin,BoardofDirectorPresentation,PowerPointpresentation,Ianuarv2006.
168.MinutesoftheFebruarv21,2006,meetingoftheBoardofDirectorsofFannieMae(approvedon
April25,2006).
169.StephenB.Ashlev,ChairmanFannieMae,remarkspreparedfordelivervattheSeniorManage-
mentMeeting,Cambridge,Marvland,Iune27,2006.
170.FannieMae,NotestoSingleFamilvConventionalAcquisitionReport,August3,2007;Seealso
Federal National Mortgage Association, Form 10-K, for the fiscal vear ended December 31, 2006, filed
August16,2007.
171.FCICstaffestimatesbasedondataprovidedbvFannieMae.
172.FederalNationalMortgageAssociation,FormDEF14A,November2,2007,p.42;FederalNa-
tionalMortgageAssociation,Form10-K,Mav2,2007,p.202.
173.OFHEO,ReportoftheSpecialExaminationforFannieMae,Mav2006,p.8.
174.FederalHomeLoanMortgageCorporation,Form10-K,forthefiscalvearendedDecember31,
2005,filedIune28,2006,pp.3,19.FederalHomeLoanMortgageCorporation,Form10-K,forthefiscal
vearendedDecember31,2006,filedMarch23,2007,pp.3,22.
587 Notes to Chapter 9
175.FederalHomeLoanMortgageCorporation,ProxvStatementandNoticeofAnnualMeetingof
Stockholders(Mav7,2007),SummarvCompensationTable,p.52(for2006figures).FederalHomeLoan
MortgageCorporation,ProxvStatementandNoticeofAnnualMeetingofStockholders(Iulv12,2006),
SummarvCompensationTable,p.37(for2005figures).
176.Ibid.
177.OFHEO,ReportoftheSpecialExaminationforFannieMae,Mav2006,pp.3,910,15.
178.Ibid.,p2.
179.Ibid.
180.Ibid.,pp.78.
181.Ibid.
182.MarkWiner,interviewbvFCIC,March23,2010.
183.ToddHempstead,interviewbvFCIC,March23,2010.
184.DanielMudd,interviewbvFCIC,March26,2010.
185.DickersontoLockhart,FannieMaeconservatorshipmemo,September6,2008,p.14.
186.MinutesofaMeetingoftheFannieMaeBoardofDirectors,April21,2007.
187.MinutesofaMeetingoftheFannieMaeBoardofDirectors,Mav21,2007.
188.FederalNationalMortgageAssociation,Form10-K,forthefiscalvearendedDecember31,2007,
p.24.
189.FCICstaffestimatebasedondataprovidedbvFannieMae.
190.DeepenSegmentsDevelopBreadth,FannieMaeStrategicPlan,20072011.
191. Enrico Dallavecchia, email to Daniel Mudd, Budget 2008 and strategic investments, Iulv 16,
2007.
192.EnricoDallavecchia,emailtoMichaelWilliams,RE:,Iulv16,2007.
193.DanielMudd,emailtoEnricoDallavecchia,RE:Budget2008andstrategicinvestments,Iulv17,
2007.
194.EnricoDallavecchia,interviewbvFCIC,March16,2010.
195. Freddie Mac, Freddie Macs Business Strategv, Board of Directors Meeting, March 23, 2007,
pp.34.
196. Freddie Mac, Freddie Macs Business Strategv, Board of Directors Meeting, March 23, 2007,
pp.34,70,73.
197.OFHEO,2006ReportofExaminationfortheFederalHomeLoanMortgageCorporation,pp.8
9,1011.
198. Federal Housing Finance Agencv, Mortgage Market Note 102: The Housing Goals of Fannie
MaeandFreddieMacintheContextoftheMortgage,Februarv1,2010.
199.HUDAnnouncesNewRegulationstoProvide$2.4TrillioninMortgagesforAffordableHous-
ingfor28.1MillionFamilies,DepartmentofHousingandUrbanDevelopment,pressrelease,October
31,2000.
200.Mudd,interview.
201.RobertLevin,interviewbvFCIC,March17,2010.
202.HUDFinalizesRuleonNewHousingGoalsforFannieMaeandFreddieMac,Departmentof
HousingandUrbanDevelopmentpressrelease,November1,2004.
203.Mudd,testimonvbeforetheFCIC,HearingonSubprimeLendingandSecuritizationandGov-
ernment-SponsoredEnterprises(GSEs),dav3,session:1FannieMae,April9,2010,transcript,pp.63
64.
204.SeeFHFA,AnnualReporttoCongress2009,pp.131,148.Thenumbersareformortgageassets
+outstandingMBSguaranteed.Totalassets+MBSareslightlvgreater.
205.OFHEO,2008ReporttoCongress,April15,2008.
206. Robert Levin, interview bv FCIC, March 17, 2010; Robert Levin, testimonv before the FCIC,
HearingonSubprimeLendingandSecuritizationandGovernment-SponsoredEnterprises(GSEs),dav
3,session1:FannieMae,April9,2010,transcript,pp.6872.
207.TomLund,interviewbvFCIC,March4,2010.
208.Dallavecchia,interview.
209.ToddHempstead,interviewbvFCIC,March23,2010.
210.KennethBacon,interviewbvFCIC,March5,2010.
588 Notes to Chapter 10
211.StephenAshlev,interviewbvFCIC,March31,2010.
212.Levin,interview.
213.MikeOuinn,interviewbvFCIC,March10,2010.
214.Ashlev,interview.
215.ArmandoFalcon,testimonvbeforetheFCIC,HearingonSubprimeLendingandSecuritization
andGovernment-SponsoredEnterprises(GSEs),dav3,session2:OfficeofFederalHousingEnterprise
Oversight,April9,2010,transcript,pp.15556,192;.writtentestimonv,p.10.
216. Lockhart, written testimonv for the FCIC, April 9, 2010, p. 6;; Lockhart, testimonv before the
FCIC,April9,2010,transcript,pp.15661.
217.IamesLockhart,interviewbvFCIC,March19,2010.
218. Edward DeMarco, interview bv FCIC, March 18, 2010; Maria Fernandez (with Alfred Pollard,
ChrisDickerson,IeffrevSpohn,andIamieNewell),interviewbvFCIC,March5,2010.
219.MikePrice(withIaniceKuhl,PaulManchester,CharlotteReid,AlfredPollard,andKevinShee-
han),interviewbvFCIC,Februarv19,2010.
220. Department of Housing and Urban Development, HUDs Housing Goals for the Federal Na-
tionalMortgageAssociation(FannieMae)andtheFederalHomeLoanMortgageCorporation(Freddie
Mac)fortheYears20052008andAmendmentstoHUDsRegulationofFannieMaeandFreddieMac,
Federal Register 69,no.211(2Nov.2004):63629.
221. FHFA, The Housing Goals of Fannie Mae and Freddie Mac in the Context of the Mortgage
Market.
222.DanielMudd,lettertoBrianMontgomervreaffordablehousinggoals,December21,2007.
223.DeepenSegmentsDevelopBreadth,FannieMaeStrategicPlan.
224.BrianD.Montgomerv,FederalHousingCommissioner,toDanielMudd,FannieMae,tvpedlet-
ter,April24,2008;BrianD.Montgomerv,FederalHousingCommissioner,toRichardF.Svron,Fannie
Mae,tvpedletter,April24,2008.
225.CostofFreddieMacsAffordableHousingMission,PowerPointpresentation,Iune4,2009,pp.
78,1011.
226.Freddiesnetincomewas$4.8billionin2003,$2.6billionin2004,$2.1billionin2005,$2.3bil-
lion in 2006, net loss of $3.1 billion in 2007, and net loss of $50.1 billion in 2008. Federal Home Loan
MortgageCorporation,Form10-K,forthefiscalvearendedDecember31,2009,filedFebruarv24,2010,
Item6,SelectedFinancialData,p.57(for2008figure).FederalHomeLoanMortgageCorporation,In-
formationStatementandAnnualReporttoStockholders:ForthefiscalvearendedDecember31,2007,
Februarv28,2008,SelectedFinancialDataandOtherOperatingMeasures,p.28(for200307figures).
227.CostandBenefitsofMissionActivities:ProjectPhineas,presentation,Iune14,2005.
228.March13,2007,BusinessReviewBriefing;informationconfirmedbvcounseltoFannieMaeon
Ianuarv4,2011.
229.FannieMaesHousingGoals,AuditTeambriefing,Mav8,2007.
230.FannieMaeBoardofDirectorsManagementReport,PowerPointpresentation,Iulv17,2007.
231.CostofFreddieMacsAffordableHousingMission,PowerPointpresentation,Iune4,2009,pp.
78,1011.
Chapter 10
1.GarvGorton,interviewbvFCIC,Mav11,2010.
2.LewisRanieri,interviewbvFCIC,Iulv30,2010.
3.Complaint,SECv.GoldmanSachs&Co.andFabriceTourre(S.D.N.Y.April16,2010).
4.OfficeoftheComptrolleroftheCurrencv,Treasurv;OfficeofThriftSupervision,Treasurv;Board
ofGovernorsoftheFederalReserveSvstem;FederalDepositInsuranceCorporation;andSecuritiesand
ExchangeCommission,InteragencvStatementonSoundPracticesConcerningElevatedRiskComplex
StructuredFinanceActivities(Noticeoffinalinteragencvstatement),Ianuarv5,2007.
5.WingChau,interviewbvFDIC,November11,2010.
6.FCIC,Survevof40CDOManagers,ScheduleAandB(1stproductionservedon28managers,2nd
productionservedon12managers).
7.VerticalCapital,emailresponsetoFCICsurvev,October29,2010.
589 Notes to Chapter 10
8.Astwomarketobserverswouldlaterwrite,Startingin2004,CDOsandCDOinvestorsbecamethe
dominantclassofagentspricingcreditriskonsub-primemortgageloans. . . .Intheabsenceofrestraints,
lendersstartedoriginatingunreasonablvriskvloansinlate2005andcontinuedtodosointo2007.Mark
AdelsonandDavidIacob,TheSub-primeProblem:CausesandLessons,Ianuarv8,2008,p.1.
9.ScottSimon,quotedinAllisonPvburn,CDOInvestorsDebateMoralitvofSpreadEnvironment,
Asset Securitization Report, Mav9,2005,p.1.
10.ArmandPastine,quotedinibid.AccordingtotheFCICdatabase,PIMCOdidmanageonemore
newCDO,CostaBellaCDO,whichwasissuedinDecember2006.
11. Source on downgrades: Bloomberg. Source on events on default: Moodvs Investors Service,
MoodvsdowngradesratingsofNotesissuedbvMaximHighGradeCDOI,Ltd.,April18,2008,and
MoodvsdowngradesratingsofNotesissuedbvMaximHighGradeCDOII,Ltd.,April18,2008.
12.ACACapital,200610-K,p.12.
13.ISDAPublishesTemplateforCreditDefaultSwapsonAsset-BackedSecuritieswithPavAsYou
Go Settlement, International Swaps and Derivatives Association press release, Iune 21, 2005
(www.isda.org/press/press062105.html). Under the terms of the pav-as-vou-go swap, if the referenced
mortgage-backed securitv does not receive the full interest and principal pavments, the pav-as-vou-go
protectionsellerisrequiredtopavthebuvertheamountoftheshortfall.Forlonginvestorstheprotec-
tion providerundertheswaptheadvantagewastheleverageembeddedinthetrade:thevdidnothave
tocomeupwiththecashupfrontfortheprincipalamountofthebond;thevsimplvagreedtoreceive
quarterlvswapfeesinreturnforacceptingtheriskoflossifthesecuritiesexperiencedashortfall.
14.LauraSchwartz,interviewbvFCIC,Mav10,2010.
15.LaurieS.Goodman,ShuminLi,DouglasI.Lucas,ThomasA.Zimmerman,andFrankI.Fabozzi,
Subprime Mortgage Credit Derivatives (FrankI.FabozziSeries)(Hoboken,NI:IohnWilev,2008), p.176.
16.GregLippmann,interviewbvFCIC,Mav20,2010.
17.FCICstaffestimatesbasedonanalvsisofMoodvsCDOEMSdatabase.
18.FCICHedgeFundSurvev.FromIulvthroughDecember2006,severalhedgefundswithaverage
assets under management of $4$8 billion accumulated positions totaling more than $1.4 billion in
mortgage-related CDO equitv tranches and almost $3 billion of short positions in mortgage-related
CDO mezzanine tranches. FCIC staff used a Moodvs proprietarv CDO database to estimate the total
mortgage-relatedCDOequitvtrancheissuance.PleaseseeFCICwebsiteformoreinformationaboutthe
hedge fund survev. Note: the FCIC did not survev hedge funds that fullv liquidated or closed. These
fundsmavhavepurchasedsubstantiallongonlvpositionsinmortgage-relatedsecurities.
19.FCICHedgeFundSurvev.SeeFCICwebsitefordetails.
20.Rabobankscounsel,lettertoIudgeFriedoftheSupremeCourtofNY,Mav11,2010.
21.NormaFlowofFunds,informationprovidedbvMerrillLvnch.
22.StevenRoss,emailtoFCIC,December21,2010.
23.SeeletterfromRabobankscounsel,lettertoIudgeFried,Mav11,2010;theletterwasneverfiled
withthecourtbecausethecasewassettled.
24.DocumentofMagnetarInvestmentsinNorma,AttachmentG-13(showingMagnetarpurchases
ofequitvtrancheinNorma);providedbvMerrillLvnch.
25.InformationprovidedbvMerrillLvnch,December22,2010.
26.Complaint,SECv.GoldmanSachs&Co.andFabriceTourre.
27.IraWagner,interviewbvFCIC,April20,2010.
28.AlanRoseman,interviewbvFCIC,Mav17,2010.
29.Schwartz,interview.
30.IohnPaulson,interviewbvFCIC,October28,2010.
31.GoldmanSachstoPavRecord$550MilliontoSettleSECChargesRelatedtoSubprimeMortgage
CDO,SECpressrelease,Iulv15,2010.
32.IamieMaiandBenHockett,interviewbvFCIC,April22,2010.
33.SihanShu,interviewbvFCIC,September27,2010.
34.StevenEisman,interviewbvFCIC,April22,2010.
35.IamesGrant,InsidetheMortgageMachine,inMr. Market Miscalculates. The Bubble Years and
Beyond (MountIackson,VA:Axios,2008),pp.18081,18283.
36.Eisman,interview.
590 Notes to Chapter 10
37.MichaelBurrv,interviewbvFCIC,Mav18,2010.
38.Paulson,interview.
39.Burrv,interview.
40.FCICHedgeFundSurvev.SeeFCICwebsitefordetails.
41.IohnGeanakoplos,writtentestimonvfortheFCIC,ForumtoExploretheCausesoftheFinancial
Crisis,dav1,session3:RiskTakingandLeverage,Februarv26,2010,p.16.
42.OCC,SubprimeCDOValuationandOversightReviewConclusionMemorandum,memoran-
dumfromMichaelSullivan,RAD,andRonFrake,NBE,toIohnLvons,Examiner-in-Charge,Citibank,
NA,Ianuarv17,2008,p.6;Paul,Weiss,Citigroupscounsel,lettertoFCIC,Iune23,2010,Responsesof
NestorDominguez.
43.RichardBookstaber,interviewbvFCIC,Mav11,2010.
44.RMBSandCiti-RMBSasaPercentageofCiti-CDOPortfolioNotionals,producedbvCitiforthe
FCIC.
45.FederalReserveBankofNewYork,FederalReserveBoard,OfficeoftheComptrolleroftheCur-
rencv, Securities and Exchange Commission, U.K. Financial Services Authoritv, and Iapan Financial
ServicesAuthoritv,NotesonSeniorSupervisorsMeetingswithFirms,November19,2007,p.3.
46.FCICstaffestimates,basedonanalvsisofMoodvsCDOEMSdatabase.
47. Paul, Weiss, Citigroups counsel, letter to FCIC, March 1, 2010, in re the FCICs second supple-
mentalrequest,ResponsetoInterrogatorvno.7;Paul,Weiss,lettertoFCIC,March31,2010,updated
responsetointerrogatorvno.7,p.5.
48.NestorDominguez,interviewbvFCIC,March2,2010;Paul,Weiss,letterofMarch31,2010,pp.
36.
49.BoardAnalvstProfileforCitigroupInc.,April16,2007.
50. SEC staff (Sam Forstein, Tim McGarev, Marv Ann Gadziala, Kim Mavis, Bob Sollazo, Suzanne
McGovern,andChrisEaster),interviewbvFCIC,Februarv9,2010.
51. Comptroller of the Currencv, memorandum, Examination of Citigroup Risk Management
(CRM),Ianuarv13,2005,p.3.
52. Ronald Frake, Comptroller of the Currencv, letter to Geoffrev Colev, Citibank, N.A., December
22,2005.
53.FederalReserve,NewYorkOperationsReview,Mav1725,2005,p.4.
54. Federal Reserve Bank of New York Bank Supervision Group, Operations Review Report, De-
cember2009.
55. Federal Reserve Bank of New York, Summarv of Supervisorv Activitv and Findings, Citigroup
Inc.,Ianuarv1,2005December31,2005,April10,2006;FederalReserveBankofNewYork,Summarv
of Supervisorv Activitv and Findings, Citigroup Inc., Ianuarv 1, 2004December 31, 2004, April 5,
2005.
56.CitigroupInc.,Form8-K,April3,2006,Exhibit99.1.
57.FederalReserveBoard,memotoGovernorSusanBies,Februarv17,2006.
58.Theboardreverseda15reductionthathadbeenimplementedwhentheissuesbeganandthen
addeda5raise.Citigroup,2006ProxvStatement,p.37.
59. Comptroller of the Currencv, letter to Citigroup CEO Vikram Pandit (Supervisorv Letter 2008-
05),Februarv14,2008;quotation,p.2.
60.FederalReserveBankofNewYork,lettertoVikramPanditandtheBoardoftheDirectorsofCiti-
group,April15,2008,pp.67.
61. Timothv Geithner, testimonv before the FCIC, Hearing on the Shadow Banking Svstem, dav 2,
session1:PerspectiveontheShadowBankingSvstem,Mav6,2010,transcript,p.128.
62.GenePark,interviewbvFCIC,Mav18,2010.
63.AndrewForster,emailtoGarvGorton,AlanFrost,etal.,Iulv21,2005.
64.Park,interview.
65.Gorton,interview.
66.Park,interview.
67.GenePark,emailtoIosephCassano,Februarv28,2006.
68.Park,interview.
591 Notes to Chapter 10
69.DatasuppliedbvAIG.TheCDORFCCDOIIILtd.was93subprimeand7RMBSHome
Equitv, according to the AIG credit committee. A review bv FCIC staff showed that the remaining 7
designatedasRMBSHomeEquitvincludedsubprimecollateral.
70. AIG, Residential Mortgage Presentation (Financial Figures are as of Iune 30, 2007), August 9,
2007,p.28.
71.Park,interview.
72.IosephCassano,interviewbvFCIC,Iune25,2010.
73.Park,interview.
74.DowKim,interviewbvFCIC,September9,2010.
75.StanlevONeal,interviewbvFCIC,September16,2010.
76.Kim,interview.
77.FCICstaffestimatesbasedonanalvsisofMoodvsCDOEMSdatabase.
78. Complaint, Coperatieve Centrale Raiffeisen=Boerenleenbank v. Merrill Lvnch, No. 601832/09
(N.Y.S.Iune12,2009),paragraph147.
79.Kim,interview.
80.FCICanalvsisbasedonMoodvsCDOEMSdatabase.
81. Presentation to Merrill Lvnch and Co. Board of Directors, Leveraged Finance and
Mortgage/CDOReview,October21,2007,p.35.
82.Chau,interview.
83.FCICstaffanalvsisofMoodvsCDOEMSdatabase.
84.FCICstaffestimatesbasedonMoodvsCDOEMSdatabase.DatasuppliedbvMerrillLvnch.Rele-
vantinformationnotprovidedforRobecoHighGradeCDOI.
85.FCICstaffanalvsisofMoodvsCDOEMSdatabase.
86.DatasuppliedbvMerrillLvnch.
87. FCIC staff analvsis of Moodvs CDO EMS database. The total value of Baa tranches issued bv
CDOsintheFCICdatabasewas$684millionin2003and$3.9billionin2007;Aatranches,$1.4billion
in2003and$8.3billionin2007;Atranches,$522millionin2003and$4.3billionin2007.
88.FCICstafftelephonediscussionwithSECstaff,September1,2010.
89.FCICstaffanalvsisofMoodvsCDOEMSdatabase.
90.Chau,interview;fornumberoftheCDOshemanaged,FCICstaffanalvsisofMoodvsEnhanced
CDOMonitoringDatabase.
91.SuperSeniorCreditTransactionsPrincipalCollateralProvisions,December7,2007,producedbv
AIG.
92.PresentationtotheMerrillLvnchBoard,LeveragedFinanceandMortgage/CDOReview,p.23;
IeffKronthal,formerheadofMerrillLvnchsGlobalCredit,RealEstateandStructuredProducts,inter-
viewbvFCIC,September14,2010.
93.AlYoon,MerrillsOwnSubprimeWarningsUnheeded,Reuters,October30,2007.
94.SEC,RiskManagementReviewsofConsolidatedSupervisedEntities,internalmemotoErikSi-
rriandothers,Februarv2,2007,p.3.
95.Ibid.,p.1.
96.Yoon,MerrillsOwnSubprimeWarningsUnheeded.
97.Kim,interview.
98. Senate Permanent Subcommittee on Investigations, Fishtail, Bacchus, Sundance, and Slapshot.
Four Enron Transactions Funded and Facilitated by U.S. Financial Institutions, 107thCong.,2ndsess.,Ian-
uarv2,2003,S-Prt10782,pp.36,37.
99. Interagencv Statement on Sound Practices (Notice of final interagencv statement), Ianuarv 5,
2007(seen.4,above).
100. Office of the Comptroller of the Currencv, Treasurv; Office of Thrift Supervision, Treasurv;
BoardofGovernorsoftheFederalReserveSvstem;FederalDepositInsuranceCorporation;andSecuri-
tiesandExchangeCommission,InteragencvStatementonSoundPracticesConcerningComplexStruc-
tured Finance Activities (Notice of interagencv statement with request for public comments),Mav 13,
2004.
101.Ibid.,pp.78.
592 Notes to Chapter 10
102.IohnC.Dugan,ComptrolleroftheCurrencv,writtentestimonvfortheFCIC,HearingonSub-
primeLendingandSecuritizationandGovernment-SponsoredEnterprises(GSEs),dav2,session2:Of-
ficeoftheComptrolleroftheCurrencv,April8,2010,AppendixE:OCCSupervisionofCitibank,N.A.,
p.10.
103.InteragencvStatementonSoundPractices(Noticeoffinalinteragencvstatement),Ianuarv5,
2007,p.6.
104.BaselCommitteeonBankingSupervision:IointForum,CreditRiskTransfer,BankforInterna-
tionalSettlements,March2005,pp.34,67,510.
105.Ibid.,p.4.
106.Ibid.
107.Ibid.,pp.34.
108.SEC,OfficeofComplianceInspectionsandExaminations,ExaminationReporttoMoodvsIn-
vestorServices,Inc.,p.4(examinationbegunAugust31,2007).
109.WarrenBuffett,testimonvbeforetheFCIC,HearingontheCredibilitvofCreditRatings,theIn-
vestmentDecisionsMadeBasedonThoseRatings,andtheFinancialCrisis,session2:CreditRatingsand
theFinancialCrisis,Iune2,2010,transcript,p.301.
110. Warren Buffett, interview bv FCIC, Mav 26, 2010; Buffett, testimonv before the FCIC, Iune 2,
2010,transcript,p.302.
111. Eric Kolchinskv, written testimonv for the FCIC, Hearing on the Credibilitv of Credit Ratings,
theInvestmentDecisionsMadeBasedonThoseRatings,andtheFinancialCrisis,session1:TheRatings
Process,Iune2,2010,p.2.
112.BrianClarkson,interviewbvFCIC,Mav20,2010.
113. Garv Witt, interview bv FCIC, April 21, 2010. Iohn Rutherford was the president and CEO of
MoodvsCorporationfromthetimeofitsspin-offfromDun&Bradstreetin2000untilheretiredfrom
thefirmin2005.
114.IeromeFons,interviewbvFCIC,April22,2010.
115.RavmondMcDaniel,interviewbvFCIC,Mav21,2010.
116.Clarkson,interview.
117.Ibid.
118.McDaniel,interview.
119. Ravmond McDaniel, testimonv before the FCIC, Hearing on the Credibilitv of Credit Ratings,
theInvestmentDecisionsMadeBasedonThoseRatings,andtheFinancialCrisis,session2:CreditRat-
ingsandtheFinancialCrisis,Iune2,2010,transcript,pp.2034.
120.ScottMcCleskev,interviewbvFCIC,April16,2010.
121.Clarkson,interview.
122.Witt,interview.
123.MarkFroeba,testimonvbeforetheFCIC,HearingontheCredibilitvofCreditRatings,theIn-
vestmentDecisionsMadeBasedonThoseRatings,andtheFinancialCrisis,session3:TheCreditRating
AgencvBusinessModel,Iune2,2010,transcript,p.347.
124.Clarkson,interview;McDaniel,interview.
125.Witt,interview;GarvWitt,testimonvbeforetheFCIC,HearingontheCredibilitvofCreditRat-
ings, the Investment Decisions Made Based on those Ratings, and the Financial Crisis, Session 3: The
CreditRatingAgencvBusinessModel,Iune2,2010,transcript,p.394.
126.BrianClarkson,emailtoEdBankole,PramilaGupta,MichaelKanef,AndrewKriegler,SamPil-
cer,AndrewSilver,andLindaStesnev,subject:IuneYTDAFGbvanalvst.xls,Iulv5,2001.
127.WilliamMav,emailtoGusHarris,subject:RE:BESandPEs,Ianuarv12,2006.
128.YuriYoshizawa,emailtodirectreportmanagingdirectors,subject:3OMarketCoverage-CDO,
October5,2007.
129.Clarkson,interview.
130.McDaniel,interview.
131.Witt,testimonvbeforetheFCIC,Iune2,2010,transcript,pp.45657.
132.MoodvsInvestorsService:ManagingDirectorsTownHallMeeting,September11,2007,tran-
script,pp.42,5152.
133.Witt,interview.
593 Notes to Chapter 11
134. Andrew Kimball, internal email, October 21, 2007, attaching memorandum, Credit policv is-
suesatMoodvssuggestedbvthesubprime/liquiditvcrisis.Thesusceptibilitvofaratingscommitteeto
externalpressureswasshownintheconstantproportiondebtobligation(CPDO)scandalinEurope.
135.Ibid.,p.3.
136.DavidTeicher,projectmanageratMoodvs,interviewbvFCIC,Mav4,2010;Standard&Poors,
CreditFAO:TheBasicsofCreditEnhancementinSecuritizations,RatingsDirect,Iune24,2008.
137.RichardMichalek,testimonvbeforetheFCIC,HearingontheCredibilitvofCreditRatings,the
InvestmentDecisionsMadeBasedonThoseRatings,andtheFinancialCrisis,session3:TheCreditRat-
ingAgencvBusinessModel,Iune2,2010,transcript,p.361.
138.Witt,interview.
139.Clarkson,interview.
140.Fons,interview.
141.Kimball,memorandum,CreditpolicvissuesatMoodvs,p.1.
142.EricKolchinskv,testimonvbeforetheFCIC,HearingontheCredibilitvofCreditRatings,theIn-
vestment Decisions Made Based on Those Ratings, and the Financial Crisis, session 1: The Ratings
Process,Iune2,2010,transcript,pp.6869.
143.EKolchinskv,emailtoYFuandYYoshizawa,Mav30,2005.
144.Kolchinskv,testimonvbeforetheFCIC,Iune2,2010,transcript,pp.6869.
145.EricKolchinskv,interviewbvFCIC,April14,2010.
146.FCICstaffestimates,basedonanalvsisofMoodvsSFDRSdatabase.
147.RiachraODriscoll,emailtoYuriYoshizawa,subject:Magnolia20065ClassDs,April27,2006.
148.Kimball,memorandum,CreditpolicvissuesatMoodvs,p.2.
149.SEC,OfficeofComplianceInspectionsandExaminations,ExaminationReportforMoodvsIn-
vestorsServices,Inc.,p.2.
Chapter 11
1.WilliamDudlev,interviewbvFCIC,October15,2010.
2.InsideMortgageFinance,The 2009 Mortgage Market Statistical Annual, vol.2,The Secondary Mar-
ket (Bethesda,Md.:InsideMortgageFinance,2009),p.13,Non-AgencvMBSIssuancebvTvpe.
3.FCICstaffestimatesbasedonMoodvsCDOEnhancedMonitoringSvstem(EMS)database.
4.2009 Mortgage Market Statistical Annual, 2:373,CommercialMBSIssuance.
5.BenS.Bernanke,chairmanoftheFederalReserve,lettertoPhilAngelides,chairmanoftheFCIC,
December21,2010.
6.MarkZandi,CeliaChen,andBrianCarev,HousingattheTippingPoint,MoodvsEconomv.com,
October2006,pp.67.
7. CoreLogic Home Price Index, Single-Familv Combined (available at www.corelogic.com/
Products/CoreLogic-HPI.aspx),FCICstaffcalculations,IanuarvtoIanuarv.
8.CoreLogicCensusBureauStatisticalArea(CBSA)HomePriceIndex,FCICstaffcalculations.
9. Data provided bv Mark Fleming, chief economist for CoreLogic, in his written testimonv for the
FCIC, Hearing on the Impact of the Financial CrisisSacramento, session 1: Overview of the Sacra-
mentoHousingandMortgageMarketsandtheImpactoftheFinancialCrisisontheRegion,September
9,2010,figures4,5.
10.MarkFleming,testimonvbeforetheFCIC,HearingontheImpactoftheFinancialCrisisSacra-
mento,session1:OverviewoftheSacramentoHousingandMortgageMarketsandtheImpactoftheFi-
nancialCrisisontheRegion,September9,2010,transcript,p.14.
11.MortgageBankersAssociation,NationalDelinquencvSurvev,dataprovidedtotheFCIC.
12.Ibid.,withFCICstaffcalculations.
13.FCICstaffanalvsis,Analvsisofhousingdata,Iulv7,2010.TheunderlvingdatacomefromCore-
LogicandLoanProcessingSvcs.TabulationswereprovidedtotheFCICbvstaffattheFederalReserve.
14. Subprime and Alt-A mortgages are defined as those included in subprime or Alt-A securitiza-
tions,respectivelv.GSEmortgagesincludedmortgagespurchasedorguaranteedbvFannieMaeorFred-
dieMac.FHAmortgagesincludedmortgagesinsuredbvtheFHAorVA.
15.FCICstaffanalvsis.
594 Notes to Chapter 11
16. A recent analvsis published bv FHFA comes to verv similar conclusions. See Data on the Risk
Characteristics and Performance of Single-Familv Mortgages Originated from 2001 through 2008 and
FinancedintheSecondarvMarket,September13,2010.
17.FCICstaffanalvsis,AnalvsisofhousingdataandcomparisonwithEdPintosanalvsis,August9,
2010.InthesampledataprovidedbvtheFederalReserve,FannieMaeandFreddieMacmortgageswitha
FICOscorebelow660hadanaveragerateofseriousdelinquencvof6.2in2008.Inpublicreports,the
GSEsstatedthattheaverageseriousdelinquencvratesforloanswithFICOscoreslessthan660intheir
guaranteebookswas6.3.FannieMae2008CreditSupplement,p.5;FreddieMacFourthOuarter2008
FinancialResultsSupplement,March11,2009,p.15.
18.InthesampledataprovidedbvtheFederalReserve,FannieMaeandFreddieMacmortgageswith
LTVsabove90hadanaveragerateofseriousdelinquencvof5.7in2008.Inpublicreports,theGSEs
statedthattheaverageseriousdelinquencvratesforloanswithLTVsabove90intheirguaranteebooks
was5.8.FannieMae2008CreditSupplement,p.5;
FreddieMacFourthOuarter2008FinancialResultsSupplement,March11,2009,p.15.
19.EdwardPinto,Memorandum:SizingTotalFederalGovernmentandFederalAgencvContribu-
tionstoSubprimeandAlt-ALoansinU.S.FirstMortgageMarketasof6.30.08,Exhibit2withcorrec-
tions through October 11, 2010 (www.aei.org/docLib/PintoFCICTriggersMemo.pdf). The 26.7 million
loansinclude6.7millionloansinsubprimesecuritizationsandanother2.1millionloansinAlt-Asecuri-
tizations,foratotalof8.8millionmortgagesinsubprimeorAlt-Apools,whichPintocallsself-denomi-
natedsubprimeandAlt-A,respectivelv.Tothese,headdsanother8.8millionloanswithFICOscores
below660,whichhelabelssubprimebvcharacteristic.Healsoadds6.3millionloansattheGSEsthat
areeitherinterest-onlvloans,negativeamortizationloans,orloanswithanLTVincludinganvsecond
mortgagegreater than 90, which he collectivelv refers to as Alt-A bv characteristic. The last addi-
tionsincludeanestimated1.4millionloansinsuredbvtheFHAandVAwithanLTVgreaterthan90
outofatotalofroughlv5.5millionFHAandVAloansand1.3millionloansinbankportfoliosthatare
inferredtohavehisdefinedAlt-Acharacteristics.
20. Fannie Mae 2008 Credit Supplement, p. 5; Freddie Mac Fourth Ouarter 2008 Financial Results
Supplement,March11,2009.
21.EdwardPinto,Yes,theCRAIsToxic,City Iournal, Autumn2009.
22. Neil Bhutta and Glenn Canner, Did the CRA Cause the Mortgage Market Meltdown: Federal
Reserve Board of Governors, March 2009. The authors use the Home Mortgage Disclosure Act data,
whichcoverroughlv80ofthemortgagemarketintheUnitedStatesseeRobertB.Averv,KennethP.
Brevoort,andGlennB.Canner,OpportunitiesandIssuesinUsingHMDAData,Iournal of Real Estate
Research 29,no.4(October2007):35179.
23.ElizabethLadermanandCarolinaReid,Lendinginlowandmoderateincomeneighborhoodsin
California: The Performance of CRA Lending During the Subprime Meltdown, November 26, 2008,
workingpapertobepresentedattheFederalReserveSvstemConferenceonHousingandMortgageMar-
kets,Washington,DC,December4,2008.
24.FCIC,PreliminarvStaffReport:TheMortgageCrisis,April7,2010.
25.BankofAmericaresponselettertoFCIC,August20,2010.
26.IohnReed,interviewbvFCIC,March4,2010.
27.LewisRanieri,interviewbvFCIC,Iulv30,2010.
28.NicolasWeill,interviewbvFCIC,Mav11,2010.
29.Ibid.
30.NicolasWeill,emailtoRavmondMcDanielandBrianClarkson,Iulv4,2007.
31.MoodvsInvestorsService,EarlvDefaultsRiseinMortgageSecuritizations,StructuredFinance:
SpecialReport,Ianuarv18,2007,pp.1,3.
32. Moodvs Investors Service, Moodvs Downgrades Subprime First-lien RMBS-Global Credit Re-
searchAnnouncement,Iulv10,2007.
33.Weill,interview.
34.FCICstaffestimates,basedonanalvsisofBlackboxdata.
35.DataonBearStearnsprovidedbvIPMorgantotheFCIC.
595 Notes to Chapter 11
36. Moodvs Investors Service, Moodvs Downgrades $33.4 billion of 2006 Subprime First-Lien
RMBSandAffirms$280billionAaasandAas,October11,2007;October11RatingActionsRelatedto
2006SubprimeFirst-LienRMBS,StructuredFinance:SpecialReport,October17,2007,pp.12.
37.FCICstaffestimates,basedonanalvsisofBlackboxdata.
38.FCICstaffestimates,basedonanalvsisofMoodvsSFDRSdataasofApril2010.
39.MoodvsInvestorsService,TheImpactofSubprimeResidentialMortgage-BackedSecuritieson
Moodvs-Rated Structured Finance CDOs: A Preliminarv Review, Structured Finance: Special Com-
ment,March23,2007,p.2.
40. Yuri Yoshizawa, email to Noel Kirnon and Ravmond McDaniel, cc Eric Kolchinskv, subject:
CSFBPipelineinformation,March28,2007.
41.MoodvsInvestorsService,FirstOuarter2007U.S.CDOReview:ClimbingtheWallofSubprime
Worrv,StructuredFinance:SpecialReport,Mav31,2007,p.2.
42. Richard Michalek, testimonv before the FCIC, Hearing on the Credibilitv of Credit Ratings, the
InvestmentDecisionsMadeBasedonThoseRatings,andtheFinancialCrisis,session3:TheCreditRat-
ingAgencvBusinessModel,Iune2,2010,transcript,pp.44849.
43.2007MCOStrategicPlanOverview,presentationbvRavMcDaniel,Iulv2007.
44.EricKolchinskvretaliationcomplaint,ChronologvPreparedbvEricKolchinskv.
45.FCICstaffestimatesbasedonanalvsisofMoodvsSFDRS;FCIC,PreliminarvStaffReport:Credit
RatingsandtheFinancialCrisis,Iune2,2010.
46.EricKolchinskv,interviewbvFCIC,April27,2010.483823036167(checkedBLK);Kolchinskv
retaliationcomplaint.
47.EricKolchinskvretaliationcomplaint.
48.FCIC,PSR:CreditRatingsandtheFinancialCrisis,pp.3033.
49.BinghamMcCutchen,FannieMaecounsel,lettertoFCIC,September21,2010(hereafterBing-
hamLetter);OMelvenv&MeversLLP,FreddieMaccounsel,lettertoFCIC,September21,2010(here-
afterOMelvenvLetter).
50. Federal Housing Finance Agencv, Conservators Report on the Enterprises Financial Perform-
ance:ThirdOuarter2010,tables3.1and4.1.
51.RavmondRomano,interviewbvFCIC,September14,2010;BinghamLetter.
52.BinghamLetter.
53.BinghamLetter,Tab3;Tab1,RepurchaseCollectionsbvTopTenSellers/Servicers.
54.OMelvenvletter.
55.BankofAmericaannouncesfourth-quarteractionswithrespecttoitshomeloansandinsurance
business,BankofAmericapressrelease,Ianuarv3,2011.
56.MortgageInsuranceCompaniesofAmerica,20092010 Fact Book and Member Directory,Exhibit
3:PrimarvInsuranceActivitv(InsuranceinForce)p17.
57.DocumentsproducedfortheFCICbvUnitedGuarantvResidentialInsurance,MGIC,Genworth,
RMIC,Triad,PMI,andRadian.
58. FCIC staff calculations based on productions from Fannie and Freddie. Figures are for Alt-A,
optionARMAlt-A,andsubprimeloans.
59.FHFA,ConservatorsReport:ThirdOuarter2010.Accountingchangesforimpairmentshavere-
sultedinoffsettinggainsof$8billion.
60.FHFAIssueSubpoenasforPLSDocuments,FederalHousingFinanceAgencvnewsrelease,Iulv
12,2010.
61.Covington&BurlingLLP,FreddieMaccounsel,lettertoFCIC,October19,2010;seeOMelvenv
&MeversLLP,lettertoFCIC,datedOctober19,2010.
62.NERAEconomicConsulting,CreditCrisisLitigationRevisited:LitigatingtheAlphabetofStruc-
turedProducts,PartVIIofaNERAInsightsSeries,Iune4,2010,p.1.
63.DefendantsWellsFargoAssetSecuritiesCorp.andWellsFargoBank,N.A.sNoticeofRemoval,
Charles Schwab Corp. v. BNP Paribas Securities Corp, et al., No. cv-10-4030 (N.D. Cal. September 8,
2010).
596 Notes to Chapter 12
64. Attornev General of Massachusetts, Attornev General Martha Coaklev and Goldman Sachs
ReachSettlementRegardingSubprimeLendingIssues,Mav11,2009;MorganStanlevtoPav$102Mil-
lionforRoleinMassachusettsSubprimeMortgageMeltdownunderSettlementwithAGCoaklevsOf-
fice,Iune24,2010.
65.Complaint,CambridgePlacev.MorganStanlevetal.,No.10-2741(Mass.Super.Ct.filedIulv9,
2010),p.28.
66.SarahIohnson,HowFarCanFairValueGo: CFO.com, Mav6,2008.
67.VikasShilpiekandulaandOlgaGorodetskv,WhoOwnsResidentialCreditRisk:LehmanBroth-
ersFixedIncome,U.S.SecuritizedProductsResearch,September7,2007.
68. Moodvs Investor Service, Default & Loss Rates of Structured Finance Securities: 19932009,
SpecialComment,September23,2010.
69.BenBernanke,closed-doorsessionwiththeFCIC,November17,2009.
70.VikasShilpiekandulaandOlgaGorodetskv,WhoOwnsResidentialCreditRisk:,September7,
2007,p.1.TheLehmananalvstspeggedultimatesubprimeandAlt-Alossesat$200billion.Thosefore-
castswerebased,theanalvstssaid,onascenarioinwhichhousepricesfellanaverageof30acrossthe
countrv.Forthesecuritizationfigures,seeInsideMortgageFinance,The 2009 Mortgage Market Statisti-
cal Annual, vol.2,The Secondary Market.
71.IMF,FinancialStressandDeleveraging:Macro-FinancialImplicationsandPolicv,Global Finan-
cial Stability Report, October 2008, p. 78; IMF, Containing Svstemic Risks and Restoring Financial
Soundness,Global Financial Stability Report, April2008.
72.FCICstaffestimates,basedonMoodvsInvestorService,Default&LossRatesofStructuredFi-
nanceSecurities:19932009,SpecialComment,September23,2010,andanalvsisofMoodvsStructured
FinanceDefaultRiskService.
73.BenBernanke,testimonvbeforetheFCIC,HearingonTooBigtoFail:ExpectationsandImpactof
ExtraordinarvGovernmentInterventionandtheRoleofSvstemicRiskintheFinancialCrisis,dav2,ses-
sion1:TheFederalReserve,September2,2010,transcript,p.54.
Chapter 12
1. FCIC staff calculations using data in worksheets Markit ABX.HE. 06-1 prices and ABX.HE. 06-2
prices,producedbvMarkit;NomuraFixedIncomeResearch,CDO/CDS Update 12/18/0.Thefiguresre-
fertotheBBB-indexoftheABX.HE.06-2.
2.NomuraFixedIncomeResearch,CDO/CDS Update 12/18/0,p.2.
3.SEC,RiskManagementReviewsofConsolidatedSupervisedEntities,internalmemotoErikSirri
andothers,Ianuarv4,2007.
4.IimChanos,interviewbvFCIC,October5,2010.
5.SEC,RiskManagementReviewsofConsolidatedSupervisedEntities,memo,Ianuarv4,2007.
6. Fed Chairman Ben S. Bernanke, The Economic Outlook, testimonv before the Ioint Economic
Committee,U.S.Congress,110thCong.,1stsess.,March28,2007.
7. Henrv Paulson, quoted in Iulie Haviv, Bernanke Allavs Subprime Fears as Beazer Faces Probe,
Reuters,March28,2007.
8.DavidViniar,writtentestimonv,Vall Street and the Financial Crisis. The Role of Investment Banks,
SenatePermanentSubcommitteeonInvestigation,111thCong.,2ndsess.,April27,2010,pp.34.
9.MichaelDinias,emailtoDavidViniarandCraigBroderick,December13,2006,SenatePermanent
SubcommitteeonInvestigations,Exhibit2.
10. Viniar, written testimonv, Permanent Subcommittee on Investigation, pp. 34; Daniel Sparks,
emailtoTomMontagandRichardRuzika,December14,2006,SenatePermanentSubcommitteeonIn-
vestigations,Exhibit3.
11. Kevin Gasvoda, email to Genevieve Nestor and others, December 14, 2006, Senate Permanent
SubcommitteeonInvestigations,Exhibit72.
12.DavidViniar,emailtoTomMontag,December15,2006,SenatePermanentSubcommitteeonIn-
vestigations,Exhibit3.
13.StacvBash-Pollev,emailtoMichaelSwensonandothers,December20,2006,SenatePermanent
SubcommitteeonInvestigations,Exhibit151.
597 Notes to Chapter 12
14.TetsuvaIshikawa,emailtoDarrvlHerrick,October11,2006,SenatePermanentSubcommitteeon
Investigations, Exhibit 170c; Geoffrev Williams, email to Ficc-Mtgcorr-desk, October 24, 2006, Senate
PermanentSubcommitteeonInvestigations,Exhibit170d.
15. Fabrice Tourre, email to Ionathan Egol and others, December 28, 2006, Senate Permanent Sub-
committeeonInvestigations,Exhibit61.
16. Daniel Sparks, email to Tom Montag, Ianuarv 31, 2007, Senate Permanent Subcommittee on
Investigations,Exhibit91.
17. Fabrice Tourre, email to Marine Serres, Ianuarv 23, 2007, Senate Permanent Subcommittee on
Investigations,Exhibit62.
18.LlovdBlankfein,emailtoTomMontag,Februarv11,2007,SenatePermanentSubcommitteeon
Investigations,Exhibit130.
19. FCIC calculations using data from 20042007 GS Svnthetic CDOs, produced bv Goldman
Sachs.
20.GretchenMorgensonandLouiseStorv,BanksBundledBadDebt,BetAgainstItandWon,^ew
York Times,December24,2009.
21.LlovdBlankfein,testimonvbeforetheFCIC,FirstPublicHearingoftheFCIC,firstdav,panel1:
FinancialInstitutionRepresentatives,Ianuarv13,2010,transcript,pp.2627.
22. Goldman Sachs Clarifies Various Media Reports of Aspect of FCIC Hearing, Goldman Sachs
pressrelease,Ianuarv14,2010.
23.GarvCohn,testimonvbeforetheFCIC,HearingontheRoleofDerivativesintheFinancialCrisis,
dav1,session3:GoldmanSachsGroup,Inc.andDerivatives,Iune30,2010,transcript,p.267.
24.MichaelSwenson,openingstatement,Hearing on Vall Street and the Financial Crisis. The Role of
Investment Banks, SenatePermanentSubcommitteeonInvestigations,pp.23.
25.Complaint,BasisYieldAlphaFundv.GoldmanSachsGroup,Inc.,etal.(S.D.N.Y.Iune9,2010),
p.29.
26.Blankfein,testimonvbeforetheFCIC,Ianuarv13,2010,transcript,p.140.
27.CraigBroderick,writtentestimonvfortheFCIC,HearingontheRoleofDerivativesintheFinan-
cialCrisis,dav1,session3:GoldmanSachsGroup,Inc.andDerivatives,Iune30,2010,p.1.
28.CraigBroderick,emailtoAlanRapfogelandothers,Mav11,2007,SenatePermanentSubcommit-
teeonInvestigations,Exhibit84.
29.HighGradeRiskAnalvsis,April27,2007,p.4;HighGradeEnhancedLeverageO&/A,Iune13,
2007,statingthepercentageofunderlvingcollateralinourinvestmentgradestructurescollateralizedbv
sub-primemortgagesisapproximatelv60.OntheMarch12,2007,investorcall,MatthewTannintold
investorsthatmostoftheCDOsthatwepurchasedarebackedinsomeformbvsubprime(Conference
Calltranscript,pp.2122).
30.Emailfrommatt.tanningmail.comtomatt.tanningmail.com,November23,2006.
31.MatthewTannin,BearStearns,emailtoChavanneKlaus,MEAGNewYork,March7,2007.
32.BSAMConferenceCall,April25,2007,transcript,p.5.
33.MattTannin,BearStearns,emailtoKlausChavanne,MEAGNewYork,March7,2007;Matthew
Tannin, email to Steven Van Solkema, March 30, 2007; Complaint, SEC v. Cioffi, No. 08 Civ. 2457
(E.D.N.Y.Iune19,2008),p.32.
34.IimCrvstal,BearStearns,emailtoRalphCioffi(andothers),March22,2007;RalphCioffi,Bear
Stearns,emailtoKenMak,BearStearns,March23,2007.
35.WarrenSpector,testimonvbeforetheFCIC,HearingontheShadowBankingSvstem,dav1,ses-
sion1:InvestmentBanksandtheShadowBankingSvstem,Mav5,2010,transcript,pp.8384.
36.InformationprovidedtoFCICbvlegalcounseltoBankofAmerica,September28,2010.
37.Ibid.
38.AlanSchwartz,interviewbvFCIC,April23,2010.Notablv,asoneofonlvtwotri-partvrepoclear-
ingbanks,IPMorganhadmoreinformationaboutBSAMslendingobligationsthandidmostothermar-
ket participants or regulators. As discussed in greater detail later in this chapter, this superior market
knowledgelaterputIPMorganinapositiontostepinandpurchaseBearStearnsvirtuallvovernight.
39.EmailfromGoldmantoBear,April2,2007.
40. Steven Van Solkema, Bear Stearns, internal email, Summarv of CDO Analvsis Using Credit
Model,April19,2007.
598 Notes to Chapter 12
41.MattTannin,BearStearns,emailfromGmailaccounttoRalphCioffi,BearStearns,athisHotmail
account,April22,2007.
42.BSAMConferenceCall,April25,2007,transcript.
43.IrisSemic,emailtoMatthewTanninetal.,Mav1,2007.
44.RobertErvin,emailtoRalphCioffietal.,Mav1,2007;emailfromGoldman(ficc-ops-cdopricing)
torervinbear.com,Mav1,2007.
45.BSAMPricingCommitteeminutes,Iune5,2007;RobertErvin,emailtoGregOuentaletal.,Mav
10,2007,showingthatlossesfortheHighGradefundwouldbe7.02ifBSAMusedthepricesLehmans
repodeskwasusing,ratherthan11.45thelosswithoutLehmansmarks.
46. Email from BSAM Hedge Fund Product Management (Generic), Mav 16, 2007, produced bv
IPMorgan.
47. BSAMFCIC-e0000013. An untitled chart produced bv IPMorgan shows losses would have been
over $50 million less; NAV estimate reconciliation chart, produced bv IPMorgan, shows losses would
havebeenalmost$25millionless.
48.BSAMPricingCommitteeminutes,Iune4,2007.
49.RalphCioffi,interviewbvFCIC,October19,2010.
50.RalphCioffi,emailtoIohnGeissinger,Iune6,2007.
51.Schwartz,interview.
52.Ibid.
53.Ibid.;CSEProgramMemorandumtoErikSirriandothersthroughMatthewEichner,Iulv5,2007.
54.CSEProgramMemorandum,Iulv5,2007.
55. CSE Program Memorandum, Iulv 5, 2007; Merrill Lvnch analvsis, Bear Stearns Asset Mgmt:
WhatWentWrong;PaulFriedman,interviewbvFCIC,April28,2010.WhilemostoftheBearStearns
executivesinterviewedbvFCICstaffdidnotrecallthepercentagediscountatwhichthecollateralseized
bvMerrillLvnchwasauctioned,thevdidbelievethatitwassignificant(e.g.,RobertUpton,interviewbv
FCIC,April13,2010).
56.WhiletheHighGradefundwasnotindefault/hadnotmissedanvmargincalls,creditorswere
cutting off its liquiditv bv increasing haircuts or not rolling repo facilities. Bear Stearns Packet dated
Mav30,meetingheldonIune20,producedbvtheSecuritiesandExchangeCommission,p.3;Upton,
interview.
57.WarrenSpector,emailtoMarvKavScucci,April26,2007.
58.Friedman,interview;WarrenSpector,interviewbvFCIC,March30,2010;SamMolinaro,inter-
viewbvFCIC,April9,2010.
59.ThomasMarano,interviewbvFCIC,April19,2010;Spector,interview(onMaranosbeingsentto
Marin).
60.FedChairmanBenS.Bernanke,lettertoFCICChairmanPhilAngelides,December21,2010.
61.IamesCavne,interviewbvFCIC,April21,2010.
62. SEC, Risk Management Reviews of Consolidated Supervised Entities, memo to Erik Sirri and
others, August 3, 2007, p. 2; SEC, Risk Management Reviews of Consolidated Supervised Entities,
memotoErikSirriandothers,Iulv5,2007,p.3,bothproducedbvSEC.
63.Marano,interview.
64.BillIamison,internalemail,Iune21,2007,producedbvFederated.
65. IPMorgan, Directors Risk Policv Committee, Worldwide Securities Services Risk Review, Sep-
tember18,2007;MichaelAlix,interviewbvFCIC,April8,2010.
66. For the downgrades, see Moodvs Investor Service, Announcement: Moodvs Downgrades Sub-
prime First-Lien RMBS, Iulv 10, 2007; Standard & Poors, S&PCorrect: 612 U.S. Subprime RMBS
ClassesPutonWatchNeg;MethodologvRevisionsAnnounced,Iulv11,2007;Standard&Poors,Vari-
ousU.S.First-LienSubprimeRMBSClassesDowngraded,Iulv12,2007,p.2;GlennCostello,U.S.Sub-
primeRatingSurveillanceUpdate,FitchRatings,Iulv2007.
67.FCIC,PreliminarvStaffReport:CreditRatingsandtheFinancialCrisis,Iune2,2010,p.29.
68.StevenEismanandTomWarrack,Standard&PoorsStructuredFinance,Iulv10,2007,teleconfer-
ence,transcript,p.16.
69.AndrewForster,telephoneconversation,Iulv11,2007,transcript,pp.35.
599 Notes to Chapter 13
70.MartinSullivan,interviewbvFCIC,Iune17,2010;SteveBensinger,interviewbvFCIC,Iune16,
2010;RobertLewis,interviewbvFCIC,Iune15,2010;KevinMcGinn,interviewbvFCIC,Iune10,2010;
AndrewForster,EliasHabaveb,andSteveBensinger,testimonvbeforetheFCIC,HearingontheRoleof
Derivatives in the Financial Crisis, dav 2, session 1: American International Group, Inc. and Goldman
SachsGroup,Inc.,Iulv1,2010,transcript,pp.11,6162.
71.ClarenceK.Lee,formermanagingdirectorforComplexandInternationalOrganizations,Office
of Thrift Supervision, testimonv before the FCIC, Hearing on the Role of Derivatives in the Financial
Crisis,dav2,session2:Derivatives:SupervisorsandRegulators,Iulv1,2010,transcript,pp.23235.
72.AlanFrost,interviewbvFCIC,Mav11,2010.
73.IosephCassano,interviewbvFCIC,Iune25,2010.
74. Information Pertaining to the Multi-Sector CDS Portfolio, produced bv AIG, with FCIC staff
calculations.
75.AndrewDavilman,emailtoAlanFrost,subject:Sorrvtobothervouon;Frost,emailtoDavil-
man,subject:Re:Sorrvtobothervouon;Davilman,emailtoFrost,subject:Re:Sorrvtobothervou
onallIulv26,2007.
76.GoldmanSachsInternational,CollateralInvoicetoAIGFinancialProductsCorp.,Iulv27,2007,
producedbvGoldmanSachs.
77.AIGhedges,Ianuarv2006December2008,producedbvGoldmanSachs.
78.AndrewForster,interviewbvFCIC,Iune23,2010.
79.DanielSparks,interviewbvFCIC,Mav11,2010.
80. Valuation & Pricing Related to Initial Collateral Calls on Transactions with AIG, produced bv
GoldmanSachs.
81.IonLiebergallandAndrewForster,telephoneconversation,Iulv30,2007,transcript,pp.4024.
82.DavidViniar,writtentestimonvfortheFCIC,HearingontheRoleofDerivativesintheFinancial
Crisis,dav2,session1:AmericanInternationalGroup,Inc.andGoldmanSachsGroup,Inc.,Iulv1,2010,
p.2.
83.LiebergallandForster,telephoneconversation,Iulv30,2007,transcript,p.407.
84.TomAthan,emailtoAndrewForster,August1,2007.
Chapter 13
1.HenrvPaulson,quotedinKevinCarmichaelandPeterCook,PaulsonSavsSubprimeRoutDoesnt
ThreatenEconomv,Bloomberg,Iulv26,2007.
2.MoodvsInvestorsService,MoodvsABCPProgramIndex:CPOutstandingasof06/30/2007.
3.MoodvsInvestorsService,MoodvsPerformanceOverview:RhinelandFundingCapitalCorpora-
tion,Iune30,2007.
4.Asnoted,intheUnitedStates,therewasaminimalcapitalchargeforliquiditvputsequalto10of
the base 8, or 0.8. Staff of Bundesanstalt fur Finanzdienstleistungsaufsicht (the Federal Financial
ServicesSupervisorvAuthoritv,Germanvsbankregulators),interviewbvFCIC,September8,2010.See
also OfficeoftheComptrolleroftheCurrencv,InteragencvGuidanceontheEligibilitvofAsset-Backed
CommercialPaperLiquiditvFacilitiesandtheResultingRisk-BasedCapitalTreatment,August4,2005.
Forexample,Citigroupwouldhaveheld$200millionincapitalagainstpotentiallossesonthe$25billion
inliquiditvputexposurethatithadaccumulatedonCDOsithadissued.
5.IKB,2006/2007AnnualReport,Iune28,2007,p.78.
6. Securities Fraud Complaint, Securities and Exchange Commission v. Goldman Sachs & Co. and
FabriceTourre,no.10-CV-3229(S.D.N.Y.April15,2010),p.6.
7. IKB staff, interview bv FCIC, August 27, 2010; Securities and Exchange Commission (plaintiff)
v. Goldman Sachs & Co. and Fabrice Tourre (defendants), Securities Fraud Complaint, 10-CV-3229,
UnitedStatesDistrictCourt,SouthernDistrictofNewYork,April15,2010,at17,paragraph58.
8. Preliminarv results for the first quarter (1April-30 Iune 2007)
9. IKB staff, interview; IKB, clarification of interview bv FCIC, November 15, 2010; IKB, restated
2006/2007AnnualReport,p.5.
10.StevenMeier,testimonvbeforetheFCIC,HearingontheShadowBankingSvstem,dav2,session
3:InstitutionsParticipatingintheShadowBankingSvstem,Mav6,2010,transcript,p.307.
, IKBpressrelease,Iulv20,2007.
600 Notes to Chapter 13
11. Angelo Mozilo, testimonv taken bv the SEC in the matter of Countrvwide Financial Corp., File
No.LA-03370-A,November9,2007,pp.150,3637.
12.AngeloMozilo,emailtoLvleGramlev,memberofBoardofCountrvwideFinancialCorporation
(ccMichaelPerrv,chiefexecutiveofficer,IndvMacBank),August1,2007.
13. Eric Sieracki, quoted in Mark DeCambre, Countrvwide Defends Liquiditv, TheStreet.com, Au-
gust2,2007.
14. Minutes of a Special Telephonic Meeting of the Board of Directors of Countrvwide Financial
Corporation,August6,2007,pp.1,2,1.
15.FedChairmanBenBernanke,lettertoFCICChairmanPhilAngelides,December21,2010.
16.FederalReserveStaff,memotoBoardofGovernorsoftheFederalReserveSvstem,Background
onCountrvwideFinancialCorporation,August14,2007,pp.12.
17.Ibid.,pp.1213.
18.CountrvwideFinancialCorporation,Form8-K,Exhibit99.1,filedAugust6,2007.SeealsoMin-
utesofaSpecialTelephonicMeetingoftheBoardsofDirectorsofCountrvwideFinancialCorporation
andCountrvwideBank,FSB,August15,2007.
19.AngeloMozilo,interviewbvFCIC,September24,2010.
20.KennethBruce,LiquiditvIstheAchillesHeel,MerrillLvnchAnalvstReport,August15,2007,p.
4; Kenneth Bruce, Attractive Upside, but Not without Risk, Merrill Lvnch Analvst Report, August 13,
2007,p.4.
21.Mozilo,interview;thearticle,bvE.ScottReckardandAnnetteHaddad,wastitledCreditCrunch
Imperils Lender: Worries Grow about Countrvwides Abilitv to Borrowand Even a Possible Bank-
ruptcv.
22.AngeloMozilo,quotedinOneonOnewithAngeloMozilo,ChairmanandCEOofCountrvwide
Financial,^ightly Business Report, PBS, August 23, 2007, transcript; and in CEO Exclusive: Countrv-
wideCEO,Pt.1,The Call, CNBC,interviewbvMariaBartiromo,August23,2007,transcript,p.1.
23.SebastianBovd,BNPParibasFreezesFundsasLoanLossesRoilMarkets,Bloomberg, August9,
2007.
24. BNP Paribas Investment Partners Temporallv [sic] Suspends the Calculation of the Net Asset
Valueofthefollowingfunds:ParvestDvnamicABS,BNPParibasABSEURIBORandBNPParibasABS
EONIA,BNPParibaspressrelease,August9,2007.
25.PaulA.McCullev,testimonvbeforetheFCIC,HearingontheShadowBankingSvstem,dav2,ses-
sion3:InstitutionsParticipatingintheShadowBankingSvstem,Mav6,2010,pp.237,309.
26.DanielM.Covitz,NellieLiang,andGustavoA.Suarez,TheEvolutionofaFinancialCrisis:Panic
intheAsset-BackedCommercialPaperMarket,August24,2009,p.39.
27.Ibid.,figure1,panelB,p.33.
28. The Federal Reserve Is Providing Liquiditv to Facilitate the Orderlv Functioning of Financial
Markets,FederalReserveBoardpressrelease,August10,2007.
29.FederalReserveBoard,pressrelease,August17,2007.
30. Henrv Tabe, Moodvs Investors Service, SIVs: An Oasis of Calm in the Sub-prime Maelstrom:
StructuredInvestmentVehicles,InternationalStructuredFinance:SpecialReport,Iulv20,2007,p.1.
31.Ibid.
32.HenrvTabe,interviewbvFCIC,October4,2010.
33. Moodvs Investors Service, From Illiquiditv to Liquiditv: The Path Toward Credit Market Nor-
malization,MoodvsInternationalPolicvPerspectives,September5,2007,p.1.
34.Tabe,interview.
35.MoodvsInvestorsService,MoodvsUpdateonStructuredInvestmentVehicles,MoodvsSpecial
Report,Ianuarv16,2008,p.12.
36.InformationprovidedtotheFCICbvDeloitteLLPscounsel,August2,2010.
37. Moodvs Rating Action, Sigma Finance, September 30, 2008; Henrv Tabe, The Unravelling of
Structured Investment Vehicles. How Liquidity Leaked through SIVs. Lessons in Risk Management and Reg-
ulatory Oversight ([Chatham,Kent]:ThothCapital,2010),p.60.
38.TheSECindicateditisawareofatleast44monevmarketfundsthatweresupportedbvaffiliates
becauseofSIVinvestments.SeeSecuritiesandExchangeCommission,MonevFundReform(Proposed
rule),Iune20,2009,p.14n.38.
601 Notes to Chapter 14
39. Christopher Condon and Rachel Lavne, GE Bond Fund Investors Cash Out After Losses from
Subprime,Bloomberg, November15,2007.
40. The identitv of the investor has never been publiclv disclosed. See Shannon D. Harrington and
SreeVidvaBhaktavatsalam,BankofAmericatoLiquidate$12BillionCashFund,Bloomberg, Decem-
ber10,2007.SeealsoMichaelM.Grvnbaum,MortgageCrisisForcestheClosingofaFund,^ew York
Times, December11,2007.
41.RichRokus,portfoliomanageratMarshallMonevMarketFunds,interviewbvCraneData,Money
Fund Intelligence, Iune2009;CraneData,Money Fund Intelligence, Ianuarv2008.
42.CreditSuisseInstitutionalMonevMarketFund,Inc.,NotestoFinancialStatements,December31,
2008,Note3,p.30.
43.FloridaLegislature,OfficeofProgramPolicvAnalvsisandGovernmentAccountabilitv,TheSBA
[StateBoardofAdministration]IsCorrectingProblemsRelatingtoItsOversightoftheLocalGovern-
mentInvestmentPool,ResearchMemorandum,March31,2009,p.2.
44. SBA report, Update on Sub-Prime Mortgage Meltdown and State Board of Administration In-
vestments,November9,2007,pp.72122.
Chapter 14
1.BloombergProfessional,WritedownsandCreditLossesvs.CapitalRaised(WDCI)function,data
reportedforsecondhalfof2007.Write-downsareforlosses toholdingsinstructuredfinanceandmort-
gages.
2.RovC.Smith,Paper Fortune$. Modern Vall Street. Vhere Its Been and Vhere Its Going (NewYork:
St.Martins2009),p.341.
3.BloombergHistoricalPricesIndexDecember31,2007;CGS1U5;CBSC1U5;andCLEH1U5.Fig-
uresrefertocreditdefaultswapsonfive-vearseniordebt.
4.PresentationtoMerrillLvnch&Co.BoardofDirectors,LeveragedFinanceandMortgage/CDO
Review,October21,2007,p.23.
5.PresentationtoMerrillboard,October21,2007,p.23.
6.DowKim,interviewbvFCIC,September10,2010.
7.PresentationtoMerrillBoardofDirectors,October21,2007,p.23.
8.Ibid.,pp.2324.
9.PresentationtoMerrillLvnchRiskOversightCommittee,MarketRiskManagementUpdate,Sep-
tember26,2007,p.7.
10.MerrillLvnch,1O2007EarningsCalltranscript,April19,2007,p.3.
11.MerrillLvnch,2O2007EarningsRelease,Iulv17,2007,p.1.
12.MerrillLvnch,2O2007EarningsCalltranscript,Iulv17,2007,pp.8,20.
13.MerrillLvnchFinanceCommitteeSummarv,Iulv22,2007,p.7.
14.Ibid.
15.Kim,interview.
16.StanlevONeal,interviewbvFCIC,September16,2010.
17.ABSCDOUpdatebvDaleLattanzio,Iulv2007,p.10.
18.ONeal,interview.
19.MerrillLvnch,3O2007EarningsCalltranscript,October24,2007,pp.7,10.
20.SECnarrativechronologv,MerrillLvnchspecific,p.1.
21. Nancv Moran and Rodnev Yap, ONeal Ranks No. 5 on Pavout List, Group Savs: Table (Up-
date1),Bloomberg, November2,2007.
22.Kiminterview;MerrillLvnch,2007ProxvStatement,April27,2007,p.47.
23.CharlesPrince,interviewbvFCIC,March17,2010;RobertRubin,interviewbvFCIC,March11,
2010.
24.Prince,interview.
25. Moodvs Investors Service, Structured Finance Rating Transitions: 19832006, Special Com-
ment,Ianuarv2007.
26.CharlesPrince,testimonvbeforetheFCIC,HearingonSubprimeLendingandSecuritizationand
Government-Sponsored Enterprises (GSEs), dav 2, session 1: Citigroup Senior Management, April 8,
2010,transcript,p.11.
602 Notes to Chapter 14
27.Prince,interview.
28.TobiasBrushammar,IamesHua,GrahamIackson,andSubraViswanathan,Citigroupmemoran-
dumtoNestorDominguez,IaniceWarne,MichaelRavnes,andIo-AnneWilliams,subject:LiquiditvPut
Valuation,October19,2006.
29.SusanMills,interviewbvFCIC,Februarv3,2010;IamesXanthos,interviewbvFinancialIndustrv
RegulatorvAuthoritv(FINRA),March24,2009.
30. Susan Mills, testimonv before the FCIC, hearing on Subprime Lending and Securitization and
Government-SponsoredEnterprises(GSEs),dav1,session2:SubprimeOriginationandSecuritization,
April7,2010,transcript,pp.18687.
31.Mills,interview.
32. Murrav Barnes, former managing director of Independent Risk, interview bv FCIC, March 2,
2010.
33. Notes on Senior Supervisors Meeting with Firms, meeting between Citigroup and Federal Re-
serve Bank of New York, Federal Reserve Board, Office of the Comptroller of the Currencv, Securities
andExchangeCommission,U.K.FinancialServicesAuthoritv,andIapanFSA,November19,2007,p.17.
34. Ianice Warne, interview bv FCIC, Februarv 2, 2010; Nestor Dominguez, interview bv FCIC,
March2,2010.
35.Dominguez,interview.
36.NestorDominguez,testimonvbeforetheFCIC,HearingonSubprimeLendingandSecuritization
and Government-Sponsored Enterprises (GSEs), dav 1, session 3: Citigroup Subprime-Related Struc-
turedProductsandRiskManagement,April7,2010,transcript,pp.28283.
37.Barnes,interview.
38.Ibid.
39. Notes on Senior Supervisors Meeting with Firms, meeting with Citigroup, November 19, 2007,
p.6.
40.FCICstaffcalculations.
41.Prince,testimonvbeforetheFCIC,April8,2010,transcript,p.118;DavidBushnell,interviewbv
FCIC,April1,2010.
42.Bushnell,interview.
43.EllenBebeDuke,CitigroupIndependentRisk,interviewbvFCIC,March18,2010.
44.Barnes,interview.
45.IamesXanthos,interviewbvFinancialIndustrvRegulatorvAuthoritv(FINRA),March24,2009.
46.Barnes,interview.
47.Prince,interview.
48. Robert Rubin, former chairman of the Executive Committee and adviser, interview bv FCIC,
March11,2010.
49.ThomasMaheras,formerco-CEOofCitiMarkets&Banking,interviewbvFCIC,March10,2010.
50.Prince,interview.
51. Citigroup, Presentation to the Securities and Exchange Commission Regarding Overall CDO
BusinessandSubprimeExposure,Iune2007,p.11.
52.Paul,Weiss,Citigroupscounsel,responsetoFCICInterrogatorv#18,March1,2010.
53.Citigroup,2O2007EarningsCallO&Atranscript,Iulv20,2007.
54. Complaint, Securities and Exchange Commission v. Citigroup Inc., 1:10-cv-01277 (D.D.C), Iulv
29,2010.
55. Federal Reserve Board of New York, letter to Vikram Pandit and the Board of the Directors of
Citigroup,April15,2008,p.11.
56.Dominguez,testimonvbeforetheFCIC,April7,2010,transcript,p.281.
57.Maheras,interview,andtestimonvbeforetheFCIC,HearingonSubprimeLendingandSecuriti-
zation and Government-Sponsored Enterprises (GSEs), dav 1, session 3: Citigroup Subprime-Related
StructuredProductsandRiskManagement,April7,2010,transcript,p.269.
58.Bushnell,interview.
59.Prince,interview.
60.Complaint,SecuritiesandExchangeCommissionv.CitigroupInc.,p.13.
61.Maheras,interview.
603 Notes to Chapter 14
62. Prince, interview; Charles Prince, email to Robert Rubin, re, September 9, 2007, 9:43 A.M. (on
ThomasMaherasandsuperseniors).
63. Robert Rubin, email to Charles Prince, September 9, 2007, 5:30 P.M.; Charles Prince, email to
RobertRubin,September9,2007,5:51P.M.
64.RobertRubin,interviewbvFCIC,March11,2010.
65.Prince,interview.
66.Ibid.
67.Citigroup,RiskManagementReview:AnUpdatetotheCorporateAuditandRiskManagement
Committee,October15,2007,p.4.
68.Citigroup,O32007EarningsCalltranscript,October15,2007.
69.Prince,interview.
70.Paul,Weiss,Citigroupscounsel,lettertoFCICinretheFCICssecondandthirdsupplementalre-
quests,March31,2010;Citigroup,2008ProxvStatementforfiscalvear2007,March13,2008,p.74.
71.FederalReserveBoardofNewYork,lettertoVikramPanditandtheBoardofDirectorsofCiti-
group,April15,2008,p.8.
72.FCICstaffcalculationsfromCitigroupproxvstatements(informationfor200006)andinforma-
tionon200709providedbvPaul,Weiss(onbehalfofCitigroup),lettertoFCIC,March31,2010,Re-
sponsetoInterrogatorvNo.7,pp.36.
73.RobertRubin,testimonvbeforetheFCIC,HearingonSubprimeLendingandSecuritizationand
Government-Sponsored Enterprises (GSEs), dav 2, session 1: Citigroup Senior Management, April 8,
2010,transcript,pp.1516.
74.IohnReed,interviewbvFCIC,March24,2010.
75.AIG,EarningsCallcreditsupplement,August9,2007.
76.IosephSt.Denis,lettertoHouseCommitteeonOversightandGovernmentReform,U.S.Houseof
Representatives,October4,2008,p.4.
77.IosephSt.Denis,interviewbvFCIC,April23,2010.
78.GenePark,interviewbvFCIC,Mav18,2010.
79.IakeSun,interviewbvFCIC,Iune21,2010.
80.AlanFrost,interviewbvFCIC,Mav11,2010.
81.PierreMicottis,interviewbvFCIC,Iune24,2010.
82.Park,interview.
83.PricewaterhouseCooperauditteam,memore3O07reviewofAIGssuper-seniorCDSportfolio,
November7,2007,p.2.
84.IosephCassano,interviewbvFCIC,Iune25,2010.
85.Park,interview.
86.GoldmanssubmissionstotheFCIConitsvaluationandpricingrelatedtocollateralcallsmadeto
AIG are available on Goldman Sachss website (http://www2.goldmansachs.com/our-firm/on-the
-issues/responses-fcic.print.html).
87.AndrewForster,telephonecalltoIonLiebergall,Iulv30,2007,transcript.
88.PricewaterhouseCooper,memotoAIGFP20072Oreviewfiles,August8,2007.
89.AndrewForster,emailtoIosephCassanoandPierreMicottis,November9,2007,enclosingmarks
fromMerrillLvnch,
90.AIG,EarningsCallcreditsupplement,August9,2007,pp.28,14,21,22.
91. These estimates are based on Federal Reserve Bank of New York, Maiden Lane III Ouarterlv
Holdings Report, Ianuarv 2010. This probablv isnt a complete list of their positions, because not all
CDOtranchesarepartoftheMaidenLaneIIIportfolio.Ofthe335securitieslistedinthatdocument,
FCICstafffounddataon327inMoodvsCDOEMSdatabaseandBloomberg.Forthose327securities,
313sufferedadowngradeand206becamemateriallvimpaired(i.e.,weredowngradedtoCa/C).Ofthe
139initiallvratedAaa,134suffereddowngradesand55becamemateriallvimpaired.
92.AlanFrost,emailtoAndrewForster,August16,2007.
93.Cassano,interview.
94.Frost,emailtoForster,August16,2007.
95.TomAthan,emailtoAndrewForster,ccAdamBudnick,September11,2007.
96.IosephCassano,emailtoEliasHabaveb,November11,2007.
604 Notes to Chapter 14
97.MinutesofthemeetingoftheAIGAuditCommittee,November6,2007,p.5.
98.AndrewForster,emailtoIosephCassano,subject:GSPricesvsOthers,November18,2007.
99. Goldman, submission to the FCIC, Valuation & Pricing Related to Initial Collateral Calls on
TransactionswithAIG,pp.23.
100.BasedonstaffanalvsisofdataprovidedtotheFCICbvtheDepositorvTrust&ClearingCorpo-
rationandMarkit. ABXincludesalltranchesoftheABX.HE06-2. TABXisconstructedbasedonthe
referenceobligationsforthe06-2and07-1BBBandBBB-tranchesoftheABX.
101.Cassano,interview.
102.AndrewForster,emailtoAlanFrost,August16,2007.
103.TimRvan,PricewaterhouseCooper,interviewbvFCIC,Iune1,2010.
104.SECstaffbriefingofFCICstaff,Iune4,2010.
105. Ioseph Cassano, email to Andrew Forster, Pierre Micottis, Iames Bridgwater, and Peter Robin-
son,subject:Fw:SSCDSValuation,October8,2007.
106. PricewaterhouseCooper, minutes of meeting at AIGFP, October 11, 2007. See also PwC audit
team,memore3O07reviewofAIGssuper-seniorCDSportfolio,November7,2007,pp.23031.
107.AIG,3O2007EarningsCalltranscript,November7,2007,pp.5,17.
108.PwCauditteammemo,p.6.
109. Goldman Sachs International, to AIG Financial Products Corp., Amended Side Letter Agree-
ment,November23,2007.
110. Ioe Cassano, email to Bill Doolev, November 27, 2007, attaching memo from Andrew Forster,
CollateralCallStatus.
111.AndrewForster,CollateralCallStatus,memopreparedforIoeCassano.
112.IoeCassano,emailtoBillDoolev,subject:CollateralCalls,November27,2007.
113.IoeCassano,emailtoBillDoolev,subject:GScallback,November30,2007.
114.GoldmanSachsInternational,CollateralInvoicetoAIGFinancialProductsCorp.,margincall,
November23,2007.
115.PwCauditteam,memo,November7,2007,p.5.
116.PricewaterhouseCooper,notesofameetingtodiscusssuper-seniorvaluationsandcollateraldis-
putes,November29,2007,p.2,producedbvPwC.
117.AndrewForster,interviewbvFCIC,Iune21,2010.
118.MartinSullivan,interviewbvFDIC,Iune17,2010.
119.PwC,notesofmeetingofNovember29,2007,p.2.
120.Ibid.,p.3.
121.KevinMcGinn,emailtoPaulNaravanan,November20,2007.
122.Sullivan,interview.
123.AIGInvestorConferenceCall,December5,2007,transcript,pp.46,25.
124.IosephCassano,emailtoMichaelSherwoodandDavidViniar,subject:CDOValuations,Ianuarv
16,2008.
125.AndrewDavilman,interviewbvFCIC,Iune18,2010;DavidLehman,interviewbvFCIC,Iune
23,2010.
126. AIG/Goldman Sachs Collateral Call Timeline, available on FCIC website at http://fcic.gov/
hearings/pdfs/20100701-AIG-Goldman-supporting-docs.pdf.
127.PricewaterhouseCooper,memotoAIGworkpaperfiles,Februarv24,2008,pp.23,10.
128.PricewaterhouseCooper,notesonaFebruarv6,2008,meetingwithAIG,Februarv13,2008,p.2.
129.MartinSullivan,testimonvbeforetheFCIC,HearingontheRoleofDerivativesintheFinancial
Crisis,dav1,session2:AmericanInternationalGroup,Inc.andDerivatives,Iune30,2010,transcript,p.
233.
130.PricewaterhouseCooper,notesontheAIGAuditCommitteemeeting,Februarv7,2008,p.2.
131.IosephCassano,testimonvbeforetheFCIC,HearingontheRoleofDerivativesintheFinancial
Crisis.dav1,session2:AmericanInternationalGroup,Inc.andDerivatives,Iune30,2010,p.233;Cas-
sano,interview.
132.OfficeofThriftSupervision,lettertoAIGGeneralCounselandBoard,March7,2008.
133.WilliamDudlev,interviewbvFCIC,October15,2010.
605 Notes to Chapter 15
134.AdamB.Ashcraft,MortenL.Bech,andW.ScottFrame,TheFederalHomeLoanBankSvstem:
TheLenderofNexttoLastResort:FederalReserveBankofNewYorkStaffReports,no.357(November
2008),p.4.
135. Federal Reserve Board, October 2007 Senior Loan Officer Opinion Survev on Bank Lending
Practices,October2007.
136.FredericMishkin,interviewbvFCIC,October1,2010.
137.Dudlev,interview.
138.Ibid.
139.Ibid.
140.Standard&Poors,DetailedResultsofSubprimeStressTestofFinancialGuarantors,Ratings-
Direct,Februarv25,2008.
141.AlanRoseman,interviewbvFCIC,Mav17,2010.
142. SEC, Risk Management Reviews of Consolidated Supervised Entities, internal memo to Erik
Sirriandothers,November6,2007,p.3.
143.Roseman,interview,Mav17,2010.
144.SEC,RiskManagementofConsolidatedSupervisedEntities,internalmemotoErikSirriand
others,Ianuarv2,2008,p.2.
145.BillLockver,State of California 2008 Debt Affordability Report. Making the Municipal Bond Mar-
ket Vork for Taxpayers in Turbulent Times (October1,2008),p.4.
146.IohnI.McConnellandAlessioSaretto,AuctionFailuresandtheMarketforAuctionRateSecu-
rities(TheKrannertSchoolofManagement,PurdueUniversitv,April2009),p.10.
147. Erik R. Sirri, director of Trading and Markets, U.S. Securities and Exchange Commission,
MunicipalBoundTurmoil:ImpactonCities,TownsandStates,testimonvbeforetheHouseFinancial
ServicesCommittee,110thCong.,2ndsess.,March12,2008.
148.GeorgetownUniversitv,AnnualFinancialReport,20082009,p.5.
149.IacquelineDohertv,TheSadStorvofAuction-RateSecurities,Barrons,Mav26,2008.
150.SECFinalizesARSSettlementswithBankofAmerica,RBC,andDeutscheBank,SECpressre-
lease,Iune3,2009.
Chapter 15
1. Prime Asset, 2007 Upper HedgeWorld Prime Brokerage League Table, accessible at Gregorv
Zuckerman,HedgeFunds,OnceaWindfall,ContributetoBearsDownfall,Vall Street Iournal,March
17,2008.
2. Ieff Maver and Thomas Marano, Fixed Income Overview, March 29, 2007, p. 8, produced bv
IPMorgan.
3.InsideMortgageFinance,The 2009 Mortgage Market Statistical Annual, vol.2,The Secondary Mar-
ket (Bethesda,MD:InsideMortgageFinance,2009),pp.1825.
4.FCICstaffestimates,basedonMoodvsCDOEMSdatabase.DifferentnumbersareprovidedinIeff
MaverandThomasMarano,FixedIncomeOverview,March29,2007,p.16.
5.SamuelMolinaro,interviewbvFCIC,April9,2010;MichaelAlix,interviewbvFCIC,April8,2010.
6. SEC, Risk Management Reviews of Consolidated Supervised Entities, memorandum to Robert
Colbvandothers,Mav8,2006.
7.RobertUpton,interviewbvFCIC,April13,2010.
8.SEC,RiskManagementReviewsofConsolidatedSupervisedEntities,memorandumtoErikSirri
andothers,March1,2007.
9.Ibid.
10.BearStearns,FitchPresentation,PowerPointslides,August2007.
11.Upton,interview.
12.BearStearns,Form10-KforthevearendedNovember30,2007,filedIanuarv29,2008,pp.52,22.
13.Upton,interview.
14.Ibid.
15.Standard&Poors,GlobalCreditPortalRatingsDirect,ResearchUpdate:BearStearnsCos.Inc.
OutlookRevisedtoNegative;A+/A-1RatingAffirmed,August3,2007.
16.IimmvCavne,interviewbvFCIC,April21,2010.
606 Notes to Chapter 15
17.MatthewEichner,interviewbvFCIC,April14,2010.
18.WendvdeMonchaux,interviewbvFCIC,April27,2010;StevenMever,interviewbvFCIC,April
22,2010.
19.MikeAlix,interviewbvFCIC,April8,2010.
20.Eichner,interview.
21.TimelineRegardingBearStearnsCompaniesInc.,April3,2008,producedbvSEC.
22.SECOfficeofInspectorGeneral,OfficeofAudits,SECsOversightofBearStearnsandRelated
Entities:TheConsolidatedSupervisedEntitvProgram,ReportNo.446-A,September25,2008,pp.ixx.
23.MichaelHalloran,interviewbvFCIC.
24.Cavne,interview.
25. Samuel Molinaro, testimonv before the FCIC, Hearing on the Shadow Banking Svstem, dav 1,
session 1: Investment Banks and the Shadow Banking Svstem, Mav 5, 2010, transcript, p. 43; Cavne,
interview.
26. Changes in Approved Commercial Paper List10/01/200712/31/2007 and Changes in Ap-
provedCommercialPaperList1/01/20083/31/2008,producedbvFederatedAdvisedFunds.
27.FederalReserveBankofNewYork,Tri-PartvRepoInfrastructureReform,whitepaper,Mav17,
2010,p.7.
28.SethCarpenter,interviewbvFCIC,September20,2010.
29.InformationprovidedbvFederatedtotheFCIC.
30.ScottGoebel,KevinGaffnev,andNormLind(Fidelitvemplovees),interviewbvFCIC,Februarv
25,2010.
31.SteveMeier,executivevicepresidentStateStreetGlobalAdvisors,interviewbvFCIC,March15,
2010.
32. Timeline Regarding the Bear Stearns Companies Inc., April 3, 2008, pp. 12, provided to the
FCIC.
33.AlanSchwartz,interviewbvFCIC,April23,2010.
34. Lucian A. Bebchuk et al., The Wages of Failure: Executive Compensation at Bear Stearns and
Lehman20002008,November22,2009,Table2,p.15;SNLFinancial.
35.ThomasMarano,interviewbvFCIC,April19,2010.
36.PaulFriedman,quotedinWilliamCohan,House of Cards. A Tale of Hubris and Vretched Excess
on Vall Street (NewYork:Doubledav,2009),p.71.AlthoughFriedmanacknowledgedtotheFCICmak-
ingthecitedstatements,andmanvothersaswell,heattributesthemtoangerandfrustrationoverBear
Stearnss failure. Currentlv, Friedman is emploved at Guggenheim Securities, Inc., where he works for
AlanSchwartz,theformerpresidentofBearStearns.PaulFriedman,interviewbvFCIC,April28,2010.
37. The Corporate Librarv, The Bear Stearns Companies Inc.: Governance Profile, Iune 20, 2008,
p.4.
38.Cavne,interview.
39.Molinaro,interview.
40.Cavne,interview;Schwartz(interviewbvFCIC)statedthatbonusesforindividualexecutiveswere
discussedbvtheCompensationCommittee,andthefinalrecommendationforbonusescamefromthe
CEO.
41.Alix,interview.
42. Bear Stearns, 2007 Performance Compensation Plan, p. I-1 (provided to the FCIC); Alix, inter-
view.Thesalarvcaphadbeenraisedfrom$200,000to$250,000in2006(Alix,interview;Cavne,inter-
view).
43.Bebchuketal.,TheWagesofFailure,Table1,p.12;Table2,p.15;Table4,p.20.Thebudgetau-
thoritvfortheSECin2008was$906million;in2010,itwas$1.026billion.
44.In2006,Alixreceived$3millionintotalcompensation,Cavnereceivedmorethan$38.3million
insalarvandbonus,andSchwartzreceivedmorethan$35.7millioninsalarvandbonus.SNLFinancial;
interviewswithSpectorandAlix.
45.Marano,interview.
46.TomMarano,emailtoAlanSchwartzandRichieMetrick,Februarv12,2008.
47.MatthewEichner,emailtoIamesGilesetal.,Ianuarv30,2008.
48.LouLebedin,interviewbvFCIC,April23,2010.
607 Notes to Chapter 15
49.TimelineRegardingBearStearnsCompaniesInc.,April3,2008,producedbvSEC.
50.Upton,interview.
51.MinutesofSpecialMeetingofBearStearnsBoardofDirectors,March13,2008.
52.PatLewis,BearStearns,emailtoMatthewEichner,StevenSpurrv,IamesGiles,andKevinSilva,
March10,2008.
53.MatthewEichner,emailtoBrianPeters,March11,2008.
54.DavidFettig,TheHistorvofaPowerfulParagraph,FederalReserveBankofMinneapolis,Iune
2008.
55.IamesEmbersit,emailtoDeborahBailev,March3,2008.
56.InresponsetotheFCICsinterrogatories,IPMorganproducedalistofallpavmentsBearStearns
madetoorreceivedfromOTCderivativescounterpartiesfromMarch10,2008,throughMarch14,2008.
ThespreadsheetwascreatedinSeptember2008bvBearStearnsinresponsetoarequestbvtheSECDivi-
sionofTradingandMarkets.ThelargevolumeofnovationsawavfromBearStearnsduringtheweekof
March 10, 2008 and the previous week was confirmed bv the New York Federal Reserve and Interna-
tional Swaps and Derivatives Association. (New York Federal Reserve personnel, interview bv FCIC;
ISDApersonnel,interviewsbvFCIC,Mav13and27,2010).
57.BrianPeters,emailtoMatthewEichner,March11,2008.
58.StuartSmith,emailtoBearStearns,March11,2008;MarvinWoolard,emailStuartSmithetal.,
March11,2008;KvleBass,interviewbvFCIC,April30,2010.
59.Bass,interview.
60.DebbvLaMov,emailtoFainaEpshtevn,March12,2008;FainaEpshtevn,emailtoDebbvLaMov,
March12,2008.
61.MarvinWoolard,emailtoStuartSmithetal.,March12,2008.
62.CNBCvideo,SchwartzandCNBCsDavidFaber,originalairdateMarch12,2008.
63.YalmanOnaran,BearStearnsInvestorLewisMavIncreaseHisStake,BloombergNews,March
11,2008.
64.MatthewEichner,emailtoErikSirri,RobertColbv,andMichaelMacchiaroli,March12,2008.
65.MinutesofSpecialMeetingofBearStearnsBoardofDirectors,March13,2008,pp.12.
66.Upton,interview.
67.MatthewEichner,emailtoErikSirri,RobertColbv,andMichaelMacchiaroli,March12,2008.
68. Alan Schwartz, interview bv FCIC; Matthew Eichner, email to Erik Sirri, Robert Colbv, and
MichaelMacchiaroli,March13,2008.
69.Upton,interview.
70.MinutesofSpecialMeetingofBearStearnsBoardofDirectors,March13,2008([Schwartz]said
therehadbeenseventeenbilliondollarsincashwithatwobillioneighthundredmilliondollarbackstop,
unsecuredline.TheBoardwastoldthattwelvetofifteenbilliondollarshadgoneoutofTBSCIinthelast
twodavsandthatTBSCIhadreceivedabilliondollarsinmargincalls).
71.Upton,interview;Goebel,Gaffnev,andLind,interview;StevenMeier,interviewbvFCIC,March
15,2010;MichaelMacchiaroli,interviewbvFCIC,April13,2010.
72.ChristopherCox,writtentestimonvfortheFCIC,HearingontheShadowBankingSvstem,dav1,
session3:SECRegulationofInvestmentBanks,Mav5,2010,p.6.
73.TimelineRegardingBearStearnsCompaniesInc.,April3,2008,producedbvSEC.
74.IamieDimon,interviewbvFCIC,October20,2010.
75.AlanSchwartz,testimonvbeforetheFCIC,HearingontheShadowBankingSvstem,dav1,session
2:InvestmentBanksandtheShadowBankingSvstem,Mav5,2010,transcript,p.167;Schwartz,inter-
view.
76.Schwartz.,interview.
77.Ibid.;Molinaro,interview;Alix,interview.
78.IohnChrin,interviewbvFCIC,April28,2010.
79.Dimon,interviewbvFCIC,October20,2010;minutesofSpecialMeetingofBearStearnsBoardof
Directors,March16,2008.
80.FederalReserve,ReportPursuanttoSection129oftheEmergencvEconomicStabilizationActof
2008:LoantoFacilitatetheAcquisitionofTheBearStearnsCompanies,Inc.bvIPMorgan&Co.,pp.1,
4;Ernst&Young,ProjectLLC:SummarvofFindingsandObservationsReport,Iune26,2008,p.10.
608 Notes to Chapter 16
81.Contrarvtowhatisstatedintheboardminutes(SpecialMeetingofBearStearnsBoardofDirec-
tors,March16,2008,p.5),whenFCICstaffinterviewedSchwartzhesaidthatthe$2asharepricecame
fromIPMorgan,notPaulson.SchwartzalsotoldstaffthatbecauseBeardidnotreceivealotofcompet-
ingoffers,ithadtoacceptIPMorgansofferof$2ashare.
82.Chrin,interview.
83.AlanSchwartz,testimonvbeforetheFCIC,HearingontheShadowBankingSvstem,dav1,session
2:InvestmentBanksandtheShadowBankingSvstem,Mav5,2010,transcript,p.142.
84.Macchiaroli,interview.
85.BenBernanke,closed-doorsessionwithFCIC,November17,2009.
86.Ibid.
87.TimothvGeithner,president,FederalReserveBankofNewYork,ActionsbvtheNewYorkFedin
ResponsetoLiquiditvPressuresinFinancialMarkets,preparedtestimonvbeforetheSenateCommittee
onBanking,Housing,andUrbanAffairs,110thCong.,2ndsess.,April3,2008,p.10.
88.HenrvPaulson,testimonvbeforetheFCIC,HearingontheShadowBankingSvstem,dav2,ses-
sion1:PerspectiveontheShadowBankingSvstem,Mav6,2010,transcript,pp.68,59,78.
Chapter 16
1.DavidWong,interviewbvFCIC,October15,2010.
2. IoshFinemanandYalmanOnaran,LehmansFuldSavsWorstIsBehindUsinCrisis(Update3),
Bloomberg,April15,2008.
3. HenrvPaulson,testimonvbeforetheFCIC,HearingontheShadowBankingSvstem,dav2,session
1:PerspectiveontheShadowBankingSvstem,Mav6,2010,transcript,p.28.
4. ViralV.AcharvaandT.SabriOnc,TheDodd-FrankWallStreetReformandConsumerProtec-
tion Act and a Little Known Corner of Wall Street: The Repo Market, Regulating Vall Street, Iulv 16,
2010.
5.SandieOConnor,IPMorgan,interviewbvFCIC,March4,2010.
6. IamieDimon,interviewbvFCIC,October20,2010.
7. Adam Copeland, Antoine Martin, Michael Walker, The Tri-Partv Repo Market Before the 2010
Reforms,FRBNYStaffReportNo.477,November2010,p.24.
8. StevenMeier,testimonvbeforetheFCIC,HearingontheShadowBankingSvstem,dav2,session3:
InstitutionsParticipatingintheShadowBankingSvstem,Mav6,2010,transcript,p.276.
9. WilliamDudlev,interviewbvFCIC,October15,2010.
10. DarrvllHendricks,interviewbvFCIC,August6,2010.
11. IamesCavne,testimonvbeforetheFCIC,HearingontheShadowBankingSvstem,dav1,session
2:InvestmentBanksandtheShadowBankingSvstem,Mav5,2010,transcript,p.168.
12. SethCarpenter,interviewbvFCIC,September20,2010.
13. FederalReserve,RegulatorvReform:PrimarvDealerCreditFacilitv(PCDF),UsageofFederal
Reserve Credit and Liquiditv Facilities, data available at www.federalreserve.gov/newsevents/
reform_pdcf.htm.
14. Anton R. Valukas, Report of Examiner, In re Lehman Brothers Holdings Inc., et al., Chapter 11
CaseNo.08-13555(IMP),(Bankr.S.D.N.Y.),March11,2010,4:139698;quotation,1396(hereaftercited
asValukas;availableathttp://lehmanreport.jenner.com/).
15. WilliamDudlev,emailtoChairman,Iune17,2008.
16. Dimon,interview.
17. Ibid.
18. Hendricks,interview.
19.LucindaBrickler,emailtoPatrickParkinson,Iulv11,2008;LucindaBrickleretal.,memorandum
toTimothvGeithner,Iulv11,2008.
20.The$200billionfigureisnotedinPatrickParkinson,emailtoBenBernankeetal.,Iulv20,2008.
21.Brickleretal.,memorandum,p.1.
22.PatrickParkinson,emailtoLucindaBrickler,Iulv11,2008.
23.PatrickParkinson,emailtoBenBernankeetal.,Iulv20,2008.
24.Ibid.
609 Notes to Chapter 16
25. BasedonchartinFederalReserveBankofNewYork,Developing Metrics for the Four Largest Secu-
rities Firms, August2008,p.5.
26.Ibid.
27.TobiasAdrian,ChristopherBurke,andIamesMcAndrews,TheFederalReservesPrimarvDealer
Credit Facilitv, Federal Reserve Bank of New York, Current Issues in Economics and Finance 15, no. 4
(August2009):2.
28.ErikSirri,interviewbvFCIC,April9,2010,p.3.
29. Fed Chair Ben Bernanke, Lessons from the Failure of Lehman Brothers, testimonv before the
HouseFinancialServicesCommittee,111thCong.,2ndsess.,April20,2010,p.1.
30.Valukas,1:8n.30:ExaminersInterviewofTimothvF.Geithner,Nov.24,2009,p.4.
31.Valukas,4:1486.
32.Sirri,interview.
33.WilliamBrodowsandTilSchuermann,FederalReserveBankofNewYork,PrimarvDealerMon-
itoring:InitialAssessmentofCSEs,Mav12,2008,slides910,1516.
34.FederalReserveBankofNewYork,PrimarvDealerMonitoring:LiquiditvStressAnalvsis,Iune
25,2008,p.3.
35.Ibid.,p.5.
36.Valukas,4:1489.
37.Ibid.,4:1496,1497.
38. Christopher Cox, statement before the House Financial Services Committee, 111th Cong., 2nd
sess.,April20,2010,p.5.
39.PatrickParkinson,emailtoStevenShafran,August8,2008.
40.CounterpartvRiskManagementPolicvGroup,TowardGreaterFinancialStabilitv:APrivateSec-
torPerspective,TheReportoftheCRMPGII,Iulv27,2005.
41. Federal Reserve Bank of New York, Statement Regarding Meeting on Credit Derivatives, Sep-
tember15,2005;FederalReserveBankofNewYork,NewYorkFedWelcomesNewIndustrvCommit-
ments on Credit Derivatives, March 13, 2006; Federal Reserve Bank of New York, Third Industrv
MeetingHostedbvtheFederalReserveBankofNewYork,September27,2006.
42.SeeComptrolleroftheCurrencv,OCCsOuarterlvReportonBankTradingandDerivativesAc-
tivities,FirstOuarter2009,Table1;thefiguresinthetextarereachedbvsubtractingexchangetradedfu-
turesandoptionsfromtotalderivatives.
43.ChrisMewbourne,interviewbvFCIC,Iulv28,2010.
44.Thisfigurecompareswithalowin2005,attheheightofthemortgageboom,of$7billioninprob-
lem assets. Problem institutions are those with financial, operational, or managerial weaknesses that
threatentheircontinuedfinancialviabilitv;thevareratedeithera4or5undertheUniformFinancialIn-
stitutionsRatingSvstem.FDICreportingforinsuredinstitutionsi.e.,theregulatedbankingandthrift
industrvoverall.SeeOuarterly Banking Profile. Fourth Ouarter 2007= FDIC Ouarterly 2,no.1(Decem-
ber31,2007):1,4;Ouarterly Banking Profile. First Ouarter 2008 =FDIC Ouarterly 2,no.2(March31,
2008):2,4;Ouarterly Banking Profile. Second Ouarter 2008 =FDIC Ouarterly 2,no.3(Iune30,2008):1.
45. Bv2009,theproblemlistwouldswellto702banks,withassetsof$403billion.Ouarterly Banking
Profile. Fourth Ouarter 2009 = FDIC Ouarterly 4,no.1(December31,2009):4.
46. Ouarterly Banking Profile. First Ouarter 2008, p.4.
47.RogerCole,interviewbvFCIC,August2,2010.
48.FCICinterviewwithMichaelSolomonandFredPhillips-Patrick,September20,2010.
49.FederalReserveBankofNewYork,lettertoCharlesPrince,April9,2007.
50.FederalReserveBankofNewYork,FederalReserveBoard,OfficeoftheComptrolleroftheCur-
rencv, Securities and Exchange Commission, U.K. Financial Services Authoritv, and Iapan Financial
ServicesAuthoritv,NotesonSeniorSupervisorsMeetingswithFirms,November19,2007,p.3.
51.FederalReserveBoard,FRBNewYork2009OperationsReview:CloseOutReport,p.3.
52. Timothv Geithner, testimonv before the FCIC, Hearing on the Shadow Banking Svstem, dav 2,
session1:PerspectiveontheShadowBankingSvstem,Mav6,2010,transcript,p.210.
53.SteveManzariandDianneDobbeck,interviewbvFCIC,April26,2010.
54.FederalReserveBoard,WachoviaCaseStudv,November12and13,p.20;
55.AngusMcBrvde,interviewbvFCIC,Iulv30,2007.
610 Notes to Chapter 17
56.Thompsonreceivedaseverancepackageworthabout$8.7millionincompensationandacceler-
atedvestingofstock.Inaddition,henegotiatedhimselfthreevearsofofficespaceandapersonalassis-
tantatWachoviasexpense.Thompsonhadpreviouslvreceivedmorethan$21millioninsalarvandstock
compensation in 2007 and more than $23 million in 2006; his total compensation from 2002 through
2008exceeded$112million.
57.FederalReserveBankofRichmond,lettertoWachovia,Iulv22,2008,pp.35.
58.ComptrolleroftheCurrencv,lettertoWachovia,August4,2008,withReportofExamination;let-
ter,pp.8,3.
59.Ibid.,pp.36.
60.Ibid.,letter,p.2;ReportofExamination,p.18.
61.Ibid.,ReportofExamination,p.12.
62. Home Loans Discussion, materials prepared for WaMu Board of Directors meeting, April 18,
2006,p.4;SenatePermanentSubcommitteeonInvestigations, Vall Street and the Financial Crisis. The
Role of High Risk Home Loans, 111thCong.,2ndsess.,April13,2010,Exhibits,p.83.
63. SenatePermanentSubcommitteeonInvestigations,Vall Street and the Financial Crisis. Role of the
Bank Regulators, 111thCong.,2ndsess.,April16,2010,Exhibits,p.6.
64.OTSRegionalDirectorDarrelDochow,lettertoFDICRegionalDirectorStanIvie,Iulv22,2008.
65.OfficesofInspectorGeneral,DepartmentoftheTreasurvandFederalDepositInsuranceCorpo-
ration,EvaluationofFederalRegulatorvOversightofWashingtonMutualBank,ReportNo.EVAL10-
002,April2010,pp.31,12.
66.FDIC,ConfidentialProblemBankMemorandum,September8,2008,p.4.
67.TreasurvandFDICIGs,EvaluationofFederalRegulatorvOversightofWaMu,p.39.
68. Confidential OTS Memorandum to FDIC Regional Director, September 11, 2008; Treasurv and
FDICIGs,EvaluationofFederalRegulatorvOversightofWaMu,pp.4547.
69. OuotedinDamianPaletta,FDICPressesBankRegulatorstoUseWarierEve,Vall Street Iournal,
August19,2008.
70.SheilaBair,interviewbvFCIC,August18,2010.
71.TreasurvandFDICIGs,EvaluationofFederalRegulatorvOversightofWaMu,p.3.
72.ComptrolleroftheCurrencv,Large Bank Supervision. Comptrollers Handbook, Ianuarv2010,p.3.
73.Cole,interview.
74. Rich Spillenkothen, Observations and Perspectives of the Director of Banking Supervision and
RegulationattheFederalReserveBoardfrom1991to2006onthePerformanceofPrudentialSupervi-
sionintheYearsPrecedingtheFinancialCrisis,paperpreparedfortheFCIC,Mav21,2010,p.24.
75.DougRoeder,interviewbvFCIC,August4,2010.
76. Treasurv Releases Blueprint for Stronger Regulatorv Structure, Treasurv Department press re-
lease,March31,2008.
Chapter 17
1.HenrvPaulson,interviewbvFCIC,April2,2010;HenrvPaulson,On The Brink. Inside the Race to
Stop the Collapse of the Global Financial System(NewYork:BusinessPlus,2010),p.57.
2.Paulson,interview.
3.IamesLockhart,testimonvbeforetheFCIC,HearingonSubprimeLendingandSecuritizationand
Government-SponsoredEnterprises(GSEs),dav3,session2:OfficeofFederalHousingEnterpriseOver-
sight,April9,2010,transcript,p.163.
4.DanielMudd,lettertoIamesLockhart,August1,2007,p.1.
5.Ibid.,pp.1,5.
6.DanielMudd,lettertoshareholders,inFannieMae,2007AnnualReport,p.3.
7.ThomasLund,interviewbvFCIC,March4,2010.
8.RobertLevin,interviewbvFCIC,March17,2010.
9.IamesLockhart,lettertoDanielMudd,August10,2007,p.1.
10.IamesLockhart,lettertoSenatorCharlesSchumer,August10,2007.
11. Iames Lockhart, written testimonv for the FCIC, Hearing on Subprime Lending and Securitiza-
tionandGovernment-SponsoredEnterprises(GSEs),dav3,session2:OfficeofFederalHousingEnter-
priseOversight,April4,2010,pp.12,2,12.
611 Notes to Chapter 17
12.Ibid.,pp.2,4,7.
13.Paulson,interview.
14.DavidNason,TonvRvan,andIeremiahNorton,Treasurvofficials,interviewbvFCIC,March12,
2010.
15. Iames Lockhart, quoted in Steven Sloan, Setting an OFHEO Plan, But Wishing Otherwise,
American Banker, December21,2007.
16.FannieMae,Single-FamilvBookCharacteristicsReport,September2008.
17.OFHEOProvidesFlexibilitvonFannieMae,FreddieMacMortgagePortfolios,OFHEOnewsre-
lease,September19,2007,p.1.
18.Lockhart,writtentestimonvfortheFCIC,April4,2010,p.13.
19. Ben Bernanke, quoted in Eric Dash, Fannie Mae to Be Allowed to Expand Its Portfolio, ^ew
York Times,September20,2007.
20.SenatorCharlesE.Schumer,lettertoOFHEODirectorIamesB.LockhartIII,Februarv25,2008;
Schumercontinued,Ifvouhavedecidedthatvouwillbekeepingthecapitalsurchargeinplace . . .,I
would like an explanation as to whv vou think upholding that restriction outweighs the importance of
providing capital relief that could better position the GSEs to provide rescue products for borrowers
stuckinunaffordableloans.
21.FannieMaeReports2007FinancialResults,FannieMaepressrelease,Februarv17,2008.
22.DanielMudd,interviewbvFCIC,March26,2010.
23.RobertSteel,emailtoIeremiahNorton,Februarv28,2008.
24.MichaelFarrell,emailtoRobertSteel,March6,2008.
25.EmailsbetweenRobertK.SteelandDanielMudd,March7,2008.
26.DanielMudd,emailtoRobertLevin,March7,2008.
27.FannieMaeInsolvencvandItsConsequences,p.1;attachmenttoemailfromIasonThomasto
RobertSteel,March8,2008.
28.RobertSteel,emailtoDavidNason,TonvRvan,IeremiahNorton,andNeelKashkari,subject:re:
GSEs,March16,2008.
29.IamesLockhart,interviewbvFCIC,March19,2010.
30.Paulson,interview.
31.IamesLockhart,emailtoDanielH.Mudd,RobertSteel,andDickSvron,subject:Re:announce-
mentdraft,March17,2008.
32.Ibid.
33.OFHEO,FannieMaeandFreddieMacAnnounceInitiativetoIncreaseMortgageMarketLiquid-
itv,OFHEOnewsrelease,March19,2008.
34.Paulson,interview.
35.IoshuaRosner,OFHEOGotRolled,GrahamFisherWeeklvSpew,March19,2008.
36.DonaldBisenius,interviewbvFCIC,September29,2010.
37. Freddie Mac CEO Richard Svron Talks about the Stock Slide, PBS ^ightly Business Report,
Wednesdav,August6,2008,transcript.
38.Lockhart,interview.
39.DanielMudd,letterstoIamesLockhart,August1,2008,andAugust15,2008.
40. Timothv P. Clark (senior adviser, Division of Banking and Supervision, Federal Reserve Board)
andScottAlvarez(generalcounsel,FederalReserveBoard),interviewbvFCIC,Februarv23,2010.
41.BoardGrantsFederalReserveBankofNewYorktheAuthoritvtoLendtoFannieMaeandFred-
dieMacShouldSuchLendingProveNecessarv,FederalReserveBoardpressrelease,Iulv13,2008.
42.Alvarez,interview.
43.TreasurvSecretarvHenrvPaulson,testimonvonGSEinitiatives,Recent Developments in U.S. Fi-
nancial Markets and the Regulatory Responses to Them, SenateCommitteeonBanking,Housing,andUr-
banAffairs,110thCong.,2ndsess.,Iulv15,2008.
44.StatementbvDanielH.Mudd,PresidentandCEO,FannieMaepressrelease,Iulv13,2008.
45.Clark,interview
46.Mudd,interview.
47.Clark,interview.
48.SusanEckert,KevinBailev,andotherOCCstaff,interviewbvFCIC,Februarv19,2010.
612 Notes to Chapter 17
49.Ibid.
50.OfficeoftheComptrolleroftheCurrencv,ObservationsAllowanceProcessandMethodologv,
August2008(lastrevisedSeptember8,2008),p.3.
51.Paulson,interview.
52.ChristopherH.Dickerson(FHFAActingDeputvDirector,DivisionofEnterpriseRegulation),let-
tertoDanielH.Mudd(PresidentandCEOofFannieMae),Re:NoticeofProposedCapitalClassifica-
tion at Iune 30, 2008, August 22, 2008, pp. 1, 2; Christopher H. Dickerson (FHFA Acting Deputv
Director, Division of Enterprise Regulation), letter to Richard F. Svron (President and CEO of Freddie
Mac),Re:NoticeofProposedCapitalClassificationatIune30,2008,August22,2008.
53.DraftMid-vearLetter,pp.1113(quotation,p.13),attachedtoChristopherH.Dickerson,let-
tertoDanielH.Mudd,September4,2008.
54.DickersontoMudd,September4,2008;ChristopherH.Dickerson,lettertoRichardSvron,Sep-
tember4,2008,withDraftMidYearLetterattached.
55.DraftMid-vearLetter(Fannie),pp.57.
56.Ibid.,p.5.
57.Ibid.,p.6.
58.Ibid.,pp.910.
59.DraftMidYearLetter(Freddie),pp.1,12,7.
60.Ibid.,p.8.
61.Mudd,interview.
62.ChristopherH.DickersontoIamesB.LockhartIII,memorandum,ProposedAppointmentofthe
Federal Housing Finance Agencv as Conservator for the Federal Home Loan Mortgage Corporation,
September 6, 2008 (hereafter Freddie conservatorship memorandum); Christopher H. Dickerson to
IamesB.LockhartIII,memorandum,ProposedAppointmentoftheFederalHousingFinanceAgencvas
ConservatorfortheFederalNationalMortgageAssociation,September6,2008(hereafterFanniecon-
servatorshipmemorandum).
63.Paulson,interview;Lockhart,interview;Paulson,On the Brink, p.8.
64.Lockhart,testimonvbeforetheFCIC,April9,2010,transcript,p.191.
65.Paulson,interview;Paulson,On the Brink, p.10.
66.Paulson,On the Brink, p.10.
67.Lund,interview.
68.Levin,interview.
69.Mudd,interview.
70.FHFA,Fannieconservatorshipmemorandum,pp.2,29.
71.FHFA,Freddieconservatorshipmemorandum,pp.3,29.
72.Svron,interview.
73.DanielMudd,testimonvbeforetheFCIC,HearingonSubprimeLendingandSecuritizationand
Government-Sponsored Enterprises (GSEs), dav 3, session 1: Fannie Mae, April 9, 2010, transcript,
p.38.
74.PaulNash,FDIC,lettertoFCIC,providingresponsestofollow-upquestionstoSheilaBairstesti-
monvduringtheSeptember2,2010,hearing,p.5.
75.Paulson,interview.
76.NeelKashkari,interviewbvFCIC,November2,2010.
77. Tom Baxter, interview bv FCIC, April 30, 2010; Kevin Warsh, interview bv FCIC, October 28,
2010.
78.Warsh,interview.
79.Lockhart,testimonvbeforetheFCIC,April9,2010,transcript,p.232.
80.StaffoftheFederalReserveSvstem,DivisionofBankingSupervisionandRegulation,memoran-
dumtotheBoardofGovernors,StressScenariosonBankExposurestoGovernmentSponsoredEnter-
prise(GSE)Debt,Ianuarv24,2005,p.5.
81.DanielMudd,writtentestimonvfortheFCIC,HearingonSubprimeLendingandSecuritization
andGovernment-SponsoredEnterprises(GSEs),dav3,session1:FannieMae,April9,2010,p.3.
82. Iohn Kerr, Scott Smith, Steve Corona (FHFA examination manager), and Alfred Pollard (FHFA
generalcounsel),groupinterviewbvFCIC,March12,2010.
613 Notes to Chapter 18
83.Lockhart,interview.
84.EdwardDeMarco,interviewbvFCIC,March18,2010.
85.Mudd,interview.
86.HenrvCisneros,interviewbvFCIC,October13,2010.
87.Mudd,testimonvbeforetheFCIC,April9,2010,transcript,p.104.
88.RobertLevin,testimonvbeforetheFCIC,HearingonSubprimeLendingandSecuritizationand
Government-Sponsored Enterprises (GSEs), dav 3, session 1: Fannie Mae, April 9, 2010, transcript,
p.104.
Chapter 18
1.IosephSommer,counsel,FederalReserveBankofNewYork,emailtoPatrickM.Parkinson,deputv
research director, Board of Governors of the Federal Reserve Svstem, et al., Re: another option we
shouldpresentretripartv:Iulv13,2008.
2.IamesDimon,interviewbvFCIC,October20,2010.
3.BarrvZubrow,testimonvbeforetheFCIC,HearingonTooBigtoFail:ExpectationsandImpactof
ExtraordinarvGovernmentInterventionandtheRoleofSvstemicRiskintheFinancialCrisis,dav1,ses-
sion2:LehmanBrothers,September1,2010,p.212.
4.RichardS.FuldIr.,testimonvbeforetheFCIC,HearingonTooBigtoFail:ExpectationsandImpact
ofExtraordinarvGovernmentInterventionandtheRoleofSvstemicRiskintheFinancialCrisis,dav1,
session2:LehmanBrothers,September1,2010,p.148.SeealsoFuldswrittentestimonvatsamehearing,
p.6.
5.BenBernanke,testimonvbeforetheFCIC,HearingonTooBigtoFail:ExpectationsandImpactof
ExtraordinarvGovernmentInterventionandtheRoleofSvstemicRiskintheFinancialCrisis,dav2,ses-
sion1:TheFederalReserve,September2,2010,transcript,pp.26,89.
6.KennethD.Lewis,interviewbvFCIC,October22,2010.
7.Bernanke,testimonvbeforetheFCIC,September2,2010,p.22.
8. Bernanke told the examiner that the Federal Reserve, the SEC, and markets in general viewed
Lehmanasthenextmostvulnerableinvestmentbankbecauseofitsfundingmodel.AntonR.Valukas,
ReportofExaminer,In re LehmanBrothersHoldingsInc.,etal.,Debtors,Chapter11CaseNo.08-13555
(IMP),(Bankr.S.D.N.Y.),March11,2010,2:631(hereaftercitedasValukas);seealso1:5andn.16,2:609
andnn.213334,4:1417andn.5441,4:1482andn.5728,4:1494,and5:1663andn.6269.Paulson,2:632.
GeithnertoldtheexaminerthatfollowingBearStearnssnearcollapse,heconsideredLehmantobethe
most exposed investment bank, 2:631; see also 1:5 and n. 16, 2:609, 4:1417 and n. 5441, 4:1482 and
n. 5728, 4:1491 and n. 5769, and 5:1663 and n. 6269. Cox reported that after Bear Stearns collapsed,
LehmanwastheSECsnumberonefocus;1:5andn.16,andp.1491andn.5769;seealso2:609,631.
9.TimothvGeithner,quotedinValukas,1:8andn.30,4:1496.
10. Donald L. Kohn, email to Bernanke, Re: Lehman, Iune 13, 2008. Valukas, 2:615; 2:609 and n.
2134.
11.HarvevR.Miller,bankruptcvcounselforLehmanBrothers,interviewbvFCIC,August5,2010;
Lehmanboardminutes,September14,2008,p.34.
12.ErikR.Sirri,interviewbvFCIC,April1,2010.
13.PaoloR.Tonucci,interviewbvFCIC,August6,2010.
14.Specificallv,Lehmandrew$1.6billiononMarch18;$2.3billiononMarch19and20;$2.7billion
onMarch24;$2.1billiononMarch25and26;and$2billiononApril16.LehmanBrothers,Presenta-
tion to the Federal Reserve: Update on Capital, Leverage & Liquiditv, Mav 28, 2008, p. 15. See also
RobertAzerad,vicepresident,LehmanBrothers,2008O2LiquiditvPosition(Iune6,2008),p.3.Af-
teritsbankruptcv,Lehmandrew$28billion,$19.7billion,and$20.4billion,onSeptember15,16,and
17, until Barclavs replaced the Fed in providing financing. Valukas, 4:1399. See also David Weisbrod,
seniorvicepresident,TreasurvandSecuritiesServicesRiskManagement,IPMorganChase&Co.,email
toIamesDimonetal.,Re:TriPartvClose,September15,2008.
15. Thomas A. Russo, former vice chairman and chief legal officer, Lehman Brothers, email to
RichardS.FuldIr.,forwardingarticlebvIohnBrinslev(originallvsenttoRussobvRobertSteel),Paul-
son Savs Investment Banks Making Progress in Raising Funds, Bloomberg, Iune 13, 2008 (quoting
RobertSteel),Iune13,2008.
614 Notes to Chapter 18
16.RichardS.FuldIr.,interviewbvFCIC,April28,2010.
17.Valukas,2:713andnn.276465,2:715andn.2774.SeealsoRusso,emailtoFuld,Fw:Rumorsof
hedgefundputtingtogetheragrouptohaveanotherrunatLehman,March20,2008(forwardingdis-
cussionswithSECregardingshortsellers).
18. Dan Chaudoin, Bruce Karpati, and Stephanie Shuler, Division of Enforcement, SEC, interview bv
FCIC,April6,2010;MarvL.Schapiro,chairman,SEC,writtenresponsestowrittenquestionsspecificallv,
responsetoquestion13fromFCIC,askedafterthehearingonIanuarv14,2010.
19. Iesse Eisinger, The Debt Shuffle: Wall Street Cheered Lehmans Earnings, but There Are Oues-
tionsaboutItsBalanceSheet,Portfolio.com,March20,2008.
20.DavidEinhorn,GreenlightCapital,PrivateProfitsandSocializedRisk,speechatGrantsSpring
InvestmentConference,April8,2008,p.9.SeealsoDavidEinhorn,AccountingIngenuitv,speechatIra
W.SohnInvestmentResearchConference,Mav21,2008,pp.34.
21.NellMinow,interviewbvFCIC,September13,2010.
22. Nell Minow, testimonv before the House Committee on Oversight and Government Reform,
HearingonLehmanBrothers,110thCong.,2ndsess.,October6,2008.
23. Kirsten I. Harlow, email to Timothv Geithner et al., On-Site Primarv Dealer Update: Iune 16,
Iune16,2008.
24.WilliamDudlev,emailtoTimothvGeithner,DonaldKohn,andothers,Iune17,2008.
25. Kirsten I. Harlow, email to Kevin D. Coffev, examining officer, FRBNY, et al., On-Site Primarv
DealerUpdate:Iune19,Iune19,2008.
26.ThomasFontana,Citigroup,emailtoChristopherM.Foskett,Citigroup,etal., Iune12,2008.
27.TimClark,FederalReserve,emailtoKevinCoffev,FederalReserve,etal.,Iune20,2008.
28.FederalReserveBankofNewYork,PrimarvDealerMonitoring:LiquiditvStressAnalvsis,Iune
25,2008.
29.BasedonchartinFederalReserveBankofNewYork,DevelopingMetricsfortheFourLargest
SecuritiesFirms,August2008,p.9.
30.FederalReserveBankofNewYork,PrimarvDealerMonitoring:LiquiditvStressAnalvsis,Iune
25,2008.
31.KarlMocharko,assistantvicepresidentandseniortrader,FederatedInvestors,Inc.,emailtoGail
Shanlev, Federated Investors, Inc., et al., Re: Federated SubCustodial AgreementIPMCs comments,
Iulv10,2008;CharlesWitek,FederatedInvestors,Inc.,emailtoGeorgeV.VanSchaick,LehmanBroth-
ers, et al., FW: Federated SubCustodial AgreementIPMCs comments, April 23, 2008. Despite the
FRBNYsobservation,FederateddidnotfullvterminateitsreporelationshipswithLehman.Infact,asof
September 12, Federateds repo exposure to Lehman was $2 billion, as reported in the Commissions
MarketRiskSurvevofmonevmarketmutualfunds.
32. Patrick M. Parkinson, email to David Marshall, et al., Iulv 11, 2008; David Marshall, email to
PatrickM.Parkinson,Iulv11,2008.
33.Valukas,4:149798(quotingTimothvGeithner);seealsoBartMcDade,presidentandchiefoper-
atingofficer,LehmanBrothers,interviewbvFCIC,April16,2010.
34.WilliamDudlev,emailtoGeithneretal.,Re:LehmanGoodBank/BadBankideadiscussedlast
night,Iulv15,2008.
35.PatrickM.Parkinson,emailtoStevenShafran,DepartmentoftheTreasurv,etal.,Fw:Gameplan
andStatustoDate,August19,2008.
36.PatrickM.Parkinson,emailtoStevenShafran,August11,2008.
37. Patrick M. Parkinson, email to Arthur Angulo, Theodore Lubke, Til Schuermann, and William
Brodows,August15,2010.
38.WilliamBrodows,emailtoPatrickParkinson,August15,2008.
39.Ibid.
40.Ibid.
41.Parkinson,emailtoStevenShafran,August19,2008.
42.Ibid.
43.StevenShafran,emailtoPatrickM.Parkinson,August28,2008.
44.PatrickM.Parkinson,emailtoTheodoreLubke,September5,2008.
615 Notes to Chapter 18
45.EmilCornejo,seniorvicepresident,DepartmentoftheTreasurv,LehmanBrothers,emailtoIanet
Birnev,seniorvicepresident,DepartmentoftheTreasurv,LehmanBrothers,etal.,IPMorganAgenda
forwarded for our review. FYI, September 3, 2008. See Lehman Briefing Memorandum, September 4,
2008;IPMorganAgenda,September4,2008.
46.MegMcConnell,FRBNY,emailtoArthurAnguloetal.,Meetingtomorrowat9:00,September8,
2008.
47.Ibid.
48.PatrickM.Parkinson,emailtoStevenShafran,Re:nowIamonaconfcall,September9,2008.
49.HenrvM.PaulsonIr.,On the Brink. Inside the Race to Stop the Collapse of the Global Financial Sys-
tem (NewYork:BusinessPlus,2010),p.178;RitaC.Proctor,assistanttothechairman,BoardofGover-
norsoftheFederalReserve,emailtoDonaldL.Kohnetal.,Thiseveningsconferencecallwilltakeplace
at5P.M. insteadof6P.M.,September9,2008.
50.IimWilkinson,emailtoMicheleDavis,September9,2008.
51.BarrvZubrow,interviewbvFCIC,August19,2010.
52.Paul,Weiss,counseltoStevenBlack,lettertoFCIC,August27,2007,writtenresponsestoFCIC
questionsinemailofAugust26,2007,p.6.
53. Iohn I. Hogan, IPMorgan Chase & Co., email to Steven D. Black, September 9, 2008, 7:07 P.M.;
Steven Black, email to Iohn Hogan, September 9, 2008, 8:24 P.M. See also Valukas, 4:1139, 1140 and
n.4204,and1141.
54. Complaint, In re Lehman Brothers Holdings, Inc., et al., against IPMorgan Chase Bank, N.A.,
Chapter 11 Case No. 08-13555 (IMP) (Bankr. S.D.N.Y. Mav 26, 2010), pp. 1415 (hereafter cited as
LehmanComplaint).
55.Ibid.
56.Blackresponses,August27,2010,p.6.
57.MatthewRutherford,emailtoTonvRvan,DepartmentoftheTreasurv,etal.,September10,2008.
58.MarkVanDerWeide,assistantgeneralcounsel,BoardofGovernorsoftheFederalReserveSvstem,
emailtoScottG.Alvarez,generalcounsel,BoardofGovernorsoftheFederalReserveSvstem,lehman,
September10,2008.
59.PatriciaMosser,emailtoWilliamDudlevetal.,thoughtsonLehman,September10,2008.
60.SeeMichaelNelson,counselandvicepresident,FRBNY,emailtoChristineCumming,firstvice
president,FRBNY,etal.,revisedLiquidationConsortiumgameplan+questions,September10,2008,
(attachinggameplan),
61. See Patrick M. Parkinson, email to Donald Kohn et al., Fw: revised Liquidation Consortium
gameplan+questions,September11,2008(attachinggameplan).
62.Ibid.;ThomasBaxter,interviewbvFCIC,August11,2010.
63.KenLewis,interviewbvFCIC,October22,2010.
64.SusanMcCabe,GoldmanSachsGroup,Inc.,emailtoWilliamDudlevetal.,Hopevouhavethe
Radarscreensonearlvthismorning,September11,2008.
65.RitaC.Proctor,emailtoBernanke,Fw:FinancialMarketsConferenceCall9/11/08,September
11,2008(forwardingtoChairmanBernankematerialsfortheconferencecall).
66.HavlevBoeskv,vicepresident,MarketsGroup,FRBNY,emailtoMegMcConnelletal.,forwarding
LouisBacon,emailtoHavlevBoeskv,FW:Optionsforshort-circuitingthemarket,September11,2008,
10:46A.M.
67. Email chain between Iamie McAndrews, Tobias Adrian, Patrick Parkinson and Ieff Stehm, sub-
ject :Fw :DefaultManagementGroup9Sep2008.doc,September11,2008.
68.HavlevBoeskv,emailtoDebbvPerelmuter,seniorvicepresident,FRBNY,etal.,Panic,Septem-
ber11,2008.
69. Iane Buvers-Russo, managing director, IP Morgan, email to Paolo R. Tonucci, Fw: Letter to
Lehman, Sept. 11, 2008, (attaching IPMorgan Chase & Co.s September 11, 2008, Notice to Lehman
BrothersHoldingsInc.).
70. Iane Buvers-Russo, email to Brvn Thomas, executive director, Broker Dealer Group, IPMorgan
Chase&Co.,etal.,Re:LehmanBrothersTriPartvCollateral,September12,2008.
71.PaoloR.Tonucci,interviewbvFCIC,August6,2010.
72.SeeValukas,4:115865,1162andn.4304.
616 Notes to Chapter 18
73.LehmanComplaint,pp.2223,paragraphs68,71.
74.BarrvZubrow,writtentestimonvfortheFCIC,HearingonTooBigtoFail:ExpectationsandIm-
pact of Extraordinarv Government Intervention and the Role of Svstemic Risk in the Financial Crisis,
dav1,session2:LehmanBrothers,September1,2010,p.7.
75.RichardS.Fuld,interviewbvFCIC,August24,2010.
76.LehmanComplaint,p.23,paragraph70.
77.IimWilkinson,emailtoAbbvAderman,RussellRevnoldsAssociates,Re:PaulsonStatementon
TreasurvandFHFAActiontoProtectFinancialMarketsandTaxpavers,September12,2008.
78.KevinM.Warsh,e-mailtoI.NellieLiang,seniorassociatedirector,DivisionofResearchandSta-
tistics,BoardofGovernorsoftheFederalReserveSvstem,September12,2008.
79.Valukas,2:618.
80.HarvevR.Miller,interviewbvFCIC,August5,2010.
81.TomBaxter,Speakingnotes:FinancialCommunitvMeeting,attachedtoemailfromHelenAv-
ala,NYFRB,toStevenShafron,Treasure,September12,2008.
82.ThomasC.Baxter,interviewbvFCIC,August11,2010.
83.H.RodginCohen,interviewbvFCIC,August5,2010.
84.Parkinson,emailtoKohnetal.,September11,2008.
85.FinancialServicesAuthoritvoftheUnitedKingdom,StatementoftheFinancialServicesAuthor-
itvbeforetheLehmanbankruptcvexaminer,pp.45,paragraph23.
86.Paulson,On the Brink, p.193.
87.PatrickM.Parkinson,emailtoLucindaBrickler,seniorvicepresident,pavmentspolicv,FRBNY,
Re:tripartvrepothoughtsforthisweekend,September12,2008.
88.PatrickM.Parkinson,interviewbvFCIC,August24,2010;seealsoPatrickM.Parkinson,emailto
LucindaBrickleretal.,Re:anotheroptionweshouldpresentretripartv:Iulv13,2008.
89.IohnThain,interviewbvFCIC,September17,2010.
90.ChristopherTsuboi,examiner,banksupervision/operationalrisk,FRBNY,emailtoAlejandroLa-
Torre, assistant vice president, Credit, Investment and Pavment Risk Group, FRBNY, memo re:
Lehmansinter-companvdefaultscenario,September13,2008.
91. Scott Alvarez, email to Ben Bernanke et al., Re: Fw: todav at 7:00 p.m. w/Chairman Bernanke,
ViceChairmanKohnandOthers,September13,2008.
92.ScottAlvarez,emailtoMarkVanDerWeide,Re:tri-partv,September13,2008.
93.BartMcDade,interviewbvFCIC,August9,2010.
94.Baxter,interview.
95.Paulson,On the Brink, p.207.
96.Baxter,interview;RobertDiamond,interviewbvFCIC,November15,2010.
97.Paulson,On the Brink, pp.21213.
98.FinancialServicesAuthoritvoftheUnitedKingdom,StatementoftheFinancialServicesAuthor-
itvbeforetheLehmanbankruptcvexaminer,p.9,paragraph48.
99.Paulson,On the Brink, pp.20910.SeealsoBaxter,interview.
100.Baxter,interview.
101.IimWilkinson,emailtoIesStalev,September14,2008,7:46A.M.
102.IimWilkinson,emailtoIesStalev,September14,2008,9:00A.M.
103.Paulson,On the Brink, p.210.
104. Alistair Darling, quoted in United Kingdom Press Association, Darling Vetoed Lehman Bros
Takeover,Belfast Telegraph,October9,2010.
105.H.RodginCohen,interviewbvFCIC,August5,2010.
106.BartMcDade,interviewbvFCIC,August9,2010.
107.AlexKirk,interviewbvFCIC,August16,2010;McDade,interview,August9,2010.
108.Baxter,interview.
109.ThomasC.Baxter,lettertoFCIC,October15,2010,attachingExhibit6,IamesP.Bergin,emailto
WilliamDudlevetal.,Bankruptcv,September14,2008.SeealsoKirk,interview.
110. Ibid., attaching Exhibit 5, Lehman Brothers Holdings Inc., Minutes of the Board of Directors,
September14,2008,p.2.
111.Ibid.,attachingExhibits2and8.
617 Notes to Chapter 19
112.OnSeptember15,2008,LBIborrowed$28billionfromPDCFagainst$31.7billionofcollateral;
onSeptember16,2008,LBIborrowed$19.7billionagainst$23billionofcollateral;andonSeptember17,
2008,LBIborrowed$20.4billionagainst$23.3billionofcollateral.SeeValukas,4:1399andnn.537475.
113.Kirk,interview.
114.Miller,interview.
115.Kirk,interview.
116.Miller,interview.Inhisinterview,KirktoldFCICstaffthathethoughtthereweremorethan1
millionderivativescontracts.
117.McDade,interview,August9,2010.
118.Baxter,interview.
119.HarvevR.Miller,writtentestimonvfortheFCIC,HearingonTooBigtoFail:Expectationsand
ImpactofExtraordinarvGovernmentInterventionandtheRoleofSvstemicRiskintheFinancialCrisis,
dav1,session2:LehmanBrothers,September1,2010,p.8.
120.Miller,interview.
121.Ibid.
122.Ibid.
123.BenS.Bernanke,closed-doorsessionwithFCIC,November17,2009.
124.Ibid.
125.HenrvM.PaulsonIr.,writtentestimonvfortheFCIC,HearingontheShadowBankingSvstem,
dav2,session1:PerspectiveontheShadowBankingSvstem,Mav6,2010,p.55.
126.Miller,writtentestimonvfortheFCIC,September1,2010,p.14.
127.Ibid.,p.18.
128.Ibid.,pp.6,1213,15,11,15.
129.Bernanke,testimonvbeforetheFCIC,September2,2010,transcript,p.23.
130.BenBernanke,emailtoKevinWarsh,member,BoardofGovernorsoftheFederalReserveSvs-
tem,September14,2008.
131.Bernanke,testimonvbeforetheFCIC,September2,2010,p.22.
132.Ibid.,p.24.
133. Ben Bernanke, U.S. Financial Markets, testimonv before the Senate Committee on Banking,
Housing,andUrbanAffairs,110thCong.,2ndsess.,September23,2008.
134.12U.S.C.343(A),asaddedbvactofIulv21,1932(47Stat.715);andamendedbvactsofAugust
23,1935(49Stat.714),December19,1991(105Stat.2386),andIulv21,2010(124Stat.2113).
135.ScottG.Alvarez etal.,memorandum,AuthoritvoftheFederalReservetoprovideextensionsof
creditinconnectionwithacommercialpaperfundingfacilitv(CPFF),March9,2009,p.7.
136.Fuld,writtentestimonvfortheFCIC,September1,2010,pp.7,6,3.
137.Bernanke,closed-doorsessionwithFCIC.
138. Ben S. Bernanke, chairman of the Federal Reserve, letter to Phil Angelides, chairman of the
FCIC,December21,2010.
139.Thain,interview.
140.Ibid.
141.Ibid.
142.Dimon,interview.
143.ScottG.Alvarez,testimonvbeforetheFCIC,HearingonTooBigtoFail:ExpectationsandIm-
pact of Extraordinarv Government Intervention and the Role of Svstemic Risk in the Financial Crisis,
dav 1, session 1: Wachovia Corporation, September 1, 2010, transcript, p. 95. See also Baxter, letter to
FCIC,October15,2010,p.6.
Chapter 19
1.FederalReserveBankofNewYork,notesaboutAIGmeeting,September12,2008.
2.Ibid.
3.Ibid.
4.AIGCommercialPaperOutstanding&MaturitiesweekofSept15th,September16,2008,pro-
ducedbvIPMorgan.
5.AmericanInternationalGroup,Inc.,Form10-OforthequarterlvperiodendedIune30,2008.
618 Notes to Chapter 19
6.FRBNY,notesaboutAIGmeeting.
7. Goldman Sachs International, Collateral Invoice (margin call) to AIG Financial Products Corp.,
Iulv 27, 2007; data on collateral exposures and multisector CDOs supplied bv AIG (see Timeline of
Goldman Sachs/AIG collateral calls, pp. 50, 392, 404, available at the FCIC website at http://fcic.gov/
hearings/pdfs/20100701-AIG-Goldman-supporting-docs.pdf);FRBNY,notesaboutAIGmeeting.
8.AlejandroLaTorre,emailtoChristineCumming,TimothvGeithner,WilliamDudlev,etal.,Up-
dateonAIG,September12,2008.
9.FRBNY,notesaboutAIGmeeting.
10.MarkHutchings,interviewbvFCIC,Iune22,2010.
11.EricDinallo,testimonvbeforetheFCIC,HearingontheRoleofDerivativesintheFinancialCri-
sis,dav2,session2:Derivatives:SupervisorsandRegulators,Iulv1,2010,transcript,pp.3,16.
12. Michael Moriartv, testimonv before the Congressional Oversight Panel, Hearing on American
InternationalGroup,111thCong.,2ndsess.,Mav26,2010,p.4.
13.Dinallo,testimonvbeforetheFCIC,Iulv2,2010,pp.1617.
14.FRBNY,notesaboutAIGmeeting.
15.Ibid.
16.SvstemicImpactofAIGBankruptcv,attachmenttoFRBNYinternalemailfromAlejandroLa-
TorretoTimothvGeithner,September16,2008.
17.FRBNY,internalmemoaboutAugust11,2008,meetingwiththeAIGteamoftheOfficeofThrift
Supervision.
18.Ibid.
19.FRBNY,internaldocumentaboutAIG,August14,2008.
20.Ibid.
21.GoldmanSachs,companvupdateonAIG,August18,2008.
22.IraSelig,emailtoKevinCoffev,GoldmanReportonAIG,August18,2008.
23.FRBNY,internaldocumentaboutAIG,September2,2008.
24.Ibid.
25.Ibid.;GoldmanSachs,companvupdateonAIG,August18,2008.
26.FRBNY,notesaboutAIGmeeting,September12,2008.
27.Ibid.
28.AIGCommercialPaperOutstanding&MaturitiesweekofSept15th,September16,2008.
29.FRBNY,notesaboutAIGmeeting,September12,2008.
30.HavlevBoeskv,emailtoBillDudlevetal.,AIGpanic,September12,2008.
31.FRBNY,emailsofSeptember12and13,2008.
32.ThomasBaxter,interviewbvFCIC,April30,2010.
33.RobertWillumstad,interviewbvFCIC,November15,2010.
34. Patricia Mosser, email to Alejandro LaTorre et al., re: AIG/Board call, September 13, 2008,
12:54P.M.
35.PatriciaMosser,emailtoAlejandroLatorreetal.,September13,2008,7:26P.M.
36.FRBNY,internalmemoaboutAIG,September14,2008.
37.AdamAshcraft,emailtoAlejandroLaTorreetal.,AIGandthediscountwindow,September14,
2008.
38.AlejandroLaTorre,emailtoAdamAshcraftetal.,September14,2008.
39.Ibid.
40.I.C.Flowers,interviewbvFCIC,October7,2010.
41.RobertWillumstad,interviewbvFCIC,November15,2010.
42.Ibid.
43.GoldmanSachsInternational,CollateralInvoicetoAIGFinancialProductsGroup,September15,
2008.
44.DatasuppliedbvAIG(Tab31oftheAIG/GoldmanSachscollateralcalltimeline).
45.Baxter,interview.
46.SeeSarahDahlgren,FRBNY,interviewbvFCIC,April30,2010.
47.Ibid.
48.AlexanderI.Psomas,emailtoNYBankSupAIGMonitoringandAnalvsis,September15,2005.
619 Notes to Chapter 20
49.FedChairmanBenBernanke,lettertoFCICChairmanPhilAngelides,December21,2010.
50.FederalReserveBoardofGovernors,pressrelease,September16,2008.
51.CongressionalOversightPanel,TheAIGRescue,ItsImpactonMarkets,andtheGovernments
ExitStrategv,Iune10,2010,p.98.
52.Ibid.,executivesummarv,pp.1,8.
53.TreasurvspokesmanAndrewWilliams,quotedinHughSon,AIGsRescueHadPoisonousEf-
fect,U.S.PanelSavs(Update1),Bloomberg, Iune10,2010.
54.ScottM.Polakoff,AmericanInternationalGroupsImpactontheGlobalEconomv:Before,dur-
ing,andafterFederalIntervention,testimonvbeforethe.HouseCommitteeonFinancialServices,Sub-
committee on Capital Markets, Insurance, and Government Sponsored Enterprises, 111th Cong., 1st
sess.,March18,2009.
55.IohnReich,interviewbvFCIC,Mav4,2010.
56.MichaelE.Finn,preparedtestimonvbeforetheCongressionalOversightPanel,Mav26,2010.
57.C.K.Lee,interviewbvFCIC,April28,2010.SeealsoMemorandumofUnderstandingbetween
Scott M. Albinson, managing director, OTS, and Danile Nouv, secrtaire gnral de la Commission
Bancaire,April11,2005.
58.OTS,MemotoCommission Bancaireregardingitssupervisorvrole,Ianuarv2005.
59.Reich,interview.
60.IosephGonzalez,interviewbvFCIC,Mav7,2010.
61.Ibid.
62.OTS,TargetedReviewofAIGFinancialProductsCorp.,Iulv13,2007.
63.AIG/GoldmanSachscollateralcalltimeline,p.50.
64.BradWaring,interviewbvFCIC,Mav7,2010.
65.Reich,interview.
66.Ibid.
Chapter 20
1.IohnI.Mack,writtentestimonvfortheFCIC,FirstPublicHearingoftheFCIC,dav1,panel1:Fi-
nancialInstitutionRepresentatives,Ianuarv13,2010,p.6.
2.IamieDimon,interviewbvFCIC,October20,2010.
3.TimothvGeithner,interviewbvFCIC,November17,2009.
4.TimothvGeithner,quotedbvRobertSchmidt,GeithnerSlamsBonuses,SavsBanksWouldHave
Failed(Update2),Bloomberg, December4,2009.
5.BenBernanke,closed-doorsessionwithFCIC,November17,2009.
6.Specificallv,theFedbroadenedthePDCFtomatchthetvpesofcollateralthatthetwomajorclear-
ingbanksacceptedinthetri-partvreposvstem,includingnon-investment-gradesecuritiesandequities;
previouslv, PDCF collateral had been limited to investment-grade debt securities. The Fed similarlv
broadenedtheTSLFtoincludeallinvestment-gradedebtsecurities;previouslv,TSLFcollateralhadbeen
limitedtoTreasurvsecurities,agencvsecurities,andAAA-ratedmortgage-backedandasset-backedse-
curities. The Fed also increased both the frequencv of TSLF auctions, to weeklv instead of everv two
weeks,andtheirsize.FederalReserveBoardpressrelease,September14,2008.
7.OnSeptember30,GoldmanSachshada$15billionbalanceinTSLF,anda$16.5billionbalancein
PDCF.FederalReserveBoard,RegulatorvReform:UsageofFederalReserveCreditandLiquiditvFacil-
ities,PDCF.
8. Lehman initiallv asserted that there were around 930,000 derivative transactions at the time of
bankruptcv.SeeDebtorsMotionforanOrderpursuanttoSections105and365oftheBankruptcvCode
to Establish Procedures for the Settlement or Assumption and Assignment of Prepetition Derivatives
Contracts,LehmanBrothersHoldingsInc.,etal,No.08-13555(Bankr.S.D.N.Y.Nov.13,2008),p.4.See
alsoAntonR.Valukas,ReportofExaminer,In re LehmanBrothersHoldingsInc.,etal.,Chapter11Case
No.08-13555(IMP),(Bankr.S.D.N.Y.),March11,2010,2:573.BvNovember13,2008,aspecialfacilitvto
unwindderivativestradeswithLehmanhadsuccessfullvterminatedmostofthe930,000derivativecon-
tracts. Nevertheless, in Ianuarv 2009, Lehmans counsel reported that 18,000 derivatives contracts had
notbeenterminated.Moreover,therearemassiveunresolvedclaimsrelatingtoover-the-counterderiva-
tivesinthebankruptcvproceeding:asofMav2010,bankshadfiledmorethan$50billioninclaimsfor
losses related to derivatives contracts with Lehman. See Debtors Motion for an Order pursuant to
620 Notes to Chapter 20
Sections105and365oftheBankruptcvCodetoEstablishProceduresfortheSettlementorAssumption
and Assignment of Prepetition Derivatives Contracts, Lehman Brothers Holdings Inc., et al., No. 08-
13555(Bankr.S.D.N.Y.Nov.13,2008)[DocketNo.1498],p.4;DebtorsMotionforanOrderApproving
ConsensualAssumptionandAssignmentofPrepetitionDerivativesContracts,LehmanBrothersHold-
ingsInc.,etal.,No.08-13555(Bankr.S.D.N.Y.Ian.16,2009)[DocketNo.2561],p.3.
9.Monevmarketfundholdingsofalltvpesoftaxablecommercialpaperdecreasedfrom$671billion
at the end of August 2008 to $505 billion at the end of September (data provided bv ICI/Crane to the
FCIC).BNYMellon,initsroleastri-partvclearingbank,reportedthatTreasurv-backedreposrosefrom
$195 billion (13) to $466 billion (27) of its tri-partv business between March 31 and December 31,
2008(dataprovidedbvBNYMellontotheFCIC).
10.HarvevMiller,interviewbvFCIC,August5,2010.
11.TheReserveFund,Semi-annualreporttoshareholders,March2006.
12.Complaint,SECv.ReserveManagementCompanvInc.,ResrvPartnersInc.,BruceBentSr.,Bruce
Bent II, and The Reserve Primarv Fund (S.D.N.Y. Mav 5, 2009), p. 12 (para. 35); Fidelitv, BlackRock,
Drevfus,ReserveMakeBigGainsPast12Months,CraneDataNewsArchives,September12,2008.
13.TheReservePrimarvFundmanagement,interviewbvFCIC,March25,2010.
14.SECComplaintagainstReserveManagementCompanvInc.,pp.2,18(paras.3,59),p.30(para.
101); The Reserve, The Primarv Fund: Plan of Liquidation and Distribution of Assets, December 3,
2008,p.2.
15. SEC Complaint, pp. 2633 (paras. 88113); The Reserve, The Primarv Fund: Plan of Liquida-
tion,p.2.
16. SEC Complaint, p. 35 (para. 121). The SEC notes that the Primarv Fund likelv broke the buck
priorto11:00A.M. onSeptember16becauseoftheredemptionrequestsandthevaluationofLehmans
debt;moreover,RMCIannouncedonNovember26,2008,thatowingtoanadministrativeerror,itsNAV
shouldhavebeencalculatedas$0.99between11:00A.M.and4:00P.M.onSeptember16(pp.3433,paras.
119,120).
17. Moodvs Investors Service articles, Sponsor Support Kev to Monev Market Funds, August 9,
2010,p.4;MoodvsProposesNewMonevMarketFundRatingMethodologvandSvmbols,September
7,2010.
18.PatrickMcCabeandMichaelPalumbo,interviewbvFCIC,September28,2010.
19.Ibid.
20. Investment Companv Institute, Historical Weeklv Monev Market Data. While nongovernment
funds lost $434 billion during the period between September 10 and October 1, 2008, government
fundsinvestinginTreasuriesandGSEdebtincreasedbv$357billionduringthesameperiod.
21.McCabeandPalumbo,interview.
22.FCICsurvevofmonevmarketmutualfunds.Holdingsforthefivefirmsdecreasedfrom$58bil-
lionto$29billionfromSeptember12,2008,toSeptember19,2008.SeeFCICwebsitefordetails.
23. Timothv Geithner, testimonv before the FCIC, Hearing on the Shadow Banking Svstem, dav 2,
session2:PerspectiveontheShadowBankingSvstem,Mav6,2010,transcript,p.135.
24.McCabeandPalumbo,interview.
25.TreasurvAnnouncesGuarantvProgramforMonevMarketFunds,TreasurvDepartmentpress
release,September19,2008.PresidentGeorgeW.BushapprovedtheuseofexistingauthoritiesbvSecre-
tarv Henrv M. Paulson Ir. to make available as necessarv the assets of the Exchange Stabilization Fund
(ESF)forupto$50billiontoguaranteepavmentstosupportmonevmarketmutualfunds.Theoriginal
objectiveoftheESF,establishedbvtheGoldReserveActof1934,wastostabilizethevalueofthedollar
inthedepthsoftheDepression.Itauthorizedthetreasurvsecretarv,withtheapprovalofthepresident,to
dealingold,foreignexchange,andotherinstrumentsofcreditandsecuritiestopromoteinternational
financialstabilitv.
26. The program was called the Asset-Backed Commercial Paper Monev Market Mutual Fund Liq-
uiditvFacilitv(AMLF).
27.NeelKashkari,interviewbvFCIC,November2,2010.
28.IohnMack,interviewbvFCIC,November2,2010.
29.NewYorkFederalReserve,internalemail,October22,2008,p.2.
30.DavidWong,emailtoFedandSECofficials,September15,2008.
621 Notes to Chapter 20
31.IonathanStewart,FRBNY,internalemail,September17,2008.
32. One vear later, the Senior Supervisors Groupa cross-agencv task force looking back on the
causes of the financial crisiswould write, Before the crisis [at the investment banks post-Lehman],
manvbroker-dealersconsideredtheprimebrokeragebusinesstobeeitherasourceofliquiditvoraliq-
uiditv-neutralbusiness.Asaresult,themagnitudeandunprecedentedseveritvofeventsinSeptember
October 2008 were largelv unanticipated. Senior Supervisors Group, Risk Management Lessons from
theGlobalBankingCrisisof2008,October21,2009,p.9.
33.IonathanWood,WhiteboxAdvisors,interviewbvFCIC,August11,2010.
34. The FCIC surveved hedge funds that survived the crisis. Those in the three largest quartiles
rankedbvsizereceivedinvestorredemptionrequestsaveraging20oftheirassetsinthefourthquarter
of2008(thefirstavailableredemptiondateaftertheLehmanbankruptcv).
35.IFSLResearch,HedgeFunds2009,April2009.
36.DavidWong,treasurerofMorganStanlev,interviewbvFCIC,October15,2010.
37.Mack,interview.
38.Wong,interview.
39.PatriceMaher(MorganStanlev),emailtoWilliamBrodows(FederalReserveBNY)etal.,Septem-
ber28,2008,withdatainanattachment.HedgefundvaluesarethePrimeBrokerageOutflows(NY+In-
ternational).
40.Wong,interview.
41.MatthewEichner,internalemail,September16,2008.
42.AngelaMiknius,emailtoNYBankSup,September18,2008.
43.AmvG.White,internalNYFBRemail,September19,2008.
44.MorganStanlev,LiquiditvandFinancingActivitv:08/28/08,LiquiditvandFinancingActivitv:
09/18/08,LiquiditvandFinancingActivitv:10/03/08,reportstotheNewYorkFederalReserve.
45.MorganStanlevCorporateTreasurv,MeetingwithFederalReserve:September20,2008,attach-
menttoMorganStanlevemailtoNYFRB,September20,2008,includingForwardForecast.
46.MorganStanlevCorporateTreasurv,LiquiditvLandscape:09/1209/18/2008,inattachmentto
MorganStanlevemailtoNYFRB,September20,2008;AmvWhite,internalNYFRBemails,September
16and19,2008.
47.LlovdBlankfein,testimonvbeforetheFCIC,FirstPublicHearingoftheFCIC,dav1,panel1:Fi-
nancialInstitutionRepresentatives,Ianuarv13,2010,transcript,pp.3435.
48.Bernanke,closed-doorsession.
49.ThomasBaxter,interviewbvFCIC,April30,2010.
50.Theswitchtobankholdingcompanvstatusrequiredasimplecharterchange.BothMorganand
Goldmanalreadvownedbanksthatthevhadcharteredasindustrialloancompanies,atvpeofbankthat
isallowedtoacceptFDIC-insureddepositswithouthavinganvFedsupervisionoverthebanksparentor
otheraffiliatedcompanies.
51.FederalReserve,DiscountWindowPavmentSvstemRisk:GettingStarted,lastupdatedNovem-
ber17,2009.
52.Mack,interview.
53.Mack,interview.
54.Wong,interview.
55.AmvG.White,internalFRBNYemail,September19,2008.
56. It should be borne in mind that lack of regulation of this market rendered it extremelv opaque.
Shortcomingsintransparencv,lackofreportingrequirements,andlimiteddatacollectionbvthirdpar-
tiesmakeitdifficulttodocumentanddescribethevariousmarkettradingproblemsthatemergedduring
thecrisis.
57.MichaelMasters,testimonvbeforetheFCIC,HearingontheRoleofDerivativesintheFinancial
Crisis,dav1,session1:OverviewofDerivatives,Iune30,2010,transcript,p.26.
58.DepositorvTrustandClearingCorporationdataprovidedtotheFCIC.
59.TheGlobalOTCDerivativesMarketatEnd-Iune1998,BankofInternationalSettlementspress
release,December13,1998;OTCderivativesmarketactivitvinthesecondhalfof2008,BankofInter-
nationalSettlementspressrelease,Mav9,2009,p.7.
622 Notes to Chapter 20
60. Triennial and Regular OTC Derivatives Market Statistics, Bank of International Settlements
pressrelease,November16,2010,p.7.
61.Moodvs,MoodvsdowngradesWaMuRatings;outlooknegative,September11,2008.
62.OTSFactSheetonWashingtonMutualBank,OTS08046A,September25,2008,p.3.
63.IamieDimon,interviewbvFCIC,October20,2010.
64. Sheila Bair, testimonv before the FCIC, Hearing on Too Big to Fail: Expectations and Impact of
ExtraordinarvGovernmentInterventionandtheRoleofSvstemicRiskintheFinancialCrisis,dav2:ses-
sion2:FederalDepositInsuranceCorporation,September2,2010,exchangebetweenBairandCommis-
sionerDouglasHoltz-Eakin,pp.134,149.
65.ScottAlvarez,testimonvbeforetheFCIC,HearingonTooBigtoFail:ExpectationsandImpactof
ExtraordinarvGovernmentInterventionandtheRoleofSvstemicRiskintheFinancialCrisis,dav1,Ses-
sion1:WachoviaCorporation,September1,2010,transcript,p.84.
66.Kashkari,interview.
67.GregFeldberg,WachoviaCaseStudv,presentationatLBOSupervisionConference,November
1213,2008,Atlanta,Georgia,p.15.Theserules,embodiedinsection23AoftheFederalReserveAct,
limit the support that a depositorv institution can provide to related companies in the same corporate
structure;thevareaimedatprotectingFDIC-insureddepositorsfromactivitiesthatoccuroutsideofthe
bankitself.Exemptionshavetheeffectoffundingaffiliate,nonbankassetswithinthefederalsafetvnetof
insureddeposits;thevcreateliquiditvfortheparentcompanvand/orkevaffiliates(andreducebankliq-
uiditv)duringtimesofmarketstress.
68.RobertSteel,interviewbvFCIC,August18,2010.
69.ScottAlvarez,writtentestimonvfortheFDIC,September1,2010,p.4.
70.RobertSteel,writtentestimonvbeforetheFCIC,HearingonTooBigtoFail:ExpectationsandIm-
pact of Extraordinarv Government Intervention and the Role of Svstemic Risk in the Financial Crisis,
dav1,session1:WachoviaCorporation,September1,2010,p.2.
71.DavidWilson,interviewbvFCIC,August4,2010.
72.SheilaBair,interviewbvFCIC,August18,2010.
73.RichardWesterkamp,FederalReserveBankofRichmond,interviewbvFCIC,August13,2010.
74. Wachovia was unable to roll $1.1 billion of asset-backed commercial paper that Fridav; Iames
WigandandHerbertHeld,memototheFDICBoardofDirectors,September29,2008,p.2.Onbrokered
certificatesofdeposit,seeWesterkamp,interview.
75. Iohn Corston, acting deputv director, Division of Supervision and Consumer Protection, FDIC,
written testimonv before the FCIC, Hearing on Too Big to Fail: Expectations and Impact of Extraordi-
narv Government Intervention and the Role of Svstemic Risk in the Financial Crisis, dav 1, Session 1:
WachoviaCorporation,September1,2010,p.4.
76.Wilson,interview.
77.RichWesterkamp,emailtoFCIC,November2,2010.Westerkampsaidthattheestimateofearlv
redemption requests was based on a phone conversation with officials in Wachovias treasurv depart-
ment,describingtheirconversationswithinvestors;thefigureswereneververified.
78.Bair,interview.
79.RobertSteel,interviewbvFCIC,August18,2010.
80.Bair,interview;Steel,interview;FDICstaff,interviewbvFCICreWachovia,Iulv16,2010.
81.Alvarez,writtentestimonvfortheFCIC,September1,2010,p.5.
82.Steel,interview.
83.Ibid.
84.WigandandHeld,memototheFDICboard,September29,2008,pp.2,45.
85. Federal Reserve staff, memo to the Board of Governors, subject: Considerations Regarding In-
vokingtheSvstemicRiskExceptionforWachoviaBank,NA,September28,2008,p.7.
86.IohnA.Beebe,MarketRiskTeamLeader,FederalReserveBankofRichmond,memotoIennifer
Burns,VP-LCBO,WachoviaLargeFundsProviders,September27,2008,pp.12.
87. Federal Reserve staff, memo to the Board of Governors, subject: Considerations Regarding In-
vokingtheSvstemicRiskExceptionforWachoviaBank,NA,September28,2008,p.7.
88. Bair, interview; minutes of the telephonic meeting of Federal Deposit Insurance Corporation
BoardofDirectors,September29,2008,p.8.
623 Notes to Chapter 20
89.Bair,interview.
90.FDICmemototheFDICBoardofDirectors,p.8;Corston,writtentestimonvfortheFDIC,Sep-
tember1,2010,p.10.
91.Specificallv,underWachoviasproposal,theFDICwouldprovidecreditprotectionon$200billion
ofloans,whileWachoviawouldabsorbthefirst$25billioninlossesandtheFDICwouldpotentiallvin-
curlossesonthebalanceofthe$200billion.Tooffsetthatrisk,WachoviaproposedthattheFDICreceive
$10billioninpreferredstockandwarrantsoncommonshares(FDICmemototheFDICBoardofDirec-
tors,p.8).
92.TheFDICboardhasfivemembers:thecomptrollerofthecurrencv,thedirectorofOTS,andthree
other members appointed bv the president. In Too Big to Fail. The Inside Story of How Vall Street and
Vashington Fought to Save the Financial System from Crisisand Themselves (NewYork:Viking,2009),
AndrewRossSorkin(p.497)wrotethatbeforetheSeptember29,2008,FDICboardmeeting,NewYork
FederalReserveGovernorGeithnerandotherofficialshadaconferencecallwithBair(Paulsonrecused
himself)duringwhichGeithnerurgedBairtohelpCitigroupacquireWachoviabvguaranteeingsomeof
itspotentiallosses.GeithnerarguedthatallowingtheFDICtotakeoverWachoviawouldhavetheeffect
ofwipingoutshareholdersandbondholders,which,hewasconvinced,wouldonlvspookthemarkets.
He was still furious with Bair for the wav she had abruptlv taken over Washington Mutual, which had
hadadeleteriouseffectoninvestorconfidence.
93. Federal Deposit Insurance Corporation Board of Directors meeting, September 29, 2008, tran-
script,pp.2122.
94.MinutesoftelephonicmeetingoftheFDICboard,September29,2008,p.8.
95.Ibid.;the$34.6billionfigureisasofSeptember30,2008(FDICstaff,memototheBoardofDirec-
tors,subject:ThirdOuarter2008CFOReporttotheBoard,November21,2008,p.1).
96.MinutesoftelephonicmeetingoftheFDICboard,September29,2008,p.8.
97.Bair,interview.
98.Steel,writtentestimonvfortheFCIC,September1,2010,p.4.Ontheboardsvoteandtheagree-
mentinprinciple,seeSteel,interview;seealsoAffidavitofRobertK.Steel,datedOctober5,2008,filedin
WachoviaCorp.v.Citigroup,Inc.,CaseNo.08-cv-085093-SAS(S.D.N.Y.),pp.34andexhibitA.
99.FedChairmanBenBernanke,lettertoFCICChairmanPhilAngelides,December21,2010.
100. Wachtell, Lipton, Rosen & Katz, on behalf of Wells, letter to Division of Corporation Finance,
SEC,November17,2008,p.3.
101.RichardKovacevich,interviewbvFCIC,August24,2010.
102.Bair,interview.
103.Steel,interview.
104.Bair,interview.Inhisinterview,TreasurvsKashkaritoldtheFCICthathedisagreed.Hefeltthat
thehighestprioritvwastotransfertheriskofbankstroubledassetsfromthefinancialsvstemtothegov-
ernment. Citigroups FDIC-assisted acquisition would have removed potential losses on $270 billion of
assetsfromthefinancialsvstembvtransferringthosepotentiallossestotheFDIC.
105. Wells Fargo, Wachovia Agree to Merge: Creating Premier Coast-To-Coast Financial Services
FranchisewithoutGovernmentAssistance, WellsFargopressrelease,October3,2008.
106.RichDelmar,TreasurvOfficeoftheInspectorGeneral,interviewbvFCIC,August25,2010;Rich
Delmar,memorandumforInspectorGeneralEricM.Thorson,InquirvRegardingIRSNotice2008-83,
September3,2009,pp.3,5,1112.
107.RichardLevv,interviewbvFCIC,August19,2010.
108.StatementbvSecretarvHenrvM.Paulson,Ir.onComprehensiveApproachtoMarketDevelop-
ments,TreasurvDepartmentpressrelease,September19,2008.
109.SenatorsChristopherI.DoddandRichardC.Shelbv,remarksbeforetheSenateCommitteeon
Banking,Housing,andUrbanAffairs,Turmoil in U.S. Credit Markets. Recent Actions Regarding Govern-
ment-Sponsored Entities, Investment Banks, and Other Financial Institutions, 110thCong.,2ndsess.,Sep-
tember23,2008,transcript,pp.3,6.
110.SecretarvHenrvPaulson,testimonvbeforetheSenateBankingCommittee,Turmoil in the U.S.
Credit Markets, transcript,p.37.
111.FedChairmanBenBernanke,EconomicOutlook,testimonvbeforetheIointEconomicCom-
mittee,110thCong.,2ndsess.,September24,2008,transcript.
624 Notes to Chapter 20
112. Fed Chairman Ben Bernanke, testimonv before the House Financial Services Committee, The
Future of Financial Services. Exploring Solutions for the Market Crisis, September 24, 2008, transcript,
p.48.
113.MelMartinez,interviewbvFCIC,September28,2010.
114. The TARP legislation, drafted as the Emergencv Economic Stabilization Act of 2008, was cou-
pled in Public Law 110-343 with several other vote-attracting acts, including the Energv Improvement
andExtensionActof2008,theTaxExtendersandAlternativeMinimumTaxReliefActof2008,thePaul
WellstoneandPeteDomeniciMentalHealthParitvandAddictionEquitvActof2008,andtheHeartland
and Hurricane Ike Disaster Relief Act of 2008. Congress originallv said that the deposit insurance cap
would revert to $100,000 at the beginning of 2010, but later extended the deadline through the end of
2013.
115.ThequotationispartoftheformaltitleofPublicLaw110-343,ofwhichtheTARPlegislation
officiallvnamedtheEmergencvEconomicStabilizationActof2008isapart.
116.BoardAnnouncesCreationoftheCommercialPaperFundingFacilitv(CPFF)toHelpProvide
Liquiditv to Term Funding Markets, Federal Reserve Board press release, October 7, 2008. The CPFF
complementedtheFedsothercommercialpaperprogram,theAMLF,whichwascreatedshortlvafterthe
ReservePrimarvFundbrokethebuck.WhiletheAMLFtargetedmonevmarketmutualfunds,theCPFF
aimedtocreateliquiditvforqualifiedcommercialpaperissuers.
117.FederalReserveBoard,CommercialPaperFundingFacilitv(CPFF).
118. Ken Lewis from Bank of America, Robert Kellv from BNY Mellon, Vikram Pandit from Citi-
group, Llovd Blankfein from Goldman, Iamie Dimon from IP Morgan, Iohn Thain from Merrill, Iohn
MackfromMorganStanlev,RonaldLoguefromStateStreet,andRichardKovacevichfromWells.
119.Paulson,testimonvbeforetheFCIC,Mav6,2010,transcript,p.70.Formerassistanttreasurvsec-
retarvPhillipSwagelargued,ThereisnoauthoritvintheUnitedStatestoforceaprivateinstitutionto
acceptgovernmentcapital(TheFinancialCrisis:AnInsideView,BrookingsPapersonEconomicAc-
tivitv,conferencedraft,Spring2009,pp.3334).
120.HenrvPaulson,On The Brink. Inside the Race to Stop the Collapse of the Global Financial System
(NewYork:BusinessPlus,2010),p.365.
121.Dimon,interview.
122. The Temporarv Liquiditv Guarantee Program consisted of two programs, the Temporarv Debt
GuaranteeProgram(TDGP)andtheTransactionAccountGuaranteeProgram(TAGP).TheTDGPatits
highest point in Mav 2009 guaranteed $346 billion in outstanding senior debt; see FDIC Announces
PlantoFreeUpBankLiquiditv,FDICpressrelease,October14,2008.TheTAGPguaranteed$834bil-
lionindepositsattheendof2009.
123.FactsheetonCapitalPurchaseProgram,FinancialStabilitv.gov,updatedOctober3,2010.
124. Remarks bv Secretarv Henrv M. Paulson, Ir. on Financial Rescue Package and Economic Up-
date,TreasurvDepartmentpressrelease,November12,2008.
125.Paulson,testimonvbeforetheFCIC,Mav6,2010,transcript,p.70.
126.U.S.TreasurvDepartmentOfficeofFinancialStabilitv,TroubledAssetReliefProgram;Trans-
actionsReportforPeriodEndingDecember31,2008:CapitalPurchaseProgram;FactsheetonCapital
PurchaseProgram.
127.U.S.TreasurvDepartmentOfficeofFinancialStabilitv,TroubledAssetReliefProgram:Transac-
tionsReportforPeriodEndingOctober15,2010:CapitalPurchaseProgram.
128.OfficeoftheSpecialInspectorGeneralfortheTroubledAssetReliefProgram,InitialReportto
theCongress,Februarv6,2009,p.6.
129.CongressionalOversightPanel,SeptemberOversightReport:AssessingtheTARPontheEveof
ItsExpiration,September16,2010,p.27.
130.OfficeofFinancialStabilitv,TroubledAssetReliefProgram:TwoYearRetrospective,October
2010,pp.15,51;AIG,WhatAIGOwestheU.S.Government,updatedSeptember30,2010.
131.CongressionalOversightPanel,SeptemberOversightReport,p.27;OfficeofFinancialStabil-
itv,TroubledAssetReliefProgram:TwoYearRetrospective,p.18;TaxpaversReceive$10.5Billionin
Proceeds Todav from Final Sale of Treasurv Department Citigroup Common Stock, Treasurv Depart-
mentpressrelease,December10,2010.
625 Notes to Chapter 20
132.OfficeoftheSpecialInspectorGeneralfortheTroubledAssetReliefProgram,OuarterlvReport
toCongress,October26,2010,table2.1,p.46(obligationfiguresasofOctober3,2010,andexpenditure
figuresasofSeptember30,2010).
133.ThemonevmarketfundingisthroughtheAsset-backedCommercialPaperMonevMarketMu-
tualFundLiquiditvFacilitv(AMLF);FCICstaffcalculations.
134. Board of Governors of the Federal Reserve Svstem, Regulatorv Reform: Agencv Mortgage-
backedSecurities(MBS)PurchaseProgram.
135.TheFedhadcreatedthefirstMaidenLanevehicleinMarchtotake$29billioninassetsoffthe
balancesheetofBearStearns,asdescribedinchapter15.SeeAIGRMBSLLCFacilitv:TermsandCon-
ditions,December16,2008;AIGDisclosesCounterpartiestoCDS,GIAandSecuritiesLendingTrans-
actions, AIG press release, March 15, 2009, Attachment D: Pavments to AIG Securities Lending
Counterparties.
136.FederalReserveBankofNewYork,MaidenLaneIII:TransactionOverview;FederalReserve
andTreasurvDepartmentpressrelease,November10,2008;AIGCDOLLCFacilitv:TermsandCondi-
tions,FederalReserveBankofNewYorkpressrelease,December3,2008;FRBNY,MaidenLaneTrans-
actions.$27.1billionwaspaidto16counterpartiesand$2.5billionwaspaidtoAIGFPasanadjustment
toreflectovercollateralization.
137.OfficeoftheSpecialInspectorGeneralfortheTroubledAssetReliefProgram,FactorsAffecting
EffortstoLimitPavmentstoAIGCounterparties,SIGTARP-10-003,November17,2009,pp.1920.
138.Blankfein,testimonvbeforetheFCIC,Ianuarv13,2010,transcript,pp.9093.
139.DataprovidedtoGoldmanSachstotheFCIC.
140. David Viniar, testimonv before the FCIC, Hearing on the Role of Derivatives in the Financial
Crisis,dav2,session1:AmericanInternationalGroup,Inc.andGoldmanSachsGroup,Inc.,Iulv1,2010,
transcript,p.148.
141.GoldmanSachs,emailtoFCIC,Iulv15,2010.
142.Ibid.;anddataprovidedbvGoldmanSachstotheFCIC.
143.SIGTARP,FactorsAffectingEffortstoLimitPavmentstoAIGCounterparties,pp.1516,18.
Thereportsaidcounterpartiesinsistedon100coveragebecause(1)concessionswouldmeangiving
awavvalueandvoluntarilvtakingaloss,incontraventionoftheirfiduciarvdutvtotheirshareholders;
(2)thevhadareasonableexpectationthatAIGwouldnotdefaultonfurtherobligations,giventhegov-
ernmentassistance;(3)costsalreadvincurredtoprotectagainstapossibleAIGdefaultwouldbeexacer-
batedifthevwerepaidlessthanparvalue;and(4)thevwerecontractuallventitledtoreceivethepar
valueofthecreditdefaultswapcontracts.
144.Inotherwords,thedecisiontoacquireacontrollinginterestinoneoftheworldsmostcomplex
andmosttroubledcorporationswasdonewithalmostnoindependentconsiderationofthetermsofthe
transactionortheimpactthatthosetermsmighthaveonthefutureofAIG(ibid.,p.28).
145.Ibid.,summarv,p.1.
146.CongressionalOversightPanel,IuneOversightReport:TheAIGRescue,ItsImpactonMarkets,
andtheGovernmentsExitStrategv,Iune10,2010,pp.10,8.
147.SuzanneKapner,USCongressionalPanelAttacksAIGRescue,Financial Times, Iune10,2010.
148.Baxter,interview.
149.SarahDahlgren,interviewbvFCIC,April30,2008.
150.SIGTARP,FactorsAffectingEffortstoLimitPavmentstoAIGCounterparties,p.29.
151. Timothv Geithner, quoted in Iodv Shenn, Bob Ivrv, and Alan Katz, AIG 100-Cents Fed Deal
DrivenbvFranceBeliedbvFrenchBanks,Bloomberg Businessweek, Ianuarv20,2010.
152. E.g., Baxter, interview; Iim Mahonev, Federal Reserve Bank of New York, interview bv FCIC,
April30,2010;MichaelAlix,FederalReserveBankofNewYork,interviewbvFCIC,April30,2010.
153.Dahlgren,interview.
154.Baxter,interview.
155. GAO, Federal Financial Assistance: Preliminarv Observations on Assistance Provided AIG,
GAO-094907 (Testimonv: Before the Subcommittee on Capital Markets, Insurance, and Government
SponsoredEnterprises,HouseCommitteeonFinancialServices),March18,2009,p.2;FederalReserve
pressrelease,September16,2008.
156.AIG,WhatAIGOwestheUSGovernment,updatedSeptember30,2010.
626 Notes to Chapter 20
157.EdwardI.KellvIII,interviewbvFCIC,March3,2010.
158.RogerCole,interviewbvFCIC,August2,2010.
159.Kellv,interview.
160.IamesR.WigandandHerbertI.Held,memorandumtotheFDICBoardofDirectors,regarding
recommendationforsvstemicriskdeterminationforCitigroup,November23,2008,p.5.
161.Kellv,interview.
162.MarkD.Richardson,emailtoIohnH.Corston,IasonC.Cave,etal.,subject:RE:CONFIDEN-
TIALCitigroupDeterioration of Stock Price and CDS Spreads, November 20, 2008; Mark
D. Richardson, email, to Iohn H. Corston, Iason C. Cave, et al., subject: 11-21-08 Citi Liquiditv call
notes,November21,2008.
163.WigandandHeld,NovembermemototheFDICboardregardingCitigroup,p.5.
164.Bernanke,closed-doorsession.
165. Arthur I. Murton, email to Iohn V. Thomas, Michael H. Krimminger, et al., subject: RE: Pro-
posed Conduit, November 22, 2008; Michael H. Krimminger, email to Arthur I. Murton, Iohn
V.Thomas,etal.,subject:RE:ProposedConduit,November22,2008.
166.VikramPandit,testimonvbeforetheCongressionalOversightPanel,Citigroup and the Troubled
Asset Relief Program, 111thCong.,2ndsess.,March4,2010,transcript,p.79.
167.Kellv,interview.
168.GAO,FederalDepositInsuranceAct:RegulatorsUseofSvstemicRiskExceptionRaisesMoral
HazardConcernsandOpportunitiesExisttoClarifvtheProvision,GAO-10100(ReporttoCongres-
sionalCommittees),April2010,p.2.
169.WigandandHeld,memototheFDICboardregardingCitigroup,pp.9,10.
170. Department of the Treasurv response to Congressional Oversight Panel, Ouestions for the
Record,p.3,Citigroup and the Troubled Asset Relief Program, March4,2010,p.44.
Ioint Statement bv Treasurv, Federal Reserve, and the FDIC on Citigroup, joint press release,
November23,2008.
171.IointStatementonCitigroup.
172.Intotal,Citigroupreceivedalmost$40billionincapitalbenefitsfromtheNovember2008gov-
ernmentassistance.HalfofthecapitalbenefitswerefromTreasurvs$20billionTARPinvestmentinCiti-
grouppreferredstock;$16billionofthecapitalbenefitswerederivedfromachangeintheriskweighting
of the ring-fenced assets. In addition, Citigroup issued Treasurv and the FDIC $7 billion in preferred
stockaspavmentfortheguaranteeontheringfence;theresult,afteraccountingfortheinsurancefeature
ofthearrangement,wasa$3.5billionincreaseincapitalforCitigroup.
173.Kellv,interview.
174.Thewarrantsgavethegovernmenttherighttobuv254millionsharesat$10.61ashare;atthe
time, the stock was trading at $3.76 (Congressional Oversight Panel, November Oversight Report:
GuaranteesandContingentPavmentsinTARPandRelatedPrograms,November6,2009,pp.1819).
175.FDICBoardofDirectorsmeeting,closedsession,November23,2008,transcript,p.14.
176.Ibid.,pp.2728.
177.OfficeofFinancialStabilitv,TroubledAssetReliefProgram:TwoYearRetrospective,October
2010, p. 30; Taxpavers receive $10.5 billion in proceeds todav from final sale of Treasurv Department
Citigroupcommonstock,TreasurvDepartmentpressrelease,December10,2010.
178. Merrill Lvnch Reports Third Ouarter 2008 Net Loss from Continuing Operations of $5.1 Bil-
lion,MerrillLvnchpressrelease,October16,2008,p.4;MerrillLvnch,3O2008EarningsCalltranscript,
October16,2008,p.2.
179.FederalReserveSvstem,OrderApprovingBankofAmericaCorporationAcquisitionofaSav-
ingsAssociationandanIndustrialLoanCompanv,November26,2008,pp.7,9.Toapprovesuchapro-
posal,theBankHoldingCompanvActrequirestheFedtodeterminethatatransactioncanreasonablv
be expected to produce benefits to the public, such as greater convenience, increased competition, or
gainsinefficiencv,thatoutweighpossibleadverseeffects,suchasundueconcentrationofresources,de-
creasedorunfaircompetition.12U.S.C.1843(j)(2)(A).
180.TimothvI.Mavopoulous,formergeneralcounselofBankofAmerica,writtentestimonvbefore
theHouseOversightCommittee,Bank of America and Merrill Lynch. How Did a Private Deal Turn into a
Federal Bailout? Part IV, 111thCong.,1stsess.,November17,2009.
627 Notes to Chapter 20
181. Ken Lewis, deposition In Re. Executive Compensation Investigation. Bank of AmericaMerrill
Lynch,Februarv26,2009,p.9,availablefromHouseCommitteeonOversightandGovernmentReform
andtheSubcommitteeonDomesticPolicv,Bank of America and Merrill Lynch. How Did A Private Deal
Turn into a Federal Bailout? 111thCong.,1stsess.,Iune11,2009.
182.BankofAmerica,4O2008EarningsCalltranscript,Ianuarv16,2009,p.16.
183.Ibid.,pp.3,10,16.
184.IohnThain,interviewbvFCIC,September17,2009.
185.Complaint,SECv.BankofAmerica(S.D.N.Y.Ian.12,2010);FinalConsentIudgmentAstoDe-
fendantBankofAmerica(S.D.N.Y.Feb.4,2010).
186.KenLewis,interviewbvFCIC,October22,2010.
187.Lewis,depositionIn Re. Executive Compensation Investigation. Bank of AmericaMerrill Lynch,
pp. 34, 38; Henrv Paulson, written testimonv before the House Committee on Oversight and Govern-
mentReformandtheSubcommitteeonDomesticPolicv,Bank of America and Merrill Lynch. How Did a
Private Deal Turn into a Federal Bailout? Part III, 111thCong.,1stsess.,Iulv16,2009,p.22.
188.Paulson,writtentestimonvbeforetheHouseOversightCommittee,Iulv16,2009,p.23(quota-
tion);BenBernanke,writtentestimonvbeforetheHouseCommitteeonOversightandGovernmentRe-
formandtheSubcommitteeonDomesticPolicv,Bank of America and Merrill Lynch. How Did a Private
Deal Turn into a Federal Bailout? Part II, 111thCong.,1stsess.,Iune25,2009,p.18.
189.Lewis,interview.
190.Thain,interview
191.Paulson,writtentestimonvbeforetheHouseOversightCommittee,Iulv16,2009,pp.19,25.
192.ChairmanBenBernanke,emailtoGeneralCounselScottAlvarez,Re:Fw:BAC,December23,
2008,availablefromHouseOversightCommittee,Bank of America and Merrill Lynch. How Did a Private
Deal Turn into a Federal Bailout? Part II, Iune25,2009,p.73;RepresentativeEdolphusTowns,inibid.,
p.2.
193.Lewis,interview.
194.MinutesofaSpecialMeetingofBoardofDirectorsofBankofAmericaCorporation,December
22,2008,availableinHouseCommitteeonOversightandGovernmentReform,Iune11,2009,p.183.
195. Minutes of a Special Meeting of the Bank of America board, December 30, 2008, available in
ibid.,p.188.
196.Lewis,interview.
197.SeeDepartmentoftheTreasurv,OfficeofFinancialStabilitv,TroubledAssetsReliefProgram:
TransactionsReport,forPeriodEndingNovember16,2010,November18,2010.Inadditiontodrawing
onthesefunds,itwasalsoasubstantialuseroftheFedsvariousliquiditvprograms.Theholdingcom-
panvanditssubsidiarieshadalreadvborrowed$55billionthroughtheTermAuctionFacilitv.Ithadalso
borrowed $15 billion under the Feds Commercial Paper Funding Facilitv and $20 billion under the
FDICs debt guarantee program. And newlv acquired Merrill Lvnch had borrowed another $21 billion
fromtheFedstwoBearStearnserarepo-supportprograms.YetdespiteBankofAmericasrecourseto
theseprograms,theregulatorsworriedthatitwouldexperienceliquiditvproblemsifthefourth-quarter
earningswereweak.
198. The amount of FDIC-guaranteed debt that can be issued bv each eligible entitv, or its cap, is
basedontheamountofseniorunsecureddebtoutstandingasofSeptember30,2008.
199.FRBandOCCstaff,memorandumtoRickCox,FDIC,subject:BankofAmericaCorporation
(BAC) Funding Vulnerabilities and Implications for Other Financial Market Participants, Ianuarv 10,
2009,p.2.
200. Sheila C. Bair, FDIC Chairman, written testimonv before the House Committee on Oversight
andGovernmentReformandtheSubcommitteeonDomesticPolicv,Bank of America and Merrill Lynch.
How Did a Private Deal Turn into a Federal Bailout? Part V, 110thCong.,1stsess.,December11,2009,
p.2.
201.FRBandOCCstaffmemotoRickCox,BankofAmericaCorporation(BAC)FundingVulnera-
bilities,pp.2,4;MitchellGlassman,SandraThompson,ArthurMurton,andIohnThomas,memoran-
dumtotheFDICBoardofDirectors,subject:BankofAmerica,etc.,Ianuarv15,2009,pp.8,9.
202.Bair,writtentestimonvbeforetheHouseOversightCommittee,December11,2009,p.3.
628 Notes to Chapter 21
203.Glassmanetal.,memototheFDICboard,Ianuarv15,2009,p.3.Thevagreedtothis25/75split
because 25 of the assets for the ring fence were from depositorv institutions and 75 were not. See
closedmeetingoftheFDICBoardofDirectors,Ianuarv15,2009,transcript,p.18.
204. Closed meeting of the FDIC board, Ianuarv 15, 2009, transcript, p. 24. According to the FDIC
staff, Liquiditv pressure mav increase to critical levels following the announcement of fourth quarter
2008 operating results that are significantlv worse than market expectations. Market reaction to BACs
operating results mav have svstemic consequences given the size of the institution and the volume of
counterpartvtransactionsinvolved.Withoutasvstemicriskdetermination . . .significantmarketdisrup-
tionmavensueascounterpartiesloseconfidenceinBACsabilitvtofundongoingoperations. . . .[Eco-
nomicdevelopments]pointtoaclearrelationshipbetweenthefinancialmarketturmoilofrecentmonths
and impaired economic performance that could be expected to worsen further if BAC and its insured
subsidiarieswereallowedtofailed.Suchaneventwouldsignificantlvunderminebusinessandconsumer
confidence.Glassmanetal.,memototheFDICboard,Ianuarv15,2009,pp.1314.
Chapter 21
1.BrianMovnihan,writtentestimonvfortheFCIC,FirstPublicHearingoftheFinancialCrisisIn-
quirvCommission,dav1,session1:FinancialInstitutionRepresentatives,Ianuarv13,2010,p.1.
2.ClarenceWilliams,writtentestimonvfortheFCIC,HearingontheImpactoftheFinancialCrisis
Sacramento,session4:ImpactoftheFinancialCrisisonSacramentoNeighborhoodsandFamilies,Sep-
tember23,2010,p.8;andtestimonvbeforetheFCIC,transcript,pp.25960.
3.EdLazear,interviewbvFCIC,November10,2010.
4.IeannieMcDermott,testimonvbeforetheFCIC,HearingontheImpactoftheFinancialCrisis
GreaterBakersfield,session6:ForumforPublicComment,September7,2010,transcript,pp.21113.
5.MarieVasile,testimonvbeforetheFCIC,inibid.,transcript,pp.24451.
6.NationalDelinquencvSurvev,MortgageBankersAssociation,FourthOuarter2007,March2008,
p.4;ThirdOuarter2010,November2010,p.4.
7.CoreLogic,U.S.HousingandMortgageTrends:August2010,November2010,p.5.
8.IeremvAguero,principalanalvst,AppliedAnalvsis,writtentestimonvfortheFCIC,Hearingonthe
Impact of the Financial CrisisState of Nevada, session 1: Economic Analvsis of the Impact of the Fi-
nancialCrisisonNevada,September8,2010,p.3.
9. Mauricio Soto, How Is the Financial Crisis Affecting Retirement Savings: Urban Institute, De-
cember10,2008,availableatwww.urban.org/url.cfm:ID=901206.
10.StevenK.Paulson,AuditorsSavColoradoPensionPlanRecovering,AssociatedPress,August16,
2010.
11.CharlesS.Iohnson,MontanaPensionFundsGrowingbutHaventMadeUpLosses,The Billings
Gazette, Mav18,2009.
12.TheConferenceBoardnewsrelease,Mav27,2008.
13.TheConferenceBoardnewsrelease,December28,2010.
14.GregorvD.Bvnum,testimonvbeforetheFCIC,HearingontheImpactoftheFinancialCrisis
Greater Bakersfield, session 3: Residential and Communitv Real Estate, September 7, 2010, transcript,
p.102.
15. Board of Governors of the Federal Reserve Svstem, October 2010 Senior Loan Officer Opinion
Survev on Bank Lending Practices, Net Percentage of Domestic Respondents Tightening Standards on
ConsumerLoans,CreditCards,November8,2010.
16.AmericanBankruptcvInstitute,AnnualBusinessandNon-businessFilingsbvYear(19802009).
17.IeffAgosta,conferencecallwithFCIC,Februarv25,2010.
18. American Bankruptcv Institute, Annual Business and Non-Business Filings bv Year (1980
2009).
19.BoardofGovernorsoftheFederalReserveSvstem,Iulv2007SeniorLoanOfficerOpinionSurvev
onBankLendingPractices,August13,2007,p.13.
20.LizMover,RevolverattheHeads,Forbes, October7,2008.GannettCorporationwithdrew$1.2
billion,FairPointCommunicationswithdrew$200million,andDukeEnergvwithdrew$1billion.
21.MurilloCampello,IohnR.Graham,andCampbellR.Harvev,TheRealEffectsofFinancialCon-
straints:EvidencefromaFinancialCrisis,Iournal of Financial Economics 97(2010):476.
629 Notes to Chapter 21
22. Board of Governors of the Federal Reserve Svstem, Ianuarv 2009 Senior Loan Officer Opinion
Survev,fourth-quarter2008,p.8.
23.ElizabethDuke,governor,FederalReserveBoard,SmallBusinessLending,testimonvbeforethe
HouseCommitteeonFinancialServicesandCommitteeonSmallBusiness,Februarv26,2010,p.1.
24. National Federation of Independent Businesses, NFIB Small Business Economic Trends, De-
cember2010,p.12.
25.BenBernanke,RestoringtheFlowofCredittoSmallBusiness,speakingattheFederalReserve
MeetingSeries:AddressingtheFinancingNeedsofSmallBusinesses,Washington,DC,Iulv12,2010.
26.C.R.RustvCloutier,pastchairman,IndependentCommunitvBankersofAmerica,testimonv
beforetheFCIC,FirstPublicHearingoftheFCIC,dav1,panel3:FinancialCrisisImpactsontheEcon-
omv,Ianuarv13,2010,transcript,p.194.
27. Federal Reserve Statistical Release, E.2 Survev of Terms of Business Lending, E.2 Chart Data:
CommercialandIndustrialLoanRatesSpreadsoverIntendedFederalFundsRate,bvLoanSize,spread
forallsizes.
28.WilliamI.DennisIr.,SmallBusinessCreditinaDeepRecession,NationalFederationofInde-
pendentBusinesses,Februarv2010,p.18.
29.IerrvIost,interviewbvFCIC,August20,2010.
30.BoardofGovernorsoftheFederalReserveSvstem,SeniorLoanOfficerOpinionSurvevonBank
LendingPractices,April2010.
31.BoardofGovernorsoftheFederalReserveSvstem,SeniorLoanOfficerOpinionSurvevonBank
LendingPractices,Iulv2010.
32. Emilv Maltbv, Small Biz Loan Failure Rate Hits 12, CNN Monev, Februarv 25, 2009; SBA
LossesClimb154in2008,ColemanReport(www.colemanpublishing.com/public/343.cfm).
33. Michael A. Neal, chairman and CEO, GE Capital, testimonv before the FCIC, Hearing on the
ShadowBankingSvstem,dav2,session3:InstitutionsParticipatingintheShadowBankingSvstem,Mav
6,2010,transcript,p.242.
34.GE,2008AnnualReport,p.38.
35.MarkS.Barber,testimonvbeforetheFCIC,HearingontheShadowBankingSvstem,dav2,ses-
sion3:InstitutionsParticipatingintheShadowBankingSvstem,Mav6,2010,transcript,p.263.
36.InternationalMonetarvFund,InternationalFinancialStatisticsdatabase,WorldExports.
37.InternationalMonetarvFund,InternationalFinancialStatistics,WorldTables:Exports,WorldEx-
ports.
38.IaneLevere,OfficeDeals,19MonthsApart,ShowMarketsMove,^ew York Times, August10,
2010.
39. National Association of Realtors, Commercial Real Estate Ouarterlv Market Survev, December
2010,pp.4,5.
40.BrianGordon,principal,AppliedAnalvsis,testimonvbeforetheFCIC,HearingontheImpactof
theFinancialCrisisStateofNevada,session3:TheImpactoftheFinancialCrisisonNevadaRealEs-
tate,September8,2010,transcript,p.155.
41.AntonTroianovski,HighHopesasBuildersBetonSkvscrapers,Vall Street Iournal, September
29,2010.
42. Ibid.; Gregorv Bvnum, president, Gregorv D. Bvnum & Associates, Inc., testimonv before the
FCIC, Hearing on the Impact of the Financial CrisisGreater Bakersfield, session 3: Residential and
CommunitvRealEstate,September7,2010,transcript,pp.7780,7778.
43.FederalDepositInsuranceCommission,FailedBankList,Ianuarv2,2010.
44.FebruarvOversightReport,CommercialRealEstateLossesandtheRisktoFinancialStabilitv,
CongressionalOversightPanel,Februarv10,2010,pp.2,41,45.
45.TreppWire,CMBSDelinquencvRateNears9,Up21BPsinAugustafterLevelinginIulv,Rate
Now8.92MonthlvDelinquencvReport,September2010,p.1.
46.AllenKennev,CREMortgageDefaultRatetoDoublebv2010,REIT.com,Iune18,2009.Seealso
DefaultRatesReach16-YearHigh,GlobeSt.,Februarv24,2010.
47.Ibid.GreenStreetAdvisors,CommercialPropertvValuesGainMoreThan30from09Lows,
December2,2010,pp.3,1.
630 Notes to Chapter 21
48.Moodvs/REALCommercialPropertvPriceIndices,December2010,MoodvsInvestorsService
SpecialReport,December21,2010;MoodvsInvestorsService,USCommercialRealEstatePricesRise
1.3inOctober,December20,2010.
49. Congressional Oversight Panel, Commercial Real Estate Losses, Februarv Oversight Report,
Februarv10,2010,pp.23.
50.Dr.KennethT.Rosen,chairman,FisherCenterforRealEstateandEconomics,UniversitvofCali-
forniaatBerkelev,slidesintestimonvbeforetheFCIC,FirstPublicHearingoftheFCIC,dav1,panel3:
FinancialCrisisImpactsontheEconomv,Ianuarv13,2010.
51. Elizabeth McNichol, Phil Oliff, and Nicholas Iohnson, States Continue to Feel Recessions Im-
pact,CenteronBudgetandPolicvPriorities,December16,2010.
52.BruceWagstaff,SacramentoCountvwideServicesAgencv,testimonvbeforetheFCIC,Hearingon
theImpactoftheFinancialCrisisSacramento,session4:TheImpactoftheFinancialCrisisonSacra-
mentoNeighborhoodsandFamilies,September23,2010,transcript,p.234.
53.SujitCanagaRetna,interviewbvFCIC,November18,2010.
54.McNichol,Oliff,andIohnson,StatesContinuetoFeelRecessionsImpact.
55.NCSLFiscalBrief:ProjectedStateRevenueGrowthinFY2011andBevond,NationalConfer-
enceofStateLegislatures,September29,2010,p.1.
56.Ibid.
57.StateofCalifornia,LegislativeAnalvstsOffice,The201112Budget:CaliforniasFiscalOutlook.
58.KaiserCommissiononMedicaidandtheUninsured,MedicaidEnrollment:December2009Data
Snapshot,September2010,pp.1,3.
59.KaiserCommissiononMedicaidandtheUninsured,HopingforEconomicRecoverv,Preparing
for Health Reform: A Look at Medicaid Spending, Coverage and Policv Trends, September 30, 2010,
pp.16,25.
60.NationalLeagueofCities,RecessionsEffectsIntensifvinCities,October6,2010.
61.ChristopherW.HoeneandMichaelA.Pagano,CitvFiscalConditionsin2010,NationalLeague
ofCities,October2010,p.3.
62.Ibid.,pp.7,2.
63.AlanS.BlinderandMarkZandi,HowtheGreatRecessionWasBroughttoanEnd,MoodvsAn-
alvtics,Iulv27,2010,p.1.
64.DonaldL.Kohn,vicechairman,FederalReserveBoardofGovernors,TheFederalReservesPol-
icv Actions during the Financial Crisis and Lessons for the Future, speech at Carleton Universitv, Ot-
tawa,Canada,Mav13,2010.
65. U.S. Department of the Treasurv, Office of Financial Stabilitv, Troubled Asset Relief Program:
TwoYearRetrospective,October2010,p.8.
66.CongressionalBudgetOffice,ReportontheTroubledAssetReliefProgram,November2010.
67. White House Office of Management and Budget, FY2011 Budget Historical Tables, Section 1,
Table1.1SummarvofReceipts,Outlavs,andSurplusesorDeficits():17892015,TotalBudgetDeficit.
68.FDIC,FailedBankList.
69.OuarterlvBankingProfile:ThirdOuarter2010,FDIC Ouarterly 4,no.4(2010):4.
70. FDIC, Ouarterlv Banking Profile: First Ouarter 2009, FDIC Ouarterly 3, no. 2 (2009): 1, and
OuarterlvBankingProfile:FirstOuarter2010,FDIC Ouarterly 4,no.2(2010);BoardofGovernorsof
theFederalReserveSvstem,ProfitandBalanceSheetDevelopmentsatU.S.CommercialBanksin2009.
71.FDIC,StatisticsonDepositorvInstitutions,IncomeandExpense,AllCommercialBanksAssets
more than $1BNational, Standard Report #1 (reports issued on 3/31/2010 and 3/31/2009). Profit is
loggedasNetincomeattributabletobank.
72.FDIC,StatisticsonDepositorvInstitutions,IncomeandExpense,AllCommercialBanksAssets
less than $100M and Assets $100M to $1B; Standard Report #1 (reports issued on 3/31/2010 and
3/31/2009).ProfitisloggedasNetincomeattributabletobank.
73. Wall Street Bonuses Rose Sharplv in 2009, New York State Comptroller Thomas P. DiNapoli
pressrelease,Februarv23,2010.
74.N.Y.StateComptrollerThomasP.DiNapoli,EconomicTrendsinNewYorkState,October2010.
631 Notes to Chapter 22
Chapter 22
1.FCICcalculationsbasedonestimatesfromHopeNowandMoodvs.com.
2.MortgageBankersAssociationNationalDelinquencvSurvev(thesourcefortherestofthedelin-
quencvandforeclosureratesinthischapter).
3.IuliaGordon,CenterforResponsibleLending,HAMP,ServicerAbuses,andForeclosurePreven-
tion Strategies, testimonv before the Congressional Oversight Panel for the Troubled Asset Relief Pro-
gram(TARP),COPHearingonTARPForeclosureMitigationPrograms,111thCong.,2ndsess.,October
27,2010,pp.5,30;CRLtestimonvbasedonRodDubitskv,LarrvYang,StevanStevanovic,andThomas
Suehr, Foreclosure Update: Over 8 Million Foreclosures Expected, Credit Suisse (December 4, 2008),
andIanHatziusandMichaelA.Marschoun,HomePricesandCreditLosses:ProjectionsandPolicvOp-
tions,GoldmanSachsGlobalEconomicsPaper(Ianuarv13,2009),p.16.
4.RealtvTracYear-EndReportShowsRecord2.8MillionU.S.PropertieswithForeclosureFilingsin
2009AnIncreaseof21Percentfrom2008and120Percentfrom2007,RealtvTrac,Ianuarv14,2010.
5.DelinquenciesandLoansinForeclosureDecrease,butForeclosureStartsRiseinLatestMBANa-
tionalDelinquencvSurvev,MBApressrelease,November18,2010.
6.MarkFleming,chiefeconomist,CoreLogic,testimonvbeforetheFCIC,HearingontheImpactof
theFinancialCrisisSacramento,session1:OverviewoftheSacramentoHousingandMortgageMar-
ketsandtheImpactoftheFinancialCrisisontheRegion,September23,2010,transcript,p.14.
7.FCICstaffestimatesbasedonanalvsisofBlackBoxdata.
8.LaurieS.Goodman,seniormanagingdirector,AmherstSecuritiesGroupLP,writtentestimonvbe-
foretheHouseFinancialServicesCommittee,The Private Sector and Government Response to the Mort-
gage Foreclosure Crisis,111thCong.,1stsess.,December8,2009,p.3.
9.Theindexdeclinedfrom200.4inApril2006to136.6inMarch2009,adeclineof31.8.
10.NewCoreLogicDataShowsThirdConsecutiveOuarterlvDeclineinNegativeEquitv,CoreLogic
Inc.,December13,2010,p.1;nationallv,third-quarterfigureswereanimprovementfrom11.0million
residentialproperties23innegativeequitvinthesecondquarterof2010.
11.IimRokakis,treasurerofCuvahogaCountv,Ohio,interviewbvFCIC,November8,2010.
12.CuvahogaCountvexperienced13,943foreclosurefilingsin2006,14,946in2007,13,858in2008,
and14,171in2009.OhioCountvForeclosureFilings(19952009):CuvahogaCountv,PolicvMatters
Ohio.
13.Rokakis,interview.
14.TheUnitedStatesConferenceofMavors,ImpactoftheMortgageForeclosureCrisisonVacant
andAbandonedPropertiesinCities:A77-CitvSurvev,Iune2010,pp.34.
15.GuvCecala,preparedtestimonvfortheCongressionalOversightPanelfortheTroubledAssetRe-
liefProgram(TARP),COPHearingonTARPForeclosureMitigationPrograms,111thCong.,2ndsess.,
October27,2010,p.2.
16.IohnTavlor,interviewbvFCIC,October27,2010.
17.CongressionalOversightPanel,DecemberOversightReport:AReviewofTreasurvsForeclosure
PreventionPrograms,December14,2010,pp.4,7,18.
18.HOPENOW,IndustrvExtrapolationsandMetrics(October2010),December6,2010,p.3.
19. New Iersev HomeKeeper Program, New Iersev Housing and Mortgage Financing Agencv, ap-
provedSeptember23,2010.
20. Kirsten Keefe, presentation to the meeting of the Federal Reserve Svstems Consumer Advisorv
Council,Washington,D.C.,March25,2010,transcript,p.34.
21. Diane E. Thompson, testimonv to the Senate Committee on Banking, Housing, and Urban Af-
fairs,Problems in Mortgage Servicing from Modification to Foreclosure, 111thCong.,2ndsess.,November
16,2010,p.3.
22.See,forexample,NationalConsumerLawCenter,WhvServicersForecloseWhenThevShould
ModifvandOtherPuzzlesofServicerBehavior,October2009.
632 Notes to Chapter 22
23.IosephH.Evers,OfficeoftheComptrolleroftheCurrencv,deputvcomptrollerforlargebanksu-
pervision,writtentestimonvbeforetheCongressionalOversightPanelfortheTroubledAssetReliefPro-
gram(TARP),COPHearingonTARPForeclosureMitigationPrograms,111thCong.,2ndsess.,October
27,2010,pp.710.TheOCCreportedthatmortgageservicershavemodified1,239,896loanssinceearlv
2008.Bvtheendofthesecondquarterof2010,morethan26ofthemodificationswereseriouslvdelin-
quent; 9 were in the process of foreclosure; and 4 had completed foreclosure. The OCC examined
modified loans that were 60 or more davs delinquent that were modified during the second quarter of
2009,todeterminewhenafterloanmodificationthatseriousdelinquencvrecurred.At12monthsafter
modification,43ofloansweredelinquentbvtwoormoremonths;atninemonthsaftermodification,
41wereinarrears;atsixmonths,34;andatthreemonthsafteraloanchange,nearlv19weredelin-
quent.TheOCCnotedthatmorerecentmodificationshaveperformedbetterthanearliermodifications.
24.IuliaGordon,seniorpolicvcounsel,CenterforResponsibleLending,writtentestimonvbeforethe
CongressionalOversightPanelfortheTroubledAssetReliefProgram(TARP),COPHearingonTARP
ForeclosureMitigationPrograms,111thCong.,2ndsess.,October27,2010,p.11.
25.DavidI.Grais,partnerwithGrais&EllsworthLLP,interviewbvFCIC,November2,2010.
26.CalculationbvLaurieGoodman,seniormanagingdirector,AmherstSecurities.SeePowerPoint
presentationtotheGraisandEllsworthLLPconferenceRobosignersandOtherServicingFailures:Pro-
tecting the Rights of RMBS Investors, October 27, 2010 (http://video.remotecounsel.com/
mediasite/Viewer/:peid=12e6411377a744b9a9f2eefd1093871c1d).
27.Grais,interview.
28.GoodmantestimonvbeforetheHouseFinancialServicesCommittee,December8,2009.
29. See Deposition of Ieffrev Stephan, GMAC Mortgage LLC v. Ann M. Neu a/k/a Ann Michelle
Perez,No.502008CA040805XXXXMB(Fla.Cir.Ct.Dec.10,2009),pp.7,10.
30. See, for example, Dwavne Ransom Davis and Melisa Davis v. Countrvwide Home Loans, Inc.;
Bank of America, N.A.; BAC GP LLC; and BAC Home Loans Servicing, LP, 1:10-cv-01303-IMS-DML
(S.D.Ind.October19,2010).
31. Congressional Oversight Panel, November Oversight Report: Examining the Consequences of
MortgageIrregularitiesforFinancialStabilitvandForeclosureMitigation,November16,2010,p.20.
32.See,e.g.,Mortg.Elec.RegistrvSvs.v.Iohnston,No.420-6-09Rdcv(RutlandCo.Vt.Super.Ct.Oct.
28,2009),holdingthatMERSdidnothavestandingtoinitiateforeclosurebecausethenoteandmortgage
hadbeenseparated.
33.TheHonorableF.DanaWinslow,writtentestimonvbeforetheHouseCommitteeontheIudiciarv,
Foreclosed Iustice. Causes and Effects of the Foreclosure Crisis, 111thCong.,2ndsess.,December2,2010,
pp.2,4.
34.Order,ObjectiontoClaimsofCitibank,N.A.4-6-10,(Bankr.E.D.Cal.Mav20,2010),p.3.Theor-
der cites In re Foreclosure Cases, 521 F. Supp. 2d 650 (S.D. Oh. 2007); In re Vargas, 396 B.R. 511, 520
(Bankr.C.D.Cal.2008);LandmarkNatlBankv.Kesler,216P.3d158(Kan.2009);LaSalleBankv.Lamv,
824N.Y.S.2d769(N.Y.Sup.Ct.2006).
35.Winslow,writtentestimonvbeforetheHouseCommitteeontheIudiciarv,pp.23.
36.SeeIohnT.Kempv.CountrvwideHomeLoans,Inc.,CaseNo.08-18700-IHW(D.N.I.),pp.78.
37.Grais,interview.
38.AdamI.Levitin,associateprofessoroflaw,GeorgetownUniversitvLawCenter,testimonvtoSen-
ateCommitteeonBanking,Housing,andUrbanAffairs,Problems in Mortgage Servicing from Modifica-
tion to Foreclosure, 111thCong.,2ndsess.,November16,2010,p.20.
39.CongressionalOversightPanel,NovemberOversightReport,pp.5,7.
40.KatherinePorter,professoroflaw,UniversitvofIowaCollegeofLaw,writtentestimonvbeforethe
CongressionalOversightPanelfortheTroubledAssetReliefProgram(TARP),COPHearingonTARP
ForeclosureMitigationPrograms,October27,2010,p.8.
41.Levitin,writtentestimonvbeforetheSenateCommitteeonBanking,Housing,andUrbanAffairs,
p.20.
42.ErikaPoethig,writtentestimonvfortheHouseSubcommitteeonHousingandCommunitvOp-
portunitv, Impact of the Foreclosure Crisis on Public and Affordable Housing in the Twin Cities, 111th
Cong.,2ndsess.,Ianuarv23,2010,p.5.
633 Notes to Chapter 22
43.NationalAssociationfortheEducationofHomelessChildrenandYouth(NAEHCY)andFirstFo-
cus,ACriticalMoment:ChildandYouthHomelessnessinOurNationsSchools,Iulv2010,p.2.Inearlv
2010,NAEHCYandFirstFocusconductedasurvevof2,200schooldistricts.Whenthevwereaskedthe
reasons for the increased enrollment of students experiencing homelessness, 62 cited the economic
downturn,40attributedittogreaterschoolandcommunitvawarenessofhomelessness,and38cited
problemsstemmingfromtheforeclosurecrisis.
44.Dr.HeathMorrison,testimonvbeforetheFCIC,HearingontheImpactoftheFinancialCrisis
StateofNevada,session4:TheImpactoftheFinancialCrisisonNevadaPublicandCommunitvServices,
September8,2010,transcript,pp.26164.
45. Gail Burks, testimonv before the FCIC, Hearing on the Impact of the Financial CrisisState of
Nevada, session 3: The Impact of the Financial Crisis on Nevada Real Estate, September 8, 2010, tran-
script,pp.23031.
46.KarenMann,presidentandchiefappraiser,MannandAssociatesRealEstateAppraisers&Con-
sultants, written testimonv for the FCIC, Hearing on the Impact of the Financial CrisisSacramento,
session2:MortgageOrigination,MortgageFraudandPredatorvLendingintheSacramentoRegion,Sep-
tember23,2010,p.12;oraltestimonv,p.66.
47.DawnHunt,homeownerinCapeCoral,FL,interviewbvFCIC,December20,2010.
48.Zipcode33991,default,foreclosuresandREO,S&PGlobalDataSolutionsRMBSdatabase,Iulv
2010.
49.Hunt,interview.
INDEX
Theindexisavailableonlineatwww.publicaffairsbooks.com/fcicindex.pdf