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

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

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

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

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

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

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

Alan Greenspan, the Fed chairman during the

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The following yearafter Borns resignationthe Presidents Working Group on

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

Rubin testifed that when the CFMA passed

hewasnotopposedtotheregulationofderivativesandhadpersonallyagreedwith
Bornsviews,butthatverystronglyheldviewsinthefnancialservicesindustryin
oppositiontoregulationwereinsurmountable.

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

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

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

Some agencies responded

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

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

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

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

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

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

DOTCOM CRASH: LAY ON MORE RISK

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

In response, the Sarbanes-

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

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

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

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

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

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

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

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

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

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

Following losses by several banks in sub-

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

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

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

Criticsarguedthatwiththismuchmoneyatstake,mortgagebrokershadeveryin-
centivetoseekthehighestcombinationoffeesandmortgageinterestratesthemarket
will bear.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Everyone involved in keeping this machine hummingthe CDO managers and

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

CDOS: WE CREATED THE INVESTOR

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

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

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

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

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

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

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

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

Thanks to the combination of mortgage-backed securities,

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

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

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

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

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

more than in any decade since at least 1io.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Over 8o billion of collateralized loan obligations

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

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

Responding to questions about that data,

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

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

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

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

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

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

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

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

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

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

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

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

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

Thatsameday,GoldmansentBSAMmarksrangingfrom,,centsto1oocentson
thedollar.

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

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

Importantly,GermanregulatorsatthetimedidnotrequireIKBtoholdanycapitalto
offsetpotentialRhinelandlosses.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Citigroupsriskmanagementfunctionwassimplynotveryconcernedabouthous-
ingmarketrisks.AccordingtoPrince,Bushnellandotherstoldhim,ineffect,Gosh,
housingpriceswouldhavetogodownonationwideforustohave,notaproblem
with[mortgage-backedsecurities]CDOs,butforustohaveproblems,andthathas
never happened since the Depression.
,o
Housing prices would be down much less
than o when Citigroup began having problems because of write-downs and the
liquidityputsithadwritten.
By June ioo,, national house prices had fallen .,, and about 1o of subprime
adjustable-ratemortgagesweredelinquent.YetCitigroupstilldidnotexpectthatthe
liquidityputscouldbetriggered,anditremainedunconcernedaboutthevalueofits
retainedsuper-seniortranchesofCDOs.OnJune,ioo,,Citigroupmadeapresenta-
tiontotheSECaboutsubprimeexposureinitsCDObusiness.Thepresentationnoted
thatCitigroupdidnotfactortwopositionsintothisexposure:1.obillioninsuper-
seniortranchesandi.ibillioninliquidityputs.Thepresentationexplainedthatthe
liquidityputswerenotaconcern:Theriskofdefaultisextremelyunlikely . . .[and]
certain market events must also occur for us to be required to fund. Therefore, we
viewthesepositionstobeevenlessriskythantheSuperSeniorBook.
,1
Just a few weeks later, the July ioo, failure of the two Bear Stearns hedge funds
spelled trouble. Commercial paper written against three Citigroup-underwritten
CDOs for which Bear Stearns Asset Management was the asset manager and on
i\1i z++, 1u i\ii z++ 8i iii uN: i N :U8iii \i iu: :i: z,
whichCitigrouphadissuedliquidityputsbeganlosingvalue,andtheirinterestrates
began rising. The liquidity puts would be triggered if interest rates on the asset-
backedcommercialpaperroseaboveacertainlevel.
The Omce of the Comptroller of the Currency, the regulator of Citigroups na-
tional bank subsidiary, had expressed no apprehensions about the liquidity puts in
ioo. But by the summer of ioo,, OCC Examiner-in-Charge John Lyons told the
FCIC, the OCC became concerned. Buying the commercial paper would drain i,
billionofthecompanyscashandexposeittopossiblebalance-sheetlossesatatime
whenmarketswereincreasinglyindistress.Butgiventherisingrates,Lyonsalsosaid
Citigroupdidnothavetheoptiontowait.Overthenextsixmonths,Citigrouppur-
chasedalli,billionofthepaperthathadbeensubjecttoitsliquidityputs.
,i
On a July io conference call, CFO Gary Crittenden told analysts and investors
thatthecompanyssubprimeexposureshadfallenfromibillionattheendofiooo
to1billiononJuneo.Buthemadenomentionofthesuper-seniorexposuresand
liquidityputs.Ithinkourriskteamdidanicejobofanticipatingthatthiswasgoing
tobeadimcultenvironment,andsosetaboutinaprettyconcentratedefforttore-
duceourexposureoverthelastsixmonths,
,
hesaid.Aweeklater,onaJulyi,call,
Crittenden reiterated that subprime exposure had been cut: So I think weve had
goodriskmanagementthathasbeenanticipatingsomemarketdislocationhere.
,
ByAugust,asmarketconditionsworsened,CitigroupsCDOdeskwasrevaluing
itssuper-seniortranches,thoughithadnoeffectivemodelforassigningvalue.How-
ever,asthemarketcongealed,thenfroze,thepaucityofactualmarketpricesforthese
tranchesdemandedamodel.TheNewYorkFedlaternotedthatthemodelforSuper
SeniorCDOs,basedonfundamentaleconomicfactors,couldnotbefullyvalidated
byCitigroupscurrentvalidationmethodologiesyetitwasrelieduponforreporting
exposures.
,,
Barnes, the CDO risk omcer, told the FCIC that sometime that summer he met
withtheco-headsoftheCDOdesktoexpresshisconcernsaboutpossiblelosseson
boththeunsoldCDOinventoryandtheretainedsuper-seniortranches.Themessage
got through. Nestor Dominguez told the FCIC, We began extensive discussions
abouttheimplicationsofthe . . .dramaticdeclineoftheunderlyingsubprimemar-
kets,andhowthatwouldfeedintothesuper-seniorpositions.
,o
Alsoatthistime
for the frst timesuch concerns reached Maheras. He justifed his lack of prior
knowledgeofthebillionsofdollarsininventoryandsuper-seniortranchesbypoint-
ing out that the business was appropriately supervised by experienced and highly
competentmanagersandbyanindependentriskgroupandthatIwasproperlyap-
prisedofthegeneralnatureofourworkinthisareaanditsattendantrisks.
,,
Theexactdatesarenotcertain,butaccordingtoBushnell,heremembersadiscus-
sionataBusinessHeadsmeetingaboutthegrowingmark-to-marketvolatilityon
those super-senior tranches in late August or early September, well after Citigroup
startedtobuythecommercialpaperbackingthesuper-seniortranchesoftheCDOs
that BSAM managed.
,8
This was also when Chairman and CEO Prince frst heard
about the possible amount of open positions on the super-senior CDO tranches
that Citigroup held: It wasnt presented at the time in a startling fashion . . . [but]
z, ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
then it got bigger and bigger and bigger, obviously, over the next o days.
,
In late
August, Citigroups valuation models suggested that losses on the super-senior
tranchesmightrangefrom1,milliontoibillion.Thisnumberwasrecalculatedas
ooto,oomillioninmid-September,asthevaluationmethodologywasrefned.
oo
Intheweeksahead,thosenumberswouldskyrocket.
uIIt0X cells
To get a handle on potential losses from the CDOs and liquidity puts, starting on
September Prince convened a series of meetingsand later, nightly DEFCON
callswith members of his senior management team; they included Rubin, Ma-
heras,Crittenden,andBushnell,aswellasLouKaden,thechiefadministrativeom-
cer.
o1
Rubin was in Korea during the frst meeting but Kaden kept him informed.
oi
RubinlateremailedPrince:AccordingtoLou,Tom[Maheras]neverdidprovidea
clear and direct answer on the super seniors. If that is so, and the meeting did not
bringthattoahead,isntthatdeeplytroublingnotastowhathappenedthatisadif-
ferentquestionthatisalsotroublingbutastoprovidingfullandclearinformation
andanalysisnow.Princedisagreed,writing,Ithought,forfrstmtg,itwasgood.We
werenttryingtogettofnalanswers.
o
A second meeting was held September 1i, after Rubin was back in the country.
This meeting marked the frst time Rubin recalled hearing of the super-senior and
liquidityputexposure.Helatercommented,AsfarasIwasconcernedtheywereall
onething,becauseiftherewasaputbacktoCitiunderanycircumstance,however
remotethatcircumstancemightbe,youhadntfullydisposedoftherisk.
o
And,of
course,thecircumstancewasnotremote,sincebillionsofdollarsinsubprimemort-
gageassetshadalreadycomebackontoCitigroupsbooks.
PrincetoldtheFCICthatMaherashadassuredhimthroughoutthemeetingsand
theDEFCONcallsthatthesuperseniorsposednorisktoCitigroup,evenasthemar-
ketdeteriorated;headdedthathebecameincreasinglyuneasywithMaherassassess-
ment. Tom had said and said till his last day at work [October 11]: We are never
goingtoloseapennyonthesesuperseniors.Wearenevergoingtoloseapennyon
thesesuperseniors. . . .AndaswewentalongandIwasmoreandmoreuncomfort-
ablewiththisandmoreandmoreuncomfortablewithTomsconclusionsonultimate
valuations,thatiswhenIreallybegantohavesomeveryseriousconcernsaboutwhat
wasgoingtohappen.
o,
DespitePrincesconcerns,Citigroupremainedpubliclysilentabouttheadditional
subprimeexposurefromthesuper-seniorpositionsandliquidityputs,evenasitpre-
announcedsomedetailsofitsthird-quarterearningsonOctober1,ioo,.
OnOctober11,theratingagenciesannouncedthefrstinaseriesofdowngrades
onthousandsofsecurities.InPrincesview,thesedowngradesweretheprecipitating
event in the fnancial crisis.
oo
On the same day, Prince restructured the investment
bank,amovethatledtotheresignationofMaheras.
Four days later, the question of the super-senior CDOs and liquidity puts was
specifcallyraisedattheboardofdirectorsCorporateAuditandRiskManagement
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 1bn with an additional
1obninDirectSuperSeniorandi,bninLiquidityandParPuts.
o,
Citigroupstotal
subprime exposure was ,o billion, nearly half of its capital. The calculation was
straightforward,butduringananalystsconferencecallthatdayCrittendenomitted
anymentionofthesuper-senior-andliquidity-put-relatedexposureashetoldpar-
ticipantsthatCitigrouphadunder1billioninsubprimeexposure.
o8
A week later, on Saturday, October i,, Prince learned from Crittenden that the
companywouldhavetoreportsubprime-relatedlossesof8to11billion;onMon-
dayhetenderedhisresignationtotheboard.Helaterrefected,WhenIdrovehome
andGarycalledmeandtoldmeitwasntgoingtobetwooroomillionbutitwasgo-
ing to be eight billionI will never forget that call. I continued driving, and I got
home,Iwalkedinthedoor,Itoldmywife,IsaidhereswhatIjustheardandifthis
turnsouttobetrue,Iamresigning.
o
OnNovember,Citigrouprevealedtheaccuratesubprimeexposurenowesti-
mated at ,, billionand it disclosed the subprime-related losses. Though Prince
had resigned, he remained on Citigroups payroll until the end of the year, and the
boardofdirectorsgavehimagenerouspartingcompensationpackage:11.million
incashandimillioninstock,bringinghistotalcompensationto,millionfrom
ioo to ioo,.
,o
The SEC later sued Citigroup for its delayed disclosures. To resolve
the charges, the bank paid ,, million. The New York Fed would later conclude,
Therewaslittlecommunicationsontheextensivelevelofsubprimeexposureposed
bySuperSeniorCDO. . . .Seniormanagement,aswellastheindependentRiskMan-
agementfunctionchargedwithmonitoringresponsibilities,didnotproperlyidentify
andanalyzetheserisksinatimelyfashion.
,1
PrincesreplacementsaschairmanandCEORichardParsonsandVikramPan-
ditwere announced in December. Rubin would stay until January ioo, having
beenpaidmorethan11,millionfromioootoioo
,i
duringhistenureatthecom-
pany,includinghisroleaschairmanoftheExecutiveCommittee,apositionthatcar-
riednooperationalresponsibilities,RubintoldtheFCIC.MyagreementwithCiti
providedthatIdhavenomanagementofpersonneloroperations.
,
JohnReed,formerco-CEOofCitigroup,attributedthefrmsfailuresinparttoa
culturechangethatoccurredwhenthebanktookonSalomonBrothersaspartofthe
18Travelersmerger.HesaidthatSalomonexecutiveswereusedtotakingbigrisks
andhadahistory . . .[of]makingalotofmoney . . .butthengettingintotrouble.
,
AIG S DISPUTE WITH GOLDMAN:
THERE COULD NEVER BE LOSSES
BeginningonJulyio,ioo,,whenGoldmansDavilmansenttheemailthatdisrupted
thevacationofAIGsAlanFrost,thedisputebetweenGoldmanandAIGovertheneed
forcollateraltobackcreditdefaultswapscapturedtheattentionoftheseniormanage-
mentofbothcompanies.For1months,GoldmanpresseditscaseandsentAIGafor-
mal demand letter every single business day. It would pursue AIG relentlessly with
z ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
demands for collateral based on marks that were initially well below those of other
frmswhileAIGanditsmanagementstruggledtocometogripswiththeburgeoning
crisis.
The initial collateral call was a shock to AIGs senior executives, most of whom
hadnotevenknownthatthecreditdefaultswapswithGoldmancontainedcollateral
callprovisions.
They had known there were enormous exposures, billion, backed in large
partbysubprimeandAlt-Aloans,inioo,,
,,
comparedwiththeparentcompanysto-
tal reported capital of ,.8 billionbut executives said they had never been con-
cerned. The mantra at [AIG Financial Products] had always been (in my
experience) that there could never be losses, Vice President of Accounting Policy
JosephSt.Denissaid.
,o
Then came that frst collateral call. St. Denis told FCIC staff that he was so
stunnedwhenhegotthenewsthathehadtositdown.
,,
Thecollateralprovisions
surprisedevenGenePark,theexecutivewhohadinsisted18monthsearlierthatAIG
stop writing the swaps. He told the FCIC that rule Number 1 at AIG FP was to
neverpostcollateral.Thiswasparticularlyimportantinthecreditdefaultswapbusi-
ness,hesaid,becauseitwastheonlyunhedgedbusinessthatAIGran.
,8
But Jake Sun, the general counsel of the Financial Products subsidiary, who re-
viewedtheswapcontractsbeforetheywereexecuted,toldtheFCICthattheprovi-
sions were standard both at AIG and in the industry.
,
Frost, who was the frst to
learnofthecollateralcall,agreedandsaidthatotherfnancialinstitutionsalsocom-
monlydiddealswithcollateralpostingprovisions.
8o
PierreMicottis,theParis-based
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
Ambactopayoutexceptwhentheinsuredentitysufferedanactualloss,andthere-
forethosecompanieswereforbiddentopostcollateralforadeclineinmarketvalue
orunrealizedlosses.BecauseAIGFinancialProductswasnotregulatedasaninsur-
ancecompany,itwasnotsubjecttothisprohibition.
As disturbing as the senior AIG executives surprise at the collateral provisions
wastheirfrmsinabilitytoassessthevalidityofGoldmansnumbers.AIGFinancial
Products did not have its own model or otherwise try to value the CDO portfolio
thatitguaranteedthroughcreditdefaultswaps,nordidithedgeitsexposure.Gene
Parkexplainedthathedgingwasseenasunnecessaryinpartbecauseofthemistaken
beliefthatAIGwouldhavetopaycounterpartiesonlyifholdersofthesuper-senior
tranchesincurredactuallosses.HealsosaidthatpurchasingahedgefromUBS,the
Swiss bank, was considered, but that Andrew Forster, the head of credit trading at
AIG Financial Products, rejected the idea because it would cost more than the fees
that AIG Financial Products was receiving to write the CDS protection. Were not
goingtopayadimeforthis,ForstertoldPark.
8i
Therefore,AIGFinancialProductsreliedonanactuarialmodelthatdidnotpro-
vide a tool for monitoring the CDOs market value. The model was developed by
i\1i z++, 1u i\ii z++ 8i iii uN: i N :U8iii \i iu: :i: z,
Gary Gorton, then a fnance professor at the University of Pennsylvanias Wharton
School, who began working as a consultant to AIG Financial Products in 1o and
wasclosetoitsCEO,JoeCassano.TheGortonmodelhaddeterminedwith.8,
confdencethattheownersofthesuper-seniortranchesoftheCDOsinsuredbyAIG
FinancialProductswouldneversufferrealeconomiclosses,eveninaneconomyas
troubledastheworstpostWorldWarIIrecession.Thecompanysauditors,Pricewa-
terhouseCoopers (PwC), who were apparently also not aware of the collateral re-
quirements, concluded that the risk of default on [AIGs] portfolio has been
effectivelyremovedandasaresultfromariskmanagementperspective,thereareno
substantiveeconomicrisksintheportfolioandasaresultthefairvalueoftheliability
streamonthesepositionsfromariskmanagementperspectivecouldreasonablybe
consideredtobezero.
8
InspeakingwiththeFCIC,CassanowasadamantthattheCDSbookwaseffec-
tivelyhedged.HesaidthatAIGcouldneversufferlossesontheswaps,becausethe
CDScontractswerewrittenonlyonthesuper-seniortranchesoftop-ratedsecurities
withhighattachmentpointsthatis,manysecuritiesintheCDOswouldhaveto
defaultinorderforlossestoreachthesuper-seniortranchesandbecausethebulk
oftheexposurecamefromloansmadebeforeiooo,whenhethoughtunderwriting
standardshadbeguntodeteriorate.
8
Indeed,accordingtoGenePark,Cassanoputa
halttoa1,omillionhedge,inwhichAIGhadtakenashortpositionintheABXin-
dex.AsParkexplained,Joestoppedthatbecauseafterweputonthefrst1,o . . .the
marketmovedagainstus . . .wewerelosingmoneyonthe1,omillion. . . .Joesaid,
Youknow,Idontthinktheworldisgoingtoblowup . . .Idontwanttospendthat
money.Stopit.
8,
Despitethelimitedmarkettransparencyinthesummerofioo,,Goldmanused
whatinformationtherewas,includinginformationfromABXandotherindices,to
estimate what it considered to be realistic prices. Goldman also spoke with other
companies to see what values they assigned to the securities. Finally, Goldman
lookedtoitsownexperience:inmostcases,whenthebankboughtcreditprotection
on an investment, it turned around and sold credit protection on the same invest-
menttoothercounterparties.Thesedealsyieldedmorepriceinformation.
8o
UntilthedisputewithGoldman,AIGreliedontheGortonmodel,whichdidnot
estimatethemarketvalueofunderlyingsecurities.SoGoldmansmarkscaughtAIG
bysurprise.WhenAIGpushedback,GoldmanalmostimmediatelyreduceditsJuly
i,collateraldemandfrom1.8billionto1.ibillion,amovethatunderscoredthe
dimculty of fnding reliable market prices. The new demand was still too high, in
AIGs view, which was corroborated by third-party marks. Goldman valued the
CDOsbetween8oand,centsonthedollar,whileMerrillLynch,forexample,val-
uedthesamesecuritiesbetween,and1oocents.
8,
On August ,, Cassano told PwC that there was little or no price transparency
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 actually execute transactions at the
z ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
quotedprices.Theaboveestimatedvalues . . .donotrepresentactualbidsoroffers
byMerrillLynchwasthedisclaimerinalistingofestimatedmarketvaluesprovided
byMerrilltoAIG.
8
GoldmanSachsdisputedthereliabilityofsuchestimates.
\it/outocingjlient
OnAugust,forthefrsttime,AIGexecutivespubliclydisclosedthe,billionin
creditdefaultswapsonthesuper-seniortranchesofCDOsduringthecompanyssec-
ond-quarterearningscall.Theyacknowledgedthatthegreatmajorityoftheunderly-
ing bonds thus insuredo billionwere backed by subprime mortgages. Of this
amount,1billionwaswrittenonCDOspredominantlybackedbyriskyBBB-rated
collateral.Onthecall,Cassanomaintainedthattheexposureswerenoproblem:Itis
hardforus,withoutbeingfippant,toevenseeascenariowithinanykindofrealmor
reasonthatwouldseeuslosing1inanyofthosetransactions.Heconcluded:We
see no issues at all emerging. We see no dollar of loss associated with any of [the
CDO]business.Anyreasonablescenariothatanyonecandraw,andwhenIsayrea-
sonable,Imeanasevererecessionscenariothatyoucandrawoutforthelifeofthe
securities.SeniorVicePresidentandChiefRiskOmcerRobertLewissecondedthat
reassurance: We believe that it would take declines in housing values to reach de-
pression proportions, along with default frequencies never experienced, before our
AAAandAAinvestmentswouldbeimpaired.
o
Theseassurancesfocusedontheriskthatactualmortgagedefaultswouldcreate
realeconomiclossesonthecompanyscreditdefaultswappositions.
1
Butmoreim-
portantatthetimeweretheothertremendousrisksthatAIGexecutiveshadalready
discussed internally. No one on the conference call mentioned Goldmans demand
for 1.i billion in collateral; the clear possibility that future, much-larger collateral
callscouldjeopardizeAIGsliquidity;ortheriskthatAIGwouldbeforcedtotakean
enormousmarkonitsexistingbook,theconcernForsterhadnoted.
Thedayaftertheconferencecall,AIGposted,omillionincashtoGoldman,
its frst collateral posting since Goldman had requested the 1.i billion. As Frost
wrotetoForsterinanAugust1o,ioo,,email,theideawastogeteveryonetochill
out.
i
Foronething,someAIGexecutives,includingCassano,hadlate-summerva-
cationsplanned.Cassanosignedoffonthe,omilliongoodfaithdepositbefore
leavingforacyclingtripthroughGermanyandAustria.

Thepartiesexecutedaside
lettermakingclearthatbothdisputedtheamount.Forthetimebeing,twocompa-
niesthathadbeendoingbusinesstogetherfordecadesagreedtodisagree.
On August 1, Frost went to Goldmans omces to start the dialog, which had
stalledwhileCassanoandotherkeyexecutiveswereonvacation.Twodayslater,Frost
wrotetoForster:Trustme.Thisisnotthelastmargincallwearegoingtodebate.

He was right. By September 11, Socit Gnraleknown more commonly as Soc-

GenhaddemandedomillionincollateralonCDSithadpurchasedfromAIGFi-
nancial Products, UBS had demanded o, million, and Goldman had upped its
demand by oo million. The SocGen demand was based on an 8i., bid price pro-
vided by Goldman, which AIG disputed. Tom Athan, managing director at AIG Fi-
i\1i z++, 1u i\ii z++ 8i iii uN: i N :U8iii \i iu: :i: z,
nancialProducts,toldForsterthatSocGenreceivedmarksfromGSonpositionsthat
would result in big collateral calls but SG disputed them with GS.
,
Several weeks
later, Cassano told AIG Financial Services CFO Elias Habayeb that he believed the
SocGenmargincallhadbeenspurredbyGoldman,andthatAIGdisputedthecall
and[had]notheardfromSocGenagainonthatspecifccall.
o
Inthesecondweekof
October,theratingagenciesannouncedhundredsofadditionaldowngradesaffecting
tens of billions of dollars of subprime mortgagebacked securities and CDOs. By
Novemberi,Goldmansdemandhadalmostdoubled,toi.8billion.OnNovembero,
Bensinger,theCFO,informedAIGsAuditCommitteethatFinancialProductshadre-
ceivedmargincallsfromfvecounterpartiesandwasdisputingeverysingleone.
,
ThisstancewasrootedinthecompanyscontinuingbeliefthatGoldmanhadset
valuestoolow.AIGspositionwascorroborated,atleastinpart,bythewidedisparity
inmarksfromothercounterparties.Atonepoint,MerrillLynchandGoldmanmade
collateral demands on the very same CDS positions, but Goldmans marks were al-
most , lower than Merrills.
8
Goldman insisted that its marks represented the
constantly evolving additional information from our market making activities, in-
cluding trades that we had executed, market activity we observed, price changes in
comparablesecuritiesandderivativesandthecurrentpricesofrelevantliquid . . .in-
dices.

Trading in the ABX would fall from over oo trades per week through the
endofSeptemberioo,tolessthani,operweekinthefourthquarterofioo,;trad-
ing in the TABX, which focuses on lower-rated tranches, dropped from roughly ,o
tradesperweekthroughmid-Julytoalmostzerobymid-August.
1oo
But Cassano believed that the quick reduction in Goldmans frst collateral de-
mand (from 1.8 billion on July i, to 1.i billion on August i) and the interim
agreementonthe,omilliondepositconfrmedthatGoldmanwasnotascertainof
its marks as it later insisted. According to Cassano, Michael Sherwood, co-CEO of
GoldmanSachsInternational,toldhimthatGoldmandidntcoverourselvesinglory
during this period but that the markets starting to come our [Goldmans] way;
CassanotookthosecommentsasanimplicitadmissionthatGoldmansinitialmarks
hadbeenaggressive.
1o1
Morclovcnotcs
Inmid-August,ForstertoldFrostinanemailthatGoldmanwaspursuingastrategy
of aggressively marking down assets to cause maximum pain to their competi-
tors.
1oi
PricewaterhouseCoopers, which served as auditor for both AIG and Gold-
man during this period, knew full well that AIG had never before marked these
positionstomarket.Inthethirdquarterofioo,,withthecollateraldemandspiling
up,PwCpromptedAIGtobegindevelopingamodelofitsown.PriortotheGold-
man margin call, PwC had concluded that compensating controls made up for
AIGsnothavingamodel.Amongthosewasnoticefromcounterpartiesthatcollat-
eralwasdue.
1o
Inotherwords,oneofAIGsriskmanagementtoolswastolearnofits
ownproblemsfromcounterpartieswhodidhavetheabilitytomarktheirownposi-
tionstomarketpricesandthendemandcollateralfromAIG.
z,+ ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
Thedecisiontodevelopavaluationmodelwasnotunanimous.Inmid-Septem-
ber,CassanoandForstermetwithHabayebandotherstodiscussmarkingtheposi-
tions down and actually recording valuation losses in AIGs fnancial statements.
Cassanostillthoughtthevaluationprocessunnecessarybecausethepossibilityofde-
faults was remote.
1o
He sent Forster and others emails describing requests from
Habayebasmorelovenotes . . .[askingustogothrough]thesamedrillofdrafting
answers.
1o,
Nevertheless,byOctober,andinconsultationwithPwC,AIGstartedto
evaluate the pricing model for subprime instruments developed and used by
Moodys.CassanoconsideredtheMoodysmodelonlyagutcheckuntilitwasfully
validatedinternally.
1oo
AIGcoupledthismodelwithgenericCDOtranchedatasold
byJPMorganthatwereconsideredtoberelativelyrepresentativeofthemarket.Of
course,bythistimeandforseveralprecedingmonthstherewasnoactivemarket
formanyofthesetranches.Everyoneunderstoodthatthiswasnotaperfectsolution,
but AIG and its auditors thought it could serve as an interim step. The makeshift
modelwasupandrunninginthethirdquarter.
tonjicntinourmerks
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-
proximately,,omillionbeforetax[onthat]portfolio.Onaconferencecall,CEO
Sullivan assured investors that the insurance company had active and strong risk
management.Hesaid,AIGcontinuestobelievethatitishighlyunlikelythatAIGFP
willberequiredtomakepaymentswithrespecttothesederivatives.Cassanoadded
that AIG had more than enough resources to meet any of the collateral calls that
mightcomein.
1o,
Whilethecompanyremainedadamantthattherewouldbenore-
alizedeconomiclossesfromthecreditdefaultswaps,itusedthenewlyadoptedand
adaptedMoodysmodeltoestimatethe,imillioncharge.Infact,PwChadques-
tionedtherelevanceofthemodel:ithadntbeenvalidatedinadvanceoftheearnings
release,itdidnttakeintoaccountimportantstructuralinformationabouttheswap
contracts,andtherewerequestionsaboutthequalityofthedata.
1o8
AIGdidntmen-
tionthosecaveatsonthecall.
Twoweekslater,onNovemberi,Goldmandemandedanadditionalbillionin
cash.AIGprotested,butpaid1.,,billion,bringingthetotalpostedtoibillion.
1o
Fourdayslater,CassanocirculatedamemofromForsterlistingthepertinentmarks
for the securities from Goldman Sachs, Merrill Lynch, Calyon, Bank of Montreal,
andSocGen.
11o
Themarksvariedwidely,fromaslittleas,,ofthebondsoriginal
valuetovirtuallyfullvalue.Goldmansestimatedvaluesweremuchlowerthanthose
ofotherdealers.Forexample,GoldmanvaluedoneCDO,theDunhillCDO,at,,
ofpar,whereasMerrillvalueditat,ofpar;theOrientPointCDOwasvaluedat
ooofparbyGoldmanbutat,ofparbyMerrill.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. billion. He told both AIG and Goldman executives
that independent third-party pricing for ,o of the ,,oo securities underlying the
CDOsonwhichAIGFPhadwrittenCDSandAIGsownvaluationfortheothero
indicatedthatGoldmansdemandwasunsupportedthereforeGoldmanshouldre-
turnthemoney.
11
Goldmanrefused,andinsteaddemandedmore.
11
BylateNovember,therewasrelativeagreementwithinAIGandwithitsauditor
thattheMoodysmodelincorporatedintoAIGsvaluationsystemwasinadequatefor
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 Moodys model
wouldresultina1.,billionvaluationloss;usingGoldmansmarkswouldresultina
,billionvaluationloss,whichwouldwipeoutthequartersprofts.
11o
OnNovember
i, PwC auditors met with senior executives from AIG and the Financial Products
subsidiarytodiscussthewholesituation.AccordingtoPwCmeetingnotes,AIGre-
ported that disagreements with Goldman continued, and AIG did not have data to
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 rely on dealer quotes.
JamesBridgewater,theFinancialProductsexecutivevicepresidentinchargeofmod-
els, came up with a solution. Convinced that there was a calculable difference be-
tween the value of the underlying bonds and the value of the swap protection AIG
had written on those bonds, Bridgewater suggested using a negative basis adjust-
ment,whichwouldreducetheunrealizedlossestimatefrom,.1billion(Goldmans
fgure) to about 1., billion. With their auditors knowledge, Cassano and others
agreedthatthenegativebasisadjustmentwasthewaytogo.
SeveraldocumentsgiventotheFCICbyPwC,AIG,andCassanorefectdiscus-
sionsduringandaftertheNovemberimeeting.Duringasecondmeetingatwhich
onlytheauditorandparentcompanyexecutiveswerepresent(FinancialProductsex-
ecutives, including Cassano and Forster, did not attend), PwC expressed signifcant
concerns about risk management, specifcally related to the valuation of the credit
default swap portfolio, as well as to the companys procedures in posting collateral.
AIGFinancialProductshadpaidoutibillionwithoutactiveinvolvementfromthe
parentcompanysEnterpriseRiskManagementgroup.Anotherissuewasthewayin
whichAIGFP[had]beenmanagingtheSS[supersenior]valuationprocesssaying
PwCwillnotgetanymoreinformationuntilaftertheinvestordaypresentation.
11
TheauditorslaidouttheirconcernsaboutconfictingstrategiespursuedbyAIG
subsidiaries. Notably, the securities-lending subsidiary had been purchasing mort-
gage-backed securities, using cash raised by lending securities that AIG held on
z,z ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
behalfofitsinsurancesubsidiaries.FromtheendofiooothroughSeptemberioo,,
itsholdingsrosefromobillionto88billion.Meanwhile,FinancialProducts,act-
ingonitsownanalysis,haddecidedinioootobeginpullingbackonwritingcredit
defaultswapsonCDOs.InPwCsview,inallowingonesubsidiarytoincreaseexpo-
sure to subprime while another subsidiary worked to exit the market entirely, the
parentcompanysriskmanagementfailed.PwCalsosaidthatthecompanyssecond
quarterofioo,fnancialdisclosureswouldhavebeenchangediftheexposureofthe
securities-lending business had been known. The auditors concluded that these
items together raised control concerns around risk management which could be a
material weakness.
1io
Kevin McGinn, AIGs chief credit omcer, shared these con-
cernsabouttheconfictingstrategies.InaNovemberio,ioo,,email,McGinnwrote:
All units were apprised regularly of our concerns about the housing market. Some
listenedandresponded;otherssimplychosenottolistenandthen,toaddinsultto
injury,nottospotthemanifestsigns.HeconcludedthatthiswasakintoNeroplay-
ing the fddle while Rome burns.
1i1
On the opposite side, Sullivan insisted to the
FCICthattheconfictingstrategiesinthesecurities-lendingbusinessandatAIGFi-
nancialProductssimplyrevealedthatthetwosubsidiariesadopteddifferentbusiness
models,anddidnotconstituteariskmanagementfailure.
1ii
OnDecember,,sixdaysafterreceivingPwCswarnings,Sullivanboastedonan-
otherconferencecallaboutAIGsriskmanagementsystemsandthecompanysover-
sight of the subprime exposure: The risk we have taken in the U.S. residential
housingsectorissupportedbysoundanalysisandariskmanagementstructure. . . .
webelievetheprobabilitythatitwillsustainaneconomiclossisclosetozero. . . .We
areconfdentinourmarksandthereasonablenessofourvaluationmethods.Charlie
Gates, an analyst at Credit Suisse, a Swiss bank, asked directly about valuation and
collateraldisputeswithcounterpartiestowhichAIGhadalludedinitsthird-quarter
fnancialresults.Cassanoreplied,Wehavefromtimetotimegottencollateralcalls
frompeopleandthenwesaytothem,wellwedontagreewithyournumbers.And
theygo,oh,andtheygoaway.Andyousaywellwhatwasthat:Itslikeadrive-byina
way.Andtheothertimestheysatdownwithus,andnoneofthisishostileorany-
thing,itsallverycordial,andwesitdownandwetryandfndthemiddlegroundand
comparewhereweare.
1i
Cassano did not reveal the i billion collateral posted to Goldman, the several
hundredmilliondollarspostedtoothercounterparties,andthedailydemandsfrom
Goldman and the others for additional cash. The analysts and investors on the call
were not informed about the negative basis adjustment used to derive the an-
nounced1.,billionmaximumpotentialexposure.Investorsthereforedidnotknow
that AIGs earnings were overstated by .o billionand they would not learn that
informationuntilFebruary11,ioo8.
Metcrielvcekncss
ByJanuaryioo8,AIGstilldidnothaveareliablewaytodeterminethemarketprice
ofthesecuritiesonwhichithadwrittencreditprotection.Nevertheless,onJanuary
i\1i z++, 1u i\ii z++ 8i iii uN: i N :U8iii \i iu: :i: z,,
1o,CassanosentanemailtoMichaelSherwoodandCFODavidViniaratGoldman
demanding that they return 1.1 billion of the i billion posted.
1i
He attached a
spreadsheetshowingthatAIGvaluedmanysecuritiesatpar,asiftherehadbeenno
decline in their value. That was simply not credible, Goldman executives told the
FCIC.
1i,
Meanwhile, Goldman had by then built up 1., billion in protection by
purchasingcreditdefaultswapsonAIGtocoverthedifferencebetweentheamount
ofcollateraltheyhaddemandedandtheamountthatAIGhadpaid.
1io
OnFebruaryo,ioo8,PwCauditorsmetwithRobertWillumstad,thechairmanof
AIGs board of directors. They informed him that the negative basis adjustment
usedtoreachthe1.,billionestimatedisclosedontheDecember,investorcallhad
beenimproperandunsupported,andwasasignthatcontrolsovertheAIGFinan-
cialProductssuperseniorcreditdefaultswapportfoliovaluationprocessandover-
sightthereofwerenoteffective.PwCconcludedthatthisdefciencywasamaterial
weaknessasofDecember1,ioo,.
1i,
Inotherwords,PwCwouldhavetoannounce
thatthenumbersAIGhadalreadypubliclyreportedwerewrong.Whytheauditors
waitedsolongtomakethispronouncementisunclear,particularlygiventhatPwC
hadknownabouttheadjustmentinNovember.
In the meeting with Willumstad, the auditors were broadly critical of Sullivan;
Bensinger,whomtheydeemedunabletocompensateforSullivansweaknesses;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,Sullivanreceived1o,millionoverfouryearsincompensationfrom
AIG,includingaseverancepackageof18million.Whenaskedaboutthesefgures
at a FCIC hearing, he said, I have no knowledge or recollection of those numbers
whatsoever,sir. . . .Icertainlydontrecallearningthatamountofmoney,sir.
1i
Thefollowingday,PwCmetwiththeentireAIGAuditCommitteeandrepeated
the analysis presented to Willumstad. The auditors said they could complete AIGs
audit,butonlyifCassanodidnotinterfereintheprocess.RetainingCassanowasa
managementjudgment,butthecultureneededtochangeatFP.
1o
OnFebruary11,
AIGdisclosedinanSECflingthatitsauditorhadidentifedthematerialweakness,
acknowledgingthatithadreduceditsDecembervaluationlossestimatesby.obil-
lionthatis,thedifferencebetweentheestimatesof,.1billionand1.,billion
becauseoftheunsupportablenegativebasisadjustment.
Theratingagenciesrespondedimmediately.MoodysandS&Pannounceddown-
grades,andFitchplacedAIGonRatingsWatchNegative,suggestingthatafuture
downgradewaspossible.AIGsstockdeclined1ifortheday,closingat.,.
AttheendofFebruary,Goldmanheldibillionincashcollateral,wasdemand-
ing an additional i., billion, and had upped to i.1, billion its CDS protection
against an AIG failure. On February i8, AIG disappointed Wall Street againthis
time with dismal fourth-quarter and fscal year ioo, earnings. The company re-
portedanetlossof,.ibillion,largelydueto11.1ibillioninvaluationlossesre-
lated to the super-senior CDO credit default swap exposure and more than i.o
z,, ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
billion in losses relating to the securities-lending businesss mortgage-backed pur-
chases.Alongwiththelosses,SullivanannouncedCassanosretirement,butthenews
wasntallbadfortheformerFinancialProductschief:Hemademorethanoomil-
lionfromthetimehejoinedAIGFinancialProductsinJanuaryof18,untilhisre-
tirement in ioo8, including a 1 million-a-month consulting agreement after his
retirement.
11
InMarch,theOmceofThriftSupervision,thefederalregulatorinchargeofregu-
latingAIGanditssubsidiaries,downgradedthecompanyscompositeratingfroma
i,signifyingthatAIGwasfundamentallysound,toa,indicatingmoderatetose-
vere supervisory concern. The OTS still judged the threat to overall viability as re-
mote.
1i
Itdidnotscheduleafollow-upreviewofthecompanysfnancialcondition
foranothersixmonths.
Bythen,itwouldbetoolate.
FEDERAL RESERVE:
THE DISCOUNT WINDOW WASN T WORKING
Over the course of the fall, the announcements by Citigroup, Merrill, and others
made it clear that fnancial institutions were going to take serious losses from their
exposurestothemortgagemarket.Stocksoffnancialfrmsfellsharply;bytheendof
November,theS&PFinancialsIndexhadlostmorethan1ofortheyear.Between
July and November, asset-backed commercial paper declined about o, which
meantthatthoseassetshadtobesoldorfundedbyothermeans.Investmentbanks
and other fnancial institutions faced tighter funding markets and increasing cash
pressures.Asaresult,theFederalReservedecidedthatitsinterestratecutsandother
measuressinceAugusthadnotbeensumcienttoprovideliquidityandstabilitytof-
nancialmarkets.TheFedsdiscountwindowhadntattractedmuchbankborrowing
becauseofthestigmaattachedtoit.Theproblemwiththediscountwindowisthat
people dont like to use it because they view it as a risk that they will be viewed as
weak,WilliamDudley,thenheadofthecapitalmarketsgroupattheNewYorkFed
andcurrentlyitspresident,toldtheFCIC.
1
Banks and thrifts preferred to draw on other sources of liquidity; in particular,
during the second half of ioo,, the Federal Home Loan Bankswhich are govern-
ment-sponsoredentitiesthatlendtobanksandthrifts,acceptingmortgagesascollat-
eralboostedtheirlendingbyi,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; Countrywide increased its bor-
rowing from i, billion to 8 billion; Bank of America increased its borrowing
from8billionto,obillion.TheFederalHomeLoanBankscouldthusbeseenas
thelenderofnexttolastresortforcommercialbanksandthriftstheFedbeingthe
lastresort.
1
Inaddition,thelossofliquidityinthefnancialsectorwasmakingitmoredim-
i\1i z++, 1u i\ii z++ 8i iii uN: i N :U8iii \i iu: :i: z,,
cultforbusinessesandconsumerstogetcredit,raisingtheFedsconcerns.FromJuly
to October, the percentage of loan omcers reporting tightening standards on prime
mortgagesincreasedfrom1,toabouto.Overthattime,thepercentageofloan
omcersreportingtighteningstandardsonloanstolargeandmidsizecompaniesin-
creasedfrom8to1,itshighestlevelsinceioo.
1,
TheFederalReservepursued
a whole slew of nonconventional policies . . . very creative measures when the dis-
count window wasnt working as hoped, Frederic Mishkin, a Fed governor from
ioootoioo8,toldtheFCIC.Theseactionswereveryaggressive,[and]theywereex-
tremely controversial.
1o
The frst of these measures, announced on December 1i,
wasthecreationoftheTermAuctionFacility(TAF).Theideawastoreducethedis-
countwindowstigmabymakingthemoneyavailabletoallbanksatoncethrougha
regularauction.Theprogramhadsomesuccess,withbanksborrowingobillionby
theendoftheyear.Overtime,theFedwouldcontinuetotweaktheTAFauctions,of-
feringmorecreditandlongermaturities.
AnotherFedconcernwasthatbanksandotherswhodidhavecashwouldhoard
it.Hoardingmeantforeignbankshaddimcultyborrowingindollarsandwerethere-
foreunderpressuretoselldollar-denominatedassetssuchasmortgage-backedsecu-
rities. Those sales and fears of more sales to come weighed on the market prices of
U.S. securities. In response, the Fed and other central banks around the world an-
nounced (also on December 1i) new currency swap lines to help foreign banks
borrow dollars. Under this mechanism, foreign central banks swapped currencies
with the Federal Reservelocal currency for U.S. dollarsand lent these dollars to
foreignbanks.Duringthecrisis,theU.S.bankswereveryreluctanttoextendliquid-
itytoEuropeanbanks,Dudleysaid.
1,
Centralbankshadusedsimilararrangements
in the aftermath of the /11 attacks to bolster the global fnancial markets. In late
ioo1,theswaplinestotaled88billion.Duringthefnancialcrisissevenyearslater,
theywouldreach,8obillion.
The Fed hoped the TAF and the swap lines would reduce strains in short-term
moneymarkets,easingsomeofthefundingpressureonotherstrugglingparticipants
such as investment banks. Importantly, it wasnt just the commercial banks and
thriftsbutthebroaderfnancialsystemthatconcernedtheFed,Dudleysaid.His-
torically,theFederalReservehasalwaystendedtosupplyliquiditytothebankswith
theideathatliquidityprovidedtothebankingsystemcanbe[lenton]tosolventin-
stitutions in the nonbank sector. What we saw in this crisis was that didnt always
takeplacetotheextentthatithadinthepast. . . .Idontthinkpeoplegoinginreally
hadafullunderstandingofthecomplexityoftheshadowbankingsystem,theroleof
[structuredinvestmentvehicles]andconduits,thebackstopsthatbankswereprovid-
ingSIVconduitseitherexplicitlyorimplicitly.
18
Burdened with capital losses and desperate to cover their own funding commit-
ments,thebankswerenotstableenoughtofllthevoid,evenaftertheFedlowered
interestratesandbegantheTAFauctions.InJanuaryioo8,theFedcutratesagain
andthenagain,twicewithintwoweeks,ahighlyunusualmovethatbroughtthefed-
eralfundsratefrom.i,to.o.
z, ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
The Fed also started plans for a new program that would use its emergency au-
thority,theTermSecuritiesLendingFacility,thoughitwasntlauncheduntilMarch.
The TLSF was more a view that the liquidity that we were providing to the banks
through the TAF was not leading to a signifcant diminishment of fnancing pres-
sureselsewhere,DudleytoldtheFCIC.Somaybeweshouldthinkaboutbypassing
thebankingsystemand[try]tocomeupwithavehicletoprovideliquiditysupport
totheprimarydealercommunitymoredirectly.
1
OnMarch,,theFedincreasedthetotalavailableineachofthebiweeklyTAFauc-
tions from o billion to ,o billion, and guaranteed at least that amount for six
months.TheFedalsoliberalizeditsstandardforcollateral.Primarydealersmainly
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
outstandingatanygiventime.
Alsoatthistime,theU.S.centralbankbegancontemplatingastepthatwasrevo-
lutionary: a program that would allow investment banksinstitutions over which
the Fed had no supervisory or regulatory responsibilityto borrow from the dis-
countwindowontermssimilartothoseavailabletocommercialbanks.
MONOLINE INSURERS: WE NEVER EXPECTED LOSSES
Meanwhile,theratingagenciescontinuedtodowngrademortgage-backedsecurities
andCDOsthroughioo,.ByJanuaryioo8,asaresultofthestressinthemortgage
market,S&Phaddowngraded,8tranchesofresidentialmortgagebackedsecuri-
tiesand1,8tranchesfromioCDOs.MBIAandAmbac,thetwolargestmonoline
insurers,hadtakenonacombinedio,billionofguaranteesonmortgagesecurities
and other structured products. Downgrades on the products that they insured
brought the fnancial strength of these companies into question. After conducting
stressanalysis,S&PestimatedinFebruaryioo8thatAmbacwouldneeduptooo
million in capital to cover potential losses on structured products.
1o
Such charges
would affect the monolines own credit ratings, which in turn could lead to more
downgradesoftheproductstheyhadguaranteed.
Likemanyofthemonolines,ACA,thesmallestofthem,keptrazor-thincapital
lessthan,oomillionagainstitsobligationsthatincludedobillionincreditde-
fault swaps on CDOs. In late ioo,, ACA reported a net loss of 1., billion, almost
entirelyduetocreditdefaultswaps.
Thiswasnews.Thenotionofzero-losstolerancewascentraltotheviabilityof
the monoline business model, and they and various stakeholdersthe rating agen-
cies, investors, and monoline creditorshad traditionally assumed that the mono-
lines never would have to take a loss. As Alan Roseman, CEO of ACA, told FCIC
staff:Weneverexpectedlosses. . . .Wewereprovidinghedgesonmarketvolatilityto
institutionalcounterparties. . . .Wewerepositioned,webelieved,totakethevolatil-
ity because we didnt have to post collateral against the changes in market value to
ourcounterparty,numberone.Numbertwo,weweretoldbytheratingagenciesthat
i\1i z++, 1u i\ii z++ 8i iii uN: i N :U8iii \i iu: :i: z,,
ratedusthatthatmark-to-marketvariationwasnotimportanttoourrating,froma
fnancialstrengthpointofviewattheinsurancecompany.
11
InearlyNovember,theSECcalledthegrowingconcernaboutMerrillsuseofthe
monolinesforhedgingaconcernthatwealsoshare.
1i
ThelargeWallStreetfrms
attempted to minimize their exposure to the monolines, particularly ACA. On De-
cember 1, S&P downgraded ACA to junk status, rating the company CCC, which
wasfatalforacompanywhoseCEOsaidthatitsratingisthefranchise.
1
Firmslike
Merrill Lynch would get virtually nothing for the guarantees they had purchased
fromACA.
Despitethestressesinthemarket,theSECsawthemonolineproblemsaslargely
confnedtoACA.AJanuaryioo8internalSECdocumentsaid,Whilethereisaclear
sentimentthatcapitalraisingwillneedtocontinue,thefactthattheguarantors(with
theexceptionofACA)arerelativelyinsulatedfromliquiditydrivenfailuresprovides
hopethatevent[s]inthissectorwillunfoldinamanageablemanner.
1
Still,theratingagenciestoldthemonolinesthatiftheywantedtoretaintheirstel-
lar ratings, they would have to raise capital. MBIA and Ambac ultimately did raise
1.o, billion and 1., billion, respectively. Nonetheless, S&P downgraded both to
AAinJuneioo8.Asthecrisisunfolded,mostofthemonolinesstoppedwritingnew
coverage.
The subprime contagion spread through the monolines and into a previously
unimpairedmarket:municipalbonds.Thepathofthesefallingdominoesiseasyto
follow: in anticipation of the monoline downgrades, investors devalued the protec-
tionthemonolinesprovidedforothersecuritieseventhosethathadnothingtodo
withthemortgage-backedmarkets,includingasetofinvestmentsknownasauction
rate securities, or ARS. An ARS is a long-term bond whose interest rate is reset at
regularlyscheduledauctionsheldeveryonetosevenweeks.
1,
Existinginvestorscan
choosetorebidforthebondsandnewinvestorscancomein.Thedebtisfrequently
municipalbonds.AsofDecember1,ioo,,stateandlocalgovernmentshadissued
1o, billion in ARS, accounting for half of the o billion market. The other half
wereprimarilybundlesofstudentloansanddebtofnonproftssuchasmuseumsand
hospitals.
The key point: these entities wanted to borrow long-term but get the beneft of
lowershort-termrates,andinvestorswantedtogetthesafetyofinvestinginthesese-
curitieswithouttyinguptheirmoneyforalongtime.Unlikecommercialpaper,this
market had no explicit liquidity backstop from a bank, but there was an implicit
backstop: often, if there were not enough new buyers to replace the previous in-
vestors,thedealersrunningtheseauctions,includingfrmslikeUBS,Citigroup,and
Merrill Lynch, would step in and pick up the shortfall. Because of these interven-
tions,therewereonly1failuresbetween18andearlyioo,inmorethan1oo,ooo
auctions. Dealers highlighted those minuscule failure rates to convince clients that
ARSwereveryliquid,short-terminstruments,evenintimesofstress.
1o
However,ifanauction didfail,thepreviousARSinvestorswouldbeobligatedto
retaintheirinvestments.Incompensation,theinterestratesonthedebtwouldreset,
oftenmuchhigher,butinvestorsfundswouldbetrappeduntilnewinvestorsorthe
z, ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
dealer stepped up or the borrower paid off the loan. ARS investors were typically
veryriskaverseandvaluedliquidity,andsotheywerewillingtopayapremiumfor
guaranteesontheARSinvestmentsfrommonolines.Itnecessarilyfollowedthatthe
monolines growing problems in the latter half of ioo, affected the ARS market.
Fearing that the monolines would not be able to perform on their guarantees, in-
vestors fed. The dealers interventions were all that kept the market going, but the
stressbecametoogreat.Withtheirownproblemstocontendwith,thedealerswere
unabletostepinandensuresuccessfulauctions.InFebruary,enmasse,theypulled
up stakes. The market collapsed almost instantaneously. On February 1, in one of
thestarkestmarketdislocationsofthefnancialcrisis,8ooftheARSauctionsfailed;
thefollowingweek,o,failed.
Hundreds of billions of dollars were trapped by ARS instruments as investors
wereobligatedtoretaintheirinvestments.Andretailinvestorsindividualsinvest-
ing less than 1 million, small businesses, and charitiesconstituted more than
11o billion of this o billion market.
1,
Moreover, investors who chose to re-
maininthemarketdemandedapremiumtotakeontherisk.Betweeninvestorde-
mandsandinterestrateresets,countlessgovernments,infrastructureprojects,and
nonprofits on tight budgets were slammed with interest rates of 1o or higher.
ProblemsintheARSmarketcostGeorgetownUniversity,aborrower,omillion.
18
NewYorkStatewasstuckwithinterestratesthatsoaredfromabout.,tomore
than1onbillionofitsdebt.ThePortAuthorityofNewYorkandNewJersey
sawtheinterestrateonitsdebtjumpfrom.toioinasingleweekinFebru-
ary.
1
In ioo8 alone, the SEC received more than 1,ooo investor complaints regarding
the failed ARS auctions. Investors argued that brokers had led them to believe that
ARS were safe and liquid, essentially the equivalent of money market accounts but
with the potential for a slightly higher interest rate. Investors also reported that the
frozen market blocked their access to money for short-term needs such as medical
expenses, college tuition, and, for some small businesses and charities, payroll. By
ioo,theSEChadsettledwithfnancialinstitutionsincludingBankofAmerica,RBC
Capital Markets, and Deutsche Bank to resolve charges that the frms misled in-
vestors. As a result, these and other banks made more than ,o billion available to
payofftensofthousandsofARSinvestors.
1,o
COMMISSION CONCLUSIONS ON CHAPTER 14
The Commission concludes that some large investment banks, bank holding
companies, and insurance companies, including Merrill Lynch, Citigroup, and
AIG, experienced massive losses related to the subprime mortgage market be-
causeofsignifcantfailuresofcorporategovernance,includingriskmanagement.
Executive and employee compensation systems at these institutions dispropor-
tionallyrewardedshort-termrisktaking.
TheregulatorstheSecuritiesandExchangeCommissionforthelargeinvest-
ment banks and the banking supervisors for the bank holding companies and
AIGfailedtoadequatelysupervisetheirsafetyandsoundness,allowingthemto
take inordinate risk in activities such as nonprime mortgage securitization and
over-the-counter (OTC) derivatives dealing and to hold inadequate capital and
liquidity.
i\1i z++, 1u i\ii z++ 8i iii uN: i N :U8iii \i iu: :i: z,,
z+
15
MARCH 2008:
THE FALL OF BEAR STEARNS
CONTENTS
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After its hedge funds failed in July ioo,, Bear Stearns faced more challenges in the
secondhalfoftheyear.TakingouttherepolenderstotheHigh-GradeFundbrought
nearly1.obillioninsubprimeassetsontoBearsbooks,contributingtoa1.billion
write-down on mortgage-related assets in November. That prompted investors to
scrutinizeBearStearnssfnances.Overthefall,Bearsrepolendersmostlymoney
market mutual fundsincreasingly required Bear to post more collateral and pay
higherinterestrates.Then,injustoneweekinMarchioo8,arunbytheselenders,
hedgefundcustomers,andderivativescounterpartiesledtoBearshavingtobetaken
overinagovernment-backedrescue.
MortgagesecuritizationwasthebiggestpieceofBearStearnssmost-proftabledi-
vision, its fxed-income business, which generated , of the frms total revenues.
Growing fast was the Global Client Services division, which included Bears prime
brokerageoperation.BearStearnswasthesecond-biggestprimebrokerinthecoun-
try,withai1marketshareiniooo,trailingMorganStanleysi.
1
Thisbusiness
wouldfgureprominentlyinthecrisis.
Inmortgagesecuritization,Bearfollowedaverticallyintegratedmodelthatmade
money at every step, from loan origination through securitization and sale. It both
acquired and created its own captive originators to generate mortgages that Bear
bundled,turnedintosecurities,andsoldtoinvestors.
i
Thesmallestofthefvelarge
investment banks, it was still a top-three underwriter of private-label mortgage
backedsecuritiesfromioootoioo,.

Iniooo,itunderwroteobillionincollateral-
ized debt obligations of all kinds, more than double its ioo, fgure of 1., billion.
\\itu z++ 1ui i\ii ui 8i\i :1i\iN: z.
The total included o. billion in CDOs that included mortgage-backed securities,
puttingitinthetop1iinthatbusiness.

AswastypicalonWallStreet,thecompanys
viewwasthatBearwasinthemovingbusiness,notthestoragebusinessthatis,it
sought to provide services to clients rather than take on long-term exposures of its
own.
,
Bearexpandeditsmortgagebusinessdespiteevidencethatthemarketwasbegin-
ningtofalter,asdidotherfrmssuchasCitigroupandMerrill.AsearlyasMayiooo,
Bearhadlostmillionrelatingtodefaults
o
onmortgageswhichoccurredwithino
daysoforigination,whichhadbeenrareinthedecade.ButBearpersisted,assuming
the setback would be temporary. In February ioo,, Bear even acquired Encore
Credit,itsthirdcaptivemortgageoriginatorintheUnitedStates,doublingitscapac-
ity.ThepurchasewasconsistentwithBearscontrarianbusinessmodelbuyinginto
distressedmarketsandwaitingforthemtoturnaround.
,
OnlyamonthafterthepurchaseofEncore,theSecuritiesandExchangeCommis-
sionwroteinaninternalreport,Bearsmortgagebusinessincurredsignifcantmarket
risklossesonitsAlt-Amortgageassets.
8
Thelossesweresmall,buttheSECreported
thatriskmanagersnote[d]thattheseeventsrefectamorerapidandseveredeteriora-
tionincollateralperformancethananticipatedinexantemodelsofstressevents.

I REQUESTED SOME FORBEARANCE

VacationingonNantucketIslandwhenthetwoBear-sponsoredhedgefundsdeclared
bankruptcy on July 1, ioo,, former Bear treasurer Robert Upton anticipated that
the rating agencies would downgrade the company, raising borrowing costs. Bear
fundedmuchofitsoperationsborrowingshort-termintherepomarket;itborrowed
between ,o and ,o billion overnight.
1o
Even a threat of a downgrade by a rating
agencywouldmakefnancingmoreexpensive,startingthenextmorning.
Investors,analysts,andthecreditratingagenciescloselyscrutinizedleveragera-
tios,availableattheendofeachquarter.ByNovemberioo,,Bearsleverageratiohad
reachednearly8to1.Bytheendofioo,,BearsLevelassetsilliquidassetsdim-
cult to value and to sellwere io of its tangible common equity; thus, writing
downtheseilliquidassetsby,wouldwipeouttangiblecommonequity.
At the end of each quarter, Bear would lower its leverage ratio by selling assets,
only to buy them back at the beginning of the next quarter. Bear and other frms
bookedthesetransactionsassaleseventhoughtheassetsdidntstayoffthebalance
sheetforlonginordertoreducetheamountofthecompanysassetsandlowerits
leverageratio.BearsformertreasurerUptoncalledthemovewindowdressingand
saiditensuredthatcreditorsandratingagencieswerehappy.
11
Bearspublicflingsre-
fected this, to some degree: for example, its ioo, annual report said the balance
sheet was approximately 1i lower than the average month-end balance over the
previoustwelvemonths.
1i
To forestall a downgrade, Upton spoke with the three main rating agencies,
Moodys, Standard & Poors, and Fitch, in early August.
1
Several times in ioo,
zz ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
includingAprilandJuneiiS&PhadconfrmedBearsstrongratings,notingin
April that Bears risk profle is relatively conservative and strong senior manage-
mentoversightandastrongculturethroughoutthefrmarethefoundationofBears
risk management process. On June ii, Moodys had also confrmed its A1 rating,
andFitchhadconfrmeditsstableoutlook.
Now,inearlyAugust,UptonprovidedtheminformationaboutBearandargued
that management had learned its lesson about governance and risk management
fromthefailureofthetwohedgefundsandwasgoingtorelylessonshort-termun-
secured funding and more on the repo market. Bear and other market participants
didnotforeseethatBearsownrepolendersmightrefusetolendagainstriskymort-
gageassetsandeventuallynotevenagainstTreasuries.
IrequestedsomeforbearancefromS&P,UptontoldtheFCIC.
1
Hedidnotget
it.OnAugust,justthreedaysafterthetwoBearStearnshedgefundsdeclaredbank-
ruptcy,S&Phighlightedthefunds,Bearsmortgage-relatedinvestments,anditsrela-
tivelysmallcapitalbaseasitplacedBearonanegativeoutlook.
1,
Askedhowhefeltabouttheratingagencysactions,JimmyCayne,BearsCEOun-
tilioo8,said,Anegativeoutlookcantouchanumberofpartsofyourbusinesses. . . .
It was like having a beautiful child and they have a disease of some sort that you
neverexpecttohappenanditdid.HowdidIfeel:Lousy.
1o
Toreassureinvestorsthatnomoreshoeswoulddrop,Bearinvitedthemonacon-
ferencecallthatsameday.Thecalldidnotgowell.Bytheendoftheday,Bearsstock
slido,to1o8.,,obelowitsall-timehighof1o.o1,reachedearlierinioo,.
WE WERE SUITABLY SKEPTICAL
OnSunday,August,,twodaysaftertheconferencecall,Bearhadanotheropportu-
nitytomakeitscase:thistime,withtheSEC.ThetwoSECsupervisorswhovisited
the company that Sunday were Michael Macchiaroli and Matthew Eichner, respec-
tively, associate director and assistant director of the division of market regulation.
TheregulatorsreviewedBearsexposurestothemortgagemarket,includingthe1
billioninadjustable-ratemortgagesonthefrmsbooksthatwerewaitingtobesecu-
ritized. Bear executives gave assurances that inventory would shrink once investors
returned in September from their retreats in the Hamptons. Obviously, regulators
arenotsupposedtolistentohappytalkandgoawaysmiling,EichnertoldtheFCIC.
ThirteenbillioninARMsisnojoke.Still,EichnerdidnotbelievetheBearexecu-
tiveswerebeingdisingenuous.Hethoughttheywerejustemphasizingtheupside.
1,
AlanSchwartz,theco-presidentwholatersucceededJimmyCayneasCEO,and
ThomasMarano,headofGlobalMortgagesandAssetBackedSecurities,seemedun-
concerned.Butotherexecutiveswereleery.WendydeMonchaux,theheadofpropri-
etarytrading,urgedMaranototrimthemortgageportfolio,asdidStevenMeyer,the
co-head of stock sales and trading.
18
According to Chief Risk Omcer Michael Alix,
formerchairmanAlanGreenbergwouldsay,thebesthedgeisasale.
1
Bearfnally
reducedtheportfoliofrom,obillioninthethirdquarterofioo,too.1billionin
thefourthquarter,butitwastoolittletoolate.
\\itu z++ 1ui i\ii ui 8i\i :1i\iN: z,
Thatsummer,theSECfeltBearsliquiditywasadequatefortheimmediatefuture,
butsupervisorsweresuitablyskeptical,Eichnerinsisted.AftertheAugust,meet-
ing, the SEC required that Bear Stearns report daily on Bears liquidity. However,
Eichneradmittedthatheandhisagencyhadgrosslyunderestimatedthepossibility
ofaliquiditycrisisdowntheroad.
io
Every weeknight Upton updated the SEC on Bears oo billion balance sheet,
withspecifcsonrepoandcommercialpaper.OnSeptemberi,,BearStearnsraised
approximatelyi.,billioninunsecured1o-yearbonds.Thereportsslowedtooncea
week.
i1
The SECs inspector general later criticized the regulators, writing that they
didnotpushBeartoreduceleverageormakeanyeffortstolimitBearStearnsmort-
gage securities concentration, despite aware[ness] that risk management of mort-
gagesatBearStearnshadnumerousshortcomings,includinglackofexpertisebyrisk
managers in mortgage backed securities and persistent understamng; a proximity
ofriskmanagerstotraderssuggestingalackofindependence;turnoverofkeyper-
sonnelduringtimesofcrisis;andtheinabilityorunwillingnesstoupdatemodelsto
refectchangingcircumstances.
ii
Michael Halloran, a senior adviser to SEC Chairman Christopher Cox, told the
FCIC the SEC had ample information and authority to require Bear Stearns to de-
crease leverage and sell mortgage-backed securities, as other fnancial institutions
weredoing.Halloransaidthatasearlyasthefrstquarterofioo,,hehadaskedErik
Sirri, in charge of the SECs Consolidated Supervised Entities program, about Bear
Stearns(andLehmanBrothers),Whycantwemakethemreducerisk:According
toHalloran,SirrisaidtheSECsjobwasnottotellthebankshowtoruntheircompa-
niesbuttoprotecttheircustomersassets.
i
TURN INTO A DEATH SPIRAL
InAugust,aftertheratingagenciesrevisedtheiroutlookonBear,Caynetriedtoob-
tain lines of credit from Citigroup and JP Morgan. Both banks acknowledged Bear
hadalwaysbeenaverygoodcustomerandmaintainedtheywereinterestedinhelp-
ing.
i
Wewantedtotrytobebelts-and-suspenders,saidCFOSamuelMolinaro,as
Bearattemptedbothtoobtainlinesofcreditwithbanksandtoreinforcetraditional
sources of short-term liquidity such as money market funds. But, Cayne told the
FCIC, nothing happened. Why the [large] banks were not more willing to partici-
pateandprovidelinesduringthatperiodoftime,Icanttellyou,Molinarosaid.
i,
Amajormoneymarketfundmanager,FederatedInvestors,haddecidedonOcto-
ber 1 to drop Bear Stearns from its list of approved counterparties for unsecured
commercial paper,
io
illustrating why unsecured commercial paper was traditionally
seenasariskierlifelinethanrepo.Throughoutioo,,BearStearnsreduceditsunse-
curedcommercialpaper(fromio.,billionattheendofioootoonly.billionat
theendofioo,)andreplaceditwithsecuredrepoborrowing(whichrosefromo
billion to 1oi billion). But Bear Stearnss growing dependence on overnight repo
wouldcreateadifferentsetofproblems.
Thetri-partyrepomarketusedtwoclearingbanks,JPMorganandBNYMellon.
z, ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
Duringeverybusinessday,theseclearingbanksreturncashtolenders;takeposses-
sionofborrowerscollateral,essentiallykeepingitinescrow;andthenlendtheirown
cashtoborrowersduringtheday.Thisisreferredtoasunwindingtherepotransac-
tion; it allows borrowers to change the assets posted as collateral every day. The
transactionisthenrewoundattheendoftheday,whenthelenderspostcashtothe
clearingbanksinreturnforthenewcollateral.
Thelittle-regulatedtri-partyrepomarkethadgrownfrom8oobillioninaverage
dailyvolumeiniooito1.,trillioninioo,,i.trillioninioo,,andi.8trillionby
early ioo8.
i,
It had become a very deep and liquid market. Even though most bor-
rowers rolled repo overnight, it was also considered a very safe market, because
transactionswereovercollateralized(loansweremadeforlessthanthecollateralwas
worth).Thatwasthegeneralviewbeforetheonsetofthefnancialcrisis.
AsBearincreaseditstri-partyrepoborrowing,itbecamemoredependentonJP
Morgan, the clearing bank. A risk that was little appreciated before ioo, was that
JPMorganandBNYMelloncouldfacelargelossesifacounterpartysuchasBearde-
faultedduringtheday.Essentially,JPMorganservedasBearsdaytimerepolender.
Evenlong-termrepoloanshavetobeunwoundeverydaybytheclearingbank,if
notbythelender.SethCarpenter,anomcerattheFederalReserveBoard,compared
ittoamortgagethathastoberefnancedeveryweek:Imaginethatyourmortgageis
onlyaweek.Insteadofao-yearmortgage,youvegotaone-weekmortgage.Ifevery-
thingsgoingfne,yougettotheendoftheweek,yougooutandyourefnancethat
mortgage because you dont have enough cash on hand to pay off the whole mort-
gage.Andthenyougettotheendofanotherweekandyourefnancethatmortgage.
Andthats,forallintentsandpurposes,whatreposarelikeformanyinstitutions.
i8
During the fall, Federated Investors, which had taken Bear Stearns off its list of
approved commercial paper counterparties, continued to provide secured repo
loans.
i
Fidelity Investments, another major lender, limited its overall exposure to
Bear,andshortenedthematurities.
o
InOctober,StateStreetGlobalAdvisorsrefused
anyrepolendingtoBearotherthanovernight.
1
Often, backing Bears borrowing were mortgage-related securities and of these,
1,.ibillionmorethanBearsequitywereLevelassets.
In the fourth quarter of ioo,, Bear Stearns reported its frst quarterly loss, ,
million.Still,theSECsawnoevidenceofanydeteriorationinthefrmsliquiditypo-
sitionfollowingthereleaseandrelatednegativepresscoverage.TheSECconcluded,
BearStearnsliquiditypoolremainsstable.
i
Inthefallofioo,,BearsboardhadcommissionedtheconsultantOliverWyman
toreviewthefrmsriskmanagement.Thereport,RiskGovernanceDiagnostic:Rec-
ommendationsandCaseforEconomicCapitalDevelopment,waspresentedonFeb-
ruary ,, ioo8, to the management committee. Among its conclusions: risk
assessment was infrequent and ad hoc and hampered by insumcient and poorly
alignedresources,riskmanagers[were]noteffectivelypositionedtochallengefront
omcedecisions,andriskmanagementwasunderstaffedandconsideredalowpri-
ority.SchwartztoldtheFCICthefndingsdidnotindicatesubstantialdefciencies.
Hewasntlookingforpositivefeedbackfromtheconsultants,becausetheWymanre-
\\itu z++ 1ui i\ii ui 8i\i :1i\iN: z,
portwasmeanttoprovidearoadmapofwhatthegoldstandardinriskmanage-
mentwouldbe.

InJanuaryioo8,beforethereportwascompleted,CayneresignedasCEO,after
receiving.omillionincompensationfromioothroughioo,.

Heremainedas
non-executivechairmanoftheboard.Someseniorexecutivessharplycriticizedhim
and the board. Thomas Marano told the FCIC that Cayne played a lot of golf and
bridge.
,
Speakingoftheboard,PaulFriedman,aformerseniormanagingdirectorat
Bear Stearns, said, I guess because Id never worked at a frm with a real board, it
neverdawnedonmethatatsomepointsomebodywouldhaveorshouldhavegotten
theboardinvolvedinallofthis,althoughhetoldtheFCICthathemadethesecom-
ments in anger and frustration in the wake of Bears failure.
o
In its fnal report on
Bear, the Corporate Library, which researches and rates frms for corporate gover-
nance,gavethecompanyaD,refectingahighdegreeofgovernanceriskresulting
fromhighlevelsofconcernrelatedtotheboardandcompensation.
,
Whenaskedif
hehadmademistakeswhileatBearStearns,CaynetoldtheFCIC,Itakeresponsi-
bilityforwhathappened.Imnotgoingtowalkawayfromtheresponsibility.
8
AtBear,compensationwasbasedlargelyonthereturnonequityinagivenyear.
Forseniorexecutives,abouthalfofeachbonuswaspaidincash,andabouthalfinre-
strictedstockthatvestedoverthreeyearsandhadtobeheldforfve.

Theformulafor
the size of each years compensation pool was determined by a subcommittee of the
board.Stockholdersapprovedtheperformancecompensationplanandcapitalaccu-
mulation plan for senior managing directors. Cayne told the FCIC he set his own
compensationandthecompensationforallfvemembersoftheExecutiveCommit-
tee.AccordingtoCayne,noone,includingtheboard,questionedhisdecisions.
o
Forioo,,evenwithitslosses,BearStearnspaidout,8ofrevenuesincompensa-
tion.Alix,whosatontheCompensationCommittee,toldFCICstaffthefrmtypically
paid,obutthatthepercentageincreasedinioo,becauserevenuesfellifmanage-
ment had lowered compensation proportionately, he said, many employees might
have quit.
1
Base salaries for senior managers were capped at i,o,ooo, with the re-
mainderofcompensationadiscretionarymixofcash,restrictedstock,andoptions.
i
Fromiooothroughioo8,thetopfveexecutivesatBearStearnstookhomeover
io.,millionincashandover1.1billionfromstocksales,formorethanatotalof
1.billion.ThisexceededtheannualbudgetfortheSEC.

AlanSchwartz,whotook
overasCEOafterCayneandhadbeenaleadingproponentofinvestinginthemort-
gage sector, earned more than 8, million from ioo to ioo,. Warren Spector, the
co-presidentresponsibleforoverseeingthetwohedgefundsthathadfailed,received
more than 8 million during the same period. Although Spector was asked to re-
sign,Bearneveraskedhimtoreturnanymoney.Iniooo,Cayne,Schwartz,andSpec-
toreachearnedmorethan1otimesasmuchasAlix,thechiefriskomcer.

Caynewasout,Schwartzwasin,andBearStearnscontinuedhangingoninearly
ioo8. Bear was still able to fund its balance sheet through repo loans, though the
interest rates the frm had to pay had increased.
,
Marano said he worried this in-
creasedcostwouldsignaltothemarketthatBearwasdistressed,whichcouldmake
ourproblemsturnintoadeathspiral.
o
z ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
DUTY TO PROTECT THEIR INVESTORS
OnWednesday,Januaryo,ioo8,TreasurerUptonreportedaninternalaccounting
errorthatshowedBearStearnstohavelessthan,billioninliquiditytriggeringa
reporttotheSEC.Whilethecompanyidentifedtheerror,theSECreinstituteddaily
reportingbythecompanyofitsliquidity.
,
Lenders and customers were more and more reluctant to do business with the
company. On February 1,, Bear Stearns had o., billion in mortgages, mortgage-
backedsecurities,andasset-backedsecuritiesonitsbalancesheet,downalmost1o
billionfromNovember.NearlyiobillionweresubprimeorAlt-Amortgagebacked
securitiesandCDOs.
ThehedgefundsthatwereclientsofBearsprimebrokerageserviceswereparticu-
larly 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
occasionallyinquiredaboutthebanksfnancialconditioninthelatterhalfofioo,,
butthatsuchinquiriespickedupatthebeginningofioo8,particularlyasthecostin-
creasedofpurchasingcreditdefaultswapprotectiononBear.Theinquiriesbecame
withdrawalshedge funds started taking their business elsewhere. They felt there
weretoomanyconcernsaboutusandfeltthatthiswasashort-termmove,Lebedin
said. Often they would tell us theyd be happy to bring the business back, but that
theyhadthedutytoprotecttheirinvestors.RenaissanceTechnologies,oneofBears
biggest prime brokerage clients, pulled out all of its business. By April, Lebedins
prime brokerage operation would be holding o billion in assets under manage-
ment,downmorethanofrom1oobillioninJanuary.
8
Nonetheless,duringtheweekofMarch,whenSECstaffinspectedBearsliquid-
ity pool, they identifed no signifcant issues. The SEC found Bears liquidity pool
rangedfrom18billiontoiobillion.

Bear opened for business on Monday, March 1o, with approximately 18 billion
incashreserves.Thesameday,Moodysdowngraded1,mortgage-backedsecurities
issued by Bear Stearns Alt-A Trust, a special purpose entity. News reports on the
downgrades carried abbreviated headlines stating, Moodys Downgrades Bear
Stearns, Upton said.
,o
Rumors few and counterparties panicked.
,1
Bears liquidity
poolbegantodryup,andtheSECwasnowconcernedthatBearwasbeingsqueezed
from all directions.
,i
While everything rolled during the daythat is, Bears repo
lendersrenewedtheircommitmentsSEComcialsworriedthatthiswouldproba-
blynotcontinue.
,
On Tuesday, the Fed announced it would lend to investment banks and other
primary dealers. The Term Securities Lending Facility (TSLF) would make avail-
ableuptoioobillioninTreasurysecurities,acceptingascollateralGSEmortgage
backedsecuritiesandnon-GSEmortgagebackedsecuritiesratedtriple-A.Thehope
was that lenders would lend to investment banks if the collateral was Treasuries
ratherthanotherhighlyratedbutnowsuspectassetssuchasmortgage-backedsecu-
rities.TheFedalsoannounceditwouldextendloansfromovernighttoi8days,giv-
\\itu z++ 1ui i\ii ui 8i\i :1i\iN: z,
ing investment banks an added breather from the relentless need to unwind repos
everymorning.
WiththeTSLF,theFedwouldbesettinganewprecedentbyextendingemergency
credit to institutions other than commercial banks. To do so, the Federal Reserve
Boardwasrequiredundersection1()oftheFederalReserveActtodeterminethat
therewereunusualandexigentcircumstances.TheFedhadnotinvokeditssection
1()authoritysincetheGreatDepression;itwastheFedsfrstuseoftheauthority
sinceCongresshadexpandedthelanguageoftheactin11toallowtheFedtolend
toinvestmentbanks.
,
TheFedwastakingtheunusualstepofdeclaringitswilling-
nesstosoonopenitscheckbooktoinstitutionsitdidnotregulateandwhosefnan-
cialconditionithadneverexamined.
But the Fed would not launch the TSLF until March i,, more than two weeks
lateranditwasnotclearthatBearcouldlastthatlong.Thefollowingday,JimEm-
bersit of the Federal Reserve Board checked on Bears liquidity with the SEC. The
SECsaidBearhad1i.,billionincashdownfromabout18billionatthestartof
theweekandwasabletofnanceallitsbankloansandmostofitsequitysecurities
throughtherepomarket.Hesummarized,TheSECindicatesthatnonotablelosses
havebeensustainedandthatthecapitalpositionofthefrmisfne.
,,
Derivatives counterparties were increasingly reluctant to be exposed to Bear. In
somecasestheyunwoundtradesinwhichtheyfacedBear,andinotherstheymade
marginorcollateralcalls.
,o
InBearslastfewyearsasanindependentcompany,ithad
substantiallyincreaseditsexposuretoderivatives.Attheendoffscalyearioo,,Bear
had1.trillioninnotionalexposureonderivativescontracts,comparedwith8.,
trillionatiooofscalyear-endand,.,trillionattheendofioo,.
Derivatives counterparties who worried about Bears ability to make good on
theirpaymentscouldgetoutoftheirderivativepositionswithBearthroughassign-
ments or novations. Assignments allow counterparties to assign their positions to
someoneelse:iffrmX hasaderivativescontractwithfrmY, thenfrmX canassign
itspositiontofrmZ, sothatZ nowistheonethathasaderivativescontractwithY.
Novationsalsoallowcounterpartiestogetoutoftheirexposuretoeachother,butby
bringinginathirdparty:insteadofX facingY,X faces Z and Z faces Y.Bothassign-
mentsandnovationsareroutinetransactionsonWallStreet.ButonTuesday,Brian
Peters of the New York Fed advised Eichner at the SEC that the New York Fed was
seeing some HFs [hedge funds] wishing to assign trades the clients had done with
BeartootherCPs[counterparties]sothatBearstepsout.
,,
Counterpartiesdidnot
wanttohaveBearStearnsasaderivativescounterpartyanymore.
Bear Stearns also encountered dimculties stepping into trades. Hayman Capital
Partners, a hedge fund in Texas wanting to decrease its exposure to subprime mort-
gages,haddecidedtocloseoutarelativelysmall,millionsubprimederivativeposi-
tion with Goldman Sachs. Bear Stearns offered the best bid, so Hayman expected to
assign its position to Bear, which would then become Goldmans counterparty in the
derivative.HaymannotifedGoldmanbyaroutineemailonTuesday,March11,at:oo
P.M.Thereply1minuteslaterwasunexpected:GSdoesnotconsenttothistrade.
,8
z ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
ThatstartledKyleBass,Haymansmanagingpartner.HetoldtheFCIChecouldnot
recall any counterparty rejecting a routine novation.
,
Pressed for an explanation,
Goldmanthenextmorningofferednodetails:Ourtradingdeskwouldprefertostay
facingHayman.WedonotwanttofaceBear.
oo
Addingtothemystery,1ominuteslater
GoldmanagreedtoacceptBearSternsasthecounterpartyafterall.
o1
Butthedamage
wasdone.ThenewshitthestreetthatGoldmanhadrefusedaroutinetransactionwith
oneoftheotherbigfveinvestmentbanks.Themessage:dontrelyonBearStearns.
CEO Alan Schwartz hoped an appearance on CNBC would reassure markets.
Questionedaboutthisincident,Schwartzsaidhehadnoknowledgeofsucharefusal
andrhetoricallyasked,Whydorumorsstart:
oi
SECChairmanCoxtoldreporters
his agency was monitoring capital levels at Bear Stearns and other securities frms
on a constant basis and has a good deal of comfort about the capital cushions at
thesefrmsatthemoment.
o
Still, the run on Bear accelerated. Many investors believed the Feds announce-
ment about its new loan program was directed at Bear Stearns, and they worried
about the facilitys not being available for several weeks. On Wednesday, March 1i,
theSECnotedthatBearpaidanother1.1billionformargincallsfrom1inervous
derivativescounterparties.
o
Repo lenders who had already tightened the terms for their contracts over the
precedingfourorfvemonthsshortenedtheleashagain,demandingmorecollateral
fromBearStearns.
o,
Worriesaboutadefaultquicklymounted.
oo
By that evening, Bears ability to borrow in the repo market was drying up. The
SECnotedthatsomelargeandimportantmoneyfunds,includingFidelityandMel-
lon,hadtoldBearafterthecloseofbusinessWednesdaytheymightbehesitantto
rollsomefundingtomorrow.TheSECsaidthatthoughtheybelievedtheamounts
wereverymanageable(between1andibillion),thewithdrawalswouldnotsend
ahelpfulsignaltothemarket.
o,
Buttheissuewasalmostmoot.SchwartzcalledNew
YorkFedPresidentTimothyGeithnerthatnighttodiscusspossibleFedfexibilityin
theeventthatsomerepolendersdidpullaway.
o8
Upton,thetreasurer,saidthatbeforethatweek,hehadneverworriedaboutthe
disappearanceofrepolending.ByThursday,hebelievedtheendwasnear.
o
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,that1billioninrepowasnotgoingtorollover,andthattherewasareason-
ablechancethattherewouldnotbeenoughcashtomeet[Bears]needs.
,o
Somerepo
lenderswerealreadysoaversetoBearthattheystoppedlendingtothecompanyat
all,notevenagainstTreasurycollateral,UptontoldtheFCIC.
,1
Derivativescounter-
partiescontinuedtorunfromBear.Bythatnight,liquidityhaddwindledtoamere
ibillion(seefgure1,.1).
Bearhadrunoutofcashinoneweek.Executivesandregulatorscontinuedtobe-
lievethefrmwassolvent,however.FormerSECChairmanCoxtestifedbeforethe
FCIC,AtalltimesduringtheweekofMarch1oto1,,uptoandincludingthetime
ofitsagreementtobeacquiredbyJPMorgan,BearStearnshadacapitalcushionwell
abovewhatisrequired.
,i
Bear Stearns Liquidity
IN BILLIONS OF DOLLARS, DAILY
0
10
5
15
20
$25
22 23 24 25 26 27 28 29 1 2 3 4 5 6 7 8 9 10 11 12 13
SOURCE: Securities and Exchange Commission
FEBRUARY 2008 MARCH 2008
In the four days before Bear Stearns collapsed, the 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 Thursday evening, March 1, Bear Stearns informed the SEC that it would be
unabletooperatenormallyonFriday.
,
CEOAlanSchwartzcalledJPMorganCEO
JamieDimontorequestaobillioncreditline.Dimonturnedhimdown,
,
citing,
according to Schwartz, JP Morgans own signifcant exposure to the mortgage mar-
ket. Because Bear also had a large, illiquid portfolio of mortgage assets, JP Morgan
wouldnotrenderassistancewithoutgovernmentsupport.SchwartzspokewithGei-
thneragain.SchwartzinsistedBearsproblemwasliquidity,notinsumcientcapital.A
series of calls between Schwartz, Dimon, Geithner, and Treasury Secretary Henry
Paulsonfollowed.
,,
ToaddressBearsliquidityneeds,theNewYorkFedmadea1i.
billionloantoBearStearnsthroughJPMorganonthemorningofFriday,March1.
Standard&PoorsloweredBearsratingthreelevelstoBBB.MoodysandFitchalso
downgraded the company. By the end of the day, Bear was out of cash. Its stock
plummeted,,closingbelowo.
The markets evidently viewed the loan as a sign of terminal weakness. After
marketsclosedonFriday,PaulsonandGeithnerinformedBearCEOSchwartzthat
theFedloantoJPMorganwouldnotbeavailableaftertheweekend.Withoutthat
loan,Bearcouldnotconductbusiness.Infact,BearStearnshadtofindabuyerbe-
foretheAsianmarketsopenedSundaynightorthegamewouldbeover.
,o
Schwartz,
z,+ ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
Molinaro, Alix, and others spent the weekend in due diligence meetings with JP
Morgan and other potential buyers, including the private equity frm J.C. Flowers
and Co. According to Schwartz, the participants determined JP Morgan was the
onlycandidatewiththesizeandstaturetomakeacredibleofferwithin8hours.
,,
As Bear Stearnss clearing bank for repo trades, JP Morgan held much of Bear
Stearnssassetsascollateralandhadbeenassessingtheirvaluedaily.
,8
Thisknowl-
edgeletJPMorganmovemorequickly.
OnSunday,March1o,JPMorganinformedtheNewYorkFedandtheTreasury
that it was interested in a deal if it included fnancial support from the Fed.
,
The
Federal Reserve Board, again fnding unusual and exigent circumstances as re-
quiredundersection1()oftheFederalReserveAct,agreedtopurchasei.,bil-
lion of Bears assets to get them off the frms books through a new entity called
MaidenLaneLLC(namedforastreetalongsidetheNewYorkFed).Thoseassets
mostly mortgage-related securities, other assets, and hedges from Bears mortgage
tradingdeskwouldbeunderNewYorkFedmanagement.Tofnancethepurchases,
JPMorganmadea1.1,billionsubordinatedloanandtheNewYorkFedlenti8.8i
billion.Becauseofitsloan,JPMorganboretheriskofthefrst1.1,billionoflosses;
theFedwouldbearanyfurtherlossesuptoi8.8ibillion.
8o
TheFedsloanwouldbe
repaidasMaidenLanesoldthecollateral.
On Sunday night, with Maiden Lane in place, JP Morgan publicly announced a
dealtobuyBearStearnsforiashare.MinutesofBearsboardmeetingindicatethat
JP Morgan had considered but cut it to i because the government would not
permitahighernumber. . . .TheFedandtheTreasuryDepartmentwouldnotsup-
portatransactionwhere[BearStearns]equityholdersreceivedanysignifcantcon-
sideration because of the moral hazard of the federal government using taxpayer
moneytobailouttheinvestmentbanksstockholders.
81
Eightdayslater,onMarchi,BearStearnsandJPMorganagreedtoincreasethe
price to 1o. John Chrin, co-head of the fnancial institutions mergers and acquisi-
tionsgroupatJPMorgan,toldtheFCICtheyincreasedthepricetomakeBearshare-
holders approval more likely.
8i
Bear CEO Schwartz told the FCIC the increase let
Bearpreservethecompanysvaluetothegreatestextentpossibleunderthecircum-
stancesforourshareholders,our1,oooemployees,andourcreditors.
8
IT WAS HEADING TO A BLACK HOLE
TheSECregulatorsMacchiaroliandEichnerwereasstunnedaseveryoneelsebythe
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.
8
FedChairmanBenBernankelatercalledtheBearStearnsdecisionthetoughestof
the fnancial crisis. The i.8 trillion tri-party repo market had really [begun] to
break down, Bernanke said. As the fear increased, short-term lenders began de-
manding more collateral, which was making it more and more dimcult for the f-
nancialfrmstofnancethemselvesandcreatingmoreandmoreliquiditypressureon
COMMISSION CONCLUSIONS ON CHAPTER 15
The Commission concludes the failure of Bear Stearns and its resulting govern-
ment-assistedrescuewerecausedbyitsexposuretoriskymortgageassets,itsre-
lianceonshort-termfunding,anditshighleverage.Thesewerearesultofweak
corporategovernanceandriskmanagement.Itsexecutiveandemployeecompen-
sationsystemwasbasedlargelyonreturnonequity,creatingincentivestouseex-
cessiveleverageandtofocusonshort-termgainssuchasannualgrowthgoals.
Bearexperiencedrunsbyrepolenders,hedgefundcustomers,andderivatives
counterpartiesandwasrescuedbyagovernment-assistedpurchasebyJPMorgan
because the government considered it too interconnected to fail. Bears failure
was in part a result of inadequate supervision by the Securities and Exchange
Commission,whichdidnotrestrictitsriskyactivitiesandwhichallowedundue
leverageandinsumcientliquidity.
them.And,itwasheadingsortoftoablackhole.HesawthecollapseofBearStearns
as threatening to freeze the tri-party repo market, leaving the short-term lenders
withcollateraltheywouldtrytodumponthemarket.Youwouldhaveabigcrunch
inassetprices.
8,
BearStearns,whichisnotthatbigafrm,ourviewonwhyitwasimportantto
save ityou may disagreebut our view was that because it was so essentially in-
volved in this critical repo fnancing market, that its failure would have brought
down that market, which would have had implications for other frms, Bernanke
toldtheFCIC.
8o
GeithnerexplainedtheneedforgovernmentsupportforBearsacquisitionbyJP
Morgan as follows: The sudden discovery by Bears derivative counterparties that
importantfnancialpositionstheyhadputinplacetoprotectthemselvesfromfnan-
cial risk were no longer operative would have triggered substantial further disloca-
tion in markets. This would have precipitated a rush by Bears counterparties to
liquidate the collateral they held against those positions and to attempt to replicate
thosepositionsinalreadyveryfragilemarkets.
8,
PaulsontoldtheFCICthatBearhadbothaliquidityproblemandacapitalprob-
lem. Could you just imagine the mess we would have had: If Bear had gone there
werehundreds,maybethousandsofcounterpartiesthatallwouldhavegrabbedtheir
collateral,wouldhavestartedtryingtoselltheircollateral,drovedownprices,create
evenbiggerlosses.Therewashugefearabouttheinvestmentbankingmodelatthat
time. Paulson believed that if Bear had fled for bankruptcy, you would have had
Lehmangoing . . .almostimmediatelyifBearhadgone,andjustthewholeprocess
wouldhavejuststartedearlier.
88
\\itu z++ 1ui i\ii ui 8i\i :1i\iN: z,.
z,z
16
MARCH TO AUGUST 2008:
SYSTEMIC RISK CONCERNS
CONTENTS
1hcIcdcra|RcscrvcVhcnpccp|cgctscarcd:,,
|IMcrganRcjusingtcunwind wcu|d|cunjcrgiva||c :,,
1hcIcdandthcSLCVcak|iquiditypcsiticn :,e
DcrivativcsLar|ystagcscjasscssingthcpctcntia|systcnicrisk :,:
Banks1hcnarkctswcrcrca||y,rca||ydiccy ,o+
JP Morgans federally assisted acquisition of Bear Stearns averted catastrophefor
thetimebeing.TheFederalReservehadfoundnewwaystolendcashtothefnancial
system,andsomeinvestorsandlendersbelievedtheBearepisodehadsetaprecedent
forextraordinarygovernmentintervention.Investorsbegantoworrylessaboutare-
cessionandmoreaboutinfation,asthepriceofoilcontinuedtorise(hittingalmost
1perbarrelinJuly).Atthebeginningofioo8,thestockmarkethadfallenalmost
1,fromitspeakinthefallofioo,.Then,inMayioo8,theDowJonesclimbedto
1,o,8, within 8 of the record 1,1o set in October ioo,. The cost of protecting
against the risk of default by fnancial institutionsrefected in the prices of credit
defaultswapsdeclinedfromthehighsofMarchandApril.Inhindsight,themar-
kets were surprisingly stable and almost seemed to be neutral a month after Bear
Stearns, leading all the way up to September, said David Wong, Morgan Stanleys
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,
raisedjustunder1oobillionandobillion,respectively,innewequitybytheend
ofJune.
Despitethisgoodnews,bankersandtheirregulatorswerehauntedbythespeedof
BearStearnssdemise.AndtheyknewthattheotherinvestmentbankssharedBears
weaknesses: leverage, reliance on overnight funding, dependence on securitization
markets,andconcentrationsinilliquidmortgagesecuritiesandothertroubledassets.
Inparticular,therunonBearhadexposedthedangersoftri-partyrepoagreements
andthecounterpartyriskcausedbyderivativescontracts.
AndthewordonthestreetdespitetheassurancesofLehmanCEODickFuldat
\\itu 1u \UtU:1 z++ ::1i\i t ii :i tuNtiiN: z,,
anAprilshareholdermeetingthattheworstisbehindus
i
wasthatBearwouldnot
betheonlyfailure.
THE FEDERAL RESERVE: WHEN PEOPLE GOT SCARED
Themostpressingdangerwasthepotentialfailureoftherepomarketamarketthat
grew very, very quickly with no single regulator having a purview of it, former
TreasurySecretaryHenryPaulsonwouldtelltheFCIC.

Marketparticipantsbelieved
thatthetri-partyrepomarketwasarelativelysafeanddurablesourceofcollateral-
ized short-term fnancing. It was on precisely this understanding that Bear had
shifted approximately o billion of its unsecured funding into repos in ioo,. But
nowitwasclearthatrepofundingcouldbejustasvulnerabletorunsaswereother
formsofshort-termfnancing.
The repo runs of ioo,, which had devastated hedge funds such as the two Bear
Stearns Asset Management funds and mortgage originators such as Countrywide,
hadseizedtheattentionofthefnancialcommunity,andtherunonBearStearnswas
similarly eye-opening. Market participants and regulators now better appreciated
howthequalityofrepocollateralhadshiftedovertimefromTreasurynotesandse-
curitiesissuedbyFannieMaeandFreddieMactohighlyratednon-GSEmortgage
backedsecuritiesandcollateralizeddebtobligations(CDOs).

Atitspeakbeforethe
crisis, this riskier collateral accounted for as much as o of the total posted.
,
In
Aprilioo,,theBankruptcyAbusePreventionandConsumerProtectionActofioo,
had dramatically expanded protections for repo lenders holding collateral, such as
mortgage-relatedsecurities,thatwasriskierthangovernmentorhighlyratedcorpo-
ratedebt.Theseprotectionsgavelendersconfdencethattheyhadclear,immediate
rights to collateral if a borrower should declare bankruptcy. Nonetheless, Jamie Di-
mon,theCEOofJPMorgan,toldtheFCIC,Whenpeoplegotscared,theywouldnt
fnancethenonstandardstuffatall.
o
Tothesurpriseofbothborrowersandregulators,high-qualitycollateralwasnot
enoughtoensureaccesstotherepomarket.Repolenderscaredjustasmuchabout
thefnancialhealthoftheborrowerasaboutthequalityofthecollateral.Infact,even
forthesamecollateral,repolendersdemandeddifferenthaircutsfromdifferentbor-
rowers.
,
Despitethebankruptcyprovisionsintheioo,act,lenderswerereluctantto
riskthehassleofseizingcollateral,evengoodcollateral,fromabankruptborrower.
StevenMeierofStateStreettestifedtotheFCIC:Iwouldsaythecounterpartiesare
afrstlineofdefense,andwedontwanttogothroughthatuncomfortableprocessof
havingtoliquidatecollateral.
8
WilliamDudleyoftheNewYorkFedtoldtheFCIC,
Atthefrstsignoftrouble,theseinvestorsintri-partyrepotendtorunratherthan
takethecollateralthattheyvelentagainst. . . .Sohigh-qualitycollateralitselfisnot
sumcientwhenandifaninstitutiongetsintrouble.

Moreover, if a borrower in the repo market defaults, money market fundsfre-

quent lenders in this marketmay have to seize collateral that they cannot legally
own. For example, a money market fund cannot hold long-term securities, such as
z,, ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
agencymortgagebackedsecurities.Typically,ifafundtakespossessionofsuchcol-
lateral,itliquidatesthesecuritiesimmediately,evenaswasthecaseduringthecri-
sisinto a declining market. As a result, funds simply avoided lending against
mortgage-relatedsecurities.Inthecrisis,investorsdidntconsidersecuredfundingto
bemuchbetterthanunsecured,accordingtoDarryllHendricks,amanagingdirector
andglobalheadofriskmethodologyatUBS,aswellastheheadofaprivate-sector
taskforceontherepomarketorganizedbytheNewYorkFed.
1o
As noted, the Fed had announced a new program, the Term Securities Lending
Facility(TSLF),ontheTuesdaybeforeBearscollapse,butitwouldnotbeavailable
untilMarchi,.TheTSLFwouldlendatotalofuptoioobillionofTreasurysecuri-
tiesatanyonetimetotheinvestmentbanksandotherprimarydealersthesecuri-
tiesamliatesofthelargecommercialbanksandinvestmentbanksthattradewiththe
New York Fed, such as Citigroup, Morgan Stanley, or Merrill Lynchfor up to i8
days. The borrowers would trade highly rated securities, including debt in govern-
ment-sponsoredenterprises,inreturnforTreasuries.Theprimarydealerscouldthen
usethoseTreasuriesascollateraltoborrowcashintherepomarket.LiketheTerm
Auction Facility for commercial banks, described earlier, the TSLF would run as a
regular auction to reduce the stigma of borrowing from the Fed. However, after
Bears collapse, Fed omcials recognized that the situation called for a program that
couldbeupandrunningrightaway.AndtheyconcludedthattheTSLFalonewould
notbeenough.
So,theFedwouldcreateanotherprogramfrst.OntheSundayofBearscollapse,
the Fed announced the new Primary Dealer Credit Facilityagain invoking its au-
thority under 1() of the Federal Reserve Actto provide cash, not Treasuries, to
investmentbanksandotherprimarydealersontermsclosetothosethatdepository
institutionsbanks and thriftsreceived through the Feds discount window. The
movecamejustabout,minutestoolateforBear,JimmyCayne,itsformerCEO,
toldtheFCIC.
11
Unlike the TSLF, which would offer Treasuries for i8 days, the PDCF offered
overnightcash loansinexchangeforcollateral.Ineffect,thisprogramcouldserveas
analternativetotheovernighttri-partyrepolenders,potentiallyprovidinghundreds
ofbillionsofdollarsofcredit.SotheideaofthePDCFthenwas . . .anythingthatthe
dealercouldntfnancethesecuritiesthatwereacceptableunderthediscountwin-
dowiftheycouldntgetfnancinginthemarket,theycouldgetfnancingfromthe
Federal Reserve, said Seth Carpenter, deputy associate director in the Division of
Monetary Affairs at the Federal Reserve Board. And that way, you dont have to
worry. And by providing that support, other lenders know that theyre going to be
abletogettheirmoneybackthenextday.
1i
BychargingtheFederalReservesdiscountrateandaddingadditionalfeesforreg-
ularuse,theFederalReserveencourageddealerstousethePDCFonlyasalastre-
sort. In its frst week of operation, this program immediately provided over o
billionincashtoBearStearns(asbridgefnancinguntiltheJPMorgandealomcially
closed), Lehman Brothers, and the securities amliate of Citigroup, among others.
However,astheimmediatepost-Bearconcernssubsided,useofthefacilitydeclined
\\itu 1u \UtU:1 z++ ::1i\i t ii :i tuNtiiN: z,,
afterAprilandceasedcompletelybylateJuly.
1
Becausethedealersfearedthatmar-
kets would see reliance on the PDCF as an indication of severe distress, the facility
carried a stigma similar to the Feds discount window. Paradoxically, while the
PDCFwascreatedtomitigatetheliquidityfightcausedbythelossofconfdencein
aninvestmentbank,useofthePDCFwasseenbothwithinLehman,andpossiblyby
the broader market, as an event that could trigger a loss of confdence, noted the
Lehmanbankruptcyexaminer.
1
On May i, the Fed broadened the kinds of collateral allowed in the TSLF to in-
cludeothertriple-A-ratedasset-backedsecurities,suchasautoandcreditcardloans.
InJune,theFedsDudleyurgedinaninternalemailthatbothprogramsbeextended
atleastthroughtheendoftheyear.PDCFremainscriticaltothestabilityofsomeof
the[investmentbanks],hewrote.Amountsdontmatterhere,itisthefactthatthe
PDCFunderpinsthetri-partyreposystem.
1,
OnJulyo,theFedextendedbothpro-
gramsthroughJanuaryo,ioo.
JP MORGAN: REFUSING TO UNWIND . . .
WOULD BE UNFORGIVABLE
ThereporunonBearalsoalertedthetworepoclearingbanksJPMorgan,themain
clearing bank for Lehman and Merrill Lynch, as it had been for Bear Stearns, and
BNYMellon,themainclearingbankforGoldmanSachsandMorganStanleytothe
riskstheyweretaking.
Before Bears collapse, the market had not really understood the colossal expo-
sures that the tri-party repo market created for these clearing banks. As explained
earlier, the unwind/rewind mechanism could leave JP Morgan and BNY Mellon
withanenormousintradayexposureaninterimexposure,butnolessrealforits
brevity. In an interview with the FCIC, Dimon said that he had not become fully
awareoftherisksstemmingfromhisbankstri-partyrepoclearingbusinessuntilthe
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.Iftheydefaultedintraday,weownthesecuritiesandwehaveto
liquidatethem.Thatsahugerisktous,Dimonexplained.
1,
Toaddressthoserisksinioo8,forthefrsttimebothJPMorganandBNYMellon
startedtodemandthatintradayloanstotri-partyrepoborrowersmostlythelarge
investmentbanksbeovercollateralized.
TheFedincreasinglyfocusedonthesystemicriskposedbythetworepoclearing
banks.Inthechain-reactionscenariothatitenvisioned,ifeitherJPMorganorBNY
Mellonchosenottounwinditstradesonemorning,themoneyfundsandotherrepo
lenderscouldbestuckwithbillionsofdollarsinrepocollateral.Thoselenderswould
thenbeinthedimcultpositionofhavingtosellofflargeamountsofcollateralinor-
dertomeettheirowncashneeds,anactionthatinturnmightleadtowidespreadfre
salesofrepocollateralandrunsbylenders.
18
The PDCF provided overnight funding, in case money market funds and other
z, ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
repolendersrefusedtolendastheyhadinthecaseofBearStearns,butitdidnotpro-
tectagainstclearingbanksrefusingexposuretoaninvestmentbankduringtheday.
OnJuly11,Fedomcialscirculatedaplan,ultimatelyneverimplemented,thatad-
dressedthepossibilitythatoneofthetwoclearingbankswouldbecomeunwillingor
unabletounwinditstrades.
1
TheplanwouldallowtheFedtoprovidetroubledin-
vestmentbanks,suchasLehmanBrothers,withioobillionintri-partyrepofnanc-
ing during the dayessentially covering for JP Morgan or BNY Mellon if the two
clearingbankswouldnotorcouldnotprovidethatleveloffnancing.
io
Fedomcials
made a case for the proposal in an internal memo: Should a dealer lose the conf-
dence of its investors or clearing bank, their efforts to pull away from providing
creditcouldbedisastrousforthefrmandalsocastwidespreaddoubtaboutthein-
strumentasanearlyriskfree,liquidovernightinvestment.
i1
ButtheNewYorkFedsnewplanshouldntbenecessaryaslongasthePDCFwas
theretobackuptheovernightlenders,arguedPatrickParkinson,thendeputydirec-
toroftheFederalReserveBoardsDivisionofResearchandStatistics.Weshouldtell
[JP Morgan] that with the PDCF in place refusing to unwind is unnecessary and
wouldbeunforgiveable,heemailedDudleyandothers.
ii
Aweeklater,onJulyio,ParkinsonwrotetoFedGovernorKevinWarshandFed
General Counsel Scott Alvarez that JP Morgan, because of its clearing role, was
likelytobethefrsttorealizethatthemoneyfundsandotherinvestorsthatprovide
tri-party fnancing to [Lehman Brothers] are pulling back signifcantly. Parkinson
described the chain-reaction scenario, in which a clearing banks refusal to unwind
wouldleadtoawidespreadfresaleandmarketpanic.Fearoftheseconsequencesis,
ofcourse,whywefacilitatedBearsacquisitionbyJPMC,hesaid.
i
Still,itwaspossiblethatthePDCFcouldproveinsumcienttodissuadeJPMorgan
fromrefusingtounwindLehmansrepos,Parkinsonsaid.Becausealargeportionof
Lehmans collateral was ineligible to be funded by the PDCF, and because Lehman
couldfailduringtheday(beforethereposweresettled),JPMorganstillfacedsignif-
cant risks. Parkinson noted that even if the Fed lent as much as ioo billion to
Lehman,thesummightnotbeenoughtoensurethefrmssurvivalintheabsenceof
an acquirer: if the stigma associated with PDCF borrowing caused other funding
counterpartiestostopprovidingfundingtoLehman,thecompanywouldfail.
i
THE FED AND THE SEC: WEAK LIQUIDITY POSITION
Amongthefourremaininginvestmentbanks,onekeymeasureofliquidityriskwas
theportionoftotalliabilitiesthatthefrmsfundedthroughtherepomarket:1,to
ioforLehmanandMerrillLynch,1oto1,forMorganStanley,andabout1o
forGoldmanSachs.
i,
Anothermetricwastherelianceonovernightrepo(whichma-
tureinoneday)oropenrepo(whichcanbeterminatedatanytime).Despiteefforts
amongtheinvestmentbankstoreducetheportionoftheirrepofnancingthatwas
overnightoropen,theratioofovernightandopenrepofundingtototalrepofund-
ing still exceeded o for all but Goldman Sachs. Comparing the period between
March and May to the period between July and August, Lehmans percentage fell
\\itu 1u \UtU:1 z++ ::1i\i t ii :i tuNtiiN: z,,
from , to o, Merrill Lynchs fell from o to , Morgan Stanleys 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 analysts later noted,
Withlendersworryingthattheycouldlosemoneyonthesecuritiestheyheldascol-
lateral, haircuts increaseddoubling for some agency mortgage securities and in-
creasing signifcantly even for borrowers with high credit ratings and on relatively
safecollateralsuchasTreasurysecurities.
i,
OnthedayofBearsdemise,inanefforttogetabetterunderstandingofthein-
vestment banks, the New York Fed and the SEC sent teams to work on-site at
LehmanBrothers,MerrillLynch,GoldmanSachs,andMorganStanley.Accordingto
ErikSirri,directoroftheSECsDivisionofTradingandMarkets,theinitialroundsof
meetingscoveredthequalityofassets,funding,andcapital.
i8
Fed Chairman Ben Bernanke would testify before a House committee that the
Feds primary role at the investment banks in ioo8 was not as a regulator but as a
lender through the new emergency lending facilities.
i
Two questions guided the
Fedsanalyses:First,waseachinvestmentbankliquiddidithaveaccesstothecash
needed to meet its commitments: Second, was it solventwas its net equity (the
valueofassetsminusthevalueofliabilities)sumcienttocoverprobablelosses:
o
TheU.S.Treasuryalsodispatchedso-calledSWATteamstotheinvestmentbanks
inthespringofioo8.ThearrivalofomcialsfromtheTreasuryandtheFedcreateda
full-timeon-sitepresencesomethingtheSEChadneverhad.Historically,theSECs
primary concern with the investment banks had been liquidity risk, because these
frmswereentirelydependentonthecreditmarketsforfunding.
1
TheSECalready
requiredthesefrmstoimplementso-calledliquiditymodels,designedtoensurethat
they had sumcient cash available to sustain themselves on a stand-alone basis for a
minimum of one year without access to unsecured funding and without having to
sell a substantial amount of assets. Before the run on Bear in the repo market, the
SECsliquiditystressscenariosalsoknownasstresstestshadnottakenaccountof
the possibility that a frm would lose access to secured funding. According to the
SECsSirri,theSECneverthoughtthatasituationwouldarisewhereaninvestment
bankcouldntenterintoarepotransactionbackedbyhigh-qualitycollateralinclud-
ingTreasuries.HetoldtheFCICthatasthefnancialcrisisworsened,theSECbegan
toseeliquidityandfundingrisksasthemostcriticalfortheinvestmentbanks,and
theSECencouragedareductioninrelianceonunsecuredcommercialpaperandan
extensionofthematuritiesofrepoloans.
i
TheFedandtheSECcollaboratedindevelopingtwonewstressteststodetermine
theinvestmentbanksabilitytowithstandapotentialrunorasystemwidedisruption
in the repo market. The stress scenarios, called Bear Stearns and Bear Stearns
Light, were developed jointly with the remaining investment banks. In May,
Lehman,forexample,wouldbe8billionshortofcashinthemorestringentBear
Stearnsscenarioand1,billionshortunderBearStearnsLight.

TheFedconductedanotherliquiditystressanalysisinJune.Whileeachfrmran
z, ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
different scenarios that matched its risk profle, the supervisors tried to maintain
comparabilitybetweenthetests.Thetestsassumedthateachfrmwouldlose1ooof
unsecuredfundingandafractionofrepofundingthatwouldvarywiththequalityof
its collateral. The stress tests, under just one estimated scenario, concluded that
Goldman Sachs and Morgan Stanley were relatively sound. Merrill Lynch and
LehmanBrothersfailed:thetwobankscameoutiibillionand1,billionshortof
cash,respectively;eachhadonly,8oftheliquidityitwouldneedunderthestress
scenario.

TheFedsinternalreportonthestresstestscriticizedMerrillssignifcantamount
of illiquid fxed income assets and noted that Merrills liquidity pool is low, a fact
[thecompany]doesnotacknowledge.AsforLehmanBrothers,theFedconcluded
that Lehmans weak liquidity position is driven by its relatively large exposure to
overnight [commercial paper], combined with signifcant overnight secured [repo]
funding of less liquid assets.
,
These less liquid assets included mortgage-related
securitiesnowdevalued.Meanwhile,Lehmanranstresstestsofitsownandpassed
withbillionsinexcesscash.
o
AlthoughtheSECandtheFedworkedtogetherontheliquiditystresstests,with
equalaccesstothedata,eachagencyhassaidthatformonthsduringthecrisis,the
other did not share its analyses and conclusions. For example, following Lehmans
failure in September, the Fed told the bankruptcy examiner that the SEC had de-
clined to share two horizontal (cross-frm) reviews of the banks liquidity positions
andexposurestocommercialrealestate.TheSECsresponsewasthatthedocuments
wereindraftformandhadnotbeenreviewedorfnalized.Addingtothetension,
theFedson-sitepersonnelbelievedthattheSECon-sitepersonneldidnothavethe
backgroundorexpertisetoadequatelyevaluatethedata.
,
Thislackofcommunica-
tionwasremediedonlybyaformalmemorandumofunderstanding(MOU)togov-
ern information sharing. According to former SEC Chairman Christopher Cox,
OnereasontheMOUwasneededwasthattheFedwasreluctanttosharesupervi-
soryinformationwiththeSEC,outofconcernthattheinvestmentbankswouldnot
beforthcomingwithinformationiftheythoughttheywouldbereferredtotheSEC
for enforcement.
8
The MOU was not executed until July ioo8, more than three
monthsafterthecollapseofBearStearns.
DERIVATIVES: EARLY STAGES OF ASSESSING
THE POTENTIAL SYSTEMIC RISK
The Feds Parkinson advised colleagues in an internal August 8 email that the sys-
temicrisksoftherepoandderivativesmarketsdemandedattention:Wehavegiven
considerablethoughttowhatmightbedonetoavoidafresaleoftri-partyrepocol-
lateral.(Thatsaid,theoptionsunderexistingauthorityarenotveryattractivelots
ofrisktoFed/taxpayer,lotsofmoralhazard.)Westillareattheearlystagesofassess-
ingthepotentialsystemicriskfromclose-outofOTCderivativestransactionsbyan
investmentbankscounterpartiesandidentifyingpotentialmitigants.

Therepomarketwashuge,butasdiscussedinearlierchapters,itwasdwarfedby
Notional Amount and Gross Market
Value of OTC Derivatives Outstanding
IN TRILLIONS OF DOLLARS, SEMIANNUAL
SOURCE: Bank for International Settlements
1999 2003 2001 2005 2007 2009
0
100
200
300
400
500
600
700
$800
0
5
10
15
20
25
30
35
$40
Gross Market Value Notional Amount
June 2010
Iigurc:.:
\\itu 1u \UtU:1 z++ ::1i\i t ii :i tuNtiiN: z,,
the global derivatives market. At the end of June ioo8, the notional amount of the
over-the-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 by statute in iooo, market partici-
pants were not subject to reporting or disclosure requirements and no government
agencyhadoversightresponsibility.WhiletheOmceoftheComptrolleroftheCur-
rency did report information on derivatives positions from commercial banks and
bank holding companies, it did not collect such information from the large invest-
mentbanksandinsurancecompanieslikeAIG,whichwerealsomajorOTCderiva-
tivesdealers.Duringthecrisisthelackofsuchbasicinformationcreatedheightened
uncertainty.
Atthispointinthecrisis,regulatorsalsoworriedabouttheinterlockingrelation-
ships that derivatives created among the small number of large fnancial frms that
actasdealersintheOTCderivativesbusiness.Aderivativescontractcreatesacredit
relationshipbetweenparties,suchthatonepartymayhavetomakelargeandunex-
pectedpaymentstotheotherbasedonsuddenpriceorratechangesorloandefaults.
Ifapartyisunabletomakethosepaymentswhentheybecomedue,thatfailuremay
,++ ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
causesignifcantfnancialharmtoitscounterparty,whichmayhaveoffsettingobli-
gationstothirdpartiesanddependonpromptpayment.Indeed,mostOTCderiva-
tives dealers hedge their contracts with offsetting contracts; thus, if they are owed
payments on one contract, they most likely owe similar amounts on an offsetting
contract,creatingthepotentialforaseriesoflossesordefaults.Sincethesecontracts
numbered in the millions and allowed a party to have virtually unlimited leverage,
thepossibilityofsuddenlargeanddevastatinglossesinthismarketcouldposeasig-
nifcantdangertomarketparticipantsandthefnancialsystemasawhole.
TheCounterpartyRiskManagementPolicyGroup,ledbyformerNewYorkFed
President E. Gerald Corrigan and consisting of the major securities frms, had
warnedthatabackloginpaperworkconfrmingderivativestradesandmasteragree-
ments exposed frms to risk should corporate defaults occur.
o
With urging from
New York Fed President Timothy Geithner, by September iooo, 1 major market
participantshadsignifcantlyreducedthebacklogandhadendedthepracticeofas-
signingtradestothirdpartieswithoutthepriorconsentoftheircounterparties.
1
Largederivativespositions,andtheresultingcounterpartycreditandoperational
risks, were concentrated in a very few frms. Among U.S. bank holding companies,
the following institutions held enormous OTC derivatives positions as of June o,
ioo8: ., trillion in notional amount for JP Morgan, ,., trillion for Bank of
America,,.8trillionforCitigroup,.1trillionforWachovia,and.trillionfor
HSBC. Goldman Sachs and Morgan Stanley, which began to report their holdings
only after they became bank holding companies in ioo8, held ,. and ,.o tril-
lion, respectively, in notional amount of OTC derivatives in the frst quarter of
ioo.
i
Inioo8,thecurrentandpotentialexposuretoderivativesatthetopfveU.S.
bankholdingcompanieswasonaveragethreetimesgreaterthanthecapitaltheyhad
onhandtomeetregulatoryrequirements.Theriskwasevenhigherattheinvestment
banks. Goldman Sachs, just after it changed its charter, had derivatives exposure
more than 1o times capital. These concentrations of positions in the hands of the
largest bank holding companies and investment banks posed risks for the fnancial
systembecauseoftheirinterconnectionswithotherfnancialinstitutions.
BroadclassesofOTCderivativesmarketsshowedstressinioo8.Bythesummer
of ioo8, outstanding amounts of some types of derivatives had begun to decline
sharply.Aswewillsee,overthecourseofthesecondhalfofioo8,theOTCderiva-
tives market would undergo an unprecedented contraction, creating serious prob-
lemsforhedgingandpricediscovery.
TheFedwasuneasyinpartbecausederivativescounterpartieshadplayedanim-
portantroleintherunonBearStearns.Thenovationsbyderivativescounterparties
to assign their positions away from Bearand the rumored refusal by Goldman to
accept Bear as a derivatives counterpartywere still a fresh memory across Wall
Street. Chris Mewbourne, a portfolio manager at PIMCO, told the FCIC that the
ability to novate ceased to exist and this was a key event in the demise of Bear
Stearns.

Creditderivativesinparticularwereaserioussourceofworry.Ofgreatestinterest
werethesellersofcreditdefaultswaps:themonolineinsurersandAIG,whichback-
\\itu 1u \UtU:1 z++ ::1i\i t ii :i tuNtiiN: ,+.
stoppedthemarketinCDOs.Inaddition,thecreditratingagenciesdecisiontoissue
anegativeoutlookonthemonolineinsurershadjoltedeveryone,becausetheyguar-
anteedhundredsofbillionsofdollarsinstructuredproducts.Aswehaveseen,when
theircreditratingsweredowngraded,thevalueofall theassetstheyguaranteed,in-
cludingmunicipalbondsandothersecurities,necessarilylostsomevalueinthemar-
ket,adropthataffectedtheconservativeinstitutionalinvestorsinthosemarkets.In
thevernacularofWallStreet,thisoutcomeistheknock-oneffect;inthevernacular
ofMainStreet,thedominoeffect;inthevernacularoftheFed,systemicrisk.
BANKS: THE MARKETS WERE REALLY, REALLY DICEY
Bythefallofioo,,signsofstrainwerebeginningtoemergeamongthecommercial
banks. In the fourth quarter of ioo,, commercial banks earnings declined to a 1o-
year low, driven by write-downs on mortgage-backed securities and CDOs and by
recordprovisionsforfutureloanlosses,asborrowershadincreasingdimcultymeet-
ing their mortgage paymentsand even greater dimculty was anticipated. The net
charge-offratetheratiooffailedloanstototalloansrosetoitshighestlevelsince
iooi,whentheeconomywascomingoutofthepost-/11recession.Earningscon-
tinuedtodeclineinioo8atfrst,moreforbigbanksthansmallbanks,inpartbe-
cause of write-downs related to their investment bankingtype activities, including
thepackagingofmortgage-backedsecurities,CDOs,andcollateralizedloanobliga-
tions. Declines in market values required banks to write down the value of their
holdingsofthesesecurities.Aspreviouslynoted,severalofthelargestbankshadalso
provided support to off-balance-sheet activities, such as money market funds and
commercial paper programs, bringing additional assets onto their balance sheets
assetsthatwerelosingvaluefast.Supervisorshadbeguntodowngradetheratingsof
manysmallerbanksinresponsetotheirhighexposuresinresidentialrealestatecon-
struction, an industry that virtually went out of business as fnancing dried up in
mid-ioo,. By the end of ioo,, the FDIC had ,o banks, mainly smaller ones, on its
problem list; their combined assets totaled ii.i billion.

(When large banks

started to be downgraded, in early ioo8, they stayed off the FDICs problem list, as
supervisorsrarelygivethelargestinstitutionsthelowestratings.)
,
Themarketfornonconformingmortgagesecuritizations(thosebackedbymort-
gagesthatdidnotmeetFannieMaesorFreddieMacsunderwritingormortgagesize
guidelines)hadalsovanishedinthefourthquarterofioo,.Notonlydidthesenon-
conformingloansprovehardertosell,buttheyalsoprovedlessattractivetokeepon
balance sheet, as house price forecasts looked increasingly grim. Already, house
priceshadfallenabout,fortheyear,dependingonthemeasure.Inthefrstquarter
ofioo8,realestateloansinthebankingsectorshowedthesmallestquarterlyincrease
since ioo.
o
IndyMac reported a i1 decline in loan production for that quarter
fromayearearlier,becauseithadstoppedmakingnonconformingloans.Washing-
ton Mutual, the largest thrift, discontinued all remaining lending through its sub-
primemortgagechannelinAprilioo8.
But those actions could not reduce the subprime and Alt-A exposure that these
,+z ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
largebanksandthriftsalready had.Andontheseassets,themarkdownscontinued
inioo8.Regulatorsbegantofocusonsolvency,urgingthebankstoraisenewcapital.
InJanuaryioo8,Citigroupsecuredatotalof1billionincapitalfromKuwait,Sin-
gapore, Saudi Prince Alwaleed bin Talal, and others. In April, Washington Mutual
raised , billion from an investor group led by the buyout frm TPG Capital. Wa-
choviaraisedobillionincapitalattheturnoftheyearandthenanadditional8bil-
lion in April ioo8. Despite the capital raises, though, the downgrades by banking
regulatorscontinued.
The markets were really, really dicey during a signifcant part of this period,
startingwithAugustioo,,RogerCole,then-directoroftheDivisionofBankingSu-
pervision and Regulation at the Federal Reserve Board, told the FCIC.
,
The same
wastrueforthethrifts.MichaelSolomon,amanagingdirectorinriskmanagement
manager in the Omce of Thrift Supervision (OTS), told the FCIC, It was hard for
businesses, particularly small, midsized thriftsto keep up with [how quickly the
ratings downgrades occurred during the crisis] and change their business models
andnotgetstuckwithoutthechairwhenthemusicstopped . . .Theygotcaught.The
ratingdowngradesstartedandbythetimethethriftwasabletodosomethingabout
it,itwastoolate . . .Businessmodels . . .cantkeepupwithwhatwesawinioo8.
8
Asthecommercialbankshealthworsenedinioo8,examinersdowngradedeven
large institutions that had maintained favorable ratings and required several to fx
their risk management processes. These ratings downgrades and enforcement ac-
tionscamelateinthedayoftenjustasfrmswereonthevergeoffailure.Incases
that the FCIC investigated, regulators either did not identify the problems early
enoughordidnotactforcefullyenoughtocompelthenecessarychanges.
titigrou.1imctocomcuvit/encvle;oook
For Citigroup, supervisors at the New York Fed, who examined the bank holding
company,andattheOmceoftheComptrolleroftheCurrency,whooversawthena-
tional bank subsidiary, fnally downgraded the company and its main bank to less
thansatisfactoryinAprilioo8fvemonthsafterthefrmsannouncementinNo-
vember ioo, of billions of dollars in write-downs related to its mortgage-related
holdings.ThesupervisorsputthecompanyundernewenforcementactionsinMay
andJune.Onlyayearearlier,boththeFedandtheOCChadupgradedthecompany,
after lifting all remaining restrictions and enforcement actions related to complex
transactionsthatithadstructuredforEnronandtotheactionsofitssubprimesub-
sidiaryCitiFinancial,discussedinanearlierchapter.Theriskmanagementassess-
mentforioooisrefectiveofacontrolenvironmentwheretherisksfacingCitigroup
continuetobemanagedinasatisfactorymanner,theNewYorkFedsratingupgrade,
deliveredinitsannualinspectionreportonApril,ioo,,hadnoted.Duringiooo,
all formal restrictions and enforcement actions between the Federal Reserve and
Citigroupwerelifted.Boardandseniormanagementremainactivelyengagedinim-
provingrelevantprocesses.

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,thesupervisorswroteinaninternalNovember1memodescrib-
ing meetings with Citigroup management. Stress tests were not designed for this
type of extreme market event. . . . Management had believed that CDOs and lever-
agedloanswouldbesyndicated,andthatthecreditriskinsuperseniorAAACDOs
wasnegligible.
,o
Inretrospect,Citigrouphadtwokeyproblems:alackofeffectiveenterprise-wide
managementtomonitorandcontrolrisksandalackofproperinfrastructureandin-
ternalcontrolswithrespecttothecreationofCDOs.TheOCCappearstohaveiden-
tifedsomeoftheseissuesasearlyasioo,butdidnoteffectivelyacttorectifythem.
Inparticular,theOCCassessedboththeliquidityputsandthesuper-seniortranches
aspartofitsreviewsofthebankscompliancewiththepost-Enronenforcementac-
tion,butitdidnotexaminetherisksoftheseexposures.Asfortheissuesitdidspot,
theOCCfailedtotakeforcefulstepstorequiremandatorycorrectiveaction,andit
reliedonmanagementsassurancesiniooothattheexecutiveswouldstrivetomeet
theOCCsgoalsforimprovingriskmanagement.
Incontrast,documentsobtainedbytheFCICfromtheNewYorkFedgivenoin-
dicationthatitsexaminationstaffhadanyindependentknowledgeofthosetwocore
problems.AnevaluationoftheNewYorkFedssupervisionofCitigroup,conducted
byexaminersfromotherReserveBanks(theDecemberiooOperationsReviewof
theNewYorkFed,whichcoveredthepreviousfouryears),concluded:
ThesupervisionprogramforCitigrouphasbeenlessthaneffective.Al-
though the dedicated supervisory team is well qualifed and generally
has sound knowledge of the organization, there have been signifcant
weaknessesintheexecutionofthesupervisoryprogram.Theteamhas
not been proactive in making changes to the regulatory ratings of the
frm, as evidenced by the double downgrades in the frms fnancial
componentandrelatedsubcomponentsatyear-endioo,.Additionally,
thesupervisoryprogramhaslackedtheappropriateleveloffocusonthe
frms risk oversight and internal audit functions. As a result, there is
currentlysignifcantworktobedoneinbothoftheseareas.Moreover,
the team has lacked a disciplined and proactive approach in assessing
andvalidatingactionstakenbythefrmtoaddresssupervisoryissues.
,1
TimothyGeithner,secretaryoftheTreasuryandformerpresidentoftheFederal
ReserveBankofNewYork,refectedontheFedsoversightofCitigroup,tellingthe
Commission,Idonotthinkwedidenoughasaninstitutionwiththeauthoritywe
hadtohelpcontaintherisksthatultimatelyemergedinthatinstitution.
,i
In January ioo8, an OCC review of the breakdown in the CDO business noted
that the risk in the unit had grown rapidly since iooo, after the OCCs and Feds
,+, ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
lifting of supervisory agreements associated with various control problems at Citi-
group.InAprilioo8,theFedandOCCdowngradedtheiroverallratingsofthecom-
panyanditslargestbanksubsidiaryfromi(satisfactory)to(lessthansatisfactory),
refectingweaknessesinriskmanagementthatwerenowapparenttothesupervisors.
BothFedandOCComcialscitedtheGramm-Leach-BlileyActof1asanob-
stacle that prevented each from obtaining a complete understanding of the risks
assumedbylargefnancialfrmssuchasCitigroup.Theactmadeitmoredimcult
though not impossiblefor regulators to look beyond the legal entities under their
directpurviewintootherareasofalargefrm.Citigroup,forexample,hadmanyreg-
ulatorsacrosstheworld;eventhesecuritizationbusinessesweredispersedacrosssub-
sidiarieswithdifferentsupervisorsincludingthosefromtheFed,OCC,SEC,OTS,
andstateagencies.
InMayandJuneioo8,Citigroupenteredintomemorandaofunderstandingwith
boththeNewYorkFedandOCCtoresolvetheriskmanagementweaknessesthatthe
eventsofioo,hadlaidbare.Intheensuingmonths,FedandOCComcialssaid,they
were satisfed with Citigroups compliance with their recommendations. Indeed, in
speakingtotheFCIC,SteveManzari,theseniorrelationshipmanagerforCitigroup
attheNewYorkFedfromApriltoSeptemberioo8,complimentedCitigrouponits
assertiveness in executing its regulators requests: aggressively replacing manage-
ment, raising capital from investors in late ioo,, and putting in place a number of
muchneededinternalfxes.However,Manzariwenton,Citiwastrappedinwhat
wasaprettyvicious . . .systemicevent,andforregulatorsitwastimetocomeup
withanewplaybook.
,
\ec/ovie.1/c6olcn\cstecuisitionvesemistekc
AtWachovia,whichwassupervisedbytheOCCaswellastheOTSandtheFederal
Reserve,aioo,end-of-yearreportshowedthatcreditlossesinitssubsidiaryGolden
WestsportfolioofPick-a-Payadjustable-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 company would hike its estimate of the eventual
lossesontheportfoliotobyJuneandtoiibySeptember.
Facing these and other growing concerns, Wachovia raised additional capital.
Then,inApril,Wachoviaannouncedalossof,omillionforthefrstthreemonths
of the year. Depositors withdrew about 1, billion in the following weeks, and
lenders reduced their exposure to the bank, shortening terms, increasing rates, and
reducing loan amounts.
,
By June, according to Angus McBryde, then Wachovias
seniorvicepresidentforTreasuryandBalanceSheetManagement,managementhad
launchedaliquiditycrisismanagementplaninanticipationofanevenmoreadverse
marketreactiontosecond-quarterlossesthatwouldbeannouncedinJuly.
,,
On June i, Wachovias board ousted CEO Ken Thompson after he had spent i
years at the bank, 8 of them at its helm.
,o
At the end of the month, the bank an-
nouncedthatitwouldstoporiginatingGoldenWestsPick-a-Payproductsandwould
\\itu 1u \UtU:1 z++ ::1i\i t ii :i tuNtiiN: ,+,
waiveallfeesandprepaymentpenaltiesassociatedwiththem.OnJulyii,Wachovia
reported an 8. billion second-quarter loss. The new CEO, Robert Steel, most re-
centlyanundersecretaryofthetreasury,announcedaplantoimprovethebanksf-
nancialcondition:raisecapital,cutthestockdividend,andlayoff1oto1iofthe
staff.
Theratingagenciesandsupervisorsignoredthosereassurances.Onthesameday
astheannouncement,S&Pdowngradedthebank,andtheFed,afteryearsofsatis-
factory ratings, downgraded Wachovia to , or less than satisfactory. The Fed
noted that ioo8 projections showed losses that could wipe out the recently raised
capital:ioo8lossesalonecouldexceedbillion,anamountthatcouldcauseafur-
ther ratings downgrade.
,,
The Fed directed Wachovia to reevaluate and update its
capital plans and its liquidity management. Despite having consistently rated Wa-
choviaassatisfactoryrightuptothesummermeltdown,theFednowdeclaredthat
manyofWachoviasproblemswerelong-terminnatureandresult[ed]fromdelayed
investmentdecisionsandadesiretohavebusinesslinesoperateautonomously.
,8
TheFedbluntlycriticizedtheboardandseniormanagementforanenvironment
with inconsistent and inadequate identifcation, escalation and coverage of all risk-
takingactivities,includingdefcienciesinstresstestingandlittleaccountabilityfor
errors. Wachovia management had not completely understood the level of risk
across the company, particularly in certain nonbank investments, and management
had delayed fxing these known defciencies. In addition, the companys board had
not sumciently questioned investment decisions.
,
Nonetheless, the Fed concluded
thatWachoviasliquiditywascurrentlyadequateandthatthroughoutthemarketdis-
ruption,managementhadminimizedexposuretoovernightfundingmarkets.
OnAugust,theOCCdowngradedWachoviaBankandassesseditsoverallrisk
profleashigh.TheOCCnotedmanyofthesameissuesastheFed,andaddedpar-
ticularlystrongremarksabouttheacquisitionofGoldenWest,identifyingthatmort-
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
TheOCCwrotethatthemarketwasfocusedonthecompanysweakenedcondi-
tion and that some large fund providers had already limited their exposure to Wa-
chovia. Like the Fed, however, the OCC concluded that the banks liquidity was
adequate, unless events undermined market confdence.
o1
And, like the Fed, the
OCCapprovedofthenewmanagementandanew,morehands-onoversightrolefor
theboardofdirectors.
YetWachoviasproblemswouldcontinue,andinthefallregulatorswouldscram-
bletofndabuyerforthetroubledbank.
\es/ingtonMutuel.Menegcmcntscrsistcntleckojrogrcss
Washington Mutual, often called WaMu, was the largest thrift in the country, with
over oo billion in assets at the end of ioo,. At the time, , billion of the home
loansonitsbalancesheetwereoptionARMs,twotimesitscapitalandreserves,with
,+ ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
concentratedexposureinCalifornia.ThereasonWaMulikedoptionARMswassim-
ple:inioo,,incombinationwithothernontraditionalmortgagessuchassubprime
loans,theyhadgeneratedreturnsupto8timesthoseonGSEmortgagebackedsecu-
rities.
oi
But that was then. WaMu was forced to write off 1. billion for the fourth
quarterofioo,andanother1.1billioninthefrstquarterofioo8,mostlyrelatedto
itsportfolioofoptionARMs.
Inresponsetotheselosses,theOmceofThriftSupervision,WaMusregulator,re-
questedthatthethriftaddressconcernsaboutassetquality,earnings,andliquidity
issues that the OTS had raised in the past but that had not been refected in
supervisory ratings. It has been hard for us to justify doing much more than con-
stantlynagging(okay,chastising)throughROE[ReportsofExamination]andmeet-
ings,sincetheyhavenotreallybeenadverselyimpactedintermsoflosses,
o
theOTSs
leadexamineratthecompanyhadcommentedinaioo,email.Indeed,thenontradi-
tionalmortgageportfoliohadbeenperformingverywellthroughioo,andiooo.
But with WaMu now taking losses, the OTS determined on February i,, ioo8,
thatitsconditionrequiredadowngradeinitsratingfromaitoa,orlessthansat-
isfactory.
o
InMarch,theOTSadvisedthatWaMuundertakestrategicinitiatives
thatis,eitherfndabuyerorraisenewcapital.InApril,WaMusecureda,billion
investmentfromaconsortiumledbytheTexasPacifcGroup,aprivateequityfrm.
o,
Butbadnewscontinuedforthrifts.OnJuly1,theOTSclosedIndyMacBankin
Pasadena,California,makingthatcompanythelargest-everthrifttofail.OnJulyii,
ioo8, WaMu reported a . billion loss in the second quarter. WaMus depositors
withdrew1obillionoverthenexttwoweeks.
oo
AndtheFederalHomeLoanBankof
San Franciscowhich, as noted, had historically served with the other 11 Federal
HomeLoanBanksasanimportantsourceoffundsforWaMuandothersbeganto
limit WaMus borrowing capacity. The OTS issued more downgrades in various as-
sessmentcategories,whilemaintainingtheoverallratingat.
As the insurer of many 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 already
dropped WaMus rating signifcantly in March ioo8, indicating a high level of
concern.
o,
The FDIC expressly disagreed with the OTSs decision to maintain the overall
rating,recommendingainstead.
o8
Ordinarily,wouldhavetriggeredaformalen-
forcementaction,butnonewasforthcoming.InanAugustioo8interview,William
Isaac,whowaschairmanoftheFDICfrom181until18,,notedthattheOTSand
FDIC had competing interests. OTS, as primary regulator, tends to want to see if
theycanrehabilitatethebankanddoesntwanttoactprecipitouslyasarule.Onthe
other hand, The FDICs job is to handle the failures, and itgenerally speaking
wouldratherbetougher . . .onthetheorythatthesoonertheproblemsareresolved,
thelessexpensivethecleanupwillbe.
o
FDICChairmanSheilaBairunderscoredthistension,tellingtheFCICthatour
examiners, much earlier, were very concerned about the underwriting quality of
WaMusmortgageportfolio,andwewereactivelyopposedbytheOTSintermsofgo-
inginandlettingour[FDIC]examinersdoloan-levelanalysis.
,o
\\itu 1u \UtU:1 z++ ::1i\i t ii :i tuNtiiN: ,+,
TheTreasurysinspectorgeneralwouldlatercriticizeOTSssupervisionofWash-
ingtonMutual:WeconcludedthatOTSshouldhaveloweredWaMuscompositerat-
ing sooner and taken stronger enforcement action sooner to force WaMus
management to correct the problems identifed by OTS. Specifcally, given WaMu
managements persistent lack of progress in correcting OTS-identifed weaknesses,
webelieveOTSshouldhavefolloweditsownpoliciesandtakenformalenforcement
actionratherthaninformalenforcementaction.
,1
kcguletors.\lotojt/etus/oeck
IntheseexamplesandothersthattheCommissionstudied,regulatorseitherfailedor
werelatetoidentifythemistakesandproblemsofcommercialbanksandthriftsordid
notreactstronglyenoughwhentheywereidentifed.Inpart,thisfailurerefectsthe
nature of bank examinations conducted during periods of apparent fnancial calm
wheninstitutionswerereportingprofts.Inadditiontotheirroleasenforcersofregu-
lation,regulatorsactedsomethinglikeconsultants,workingwithbankstoassessthe
adequacyoftheirsystems.Thisfunctionwas,toadegree,arefectionofthesupervi-
sorsrisk-focusedapproach.TheOCCLarge Bank Supervision Handbook published
inJanuaryio1oexplains,Underthisapproach,examinersdonotattempttorestrict
risk-takingbutratherdeterminewhetherbanksidentify,understand,andcontrolthe
riskstheyassume.
,i
Asthecrisisdeveloped,bankregulatorswereslowtoshiftgears.
SeniorsupervisorstoldtheFCICitwasdimculttoexpresstheirconcernsforce-
fullywhenfnancialinstitutionsweregeneratingrecord-levelprofts.TheFedsRoger
Cole told the FCIC that supervisors did discuss issues such as whether banks were
growingtoofastandtakingtoomuchrisk,butranintopushback.Franklyalotof
that pushback was given credence on the part of the frms by the fact thatlike a
Citigroupwasearningto,billionaquarter.Andthatisreallyhardforasupervi-
sor to successfully challenge. When that kind of money is fowing out quarter after
quarterafterquarter,andtheircapitalratiosarewayabovetheminimums,itsvery
hardtochallenge.
,
SupervisorsalsotoldtheFCICthattheyfearedaggravatingabanksalready-exist-
ingproblems.Forthelargebanks,theissuanceofaformal,publicsupervisoryaction
taken under the federal banking statutes marked a severe regulatory assessment of
thebanksriskpractices,anditwasrarelyemployedforbanksthatweredetermined
tobegoingconcerns.RichardSpillenkothen,theFedsheadofsupervisionuntilearly
iooo, attributed supervisory reluctance to a belief that the traditional, nonpublic
(behind-the-scenes) approach to supervision was less confrontational and more
likelytoinducebankmanagementtocooperate;adesirenottoinjectanelementof
contentiousnessintowhatwasfelttobeaconstructiveorequablerelationshipwith
management; and a fear that fnancial markets would overreact to public actions,
possiblycausingarun.Spillenkothenarguedthattheseconcernswererelevantbut
thatattimestheycanimpedeeffectivesupervisionanddelaytheimplementationof
neededcorrectiveaction.Oneofthelessonsofthiscrisis . . .isthattheworkingpre-
sumptionshouldbeearlierandstrongersupervisoryfollowup.
,
COMMISSION CONCLUSIONS ON CHAPTER 16
TheCommissionconcludesthatthebankingsupervisorsfailedtoadequatelyand
proactively identify and police the weaknesses of the banks and thrifts or their
poorcorporategovernanceandriskmanagement,oftenmaintainingsatisfactory
ratingsoninstitutionsuntiljustbeforetheircollapse.Thisfailurewascausedby
many factors, including beliefs that regulation was unduly burdensome, that f-
nancialinstitutionswerecapableofself-regulation,andthatregulatorsshouldnot
interferewithactivitiesreportedasproftable.
Largecommercialbanksandthrifts,suchasWachoviaandIndyMac,thathad
signifcant exposure to risky mortgage assets were subject to runs by creditors
anddepositors.
TheFederalReserverealizedfartoolatethesystemicdangerinherentinthe
interconnections of the unregulated over-the-counter (OTC) derivatives market
anddidnothavetheinformationneededtoact.
DouglasRoeder,theOCCsseniordeputycomptrollerforLargeBankSupervision
from ioo1 to io1o, said that the regulators were hampered by inadequate informa-
tionfromthebanksbutacknowledgedthatregulatorsdidnotdoagoodjobofinter-
vening at key points in the run-up to the crisis. He said that regulators, market
participants,andothersshouldhavebalancedtheirconcernsaboutsafetyandsound-
ness with the need to let markets work, noting, We underestimated what systemic
riskwouldbeinthemarketplace.
,,
Regulators also blame the complexity of the supervisory system in the United
States.Thepatchworkquiltofregulatorscreatedopportunitiesforbankstoshopfor
themostlenientregulator,andthepresenceofmorethanonesupervisoratanorgan-
ization.Forexample,alargefrmlikeCitigroupcouldhavetheFedsupervisingthe
bankholdingcompany,theOCCsupervisingthenationalbanksubsidiary,theSEC
supervisingthesecuritiesfrm,andtheOTSsupervisingthethriftsubsidiarycreat-
ingthepotentialforbothgapsincoverageandproblematicoverlap.SuccessiveTreas-
ury secretaries and Congressional leaders have proposed consolidation of the
supervisorstosimplifythissystemovertheyears.Notably,SecretaryHenryPaulson
releasedtheBlueprintforaModernizedFinancialRegulatoryStructureonMarch
1, ioo8, two weeks after the Bear rescue, in which he proposed getting rid of the
thriftcharter,creatingafederalcharterforinsurancecompanies(nowregulatedonly
bythestates),andmergingtheSECandCFTC.Theproposalsdidnotmoveforward
inioo8.
,o
,+ ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
,+,
17
SEPTEMBER 2008: THE TAKEOVER
OF FANNIE MAE AND FREDDIE MAC
CONTENTS
Agccdtinctc|uy,+o
1hccn|ygancintcwn,++
Itsatincganc |cccc|,+:
1hcidcastrikcsncaspcrvcrsc ,+,
Itwi||incrcascccndcncc,+,
Critica|unsajcandunscundpracticcs ,+:
1hcywcntjrcn:crctcthrccwithncwarningin|ctwccn ,+,
1hcwcrst-runnancia|instituticn,:+
Vasntdcncatnypaygradc,::
Fromthefallofioo,untilFannieMaeandFreddieMacwereplacedintoconserva-
torshiponSeptember,,ioo8,governmentomcialsstruggledtostriketherightbal-
ancebetweenthesafetyandsoundnessofthetwogovernment-sponsoredenterprises
andtheirmissiontosupportthemortgagemarket.Thetaskwascriticalbecausethe
mortgage market was quickly 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
theGSEswithmoreriskontheiralready-strainedbalancesheets.
TheGSEswerehighlyleveragedowningandguaranteeing,.trillionofmort-
gageswithcapitaloflessthani.WheninterviewedbytheFCIC,formerTreasury
SecretaryHenryPaulsonacknowledgedthatafterhewasbriefedontheGSEsupon
takingomceinJuneiooo,hebelievedthattheywereadisasterwaitingtohappen
and that one key problem was the legal defnition of capital, which their regulator
lackeddiscretiontoadjust;indeed,hesaidthatsomepeoplereferredtoitasbullsht
capital.
1
Still,theGSEskeptbuyingmoreoftheriskiermortgageloansandsecuri-
ties, which by fall ioo, constituted multiples of their reported capital. The GSEs
,.+ ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
reported billions of dollars of net losses on these loans and securities, beginning in
thethirdquarterofioo,.
ButmanyinTreasurybelievedthecountryneededtheGSEstoprovideliquidity
to the mortgage market by purchasing and guaranteeing loans and securities at a
timewhennooneelsewould.PaulsontoldtheFCICthatafterthehousingmarket
driedupinthesummerofioo,,thekeytogettingthroughthecrisiswastolimitthe
declineinhousing,preventforeclosures,andensurecontinuedmortgagefunding,all
ofwhichrequiredthattheGSEsremainviable.
i
However,therewereconstraintson
howmanyloanstheGSEscouldfund;theyandtheirregulatorshadagreedtoportfo-
lio capslimits on the loans and securities they could hold on their booksand a
ocapitalsurplusrequirement.
So,evenaseachcompanyreportedbillionsofdollarsinlossesinioo,andioo8,
theirregulator,theOmceofFederalHousingEnterpriseOversight(OFHEO),loos-
ened those constraints. From the fall of ioo,, to the conservatorships, it was a
tightrope with no safety net, former OFHEO Director James Lockhart testifed to
the FCIC.

Unfortunately, the balancing act ultimately failed and both companies

wereplacedintoconservatorship,costingtheU.S.taxpayers1,1billionsofar.
A GOOD TIME TO BUY
InanAugust1,ioo,,lettertoLockhart,FannieMaeCEODanielMuddsoughtim-
mediaterelieffromtheportfoliocapsrequiredbytheconsentagreementexecutedin
May iooo following Fannies accounting scandal. We have witnessed growing evi-
denceofturmoilinvirtuallyallsectorsofthehousingfnancemarket,Muddwrote,
and the immediate crisis in subprime is indicative of a serious liquidity event im-
pactingtheentirecreditmarket,notjustsubprime.

Asdemandforpurchasingloans
dried up, large lenders like Countrywide kept loans that they normally securitized,
andsmallerlenderswentunder.AnumberoffrmstoldFanniethattheywouldstop
makingloansifFanniewouldnotbuythem.
Muddarguedthatarelaxedcapwouldlethiscompanyprovidethatliquidity.A
moderate,1opercentincreaseintheFannieMaeportfoliocapwouldprovideuswith
fexibility . . .andsendastrongsignaltothemarketthattheGSEsareabletoaddress
liquidity events before they become crises. He maintained that the consent agree-
mentallowedOFHEOtoliftthecaptoaddressmarketliquidityissues.Moreover,
thecompanyhadlargelycorrecteditsaccountingandinternalcontroldefciencies
theprimaryconditionforremovingthecap.Finally,hestressedthattheGSEschar-
ter required Fannie to provide liquidity and stability to the market. Ultimately,
Mudd concluded, this request is about restoring market confdence that the GSEs
canfulflltheirstabilizingroleinhousing.
,
Fannie Mae executives also saw an opportunity to make money. Because there
was less competition, the GSEs could charge higher fees for guaranteeing securities
andpaylessforloansandsecuritiestheywantedtoown,enablingthem(intheory)
toincreasereturns.
o
TomLund,alongtimeFannieMaeexecutivewholedthefrms
single-familybusiness,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.
LundtoldFCICstaffthataftertheioo,liquidityshock,Fanniehadmorecomfort
that the relationship between risk and price was correct.
,
Robert Levin, the com-
panyschiefbusinessomcer,recalled,Itwasagoodtimetobuy.
8
On August 1o, OFHEOs Lockhart notifed Fannie that increasing the portfolio
cap would be premature but the regulator would keep the request under active
consideration.Lockhartwrotethathewouldnotauthorizechanges,becauseFannie
couldstillguaranteemortgagesevenifitcouldntbuythemandbecauseFanniere-
mainedasignifcantsupervisoryconcern.Inaddition,LockhartnotedthatFannie
couldnotprudentlyaddresstheproblemsinthesubprimeandAlt-Amortgagemar-
ket,andthecompanyscharterdidnotpermitittoaddressproblemsinthemarket
for jumbo loans (mortgages larger than the GSEs loan limit).

Although there had

beenprogressindealingwiththeaccountingandinternalcontroldefciencies,heob-
served,muchworkremained.Fanniestillhadnotfledfnancialstatementsforiooo
orioo,,aparticularlytroublingissueinunsettledmarkets.
1o
AsLockharttestifedtotheFCIC,ItbecameclearbyAugustioo,thatthetur-
moilwastoobigfortheEnterprises[theGSEs]tosolveinasafeandsoundmanner.
He was worried that fewer controls would mean more losses. They were fulflling
theirmission,LockharttoldtheFCIC,buttheyhadnopowertodomoreinasafe
andsoundmanner.Iftheirmissionistoprovidestabilityandlessenmarketturmoil,
therewasnothingintheircapitalstructurethatwouldallowthemtodoso.
11
Lockhart had worried about the fnancial stability of the two GSEs and about
OFHEOsabilitytoregulatethebehemothsfromthedayhebecamedirectorinMay
iooo,andheadvocatedformoreregulatorypowersforhislargelytoothlessagency.
Lockhartpushedforthepowertoincreasecapitalrequirementsandtolimitgrowth,
and he sought authority over mission goals set by the Department of Housing and
UrbanDevelopment,aswellaslitigationauthorityindependentoftheDepartmentof
Justice.HisshoppinglistalsoincludedtheauthoritytoputFannieandFreddieinto
receivership,apowerheldbybankregulatorsoverbanks,andtoliquidatetheGSEsif
necessary.Asitstood,OFHEOhadtheauthoritytoplacetheGSEsinconservator-
shipineffect,toforceagovernmenttakeoverbutbecauseitlackedfundingtoop-
erate the GSEs as conservator, that authority was impracticable. The GSEs would
deteriorateevenfurtherbeforeLockhartsecuredthepowershesought.
1i
THE ONLY GAME IN TOWN
ButFannieandFreddieweretheonlygameintownoncethehousingmarketdried
upinthesummerofioo,,PaulsontoldtheFCIC.Andbythespringofioo8,[the
GSEs,]morethananyone,weretheengineweneededtogetthroughtheproblem.
1
FewdoubtedFannieandFreddiewereneededtosupportthestrugglinghousing
market. The question was how to do so safely.
1
Purchasing and guaranteeing risky
mortgage-backedsecuritieshelpedmakemoneyavailableforborrowers,butitcould
alsoresultinfurtherlossesforthetwohugecompanieslateron.Theresarealtrade-
off,Lockhartsaidinlateioo,atrade-offmadeallthemoredimcultbythestateof
,.z ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
the GSEs balance sheets.
1,
The value of risky loans and securities was swamping
theirreportedcapital.Bytheendofioo,,guaranteedandportfoliomortgageswith
FICO scores less than ooo exceeded reported capital at Fannie Mae by more than
seven to one; Alt-A loans and securities, by more than six to one. Loans for which
borrowersdidnotprovidefulldocumentationamountedtomorethantentimesre-
portedcapital.
1o
Inmid-September,OFHEOrelentedandmarginallyloosenedtheGSEsportfolio
cap,fromabout,i8billionto,,billion.ItallowedFannietoincreasetheamount
ofmortgageloansandsecuritiesitownedbyiperyearapowerthatFreddieal-
ready had under its agreement with OFHEO. OFHEO ruled out more dramatic in-
creases because the remediation process is not yet fnished, many safety and
soundness issues are not yet resolved, and the criteria in the Fannie Mae consent
agreementandFreddieMacsvoluntaryagreementhavenotbeenmet.
1,
Astheyearprogressed,FannieandFreddiebecameincreasinglyimportanttothe
mortgage market. By the fourth quarter of ioo,, they were purchasing ,, of new
mortgages,nearlytwicetheiooolevel.With,trillioninmortgagesrestingonra-
zor-thincapital,theGSEsweredoomedifthemarketdidnotstabilize.Accordingto
Lockhart, a withdrawal by Freddie Mac and Fannie Mae or even a drop in conf-
denceintheEnterpriseswouldhavecreatedaself-fulfllingcreditcrisis.
18
InearlyOctober,SenatorCharlesSchumerandRepresentativeBarneyFrankin-
troducedsimilarbillstotemporarilyliftportfoliolimitsontheGSEsby1opercent,
or approximately 1,o billion, most of which would be designated for refnancing
subprime loans. The measures, which Federal Reserve Chairman Ben Bernanke
calledilladvised,werenotenacted.
1
InNovember,FannieandFreddiereportedthird-quarterlossesof1.,billionand
ibillion,respectively.AttheendofDecemberioo,,Fanniereportedthatithad
billionofcapitaltoabsorbpotentiallosseson8,billionofassetsandi.itrillion
of guarantees on mortgage-backed securities; if losses exceeded 1.,, it would be
insolvent.Freddiewouldbeinsolventiflossesexceeded1.,.Moreover,therewere
seriousquestionsaboutthevalidityoftheirreportedcapital.
IT S A TIME GAME . . . BE COOL
Inthefrstquarter,realgrossdomesticproductfello.,atanannualrate,refecting
inpartthefrstdeclineinconsumerspendingsincetheearly1os.Theunemploy-
ment rate averaged , in the frst three months of ioo8, up from a low of . in
springofioo,.AstheFedcontinuedtocutinterestrates,theeconomywassinking
further into recession. In February, Congress passed the Economic Stimulus Act,
whichraisedthelimitsonthesizeofmortgagesthatFannieandFreddiecouldpur-
chase,amongothermeasures.
The push to get OFHEO to loosen requirements on the GSEs also continued.
SchumerpressedOFHEOtojustifyorlowertheocapitalsurcharge;suchastrin-
gent requirement, he wrote Lockhart on February i,, hampered Fannies ability to
providefnancingtohomeowners.
io
:ii1i\8ii z++ 1ui 1\iiu\ii ui i\NNi i \\i \Ni iiiiii i \\t ,.,
Twodayslater,FannieCEOMuddreportedlossesinthefourthquarterofioo,,
acknowledging that Fannie was working through the toughest housing and mort-
gage markets in a generation.
i1
The company had issued ,.8 billion of preferred
stock, had completed all 81 requirements of the consent agreement with OFHEO,
andwasdiscussingwithOFHEOthepossibilityofreducingtheocapitalsurplus
requirement. The next day, Freddie also reported losses and said the company had
raisedobillionofpreferredstock.
Asbothcompanieshadfledcurrentfnancialstatementsbythistime,fulfllinga
conditionofliftingtherestrictionsimposedbytheconsentagreements,Lockhartan-
nounced that OFHEO would remove the portfolio caps on March 1, ioo8. He also
said OFHEO would consider gradually lowering the o capital surplus require-
ment,becausebothcompanieshadmadeprogressinsatisfyingtheirconsentagree-
ments and had recently raised capital through preferred stock offerings. Mudd told
the FCIC that he sought relief from the capital surplus requirement because he did
notwanttofacefurtherregulatorydisciplineifFanniefellshortofrequiredcapital
levels.
ii
OnFebruaryi8,ioo8,thedayafterOFHEOliftedthegrowthlimits,aNewYork
Fed analyst noted to Treasury that the o capital surcharge was a constraint that
prevented the GSEs from providing additional liquidity to the secondary mortgage
market.
i
Calls to ease the surcharge also came from the marketplace. Mike Farrell, the
CEOofAnnalyCapitalManagement,warnedTreasuryUndersecretaryRobertSteel
that a crisis loomed in the credit markets that only the GSEs could solve. We be-
lievethatwearenearingatippingpoint; . . .lackoftransparencyonpricingforvir-
tuallyeveryassetclassandadearthofbuyersforeshadowedworsenews,Farrell
wrote.RemovingthecapitalsurchargeandpassinglegislationtooverhaultheGSEs
would make it possible for them to provide more stability, he said. Farrell recog-
nizedthattheGSEsmightbelievetheirreturnoncapitalwouldbeinsumcient,but
contendedthattheywillhavetogetpastthatandfocusonfulfllingtheircharters,
becausethebigpictureisthatrightnowwhateverisbestfortheeconomyandthe
fnancialsecurityofAmericatrumpstheROI[returnoninvestment]forFannieand
Freddieshareholders.
i
DaysbeforeBearStearnscollapsed,SteelreportedtoMuddthathehadencour-
agingconversationswithSenatorRichardShelby,therankingmemberoftheSenate
Committee on Banking, Housing, and Urban Affairs, and Representative Frank,
chairman of the House Financial Services Committee, about the possibility of GSE
reformlegislationandcapitalrelieffortheGSEs.HeintendedtospeakwithSenate
Banking Committee Chairman Christopher Dodd. Confdent that the government
desperately needed the GSEs to back up the mortgage market, Mudd proposed an
easiertrade.Ifregulatorswouldeliminatethesurcharge,FannieMaewouldagreeto
raisenewcapital.
i,
InaMarch,emailtoFanniechiefbusinessomcerLevin,Mudd
suggested that the o capital surplus requirement might be reduced without any
trade:Itsatimegame . . .whethertheyneedusmore . . .orifwehitthecapitalwall
frst.Becool.
io
,., ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
Onthenextday,March8,TreasuryandWhiteHouseomcialsreceivedadditional
information about Fannies condition. The White House economist Jason Thomas
sent Steel an email enclosing an alarming analysis: it claimed that in reporting its
ioo, fnancial results, Fannie was masking its insolvency through fraudulent ac-
countingpractices.Theanalysis,whichresembledoneofferedinaMarch1oBarrons
article,stated:
Any realistic assessment of Fannie Maes capital position would show
the company is currently insolvent. Accounting fraud has resulted in
severalassetcategories(non-agencysecurities,deferredtaxassets,low-
income partnership investment) being overstated, while the guarantee
obligationliabilityisunderstated.Theseaccountingshenanigansaddup
totensofbillionsofexaggeratednetworth.
Yet, the impact of a tsunami of mortgage defaults has yet to run
through Fannies income statement and further annihilate its capital.
SuchgrimresultsarealogicalconsequenceofFanniesdualmandateto
servethehousingmarketwhilemaximizingshareholderreturns.Intry-
ingtodoboth,Fanniehasdoneneitherwell.Withshareholdercapital
depleted,agovernmentseizureofthecompanyisinevitable.
i,
Given the turmoil of the Bear Stearns crisis, Paulson said he wanted to increase
confdenceinthemortgagemarketbyhavingFannieandFreddieraisecapital.Steel
toldhimthatTreasury,OFHEO,andtheFedwerepreparingplanstorelaxtheGSEs
capitalsurchargesinexchangeforassurancesthatthecompanieswouldraisecapital.
On March 1o, ioo8, Steel also reported to his Treasury colleagues that William
Dudley, then executive vice president of the New York Fed, wanted to harden the
implicit government guarantee of Freddie and Fannie. Steel wrote that Dudley
leanedonmehardtomaketheguaranteeexplicitinconjunctionwithdialingback
thesurchargeandattemptingtoraisenewcapital,andSteelworriedabouthowthis
mightaffectthefederalgovernmentsbalancesheet:Idonotlikethatandithasnot
beenpartofmyconversationwithanyoneelse.Iviewthatasaverysignifcantmove,
wayabovemypaygradetodoublethesizeoftheU.S.debtinonefellswoop.
i8
THE IDEA STRIKES ME AS PERVERSE
RegulatorsatOFHEOandtheTreasuryhuddledwithGSEexecutivestodiscusslow-
ering capital requirements if the GSEs would raise more capital. The entire mort-
gage market was at risk, Lockhart told the FCIC.
i
The pushing and tugging
continued.PaulsontoldtheFCICthatpersonalcommitmentsfromMuddandFred-
die Mac CEO Richard Syron to raise capital cinched the deal.
o
Just days earlier, on
March 1, Syron had announced in a quarterly call to investors that his company
wouldnotraisenewcapital.FannieandFreddieexecutivespreparedadraftpressre-
lease before a discussion with Lockhart and Steel. It announced a reduction in the
capitalsurchargefromotoio.Lockhartwasnotpleased;thedraftlackedacom-
:ii1i\8ii z++ 1ui 1\iiu\ii ui i\NNi i \\i \Ni iiiiii i \\t ,.,
mitmenttoraiseadditionalcapital,statinginsteadthattheGSEsplannedtoraiseit
overtimeasneeded.
1
ItlookedasiftheGSEsweremakingthedealwiththeirfn-
gerscrossed.InanemailtoSteelandtheCEOsofbothentities,Lockhartwrote:The
ideastrikesmeasperverse,andIassumeitwouldseemperversetothemarketsthat
aregulatorwouldagreetoallowaregulateetoincreaseitsveryhighmortgagecredit
riskleverage(nottomentionincreasinginterestraterisk)withoutanynewcapital.
TheinitialnegotiationshadtheGSEsraisingiofcapitalforeach1ofreductionin
thesurplus.Lockhartwroteinfrustration,Weseemtohavegonefromito1right
through1to1tonowoto1.
i
Despite Lockharts reservations, OFHEO announced the deal, unaltered in any
materialway,onMarch1.OFHEOagreedtoeasethecapitalrestraintfromoto
io; Fannie and Freddie pledged to begin the process to raise signifcant capital,
givingnoconcretecommitment.

PaulsontoldtheFCICthattheagreement,which
includedapromisetoraisecapital,wasano-brainer,andthathehadnomemoryof
Lockharteverhavingcalleditperverse.

ThemarketanalystJoshuaRosnerpannedthedeal.Weviewanyreduction[in
capital]asacommentnotonlyontheGSEsbutontheburgeoningpanicinWash-
ington, he wrote. If this action results in the destabilizing of the GSEs, OFHEO
will go from being the only regulator that prevented its charges from getting into
trouble, to a textbook example of why regulators should be shielded from outside
politicalpressure.
,
Fanniewouldkeepitspromisebyraising,.billioninpreferredstock.Freddie
reneged.ExecutiveVicePresidentDonaldBiseniusofferedtworeasonswhy,inhind-
sight, Fannie Mae did not raise additional capital. First was protecting the assets of
existingshareholders.Imsure[Fannies]investorsarenotveryhappy,Biseniustold
theFCIC.Parttwois . . .ifyouactuallyfundamentallybelieveyouhaveenoughcap-
ital to withstand even a fairly signifcant downturn in house prices, you wouldnt
raisecapital.
o
Similarly,CEOSyronspokeofthedownsideofraisingcapitalonAugusto,ioo8:
Raising a lot more capital at these kinds of prices could be quite dilutive to our
shareholders,sowehavetobalancetheinterestofourshareholders.
,
ButLockhart
sawitdifferently;inhisview,SyronspubliccommentsputagoodfaceonFreddies
inabilitytoraisecapital.HespeculatedthatSyronwasmaskingadifferentconcern:
lawsuits.[Syron]wasgettingadvicefromhisattorneysaboutthehighriskofraising
capital before releasing [quarterly earnings] . . . and our lawyers could not disagree
becauseweknowabouttheiraccountingissues,LockharttoldtheFCIC.
8
IT WILL INCREASE CONFIDENCE
InMay,thetwocompaniesannouncedfurtherlossesinthefrstquarter.Evenasthe
situationdeteriorated,onJuneOFHEOrewardedFannieMaeforraising,.bil-
lion in new capital by further lowering the capital surcharge, from io to 1,. In
June,Fanniesstockfelli8;Freddies,.Thepriceofprotectionon1omillionin
Fannies debt through credit default swaps jumped to oo,ooo in June, up from
,. ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
,,,ooinMay;betweeniooandiooo,ithadtypicallybeenabout1,ooo.InAu-
gust,theybothreportedmorelossesforthesecondquarter.
Even after both Fannie and Freddie became public companies owned by share-
holders,theyhadcontinuedtopossessanassetthatishardtoquantify:theimplicit
full faith and credit of the U.S. government. The government worried that it could
notletthe,.trillionGSEsfail,becausetheyweretheonlysourceofliquidityinthe
mortgagemarketandbecausetheirfailurewouldcauselossestoownersoftheirdebt
and their guaranteed mortgage securities. Uncle Sam had rescued GSEs before. It
bailedoutFanniewhendouble-digitinfationwreckeditsbalancesheetintheearly
18os, and it came through in the mid-18os for another GSE in duress, the Farm
CreditSystem.Inthemid-1os,evenaGSE-typeorganization,theFinancingCor-
poration,wasgivenahelpinghand.
As the market grappled with the fundamental question of whether Fannie and
Freddiewouldbebackedbythegovernment,theyieldontheGSEslong-termbonds
rose.ThedifferencebetweentheratethattheGSEspaidontheirdebtandrateson
Treasuriesapremiumthatrefectsinvestorsassessmentofriskwidenedinioo,
toone-halfapercentagepoint.Thatwaslowcomparedwiththesamefgureforother
publiclytradedcompanies,buthighfortheultra-safeGSEs.ByJuneioo8,thespread
hadriseno,overtheioo,level;bySeptember,,justbeforeregulatorsparachuted
in, the spread had nearly doubled from its ioo, level to just under 1, making it
more dimcult and costly for the GSEs to fund their operations. On the other hand,
thepricesofFannieMaemortgagebackedsecuritiesactuallyincreasedslightlyover
this time period, while the prices of private-label mortgagebacked securities dra-
matically declined. For example, the price of the FNCI, indexan index of Fannie
mortgagebacked securities with an average coupon of ,increased from 1oi in
Januaryioo,to1oonSeptember,,ioo8,twodayspriortotheconservatorship.As
another example, the price of the FNCI, indexFannie securities with an average
couponof,increasedfrom,tooduringthesametimeperiod.
InJulyandAugustioo8,Fanniesufferedaliquiditysqueeze,becauseitwasun-
abletoborrowagainstitsownsecuritiestoraisesumcientcashintherepomarket.
Itsstockpricedovetolessthan,ashare.FannieaskedtheFedforhelp.

Asenior
adviserintheFederalReserveBoardsDivisionofBankingSupervisionandRegula-
tiongavetheFCICableakaccountofthesituationatthetwoGSEsandnotedthat
liquiditywasjustbecomingsoessential,sotheFederalReserveagreedtohelppro-
videit.
o
On July 1, the Federal Reserve Board in Washington authorized the New York
FedtoextendemergencyloanstotheGSEsshouldsuchlendingprovenecessary . . .
to promote the availability of home mortgage credit during a period of stress in f-
nancialmarkets.
1
FannieandFreddiewouldnevertaptheFedforthatfunding.
i
Also on July 1, Treasury laid out a three-part legislative plan to strengthen the
GSEs by temporarily increasing their lines of credit with the Treasury, authorizing
TreasurytoinjectcapitalintotheGSEs,andreplacingOFHEOwiththenewFederal
Housing Finance Agency (FHFA), with the power to place the GSEs into receiver-
ship. Paulson told the Senate that regulators needed a bazooka at their disposal.
:ii1i\8ii z++ 1ui 1\iiu\ii ui i\NNi i \\i \Ni iiiiii i \\t ,.,
Youarenotlikelytotakeitout,Paulsontoldlegislators.Ijustsaythatbyhaving
something that is unspecifed, it will increase confdence. And by increasing conf-
denceitwillgreatlyreducethelikelihooditwilleverbeused.

FanniesMuddand
FreddiesSyronpraisedtheplan.

At the end of July, Congress passed the Housing and Economic Recovery Act
(HERA)ofioo8,givingPaulsonhisbazookatheabilitytoextendsecuredlinesof
credit to the GSEs, to purchase their mortgage securities, and to inject capital. The
io1-page bill also strengthened regulation of the GSEs by creating FHFA, an inde-
pendent federal agency, as their primary regulator, with expanded authority over
Fannies and Freddies portfolios, capital levels, and compensation. In addition, the
billraisedthefederaldebtceilingby8oobillionto1o.otrillion,providingfundsto
operatetheGSEsiftheywereplacedintoconservatorship.
After the Federal Reserve Board consented in mid-July to furnish emergency
loans,FedstaffandrepresentativesoftheOmceoftheComptrolleroftheCurrency
(OCC),alongwithMorganStanley,whichactedasanadvisertoTreasury,initiateda
review of the GSEs. Timothy Clark, who oversaw the weeklong review for the Fed,
toldtheFCICthatitwasthefrsttimetheyeverhadaccesstoinformationfromthe
GSEs. He said that previously, The GSEs [saw] the Fed as public enemy number
one. . . .Therewasabattlebetweenusandthem.Clarkadded,Wewoulddealwith
OFHEO,whichwasalsoveryguarded.Sowedidnothaveaccesstoinfountilthey
wantedfundingfromus.
,
AlthoughFedandOCCpersonnelwereattheGSEsand
conferringwithexecutives,MuddtoldtheFCICthathedidnotknowoftheagencies
involvementuntiltheirenterpriseswerebothinconservatorship.
o
TheFedandtheOCCdiscoveredthattheproblemswereworsethantheirsuspi-
cionsandreportsfromFHFAhadledthemtobelieve.AccordingtoClark,theFed
found that the GSEs were signifcantly underreserved, with huge potential losses,
andtheiroperationswereunsafeandunsound.
,
TheOCCrejectedtheforecasting
methodologiesonwhichFannieandFreddierelied.Usingitsownmetrics,itfound
insumcientreservesforfuturelossesandidentifedsignifcantproblemsincreditand
risk management. Kevin Bailey, the OCC deputy comptroller for regulatory policy,
told the FCIC that Fannies loan loss forecasting was problematic, and that its loan
lossesthereforewereunderstated.HeaddedthatFanniehadovervalueditsdeferred
taxassetsbecausewithoutfutureprofts,deferredtaxassetshadnovalue.
8
LossprojectionscalculatedbyMorganStanleysubstantiatedtheFedsandOCCs
fndings. Morgan Stanley concluded that Fannies loss projection methodology was
fawed, and resulted in the company substantially understating losses. Nearly all of
thelossprojectionscalculatedbyMorganStanleyshowedthatFanniewouldfallbe-
lowitsregulatorycapitalrequirement.Fanniesprojectionsdidnot.
All told, the litany of understatements and shortfalls led the OCCs Bailey to a
frmconclusion.IftheGSEswerenotinsolventatthetime,theywerealmostthere,
hetoldtheFCIC.

RegulatorsalsolearnedthatFanniewasnotchargingoffloansun-
til they were delinquent for two years, a head-in-the-sand approach. Banks are re-
quiredtochargeoffloansoncetheyare18odaysdelinquent.Fortheseandnumerous
othererrorsandfawedmethodologies,FannieandFreddieearnedrebukes.Given
,. ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
theroleoftheGSEsandtheirmarketdominance,theOCCreportsaid,theyshould
beindustryleaderswithrespecttoeffectiveandproactiveriskmanagement,produc-
tive analysis, and comprehensive reporting. Instead they appear to signifcantly lag
theindustryinallrespects.
,o
CRITICAL UNSAFE AND UNSOUND PRACTICES
PaulsontoldtheFCICthatalthoughhelearnedoftheFedandOCCfndingsbyAu-
gust1,,ittookhimthreeweekstoconvinceLockhartandFHFAthattherewasacap-
ital shortfall, that the GSEs were not viable, and that they should be placed under
governmentcontrol.
,1
OnAugustii,FHFAinformedbothMuddandSyronthattheir
frmswereadequatelycapitalizedundertheregulations,ajudgmentbasedonfnan-
cialinformationthatwascertifedandrepresentedastrueandcorrectby[GSE]man-
agement. But FHFA also emphasized that it was seriously concerned about the
currentlevelofFannieMaescapitalifthehousingmarketdeclinecontinued.
,i
Fanniesprospectsforincreasingcapitalgrewgloomier.FannieinformedTreasury
on August i,and repeatedly told FHFAthat raising capital was infeasible and
thatthecompanywasexpectingadditionallosses.EvenFanniesbase-caseearnings
forecastpointedtosubstantialpressureonsolvency,andastressedforecastindi-
catedthatcapitalresourceswillcontinuetodecline.
,
BySeptember,LockhartandFHFAagreedwithTreasurythattheGSEsneeded
to be placed into conservatorship. That day, Syron and Mudd received blistering
midyear reviews from FHFA. The opening paragraph of each letter informed the
CEOsthattheircompanieshadbeendowngradedtocriticalconcerns,andthatthe
criticalunsafeandunsoundpracticesandconditionsthatgaverisetotheEnterprises
existingcondition,thedeteriorationinoverallassetqualityandsignifcantearnings
losses experienced through June ioo8, as well as forecasted future losses, likely re-
quirerecapitalizationoftheEnterprise.
,
Abadsituationwasexpectedtoworsen.
The i1-page report sent to Fannie identifed sweeping concerns, including fail-
uresbytheboardandseniormanagement,asignifcantdropinthequalityofmort-
gages and securities owned or guaranteed by the GSE, insumcient reserves, the
almostexclusiverelianceonshort-termfunding,andtheinabilitytoraiseadditional
capital. FHFA admonished management and the board for their imprudent deci-
sionstopurchaseorguaranteehigherriskmortgageproducts.Theletterfaulted
Fannieforpurchasinghigh-riskloanstoincreasemarketshare,raiserevenueand
meethousinggoals,andforattemptingtoincreasemarketsharebycompetingwith
Wall Street frms that purchased lower-quality securities. FHFA, noting a confict
betweenprudentcreditriskmanagementandcorporatebusinessobjectives,found
thatthesepurchasesofhigher-riskloanswerepredicatedontherelaxingofunder-
writing and eligibility standards. Using models that underestimated this risk, the
GSE then charged fees even lower than what its own defcient models suggested
wereappropriate.FHFAdeterminedthattheselowerfeeswerechargedbecausefo-
cus was improperly placed on market share and competing with Wall Street and
[FreddieMac].
,,
:ii1i\8ii z++ 1ui 1\iiu\ii ui i\NNi i \\i \Ni iiiiii i \\t ,.,
Evenafterinternalreportspointedtomarketproblems,Fanniekeptbuyingand
guaranteeing riskier loan products, FHFA said. Despite signs in the latter half of
ioooandioo,ofemergingproblems,managementcontinuedactivityinriskypro-
grams,andmaintaineditshighereligibilityprogramforAlt-Aloanswithoutestab-
lishing limits.
,o
The company also bought private-label securities backed by Alt-A
andsubprimeloans.
,,
LosseswerelikelytobehigherthantheGSEshadestimated,
FHFAfound.
FHFAalsonotedincreasingquestionsandconcernsregardingFanniesaccount-
ing. The models it used to forecast losses had not been independently validated or
updatedforseveralyears.FHFAjudgedthatinanup-to-datemodel,estimatedlosses
would likely show a material increase. In addition, Fannie had overvalued its de-
ferredtaxassets.Applyingmorereasonableprojectionsoffutureperformance,FHFA
foundthisbenefttobesignifcantlyoverstated.
,8
Theii-pagereportdeliveredtoFreddieincludedsimilarlyharshassessmentsof
that GSEs safety and soundness, but more severe criticisms of its management and
board.Inparticular,thereportnotedasignifcantlackofmarketconfdence,which
hadeliminatedtheabilitytoraisecapital.FHFA,foritspart,lostconfdenceinthe
BoardofDirectorsandtheexecutivemanagementteam,holdingthemaccountable
forlossesstemmingfromaseriesofill-advisedandpoorlyexecuteddecisionsand
otherseriousmisjudgments.Accordingtotheregulator,theythereforecouldnotbe
reliedon,particularlyinlightoftheirwidespreadfailurestoresolveregulatoryissues
and address criticisms. In addition, FHFA said that Freddies failure to raise capital
despiteitsassurancesinvite[d]theconclusionthattheboardandCEOhadnotne-
gotiatedingoodfaithaboutthecapitalsurchargereduction.
,
As in its assessment of Fannie, FHFA found that Freddies unsafe and unsound
practices included the purchase and guarantee of higher-risk loan products in iooo
andioo,inadecliningmarket.Evenafterbeingtoldbytheregulatoriniooothatits
purchasesofsubprimeprivate-labelsecuritieshadoutpaceditsriskmanagementabil-
ities,Freddieboughtiibillionofsubprimesecuritiesineachsubsequentquarter.
FHFA also found that aggressive accounting cast doubt on Freddies reported
earningsandcapital.Despiteclearsignalsthatlossesonmortgageassetswerelikely,
Freddiewaitedtorecordwrite-downsuntiltheregulatorthreatenedtoissueacease
anddesistorder.Eventhen,onewrite-downwasreversedjustpriortotheissuance
of the second quarter fnancial statements. The regulator concluded that rising
delinquenciesandcreditlosseswouldresultinasubstantialdissipationofearnings
andcapital.
oo
THEY WENT FROM ZERO
TO THREE WITH NO WARNING IN BETWEEN
Mudd told the FCIC that its regulator had never before communicated the kind of
criticismsleveledintheSeptemberletter.Hesaidtheregulatorschroniclingofthe
situation then was inconsistent with what you would consider better regulatory
practicetobelike,frstwarning:fxit;secondwarning:fxit;thirdwarning:youre
,z+ ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
outofhere.Instead,theywentfromzerotothreewithnowarninginbetween.
o1
A
review of the examination reports and other documents provided by FHFA to the
FCIClargelysupportsMuddsviewonthisspecifcpoint.WhileOFHEOsexamina-
tionreportsnotedconcernsaboutincreasingcreditriskandslowremediationofde-
fciencies required by the May iooo consent agreement, they do not include the
sweepingcriticismscontainedintheSeptemberletter.
Twodaysaftertheirtwocompaniesweredesignatedcriticalconcerns,Muddat
Fannie and Syron at Freddie faced a government takeover. On September o, FHFA
Acting Deputy Director Chris Dickerson sent separate memos to Lockhart recom-
mendingthatFHFAbeappointedconservatorforeachGSE.
oi
Still, conservatorship was not a foregone conclusion. Paulson, Lockhart, and
Bernanke met with Mudd, Syron, and their boards to persuade them to cede con-
trol.
o
EssentiallytheGSEsfacedaHobsonschoice:takethehorseofferedornoneat
all.Theyhadtovoluntarilyagreetoaconsentagreement,LockharttoldtheFCIC.
Thealternative,ahostileaction,invitedtroubleandnastylawsuits,henoted.Sowe
madea . . .verystrongcasesotheboardofdirectorsdidnothaveachoice.
o
Paulson
remindedtheGSEsthathehadauthoritytoinjectcapital,buthewouldnotdosoun-
lesstheywereinconservatorship.
o,
Muddwasstunnedandangry,accordingtoPaulson.
oo
TomLund,whoranFan-
nie Maes single-family business, told the FCIC that conservatorship came as a sur-
prise to everyone.
o,
Levin told the FCIC that he never saw a government seizure
coming. He never imagined, he said, that Fannie Mae was or might become insol-
vent.
o8
Interviewedinio1o,MuddtoldtheFCIC:Ididnotthinkinanywayitwas
fairforthegovernmenttohavebeeninapositionofbeinginthechorusforthecom-
panytoaddcapital,andthentoinjectitselfinthecapitalstructure.
o
Theconserva-
torshipmemorandareiteratedallthedamningevidencepresentedintheletterstwo
daysearlier.LossesatFannieMaefortheyearwereestimatedtobebetween18bil-
lion and ,o billion.
,o
Freddie Macs memorandum differed only in the details. Its
losses,recordedat1billioninthefrstsixmonthsofioo8,wereprojectedtoendup
between11andibillionbytheendoftheyear.
,1
Althoughtheboardshadachoice,theonlyrealisticoptionwasassent.Wewerego-
ingtoagreetogoinaconservatorshipanyway,SyrontoldtheFCIC.Therewasavery
clearmessagethatthe[September]letterwasthereasamechanismtobringabouta
result.
,i
Muddagreed,observingthatthepurposeoftheletterwasreallytoforcecon-
servatorship.
,
Theboardsofbothcompaniesvotedtoacceptconservatorship.
Both CEOs were ousted, but the fundamental problems persisted. As promised,
theTreasurywaspreparedtotaketwodirectstepstosupportsolvency.First,itwould
buy up to ioo billion of senior preferred stock from the GSEs and extend them
short-termsecuredloans.Inaddition,itpledgedtobuyGSEmortgagebackedsecu-
rities from Wall Street frms and others until the end of ioo. Up front, Treasury
boughtfromeachGSE1billioninpreferredstockwitha1odividend.EachGSE
alsogaveTreasurywarrantstopurchasecommonstockrepresenting,.ofshares
outstanding. Existing common and preferred shareholders were effectively wiped
out.Thedeclineinvalueofthepreferredstockcausedlossesatmanybanksthatheld
:ii1i\8ii z++ 1ui 1\iiu\ii ui i\NNi i \\i \Ni iiiiii i \\t ,z.
thesesecurities,contributingtothefailureof1oinstitutionsandtothedowngrading
of,tolessthanwellcapitalizedbytheirregulators.
,
PaulsontoldtheFCICthathewasnaiveenoughtobelievethattheactionwould
halt the crisis because it would put a foor under the housing market decline, and
provideconfdencetothemarket.Herealizedhewaswrongonthenextday,when,
as he told the FCIC, Lehman started to go.
,,
Former Treasury Assistant Secretary
NeelKashkariagreed.WethoughtthatafterwestabilizedFannieandFreddiethat
weboughtourselvessometime.Maybeamonth,maybethreemonths.Buttheywere
such profound interventions, stabilizing such a huge part of the fnancial markets,
thatwouldbuyussometime.WeweresurprisedthatLehmanthenhappenedaweek
later,thatLehmanhadtobetakenoveroritwouldgointobankruptcy.
,o
Thefrmsfailurewasahugeeventand increasedthemagnitudeofthecrisis,ac-
cordingtoFedGovernorKevinWarshandNewYorkFedGeneralCounselTomBax-
ter.
,,
WarshalsotoldtheFCICthattheeventssurroundingtheGSEtakeoverledtoa
massive, underreported, underappreciated jolt to the system. Then, according to
Warsh,whenthemarketgraspedthatithadmisunderstoodtherisksassociatedwith
theGSEs,andthatthegovernmentcouldhaveconceivablyletthemfail,itcausedin-
vestorstopanicaboutthevalueofeveryasset,toreassesseveryportfolio.
,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 bankruptcy would have paled in comparison to a GSE failure. He said,
WhathappenedafterLehmanwouldhavebeenverysmallcomparedtothese,.,
trillion institutions failing.
,
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 study concluded that U.S. banks owned more
than1trillioninGSEdebtandsecuritiesmorethan1,oofthebanksTier1cap-
italand11oftheirtotalassetsatthetime.
8o
TestifyingbeforetheFCIC,Muddclaimedthatfailurewasallbutinevitable.In
ioo8,thecompanieshadnorefugefromthetwinshocksofahousingcrisisfollowed
byafnancialcrisis,hesaid.AmonolineGSEstructureaskedtoperformmultiple
taskscannotwithstandamultiyearohomepricedeclineonanationalscale,even
withouttheaccompanyingglobalfnancialturmoil.Themodelallowedabalanceof
businessandmissionwhenhomepriceswererising.Whenpricescrashedfarbeyond
therealmofhistoricalexperience,itbecameThePitandthePendulum,achoicebe-
tweenhorriblealternatives.
81
THE WORSTRUN FINANCIAL INSTITUTION
WheninterviewedbytheFCIC,FHFAomcialswereverycriticalofFanniesmanage-
ment.JohnKerr,theFHFAexaminer(andanOCCveteran)inchargeofFannieex-
aminations, minced no words. He labeled Fannie the worst-run fnancial
institutionhehadseeninhisoyearsasabankregulator.ScottSmith,whobecame
,zz ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
associatedirectoratFHFAafterthatagencyreplacedOFHEO,concurred;inhisview,
Fanniesforecastingcapabilitieswerenotparticularlywellthoughtout,andlackeda
variety of stress scenarios. Both omcials noted Fannies weak forecasting models,
whichincludedhundredsofmarketsimulationsbutscarcelyanythatcontemplated
declines in house prices. To Austin Kelly, an OFHEO examination specialist, there
was no relying on Fannies numbers, because their processes were a bowl of
spaghetti. Kerr and a colleague said that that they were struck that Fannie Mae, a
multitrillion-dollarcompany,employedunsophisticatedtechnology:itwaslesstech-
savvythantheaveragecommunitybank.
8i
Nonetheless, OFHEOs communications with Fannie prior to September did
notfullyrefectthesecriticisms.FHFAomcialsconcededthattheyhadmademis-
takesintheiroversightofFannieandFreddie.Theypaidtoomuchattentiontofx-
ing operational problems and did not react to Fannies increasing credit risk.
LockharttoldtheFCICthatmoreresourcesshouldhavebeendedicatedtoassessing
creditriskoftheirmortgageassetsandguarantees.
8
CurrentFHFAActingDirector
EdwardDeMarcotoldtheFCICthatitwouldnotpassthereasonablepersontest
to deny that OFHEO took its eye off the ball by not paying sumcient attention to
creditriskandinsteadfocusedonoperationalrisk,accountingandlackofaudited
results.
8
To Mudd and others, OFHEOs mistakes were not surprising. Mudd told the
FCIC that the regulators skill levels were developing but below average.
8,
Henry
Cisneros, a former housing and urban development secretary, expressed a similar
view. OFHEO, Cisneros told the FCIC, was puny compared to what Fannie Mae
andFreddieMaccouldmusterintheirintelligence,theirIvyLeagueeducations,their
rocketscientistsintheirplace,theirlobbyists,theirabilitytoworktheHill.
8o
Thecostsofthebailoutshavebeenenormousandareexpectedtoincrease.From
January1,ioo8,throughthethirdquarterofio1o,thetwocompanieslostiibil-
lion,wipingout,1billionofcombinedcapitalthattheyhadreportedattheendof
ioo,andthe,billionofcapitalraisedbyFannieinioo8.Treasurynarrowedthe
gapwith1,1billioninsupport.FHFAhasestimatedthatcoststhroughio1will
rangefromii1billiontoobillion.TheCongressionalBudgetOmcehaspro-
jected that the economic cost of the GSEs downfall, including the total fnancial
costofgovernmentsupportaswellasactualdollaroutlays,couldreach8billion
byio1.
WASN T DONE AT MY PAY GRADE
FanniestwomostseniorexecutiveswereaskedatanFCIChearinghowtheircharter
couldhavebeenchangedtomakethecompanymoresound,andtoavoidthemulti-
billion-dollar bailout. Mudd, who made approximately o, million from iooo to
ioo8, testifed that the thing that would have made the institution more sound or
haveproducedadifferentoutcomewouldhavebeenforittohavebecomeovertime
amorenormalfnancialinstitutionabletodiversify,abletoallocatecapital,abletobe
COMMISSION CONCLUSIONS ON CHAPTER 17
TheCommissionconcludesthatthebusinessmodelofFannieMaeandFreddie
Mac(theGSEs),asprivate-sector,publiclytraded,proft-makingcompanieswith
implicitgovernmentbackingandapublicmission,wasfundamentallyfawed.We
fndthattheriskypracticesofFannieMaetheCommissionscasestudyinthis
areaparticularlyfromioo,on,ledtoitsfall:practicesundertakentomeetWall
Streets expectations for growth, to regain market share, and to ensure generous
compensation for its employees. Affordable housing goals imposed by the De-
partmentofHousingandUrbanDevelopment(HUD)didcontributemarginally
to these practices. The GSEs justifed their activities, in part, on the broad and
sustainedpublicpolicysupportforhomeownership.Riskylendingandsecuriti-
zationresultedinsignifcantlossesatFannieMae,which,combinedwithitsex-
cessiveleveragepermittedbylaw,ledtothecompanysfailure.
Corporategovernance,includingriskmanagement,failedattheGSEsinpart
becauseofskewedcompensationmethodologies.TheOmceofFederalHousing
Enterprise Oversight (OFHEO) lacked the authority and capacity to adequately
regulatetheGSEs.TheGSEsexercisedconsiderablepoliticalpowerandweresuc-
cessfullyabletoresistlegislationandregulatoryactionsthatwouldhavestrength-
enedoversightofthemandrestrictedtheirrisk-takingactivities.
Inearlyioo8,thedecisionbythefederalgovernmentandtheGSEstoincrease
theGSEsmortgageactivitiesandrisktosupportthecollapsingmortgagemarket
wasmadedespitetheunsoundfnancialconditionoftheinstitutions.Whilethese
actionsprovidedsupporttothemortgagemarket,theyledtoincreasedlossesat
theGSEs,whichwereultimatelybornebytaxpayers,and refectedtheconficted
natureoftheGSEsdualmandate.
GSE mortgage securities essentially maintained their value throughout the
crisisanddidnotcontributetothesignifcantfnancialfrmlossesthatwerecen-
traltothefnancialcrisis.
longorshortinthemarket,abletooperateinternationally.Andifthetradeforthat
wouldhavebeen,youknow,acutintheso-calledimplicittieswiththegovernment,I
thinkthatwouldhavethatwouldhavebeenabettersolution.
8,
ChiefBusinessOf-
fcer Levin, who received approximately , million from iooo to ioo8, answered
onlythatmakingsuchdecisionswasntdoneatmypaygrade.
88
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,z,
18
SEPTEMBER 2008:
THE BANKRUPTCY OF LEHMAN
CONTENTS
Gctncrcccnscrvativc|yjundcd ,:,
1hisisnctscundinggccdata||,:,
Spcckthcnarkct ,::
Inaginaticnhat ,,+
Hcadscjjani|y ,,,
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1hccn|ya|tcrnativcwasthatIchnanhadtcjai|,,:
Aca|anity ,,,
Solvency should be a simple fnancial concept: if your assets are worth more than
yourliabilities,youaresolvent;ifnot,youareindangerofbankruptcy.Butontheaf-
ternoonofFriday,September1i,ioo8,expertsfromthecountrysbiggestcommer-
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,,-
year-oldfrmwassolvent.
Onlytwodaysearlier,Lehmanhadreportedshareholderequitythemeasureof
solvencyof 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
withmorereportedequitythanithadayearearlier.
Butthisarithmeticreassuredhardlyanyoneoutsidetheinvestmentbank.Fedom-
cials had been discussing Lehmans solvency for months, and the stakes were very
high.Toresolvethequestion,theFedwouldnotrelyonLehmansi8billionfgure,
givenquestionsaboutwhetherLehmanwasreportingassetsatmarketvalue.Asone
NewYorkFedomcialwrotetocolleaguesinJuly,Balance-sheetcapitalisnttoorele-
vantifyouresufferingamassiverun.
1
Ifthereisarun,andafrmcanonlygetfre-
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,bil-
lioninrealestateassets(excludingrealestateheldforsale)onLehmansbookswas
anaccuratefgure.Iftheassetswereworthonlyhalfthatamount(alikelyscenario,
given market conditions), then Lehmans i8 billion in equity would be gone. In a
fresale,somemightsellforevenlessthanhalftheirstatedvalue.
What does solvent mean: JP Morgan CEO Jamie Dimon responded when the
FCIC asked if Lehman had been solvent. The answer is, I dont know. I still could
notanswerthatquestion.
i
JPMorgansChiefRiskOmcerBarryZubrowtestifedbe-
foretheFCICthatfromapureaccountingstandpoint,itwassolvent,althoughit
obviouslywasfnancingitsassetsonaveryleveragedbasiswithalotofshort-termf-
nancing.

TestifyingbeforetheFCIC,formerLehmanBrothersCEORichardFuldinsisted
hisfrmhadbeensolvent:TherewasnocapitalholeatLehmanBrothers.Attheend
ofLehmansthirdquarter,wehadi8.billionofequitycapital.

FedChairmanBen
Bernanke disagreed: I believe it had a capital hole. He emphasized that New York
Federal Reserve Bank President Timothy Geithner, Treasury Secretary Henry Paul-
son,andSECChairmanChristopherCoxagreeditwasjustwaytoobigahole.And
my own view is its very likely that the company 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 by oo to ,o bil-
liona message he had delivered to Paulson a few days before Lehman declared
bankruptcy.
o
Ithadbeenquiteaweek;itwouldbequiteaweekend.Thedebatewillcontinue
over the largest bankruptcy in American history, 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
money, the frm would fail, and not only would we be unsuccessful but we would
havesaddledthetaxpayerwithtensofbillionsofdollarsoflosses.
,
GET MORE CONSERVATIVELY FUNDED
After the demise of Bear Stearns in March ioo8, most observersincluding
Bernanke, Paulson, Geithner, and Cox
8
viewed Lehman Brothers as the next big
worryamongthefourremaininglargeinvestmentbanks.Geithnersaidhewascon-
sumed with fnding a way that Lehman might get more conservatively funded.

FedViceChairmanDonaldKohntoldBernankethatinthewakeofBearscollapse,
some institutional investors believed it was a matter not of whether Lehman would
fail,butwhen.
1o
Onesetofnumbersinparticularreinforcedtheirdoubts:onMarch
18, the day after JP Morgan announced its acquisition of Bear Stearns, the market
,z ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
(throughcreditdefaultswapsonLehmansdebt)putthecostofinsuring1omillion
of Lehmans fve-year senior debt at 1o,ooo annually; for Merrill Lynch, the cost
wasi1,ooo;andforGoldmanSachs,1o,,ooo.
ThechiefconcernswereLehmansrealestaterelatedinvestmentsanditsreliance
onshort-termfundingsources,including,.8billionofcommercialpaperand1,
billionofreposattheendofthefrstquarterofioo8.Therewerealsoconcernsabout
thefrmsmorethanoo,oooderivativecontractswithamyriadofcounterparties.
11
Astheydidforallinvestmentsbanks,theFedandSECasked:DidLehmanhave
enoughcapitalreal capital,afterpossibleassetwrite-downs:Anddidithavesum-
cient liquiditycashto withstand the kind of run that had taken down Bear
Stearns: Solvency and liquidity were essential and related. If money market funds,
hedge funds, and investment banks believed Lehmans assets were worth less than
Lehmansvaluations,theywouldwithdrawfunds,demandmorecollateral,andcur-
taillending.ThatcouldforceLehmantosellitsassetsatfre-saleprices,wipingout
capitalandliquidityvirtuallyovernight.Bearproveditcouldhappen.
TheSECtraditionallytooktheviewthatliquiditywasparamountinlargesecuri-
tiesfrms,buttheFed,asaconsequenceofitsbankingmandate,hadmoreofanem-
phasis on capital raising, Erik Sirri, head of the SECs Division of Trading and
Markets,toldtheFCIC.BecausetheFedhadbecomethedefactoprimaryregulator
becauseofitsbalancesheet,itsviewprevailed.TheSECwantedtobecollaborative,
andsocametoaccepttheFedsfocusoncapital.However,astimeprogressed,both
sawtheimportanceofliquiditywithrespecttotheproblemsatthelargeinvestment
banks.
1i
In fact, both problems had to be resolved. Bears demise had precipitated
Lehmans frst real fnancing dimculties since the liquidity crisis began in ioo,,
Lehman Treasurer Paolo Tonucci told the FCIC.
1
Over the two weeks following
Bears collapse, Lehman borrowed from the Feds new lending facility, the Primary
Dealer Credit Facility (PDCF),
1
but had to be careful to avoid seeming overreliant
onthePDCFforcash,whichwouldsignalfundingproblems.
Lehmanbuiltupitsliquidityto,billionattheendofMay,butitandMerrill
performed the worst among the four investment banks in the regulators liquidity
stresstestsinthespringandsummerofioo8.
Meanwhile,thecompanywasalsoworkingtoimproveitscapitalposition.First,it
reducedrealestateexposures(again,excludingrealestateheldforsale)fromobil-
lionto,1billionattheendofMayandto,billionattheendofthesummer.Sec-
ond,itraisednewcapitalandlonger-termdebtatotalof1,.,billionofpreferred
stockandseniorandsubordinateddebtfromAprilthroughJuneioo8.
Treasury Undersecretary Robert Steel praised Lehmans efforts, publicly stating
that it was addressing the issues.
1,
But other dimculties loomed. Fuld would later
describeLehmansmainproblemasoneofmarketconfdence,andhesuggestedthat
thecompanysimagewasdamagedbyinvestorstakingnakedshortpositions(short
sellingLehmanssecuritieswithoutfrstborrowingthem),hopingLehmanwouldfail,
and potentially even helping it fail by eroding confdence. Bear went down on ru-
mors and a liquidity crisis of confdence, Fuld told the FCIC. Immediately there-
:ii1i\8ii z++ 1ui 8\NiiUi1t ui iiu\\N ,z,
after,therumorsandthenakedshortsellerscameafterus.
1o
Thecompanypressed
the SEC to clamp down on the naked short selling.
1,
The SECs Division of Risk,
Strategy and Financial Innovation shared with the FCIC a study it did concerning
shortselling.AsChairmanMarySchapiroexplainedtotheCommission,Wedonot
haveinformationatthistimethatmanipulativeshortsellingwasthecauseofthecol-
lapseofBearandLehmanorofthedimcultiesfacedbyotherinvestmentbanksdur-
ingthefallofioo8.TheSECtodatehasnotbroughtshortsellingchargesrelatedto
thefailureoftheseinvestmentbanks.
18
On March 18, Lehman reported better-than-expected earnings of 8 million
forthefrstquarterofioo8.Itsstockjumpednearly,o,too..Butinvestorsand
analysts quickly raised questions, especially concerning the reported value of
Lehmansrealestateassets.Portfolio.comcalledLehmanswrite-downssuspiciously
minuscule.
1
In a speech in May, David Einhorn of Greenlight Capital, which was
thenshortingLehmansstock,notedthebankslargeportfolioofcommercialreales-
tate loans and said, There is good reason to question Lehmans fair value calcula-
tions. . . . I suspect that greater transparency on these valuations would not inspire
marketconfdence.
io
Nell Minow, editor and co-founder of the Corporate Library, which researches
and rates frms on corporate governance, raised other reasons that observers might
havebeenskepticalofmanagementatLehman.OnLehmanBrothers[board], . . .
theyhadanactress,atheatricalproducer,andanadmiral,andnotonepersonwho
understood fnancial derivatives.
i1
The Corporate Library gave Lehman a D rating
inJuneioo,agradeitdowngradedtoFinSeptemberioo8.
ii
OnJune,Lehman
announcedapreliminaryi.8billionlossforitssecondquarterthefrstlosssinceit
became a public company in 1. The share price fell to o. Three days later
Lehman announced it was replacing Chief Operating Omcer Joseph Gregory and
ChiefFinancialOmcerErinCallan.Thestockslumpedagain,toii.,o.
THIS IS NOT SOUNDING GOOD AT ALL
After Lehman reported its fnal second-quarter results on June 1i, the New York
Feds on-site monitor at Lehman, Kirsten Harlow, reported that there had been no
adverseinformationonliquidity,novations,terminationsorabilitytofundeitherse-
cured or unsecured [funds].
i
The announced liquidity numbers were better that
quarter,aswerethecapitalnumbers.
Nevertheless,Lehmanslendersandsupervisorswereworried.Thenextmorning,
William Dudley, then head of the New York Feds Markets Group (and its current
president),emailedBernanke,Geithner,Kohn,andothersthatthePDCFshouldbe
extended because it remains critical to the stability of some of the investment
banksparticularlyLehman.IthinkwithoutthePDCF,Lehmanmighthaveexperi-
encedafullblownliquiditycrisis,hewrote.
i
Just one week after the earnings release, Harlow reported that Lehman was in-
deed having funding dimculties. Four fnancial institutions had trading issues
with Lehman and had reduced their exposure to the frm, including Natixis, a
,z ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
French investment bank that had already eliminated all activity with Lehman. JP
Morgan reported that large pension funds and some smaller Asian central banks
were reducing their exposures to Lehman, as well as to Merrill Lynch. And Citi-
group requested a to , billion comfort deposit to cover its exposure to
Lehman, settling later for i billion.
i,
In an internal memo, Thomas Fontana, the
head of risk management in Citigroups global fnancial institutions group, wrote
thatlossofconfdence[inLehman]ishugeatthemoment.
io
TimothyClark,sen-
ioradviserintheFederalReservesbankingsupervisionandregulationdivision,was
shortanddirect:Thisisnotsoundinggoodatall.
i,
On June i,, results from the regulators most recent stress test showed that
Lehmanwouldneed1,billionmorethanthe,billioninitsliquiditypooltosur-
vivealossofallunsecuredborrowingsandvaryingamountsofsecuredborrowings.
i8
Lehmans borrowings in the overnight commercial paper market were increasing,
however,frombillionattheendofNovemberioo,to8billionattheendofMay
ioo8. And it was reliant on repo funding, particularly the portions that matured
overnight and were collateralized by illiquid assets.
i
As of mid-June, oi of
Lehmans liquidity was dependent on borrowing against nontraditional securities,
such as illiquid mortgage-related securitieswhich could not be fnanced with the
PDCFandofwhichinvestorswerebecomingincreasinglywary.
o
OnJuly1o,FederatedInvestorsalargemoneymarketfundandoneofLehmans
largesttri-partyrepolendersnotifedJPMorgan,Lehmansclearingbank,thatFed-
eratedwouldnolongerpursueadditionalbusinesswithLehman,becauseJPMor-
gan was unwilling to negotiate in good faith and had become increasingly
uncooperative on repo terms.
1
Dreyfus, another large money market fund and a
Lehmantri-partyrepolender,alsopulleditsrepolinefromthefrm.
i
SPOOK THE MARKET
AstheFedconsideredtherisksofthetri-partyrepomarket,italsomulledovermore
specifc measures to help Lehman. The New York Fed and FDIC both rejected the
companysproposaltoconverttoabankholdingcompany,aproposalwhichGeith-
nertoldFuldwasgimmickyand[couldnot]solvealiquidity/capitalproblem.

A
proposal by the Feds Dudley followed the Bear Stearns model: oo billion of
Lehmansassetswouldbeheldbyanewspecial-purposevehicle,fnancedby,bil-
lionofLehmansequityanda,,billionloanfromtheFed.Thisproposalwouldre-
move the illiquid assets from the market and potentially avert a fre sale that could
renderLehmaninsolvent.

Itdidntgoanywhere.
ButwhenthatideawasfoatedinJuly,theneedforsuchactionwasstillsomewhat
speculative.NotsobyAugust. InanAugust8emailtocolleaguesattheFederalRe-
serve and Treasury, Patrick Parkinson, then the deputy director of the Federal Re-
serveBoardsDivisionofResearchandStatistics,describedagameplanthatwould
(1)identifyactivitiesofLehmanthatcouldsignifcantlyharmfnancialmarketsand
theeconomyifitfledforchapter11bankruptcyprotection,(i)gatherinformation
:ii1i\8ii z++ 1ui 8\NiiUi1t ui iiu\\N ,z,
tomoreaccuratelyassessthepotentialeffectsofitsfailure,and()identifyriskmiti-
gationactionsforareasofseriouspotentialharm.
,
As they now realized, regulators did not know nearly enough about over-the-
counterderivativesactivitiesatLehmanandotherinvestmentbanks,whichwerema-
jor OTC derivatives dealers. Investment banks disclosed the total number of OTC
derivative contracts they had, the total exposures of the contracts, and their esti-
matedmarketvalue,buttheydidnotpubliclyreportthetermsofthecontractsorthe
counterparties.Thus,therewasnowaytoknowwhowouldbeowedhowmuchand
whenpaymentswouldhavetobemadeinformationthatwouldbecriticallyimpor-
tanttoanalyzethepossibleimpactofaLehmanbankruptcyonderivativescounter-
partiesandthefnancialmarkets.
Parkinsonreviewedastandingrecommendationtoformadefaultmanagement
groupofseniorexecutivesofmajormarketparticipantstoworkwithregulatorsto
anticipate issues if a major counterparty should default. The recommendation was
from the private-sector Counterparty Risk Management Policy Group, the same
groupthathadalertedtheFedtothebacklogproblemintheOTCderivativesmarket
earlier in the decade. Parkinson suggested accelerating the formation of this group
while being careful not to signal concerns about any one market participant.
o
On
August 1,, Parkinson emailed New York Fed omcials that he was worried that no
sensible game plan could be formulated without more information.
,
He was in-
formedthatNewYorkFedomcialshadjustmetwithLehmantwodaysearliertoob-
tainderivative-relatedinformation,thattheystillneededmoreinformation,andthat
the meeting had caused a stir, which in turn required assurances that requests for
informationwouldnotbelimitedtoLehman.
8
NewYorkFedomcialswerealsoveryreluctanttorequestcopiesofthemaster
agreements that would shed light on the Lehmans derivatives counterparties, be-
causesucharequestwouldsendahugenegativesignal.

Theformationofthein-
dustrygroupseemedlessprovocative,wroteaNewYorkFedomcial,butcouldstill
spookthemarket.
o
Parkinsonbelievedthattheinformationwasimportant,butat-
temptingtocollectitwasnotwithoutrisks.
1
Healsorecognizedthedimcultiesin
unraveling the complex dependencies among the many Lehman subsidiaries and
their counterparties, which would keep lawyers and accountants busy for a long
time.
i
OnAugusti8,TreasurysSteveShafraninformedParkinsonthatSecretaryPaul-
sonagreedontheneedtocollectinformationonOTCderivatives.

Itjusthadtobe
doneinawaythatminimizeddisruptions.OnSeptember,,Parkinsoncirculateda
draft letter requesting the information from Lehman CEO Fuld.

Geithner would
ask E. Gerald Corrigan, the Goldman Sachs executive and former New York Fed
presidentwhohadco-chairedtheCounterpartyRiskManagementPolicyGroupre-
port,toformanindustrygrouptoadviseoninformationneededfromatroubledin-
vestmentbank.Parkinson,Shafran,andotherswouldalsocreateaplaybookforan
investment bank failure at Secretary Paulsons request. Events over the following
weekwouldrendertheseeffortsmoot.
,,+ ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
On September , executives from Lehman Brothers apprised executives at JP
Morgan, Lehmans tri-party repo clearing bank, of the third-quarter results that it
would announce two weeks later. A . billion loss would refect signifcant asset
write-downs.Thefrmwasalsoconsideringseveralstepstobolstercapital,includ-
inganinvestmentbyKoreaDevelopmentBankorothers,thesaleofLehmansinvest-
ment management division (Neuberger Berman), the sale of real estate assets, and
thedivisionofthecompanyintoagoodbankandbadbankwithprivateequity
sponsors.
,
TheexecutivesalsodiscussedJPMorgansconcernsaboutLehmansrepo
collateral.
OnMonday,September8,morethanioNewYorkFedomcialswerenotifedofa
meetingthenextmorningtocontinuethediscussionofnear-termoptionsfordeal-
ing with a failing nonbank. They received a list documenting Lehmans tri-party
repoexposureatroughlyioobillion.Beforeitscollapse,BearStearnssexposurehad
beenonly,oto8obillion.Thedocumentationfurthernotedthat1ocounterpar-
tiesprovided8oofLehmansrepofnancing,andthatintradayliquidityprovidedby
Lehmans clearing banks could become a problem. Indeed, JP Morgan, Citigroup,
and Bank of America had all demanded more collateral from Lehman, with the
threattheymightcutoffLehmaniftheydontreceiveit.
o
OnTuesdaymorning,September,newstherewouldbenoinvestmentfromKo-
reaDevelopmentBankshookthemarket.Lehmansstockplunged,,fromtheday
before,closingat,.,.ToprepareforanafternooncallwithBernanke,Geithnerdi-
rectedhisstafftoputtogetheraquickwhatsdifferent:whatsthesame:listabout
[Lehman] vs [Bear Stearns], as well as about mid-March (then) vs. early Sept
(now).
,
The Feds Parkinson emailed Treasurys Shafran about his concerns that
Lehman would announce further losses the next week, that it might not be able to
raiseequity,andthateventhoughitsliquiditypositionwasbetterthanBearStearnss
hadbeen,Lehmanremainedvulnerabletoalossofconfdence.
8
At,:ooP.M.,PaulsonconvenedacallwithCox,Geithner,Bernanke,andTreasury
staff to deal with a possible Lehman bankruptcy.

At ,:io P.M., Treasury Chief of

StaffJimWilkinsonemailedMichelleDavis,theassistantsecretaryforpublicaffairsat
Treasury,toexpresshisdistasteforgovernmentassistance:Weneedtotalk. . . .Ijust
cantstomachusbailingoutlehman. . . .Willbehorribleinthepressdontuthink.
,o
That same day, Fuld agreed to post an additional .o billion of collateral to JP
Morgan.LehmansbankruptcyestatewouldlaterclaimthatLehmandidsobecause
ofJPMorgansimproperthreattowithholdrepofunding.ZubrowsaidJPMorganre-
questedthecollateralbecauseofitsgrowingexposureasaderivativestradingcoun-
terparty to Lehman.
,1
Steven Black, JP Morgans president, said he requested ,
billionfromLehman,whichagreedtopost.obillion.
,i
Hedidnotbelievethere-
questputunduepressureonLehman.OnTuesdaynight,executivesofLehmanand
JPMorganmetagainatLehmansrequesttodiscussoptionsforraisingcapital.The
JPMorgangroupwasnotimpressed.[Lehman]senttheJuniorVarsity,JPMorgan
executives reported to Black. They have no proposal and are looking to us for
ideas/credit line to bridge them to the frst quarter when they intend to split into
goodbank/badbank.Blackresponded,Letsgivethemanorderforthesamedrugs
:ii1i\8ii z++ 1ui 8\NiiUi1t ui iiu\\N ,,.
they have apparently been taking to think we would do something like that.
,
The
Lehmanbankruptcyestatehasadifferentview.ItallegesBlackagreedtosendadue
diligence team, following Dimons suggestion that his frm might be willing to pur-
chase Lehman preferred stock, but instead sent over senior risk managers to probe
Lehmansconfdentialrecordsandplans.
,
The bankruptcy estate alleges that later that night, JP Morgan demanded that
Lehman execute amended agreements to its tri-party repo services before prean-
nouncingitsthird-quarterearningsat,:othenextmorning.Theamendmentsre-
quired Lehman to provide additional guarantees, increased Lehmans potential
liability,andgaveJPMorganadditionalcontroloverLehmanbankaccounts.
,,
Again,
theLehmanbankruptcyestatearguesthatLehmanexecutedtheagreementsbecause
JPMorganexecutivesledLehmantobelieveitsbankwouldrefusetoextendintraday
creditifLehmandidnotdoso.JPMorgandeniesthis.BlacktoldtheFCIC,JPMC
nevertoldLehmanthatitwouldstopextendingcreditandclearingiftheSeptember
Agreementswerenotexecutedbeforethemarketsopenedon[Wednesday,]Septem-
ber1o,ioo8.
,o
Before the market opened on Wednesday, Lehman announced its . billion
third-quarter loss, including a ,.o billion write-down. Four hours later, Matthew
Rutherford,anadvisertoTreasury,emailedcolleaguesthatseverallargemoneyfunds
hadreducedtheirexposuretoLehman,althoughtherewasnotyetawholesalepull
backof[repo]lines.
,,
Importantly, Fidelity, the largest fund complex, stressed that while they hadnt
made any signifcant shifts yet today, they were still in the process of making deci-
sionsandwantedtoupdatemelaterintheday,Rutherfordwrote.ByFriday,Fidelity
wouldhavereduceditstri-partyrepolendingtoLehmantolessthanibillionfrom
over1ibillionthepreviousFriday;accordingtoFidelitysresponsetoanFCICsur-
veyofmarketparticipants,intheweekpriortoBearsdemiseinMarch,Fidelityhad
pulleditsentire.obillionrepolinetothatcompany.
IMAGINATION HAT
AttheFederalReserve,workinggroupsweredirectedtospendthenextfewhours
feshingouthowaFed-assistedBofAacquisitiontransactionmightlook,howapri-
vateconsortiumofpreferredequityinvestorstransactionmightlook,andhowaFed
takeoutoftri-partyrepolenderswouldlook.
,8
Thatday,NewYorkFedSeniorVice
President Patricia Mosser circulated her opinion on Dudleys request for thoughts
onhowtoresolveLehman.Shelaidoutthreeoptions:(1)fndabuyeratanyprice,
(i)winddownLehmansaffairs,or()forceitintobankruptcy.Regardingoption1,
Mossersaiditshouldbedoneinawaythatrequiresminimaltemporarysupport. . . .
NomoreMaidenLaneLLCsandnoequitypositionby[the]Fed.Moralhazardand
reputationcostistoohigh.IftheFedagreestoanotherequityinvestment,itsignals
thateverything[theFed]didinMarchintermsoftemporaryliquiditybackstopsis
useless.Horribleprecedent;inthelongrunMUCHworsethanoption.Option,
bankruptcy,wouldbe[a]messoneverylevel,butfxesthemoralhazardproblem.
,
,,z ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
OnWednesdaynight,aNewYorkFedomcialcirculatedaLiquidationConsor-
tium game plan to colleagues.
oo
The plan was to convene in one room senior-level
representativesofLehmanscounterpartiesinthetri-partyrepo,creditdefaultswap,
and over-the-counter derivatives marketseveryone who would suffer most if
Lehmanfailedandhavethemexplorejointfundingmechanismstoavertafailure.
Accordingtotheproposedgameplan,SecretaryPaulsonwouldtelltheparticipants
theyhaduntiltheopeningofbusinessinAsiathefollowingMondaymorning(Sun-
daynight,NewYorktime)todeviseacredibleplan.Thegameplanstatedthatwe
shouldhaveinmindamaximumnumberofhowmuchwearewillingtofnancebe-
forethemeetingstarts,butnotdivulgeourwillingnesstodosototheconsortium.
o1
Indeed,Paulsonwouldtelltheconsortiumwhenitmettwodayslaterthatthegov-
ernmentwaswillingtoletLehmanfail.
oi
FormerBankofAmericaCEOKenLewistoldtheFCICthatTreasurySecretary
PaulsonhadcalledhimonWednesday,September1o,andaskedhimtotakeanother
look at acquiring Lehman, assuring him that Fuld was ready to deal. Paulson and
GeithnerhadarrangedforFuldandLewistodiscussanacquisitioninJuly,butFuld
hadnotbeeninterestedinsellingtheentirefrmatthattime.Becauseofthishistory,
LewisexpressedhisconcernstoPaulsonthatFuldwouldnotwanttoselltheentire
company or would not be willing to sell at a realistic price. Still, a team of Bank of
America executives began reviewing Lehmans books, and on the next day, Fuld
soundedoptimisticaboutadeal.ButBankofAmericadeterminedthatLehmansas-
setswereovervalued,andLewistoldPaulsontherewouldbenodealwithoutgovern-
ment assistance. Undeterred, Paulson told Lewisas Lewis informed the FCICto
put on his imagination hat and fgure out a deal. His insistence kept the Bank of
America executives working, but on Friday, September 1i, Lewis called Paulson to
repeathisassessmentnogovernmentsupport,nodeal.ApparentlyFuldhadbeen
kept out of the loop, and began to call Lewis at home. Lewiss wife told Fuld that
Lewiswouldnotcometothephoneandtostopcalling.
o
On Thursday September 11, an email time-stamped 8:io A.M. from Susan Mc-
Cabe,aGoldmanSachsexecutive,toDudleyandotherssetthetonefortheday:Itis
notpretty,Thisisgettingprettyscaryanduglyagain. . . .They[Lehman]havemuch
bigger counter-party risk than Bear did, especially in Derivatives market, so [t]he
marketisgettingveryspooked,nervous.AlsohaveAig,Wamuconcerns.Thisisjust
spinningoutofcontrolagain.Justfyi,thisisshapingupasgoingtobearoughday.
o
Bernanke was informed that if Lehman failed, it would be a much more complex
proposition to unwind their positions than it would have been to unwind the posi-
tions held by Bear Stearns, because Lehman was nearly twice the size of Bear
Stearns.
o,
Somebelievedgovernmentactionwasrequired.At1o:oA.M.,HayleyBoesky,a
senior New York Fed omcial, forwarded to her colleagues an email from the hedge
fundmanagerLouisBaconsuggestingtheNewYorkFedcouldattempttostabilize
orsupporttheLEHsituationbutnotingthatnoneoftheabovewillfxthefunda-
mentalproblem,whichistoomanybadassetsthatneedtogetofftoomanybalance
sheets.
oo
:ii1i\8ii z++ 1ui 8\NiiUi1t ui iiu\\N ,,,
At1:oP.M.,FedomcialscirculatedtheoutlineofaplantocreateaLehmanDe-
fault Management Group, a group of Lehman counterparties and creditors who
wouldmakeplanstocopewithaLehmanbankruptcy.Theywouldagreetoholdoff
on fully exercising their rights to close out their trades with Lehman; instead, they
wouldestablishaprocesstonetdownthatis,reduceallexposuresusingacom-
monvaluationmethod.
o,
AlittlebeforemidnightonThursday,Boeskynotifedcol-
leagues that panicked hedge funds had called to say they were expecting [a] full
blownrecessionandthattherewasafullexpectationthatLehgoes,wamuandthen
ML [Merrill Lynch]. They were ALL begging, pleading for a large scale solution
whichspansbeyondjustLEH.Boeskycomparedthelevelofpanictothefailureof
BearStearnsOnascaleof1to1o,where1oisBear-Stearns-week-panic,Iwould
putsentimenttodayata1i.
o8
Atalmostthesametime,JPMorgandemandedthatLehmanpostanother,bil-
lionincashbytheopeningofbusinesstomorrowinNewYork;ifitdidnt,JPMor-
ganwouldexerciseourrighttodeclinetoextendcredittoyou.
o
JPMorganCEO
Dimon, President Black, and CRO Zubrow had frst made the demand in a phone
callearlierthateveningtoLehmanCEOFuld,CFOIanLowitt,andTreasurerPaolo
Tonucci.
,o
TonuccitoldtheJPMorganexecutivesonthecallthatLehmancouldnot
meet the demand. Dimon said Lehmans dimculties in coming up with the money
were not JP Morgans problem, Tonucci told the FCIC. They just wanted the cash.
We made the point that its too much cash to mobilize. There was no give on that.
Again, they said thats not our problem, we just want the cash.
,1
When Tonucci
asked what would keep JP Morgan from asking for 1o billion tomorrow, Dimon
replied,Nothing,maybewewill.
,i
Under normal circumstances, Tonucci would not have tolerated this treatment,
butcircumstanceswerefarfromnormal.JPMasclearingbankcontinuestoaskfor
morecashcollateral.Ifwedontprovidethecash,theyrefusetoclear,wefail,wasthe
message circulated in an email to Lehman executives on Friday, September 1i. So
Lehman delivered the , billion in cash only by pulling virtually every unencum-
beredassetitcoulddeliver.
,
JP Morgans Zubrow saw it differently. He told the FCIC that the previously
posted.obillionofcollateralbyLehmanwasinappropriatebecauseitwasilliq-
uidandcouldnotbereasonablyvalued.Moreover,Zubrowsaidthepotentialcol-
lateral shortfall was greater than , billion.
,
Lehmans former CEO, Fuld, told the
FCIC that he agreed to post the , billion because JP Morgan said it would be re-
turned to Lehman at the close of business the following day.
,,
The Lehman bank-
ruptcyestatemadethesameallegation.Thisdisputeisnowthesubjectoflitigation;
theLehmanbankruptcyestateissuingJPMorgantoretrievethe,billionandthe
original.obillion.
,o
HEADS OF FAMILY
ShouldLehmanbeallowedtogobankrupt:Withinthegovernment,sentimentsvar-
ied.OnFridaymorning,asSecretaryPaulsonheadedtoNewYorktosortthrough
,,, ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
this Lehman mess, Wilkinson wrote that he still [couldnt] imagine a scenario
whereweputin[government]money . . .weshallsee.
,,
Thatafternoon,FedGover-
norWarshwrote,inresponsetoacolleagueshopetheFedwouldnothavetoprotect
someofLehmansdebtholders,Ihopewedon[]tprotectanything!
,8
ButonFriday,
FedChairmanBernankewastakingnochances.HestayedbehindinWashington,in
casehehadtoconvenetheFedsboardtoexerciseitsemergencylendingpowers.
,
Early Friday evening, Treasury Secretary Paulson summoned the heads of fam-
ilythephraseusedbyHarveyMiller,Lehmansbankruptcycounsel,todescribethe
CEOsofthebigWallStreetfrms
8o
totheNewYorkFedsheadquarters.Paulsontold
them that a private-sector solution was the only option to prevent a Lehman bank-
ruptcy. The people in the room needed to come up with a realistic set of options to
helplimitdamagetothesystem.Asuddenanddisorderlywind-downcouldharmthe
capitalmarketsandposethesignifcantriskofaprecipitousdropinassetprices,re-
sultingincollateralcallsandreducedliquidity:thatis,systemicrisk.Hecouldnotof-
fertheprospectofcontainingthedamageiftheexecutiveswereunabletofashionan
orderlyresolutionofthesituation,ashadbeendonein18forLong-TermCapital
Management.PaulsondidoffertheFedshelpthroughregulatoryapprovalsandaccess
tolendingfacilities,butemphasizedthattheFedwouldnotprovideanyformofex-
traordinarycreditsupport.
81
AsNewYorkFedGeneralCounselTomBaxtertoldthe
FCIC,Paulsonmadeitcleartherewouldbenogovernmentassistance,notapenny.
8i
H.RodginCohen,aveteranWallStreetlawyerwhohasrepresentedmostofthe
majorbanks,includingLehman,toldtheFCICthatthegovernmentsnotapenny
posture was a calculated strategy: I dont know exactly what the government was
thinking, but my impression was they were playing a game of chicken or poker or
whatever.Itwassaidonmorethanoneoccasionthatitwouldbeverypoliticallydim-
culttorescueLehman.TherehadbeenalotofblowbackafterBearStearns.Ibelieve
thegovernmentthoughtthatitcould,withrespecttoagameofchicken,persuadethe
privatesectortotakeabigchunkofLehmansliabilities.
8
TheFedsinternalliquidationconsortiumgameplanwouldseemtoconfrmCo-
hensview,giventhatitcontemplatedafnancialcommitment,eventhoughthatwas
not to be divulged.
8
Moreover, notwithstanding Paulsons not a penny statement,
theUnitedKingdomschancelloroftheexchequer,AlistairDarling,saidthatPaulson
toldhimthattheFRBNYmightbepreparedtoprovideBarclayswithregulatoryas-
sistancetosupportatransactionifitwasrequired.
8,
AtthatconsortiummeetingonFridaynight,CitigroupCEOVikramPanditasked
ifthegroupwasalsogoingtotalkaboutAIG.TimothyGeithnersaidsimply:Lets
focusonLehman.
8o
TELL THOSE SONS OF BITCHES TO UNWIND
WhatwouldhappenifJPMorganrefusedtoprovideintradaycreditforLehmanin
thetri-partyrepomarketonMonday,September1,:TheFedhadbeenconsidering
thispossibilitysincethesummer.AsParkinsonnoted,thefundamentalproblemwas
that even if Lehman fled for bankruptcy, the SEC would want Lehmans broker-
:ii1i\8ii z++ 1ui 8\NiiUi1t ui iiu\\N ,,,
dealertoliveonandwouldnotwanttheFedinitspositionaslendertograbtri-party
collateral.
8,
ParkinsontoldtheFCICstaffthatZubrowinformedhimovertheweek-
endthatJPMorganwouldnotunwindLehmansreposonMondayiftheFeddidnot
expandthetypesofcollateralthatcouldbefnancedthroughthePDCFlendingfacil-
ity.Earlierintheyear,ParkinsonhadsaidthatJPMorgansrefusaltounwindwould
beunforgiveable.NowhetoldGeithnertotellthosesonsofbitches . . .tounwind.
88
MerrillCEOJohnThaintoldtheFCICthatbySaturdaymorning,thegroupofex-
ecutivesreviewingLehmansassetshadestimatedthattheywereovervaluedbyany-
where from 1, to i, billion. Thain thought that was more than the assembled
executiveswouldbewillingtofnanceand,therefore,ThainbelievedLehmanwould
fail.
8
IfLehmanfailed,Thainbelieved,Merrillwouldbenext.SohehadcalledKen
Lewis,theCEOofBankofAmerica,andtheymetlaterthatdayatBankofAmericas
New York corporate apartment. By Sunday, the two agreed that Bank of America
wouldacquireMerrillforipershare,payableinBankofAmericastock.
OnSaturdayafternoon,LehmanscounselprovidedtheFedwithadocumentde-
scribinghowLehmansdefaultonitsobligationswouldtriggeracascadeofdefaults
throughtothe[subsidiaries]whichhavelargeOTC[derivatives]books.
o
Bernanke,
Fed Governor Kohn, Geithner, and other senior Fed omcials subsequently partici-
patedinaconferencecalltodiscussthepossibilityofgoingtoCongresstoaskfor
other authorities, something Geithner planned to pitch.
1
However, Fed General
Counsel Scott Alvarez cautioned others not to mention the plan to JP Morgan, be-
cause he did not want to suggest Fed willingness to give JPMC cover to screw
[Lehman]oranyoneelse.
i
BySaturdaynight,however,itappearedthattheparadeofhorrorsthatwouldre-
sult from a Lehman bankruptcy had been avoided. An agreement apparently had
beenreached.BarclayswouldpurchaseLehman,excludingoto,obillionofas-
setsfnancedbytheprivateconsortium(eventhoughthebankersintheconsortium
hadestimatedthoseassetstobesignifcantlyovervalued).MichaelKlein,anadviser
to Barclays, had told Lehman President Bart McDade that Barclays was willing to
purchase Lehman, given the private consortium agreement to assist the deal.

It
seemedadealwouldbecompleted.

THIS DOESN T SEEM LIKE IT IS GOING TO END PRETTY

ButonSunday,thingswentterriblywrong.At8:ooA.M.,BarclaysCEOJohnVarley
and President Robert Diamond told Paulson, Geithner, and Cox that the Financial
ServicesAuthority(FSA)haddeclinedtoapprovethedeal.
,
Theissueboileddown
to a guaranteethe New York Fed required Barclays to guarantee Lehmans obliga-
tions from the sale until the transaction closed, much as JP Morgan had done for
Bear Stearns in March.
o
Under U.K. law, the guarantee required a Barclays share-
holdervote,whichcouldtakeotooodays.Thoughitcouldwaivethatrequirement,
the FSA asserted that such a waiver would be unprecedented, that it had not heard
about this guarantee until Saturday night, and that Barclays did not really want to
takeonthatobligationanyway.
,, ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
GeithnerpleadedwithFSAChairmanCallumMcCarthytowaivetheshareholder
vote, but McCarthy wanted the New York Fed to provide the guarantee instead of
Barclays.
,
Otherwise,accordingtotheFSA,Barclayswouldhavehadtoprovidea
(possiblyunlimited)guarantee,foranundefnedperiodoftime,coveringpriorand
futureexposuresandliabilitiesofLehmanthatwouldcontinuetoapplyincludingin
respect of all transactions entered into prior to the purchase, even in the event the
transactionultimatelyfailed.
8
ForPaulson,suchaguaranteebytheFedwasunequivocallyoutofthequestion.

TheguaranteecouldhaveputtheFedonthehookfortensofbillionsofdollars.Ifthe
runonLehmanhadcontinueddespitetheguarantee,Barclaysshareholderscouldre-
jecttheacquisition,andtheFedwouldbeinpossessionofaninsolventbank.
BaxtertoldtheFCICthatBarclayshadknownallalongthattheguaranteewasre-
quired, because JP Morgan had to provide the same type of guarantee when it ac-
quired Bear Stearns. Indeed, Baxter said he was stunned at this development. He
believed that the real reason Barclays said it could not guarantee Lehmans obliga-
tionswastheU.K.governmentsdiscomfortwiththetransaction.
1oo
OnSundaymorning,TreasurysWilkinsonemailedJPMorganInvestmentBank
CEOJesStaleythathewasinameetingwithPaulsonandGeithnerandthatthings
didnotlookgood.Heconcluded,Thisdoesntseemlikeitisgoingtoendpretty.
1o1
Inanothernotealittlemorethananhourlater,headdedthattherewouldbenogov-
ernmentassistance:Noway[government]moneyiscomingin. . . .Imherewriting
the usg coms [United States government communications] plan for orderly un-
wind . . .alsojustdidacallwiththeWH[WhiteHouse]andusgisunitedbehindno
money. No way 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-
claysdealgetsuntangled.
1oi
It did not. Paulson made a last-ditch pitch to his U.K. counterpart, Darling,
withoutsuccess.
1o
Twoyearslater,Darlingadmittedthathehadvetoedthetrans-
action:YeahIdid.ImagineifIhadsaidyestoaBritishbankbuyingaverylarge
American bank which . . . collapsed the following week. He would have found
himself telling a British audience, Everybody sitting in this room and your chil-
drenandyourgrandchildrenandtheirgrandchildrenwouldbepayingforyearsto
come.ThatBankofAmericahadtakenitselfoutofthepicturemayhaveplayeda
role in Darlings decision: My first reaction was If this is such a good deal how
comenoAmericanbankisgoingtogonearit:SoDarlingconcludedthatforBar-
claystoaccepttheguarantee,whichcouldhaveagraveimpactontheBritishecon-
omy, was simply out of the question: I spoke to Hank Paulson and said Look,
theresnowaywecouldallowaBritishbanktotakeovertheliabilityofanAmeri-
canbank,whichineffectmeanttheBritishtaxpayerwasunderwritinganAmeri-
canbank.
1o
Following that decision in London, Lehman Brothers was, for all practical pur-
poses, dead. Cohen, Lehmans counsel at the time, told the FCIC, When Secretary
PaulsoncameoutofthemeetingwithGeithnerandCox,theycalledLehmanspresi-
: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
digestwhatobviouslywasstarknews.Uponarriving,theyheardthattheNewYork
Fed would provide more fexible terms for the PDCF lending facility, which would
include expanding the types 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 Dudley, the SECs Sirri, and others to discuss the expanded PDCF pro-
gram. According to McDade and Kirk, the government omcialsled by Baxter
madeitplaintheywouldnotpermitLehmantoborrowagainsttheexpandedtypes
of collateral, as other frms could. The sentiment was clear but the reasons were
vague,McDadetoldtheFCIC.HesaidtherefusaltoallowLehmantoprovidetheex-
pandedtypesofcollateralmadethedifferenceinLehmansbeingabletoobtainthe
fundingneededtoopenforbusinessonMonday.
1o,
BaxterexplainedtotheFCIC,however,thatLehmansbroker-dealeramliatenot
the holding companycould borrow against the expanded types of collateral.
1o8
A
New York Fed email written at i:1, P.M. on that Sunday, September 1, stated that
LehmanscounselwasinformedoftheexpansionofPDCF-eligiblecollateralbutthat
suchcollateralwouldnotbeavailabletothebroker-dealerifitfledforbankruptcy.
1o
The minutes of Lehmans September 1 board meeting show that the Fed rejected
Lehmans request for an even broader range of collateral to be eligible for PDCF f-
nancingandpreferredthatLehmansholdingcompanybutnotthebroker-dealer
fle for bankruptcy and that the broker-dealer be wound down in an orderly
fashion.
11o
InaletterdatedSeptember1,theNewYorkFedinformedLehmanSen-
iorVicePresidentRobertGuglielmothatthebroker-dealercouldfnanceexpanded
typesofcollateralwiththePDCF,butthatletterwasnotsentuntili:iA.M.onSep-
tember 1,after Lehman had fled for bankruptcy.
111
The Lehman broker-dealer
borrowediotoi8billionfromthePDCFeachdayoverthenextthreedays.
11i
AsKirkrecountedtotheFCIC,duringthatSundaymeetingattheNewYorkFed,
government omcials stepped out for an hour and came back to ask: Are you plan-
ningonflingbankruptcytonight:
11
AsurprisedMillerrepliedthatnooneinthe
roomwasauthorizedtoflethecompany,onlytheBoardcould . . .andtheBoardhad
tobecalledtoameetingandhaveavote. . . .Therewouldbesomelagintermsof
havingtoputallthepaperstogethertoactuallyfleit.Therewasapracticalissuethat
youcouldnt . . .getitdonequickly.
11
Unmoved,governmentomcialsexplainedthat
directorsofLehmansU.K.subsidiaryLBIEwouldbepersonallyliableiftheydid
notfleforbankruptcybytheopeningofbusinessMonday.AsKirkrecalled,They
thentolduswewouldlikeyoutofletonight. . . .Itstherightthingtodo,because
theres something else which we cant tell you that will happen this evening. We
would like both events to happen tonight before the opening of trading Monday
morning.
11,
The second event would turn out to be the announcement of Bank of
AmericasacquisitionofMerrillLynch.
,, ii N\Nti \i tii :i : i NQUi 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 bankruptcy
would be Armageddon.
11o
Lehman had prepared a presentation arguing that a
Lehmanbankruptcywouldbecatastrophic.Itwouldtakeatleastfveyearstoresolve,
cost8to1obillion,andcausemajordisruptionsintheUnitedStatesandabroad.
11,
Baxter told the FCIC, I knew that the consequences were going to be bad; that
wasntanissue.Lehmanwasindenialatthatpointintime.Therewasnowaytheybe-
lievedthatthisstoryendswithaLehmanbankruptcy . . .theykeptthinkingthatthey
weregoingtobebailedoutbythetaxpayeroftheUnitedStates.AndImnottryingto
convinceyouthatthatbeliefwasacrazybeliefbecausetheyhadseenthathappenin
theBearcase.Baxtersmission,however,wastotrytogetthemtounderstandthat
they werent going to be rescued, and then focus on what their real options were,
whichweredriftintoMondaymorningwithnothingdoneandthenhavechaosbreak
out,oralternativelyfle.Heconcluded,Frommypointofview,frstthingwastocon-
vinceHarveythatitwasfarbettertoflethantogointoMondayandhavecomplete
pandemonium break out. And then he had to have discussions with the Lehman
Boardbecausetheyhadafduciarydutytoresolvewhatwasinthebestinterestsofthe
companyanditsshareholdersandotherstakeholders.
118
TheonlyalternativewasthatLehmanhadtofail,MillertestifedtotheFCIC.
11
He stated that Baxter provided no further details on the governments plan for the
falloutfrombankruptcy,butassuredhimthatthesituationwasundercontrol.Then,
Miller told the FCIC, Baxter told the Lehman delegation to leave the Fed omces.
Theybasicallythrewusout,Millersaid.Millerrememberedtellinghiscolleagues
astheyleftthebuilding,Idontthinktheylikeus.
Millercontinued:
Wewentbacktotheheadquarters,anditwaspandemoniumupthere
itwaslikeascenefrom[the1oflm]Its a Wonderful Life withtherun
on the savings and loan crisis. . . . [A]ll of paparazzi running around.
Therewasaguythere . . .inasortofaNorsegoduniformwithahelmet
andapicketsignsayingDownwithWallStreet. . . .Therewerehun-
dredsofemployeesgoinginandout. . . .BartMcDadewasreportingto
the board what had happened. Most of the board members were
stunned. Henry Kaufman, in particular, was asking How could this
happeninAmerica:
1io
The group informed the board that the Barclays deal had fallen apart. The gov-
ernmenthadinstructedtheboardtofleforbankruptcy.SECsCoxcalled.WithTom
Baxteralsoontheline,Coxtoldtheboardthatthesituationwasseriousandrequired
action.TheboardaskedCoxifhewasdirectingthemtofleforbankruptcy.Coxand
Baxter conferred for a few minutes, and then answered that the decision was the
boardstomake.TheboardagainaskedifCoxandBaxterweretellingthemtoflefor
bankruptcy.CoxandBaxterconferredagain,thenrepliedthattheybelievedthegov-
:ii1i\8ii z++ 1ui 8\NiiUi1t ui iiu\\N ,,,
ernmentspositionhadbeenmadeperfectlyclearatthemeetingattheFedearlierin
theday.
1i1
Followingthatcall,McDadeadvisedtheboardthatLehmanwouldbeunableto
obtain funding without government assistance. The board voted to fle for bank-
ruptcy.Thecompanyfledat1:,A.M.onMondaymorning.
1ii
A CALAMITY
Fed Chairman Bernanke told the FCIC that government omcials understood a
Lehmanbankruptcywouldbecatastrophic:
Weneverhadanydoubtaboutthat.Itwasgoingtohavehugeimpacts
onfundingmarkets.Itwouldcreateahugelossofconfdenceinother
fnancialfrms.ItwouldcreatepressureonMerrillandMorganStanley,
if not Goldman, which it eventually did. It would probably bring the
short-termmoneymarketsintocrisis,whichwedidntfullyanticipate;
but,ofcourse,intheenditdidbringthecommercialpapermarketand
themoneymarketmutualfundsunderpressure.Sotherewasneverany
doubt in our minds that it would be a calamity, catastrophe, and that,
youknow,weshoulddoeverythingwecouldtosaveit.
1i
Whats the connection between Lehman Brothers and General Motors: he
askedrhetorically.LehmanBrothersfailuremeantthatcommercialpaperthatthey
used to fnance went bad. Bernanke noted that money market funds, in particular
onenamedtheReservePrimaryFund,heldLehmanspaperandsufferedlosses.He
explainedthatthismeanttherewasaruninthemoneymarketmutualfunds,which
meant the commercial paper market spiked, which [created] problems for General
Motors.
1i
As the fnancial industry came under stress, Paulson told the FCIC, investors
pulledbackfromthemarket,andwhenLehmancollapsed,evenmajorindustrialcor-
porationsfounditdimculttoselltheirpaper.Theresultingliquiditycrunchshowed
that frms had overly relied on this short term funding and had failed to anticipate
howrestrictedthecommercialpapermarketcouldbecomeintimesofstress.
1i,
HarveyMillertestifedtotheFCICthatthebankruptcyofLehmanwasacatalyst
forsystemicconsequencesthroughouttheworld.Itfosteredanegativereactionthat
endangeredtheviabilityofthefnancialsystem.Asaresultoffailedexpectationsof
the fnancial markets and others, a major loss of confdence in the fnancial system
occurred.
1io
OnthedaythatLehmanfledforbankruptcy,theDowplummetedmorethan,oo
points;,oobillioninvaluefromretirementplans,governmentpensionfunds,and
otherinvestmentportfoliosdisappeared.
1i,
AsforLehmanitself,thebankruptcyaffectedabout8,ooosubsidiariesandamliates
withooobillioninassetsandliabilities,thefrmsmorethan1oo,ooocreditors,and
about io,ooo employees. Its failure triggered default clauses in derivatives contracts,
,,+ ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
allowingitscounterpartiestohavetheoptionofseizingitscollateralandterminating
thecontracts.Aftertheparentcompanyfled,about8oinsolvencyproceedingsofits
subsidiaries in 18 foreign countries followed. In the main bankruptcy proceeding,
about oo,ooo claimsexceeding 8, billionhave been fled against Lehman as of
September io1o. Miller told the FCIC that Lehmans bankruptcy represents the
largest, most complex, multi-faceted and far-reaching bankruptcy case ever fled in
theUnitedStates.Thecostsofthebankruptcyadministrationareapproaching1bil-
lion;asofthiswriting,theproceedingisexpectedtolastatleastanothertwoyears.
1i8
InhistestimonybeforetheFCIC,Bernankeadmittedthattheconsiderationsbe-
hindthegovernmentsdecisiontoallowLehmantofailwerebothlegalandpractical.
Fromalegalstandpoint,Bernankeexplained,Wearenotallowedtolendwithouta
reasonableexpectationofrepayment.Theloanhastobesecuredtothesatisfactionof
theReserveBank.Remember,thiswasbeforeTARP.Wehadnoabilitytoinjectcapi-
talortomakeguarantees.
1i
ASundayafternoonemailfromBernanketoFedGov-
ernor Warsh indicated that more than 1i billion in capital assistance would have
beenneededtopreventLehmansfailure.IncaseIamasked:Howmuchcapitalin-
jectionwouldhavebeenneededtokeepLEHaliveasagoingconcern:Igather1iB
orsofromtheprivateguystogetherwithFedliquiditysupportwasnotenough.
1o
InMarch,theFedhadprovidedaloantofacilitateJPMorganspurchaseofBear
Stearns, invoking its authority under section 1() of the Federal Reserve Act. But,
even with this authority, practical considerations were in play. Bernanke explained
thatLehmanhadinsumcientcollateralandtheFed,haditacted,wouldhavelentinto
arun:OnSundaynightofthatweekend,whatwastoldtomewasthatandIhave
every reason to believewas that there was a run proceeding on Lehman, that is
peoplewereessentiallydemandingliquidityfromLehman;thatLehmandidnothave
enoughcollateraltoallowtheFedtolenditenoughtomeetthatrun.Thus,Ifwe
lentthemoneytoLehman,allthatwouldhappenwouldbethattherun[onLehman]
wouldsucceed,becauseitwouldntbeabletomeetthedemands,thefrmwouldfail,
andnotonlywouldwebeunsuccessfulbutwewould[have]saddledthe[t]axpayer
withtensofbillionsofdollarsoflosses.
11
TheFedhadnochoicebuttostandbyas
Lehmanwentunder,Bernankeinsisted.
AsBernankeacknowledgedtotheFCIC,however,hisexplanationfornotprovid-
ing assistance to Lehman was not the explanation he offered days after the bank-
ruptcyat that time, he said that he believed the market was prepared for the
event.
1i
OnSeptemberi,ioo8,hetestifed:ThefailureofLehmanposedrisks.But
thetroublesatLehmanhadbeenwellknownforsometime,andinvestorsclearlyrec-
ognizedas evidenced, for example, by the high cost of insuring Lehmans debt in
themarketforcreditdefaultswapsthatthefailureofthefrmwasasignifcantpos-
sibility.Thus,wejudgedthatinvestorsandcounterpartieshadhadtimetotakepre-
cautionary measures.
1
In addition, though the Federal Reserve subsequently
assertedthatitdidnothavethelegalabilitytosaveLehmanbecausethefrmdidnot
have sumcient collateral to secure a loan from the Fed under section 1(), the au-
thoritytolendunderthatprovisionisverybroad.Itrequiresnotthatloansbefully
secured but rather that they be secured to the satisfaction of the Federal Reserve
:ii1i\8ii z++ 1ui 8\NiiUi1t ui iiu\\N ,,.
bank.
1
Indeed,inMarchioo,FederalReserveGeneralCounselScottAlvarezcon-
cluded that requiring loans under 1() to be fully secured would undermine the
verypurposeofsection1(),whichwastomakecreditavailableinunusualandex-
igentcircumstancestohelprestoreeconomicactivity.
1,
ToCEOFuldandothers,theFedsemergencylendingpowersundersection1()
providedapermissiblevehicletoobtaingovernmentsupport.AlthoughFedomcials
discussedanddismissedmanyideasinthechaoticdaysleadinguptothebankruptcy,
the Fed did not furnish to the FCIC any written analysis to illustrate that Lehman
lacked sumcient collateral to secure a loan under 1(). Fuld asserted to the FCIC
thatinfact,Lehmanhadadequatefnanceablecollateral. . . .[O]nSeptember1i,the
Friday night preceding Lehmans bankruptcy fling, Lehman fnanced itself and did
notneedaccesstotheFedsdiscountwindow. . . .WhatLehmanneededonthatSun-
day night was a liquidity bridge. We had the capital. Along with its excess available
collateral, Lehman also could have used whole businesses as collateralsuch as its
Neuberger Berman subsidiaryas did AIG some two days later. Fuld also rejected
assertionsaboutLehmanscapitalhole.HetoldtheFCIC,AsofAugust1,ioo8,two
weekspriortothebankruptcyfling,Lehmanhad . . .io.,billioninequitycapital.
Positiveequityofio.,billionisverydifferentfromthenegativeooroobillion
holesclaimedbysome.Moreover,FuldmaintainedthatLehmanwouldhavebeen
savedifithadbeengrantedbankholdingcompanystatusaswereGoldmanSachs
andMorganStanleytheweekafterLehmansbankruptcy.
1o
TheFedchairmandeniedanybiasagainstLehmanBrothers.Inhisview,theonly
realresolutionshortofbankruptcyhadbeentofndabuyer.Bernankesaid:When
thepotentialbuyerswereunabletocarrythroughinthecaseofBankofAmerica,
becausetheychangedtheirmindsanddecidedtheywantedtobuyMerrillinstead;in
the case of Barclays, [because they withdrew] . . . we essentially 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 only strengthen the perception that some
frms were too big to fail and erode market discipline. They noted that letting
Lehmanfailwastheonlywaytoprovidecredibilitytotheassertionthatnofrmwas
toobigtofailandonememberstatedthatthemarketwasbeginningtoplaythe
Treasury and Federal Reserve. Other meeting participants believed that the disor-
derlyfailureofakeyfrmcouldhaveabroadanddisruptiveeffectonfnancialmar-
kets and the economy, but that the appropriate solution was capital injections, a
power the Federal Reserve did not have. Bernankes view was that only a fscal and
perhaps regulatory response could address the potential for wide-scale failure of f-
nancialinstitutions.
18
MerrillsThainmadeitthroughtheLehmanweekendbynegotiatingalifesaving
acquisitionbyBankofAmerica,formerlyLehmanspotentialsuitor.Thainblamed
thefailuretobailoutLehmanonpoliticiansandregulatorswhofearedthepolitical
consequencesofrescuingthefirm.Therewasatremendousamountofcriticismof
what was done with Bear Stearns so that JP Morgan would buy them, Thain told
,,z ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
theFCIC.TherewasacriticismofbailingoutWallStreet.Itwasacombinationof
politicalunwillingnesstobailoutWallStreetandabeliefthatthereneededtobea
reinforcementofmoralhazard.Therewasneveradiscussionaboutthelegalability
oftheFedtodothis.Henoted,Therewasneverdiscussiontothebestofmyrec-
ollectionthattheycouldnt[bailoutLehman].Itwasonlythattheywouldnt.
1
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:AsIthinkaboutwhatIwoulddodifferentlyafterthat
weekend . . .istrytograbthemandshakethemthattheycantletthishappen. . . .
Theywerenotverymuchinthemoodtolisten.Theywerenotwillingtolistentothe
ideathattherehadtobegovernmentsupport. . . .Thegroupofusshouldhavejust
grabbedthemandshakenthemandsaid,Look,youguyscouldnotdothis.Butwe
didnt,andtheywerenotwillingtoentertainthatdiscussion.
1o
FCIC staff asked Thain if he and the other executives explicitly said to Paulson,
Geithner,oranyoneelse,Youcantletthishappen.Thainreplied,Wedidntdoit
strongly enough. We said to them, Look, this is going to be bad. But it wasnt like,
No . . .youhave tohelp.
11
Anotherprominentmemberofthatselectgroup,JPMorgansDimon,hadadif-
ferentview.HetoldtheFCIC,Ididntthinkitwassobad.Ihatetosaythat. . . .ButI
[thought]itwasalmostthesameifonMondaymorningthegovernmenthadsaved
Lehman. . . .Youstillwouldhaveterriblethingshappen. . . .AIGwasgoingtohave
theirproblemsthathadnothingtodowithLehman.Youwerestillgoingtohavethe
runs on the other banks and you were going to have absolute fear and panic in the
globalmarkets.WhetherLehmanitselfgotsavedornot . . .thecrisiswouldhaveun-
foldedalongadifferentpath,butitprobablywouldhaveunfolded.
1i
FedGeneralCounselAlvarezandNewYorkFedGeneralCounselBaxtertoldthe
FCICthattherewouldhavebeenquestionseitherway.AsBaxterputit,Ithinkthat
if the Federal Reserve had lent to Lehman that Monday in a way that some people
thinkwithout adequate collateral and without other security to ensure repay-
mentthishearingandotherhearingswouldhaveonlybeenabouthowwewasted
thetaxpayersmoney.
1
COMMISSION CONCLUSIONS ON CHAPTER 18
The Commission concludes the fnancial crisis reached cataclysmic proportions
withthecollapseofLehmanBrothers.
Lehmanscollapsedemonstratedweaknessesthatalsocontributedtothefailures
or near failures of the other four large investment banks: inadequate regulatory
oversight, risky 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 initially more vulnerable, commercial
bankssufferedfrommanyofthesameweaknesses,includingtheirinvolvementin
theshadowbankingsystem,andultimatelymanysufferedmajorlosses,requiring
governmentrescue.
Lehman,likeotherlargeOTCderivativesdealers,experiencedrunsonitsde-
rivatives operations that played a role in its failure. Its massive derivatives posi-
tions greatly complicated its bankruptcy, and the impact of its bankruptcy
throughinterconnectionswithderivativescounterpartiesandotherfnancialin-
stitutionscontributedsignifcantlytotheseverityanddepthofthefnancialcrisis.
Lehmans failure resulted in part from signifcant problems in its corporate
governance,includingriskmanagement,exacerbatedbycompensationtoitsex-
ecutivesandtradersthatwasbasedpredominantlyonshort-termprofts.
Federal government omcials decided not to rescue Lehman for a variety of
reasons,includingthelackofaprivatefrmwillingandabletoacquireit,uncer-
taintyaboutLehmanspotentiallosses,concernsaboutmoralhazardandpolitical
reaction,anderroneousassumptionsthatLehmansfailurewouldhaveamanage-
ableimpactonthefnancial systembecausemarketparticipantshadanticipated
it.Afterthefact,theyjustifedtheirdecisionbystatingthattheFederalReserve
didnothavelegalauthoritytorescueLehman.
TheinconsistencyoffederalgovernmentdecisionsinnotrescuingLehmanaf-
terhavingrescuedBearStearnsandtheGSEs,andimmediatelybeforerescuing
AIG,addedtouncertaintyandpanicinthefnancialmarkets.
:ii1i\8ii z++ 1ui 8\NiiUi1t ui iiu\\N ,,,
,,,
19
SEPTEMBER 2008:
THE BAILOUT OF AIG
CONTENTS
Currcnt|iquiditypcsiticnisprccaricus ,,,
Spi||cvcrcjjcct ,,,
Iikcagnatcnanc|cphant ,,o
Ninebilliondollarsisalotofmoney,butasAIGexecutivesandtheboardexamined
theirbalancesheetandponderedthemarketsinthesecondweekofSeptemberioo8,
theywerealmostcertainbillionincashcouldnotkeepthecompanyalivethrough
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 by regulated insurance sub-
sidiaries whose regulators did not allow the cash to fow freely up to the holding
company, much less out to troubled subsidiaries such as AIG Financial Products.
i
The companys liabilities, especially those due in the near future, were much larger
thanthebilliononhand.
OnFriday,September1i,ioo8,AIGwasfacingchallengesonanumberoffronts.
It had to fund 1. billion of its own commercial paper on that day

because tradi-
tional investorsfor example, money market fundsno longer wanted even short-
termunsecuredexposuretoAIG;andthecompanyhadanother.ibillioncoming
duethefollowingweek.

Onanotherfront,therepolenderswhohadthecomfort
of holding collateral for their loans to AIG (., billion in mostly overnight fund-
ing)
,
werenonethelessbecomingskittishabouttheperceivedweaknessofthecom-
panyandthelowqualityofmostofitscollateral:mortgage-relatedsecurities.
o
On a third front, AIG had already put up billions of dollars in collateral to its
creditdefaultswapcounterparties.ByJuneofioo8,counterpartiesweredemanding
1,., billion, and AIG had posted 1.i billion. By September 1i, the calls had
soared to i. billion, and AIG had paid 18. billion,.o billion to Goldman
aloneand it looked very likely that AIG would need to post billions more in the
near future.
,
That day, S&P and Moodys both warned of potential coming down-
grades to AIGs credit rating, which, if they happened, would lead to an estimated
1obillioninnewcollateralcalls.
8
Adowngradewouldalsotriggerliquidityputsthat
:ii1i\8ii z++ 1ui 8\i iuU1 ui \i t ,,,
AIGhadwrittenoncommercialpaper,requiringAIGtocomeupwithanotherto
,billion.

Finally, AIG was increasingly strained by its securities lending business. As a

lender of securities, AIG received cash from borrowers, typically equal to between
1ooand1oiofthemarketvalueofthesecuritiestheylent.Asborrowersbegan
questioningAIGsstability,thecompanyhadtoacceptbelow-markettermssome-
timesacceptingcashequaltoonlyoofthevalueofthesecurities.
1o
Furthermore,
AIGhadinvestedthiscashinmortgage-relatedassets,whosevaluehadfallen.Since
Septemberioo,,stateregulatorshadworkedwithAIGtoreduceexposuresofthese-
curitieslendingprogramtomortgage-relatedassets,accordingtotestimonybyEric
Dinallo, the former superintendent of the New York State Insurance Department
(NYSID).
11
Still, by the end of June ioo8, AIG had invested ,, billion in cash in
mortgage-relatedsecurities,whichhaddeclinedinvalueto,.,billion.BylateAu-
gustioo8,theparentcompanyhadtoprovide.billiontoitsstrugglingsecurities
lending subsidiary, and counterparties were demanding i billion to offset the
shortfallbetweenthecashcollateralprovidedandthediminishedvalueofthesecuri-
ties.
1i
AccordingtoDinallo,thecollateralcalldisputesbetweenAIGanditscreditde-
fault swap counterparties hindered an orderly wind down of the securities lending
business,andinfactaccelerateddemandsfromsecuritieslendingcounterparties.
1
ThatFriday,AIGsboarddispatchedateamledbyViceChairmanJacobFrenkel
tomeetwithtopomcialsattheFederalReserveBankofNewYork.
1
Elsewherein
thebuilding,TreasurySecretaryHenryPaulsonandNewYorkFedPresidentTimo-
thyGeithnerweretellingWallStreetbankersthattheyhadtheweekendtodevisea
solutiontopreventLehmansbankruptcywithoutgovernmentassistance.Nowcame
thisemergencymeetingregardinganotherbeleagueredAmericaninstitution.Bot-
tomline,theNewYorkFedlaterreportedofthatmeeting,[AIGs]Treasureresti-
mates that parent and [Financial Products] have ,1o days before they are out of
liquidity.
1,
AIGposedasimplequestion:howcoulditobtainanemergencyloanunderthe
Federal Reserves 1() authority: Without a solution, there was no way this con-
glomerate,despitemorethan1 trillion inassets,wouldsurviveanotherweek.
CURRENT LIQUIDITY POSITION IS PRECARIOUS
AIGsvisittotheNewYorkFedmayhavebeenanemergency,butitshouldnothave
beenasurprise.WiththePrimaryDealerCreditFacility(PDCF),theFedhadeffec-
tivelyopeneditsdiscountwindowtraditionallyavailableonlytodepositoryinstitu-
tionsto investment banks that qualifed as primary dealers; AIG did not qualify.
Butoverthesummer,NewYorkFedomcialshadbeguntoconsiderprovidingemer-
gency collateralized funding to even more large institutions that were systemically
important.Thatledtheregulatorstolookcloselyattwotrillion-dollarholdingcom-
panies, AIG and GE Capital. Both were large participants in the commercial paper
market:AIGwithiobillioninoutstandingpaper,GECapitalwithobillion.
1o
In
,, ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
August,theNewYorkFedsetupateamtostudythetwocompaniesfundingandliq-
uidityrisk.
OnAugust11,NewYorkFedomcialsmetwithOmceofThriftSupervision(OTS)
regulators to discuss AIG.
1,
The OTS said that it was generally comfortable with
[the]frmscurrentliquidity . . .[and]confdentthatthefrmcouldaccessthecapital
marketswithnoproblemifithadto.
18
TheNewYorkFeddidnotagree.OnAugust
1,ioo8,KevinCoffey,ananalystfromtheFinancialSectorPolicyandAnalysisunit,
wrotethatdespiteraisingiobillionearlierintheyear,AIGisunderincreasingcap-
ital and liquidity pressure and appears to need to raise substantial longer term
fundstoaddresstheimpactofdeterioratingassetvaluesonitscapitalandavailable
liquidityaswellastoaddresscertainasset/liabilityfundingmismatches.
1
Coffey listed six concerns: (1) AIGs signifcant losses on investments, primarily
becauseofsecuritieslendingactivities;(i)io.,billioninmark-to-marketlosseson
AIGFinancialProductscreditdefaultswapbookandrelatedmargincalls,forwhich
AIG had posted 1o., billion in collateral by mid-August; () signifcant near-term
liabilities; () commitments to purchase collateralized debt obligations due to out-
standing liquidity puts; (,) ratings-based triggers in derivative contracts that could
causesignifcantadditionalcollateralcallsifAIGweredowngraded;and(o)limited
standby credit facilities to manage sudden cash needs. He noted Moodys and S&P
had highlighted worries about earnings, capital, and liquidity following AIGs ioo8
second-quarterearnings.TheagencieswarnedtheywoulddowngradeAIGifitdid
notaddresstheseissues.
io
Four days later, Goldman Sachs issued a report to clients that echoed much of
Coffeysinternalanalysis.Thereport,DontBuyAIG:PotentialDowngrades,Capi-
talRaiseontheHorizon,warnedthatweforeseeiobillionineconomiclosses
from[AIGscreditdefaultswap]book,whichcouldresultinlargercashoutlays . . .
resulting in a signifcant shift in the risk quality of AIGs assets. . . . Put simply, we
haveseenthiscreditoverhangstorybeforewithanotherstockinourcoverageuni-
verse,andforeseeoutcomessimilarinnaturebutonamuchlargerscale.
i1
Goldman
appeared to be referring to Bear Stearns. Ira Selig, a manager at the New York Fed,
emailedtheGoldmanreporttoCoffeyandothers.Thebottomline:largescalecash
outfows and posting of collateral could substantially weaken AIGs balance sheet,
themanagerwrote.
ii
On September i, the New York Feds Danielle Vicente noted the situation had
worsened:AIGscurrentliquiditypositionisprecariousandassetliabilitymanage-
mentappearsinadequategiventhesubstantialoffbalancesheetliquidityneeds.Liq-
uidating an 8, billion securities portfolio to cover liabilities would mean
substantiallossesandpotentiallyaffectprices,shewrote.BorrowingagainstAIGs
securities through the Feds PDCF might allow AIG to unwind its positions calmly
while satisfying immediate cash needs, but Vicente questioned whether the PDCF
wasnecessaryforthesurvivalofthefrm.
i
Arguably,however,AIGsvolatilefund-
ingsourcesmadethefrmvulnerabletoruns.Off-balance-sheetcommitmentsin-
cludingcollateralcalls,contractterminations,andliquidityputscouldbeashighas
:ii1i\8ii z++ 1ui 8\i iuU1 ui \i t ,,,
billionifAIGwasdowngraded.YetAIGhadonlybillionofrevolvingcredit
facilitiesinadditiontothe1ito1billionofcashithadonhandatthetime.
i
TheratingagencieswaitedtoseehowAIGwouldaddressitsliquidityandcapital
needs.AnalystsworriedaboutthelossesinAIGscreditdefaultswapsandinvestment
portfolios,aboutratingagencyactions,andaboutsubsequentimpactsoncapital.In-
deed,GoldmansAugust18reportonAIGconcludedthatthefrmitselfandtherat-
ingagencieswereindenialaboutimpendinglosses.
i,
ByearlySeptember,managementwasnolongerindenial.AttheFriday,Septem-
ber1i,meetingattheNewYorkFed,AIGexecutivesreportedthatthecompanywas
facing serious liquidity issues that threaten[ed] its survival viability and that a
downgrade,possiblyafteraratingagencymeetingSeptember1,,wouldtriggerbil-
lions of dollars in collateral calls, liquidity puts, and other liquidity needs.
io
AIGs
stockhadfallensignifcantly(shareshitanintradaylowof11.Friday,downfrom
a1,.,,closethedaybefore)andcreditdefaultswapspreadshadreached1dur-
ing the day,
i,
indicating that protection on 1o million of AIG debt would cost ap-
proximately 1. million per year. AIG reported it was having problems with its
commercial paper, able to roll only 1.1 billion of the i., billion that matured on
September1i.
i8
Inaddition,somebankswerepullingawayandevenrefusingtopro-
vide repo funding.
i
Assets were illiquid, their values had declined, borrowing was
restricted,andraisingcapitalwasnotviable.
SPILLOVER EFFECT
TheNewYorkFedknewthatafailureofAIGwouldhavedramatic,far-reachingcon-
sequences. By the evening of September 1i, after the meeting with AIG executives,
that possibility looked increasingly realistic. Hayley Boesky of the New York Fed
emailedWilliamDudleyandothers.Morepanicfrom[hedgefunds].Nowfocusis
onAIG,shewrote.IamhearingworsethanLEH.Everybankanddealerhasexpo-
suretothem.
o
Shortly before midnight, New York Fed Assistant Vice President Alejandro La-
TorreemailedGeithner,Dudley,andothersenioromcialsaboutAIG:Thekeytake-
awayisthattheyarepotentiallyfacingasevererunontheirliquidityoverthecourse
ofthenextseveral(approx.1o)daysiftheyaredowngraded. . . .Theirriskexposures
areconcentratedamongthe1ilargestinternationalbanks(bothU.S.andEuropean)
acrossawidearrayofproducttypes(banklines,derivatives,securitieslending,etc.)
meaning[there]couldbesignifcantcounterpartylossestothosefrmsintheevent
ofAIGsfailure.
1
NewYorkFedomcialsmetonSaturdaymorning,andgatheredadditionalinfor-
mation about AIGs fnancial condition, but according to New York Fed General
CounselTomBaxter,itseemedclearthattheprivatesectorsolutionwouldmaterial-
izeforAIG.
i
Indeed,ChristopherFlowers,headofJ.C.Flowers&Co.,aprivateeq-
uity frm, had spoken to AIG CEO Robert Willumstad the prior Thursday, and the
twohadcalledWarrenBuffetttodiscussapossibledeal.WillumstadtoldtheFCIC
,, ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
that he was in contact with about a dozen private equity frms over the weekend.

AIG executives also worked with then-Superintendent Eric Dinallo to help craft a
dealthatwouldhaveallowedAIGsregulatedsubsidiariestoessentiallylendmoney
totheparentcompany.FedomcialsreportedtoAIGexecutivesduringaconference
callonSaturdaythattheyshouldnotbeparticularlyoptimistic[aboutfnancialas-
sistance],giventhehurtles[sic]andhistoryof[theFeds]1-lending[authority].

AndbytheendofthedayonSaturday,AIGappearedtotheFedtobepursuingpri-
vate-sector leads. It was clear from the conversation that Flowers [is] actively in-
volvedinworkingwitheverything(AIG,regulators,bankers,etc)inputtingtogether
boththetermsheetwithAIG,andprovidinganalysistoNYSIDonliquidityprofle
oftheparentcompany,PatriciaMosser,aseniorvicepresidentattheNewYorkFed,
wrotetoLaTorreandothers.
,
OnSundaymorning,September1,AdamAshcraftoftheNewYorkFedcircu-
latedamemo,CommentonPossible1-LendingtoAIG,discussingtheeffectofa
fre sale by AIG on asset markets.
o
In an accompanying email, Ashcraft wrote that
thethreatbyAIGtosellassetswasaclearattempttoscarepolicymakersintogiv-
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,LaTorresentananalysis,Prosandconsoflendingto
AIG,tocolleagues.Theprosincludedavoidingamessycollapseanddislocationsin
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
by buying credit default swaps from AIG would lose that protection if AIG failed.
AIGsbankruptcywouldalsoaffectothercompaniesbecauseofitsnon-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
bookssignifcantlyunbalanced.
8
The cons of a bailout included a chilling effect on private-sector solutions
thoughttobeunderway;thepossibilitythataFedloanwouldbeinsumcienttokeep
AIG afoat, undermining emcacy of 1- lending as a policy tool; an increase in
moral hazard; the perception that it would be incoherent to lend to AIG and not
Lehman; the possibility of assets being insumcient to cover the potential liquidity
hole. LaTorre concluded, Without punitive terms, lending [to AIG] could reward
poorriskmanagement,whichincludedAIGsunwillingnesstosellorhedgesomeof
itsCDOrisk.

Theprivate-sectorsolutionsLaTorrereferredtohadhitawall,however.BySunday
afternoon,FlowershadbeensummarilydismissedbyAIGsboard.Flowerstoldthe
FCIC that under his proposal, his frm and Allianz, the giant insurance company,
wouldhaveeachinvested,billioninexchangeforthestockofAIGsubsidiaries.With
:ii1i\8ii z++ 1ui 8\i iuU1 ui \i t ,,,
approvalfromtheNYSID,thesubsidiarieswouldupstreamiobilliontotheparent
company,andtheparentcompanywouldgetaccesstobridgefnancingfromtheFed.
Then,AllianzwouldtakecontrolofAIGalmostimmediately.Flowerssaidthathewas
surprisedbyAIGsunwillingnesstonegotiate.Imnotsayingitwouldhaveworkedor
thatitwasperfectaswritten,butitwasastoundingtomethatgivenwhathappened,
nobodybotheredtocheckthis[deal]out,hesaid.
o
WillumstadreferredtotheFlowers
dealasaso-calledofferhedidnotconsiderittobeaseriouseffort,andsoitwas
dismissedimmediately.WithrespecttotheotherpotentialinvestorsAIGspokewith
overtheweekend,Willumstadsaidthatnegotiationswereunsuccessfulbecauseevery
potential deal would have required government assistancesomething Willumstad
hadbeenassuredbythehighestlevelswouldnotbeforthcoming.
1
On Monday morningafter Lehman had declared bankruptcy, and with no pri-
vate-sectorsolutiononthehorizontheFedinitiatedanefforttohaveJPMorganand
GoldmanSachsassembleasyndicateofbankstolendabout,,billiontokeepAIG
afoat.
i
In the afternoon, the rating agencies announced their assessments, which
were even worse than expected. All three rating agencies announced downgrades of
AIG:S&PbythreenotchestoA-,andMoodysandFitchbytwonotchestoAiandA,
respectively. The downgrades triggered an additional 1 billion in cash collateral
callsonAIGFinancialProductscreditdefaultswaps.GoldmanSachsalonerequested
i.1billion.

Demandshitibillion,andAIGspayoutsincreasedto1.,billion.

The companys stock plummeted o1 to .,o from the closing price of 1i.1 the
previousFridayafractionofitsall-timehighof1,.8.
Thesyndicateofbanksdidnotagreeonadeal,despitetheexpectationsofFedof-
fcials. Once Lehman fled [for bankruptcy] on the morning of the 1,th, everyone
decidedthat,wevegottoprotectourownbalancesheet,andthebanksthatwerego-
ing to provide the ,, billion decided that they were not going to, Baxter told the
FCIC.
,
SarahDahlgren,aseniorNewYorkFedomcial,agreedwithBaxter.Lehmans
bankruptcywastheendoftheprivate-sectorsolution,shetoldtheCommission.
o
Afterthemarketsclosed,AIGinformedtheNewYorkFeditwasunabletoaccess
the short-term commercial paper market.
,
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.
8
Late that
night,forthesecondtimesincethebeginningofthecrisis,theFederalReserveBoard
invoked section 1() of the Federal Reserve Act to bail out a company. As it had
done for Bear Stearns, the New York Fed, with the support of the Treasury, would
rescueabrand-namefnancialinstitution.
TheFederalOpenMarketCommitteewasbriefedaboutAIG.Membersweretold
thatAIGfacedaliquiditycrisisbutthatitwasuncleariftherewerealsosolvencyis-
sues. In addition, the staff noted that money market funds had even broader expo-
sure to AIG than to Lehman and that the parent company could run out of money
quitesoon,evenwithindays.

,,+ ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1

OnTuesdaymorning,theFedputanumberonthetable:itwouldloan8,billion
sothatAIGcouldmeetitsimmediateobligations.Thecollateralwouldbetheassets
oftheparentcompanyanditsprimarynonregulatedsubsidiaries,plusthestockofal-
mostalltheregulatedinsurancesubsidiaries.TheFedstatedthatadisorderlyfailure
ofAIGcouldaddtoalreadysignifcantlevelsoffnancialmarketfragilityandleadto
substantially higher borrowing costs, reduced household wealth, and materially
weakereconomicperformance.
,o
ByWednesday,ashareofAIGsoldforaslittleas
1..Thepreviouseightyearsproftsofoobillionwouldbedwarfedbythe.
billionlossforthisoneyear,ioo8.
But8,billionwouldsoonproveinsumcient.Treasuryadded.1billionunder
its Troubled Asset Relief Program (TARP).
,1
Ultimately, according to the Congres-
sionalOversightPanel,taxpayerfundscommittedtoAIGreached18ibillion.The
panelfaultedthegovernmentfordecidingtobailoutAIGtoohastily:WithAIG,the
FederalReserveandTreasurybrokenewground.TheyputtheU.S.taxpayeronthe
lineforthefullcostandfullriskofrescuingafailingcompany.
,i
TheTreasuryDe-
partmentdefendeditsdecision,sayingthatthepanelreportoverlooksthebasicfact
that the global economy was on the brink of collapse and there were only hours in
whichtomakecriticaldecisions.
,
LIKE A GNAT ON AN ELEPHANT
TheOmceofThriftSupervisionhasacknowledgedfailuresinitsoversightofAIG.In
aMarch18,ioo,congressionalhearing,ActingDirectorScottPolakofftestifedthat
supervisors failed to recognize the extent of liquidity risk of the Financial Products
subsidiarys credit default swap portfolio.
,
John Reich, a former OTS director, told
the FCIC that as late as September ioo8, he had no clueno ideawhat [AIGs]
CDSliabilitywas.
,,
According to Mike Finn, the director for the OTSs northeast region, the OTSs
authority to regulate holding companies was intended to ensure the safety and
soundnessoftheFDIC-insuredsubsidiaryofAIGandnottofocusonthepotential
impact on AIG of an uninsured subsidiary like AIG Financial Products.
,o
Finn ig-
nored the OTSs responsibilities under the European Unions Financial Conglomer-
ates Directive (FCD)responsibilities the OTS had actively sought. The directive
required foreign companies doing business in Europe to have the equivalent of a
consolidatedsupervisorintheirhomecountry.Startinginioo,theOTSworked
topersuadetheEuropeanUnionthatitwascapableofservingasAIGshomecoun-
tryconsolidatedsupervisor.
,,
Inioo,theagencywrote:AIGanditssubsidiariesare
subjecttoconsolidatedsupervisionbyOTS. . . .Aspartofitssupervision,OTSwill
conductcontinuouson-sitereviewsofAIGanditssubsidiaries.
,8
YetevenReichtold
FCIC staff that he did not understand his agencys responsibilities under the FCD.
TheformerdirectorsaidhewasneversurewhatauthoritytheOTShadoverAIGFi-
nancialProducts,whichhesaidhadslippedthrougharegulatorygap.
,
:ii1i\8ii z++ 1ui 8\i iuU1 ui \i t ,,.
FurtherunderminingtheOTSsclaimthatitlackedauthorityoverAIGFinancial
Productsareitsownactions:theOTSdidinfactexaminethesubsidiary,albeitmuch
too late to matter. OTS examiners argued they got little cooperation from Joseph
Cassano, the head of the subsidiary. Joseph Gonzales, the examiner in charge from
ApriliootoNovemberiooo,toldFCICstaff,Ioverheardoneemployeesayingthat
JoeCassanofeltthat[theOTSwas]overreachingourscopebygoingintoFP.
oo
TheOTSdidnotlookcarefullyatthecreditdefaultswapportfolioguaranteedby
the parent companyeven though AIG did describe the nature of its super-senior
portfolioinitsannualreportsatthattime,includingthedollaramountoftotalcredit
defaultswapsthatithadwritten.GonzalessaidthattheOTSdidnotknowaboutthe
CDSduringtheiooo,period.
o1
AfteralimitedreviewinJulyioo,conducteda
week before Goldman sent AIG Financial Products its frst demand for collateral
theOTSconcludedthattheriskintheCDSbookwastoosmalltobemeasuredand
decidedtoputoffamoredetailedreviewuntilioo8.
oi
Theagencysstatedreasonwas
itslimitedtimeandstaffresources.
o
In February ioo8, AIG reported billions of dollars in losses and material weak-
nessesinthewayitvaluedcreditdefaultswappositions.YettheOTSdidnotinitiate
anin-depthreviewofthecreditdefaultswapsuntilSeptemberioo8tendaysbefore
AIGwenttotheFedseekingarescuecompletingthereviewonOctober1,,more
thanamonthafterAIGfailed.Itwas,formerOTSdirectorofConglomerateOpera-
tionsBradWaringadmitted,inhindsight,abadchoice.
o
ReichtoldtheFCICthatbeforeioo8,AIGhadnotbeenagreatconcern.Healso
acknowledgedthattheOTShadneverfullyunderstoodtheFinancialProductsunit,
andthuscouldntregulateit.Atthesimplestlevel, . . .anorganizationlikeOTScan-
notsuperviseAIG,GE,MerrillLynch,andentitiesthathaveworldwideomces. . . .I
wouldbethefrsttosaythatforanorganizationlikeOTStopretendthatithastotal
responsibilityoverAIGandallofitssubsidiaries . . .itslikeagnatonanelephant
theresnoway.ReichsaidthatfortheOTStothinkitcouldregulateAIGwastotally
impracticalandunrealistic. . . .Ithinkwethoughtwecouldgrowintothatresponsi-
bility. . . .ButIthinkthatwassortofpieintheskydreaming.
o,
Geithneragreed,andtoldReichsobluntly.ReichtoldtheFCICaboutaphonecall
fromGeithneraftertherescue.AboutallIcanrememberisthefoullanguagethatI
heard on the other end of the line, Reich said. He recalled Geithner telling him.
Youguyshavehandedmeabagofsht.Ijustlistened.
oo
COMMISSION CONCLUSIONS ON CHAPTER 19
TheCommissionconcludesAIGfailedandwasrescuedbythegovernmentprima-
rilybecauseitsenormoussalesofcreditdefaultswapsweremadewithoutputting
up initial collateral, setting aside capital reserves, or hedging its exposurea pro-
foundfailureincorporategovernance,particularlyitsriskmanagementpractices.
AIGs failure was possible because of the sweeping deregulation of over-the-
counter(OTC)derivatives,includingcreditdefaultswaps,whicheffectivelyelim-
inatedfederalandstateregulationoftheseproducts,includingcapitalandmargin
requirementsthatwouldhavelessenedthelikelihoodofAIGsfailure.TheOTC
derivativesmarketslackoftransparencyandofeffectivepricediscoveryexacer-
batedthecollateraldisputesofAIGandGoldmanSachsandsimilardisputesbe-
tween other derivatives counterparties. AIG engaged in regulatory arbitrage by
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).
TheOTSfailedtoeffectivelyexerciseitsauthorityoverAIGanditsamliates:it
lackedthecapabilitytosuperviseaninstitutionofthesizeandcomplexityofAIG,
didnotrecognizetherisksinherentinAIGssalesofcreditdefaultswaps,anddid
not understand its responsibility to oversee the entire company, including AIG
FinancialProducts.Furthermore,becauseofthederegulationofOTCderivatives,
state insurance supervisors were barred from regulating AIGs sale of credit de-
faultswapseventhoughtheyweresimilarineffecttoinsurancecontracts.Ifthey
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-
inginsuchariskymanner.
AIG was so interconnected with many large commercial banks, investment
banks,andotherfnancialinstitutionsthroughcounterpartycreditrelationships
oncreditdefaultswapsandotheractivitiessuchassecuritieslendingthatitspo-
tentialfailurecreatedsystemicrisk.ThegovernmentconcludedAIGwastoobig
tofailandcommittedmorethan18obilliontoitsrescue.Withoutthebailout,
AIGs default and collapse could have brought down its counterparties, causing
cascadinglossesandcollapsesthroughoutthefnancialsystem.
,,z ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
,,,
20
CRISIS AND PANIC
CONTENTS
McncynarkctjundsDca|crswcrcntcvcnpickingupthcirphcncs ,,e
McrganStan|cyNcwwcrcthcncxtin|inc,eo
Ovcr-thc-ccuntcrdcrivativcsAgrindingha|t ,e,
VashingtcnMutua|Itsycurs,e,
VachcviaAtthcjrcntcndcjthcdcninccsascthcrdcninccsjc||,ee
1ARICcnprchcnsivcapprcach ,,+
AIGVcnccdcdtcstcpthcsuckingchcstwcundinthispaticnt,,e
CitigrcupIctthcwcr|dkncwwcwi||nctpu||aIchnan,,,
BankcjAncricaAshctgunwcdding ,::
September 1,, ioo8the date of the bankruptcy of Lehman Brothers and the
takeoverofMerrillLynch,followedwithinihoursbytherescueofAIGmarked
the beginning of the worst market disruption in postwar American history and an
extraordinary rush to the safest possible investments. Creditors and investors sus-
pectedthatmanyotherlargefnancialinstitutionswereontheedgeoffailure,andthe
Lehmanbankruptcyseemedtoprovethatatleastsomeofthemwouldnothaveac-
cesstothefederalgovernmentssafetynet.
JohnMack,CEOofMorganStanleyduringthecrisis,toldtheFCIC,Intheimme-
diatewakeofLehmansfailureonSeptember1,,MorganStanleyandsimilarinstitu-
tionsexperiencedaclassicrunonthebank,asinvestorslostconfdenceinfnancial
institutionsandtheentireinvestmentbankingbusinessmodelcameundersiege.
1
The markets were very bad, the volatility, the illiquidity, some things couldnt
tradeatall,Imeancompletelylocked,themarketswereinterribleshape,JPMorgan
CEOJamieDimonrecalledtotheFCIC.Hethoughtthecountrycouldfaceioun-
employment.Wecouldhavesurviveditinmyopinion,butitwouldhavebeenterri-
ble. I would have stopped lending, marketing, investing . . . and probably laid off
io,ooopeople.AndIwouldhavedoneitinthreeweeks.Yougetcompaniesstarting
totakeactionslikethat,thatswhataGreatDepressionis.
i
TreasurySecretaryTimothyGeithnertoldtheFCIC,Youhadpeoplestartingto
taketheirdepositsoutofvery,verystrongbanks,longwayremovedindistanceand
,,, ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
riskandbusinessfromtheguysonWallStreetthatwereattheepicenteroftheprob-
lem.Andthatisagoodmeasure,classicmeasureofincipientpanic.

Inaninterview
inDecemberioo,Geithnersaidthatnoneof[thebiggestbanks]wouldhavesur-
vivedasituationinwhichwehadletthatfretrytoburnitselfout.

Fed Chairman Ben Bernanke told the FCIC, As a scholar of the Great Depres-
sion,IhonestlybelievethatSeptemberandOctoberofioo8wastheworstfnancial
crisisinglobalhistory,includingtheGreatDepression.Ifyoulookatthefrmsthat
came under pressure in that period . . . only one . . . was not at serious risk of fail-
ure. . . .Sooutofmaybethe1,1ofthemostimportantfnancialinstitutionsinthe
UnitedStates,1iwereatriskoffailurewithinaperiodofaweekortwo.
,
As it had on the weekend of Bears demise, the Federal Reserve announced new
measuresonSunday,September1,tomakemorecashavailabletoinvestmentbanks
andotherfrms.Yetagain,itlowereditsstandardsregardingthequalityofthecollateral
thatinvestmentbanksandotherprimarydealerscouldusewhileborrowingunderthe
twoprogramstosupportrepolending,thePrimaryDealerCreditFacility(PDCF)and
theTermSecuritiesLendingFacility(TSLF).
o
And,providingatemporaryexceptionto
itsrules,itallowedtheinvestmentbanksandotherfnancialcompaniestoborrowcash
from their insured depository amliates. The investment banks drew liberally on the
Feds lending programs. By the end of September, Morgan Stanley was getting by on
o.1billionofFed-providedlifesupport;Goldmanwasreceiving1.,billion.
,
But the new measures did not quell the market panic. Among the frst to be di-
rectly affected were the money market funds and other institutions that held
Lehmansbillioninunsecuredcommercialpaperandmadeloanstothecompany
through the tri-party repo market. Investors pulled out of funds with known expo-
sure to that jeopardy, including the Reserve Management Companys Reserve Pri-
maryFundandWachoviasEvergreenInvestments.
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
oo,ooo over-the-counter derivatives contracts. For example, Deutsche Bank, JP
Morgan,andUBStogetherhadmorethan1,o,ooooutstandingtradeswithLehman
asofMayioo8.TheLehmanbankruptcycausedimmediateproblemsfortheseOTC
derivatives counterparties. They had the right under U.S. bankruptcy law to termi-
natetheirderivativescontractswithLehmanuponitsbankruptcy,andtotheextent
thatLehmanowedthemmoneyonthecontractstheycouldseizeanyLehmancollat-
eralthattheyheld.However,anyadditionalamountowedtothemhadtobeclaimed
inthebankruptcyproceeding.IftheyhadpostedcollateralwithLehman,theywould
havetomakeaclaimforthereturnofthatcollateral,anddisputesovervaluationof
thecontractswouldstillhavetoberesolved.Theseproceedingswoulddelaypayment
andmostlikelyresultinlosses.Moreover,anyhedgesthatrestedonthesecontracts
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.

When the commercial paper market died, the biggest

corporationsinAmericathoughttheywerefnished,HarveyMiller,thebankruptcy
attorneyfortheLehmanestate,toldtheFCIC.
1o
Investors and uninsured depositors yanked tens of billions of dollars out of banks
whose real estate exposures might be debilitating (Washington Mutual, Wachovia) in
favorofthosewhoserealestateexposuresappearedmanageable(WellsFargo,JPMor-
gan).Hedgefundswithdrewtensofbillionsofdollarsofassetsheldincustodyatthere-
maininginvestmentbanks(GoldmanSachs,MorganStanley,andevenMerrillLynch,
asthejust-announcedBankofAmericaacquisitionwouldntcloseforanotherthreeand
ahalfmonths)infavoroflargecommercialbankswithprimebrokeragebusinesses(JP
Morgan, Credit Suisse, Deutsche Bank), because the commercial banks had more di-
versesourcesofliquiditythantheinvestmentbanksaswellaslargebasesofinsuredde-
posits.JPMorganandBNYMellon,thetri-partyrepoclearingbanks,clampeddown
ontheirintradayexposures,demandingmorecollateralthaneverfromtheremaining
investment banks and other primary dealers. Many banks refused to lend to one an-
other;thecostofinterbanklendingrosetounprecedentedlevels(seefgureio.1).
,, ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
OnMonday,September1,,theDowJonesIndustrialAveragefellmorethan,oo
points, or , the largest single-day point drop since the /11 terrorist attacks.
ThesedropswouldbeexceededonSeptemberithedaythattheHouseofRepre-
sentatives initially voted against the ,oo billion Troubled Asset Relief Program
(TARP)proposaltoprovideextraordinarysupporttofnancialmarketsandfrms
whentheDowJonesfell,andfnancialstocksfell1o.Forthemonth,theS&P
,oo would lose 88 billion of its value, a decline of the worst month since
Septemberiooi.
Andspecifcinstitutionswouldtakedirecthits.
MONEY MARKET FUNDS:
DEALERS WEREN T EVEN PICKING UP THEIR PHONES
WhenLehmandeclaredbankruptcy,theReservePrimaryFundhad,8,millionin-
vestedinLehmanscommercialpaper.ThePrimaryFundwastheworldsfrstmoney
market mutual fund, established in 1,1 by Reserve Management Company. The
fundhadtraditionallyinvestedinconservativeassetssuchasgovernmentsecurities
andbankcertifcatesofdepositandhadforyearsenjoyedMoodysandS&Pshighest
ratingsforsafetyandliquidity.
In March iooo, the fund had advised investors that it had slightly underper-
formeditsrivals,owingtoamoreconservativeandriskaversemannerofinvest-
ingfor example, the Reserve Funds do not invest in commercial paper.
11
But
immediatelyafterpublishingthisstatement,itquietlybutdramaticallychangedthat
strategy.Within18months,commercialpapergrewfromzerotoone-halfofReserve
Primarysassets.ThehigheryieldsattractednewinvestorsandtheReservePrimary
Fund was the fastest-growing money market fund complex in the United States in
iooo,ioo,,andioo8doublinginthefrsteightmonthsofioo8alone.
1i
Earlierinioo8,PrimaryFundsmanagershadloanedBearStearnsmoneyinthe
repomarketuptotwodaysbeforeBearsnear-collapse,pullingitsmoneyonlyafter
Bear CEO Alan Schwartz appeared on CNBC in the companys fnal days, Primary
FundPortfolioManagerMichaelLucianotoldtheFCIC.Butafterthegovernment-
assisted rescue of Bear, Luciano, like many other professional investors, said he as-
sumedthatthefederalgovernmentwouldsimilarlysavethedayifLehmanoroneof
theotherinvestmentbanks,whichweremuchlargerandposedgreaterapparentsys-
temicrisks,ranintotrouble.Thesefrms,Lucianosaid,weretoobigtofail.
1
On September 1,, when Lehman declared bankruptcy, the Primary Funds
Lehman holdings amounted to 1.i of the funds total assets of oi. billion. That
morning,thefundwasfoodedwithredemptionrequeststotaling1o.8billion.State
Street, the funds custodian bank, initially helped the fund meet those requests,
largelythroughanexistingoverdraftfacility,butstoppeddoingsoat1o:1oA.M.With
nomeanstoborrow,PrimaryFundrepresentativesreportedlydescribedStateStreets
actionasthekissofdeathforthePrimaryFund.
1
Despitepublicassurancesfrom
thefundsinvestmentadvisors,BruceBentSr.andBruceBentII,thatthefundwas
tii :i : \Ni i\Ni t ,,,
committedtomaintaininga1.oonetassetvalue,investorsrequestedanadditional
ibillionlateronMondayandTuesday,September1o.
1,
Meanwhile,onMonday,thefundsboardhaddeterminedthattheLehmanpaper
wasworth8ocentsonthedollar.Thatappraisalhadquicklyprovedoptimistic.After
themarketclosedTuesday,ReserveManagementpubliclyannouncedthatthevalue
of its Lehman paper was zero, effective :ooPM New York time today. As a result,
the fund broke the buck.
1o
Four days later, the fund sought SEC permission to om-
ciallysuspendredemptions.
Otherfundssufferingsimilarlosseswereproppedupbytheirsponsors.OnMon-
day, Wachovias asset management unit, Evergreen Investments, announced that it
would support three Evergreen mutual funds that held about ,o million in
Lehman paper. On Wednesday, BNY Mellon announced support for various funds
that held Lehman paper, including the ii billion Institutional Cash Reserves fund
andfourofitstrademarkDreyfusfunds. BNYMellonwouldtakeanafter-taxcharge
ofi,millionbecauseofthisdecision.Overthenexttwoyears,oimoneymarket
fundsobasedintheUnitedStates,ioinEurope
1,
wouldreceivesuchassistance
tokeeptheirfundsfrombreakingthebuck.
After the Primary Fund broke the buck, the run took an ominous turn: it even
slammedmoneymarketfundswithnodirectLehmanexposure.Thislackofexpo-
sure was generally known, since the SEC requires these funds to report details on
theirinvestmentsatleastquarterly.Investorspulledoutsimplybecausetheyfeared
thattheirfellowinvestorswouldrunfrst.Itwasoverwhelminglyclearthatwewere
staringintotheabyssthattherewasntabottomtothisastheoutfowspickedup
steamonWednesdayandThursday,FedeconomistPatrickMcCabetoldtheFCIC.
The overwhelming sense was that this was a catastrophe that we were watching
unfold.
18
We were really cognizant of the fact that there werent backstops in the system
thatwereresilientatthattime,theFedsMichaelPalumbosaid.Liquiditycrises,by
theirnature,invokerapid,emergentepisodesthatswhattheyare.Bytheirnature,
theyspreadveryquickly.
1
An early and signifcant casualty was Putnam Investments 1i billion Prime
Money Market Fund, which was hit on Wednesday with a wave of redemption re-
quests.Thefund,unabletoliquidateassetsquicklyenough,haltedredemptions.One
weeklater,itwassoldtoFederatedInvestors.
Within a week, investors in prime money market fundsfunds that invested in
highly rated securitieswithdrew billion; within three weeks, they withdrew
another8,billion.Thatmoneywasmostlyheadedforotherfundsthatboughtonly
Treasuriesandagencysecurities;indeed,itwasmoremoneythanthosefundscould
invest, and they had to turn people away
io
(see fgure io.i). As a result of the un-
precedented demand for Treasuries, the yield on four-week Treasuries fell close to
o,levelsnotseensinceWorldWarII.
Moneymarketmutualfundsneedingcashtohonorredemptionssoldtheirnow
illiquid investments. Unfortunately, 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 NQUi i tu\\i : :i uN iiiui1
anecdotallythatthedealerswerentevenpickinguptheirphones. Thefundshadto
getridoftheirpaper;theydidnthaveanyonetogiveitto,McCabesaid.
i1
And holding unsecured commercial paper from any large fnancial institution
was now simply out of the question: fund managers wanted no part of the next
Lehman.AnFCICsurveyofthelargestmoneymarketfundsfoundthatmanywere
unwillingtopurchasecommercialpaperfromfnancialfrmsduringtheweekafter
Lehman. Of the respondents, the fve with the most drastic reduction in fnancial
commercial paper cut their holdings by half, from ,8 billion to i billion.
ii
This
ledtounprecedentedincreasesintheratesoncommercialpaper,creatingproblems
for borrowers, particularly for fnancial companies, such as GE Capital, CIT, and
AmericanExpress,aswellasfornonfnancialcorporationsthatusedcommercialpa-
per to pay their immediate expenses such as payroll and inventories. The cost of
commercialpaperborrowingspikedinmid-September,dramaticallysurpassingthe
previoushighsinioo,(seefgureio.).
You had a broad-based run on commercial paper markets, Geithner told the
FCIC.Andsoyoufacedtheprospectofsomeofthelargestcompaniesintheworld
andtheUnitedStateslosingthecapacitytofundandaccessthosecommercialpaper
markets.
i
Threedecadesofeasyborrowingforthosewithtop-ratedcreditinavery
liquidmarkethaddisappearedalmostovernight.Thepanicthreatenedtodisruptthe
paymentssystemthroughwhichfnancialinstitutionstransfertrillionsofdollarsin
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 issuing 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 ,,,
cashandassetseverydayanduponwhichconsumersrelyforexample,tousetheir
creditcardsanddebitcards.Atthatpoint,youdontneedtomapoutwhichparticu-
larmechanismitsnotrelevantanymoreitsbecomesystemicandendemicandit
needstobestopped,Palumbosaid.
i
The government responded with two new lending programs on Friday, Septem-
ber 1. Treasury would guarantee the 1 net asset value of eligible money market
funds,forafeepaidbythefunds.
i,
AndtheFedwouldprovideloanstobankstopur-
chase high-quality-asset-backed commercial paper from money market funds.
io
In
itsfrsttwoweeks,thisprogramloanedbanks1,obillion,althoughusagedeclined
overtheensuingmonths.Thetwoprogramsimmediatelyslowedtherunonmoney
marketfunds.
Withthefnancialsectorindisarray,theSECimposedatemporarybanonshort-
sellingonthestocksofabout8oobanks,insurancecompanies,andsecuritiesfrms.
Thisaction,takenonSeptember18,followedanearliertemporarybanputinplace
overthesummeronnakedshort-sellingthatis,shortingastockwithoutarranging
todeliverittothebuyerof1fnancialstocksinordertoprotectthemfromun-
lawfulmanipulation.
Meanwhile,TreasurySecretaryHenryPaulsonandothersenioromcialshadde-
cided they needed a more systematic approach to dealing with troubled frms and
troubledmarkets.PaulsonstartedseekingauthorityfromCongressforTARP.One
,+ ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
thingthatwasconstantaboutthecrisisisthatwewerealwaysbehind.Itwasalways
morphingandmanifestingitselfinwayswedidntexpect,NeelKashkari,thenassis-
tantsecretaryofthetreasury,toldtheFCIC.Soweknewwedgetoneshotatthisau-
thority and it was important that we provided ourselves maximum frepower and
maximum fexibility. We specifcally designed the authority to allow us basically to
dowhateverweneededtodo.Kashkarispentthenexttwoweeksbasicallylivingon
CapitolHill.
i,
Asdiscussedbelow,theprogramwasatoughsell.
MORGAN STANLEY: NOW WE RE THE NEXT IN LINE
Investorsscrutinizedthetworemaininglarge,independentinvestmentbanksafter
thefailureofLehmanandtheannouncedacquisitionofMerrill.EspeciallyMorgan
Stanley. On Monday, September 1,, the annual cost of protecting 1o million in
Morgan Stanley debt through credit default swaps jumped to o8i,ooofrom
o,oooonFridayaboutdoublethecostforGoldman.Assoonaswecomeinon
Monday, were in the eye of the storm with Merrill gone and Lehman gone, John
Mack,thenMorganStanleysCEO,saidtotheFCIC.Helateradded,Nowwerethe
nextinline.
i8
MorganStanleyomcialshadsomereasonforconfdence.OnthepreviousFriday,
the companys liquidity pool was more than 1o billionGoldmans was 1io
billion
i
and, like Goldman, it had passed the regulators liquidity stress tests
months earlier. But the early market indicators were mixed. David Wong, Morgan
Stanleystreasurer,heardearlyfromhisLondonomcethatseveralEuropeanbanks
were not accepting Morgan Stanley as a counterparty on derivatives trades.
o
He
calledthosebanksandtheyagreedtokeeptheirtradeswithMorganStanley,atleast
forthetimebeing.ButWongwellknewthatrumorsaboutderivativescounterpar-
tiesfeeingthroughnovationshadcontributedtothedemiseofBearandLehman.
Repo lenders, primarily money market funds, likewise did not panic immediately.
OnMonday,onlyafewofthemrequestedslightlymorecollateral.
1
But the relative stability was feeting. Morgan Stanley immediately became the
targetofahedgefundrun.Beforethefnancialcrisis,ithadtypicallybeenprimebro-
kers like Morgan Stanley who were worried about their exposures to hedge fund
clients.Nowtheroleswerereversed.TheLehmanepisodehadrevealedthatbecause
primebrokerswereabletoreuseclientsassetstoraisecashfortheirownactivities,
clientsassetscouldbefrozenorlostinbankruptcyproceedings.
i
Toprotectthemselves,hedgefundspulledbillionsofdollarsincashandotheras-
setsoutofMorganStanley,Merrill,andGoldmaninfavorofprimebrokersinbank
holding companies, such as JP Morgan; big foreign banks, such as Deutsche Bank
and Credit Suisse; and custodian banks, such as BNY Mellon and Northern Trust,
whichtheybelievedweresaferandmoretransparent.FundmanagerstoldtheFCIC
thatsomeprimebrokerstookaggressivemeasurestopreventhedgefundcustomers
fromdemandingtheirassets.Forexample,Most[hedgefunds]requestcashmove-
ment from [prime brokers] primarily through a fax, the hedge fund manager
JonathanWoodtoldtheFCIC.Whattendstohappeninverystressfultimesisthose
tii :i : \Ni i\Ni t ,.
faxestendtogetlost.Imnotsurethatsjustcoincidental . . .thatwascollateralfor
whatever lending [prime brokers] had against you and they didnt want to give it
[away].

Soon, hedge funds would suffer unprecedented runs by their own investors. Ac-
cordingtoanFCICsurveyofhedgefundsthatsurvived,investorredemptionrequests
averagedioofclientfundsinthefourthquarterofioo8.

Thispummeledthemar-
kets.Moneyinvestedinhedgefundstotaledi.itrillion,globally,attheendofioo,,
,
butbecauseofleverage,theirmarketimpactwasseveraltimeslarger.Widespreadre-
demptions forced hedge funds to sell extraordinary amounts of assets, further de-
pressingmarketprices.Manyhedgefundswouldhaltredemptionsorcollapse.
On Monday, hedge funds requested about 1o billion from Morgan Stanley.
o
Then,onTuesdaymorning,MorganStanleyannouncedaproftof1.billionforthe
three months ended August 1, ioo8, about the same as that period a year earlier.
Mackhaddecidedtoreleasethegoodnewsadayearly,butthismovehadbackfred.
Onehedgefundmanagersaidtomeafterthefact . . .thathethoughtpreannounc-
ingearningsadayearlywasasignofweakness.SoIguessitwas,becausepeoplecer-
tainly continued to short our stock or sell our stockI dont know if they were
shortingitbuttheywerecertainlysellingit,MacktoldtheFCIC.
,
Wongsaid,We
weremanagingourfunding . . .butreallytherewereotherthingsthatwerehappen-
ingasaresultoftheLehmanbankruptcythatwerebeginningtoaffect,reallyripple
throughandaffectsomeofourclients,ourmoresophisticatedclients.
8
The hedge fund run became a i billion torrent on Wednesday,

the day after

AIGwasbailedoutandthedaythatmanyofoursophisticatedclientsstartedtoliq-
uefy, as Wong put it.
o
Many of the hedge funds now sought to exercise their con-
tractual capability to borrow more from Morgan Stanleys prime brokerage without
needing to post collateral. Morgan Stanley borrowed 1 billion from the Feds
PDCFonTuesday,i,billiononWednesday,and,.billiononFriday.
ThesedevelopmentstriggeredtheeventthatFedpolicymakershadworriedabout
over the summer: an increase in collateral calls by the two tri-party repo clearing
banks,JPMorganandBNYMellon.AshadhappenedduringtheBearepisode,the
two clearing banks became concerned about their intraday exposures to Morgan
Stanley,Merrill,andGoldman.OnSundayoftheLehmanweekend,theFedhadlow-
ered the bar on the collateral that it would take for overnight lending through the
PDCF.ButthePDCFwasnotdesignedtotaketheplaceoftheintraday fundingpro-
videdbyJPMorganandBNYMellon,andneitherofthemwantedtoacceptfortheir
intradayloansthelower-qualitycollateralthattheFedwasacceptingforitsovernight
loans. They would not make those loans to the three investment banks without re-
quiringbiggerhaircuts,whichtranslatedintorequestsformorecollateral.
Bigintradayissuesattheclearingbanks,theSECsMattEichnerinformedNew
YorkFedcolleaguesinanearlyWednesdayemail.Theydontwantexposureandare
askingforcash/securities. . . .Lotsofdesklevelnoisearound[MorganStanley]and
[MerrillLynch]andtakingthename.Notpretty.
1
TakingthenameisWallStreetparlanceforacceptingacounterpartyonatrade.
On Thursday, BNY Mellon requested billion in collateral from Morgan Stanley.
,z ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
AndNewYorkFedomcialsreportedthatJPMorganwasthinkingaboutrequesting
i.8billionontopofai.ibillionondeposit.
i
AccordingtoaFedexamineratCiti-
group, a banker from that frm had said that Morgan [Stanley] is the deer in the
headlightsandhavingsignifcantstressinEurope.ItslookinglikeLehmandidafew
weeksago.

CommercialpapermarketsalsoseizedupforMorganStanley.FromFriday,Sep-
tember1i,totheendofSeptember,theamountofthefrmsoutstandingcommercial
paperhadfallennearlyo,andithadrolledoveronlyiomillion.Bycomparison,
onaverageMorganStanleyrolledoveraboutiomillioneverydayinthelasttwo
weeksofAugust.

On Saturday, Morgan Stanley executives briefed the New York Fed on the situa-
tion.Bythistime,thefrmhadatotalof,.billioninPDCFfundingandi.,bil-
lion in TSLF funding from the Fed.
,
Morgan Stanleys liquidity pool had dropped
from1obillionto,,billioninoneweek.Repolendershadpulledout1billion
andhedgefundshadtaken8obillionoutofMorganStanleysprimebrokerage.That
runhadvastlyexceededthecompanysmostseverescenarioinstresstestsadminis-
teredonlyonemonthearlier.
o
During the week, Goldman Sachs had encountered a similar run. Its liquidity
pool had fallen from about 1io billion on the previous Friday to ,, billion on
Thursday. At the end of the week, its Fed borrowing totaled , billion from the
PDCF and 1., billion from the TSLF. Lloyd Blankfein, Goldmans CEO, told the
FCIC,
We had tremendous liquidity through the period. But there were sys-
temiceventsgoingon,andwewereverynervous.Ifyouareaskingme
whatwouldhavehappenedbutfortheconsiderablegovernmentinter-
vention, I would say we were init was a more nervous position than
wewouldhavewanted[tobe]in.Weneveranticipatedthegovernment
help.Wewerentrelyingonthosemechanisms. . . .Ifeltgoodaboutit,
butweweregoingtobedeverynightwithmoreriskthananyresponsi-
blemanagershouldwanttohave,eitherforourbusinessorforthesys-
temasawholerisk,notcertainty.
,
BernanketoldtheFCICthattheFedbelievedtherunonGoldmanthatweekcould
leadtoitsfailure:[LikeJPMorgan,]GoldmanSachsIwouldsayalsoprotectedthem-
selvesquitewellonthewhole.Theyhadalotofcapital,alotofliquidity.Butbeingin
theinvestmentbankingcategoryratherthanthecommercialbankingcategory,when
thathugefundingcrisishitalltheinvestmentbanks,evenGoldmanSachs,wethought
there was a real chance that they would go under.
8
Although it did not keep pace
withMorganStanleysuseoftheFedsfacilities,GoldmanSachswouldcontinuetoac-
cesstheFedsfacilities,increasingitsPDCFborrowingtoahighofibillioninOc-
toberanditsTSLFborrowingtoahighof.,billioninDecember.
On Sunday, September i1, both Morgan Stanley and Goldman Sachs applied to
theFedtobecomebankholdingcompanies.Inmyo-yearhistory,[Goldmanand
tii :i : \Ni i\Ni t ,,
Morgan Stanley] had consistently opposed Federal Reserve supervision[but after
Lehman,]thosefranchisessawthattheywerenextunlesstheydidsomethingdrastic.
That drastic thing was to become bank holding companies, Tom Baxter, the New
YorkFedsgeneralcounsel,toldtheFCIC.

TheFed,intandemwiththeDepartment
ofJustice,approvedthetwoapplicationswithextraordinaryspeed,waivingthestan-
dard fve-day antitrust waiting period.
,o
Morgan Stanley instantly converted its
billion industrial loan company into a national bank, subject to supervision by the
Omce of the Comptroller of the Currency (OCC), and Goldman converted its io
billionindustrialloancompanyintoastate-charteredbankthatwasamemberofthe
FederalReserveSystem,subjecttosupervisionbytheFedandNewYorkState.The
Fedwouldbegintosupervisethetwonewbankholdingcompanies.
Thetwocompaniesgainedtheimmediatebeneftofemergencyaccesstothedis-
countwindowfortermsofuptoodays.
,1
But,moreimportant,Ithinkthebiggest
beneftisitwouldshowyouthatyoureimportanttothesystemandtheFedwould
notmakeyouaholdingcompanyiftheythoughtinaveryshortperiodoftimeyoud
beoutofbusiness,MacktoldtheFCIC.Itsendsasignalthatthesetwofrmsarego-
ingtosurvive.
,i
In a show of confdence, Warren Buffett invested , billion in Goldman Sachs,
and Mitsubishi UFJ invested billion in Morgan Stanley. Mack said he had been
waiting all weekend for confrmation of Mitsubishis investment when, late Sunday
afternoon,hereceivedacallfromBernanke,Geithner,andPaulson.Basicallythey
said they wanted me to sell the frm, Mack told the FCIC. Less than an hour later,
Mitsubishicalledtoconfrmitsinvestmentandtheregulatorsbackedoff.
,
Despitetheweekendannouncements,however,therunonMorganStanleycon-
tinued.Overthecourseofaweek,adecreasingnumberofpeople[were]willingto
donewrepos,Wongsaid.Theyjustcouldntlendanymore.
,
BytheendofSeptember,MorganStanleysliquiditypoolwouldbe,,billion.
,,
ButMorganStanleysliquiditydependedcriticallyonborrowingfromtwoFedpro-
grams,oobillionfromthePDCFandobillionfromtheTSLF.GoldmanSachss
liquidity pool had recovered to about 8o billion, backed by 1o., billion from the
PDCFand1,billionfromtheTSLF.
OVERTHECOUNTER DERIVATIVES: A GRINDING HALT
Tradingintheover-the-counterderivativesmarketshadbeendecliningasinvestors
grewmoreconcernedaboutcounterpartyriskandashedgefundsandothermarket
participants reduced their positions or exited. Activity in many of these markets
slowedtoacrawl;insomecases,therewasnomarketatallnotradeswhatsoever.A
sharpandunprecedentedcontractionofthemarketoccurred.
,o
TheOTCderivativesmarketscametoagrindinghalt,jeopardizingtheviability
ofeveryparticipantregardlessoftheirdirectexposuretosubprimemortgage-backed
securities,thehedgefundmanagerMichaelMasterstoldtheFCIC.
,,
Furthermore,
when the OTC derivatives markets collapsed, participants reacted by liquidating
theirpositionsinotherassetsthoseswapsweredesignedtohedge.Thismarketwas
,, ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
unregulatedandlargelyopaque,withnopublicreportingrequirementsandlittleor
nopricediscovery.WiththeLehmanbankruptcy,participantsinthemarketbecame
concernedabouttheexposuresandcreditworthinessoftheircounterpartiesandthe
valueoftheircontracts.Thatuncertainlycausedanabruptretreatfromthemarket.
Badlyhitwasthemarketforderivativesbasedonnonprimemortgages.Firmshad
come to rely 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
ioo,hadbeenanearlybellwetherforthemarketcrisis,hadbeentradingaround,
centsonthedollarsinceMay.Buttradingonthisindexhadbecomesothin,falling
fromanaverageofabout,otransactionsperweekfromJanuaryioo,toSeptember
ioo8 to fewer than transactions per week in October ioo8, that index values
werentinformative.
,8
So,whatwasavalidpricefortheseassets:Pricediscoverywas
aguessinggame,evenmorethanithadbeenundernormalmarketconditions.
ThecontractionoftheOTCderivativesmarkethadimplicationsbeyondthevalu-
ation of mortgage securities. Derivatives had been used to manage all manner of
risktheriskthatcurrencyexchangerateswouldfuctuate,theriskthatinterestrates
wouldchange,theriskthatassetpriceswouldmove.Emcientlymanagingtheserisks
inderivativesmarketsrequiredliquiditysothatpositionscouldbeadjusteddailyand
atlittlecost.Butinthefallofioo8,everyonewantedtoreduceexposuretoeveryone
else.Therewasarushfortheexitsasparticipantsworkedtogetoutofexistingtrades.
And because everyone 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-
covery,everyfrmsriskmanagementbecamemoreexpensiveanddimcult.Theusual
hedgingmechanismswereimpaired.Aninvestorthatwantedtotradeatalosstoget
outofalosingpositionmightnotfndabuyer,andthosethatneededhedgeswould
fndthemmoreexpensiveorunavailable.
Several measures revealed the lack of liquidity in derivatives markets. First, the
number of outstanding contracts in a broad range of OTC derivatives sharply de-
clined. Since its deregulation by federal statute in December iooo, this market had
increasedmorethansevenfold.FromJuneo,ioo8totheendoftheyear,however,
outstanding notional amounts of OTC derivatives fell by more than 1o. This de-
clinedefedhistoricalprecedent.Itwasthefrstsignifcantcontractioninthemarket
overasix-monthperiodsincetheBankforInternationalSettlementsbegankeeping
statisticsin18.
,
Moreover,itoccurredduringaperiodofgreatvolatilityinthef-
nancialmarkets.Atsuchatime,frmsusuallyturntothederivativesmarkettohedge
theirincreasedrisksbutnowtheyfedthemarket.
Thelackofliquidityinderivativesmarketswasalsosignaledbythehigherprices
charged by OTC derivatives dealers to enter into contracts. Dealers bear additional
risks when markets are illiquid, and they pass the cost of those risks on to market
participants.Thecostisevidentintheincreasedbid-askspreadthedifferencebe-
tweenthepriceatwhichdealerswerewillingtobuycontracts(thebidprice)andthe
priceatwhichtheywerewillingtosellthem(theaskprice).Asmarketsbecameless
tii :i : \Ni i\Ni t ,,
liquid during the crisis, dealers worried that they might be saddled with unwanted
exposure. As a result, they began charging more to sell contracts (raising their ask
price), and the spread rose. In addition, they offered less to buy contracts (lowered
their bid price), because they feared involvement with uncreditworthy 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,outstandingcreditderivativescontractedby8betweenDecember
ioo,, when they reached their height of ,8.i trillion in notional amount, and the
latestfguresasofJuneio1o,whentheyhadfallentoo.trillion.
oo
In sum, the sharp contraction in the OTC derivatives market in the fall of ioo8
greatlydiminishedtheabilityofinstitutionstoenterorunwindtheircontractsorto
effectivelyhedgetheirbusinessrisksatatimewhenuncertaintyinthefnancialsys-
temmaderiskmanagementatoppriority.
WASHINGTON MUTUAL: IT S YOURS
In the eight days after Lehmans bankruptcy, depositors pulled 1o., billion out of
WashingtonMutual,whichnowfacedimminentcollapse.WaMuhadbeenthesubject
ofconcernforsometimebecauseofitspoormortgage-underwritingstandardsandits
exposurestopayment-optionadjustable-ratemortgages(ARMs).Moodyshaddown-
gradedWaMusseniorunsecureddebttoBaa,thelowest-tierinvestment-graderat-
ing, in July, and then to junk status on September 11, citing WAMUs reduced
fnancialfexibility,deterioratingassetquality,andexpectedfranchiseerosion.
o1
TheOmceofThriftSupervision(OTS)determinedthatthethriftlikelycouldnot
payitsobligationsandmeetitsoperatingliquidityneeds.
oi
Thegovernmentseized
thebankonThursday,Septemberi,,ioo8,appointingtheFederalDepositInsurance
Corporationasreceiver;manyunsecuredcreditorssufferedlosses.Withassetsofo,
billionasofJuneo,ioo8,WaMuthusbecamethelargestinsureddepositoryinstitu-
tioninU.S.historytofailbiggerthanIndyMac,biggerthananybankorthriftfailure
inthe18osand1os.JPMorganpaid1.billiontoacquireWaMusbankingoper-
ationsfromtheFDIConthesameday;onthenextday,WaMusparentcompany(now
minusthethrift)fledforChapter11bankruptcyprotection.
FDIComcialstoldtheFCICthattheyhadknowninadvanceofWaMustroublesand
thushadtimetoarrangethetransactionwithJPMorgan.JPMorganCEOJamieDimon
saidthathisbankwasalreadyexaminingWaMusassetsforpurchasewhenFDICChair-
man Sheila Bair called him and asked, Would you be prepared to bid on WaMu: I
saidyeswewould,DimontoldtheFCIC.Shecalledmeupliterallythenextdayand
saidIts yours. . . . I thought there was another bidder, by the way, the whole time,
otherwiseIwouldhavebidadollarnot[1.billion],butwewantedtowin.
o
TheFDICinsurancefundcameoutoftheWaMubankruptcywhole.Sodidthe
uninsured depositors, and (of course) the insured depositors. But the FDIC never
contemplatedusingFDICfundstoprotectunsecuredcreditors,whichitcouldhave
donebyinvokingthesystemicriskexceptionundertheFDICImprovementActof
, ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
11.(RecallthatFDICIArequiredthatfailingbanksbedismantledattheleastcost
totheFDICunlesstheFDIC,theFed,andTreasuryagreethataparticularcompanys
collapseposesarisktotheentirefnancialsystem;ithadnotbeentestedin1,years.)
Lossesamongthosecreditorscreatedpanicamongtheunsecuredcreditorsofother
struggling banks, particularly Wachoviawith serious consequences. Nevertheless,
FDICChairmanBairstoodbehindthedecision.Iabsolutelydothinkthatwasthe
rightdecision,shetoldtheFCIC.WaMuwasnotawell-runinstitution.Shechar-
acterizedtheresolutionofWaMuassuccessful.
o
TheFDICsdecisionwouldbehotlydebated.FedGeneralCounselScottAlvarez
toldtheFCICthatheagreedwithBairthatthereshouldnothavebeenintervention
inWaMu.
o,
ButTreasuryomcialsfeltdifferently:Weweresayingthatsgreat,wecan
all be tough, and we can be so tough that we plunge the fnancial system into the
Great Depression, Treasurys Neel Kashkari told the FCIC. And so, I think, in my
judgmentthatwasamistake. . . .[A]tthattime,theeconomywasinsuchaperilous
state,itwaslikeplayingwithfre.
oo
WACHOVIA: AT THE FRONT END OF
THE DOMINOES AS OTHER DOMINOES FELL
Wachovia, having bought Golden West, was the largest holder of payment-option
ARMs,thesameproductthathadhelpedbringdownWaMuandCountrywide.Con-
cerns about Wachoviathen the fourth-largest bank holding companyhad also
been escalating for some time. On September , the Merrill analyst Ed Najarian
downgradedthecompanysstocktounderperform,pointingtoweaknessinitsop-
tion ARM and commercial loan portfolios. On September 11, Wachovia executives
metFedomcialstoaskforanexemptionfromrulesthatlimitedholdingcompanies
useofinsureddepositstomeettheirliquidityneeds.TheFeddidnotaccede;staffbe-
lieved that Wachovias cash position was strong and that the requested relief was a
wantratherthananeed.
o,
ButtheychangedtheirmindsaftertheLehmanbankruptcy,immediatelylaunch-
ingdailyconferencecallstodiscussliquiditywithWachoviamanagement.Depositor
outfows increased. On September 1, the Fed supported the companys request to
useinsureddepositstoprovideliquiditytotheholdingcompany.OnSeptemberio,a
Saturday, Wells Fargo Chairman Richard M. Kovacevich told Robert Steel, Wa-
choviasCEOandrecentlyaTreasuryundersecretary,thatWellsmightbeinterested
in acquiring the besieged bank, and the two agreed to speak later in the week. The
sameday,FedGovernorKevinWarshsuggestedthatSteelalsotalktoGoldman.Asa
formervicechairmanofGoldman,Steelcouldeasilyapproachthefrm,buttheensu-
ingconversationswereshort;Goldmanwasnotinterested.
o8
Throughout the following week, it became increasingly clear that Wachovia
neededtomergewithastrongerfnancialinstitution.Then,WaMusfailureonSep-
temberi,raisedcreditorconcernaboutthehealthofWachovia,theFedsAlvarez
toldtheFCIC.ThedayafterthefailureofWaMu,WachoviaBankdepositorsacceler-
atedthewithdrawalofsignifcantamountsfromtheiraccounts,Alvarezsaid.Inad-
tii :i : \Ni i\Ni t ,,
dition, wholesale funds providers withdrew liquidity support from Wachovia. It ap-
pearedlikelythatWachoviawouldsoonbecomeunabletofunditsoperations.
o
Steel
said, As the day progressed, some liquidity pressure intensifed as fnancial institu-
tionsbegandecliningtoconductnormalfnancingtransactionswithWachovia.
,o
David Wilson, the Omce of the Comptroller of the Currencys lead examiner at
Wachovia,agreed.ThewholeworldchangedforWachoviaafterWaMusfailure,he
said.
,1
TheFDICsBairhadaslightlydifferentview.WaMusfailurewaspracticallya
nonevent, she told the FCIC. It was below the fold if it was even on the front
page . . .barelyablipgiveneverythingelsethatwasgoingon.
,i
TherunonWachoviaBank,thecountrysfourth-largestcommercialbank,wasa
silentrunbyuninsureddepositorsandunsecuredcreditorssittinginfrontoftheir
computers,ratherthanbydepositorsstandinginlinesoutsidebankdoors.
,
Bynoon
on Friday, September io, creditors were refusing to roll over the banks short-term
funding, including commercial paper and brokered certifcates of deposit.
,
The
FDICsJohnCorstontestifedthatWachovialost,.,billionofdepositsand1.1bil-
lionofcommercialpaperandreposthatday.
,,
BytheendofthedayonFriday,WachoviatoldtheFedthatworriedcreditorshad
askedittorepayroughlyhalfofitslong-termdebt,obilliontooobillion.
,o
Wa-
choviadidnothavetopayallthesefundsfromacontractualbasis(theyhadnotma-
tured),butwouldhavedimculty[borrowingfromtheselenders]goingforwardgiven
thereluctancetorepayearly,RichardWesterkamp,theRichmondFedsleadexam-
ineratWachovia,toldtheFCIC.
,,
Inoneday,thevalueofWachovias1o-yearbondsfellfrom,centstoicentson
thedollar,andthecostofbuyingprotectionon1omillionofWachoviadebtjumped
from,,1,oootoalmost1,oo,oooannually.Wachoviasstockfelli,,wipingout
8billioninmarketvalue.ComptrolleroftheCurrencyJohnDugan,whoseagency
regulatedWachoviascommercialbanksubsidiary,sentFDICChairmanBairashort
andalarmingemailstatingthatWachoviasliquiditywasunstable.
,8
Wachoviawasat
thefrontendofthedominoesasotherdominoesfell,SteeltoldtheFCIC.
,
Government omcials were not prepared to let Wachovia open for business on
Monday,Septemberi,withoutadealinplace.
8o
Marketswerealreadyundercon-
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 already expressed interest in buying Wachovia; by Friday, Citi-
grouphadaswell.Wachoviaenteredintoconfdentialityagreementswithbothcom-
panies on Friday and the two suitors immediately began their due diligence
investigations.
8i
ThekeyquestionwaswhethertheFDICwouldprovideassistanceinanacquisi-
tion.ThoughCitigroupneverconsideredmakingabidthatdidnotpresupposesuch
assistance,WellsFargowasinitiallyinterestedinpurchasingallofWachoviawithout
it.
8
FDICassistancewouldrequirethefrst-everapplicationofthesystemicriskex-
ceptionunderFDICIA.Overtheweekend,federalomcialshurriedlyconsideredthe
, ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
systemicrisksiftheFDICdidnotinterveneandifcreditorsanduninsureddeposi-
torssufferedlosses.
The signs for the bank were discouraging. Given the recent withdrawals, the
FDICandOCCpredictedinaninternalanalysisthatWachoviacouldfaceupto11,
billionofadditionalcashoutfowsthefollowingweekincluding,mostprominently,
ibillionoffurtherdepositoutfows,aswellas1ibillionfromcorporatedeposit
accountsandobillionfromretailbrokeragecustomers.YetWachoviahadonly1,
billion in cash and cash equivalents. While the FDIC and OCC estimated that the
company 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 only 1o billion to cover the potential
11,billionoutfow.
8
Duringtheweekend,theFedarguedthatWachoviashouldbesaved,withFDIC
assistance if necessary. Its analysis focused on the frms counterparties and other
interdependencies with large market participants, and stated that asset sales by
mutual funds could cause short-term funding markets to virtually shut down.
8,
AccordingtosupportinganalysisbytheRichmondFed,mutualfundsheldoobil-
lion of Wachovia debt, which Richmond Fed staff concluded represented signif-
cantsystemicconsequences;andinvestmentbanks,alreadyweakandexposedto
lowlevelsofconfdence,ownedbillionofWachovias11billiondebtandde-
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,higherunemployment,andre-
ducedwealth.
8,
SecretaryPaulsonhadrecusedhimselffromthedecisionbecauseof
his ties to Steel, but other members of Treasury had vigorously advocated saving
Wachovia.
88
WhiteHouseChiefofStaffJoshBoltencalledBaironSundaytoexpress
supportforthesystemicriskexception.
8
Atabouto:ooP.M.onSunday,Septemberi8,WellssKovacevichtoldSteelthathe
wantedmoretimetoreviewWachoviasassets,particularlyitscommercialrealestate
holdings,andcouldnotmakeabidbeforeMondayifthereweretobenoFDICassis-
tance.SoWellsandCitigroupcametothetablewithproposalspredicatedonsuchas-
sistance.Wellsofferedtocoverthefrstibillionoflossesonapoolof1i,billion
worth of assets as well as 8o of subsequent losses, if they grew large enough, cap-
pingtheFDICslossesatiobillion.CitigroupwantedtheFDICtocoverlossesona
different,andlarger,poolof1ibillionworthofassets,butproposedtocoverthe
frstobillionoflossesandanadditionalbillionayearforthreeyears,whilegiv-
ingtheFDIC1ibillioninWachoviapreferredstockandstockwarrants(rightsto
buystockatapredeterminedprice)ascompensation;theFDICwouldcoveranyad-
ditionallossesaboveibillion.
o
FDICstaffexpectedWachoviaslossestobebetween,billionand,ibillion.
Onthebasisofthatanalysisandtheparticularsoftheoffers,theyestimatedthatthe
tii :i : \Ni i\Ni t ,,
Wells proposal would cost the FDIC between ,.o billion and ,.i billion, whereas
theCitigroupproposalwouldcosttheFDICnothing.LateSunday,Wachoviasubmit-
teditsownproposal,underwhichtheFDICwouldprovideassistancedirectlytothe
banksothatitcouldsurviveasastand-aloneentity.
1
But the FDIC still hadnt decided to support the systemic risk exception. Its
boardwhichincludedtheheadsoftheOCCandOTSmetato:ooA.M.onMon-
day,Septemberi,todecideWachoviasfatebeforethemarketsopened.
i
FDICAs-
sociate Director Miguel Browne hewed closely to the analysis prepared by the
RichmondFed:Wachoviasfailurecarriedtheriskofknockingdowntoomanydomi-
noes in lines stretching in too many directions whose fall would hurt too many
people,includingAmericantaxpayers.Healsoraisedconcernsaboutpotentialglobal
implicationsandreducedconfdenceinthedollar.Bairremainedreluctanttointer-
vene in private fnancial markets but ultimately agreed. Well, I think this is, you
know . . . one option of a lot of not-very-good options, she said at the meeting. I
haveacquiescedinthatdecisionbasedontheinputofmycolleagues,andthefactthe
statutegivesmultipledecisionmakersasayinthisprocess.Imnotcompletelycom-
fortablewithitbutweneedtomoveforwardwithsomething,clearly,becausethisin-
stitutionisinatenuoussituation.

TowintheapprovalofBairandJohnReich(theOTSdirectorwhoservedonthe
FDICboard),Treasuryultimatelyagreedtotaketheunusualstepoffundingallgov-
ernment losses from the proposed transaction.

Without this express commitment

from Treasury, the FDIC would have been the frst to bear losses out of its Deposit
Insurance Fund, which then held about .o billion; normally, help would have
comefromTreasuryonlyafterthatfundwasdepleted.
,
Accordingtotheminutesof
the meeting, Bair thought it was especially important that Treasury agree to fund
losses,giventhatithasvigorouslyadvocatedthetransaction.
o
After just o minutes, the FDIC board voted to support government assistance.
Theresolutionalsoidentifedthewinningbidder:Citigroup.Itwasthefogofwar,
Bair told the FCIC. The system was highly unstable. Who was going to take the
chancethatWachoviawouldhaveadepositoryrunonMonday:
,
Wachovias board quickly voted to accept Citigroups bid. Wachovia, Citigroup,
and the FDIC signed an agreement in principle and Wachovia and Citigroup exe-
cutedanexclusivityagreementthatprohibitedWachoviafrom,amongotherthings,
negotiatingwithotherpotentialacquirers.
8
Inthemidstofthemarketturmoil,theFederalOpenMarketCommitteemetat
theendofSeptemberioo8,ataboutthetimeoftheannouncedCitigroupacquisition
ofWachoviaandtheinvocationofthesystemicriskexception.Theplannedmerger
of two very large institutions led to some concern among FOMC participants that
biggerandbiggerfrmswerebeingcreatedthatwouldbetoobigtofail,accordinga
letterfromChairmanBernanketotheFCIC.Headdedthathesharedthisconcern,
andvoicedmyhopethatTARPwouldcreateoptionsotherthanmergersformanag-
ingproblemsatlargeinstitutionsandthatsubsequently,throughtheprocessofregu-
latoryreform,wemightdevelopgoodresolutionmechanismsanddecisivelyaddress
theissuesoffnancialconcentrationandtoobigtofail.

,,+ ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1

Citigroup and Wachovia immediately began working on the dealeven as Wa-
choviasstockfell81.oto1.8onSeptemberi,thedaythatTARPwasinitiallyre-
jected by lawmakers. They faced tremendous pressure from the regulators and the
markets to conclude the transaction before the following Monday, but the deal was
complicated: Citigroup was not acquiring the holding company, just the bank, and
Citigroup wanted to change some of the original terms. Then came a surprise: on
Thursdaymorning,Octoberi,WellsFargoreturnedtothetableandmadeacompet-
ing bid to buy 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,particularlygivenIRSNoticeioo8-8.Thisadministrativeruling,issuedjust
twodaysearlier,allowedanacquiringcompanytowriteoffthelossesofanacquired
companyimmediately,ratherthanspreadingthemovertime. WellstoldtheSECthat
theIRSrulingpermittedthebanktoreducetaxableincomebybillioninthefrst
yearfollowingtheacquisitionratherthanby1billionperyearforthreeyears.How-
ever,WellssaidthiswasitselfnotamajorfactorinitsdecisiontobidforWachovia
withoutdirectgovernmentassistance.
1oo
FormerWellschairmanKovacevichtoldthe
FCIC that Wellss revised bid refected additional due diligence, the point he had
madetoWachoviaCEOSteelatthetime.
1o1
ButtheFDICsBairsaidKovacevichtold
heratthetimethatthetaxchangehadbeenafactorleadingtoWellssrevisedbid.
1oi
OnThursday,Octoberi,threedaysafteracceptingCitigroupsfederallyassisted
offer,Wachoviasboardconvenedanemergency11:ooP.M.sessiontodiscussWellss
revisedbid.TheWachoviaboardvotedunanimouslyinfavor.
Atabout:ooA.M.Friday,WachoviasSteel,itsGeneralCounselJaneSherburne,
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 already 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
standinthewayofaprivatedeal.NorwasittheroleoftheagencytohelpCitigroup
inabiddingwar.ShealsotoldtheFCICthatshehadconcernsaboutCitigroupsown
viabilityifitacquiredWachoviaforthatprice.Inreality,wedidntknowhowunsta-
bleCitigroupwasatthatpoint,ChairmanBairsaid.Hereweweresellingatroubled
institution . . .withatroubledmortgageportfoliotoanothertroubledinstitution. . . .
Ithinkifthatdealhadgonethrough,Citigroupwouldhavehadtohavebeenbailed
outagain.
1o
LaterFridaymorning,WachoviaannouncedthedealwithWellswiththeblessing
oftheFDIC.ThisagreementwontrequireevenapennyfromtheFDIC,Kovacevich
saidinthepressrelease.SteeladdedthatthedealenablesustokeepWachoviaintact
andpreservethevalueofanintegratedcompany,withoutgovernmentsupport.
1o,
OnMonday,Octobero,CitigroupfledsuittoenjoinWellsFargosacquisitionof
tii :i : \Ni i\Ni t ,,.
Wachovia,butwithoutsuccess.TheWellsFargodealwouldcloseatmidnightonDe-
cember1,for,pershare.
IRSNoticeioo8-8wasrepealedinioo.TheTreasurysinspectorgeneral,who
later conducted an investigation of the circumstances of its issuance, reported that
thepurposeofthenoticewastoencouragestrongbankstoacquireweakbanksbyre-
moving limitations on the use of tax losses. The inspector general concluded that
therewasalegitimateargumentthatthenoticemayhavebeenanimproperchangeof
thetaxcodebyTreasury;theConstitutionallowsCongressalonetochangethetax
code.Acongressionalreportestimatedthatrepealingthenoticesavedabout,bil-
lionoftaxrevenuesover1oyears.
1oo
However,theWellscontroller,RichardLevy,told
theFCICthattodateWellshasnotrecognizedanybeneftsfromthenotice,because
ithasnotyethadtaxableincometooffset.
1o,
TARP: COMPREHENSIVE APPROACH
TendaysaftertheLehmanbankruptcy,theFedhadprovidednearlyoobillionto
investmentbanksandcommercialbanksthroughthePDCFandTSLFlendingfacili-
ties,inanattempttoquellthestormsintherepomarkets,andtheFedandTreasury
had announced unprecedented programs to support money market funds. By the
endofSeptember,theFedsbalancesheethadgrowno,to1.,trillion.
ButtheFedwasrunningoutofoptions.Intheend,itcouldonlymakecollateral-
ized loans to provide liquidity support. It could not replenish fnancial institutions
capital,whichwasquicklydissolving.Uncertaintyaboutfuturelossesonbadassets
made it dimcult for investors to determine which institutions could survive, even
with all the Feds new backstops. In short, the fnancial system was slipping away
fromitslenderoflastresort.
OnThursday,September18,theFedandTreasuryproposedwhatSecretaryPaul-
son called a comprehensive approach to stem the mounting crisis in the fnancial
system by purchasing the toxic mortgage-related assets that were weighing down
manybanksbalancesheets.
1o8
IntheearlyhoursofSaturday,Septemberio,asGold-
manSachsandMorganStanleywerepreparingtobecomebankholdingcompanies,
Treasury sent Congress a draft proposal of the legislation for TARP. The modest
lengthofthatdocumentjustthreepagesbelieditshistoricalsignifcance.Itwould
giveTreasurytheauthoritytospendasmuchas,oobilliontopurchasetoxicassets
fromfnancialinstitutions.
Theinitialreactionwasnotpromising.Forexample,SenateBankingCommittee
Chairman Christopher Dodd said on Tuesday, This proposal is stunning and un-
precedentedinitsscopeandlackofdetail,Imightadd.Thereareveryfewdetails
inthislegislation,RankingMemberRichardShelbysaid.Ratherthanestablishinga
comprehensive, workable plan for resolving this crisis, I believe this legislation
merelycodifesTreasurysadhocapproach.
1o
Paulson told a Senate committee on Tuesday, Of course, we all believe that the
very best thing we can do is make sure that the capital markets are open and that
,,z ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
lendersarecontinuingtolend.Andsothatiswhatthisoverallprogramdoes,itdeals
withthat.
11o
BernanketoldtheJointEconomicCommitteeWednesday:Ithinkthat
this is the most signifcant fnancial crisis in the post-War period for the United
States,andithasinfactaglobalreach. . . .Ithinkitisextraordinarilyimportantto
understand that, as we have seen in many previous examples of different countries
and different times, choking up of credit is like taking the lifeblood away from the
economy.
111
He told the House Financial Services Committee on the same day,
People are saying, Wall Street, what does it have to do with me: That is the way
they are thinking about it. Unfortunately, it has a lot to do with them. It will affect
their company, it will affect their job, it will affect their economy. That affects their
ownlives,affectstheirabilitytoborrowandtosaveandtosaveforretirementandso
on.
11i
BytheeveningofSunday,Septemberi8,asbankersandregulatorshammered
outWachoviasrescue,congressionalnegotiatorshadagreedontheoutlinesofadeal.
SenatorMelMartinez,aformerHUDsecretaryandthenamemberoftheBank-
ing Committee, told the FCIC about a meeting with Paulson and Bernanke that
Sunday:
Ijustrememberthinking,youknow,Armageddon.Thethingthatwas
themostfrighteningaboutitisthatevenwiththemaskingforextraor-
dinarypowers,thattheywerenotatallassuredthattheycouldprevent
the kind of fnancial disaster that I think really was greater than the
GreatDepression. . . .AndobviouslytoapersonlikemyselfIthinkyou
think,Wow,iftheseguysthatareinthemiddleofitandholdthetitles
thattheyholdbelievethistobeasdarkastheyrepaintingit,itmustbe
prettydarneddark.
11
Nevertheless, on Monday, September i, just hours after Citigroup had an-
nounced its proposed government-assisted acquisition of Wachovia, the House re-
jectedTARPbyavoteofii8toio,.Themarketsresponsewasimmediate:theDow
JonesIndustrialAveragequicklyplunged,,8points,oralmost,.
Tobroadenthebillsappeal,TARPssupportersmadechanges,includingatempo-
rary increase in the cap on FDICs deposit insurance coverage from 1oo,ooo to
i,o,ooopercustomeraccount.
11
OnWednesdayevening,theSenatevotedinfavor
by a margin of , to i,. On Friday, October , the House agreed, io to 1,1, and
President George W. Bush signed the law, which had grown to 1o pages. TARPs
statedgoalwastorestoreliquidityandconfdenceinfnancialmarketsbyproviding
authorityfortheFederalGovernmenttopurchaseandinsurecertaintypesoftrou-
bledassetsforthepurposesofprovidingstabilitytoandpreventingdisruptioninthe
economyandfnancialsystemandprotectingtaxpayers.
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.OnMonday,Octobero,theDowclosed
below1o,oooforthefrsttimeinfouryears;bytheendoftheweekitwasdownal-
tii :i : \Ni i\Ni t ,,,
most1,oopoints,or18,belowitspeakinOctoberioo,.Thespreadbetweenthe
interestrateatwhichbankslendtooneanotherandinterestratesonTreasuriesa
closelywatchedindicatorofmarketconfdencehitanall-timehigh.Andthedollar
value of outstanding commercial paper issued by both fnancial and nonfnancial
companies had fallen by io 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 ,,
theFedcreatedyetanotheremergencyprogram,theCommercialPaperFundingFa-
cility,topurchasesecuredandunsecuredcommercialpaperdirectlyfromeligibleis-
suers.
11o
Thisprogram,whichallowedfrmstorollovertheirdebt,wouldbewidely
used by fnancial and nonfnancial frms. The three fnancial frms that made the
greatestuseoftheprogramwereforeigninstitutions:UBS(whichborrowedacumu-
lative ,i billion over time), Dexia (, billion), and Barclays (8 billion). Other
fnancialfrmsincludedGECapital(1obillion),PrudentialFunding(i.billion),
andToyotaMotorCreditCorporation(.obillion).Nonfnancialfrmsthatpartici-
pated included Verizon (1., billion), Harley-Davidson (i. billion), McDonalds,
(iomillion)andGeorgiaTransmission(1omillion).
11,
Treasury was already rethinking TARP. The best way to structure the program
wasnotobvious.Whichtoxicassetswouldqualify:Howwouldthegovernmentde-
terminefairpricesinanilliquidmarket:Wouldfrmsholdingtheseassetsagreeto
sellthematafairpriceifdoingsowouldrequirethemtorealizelosses:Howcould
the government avoid overpaying: Such problems would take time to solve, and
Treasurywantedtobringstabilitytothedeterioratingmarketsasquicklyaspossible.
The key concern for markets and regulators was that they werent sure they un-
derstoodtheextentoftoxicassetsonthebalancesheetsoffnancialinstitutionsso
they couldnt be sure which banks were really solvent. The quickest reassurance,
then, would be to simply recapitalize the fnancial sector. The change was allowed
undertheTARPlegislation,whichstatedthatTreasury,inconsultationwiththeFed,
could purchase fnancial instruments, including stock, if they deemed such pur-
chases necessary to promote fnancial market stability. However, the new proposal
wouldposeahostofnewproblems.Byinjectingcapitalinthesefrms,thegovern-
mentwouldbecomeamajorshareholderintheprivatefnancialsector.
OnSunday,October1i,afteragreeingtothetermsofthecapitalinjections,Paul-
son,Bernanke,Bair,Dugan,andGeithnerselectedasmallgroupofmajorfnancial
institutionstowhichtheywouldimmediatelyoffercapital:thefourlargestcommer-
cial bank holding companies (Bank of America, Citigroup, JP Morgan, and Wells),
the three remaining large investment banks (Goldman and Morgan Stanley, which
werenowbankholdingcompanies,andMerrill,whichBankofAmericahadagreed
toacquire),andtwoimportantclearingandsettlementbanks(BNYMellonandState
Street). Together, these nine institutions held more than 11 trillion in assets, or
about,,ofallassetsinU.S.banks.
PaulsonsummonedthefrmschiefexecutivestoWashingtononColumbusDay,
October1.
118
AlongwithBernanke,Bair,Dugan,andGeithner,Paulsonexplained
thatTreasuryhadsetasidei,obillionfromTARPtopurchaseequityinfnancial
,,, ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
institutionsunderthenewlyformedCapitalPurchaseProgram(CPP).Specifcally,
Treasury would purchase senior preferred stock that would pay a , dividend for
thefrstfveyears;theratewouldrisetothereaftertoencouragethecompanies
topaythegovernmentback.FirmswouldalsohavetoissuestockwarrantstoTreas-
uryandagreetoabidebycertainstandardsforexecutivecompensationandcorpo-
rategovernance.
Theregulatorshadalreadydecidedtoallocatehalfofthesefundstotheninefrms
assembledthatday:i,billioneachtoCitigroup,JPMorgan,andWells;1,billion
to Bank of America; 1o billion each to Merrill, Morgan Stanley, and Goldman;
billiontoBNYMellon;andibilliontoStateStreet.
Wedidntwantittolookorbelikeanationalizationofthebankingsector,Paul-
sontoldtheFCIC.Forthatreason,thecapitalinjectionstooktheformofnonvoting
stock, and the terms were intended to be attractive.
11
Paulson emphasized the im-
portanceofthebanksparticipationtoprovideconfdencetothesystem.Hetoldthe
CEOs:Ifyoudonttake[thecapital]andsometimelateryourregulatortellsyouthat
youareundercapitalized . . .youmaynotlikethetermsifyouhavetocomebackto
me.
1io
Allninefrmstookthedeal.Theymadeacoherent,Ithought,acogentargu-
ment about responding to this crisis, which, remember, was getting dramatically
worse.Itwasntleadingtoarunonsomeofthebanksbutitwasgettingworseinthe
marketplace,JPMorgansDimontoldtheFCIC.
1i1
To further reassure markets that it would not allow the largest fnancial institu-
tionstofail,thegovernmentalsoannouncedtwonewFDICprogramsthenextday.
ThefrsttemporarilyguaranteedcertainseniordebtforallFDIC-insuredinstitutions
and some holding companies. This program was used broadly. For example, Gold-
manSachshadiobillionindebtbackedbytheFDICoutstandinginJanuaryioo,
and i1 billion at the end of ioo, according to public flings; Morgan Stanley had
1obillionattheendofioo8andibillionattheendofioo.GECapital,oneof
theheaviestusersoftheprogram,had,billionofFDIC-backeddebtoutstanding
at the end of ioo8 and oo billion at the end of ioo. Citigroup had i billion of
FDIC guaranteed debt outstanding at the end of ioo8 and o, billion at the end of
ioo;JPMorganChasehadi1billionoutstandingattheendofioo8and1billion
attheendofioo.
Thesecondprovideddepositinsurancetocertainnon-interest-bearingdeposits,
likecheckingaccounts,atallinsureddepositoryinstitution.
1ii
Becauseoftheriskto
taxpayers, the measures required the Fed, the FDIC, and Treasury to declare a sys-
temicriskexceptionunderFDICIA,astheyhaddonetwoweeksearliertofacilitate
CitigroupsbidforWachovia.
Later in the week, Treasury opened TARP to qualifying healthy and viable
banks,thrifts,andholdingcompanies,underthesametermsthatthefrstninefrms
had received.
1i
The appropriate federal regulatorthe Fed, FDIC, OCC, or OTS
wouldreviewapplicationsandpassthemtoTreasuryforfnalapproval.Theprogram
wasintendednotonlytorestoreconfdenceinthebankingsystembutalsotoprovide
banks with sumcient capital to fulfll their responsibilities in the areas of lending,
dividendandcompensationpolicies,andforeclosuremitigation.
1i
tii :i : \Ni i\Ni t ,,,
Thewholereasonfordesigningtheprogramwassomanybankswouldtakeit,
wouldhavethecapital,andthatwouldleadtolending.Thatwasthewholepurpose,
PaulsontoldtheFCIC.However,therewerenospecifcrequirementsforthosebanks
to make loans to businesses and households. Right after we announced it we had
criticsstartsaying,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 ability to pay divi-
dends to shareholders. Over time, these provisions would become more stringent,
and the following year, in compliance with another measure in the act that created
TARP, Treasury would create the Omce of the Special Master for TARP Executive
Compensation to review the appropriateness of compensation packages among
TARPrecipients.
Treasuryinvestedabout188billioninfnancialinstitutionsunderTARPsCapi-
talPurchaseProgrambytheendofioo8;ultimately,itwouldinvestio,billionin
,o,fnancialinstitutions.
1io
Intheensuingmonths,TreasurywouldprovidemuchofTARPsremaining,o
billiontospecifcfnancialinstitutions,includingAIG(obillionplusaobillion
lending facility), Citigroup (io billion plus loss guarantees), and Bank of America
(io billion). On December 1, it established the Automotive Industry Financing
Program,underwhichitultimatelyinvested81billionofTARPfundstomakein-
vestments in and loans to automobile manufacturers and auto fnance companies,
specifcallyGeneralMotors,GMAC,Chrysler,andChryslerFinancial.
1i,
OnJanuary
1i,ioo,PresidentBushnotifedCongressthatheintendednottoaccessthesecond
halfofthe,oobillioninTARPfunds,sothathemightensurethatsuchfundsare
availableearlyforthenewadministration.
1i8
AsofSeptemberio1otwoyearsafterTARPscreationTreasuryhadallocated
,billionofthe,oobillionauthorized.Ofthatamount,iobillionhadbeenre-
paid, 18, billion remained outstanding, and . billion in losses had been in-
curred.
1i
About ,, billion of the outstanding funds were in the Capital Purchase
Program.TreasurystillheldlargestakesinGM(o1ofcommonstock),AllyFinan-
cial(formerlyknownasGMAC;,o),andChrysler().Moreover,,.,billionof
TARPfundsremainedinvestedinAIGinadditionto.,billionofloansfromthe
NewYorkFedandaiobillionnon-TARPequityinvestmentbytheNewYorkFedin
twoofAIGsforeigninsurancecompanies.
1o
ByDecemberio1o,allninecompanies
invitedtotheinitialColumbusDaymeetinghadfullyrepaidthegovernment.
11
Ofcourse,TARPwasonlyoneofmorethantwodozenemergencyprogramsto-
talingtrillionsofdollarsputinplaceduringthecrisistostabilizethefnancialsystem
andtorescuespecifcfrms.Indeed,TARPwasnoteventhelargest.
1i
Manyofthese
programs are discussed in this and previous chapters. For just some examples: The
FedsTSLFandPDCFprogramspeakedat8billionand1,obillion,respectively.
Itsmoneymarketfundingpeakedat,obillioninJanuaryioo,anditsCommer-
cial Paper Funding Facility peaked at o, billion, also in January ioo.
1
When it
was introduced, the FDICs program to guarantee senior debt for all FDIC-insured
,, ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
institutionsstoodreadytobackstopasmuchasbillioninbankdebt.TheFeds
largest program, announced in November ioo8, purchased 1.i, trillion in agency
mortgagebackedsecurities.
1
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 payments in September
andOctoberofibillionthattheFedloanhadenabled;anditstillneededi,bil-
liontopaycreditdefaultswap(CDS)counterparties,despiteearlierpaymentsof,
billion.
OnNovember1o,thegovernmentannouncedthatitwasrestructuringtheNew
YorkFedloanand,intheprocess,TreasurywouldpurchaseobillioninAIGpre-
ferredstock.AswasdoneintheCapitalPurchaseProgram,inreturnfortheequity
provided, Treasury received stock warrants from AIG and imposed restrictions on
dividendsandexecutivecompensation.
That day, 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,theNewYorkFedloanedMaidenLaneII1.8bil-
lion so that it could purchase mortgage-backed securities from AIGs life insurance
company subsidiaries. This enabled those subsidiaries to pay back their securities-
lendingcounterparties,bringingto.,billionthetotalpaymentsAIGwouldmake
withgovernmenthelp.Thesepaymentsarelistedinfgureio..
1,
MaidenLaneIIIwascreatedwithai.billionloanfromtheNewYorkFedand
anAIGinvestmentof,billion,supportedbytheTreasuryinvestment.Thatmoney
went to buy CDOs from 1o of AIG Financial Products CDS counterparties. The
CDOshadafacevalueofoi.1billion,whichAIGFinancialProductshadguaran-
teedthroughitsCDS.
1o
BecauseAIGhadalreadyposted,billionincollateralto
itscounterparties,MaidenLaneIIIpaidi,.1billiontothosecounterparties,provid-
ingthemwiththefullfaceamountoftheCDOsinreturnforthecancellationoftheir
rightsundertheCDS.
1,
AconditionofthistransactionwasthatAIGwaiveitslegal
claimsagainstthosecounterparties.Thesepaymentsarelistedinfgureio..
GoldmanSachsreceived1billioninpaymentsfromMaidenLaneIIIrelatedto
the CDS it had purchased from AIG. During the FCICs January 1, io1o, hearing,
GoldmanCEOLloydBlankfeintestifedthatGoldmanSachswouldnothavelostany
moneyifAIGhadfailed,becausehisfrmhadpurchasedcreditprotectiontocover
the difference between the amount of collateral it demanded from AIG and the
amountofcollateralpaidbyAIG.
18
DocumentssubmittedtotheFCICbyGoldman
afterthehearingdoshowthatthefrmownedi.billionofcreditprotectioninthe
formofCDSonAIG,althoughmuchofthatprotectioncamefromfnanciallyunsta-
ble companies, including Citibank (oi. million), which itself had to be propped
up by the government, and Lehman (1,.8 million), which was bankrupt by 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
InanFCIChearing,GoldmanCFODavidViniarsaidthat
thosecounterpartieshadpostedcollateral.
1o
Goldman also argued that the 1 billion of CDS protection that it purchased
from AIG was part of Goldmans matched book, meaning that Goldman sold 1
billioninoffsettingprotectiontoitsownclients;itprovidedinformationtotheFCIC
indicatingthatthe1billionreceivedfromMaidenLaneIIIwasentirelypaidtoits
clients.
11
Without the federal assistance, Goldman would have had to fnd the 1
billionsomeotherway.
,, ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
GoldmanalsoproduceddocumentstotheFCICthatshoweditreceived.bil-
lionfromAIGrelatedtocreditdefaultswapsonCDOsthatwerenotpartofMaiden
LaneIII.Ofthat.billion,1.billionwasreceivedafter,andthusmadepossible
by,thefederalbailoutofAIG.Andmosti.billionofthetotalwasforpropri-
etarytrades(thatis,tradesmadesolelyforGoldmansbeneftratherthanonbehalfof
aclient)largelyrelatingtoGoldmansAbacusCDOs.Thus,unlikethe1billionre-
ceivedfromAIGontradesinwhichGoldmanowedthemoneytoitsowncounter-
parties,thisi.billionwasretainedbyGoldman.
1i
ThatAIGscounterpartiesdidnotincuranylossesontheirinvestmentsbecause
AIG, once it was backed by the government, paid claims to CDS counterparties at
1oooffacevaluehasbeenwidelycriticized.InNovemberioo,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.
1
SIGTARPwashighlycriticaloftheNewYorkFedsnegotiations.Fromtheoutset,
itfound,theNewYorkFedwaspoorlypreparedtoassistAIG.TopreventAIGsfail-
ure,theNewYorkFedhadhastilyagreedtothe8,billionbailoutonsubstantially
the same terms that a private-sector group had contemplated.
1
SIGTARP blamed
theFedsownnegotiatingstrategyfortheoutcome,whichitdescribedasthetransfer
of billions of dollars of cash from the Government to AIGs counterparties, even
thoughseniorpolicymakerscontendthatassistancetoAIGscounterpartieswasnot
arelevantconsideration.
1,
In June io1o, TARPs Congressional Oversight Panel criticized the AIG bailout
forhavingapoisonouseffectoncapitalmarkets.Thereportsaidthegovernments
failuretorequiresharedsacrifceamongAIGscreditorseffectivelyalteredtherela-
tionshipbetweenthegovernmentandthemarkets,signalinganimplicittoobigto
failguaranteeforcertainfrms.ThereportsaidtheNewYorkFedshouldhavein-
sistedonconcessionsfromcounterparties.
1o
TreasuryandFedomcialscounteredthatconcessionswouldhaveledtoaninstant
ratingsdowngradeandprecipitatedarunonAIG.
1,
NewYorkFedomcialstoldthe
FCICthattheyhadverylittlebargainingpowerwithcounterpartieswhowerepro-
tected by the terms of their CDS contracts. And, after providing a 8, billion loan,
thegovernmentcouldnotletAIGfail.Counterpartiessaidwegotthecollateral,the
contractual rights, youve been rescued by the Fed, Uncle Sams behind you, why
wouldweletyououtofacontractyouagreedto:NewYorkFedGeneralCounsel
TomBaxtertoldtheFCIC.Andthenthequestionwas,shouldweuseourregulatory
power to leverage counterparties. From my view, that would have been completely
inappropriate, an abuse of power, and not something we were willing to even con-
template.
18
SarahDahlgren,whowasinchargeoftheMaidenLaneIIItransactionattheNew
YorkFed,saidthegovernmentcouldnothavethreatenedbankruptcy.Therewasa
fnancialmeltdown,shetoldtheFCIC.ThecredibilityoftheUnitedStatesgovern-
ment was on the line.
1
SIGTARP acknowledged that the New York Fed felt ethi-
tii :i : \Ni i\Ni t ,,,
callyrestrainedfromthreateninganAIGbankruptcybecauseithadnoactualplans
tocarryoutsuchathreatandthatitwasuncomfortableinterferingwiththesanc-
tity of the counterparties contractual rights with AIG, which were certainly valid
concerns.
1,o
Geithnerhassaidhewasconfdentthatfullreimbursementwasabsolutelythe
rightdecision.WediditinawaythatIbelievewasnotjustleastcosttothetaxpayer,
best deal for the taxpayer, but helped avoid much, much more damage than would
havehappenedwithoutthat.
1,1
NewYorkFedomcialstoldtheFCICthatthreatstoAIGssurvivalcontinuedafter
the 8, billion loan on September 1o.
1,i
If you dont fx the [securities] lending or
theCDOs,[AIGwould]blowthroughthe8,billion.Soweneededtostopthesuck-
ingchestwoundinthispatient,Dahlgrensaid.ItwasntjustAIGitwasthefnan-
cialmarkets. . . .Itkeptgettingworseandworseandworse.
1,
BaxtertoldtheFCICthatMaidenLaneIIIstoppedthehemorrhagefromAIG
FinancialProducts,whichwaspayingcollateraltocounterpartiesbydrawingonthe
8, billion government loan. In addition, because Maiden Lane III received the
CDOsunderlyingtheCDS,asvaluecomesbackinthoseCDOs,thatsvaluethatis
goingtobefrstusedtopayofftheFedloan; . . .thelikelyoutcomeofMaidenLane
IIIisthatweregoingtobepaidinfull,hesaid.
1,
Intotal,theFedandTreasuryhadmadeavailableover18obillioninassistance
toAIGtopreventitsfailure.
1,,
AsofSeptembero,io1o,thetotaloutstandingassis-
tancehasbeenreducedto1i.8billion,primarilythroughthesaleofAIGbusiness
units.
1,o
CITIGROUP: LET THE WORLD KNOW
THAT WE WILL NOT PULL A LEHMAN
ThefailedbidforWachoviarefectedbadlyonCitigroup.Itsstockfell18onOcto-
ber,ioo8,thedayWachoviaannouncedthatitpreferredWellssoffer,andanother
withinaweek.Havingagreedtodothedealwasarecognitiononourpartthat
we needed it, Edward Ned Kelly III, vice chairman of Citigroup, told the FCIC.
Andifweneededitanddidntgetit,whatdidthatimplyforthestrengthofthefrm
goingforward:
1,,
RogerCole,thenheadofbankingsupervisionattheFederalReserveBoard,saw
thefailedacquisitionasaturningpoint,themomentwhenCitireallycameunder
the microscope. It was regarded [by the market] as an indication of bad manage-
ment at Citi that they lost the deal, and had it taken away from them by a smarter,
moreastuteWellsFargoteam,ColetoldtheFCIC.Andthenheresanorganization
thatdoesnthavethecorefunding[insureddeposits]thatwewereassumingthatthey
wouldgetbythatdeal.
1,8
Citigroupsstockrose18thedayaftertheColumbusDayannouncementthatit
wouldreceivegovernmentcapital,buttheoptimismdidnotlast.Twodayslater,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 NQUi i tu\\i : :i uN iiiui1
investment vehicle (SIV) write-downs. The banks stock fell 1, in the following
weekand,byNovember1i,hitsingledigitsforthefrsttimesince1o.
The markets unease was heightened by press speculation that the companys
boardhadlostconfdenceinseniormanagement,Kellysaid.
1,
OnNovember1,the
company announced that the value of the SIVs had fallen by 1.1 billion in the
monthsinceithadreleasedthird-quarterearnings.Citigroupwasthereforegoingto
bringtheremaining1,.billioninoff-balance-sheetSIVassetsontoitsbooks.In-
vestors clipped almost another i off the value of the stock, its largest single-day
dropsincetheOctober18,stockmarketcrash.Twodayslater,thestockclosedat
.,,.CreditdefaultsswapsonCitigroupreachedasteep,oo,oooannuallytopro-
tect1omillioninCitigroupdebtagainstdefault.
1oo
AccordingtoKelly,thesedevel-
opmentsthreatenedtomakeperceptionsbecomearealityforthebank:[Investors]
lookatthosespreadsandsay,IsthissomeplaceIreallywanttoputmymoney:And
thats not just in terms of wholesale funding, thats people who also have deposits
withusatvariouspoints.
1o1
Thefrmsvariousregulatorswatchedthestockprice,thedailyliquidity,andthe
CDSspreadswithalarm.OnFriday,Novemberi1,theUnitedKingdomsFinancial
ServicesAuthority(FSA)imposedao.billioncashlockuptoprotectCitigroups
London-basedbroker-dealer.FDICexaminersknewthatthisactionwouldbevery
damagingtothebanksliquidityandworriedthattheFSAorotherforeignregula-
torsmightimposeadditionalcashrequirementsinthefollowingweek.
1oi
Bytheclose
ofbusinessFriday,therewaswidespreadconcernthatiftheU.S.governmentfailedto
act, Citigroup might not survive; its liquidity problems had reached crisis propor-
tions.AmongregulatorsattheFDICandtheFed,therewasnodebate.
1o
FedChair-
manBernanketoldtheFCIC,Wewerelookingatthisfrm[inthefallofioo8]and
saying,Citigroupisnotaverystrongfrm,butitsonlyonefrmandtheothersare
okay, but not recognizing that thats sort of like saying, Well, four out of your fve
heartventriclesarefne,andtheffthoneislousy.Theyreallinterconnected,theyall
connecttoeachother;and,therefore,thefailureofonebringstheothersdown.
1o
The FDICs Arthur Murton emailed his colleague Michael Krimminger on No-
vemberii:Giventhattheimmediateriskisliquidity,thewaytoaddressthatisby
lettingcounterpartiesknowthattheywillbeprotectedbothatthebankandholding
companylevel. . . .[T]hemainpointistolettheworldknowthatwewillnotpulla
Lehman.Krimminger,specialadvisertotheFDICchairman,agreed:Atthisstage,it
isprobablyappropriatetobeclearanddirectthattheUSgovernmentwillnotallow
Cititofailtomeetitsobligations.
1o,
Citigroupsowncalculationssuggestedthatadropindepositsofjust,.iwould
wipeoutitscashsurplus.Ifthetrendofrecentwithdrawalscontinued,thecompany
couldexpectaioutfowofdepositsperday.UnlessCitigroupreceivedalargeand
immediateinjectionoffunds,itscofferswouldbeemptybeforetheweekend.Mean-
while, Citigroup executives remained convinced that the company was sound and
that the market was simply panicking. CEO Pandit argued, This was not a funda-
mentalsituation,itwasnotaboutthecapitalwehad,notaboutthefundingwehadat
thattime,butwiththestockpricewhereitwas . . .perceptionbecomesreality.
1oo
All
tii :i : \Ni i\Ni t ,.
that was needed, Citigroup contended, was for the government to expand access to
existing liquidity facilities. People were questioning what everything was worth at
thetime. . . .[T]herewasafightnotjusttoqualityandsafety,butalmostafightto
certainty,Kelly,thenPanditsadviser,toldtheFCIC.
1o,
The FDIC dismissed Citigroups request that the government simply expand its
access to existing liquidity programs, concluding that any incremental liquidity
couldbequicklyeliminatedasdepositorsrushedoutthedoor.Omcialsalsobelieved
thecompanydidnothavesumcienthigh-qualitycollateraltoborrowmoreunderthe
Fedsmostlycollateral-basedliquidityprograms.Inadditiontothei,billionfrom
TARP, Citigroup was already getting by on substantial government support. As of
Novemberi1,ithadi.billionoutstandingundertheFedscollateralizedliquidity
programsandioomillionundertheFedsCommercialPaperFundingFacility.And
ithadborrowed8billionfromtheFederalHomeLoanBanks.InDecember,Citi-
groupwouldhaveatotalofibillioninseniordebtguaranteedbytheFDICunder
thedebtguaranteeprogram.
OnSunday,Novemberi,FDICstaffrecommendedtoitsboardthatathirdsys-
temicriskexceptionbemadeunderFDICIA.
1o8
Astheyhaddonepreviously,regula-
tors decided that a proposed resolution had to be announced over the weekend to
buttressinvestorconfdencebeforemarketsopenedMonday.ThefailureofCitigroup
would signifcantly undermine business and household confdence, according to
FDIC staff.
1o
Regulators were also concerned that the economic effects of a Citi-
groupfailurewouldunderminetheimpactoftherecentlyimplementedCapitalPur-
chaseProgramunderTARP.
1,o
Treasury agreed to provide Citigroup with an additional io billion in TARP
fundsinexchangeforpreferredstockwithan8dividend.
1,1
Thisinjectionofcash
broughtthecompanysTARPtabto,billion.Thebankalsoreceived1.,billion
in capital benefts related to its issuance of preferred stock and the governments
guarantee of certain assets.
1,i
Under the guarantee, Citigroup and the government
would identify a oo billion pool of assets around which a protective ring fence
wouldbeplaced.Ineffect,thiswasaloss-sharingagreementbetweenCitigroupand
thefederalgovernment.Therewasnotahugeamountofscienceincomingtothat
[oobillion]number,CitigroupsKellytoldtheFCIC.Hesaidthedealwasstruc-
tured to give the market comfort that the catastrophic risk has been taken off the
table.
1,
WhenitstermswerefnalizedinJanuaryioo,theguaranteedpool,which
containedmainlyloansandresidentialandcommercialmortgagebackedsecurities,
wasadjusteddownwardtoo1billion.
Citigroupassumedresponsibilityforthefrst.,billioninlossesonthering-
fenced assets. The federal government would assume responsibility for o of all
losses above that amount. Should these losses actually materialize, Treasury would
absorb the frst , billion using TARP funds, the FDIC would absorb the next 1o
billionfromtheDepositInsuranceFund(forwhichithadneededtoapprovethesys-
temic risk exception), and the Fed would absorb the balance. In return, Citigroup
agreedtograntthegovernment,billioninpreferredstock,aswellaswarrantsthat
gavethegovernmenttheoptiontopurchaseadditionalshares.
1,
Afteranalyzingthe
,z ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
qualityoftheprotectedassets,FDICstaffprojectedthattheDepositInsuranceFund
wouldnotincuranylosses.
1,,
Onceagain,theFDICBoardmetlateonaSundaytodeterminethefateofastrug-
glinginstitution.Briefdissentonthe1oP.M.conferencecallcamefromOTSDirector
JohnReich,whoquestionedwhysimilarreliefhadnotbeenextendedtoOTS-super-
visedthriftsthatfailedearlier.Thereisntanydoubtinmymindthatthisisasys-
temicsituation,hesaid.Butheadded,
Inhindsight,Ithinktherehavebeensomesystemicsituationspriorto
thisonethatwerenotclassifedassuch.ThefailureofIndyMacpointed
thefocustothenextweakestinstitution,whichwasWaMu,anditsfail-
ure pointed to Wachovia, and now were looking at Citi and I wonder
whosnext.Ihopethatalloftheregulators,allofus,includingTreasury
andtheFed,arelookingatthesesituationsinabalancedmanner,andI
feartherehasbeensomeselectivecreativityexercisedinthedetermina-
tionofwhatissystemicandwhatsnotandwhatspossibleforthegov-
ernmenttodoandwhatsnot.
1,o
The FDIC Board approved the proposal unanimously. The announcement beat
theopeningbell,andthemarketsrespondedpositively:Citigroupsstockpricesoared
almost ,8, closing at ,.,. The ring fence would stay in place until December
ioo,atwhichtimeCitigroupterminatedthegovernmentguaranteeintandemwith
repayingiobillioninTARPfunds.InDecemberio1o,Treasuryannouncedthesale
ofitsfnalsharesofCitigroupscommonstock.
1,,
BANK OF AMERICA: A SHOTGUN WEDDING
WithCitigroupstabilized,themarketswouldquicklyshiftfocustothenextdomino:
BankofAmerica,whichhadswallowedCountrywideearlierintheyearand,onSep-
tember1,,hadannounceditwasgoingtotakeonMerrillLynchaswell.Themerger
wouldcreatetheworldslargestbrokerageandreinforceBankofAmericasposition
asthecountryslargestdepositoryinstitution.Giventhesharepricesofthetwocom-
paniesatthetime,thetransactionwasvaluedat,obillion.
Butthedealwasnotsettocloseuntilthefrstquarterofthefollowingyear.Inthe
interim,thecompaniescontinuedtooperateasindependententities,pendingshare-
holderandregulatoryapproval.Forthatreason,MerrillCEOJohnThainandBank
of America CEO Ken Lewis had represented their companies separately at the
Columbus Day meeting at Treasury. Treasury would invest the full i, billion in
BankofAmericaonlyaftertheMerrillacquisitionwascomplete.
InOctober,MerrillLynchreportedanetlossforthethirdquarterof,.1billion.
InitsOctober1oearningspressrelease,MerrillLynchdescribedwrite-downsrelated
toitsCDOpositionsandotherrealestaterelatedsecuritiesandassetsaffectedbythe
severemarketdislocations.ThaintoldinvestorsontheconferencecallthatMerrills
strategywastocleanhouse.Itnowheldlessthan1billioninasset-backed-security
tii :i : \Ni i\Ni t ,,
CDOsandnoAlt-Apositionsatall.Weredowntoi,millioninsubprimeonour
trading books, Thain said. We cut our non-U.S. mortgage business positions in
half.
1,8
TheFedapprovedthemergeronNovemberio,notingthatbothBankofAmerica
and Merrill were well capitalized and would remain so after the merger, and that
BankofAmericahassumcientfnancialresourcestoeffecttheproposal.
1,
Share-
holdersofbothcompaniesapprovedtheacquisitiononDecember,.
ButthenBankofAmericaexecutivesbegantohavesecondthoughts,Lewistold
the FCIC. In mid-November, Merrill Lynchs after-tax losses for the fourth quarter
hadbeenprojectedtoreachabout,billion;theprojectiongrewtoabout,billion
byDecember,billionbyDecember,and1ibillionbyDecember1.
18o
Lewis
saidhelearnedonlyonDecember1thatMerrillslosseshadacceleratedprettydra-
matically.
181
Lewisattributedthelossestoamuch,much,higherdeteriorationofthe
assetsweidentifedthanwehadexpectedgoingintothefourthquarter.
18i
InaJanuaryconferencecall,LewisandCFOJoePricetoldinvestorsthatthebank
hadnotbeenawareoftheextentofMerrillsfourth-quarterlossesatthetimeofthe
shareholdervote.Itwasntanissueofnotidentifyingtheassets,KenLewissaid.It
wasthatwedidnotexpectthesignifcantdeterioration,whichhappenedinmid-to
lateDecemberthatwesaw.
18
MerrillsThainconteststhatversionofevents.Hetold
theFCICthatMerrillprovideddailyproftandlossreportstoBankofAmericaand
that bank executives should have known about losses as they occurred.
18
The SEC
laterbroughtanenforcementactionagainstBankofAmerica,chargingthecompany
withfailingtodiscloseabout.,billionofknownandexpectedMerrillLynchlosses
beforetheDecember,shareholdervote.AccordingtotheSECscomplaint,thesein-
sumcientdisclosuresdeprivedshareholdersofmaterialinformationthatwascritical
to their ability to fairly evaluate the merger. In February io1o, Bank of America
wouldpay1,omilliontosettletheSECsaction.
18,
On December 1,, Lewis called Treasury Secretary Paulson to inform him that
Bank of America was considering invoking the material adverse change (MAC)
clauseofthemergeragreement,whichwouldallowthecompanytoexitorrenegoti-
atethetermsoftheacquisition.Theseverityofthelosseswerehighenoughthatwe
shouldatleastconsideraMAC,LewistoldtheFCIC.Theacceleration,wethought,
wasbeyondwhatshouldbehappening.Andthensecondly,youhadamajorholebe-
ing created in the capital base with the lossesthat dramatically reduced [Merrill
Lynchs]equity.
18o
Thatafternoon,LewisfewfromNorthCarolinatoWashingtontomeetattheFed
withPaulsonandFedChairmanBernanke.ThetwoaskedLewistostanddownon
invokingtheclausewhiletheyconsideredthesituation.
18,
Paulson and Bernanke concluded that an attempt by Bank of America to invoke
the MAC clause was not a legally reasonable option. They believed that Bank of
Americawouldbeultimatelyunsuccessfulinthelegalaction,andthattheattendant
litigationwouldlikelyresultinBankofAmericastillbeingcontractuallyboundtoac-
quire a considerably weaker Merrill Lynch. Moreover, Bernanke thought the market
would lose faith in Bank of Americas management, given that review, preparation,
,, ii N\Nti \i tii :i : i NQUi 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 systemic crisis that would result in
furtherdeteriorationatthetwocompanies.
188
Neither Merrill nor its CEO, John Thain, was informed of these deliberations at
BankofAmerica.LewistoldtheFCICthathedidntcontactMerrillLynchaboutthe
situationbecausehedidntwanttocreateanadversarialrelationshipifitcouldbe
avoided.
18
WhenThainlaterfoundoutthatBankofAmericahadcontemplatedput-
tingtheMACclauseintoeffect,hewasskepticalaboutitschancesofsuccess:Oneof
the things we negotiated very heavily was the Material Adverse Change clause. [It]
specifcallyexcludedmarketmoves . . .[and]prettymuchnothinghappenedtoMer-
rillinthefourthquarterotherthanthemarketmove.
1o
On Sunday, December i1, Paulson informed Lewis that invoking the clause
woulddemonstrateacolossallossofjudgmentbythecompany.Paulsonreminded
LewisthattheFed,asitsregulator,hadthelegalauthoritytoreplaceBankofAmer-
icasmanagementandboardiftheyembarkedonadestructivestrategythathadno
reasonable legal basis.
11
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 (safety and soundness) of his
company.CongressmanEdolphusTownsofNewYorkwouldlaterrefertotheBank
ofAmericaandMerrillLynchmergerasashotgunwedding.
1i
RegulatorsbegantodiscussarescuepackagesimilartotheoneforCitigroup,in-
cluding preferred shares and an asset pool similar to Citigroups ring fence. The
staff s analysis was essentially the same as it had been for Citigroup. Meanwhile,
Lewisdecidedtodeescalatethesituation,explainingthatwhenthesecretaryofthe
treasury and the chairman of the Fed say that invoking the MAC would cause sys-
temic risk, then it obviously gives you pause.
1
At a board meeting on December
ii,LewistoldhisboardthattheFedandTreasurybelievedthatafailedacquisition
wouldposesystemicriskandwouldleadtoremovalofmanagementandtheboardat
theinsistenceofthegovernment,andthatthegovernmentwouldprovideassistance
toprotect[BankofAmerica]againsttheadverseimpactofcertainMerrillLynchas-
sets,althoughsuchassistancecouldnotbeprovidedintimeforthemergerscloseon
January1,ioo.
1
TheboarddecidednottoexercisetheMACandtoproceedasplanned,withthe
understandingthatthegovernmentsassistancewouldbefullydocumentedbythe
time fourth-quarter earnings were announced in mid-January.
1,
Obviously if [the
MAC clause] actually would cause systemic risk to the fnancial system, then thats
notgoodforBankofAmerica,LewistoldtheFCIC.Whichisfnallytheconclusion
thatIcametoandtheboardcameto.
1o
ThemergerwascompletedonJanuary1,ioo,withnohintofgovernmentassis-
tance. By the time the acquisition became omcial, the purchase price of ,o billion
announcedinSeptemberhadfallento1billion,thankstothedeclineinthestock
pricesofthetwocompaniesovertheprecedingthreemonths.OnJanuary,Bankof
America received the 1o billion in capital from TARP that had been allocated to
MerrillLynch,addingtothe1,billionithadreceivedinOctober.
1,
tii :i : \Ni i\Ni t ,,
InadditiontothoseTARPinvestments,attheendofioo8BankofAmericaand
MerrillLynchhadborrowed88billionundertheFedscollateralizedprograms(oo
billion through the Term Auction Facility and i8 billion through the PDCF and
TSLF) and 1, billion under the Feds Commercial Paper Funding Facility. (During
the previous fall, Bank of Americas legacy securities arm had borrowed as much as
1,billionunderTSLFandasmuchas11billionunderPDCF.)Alsoattheendof
ioo8,thebankhadissued1.,billioninseniordebtguaranteedbytheFDICunder
the debt guarantee program.
18
And it had borrowed i billion from the Federal
HomeLoanBanks.YetdespiteBankofAmericasrecoursetothesemanysupports,the
regulators worried that it would experience liquidity problems if the fourth-quarter
earningswereweak.
1
The regulators wanted to be ready to announce the details of government sup-
port in conjunction with Bank of Americas disclosure of its fourth-quarter per-
formance. They had been working on the details of that assistance since late
December,
ioo
andhadreasontobecautious:forexample,o,ofBankofAmericas
repo and securities-lending funding, a total of 8 billion, was rolled over every
night, and Merrill legacy businesses also funded 1 billion overnight. A one-
notch downgrade in the new Bank of Americas credit rating would contractually
obligate the posting of 1o billion in additional collateral; a two-notch downgrade
wouldrequireanotherbillion.Althoughthecompanyremainedadequatelycapi-
talizedfromaregulatorystandpoint,itstangiblecommonequitywaslowand,given
thestressedmarketconditions,waslikelytofallunderi.
io1
Lowlevelsoftangible
common equitythe most basic measure of capitalworried the market, which
seemedtothinkthatinthemidstofthecrisis,regulatorymeasuresofcapitalwere
notinformative.
On January 1,, the Federal Reserve and the FDIC, after intense discussions,
agreed on the terms:
ioi
Treasury would use TARP funds to purchase io billion of
BankofAmericapreferredstockwithan8dividend.Thebankandthethreeperti-
nent government agenciesTreasury, the Fed, and the FDICdesignated an asset
poolof118billion,primarilyfromtheformerMerrillLynchportfolio,whoselosses
the four entities would share. The pool was analogous to Citigroups ring fence. In
thiscase,BankofAmericawouldberesponsibleforthefrst1obillioninlosseson
thepool,andthegovernmentwouldcoveroofanyadditionallosses.Shouldthe
government losses materialize, Treasury would cover ,,, up to a limit of ,., bil-
lion,andtheFDICi,,uptoalimitofi.,billion.Ninetypercentofanyadditional
losseswouldbecoveredbytheFed.
io
The FDIC Board had a conference call at 1o P.M. on Thursday, January 1,, and
votedforthefourthtime,unanimously,toapproveasystemicriskexceptionunder
FDICIA.
io
Thenextmorning,January1o,BankofAmericadisclosedthatMerrillLynchhad
recorded a 1,. billion net loss on real estate-related write-downs and charges. It
alsoannouncedtheiobillionTARPcapitalinvestmentand118billionringfence
thatthegovernmenthadprovided.Despitethegovernmentssupport,BankofAmer-
icasstockcloseddownalmost1fromthedaybefore.
COMMISSION CONCLUSIONS ON CHAPTER 20
TheCommissionconcludesthat,asmassivelossesspreadthroughoutthefnan-
cialsysteminthefallofioo8,manyinstitutionsfailed,orwouldhavefailedbut
forgovernmentbailouts.Aspanicgrippedthemarket,creditmarketsseizedup,
trading ground to a halt, and the stock market plunged. Lack of transparency
contributed greatly to the crisis: the exposures of fnancial institutions to risky
mortgageassetsandotherpotentiallosseswereunknowntomarketparticipants,
andindeedmanyfrmsdidnotknowtheirownexposures.
The scale and nature of the over-the-counter (OTC) derivatives market cre-
atedsignifcantsystemicriskthroughoutthefnancialsystemandhelpedfuelthe
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 counterparty credit risk, thus exposing the system to a contagion of
spreading losses and defaults. Enormous positions concentrated in the hands of
systemically signifcant institutions that were major OTC derivatives dealers
added to uncertainty 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 country with stark
andpainfulalternativeseitherriskthetotalcollapseofourfnancialsystemor
spendtrillionsoftaxpayerdollarstostabilizethesystemandpreventcatastrophic
damagetotheeconomy.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
moreconcentratedthaneverinthehandsofafewverylarge,systemicallysignif-
cant institutions. This concentration places greater responsibility on regulators
foreffectiveoversightoftheseinstitutions.
OverthenextseveralmonthsBankofAmericaworkedwithitsregulatorstoiden-
tify the assets that would be included in the asset pool. Then, on May o, Bank of
America asked to exit the ring fence deal, explaining that the company had deter-
minedthatlosseswouldnotexceedthe1obillionthatBankofAmericawasrequired
tocoverinitsfrst-lossposition.Althoughthecompanywaseventuallyallowedtoter-
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,BankofAmericaagreedtopayai,millionterminationfee:
i,omilliontoTreasury,,,milliontotheFed,andimilliontotheFDIC.
, ii N\Nti \i tii :i : i NQUi 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 ,,:
1hcnancia|scctcrA|ncsttrip|cthc|cvc|cjthrccycarscar|icr,oo
Panicanduncertaintyinthefnancialsystemplungedthenationintothelongestand
deepest recession in generations. The credit squeeze in fnancial markets cascaded
throughout the economy. In testifying to the Commission, Bank of America CEO
Brian Moynihan described the impact of the fnancial crisis on the economy: Over
thecourseofthecrisis,we,asanindustry,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 system rumbled
throughtheU.S.economy.Seventeentrilliondollarsinhouseholdwealthevaporated
withini1months,andreportedunemploymenthit1o.1atitspeakinOctoberioo.
Asthehousingbubbledefated,familiesthathadcountedonrisinghousingval-
ues for cash and retirement security became anchored to mortgages that exceeded
the declining value of their homes. They ratcheted back on spending, cumulatively
puttingthebrakesoneconomicgrowththeclassicparadoxofthrift,describedal-
mostacenturyagobyJohnMaynardKeynes.
Intheaftermathofthepanic,whencreditwasseverelytightened,ifnotfrozen,for
fnancialinstitutions,companiesfoundthatcheapandeasycreditwasgoneforthem,
too.Itwastoughertoborrowtomeetpayrollsandtoexpandinventories;businesses
thathadneithercreditnorcustomerstrimmedcostsandlaidoffemployees.Stillto-
day,creditavailabilityistighterthanitwasbeforethecrisis.
Without jobs, people could no longer afford their house payments. Yet even if
moving could improve their job prospects, they were stuck with houses they could
not sell. Millions of families entered foreclosure and millions more fell behind on
their mortgage payments. Others simply walked away from their devalued proper-
ties,returningthekeystothebanksanactionthatwoulddestroyfamiliescreditfor
,,+ ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
years.Thesurgeinforeclosedandabandonedpropertiesdraggedhomepricesdown
still more, depressing the value of surrounding real estate in neighborhoods across
the country. Even those who stayed current on their mortgages found themselves
whirledintothestorm.
Townsthatoverseveralyearshadcometoexpectandrelyonthehousingboom
nowsawjobsandtaxrevenuevanish.Astheirresourcesdwindled,thesecommuni-
tiesfoundthemselvessaddledwiththemunicipalcoststheyhadtakenoninpartto
expand services for a growing population. Sinking housing prices upended local
budgets that relied on property taxes. Problems associated with abandoned homes
requiredmorepoliceandfreprotection.
AtFCIChearingsaroundthecountry,regionalexpertstestifedthatthelocalim-
pact of the crisis has been severe. From ioo, to ioo, for example, banks in Sacra-
mento had stopped lending and potential borrowers retreated, said Clarence
Williams, president of the California Capital Financial Development Corporation.
Bankersstillcomplaintohimnotonlythatdemandfromborrowershasfallenoffbut
also that they may be subject to increased regulatory scrutiny if they do make new
loans.InSeptemberio1o,whentheFCIChelditsSacramentohearing,thatregions
once-robust construction industry was still languishing. Unless we begin to turn
arounddemand,unlesswebegintoturnaroundthebusinesssituation,theemploy-
mentisnotgoingtoincreasehereintheSacramentoarea,andhousingiscriticaltoit.
Itisaviciouscircle,Williamstestifed.
i
TheeffectsofthefnancialcrisishavebeenfeltinindividualU.S.householdsand
businesses,bigandsmall,andaroundtheworld.Policymakersonthestate,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 omcially began in December ioo,. By many measures, its effects on
thejobmarketweretheworstonrecord,asrefectedinthespeedandbreadthofthe
falloffinjobs,theriseoftheranksofunderemployedworkers,andthelongstretches
of time that millions of Americans were and still are surviving without work. The
economyshed.omillionjobsinioo8thelargestannualplungesincerecordkeep-
ingbeganin1o.ByDecemberioo,theUnitedStateshadlostanother.,million
jobs.ThroughNovemberio1o,theeconomyhadregainednearly1millionjobs,put-
tingonlyasmalldentinthedeclines.
The underemployment ratethe total of unemployed workers who are actively
looking for jobs, those with part-time work who would prefer full-time jobs, and
those who need jobs but say they are too discouraged to searchincreased from
8.8 in December ioo, to 1., in December ioo8, reaching 1,. in October
ioo. This was the highest level since calculations for that labor category were frst
madein1.AsofNovemberio1o,theunderemploymentratestoodat1,.The
averagelengthoftimeindividualsspentunemployedspikedfrom.weeksinJune
ioo8to18.iweeksinJuneioo,andi,.,weeksinJuneio1o.Fifty-ninepercentof
1ui ituNu\i t i\iiuU1 ,,.
alljobseekers,accordingtothemostrecentgovernmentstatistics,searchedforwork
foratleast1,weeks.
The labor market is daunting across the board, but it is especially 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 1 years old, at
i.o;andHispanics,at1.i.Andtheimpacthasbeenespeciallysevereincertain
professions: unemployment in construction, for instance, climbed to an average of
1.1inioo,andaveragedio.oduringthefrst11monthsofio1o.
Real gross domestic product, the nations measure of economic output adjusted
forinfation,fellatanannualrateofinthethirdquarterofioo8ando.8inthe
fourthquarter.Afterfallingagaininthefrsthalfofiooandthenmodestlygrowing
inthesecondhalf,averageGDPfortheyearwasi.olowerthaninioo8,thebiggest
dropsince1o.
Looking at the labor market, Edward Lazear, chairman of President George W.
BushsCouncilofEconomicAdvisersduringthecrisis,toldtheCommissionthatthe
fnancialcrisiswaslinkedwithtodayseconomicproblems:Ithinkmostofithadto
dowithinvestment. . . .Panicinfnancialmarketsandtightnessinfnancialmarkets
thatpersistedthroughioopreventedfrmsfrominvestinginthewaythattheyoth-
erwisewould,andIthinkthatslowstherehiringofworkersandstillcontinuestobe
aprobleminlabormarkets.

InJuneioo,thenationomciallyemergedoutoftherecessionthathadbegun18
monthsearlier.Thegoodnewsstillhadnotreachedmanyoftheio.imillionAmeri-
canswhowereoutofwork,whocouldnotfndfull-timework,orwhohadstopped
looking for work as of November io1o. Jeannie McDermott of Bakersfeld told the
FCIC she started a business reflling printer ink cartridges, but in a tight economy,
shedidntearnenoughtomakealiving.Shesaidshehadbeensearchingforafull-
timejobsinceioo8.

Householdssufferedtheimpactofthefnancialcrisisnotonlyinthejobmarket
but also in their net worth and their access to credit. Of the 1, trillion lost from
ioo, to the frst quarter of ioo in household net wealththe difference between
what households own and what they oweabout ,.o trillion was due to declining
houseprices,withmuchoftheremainderduetothedecliningvalueoffnancialas-
sets.Asapointofreference,GDPinioo8was1.trillion.And,asaseparatepoint,
theamountofwealthlostinthedot-comcrashearlyinthedecadewaso.,trillion,
withfarfewerrepercussionsfortheeconomyasawhole.Thepainfuldropinreales-
tateandfnancialassetvaluesfollowedao.8trillionrun-upinhouseholddebtfrom
ioootoioo,.Aidedbythegainsinhomepricesand,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,.trillion,a
1o.,drop-offfromitspinnaclejustthreeyearsearlier(seefgurei1.1).
Nationwide,homepricesdroppedifromtheirpeakiniooototheirlowpoint
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 NQUi i tu\\i : :i uN iiiui1
early in ioo. The homeownership rate declined from its peak of o.i in ioo to
oo.asofthefallofio1o.BecausesomanyAmericanhouseholdsownhomes,and
becauseformosthomeownerstheirhousingrepresentstheirsinglemostimportant
asset, these declines have been especially debilitating. Borrowing via home equity
loansorcash-outrefnancinghasfallensharply.
At an FCIC hearing in Bakersfeld, California, Marie Vasile explained how her
familyhadrelocatedomilesintothemountainstoarentalhousetohelpherhus-
bandsfragilehealth.
,
Theiroldhomewasputupforsaleandlanguishedonthemar-
ket,losingvalue.Eventually,sheandherhusbandfoundbuyerswillingtotaketheir
houseinashortsalethatis,asaleatapricelessthanthebalanceofthemortgage.
Butbecausethelenderwasactingslowlytoapprovethatdeal,theyriskedlosingthe
saleandthengoingintoforeclosure.Totopthisalloff,Vasiletoldcommissioners,
myhusbandisinthepositionofpossiblylosinghisjob. . . .SonotonlydoIhavea
housethatIdontknowwhatshappeningto,Idontknowifhesgoingtohaveajob
comeDecember.ThisismorethanIcanhandle.Imnoteating.Imnotsleeping.
Serious mortgage delinquenciespayments that are late o days or more or
homesintheforeclosureprocesshavespreadsincethecrisis.Amongregions,the
1ui ituNu\i t i\iiuU1 ,,,
easternstatesintheMidwest(Ohio,Indiana,Illinois,Wisconsin,andMichigan)had
thehighestdelinquencyrate,topping,inioo,.
o
Byfallio1o,thisratehadrisento
.i. Other regions also endured high ratesespecially the so-called sand states,
wherethehousingcrisiswastheworst.Thethirdquarterio1oseriousdelinquency
rateforFloridawas1.,;Nevada,1,.8;Arizona,1o.8;andCalifornia,1o..
The data company 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 state was overbuilt and some 1oo,ooo jobs were
predicatedonalevelofgrowthandconsumerspendingthatseemedtoevaporateal-
mostovernight,JeremyAguero,aneconomicandmarketinganalystwhofollowsthe
Nevadaeconomy,testifedtotheCommission.
8
The performance of the stock market in the wake of the crisis also reduced
wealth.TheStandardandPoors,ooIndexfellbyathirdinioo8thelargestsingle-
year decline since 1,as big institutional investors moved to Treasury securities
and other investments that they perceived as safe. Individuals felt these effects not
onlyintheircurrentbudgetsbutalsointheirprospectsforretirement.Byonecalcu-
lation,assetsinretirementaccountssuchaso1(k)slosti.8trillion,oraboutathird
oftheirvalue,betweenSeptemberioo,andDecemberioo8.

Whilethestockmar-
ket has recovered somewhat, the S&P ,oo as of December 1, io1o, was still about
1belowwhereitwasatthestartofioo8.Similarly,stockpricesworldwideplum-
metedmorethanoinioo8butreboundedbyiinioo,accordingtotheMSCI
WorldIndexstockfund(whichrepresentsacollectionof1,,ooglobalstocks).
The fnancial market fallout jeopardized some public pension plansmany of
which were already troubled before the crisis. In Colorado, state budget omcials
warnedthatlossesof11billion,unaddressed,couldcausethePublicEmployeesRe-
tirement Association planwhich covers ,o,ooo public workers and teachersto
gobustintwodecades.Thestatecutretireebeneftstoadjustforthelosses.
1o
Mon-
tanaspublicpensionfundslostibillion,orafourthoftheirvalue,inthesixmonths
followingtheioo8downturn,inpartbecauseofinvestmentsincomplexWallStreet
securities.
11
Evenbeforethefallofioo8,consumerconfdencehadbeenonadownwardslope
for months. The Conference Board reported in May ioo8 that its measure of con-
sumerconfdencefelltothelowestpointsincelate1i.
1i
Byearlyioo,confdence
hadplummetedtoanewlow;ithasrecoveredsomewhatsincethenbuthasremained
stubbornlybleak.
1
[We fnd] nobody willing to make a decision. . . . nobody willing to take a
chance, because of the uncertainty in the economic environment, and that goes for
both the state and the federal level, the commercial real estate developer and ap-
praiserGregoryBynumtestifedattheFCICsBakersfeldhearing.
1
Infuencedbythedramaticlossinwealthandbyjobinsecurity,householdshave
cutbackondebt.Totalcreditcarddebtexpandedeveryyearfortwodecadesuntilit
peakedat8billionattheendofioo8.Almosttwoyearslater,thattotalhadfallen
1,to8oibillion.Theactionsofbankshavealsoplayedanimportantrole:since
,,, ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
ioo8,theyhavetightenedlendingstandards,reducedlinesofcreditoncreditcards,
andincreasedfeesandinterestrates.Inthethirdquarterofioo8,o,ofbanksim-
posedstandardsoncreditcardsthatweretighterthanthoseinplaceintheprevious
quarter.Inthefourthquarter,,didso,meaningthatmanybankstightenedagain.
In fact, a signifcant number of banks tightened credit card standards quarter after
quarteruntilthesummerofioo.Onlyinthelatestsurveyshaveevenasmallnum-
bersofbanksbeguntoloosenthem.
1,
Facedwithfnancialdimculties,over1.mil-
lion households declared bankruptcy in ioo, up from approximately 1.1 million
inioo8.
1o
Together,thedeclineinhouseholdsfnancialresources,bankstighteningoflend-
ingstandards,andconsumerslackofconfdencehaveledtolargecutsinspending.
Consumer spending, which in the United States makes up more than two-thirds of
GDP,fellatanannualrateofroughly.,inthesecondhalfofioo8andthenfell
againinthefrsthalfofioo.Gainssincethenhavebeenmodest.Spendingoncars
and trucks fell by an extraordinary o between the end of ioo, and the spring of
ioo,inpartbecauseconsumerfnancingwaslessavailableaswellasbecauseofjob
andwagelosses.
BUSINESSES: SQUIRRELS STORING NUTS
WhenthefnancialpanichitinSeptemberioo8,businessfnancingdriedup.Firms
that could roll over their commercial paper faced higher interest rates and shorter
terms.Thosethatcouldnotrollovertheirpaperreliedonold-fashionedfnancing
bank loansor used their own cash reserves. Large frms, one analyst said at the
time,turnedtotheircashbalanceslikesquirrelsstoringnuts.JeffAgosta,anexecu-
tiveatDevonEnergyCorporation,toldtheFCICthathadthegovernmentnotsup-
portedthecommercialpapermarket,Wewouldhavebeeneatinggrasshoppersand
livingintents.Thingscouldhavebeenthatbad.
1,
Whilehisexpressionwashyper-
bolic,thefearwasveryreal.Thelackofcreditandthesharpdropindemandtookits
toll on businesses. In iooo, just under io,ooo U.S. companies fled for bankruptcy
protection.Thatfguremorethantripledtonearlyo1,oooinioo.
18
Firmslong-term
plans suddenly had to be reevaluatedthe effects of those decisions persist, even
thoughcreditmarketshaverecoveredsomewhat.
Asforthebanks,bymid-ioo,theyhadbeguntorestrictaccesstocreditevenfor
largeandmedium-sizebusinesses.
1
TheFederalOpenMarketCommitteenotedthis
tighteningwhenitannouncedonSeptember18,ioo,,thatitwascuttingthefederal
fundsrate.AftertheLehmanbankruptcy,companiessuchasGannettCorporation,
FairPoint Communications, and Duke Energy drew down their existing lines of
creditbecausetheywereworriedaboutgettingshutoutofcreditmarkets.
io
Without access to credit, with cash reserves dwindling, and with uncertainty
abouttheeconomyhigh,corporationslaidoffworkersorcuttheirinvestments,in-
hibitinggrowthandreducingtheirpotentialforimprovingproductivity.Asurveyof
chieffnancialomcersfoundthat,,ofU.S.companiesweresomewhatorveryaf-
fectedbycreditconstraints,leadingtodecisionstomakecutsincapitalinvestment,
1ui ituNu\i t i\iiuU1 ,,,
technology,andelsewhere.
i1
Newsheadlineschronicledtheproblems:scarcecapital
forced midsize frms to pare back investments and shutter omces, while industrial
companies including Caterpillar, Corning, and John Deere; pharmaceutical compa-
niessuchasMerckandWyeth;andtechcompaniesalikelaidoffemployeesasthere-
cessiontookhold.Somebusinessesstruggledtocoverpayrollsandthefnancingof
inventory.
TheintroductioninOctoberioo8oftheCommercialPaperFundingFacility,un-
der which the Federal Reserve loaned money to nonfnancial entities, enabled the
commercial paper market to resume functioning at more normal rates and terms.
Butevenwiththecentralbankshelp,nearly,oofbankstightenedcreditstandards
andlendinginthefourthquarterofioo8.
ii
Andsmallbusinessesparticularlyfeltthe
squeeze.Becausetheyemploynearlyoofthecountrysprivate-sectorworkforce,
loanstosmallbusinessesareespeciallyvitaltooureconomy,FederalReserveBoard
Governor Elizabeth Duke told Congress early in io1o.
i
Unlike the larger frms,
whichhadcometorelyoncapitalmarketsforborrowing,thesecompanieshadgen-
erallyobtainedtheircreditfromtraditionalbanks,otherfnancialinstitutions,nonf-
nancialcompanies,orpersonalborrowingbyowners.Thefnancialcrisisdisrupted
allthesesources,makingcreditmorescarceandmoreexpensive.
InasurveyofsmallbusinessesbytheNationalFederationofIndependentBusiness
inioo,1ofrespondentscalledcredithardertoget.Thatfgurecompareswith
inioo8andapreviouspeak,ataround11,duringthecreditcrunchof11.
i
FedChairmanBenBernankesaidinaJulyio1ospeechthatgettingasmallbusi-
nessloanwasstillverydimcult.Healsonotedthatbanksloanstosmallbusinesses
haddroppedfrommorethan,1obillioninthesecondquarterofioo8tolessthan
o,obillioninthefrstquarterofio1o.
i,
Anotherfactorhesitancytotakeonmoredebtinananemiceconomyiscer-
tainlybehindsomeofthestatisticstrackinglendingtosmallbusinesses.Speakingon
behalfoftheIndependentCommunityBankersofAmerica,C.R.Cloutier,president
and CEO of Midsouth Bank in Lafayette, Louisiana, told the FCIC, Community
banksarewillingtolend.Thatshowbanksgenerateareturnandsurvive.However,
qualityloandemandisdown. . . .Icantellyoufrommyownbanksexperience,cus-
tomers are scared about the economic climate and are not borrowing. . . . Credit is
available,butbusinessesarenotdemandingit.
io
Still, creditworthy borrowers seeking loans face tighter credit from banks than
theydidbeforethecrisis,surveysandanecdotalevidencesuggest.Historically,banks
charged a i percentage point premium over their funding costs on business loans,
but that premium had hit points by year-end ioo8 and had continued to rise in
ioo,raisingthecostsofborrowing.
i,
Small businesses access to credit also declined when the housing market col-
lapsed.Duringtheboom,manybusinessownershadtappedtherisingequityintheir
homes, taking out low-interest home equity loans. Seventeen percent of small em-
ployerswithamortgagerefnanceditspecifcallytocapitalizetheirbusinesses.
i8
As
housingpricesdeclined,theirabilitytousethisoptionwasreducedorblockedalto-
getherbythelenders.JerryJosttoldtheFCICheborrowedagainsthishometohelp
,, ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
hisdaughterstartabridaldressbusinessinBakersfeldseveralyearsago.Whenthe
economy collapsed, Jost lost his once-proftable construction business, and his
daughters business languished. The Jost family has exhausted its life savings while
strugglingtofndsteadyworkandreliableincomes.
i
The standards for credit card loans, another source of fnancing for small busi-
nesses,alsobecamemorestringent.IntheFedsAprilio1oSeniorLoanOmcerSur-
vey, a majority of banks indicated that their standards for approving credit card
accounts for small businesses were tighter than the longer-run average level that
prevailedbeforethecrisis.Bankshadcontinuedtotightentheirtermsonbusiness
credit card loans to small businesses, for both new and existing accounts, since the
end of ioo.
o
But the July io1o update of the Fed survey showed the frst positive
signssincetheendofiooothatbankswereeasinguponunderwritingstandardsfor
smallbusinesses.
1
In an effort to assist small business lenders, the Federal Reserve in March ioo
createdtheTermAsset-BackedSecuritiesLoanFacility(TALF),aprogramtoaidse-
curitization of loans, including auto loans, student loans, and small business loans.
Another federal effort aimed at improving small businesses access to credit was
guidanceinFebruaryio1ofromtheFederalReserveandotherregulators,advising
bankstotrytomeetthecreditneedsofcreditworthysmallbusinessborrowerswith
theassurancesthatgovernmentsupervisorswouldnothinderthoseefforts.
Yettheprevailingheadwindshavebeendimculttoovercome.Withoutaccessto
credit,manysmallbusinessesthathaddepletedtheircashreserveshadtroublepay-
ing bills, and bankruptcies and loan defaults rose. Defaults on small business loans
increasedto1iinioo8,from8inioo,.
i
Overall,thecurrentstateofthesmall
business sector is a critical factor in the struggling labor market: ailing small busi-
nesses have laid people off in large numbers, and stronger small businesses are not
hiringadditionalworkers.
Independent fnance companies, which had often funded themselves by issuing
commercial paper, were constrained as well. The business fnance company CIT
Group Inc. was one such frm. Even i. billion in additional capital support from
the federal Troubled Asset Relief Program (TARP) program did not save CIT from
fling for bankruptcy protection in November ioo. Still, some active lenders to
smallerbusinesses,suchasGECapital,acommerciallenderwithafocusonmiddle-
marketcustomers,wereabletocontinuetoofferfnancing.GECapitalscommercial
paperborrowingfaredbetterthanothers.

Nonetheless,thetermsofthecompanysborrowingdidworsen.Inioo8,itregis-
teredtoborrowupto8billionincommercialpaperthroughonegovernmentpro-
gram and issued 1. billion in long-term debt and i1.8 billion in commercial
paperunderanotherprogram.

ThatGECapitalhadtrimmedcommercialpaperbe-
forethecrisistolessthan1oofitstotaldebt,oraboutobillion,alsosoftenedthe
effectsofthecrisisonthecompany.Adecisionwasmadethatitwouldbeprudent
for us to reduce our reliance on the commercial paper market, and we did, Mark
Barber,thedeputytreasurerofGECompanyandGECapital,toldtheCommission.
1ui ituNu\i t i\iiuU1 ,,,
Thefrmputmorethanoobillionincashonitsbalancesheet,with,ibillionin
back-upbanklinesofcredit,ifneeded.
,
ThedeclineinglobaltradealsohurttheU.S.economyaswellaseconomiesacross
theworld.AsthefnancialcrisispeakedinEuropeandtheUnitedStates,exportscol-
lapsedinnearlyeverymajortradingcountry.
o
Thedeclineinexportsshavedmore
than percentage points off GDP growth in the third and fourth quarters of ioo8.
Recently,exportshavebeguntorecover,andasofthefallofio1otheyarebacknear
precrisislevels.
,
COMMERCIAL REAL ESTATE: NOTHING S MOVING
Commercialrealestateomces,stores,warehousesalsotookapounding,anindi-
catorbothofthesectorsrelianceonthelendingmarkets,whichwereimpairedbythe
crisis,andofitsroleasabarometerofbusinessactivity.Companiesdonotneedmore
spaceiftheygooutofbusiness,layoffworkers,ordecidenottoexpand.Weakde-
mand,inturn,lowersrentsandforceslandlordstogivetheirbigtenantsincentivesto
stay put. One example: two huge real estate brokerages with headquarters in New
YorkCityreceivedninemonthsfreerentforsigningleasesinioo8andioo.
8
In fall io1o, commercial vacancy rates were still sky-high, with io of all omce
spaceunoccupied.Andtheactualrateisprobablymuchhigherbecauselayoffscreate
shadowvacanciesacoupleofdeskshere,partofafoortherethattenantsmust
fllbeforedemandpicksbackup.Intheabsenceofdemand,banksremainunwilling
tolendtoallbutthesafestprojectsinvolvingthemostcreditworthydevelopersthat
haveprecommittedtenants.Banksareneitherfnancing,noraretheydumpingtheir
bad properties, creating a log jam, one developer told a National Association of
Realtorssurvey.Nothingsmoving.

InNevada,wheretourismandconstructiononcefedthelaborforce,commercial
property took a huge hit. Omce vacancies in Las Vegas are now hovering around
i,comparedwiththeirlowof8midwaythroughioo,.Vacanciesinretailcom-
mercialspaceinLasVegastop1o,comparedwithhistoricalvacancyratesofto
.Theeconomicdownturntuggednational-brandretailersintobankruptcy,emp-
tyingouttheanchorretailspaceinNevadasmallsandshoppingcenters.Asdemand
forvacantpropertyfell,landvaluesinandaroundLasVegasplummeted.
o
Becauselenderswerestillreluctant,fewdevelopersnationallycouldaffordtobuild
orbuy,rightintothefallofio1o.LehmansbankruptcymeantthatMondayProperties
cameupshortinitseffortstobuildaoomillion,,-storyglassomcetowerinAr-
lington,Virginia,acrosstheriverfromWashington,D.C.Potentialtenantswantedto
knowifthedeveloperhadfnancing;potentiallenderswantedtoknowifithadten-
ants. Its a bit of a cart-and-horse situation, said CEO Anthony Westreich, who in
Octoberio1otookthebigriskofstartingconstructiononthebuildingwithoutsigned
tenants or permanent fnancing.
1
The collapse of teetering fnancial institutions put
commercial real estate developers and commercial landlords in binds when overex-
tendedbankssuddenlypulledoutofcommercialconstructionloans.Andwhenbanks
,, ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
failedandweretakenoverbytheFederalDepositInsuranceCommission,thecom-
mercial landlords overnight lost major bank tenants and the long-term leases that
wentwiththem.
i
InCalifornia,atleast,bankshavefailedsinceioo.

AlmosthalfofcommercialrealestateloanswereunderwaterasofFebruaryio1o,
meaningtheloanswerelargerthanthemarketvalueoftheproperty.Commercialreal
estate loans are especially concentrated among the holdings of community and re-
gional banks.

Some commercial mortgages were also securitized, and by August

io1o, the delinquency rate on these packaged mortgages neared the highest in
thehistoryoftheindustryandanominoussignforrealestateafulltwoyearsafterthe
heightofthefnancialstorm.
,
Attheendofioo8,thedefaultratehadbeen1.o.
o
Neartheendofio1o,itwasnotatallclearwhenorevenifthecommercialreal
estate market had hit bottom. Green Street Advisors of Newport Beach, California,
which tracks real estate investment trusts, believed that it reached its nadir in mid-
ioo.Abouthalfofthedeclinebetweenioo,andioohasbeenrecovered,accord-
ing to Mike Kirby, Green Streets director of research. Nevertheless, Kirby added,
valuesremainroughlyioshyoftheirpeak.
,
Thatsoneperspective.Ontheother
side, Moodys Investors Service, whose REAL Commercial Property Price Index
trackssalesofcommercialbuildings,saysitistooearlytomakeacall.Moodysde-
tectedsomesignsofapickupinthespringandfallofio1o,andManagingDirector
Nick Levidy said, We expect commercial real estate prices to remain choppy until
transactionvolumespickup.
8
Thelargestcommercialrealestateloanlossesarepro-
jectedforio11andbeyond,accordingtoareportissuedbytheCongressionalOver-
sight Panel.

And, looking forward, nearly ,oo billion in commercial real estate

debtwillcomeduefromio11throughio1.
,o
GOVERNMENT: STATES STRUGGLED TO CLOSE SHORTFALLS
Stetcenlocelgovcrnmcntjinenccs
Therecessiondevastatednotonlymanycompaniesandtheirworkersbutalsostate
andlocalgovernmentsthatsawtheirtaxrevenuefalljustwhenpeoplewhohadlost
theirjobs,orwereinbankruptcyorforeclosureproceedings,weredemandingmore
services.ThoseservicesincludedMedicaid,unemploymentcompensation,andwel-
fare, in addition to local assistance for mental health care, for children, and for the
homeless.Atleastostatesstruggledtocloseshortfallswhenadoptingbudgetsfor
thecurrentfscalyear,recentlyreportedtheCenteronBudgetandPolicyPriorities,
aWashingtonthinktank.
,1
A critical aspect of our situation in Sacramento and . . . throughout the state is
thattheseincreaseddemandsforservicesareoccurringatatimethatresources . . .
are being dramatically reduced, Bruce Wagstaff, the agency administrator with
SacramentosCountywideServicesAgency,explainedtotheCommission.
,i
Unlikethefederalgovernment,almosteverystateisconstitutionallyrequiredto
produceabalancedbudget,sorunningadefcitisnotanoption.SujitCanagaRetna,
aseniorfscalanalystwiththeCouncilofStateGovernments,toldtheFCICthatthe
1ui ituNu\i t i\iiuU1 ,,,
budgetshortfallsfacingthestatesarestaggeringnumbers.Itsnotjustthebigstates;
its almost all states. He said the great transformation occurring in state fnances
meansstatesareforcedtoreorienttheirwholestancevisavisthekindofprograms
and services they offer their citizens.
,
In the io11 fscal year alone, which started
Julyio1o,statesmustcomeupwith1obillioninsavingsornewrevenuetobalance
theirbudgets,onestudyestimated.
,
Bythefallofio1o,therewassomegoodnews:
revenue from some taxes and fees in some states had started to pick up, or at least
slowedtheirrateofdecline.
,,
In a September io1o report, the National Conference of State Legislatures de-
claredthatthestatesarewaitingtoseeiftheeconomywillsustainthisnascentrev-
enuegrowth. . . .Anddespiterecentrevenueimprovements,moregapsloomasstates
confrontthephaseoutoffederalstimulusfunds,expiringtaxincreasesandgrowing
spendingpressures.
,o
Some states were hit harder than others, either because they were particularly
affected by the crisis or because they came into the crisis with structural budget
problems. In io1o, New Jersey Governor Chris Christie proposed chopping 11
billionoraquarterofthestatebudgettoeliminateadeficit.Californiaofficials
struggledthroughthesummerandfalltoclosea1billionshortfall,anamount
largerthantheentirebudgetsofsomestates.Nonetheless,thestatesindependent
budgetanalysisofficesaidinNovemberthatthedeficithadinsteadgrowntoi,
billionobillioninthe8,billionbudgetforthisyearand1billioninthefis-
calyearcommencinginJuneio11.
,,
Aspeoplelostjobs,manyalsolosttheirhealth
insurance, helping to drive .8 million Americans into the Medicaid program in
iooalone,an8increasethelargestinasingleyearsincetheearlydaysofthis
government health insurance plan, according to the Kaiser Family Foundation, a
nonprofitorganizationfocusingonhealthcareresearch.Everystateshowedanen-
rollmentincrease:inninestatesitwasgreaterthan1,;inNevadaandWisconsin,
greaterthanio.
,8
StatessharethecostofMedicaidwiththefederalgovernment.Congressincluded
8, billion in the stimulus package to help them with this expense, and it has ex-
tended the assistance through June io11 at a reduced level. If the economy has not
improvedbythen,Kaiserpredicts,payingforthisprogramwillbeanotherhugepo-
tentialsourceoftroubleforthestates.
,
TheNationalLeagueofCitiesrecentlysaidthatU.S.citiesareintheirworstfscal
shapeinatleastaquarterofacenturyandprobablyhavenotyethitbottomeven
after four straight years of falling revenue.
oo
Because property taxes are one of the
mainsourceofrevenueformostlocalgovernments,andbecausesomelocalassessors
areonlynowrecordinglowerpropertyvalues,theirrevenueislikelytocontinueto
declineforatleastseveralmoreyears.
o1
Theeffectsofadepressedrealestatemarket,lowlevelsofconsumerconfdence,
andhighlevelsofunemploymentwilllikelyplayoutincitiesthroughio1o,io11and
beyond,thesurveyof8citiesreported.Theauthorsofthesurveyprojectedthat
revenue would fall in io1o, and cities budgets would shrink another i, the
largestcutbacksinthei,yearsforwhichthegrouphaspublishedthereport.
oi
,++ ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
Investorsnowlookaskanceatonce-solidstateandlocalbonds,raisingborrowing
costsformanystatesandmakingtheirtaskofbalancingthebudgetevenharder.Mu-
nicipalitiesinFlorida,thestatewiththethird-highestrateofhomeforeclosures,saw
borrowingcostsrisewhentheysoldimillioninbondsinSeptemberio1o.
Imectett/cjccrellcvcl
The federal governments response to the fnancial crisis and the ensuing recession
included some of the most aggressive fscal and monetary policies in history, said
theeconomistsMarkZandiandAlanBlinder.Yetalmosteveryoneofthesepolicy
initiativesremaincontroversialtothisday,withcriticscallingthemmisguided,inef-
fectiveorboth.
o
Thegovernmentsfscalinitiativesbegansoonaftertherecessionstarted:theEco-
nomicStimulusActofioo8,signedintolawinFebruary,providedroughly1,obil-
lionintaxrebatesforhouseholdsandtaxincentivesforbusinesses.InOctoberioo8,
attheheightofthecrisis,the,oobillionTARPwasenacted;andinearlyioo,the
AmericanRecoveryandReinvestmentActofioowasenactedtostimulatetheweak-
eningeconomy,costinganother,8,billionintaxcutsandgovernmentspending.
Beginning with the rate cuts in mid-ioo, through the implementation of the
TALFinearlyioo,theFederalReserveprovidedsupporttotheeconomythrough-
outthecrisis.Asidefromitsemergencylendingprogramsputinplaceduringthef-
nancialcrisis,theFedputabout1.,trillionintotheeconomyfromSeptemberioo8
toOctoberio1oprimarilybybuyingfnancialassetssuchasmortgages-backedse-
curitiesandTreasurybonds,aprocessknownasquantitativeeasing.
o
AndinNo-
vember io1o, omcials announced another ooo billion in easing, designed to keep
long-termandshort-terminterestratesdown.
In October io1o, the Treasury Department reported that the TARP program
wouldcostfarlessthanthe,oobillionthatCongresshadappropriatedinthefallof
ioo8,becausebankshadbeguntorepaytheTreasuryinioo.Infact,Treasurysaid,
TARP would wind up costing about i billion, mostly owing to the bailout of the
automakersGeneralMotorsandChryslerandthemortgagemodifcationprogram.
o,
ThelatestestimatesfromtheCongressionalBudgetOmce(CBO)putitscostati,
billion.
oo
As reported earlier, the CBO projects that the economic cost of the GSEs
downfall,includingthefnancialcostofgovernmentsupportandactualdollarout-
lays,couldreach8billionbyio1.
Overall, as spending increased and revenues declined during the recession, the
federaldefcitgrewfrom,billioninioo8to1.trillioninioo.Anditisesti-
matedtohaverisento1.otrillioninio1o.
o,
THE FINANCIAL SECTOR:
ALMOST TRIPLE THE LEVEL OF THREE YEARS EARLIER
Whiletheoveralleconomyhasstruggled,thestoryforthefnancialsectorissome-
what different. Like other sectors of the economy, the fnancial industry has cut
1ui ituNu\i t i\iiuU1 ,+.
jobs. After growing steadily for years, employment in the fnancial sector fell by
1i8,oooinioo,,i,,oooinioo8,andanother1o,oooinioo.Areasdependenton
thefnancialindustry,suchasCharlotte,NorthCarolina,havebeenhithard.Theun-
employment rate in the Charlotte area rose from .8 in iooo to a recent peak of
1i.8inFebruaryio1o.
Between January ioo and December io1o, i, banks have failed; most were
small and medium-size banks.
o8
The number of small banks on the FDICs list of
troubledinstitutionsrosefrom8iinthesecondquarterofio1oto8oointhethird
quarter,thelargestnumbersinceMarch1.
o
Thoughanumberoflargefnancial
institutionsfailedornearlyfailedduringthecrisis,onthewholetheyhavedonebet-
tersincethefallofioo8.Totalfnancialsectorproftspeakedati8billioniniooo
andthenfellto1i8billioninioo8,thelowestlevelsincetheearly1os.Theyhave
sincereboundediniooandio1o,boostedbylowinterestratesandaccesstolow-
cost government borrowing. Financial sector profts were ii billion in ioo and
reachedanannualrateofobillioninthefallofio1o.
Withinthefnancialsector,commercialbankproftsrosefrom,.obillioninthe
frstquarterofiooto18.obillioninthefrstquarterofio1o.Thegainswerecon-
centrated among the larger banks.
,o
For banks with assets greater than 1 billion,
proftsmorethandoubled,fromo.billionto1.,billion,fromthefrstquarterof
iootothefrstquarterofio1o.
,1
Forcommercialbankswithlessthan1billionin
assets,proftsroseonlyio,fromlessthan1billionto1.ibillion.
,i
Thesecuritiesindustryhasreportedrecordproftsandisonceagaindistributing
largebonuses.JustforthosewhoworkinNewYorkCity,bonusesatWallStreetsecu-
rities frms in ioo were io. billion, up 1, from the year before, with average
compensation [rising] by i, percent to more than o,ooo.
,
After reporting ,
billionoflossesduringioo,andioo8,theNewYorkStateComptrollerreportedthat
in ioo, industry profts reached a record o1. billionalmost triple the level of
threeyearsearlier.
,
,+z
22
THE FORECLOSURE CRISIS
CONTENTS
Icrcc|csurcscnthcriscHardtcta|ka|cutanyrcccvcry ,o:
Initiativcstcstcnjcrcc|csurcsIcrsistcnt|ydisrcgard ,o,
I|awsinthcprcccssSpccu|aticnandwcrst-cascsccnarics ,o,
Ncigh|crhccdcjjcctsInnct|caving,o:
FORECLOSURES ON THE RISE:
HARD TO TALK ABOUT ANY RECOVERY
Sincethehousingbubbleburst,aboutfourmillionfamilieshavelosttheirhomesto
foreclosure
1
and another four and a half million
i
have slipped into the foreclosure
process or are seriously behind on their mortgage payments. When the economic
damage fnally abates, foreclosures may total between 8 million and more than 1
million,accordingtovariousestimates.

Theforeclosureepidemichashurtfamilies
andunderminedhomevaluesinentirezipcodes,strainedschoolsystemsaswellas
communitysupportservices,anddepletedstatecoffers.Eveniftheeconomybegan
suddenlyboomingthecountrywouldneedyearstorecover.
Prior to ioo,, the foreclosure rate was historically less than 1. But the trend
sincethehousingmarketcollapsedhasbeendramatic:Inioo,i.iofallhouses,or
1outof,,receivedatleastoneforeclosurefling.

Inthefallofio1o,1inevery11
outstandingresidentialmortgageloansintheUnitedStateswasatleastonepayment
pastduebutnotyetinforeclosureanominouswarningthatthiswavemaynothave
crested.
,
Distressedsalesaccountforthemajorityofhomesalesincitiesaroundthe
country,includingLasVegas,Phoenix,Sacramento,andRiverside,California.
o
Returning to the , borrowers whose loans were pooled into CMLTI iooo-
NCi: by September io1o, many had moved or refnanced their mortgages; by that
point,1,1,hadenteredforeclosure(mostlyinFloridaandCalifornia),and,ihad
started loan modifcations. Of the 1,,1, still active loans then, ,, were seriously
pastdueintheirpaymentsorcurrentlyinforeclosure.
,
The causes of foreclosures have been analyzed by many academics and govern-
ment agencies. Two events are typically necessary for a mortgage default. First,
monthlypaymentsbecomeunaffordableowingtounemploymentorotherfnancial
1ui iuiitiu:Uii tii :i : ,+,
hardship, or because mortgage payments increase. And second (in the opinion of
many,nowthemoreimportantfactor),thehomesvaluebecomeslessthanthedebt
owedinotherwords,theborrowerhasnegativeequity.
Theevidenceisirrefutable,LaurieGoodman,aseniormanagingdirectorwith
Amherst Securities, told Congress in ioo: Negative equity is the most important
predictorofdefault.Whentheborrowerhasnegativeequity,unemploymentactsas
oneofmanypossiblecatalysts,increasingtheprobabilityofdefault.
8
Afterfallingifromtheirpeakinioootothespringofioo,homepriceshave
rebounded somewhat, but improvements are uneven across regions.

Nationwide,
1o.8millionhouseholds,orii.,ofthosewithmortgages,owemoreontheirmort-
gagesthanthemarketvalueoftheirhouse(seefgureii.1).InNevada,o,ofhomes
with mortgages are under water, the highest rate in the country; in California, the
rateisi.
1o
Giventheextraordinaryprevalenceandextentofnegativeequity,thephenomenon
ofstrategicdefaultshasalsobeenontherise:homeownerspurposefullywalkaway
from mortgage obligations when they perceive that their homes are worth less than
whattheyoweandtheybelievethatthevaluewillnotbegoingupanytimesoon.
Bythefallofio1o,threestatesparticularlyhardhitbyforeclosuresCalifornia,
Florida,andNevadareportedsomerecentimprovementintheinitiationofforeclo-
sures,butinNovemberNevadasratewasstillfvetimeshigherthanthenationalav-
erage.Foreclosurestartsclimbedinstatesfromtheirlevelsayearearlier,withthe
largest increases in Washington State (which has .i unemployment), Indiana
(.8unemployment),andSouthCarolina(1o.ounemployment),accordingtothe
MortgageBankersAssociation.
InOhio,thecityofClevelandandsurroundingCuyahogaCountyarebulldozing
blocksofabandonedhousesdowntothedirtwiththeaimofcreatinganortheastern
Ohio bank of land preserved for the future. To do this, authorities seize blighted
propertiesforunpaidtaxes,andtheytakedonationsofhomesfromtheDepartment
ofHousingandUrbanDevelopment,FannieMae,andsomeprivatelenders.
11
Now,
thecountyfndsitselfunderincreasingduress,havingendured1,oooforeclosuresin
ioo.
1i
Afteryearsofhighunemploymentandafragileeconomy,thefnancialcrisis
tookvulnerableresidentsandshovedthemovertheedgeofthecliff,JimRokakis,
Cuyahogastreasurer,toldtheCommission.
1
Inaspringio1osurvey,8,oftherespondingmayorsrankedtheprevalenceof
nonprimeorsubprimemortgagesaseitherfrstorsecondonalistoffactorscausing
foreclosuresintheircities.Almostallthemayors,i,saidtheyexpectedthefore-
closureproblemstostaythesameorworsenintheircitiesoverthenextyear.
1
Therehasbeennomeaningfuldeclineintheinventoryofdistressedproperties
foundinthehousingmarket,GuyCecala,thechiefexecutiveandpublisherofInside
Mortgage Finance Publications, told a congressional panel overseeing the Troubled
Asset Relief Program in October io1o. It is hard to talk about any recovery of the
housingmarketwhentheshareofdistressedpropertytransactionsremainscloseto
,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 NQUi i tu\\i : :i uN iiiui1
Therewasafundamentalchangeinourfnancialservicessectorthatreallyisthe
reasonwereinthiscrisis,thiseconomiccrisis,andisthereasonwereseeingandwill
seeintotalprobablybeforeweredone,between1,and1omillionforeclosureflings
in this country, John Taylor, the president and CEO of the National Community
Reinvestment Coalition, explained to the FCIC. And by the way, a few hundred
thousandpeople,evenamillionpeoplegoingintoforeclosure,youcankindofblame
andsay,Welltheyshouldhaveknownbetter.But1,[or]1omillionAmericanfami-
liescantallbewrong.Theycantallbegreedyandtheycantallbestupid.
1o
1ui iuiitiu:Uii tii :i : ,+,
INITIATIVES TO STEM FORECLOSURES:
PERSISTENTLY DISREGARD
Thesamesystemthatwassoemcientatcreatingmillionsofmortgageloansoverthe
pastdecadehasbeenineffectiveatresolvingproblemsinthehousingmarket,includ-
ing the efforts of homeowners to modify their mortgages. As mortgage problems
mounted, the federal and state governments responded with fnancial incentives to
encouragebankstoadjustinterestrates,spreadloanpaymentsoverlongerterms,or
simply 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)isfallingshortoftheto
millionfamiliestargetedforhelpbytheendofio1i.(Theprogramsresourcescome
fromthefederalTARPfunds.)AsofDecemberio1o,HAMPhasresultedintheper-
manentmodifcationofonly,io,ooomortgages.
1,
Meanwhile,thebanksreportthat
they have independently approved . million loan alterations of various kinds, al-
though many of these modifcations simply roll missed payments into a new mort-
gageandthusresultinhighermonthlypayments.
18
The effectiveness of state mortgage modifcation and foreclosure assistance pro-
grams is unclear. Some are just getting started. New Jersey, for instance, will begin a
11imillionHomeKeeperPrograminio11,tooffersomeresidentswhofaceforeclo-
surebecauseofunemploymentorsubstantialunderemploymentadeferred-payment,
no-interestloansothattheycancontinuemakingpaymentsontheirmortgages.
1
During a series of hearings in communities around the country affected by the
housingcrisis,theCommissionheardfrommanywitnessesabouttheextraordinary
dimculties they had encountered in seeking to modify their mortgages and stay in
their homes. Borrowers who have been paying down mortgages for years and have
built up substantial equity are especially susceptible to being turned down for loan
modifcations, because the lender would prefer that they simply sell their homes.
KirstenKeefe,aseniorstaffattorneywiththeEmpireJusticeCenterinAlbany,New
York,broughtthisissuetoregulatorsattentioninMarchio1o.SpeakingtotheFed-
eral Reserve Boards Consumer Advisory Council in Washington, Keefe identifed
trends among borrowers in New York who tried to qualify for the governments
HAMP program. We are also routinely hearing that folks who have a lot of equity
are . . . being denied HAMP modifcations, she said.
io
Diane Thompson, from the
NationalConsumerLawCenter,testifedtotheUnitedStatesSenateCommitteeon
Banking,Housing,andUrbanAffairsinNovemberio1oaboutthechallengesofthe
program.Shestated,Onlyaveryfewofthepotentiallyeligibleborrowershavebeen
abletoobtainpermanentmodifcations.Advocatescontinuetoreportthatborrowers
aredeniedimproperlyforHAMP . . .andthatsomeservicerspersistentlydisregard
HAMPapplications.
i1
Competing incentives may encourage banks to view foreclosure as quicker,
cleaner, and often cheaper than modifying the terms of existing mortgages.
ii
,+ ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
For them, foreclosure is a prudent response to default because, the data suggest,
many borrowers who receive temporary or permanent forgiveness on their terms
willslideintodefaultagain.
i
Also,servicersmayreceivesubstantialfeesforguid-
ing a mortgage through the foreclosure process, creating an incentive to deny a
modification.
i
Frequently,theresanothercomplicationtoattemptingaforeclosureormodifi-
cation: the second mortgages that were layered onto first mortgages. The first
mortgages were commonly sold by banks into the securitization machine. The
second mortgages were often retained by the same lenders who typically service
the mortgage: that is, they process the monthly payments and provide customer
service to borrowers. If a first mortgage is modified or foreclosed on, the entire
value of the second mortgage may be wiped out. Under these circumstances,
the lender holding that second lien has an incentive to delay a modification into
a new loan that would make the mortgage payments more affordable to the
borrower.
i,
Thecountrysleadingbanksnowholdontheirbooksmorethanoobillionin
secondmortgages.
io
Totheextentthebankshavereportedtheseloansasperforming,
theloanshavenotbeenmarkeddownontheirbooks.Theactualvalueofthesesec-
ondmortgagescouldbemuchlessthantheiroobillion-plusreportedvalue.
i,
The
dangeroffuturelossesisself-evident.Somefrustratedfrst-lieninvestorshavesued
servicers,assertingtheyarenotprotectinginvestorsfnancialinterests.Instead,they
claim that because the servicer is holding the second lien, the servicers are looking
aftertheirownbalancesheetsbyencouragingborrowerstokeepupthepaymentson
their second mortgage when they cannot afford to make payments on both obliga-
tions.AccordingtoLaurieGoodman,formortgagemodifcationstowork,thehold-
ersofthesecondmortgageswillhavetoacceptsomelossesapotentiallyexpensive
proposition.
i8
A number of other obstacles have made modifcations dimcult. For example,
therearecompetinginterestsamongvariousinvestorsinamortgage-backedsecurity.
Proceedsfromaforeclosuremaybeenoughtopayofftheinvestorsholdingthehigh-
est-ratedtranchesofsecurities,whiletheholdersofthelowertrancheswouldlikely
bewipedout.Asaresult,theholdersofthelower-ratedtranchesmightpreferamod-
ifcation,ifitproducedmorecashfowthanaforeclosure.
Other efforts in the private and public sectors to address the foreclosure crisis
havefocusedonencouragingshortsales.Intheory,shortsalesshouldhelpborrow-
ers, neighborhoods, and lenders. Borrowers avoid foreclosure; neighborhoods
avoid vacant, dilapidated homes that encourage crime; and lenders avoid some of
thecostsofforeclosure.Nonetheless,suchdealsfrequentlystallbecausetheprocess
iscumbersome,demandscoordination,andeatsupresources.Forexample,lenders
can be reluctant to sign off on the buyers bid because they 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-
sureshaverevealedsystemicfawsinhowlendersdocumentedandprocessedmort-
gagesforsecuritization.LegalexpertsandconsumeradvocatestoldtheCommission
thatproceduralanddocumentationproblemswithforeclosurehavebeenlaidoutin
court cases and academic studies for years, but were ignored until the number of
foreclosuresrosesodramatically.
All,oofthenationsstateattorneysgeneralbandedtogetherinthefallofio1oto
investigate foreclosure irregularities, identify possible solutions, and explore poten-
tialredressforborrowerswhowereharmedbyimproperforeclosures.Forexample,
lendershavereliedonrobo-signerswhosubstitutedspeedforaccuracybysigning,
and sometimes backdating, hundreds of amdavits claiming personal knowledge of
facts about mortgages that they did not actually know to be true. One such robo-
signer,JeffreyStephanofGMAC,saidthathesigned1o,oooamdavitsinamonth
roughly 1 per minute, in a o-hour workweekmaking it highly unlikely that he
verifed payment histories in each individual case of foreclosure.
i
In addition, a
number of court cases have been fled alleging invalid notarizations, forged signa-
tures,backdatedmortgagepaperwork,andfailuretodemonstratehavinglegalstand-
ingtoforeclosethatis,beingtheentitywiththerighttorepossessahome.
o
Theproblemoflegalstandingarosebecausetherapidgrowthofmortgagesecuri-
tization outpaced the ability of the legal and fnancial system to accurately record
whoownsthemortgage.Duringthesecuritizationprocess,loansweresoldmultiple
times. To speed up processing, the fnancial industry created Mortgage Electronic
Registration Systems, Inc. (MERS), an organization made up of ,ooo mortgage
lenders. It tracks changes in servicing rights and ownership interests in mortgage
loans.MERSisdesignatedasthemortgageeofrecordonbehalfofitsmembers,a
statusthatismeanttogiveitthelegalrighttoforecloseiftheborrowerfailstopaythe
loan.MERShasregisteredoomillionmortgagessincelaunchingin1,andhad
millionloansoutstandingasofNovemberio1o.
1
ThestandingofMERSoritsdesigneestoforeclosehasbeencalledintoquestion
by courts and academics, however.
i
In a hearing before the House Judiciary Com-
mittee on the foreclosure crisis, New York State Supreme Court Justice F. Dana
WinslowtestifedthatstandinghasbecomesuchapervasiveissuethatIfrequently
usethetermpresumptivemortgageeinforeclosuretodescribeMERS.Becauseof
multipleunrecordedtransfersofthelegalownershipofthe[m]ortgage,itisunclear
whetherMERScontinuedtobethemortgageeaftersubsequentsalesoftheloan,ac-
cordingtoWinslow.

Moreover,courtshaveheldthatMERSdoesnotowntheun-
derlyingnoteandthereforecannottransferthenoteorthedeedoftrust,orforeclose
upontheproperty.

Winslow also highlighted other defciencies in MERS standing, many involving

sloppypaperwork:thefailuretoproducethecorrectpromissorynotesincourtduring
,+ ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
foreclosureproceedings;gapsinthechainoftitle,includingprintoutsofthetitlethat
havedifferedsubstantiallyfrominformationprovidedpreviously;retroactiveassign-
mentsofnotesandmortgagesinanefforttocleanupthepaperworkproblemsfrom
earlier years; questionable signatures on assignments and amdavits attesting
to the ownership of the note and mortgage; and questionable notary stamps on
assignments.
,
On November 1o, io1o, a bankruptcy court ruled that the Bank of New York
could not foreclose on a loan it had purchased from Countrywide, because MERS
hadfailedtoendorseordeliverthenotetotheBankofNewYorkasrequiredbythe
pooling and servicing agreement. This ruling could have further implications, be-
causeitwascustomaryforCountrywidetomaintainpossessionofthenoteandre-
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 buy them back at the original pricepossibly with interest. The issuers
wouldthenbetheownersofthesecuritiesandwouldbeartheriskofloss.
8
TheCongressionalOversightPanel,inareportissuedinNovemberio1o,saidit
is on the lookout for such risks: If documentation problems prove to be pervasive
and,moreimportantly,throwintodoubttheownershipofnotonlyforeclosedprop-
ertiesbutalsopooledmortgages,theconsequencescouldbesevere.

Thissentiment
was echoed by University of Iowa law professor Katherine Porter who has studied
foreclosures and the law: It is lack of knowledge of how widespread the problems
maybethatisturningtheallegationsintoacrisis.Lackofknowledgefeedsspecula-
tion and worst-case scenarios.
o
Adam Levitin, a Georgetown University associate
professoroflaw,hasestimatedthattheclaimscouldbeinthetrillionsofdollars,ren-
deringmajorU.S.banksinsolvent.
1
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-
cletoforestsofforsalesignsbutthistimeattractingfewbuyers.Storeshaveshut-
tered; employers have cut jobs; hopes have fed. Too many Americans today 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
lendersseizepropertyafterlandlordsdefaultonloans.Renterscanlosetheroofover
their heads as well as their security deposits. In Minneapolis, as many as oo of
buildingswithforeclosuresinioooandioo,wererenter-occupied,accordingtosta-
tisticscitedintestimonybyDeputyAssistantSecretaryErikaPoethigfromtheU.S.
Department of Housing and Urban Development to the House of Representatives
SubcommitteeonHousingandCommunityOpportunity.
i
1ui iuiitiu:Uii tii :i : ,+,
For children, a repossessed housewhether rented or boughtis destabilizing.
Theimpactofforeclosuresonchildrenaroundthecountryhasbeenenormous.One-
third of the children who experienced homelessness after the fnancial crisis did so
becauseofforeclosuresofthehousingthattheirparentsownedorwererenting,ac-
cordingtoarecentstudy.

OneschoolomcialinNevadatoldtheCommissionabout
thesignifcantchallengestotheeducationalsystemcreatedbytheeconomiccrisis.

All around, the demand from people who need help is outstripping community
resources. Coast to coast, communities are trying to stretch housing aid budgets to
helppeopledisplacedbyforeclosures.InNevada,forexample,ClarkCounty,which
contains1.millionpeoplelivinginandaroundLasVegas,wasforcedtocutitsFi-
nancialHousingAssistanceprogram,despitetheclearneedsinthecommunity.Gail
Burks,thepresidentandchiefexecutiveoftheNevadaFairHousingCenter,toldthe
Commission that her group fnds that many they counsel through the foreclosure
process are in despair. Its very stressful. There are times that the couples we are
helpingendupdivorcing,sometimesbeforetheprocessisover. . . .Wevealsoseen
threatsofsuicide.
,
Andthestoriescontinue.KarenMann,theappraiserfromDiscoveryBay,Cali-
fornia,testifedtotheCommissionaboutherfamilyscircumstances.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 pay-
mentsmorethanthefamilycouldafford.Becausethemarketvalueofthehomewas
nearlyequaltotheirmortgagedebt,thefamilysattemptstogetthemortgagemodi-
fed were fruitless. They lined up a buyer for a short sale, but the deal was nixed.
Then, when medical problems created yet another challenge, the couple and their
four children moved in with Mann. The children were relocated to new schools,
andtheadultsdealtwiththepainandemotionalsufferingwhiletheyweretryingto
rebuild their lives, Mann said. The couple fled for bankruptcy. Two months after
the bankruptcy was completed, the lender asked them if they wanted to modify
theirmortgage.
o
InCapeCoral,Florida,DawnHuntandherhusband,amailman,andtheirtwo
childrenliveinanattractiveranch-stylehometheyboughtforabout1oo,ooomore
thanadecadeago.Itwasaquiet,io-year-oldsubdivisionwheremostoftheresidents
were homeowners. In ioo, and iooo, builders rushed to the area and threw up
dozens of new homes on empty lots. Homebuilder Comfort Homes of Florida LLC
brokegroundforahouseacrossthestreetfromtheHunts,butdidnotcompleteit.
Thisfall,thehousesatvacant,anemptyshell.Nostuccowaseverappliedtothecon-
creteblockexterior,andthehousehadnointeriorwalls.Awaspnestdecoratedthe
electrical box near the front door. The untended grass had grown four feet high.
Sharpsandspursinthebrushmadeitdimculttoapproachtheproperty.Twodoors
downfromtheHunts,anotherhousewasalsovacant,leftemptywhenafamilysplit
up and moved a year earlier. They abandoned a car in the garage. The roof leaked,
andablueplastictarpputinplacetokeeptherainoutnowfapsinthebreeze.The
Huntscalledthepoliceaftervandalsbrokeintothehouseonenight;intrudershave
beenbacktwicemoreinthedaylight.
,
,.+ ii N\Nti \i tii :i : i NQUi i tu\\i : :i uN iiiui1
NowofthehomesintheHuntsneighborhoodareindefault,areinthefore-
closureprocess,orhavebeentakenbackbythebank.
8
Mostoftheotherhousesin
thecommunityareoccupiedbyrenterswhoseabsenteelandlordsboughtthehouses
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 lovely as it used to be, Dawn Hunt told the FCIC, Im not
leaving.

COMMISSION CONCLUSIONS ON CHAPTER 22

TheCommissionconcludestheuncheckedincreaseinthecomplexityofmort-
gages and securitization has made it more dimcult to solve problems in the
mortgagemarket.Thiscomplexityhascreatedpowerfulcompetinginterests,in-
cludingthoseoftheholdersoffrstandsecondmortgagesandofmortgageser-
vicers; has reduced transparency for policy makers, regulators, fnancial
institutions, and homeowners; and has impeded mortgage modifcations. The
resulting disputes and inaction have caused pain largely borne by individual
homeowners and created further uncertainty 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|icy,+,
1hcHcusingBu|||c ,::
1urningBadMcrtgagcsintc1cxicIinancia|Asscts ,:,
BigBankBctsandVhyBanksIai|cd,:,
1wc1ypcscjSystcnicIai|urc,,+
1hcShcckandthcIanic,,,
1hcSystcnIrcc:ing ,,,
INTRODUCTION
We have identifed ten causes that are essential to explaining the crisis. In this dis-
sentingview:
Weexplainhowourapproachdiffersfromothers;
Webriefydescribethestagesofthecrisis;
Welistthetenessentialcausesofthecrisis;and
Wewalkthrougheachcauseinabitmoredetail.
Wefndareasofagreementwiththemajoritysconclusions,butunfortunatelythe
areasofdisagreementaresignifcantenoughthatwedissentandpresentourviewsin
thisreport.
We wish to compliment the Commission staff for their investigative work. In
manywaysithelpedshapeourthinkingandconclusions.
DuetoalengthlimitationrecentlyimposeduponusbysixmembersoftheCom-
mission,
1
thisreportfocusesonlyonthecausesessential toexplainingthecrisis.We
regret that the limitation means that several important topics that deserve a much
fullerdiscussiongetonlyabriefmentionhere.
,.,
HOW OUR APPROACH DIFFERS FROM OTHERS
During the course of the Commissions hearings and investigations, we heard fre-
quentargumentsthattherewasasinglecauseofthecrisis.Forsomeitwasinterna-
tional capital fows or monetary policy; for others, housing policy; and for still
others,itwasinsumcientregulationofanambiguouslydefnedshadowbankingsec-
tor,orunregulatedover-the-counterderivatives,orthegreedofthoseinthefnancial
sectorandthepoliticalinfuencetheyhadinWashington.
In each case, these arguments, when used as single-cause explanations, are too
simplistic because they are incomplete. While some of these factors were essential
contributorstothecrisis,eachisinsumcientasastandaloneexplanation.
The majoritys approach to explaining the crisis suffers from the opposite prob-
lemit is too broad. Not everything that went wrong during the fnancial crisis
causedthecrisis,andwhilesomecauseswereessential,othershadonlyaminorim-
pact.Noteveryregulatorychangerelatedtohousingorthefnancialsystempriorto
thecrisiswasacause.Themajoritysalmost,,o-pagereportismoreanaccountof
badeventsthanafocusedexplanationofwhathappenedandwhy.Wheneverything
isimportant,nothingis.
As an example, non-credit derivatives did not in any meaningful way cause or
contributetothefnancialcrisis.NeithertheCommunityReinvestmentActnorre-
moval of the Glass-Steagall frewall was a signifcant cause. The crisis can be ex-
plainedwithoutresortingtothesefactors.
Wealsorejectastoosimplisticthehypothesisthattoolittleregulationcausedthe
crisis,aswellasitsopposite,thattoomuchregulationcausedthecrisis.Wequestion
this metric for determining the effectiveness of regulation. Theamount of fnancial
regulationshouldrefecttheneedtoaddressparticularfailuresinthefnancialsys-
tem. For example, high-risk, nontraditional mortgage lending by nonbank lenders
fourishedintheiooosanddidtremendousdamageinanineffectivelyregulateden-
vironment,contributingtothefnancialcrisis.Poorlydesignedgovernmenthousing
policies distorted market outcomes and contributed to the creation of unsound
mortgagesaswell.CountrywidesirresponsiblelendingandAIGsfailurewereinpart
attributabletoineffectiveregulationandsupervision,whileFannieMaeandFreddie
Macs failures were the result of policymakers using the power of government to
blendpublicpurposewithprivategainsandthensocializingthelosses.Boththetoo
little government and too much government approaches are too broad-brush to
explainthecrisis.
The majority says the crisis was avoidable if only the United States had adopted
across-the-board more restrictive regulations, in conjunction with more aggressive
regulatorsandsupervisors.Thisconclusionbythemajoritylargelyignorestheglobal
natureofthecrisis.Forexample:
A credit bubble appeared in both the United States and Europe. This tells us
that our primary explanation for the credit bubble should focus on factors
commontobothregions.
,., ii : :iN1i Nt :1\1i\iN1 ,., ii : :iN1i Nt :1\1i\iN1
Thereportlargelyignoresthecreditbubblebeyondhousing.Creditspreadsde-
clinednotjustforhousing,butalsoforotherassetclasseslikecommercialreal
estate.ThistellsustolooktothecreditbubbleasanessentialcauseoftheU.S.
housingbubble.ItalsotellsusthatproblemswithU.S.housingpolicyormar-
ketsdonotbythemselvesexplaintheU.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-stylemortgagesecuritization.A
good explanation of the U.S. housing bubble should also take into account its
parallelsinothernations.ThisleadsustoexplanationsbroaderthanjustU.S.
housingpolicy,regulation,orsupervision.Italsotellsusthatwhilefailuresin
U.S. securitization markets may be an essential cause, we must look for other
thingsthatwentwrongaswell.
Large fnancial frms failed in Iceland, Spain, Germany, and the United King-
dom,amongothers.NotallofthesefrmsbetsolelyonU.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\\: ,.,
they operated in different regulatory and supervisory regimes than U.S. com-
mercial and investment banks. In many cases these European systems have
stricterregulationthantheUnitedStates,andstilltheyfacedfnancialfrmfail-
uressimilartothoseintheUnitedStates.
Thesefactstellusthatourexplanationforthecreditbubbleshouldfocusonfac-
torscommontoboththeUnitedStatesandEurope,thatthecreditbubbleislikelyan
essentialcauseoftheU.S.housingbubble,andthatU.S.housingpolicyisbyitselfan
insumcient explanation of the crisis. Furthermore, any explanation that relies too
heavilyonauniqueelementoftheU.S.regulatoryorsupervisorysystemislikelyto
be insumcient to explain why the same thing happened in parts of Europe. This
movesinadequateinternationalcapitalandliquiditystandardsupourlistofcauses,
anditmovesthedifferencesbetweentheregulationofU.S.commercialandinvest-
mentbanksdownthatlist.
Applying these international comparisons directly to the majoritys conclusions
provokesthesequestions:
IfthepoliticalinfuenceofthefnancialsectorinWashingtonwasanessential
causeofthecrisis,howdoesthatexplainsimilarfnancialinstitutionfailuresin
the United Kingdom, Germany, Iceland, Belgium, the Netherlands, France,
Spain,Switzerland,Ireland,andDenmark:
Howcantherunawaymortgagesecuritizationtraindetailedinthemajoritys
report explain housing bubbles in Spain, Australia, and the United Kingdom,
countries with mortgage fnance systems vastly different than that in the
UnitedStates:
Howcanthecorporateandregulatorystructuresofinvestmentbanksexplain
the decisions of many U.S. commercial banks, several large American univer-
sityendowments,andsomestatepublicemployeepensionfunds,nottomen-
tion a number of large and midsize German banks, to take on too much U.S.
housingrisk:
HowdidformerFedChairmanAlanGreenspansderegulatoryideologyalso
precipitatebankregulatoryfailuresacrossEurope:
Not all of these factors identifed by the majority were irrelevant; they 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.
Webeginourexplanationbybriefydescribingthestagesofthecrisis.
,. ii : :iN1i Nt :1\1i\iN1 ,. ii : :iN1i Nt :1\1i\iN1
STAGES OF THE CRISIS
AsofDecemberio1o,theUnitedStatesisstillinaneconomic slump causedbyaf-
nancial crisis thatfrstmanifesteditselfinAugustioo,andendedinearlyioo.The
primaryfeaturesofthatfnancialcrisiswereafnancial shock inSeptemberioo8and
aconcomitantfnancial panic.Thefnancialshockandpanictriggeredaseverecon-
tractioninlendingandhiringbeginninginthefourthquarterofioo8.
Some observers describe recent economic history as a recession that began in
Decemberioo,andcontinueduntilJuneioo,andfromwhichweareonlynowbe-
ginningtorecover.Whilethisdefnitionoftherecessionistechnicallyaccurate,itob-
scures a more important chronology that connects fnancial market developments
with the broader economy. We describe recent U.S. macroeconomic history in fve
stages:
A series of foreshocks beginning in August ioo,, followed by an economic
slowdown and then a mild recession through August ioo8, as liquidity prob-
lemsemergedandthreelargeU.S.fnancialinstitutionsfailed;
AseverefnancialshockinSeptemberioo8,inwhichtenlargefnancialinstitu-
tionsfailed,nearlyfailed,orchangedtheirinstitutionalstructure;triggering
Afnancialpanicandthebeginningofalargecontractionintherealeconomy
inthelastfewmonthsofioo8;followedby
The end of the fnancial shock, panic, and rescue at the beginning of ioo;
followedby
Acontinuedanddeepeningcontractionintherealeconomyandthebeginning
ofthefnancialrecoveryandrebuildingperiod.
AsofDecemberio1o,theUnitedStatesisstillinthelaststage.Thefnancialsys-
temisstillrecoveringandbeingrestructured,andtheU.S.economystrugglestore-
turn to sustained strong growth. The remainder of our comments focuses on the
fnancialcrisisinthefrstthreestagesbyexaminingitstenessentialcauses.
THE TEN ESSENTIAL CAUSES
OF THE FINANCIAL AND ECONOMIC CRISIS
Thefollowingtencauses,globalanddomestic,areessentialtoexplainingthefnan-
cialandeconomiccrisis.
I. Credit bubble. Starting in the late 1os, China, other large developing
countries,andthebigoil-producingnationsbuiltuplargecapitalsurpluses.
TheyloanedthesesavingstotheUnitedStatesandEurope,causinginterest
ratestofall.Creditspreadsnarrowed,meaningthatthecostofborrowingto
fnance risky 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. monetary policy may have con-
tributedtothecreditbubblebutdidnotcauseit.
II. Housing bubble. Beginninginthelate1osandacceleratingintheiooos,
there was a large and sustained housing bubble in the United States. The
bubble was characterized both by national increases in house prices well
above the historical trend and by rapid regional boom-and-bust cycles in
California, Nevada, Arizona, and Florida. Many factors contributed to the
housing bubble, the bursting of which created enormous losses for home-
ownersandinvestors.
III. Nontraditional mortgages. Tighteningcreditspreads,overlyoptimisticas-
sumptions about U.S. housing prices, and faws in primary and secondary
mortgage markets led to poor origination practices and combined to in-
creasethefowofcredittoU.S.housingfnance.Fueledbycheapcredit,frms
like Countrywide, Washington Mutual, Ameriquest, and HSBC Finance
originatedvastnumbersofhigh-risk,nontraditionalmortgagesthatwerein
somecasesdeceptive,inmanycasesconfusing,andoftenbeyondborrowers
ability to repay. At the same time, many homebuyers 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
thecreditqualityofthemortgagestheysecuritized.Creditratingagencieser-
roneously rated mortgage-backed securities and their derivatives as safe in-
vestments. Buyers failed to look behind the credit ratings and do their own
duediligence.Thesefactorsfueledthecreationofmorebadmortgages.
V. Financial institutions concentrated correlated risk. Managers of many
large and midsize fnancial institutions in the United States amassed enor-
mousconcentrationsofhighlycorrelatedhousingrisk.Somedidthisknow-
ingly by betting on rising housing prices, while others paid insumcient
attention to the potential risk of carrying large amounts of housing risk on
theirbalancesheets.Thisenabledlargebutseeminglymanageablemortgage
lossestoprecipitatethecollapseoflargefnancialinstitutions.
VI. Leverage and liquidity risk. Managersofthesefnancialfrmsamplifedthis
concentrated housing risk by holding too little capital relative to the risks
theywerecarryingontheirbalancesheets.Manyplacedtheirfrmsonahair
trigger by relying heavily on short-term fnancing in repo and commercial
paper markets for their day-to-day liquidity. They placed solvency bets
(sometimesunknowingly)thattheirhousinginvestmentsweresolid,andliq-
uiditybetsthatovernightmoneywouldalwaysbeavailable.Bothturnedout
tobebadbets.Inseveralcases,failedsolvencybetstriggeredliquiditycrises,
causingsomeofthelargestfnancialfrmstofailornearlyfail.Firmswerein-
sumcientlytransparentabouttheirhousingrisk,creatinguncertaintyinmar-
,. ii : :iN1i Nt :1\1i\iN1
iii 1u uiNNi: :i, iuUti\: uui1/ i\ii N, \Ni 8i ii 1uu\\: ,.,
ketsthatmadeitdimcultforsometoaccessadditionalcapitalandliquidity
whenneeded.
VII. Risk of contagion. Theriskofcontagionwasanessentialcauseofthecrisis.
In some cases, the fnancial system was vulnerable because policymakers
wereafraidofalargefrmssuddenanddisorderlyfailuretriggeringbalance-
sheetlossesinitscounterparties.Theseinstitutionsweredeemedtoobigand
interconnected to other frms through counterparty credit risk for policy-
makerstobewillingtoallowthemtofailsuddenly.
VIII. Common shock. In other cases, unrelated fnancial institutions failed be-
causeofacommonshock:theymadesimilarfailedbetsonhousing.Uncon-
nected fnancial frms failed for the same reason and at roughly the same
timebecausetheyhadthesameproblem:largehousinglosses.Thiscommon
shock meant that the problem was broader than a single failed bankkey
large fnancial institutions were undercapitalized because of this common
shock.
IX. Financial shock and panic. InquicksuccessioninSeptemberioo8,thefail-
ures,near-failures,andrestructuringsoftenfrmstriggeredaglobalfnancial
panic.Confdenceandtrustinthefnancialsystembegantoevaporateasthe
health of almost every large and midsize fnancial institution in the United
StatesandEuropewasquestioned.
X. Financial crisis causes economic crisis. The fnancial shock and panic
causedaseverecontractionintherealeconomy.Theshockandpanicended
inearlyioo.Harmtotherealeconomycontinuesthroughtoday.
Wenowdescribethesetenessentialcausesofthecrisisinmoredetail.
THE CREDIT BUBBLE: GLOBAL CAPITAL FLOWS,
UNDERPRICED RISK, AND FEDERAL RESERVE POLICY
ThefnancialandeconomiccrisisbeganwithacreditbubbleintheUnitedStatesand
Europe.Creditspreadsnarrowedsignifcantly,meaningthatthecostofborrowingto
fnanceriskyinvestmentsdeclinedrelativetosafeassetssuchasU.S.Treasurysecuri-
ties.Themostnotableoftheseriskyinvestmentswerehigh-riskmortgages.
The U.S. housing bubble was the most visible effect of the credit bubble but not
the only one. Commercial real estate, high-yield debt, and leveraged loans were all
boostedbythesurplusofinexpensivecredit.
There are three major possible explanations for the credit bubble: global capital
fows,therepricingofrisk,andmonetarypolicy.
6looelceiteljlovs
Starting in the late 1os, China, other large developing countries, and the big oil-
producing nations consumed and invested domestically less than they earned. As
China and other Asian economies grew, their savings grew as well. In addition,
boostedbyhighglobaloilprices,thelargestoil-producingnationsbuiltuplargecap-
italsurplusesandlookedtoinvestintheUnitedStatesandEurope.Massiveamounts
ofinexpensivecapitalfowedintotheUnitedStates,makingborrowinginexpensive.
Americans used the cheap credit to make riskier investments than in the past. The
samedynamicwasatworkinEurope.Germanysaved,anditscapitalfowedtoIre-
land,Italy,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 highly signifcant, both statistically and economically, and about 1
percentofthevariabilityinhousepriceappreciationacrosscountriesisexplained.
i
Global imbalances are an essential cause of the crisis and the most important
macroeconomic explanation. Steady and large increases in capital infows into the
U.S.andEuropeaneconomiesencouragedsignifcantincreasesindomesticlending,
especiallyinhigh-riskmortgages.
1/crcricingojrisk
Low-costcapitalcanbutdoesnotnecessarilyhavetoleadtoanincreaseinriskyin-
vestments.IncreasedcapitalfowstotheUnitedStatesandEuropecannotaloneex-
plainthecreditbubble.
We still dont know whether the credit bubble was the result of rational or irra-
tional behavior. Investors may have been rationaltheir preferences may have
changed, making them willing to accept lower returns for high-risk investments.
Theymayhavecollectivelybeenirrationaltheymayhaveadoptedabubblemental-
ity and assumed that, while they were paying a higher price for risky assets, they
couldresellthemlaterforevenmore.Ortheymayhavemistakenlyassumedthatthe
worldhadgottensaferandthattheriskofbadoutcomes(especiallyinU.S.housing
markets)haddeclined.
Forsomecombinationofthesereasons,overaperiodofmanyyearsleadingupto
thecrisis,investorsgrewwillingtopaymoreforriskyassets.Whenthehousingbub-
bleburstandthefnancialshockhit,investorseverywherereassessedwhatreturnthey
would demand for a risky investment, and therefore what price they were willing to
pay for a risky asset. Credit spreads for all types of risk around the world increased
suddenlyandsharply,andthepricesofriskyassetsplummeted.Thiswasmostevident
inbutnotlimitedtotheU.S.marketforfnancialassetsbackedbyhigh-risk,nontradi-
tionalmortgages.Thecreditbubbleburstandcausedtremendousdamage.
Moncter;olic;
The Federal Reserve signifcantly affects the availability and price of capital. This
leads some to argue that the Fed contributed to the increased demand for risky in-
,z+ ii : :iN1i Nt :1\1i\iN1
vestmentsbykeepinginterestratestoolowfortoolong.CriticsofFedpolicyargue
that, beginning under Chairman Greenspan and continuing under Chairman
Bernanke,theFedkeptratestoolowfortoolongandcreatedabubbleinhousing.
Dr.JohnB.Taylorisaproponentofthisargument.HearguesthattheFedsetin-
terestratestoolowiniooiioooandthattheselowratesfueledthehousingbubble
asmeasuredbyhousingstarts.HesuggeststhatthisFed-createdhousingbubblewas
the essential cause of the fnancial crisis. He further argues that, had federal funds
ratesinsteadfollowedthepathrecommendedbytheTaylorRule(amonetarypolicy
formula for setting the funds rate), the housing boom and subsequent bust would
have been much smaller. He also applies this analysis to European economies and
concludesthatsimilarforceswereatplay.
CurrentFedChairmanBernankeandformerFedChairmanGreenspandisagree
withTaylorsanalysis.ChairmanBernankearguesthattheTaylorRuleisadescriptive
rule of thumb, but that simple policy rules are insumcient for making monetary
policydecisions.

Hefurtherarguesthat,dependingontheconstructionofthepar-
ticularTaylorRule,themonetarypolicystanceoftheFedmaynothavedivergedsig-
nifcantly from its historical path. Former Chairman Greenspan adds that the
connectionbetweenshort-terminterestratesandhousepricesisweakthatevenif
theFedstargetforovernightlendingbetweenbankswastoolow,thishaslittlepower
toexplainwhyratesonthirty-yearmortgageswerealsotoolow.
Thisdebateintertwinesseveralmonetarypolicyquestions:
HowheavilyshouldtheFedweighapolicyruleinitsdecisionstosetinterest
rates:Shouldmonetarypolicybemostlyrule-basedormostlydiscretionary:
IftheFedthinksanassetbubbleisdeveloping,shoulditusemonetarypolicyto
trytopoporpreventit:
Wereinterestratestoolowiniooiiooo:
Didtoo-lowfederalfundsratescauseorcontributetothehousingbubble:
Thisdebateiscomplexandthusfarunresolved.Loosemonetarypolicydoesnot
necessarilyleadtosmallercreditspreads.Thereareopenquestionsaboutthelinkbe-
tweenshort-terminterestratesandhousepriceappreciation,whetherhousingstarts
arethebestmeasureofthehousingbubble,thetimingofhousingpriceincreasesrel-
ativetotheinterestratesiniooiiooo,theEuropeancomparison,andwhetherthe
magnitude of the bubble can be explained by the gap between the Taylor Rule pre-
scription and historic rates. At the same time, many observers argue that Taylor 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. monetary policy may
have been an amplifying factor, but it did not by itself cause the credit bubble, nor
wasitessentialtocausingthecrisis.
TheCommissionshouldhavefocusedmoretimeandenergyonexploringthese
questionsaboutglobalcapitalfows,riskrepricing,andmonetarypolicy.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 nearly
enough on analyzing these critical economic questions. The investigations were in
manycasesproductiveandinformative,butthereshouldhavebeenmorebalancebe-
tweeninvestigationandanalysis.
tonclusions.
Thecreditbubblewasanessentialcauseofthefnancialcrisis.
GlobalcapitalfowsloweredthepriceofcapitalintheUnitedStatesandmuch
ofEurope.
Over time, investors lowered the return they required for risky investments.
Theirpreferencesmayhavechanged,theymayhaveadoptedanirrationalbub-
blementality,ortheymayhavemistakenlyassumedthattheworldhadbecome
safer.Thisinfatedpricesforriskyassets.
U.S. monetary policy may have contributed to the credit bubble but did not
causeit.
THE HOUSING BUBBLE
Thehousingbubblehadtwocomponents:theactualhomesandthemortgagesthat
fnancedthem.Welookbriefyateachcomponentanditspossiblecauses.
There was a housing bubble in the United Statesthe price of U.S. housing in-
creased by more than could be explained by 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 youre in one, and
painfullyobviousafterithasburst.EvenaftertheU.S.housingbubbleburst,thereis
noconsensusonwhatcausedit.
While we still dont know the relative importance of the possible causes of the
housingbubble,wecanatleastidentifysomeofthemostimportanthypotheses:
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
supplyisconstrainedanddemandincreases,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 homebuyers to borrow enough to buy more expensive homes. This
doesnt mean they could afford those homes or future mortgage payments in
,zz ii : :iN1i Nt :1\1i\iN1 ,zz ii : :iN1i Nt :1\1i\iN1
the long run, but only that someone was willing to provide the initial loan.
Mortgage originators often had insumcient incentive to encourage borrowers
togetsustainablemortgages.
SomecombinationofthefrsttwofactorsmayapplyinpartsoftheSandStates,
butthesedontexplainthenationwideincreaseinprices.
Thecloselyrelatedandnationwidemortgage bubblewasthelargestandmostsig-
nifcantmanifestationofamoregeneralizedcreditbubbleintheUnitedStatesandEu-
rope.Mortgagerateswerelowrelativetotheriskoflosses,andriskyborrowers,who
inthepastwouldhavebeenturneddown,founditpossibletoobtainamortgage.

In addition to the credit bubble, the proliferation of nontraditional mortgage

productswasakeycauseofthissurgeinmortgagelending.Useoftheseproductsin-
creasedrapidlyfromtheearlypartofthedecadethroughiooo.Therewasasteady
deteriorationinmortgageunderwritingstandards(enabledbysecuritizersthatlow-
eredthecreditqualityofthemortgagestheywouldaccept,andcreditratingagencies
thatoverratedthesubsequentsecuritiesandderivatives).Therewasacontemporane-
ousincreaseinmortgagesthatrequiredlittletonodocumentation.
As house prices rose, declining affordability would normally have constrained
demand,butlendersandborrowersincreasinglyreliedonnontraditionalmortgage
products to paper over this affordability issue. These mortgage products included
interest-only adjustable rate mortgages (ARMs), pay-option ARMs that gave bor-
rowersfexibilityonthesizeofearlymonthlypayments,andnegativeamortization
productsinwhichtheinitialpaymentdidnotevencoverinterestcosts.Theseexotic
mortgage products would often result in signifcant reductions in the initial
monthlypaymentcomparedwithevenastandardARM.Notsurprisingly,theywere
the mortgages of choice for many lenders and borrowers focused on minimizing
initialmonthlypayments.
Fed Chairman Bernanke sums up the situation this way: At some point, both
lendersandborrowersbecameconvincedthathousepriceswouldonlygoup.Bor-
rowerschose,andwereextended,mortgagesthattheycouldnotbeexpectedtoserv-
ice in the longer term. They were provided these loans on the expectation that
accumulating home equity would soon allow refnancing into more sustainable
mortgages.Foratime,risinghousepricesbecameaself-fulfllingprophecy,butulti-
mately,furtherappreciationcouldnotbesustainedandhousepricescollapsed.
,
Thisexplanationpositsarelationshipbetweenthesurgeinhousingpricesandthe
surgeinmortgagelending.Thereisnotyetaconsensusonwhichwasthecauseand
whichtheeffect.Theyappeartohavebeenmutuallyreinforcing.
Inunderstandingthegrowthofnontraditionalmortgages,itisalsodimculttode-
terminetherelativeimportanceofcausalfactors,butagainwecanatleastlistthose
thatareimportant:
Nonbank mortgage lenders like New Century and Ameriquest fourished un-
derineffectiveregulatoryregimes,especiallyatthestatelevel.Weakdisclosure
standardsandunderwritingrulesmadeiteasyforirresponsiblelenderstoissue
iii 1u uiNNi: :i, iuUti\: uui1/ i\ii N, \Ni 8i ii 1uu\\: ,z,
mortgagesthatwouldprobablyneverberepaid.Federallyregulatedbankand
thrift lenders, such as Countrywide, Wachovia, and Washington Mutual, had
lenientregulatoryoversightonmortgageoriginationaswell.
Mortgage brokers were paid for new originations but did not ultimately bear
thelossesonpoorlyperformingmortgages.Mortgagebrokersthereforehadan
incentivetoignorenegativeinformationaboutborrowers.
Manyborrowersneitherunderstoodthetermsoftheirmortgagenorappreci-
ated the risk that home values could fall signifcantly, while others borrowed
toomuchandboughtbiggerhousesthantheycouldeverreasonablyexpectto
afford.
All these factors were supplemented by government policies, many of which
hadbeenineffectfordecades,thatsubsidizedhomeownershipbutcreatedhid-
dencoststotaxpayersandtheeconomy.Electedomcialsofbothpartiespushed
housingsubsidiestoofar.
The Commission heard convincing testimony of serious mortgage fraud prob-
lems. Excruciating anecdotes showed that mortgage fraud increased substantially
during the housing bubble. There is no question that this fraud did tremendous
harm.Butwhilethatfraudisinfuriatingandmayhavebeensignifcantincertainar-
eas(likeFlorida),theCommissionwasunabletomeasuretheimpactoffraudrela-
tivetotheoverallhousingbubble.
The explosion of legal but questionable lending is an easier explanation for the
creationofsomanybadmortgages.Lendingstandardswerelaxenoughthatlenders
couldremainwithinthelawbutstillgeneratehugevolumesofbadmortgages.Itis
likely that the housing bubble and the crisis would have occurred even if there had
been no mortgage fraud. We therefore classify mortgage fraud not as an essential
causeofthecrisisbutasacontributingfactorandadeplorableeffectofthebubble.
Evenifthenumberoffraudulentloanswasnotsubstantialenoughtohavealargeim-
pactonthebubble,theincreaseinfraudulentactivityshouldhavebeenaleadingin-
dicatorofdeeperstructuralproblemsinthemarket.
tonclusions.
Beginninginthelate1osandacceleratingintheiooos,therewasalargeand
sustained housing bubble in the United States. The bubble was characterized
bothbynationalincreasesinhousepriceswellabovethehistoricaltrendandby
morerapidregionalboom-and-bustcyclesinCalifornia,Nevada,Arizona,and
Florida.
There was also a contemporaneous mortgage bubble, caused primarily by the
broadercreditbubble.
Thecausesofthehousingbubblearestillpoorlyunderstood.Explanationsin-
cludepopulationgrowth,landuserestrictions,bubblepsychology,andeasyf-
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 poorly understood. Important factors include weak disclosure
standards and underwriting rules for bank and nonbank mortgage lenders
alike, the way in which mortgage brokers were compensated, borrowers who
bought too much house and didnt understand or ignored the terms of their
mortgages,andelectedomcialswhooveryearspiledonlayeruponlayerofgov-
ernmenthousingsubsidies.
Mortgagefraudincreasedsubstantially,buttheevidencegatheredbytheCom-
missiondoesnotshowthatitwasquantitativelysignifcantenoughtoconclude
thatitwasanessentialcause.
TURNING BAD MORTGAGES INTO TOXIC FINANCIAL ASSETS
Themortgagesecuritizationprocessturnedmortgagesintomortgage-backedsecuri-
tiesthroughthegovernment-sponsoredenterprises(GSEs)FannieMaeandFreddie
Mac, as well as Countrywide and other private label competitors. The securitiza-
tionprocessallowscapitaltofowfrominvestorstohomebuyers.Withoutit,mort-
gage lending would be limited to banks and other portfolio lenders, supported by
traditional funding sources such as deposits. Securitization allows homeowners ac-
cesstoenormousamountsofadditionalfundingandtherebymakeshomeownership
moreaffordable.Italsocandiversifyhousingriskamongdifferenttypesoflenders.If
everything else is working properly, these are good things. Everything else was not
workingproperly.
Somefocustheircriticismontheform ofthesefnancialinstruments.Forexam-
ple, fnancial instruments called collateralized debt obligations (CDOs) were engi-
neered from different bundled payment streams from mortgage-backed securities.
Some argue that the conversion of a bundle of simple mortgages to a mortgage-
backedsecurity,andthentoacollateralizeddebtobligation,wasaproblem.Theyar-
guethatcomplexfnancialderivativescausedthecrisis.Weconcludethatthedetails
ofthisengineeringareincidentaltounderstandingtheessentialcausesofthecrisis.If
thesystemworksproperly,reconfguringstreamsofmortgagepaymentshaslittleef-
fect. The total amount of risk in a mortgage is unchanged if the pieces are put to-
getherinadifferentway.
Unfortunately,thesystemdidnotworkasitshouldhave.Therewereseveralfaws
inthesecuritizationandcollateralizationprocessthatmadethingsworse.
Fannie Mae and Freddie Mac, as well as Countrywide and other private label
competitors,allloweredthecreditqualitystandardsofthemortgagestheyse-
curitized.
o
Amortgage-backedsecuritywasthereforeworseduringthecrisis
than in preceding years because the underlying mortgages were generally of
poorerquality.Thisturnedabadmortgageintoaworsesecurity.
Mortgageoriginatorstookadvantageoftheselowercreditqualitysecuritization
standardsandtheeasyfowofcredittorelaxtheunderwritingdisciplineinthe
loanstheyissued.Aslongastheycouldresellamortgagetothesecondarymar-
ket,theydidntcareaboutitsquality.
The increasing complexity of housing-related assets and the many steps be-
tweentheborrowerandfnalinvestorincreasedtheimportanceofcreditrating
agenciesandmadeindependentriskassessmentbyinvestorsmoredimcult.In
thisrespect,complexitydidcontributetotheproblem,buttheotherproblems
listedherearemoreimportant.
Credit rating agencies assigned overly optimistic ratings to the CDOs built
from mortgage-backed securities.
,
By erroneously rating these bundles of
mortgage-backedsecuritypaymentstoohighly,thecreditratingagenciessub-
stantiallycontributedtothecreationoftoxicfnancialassets.
Borrowers,originators,securitizers,ratingagencies,andtheultimatebuyersof
thesecuritiesintowhichtheriskymortgageswerepackagedallfailedtoexer-
cise prudence and perform due diligence in their respective transactions. In
particular,CDObuyerswhowere,intheory,sophisticatedinvestorsreliedtoo
heavilyoncreditratings.
Manyfnancialinstitutionschosetomakehighlyconcentratedbetsonhousing
prices. While in some cases they did that with whole loans, they were able to
moreeasilyandemcientlydosowithCDOsandderivativesecurities.
Regulatorycapitalstandards,bothdomesticallyandinternationally,gavepref-
erentialtreatmenttohighlyrateddebt,furtherempoweringtheratingagencies
andincreasingthedesirabilityofmortgage-backedstructuredproducts.
Thereisawaythathousingbetscanbemagnifedusingaformofderivative.A
synthetic CDO isasecuritywhosepaymentsmimicthatofaCDOthatcontains
realmortgages.Thisisasidebetthatallowsyoutoassumethesameriskasif
youheldpiecesofactualmortgages.Totheextentthatinvestorsandfnancial
institutionswantedtoincreasetheirbetsonhousing,theywereabletousesyn-
theticCDOs.TherisksinthesesyntheticCDOs,however,arezero-sum,since
for every investor making a bet that housing performance will fall there must
beotherinvestorswithequal-sizedbetsintheoppositedirection.
These are related but different problems. While many involve the word deriva-
tive, it is a mistake to bundle them together and say, Derivatives or CDOs caused
thecrisis.Ineachcase,weassignresponsibilityforthefailurestothepeopleandin-
stitutionsratherthantothefnancialinstrumentstheyused.
tonclusions.
Rather than derivatives and CDOs caused the fnancial crisis, it is more accurate
tosay:
Securitizersloweredcreditqualitystandards;
Mortgageoriginatorstookadvantageofthistocreatejunkmortgages;
Creditratingagenciesassignedoverlyoptimisticratings;
Securitiesinvestorsandothersfailedtoperformsumcientduediligence;
,z ii : :iN1i Nt :1\1i\iN1
Internationalanddomesticregulatorsencouragedarbitragetowardlowercapi-
talstandards;
Some investors used these securities to concentrate rather than diversify risk;
and
OthersusedsyntheticCDOstoamplifytheirhousingbets.
1/cengcrousimrccisionojt/ctcrms/eovoenking
PartIIofthemajoritysreportbeginswithanextensivediscussionofthefailuresof
theshadowbankingsystem,whichitdefnesasafnancialinstitutionsandactivi-
tiesthatinsomerespectsparallelbankingactivitiesbutaresubjecttolessregulation
thancommercialbanks.Themajoritysreportsuggeststhattheshadowbankingsys-
temwasacauseofthefnancialcrisis.
Shadowbankingisatermusedtorepresentacollectionofdifferentfnancialin-
stitutions, instruments, and issues within the fnancial system. Indeed, shadow
banking can refer to any fnancial activity that transforms short-term borrowing
intolong-termlendingwithoutagovernmentbackstop.Thistermcanthereforein-
cludefnancialinstrumentsandinstitutionsasdiverseas:
Thetri-partyrepomarket;
StructuredInvestmentVehiclesandotheroff-balance-sheetentitiesusedtoin-
creaseleverage;
FannieMaeandFreddieMac;
Creditdefaultswaps;and
Hedge funds, monoline insurers, commercial paper, money market mutual
funds,andinvestmentbanks.
As discussed in other parts of this paper, some of these items were important
causesofthecrisis.Nomatterwhattheirindividualrolesincausingorcontributing
tothecrisis,however,theyareundoubtedlydifferent.Itisamistaketogrouptheseis-
sues and problems together. Each should be considered on its merits, rather than
paintingapoorlydefnedswathofthefnancialsectorwithacommonbrushoftoo
littleregulation.
BIG BANK BETS AND WHY BANKS FAILED
Thestorysofarinvolvessignifcantlosthousingwealthanddiminishedvaluesofse-
curities fnancing those homes. Yet even larger past wealth losses did not bring the
globalfnancialsystemtoitsknees.Thekeydifferencesinthiscasewereleverageand
risk concentration. Highly correlated housing risk was concentrated in large and
highlyleveragedfnancialinstitutionsintheUnitedStatesandmuchofEurope.This
leveragemagnifedtheeffectofahousinglossonafnancialinstitutionscapitalre-
serve,andtheconcentrationmeanttheselossesoccurredinparallel.
iii 1u uiNNi: :i, iuUti\: uui1/ i\ii N, \Ni 8i ii 1uu\\: ,z,
Ineffect,manyofthelargestfnancialinstitutionsintheworld,alongwithhun-
dredsofsmallerones,betthesurvivaloftheirinstitutionsonhousingprices.Some
didthisknowingly;othersnot.
Many investors made three bad assumptions about U.S. housing prices. They
assumed:
Alowprobabilitythathousingpriceswoulddeclinesignifcantly;
Priceswerelargelyuncorrelatedacrossdifferentregions,sothatalocalhousing
bubbleburstinginNevadawouldnothappenatthesametimeasonebursting
inFlorida;and
Arelativelylowlevelofstrategic defaults,inwhichanunderwaterhomeowner
voluntarilydefaultsonanon-recoursemortgage.
Whenhousingpricesdeclinednationallyandquiteseverelyincertainareas,these
fawed assumptions, magnifed by other problems described in previous steps, cre-
atedenormousfnanciallossesforfrmsexposedtohousinginvestments.
An essential cause of the fnancial and economic crisis was appallingly bad risk
managementbytheleadersofsomeofthelargestfnancialinstitutionsintheUnited
StatesandEurope.EachfailedfrmthattheCommissionexaminedfailedinpartbe-
causeitsleaderspoorlymanagedrisk.
Basedontestimonyfromtheexecutivesofseveralofthelargestfailedfrmsand
theCommissionstaff sinvestigativework,wecangroupcommonriskmanagement
failuresintoseveralclasses:
Concentration of highly correlated (housing) risk. Firm managers bet mas-
sivelyononetypeofasset,countingonhighratesofreturnwhilecomforting
themselvesthattheircompetitorsweredoingthesame.
Insufcient capital. Someofthefailedinstitutionswerelevered,:1orhigher.
Thismeantthatevery,ofassetswasfnancedwith1ofequitycapitaland
ofdebt.Thismadethesefrmsenormouslyproftablewhenthingswerego-
ingwell,butincrediblysensitivetoevenasmallloss,asapercentdeclinein
the market value of these assets would leave them technically insolvent. In
somecases,thisincreasedleveragewasdirectandtransparent.Inothercases,
frms used Structured Investment Vehicles, asset-backed commercial paper
conduits, and other off-balance-sheet entities to try to have it both ways: fur-
ther increasing their leverage while appearing not to do so. Highly concen-
trated, highly correlated risk combined with high leverage makes a fragile
fnancialsectorandcreatesafnancialaccidentwaitingtohappen.Thesefrms
shouldhavehadmuchlargercapitalcushionsand/ormechanismsforcontin-
gentcapitaluponwhichtodrawinacrisis.
Overdependence on short-term liquidity from repo and commercial paper
markets. Justaseachlackedsumcientcapitalcushions,ineachcasethefailing
frms liquidity cushion ran out within days. The failed frms appear to have
basedtheirliquiditystrategiesonthefawedassumptionthatboththefrmand
,z ii : :iN1i Nt :1\1i\iN1
thesefundingmarketswouldalwaysbehealthyandfunctioningsmoothly.By
failing to provide sumciently for disruptions in their short-term fnancing,
managementputtheirfrmssurvivalonahairtrigger.
Poor risk management systems. Anumberoffrmswereunabletoeasilyag-
gregate their housing risks across various business lines. Once the market be-
gan to decline, those frms that understood their total exposure were able to
effectivelysellorhedgetheirriskbeforethemarketturneddowntoofar.Those
thatdidntwerestuckwithtoxicassetsinadisintegratingmarket.
Solvcnc;jeilurcvcrsusliuiit;jeilurc
TheCommissionheardtestimonyfromtheformerheadsofBearStearns,Lehman,
Citigroup, and AIG, among others. A common theme pervaded the testimony of
thesewitnesses:
Weweresolventbeforetheliquidityrunstarted.
Someone(unnamed)spreadbadinformationandstartedanunjustifedliquid-
ityrun.
Hadthatunjustifedliquidityrunnothappened,givenenoughtimewewould
haverecoveredandreturnedtoapositionofstrength.
Therefore,thefrmfailedbecauseweranoutoftime,anditsnotmyfault.
Ineachcase,expertsandregulatorscontestedtheformerCEOsweweresolvent
claim.Technicalissuesmakeitdimculttoproveotherwise,especiallybecausethean-
swerdependsonwhensolvencyismeasured.Afterafewdaysofsellingassetsatfre-
sale prices during a liquidity run, a highly leveraged frms balance sheet will look
measurablyworse.Ineachcase,whetherornotthefrmwastechnicallysolvent,the
evidence strongly supports the claim that those pulling back from doing business
withthefrmwerenotirrational.Ineachofthecasesweexamined,therewerehuge
fnanciallossesthatataminimumplacedthefrmssolvencyinseriousdoubt.
Interestingly,ineachcase,theCEOwaswillingtoadmitthathehadpoorlyman-
aged his frms liquidity risk, but unwilling to admit that his frm was insolvent or
nearlyso.IneachcasetheCEOsclaimswerehighlyunpersuasive.Thesefrmman-
agerskneworshouldhaveknownthattheywereriskingthesolvencyandtherefore
thesurvivaloftheirfrms.
tonclusions.
ManagersofmanylargeandmidsizefnancialinstitutionsintheUnitedStates
and Europe amassed enormous concentrations of highly correlated housing
riskontheirbalancesheets.Indoingsotheyturnedabuildinghousingcrisis
into a subsequent crisis of failing fnancial institutions. Some did this know-
ingly;others,unknowingly.
Managersofthelargestfnancialfrmsfurtheramplifedthesebigbadbetsby
iii 1u uiNNi: :i, iuUti\: uui1/ i\ii N, \Ni 8i ii 1uu\\: ,z,
holding too little capital and having insumciently robust access to liquidity.
Manyplacedtheirfrmsonahairtriggerbybecomingdependentuponshort-
termfnancingfromcommercialpaperandrepomarketsfortheirday-to-day
funding.Theyplacedfailedsolvencybetsthattheirhousinginvestmentswere
solid,andfailedliquiditybetsthatovernightmoneywouldalwaysbethereno
matter what. In several cases, failed solvency bets triggered liquidity crises,
causingsomeofthelargestfnancialfrmstofailornearlyfail.
Invcstmcntoenksceusct/ccrisis
ApersistentdebateamongmembersoftheCommissionwastherelativeimportance
ofafrmslegalformandregulatoryregimeinthefailuresoflargefnancialinstitu-
tions.Forexample,Commissionersagreedthatinvestmentbankholdingcompanies
were too lightly (barely) regulated by the SEC leading up to the crisis and that the
Consolidated Supervised Entities program of voluntary regulation of these frms
failed.Asaresult,noregulatorcouldforcethesefrmstostrengthentheircapitalor
liquidity buffers. There was agreement among Commissioners that this was a con-
tributing factor to the failure of these frms. The Commission split, however, on
whethertherelatively weakerregulationofinvestmentbankswasanessentialcause
ofthecrisis.
Institutionalstructureanddifferentialregulationofvarioustypesoffnancialin-
stitutionswerelessimportantincausingthecrisisthancommonfactorsthatspanned
different frm structures and regulatory regimes. Investment banks failed in the
UnitedStates,andsodidmanycommercialbanks,largeandsmall,despiteastronger
regulatory and supervisory regime. Wachovia, for example, was a large insured de-
positoryinstitutionsupervisedbytheFed,OCC,andFDIC.Yetitexperiencedaliq-
uidity run that led to its near failure and prompted the frst-ever invocation of the
FDICssystemicriskexception.Insurancecompaniesfailedaswell,notablyAIGand
themonolinebondinsurers.
Banks with different structures and operating in vastly differing regulatory
regimesfailedorhadtoberescuedintheUnitedKingdom,Germany,Iceland,Bel-
gium, the Netherlands, France, Spain, Switzerland, Ireland, and Denmark. Some of
these nations had far stricter regulatory and supervisory regimes than the United
States. The bad loans in the United Kingdom, Ireland, and Spain were fnanced by
federally-regulatedlendersnotbyshadowbanks.
Rather than attributing the crisis principally to differences in the stringency of
regulationoftheselargefnancialinstitutions,itmakesmoresensetolookforcom-
monfactors:
DifferenttypesoffnancialfrmsintheUnitedStatesandEuropemadehighly
concentrated,highlycorrelatedbetsonhousing.
ManagersofdifferenttypesoffnancialfrmsintheUnitedStatesandEurope
poorlymanagedtheirsolvencyandliquidityrisk.
,,+ ii : :iN1i Nt :1\1i\iN1
TWO TYPES OF SYSTEMIC FAILURE
Government policymakers were afraid of large frms sudden and disorderly failure
andchosetointerveneasaresult.Attimes,interventionitselfcontributedtofearand
uncertaintyaboutthestabilityofthefnancialsystem.Theseinterventionsresponded
totwotypesofsystemicfailure.
S;stcmicjeilurct;conc.contegion
Webeginbydefningcontagion andtoo big to fail.
IffnancialfrmXisalargecounterpartytootherfrms,Xssuddenanddisorderly
bankruptcy might weaken the fnances of those other frms and cause them to fail.
We call this the risk of contagion, when, because of a direct fnancial link between
frms,thefailureofonecausesthefailureofanother.FinancialfrmXistoo big to
fail ifpolicymakersfearcontagionsomuchthattheyareunwillingtoallowittogo
bankrupt in a sudden and disorderly fashion. Policymakers make this judgment in
largepartbasedonhowmuchcounterpartyriskotherfrmshavetothefailingfrm,
alongwithajudgmentaboutthelikelihoodandpossibledamageofcontagion.
Policymakersmayalsoactiftheyworryabouttheeffectsofafailedfrmonapar-
ticularfnancialmarketinwhichthatfrmisalargeparticipant.
The determination of too big to fail rests in the minds of the policymakers who
must decide whether to bail out a failing frm. They may be more likely to act if
theyareuncertainaboutthesizeofcounterpartycreditriskoraboutthehealthofan
importantfnancialmarket,orifbroadermarketoreconomicconditionsmakethem
moreriskaverse.
Thislogiccanexplaintheactionsofpolicymakers
8
inseveralcasesinioo8:
InMarch,theFedfacilitatedJPMorganspurchaseofBearStearnsbyproviding
abridgeloanandlossprotectiononapoolofBearsassets.Whilepolicymakers
wereconcernedaboutthefailureofBearStearnsitselfanditsdirecteffectson
otherfrms,theirdecisiontoactwasheightenedbytheiruncertaintyaboutpo-
tentialbroadermarketinstabilityandthepotentialimpactofBearStearnssud-
denfailureonthetri-partyrepomarket.
In September, the Federal Housing Finance Agency (FHFA) put Fannie Mae
and Freddie Mac into conservatorship. Policymakers in effect promised that
the line would be drawn between debt and equity, such that equity holders
were wiped out but GSE debt would be worth 1oo cents on the dollar. They
madethisdecisionbecausebankingregulators(andothers)treatedFannieand
FreddiedebtasequivalenttoTreasuries.Abankcannotholdallofitsassetsin
debtissuedbyGeneralElectricorAT&T,butcanholditallinFannieorFred-
die debt. The same is true for many other investors in the United States and
around the worldthey assumed that GSE debt was perfectly safe and so they
weighted it too heavily in their portfolios. Policymakers were convinced that
iii 1u uiNNi: :i, iuUti\: uui1/ i\ii N, \Ni 8i ii 1uu\\: ,,.
this counterparty risk faced by many fnancial institutions meant that any
write-downofGSEdebtwouldtriggerachainoffailuresthroughoutthefnan-
cialsystem.Inaddition,GSEdebtwasusedascollateralinshort-termlending
markets, and by extension, their failure would have led to a sudden massive
contraction of credit beyond what did occur. Finally, mortgage markets de-
pendedsoheavilyontheGSEsforsecuritizationthatpolicymakersconcluded
thattheirsuddenfailurewouldeffectivelyhaltthecreationofnewmortgages.
All three reasons led policymakers to conclude that Fannie Mae and Freddie
Macweretoobigtofail.
In September, the Federal Reserve, with support from Treasury, bailed out
AIG,preventingitfromsuddendisorderlyfailure.Theytookthisactionbecause
AIG was a huge seller of credit default swaps to a number of large fnancial
frms, and they were concerned that an AIG default would trigger mandatory
write-downsonthosefrmsbalancesheets,forcingcounterpartiestoscramble
toreplacehedgesinadistressedmarketandpotentiallytriggeringacascadeof
failures. AIG also had important lines of business in insuring consumer and
businessactivitiesthatwouldhavebeenthreatenedbyafailureofAIGsfnancial
productsdivisionandpotentiallyledtosevereshockstobusinessandconsumer
confdence. The decision to aid AIG was also infuenced by the extremely
stressed market conditions resulting from other institutional failures in prior
daysandweeks.
InNovember,theFederalReserve,FDIC,andTreasuryprovidedassistanceto
Citigroup. Regulators feared that the failure of Citigroup, one of the nations
largest banks, would both undermine confdence the fnancial system gained
afterTARPandpotentiallyleadtothefailuresofCitismajorcounterparties.
tonclusion.
Theriskofcontagionwasanessentialcauseofthecrisis.Insomecasesthefnancial
systemwasvulnerablebecausepolicymakerswereafraidofalargefrmssuddenand
disorderlyfailuretriggeringbalance-sheetlossesinitscounterparties.Theseinstitu-
tions were too big and interconnected to other frms, through counterparty credit
risk,forpolicymakerstobewillingtoallowthemtofailsuddenly.
S;stcmicjeilurct;ctvo.ecommons/ock
Ifcontagionislikethefu,thenacommonshockislikefoodpoisoning.Acommon
factor affects a number of frms in the same way, and they all get sick at the same
time.Inacommonshock,thefailureofonefrmmayinformusaboutthebreadth
or depth of the problem, but the failure of one frm does not cause the failure of
another.
Thecommonfactorinthiscasewasconcentratedlossesonhousing-relatedassets
inlargeandmidsizefnancialfrmsintheUnitedStatesandsomeinEurope.
,,z ii : :iN1i Nt :1\1i\iN1
Theselosseswipedoutcapitalthroughoutthefnancialsector.Policymakerswere
notjustdealingwithasingleinsolventfrmthatmighttransmititsfailuretoothers.
Theyweredealingwithascenarioinwhichmanylarge,midsize,andsmallfnancial
institutionstooklargelossesatroughlythesametime.
tonclusion.
Some fnancial institutions failed because of a common shock: they made similar
failedbetsonhousing.Unconnectedfnancialfrmswerefailingforthesamereason
andatroughlythesametimebecausetheyhadthesameproblemoflargehousing
losses. This common shock meant the problem was broader than a single failed
bankkeylargefnancialinstitutionswereundercapitalizedbecauseofthiscommon
shock.
WeexaminetwofrequentlydebatedtopicsabouttheeventsofSeptemberioo8.
1/cgovcrnmcnts/oulnot/evcoeilcout_____
Some argue that no frm is too big to fail, and that policymakers erred when they
bailedoutBearStearns,FannieandFreddie,AIG,andlaterCitigroup.Inourview,
this misses the basic arithmetic of policymaking. Policymakers were presented, for
example,withthenewsthatAIGisabouttofailandcounseledthatitssuddenand
disorderlyfailuremight triggerachainreaction.GiventheprecedingfailuresofFan-
nieMaeandFreddieMac,theMerrillLynchmerger,Lehmansbankruptcy,andthe
ReservePrimaryFundbreakingthebuck,marketconfdencewasonaknifesedge.A
chainreactioncouldcausearunontheglobalfnancialsystem.Theyfearednotjusta
runonabank,butageneralizedpanicthatmightcrashtheentiresystemthatis,the
riskofaneventcomparabletotheGreatDepression.
For a policymaker, the calculus is simple: if you bail out AIG and youre wrong,
youwillhavewastedtaxpayermoneyandprovokedpublicoutrage.Ifyoudontbail
outAIGandyourewrong,theglobalfnancialsystemcollapses.Itshouldbeeasyto
seewhypolicymakersfavoredactiontherewasachanceofbeingwrongeitherway,
andthecostsofbeingwrongwithoutactionwerefargreaterthanthecostsofbeing
wrongwithaction.
8crnenkc.6cit/ncr.enIeulson
s/oulnot/evcc/oscntolctIc/menjeil
This is probably the most frequently discussed element of the fnancial crisis. To
makethiscaseonemustargue:
Bernanke, Geithner, and Paulson had a legal and viable option available to
themotherthanLehmanflingbankruptcy.
Theyknewtheyhadthisoption,consideredit,andrejectedit.
iii 1u uiNNi: :i, iuUti\: uui1/ i\ii N, \Ni 8i ii 1uu\\: ,,,
Theywerewrongtodoso.
TheyhadareasonforchoosingtoallowLehmantofail.
Wehaveyettofndsomeonewhocanmakeaplausiblecaseonallfourcounts.We
thinkthatthesethreepolicymakerswouldhavesavedLehmaniftheythoughtthey
hadalegalandviableoptiontodoso.Inhindsight,wealsothinktheywererightat
thetimetheydidnothavealegalandviableoptiontosaveLehman.
Many prominent public omcials and market observers have accused these three of
makingamistake.Thesecriticsusuallyarguethatthesethreeshould have savedLehman.
Whenaskedwhatelsetheycouldhavedone,thecriticsusualresponseis,Idontknow,
butsurelytheycouldhavedonesomething.Theychosenottoandcausedthecrisis.
ThosewhowanttolabelLehmansfailureapolicymistakeareobligedtosuggest
analternatecourseofaction.
TheFedsassistanceforBearStearns,andFDICandTreasurysassistanceforWa-
chovia,followedapattern.Ineachcase,thefailingfrmorthegovernmentfounda
buyer,andthegovernmentsubsidizedthepurchase.InthecaseofBearStearns,the
government subsidized the purchase, and in the case of Wachovia, the government
madeclearthatassistancewouldbeavailableifitwereneeded.Thespecifcmechan-
icsofthesubsidydifferedbetweenthetwocases,butineachbailoutthekeycondi-
tionwasthepresenceofawillingbuyer.
Lehmanhadnowillingbuyer.BankofAmericaboughtMerrillLynchinstead,and
no other American fnancial institution was willing or able to step up. For months,
government omcials had tried and failed to facilitate transactions with possible
domestic and foreign purchasers. At the end of Lehman weekend, the most viable
candidatewastheBritishbankBarclays.Tomakethepurchase,Barclaysneededeither
a shareholder vote, which would take several weeks to execute, or the permission of
theirregulator.Theycouldgetneitherinthetimeavailable.
Lehmanwasthereforefacinganimminentliquidityrunwithoutapathtosuccess.
Therewasnobuyer.TherewasthepossibilitythatBarclaysmightbeabuyer,some
weeksinthefuture.Bernanke,Geithner,andPaulsonwerethenconfrontedwiththe
questionofwhethertoprovideaneffectivelyuncappedloantoLehmantosupplant
itsdisappearingliquiditywhileLehmansearchedforabuyer.
This loan would have to come from the Fed, since before the enactment of the
TARPlegislation,Treasuryhadnoauthoritytoprovidesuchfnancing.Thelawlim-
itstheFedinthesecases.TheFedcanonlyprovidesecured loans.Theywereableto
make this work for Bear Stearns and AIG because there were sumcient unencum-
beredassetstoserveascollateral.FedomcialsarguethatLehmanhadinsumcientun-
pledged assets to secure the loan it would have needed to survive. Former Lehman
executivesandFedcriticsargueotherwise,eventhoughprivatemarketparticipants
wereunwillingtoprovidecredit.
Wasthereanotheroption:TheFedleaderswouldhavehadtodirectthestaffto
re-evaluateinamoreoptimisticwaytheanalysisofLehmansbalancesheettojustify
asecuredloan.Theythenwouldhavehadtodecidetoprovideliquiditysupportto
,,, ii : :iN1i Nt :1\1i\iN1
LehmanforanindefnitetimeperiodwhileLehmansearchedforabuyer.Thatasset
revaluationwouldlaterhavecomeunderintenselegalscrutiny,especiallygiventhe
likely large and potentially uncapped cost to the taxpayer. In the meantime, other
creditorstoLehmancouldhavecashedoutat1oocentsonthedollar,leavingtaxpay-
ersholdingthebagforlosses.
Fed Chairman Bernanke, his general counsel Scott Alvarez, and New York Fed
generalcounselThomasC.BaxterJr.allarguedinsworntestimonythatthisoption
wouldnothavebeenlegal.Bernankesuggestedthatitalsowouldhavebeenunwise
because,ineffect,theFedwouldhavebeenprovidinganopen-endedcommitmentto
allowLehmantoshopforabuyer.Bernanketestifedthatsuchaloanwouldmerely
wastetaxpayermoneyforanoutcomethatwasquiteunlikelytochange.
Basedontheiractionstodealwithotherfailingfnancialinstitutionsinioo8,we
think these policymakers would have taken any available option they thought was
legalandviable.Thiswasanactiveteamthatwasinallcaseserringonthesideofin-
tervention to reduce the risk of catastrophic outcomes. Fed Chairman Bernanke
saidthathewasvery,veryconfdentthatLehmansdemisewasgoingtobeacatas-
trophe.

Wefnditimplausibletoconcludethattheywouldhavebrokenpatternon
this one case at such an obviously risky moment if they had thought they had an-
otheroption.
Somefnditinconceivablethatpolicymakerscouldbeconfrontedwithasituation
inwhichtherewasnolegalandviablecourseofactiontoavoidfnancialcatastrophe.
Inthiscase,thatiswhathappened.
THE SHOCK AND THE PANIC
Conventional wisdom is that the failure of Lehman Brothers triggered the fnancial
panic.ThisisbecauseLehmansfailurewasunexpectedandbecausethedebateabout
whethergovernmentomcialscouldhavesavedLehmanissointense.
ThefocusonLehmansfailureistoonarrow.TheeventsofSeptemberioo8werea
chainofonefrmfailureafteranother:
Sunday, September ,, FHFA put Fannie Mae and Freddie Mac into
conservatorship.
This was followed by Lehman weekend at the New York Fed, which was in
fact broader than just Lehman. At the end of that weekend, Bank of America
hadagreedtobuyMerrillLynch,Lehmanwasflingforbankruptcy,andAIG
wasonthevergeoffailure.
Monday,September1,,LehmanfledforChapter11bankruptcyprotection.
Tuesday,September1o,theReservePrimaryFund,amoneymarketmutualfund,
brokethebuckafterfacinganinvestorrun.Itsnetassetvaluedeclinedbelow
1,meaningthataninvestmentinthefundhadactuallylostmoney.Thisisacrit-
icalpsychologicalthresholdforamoneymarketfund.Onthesameday,theFed
approvedan8,billionemergencyloantoAIGtopreventitfromsuddenfailure.
iii 1u uiNNi: :i, iuUti\: uui1/ i\ii N, \Ni 8i ii 1uu\\: ,,,
Thursday, September 18, the Bush Administration, supported by Fed Chair-
manBernanke,proposedtoCongressionalleadersthattheyappropriatefunds
foranewTroubledAssetReliefProgram(TARP)torecapitalizebanks.
Friday,September1,the,oobillionTARPwaspublicallyannounced.
Sunday, September i1, the Fed agreed to accept Goldman Sachs and Morgan
Stanley as bank holding companies, putting them under the Feds regulatory
purview.Afterthis,therewerenolargestandaloneinvestmentbanksremaining
intheUnitedStates.
Thursday,Septemberi,,theFDICwasappointedreceiverofWashingtonMu-
tualandlatersoldittoJPMorgan.
Monday,Septemberi,theTARPbillfailedtopasstheHouseofRepresenta-
tives,andtheFDICagreedtoprovideassistancetofacilitateasaleofWachovia
toCitigroup.
Wednesday,October1,theSenatepassedarevisedTARPbill.Twodayslater,
the House passed it, and the President signed it into law. Wells Fargo, rather
thanCitigroup,boughtWachovia.
Asthemonthprogressed,interbanklendingratessoared,indicatingtheheight-
enedfearandthreateningacompletefreezeoflending.
The fnancial panic was triggered and then amplifed by the close succession of
theseevents,andnotjustbyLehmansfailure.Lehmanwasthemostunexpectedbad
newsinthatsuccession,butitsamistaketoattributethepanicentirelytoLehmans
failure.Therewasgrowingrealizationbyinvestorsthatmortgagelosseswereconcen-
tratedinthefnancialsystem,butnobodyknewpreciselywheretheylay.
tonclusion.
In quick succession in September ioo8, the failure, near-failure, or restructuring of
tenfrmstriggeredaglobalfnancialpanic.Confdenceandtrustinthefnancialsys-
tembegantoevaporateasthehealthofalmosteverylargeandmidsizefnancialin-
stitutionintheUnitedStatesandEuropewasquestioned.
Webriefydiscusstwoofthesefailures.
1/ckcscrvcIrimer;Iun
TheroleoftheReservePrimaryFundsfailureintriggeringthepanicisunderappreci-
ated.Thismoneymarketmutualfundfacedescalatingredemptionrequestsandhad
totakelossesfromitsholdingsofLehmandebt.OnTuesday,September1o,itbroke
thebuckinadisorganizedmanner.Investorswhowithdrewearlyrecouped1oocents
onthedollar,withtheremaininginvestorsbearingthelosses.Thisspreadfearamong
investorsthatothersimilarlysituatedfundsmightfollow.Bythemiddleofthefollow-
ingweek,primemoneymarketmutualfundinvestorshadwithdrawnbillion.
WhentheSECwasunabletoreassuremarketparticipantsthattheproblemwasiso-
lated,moneymarketmutualfundmanagers,inanticipationoffutureruns,refusedto
,, ii : :iN1i Nt :1\1i\iN1
renewthecommercialpapertheywerefundingandbegantoconverttheirholdingsto
Treasuries and cash. Corporations that had relied on commercial paper markets for
short-termfnancingsuddenlyhadtodrawdowntheirbackstoplinesofcredit.Noone
had expected these corporate lines of credit to be triggered simultaneously, and this
involuntarylendingmeantthatbankswouldhavetopullbackonotheractivities.
1/crolcojIennicMecenIrcicMecinceusingt/ccrisis
Thegovernment-sponsoredenterprisesFannieMaeandFreddieMacwereelements
ofthecrisisinseveralways:
Theywerepartofthesecuritizationprocessthatloweredmortgagecreditquality
standards.
Aslargefnancialinstitutionswhosefailuresriskedcontagion,theyweremassive
andmultidimensionalcasesofthetoobigtofailproblem.Policymakerswereun-
willingtoletthemfailbecause:
Financialinstitutionsaroundtheworldboresignifcantcounterparty
risktothemthroughholdingsofGSEdebt;
Certainfundingmarketsdependedonthevalueoftheirdebt;and
Ongoingmortgagemarketoperationdependedontheircontinued
existence.
Theywerebyfarthemostexpensiveinstitutionalfailurestothetaxpayerandare
anongoingcost.
Thereisvigorousdebateabouthowbigarolethesetwofrmsplayedinsecuritiza-
tion relative to private label securitizers. There is also vigorous debate about why
thesetwofrmsgotinvolvedinthisproblem.Wethinkbothquestionsarelessimpor-
tantthanthemultiplepointsofcontactFannieMaeandFreddieMachadwiththef-
nancialsystem.
These two frms were guarantors and securitizers, fnancial institutions holding
enormousportfoliosofhousing-relatedassets,andtheissuersofdebtthatwastreated
likegovernmentdebtbythefnancialsystem.FannieMaeandFreddieMacdidnotby
themselvescausethecrisis,buttheycontributedsignifcantlyinanumberofways.
THE SYSTEM FREEZING
Following the shock and panic, fnancial intermediation operated with escalating
frictions. Some funding markets collapsed entirely. Others experienced a rapid
blowout in spreads following the shock and stabilized slowly as the panic subsided
and the government stepped in to backstop markets and frms. We highlight three
fundingmarketshere:
Interbank lending. Lending dynamics changed quickly in the federal funds
marketwherebanksloanexcessreservestooneanotherovernight.Evenlarge
iii 1u uiNNi: :i, iuUti\: uui1/ i\ii N, \Ni 8i ii 1uu\\: ,,,
banks were unable to get overnight loans, compounding an increasingly re-
strictedabilitytoraiseshort-termfundselsewhere.
Repo. BySeptemberioo8,reporatesincreasedsubstantially,andhaircutsbal-
looned.Nontraditionalmortgageswerenolongeracceptablecollateral.
Commercial paper. The failure of Lehman and the Reserve Primary Fund
breakingthebucksparkedarunonprimemoneymarketmutualfunds.Money
market mutual funds withdrew from investing in the commercial paper mar-
ket,leadingtoarapidincreaseinfundingcostsforfnancialandnonfnancial
frmsthatreliedoncommercialpaper.
The inability to fnd funding, fnancial frm deleveraging, and macroeconomic
weaknesstranslatedintotightercreditforconsumersandbusinesses.Securitization
marketsforotherkindsofdebtcollapsedrapidlyinioo8andstillhavenotrecovered
fully,cuttingoffasubstantialsourceoffnancingforcreditcards,carloans,student
loans,andsmallbusinessloans.
Decreased credit availability, the collapse of the housing bubble, and additional
wealthlossesfromadecliningstockmarketledtoasharpcontractioninconsump-
tionandoutputandanincreaseinunemployment.
RealGDPcontractedatanannualrateof.opercentinthethirdquarterofioo8,
o.8percentinthefourthquarter,and.percentinthefrstquarterofioo.Theeco-
nomic contraction in the fourth quarter of ioo8 was the worst in nearly three
decades.Firmsandhouseholdsthathadnotpreviouslybeendirectlyaffectedbythe
fnancial crisis suddenly pulled backbusinesses stopped hiring and halted new in-
vestments,whilefamiliesputspendingplansonhold.Afterthepanicbegan,therate
atwhichtheeconomyshedjobsjumped,goingfromanaverageof18,,ooojobslost
permonthinthefrstthreequartersofioo8,toanaverageofover,oo,ooojobslost
permonthinthefourthquarterofioo8andthefrstquarterofioo.Theeconomy
continuedtolosejobsthroughmostofioo,withtheunemploymentratepeakingat
1o.1 percent in October ioo and remaining above ., percent for the rest of ioo
andthefrstelevenmonthsofio1o.
Whiletheshockandpanicthereforeappeartohaveendedinearlyioo,theharm
totherealeconomycontinuesthroughtoday.Firmsandfamiliesarestilldeleverag-
ingandareuncertainaboutbothfutureeconomicgrowthandthedirectionoffuture
policy.Thefnaltragedyofthefnancialandeconomiccrisisisthattheneededrecov-
eryisslowandlookstobesoforawhilelonger.
NOTES
1.AvoteoftheCommissiononDecember6,2010,limiteddissenterstoninepageseachinthe
approximately330-pagecommerciallypublishedbook.Nolimitsapplytotheomcialversionsub-
mittedtothePresidentandtheCongress.
2.BenS.Bernanke,MonetaryPolicyandtheHousingBubble,SpeechattheAnnualMeetingof
the American Economic Association, Atlanta, Georgia, January 3, 2010 (www.federalreserve.gov/
newsevents/speech/bernanke20100103a.htm).
3.Ibid.
,, ii : :iN1i Nt :1\1i\iN1
4. Risky borrowers does not mean poor. While many risky borrowers were low-income, a
borrowerwithunprovenincomeapplyingforano-documentationmortgageforavacationhome
wasalsorisky.
3.Bernanke,MonetaryPolicyandtheHousingBubble.
6.TheCommissionvigorouslydebatedtherelativeimportanceandthemotivationsofthedif-
ferenttypesofsecuritizersinloweringcreditquality.Wethinkthatbothtypesofsecuritizerswere
inpartresponsibleandthatthesedebatesarelessimportantthantheexistenceoflowerstandards
andhowthisproblemftsintothebroadercontext.
7.Whilebadinformationcreatedbycreditratingagencieswasanessentialcauseofthecrisis,it
islessclearwhytheydidthis.Importanthypothesesinclude:(1)badanalyticmodelsthatfailedto
accountforcorrelatedhousingpricedeclinesacrosswidegeographies,(2)anindustrymodelthat
encouragedtheratingagenciestoskewtheirratingsupwardtogeneratebusiness,and(3)alackof
marketcompetitionduetotheirgovernment-inducedoligopoly.
8. In most cases during the crisis, the three key policymakers were Treasury Secretary Henry
Paulson,FederalReserveChairmanBenBernanke,andFederalReserveBankofNewYorkPresi-
dent Timothy Geithner. Other omcials were key in particular cases, such as FHFA Director Jim
LockhartsGSEactionsandFDICChairmanSheilaBairsextensionoftemporaryloanguarantees
tobankborrowinginthefallof2008.Duringthefnancialrecoveryandrebuildingstagethatbe-
gan in early 2009, the three key policymakers were Treasury Secretary Timothy Geithner, Fed
ChairmanBenBernanke,andWhiteHouseNationalEconomicCouncilDirectorLarrySummers.
9.BenS.Bernanke,testimonybeforetheFCIC,HearingonTooBigtoFail:Expectationsand
ImpactofExtraordinaryGovernmentInterventionandtheRoleofSystemicRiskintheFinancial
Crisis,session1:TheFederalReserve,September2,transcript,p.78.
iii 1u uiNNi: :i, iuUti\: uui1/ i\ii N, \Ni 8i ii 1uu\\: ,,,
FINANCIAL CRISIS
INQUIRY COMMISSION
DISSENTING STATEMENT
PETER J. WALLISON
ARTHUR F. BURNS
FELLOW IN FINANCIAL POLICY STUDIES
AMERICAN ENTERPRISE INSTITUTE
JANAUARY 2011
Contact: pwallison@aei.org
443
INTRODUCTION
Why a Dissent?
Te question I have been most frequently asked about the Financial Crisis
Inquiry Commission (the FCIC or the Commission) is why Congress bothered
to authorize it at all. Without waiting for the Commissions insights into the causes
of the fnancial crisis, Congress passed and the President signed the Dodd-Frank
Act (DFA), far reaching and highly consequential regulatory legislation. Congress
and the President acted without seeking to understand the true causes of the
wrenching events of 2008, perhaps following the precept of the Presidents chief of
stafNever let a good crisis go to waste. Although the FCICs work was not the
full investigation to which the American people were entitled, it has served a useful
purpose by focusing attention again on the fnancial crisis and whetherwith some
distance from itwe can draw a more accurate assessment than the media did with
what is ofen called the frst draf of history.
To avoid the next fnancial crisis, we must understand what caused the one
from which we are now slowly emerging, and take action to avoid the same mistakes
in the future. If there is doubt that these lessons are important, consider the ongoing
eforts to amend the Community Reinvestment Act of 1977 (CRA). Late in the last
session of the 111
th
Congress, a group of Democratic congressmembers introduced
HR 6334. Tis bill, which was lauded by House Financial Services Committee
Chairman Barney Frank as his top priority in the lame duck session of that
Congress, would have extended the CRA to all U.S. nonbank fnancial companies,
and thus would apply, to even more of the national economy, the same government
social policy mandates responsible for the mortgage meltdown and the fnancial
crisis. Fortunately, the bill was not acted upon. Because of the recent election, it is
unlikely that supporters of H.R. 6334 will have the power to adopt similar legislation
in the next Congress, but in the future other lawmakers with views similar to Barney
Franks may seek to mandate similar requirements. At that time, the only real
bulwark against the governments use of private entities for social policy purposes
will be a full understanding of how these policies were connected to the fnancial
crisis of 2008.
Like Congress and the Administration, the Commissions majority erred
in assuming that it knew the causes of the fnancial crisis. Instead of pursuing a
thorough study, the Commissions majority used its extensive statutory investigative
authority to seek only the facts that supported its initial assumptionsthat the
crisis was caused by deregulation or lax regulation, greed and recklessness on
Wall Street, predatory lending in the mortgage market, unregulated derivatives
and a fnancial system addicted to excessive risk-taking. Te Commission did not
seriously investigate any other cause, and did not efectively connect the factors
444 Dissenting Statement
it investigated to the fnancial crisis. Te majoritys report covers in detail many
elements of the economy before the fnancial crisis that the authors did not like, but
generally failed to show how practices that had gone on for many years suddenly
caused a world-wide fnancial crisis. In the end, the majoritys report turned out to
be a just so story about the fnancial crisis, rather than a report on what caused the
fnancial crisis.
What Caused the Financial Crisis?
George Santayana is ofen quoted for the aphorism that Tose who cannot
remember the past are condemned to repeat it. Looking back on the fnancial crisis,
we can see why the study of history is ofen so contentious and why revisionist
histories are so easy to construct. Tere are always many factors that could have
caused an historical event; the dif cult task is to discern which, among a welter of
possible causes, were the signifcant onesthe ones without which history would
have been diferent. Using this standard, I believe that the sine qua non of the
fnancial crisis was U.S. government housing policy, which led to the creation of 27
million subprime and other risky loanshalf of all mortgages in the United States
which were ready to default as soon as the massive 1997-2007 housing bubble began
to defate. If the U.S. government had not chosen this policy pathfostering the
growth of a bubble of unprecedented size and an equally unprecedented number of
weak and high risk residential mortgagesthe great fnancial crisis of 2008 would
never have occurred.
Initiated by Congress in 1992 and pressed by HUD in both the Clinton and
George W. Bush Administrations, the U.S. governments housing policy sought to
increase home ownership in the United States through an intensive efort to reduce
mortgage underwriting standards. In pursuit of this policy, HUD used (i) the
afordable housing requirements imposed by Congress in 1992 on the government-
sponsored enterprises (GSEs) Fannie Mae and Freddie Mac, (ii) its control over the
policies of the Federal Housing Administration (FHA), and (iii) a Best Practices
Initiative for subprime lenders and mortgage banks, to encourage greater subprime
and other high risk lending. HUDs key role in the growth of subprime and other
high risk mortgage lending is covered in detail in Part III.
Ultimately, all these entities, as well as insured banks covered by the CRA,
were compelled to compete for mortgage borrowers who were at or below the median
income in the areas in which they lived. Tis competition caused underwriting
standards to decline, increased the numbers of weak and high risk loans far beyond
what the market would produce without government infuence, and contributed
importantly to the growth of the 1997-2007 housing bubble.
When the bubble began to defate in mid-2007, the low quality and high
risk loans engendered by government policies failed in unprecedented numbers.
Te efect of these defaults was exacerbated by the fact that few if any investors
including housing market analystsunderstood at the time that Fannie Mae and
Freddie Mac had been acquiring large numbers of subprime and other high risk
loans in order to meet HUDs afordable housing goals.
Alarmed by the unexpected delinquencies and defaults that began to appear
in mid-2007, investors fed the multi-trillion dollar market for mortgage-backed
445 Peter J. Wallison
securities (MBS), dropping MBS valuesand especially those MBS backed by
subprime and other risky loansto fractions of their former prices. Mark-to-
market accounting then required fnancial institutions to write down the value of
their assetsreducing their capital positions and causing great investor and creditor
unease. Te mechanism by which the defaults and delinquencies on subprime and
other high risk mortgages were transmitted to the fnancial system as a whole is
covered in detail in Part II.
In this environment, the governments rescue of Bear Stearns in March of
2008 temporarily calmed investor fears but created a signifcant moral hazard;
investors and other market participants reasonably believed afer the rescue of
Bear that all large fnancial institutions would also be rescued if they encountered
fnancial dif culties. However, when Lehman Brothersan investment bank even
larger than Bearwas allowed to fail, market participants were shocked; suddenly,
they were forced to consider the fnancial health of their counterparties, many of
which appeared weakened by losses and the capital writedowns required by mark-
to-market accounting. Tis caused a halt to lending and a hoarding of casha
virtually unprecedented period of market paralysis and panic that we know as the
fnancial crisis of 2008.
Werent Tere Other Causes of the Financial Crisis?
Many other causes of the fnancial crisis have been cited, including some in
the report of the Commissions majority, but for the reasons outlined below none of
them aloneor all in combinationprovides a plausible explanation of the crisis.
Low interest rates and a fow of funds from abroad. Claims that various policies
or phenomenasuch as low interest rates in the early 2000s or fnancial fows from
abroadwere responsible for the growth of the housing bubble, do not adequately
explain either the bubble or the destruction that occurred when the bubble defated.
Te U.S. has had housing bubbles in the pastmost recently in the late 1970s and
late 1980sbut when these bubbles defated they did not cause a fnancial crisis.
Similarly, other developed countries experienced housing bubbles in the 2000s,
some even larger than the U.S. bubble, but when their bubbles defated the housing
losses were small. Only in the U.S. did the defation of the most recent housing
bubble cause a fnancial meltdown and a serious fnancial crisis. Te reason for this
is that only in the U.S. did subprime and other risky loans constitute half of all
outstanding mortgages when the bubble defated. It wasnt the size of the bubble
that was the key; it was its content. Te 1997-2007 U.S. housing bubble was in a
class by itself. Nevertheless, demand by investors for the high yields ofered by
subprime loans stimulated the growth of a market for securities backed by these
loans. Tis was an important element in the fnancial crisis, although the number
of mortgages in this market was considerably smaller than the number fostered
directly by government policy. Without the huge number of defaults that arose out
of U.S. housing policy, defaults among the mortgages in the private market would
not have caused a fnancial crisis.
Deregulation or lax regulation. Explanations that rely on lack of regulation or
deregulation as a cause of the fnancial crisis are also defcient. First, no signifcant
deregulation of fnancial institutions occurred in the last 30 years. Te repeal of a
446 Dissenting Statement
portion of the Glass-Steagall Act, frequently cited as an example of deregulation,
had no role in the fnancial crisis.
1
Te repeal was accomplished through the
Gramm-Leach-Bliley Act of 1999, which allowed banks to af liate for the frst time
since the New Deal with frms engaged in underwriting or dealing in securities.
Tere is no evidence, however, that any bank got into trouble because of a securities
af liate. Te banks that sufered losses because they held low quality mortgages or
MBS were engaged in activitiesmortgage lendingalways permitted by Glass-
Steagall; the investment banks that got into troubleBear Stearns, Lehman and
Merrill Lynchwere not af liated with large banks, although they had small bank
af liates that do not appear to have played any role in mortgage lending or securities
trading. Moreover, the Federal Deposit Insurance Corporation Improvement Act of
1991 (FDICIA) substantially increased the regulation of banks and savings and loan
institutions (S&Ls) afer the S&L debacle in the late 1980s and early 1990s, and it is
noteworthy that FDICIAthe most stringent bank regulation since the adoption of
deposit insurancefailed to prevent the fnancial crisis.
Te shadow banking business. Te large investment banksBear, Lehman,
Merrill, Goldman Sachs and Morgan Stanleyall encountered dif culty in the
fnancial crisis, and the Commission majoritys report lays much of the blame for this
at the door of the Securities and Exchange Commission (SEC) for failing adequately
to supervise them. It is true that the SECs supervisory process was weak, but many
banks and S&Lsstringently regulated under FDICIAalso failed. Tis casts doubt
on the claim that if investment banks had been regulated like commercial banks
or had been able to ofer insured deposits like commercial banksthey would not
have encountered fnancial dif culties. Te reality is that the business model of the
investment banks was quite diferent from banking; it was to fnance a short-term
trading business with short-term liabilities such as repurchase agreements (ofen
called repos). Tis made them especially vulnerable in the panic that occurred in
2008, but it is not evidence that the existence of investment banks, or the quality of
their regulation, was a cause of the fnancial crisis.
Failures of risk management. Claims that there was a general failure of risk
management in fnancial institutions or excessive leverage or risk-taking are part of
what might be called a hindsight narrative. With hindsight, it is easy to condemn
managers for failing to see the dangers of the housing bubble or the underpricing of
risk that now looks so clear. However, the FCIC interviewed hundreds of fnancial
experts, including senior of cials of major banks, bank regulators and investors.
It is not clear that any of themincluding the redoubtable Warren Bufettwere
suf ciently confdent about an impending crisis that they put real money behind
their judgment. Human beings have a tendency to believe that things will continue
to go in the direction they are going, and are good at explaining why this must
be so. Blaming the crisis on the failure to foresee it is facile and of little value for
policymakers, who cannot legislate prescience. Te fact that virtually all participants
in the fnancial system failed to foresee this crisisas they failed to foresee every
other crisisdoes not tell us anything about why this crisis occurred or what we
should do to prevent the next one.
1
See, e.g., Peter J. Wallison, Deregulation and the Financial Crisis: Another Urban Myth, Financial
Services Outlook, American Enterprise Institute, October 2009.
447 Peter J. Wallison
Securitization and structured products. Securitizationofen pejoratively
described as the originate to distribute processhas also been blamed for the
fnancial crisis. But securitization is only a means of fnancing. If securitization was
a cause of the fnancial crisis, so was lending. Are we then to condemn lending?
For decades, without serious incident, securitization has been used to fnance car
loans, credit card loans and jumbo mortgages that were not eligible for acquisition
by Fannie Mae and Freddie Mac. Te problem was not securitization itself, it was
the weak and high risk loans that securitization fnanced. Under the category of
securitization, it is necessary to mention the role of collateralized debt obligations,
known as CDOs. Tese instruments were toxic assets because they were ultimately
backed by the subprime mortgages that began to default in huge numbers when the
bubble defated, and it was dif cult to determine where those losses would ultimately
settle. CDOs, accordingly, for all their dramatic content, were just another example
of the way in which subprime and other high risk loans were distributed throughout
the worlds fnancial system. Te question still remains why so many weak loans
were created, not why a system that securitized good assets could also securitize
bad ones.
Credit default swaps and other derivatives. Despite a diligent search, the FCIC
never uncovered evidence that unregulated derivatives, and particularly credit
default swaps (CDS), was a signifcant contributor to the fnancial crisis through
interconnections. Te only company known to have failed because of its CDS
obligations was AIG, and that frm appears to have been an outlier. Blaming CDS
for the fnancial crisis because one company did not manage its risks properly is like
blaming lending generally when a bank fails. Like everything else, derivatives can
be misused, but there is no evidence that the interconnections among fnancial
institutions alleged to have caused the crisis were signifcantly enhanced by CDS
or derivatives generally. For example, Lehman Brothers was a major player in the
derivatives market, but the Commission found no indication that Lehmans failure
to meet its CDS and other derivatives obligations caused signifcant losses to any
other frm, including those that had written CDS on Lehman itself.
Predatory lending. Te Commissions report also blames predatory lending
for the large build-up of subprime and other high risk mortgages in the fnancial
system. Tis might be a plausible explanation if there were evidence that predatory
lending was so widespread as to have produced the volume of high risk loans that
were actually originated. In predatory lending, unscrupulous lenders take advantage
of unwitting borrowers. Tis undoubtedly occurred, but it also appears that many
people who received high risk loans were predatory borrowers, or engaged in
mortgage fraud, because they took advantage of low mortgage underwriting
standards to beneft from mortgages they knew they could not pay unless rising
housing prices enabled them to sell or refnance. Te Commission was never able
to shed any light on the extent to which predatory lending occurred. Substantial
portions of the Commission majoritys report describe abusive activities by some
lenders and mortgage brokers, but without giving any indication of how many such
loans were originated. Further, the majoritys report fails to acknowledge that most
of the buyers for subprime loans were government agencies or private companies
complying with government afordable housing requirements.
448 Dissenting Statement
Why Couldnt We Reach Agreement?
Afer the majoritys report is published, many people will lament that it was
not possible to achieve a bipartisan agreement on the facts. It may be a surprise
that I am asking the same question. If the Commissions investigation had been
an objective and thorough investigation, many of the points I raise in this dissent
would have been known to the other commissioners before reading this dissent, and
perhaps would have been infuential with them. Similarly, I might have found facts
that changed my own view. But the Commissions investigation was not structured
or carried out in a way that could ever have garnered my support or, I believe, the
support of the other Republican members.
One glaring example will illustrate the Commissions lack of objectivity.
In March 2010, Edward Pinto, a resident fellow at the American Enterprise
Institute (AEI) who had served as chief credit of cer at Fannie Mae, provided to
the Commission staf a 70-page, fully sourced memorandum on the number of
subprime and other high risk mortgages in the fnancial system immediately before
the fnancial crisis. In that memorandum, Pinto recorded that he had found over
25 million such mortgages (his later work showed that there were approximately 27
million).
2
Since there are about 55 million mortgages in the U.S., Pintos research
indicated that, as the fnancial crisis began, half of all U.S. mortgages were of inferior
quality and liable to default when housing prices were no longer rising. In August,
Pinto supplemented his initial research with a paper documenting the eforts of the
Department of Housing and Urban Development (HUD), over two decades and
through two administrations, to increase home ownership by reducing mortgage
underwriting standards.
3
Tis research raised important questions about the role of government
housing policy in promoting the high risk mortgages that played such a key role in
both the mortgage meltdown and the fnancial panic that followed. Any objective
investigation of the causes of the fnancial crisis would have looked carefully at this
research, exposed it to the members of the Commission, taken Pintos testimony,
and tested the accuracy of Pintos research. But the Commission took none of these
steps. Pintos research was never made available to the other members of the FCIC,
or even to the commissioners who were members of the subcommittee charged with
considering the role of housing policy in the fnancial crisis.
Accordingly, the Commission majoritys report ignores hypotheses about the
causes of the fnancial crisis that any objective investigation would have considered,
while focusing solely on theories that have political currency but far less plausibility.
Tis is not the way a serious and objective inquiry should have been carried out, but
that is how the Commission used its resources and its mandate.
Tere were many other defciencies. Te scope of the Commissions work was
determined by a list of public hearings that was handed to us in early December 2009.
At that point the Commission members had never discussed the possible causes of
the crisis, and we were never told why those particular subjects were important or
were chosen as the key issues for a set of hearings that would form the backbone
2
Edward Pinto, Triggers of the Financial Crisis (Triggers memo), http://www.aei.org/paper/100174.
3
Edward Pinto, Government Housing Policies in the Lead-up to the Financial Crisis: A Forensic Study,
http//ww.aei.org/docLib/Government-Housing-Policies-Financial-Crisis-Pinto-102110.pdf.
449 Peter J. Wallison
of all the Commissions work. Te Commission members did not get together to
discuss or decide on the causes of the fnancial crisis until July, 2010, well afer it was
too late to direct the activities of the staf. Te Commission interviewed hundreds of
witnesses, and the majoritys report is full of statements such as Smith told the FCIC
that. However, unless the meeting was public, the commissioners were not told
that an interview would occur, did not know who was being interviewed, were not
encouraged to attend, and of course did not have an opportunity to question these
sources or understand the contexts in which the quoted statements were made. Te
Commission majoritys report uses these opinions as substitutes for data, which is
notably lacking in their report; opinions in general are not worth much, especially
in hindsight and when given without opportunity for challenge.
Te Commissions authorizing statute required that the Commission report
on or before December 15, 2010. Te original plan was for us to start seeing drafs
of the report in April. We didnt see any drafs until November. We were then given
an opportunity to submit comments in writing, but never had an opportunity to go
over the wording as a group or to know whether our comments were accepted. We
received a complete copy of the majoritys report, for the frst time, on December 15.
It was almost 900 double-spaced pages long. Te date for approval of the report was
eight days later, on December 23. Tat is not the way to achieve a bipartisan report,
or the full agreement of any group that takes the issues seriously.
Tis dissenting statement is organized as follows: Part I summarizes the main
points of the dissent. Part II describes how the failure of subprime and other high
risk mortgages drove the growth of the bubble and weakened fnancial institutions
around the world when these mortgages began to default. Part III outlines in detail
the housing policies of the U.S. government that were primarily responsible for the
fact that approximately one half of all U.S. mortgages in 2007 were subprime or
otherwise of low quality. Part IV is a brief conclusion.
450 Dissenting Statement
451
SUMMARY
Although there were many contributing factors, the housing bubble of 1997-
2007 would not have reached its dizzying heights or lasted as long, nor would
the fnancial crisis of 2008 have ensued, but for the role played by the housing
policies of the United States government over the course of two administrations.
As a result of these policies, by the middle of 2007, there were approximately 27
million subprime and Alt-A mortgages in the U.S. fnancial systemhalf of all
mortgages outstandingwith an aggregate value of over $4.5 trillion.
4
Tese were
unprecedented numbers, far higher than at any time in the past, and the losses
associated with the delinquency and default of these mortgages fully account for
the weakness and disruption of the fnancial system that has become known as the
fnancial crisis.
Most subprime and Alt-A mortgages are high risk loans. A subprime
mortgage is a loan to a borrower who has blemished credit, usually signifed by
a FICO credit score lower than 660.
5
Typically, a subprime borrower has failed in
4
Unless otherwise indicated, all estimates for the number of subprime and Alt-A mortgages outstanding,
as well as the use of specifc terms such as loan to value ratios and delinquency rates, come from research
done by Edward Pinto, a resident fellow at the American Enterprise Institute. Pinto is also a consultant
to the housing fnance industry and a former chief credit of cer of Fannie Mae. Much of this work is
posted on both my and Pintos scholar pages at AEI as follows: http://www.aei.org/docLib/Pinto-Sizing-
Total-Exposure.pdf, which accounts for all 27 million high risk loans; http://www.aei.org/docLib/
Pinto-Sizing-Total-Federal-Contributions.pdf, which covers the portion of these loans that were held or
guaranteed by federal agencies and the four large banks that made these loans under CRA; and http://
www.aei.org/docLib/Pinto-High-LTV-Subprime-Alt-A.pdf, which covers the acquisition of these loans
by government agencies from the early 1990s. Te information in these memoranda is fully cited to
original sources. Tese memoranda were the data exhibits to a Pinto memorandum submitted to the
FCIC in January 2010, and revised and updated in March 2010 (collectively, the Triggers memo).
5
One of the confusing elements of any study of the mortgage markets is the fact that the key defnitions
have never been fully agreed upon. For many years, Fannie Mae treated as subprime loans only those
that it purchased from subprime originators. Inside Mortgage Finance, a common source of data on
the mortgage market, treated and recorded as subprime only those loans reported as subprime by the
originators or by Fannie and Freddie. Other loans were recorded as prime, even if they had credit scores
that would have classifed them as subprime. However, a FICO credit score of less than 660 is generally
regarded as a subprime loan, no matter how originated. Tat is the standard, for example, used by the
Of ce of the Comptroller of the Currency. In this statement and in Pintos work on this issue, loans that
are classifed as subprime by their originators are called self-denominated subprime loans, and loans
to borrowers with FICO scores of less than 660 are called subprime by characteristic. Fannie and Freddie
reported only a very small percentage of their loans as subprime, so in efect the subprime loans acquired
by Fannie and Freddie should be added to the self-denominated subprime loans originated by others in
order to derive something closer to the number and principal amount of the subprime loans outstanding
in the fnancial system at any given time. One of the important elements of Edward Pintos work was to
show that Fannie and Freddie, for many years prior to the fnancial crisis, were buying loans that should
have been classifed as subprime because of the borrowers credit scores and not simply because they were
originated by subprime lenders. Fannie and Freddie did not do this until afer they were taken over by
the federal government. Tis lack of disclosure on the part of the GSEs appears to have been a factor in
the failure of many market observers to foresee the potential severity of the mortgage defaults when the
housing bubble defated in 2007.
452 Dissenting Statement
the past to meet other fnancial obligations. Before changes in government policy
in the early 1990s, most borrowers with FICO scores below 660 did not qualify as
prime borrowers and had dif culty obtaining mortgage credit other than through
the Federal Housing Administration (FHA), the governments original subprime
lender, or through a relatively small number of specialized subprime lenders.
An Alt-A mortgage is one that is defcient by its terms. It may have an
adjustable rate, lack documentation about the borrower, require payment of interest
only, or be made to an investor in rental housing, not a prospective homeowner.
Another key defciency in many Alt-A mortgages is a high loan-to-value ratiothat
is, a low downpayment. A low downpayment for a home may signify the borrowers
lack of fnancial resources, and this lack of skin in the game ofen means a reduced
borrower commitment to the home. Until they became subject to HUDs afordable
housing requirements, beginning in the early 1990s, Fannie and Freddie seldom
acquired loans with these defciencies.
Given the likelihood that large numbers of subprime and Alt-A mortgages
would default once the housing bubble began to defate in mid- 2007with
devastating efects for the U.S. economy and fnancial systemthe key question
for the FCIC was to determine why, beginning in the early 1990s, mortgage
underwriting standards began to deteriorate so signifcantly that it was possible to
create 27 million subprime and Alt-A mortgages. Te Commission never made a
serious study of this question, although understanding why and how this happened
must be viewed as one of the central questions of the fnancial crisis.
From the beginning, the Commissions investigation was limited to validating
the standard narrative about the fnancial crisisthat it was caused by deregulation
or lack of regulation, weak risk management, predatory lending, unregulated
derivatives and greed on Wall Street. Other hypotheses were either never considered
or were treated only superfcially. In criticizing the Commission, this statement is
not intended to criticize the staf, which worked diligently and efectively under
dif cult circumstances, and did extraordinarily fne work in the limited areas they
were directed to cover. Te Commissions failures were failures of management.
1. Government Policies Resulted in an
Unprecedented Number of Risky Mortgages
Tree specifc government programs were primarily responsible for the
growth of subprime and Alt-A mortgages in the U.S. economy between 1992 and
2008, and for the decline in mortgage underwriting standards that ensued.
Te GSEs Afordable Housing Mission. Te fact that high risk mortgages
formed almost half of all U.S. mortgages by the middle of 2007 was not a chance
event, nor did it just happen that banks and other mortgage originators decided on
their own to ofer easy credit terms to potential homebuyers beginning in the 1990s.
In 1992, Congress enacted Title XIII of the Housing and Community
Development Act of 1992
6
( the GSE Act), legislation intended to give low and
6
Public Law 102-550, 106 Stat. 3672, H.R. 5334, enacted October 28, 1992.
453 Peter J. Wallison
moderate income
7
borrowers better access to mortgage credit through Fannie Mae
and Freddie Mac. Tis efort, probably stimulated by a desire to increase home
ownership, ultimately became a set of regulations that required Fannie and Freddie
to reduce the mortgage underwriting standards they used when acquiring loans
from originators. As the Senate Committee report said at the time, Te purpose of
[the afordable housing] goals is to facilitate the development in both Fannie Mae
and Freddie Mac of an ongoing business efort that will be fully integrated in their
products, cultures and day-to-day operations to service the mortgage fnance needs
of low-and-moderate-income persons, racial minorities and inner-city residents.
8

Te GSE Act, and its subsequent enforcement by HUD, set in motion a series of
changes in the structure of the mortgage market in the U.S. and more particularly
the gradual degrading of traditional mortgage underwriting standards. Accordingly,
in this dissenting statement, I will refer to the subprime and Alt-A mortgages that
were acquired because of the afordable housing AH goals, as well as other subprime
and Alt-A mortgages, as non-traditional mortgages, or NTMs
Te GSE Act was a radical departure from the original conception of the GSEs
as managers of a secondary market in prime mortgages. Fannie Mae was established
as a government agency in the New Deal era to buy mortgages from banks and other
loan originators, providing them with new funds with which to make additional
mortgages. In 1968, it was authorized to sell shares to the public and became a
government-sponsored enterprise (GSE)
9
a shareholder-owned company with a
government mission to maintain a liquid secondary market in mortgages. Freddie
Mac was chartered by Congress as another GSE in 1970. Fannie and Freddie carried
out this mission efectively until the early 1990s, and in the process established
conservative lending standards for the mortgages they were willing to purchase,
including such elements as downpayments of 10 to 20 percent, and minimum credit
standards for borrowers.
Te GSE Act, however, created a new mission for Fannie Mae and Freddie
Maca responsibility to support afordable housingand authorized HUD to
establish and administer what was in efect a mortgage quota system in which a
certain percentage of all Fannie and Freddie mortgage purchases had to be loans to
low-and- moderate income (LMI) borrowersdefned as persons with income at or
below the median income in a particular area or to borrowers living in certain low
income communities. Te AH goals put Fannie and Freddie into direct competition
with the FHA, which was then and is today an agency within HUD that functions as
the federal governments principal subprime lender.
7
Low income is usually defned as 80 percent of area median income (AMI) and moderate income as
100 percent of AMI.
8
Report of the Committee on Banking Housing and Urban Afairs, United States Senate to accompany
S. 2733. Report 102-282, May 15, 1992, pp. 34-5.
9
Fannie and Freddie were considered to be government sponsored enterprises because they had been
chartered by Congress and were given various privileges (such as exemption from the Securities Act of
1933 and the Securities Exchange Act of 1934) and a line of credit at the Treasury that signaled a special
degree of government support. As a result, the capital markets (which continued to call them Agencies)
assumed that in the event of fnancial dif culties the government would stand behind them. Tis implied
government backing gave them access to funding that was lower cost than any AAA borrower and ofen
only a few basis points over the applicable Treasury rate.
454 Dissenting Statement
Over the next 15 years, HUD consistently enhanced and enlarged the AH
goals. In the GSE Act, Congress had initially specifed that 30 percent of the GSEs
mortgage purchases meet the AH goals. Tis was increased to 42 percent in 1995,
and 50 percent in 2000. By 2008, the main LMI goal was 56 percent, and a special
afordable subgoal had been added requiring that 27 percent of the loans acquired
by the GSEs be made to borrowers who were at or below 80 percent of area median
income (AMI). Table 10, page 510, shows that Fannie and Freddie met the goals in
almost every year between 1996 and 2008.
Tere is very little data available concerning Fannie and Freddies acquisitions
of subprime and Alt-A loans in the early 1990s, so it is dif cult to estimate the GSEs
year-by-year acquisitions of these loans immediately afer the AH goals went into
efect. However, Pinto estimates the total value of these purchases at approximately
$4.1 trillion (see Table 7, page 504). As shown in Table 1, page 456, on June 30,
2008, immediately prior to the onset of the fnancial crisis, the GSEs held or had
guaranteed 12 million subprime and Alt-A loans. Tis was 37 percent of their total
mortgage exposure of 32 million loans, which in turn was approximately 58 percent
of the 55 million mortgages outstanding in the U.S. on that date. Fannie and Freddie,
accordingly, were by far the dominant players in the U.S. mortgage market before
the fnancial crisis and their underwriting standards largely set the standards for the
rest of the mortgage fnancing industry.
Te Community Reinvestment Act. In 1995, the regulations under the
Community Reinvestment Act (CRA)
10
were tightened. As initially adopted in
1977, the CRA and its associated regulations required only that insured banks
and S&Ls reach out to low-income borrowers in communities they served. Te
new regulations, made efective in 1995, for the frst time required insured banks
and S&Ls to demonstrate that they were actually making loans in low-income
communities and to low-income borrowers.
11
A qualifying CRA loan was one made
to a borrower at or below 80 percent of the AMI, and thus was similar to the loans
that Fannie and Freddie were required to buy under HUDs AH goals.
In 2007, the National Community Reinvestment Coalition (NCRC), an
umbrella organization for community activist organizations, reported that between
1997 and 2007 banks that were seeking regulatory approval for mergers committed
in agreements with community groups to make over $4.5 trillion in CRA loans.
12

A substantial portion of these commitments appear to have been converted into
mortgage loans, and thus would have contributed substantially to the number
of subprime and other high risk loans outstanding in 2008. For this reason, they
deserved Commission investigation and analysis. Unfortunately, as outlined in Part
III, this was not done.
Accordingly, the GSE Act put Fannie and Freddie, FHA, and the banks
that were seeking CRA loans into competition for the same mortgagesloans to
borrowers at or below the applicable AMI.
HUDs Best Practices Initiative. In 1994, HUD added another group to this list
when it set up a Best Practices Initiative, to which 117 members of the Mortgage
10
Pub.L. 95-128, Title VIII of the Housing and Community Development Act of 1977, 91Stat.1147, 12
U.S.C.2901 et seq.
11
http://www.fdic.gov/regulations/laws/rules/2000-6500.html.
12
See http://www.community-wealth.org/_pdfs/articles-publications/cdfs/report-silver-brown.pdf.
455 Peter J. Wallison
Bankers Association eventually adhered. As shown later, this program was explicitly
intended to encourage a reduction in underwriting standards so as to increase access
by low income borrowers to mortgage credit. Countrywide was by far the largest
member of this group and by the early 2000s was also competing, along with others,
for the same NTMs sought by Fannie and Freddie, FHA, and the banks under the
CRA .
With all these entities seeking the same loans, it was not likely that all of them
would fnd enough borrowers who could meet the traditional mortgage lending
standards that Fannie and Freddie had established. It also created ideal conditions
for a decline in underwriting standards, since every one of these competing entities
was seeking NTMs not for purposes of proft but in order to meet an obligation
imposed by the government. Te obvious way to meet this obligation was simply to
reduce the underwriting standards that impeded compliance with the governments
requirements.
Indeed, by the early 1990s, traditional underwriting standards had come to
be seen as an obstacle to home ownership by LMI families. In a 1991 Senate Banking
Committee hearing, Gail Cincotta, a highly respected supporter of low-income
lending, observed that Lenders will respond to the most conservative standards
unless [Fannie Mae and Freddie Mac] are aggressive and convincing in their eforts
to expand historically narrow underwriting.
13
In this light, it appears that Congress set out deliberately in the GSE Act not
only to change the culture of the GSEs, but also to set up a mechanism that would
reduce traditional underwriting standards over time, so that home ownership
would be more accessible to LMI borrowers. For example, the legislation directed
the GSEs to study Te implications of implementing underwriting standards
that(A) establish a downpayment requirement for mortgagors of 5 percent or
less;
14
(B) allow the use of cash on hand as a source of downpayments; and (C)
approve borrowers who have a credit history of delinquencies if the borrower can
demonstrate a satisfactory credit history for at least the 12-month period ending on
the date of the application for the mortgage.
15
None of these elements was part of
traditional mortgage underwriting standards as understood at the time.
I have been unable to fnd any studies by Fannie or Freddie in response to
this congressional direction, but HUD treated these cues as a mandate to use the
AH goals as a mechanism for eroding the traditional standards. HUD was very
explicit about this, as shown in Part II. In the end, the goal was accomplished by
gradually expanding the requirements and enlarging the AH goals over succeeding
years, so that the only way Fannie and Freddie could meet the AH goals was by
purchasing increasing numbers of subprime and Alt-A mortgages, and particularly
mortgages with low or no downpayments. Because the GSEs were the dominant
players in the mortgage market, their purchases also put competitive pressure on
the other entities that were subject to government controlFHA and the banks
13
Allen Fishbein, Filling the Half-Empty Glass: Te Role of Community Advocacy in Redefning the
Public Responsibilities of Government-Sponsored Housing Enterprises, Chapter 7 of Organizing Access
to Capital: Advocacy and the Democratization of Financial Institutions, 2003, Gregory Squires, editor.
14
At that time the GSEs minimum downpayment was 5 percent, and was accompanied by conservative
underwriting. Te congressional request was to break through that limitation.
15
GSE Act, Section 1354(a).
456 Dissenting Statement
under CRAto reach deeper into subprime lending in order to fnd the mortgages
they needed to comply with their own government requirements. Tis was also true
of the mortgage banksthe largest of which was Countrywidethat were bound to
promote afordable housing through HUDs Best Practices Initiative.
By 2008, the result of these government programs was an unprecedented
number of subprime and other high risk mortgages in the U.S. fnancial system. Table
1 shows which agencies or frms were holding the credit risk of these mortgages-
-or had distributed it to investors through mortgage-backed securities (MBS)--
immediately before the fnancial crisis began. As Table 1 makes clear, government
agencies, or private institutions acting under government direction, either held or
had guaranteed 19.2 million of the NTM loans that were outstanding at this point.
By contrast, about 7.8 million NTMs had been distributed to investors through the
issuance of private mortgage-backed securities, or PMBS,
16
primarily by private
issuers such as Countrywide and other subprime lenders.
Te fact that the credit risk of two-thirds of all the NTMs in the fnancial
system was held by the government or by entities acting under government control
demonstrates the central role of the governments policies in the development of
the 1997-2007 housing bubble, the mortgage meltdown that occurred when the
bubble defated, and the fnancial crisis and recession that ensued. Similarly, the
fact that only 7.8 million NTMs were held by investors and fnancial institutions in
the form of PMBS shows that this group of NTMs were less important as a cause of
the fnancial crisis than the governments role. Te Commission majoritys report
focuses almost entirely on the 7.8 million PMBS, and is thus an example of its
determination to ignore the governments role in the fnancial crisis.
Table 1.
17
Entity No. of Subprime
and Alt-A Loans
Unpaid Principal Amount
Fannie Mae and Freddie Mac 12 million $1.8 trillion
FHA and other Federal* 5 million $0.6 trillion
CRA and HUD Programs 2.2 million $0.3 trillion
Total Federal Government 19.2 million $2.7 trillion
Other (including subprime and
Alt-A PMBS issued by Countrywide,
Wall Street and others)
7.8 million $1.9 trillion
Total 27 million $4.6 trillion
*Includes Veterans Administration, Federal Home Loan Banks and others.
To be sure, the governments eforts to increase home ownership through the
AH goals succeeded. Home ownership rates in the U.S. increased from approximately
64 percent in 1994 (where it had been for 30 years) to over 69 percent in 2004.
18

Almost everyone in and out of government was pleased with thisa long term goal
16
In the process known as securitization, securities backed by a pool of mortgages (mortgage-
backed securities, or MBS) and issued by private sector frms were known as private label securities
(distinguishing them from securities issued by the GSEs or Ginnie Mae) or private MBS (PMBS).
17
See Edward Pintos analysis in Exhibit 2 to the Triggers Memo, April 21, 2010, p.4. http://www.aei.org/
docLib/Pinto-Sizing-Total-Federal-Contributions.pdf.
18
Census Bureau data.
457 Peter J. Wallison
of U.S. housing policyuntil the true costs became clear with the collapse of the
housing bubble in 2007. Ten an elaborate process of shifing the blame began.
2. The Great Housing Bubble and Its Effects
Figure 1 below, based on the data of Robert J. Shiller, shows the dramatic
growth of the 1997-2007 housing bubble in the United States. By mid-2007, home
prices in the U.S. had increased substantially for ten years. Te growth in real dollar
terms had been almost 90 percent, ten times greater than any other housing bubble
in modern times. As discussed below, there is good reason to believe that the 1997-
2007 bubble grew larger and extended longer in time than previous bubbles because
of the governments housing policies, which artifcially increased the demand for
housing by funneling more money into the housing market than would have been
available if traditional lending standards had been maintained and the government
had not promoted the growth of subprime lending.
Figure 1. Te Bubble According to Shiller
Tat the 1997-2007 bubble lasted about twice as long as the prior housing
bubbles is signifcant in itself. Mortgage quality declines as a housing bubble grows
and originators try to structure mortgages that will allow buyers to meet monthly
payments for more expensive homes; the fact that the most recent bubble was so
long-lived was an important element in its ultimate destructiveness when it defated.
Why did this bubble last so long? Housing bubbles defate when delinquencies and
defaults begin to appear in unusual numbers. Investors and creditors realize that the
risks of a collapse are mounting. One by one, investors cash in and leave. Eventually,
the bubble tops out, those who are still in the game run for the doors, and a defation
in prices sets in. Generally, in the past, this process took three or four years. In the
case of the most recent bubble, it took ten. Te reason for this longevity is that one
458 Dissenting Statement
major participant in the market was not in it for proft and was not worried about
the risks to itself or to those it was controlling. It was the U.S. government, pursuing
a social policyincreasing homeownership by making mortgage credit available
to low and moderate income borrowersand requiring the agencies and fnancial
institutions it controlled or could infuence through regulation to keep pumping
money into housing long afer the bubble, lef to itself, would have defated.
Economists have been vigorously debating whether the Feds monetary policy
in the early 2000s caused the bubble by keeping interest rates too low for too long.
Naturally enough, Ben Bernanke and Alan Greenspan have argued that the Fed was
not at fault. On the other hand, John Taylor, author of the Taylor rule, contends
that the Feds violation of the Taylor rule was the principal cause of the bubble.
Raghuram Rajan, a professor at the Chicago Booth School of Business, argues that
the Feds low interest rates caused the bubble, but that the Fed actually followed this
policy in order to combat unemployment rather than defation.
19
Other theories
blame huge infows of funds from emerging markets or from countries that were
recycling the dollars they received from trade surpluses with the U.S. Tese debates,
however, may be missing the point. It doesnt matter where the funds that built the
bubble actually originated; the important question is why they were transformed
into the NTMs that were prone to failure as soon as the great bubble defated.
Figure 2 illustrates clearly that the 1997-2007 bubble was built on a foundation
of 27 million subprime and Alt-A mortgages and shows the relationship between the
cumulative growth in the dollar amount of NTMs and the growth of the bubble over
time. It includes both GSE and CRA contributions to the number of outstanding
NTMs above the normal baseline of 30 percent,
20
and estimated CRA lending under
the merger-related commitments of the four large banksBank of America, Wells
Fargo, Citibank and JPMorgan Chasethat, with their predecessors, made most of
the commitments. As noted above, these commitments were made in connection
with applications to federal regulators for approvals of mergers or acquisitions. Te
dollar amounts involved were taken from a 2007 report by the NCRC,
21
and adjusted
for announced loans and likely rates of lending. Te cumulative estimated CRA
19
See, Bernanke testimony before the FCIC, September 2, 2010, Alan Greenspan, in Te Crisis, Second
Draf: March 9, 2010, Taylor, in testimony before the FCIC on October 20, 2009, John B. Taylor, Getting
Of Track, Hoover Institution Press, 2009; and Raghuram Rajan, Fault Lines: How Hidden Fractures Still
Treaten the World Economy, Princeton University Press, 2010, pp. 108-110.
20
It appears that the GSEs normal intake of mortgages included about 30 percent that were made to
borrowers who were at or below the median income in the area in which they lived and were thus eligible
for AH credit. It was only when the AH goals rose above this level, beginning in 1995, that government
policy required the GSEs to acquire more AH qualifying loans than they would have purchased as a matter
of course. In the case of the CRA contributions, the baseline is 1992, and includes the commitments
made by the four largest banks and their predecessors listed in the NCRC report, adjusted for the loans
actually announced by the banks afer that date.
21
In 2007, the National Community Reinvestment Coalition published a report on principal amount
of CRA loans that banks had committed to make in connection with merger applications. Te report
claimed that these commitments exceeded $4.5 trillion. Te original report was removed from the
NCRCs website, but can still be found at http://www.community-wealth.org/_pdfs/articles-publications/
cdfs/report-silver-brown.pdf. A portion of these commitments were in fact fulflled through CRA
qualifying loans. A full discussion of these commitments and the number of loans made pursuant to
them is contained in Section III.
459 Peter J. Wallison
production line also includes almost $1 trillion in NTM lending by Countrywide
Financial under HUDs Best Practices Initiative.
22
Figure 2. Te Efect of Government Policies on the Growth of the Bubble
It is not true that every bubble--even a large bubble-- has the potential to
cause a fnancial crisis when it defates. Tis is clear in Table 2 below, prepared by
Professor Dwight Jafee of the Haas Business School at U.C. Berkley. Te table shows
that in other developed countriesmany of which also had large bubbles during the
1997-2007 periodthe losses associated with mortgage delinquencies and defaults
when these bubbles defated were far lower than the losses sufered in the U.S. when
the 1997-2007 defated.
22
See note 144.
460 Dissenting Statement
Table 2.
23
Troubled Mortgages, Western Europe and the United States
3 Month
Arrears %
Impaired or
Doubtful %
Foreclosures Year
Belgium 0.46% 2009
Denmark 0.53% 2009
France 0.93% 2008
Ireland 3.32% 2009
Italy 3.00% 2008
Portugal 1.17% 2009
Spain 3.04% 0.24% 2009
Sweden 1.00% 2009
UK 2.44% 0.19% 2009
U.S. All Loans 9.47% 4.58% 2009
U.S. Prime 6.73% 3.31% 2009
U.S. Subprime 25.26% 15.58% 2009
Source: European Mortgage Federation (2010) and Mortgage Bankers Association for U.S. Data.
Te underlying reasons for the outcomes in Professor Jafees data were
provided in testimony before the Senate Banking Committee in September 2010 by
Dr. Michael Lea, Director of the Corky McMillin Center for Real Estate at San Diego
State University:
Te default and foreclosure experience of the U.S. market has been far worse than in
other countries. Serious default rates remain less than 3 percent in all other countries
and less than 1 percent in Australia and Canada. Of the countries in this survey only
Ireland, Spain and the UK have seen a signifcant increase in mortgage default during
the crisis.
Tere are several factors responsible for this result. First sub-prime lending was rare
or non-existent outside of the U.S. Te only country with a signifcant subprime
share was the UK (a peak of 8 percent of mortgages in 2006). Subprime accounted
for 5 percent of mortgages in Canada, less than 2 percent in Australia and negligible
proportions elsewhere.
[T]here was far less risk layering or ofering limited documentation loans
to subprime borrowers with little or no downpayment. Tere was little no doc
lendingthe proportion of loans with little or no downpayment was less than the
U.S. and the decline in house prices in most countries was also less[L]oans in other
developed countries are with recourse and lenders routinely go afer borrowers for
defciency judgments.
24
Te fact that the destructiveness of the 1997-2007 bubble came from its
compositionthe number of NTMs it containedrather than its size is also
illustrated by data on foreclosure starts published by the Mortgage Bankers
23
Dwight M. Jafee, Reforming the U.S. Mortgage Market Trough Private Market Incentives, Paper
prepared for presentation at Past, Present and Future of the Government Sponsored Enterprises,
Federal Reserve Bank of St. Louis, Nov 17, 2010, Table 4.
24
Dr. Michael J. Lea, testimony before the Subcommittee on Security and International Trade and
Finance of the Senate Banking Committee, September 29, 2010, p.6.
461 Peter J. Wallison
Association (MBA).
25
Tis data allows a comparison between the foreclosure starts
that have thus far come out of the 1997-2007 bubble and the foreclosure starts in the
two most recent housing bubbles (1977-1979 and 1985-1989) shown in Figure 1.
Afer the housing bubble that ended in 1979, when almost all mortgages were prime
loans of the traditional type, foreclosure starts in the ensuing downturn reached a
high point of only .87 percent in 1983. Afer the next bubble, which ended in 1989
and in which a high proportion of the loans were the traditional type, foreclosure
starts reached a high of 1.32 percent in 1994. However, afer the collapse of the
1997-2007 bubblein which half of all mortgages were NTMsforeclosure starts
reached the unprecedented level (thus far) of 5.3 percent in 2009. And this was true
despite numerous government and bank eforts to prevent or delay foreclosures.
All the foregoing data is signifcant for a proper analysis of the role of
government policy and NTMs in the fnancial crisis. What it suggests is that
whatever efect low interest rates or money fows from abroad might have had in
creating the great U.S. housing bubble, the defation of that bubble need not have
been destructive. It wasnt just the size of the bubble; it was also the content. Te
enormous delinquency rates in the U.S. (see Table 3 below) were not replicated
elsewhere, primarily because other developed countries did not have the numbers
of NTMs that were present in the U.S. fnancial system when the bubble defated.
As shown in later sections of this dissent, these mortgage defaults were translated
into huge housing price declines and from therethrough the PMBS they were
holdinginto actual or apparent fnancial weakness in the banks and other frms
that held these securities.
Accordingly, if the 1997-2007 housing bubble had not been seeded with an
unprecedented number of NTMs, it is likely that the fnancial crisis would never
have occurred.
3. Delinquency Rates
on Nontraditional Mortgages
NTMs are non-traditional because, for many years before the government
adopted afordable housing policies, mortgages of this kind constituted only a
small portion of all housing loans in the United States.
26
Te traditional residential
mortgageknown as a conventional mortgagegenerally had a fxed rate, ofen
for 15 or 30 years, a downpayment of 10 to 20 percent, and was made to a borrower
who had a job, a steady income and a good credit record. Before the GSE Act, even
subprime loans, although made to borrowers with impaired credit, ofen involved
substantial downpayments or existing equity in homes.
27
Table 3 shows the delinquency rates of the NTMs that were outstanding on
June 30, 2008. Te grayed area contains virtually all the NTMs. Te contrast in
quality, based on delinquency rates, between these loans and Fannie and Freddie
prime loans in lines 9 and 10 is clear.
25
Mortgage Bankers Association National Delinquency Survey.
26
See Pinto, Government Housing Policies in the Lead-Up to the Financial Crisis: A Forensic Study,
November 4, 2010, p.58, http://www.aei.org/docLib/Government-Housing-Policies-Financial-Crisis-
Pinto-102110.pdf.
27
Id., p.42.
462 Dissenting Statement
Table 3.
28
Delinquency rates on nontraditional mortgages
Loan Type Estimated # of Loans Total Delinquency Rate
(30+ Days and in Foreclosure)
1. High Rate Subprime (including Fannie/
Freddie private MBS holdings)
6.7 million 45.0%
2. Option Arm 1.1 million 30.5%
3. Alt-A (inc. Fannie/Freddie/FHLBs
private MBS holdings)
2.4 million 23.0%
4. Fannie Subprime/Atl-A/Nonprime 6.6 million 17.3%
5. Freddie Subprime/Alt-A/Nonprime 4.1 million 13.8%
6. Government 4.8 million 13.5%
Subtotal # of Loans 25.7 million
7. Non-Agency Jumbo Prime 9.4 million 6.8%
8. Non-Agency Conforming Prime * 5.6%
9. Fannie Prime ** 11.2 million 2.6%
10. Freddie Prime *** 8.7 million 2.0%
Total # of Loans 55 million
* Includes an estimated 1 million subprime (FICO<660) that were (i) not high rate and (ii) non-prime
CRA and HUD Best Practices Initiative loans. Tese are included in the CRA and HUD Programs
line in Table 1.
** Excludes Fannie subprime/Alt-A/nonprime.
*** Excludes Freddie subprime/Alt-A/nonprime.
Excludes loans owned or securitized by Fannie and Freddie.
Non-agency jumbo prime and conforming prime counted together.
Total delinquency data sources:
1, 2, 3, 6, 7 & 8: Lender Processing Services, LPS Mortgage Monitor, June 2009.
4 & 9: Based on Fannie Mae 2009 2Q Credit Supplement. Converted from a serious delinquency rate
(90+ days & in foreclosure) to an estimated Total Delinquency Rate (30+ days and in foreclosure).
5 & 10: Based on Freddie Mac 2009 2Q Financial Results Supplement. Converted from a serious
delinquency rate (90+ days & in foreclosure) to an estimated Total Delinquency Rate (30+ days and in
foreclosure).
4. The Origin and Growth of Subprime PMBS
It was only in 2002 that the market for subprime PMBSthat is private
mortgage-backed securities backed by subprime loans or other NTMsreached
$100 billion. In that year, the top fve issuers were GMAC-RFC ($11.5 billion),
Lehman ($10.6 billion), CS First Boston ($10.5 billion), Bank of America ($10.4
billion) and Ameriquest ($9 billion).
29
Te issuances of PMBS that year totaled
$134 billion, of which $43 billion in PMBS were issued by Wall Street fnancial
institutions. In subsequent years, as the market grew, Wall Street institutions fell
behind the major subprime issuers, so that by 2005the biggest year for subprime
PMBS issuanceonly Lehman was among the top fve issuers and Wall Street
issuers as a group were only 27 percent of the $507 billion in total PMBS issuance
in that year.
30
28
Id., Figure 53.
29
Inside Mortgage Finance, Te 2009 Mortgage Market Statistical AnnualVol. II, p143.
30
Id., p.140.
463 Peter J. Wallison
One of the many myths about the fnancial crisis is that Wall Street banks led
the way into subprime lending and the GSEs followed. Te Commission majoritys
report adopts this idea as a way of explaining why Fannie and Freddie acquired
so many NTMs. Tis notion simply does not align with the facts. Not only were
Wall Street institutions small factors in the subprime PMBS market, but well before
2002 Fannie and Freddie were much bigger players than the entire PMBS market
in the business of acquiring NTM and other subprime loans. Table 7, page 504,
shows that Fannie and Freddie had already acquired at least $701 billion in NTMs
by 2001. Obviously, the GSEs did not have to follow anyone into NTM or subprime
lending; they were already the dominant players in that market before 2002. Table
7 also shows that in 2002, when the entire PMBS market was $134 billion, Fannie
and Freddie acquired $206 billion in whole subprime mortgages and $368 billion in
other NTMs, demonstrating again that the GSEs were no strangers to risky lending
well before the PMBS market began to develop.
Further evidence about which frms were frst into subprime or NTM lending
is provided by Fannies 2002 10-K. Tis disclosure document reports that 14 percent
of Fannies credit obligations (either in portfolio or guaranteed) had FICO credit
scores below 660 as of December 31, 2000, 16 percent at the end of 2001 and 17
percent at the end of 2002.
31
So Fannie and Freddie were active and major buyers
of subprime loans in years when the PMBS market had total issuances of only $55
billion (2000) and $94 billion (2001). In other words, it would be more accurate
to say that Wall Street followed Fannie and Freddie into subprime lending rather
than vice versa. At the same time, the GSEs purchases of subprime whole loans
throughout the 1990s stimulated the growth of the subprime lending industry,
which ultimately became the mainstay of the subprime PMBS market in the 2000s.
2005 was the biggest year for PMBS subprime issuances, and Ameriquest
($54 billion) and Countrywide ($38 billion) were the two largest issuers in the top
25. Tese numbers were still small in relation to what Fannie and Freddie had been
buying since data became available in 1997. Te total in Table 7 for Fannie and
Freddie between 1997 and 2007 is approximately $1.5 trillion for subprime loans
and over $4 trillion for all NTMs as a group.
Because subprime PMBS were rich in NTM loans eligible for credit under
HUDs AH goals, Fannie and Freddie were also the largest individual purchasers
of subprime PMBS from 2002 to 2006, acquiring 33 percent of the total issuances,
or $579 billion.
32
In Table 3 above, which organizes mortgages by delinquency rate,
these purchases are included in line 1, which had the highest rate of delinquency.
Tese were self-denominated subprimedesignated as subprime by the lender
when originatedand thus had low FICO scores and usually a higher interest rate
than prime loans; many also had low downpayments and were subject to other
defciencies.
Ultimately, HUDs policies were responsible for both the poor quality of
the subprime and Alt-A mortgages that backed the PMBS and for the enormous
size to which this market grew. Tis was true not only because Fannie and Freddie
31
2003 10-K, Table 33, p.84 http://www.sec.gov/Archives/edgar/data/310522/000095013303001151/
w84239e10vk.htm#031.
32
See Table 3 of High LTV, Subprime and Alt-A Originations Over the Period 1992-2007 and Fannie,
Freddie, FHA and VAs Role found at http://www.aei.org/docLib/Pinto-High-LTV-Subprime-Alt-A.pdf.
464 Dissenting Statement
stimulated the growth of that market through their purchases of PMBS, but also
because the huge infow of government or government-directed funds into the
housing market turned what would have been a normal housing bubble into a bubble
of unprecedented size and duration. Tis encouraged and enabled unprecedented
growth in the PMBS market in two ways.
First, the gradual increase of the AH goals, the competition between the GSEs
and the FHA, the efect of HUDs Best Practices Initiative, and bank lending under
the CRA, assured a continuing fow of funds into weaker and weaker mortgages.
Tis had the efect of extending the life of the housing bubble as well as increasing
its size. Te growth of the bubble in turn disguised the weakness of the subprime
mortgages it contained; as housing prices rose, subprime borrowers who might
otherwise have defaulted were able to refnance their mortgages, using the equity
that had developed in their homes solely through rising home prices. Without the
continuous infusion of government or government-directed funds, delinquencies
and defaults would have begun showing up within a year or two, bringing the
subprime PMBS market to a halt. Instead, the bubble lasted ten years, permitting
that market to grow until it reached almost $2 trillion.
Second, as housing prices rose in the bubble, it was necessary for borrowers to
seek riskier mortgages so they could aford the monthly payments on more expensive
homes. Tis gave rise to new and riskier forms of mortgage debt, such as option
ARMs (resulting in negative amortization) and interest-only mortgages. Mortgages
of this kind could be suitable for some borrowers, but not for those who were only
eligible for subprime loans. Nevertheless, subprime loans were necessary for PMBS,
because they generally bore higher interest rates and thus could support the yields
that investors were expecting. As subprime loans were originated, Fannie and
Freddie were willing consumers of those that might meet the AH goals; moreover,
because of their lower cost of funds, they were able to buy the best of the worst,
the highest quality among the NTMs on ofer. Tese factorsthe need for higher
yielding loans and the ability of Fannie and Freddie to pay up for the loans they
wanteddrove private sector issuers further out on the risk curve as they sought
to meet the demands of investors who were seeking exposure to subprime PMBS.
From the investors perspective, as long as the bubble kept growing, PMBS were
ofering the high yields associated with risk but were not showing commensurate
numbers of delinquencies and defaults.
5. What was Known About NTMs
Prior to the Crisis?
Virtually everyone who testifed before the Commission agreed that the
fnancial crisis was initiated by the mortgage meltdown that began when the housing
bubble began to defate in 2007. None of these witnesses, however, including
the academics consulted by the Commission, the representatives of the rating
agencies, the of cers of fnancial institutions that were ultimately endangered by the
mortgage downdraf, regulators and supervisors of fnancial institutions and even
the renowned investor Warren Bufett,
33
seems to have understood the dimensions
33
See Bufett, testimony before the FCIC, June 2, 2010.
465 Peter J. Wallison
of the NTM problem or recognized its signifcance before the bubble defated.
Te Commission majoritys report notes that there were warning signs. Tere
always are if one searches for them; they are most visible in hindsight, in which the
Commission majority, and many of the opinions it cites for this proposition, happily
engaged. However, as Michael Lewiss acclaimed book, Te Big Short, showed so
vividly, very few people in the fnancial world were actually willing to bet money
even at enormously favorable oddsthat the bubble would burst with huge losses.
Most seem to have assumed that NTMs were present in the fnancial system, but not
in unusually large numbers.
Even today, there are few references in the media to the number of NTMs that
had accumulated in the U.S. fnancial system before the meltdown began. Yet this is
by far the most important fact about the fnancial crisis. None of the other factors
ofered by the Commission majority to explain the crisislack of regulation, poor
regulatory and risk management foresight, Wall Street greed and compensation
policies, systemic risk caused by credit default swaps, excessive liquidity and easy
creditdo so as plausibly as the failure of a large percentage of the 27 million NTMs
that existed in the fnancial system in 2007.
It appears that market participants were unprepared for the destructiveness of
this bubbles collapse because of a chronic lack of information about the composition
of the mortgage market. In September 2007, for example, afer the defation of the
bubble had begun, and various fnancial frms were beginning to encounter capital
and liquidity dif culties, two Lehman Brothers analysts issued a highly detailed
report entitled Who Owns Residential Credit Risk?
34
In the tables associated with
the report, they estimated the total unpaid principal balance of subprime and Alt-A
mortgages outstanding at $2.4 trillion, about half the actual number at the time.
Based on this assessment, when they applied a stress scenario in which housing
prices declined about 30 percent, they still found that [t]he aggregate losses in the
residential mortgage market under the stressed housing conditions could be about
$240 billion, which is manageable, assuming it materializes over a fve-to six-year
horizon. In the end, of course, the losses were much larger, and were recognized
under mark-to-market accounting almost immediately, rather than over a fve to six
year period. But the failure of these two analysts to recognize the sheer size of the
subprime and Alt-A market, even as late as 2007, is the important point.
Along with most other observers, the Lehman analysts were not aware of
the true composition of the mortgage market in 2007. Under the stressed housing
conditions they applied, they projected that the GSEs would sufer aggregate losses
of $9.5 billion (net of mortgage insurance coverage) and that their guarantee fee
income would be more than suf cient to cover these losses. Based on known losses
and projections recently made by the Federal Housing Finance Agency (FHFA), the
GSEs credit losses alone could total $350 billionmore than 35 times the Lehman
analysts September 2007 estimate. Te analysts could only make such a colossal
error if they did not realize that 37 percentor $1.65 trillionof the GSEs credit
risk portfolio consisted of subprime and Alt-A loans (see Table 1, supra) or that
these weak loans would account for about 75% of the GSEs default losses over 2007-
34
Vikas Shilpiekandula and Olga Gorodetski, Who Owns Resident al Credit Risk?Lehman Brothers
Fixed Income U.S. Securitized Products Research, September 7, 2007.
i
466 Dissenting Statement
2010.
35
It is also instructive to compare the Lehman analysts estimate that the 2006
vintage of subprime loans would sufer lifetime losses of 19 percent under stressed
conditions to other, later, more informed estimates. In early 2010, for example,
Moodys made a similar estimate for the 2006 vintage and projected a 38 percent
loss rate afer the 30 percent decline in housing prices had actually occurred.
36
Te Lehman loss rate projection suggests that the analysts did not have an
accurate estimate of the number of NTMs actually outstanding in 2006. Indeed, I
have not found any studies in the period before the fnancial crisis in which anyone
scholar or fnancial analystactually seemed to understand how many NTMs were
in the fnancial system at the time. It was only afer the fnancial crisis, when my AEI
colleague, Edward Pinto, began gathering this information from various unrelated
and disparate sources that the total number of NTMs in the fnancial markets
became clear. As a result, all loss projections before Pintos work were bound to be
faulty.
Much of the Commission majoritys report, which criticizes frms, regulators,
corporate executives, risk managers and ratings agency analysts for failure to perceive
the losses that lay ahead, is sheer hindsight. It appears that information about the
composition of the mortgage market was simply not known when the bubble began
to defate. Te Commission never attempted a serious study of what was known
about the composition of the mortgage market in 2007, apparently satisfed simply
to blame market participants for failing to understand the risks that lay before them,
without trying to understand what information was actually available.
Te mortgage market is studied constantly by thousands of analysts,
academics, regulators, traders and investors. How could all these people have
missed something as important as the actual number of NTMs outstanding? Most
market participants appear to have assumed in the bubble years that Fannie and
Freddie continued to adhere to the same conservative underwriting policies they
had previously pursued. Until Fannie and Freddie were required to meet HUDs AH
goals, they rarely acquired subprime or other low quality mortgages. Indeed, the
very defnition of a traditional prime mortgage was a loan that Fannie and Freddie
would buy. Lesser loans were rejected, and were ultimately insured by FHA or made
by a relatively small group of subprime originators and investors.
Although anyone who followed HUDs AH regulations, and thought through
their implications, would have realized that Fannie and Freddie must have been
shifing their buying activities to low quality loans, few people had incentives to
uncover the new buying pattern. Investors believed that there was no signifcant
risk in MBS backed by Fannie and Freddie, since they were thought (correctly, as
it turns out) to be implicitly backed by the federal government. In addition, the
GSEs were exempted by law from having to fle information with the Securities and
Exchange Commission (SEC)--they agreed to fle voluntarily in 2002--leaving them
free from disclosure obligations and questions from analysts about the quality of
their mortgages.
When Fannie voluntarily began fling reports with the SEC in 2003, it disclosed
35
Fannie Mae, 2010 Second Quarter Credit Supplement, http://www.fanniemae.com/ir/pdf/sec/2010/
q2credit_summary.pdf.
36
Moodys Projects Losses of Almost Half of Original Balance from 2007 Subprime Mortgage
Securities, http://seekingalpha.com/article/182556-moodys-projects-losses-of-almost-half-of-original-
balance-from-2007-subprime-mortgage-securities.
467 Peter J. Wallison
that 16 percent of its credit obligations on mortgages had FICO scores of less than
660the common defnition of a subprime loan. Tere are occasionally questions
about whether a FICO score of 660 is the appropriate dividing line between prime
and subprime loans. Te federal bank regulators use 660 as the dividing line,
37
and
in the credit supplement it published for the frst time with its 2008 10-K, Fannie
included loans with FICO scores below 660 to disclose its exposure to loans that
were other than prime. As of December 31, 2008, borrowers with a FICO of less
than 660 had a serious delinquency rate about four times that for borrowers with
a FICO equal to or greater than 660 (6.74% compared to 1.72%).
38
Fannie did not
point out in its fling that a FICO score of less than 660 was considered a subprime
loan. Although at the end of 2005 Fannie was exposed to $311 billion in subprime
loans it reported in its 2005 10-K (not fled with the SEC until May 2, 2007) that:
Te percentage of our single-family mortgage credit book of business consisting
of subprime mortgage loans or structured Fannie Mae MBS backed by subprime
mortgage loans was not material as of December31, 2005.[emphasis supplied]
39
Fannie was able to make this statement because it defned subprime loans
as loans it purchased from subprime lenders. Tus, in its 2007 10-K report, Fannie
stated: Subprime mortgage loans are typically originated by lenders specializing
in these loans or by subprime divisions of large lenders, using processes unique to
subprime loans. In reporting our subprime exposure, we have classifed mortgage
loans as subprime if the mortgage loans are originated by one of these specialty lenders
or a subprime division of a large lender.
40
[emphasis supplied] Te credit scores on
these loans, and the riskiness associated with these credit scores, were not deemed
relevant. Accordingly, as late as its 2007 10-K report, Fannie was able to make the
following statements, even though it is likely that at that point it held or guaranteed
enough subprime loans to drive the company into insolvency if a substantial number
of these loans were to default:
Subprime mortgage loans, whether held in our portfolio or backing Fannie Mae MBS,
represented less than 1% of our single-family business volume in each of 2007, 2006
and 2005.
41
[emphasis supplied]
We estimate that subprime mortgage loans held in our portfolio or subprime mortgage
loans backing Fannie Mae MBS, excluding re-securitized private label mortgage related
securities backed by subprime mortgage loans, represented approximately 0.3% of our
single-family mortgage credit book of business as of December 31, 2007, compared with
0.2% and 0.1% as of December 31, 2006 and 2005, respectively.
42
[emphasis supplied]
Tese statements could have lulled market participants and othersincluding
37
Of ce of Comptroller of the Currency, Federal Reserve, Federal Deposit Insurance Corporation,
and Of ce of Trif Supervision advised in its Expanded Guidance for Subprime Lending Programs,
published in 2001, http://www.federalreserve.gov/Boarddocs/SRletters/2001/sr0104a1.pdf that the term
subprime refers to the credit characteristics of individual borrowers. Subprime borrowers typically have
weakened credit histories that include payment delinquencies and possibly more severe problems such
as charge-ofs, judgments, and bankruptcies. A FICO score of 660 or below was evidence of relatively
high default probability.
38
Derived from Table 12.
39
Fannie Mae, 2005 10-K report, fled May 2, 2007.
40
Fannie Mae, 2007 Form 10K, pp. 129 and 155.
41
Fannie Mae, 2007 Form 10K, p.129.
42
Fannie Mae, 2007 Form 10K, p.130.
468 Dissenting Statement
the Lehman analystsinto believing that Fannie and Freddie did not hold or had
not guaranteed substantial numbers of high risk loans, and thus that there were
many fewer such loans in the fnancial system than in fact existed.
Of course, in the early 2000s there was no generally understood defnition
of the term subprime, so Fannie and Freddie could defne it as they liked, and the
assumption that the GSEs only made prime loans continued to be supported by their
public disclosures. So when Fannie and Freddie reported their loan acquisitions to
various mortgage information aggregators they did not report those mortgages as
subprime or Alt-A, and the aggregators continued to follow industry practice by
placing virtually all the GSEs loans in the prime category. Without understanding
Fannie and Freddies peculiar and self-serving loan classifcation methods, the
recipients of information about the GSEs mortgage positions simply seemed to
assume that all these mortgages were prime loans, as they had always been in the
past, and added them to the number of prime loans outstanding. Accordingly, by
2008 there were approximately 12 million more NTMs in the fnancial systemand
12 million fewer prime loansthan most market participants realized.
Appendix 1 shows that the levels of delinquency and default would be 86
percent higher than expected if there were 12 million NTMs in the fnancial system
instead of 12 million prime loans. Appendix 2 shows that the levels of delinquency
would be 150 percent higher than expected if the feedback efect of mortgage
delinquenciescausing lower housing prices, in a downward spiralwere taken
into account. Tese diferences in projected losses could have misled the rating
agencies into believing that, even if the bubble were to defate, the losses on mortgage
failures would not be so substantial as to have a more than local efect and would not
adversely afect the AAA tranches in MBS securitizations.
Te Commission never looked into this issue, or attempted to determine
what market participants believed to be the number of subprime and other NTMs
outstanding in the system immediately before the fnancial crisis. Whenever
possible in the Commissions public hearings, I asked analysts and other market
participants how many NTMs they believed were outstanding before the fnancial
crisis occurred. It was clear from the responses that none of the witnesses had ever
considered that question, and it appeared that none suspected that the number was
large enough to substantially afect losses afer the collapse of the bubble.
It was only on November 10, 2008, afer Fannie had been taken over by the
federal government, that the company admitted in its 10-Q report for the third
quarter of 2008 that it had classifed as subprime or Alt-A loans only those loans
that it purchased from self-denominated subprime or Alt-A originators, and not
loans that were subprime or Alt-A because of their risk characteristics. Even then
Fannie wasnt fully candid. Afer describing its classifcation criteria, Fannie stated,
[H]owever, we have other loans with some features that are similar to Alt-A and
subprime loans that we have not classifed as Alt-A or subprime because they do not
meet our classifcation criteria.
43
Tis hardly described the true nature of Fannies
obligations.
On the issue of the number of NTMs outstanding before the crisis the
Commission studiously averted its eyes, and the Commission majoritys report
43
Fannie Mae, 2008 3rd quarter 10-Q. p.115, http://www.fanniemae.com/ir/pdf/earnings/2008/q32008.
pdf.
469 Peter J. Wallison
never addresses the question. HUDs role in pressing for a reduction in mortgage
underwriting standards escaped the FCICs attention entirely, the GSEs AH goals
are mentioned only in passing, CRA is defended, and neither HUDs Best Practices
Initiative nor FHAs activities are mentioned at all. No reason is advanced for the
accumulation of subprime loans in the bubble other than the ideaimplicit in the
majoritys reportthat it was proftable. In sum, the majoritys report is Hamlet
without the prince of Denmark.
Indeed, the Commissions entire investigation seemed to be directed at
minimizing the role of NTMs and the role of government housing policy. In this
telling, the NTMs were a trigger for the fnancial crisis, but once the collapse of the
bubble had occurred the weaknesses and vulnerabilities of the fnancial system
which had been there all alongcaused the crisis. Tese alleged defciencies
included a lack of adequate regulation of the so-called shadow banking system
and over-the-counter derivatives, the overly generous compensation arrangements
on Wall Street, and securitization (characterized as the originate to distribute
model). Coincidentally, all these purported weaknesses and vulnerabilities then
required more government regulation, although their baleful presence hadnt been
noted until the unprecedented number of subprime and Alt-A loans, created largely
to comply with government housing policies, defaulted.
6. Conclusion
What is surprising about the many views of the causes of the fnancial crisis
that have been published since the Lehman bankruptcy, including the Commissions
own inquiry, is the juxtaposition of two facts: (i) a general agreement that the bubble
and the mortgage meltdown that followed its defation were the precipitating
causessometimes characterized as the triggerof the fnancial crisis, and (ii)
a seemingly studious efort to avoid examining how it came to be that mortgage
underwriting standards declined to the point that the bubble contained so many
NTMs that were ready to fail as soon as the bubble began to defate. Instead of
thinking through what would almost certainly happen when these assets virtually
disappeared from balance sheets, many observersincluding the Commission
majority in their reportpivoted immediately to blame the weaknesses and
vulnerabilities of the free market or the fnancial or regulatory system, without
considering whether any system could have survived such a blow.
One of the most striking examples of this approach was presented by Larry
Summers, the head of the White House economic council and one of the Presidents
key advisers. In a private interview with a few of the members of the Commission
(I was not informed of the interview), Summers was asked whether the mortgage
meltdown was the cause of the fnancial crisis. His response was that the fnancial
crisis was like a forest fre and the mortgage meltdown like a cigarette butt thrown
into a very dry forest. Was the cigarette butt, he asked, the cause of the forest
fre, or was it the tinder dry condition of the forest?
44
Te Commission majority
adopted the idea that it was the tinder-dry forest. Teir central argument is that the
mortgage meltdown as the bubble defated triggered the fnancial crisis because of
the vulnerabilities inherent in the U.S. fnancial system at the timethe absence
44
FCIC, Summers interview, p.77.
470 Dissenting Statement
of regulation, lax regulation, predatory lending, greed on Wall Street and among
participants in the securitization system, inefective risk management, and excessive
leverage, among other factors. One of the majoritys singular notions is that 30
years of deregulation had stripped away key safeguards against a crisis; this
ignores completely that in 1991, in the wake of the S&L crisis, Congress adopted the
FDIC Improvement Act, which was by far the toughest bank regulatory law since
the advent of deposit insurance and was celebrated at the time of its enactment as
fnally giving the regulators the power to put an end to bank crises.
Te forest metaphor turns out to be an excellent way to communicate the
diference between the Commissions report and this dissenting statement. What
Summers characterized as a cigarette butt was 27 million high risk NTMs with
a total value over $4.5 trillion. Lets use a little common sense here: $4.5 trillion in
high risk loans was not a cigarette butt; they were more like an exploding gasoline
truck in that forest. Te Commissions report blames the conditions in the fnancial
system; I blame 27 million subprime and Alt-A mortgageshalf of all mortgages
outstanding in the U.S. in 2008and a number that appears to have been unknown
to most if not all market participants at the time. No fnancial system, in my view,
could have survived the failure of large numbers of high risk mortgages once the
bubble began to defate, and no market could have avoided a panic when it became
clear that the number of defaults and delinquencies among these mortgages far
exceeded anything that even the most sophisticated market participants expected.
Tis conclusion has signifcant policy implications. If in fact the fnancial
crisis was caused by government housing policies, then the Dodd-Frank Act was
legislative overreach and unnecessary. Te appropriate policy choice was to reduce
or eliminate the governments involvement in the residential mortgage markets, not
to impose signifcant new regulation on the fnancial system.
* * * *
Te balance of this statement will outline (i) how the high levels of delinquency
and default among the NTMs were transmitted as losses to the fnancial system, and
(ii) how the government policies summarized above caused the accumulation of an
unprecedented number of NTMs in the U.S. and around the globe.
471
II. HOW 27 MILLION NTMS
PRECIPITATED A FINANCIAL CRISIS
Although the Commission never defned the fnancial crisis it was supposed
to investigate, it is necessary to do so in order to know where to start and stop. If, for
example, the fnancial crisis is still continuing, then the efect of government policies
such as the Troubled Asset Repurchase Program (TARP) should be evaluated.
However, it seems clear that Congress wanted the Commission to concentrate
on what caused the unprecedented events that occurred largely in the fall of 2008,
and for this purpose Ben Bernankes defnition of the fnancial crisis seems most
appropriate:
Te credit boom began to unravel in early 2007 when problems surfaced with subprime
mortgagesmortgages ofered to less-creditworthy borrowersand house prices in
parts of the country began to fall. Mortgage delinquencies and defaults rose, and the
downturn in house prices intensifed, trends that continue today. Investors, stunned
by losses on assets they had believed to be safe, began to pull back from a wide range
of credit markets, and fnancial institutionsreeling from severe losses on mortgages
and other loanscut back their lending. Te crisis deepened [in September 2008],
when the failure or near-failure of several major fnancial frms caused many fnancial
and credit markets to freeze up.
45
In other words, the fnancial crisis was the result of the losses sufered by
fnancial institutions around the world when U.S. mortgages began to fail in large
numbers; the crisis became more severe in September 2008, when the failure of
several major fnancial frmswhich held or were thought to hold large amounts
of mortgage-related assetscaused many fnancial markets to freeze up. Tis
summary encapsulates a large number of interconnected events, but it makes clear
that the underlying cause of the fnancial crisis was a rapid decline in the value of
one specifc and widely held asset: U.S. residential mortgages. Te next question is
how, exactly, these delinquencies and losses caused the fnancial crisis.
Te following discussion will show that it was not all mortgages and
mortgage-backed securities that were the source of the crisis, but primarily NTMs
including PMBS backed by NTMs. Traditional mortgages, which were generally
prime mortgages, did not sufer substantial losses at the outset of the mortgage
meltdown, although as the fnancial crisis turned into a recession and housing
prices continued to fall, losses among prime mortgages began to approach the level
of prime mortgage losses that had occurred in past housing crises. However, those
levels were far lower than the losses on NTMs, which reached levels of delinquency
and default between 15 and 45 percent (depending on the characteristics of the
loans in question) because the loans involved were weaker as a class than in any
previous housing crisis. Te fact that they were also far larger in number than any
45
Speech at Morehouse College, April 14, 2009.
472 Dissenting Statement
previous bubble was what caused the catastrophic housing price declines that fueled
the fnancial crisis.
1. How Failures Among NTMs
were Transmitted to the Financial System
When the housing bubble began to defate in mid-2007, delinquency rates
among NTMs began to increase substantially. Previously, although these mortgages
were weak and high risk, their delinquency rates were relatively low. Tis was a
consequence of the bubble itself, which infated housing prices so that homes
could be sold with no loss in cases where borrowers could not meet their mortgage
obligations. Alternatively, rising housing pricescoupled with liberal appraisal
rulescreated a form of free equity in a home, allowing the home to be refnanced
easily, perhaps even at a lower interest rate. However, rising housing prices eventually
reached the point where even easy credit terms could no longer keep the good times
rolling, and at that point the bubble fattened and weak mortgages became exposed
for what they were. As Warren Bufett has said, when the tide goes out, you can see
whos swimming naked.
Te role of the governments housing policy is crucial at this point. As
discussed earlier, if the government had not been directing money into the
mortgage markets in order to foster growth in home ownership, NTMs in the
bubble would have begun to default relatively soon afer they were originated. Te
continuous infow of government or government-backed funds, however, kept the
bubble growingnot only in size but over timeand this tended to suppress the
signifcant delinquencies and defaults that had brought previous bubbles to an end
in only three or four years. Tat explains why PMBS based on NTMs could become
so numerous and so risky without triggering the delinquencies and defaults that
caused earlier bubbles to defate within a shorter period. With losses few and time
to continue originations, Countrywide and others were able to securitize subprime
PMBS in increasingly large amounts from 2002 ($134 billion) to 2006 ($483 billion)
without engendering the substantial increase in delinquencies that would ordinarily
have alarmed investors and brought the bubble to a halt.
46
Indeed, the absence of delinquencies had the opposite efect. As investors
around the world saw housing prices rise in the U.S. without any signifcant losses
even among subprime and other high-yielding loans, they were encouraged to buy
PMBS thatalthough rated AAAstill ofered attractive yields. In other words, as
shown in Figure 2, government housing policiesAH goals imposed on the GSEs,
the decline in FHA lending standards, HUDs pressure for reduced underwriting
standards among mortgage bankers, and CRA requirements for insured banks
by encouraging the growth of the bubble, increased the worldwide demand for
subprime PMBS. Ten, in mid-2007, the bubble began to defate, with catastrophic
consequences.
46
Inside Mortgage Finance, Te 2009 Mortgage Market Statistical AnnualVolume II, MBS database.
473 Peter J. Wallison
2. The Defaults Begin
Te best summary of how the defation of the housing bubble led to the
fnancial crisis was contained in the prepared testimony that FDIC chair Sheila Bair
delivered to the FCIC in a September 2 hearing:
Starting in mid 2007, global fnancial markets began to experience serious liquidity
challenges related mainly to rising concerns about U.S. mortgage credit quality. As
home prices fell, recently originated subprime and non-traditional mortgage loans
began to default at record rates. Tese developments led to growing concerns about
the value of fnancial positions in mortgage-backed securities and related derivative
instruments held by major fnancial institutions in the U.S. and around the world.
Te dif culty in determining the value of mortgage-related assets and, therefore, the
balance-sheet strength of large banks and non-bank fnancial institutions ultimately
led these institutions to become wary of lending to one another, even on a short-term
basis.
47
[emphasis supplied]
All the important elements of what happened are in Chairman Bairs succinct
statement: (i) in mid 2007, the markets began to experience liquidity challenges
because of concerns about the credit quality of NTMs; (ii) housing prices fell; NTMs
began to default at record rates; (iii) it was dif cult to determine the value of MBS,
and thus the fnancial condition of the institutions that held them; and, (iv) fnally, as
a consequence of this uncertaintyespecially afer the failure of Lehmanfnancial
institutions would not lend to one another. Tat phenomenon was the fnancial
crisis. Te following discussion will show how each of these steps operated to bring
down the fnancial system.
Markets Began to Experience Liquidity Challenges
To understand the transmission mechanism, it is necessary to distinguish
between PMBS, on the one hand, and the MBS that were distributed by government
agencies such as FHA/Ginnie Mae and the GSEs (referred to jointly as Agencies
in this section). As shown in Table 1, by 2008, the 27 million NTMs in the U.S.
fnancial system were held as (i) whole mortgages, (ii) MBS guaranteed by the GSEs,
or insured or held by a government agency or a bank under the CRA, or (iii) as
PMBS securitized by private frms such as Countrywide. Te 27 million NTMs had
an aggregate unpaid principal balance of more than $4.5 trillion, and the portion
represented by PMBS consisted of 7.8 million mortgages with an aggregate unpaid
principal balance of approximately $1.9 trillion. As mortgage delinquencies and
defaults multiplied in the U.S. fnancial system, the losses were transmitted to
fnancial institutions through their holdings of PMBS. How did this happen, and
what role was played by government housing policy?
Both Agency MBS and PMBS pass through to investors the principal and
interest received on the mortgages in a pool that backs an issue of securities; the
diference between them is the way they protect investors against credit riski.e.,
the possibility of losses in the event that the mortgages in the pool begin to default.
Te Agencies insure or place a guarantee on all the securities issued by a pool they
or some other entity creates. Because of the Agencies real or perceived government
47
Sheila C. Bair, Systemically Important Institutions and the Issue of Too-Big-to-Fail, Testimony to
the FCIC, September 2, 2010, p.3.
474 Dissenting Statement
backing, all these securities are rated or considered to be AAA.
PMBS rely on a classifcation and subordination system known as tranching
to provide some investors in the pool with a degree of assurance that they will not
sufer losses because of mortgage defaults. In the tranching system, diferent classes
of securities are issued by the pool. Te rights of some classes to receive payments of
principal and interest from the mortgages in the pool are subordinated to the rights
of other classes, so that the superior classes are more likely to receive payment even
if there are some defaults among the mortgages in the pool.
Trough this mechanism, approximately 90 percent of an issue of PMBS
could be rated AAA or AA, even if the underlying mortgages are NTMs that have a
higher rate of delinquency than prime loans. In theory, for example, if the historic
rates of loss on a pool of NTMs is, say, fve percent, then those losses will be absorbed
by the ten percent of the securities holders who are in the classes rated lower than
AAA or AA. Of course, if the losses are greater than anticipatedexactly what
happened as the recent bubble began to defatethey will reach into the higher
classes and substantially reduce their value.
48
It is not clear whether, in 2007 or 2008,
mortgage delinquencies and defaults had actually caused cash losses in the AAA
tranches of PMBS, but the rate at which delinquencies and defaults among NTMs
were occurring throughout the fnancial system was so high that such losses were a
distinct possibilityobviously a matter of great concern to investors.
Tis means that investors in PMBS and government-backed Agency MBS
had diferent experiences when the bubble began to defate. Tose who invested
in Agency MBS did not sufer losses (the U.S. government has thus far protected
all investors in Agency MBS), while those who invested in PMBS were exposed to
losses if the losses on the underlying mortgages were so great that they threatened
to invade the AAA and AA classes. Even if no cash losses had actually been sufered,
the holders of PMBS would see a sharp decline in the market value of their holdings
as investorsshocked by the large number of defaults on mortgagesfed the asset-
backed market. So when we look for the direct efect of mortgage failures on the
fnancial condition of various fnancial institutions in the fnancial crisis we should
look only to the PMBS, not the MBS issued by the Agencies.
In addition, the default and delinquency ratios on the loans underlying the
PMBS were higher than similar ratios among the loans held or guaranteed by the
Agencies. Many of the loans which backed the PMBS were the self-denominated
subprime loans (that is, made by subprime lenders explicitly to subprime borrowers)
and were classifed in the worst-performing categories in Table 3. In part, the better-
performing characteristics of the NTMs held or guaranteed by the Agencies was
due to the fact that the Agencies were not buying for economic purposesto make
proftsbut only to meet government requirements such as the AH goals. Tey did
not want or need the higher-yielding and thus more risky mortgages that backed
the PMBS, because they did not need higher yields in order to sell their MBS. In
addition, because of their lower cost funding, the Agencies could pay more for the
NTMs they bought and thus could acquire the best of the worst.
48
A thorough description of the tranching system, and many more details about various methods of
protecting senior tranches, is contained in Gary B. Gorton, Slapped By the Invisible Hand: Te Panic of
2007, Oxford University Press, 2010, pp. 82-113.
475 Peter J. Wallison
PMBS are Connected to All Other NTMs Trough Housing Prices
But this does not mean that only the failure of the PMBS was responsible
for the fnancial crisis. In a sense, all mortgages are linked to one another through
housing prices, and housing prices in turn are highly sensitive to delinquencies and
defaults on mortgages. Tis is a characteristic of mortgages that is not present in
other securitized assets. If a credit card holder defaults on his obligations it has little
efect on other credit card holders, but if a homeowner defaults on a mortgage the
resulting foreclosure has an efect on the value of all homes in the vicinity and thus
on the quality of all mortgages on those homes.
Accordingly, the PMBS were intimately connectedthrough housing
pricesto the NTMs securitized by the Agencies. Because there were so many
more NTMs held or securitized by the Agencies (see Table 1), their unprecedented
numberseven in cases where they had a lower average rate of delinquency and
default than the NTMs that backed the PMBSwas the major source of downward
pressure on housing prices throughout the United States. Weakening housing
prices, in turn, caused more mortgage defaults, among both NTMs in general and
the particular NTMs that were the collateral for PMBS. In other words, the NTMs
underlying the PMBS were weakened by the delinquencies and defaults among the
much larger number of mortgages held or guaranteed as MBS by the Agencies.
In reality, then, the losses on the PMBS were much higher than they would
have been if the governments housing policies had not brought into being 19 million
other NTMs that were failing in unprecedented numbers. Tese failures drove down
housing prices by 30 percent--an unprecedented declinewhich multiplied the
losses on the PMBS.
Finally, the funds that the government directed into the housing market in
pursuit of its social policies enlarged the housing bubble and extended it in time.
Te longer housing bubbles grow, the riskier the mortgages they contain; lenders
are constantly trying to fnd ways to keep monthly mortgage payments down while
borrowers are buying more expensive houses. While the bubble was growing, the
risks that were building within it were obscured. Borrowers who would otherwise
have defaulted on their loans, bringing an end to the bubble, were able to use the
rising home prices to refnance, sometimes at lower interest rates. With delinquency
rates relatively low, investors did not have a reason to exit the mortgage markets,
and the continuing fow of funds into mortgages allowed the bubble to extend
for an unprecedented 10 years. Tis in turn enabled the PMBS market to grow to
enormous size and thus to have a more calamitous efect when it fnally collapsed. If
the government policies that provided a continuing source of funding for the bubble
had not been pursued, it is doubtful that there would have been a PMBS market
remotely as large as the one that developed, or thatwhen the housing bubble
collapsedthe losses to fnancial institutions would have been as great.
PMBS, as Securities, are Vulnerable to Investor Sentiment
In addition to their link to the Agencies NTMs through housing prices, PMBS
were particularly vulnerable to changes in investor sentiment about mortgages.
Te fact that the mortgages underlying the PMBS were held in securitized form
was an important element of the crisis. Tere are many reasons for the popularity
476 Dissenting Statement
of mortgage securitization. Beginning in 2002, for example, the Basel regulations
provided that mortgages held in the form of MBSpresumably because of their
superior liquidity compared to whole mortgagesrequired a bank to hold only
1.6 percent risk-based capital, while whole mortgages required risk-based capital
backing of four percent. Tis made all forms of MBS, including PMBS, much less
expensive to hold than whole mortgages. In addition, mortgages in securitized form
could be traded more easily, and used more readily as a source of liquidity through
repurchase agreements.
However, some of the benefts of securitized mortgages are also detriments
when certain mortgage market conditions prevail. If housing values are declining,
losses on whole mortgages are recognized only slowly in bank fnancial statements
and will be recognized even more slowly in the larger market. PMBS, however, are
far more vulnerable to swings in sentiment than whole mortgages held on bank
balance sheets. First, because they are more easily traded, PMBS values can be
more quickly and adversely afected by negative information about the underlying
mortgages than whole mortgages in the same principal amount. PMBS markets
tend to be thin, because PMBS pools difer from one another. If investors believe
that mortgages in general are declining in value, or they learn of a substantial and
unexpected number of defaults and delinquencies, they may abandon the market
for all PMBS, causing the general PMBS price level to fall precipitously.
For example, in his book Slapped by the Invisible Hand, Professor Gary Gorton
of Yale notes that the ABX index, initially published in late 2006, for the frst time
gave investors a picture of how others saw the value of a selected group of PMBS
pools. Te index showed steeply declining values, which caused many investors to
withdraw from the market. Gorton observed: I view the ABX indices as revealing
hitherto unknown information, namely, the aggregated view that subprime was
worth signifcantly lessIt is not clear whether the housing bubble was burst by
the ability to short the subprime housing market or whether house prices were
going down and the implications of this were aggregated and revealed by the ABX
indices
49
Whatever the underlying reason, as shown in Figure 3, this seems to be
exactly what happened in the fnancial crisis. Te result was a crash in the MBS
market as investors fed what looked like major oncoming losses.
49
Gorton, Slapped by the Invisible Hand, note 41, pp.121-123.
477 Peter J. Wallison
Figure 3. Te MBS market reacts to the bubbles defation
Source: Tompson Reuters Debt Capital Markets Review, Fourth Quarter 2008, available at http://
thomsonreuters.com/products_services/fnancial/league_tables/debt_equity/ (accessed July 30, 2009).
Te decline in housing values had a profound adverse efect on the liquidity
of all fnancial institutions that were exposed to PMBS. As noted above, one of the
benefts of holding PMBS, especially those with AAA ratings, was that they were
readily marketable. As such, they were considered sound and secure investments,
carried on balance sheets at par and suitable to serve as collateral for short term
fnancing through repurchase agreements, or repos. In a repo transaction,
a borrower sells a security to a lender with an option to repurchase it at a price
that provides the lender with a return appropriate for a secured loan. Te lender
assumes that if its counterparty defaults the collateral can be sold. Accordingly, if
the collateral asset loses its reputation for high quality and liquidity, it loses much
of its value for both capital and liquidity purposes, even if the collateral itself has
not actually sufered losses. Tis is what happened to AAA-rated PMBS as housing
prices frst leveled of and then began to fall in 2007, and as mortgage delinquencies
rolled in at rates no one had expected. As discussed more fully below, when AAA-
rated PMBS became unmarketable they lost their value for liquidity purposes,
making it dif cult or impossible for many fnancial institutions to fund themselves
using these assets as collateral for repos. Tis was the liquidity challenge to which
Chairman Bair referred in her testimony.
Te near-failure of Bear Stearns in March 2008 was an excellent example of
how the unexpected collapse of the PMBS market could cause a substantial loss of
liquidity by a fnancial institution, and ultimately its inability to survive the resulting
loss in market confdence. Te FCIC stafs review of the liquidity problems of
Bear Stearns showed that the loss of the PMBS market was the single event that
was crippling for Bear, because it eliminated a major portion of the frms liquidity
478 Dissenting Statement
poolAAA-rated PMBSas a useful source of repo fnancing. According to the
Commission stafs Preliminary Investigative Report on Bear, prepared for hearings
on May 5 and 6, 2010, 97.4 percent of Bears short term funding was secured and
only 2.6 percent unsecured. As of January 11, 2008, the FCIC staf reported,
$45.9 billion of Bear Stearns repo collateral was composed of agency (Fannie and
Freddie) mortgage-related securities, $23.7 billion was in non-agency securitized
asset backed securities [i.e., PMBS], and $19 billion was in whole loans.
50
Te
Agency MBS was unafected by the collapse of the PMBS market, and could still be
used for funding.
Tus, about 27 percent of Bears readily available sources of funding
consisted of PMBS that became unusable for repo fnancing when the PMBS market
disappeared. Te loss of this source of liquidity put the frm in serious jeopardy;
rumors swept the market about Bears condition, and clients began withdrawing
funds. Bears of cers told the Commission that the frm was proftable in its frst 2008
quarterthe quarter in which it failed; ironically they also told the Commissions
staf that they had moved Bears short term funding from commercial paper to MBS
because they believed that collateral-backed funding would be more stable. In the
week beginning March 10, 2008, according to the FCIC staf report, Bear had over
$18 billion in cash reserves, but by March 13 the liquidity pool had fallen to $2
billion.
51
It was clear that Bearsolvent and proftable or notcould not survive a
run that was fueled by fear and uncertainty about its liquidity and the possibility of
its insolvency.
Parenthetically, it should be noted that the Commissions staf focused on Bear
because the Commissions majority apparently believed that the business model of
investment banks, which relied on relatively high leverage and repo or other short
term fnancing, was inherently unstable. Te need to rescue Bear was thought to be
evidence of this fact. Clearly, the fve independent investment banksBear, Lehman
Brothers, Merrill Lynch, Morgan Stanley and Goldman Sachswere badly damaged
in the fnancial crisis. Only two of them remain independent frms, and those two
are now regulated as bank holding companies by the Federal Reserve. Nevertheless,
it is not clear that the investment banks fared any worse than the much more heavily
regulated commercial banksor Fannie and Freddie which were also regulated
more stringently than the investment banks but not as stringently as banks. Te
investment banks did not pass the test created by the mortgage meltdown and
the subsequent fnancial crisis, but neither did a large number of insured banks
IndyMac, Washington Mutual (WaMu) and Wachovia, to name the largestthat
were much more heavily regulated and, in addition, ofered insured deposits and
had access to the Feds discount window if they needed emergency funds to deal
with runs. Te view of the Commission majority, that investment banksas part of
the so-called shadow banking systemwere special contributors to the fnancial
crisis, seems misplaced for this reason. Tey are better classifed not as contributors
to the fnancial crisis but as victims of the panic that ensued afer the housing bubble
and the PMBS market collapsed.
Bear went down because the delinquencies and failures of an unprecedentedly
large number of NTMs caused the collapse of the PMBS market; this destroyed the
50
FCIC, Investigative Findings on Bear Stearns (Preliminary Draf), April 29, 2010, p.16.
51
Id., p.45.
479 Peter J. Wallison
usefulness of AAA-rated PMBS as assets that Bear and others relied on for both
capital and liquidity, and thus raised questions about the frms ability to meet its
obligations. Investment banks like Bear Stearns were not commercial banks; instead
of using short term deposits to hold long term assetsthe hallmark of a bank
their business model relied on short-term funding to carry the short term assets
of a trading business. Contrary to the views of the Commission majority, there is
nothing inherently wrong with that business model, but it could not survive an
unprecedented fnancial panic as severe as that which followed the collapse in value
of an asset class as large and as liquid as AAA-rated subprime PMBS.
Mortgage Defaults at Record Rates Created Balance Sheet Losses
Chairman Bair also pointed to the relationship between the decline in the
value of PMBS and the balance sheet strength of fnancial institutions that held
these assets. Adding to liquidity-based losses, balance sheet writedowns were
another major element of the loss transmission mechanism. Securitized assets held
by fnancial institutions are subject to the rules of fair value accounting, and must
be marked to market under certain circumstances. Tus, banks and other fnancial
institutions that are holding securitized mortgages in the form of PMBS could
be subject to large accounting lossesbut not necessarily cash lossesif investor
sentiment were to turn against securitized mortgages and market values decline.
Accordingly, once large numbers of delinquencies and losses started showing up in
the mortgage markets generally and in the mortgage pools that backed the PMBS,
it was not necessary for all the losses to be realized before the PMBS lost substantial
value. All that was necessary was that the market for these assets become seriously
impaired. Tis is exactly what happened in the middle of 2007, leading immediately
not only to severe adverse liquidity consequences for fnancial institutions that held
PMBS but also to capital writedowns that made them appear unstable and possibly
insolvent.
Tese mark-to-market capital losses could be greater than the actual
credit losses to be anticipated. As one Federal Reserve study put it, Te fnancial
turmoilput downward pressure on prices of structured fnance products across
the whole spectrum of [asset-backed] securities, even those with only minimal ties
to the riskiest underlying assets[I]n addition to discounts from higher expected
credit risk, large mark-to-market discounts are generated by uncertainty about the
quality of the underlying assets, by illiquidity, and by price volatilityTis illiquidity
discount is the main reason why the mark-to-market discount here, and in most
similar analyses, is larger than the expected credit default rates on underlying
assets.
52
In other words, the illiquidity discount associated with the uncertainties in
value of collateral are and can be substantially larger than the credit default spread,
since the spread refects only anticipated credit losses.
As shown so dramatically in Figure 3, the collapse of the market for PMBS
was a seminal event in the history of the fnancial crisis. Even though delinquencies
had only just begun to show up in mortgage pools, the absence of a functioning
52
Daniel Beltran, Laurie Pounder and Charles Tomas, Foreign Exposure to Asset-Backed Securities of
U.S. Origin, Board of Governors of the Federal Reserve System, International Finance Discussion Papers
939, August 2008, pp. 11-14.
480 Dissenting Statement
market meant that PMBS simply could not be sold at anything but distress prices.
Te inability of fnancial institutions to liquidate their PMBS assets at anything like
earlier values had dire consequences, especially under mark-to-market accounting
rules, and was the crux of the crisis. In efect, a whole class of assetsinvolving
almost $2 trillioncame to be called toxic assets in the media, and had to be
written down substantially on the balance sheets of fnancial institutions around
the world. Although this made fnancial institutions look weaker than they actually
were, the PMBS they held, despite being unmarketable at that point, were in many
cases still fowing cash at close to expected rates. Instead of a slow decline in value
which would have occurred if whole mortgages were held on bank balance sheets
and gradually deteriorated in qualitythe loss of marketability of these securities
caused a crash in value.
Te Commission majority did not discuss the signifcance of mark-to-
market accounting in its report. Tis was a serious lapse, given the views of many
that accounting policies played an important role in the fnancial crisis. Many
commentators have argued that the resulting impairment charges to balance sheets
reduced the GAAP equity of fnancial institutions and, therefore, their capital
positions, making them appear fnancially weaker than they actually were if viewed
on the basis of the cash fows they were receiving.
53
Te investor panic that began when unanticipated and unprecedented losses
started to appear among NTMs generally and in the PMBS mortgage pools now
spread to fnancial institutions themselves; investors were no longer sure which of
these institutions could survive severe mortgage-related losses. Tis process was
succinctly described in an analysis of fair value or mark-to-market accounting in
the fnancial crisis issued by the Institute of International Finance, an organization
of the worlds largest banks and fnancial frms:
[O]fen-dramatic write-downs of sound assets required under the current
implementation of fair-value accounting adversely afect market sentiment, in turn
leading to further write-downs, margin calls and capital impacts in a downward spiral
that may lead to large-scale fre-sales of assets, and destabilizing, pro-cyclical feedback
efects Tese damaging feedback efects worsen liquidity problems and contribute
to the conversion of liquidity problems into solvency problems.
54
[emphasis in the
original]
At least one study attempted to assess the efect of this on fnancial institutions
overall. In January 2009, Nouriel Roubini and Elisa Parisi-Capone estimated the
mark-to-market losses on MBS backed by both prime loans and NTMs. Teir
estimate was slightly over $1 trillion, of which U.S. banks and investment banks
were estimated to have lost $318 billion on a mark-to-market basis.
55
Tis would be a dramatic loss if all of it were realized. In 2008, the U.S.
banking system had total assets of $10 trillion; the fve largest investment banks had
53
FCIC Draf Staf Report, Te Role of Accounting During the Financial Crisis, p.16.
54
Institute of International Finance, IIF Board of Directors - Discussion Memorandum
on Valuation in Illiquid Markets, April 7, 2008, p.1.
55
Nouriel Roubini and Elisa Parisi-Carbone, Total $3.6 Trillion Projected Loan and Securities Losses in
U.S. $1.8 Trillion of Which Borneby U.S. Banks/Brokers, RGE Monitor, January 2009, p.8.
481 Peter J. Wallison
total assets of $4 trillion.
56
If we assume that the banks had a leverage ratio of about
15-to-1 in 2008 and the investment banks about 30-to-1, that would mean that the
equity capital position of the banking industry as a whole would be about $650
billion and the same number for the investment banks would be about $130 billion,
for a total of $780 billion. Under these circumstances, the collapse of the PMBS
market alone reduced the capital positions of U.S. banks and investment banks by
approximately 41 percent on a mark-to-market basis. Tis does not mean that any
actual losses were sufered, only that the assets concerned might have to be written
down or could not be sold for the price at which they were previously carried on the
frms balance sheet.
In addition, Roubini and Parisi-Capone estimated that U.S. commercial
and investment banks sufered a further mark-to-market loss of $225 billion on
unsecuritized subprime and Alt-A mortgages.
57
Tey also estimated that mark-to-
market losses for fnancial institutions outside the U.S. would be about 40 percent
of U.S. losses, so there was likely to be a major efect on banks and other fnancial
institutions around the worlddepending, of course, on their capital position at the
time the PMBS market stopped functioning. I am not aware of any data showing the
mark-to-market efect of the collapse of the PMBS market on other U.S. fnancial
institutions, but it can be assumed that they also sufered similar losses in proportion
to their holdings of PMBS.
Losses of this magnitude would certainly be enoughwhen combined
with other losses on securities and loans not related to mortgagesto call into
question the stability of a large number of banks, investment banks and other
fnancial institutions in the U.S. and around the world. However, there was one
other factor that exacerbated the adverse efect of the loss of a market for PMBS.
Although accounting rules did not require all PMBS to be written down, investors
and counterparties did not know which fnancial institutions were holding the
weakest assets and how much of their assets would have to be written down over
time. Whatever that amount, it would reduce their capital positions at a time when
investors and counterparties were anxious about their stability. Tis was the balance
sheet efect that was the third element of Chairman Bairs summary.
To summarize, then, the following are the steps through which the
governments housing policies transmitted lossesthrough PMBSto the largest
fnancial institutions: (i) the 19 million NTMs acquired or guaranteed by the
Agencies were major contributors to the growth of the bubble and its extension
in time; (ii) the growth of the bubble suppressed the losses that would ordinarily
have brought the development of NTM-backed PMBS to a halt; (ii) competition
for NTMs drove subprime lenders further out the risk curve to fnd high-yielding
mortgages to securitize, especially when these loans did not appear to be producing
losses commensurate with their risk; (iv) when the bubble fnally burst, the
unprecedented number of delinquencies and defaults among all NTMsthe great
majority of which were held or guaranteed by the Agenciescaused investors to
56
Timothy F. Geithner, Reducing Systemic Risk in a Dynamic Financial System, Remarks at the
Economic Club of New York, June 9, 2008, available at http://www.ny.frb.org/newsevents/speeches/2008/
tfg080609.html.
57
Nouriel Roubini and Elisa Parisi-Carbone, Total $3.6 Trillion Projected Loan and Securities
Losses, p.7.
482 Dissenting Statement
fee the PMBS market, reducing the liquidity of the fnancial institutions that held
the PMBS; and (v) mark-to-market accounting required these institutions to write
down the value of the PMBS they held, as well as their other mortgage-related assets,
reducing their capital positions and raising further questions about their stability
and solvency.
Government Actions Create a Panic
More than any other phenomenon, the fnancial crisis of 2008 resembles
an old-fashioned investor and creditor panic. In the classic study, Manias, Panics
and Crashes: A History of Financial Crises, Charles Kindleberger and Robert Aliber
make a distinction between a remote cause and a proximate cause of a panic: Causa
remota of any crisis is the expansion of credit and speculation, while causa proxima
is some incident that saps the confdence of the system and induces investors to sell
commodities, stocks, real estate, bills of exchange, or promissory notes and increase
their money holdings.
58
In the great fnancial panic of 2008, it is reasonably clear
that the remote cause was the build-up of NTMs in the fnancial system, primarily
as I have shown in this analysisas a result of government housing policy. Tis
unprecedented increase in weak and risky assets set the fnancial system up for
a crisis of some kind. Te event that turned a potential crisis into a full-fedged
panicthe proximate cause of the panicwas also the governments action: the
rescue of Bear Stearns in March 2008 and the subsequent failure to rescue Lehman
Brothers six months later. In terms of its ultimate cost to the public, this was one of
the great policy errors of all time, and the reasons for the misjudgments that led to
it have not yet been fully explored.
Te lesson taught by the rescue of Bear was that all large fnancial
institutionsand especially those larger than Bearwould be rescued. Te moral
hazard introduced by this one act irreparably changed the position of Lehman
Brothers and every other large frm in the worlds fnancial system. From that time
forward, (i) the critical need for more capital became less critical; the likelihood of
a government bailout would reassure creditors, so there was no need to dilute the
shareholders any further by raising additional capital; (ii) frms such as Lehman,
that might have been saved through an acquisition by a larger frm or an infusion of
fresh capital by a strategic investor, drove harder bargains with potential acquirers;
(iii) the potential acquirers themselves waited for the U.S. government to pick up
some of the cost, as it had with Bearan ofer that never came in Lehmans case;
and (iv) the Reserve Fund, a money market mutual fund, apparently assuming
that Lehman would be rescued, decided not to sell the heavily discounted Lehman
commercial paper it held; instead, with devastating results for the money market
fund industry, it waited to be bailed out on the assumption that Lehman would be
saved.
But Lehman was not saved, and its creditors were not bailed out. At a time
when large mark-to-market losses among U.S. fnancial frms raised questions about
which large fnancial institutions were insolvent or unstable, the demise of Lehman
was a major shock. It overturned all the rational expectations about government
58
Charles P. Kindleberger and Robert Aliber, Manias, Panics, and Crashes: A History of Financial Crises,
5th edition, John Wiley & Sons, Inc., 2005, p.104.
483 Peter J. Wallison
policies that market participants had developed afer the Bear rescue. With no
certainty about who was strong or who was weak, there was a headlong rush to
U.S. government securities. Banksafraid that their counterparties would want a
return of their investments or their corporate customers would draw on lines of
creditbegan to hoard cash. Banks wouldnt lend to other banks, even overnight.
As Chairman Bair suggested, that was the fnancial crisis. Everything afer that was
simply cleaning up the mess.
Tis analysis lays the principal cause of the fnancial crisis squarely at the feet
of the unprecedented number of NTMs that were brought into the U.S. fnancial
markets by government housing policy. Tese weak and high risk loans helped to
build the bubble, and when the bubble defated they defaulted in unprecedented
numbers. Tis threatened losses in the PMBS that were held by fnancial institutions
in the U.S. and around the world, impairing both their liquidity and their apparent
stability.
Te accumulation of 27 million subprime and Alt-A mortgages was not a
random event, or even the result of major forces such as global fnancial imbalances
or excessively low interest rates. Instead, these loans and the bubble to which they
contributed were the direct consequence of something far more mundane: U.S.
government housing policy, whichled by HUD over two administrations
deliberately reduced mortgage underwriting standards so that more people could
buy homes. While this process was going on, everyone was pleased. Homeownership
in the U.S. actually grew to the highest level ever recorded. But the result was a
fnancial catastrophe from which the U.S. has still not recovered.
484 Dissenting Statement
485
III. THE U.S. GOVERNMENTS ROLE
IN FOSTERING THE GROWTH OF
THE NTM MARKET
Te preceding section of this dissenting statement described the damage
that was done to the fnancial system by the unprecedented number of defaults and
delinquencies that occurred among the 27 million NTMs that were present there
in 2008. Given the damage they caused, the most important question about the
fnancial crisis is why so many low quality mortgages were created. Another way
to state this question is to ask why mortgage standards declined so substantially
before and during the 1997-2007 bubble, allowing so many NTMs to be created.
Tis massive and unprecedented change in underwriting standards had to have a
causesome factor that was present during the 1990s and thereafer that was not
present in any earlier period. Part III addresses this fundamental question.
Te conventional explanation for the fnancial crisis is the one given by Fed
Chairman Bernanke in the same speech at Morehouse College quoted at the outset
of Part II:
Saving infows from abroad can be benefcial if the country that receives those infows
invests them well. Unfortunately, that was not always the case in the United States
and some other countries. Financial institutions reacted to the surplus of available
funds by competing aggressively for borrowers, and, in the years leading up to the crisis,
credit to both households and businesses became relatively cheap and easy to obtain. One
important consequence was a housing boom in the United States, a boom that was
fueled in large part by a rapid expansion of mortgage lending. Unfortunately, much of
this lending was poorly done, involving, for example, little or no down payment by the
borrower or insuf cient consideration by the lender of the borrowers ability to make the
monthly payments. Lenders may have become careless because they, like many people
at the time, expected that house prices would continue to rise--thereby allowing
borrowers to build up equity in their homes--and that credit would remain easily
available, so that borrowers would be able to refnance if necessary. Regulators did not
do enough to prevent poor lending, in part because many of the worst loans were made
by frms subject to little or no federal regulation. [Emphasis supplied]
59
In other words, the liquidity in the world fnancial market caused U.S. banks
to compete for borrowers by lowering their underwriting standards for mortgages
and other loans. Lenders became careless. Regulators failed. Unregulated originators
made bad loans. One has to ask: is it plausible that banks would compete for
borrowers by lowering their mortgage standards? Mortgage originatorswhether
S&Ls, commercial banks, mortgage banks or unregulated brokershave been
competing for 100 years. Tat competition involved ofering the lowest rates and
the most benefts to potential borrowers. It did not, however, generally result in
59
Speech at Morehead College April 14, 2009.
486 Dissenting Statement
or involve the weakening of underwriting standards. Tose standardswhat made
up the traditional U.S. mortgagewere generally 15 or 30 year amortizing loans to
homebuyers who could provide a downpayment of at least 10-to-20 percent and had
good credit records, jobs and steady incomes. Because of its inherent quality, this
loan was known as a prime mortgage.
Tere were subprime loans and subprime lenders, but in the early 1990s
subprime lenders were generally niche players that made loans to people who
could not get traditional mortgage loans; the number of loans they generated was
relatively small and bore higher than normal interest rates to compensate for the
risks of default. In addition, mortgage bankers and others relied on FHA insurance
for loans with low downpayments, impaired credit and high debt ratios. Until the
1990s, these NTMs were never more than a fraction of the total number of mortgages
outstanding. Te reason that low underwriting standards were not generally used is
simple. Low standards would result in large losses when these mortgages defaulted,
and very few lenders wanted to hold such mortgages. In addition, Fannie and
Freddie were the buyers for most middle class mortgages in the United States, and
they were conservative in their approach. Unless an originator made a traditional
mortgage it was unlikely that Fannie or Freddie or another secondary market buyer
could be found for it.
Tis is common sense. If you produce an inferior productwhether its a
household cleaner, an automobile, or a loanpeople soon recognize the lack of
quality and you are out of business. Tis was not the experience with mortgages,
which became weaker and riskier as the 1990s and 2000s progressed. Why did this
happen?
In its report, the Commission majority seemed to assume that originators of
mortgages controlled the quality of mortgages. Much is made in the majoritys report
of the so-called originate to distribute idea, where an originator is not supposed to
care about the quality of the mortgages because they would eventually be sold of.
Te originator, it is said, has no skin in the game. Te motivation for making poor
quality mortgages in this telling is to earn fees, not only on the origination but in
each of the subsequent steps in the securitization process.
Tis theory turns the mortgage market upside down. Mortgage originators
could make all the low quality mortgages they wanted, but they wouldnt earn a
dime unless there was a buyer. Te real question, then, is why there were buyers
for inferior mortgages and this, as it turns out, is the same as asking why mortgage
underwriting standards, beginning in the early 1990s, deteriorated so badly. As
Professor Raghuram Rajan notes in Fault Lines, [A]s brokers came to know that
someone out there was willing to buy subprime mortgage-backed securities without
asking too many questions, they rushed to originate loans without checking the
borrowers creditworthiness, and credit quality deteriorated. But for a while, the
problems were hidden by growing house prices and low defaultseasy credit
masked the problems caused by easy credituntil house prices stopped rising and
the food of defaults burst forth.
60
Who were these buyers? Table 1, reporting the number of NTMs outstanding
on June 30, 2008, identifed government agencies and private organizations required
by the government to acquire, hold or securitize NTMs as responsible for two-thirds
60
Raghuram G. Rajan, Fault Lines, p.44.
487 Peter J. Wallison
of these mortgages, about 19 million. Te table also identifes the private sector as
the securitizer of the remaining one-third, about 7.8 million loans. In other words,
if we are looking for the buyer of the NTMs that were being created by originators
at the local level, the governments policies would seem to be the most likely culprit.
Te private sector certainly played a role, but it was a subordinate one. Moreover,
what the private sector did was respond to demandthats what the private sector
doesbut the governments role involved deliberate policy, an entirely diferent
matter. Of its own volition, it created a demand that would not otherwise have been
there.
Te deterioration in mortgage standards did not occurcontrary to the
Commission majoritys apparent viewbecause banks and other originators
suddenly started to make defcient loans; nor was it because of insuf cient regulation
at the originator level. Te record shows unambiguously that government regulations
made FHA, Fannie and Freddie, mortgage banks and insured banks of all kinds into
competing buyers. All of them needed NTMs in order to meet various government
requirements. Fannie and Freddie were subject to increasingly stringent afordable
housing requirements; FHA was tasked with insuring loans to low-income borrowers
that would not be made unless insured; banks and S&Ls were required by CRA to
show that they were also making loans to the same group of borrowers; mortgage
bankers who signed up for the HUD Best Practices Initiative and the Clinton
administrations National Homeownership Strategy were required to make the same
kind of loans. Proft had nothing to do with the motivations of these frms; they
were responding to government direction. Under these circumstances, it should
be no surprise that underwriting standards declined, as all of these organizations
scrambled to acquire the same low quality mortgages.
1. HUDs Central Role
In testimony before the House Financial Services Committee on April 14,
2010, Shaun Donovan, Secretary of Housing and Urban Development, said in
reference to the GSEs: Seeing their market share decline [between 2004 and 2006]
as a result of [a] change of demand, the GSEs made the decision to widen their focus
from safer prime loans and begin chasing the non-prime market, loosening long-
standing underwriting and risk management standards along the way. Tis would
be a fateful decision that not only proved disastrous for the companies themselves
but ultimately also for the American taxpayer.
Earlier, in a Report to Congress on the Root Causes of the Foreclosure
Crisis, in January 2010, HUD declared Te serious fnancial troubles of the GSEs
that led to their being placed into conservatorship by the Federal government
provides strong testament to the fact that the GSEs were, indeed, overexposed to
unduly risky mortgage investments. However, the evidence suggests that the GSEs
decisions to purchase or guarantee non-prime loans was motivated much more by
eforts to chase market share and profts than by the need to satisfy federal regulators.
61
[emphasis supplied]
Finger-pointing in Washington is endemic when problems occur, and
61
Report to Congress on the Root Causes of the Foreclosure Crisis , January 2010, p.xii, http://www.
huduser.org/portal/publications/hsgfn/foreclosure_09.html.
488 Dissenting Statement
agencies and individuals are constantly trying to fnd scapegoats for their own
bad decisions, but HUDs efort to blame Fannie and Freddie for the decline in
underwriting standards sets a new standard for running from responsibility.
Contrast the 2010 statement quoted above with this statement by HUD in 2000,
when it was signifcantly increasing Fannie and Freddies afordable housing goals:
Lower-income and minority families have made major gains in access to the
mortgage market in the 1990s. A variety of reasons have accounted for these gains,
including improved housing afordability, enhanced enforcement of the Community
Reinvestment Act, more fexible mortgage underwriting, and stepped-up enforcement
of the Fair Housing Act. But most industry observers believe that one factor behind these
gains has been the improved performance of Fannie Mae and Freddie Mac under HUDs
afordable lending goals. HUDs recent increases in the goals for 2001-03 will encourage
the GSEs to further step up their support for afordable lending.
62
[emphasis supplied]
Or this statement in 2004, when HUD was again increasing the afordable
housing goals for Fannie and Freddie:
Millions of Americans with less than perfect credit or who cannot meet some of
the tougher underwriting requirements of the prime market for reasons such as
inadequate income documentation, limited downpayment or cash reserves, or the
desire to take more cash out in a refnancing than conventional loans allow, rely on
subprime lenders for access to mortgage fnancing. If the GSEs reach deeper into the
subprime market, more borrowers will beneft from the advantages that greater stability
and standardization create.
63
[emphasis supplied]
Or, fnally, this statement in a 2005 report commissioned by HUD:
More liberal mortgage fnancing has contributed to the increase in demand for
housing. During the 1990s, lenders have been encouraged by HUD and banking
regulators to increase lending to low-income and minority households. Te
Community Reinvestment Act (CRA), Home Mortgage Disclosure Act (HMDA),
government-sponsored enterprises (GSE) housing goals and fair lending laws
have strongly encouraged mortgage brokers and lenders to market to low-income
and minority borrowers. Sometimes these borrowers are higher risk, with blemished
credit histories and high debt or simply little savings for a down payment. Lenders have
responded with low down payment loan products and automated underwriting, which
has allowed them to more carefully determine the risk of the loan.
64
[emphasis supplied]
Despite the recent efort by HUD to deny its own role in fostering the
growth of subprime and other high risk mortgage lending, there is strongindeed
irrefutableevidence that, beginning in the early 1990s, HUD led an ultimately
successful efort to lower underwriting standards in every area of the mortgage
market where HUD had or could obtain infuence. With support in congressional
legislation, the policy was launched in the Clinton administration and extended
almost to the end of the Bush administration. It involved FHA, which was under
the direct control of HUD; Fannie Mae and Freddie Mac, which were subject to
HUDs afordable housing regulations; and the mortgage banking industry, which
while not subject to HUDs legal jurisdictionapparently agreed to pursue HUDs
62
Issue Brief: HUDs Afordable Housing Goals for Fannie Mae and Freddie Mac, p.5.
63
Final Rule, http://fdsys.gpo.gov/fdsys/pkg/FR-2004-11-02/pdf/04-24101.pdf.
64
HUD PDR, May 2005, HUD Contract C-OPC-21895, Task Order CHI-T0007, Recent House Price
Trends and Homeownership Afordability, p.85.
489 Peter J. Wallison
policies out of fear that they would be brought under the Community Reinvestment
Act through legislation.
65
In addition, although not subject to HUDs jurisdiction,
the new tighter CRA regulations that became efective in 1995 led to a process in
which community groups could obtain commitments for substantial amounts of
CRA-qualifying mortgages and other loans to subprime borrowers when banks
were applying for merger approvals.
66
By 2004, HUD believed it had achieved the revolution it was looking for:
Over the past ten years, there has been a revolution in afordable lending that has
extended homeownership opportunities to historically underserved households.
Fannie Mae and Freddie Mac have been a substantial part of this revolution in
afordable lending. During the mid-to-late 1990s, they added fexibility to their
underwriting guidelines, introduced new low-downpayment products, and worked to
expand the use of automated underwriting in evaluating the creditworthiness of loan
applicants. HMDA data suggest that the industry and GSE initiatives are increasing
the fow of credit to underserved borrowers. Between 1993 and 2003, conventional
loans to low income and minority families increased at much faster rates than loans to
upper-income and nonminority families.
67
[emphasis supplied]
Tis turned out to be an immense error of policy. By 2010, even the strongest
supporters of afordable housing as enforced by HUD had recognized their error.
In an interview on Larry Kudlows CNBC television program in late August,
Representative Barney Frank (D-Mass.)the chair of the House Financial Services
Committee and previously the strongest congressional advocate for afordable
housingconceded that he had erred: I hope by next year well have abolished
Fannie and Freddie . . . it was a great mistake to push lower-income people into
housing they couldnt aford and couldnt really handle once they had it. He then
added, I had been too sanguine about Fannie and Freddie.
68
2. The Decline of Mortgage
Underwriting Standards
Before the enactment of the GSE Act in 1992, and HUDs adoption of a
policy thereafer to reduce underwriting standards, the GSEs followed conservative
underwriting practices. For example, in a random review by Fannie Mae of 25,804
loans from October 1988 to January 1992, over 78 percent had LTV ratios of 80
percent or less, while only 5.75 percent had LTV ratios of 91 to 95 percent.
69
High
risk lending was confned primarily to FHA (which was controlled by HUD) and
specialized subprime lenders who ofen sold the mortgages they originated to FHA.
What caused these conservative standards to decline? Te Commission majority,
65
Steve Cocheo, Fair-lending pressure builds, ABA Banking Journal, vol. 86, 1994, http://www.questia.
com/googleScholar.qst?docId=5001707340.
66
See NCRC, CRA Commitments, 2007.
67
Federal Register,vol. 69, No. 211, November 2, 2004, Rules and Regulations, p.63585, http://fdsys.gpo.
gov/fdsys/pkg/FR-2004-11-02/pdf/04-24101.pdf .
68
Larry Kudlow, Barney Frank Comes Home to the Facts, GOPUSA, August 23, 2010, available at
www.gopusa.com/commentary/2010/08/kudlow-barney-frank-comes-home-to-the-facts.php#ixz
z0zdCrWpCY (accessed September 20, 2010).
69
Document in authors fles.
490 Dissenting Statement
echoing Chairman Bernanke, seems to believe that the impetus was competition
among the banks, irresponsibility among originators, and the desire for proft. Te
majoritys report ofers no other explanation.
However, there is no dif culty fnding the source of the reductions in mortgage
underwriting standards for Fannie and Freddie, or for the originators for whom
they were the buyers. HUD made clear in numerous statements that its policyin
order to make credit available to low-income borrowerswas specifcally intended
to reduce underwriting standards. Te GSE Act enabled HUD to put Fannie and
Freddie into competition with FHA, and vice versa, creating what became a contest
to lower mortgage standards. As the Fannie Mae Foundation noted in a 2000 report,
FHA loans constituted the largest share of Countrywides [subprime lending]
activity, until Fannie Mae and Freddie Mac began accepting loans with higher LTVs
[loan-to-value ratios] and greater underwriting fexibilities.
70
Under the GSE Act, the HUD Secretary was authorized to establish afordable
housing goals for Fannie and Freddie. Congress required that these goals include a
low and moderate income goal and a special afordable goal (discussed below), both
of which could be adjusted in the future. Among the factors the secretary was to
consider in establishing the goals were national housing needs and the ability of
the enterprises [Fannie and Freddie] to lead the industry in making mortgage credit
available for low-and moderate-income families. Te Act also established an interim
afordable housing goal of 30 percent for the two-year period beginning January 1,
1993. Under this requirement, 30 percent of the GSEs mortgage purchases had to
be afordable housing loans, defned as loans to borrowers at or below the AMI.
71
Further, the Act established a special afordable goal to meet the
unaddressed needs of, and afordable to, low-income families in low-income
areas and very low-income families. Tis category was defned as follows: (i) 45
percent shall be mortgages of low-income families who live in census tracts in which
the median income does not exceed 80 percent of the area median income; and
(ii) 55 percent shall be mortgages of very low income families, which were later
defned as 60 percent of AMI.
72
Although the GSE Act initially required that the
GSEs spend on special afordable mortgages not less than 1 percent of the dollar
amount of the mortgage purchases by the [GSEs] for the previous year, HUD raised
this requirement substantially in later years. Ultimately, it became the most dif cult
afordable housing AH burden for Fannie and Freddie to meet.
Finally, the GSEs were directed to: (A) assist primary lenders to make
housing credit available in areas with low-income and minority families; and (B)
assist insured depository institutions to meet their obligations under the Community
Reinvestment Act of 1977.
73
Tere will be more on the CRA and its efect on the
quality of mortgages later in this section.
Congress also made clear in the act that its intention was to call into question
the high quality underwriting guidelines of the time. It did so by directing Fannie
and Freddie to examine
70
Fannie Mae Foundation, Making New Markets: Case Study of Countrywide Home Loans, 2000,
http://content.knowledgeplex.org/kp2/programs/pdf/rep_newmortmkts_countrywide.pdf.
71
GSE Act, Section 1332.
72
Id., Section 1333.
73
Id., Section 1335.
491 Peter J. Wallison
(1) Te extent to which the underwriting guidelines prevent or inhibit the purchase
or securitization of mortgages for houses in mixed-use, urban center, and
predominantly minority neighborhoods and for housing for low-and moderate-
income families;
(2) Te standards employed by private mortgage insurers and the extent to which
such standards inhibit the purchase and securitization by the enterprises of
mortgages described in paragraph (1); and
(3) Te implications of implementing underwriting standards that
(A) establish a downpayment requirement for mortgagors of 5 percent or less;
(B) allow the use of cash on hand as a source of downpayments; and
(C) approve borrowers who have a credit history of delinquencies if the borrower
can demonstrate a satisfactory credit history for at least the 12-month period
ending on the date of the application for the mortgage.
74
I could not fnd a record of reports by Fannie and Freddie required under
this section of the act, but it would have been fairly clear to both companies, and to
HUD, what Congress wanted in asking for these studies. Prevailing underwriting
standards were inhibiting mortgage fnancing for low and moderate income (LMI)
families, and would have to be substantially relaxed in order to meet the goals
of the Act. Whatever the motivation, HUD set out to assure that downpayment
requirements were substantially reduced (eventually they reached zero) and past
credit history became a much less important issue when mortgages were made
(permitting subprime mortgages to become far more common).
Until 1995, HUD enforced the temporary AH goals originally put in place
by the GSE Act. With the exception of the special afordable requirements, which
were small at this point, these goals were not burdensome. In the ordinary course of
their business, the GSEs seem to have bought enough mortgages made to borrowers
below the AMI to qualify for the 30 percent AH goal. In 1995, however, HUD raised
the LMI goal to 40 percent, applicable to 1996, and to 42 percent for subsequent
years. In terms of its efect on Fannie and Freddie, HUDs most important move at
this time was to set a Special Afordable goal (low and very low income borrowers)
of 12 percent, which increased to 14 percent in 1997. Eforts to fnd loans to low or
very low income borrowers (80 percent and 60 percent of AMI, respectively) that did
not involve high risks would prove dif cult. As early as November 1995, even before
the efect of these new and higher goals, Fannies staf had already recognized that
Fannies Community Homebuyer Program (CHBP), which featured a 97 percent
loan-to-value (LTV) ratioi.e., 3 percent downpayment
75
was showing signifcant
rates of serious delinquency that exceeded Fannies expected rates by 26percent in
origination year 1992, 93 percent in 1993 and 57 percent in 1994.
76
In 1995, continuing its eforts to erode underwriting standards in order to
increase homeownership, HUD issued a policy statement entitled Te National
Homeownership Strategy: Partners in the American Dream. Te Strategy was
prepared by HUD, under the direction of Secretary Henry G. Cisneros, in response
74
Id., Section 1354(a).
75
Fannie Mae, Opening Doors with Fannie Maes Community Lending Products, 1995, p.3.
76
Fannie Mae, Memo from Credit Policy Staf to Credit Policy Committee, CHBP Performance,
November 14, 1995, p.1.
492 Dissenting Statement
to a request from President Clinton.
77
Te frst paragraph of Chapter 1 stated: Te
purpose of the National Homeownership Strategy is to achieve an all-time high level
of homeownership in America within the next 6 years through an unprecedented
collaboration of public and private housing industry organizations.
Te Strategy paper then noted that industry representatives agreed to
the formation of working groups to help develop the National Homeownership
Strategy and made clear that one of its purposes was to increase homeownership by
reducing downpayments: Lending institutions, secondary market investors, mortgage
insurers, and other members of the partnership should work collaboratively to reduce
homebuyer downpayment requirements. Mortgage fnancing with high loan-to-value
ratios should generally be associated with enhanced homebuyer counseling and,
where available, supplemental sources of downpayment assistance.
78
According to a
HUD summary, the purpose of the Strategy was to make fnancing more available,
afordable, and fexible.
79
[emphasis supplied] It continued:
Te inability (either real or perceived) of many younger families to qualify for a
mortgage is widely recognized as a very serious barrier to homeownership. Te
National Homeownership Strategy commits both government and the mortgage
industry to a number of initiatives designed to:
Cut transaction costs through streamlined regulations and technological and
procedural ef ciencies.
Reduce downpayment requirements and interest costs by making terms more
fexible, providing subsidies to low- and moderate-income families, and creating
incentives to save for homeownership.
Increase the availability of alternative fnancing products in housing markets
throughout the country.
80
[emphasis supplied]
Reductions in downpayments, the area on which HUD particularly
concentrated in pursuing its AH goals and the National Homeownership Strategy,
are especially important in weakening underwriting standards. Table 4, below,
based on a large sample of loans from the 1990s, shows the risk relationships
between downpayments and mortgage risks. It is particularly instructive to note
that when low downpayments (i.e., high LTVs) are combined with low FICO scores
(subprime loans) the expected delinquencies and defaults are multiplied several
fold. For example, when a loan with a FICO score below 620 is combined with a
downpayment of fve percent, the risk of default is 4.2 times greater than it would be
if the downpayment were 25 percent.
77
HUD, Te National Homeownership Strategy: Partners in the American Dream, available at http://
web.archive.org/web/20010106203500/www.huduser.org/publications/af sg/homeown/chap1.html.
78
Id., Chapter 4, Action 35.
79
Te term fexible has a special meaning when HUD uses it. See note 8 supra.
80
HUD, Urban Policy Brief No.2, August 1995, available at http://www.huduser.org/publications/txt/
hdbrf2.txt.
493 Peter J. Wallison
Table 4.
81
High LTVs enhance the risk of low FICO scores
Column 1 Column 2 Column 3 Column 4 Column 5 Column 6
Row 1 FICO Score 70% LTV 71-80% LTV 81-90% LTV 91-95% LTV Relation of
Column 5 to
Column 3
Row 2 < 620 1.0 4.8 11 20 4.2 times
Row 3 620-679 0.5 2.3 5.3 9.4 4.1 times
Row 4 680-720 0.2 1.0 2.3 4.1 4.1 times
Row 5 > 720 0.1 0.4 0.9 1.6 4 times
Despite these obvious dangers, HUD saw the erosion of downpayment
requirements imposed by the private sector as one of the keys to the success of its
strategy to increase home ownership through the partnership it had established
with the mortgage fnancing community: Te amount of borrower equity is an
important factor in assessing mortgage loan quality. However, many low-income
families do not have access to suf cient funds for a downpayment. While members
of the partnership have already made signifcant strides in reducing this barrier to
home purchase, more must be done. In 1989 only 7 percent of home mortgages were
made with less than 10 percent downpayment. By August 1994, low downpayment
mortgage loans had increased to 29 percent.
82
[emphasis supplied]
HUDs policy was highly successful in achieving the goals it sought. In 1989,
only one in 230 homebuyers bought a home with a downpayment of 3 percent or
less, but by 2003 one in seven buyers was providing a downpayment at that level,
and by 2007 the number was less than one in three. Te gradual increase in LTVs
and CLTVs (frst and second loans combined to produce a lower downpayment)
under HUDs policies is shown in Figure 4. Note the date (1992) when HUD began
to have some infuence over the downpayments that the GSEs would accept.
Tat HUDs AH goals were the reason Fannie increased its high LTV (low
downpayment) lending is clearly described in a Fannie presentation to HUD
assistant secretary Albert Trevino on January 10, 2003: Analyses of the market
demonstrate the greatest barrier to home ownership for most renters are related to
wealththe lack of money for a downpaymentour low-downpayment lending
negligible until 1994has grown considerably. It is a key part of our strategy to serve
low-income and minority borrowers. Te fgure that accompanied that statement
showed that Fannies home purchase loans over 95 percent LTV had increased from
one percent in 1994 to 7.9 percent in 2001.
83
81
Deconstructing the Subprime Debacle Using New Indices of Underwriting Quality and Economic
Conditions: A First Look, by Anderson, Capozza, and Van Order, found at http://www.ufanet.com/
DeconstructingSubprimeJuly2008.pdf.
82
HUDs National Homeownership Strategy Partners in the American Dream, http://web.archive.
org/web/20010106203500/www.huduser.org/publications/af sg/homeown/chap1.html.
83
Fannie Maes Role in Afordable Housing Finance: Connecting World Capital Markets and Americas
Homebuyers, Presentation to HUD Assistant Secretary Albert Trevino, January 10, 2003.
494 Dissenting Statement
Figure 4. Estimated Percentage of Home Purchase Volume with an LTV or CLTV >=97%
(Includes FHA and Conventional Loans*)
and Combined Foreclosure Start Rate for Conventional and Government Loans
*Fannies percentage of home purchase loans with an LTV or CLTV >=97% used as the proxy for
conventional loans.
Sources: FHA 2009 Actuarial Study, and HUDs Of ce of Policy Development and Research - Profles
of GSE Mortgage Purchases in 1999 and 2000, in 2001-2004, and in 2005-2007, and Fannies 2007 10-K.
Compiled by Edward Pinto.
Te close relationship between low downpayments and delinquencies and
defaults on mortgages is shown in Figure 5, which compares the increase in FHA 97
percent (or greater) CLTV or LTV mortgages to the increase in the foreclosure start
rate on all loans published by the Mortgage Bankers Association.
Figure 5. Relationship between low downpayments and delinquencies or defaults on mortgages
Sources: MBA National Delinquency Survey, FHA 2009 Actuarial Study, and HUDs Of ce of Policy
Development and Research - Profles of GSE Mortgage Purchases in 1999 and 2000, in 2001-2004, and
in 2005-2007, SMRs Piggyback Mortgage Lending, and Fannies 2007 10-K. Fannie is used as the
proxy on the conventional market. Compiled by Edward Pinto.

495 Peter J. Wallison

In 1995, HUD also ruled that Fannie and Freddie could get AH credit for
buying PMBS that were backed by loans to low-income borrowers.
84
Tis provided
an opportunity for subprime lenders to create pools of subprime mortgages that were
likely to be AH goals-rich. Tese were then sold through Wall Street underwriters
to Fannie and Freddie, which became the largest buyers of these high risk PMBS
between 2002 and 2005.
85
Tese PMBS pools were not bought for proft. As Adolfo
Marzol, Fannies Chief Credit Of cer, noted to Fannie CEO Dan Mudd in a 2005
memorandum, large 2004 private label [PMBS] volumes were necessary to achieve
challenging minority lending goals and housing goals.
86
Tere is a strong possibility
that by creating a market for PMBS backed by NTMs Fannie and Freddie enabled
Wall Streetwhich had previously focused on securitizing prime jumbo loansto
get its start in developing an underwriting business in PMBS based on NTMs.
HUD pursued these policies throughout the balance of the Clinton
administration and into the administration of George W. Bush. Ultimately, they
would lead to the mortgage meltdown in 2007, as vast numbers of mortgages with
low or no downpayments and other non-traditional features sufused the fnancial
system. But in June, 1995, the dangers in HUDs policies were not recognized. As
President Clinton said in a 1995 speech, Our homeownership strategy will not cost
the taxpayers one extra red cent. It will not require legislation. It will not add more
federal programs or grow the Federal bureaucracy.
87
Te lesson here is that the
government can accomplish a lot of its goals without growing, as long as it has the
power to enlist the private sector. Tat does not mean, however, as we have all now
learned, that the taxpayers will not ultimately be faced with the costs.
Te next signifcant move in the AH goals was made under HUD Secretary
Andrew Cuomo, and it was a major step. On July 29, 1999, HUD issued a press
release with the heading Cuomo Announces Action to Provide $2.4 trillion in
Mortgages for Afordable Housing for 28.1 Million Families.
88
Te release began:
Housing and Urban Development Secretary Andrew Cuomo today announced a
policy to require the nations two largest housing fnance companies to buy $2.4
trillion in mortgages over the next 10 years to provide afordable housing for about
28.1 million low-and moderate-income families. Tis was followed by a quote from
President Clinton to emphasize the importance of the initiative: During the last six
and a half years, my Administration has put tremendous emphasis on promoting
homeownership and making housing more afordable for all AmericansToday,
the homeownership rate is at an all-time high, with more than 66 percent of all
American families owning their homes. Today, we take another signifcant step.
Te release then pointed out that the AH goals would be substantially
raised and that [u]nder the higher goals, Fannie Mae and Freddie Mac will buy an
additional $488.3 billion in mortgages that will be used to provide afordable housing
for 7 million more low-and moderate-income families over the next 10 years. Tose
new mortgages and families are over and above the $1.9 trillion in mortgages for
84
http://www.washingtonpost.com/wp-dyn/content/article/2008/06/09/AR2008060902626.html.
85
See Footnote 32.
86
Fannie Mae, internal memo, Adolfo Marzol to Dan Mudd, RE: Private Label Securities, March 2,
2005.
87
William J. Clinton, Remarks on the National Homeownership Strategy, June 5, 1995.
88
HUD Press Release, HUD No. 99-131, July 29, 1999.
496 Dissenting Statement
21.1 million families that would have been generated if the current goals had been
retained. Te release also noted that Fannie Mae Chairman Franklin D. Raines
joined Cuomo at the news conference in which Cuomo announced the HUD action.
Raines committed Fannie Mae to reaching HUDs increased Afordable Housing
goals.
Te policy behind this substantial increase in the AH goals was expressed in
HUDs discussion of the rule-making: To fulfll the intent of [the GSE Act], the GSEs
should lead the industry in ensuring that access to mortgage credit is made available
for very low-, low- and moderate-income families and residents of underserved
areas. HUD recognizes that, to lead the mortgage industry over time, the GSEs will
have to stretch to reach certain goals and close the gap between the secondary mortgage
market and the primary mortgage market. Tis approach is consistent with Congress
recognition that the enterprises will need to stretch their eforts to achieve the goals.
89

[emphasis supplied]
Te new AH goals announced in 1999 were not fnally issued until October
2000. Teir specifcs were stunning and drove Fannie and Freddie into a new and
far more challenging era. Te basic goal, an LMI requirement of 42 percent, was
raised to 50 percent, and the special afordable goal was raised from 14 percent to 20
percent. As a result, 75 percent of the increase in goals was concentrated in the low-
and very-low income categorywhere the risks were the greatest. A HUD memo
summarized the new rules:
90
For each year from 2001 through 2003, the goals are:
Low- and moderate-income goal. At least 50 percent of the dwelling units fnanced by
each GSEs mortgage purchases should be for families with incomes no greater than
area median income (AMI), defned as median income for the metropolitan area or
nonmetropolitan county. Te corresponding goal was 42 percent for 1997-2000.
Special afordable goal. At least 20 percent of the dwelling units fnanced by each
GSEs mortgage purchases should be for very low-income families (those with
incomes no greater than 60 percent of AMI) or for low-income families (those with
incomes no greater than 80 percent of LMI) in low-income areas. Te corresponding
goal was 14 percent for 1997-2000.
Underserved areas goal. At least 31 percent of the dwelling units fnanced by each
GSEs mortgage purchases should be for units located in underserved areas. Research
by HUD and others has demonstrated that low-income and high-minority census
tracts have high mortgage denial rates and low mortgage origination rates, and this
forms the basis for HUDs defnition of underserved areas. Te corresponding goal
was 24 percent for 1997-2000.
HUDs new and more stringent AH goal requirements immediately
stimulated strong interest at the GSEs for CRA loans, substantial portions of which
were likely to be goals-qualifying. Tis is evident in a speech by Fannies Vice Chair,
Jamie Gorelick, to an American Bankers Association conference on October 30,
89
http://frwebgate.access.gpo.gov/cgi-bin/getdoc.cgi?dbname=2000_register&docid=page+65043-
65092.
90
HUD, Of ce of Policy Development and Research, Issue Brief No. 5, January 2001, p.3.
497 Peter J. Wallison
2000, just afer HUD announced the latest increase in the AH goals for the GSEs:
Your CRA business is very important to us. Since 1997, we have done nearly $7 billion
in specially targeted CRA businessall with depositories like yours. But that is just
the beginning. Before the decade is over, Fannie Mae is committed to fnance over
$20 billion in specially targeted CRA business and over $500 billion in CRA business
altogether
We want your CRA loans because they help us meet our housing goals We will buy
them from your portfolios, or package them into securities We will also purchase
CRA mortgages you make right at the point of origination... You can originate CRA
loans for our purchase with one of our CRA-friendly products, like our 3 percent
down Fannie 97. Or we have special community lending products with fexible
underwriting and special fnancing Our approach is CRA your way.
91
Te 50 percent level in the new HUD regulations was a turning point. Fannie
and Freddie had to stretch a bit to reach the previous goal of 42 percent, but 50
percent was a signifcant challenge. As Dan Mudd told the Commission,
Fannie Maes mission regulator, HUD, imposed ever-higher housing goals that
were very dif cult to meet during my tenure as CEO [2005-2008]. Te HUD goals
greatly impacted Fannie Maes business, as a great deal of time, resources, energy,
and personnel were dedicated to fnding ways to meet these goals. HUD increased
the goals aggressively over time to the point where they exceeded the 50% mark,
requiring Fannie Mae to place greater emphasis on purchasing loans to underserved
areas. Fannie Mae had to devote a great deal of resources to running its business to
satisfy HUDs goals and subgoals.
92
Mudds point can be illustrated with simple arithmetic. At the 50 percent level,
for every mortgage acquired that was not goal-qualifying, Fannie and Freddie had
to acquire a goal-qualifying loan. Although about 30 percent of prime loans were
likely to be goal-qualifying in any event (because they were made to borrowers at or
below the applicable AMI), most prime loans were not. Subprime and other NTM
loans were goals-rich, but not every such loan was goal-qualifying. Accordingly, in
order to meet a 50 percent goal, the GSEs had to purchase ever larger amounts of
goals-rich NTMs in order to acquire suf cient quantities of goals-qualifying loans.
Tus, in a presentation to HUD in 2004, Fannie argued that to meet a 57
percent LMI goal (which was under consideration by HUD at the time) it would
have to acquire 151.5 percent more subprime loans than the goal in order to capture
enough goal-qualifying loans.
93
Moreover, with the special afordable category at
20 percent in 2004, the GSEs had to acquire large numbers of NTM loans from
borrowers who were at or below 60 percent of the AMI. Tis requirement drove
Fannie and Freddie even further into risk territory in search of loans that would
meet this subgoal.
91
Jamie S. Gorelick, Remarks at American Bankers Association conference, October 30, 2000. http://
web.archive.org/web/20011120061407/www.fanniemae.com/news/speeches/speech_152.html.
92
Daniel H. Mudds Responses to the Questions Presented in the FCICs June 3, 2010, letter, Answer
to Question 6: How infuential were HUDs afordable housing guidelines in Fannie Maes purchase of
subprime and Alt-A loans? Were Alt-A loans goals-rich? Were Alt-A loans net positive for housing
goals?
93
Fannie Mae, Discussion of HUDs Proposed Housing Goals, Presentation to the Department of
Housing and Urban development, June 9, 2004.
498 Dissenting Statement
Most of what was going on here was under the radar, even for specialists in
the housing fnance feld, but not everyone missed it. In a paper published in 2001,
94

fnancial analyst Josh Rosner recognized the deterioration in mortgage standards
although he did not recognize how many loans were subject to this problem:
Over the past decade Fannie Mae and Freddie Mac have reduced required down
payments on loans that they purchase in the secondary market. Tose requirements
have declined from 10% to 5% to 3% and in the past few months Fannie Mae
announced that it would follow Freddie Macs recent move into the 0% down payment
mortgage market. Although they are buying low down payment loans, those loans
must be insured with private mortgage insurance (PMI). On homes with PMI, even
the closing costs can now be borrowed through unsecured loans, gifs or subsidies.
Tis means that not only can the buyer put zero dollars down to purchase a new house
but also that the mortgage can fnance the closing costs.
[I]t appears a large portion of the housing sectors growth in the 1990s came from
the easing of the credit underwriting process.Te virtuous cycle of increasing
homeownership due to greater leverage has the potential to become a vicious cycle
of lower home prices due to an accelerating rate of foreclosures.
95
[emphasis supplied]
Te last increase in the AH goals occurred in 2004, when HUD raised the
LMI goal to 52 percent for 2005, 53 percent for 2006, 55 percent for 2007 and 56
percent for 2008. Again, the percentage increases in the special afordable category
outstripped the general LMI goal, putting added pressure on Fannie and Freddie
to acquire additional risky NTMs. Tis category increased from 20 percent to
27 percent over the period. In the release that accompanied the increases, HUD
declared:
Millions of Americans with less than perfect credit or who cannot meet some of
the tougher underwriting requirements of the prime market for reasons such as
inadequate income documentation, limited downpayment or cash reserves, or the
desire to take more cash out in a refnancing than conventional loans allow, rely
on subprime lenders for access to mortgage fnancing. If the GSEs reach deeper into
the subprime market, more borrowers will beneft from the advantages that greater
stability and standardization create.
96
[emphasis supplied]
Fannie did indeed reach deeper into the subprime market, confrming
in a March 2003 presentation to HUD, Higher goals force us deeper into FHA
and subprime.
97
According to HUD data, as a result of the AH goals Fannie Maes
acquisitions of goal-qualifying loans (which were primarily subprime and Alt-A)
increased (i) for very low income borrowers from 5.2 percent of their acquisitions in
1993 to 12.2 percent in 2007; (ii) for special afordable borrowers from 6.4 percent
in 1993 to 15.2 percent in 2007; and (iii) for less than median income borrowers
(which includes the other two categories) from 29.2 percent in 1993 to 41.5 percent
in 2007.
98
94
Josh Rosner, Housing in the New Millennium: A Home Without Equity is Just a Rental With Debt,
June, 2001, p.7, available at: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1162456.
95
Id., p.29.
96
http://fdsys.gpo.gov/fdsys/pkg/FR-2004-11-02/pdf/04-24101.pdf, p.63601.
97
Fannie Mae, Te HUD Housing Goals, March 2003.
98
HUD, Of ce of Policy Development and Research, Profles of GSE Mortgage Purchases, 1992-2000,
2001-2004, and 2005-2007.
499 Peter J. Wallison
By 2004, Fannie and Freddie were suf ciently in need of subprime loans
to meet the AH goals that their CEOs, as the following account shows, went to a
meeting of mortgage bankers to ask for more subprime loan production:
Te top executives of Freddie Mac and Fannie Mae [Richard Syron and Franklin
Raines] made no bones about their interest in buying loans made to borrowers
formerly considered the province of nonprime and other niche lenders. Fannie Mae
Chairman and [CEO] Franklin Raines told mortgage bankers in San Francisco that
his companys lender-customers need to learn the best from the subprime market
and bring the best from the prime market into [the subprime market]. He ofered
praise for nonprime lenders that, he said, are some of the best marketers in fnancial
services. We have to push products and opportunities to people who have lesser credit
quality, he said.
99
[emphasis supplied]
Accordingly, by 2004, when HUD put new and tougher AH goals into efect,
Fannie and Freddie were using every available resource to meet the goals, including
subprime loans, Alt-A loans and the purchase of PMBS. Some observers, including
the Commissions majority, have claimed that the GSEs bought NTM loans and
PMBS for proftthat these instruments did not assist Fannie and Freddie in
meeting the AH goals and therefore must have been acquired because they were
proftable. However, the statement by Adolfo Marzol reported above, and the data in
Table 5 furnished to the Commission by Fannie Mae shows that all three categories
of NTMssubprime loans (i.e., loans to borrowers with FICO scores less than 660),
Alt-A loans and PMBS (called PLS for Private Label Securities in the table)
fulflled the AH goals or subgoals for the years and in the percentages shown below.
(Bolded numbers exceeded the applicable goal.) Table 5 also shows, signifcantly,
that the gradual increase in Fannies purchases of these NTMs closely followed the
gradual increase in the goals between 1996 and 2008.
99
Neil Morse, Looking for New Customers, Mortgage Banking, December 1, 2004. It may be signifcant
that the chairman of Freddie Mac at the time, Leland Brendsel, did not attend the 2000 press conference
or pledge support for HUDs new goals. Raines must have forgotten his 1999 pledge to Secretary Cuomo
and his speech to the mortgage bankers when he wrote in a letter to Te Wall Street Journal on August
3, 2010: Te facts about the fnancial collapse of Fannie and Freddie are pretty clear and a matter of
public record. Te company managers, their regulator and the Treasury have all said that the losses which
crippled the companies were caused by the purchase of loans with lower credit standards between 2005
and 2007. Te companies explicitly changed their credit standards in order to regain market share afer
Wall Street began to defne market credit standards in 2004.
500 Dissenting Statement
Table 5.
100
Nontraditional Mortgages and the Afordable Housing Goals
Year Low & Moderate
Income Base Goal
Special Afordable
Base Goal
Underserved
Base Goal
Actual* Goal Actual* Goal Actual* Goal
Credit Score <660 Originations
1996 38.08% 40 % 12.31% 12% 32.10% 21%
1997 38.04% 42% 12.35% 14% 33.03% 24%
1998 37.72% 42% 11.76% 14% 29.37% 24%
1999 40.36% 42% 14.04% 14% 30.87% 24%
2000 43.69% 42% 17.83% 14% 35.79% 24%
2001 45.98% 50% 17.90% 20% 34.91% 31%
2002 49.66% 50% 20.09% 20% 37.29% 31%
2003 49.18% 50% 19.38% 20% 34.12% 31%
2004 52.71% 50% 22.14% 20% 37.54% 31%
2005 54.39% 52% 24.21% 22% 44.38% 37%
2006 56.34% 53% 25.85% 23% 46.34% 38%
2007 55.47% 55% 24.76% 25% 46.45% 38%
2008 55.24% 56% 25.50% 27% 45.39% 39%
Alt-A Originations
1999 48.83% 42% 24.17% 14% 37.41% 24%
2000 40.61% 42% 18.74% 14% 41.03% 24%
2001 39.05% 50% 16.41% 20% 40.66% 31%
2002 42.77% 50% 18.13% 20% 40.08% 31%
2003 42.42% 50% 16.81% 20% 37.34% 31%
2004 44.13% 50% 18.56% 20% 40.08% 31%
2005 43.12% 52% 18.57% 22% 45.36% 37%
2006 40.43% 53% 18.09% 23% 46.40% 38%
2007 39.02% 55% 17.29% 25% 50.29% 38%
2008 42.37% 56% 18.52% 27% 42.10% 39%
PLS Backed by Subprime
2003 51.43% 50% 19.57% 20% 47.09% 31%
2004 ^
2005 50.95% 52% 19.86% 22% 61.13% 37%
2006 60.63% 53% 23.51% 23% 60.12% 38%
2007 52.96% 55% 19.21% 25% 54.55% 38%
2008 51.42% 56% 17.68% 27% 64.45% 39%
*% of unit fnanced that qualifed for base goals.
^ Not included in housing goals scoring in 2004
Table 5 also shows that ordinary subprime loans, Alt-A loans and PMBS
backed by subprime loans were not always suf cient to meet the AH goals. For
100
Fannie Mae, disk produced for FCIC, April 7, 2010. Troughout this analysis, I have not discussed the
GSEs compliance with the Underserved Base Goal, which is included in this table. Te Underserved
Base Goal applied mostly to minorities and involved a diferent set of lending decisions than the LMI
goal and the Special Afordable Goal.
501 Peter J. Wallison
this reason, Fannie developed special categories of loans in which the frm waived
some of its regular underwriting requirements in order to supplement what they
were getting from higher quality NTMs. Te two principal categories were My
Community Mortgage (MCM) and Expanded Approval (EA). In many cases, these
two categories enabled Fannie to meet the AH goals, but at the cost of much higher
delinquency rates than occurred among higher quality NTMs they acquired. As
the years progressed and the AH goals increased, Fannie had to acquire increasing
numbers of loans in these categories, and as shown in Table 6 these increasing
numbers also exhibited increasing delinquency rates:
Table 6.
101
Higher Risk Loans Produced Higher Delinquency Rates at Fannie Mae
Goals by Vintage Loan Count Serious Delinquency Rate
2004 & Prior EA/MCM & Housing Goals 115,686 17.59%
2005 EA/MCM & Housing Goals 56,822 22.35%
2006 EA/MCM & Housing Goals 110,539 25.19%
2007 EA/MCM & Housing Goals 224, 513 29.70%
Just how desperate Fannie and Freddie were to meet their AH goals is revealed
by Fannies behavior in 2004. As reported in the American Banker on May 13, 2005,
A House Financial Services Committee report shared with lawmakers Tursday
accused Fannie Mae and Freddie Mac of engaging over several years in a series
of dubious transactions to meet their afordable-housing goalsTe report cited
several large transactions entered into by Fannie under which sellers were allowed
to repurchase loans without recourse. For example, it said that in September 2003,
Fannie bought the option to buy up to $12 billion of multifamily mortgage loans
from Washington Mutual, Inc., for a fee of $2 million, the report said. Under the
agreement, the GSE permitted WaMu to repurchase the loans Tis was the largest
multifamily transaction ever undertaken by Fannie Mae and was critical for Fannie
Mae to reach the afordable-housing goals, the report said.
102
A clearer statement of what happened here is contained in WaMus 10-K for
2003. Freddie had engaged in a similar but larger transaction with WaMu in 2003,
reported as follows in WaMus 10-K dated December 31, 2003:
Other noninterest income increased in 2003 compared with 2002 partially due to
fees paid to the Company [WaMu] by the Federal Home Loan Mortgage Corporation
(FHLMC or Freddie Mac). Te Company received $100 million in nonrefundable
fees to induce the Company to swap approximately $6 billion of multi-family loans
for 100% of the benefcial interest in those loans in the form of mortgage-backed
securities issued by Freddie Mac. Since the Company has the unilateral right to
collapse the securities afer one year, the Company has efectively retained control
over the loans. Accordingly, the assets continue to be accounted for and reported as
loans. Tis transaction was undertaken by Freddie Mac in order to facilitate fulflling
its 2003 afordable housing goals as set by the Department of Housing and Urban
Development.
Fannie and Freddie were both paying holders of mortgages to temporarily
transfer to them possession of goal-qualifying loans that the GSEs could use to
satisfy the AH goals for the year 2003. Afer the end of the year, the seller had an
101
Fannie Mae, GSE Credit Losses, presentation to House Financial Services Committee, April 16, 2010.
102
Rob Blackwell, Two GSEs Cut Corners to Hit Goals, Report Says, American Banker, May 13, 2005, p.1.
502 Dissenting Statement
absolute right to reacquire these loans. Tere can be little doubt, then, that as early
as 2003, Fannie and Freddie were under so much pressure to fnd the subprime or
other loans that they needed to meet their afordable housing obligations that they
were willing to pay substantial sums to window-dress their reports to HUD.
3. The Affordable Housing Goals were the Sole
Reason That the GSEs Acquired So Many NTMs
Up to this point, we have seen that HUDs policy was to reduce underwriting
standards in order to make mortgage credit more readily available to low-income
borrowers, and that Fannie and Freddie not only took the AH goals seriously
but were willing to go to extraordinary lengths to make sure that they met them.
Nevertheless, it seems to have become an accepted idea in some quarters
including in the Commission majoritys reportthat Fannie and Freddie bought
large numbers of subprime and Alt-A loans between 2004 and 2007 in order to
recover the market share they had lost to subprime lenders such as Countrywide
or Wall Street, or to make profts. Although there is no evidence whatever for this
beliefand a great deal of evidence to the contraryit has become another urban
myth, repeated so ofen in books, blogs and other media that it has attained a kind
of reality.
103
Te formulations of the idea vary a bit. As noted earlier, HUD has claimed
absurdly, in light of its earlier eforts to reduce mortgage underwriting standards
that the GSEs were chasing the nonprime market or chasing market share and
profts, principally between 2004 and 2007. Te inference, all too easily accepted,
is that this is another example of private greed doing harm, but it is clear that HUD
was simply trying to evade its own culpability for using the AH goals to degrade
the GSEs mortgage underwriting standards over the 15 year period between 1992
and 2007. Te Commission majority also adopted a version of this idea in its
report, blaming the GSEs loosening of their underwriting standards on a desire
to please stock market analysts and investors, as well as to increase management
compensation. None of HUDs statements about its eforts to reduce underwriting
standards managed to make it into the Commission majoritys report, which relied
entirely on the idea that the GSEs underwriting standards were reduced by their
desire to follow Wall Street and other lenders in [the] rush for fools gold.
Tese claims place the blame for Fannie and Freddies insolvencyand the
huge number of low quality mortgages in the U.S. fnancial system immediately prior
to the fnancial crisison the frms managements. Tey absolve the government,
particularly HUD, from responsibility. Te GSEs managements made plenty of
mistakesand wont be defended herebut taking risks to compete for market
share was not something they actually did. Because of the AH goals, Fannie and
103
See, e.g., Barry Ritholtz, Get Me ReWrite! in Bailout Nation, Bailouts, Credit, Real Estate, Really,
Really Bad Calls, May 13, 2010, http://www.ritholtz.com/blog/2010/05/rewriting-the-causes-of-the-
credit-crisis/print/; Dean Baker, NPR Tells Us that Republicans Believe that Fannie and Freddie Caused
the Crash Beat the Press Blog, Center for Economic and Policy Research http://www.cepr.net/index.php/
blogs/beat-the-press/npr-tells-us-that-republicans-believe-that-fannie-and-freddie-caused-the-crash;
Charles Duhigg, Roots of the Crisis, Frontline, Feb 17, 2009, http://www.pbs.org/wgbh/pages/frontline/
meltdown/themes/howwegothere.html.
503 Peter J. Wallison
Freddie were major buyers of NTMs well before Wall Street frms and the subprime
lenders who came to dominate the business entered the subprime PMBS market
in any signifcant way. Moreover, the GSEs did not (indeed, could not) appreciably
increase their purchases of NTMs during the years 2005 and 2006, when they
had lost market share to the real PMBS issuers, Countrywide and other subprime
lenders.
Te following discussion addresses each of the claims about the GSEs
motives in turn, and in the end will show that the only plausible motive for their
actions was their efort to comply with HUDs AH goals.
Did the GSEs acquire NTMs to compete for market share with
Wall Street or others?
Te idea that Fannie and Freddie were newcomers to the purchase of NTMs
between 2004 and 2007, and reduced their underwriting standards so they could
compete for market share with Wall Street or others, is wrong. As shown in Table 7,
the GSEs acquisition of subprime loans and other NTMs began in the 1990s, when
they frst became subject to the AH goals. Research shows that, in contravention
of their earlier standards, the GSEs began to acquire high loan-to-value (LTV)
mortgages in 1994, shortly afer the enactment of the GSE Act and the imposition
of the AH goals, and by 2001before the PMBS market reached $100 billion in
annual issuancesthe GSEs had already acquired at least $700 billion in NTMs,
including over $400 billion in subprime loans.
104
Far from following Wall Street or
anyone else into subprime loans between 2004 and 2007, the GSEs had become the
largest buyers of subprime and other NTMs many years before the PMBS market
began to develop. Given these facts, it would be more accurate to say that Wall Street
and the subprime lenders who later came to dominate the PMBS market followed
the GSEs into subprime lending. Table 7 does not show any signifcant increase in
the GSEs acquisition of NTMs from 2004 to 2007, and the amount of subprime
PMBS they acquired during this period actually decreased. Tis is consistent with
the factoutlined belowthat the GSEs did not make any special efort to compete
for market share during these years.
104
Pinto, Government Housing Policies in the Lead-up to the Financial Crisis: A Forensic Study, Chart
52, p.148, http://www.aei.org/docLib/Government-Housing-Policies-Financial-Crisis-Pinto-102110.pdf.
504 Dissenting Statement
Table 7.
105
GSE Purchases of Subprime and Alt-A loans
$ in billions 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 1997-2007
Subprime
PMBS
$3* $18* $18* $11* $16* $38 $82 $180 $169 $110 $62 $707
Subprime
loans**
$37 $83 $74 $65 $159 $206 $262 $144 $139 $138 $195 $1,502
Alt-A PMBS Unk. Unk, Unk. Unk. Unk. $18 $12 $30 $36 $43 $15 $154
Alt-A loans*** Unk. Unk, Unk. Unk. Unk. $66 $77 $64 $77 $157 $178 $619
High LTV
loans****
$32 $44 $62 $61 $84 $87 $159 $123 $126 $120 $226 $1,124
Total***** $72 $145 $154 $137 $259 $415 $592 $541 $547 $568 $676 $4,106
*Total purchases of PMBS for 1997-2001 are known. Subprime purchases for these years were estimated
based upon the percentage that subprime PMBS constituted of total PMBS purchases in 2002 (57%).
**Loans where borrowers FICO <660.
*** Fannie and Freddie used their various afordable housing programs and individual lender variance
programs (many times in conjunction with their automated underwriting systems once these came into
general use in the late-1990s) to approve loans with Alt-A characteristics. However, they generally did
not classify these loans as Alt-A. Classifcation as Alt-A started in the early-1990s. Tere is an unknown
number of additional loans that had higher debt ratios, reduced reserves, loosened credit requirements,
expanded seller contributions, etc. Te volume of these loans is not included.
****Loans with an original LTV or original combined LTV >90% (given industry practices, this
efectively means >=95%). Data to estimate loans with CLTV.>90% is unavailable prior to 2003.
Amounts for 2003-2007 are grossed up by 60% to account for the impact of loans with a CLTV >90%.
Tese estimates are based on disclosures by Fannie and Freddie that at the end of 2007 their total
exposures to loans with an LTV or CLTV >90% was 50% and 75% percent respectively higher than
their exposure to loans with an LTV >90%. Fannie reports on p. 128 of its 2007 10-K that 15% of its
entire book had an original combined LTV >90%. Its Original LTV percentage >90% (without counting
the impact of any 2nd mortgage simultaneously negotiated) is 9.9%. Freddie reports on p60 of its
Q2:2008 10 Q that 14% of its portfolio had an original combined LTV >90%. Its OLTV percentage
>90% (without counting any simultaneous 2nd) is 8%. While Fannie and Freddie purchased only the
frst mortgage, these loans had the same or higher incidence of default as a loan with an LTV of >90%.
*****Since loans may have more than one characteristic, they may appear in more than one category.
Totals are not adjusted to take this into account.
Te claim that the GSEs loosened their underwriting standards in order
to compete specifcally with Wall Street can be easily dismissedunless the
Commission majority and others who have made this statement are including
Countrywide (which was based in California) or other subprime lenders in the
term Wall Street. Assuming, however, that the Commission majority and other
commentators have been using the term Wall Street to apply to the commercial and
investment banks that operate in the fnancial markets of New York, the data shows
that Wall Street was not a signifcant participant in the subprime PMBS market
between 2004 and 2007 or at any time before or afer those dates. Te top fve players
in 2004 were subprime lenders Ameriquest ($55 billion) and Countrywide ($40
billion), followed by Lehman Brothers ($27 billion), GMAC RFC ($26 billion), and
New Century ($22 billion). Other than Lehman, some other Wall Street frms were
scattered through the list of the top 25, but were not signifcant players as a group.
In 2005, the biggest year for subprime issuances, the fve leaders were the
same, and the total for all Wall Street institutions was $137 billion, or about 27
105
Id.
505 Peter J. Wallison
percent of the $508 billion issued that year.
106
In 2006, Lehman had dropped out
of the top fve and Countrywide had taken over the leadership among the issuers,
but Wall Streets share had not signifcantly changed. By the middle of 2007, the
PMBS market had declined to such a degree that the market share numbers were
meaningless. However, in that year the GSEs market share in NTMs increased
because they had to continue buying NTMseven though others had defaulted or
lef the businessin order to comply with the AH goals. Accordingly, if Fannie had
ever loosened its lending standards to compete with some group, that group was
not Wall Street.
Te next question is whether the GSEs loosened their underwriting standards
to compete with Countrywide, Ameriquest and the other subprime lenders who
were the dominant players in the PMBS market between 2004 and 2007. Again, the
answer seems clearly to be no. Te subprime PMBS market was very small until
2002, when for the frst time it exceeded $100 billion and reached $134 billion in
subprime PMBS issuances.
107
Yet, Table 7 shows that in 2002 alone the GSEs bought
$206 billion in subprime loans, more than the total amount securitized by all the
subprime lenders and others combined in that year.
Te discussion of internal documents that follows will focus almost exclusively
on Fannie Mae. Te Commission concentrated its investigation on Fannie and it
was from Fannie that the Commission received the most complete set of internal
documents.
By the early 2000s, Countrywide had succeeded in creating an integrated
system of mortgage distribution that included originating, packaging, issuing and
underwriting NTMs through PMBS. Other subprime lenders, as noted above, were
also major issuers, but they sold their PMBS through Wall Street frms that were
functioning as underwriters.
Te success of Countrywide and other subprime lenders as distributors of
NTMs through PMBS was troubling to Fannie for two reasons. First, Countrywide
had been Fannies largest supplier of subprime mortgages; the fact that it could now
securitize mortgages it formerly sold to Fannie meant that Fannie would have more
dif culty fnding subprime mortgages that were AH goals-eligible. In addition, the
GSEs knew that their support in Congress depended heavily on meeting the AH
goals and leading the market in lending to low income borrowers. In 2005 and
2006, the Bush administration and a growing number of Republicans in Congress
were calling for tighter regulation of Fannie and Freddie, and the GSEs needed
allies in Congress to hold this of. Te fact that subprime lenders were taking an
increasing market share in these yearssuggesting that the GSEs were no longer the
most important sources of low income mortgage creditwas thus a matter of great
concern to Fannies management. Without strong support among the Democrats in
Congress, there was a signifcant chance that the Republican Congress would enact
tougher regulatory legislation. Tis was expressed at Fannie as concern about a loss
of relevance, and provoked wide-ranging consideration within the frm about how
they could regain their leadership role in low-income lending.
Nevertheless, although Fannie had strong reasons for wanting to compete for
market share with Countrywide and others, it did not have either the operational
106
Inside Mortgage Finance, Te 2009 Mortgage Market Statistical AnnualVolume II, pp. 139 and 140.
107
Inside Mortgage Finance, Te 2009 Market Statistical AnnualVolume II, p.143.
506 Dissenting Statement
or fnancial capacity to do so. In the end, Fannie was unable to take any signifcant
action during the key years 2005 and 2006 that would regain market share from
the subprime lenders or anyone else. Tey reduced their underwriting standards
to the degree necessary to keep pace with the increasing AH goals, but not to go
signifcantly beyond those requirements.
In a key memo dated June 27, 2005 (the Crossroads memo), Tom Lund,
Executive Vice President for Single Family Business, addressed the question of
Fannies loss of market share and how this share position could be regained. Te date
of this memo is important. It shows that even in the middle of 2005 there was still
a debate going on within Fannie about whether to compete for market share with
Countrywide and the other subprime issuers. No such competition had actually
begun. Lund starts the discussion in the memo by saying We are at a strategic
crossroad[his ellipses] We face two stark choices: 1. Stay the Course [or] 2. Meet
the Market Where the Market Is. Staying the course meant trying to maintain
the mortgage quality standards that Fannie had generally followed up to that
point (except as necessary to meet HUDs AH goals). Meeting the market meant
competing with Countrywide and others not only by acquiring substantially more
NTMs than the AH goals required, but also by acquiring much riskier mortgages
than Fanniewhich specialized in fxed rate mortgageshad been buying up to
that time.
Tese riskier potential acquisitions would have included much larger
numbers of Option ARMs (involving negative amortization) and other loans
involving multiple (or layered) risks with which Fannie had no prior experience.
Tus, Lund noted that to compete in this business Fannie lacked capabilities
and infrastructureknowledge willingness to compete on price..[and] a value
proposition for subprime. His conclusion was as stark as the choice: Realistically,
we are not in a position to Meet the Market today. Terefore, Lund continued,
we recommend that we: Pursue a Stay the Course strategy and test whether market
changes are cyclical vs secular.
108
[emphasis supplied]
In the balance of the Crossroads memo, Lund notes that subprime and Alt-A
loans are driving the leakage of goals rich products to PMBS issuers. He points
out the severity of the loss of market share, but never suggests that this changes
his view that Fannie was unequipped to compete with Countrywide and others at
that time. According to an internal FCIC staf investigation, dated March 31, 2010,
other senior of cialsRobert Levin (Executive Vice President and Chief Business
Of cer), Kenneth Bacon (Executive Vice President for Housing and Community
Development), and Pamela Johnson (Senior Vice President for Single Family
Business)all concurred that Fannie should follow Lunds recommendation to
stay the course.
Tere is no indication in any of Fannies documents afer June 2005 that
Lunds Stay the Course recommendation was ever changed or challenged during
2005 or 2006the period when Fannie and Freddie were supposed to have begun to
acquire large numbers of NTMs (beyond what was required to meet the AH goals)
in order to compete with Countrywide or (in some telling) Wall Street.
Tus, in June 2006, one year afer the Lund Crossroads memo, Stephen B.
Ashley, then the chairman of the board, told Fannies senior executives: 2006 is a
108
Tom Lund, Single Family Guarantee Business: Facing Strategic Crossroads June 27, 2005.
507 Peter J. Wallison
transition year. To be sure, there are still issues to resolve. Te consent order with
OFHEO [among other things, the order raised capital requirements temporarily] is
demanding. And from a strategy standpoint, it is clear that until we have eliminated
operations and control weaknesses, taking on more risk or opening new lines of
business will be viewed dimly by our regulators.
109
[emphasis supplied] So, again,
we have confrmation that Fannies top of cials did not believe that the frm was in
any positionin the middle of 2006to take on the additional risk that would be
necessary s to compete with Countrywide and other subprime lenders that were
selling PMBS backed by subprime and other NTMs.
Moreover, there is very strong fnancially-based evidence that Fannie
either never tried or was never fnancially able to compete for market share with
Countrywide and other subprime lenders from 2004 to 2007. For example, set out
below are Fannies key fnancial data, published by OFHEO, its former regulator, in
early 2008.
110
Table 8. Fannie Mae Financial Highlights
Earnings Performance: 2003 2004 2005 2006 2007
Net Income ($ billions) 8.1 5.0 6.3 4.2 -2.1
Net Interest Income ($ billions) 19.5 18.1 11.5 6.8 4.6
Guarantee Fees ($ billions) 3.4 3.8 4.0 4.3 5.1
Net Interest margin (%) 2.12 1.86 1.31 0.85 0.57
Average Guarantee Fee (bps) 21.9 21.8 22.3 22.2 23.7
Return on Common Equity (%) 27.6 16.6 19.5 11.3 -8.3
Dividend Payout Ratio (%) 20.8 42.1 17.2 32.4 N/M
Table 8 shows that Fannies average guarantee fee increased during the
period from 2003 to 2007. To understand the signifcance of this, it is necessary
to understand the way the mortgage business works. Most of Fannies guarantee
businessthe business that competed with securitizations of PMBS by Countrywide
and otherswas done with wholesale sellers of mortgage pools. In these deals, the
wholesaler or issuer, a Countrywide or a Wells Fargo, would assemble a pool of
mortgages and look for a guaranty mechanism that would ofer the best pricing. In
the case of a Fannie MBS, the key issue was the GSEs guarantee fee, because that
determined how much of the proft the issuer would be able to retain. In the case of a
PMBS issue, it was the amount and cost of the credit enhancement needed to attain
a AAA rating for a large percentage of the securities backed by the mortgage pool.
Te issuer had a choice of securitizing through Fannie, Freddie or one of
the Wall Street underwriters. Tus, if Fannie wanted to compete with the private
issuers for subprime and other loans there was only one way to do itby reducing
its guarantee fees (called G-fees at Fannie and Freddie) and in this way making
itself a more attractive outlet than using a Wall Street underwriter. Te fact that
Fannie does not appear to have done so is strong evidence that it never tried to
compete for share with Countrywide and the other subprime issuers afer the date
of the Crossroads memo in June 2005.
Te OFHEO fnancial summary also shows that Fannie in reality had very
109
Stephen B. Ashley Fannie Mae Chairman, remarks at senior management meeting, June 27, 2006.
110
OFHEO, Mortgage Markets and the Enterprises in 2007, pp. 33-34.
508 Dissenting Statement
little fexibility to compete by lowering its G-fees. Its net income and its return on
equity were all declining quickly during this period, and a cut in its G-fees would
have hastened this decline.
Finally, there are Fannies own reports about its acquisitions of subprime
loans. According to Fannies 10-K reports for 2004 (which, as restated, covered
periods through 2006) and 2007, Fannies acquisition of subprime loans barely
increased from 2004 through 2007. Tese are the numbers:
Table 9.
111
Fannie Maes Acquisition of Subprime Loans, 2004-2007
2004 2005 2006 2007
FICO <620 5% 5% 6% 6%
FICO 620-<660 11% 11% 11% 12%
Tese percentages are consistent with Fannies efort to comply with the
gradual increase in the AH goals during the years 2004 through 2007; they are
not consistent with an efort to substantially increase its purchases of subprime
mortgages in order to compete with frms like Countrywide that were growing their
market share through securitizing subprime and other loans.
Finally, Fannies 2005 10-K (which, as restated and fled in May 2007,
also covered 2005 and 2006), contains a statement similar to that made in 2006,
confrming that the GSE made no efort to compete for subprime loans (except as
necessary to meet the AH goals), and that in fact it lost market share by declining to
do so in 2004, 2005 and 2006:
[I]n recent years, an increasing proportion of single-family mortgage loan originations
has consisted of non-traditional mortgages such as interest-only mortgages, negative-
amortizing mortgages and sub-prime mortgages, and demand for traditional 30-year
fxed-rate mortgages has decreased. We did not participate in large amounts of these
non-traditional mortgages in 2004, 2005 and 2006 because we determined that the
pricing ofered for these mortgages ofen ofered insuf cient compensation for the
additional credit risk associated with these mortgages. Tese trends and our decision
not to participate in large amounts of these non-traditional mortgages contributed to a
signifcant loss in our share of new single-family mortgages-related securities issuances to
private-label issuers during this period, with our market share decreasing from 45.0% in
2003 to 29.2% in 2004, 23.5% in 2005 and 23.7 in 2006.
112
[emphasis supplied]
Accordingly, despite losing market share to Countrywide and others in 2004,
2005 and 2006, Fannie did not attempt to acquire unusual numbers of subprime
loans in order to regain this share. Instead, it continued to acquire only the subprime
and other NTM loans that were necessary to meet the AH goals. Tat the AH goals
were Fannies sole motive for acquiring NTMs is shown by the frms actions afer
the PMBS market collapsed in 2007. At that point, Fannies market share began to
rise as Countrywide and others could not continue to issue PMBS. Nevertheless,
despite the losses on subprime loans that were beginning to show up in the markets,
Fannie continued to buy NTMs until they were taken over by the government in
111
Fannie Mae, 2004 10-K. Tese totals do not include Fannies purchases of subprime PMBS.
http://www.fanniemae.com/ir/pdf/sec/2004/2004_form10K.pdf;jsessionid=N3RRJCZPD5SOVJ2FQSH
SFGI, p.141 and Fannies 2007 10-K, http://www.fanniemae.com/ir/pdf/sec/2008/form10k_022708.pdf
;jsessionid=N3RRJCZPD5SOVJ2FQSHSFGI, p.127.
112
Fannie Mae, 2005 10-K, p.37.
509 Peter J. Wallison
September 2008. Te reason for this nearly reckless behavior is obviousthey were
still subject to the AH goals, which were increasing through this period. If they had
only acquired these NTMs to compete with Countrywide and others for market
share the competition was already over; their competitors had abandoned the feld.
But the fact is that Fannie did notor could notincrease its market share between
2004 and 2006 shows without question that market share was not the reason they
had acquired so many NTMs by the time they failed in September 2008.
Beleaguered by accounting problems, sufering diminished proftability, and
lacking the capability to evaluate the risks of the new kinds of mortgages they would
have to buy, Fannie had no option but to stay the course they had been following for
15 years. Te NTMs they bought during the period from 2004 to 2007 were acquired
to comply with the AH goals and not to increase their market shareas much as
Fannie might have preferred to do so. Fannies market share fnally did increase in
2007, when the asset-backed market collapsed, Countrywide weakened, and neither
Countrywide nor anyone else could continue to securitize mortgages. In a report
to the board of directors on October 16, 2007, Mudd reported that Fannies market
share, which was 20 percent of the whole market at the beginning of 2007, had risen
to 42 percent.
113
Tat leaves one other possibilitythat Fannie and Freddie were buying
NTMs because they were proftable. Tat issue is addressed in the next section.
Did Fannie acquire NTMs because these loans were proftable?
From time to time, commentators on the GSEs have suggested that the GSEs
real motive for acquiring NTMs was not that they had to comply with the AH
goals, but that they were seeking the profts these risky loans produced. Tis could
have been true in the 1990s, but afer the major increase in the AH goals in 2000
Fannie began to recognize that complying with the goals was reducing the frms
proftability. By 2007, Fannie was asking for relief from the goals.
Te following table, drawn from a FHFA publication, shows the applicable
AH goals over the period from 1996 through 2008 and the GSEs success in meeting
them.
113
Fannie Mae, Minutes of a Meeting of the Board of Directors, October 16, 2007, p.18.
510 Dissenting Statement
Table 10.
114
GSEs Success in Meeting Afordable Housing Goals, 1996-2007
1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
Low & Mod
Housing Goals
40% 42% 42% 42% 42% 50% 50% 50% 50% 52% 53% 55% 56%
Fannie Actual 45% 45% 44% 46% 50% 51% 52% 52% 53% 55% 57% 56% 54%
Freddie Actual 41% 43% 43% 46% 50% 53% 50% 51% 52% 54% 56% 56% 51%
Special
Afordable Goal
12% 14% 14% 14% 14% 20% 20% 20% 20% 22% 23% 25% 27%
Fannie Actual 15% 17% 15% 18% 19% 22% 21% 21% 24% 24% 28% 27% 26%
Freddie Actual 14% 15% 16% 18% 21% 23% 20% 21% 23% 26% 26% 26% 23%
Underserved
Goal
21% 24% 24% 24% 24% 31% 31% 31% 31% 37% 38% 38% 39%
Fannie Actual 25% 29% 27% 27% 31% 33% 33% 32% 32% 41% 43% 43% 39%
Freddie Actual 28% 26% 26% 27% 29% 32% 31% 33% 34% 43% 44% 43% 38%
As the table shows, Fannie and Freddie exceeded the AH goals virtually each
year, but not by signifcant margins. Tey simply kept pace with the increases in the
goals as these requirements came into force over the years. Tis alone suggests that
they did not increase their purchases in order to earn profts. If that was their purpose
they would have substantially exceeded the goals, since their fnancial advantages
(low fnancing costs and low capital requirements) allowed them to pay more for
the mortgages they wanted than any of their competitors. As HUD noted in 2000:
Because the GSEs have a funding advantage over other market participants, they
have the ability to underprice their competitors and increase their market share.
115
As early as 1999, there were clear concerns at Fannie about how the 50
percent LMI goalwhich HUD had signaled as its next movewould be met.
In a June 15, 1999, memorandum,
116
four Fannie staf members proposed three
categories of rules changes that would enable Fannie to meet the goals more easily:
(i) persuade HUD to change the goals accounting (what goes into the numerator
and denominator); (ii) enter other businesses where the pickings might be goals-
rich, such as manufactured housing and, signifcantly, Alt-A and subprime (Eforts
to expand into Alt-A and A-markets (the highest grade of subprime lending) should
also yield incremental business that will have a salutary efect on our low-and
moderate-income score); and (iii) persuade HUD to adopt diferent methods of
goals scoring.
By 2000, Fannie was efectively in competition with banks that were required
to make mortgage loans under CRA to roughly the same population of low-income
borrowers targeted in HUDs AH goals. Rather than selling their CRA loans to
Fannie and Freddie, banks and S&Ls had begun to retain the loans in portfolio. In
a presentation in November 2000, Barry Zigas, a Senior Vice President of Fannie,
noted that Our own anecdotal evidence suggests that this increase [in banks and
114
FHFA Mortgage Market Note 10-2, http://www.ffa.gov/webfles/15408/Housing%20Goals%201996-
2009%2002-01.pdf.pdf.
115
http://frwebgate.access.gpo.gov/cgi-bin/getdoc.cgi?dbname=2000_register&docid=page+65093
-65142.
116
Bell, Kinney, Kunde and Weech, through Zigas and Marks internal memo Frank Raines, RE: HUD
Housing Goals Options, June 15, 1999.
511 Peter J. Wallison
S&Ls holding loans in portfolio] is due in part to below-market CRA products.
117

In other words, banks and S&Ls subject to CRA were making mortgage loans at
below market interest rates, and thus could not sell them without taking losses.
Tis was troubling for Fannie because it meant that in order to capture these loans
they would have to increase what they were willing to pay for these loans. Doing so
would underprice the risks they would be assuming.
It is important to recognize what was happening. Fannie, and the banks and
S&Ls under CRA, were now competing for the same kinds of NTMs, and were
doing so by lowering their mortgage underwriting standards and adding fexibilities
and subsidies. Simply as a result of supply and demand, all of the participants in
this competition were required to pay higher prices for these increasingly risky
mortgages. Te banks and S&Ls that acquired these loans could not sell them,
without taking a loss, when market interest rates were higher than the rates on the
mortgages. Tis is the frst indication in the documents that the FCIC received
from Fannie that competition for subprime loans among the GSEs, banks, S&Ls,
and FHA was causing the underpricing of riskone of the principal causes of the
mortgage meltdown and thus the fnancial crisis.
In January 2003, Fannie began planning for how to confront HUD before the
next round of increases in the AH goals, expected to occur in 2004. In an Action
Plan for the Housing Goals Rewrite, dated January 22, 2003, Fannie staf reviewed
a number of options, and concluded that Fannie should strongly oppose: goals
increases and new subgoals. (Slide 35)
118
In March 2003, as Fannie prepared for new increases in the AH goals, its
staf prepared a presentation, perhaps for HUD or for policy defense in public
forums. Te apparent purpose was to show that the goals should not be increased
signifcantly in 2004. Slide 5 stated:
In 2002, Fannie Mae exceeded all our goals for the 9th straight year. But it was probably
the most challenging environment weve ever faced. Meeting the goals required heroic
4
th
quarter eforts on the part of many across the company. Vacations were cancelled.
Te midnight oil burned. Moreover, the challenge freaked out the business side of
the house. Especially because the tenseness around meeting the goals meant that we
considered not doing dealsnot fulflling our liquidity functionand did deals at
risks and prices we would not have otherwise done.
119
[emphasis supplied]
By September 2004, it was becoming clear that continuing increases in
the AH goals were having a major adverse efect on Fannies proftability. In a
memorandum to Brian Graham (another Fannie of cial), Paul Weech, Director of
Market Research and Policy Development, wrote: Meeting the goals in dif cult
markets imposes signifcant costs on the Company and potentially causes market-
distorting behaviors. In 1998, 2002, and 2003 especially, the Company has had
to pursue certain transactions as much for housing goals attainment as for the
economics of the transaction.
120
In a June 2005 presentation entitled Costs and Benefts of Mission
117
Barry Zigas, Fannie Mae and Minority Lending: Assessment and Action Plan Presentation,
November 16, 2000.
118
Fannie Mae, Action Plan for the Housing Goals Rewrite, January 22, 2003.
119
Fannie Mae, Te HUD Housing Goals, March 2003.
120
Fannie Mae internal memo, Paul Weech to Brian Graham, RE: Mission Legislation, September 3, 2004.
512 Dissenting Statement
Activities,
121
the authors noted in slide 10 that AH goal costs had risen from
$2,632,500 in 2000 to $13,447,500 in 2003. Slide 17 is entitled: Meeting Future
HUD Goals Appear Quite Daunting and Potentially Costly and reports, Based on
2003 experience where goal acquisition costs (relative to Fannie Mae model fees)
cost between $65 per goals unit in the frst quarter to $370 per unit in the fourth
quarter, meeting the shortfall could cost the company $6.5-$36.5 million to purchase
suf cient units. Te presentation concludes (slide 20): Cost of mission activities
explicit and implicitover the 2000-2004 period likely averaged approximately
$200 million per year.
Earlier, I noted the eforts of Fannie and Freddie to window-dress their
records for HUD by temporarily acquiring loans that would comply with the AH
goals, while giving the seller the option to reacquire the loans at a later time. In 2005,
we begin to see eforts by Fannies staf to accomplish the same window-dressing in
another way--delaying acquisitions of non-goal-eligible loans so Fannie can meet
the AH goals in that year; we also see the frst eforts to calculate systematically
the efect of goal-compliance on Fannies proftability. In a presentation dated
September 30, 2005, Barry Zigas, the key Fannie of cial on afordable housing,
outlined a business deferral option. Under that initiative, Fannie would ask seven
major lenders to defer until 2006 sending non-goal loans to Fannie for acquisition.
Tis would reduce the denominator of the AH goal computation and thus bring
Fannie nearer to goal compliance in the 4th quarter of 2005. Te cost of the deferral
alone was estimated at $30-$38 million.
122
In a presentation to HUD on October 31, 2005, entitled Update on Fannie
Maes Housing Goals Performance,
123
Fannie noted several Undesirable Tradeofs
Necessary to Meet Goals. Tese included signifcant additional credit risk, and
negative returns (Deal economics are well below target returns; some deals are
producing negative returns and G-fees may not cover expected losses). One of
the most noteworthy points was the following: Liquidity to Questionable Products:
Buying exotic product encourages continuation of risky lending; many products
present with signifcant risk-layering; consumers are at risk of payment shock and
loss of equity; potential need to waive our responsible lending policies to get goals
business.
Much of the narrative about the fnancial crisis posits that unscrupulous and
unregulated mortgage originators tricked borrowers into taking on bad mortgages.
Te idea that predatory lending was a major source of the NTMs in the fnancial
system in 2008 is a signifcant element of the Commission majoritys report, although
the Commission was never able to provide any data to support this point. Tis
Fannie slide suggests that loans later dubbed predatory might actually have been
made to comply with the AH goals. Tis possibility is suggested, too, in a message
sent in 2004 to Freddies CEO, Richard Syron, by Freddies chief risk manager,
David Andrukonis, when Syron was considering whether to authorize a Ninja (no
income/no jobs/no assets) product that he ultimately approved. Andrukonis argued
against authorizing Freddies purchase: Te potential for the perception and reality
121
Fannie Mae, Costs and Benefts of Mission Activities, Project Phineas, June 14, 2005.
122
Barry Zigas, Housing Goals and Minority Lending, September 30, 2005.
123
Fannie Mae, Update on Fannie Maes Housing Goals Performance, Presentation to the U.S.
Department of Housing and Development, October 31, 2005.
513 Peter J. Wallison
of predatory lending, with this product is great.
124
But the product was approved
by Freddie, probably for the reason stated by another Freddie employee: Te Alt-A
[(low doc/no doc)] business makes a contribution to our HUD goals.
125
On May 5, 2006, a Fannie staf memo to the Single Family Business Credit
Committee revealed the serious credit and fnancial problems Fannie was facing
when acquiring subprime mortgages to meet the AH goals. Te memo describes
the competitive landscape, in which product enhancements from Freddie Mac,
FHA, Alt-A and subprime lenders have all contributed to increased competition
for goals rich loansOn the issue of seller contributions [in which the seller of the
home pays cash expenses for the buyer] even FHA has expanded their guidelines
by allowing 6% contributions for LTVs up to 97% that can be used toward closing,
prepaid expenses, discount points and other fnancing concessions.
126
Te memorandum is eye-opening for what it says about the credit risks
Fannie had to take in order to get the goals-rich loans it needed to meet HUDs
AH requirements for 2006. Table 11 below shows the costs of NTMs in terms of the
guarantee fee (G-fee) gap. (In order to determine whether a loan contributed to a
return on equity, Fannie used a G-fee pricing model that took into account credit
risk as well as a number of other factors; a G-fee gap was the diference between
the G-fees required by the pricing model for a particular loan to contribute to a
return on equity and a loan that did not.) Te table in this memo shows the results
for three subprime products under consideration, a 30 year fxed rate mortgage
(FRM), a 5 year ARM, and 35 and 40 year fxed rate mortgages. For simplicity, this
analysis will discuss only the 30 year fxed rate product. Te table shows that the base
product, the 30 year FRM, with a zero downpayment should be priced according to
the model at a G-fee of 106 basis points. However, the memo reports that Fannie is
actually buying loans like that at a price consistent with an annual fee of 37.50 basis
points, producing a gap (or loss from the model) of 68.50 basis points. Te reason
the gap is so large is shown in the table: the anticipated default rate on that zero-
down mortgage was 34 percent. Te table then goes on to look at other possible loan
alternatives, with the following results:
124
Freddie Mac, internal email, Donna Cogswell on behalf of David Andrukonis to Dick Syron, RE: No
Income/No Asset (NINA) Mortgages, September 7, 2004.
125
Freddie Mac, internal email from Mike May to Dick Syron, FW: FINAL NINA Memo, October 6, 2004.
126
Fannie Mae, internal memo, Single Family Business Product Management and Development to Single
Family Business Credit Committee, RE: PMD Proposal for Increasing Housing Goal Loans, May 5,
2006, p.6.
514 Dissenting Statement
Table 11.
127
Fannie Mae Took Losses on Higher Risk Mortgages
Necessary to Meet the Afordable Housing Goals
Individual Enhancements
(cost analysis for base MCM
enhancement-not layered)
30 YR FRM
Model Fee Average
Default %
Gap
Base: 100% LTV, 20% MI 106 34 -68.50
Interest First (IF) 129 40 -91.50
Seller Contribution (SC) 115 23 -77.50
Temporary B/D (BD) 118 37 -80.50
Zero Down (ZD) 106 34 -68.50
Manufactured Housing (MH) 227 42 -189.50
From this report, it is clear that in order to meet the AH goals Fannie had to
pay up for goals-rich mortgages, taking a huge credit risk along the way.
Te dismal fnancial results that were developing at Fannie as a result of the
AH goals were also described in Fannies 10-K report for 2006, which anticipated
both losses of revenue and higher credit losses as a result of acquiring the mortgages
required by the AH goals:
[W]e have made, and continue to make, signifcant adjustments to our mortgage
loan sourcing and purchase strategies in an efort to meet HUDs increased housing
goals and new subgoals. Tese strategies include entering into some purchase and
securitization transactions with lower expected economic returns than our typical
transactions. We have also relaxed some of our underwriting criteria to obtain goals-
qualifying mortgage loans and increased our investments in higher-risk mortgage
loan products that are more likely to serve the borrowers targeted by HUDs goals and
subgoals, which could increase our credit losses. [emphasis supplied]
128
Te underlying reasons for the lower expected returns were reported in
February 2007 in a document the FCIC received from Fannie, which noted that
for 2006 the cash fow cost of meeting the housing goals was $140 million while
the opportunity cost was $470 million.
129
In a report to HUD on the AH goals,
dated April 11, 2007, Fannie described these costs as follows: Te largest costs [of
meeting the goals] are opportunity costs of foregone revenue. In 2006, opportunity
cost was about $400 million, whereas the cash fow cost was about $134 million. If
opportunity cost was $0, our shareholders would be indiferent to the deal. Te cash
fow cost is the implied out of pocket cost.
130
By this time, Alignment Meetingsin which Fannie staf considered how
they would meet the AH goalswere taking place almost monthly (according
to the frequency with which presentations to Alignment meetings occur in the
documentary record). In an Alignment Meeting on June 22, 2007, on a Housing
Goals Forecast, three plans were considered for meeting the 2007 AH goals, even
127
Id., p.8.
128
Fannie Mae, 2006 10-K, p.146.
129
Fannie Mae, Business Update, presentation. Cash fow cost equals expected revenue minus
expected loss. Expected revenue is what will be received in G-fees; expected loss includes G&A and
credit losses. Opportunity cost is the G-fee actually charged minus the model feethe fee that Fannies
model would impose to guarantee a mortgage of the same quality in order to earn a fair market return
on capital.
130
Fannie Mae, Housing Goals Briefng for HUD, April 11, 2007.
515 Peter J. Wallison
though half the year was already gone. One of the plans was forecast to result in
opportunity costs of $767.7 million, while the other two plans resulted in opportunity
costs of $817.1 million.
131
In a Forecast meeting on July 27, 2007, a Plan to Meet
Base Goals, which probably meant the topline LMI goal including all subgoals, was
placed at $1.156 billion for 2007.
132
Finally, in a December 21, 2007, letter to Brian Montgomery, Assistant
Secretary of Housing, Fannie CEO Daniel Mudd asked that, in light of the fnancial
and economic conditions then prevailing in the countryparticularly the absence of
a PMBS market and the increasing number of mortgage delinquencies and defaults
HUDs AH goals for 2007 be declared infeasible. He noted that HUD also has an
obligation to consider the fnancial condition of the enterprise when determining
the feasibility of goals. Ten he continued: Fannie Mae submits that the company
took all reasonable actions to meet the subgoals that were both fnancially prudent
and likely to contribute to the achievement of the subgoals.In 2006, Fannie Mae
relaxed certain underwriting standards and purchased some higher risk mortgage loan
products in an efort to meet the housing goals. Te company continued to purchase
higher risk loans into 2007, and believes these eforts to acquire goals-rich loans are
partially responsible for increasing credit losses.
133
[emphasis supplied]
Tis statement confrms two facts that are critical on the question of why
Fannie (and Freddie) acquired so many high risk loans in 2006 and earlier years:
frst, the companies were trying to meet the AH goals established by HUD and not
because these loans were proftable. It also shows that the eforts of HUD and others
including the Commission majority in its reportto blame the managements
of Fannie and Freddie for purchasing the loans that ultimately dragged them to
insolvency is misplaced.
Finally, in a July 2009 report, the Federal Housing Finance Agency (FHFA,
the GSEs new regulator, replacing OFHEO), noted that Fannie and Freddie both
followed the practice of cross-subsidizing the subprime and Alt-A loans that they
acquired:
Although Fannie Mae and Freddie Mac consider model-derived estimates of cost
in determining the single-family guarantee fees they charge, their pricing ofen
subsidizes their guarantees on some mortgages using higher returns they expect to
earn on guarantees of other loans. In both 2007 and 2008, cross-subsidization in
single-family guarantee fees charged by the Enterprises was evident across product
types, credit score categories, and LTV ratio categories. In each case, there were cross-
subsidies from mortgages that posed lower credit risk on average to loans that posed
higher credit risk. Te greatest estimated subsidies generally went to the highest-risk
mortgages.
134
Te higher risk mortgages were the ones most needed by Fannie and Freddie
to meet the AH goals. Needless to say, there is no need to cross-subsidize the G-fees
of loans that are acquired because they are proftable.
Accordingly, both market share and proftability must be excluded as reasons
that Fannie (and Freddie) acquired subprime and Alt-A loans between 2004 and
131
Fannie Mae, Housing Goals Forecast, Alignment Meeting, June 22, 2007.
132
Fannie Mae, Forecast Meeting, July 27, 2007 slide 4.
133
Fannie Mae letter, Daniel Mudd to Asst. Secretary Brian Montgomery, December 21, 2007, p.6.
134
FHFA, Fannie Mae and Freddie Mac Single Family Guarantee Fees in 2007 and 2008, p.33.
516 Dissenting Statement
2007. Te only remaining motiveand the valid onewas the efect of the AH
goals imposed by HUD.
In 2008, afer its takeover by the government, Fannie Mae fnally published a
credit supplement to its 2008 10-K, which contained an accounting of its subprime
and Alt-A credit exposure. Te table is reproduced below in order to provide a
picture of the kinds of loans Fannie acquired in order to meet the AH goals. Loans
may appear in more than one category, so the table does not reveal Fannies total
net exposure to each category, nor does it include Fannies holdings of non-Fannie
MBS or PMBS, for which it did not have loan level data. Note the reference to
$8.4 billion in the column for subprime loans. As noted earlier, Fannie classifed
as subprime only those loans that it purchased from subprime lenders. However,
Fannie included loans with FICO scores of less than 660 in the table, indicating that
they are not prime loans but without classifying them formally as subprime.
In a later credit supplement, fled in August 2009, Fannie eliminated the
duplications among the loans in Table 12, and reported that as of June 30, 2009, it
held the credit risk on NTMs with a total unpaid principal amount of $2.7 trillion.
Te average loan amount was $151,000, for a total of 5.73 million NTM loans.
135

Tis number does not include Fannies holdings of subprime PMBS as to which it
does not have loan level data.
135
http://www.fanniemae.com/ir/pdf/sec/2009/q2credit_summary.pdf, p.5.
517 Peter J. Wallison
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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
JonesIndustrialAverage.
adjustable-rate mortgage Amortgagewhoseinterestratechangesperiodicallyovertime.
affordable housing goals GoalsoriginallysetbytheDepartment of Housing and Urban Develop-
ment (nowbytheFederalHousingFinanceAgency)forFannie Mae andFreddie Mac toallo-
cateaspecifedpartoftheirmortgagebusinesstoservelow-andmoderate-incomeborrowers.
ARM see adjustable-rate mortgage.
ARS seeauction rate securities.
asset-backed commercial paper Short-termdebtsecuredbyassets.
asset-backed security Debtinstrumentsecuredbyassetssuchasmortgages,creditcardloansor
autoloans.
auction rate securities Long-termbondswhoseinterestratemayberesetatregularshort-term
intervalsbyanauctionprocess.
bank holding company Companythatcontrolsabank.
broker-dealer A frm, often the subsidiary of an investment bank, that buys and sells securities
foritselfandothers.
capital Assetsminusliabilities;whatafrmownsminuswhatitowes.Regulatorsoftenrequiref-
nancialfrmstoholdminimumlevelsofcapital.
Capital Purchase Program TARP programprovidingfnancialassistanceto,oo-plusU.S.fnan-
cialinstitutionsthroughthepurchaseofseniorpreferredsharesinthecorporationsonstan-
dardizedterms.
CDO seecollateralized debt obligation.
CDO squared CDOthatholdsotherCDOs.
CDS seecredit default swap.
CFTC seeCommodity Futures Trading Commission.
collateralized debt obligation Type of security often composed of the riskier portions of mort-
gage-backed securities.
commercial paper Short-termunsecuredcorporatedebt.
Commercial Paper Funding Facility EmergencyprogramcreatedbytheFederal Reserve inioo8to
purchasethree-monthunsecuredandasset-backed commercial paper fromeligiblecompanies.
Commodity Futures Trading Commission Independentfederalagencythatregulatestradingin
futuresandoptions.
539
540 Appendix A: Glossary
Community Reinvestment Act 1,, federal law encouraging depository institutions to make
loansandprovideservicesinthelocalcommunitiesinwhichtheytakedeposits.
Consolidated Supervised Entities program ASecurities and Exchange Commission programcre-
atediniooandterminatedinioo8thatprovidedvoluntarysupervisionforthefvelargestin-
vestmentbankconglomerates.
Counterparty Apartytoacontract.
CP seecommercial paper.
CPP seeCapital Purchase Program.
CRA seeCommunity Reinvestment Act.
credit default swap Atypeofcredit derivative allowingapurchaseroftheswaptotransferloan
defaultrisktoaselleroftheswap.Theselleragreestopaythepurchaserifadefaulteventoc-
curs.Thepurchaserdoesnotneedtoowntheloancoveredbytheswap.
credit enhancement Insurance or other protection that may be purchased for a loan or pool of
loanstooffsetlossesintheeventofdefault.
credit loss Lossfromdelayedpaymentsordefaultsonloans.
credit rating agency Privatecompanythatevaluatesthecreditqualityofsecuritiesandprovides
ratingsonthosesecurities;thelargestareFitchRatings,MoodysInvestorsService,andStan-
dard&Poors.
credit risk Risktoalenderthataborrowerwillfailtorepaytheloan.
CSE ConsolidatedSupervisedEntity(seeConsolidated Supervised Entities program).
debt-to-income ratio Onemeasureofaborrowersabilitytorepayaloan,generallycalculatedby
dividingtheborrowersmonthlydebtpaymentsbygrossmonthlyincome.
delinquency rate Thenumberofloansforwhichborrowersfailtomaketimelyloanpaymentsdi-
videdbytotalloans.
Department of Housing and Urban Development Cabinet-levelfederaldepartmentresponsible
forhousingpoliciesandprograms.
Department of Justice Cabinet-levelfederaldepartmentresponsibleforenforcementoflawsand
administrationofjustice,ledbytheattorneygeneral.
Department of Treasury Treasuryofthefederalgovernment;printsandmintsallcurrencyand
coins, collects federal taxes, manages U.S. government debt instruments, supervises national
banksandthrifts,andadvisesondomesticandinternationalfscalpolicy.Itsmissionincludes
protectingtheintegrityofthefnancialsystem.
depository institution Financialinstitution,suchasacommercialbank,thrift(savingsandloan),
orcreditunion,thatacceptsdeposits,includingdepositsinsuredbytheFDIC.
derivative Financialcontractwhosepriceisdetermined(derived)fromthevalueofanunderlying
asset,rate,index,orevent.
Fannie Mae Nickname for the Federal National Mortgage Association (FNMA), a government-
sponsored enterprise providingfnancingforthehomemortgagemarket.
FCIC FinancialCrisisInquiryCommission.
FDIC seeFederal Deposit Insurance Corporation.
Federal Deposit Insurance Corporation Independentfederalagencychargedprimarilywithin-
suringdepositsatfnancialinstitutions,examiningandsupervisingsomeofthoseinstitutions,
andshuttingdownfailinginstitutions.
Federal Housing Administration PartoftheDepartment of Housing and Urban Development that
providesinsuranceonmortgageloansmadebyFHA-approvedlenders.
Federal Housing Finance Agency Independentfederalregulatorofgovernment-sponsored enter-
prises;createdbytheHousing and Economic Recovery Act ofioo8assuccessortotheOpce of
Federal Housing Enterprise Oversight andtheFederalHousingFinanceBoard.
Federal Open Market Committee ItsmembersaretheBoardofGovernorsoftheFederalReserve
541 Appendix A: Glossary
SystemandcertainofthepresidentsoftheFederalReserveBanks;overseesmarketconditions
andimplementsmonetarypolicythroughsuchmeansassettinginterestrates.
Federal Reserve Bank of New York Oneof1iregionalFederalReserveBanks,withresponsibility
forregulatingbankholdingcompaniesinNewYorkStateandnearbyareas.
Federal Reserve U.S.centralbankingsystemcreatedin11inresponsetofnancialpanics,con-
sistingoftheFederalReserveBoardinWashington,DC,and1iFederalReserveBanksaround
thecountry;itsmissionistoimplementmonetarypolicythroughsuchmeansassettinginter-
est rates, supervising and regulating banking institutions, maintaining the stability of the f-
nancialsystem,andprovidingfnancialservicestodepositoryinstitutions.
FHA seeFederal Housing Administration.
FHFA seeFederal Housing Finance Agency.
FICO score Ameasureofaborrowerscreditworthinessbasedontheborrowerscreditdata;de-
velopedbytheFairIsaacCorporation.
Financial Crimes Enforcement Network Treasury omce that collects and analyzes information
aboutfnancialtransactionstocombatmoneylaundering,terroristfnancing,andotherfnan-
cialcrimes.
FinCEN seeFinancial Crimes Enforcement ^etwork.
FOMC see Federal Open Market Committee.
foreclosure Legalprocesswherebyamortgagelendergainsownershipoftherealpropertysecur-
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 1 creating the FDIC to insure bank deposits; prohibited
commercial banks from underwriting or dealing in most types of securities, barred banks
from amliating with securities frms, and introduced other banking reforms. In 1, the
Gramm-Leach-Bliley Act repealedthe provisionsoftheGlass-SteagallActthatprohibitedaml-
iationsbetweenbanksandsecuritiesfrms.
government-sponsored enterprise Aprivatecorporation,suchasFannie Mae andFreddie Mac,
created by the federal government to pursue certain public policy goals designated in its
charter.
Gramm-Leach-Bliley Act 1legislationthatliftedcertainremainingrestrictionsestablishedby
theGlass-Steagall Act.
GSE see government-sponsored enterprise.
haircut Thedifferencebetweenthevalueofanassetandtheamountborrowedagainstit.
hedge Infnance,awaytoreduceexposureorriskbytakingonanewfnancialcontract.
hedge fund Aprivatelyofferedinvestmentvehicleexemptedfrommostregulationandoversight;
generallyopenonlytohigh-net-worthinvestors.
HOEPA seeHome Ownership and Equity Protection Act.
Home Ownership and Equity Protection Act 1 federallawthatgavetheFederal Reserve new
responsibilitytoaddressabusiveandpredatorymortgagelendingpractices.
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 backedbycollateralfoundinbothcashCDOsandsyntheticCDOs.
illiquid assets Assetsthatcannotbeeasilyorquicklysold.
interest-only loan Loanthatallowsborrowerstopayinterestwithoutrepayingprincipaluntilthe
endoftheloanterm.
542 Appendix A: Glossary
leverage Ameasureofhowmuchdebtisusedtopurchaseassets;forexample,aleverageratioof
,:1meansthat,ofassetswerepurchasedwithofdebtand1ofcapital.
LIBOR LondonInterbankOfferedRate,aninterestrateatwhichbanksarewillingtolendtoeach
otherintheLondoninterbankmarket.
liquidity Holding cashand/orassetsthatcanbequicklyandeasilyconvertedtocash.
liquidity put Acontractallowingonepartytocompeltheothertobuyanassetundercertaincir-
cumstances.Itensuresthattherewillbeabuyerforotherwiseilliquidassets.
loan-to-value ratio Ratio of the amount of a mortgage to the value of the house, typically ex-
pressedasapercentage.Combinedloan-to-valueincludesalldebtsecuredbythehouse,in-
cludingsecondmortgages.
LTV ratio seeloan-to-value ratio.
mark-to-market Theprocessbywhichthereportedamountofanassetisadjustedtorefectthe
marketvalue.
monoline Insurance company, such as AMBAC and MBIA, whose single line of business is to
guaranteefnancialproducts.
mortgage servicer Companythatactsasanagentformortgageholders,collectinganddistribut-
ingpaymentsfromborrowersandhandlingdefaults,modifcations,settlements,andforeclo-
sureproceedings.
mortgage underwriting Process of evaluating the credit characteristics of a mortgage and bor-
rower.
mortgage-backed security Debtinstrumentsecuredbyapoolofmortgages,whetherresidential
orcommercial.
NAV seenet asset value.
negative amortization loan Loanthatallowsaborrowertomakemonthlypaymentsthatdonot
fullycovertheinterestpayment,withtheunpaidinterestaddedtotheprincipaloftheloan.
net asset value Valueofanassetminusanyassociatedcosts;forfnancialassets,typicallychanges
eachtradingday.
net charge-off rate Ratioofloanlossestototalloans.
non-agency mortgage-backed securities Mortgage-backed securities sponsoredbyprivatecompa-
niesotherthanagovernment-sponsored enterprise (suchasFannie Mae orFreddie Mac);also
knownasprivate-label mortgage-backed securities.
notional amount Ameasureoftheoutstandingamountofover-the-counterderivatives contracts,
basedontheamountoftheunderlyingreferencedassets.
novation Aprocessbywhichcounterpartiesmaytransferderivatives positions.
OCC seeOpce of the Comptroller of the Currency.
Ofce of Federal Housing Enterprise Oversight Createdin1itooverseefnancialsoundness
ofFannie Mae andFreddie Mac;itsresponsibilitieswereassumedinioo8byitssuccessor,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 federally
chartered and many state-chartered savings and loans/thrift institutions and their holding
companies.
OFHEO seeOpce of Federal Housing Enterprise Oversight.
originate-to-distribute When lenders make loans with the intention of selling them to other f-
nancialinstitutionsorinvestors,asopposedtoholdingtheloansthroughmaturity.
originate-to-hold Whenlendersmakeloanswiththeintentionofholdingthemthroughmaturity,
asopposedtosellingthemtootherfnancialinstitutionsorinvestors.
543 Appendix A: Glossary
origination Processofmakingaloan,includingunderwriting,closing,andprovidingthefunds.
OTS see Opce of Thrift Supervision.
par Facevalueofabond.
payment-option adjustable-rate mortgage (also called payment ARM or option ARM) Mort-
gagesthatallowborrowerstopicktheamountofpaymenteachmonth,possiblylowenoughto
increasetheprincipal balance.
PDCF seePrimary Dealer Credit Facility.
PLS see private-label mortgage-backed securities.
pooling Combiningandpackagingagroupofloanstobeheldbyasingleentity.
Primary Dealer Credit Facility ProgramestablishedbytheFederal Reserve inMarchioo8thatal-
lowedeligiblecompaniestoborrowcashovernighttofnancetheirsecurities.
principal Amountborrowed.
private mortgage insurance Insuranceonthepaymentofamortgageprovidedbyaprivatefrm
atadditionalcosttotheborrowertoprotectthelender.
private-label mortgage-backed securities seenon-agency mortgage-backed securities.
repurchase agreement (repo) Amethodofsecuredlendingwheretheborrowersellssecuritiesto
thelenderascollateralandagreestorepurchasethematahigherpricewithinashortperiod,
oftenwithinoneday.
SEC see Securities and Exchange Commission.
section () SectionoftheFederalReserveActunderwhichtheFederal Reserve maymakese-
curedloanstonondepositoryinstitutions,suchasinvestmentbanks,underunusualandexi-
gentcircumstances.
Securities and Exchange Commission Independentfederalagencyresponsibleforprotectingin-
vestorsbyenforcingfederalsecuritieslaws,includingregulatingstockandsecurityoptionsex-
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
intoaseparatelegalentitythatthenissuesanewfnancialinstrumentorsecurityforsaletoin-
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 Tosellaborrowedsecurityintheexpectationofadeclineinvalue.
SIV seestructured investment vehicle.
special purpose vehicle Entitycreatedtofulfllanarrowortemporaryobjective;typicallyholdsa
portfolioofassetssuchasmortgage-backed securities orotherdebtobligations;oftenusedbe-
causeofregulatoryandbankruptcyadvantages.
SPV seespecial purpose vehicle.
structured investment vehicle Leveraged special purpose vehicle, funded through medium-term
notesandasset-backed commercial paper,thatinvestedinhighlyratedsecurities.
synthetic CDO ACDO thatholdscredit default swaps thatreferenceassets(ratherthanholding
cashassets),allowinginvestorstomakebetsfororagainstthosereferencedassets.
systemic risk Infnancialterms,thatwhichposesathreattothefnancialsystem.
systemic risk exception ClauseintheFederalDepositInsuranceCorporationImprovementAct
(FDICIA)underwhichtheFDIC maycommititsfundstorescueafnancialinstitution.
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,supportedbyTARP funds,
toaidsecuritizationofasset-basedloanssuchasautoloans,studentloans,andsmallbusiness
loans.
Term Auction Facility PrograminwhichtheFederal Reserve madefundsavailabletoalldeposi-
tory institutions atoncethrougharegularauction.
Term Securities Lending Facility Emergencyprograminwhichthe Federal Reserve madeupto
ioo billion in Treasury securities available to banks or broker/dealers that traded directly
withtheFederalReserve.
tranche FromtheFrench,meaningaslice;usedtorefertothedifferenttypesofmortgage-backed
securities and CDO bonds that provide specifed priorities and amounts of returns: senior
trancheshavethehighestpriorityofreturnsandthereforethelowestrisk/interestrate;mezza-
nine tranches have mid levels of risk/return; and equity (also known as residual or frst
loss)tranchestypicallyreceiveanyremainingcashfows.
Troubled Asset Relief Program Governmentprogramtoaddressthefnancialcrisis,signedinto
lawinOctoberioo8topurchaseorinsureupto,oobillioninassetsandequityfromfnan-
cialandotherinstitutions.
TSLF seeTerm Securities Lending Facility.
undercapitalized Conditioninwhichabusinessdoesnothaveenoughcapital tomeetitsneeds,
ortomeetitscapitalrequirementsifitisaregulatedentity.
Write-downs Reducingthevalueofanassetasitiscarriedonafrmsbalancesheetbecausethe
marketvaluehasfallen.
APPENDIX B:
LIST OF HEARINGS AND WITNESSES
Public Meeting of the FCIC, Washington, DC, September 1,, ioop
Statementsbycommissioners
Roundtable Discussion, Washington, DC, October io, ioop
SimonJohnson,RonaldA.KurtzProfessorofEntrepreneurship,SloanSchoolofManagement,
MassachusettsInstituteofTechnology
Hal S. Scott, Nomura Professor and Director of the Program on International Financial Sys-
tems,HarvardLawSchool
Joseph Stiglitz, Professor, Columbia Business School, Graduate School of Arts and Sciences
(DepartmentofEconomics)andtheSchoolofInternationalandPublicAffairs
JohnB.Taylor,MaryandRobertRaymondProfessorofEconomicsandtheBowenH.andJan-
iceArthurMcCoySeniorFellowattheHooverInstitution,StanfordUniversity
Luigi Zingales, Robert C. McCormack Professor of Entrepreneurship and Finance and the
DavidG.BoothFacultyFellow,UniversityofChicagoBoothSchoolofBusiness
Roundtable Discussion, Washington, DC, November 1o, ioop
DavidA.Moss,TheJohnG.McLeanProfessor,HarvardBusinessSchool
CarmenM.Reinhart,ProfessorofEconomicsandDirectoroftheCenterforInternationalEco-
nomics,UniversityofMaryland
Public Hearing, Washington, DC, Day 1, January 1, io1o
Session r. Financial Institution Representatives
Lloyd C. Blankfein, Chairman of the Board and Chief Executive Omcer, Goldman Sachs
Group,Inc.
JamesDimon,ChairmanoftheBoardandChiefExecutiveOmcer,JPMorganChase&Co.
JohnJ.Mack,ChairmanoftheBoard,MorganStanley
BrianT.Moynihan,ChiefExecutiveOmcerandPresident,BankofAmericaCorporation
Session :. Financial Market Participants
Michael Mayo, Managing Director and Financial Services Analyst, Calyon Securities
(USA)Inc.
J.KyleBass,ManagingPartner,HaymanAdvisors,LP
PeterJ.Solomon,FounderandChairman,PeterJ.SolomonCompany
Session . Financial Crisis Impacts on the Economy
MartinBaily,SeniorFellowinEconomicStudies,BrookingsInstitution
545
546 Appendix B: List of Hearings and Witnesses
MarkZandi,ChiefEconomistandCo-founder,MoodysEconomy.com
Kenneth T. Rosen, Chair, Fisher Center for Real Estate and Urban Economics, University of
California,Berkeley
JuliaGordon,SeniorPolicyCounsel,CenterforResponsibleLending
C. R. Rusty Cloutier, President and Chief Executive Omcer, MidSouth Bank, N.A., Past
Chairman,IndependentCommunityBankersAssociation
Public Hearing, Washington, DC, Day i, January 1(, io1o
Session r. Current Investigations into the Financial CrisisFederal Opcials
EricH.HolderJr.,AttorneyGeneral,U.S.DepartmentofJustice
LannyA.Breuer,AssistantAttorneyGeneral,CriminalDivision,U.S.DepartmentofJustice
SheilaC.Bair,Chairman,U.S.FederalDepositInsuranceCorporation
MaryL.Schapiro,Chairman,U.S.SecuritiesandExchangeCommission
Session :. Current Investigations into the Financial CrisisState and Local Opcials
LisaMadigan,AttorneyGeneral,StateofIllinois
JohnW.Suthers,AttorneyGeneral,StateofColorado
DeniseVoigtCrawford,Commissioner,TexasSecuritiesBoard,andPresident,NorthAmerican
SecuritiesAdministratorsAssociation,Inc.
Glenn Theobald, Chief Counsel, Miami-Dade County Police Department; Chairman, Mayor
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,UniversityofChicago
Session :. Macroeconomic Factors and U.S. Monetary Policy
Pierre-OlivierGourinchas,AssociateProfessorofEconomics,UniversityofCalifornia,Berkeley
Session . Risk Taking and Leverage
JohnGeanakoplos,JamesTobinProfessorofEconomics,YaleUniversity
Session ,. Household Finances and Financial Literacy
Annamaria Lusardi, Joel Z. and Susan Hyatt Professor of Economics, Dartmouth University;
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 Mayer, Paul Milstein Professor of Real Estate, Columbia University; Visiting Scholar at
theFederalReserveBankofNewYorkandResearchAssociateattheNationalBureauofEconomic
Research
Session o. Government-Sponsored Enterprises and Housing Policy
Dwight Jaffee, Willis Booth Professor of Banking, Finance, and Real Estate; Co-chair, Fisher
CenterforRealEstateandUrbanEconomics,UniversityofCalifornia,Berkeley
Session ,. Derivatives and Other Complex Financial Instruments
MarkusBrunnermeier,EdwardsS.SanfordProfessorofEconomics,PrincetonUniversity
547 Appendix B: List of Hearings and Witnesses
Session 8. Firm Structure and Risk Management
AnilKashyap,EdwardEagleBrownProfessorofEconomicsandFinanceandRichardN.Rosett
FacultyFellow,UniversityofChicago
Session ,. Shadow Banking
GaryGorton,ProfessorofFinance,SchoolofManagement,YaleUniversity
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,BoardofGovernorsoftheFederalReserveSystem
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.
PatriciaLindsay,FormerVicePresident,CorporateRisk,NewCenturyFinancialCorporation
SusanMills,ManagingDirectorofMortgageFinance,CitiMarkets&Banking,GlobalSecuri-
tizedMarkets
Session . Citigroup Subprime-Related Structured Products and Risk Management
MurrayC.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 :. Opce of the Comptroller of the Currency
JohnC.Dugan,Comptroller,OmceoftheComptrolleroftheCurrency
JohnD.HawkeJr.,FormerComptroller,OmceoftheComptrolleroftheCurrency
Public Hearing on Subprime Iending and Securitization and Government-Spon-
sored Enterprises (GSEs), Rayburn House Omce building, Room i1i, Washington,
DC, Day , April p, io1o
Session r. Fannie Mae
RobertJ.Levin,FormerExecutiveVicePresidentandChiefBusinessOmcer,FannieMae
DanielH.Mudd,FormerPresidentandChiefExecutiveOmcer,FannieMae
Session :. Opce of Federal Housing Enterprise Oversight
ArmandoFalconJr.,FormerDirector,OmceofFederalHousingEnterpriseOversight
JamesLockhart,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
SamuelMolinaroJr.,FormerChiefFinancialOmcerandChiefOperatingOmcer,BearStearns
WarrenSpector,FormerPresidentandCo-chiefOperatingOmcer,BearStearns
Session :. Investment Banks and the Shadow Banking System
JamesE.Cayne,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
HenryM.PaulsonJr.,FormerSecretary,U.S.DepartmentoftheTreasury
Session :. Perspective on the Shadow Banking System
Timothy F. Geithner, Secretary, U.S. Department of the Treasury; Former President, Federal
ReserveBankofNewYork
Session . Institutions Participating in the Shadow Banking System
MichaelA.Neal,ViceChairman,GeneralElectric;ChairmanandChiefExecutiveOmcer,GE
Capital
MarkS.Barber,VicePresidentandDeputyTreasurer,GECapital
PaulA.McCulley,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 1th Street, ind Floor, New
York, NY, June i, io1o
Session r. The Ratings Process
EricKolchinsky,FormerTeamManagingDirector,USDerivatives,MoodysInvestorsService
JaySiegel,FormerTeamManagingDirector,MoodysInvestorsService
NicolasS.Weill,GroupManagingDirector,MoodysInvestorsService
GaryWitt,FormerTeamManagingDirector,USDerivatives,MoodysInvestorsService
Session :. Credit Ratings and the Financial Crisis
WarrenE.Buffett,ChairmanandChiefExecutiveOmcer,BerkshireHathaway
RaymondW.McDaniel,ChairmanandChiefExecutiveOmcer,MoodysCorporation
Session . The Credit Rating Agency Business Model
BrianM.Clarkson,FormerPresidentandChiefOperatingOmcer,MoodysInvestorsService
(writtentestimonyonlyduetoamedicalemergency)
MarkFroeba,FormerSeniorVicePresident,USDerivatives,MoodysInvestorsService
RichardMichalek,FormerVicePresident/SeniorCreditOmcer,MoodysInvestorsService
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,UniversityofMarylandSchoolofLaw
SteveKohlhagen,FormerProfessorofInternationalFinance,UniversityofCalifornia,Berkeley,
andformerWallStreetderivativesexecutive
AlbertPeteKyle,CharlesE.SmithChairProfessorofFinance,UniversityofMaryland
MichaelMasters,ChiefExecutiveOmcer,MastersCapitalManagement,LLC
Session :. American International Group, Inc. and Derivatives
JosephJ.Cassano,FormerChiefExecutiveOmcer,AmericanInternationalGroup,Inc.Finan-
cialProducts
RobertE.Lewis,SeniorVicePresidentandChiefRiskOmcer,AmericanInternationalGroup,
Inc.
MartinJ.Sullivan,FormerChiefExecutiveOmcer,AmericanInternationalGroup,Inc.
Session . Goldman Sachs Group, Inc. and Derivatives
CraigBroderick,ManagingDirector,HeadofCredit,Market,andOperationalRisk,Goldman
SachsGroup,Inc.
GaryD.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.
StevenJ.Bensinger,FormerExecutiveVicePresidentandChiefFinancialOmcer,AmericanIn-
ternationalGroup,Inc.
AndrewForster,FormerSeniorVicePresidentandChiefFinancialOmcer,AmericanInterna-
tionalGroup,Inc.FinancialServices
EliasF.Habayeb,FormerSeniorVicePresidentandChiefFinancialOmcer,AmericanInterna-
tionalGroup,Inc.FinancialServices
DavidLehman,ManagingDirector,GoldmanSachsGroup,Inc
DavidViniar,ExecutiveVicePresidentandChiefFinancialOmcer,GoldmanSachsGroup,Inc.
Session :. Derivatives. Supervisors and Regulators
EricR.Dinallo,FormerSuperintendant,NewYorkStateInsuranceDepartment
GaryGensler,Chairman,CommodityFuturesTradingCommission
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,BoardofGovernorsoftheFederalReserveSystem
JohnH.Corston,ActingDeputyDirector,DivisionofSupervisionandConsumerProtection,
U.S.FederalDepositInsuranceCorporation
RobertK.Steel,FormerPresidentandChiefExecutiveOmcer,WachoviaCorporation
Session :. Lehman Brothers
ThomasC.Baxter,Jr.,GeneralCounselandExecutiveVicePresident,FederalReserveBankof
NewYork
550 Appendix B: List of Hearings and Witnesses
RichardS.DickFuldJr.,FormerChairmanandChiefExecutiveOmcer,LehmanBrothers
HarveyR.Miller,BusinessFinance&RestructuringPartner,Weil,Gotshal&Manges,LLP
BarryL.Zubrow,ChiefRiskOmcer,JPMorganChase&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,BoardofGovernorsoftheFederalReserveSystem
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
CongressmanKevinMcCarthy,CaliforniasiindDistrict
RayWatson,KernCountySupervisor,District
IrmaCarson,BakersfeldCityCouncilwoman,Ward1
Session :. Local Banking
ArnoldCattani,Chairman,MissionBank
SteveRenock,PresidentandCEO,KernSchoolsFederalCreditUnion
D.LinnWiley,ViceChairman,CVBFinancialCorporationandCitizensBusinessBank
Session . Residential and Community Real Estate
GregoryD.Bynum,President,GregoryD.BynumandAssociates,Inc.
WarrenPeterson,WarrenPetersonConstruction,Inc.
Session ,. Local Housing Market
GaryCrabtree,PrincipalOwner,AmliatedAppraisers
LloydPlank,LloydE.PlankRealEstateConsultants
Session ,. Foreclosures and Loan Modifcations
BrendaAmble,EscrowManager,TicorTitle
LaurieMcCarty,ColdwellBankerPreferred
JeannieMcDermott,SmallBusinessOwner
Session o. Forum for Public Comment
JamesStephenUrner
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
JeremyAguero,Principal,AppliedAnalysis
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
WallyMurray,PresidentandChiefExecutiveOmcer,GreaterNevadaCreditUnion
Philip G. Satre, Chairman, International Gaming Technology (IGT); Chairman, NV Energy,
Inc.
Session . The Impact of the Financial Crisis on ^evada Real Estate
DanielG.Bogden,UnitedStatesAttorney,StateofNevada
GailBurks,PresidentandChiefExecutiveOmcer,NevadaFairHousingCenter
BrianGordon,Principal,AppliedAnalysis
JayJeffries,FormerSouthwestRegionalSalesManager,FremontInvestment&Loan
Session ,. The Impact of the Financial Crisis on ^evada Public and Community Services
AndrewClinger,DirectoroftheDepartmentofAdministration,ChiefoftheBudgetDivision,
StateofNevada
JeffreyFontaine,ExecutiveDirector,NevadaAssociationofCounties
DavidFraser,ExecutiveDirector,NevadaLeagueofCities
Dr.HeathMorrison,Superintendent,WashoeCountySchoolDistrict
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, University of MissouriKansas
City
AnnFulmer,VicePresidentofBusinessRelations,Interthinx;Co-founder,GeorgiaRealEstate
FraudPreventionandAwarenessCoalition
HenryN.Pontell,ProfessorofCriminology,Law&SocietyandSociology,UniversityofCali-
fornia,Irvine
Session :. Uncovering Mortgage Fraud in Miami
DennisJ.Black,President,D.J.Black&Company
Edward Gallagher, Executive Omcer, Economic Crimes Bureau, Mortgage Fraud Task Force,
Miami-DadePoliceDepartment
JackRubin,SeniorVicePresident,JPMorganChaseBank
EllenWilcox,SpecialAgent,FloridaDepartmentofLawEnforcement
Session . The Regulation, Oversight, and Prosecution of Mortgage Fraud in Miami
J.ThomasCardwell,Commissioner,OmceofFinancialRegulation,StateofFlorida
WilfredoA.Ferrer,UnitedStatesAttorney,SouthernDistrictofFlorida
R.ScottPalmer,SpecialCounselandChiefoftheMortgageFraudTaskForce,OmceoftheAt-
torneyGeneral,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
KarenJ.Mann,PresidentandChiefAppraiser,MannandAssociatesRealEstateAppraisers&
Consultants
ThomasC.Putnam,President,PutnamHousingFinanceConsulting
552 Appendix B: List of Hearings and Witnesses
KevinStein,AssociateDirector,CaliforniaReinvestmentCoalition
BenjaminB.Wagner,UnitedStatesAttorney,EasternDistrictofCalifornia
Session . The Mortgage Securitization Chain. From Sacramento to Vall Street
VickiBeal,SeniorVicePresident,TransactionManagement,ClaytonHoldings,LLC
KurtEggert,ProfessorofLaw,ChapmanUniversitySchoolofLaw
D. Keith Johnson, 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,AgencyAdministrator,CountyofSacramentoCountywideServicesAgency
ClarenceWilliams,President,CaliforniaCapitalFinancialDevelopmentCorporation
HenryW.Wirz,PresidentandChiefExecutiveOmcer,SAFECreditUnion
Public Testimony Presented
AllenCarpenter
LovieM.Hollis
NiaLavulo
NOTES
Unlessotherwisespecified,datacomefromthesourceslistedbelow.
BoardofGovernorsoftheFederalReserveSystem,FlowofFundsReports:Debt,international
capitalflows,andthesizeandactivityofvariousfinancialsectors
BureauofEconomicAnalysis:Economicoutput(GDP),spending,wages,andsectorprofit
BureauofLaborStatistics:Labormarketstatistics
BlackBoxLogicandStandard&Poors:DataonloansunderlyingCMLTI2006-NC2
CoreLogic:Homeprices
Inside Mortgage Finance, 2009 Mortgage Market Statistical Annual: Data on origination of
mortgages,issuanceofmortgage-backedsecuritiesandvaluesoutstanding
MarkitGroup:ABX-HEindex
MortgageBankersAssociationNationalDelinquencySurvey:Mortgagedelinquencyandfore-
closurerates
10-Ks,10-Qs,andproxystatementsfiledwiththeSecuritiesandExchangeCommission:Com-
pany-specificinformation
Manyofthedocumentscitedonthefollowingpages,alongwithothermaterials,areavailable
onwww.fcic.gov.
Chapter 1
1.CharlesPrince,testimonybeforetheFCIC,HearingonSubprimeLendingandSecuritizationand
Government-Sponsored Enterprises (GSEs), day 2, session 1: Citigroup Senior Management, April 8,
2010,transcript,p.10.
2. Warren Buffett, testimony before the FCIC, Hearing on the Credibility of Credit Ratings, the In-
vestmentDecisionsMadeBasedonThose Ratings,andtheFinancialCrisis,session2:CreditRatingsand
theFinancialCrisis,June2,2010,transcript,p.208;WarrenBuffett,interviewbyFCIC,May26,2010.
3.LloydBlankfein,testimonybeforetheFirstPublicHearingoftheFCIC,day1,panel1:Financial
InstitutionRepresentatives,January13,2010,transcript,p.36.
4.BenS.Bernanke,closed-doorsessionwithFCIC,November17,2009;BenS.Bernanke,testimony
beforetheFCIC,HearingonTooBigtoFail:ExpectationsandImpactofExtraordinaryGovernmentIn-
terventionandtheRoleofSystemicRiskintheFinancialCrisis,day2,session1:TheFederalReserve,
September2,2010,transcript,p.27.
3.AlanGreenspan,writtentestimonyfortheFCIC,SubprimeLendingandSecuritizationandGov-
ernment-SponsoredEnterprises(GSEs),day1,session1:TheFederalReserve,April7,2010,p.9.
553
554 Notes to Chapter 1
6.RichardC.Breeden,interviewbyFCIC,October14,2010.
7.PaulA.McCulley,testimonybeforetheFCIC,HearingontheShadowBankingSystem,day2,ses-
sion3:InstitutionsParticipatingintheShadowBankingSystem,May6,2010,transcript,p.249.
8.ArnoldCattani,testimonybeforetheFCIC,HearingontheImpactoftheFinancialCrisisGreater
Bakersfield,session2:LocalBanking,September7,2010,transcriptpp.23,61.
9.WilliamMartin,testimonybeforetheFCIC,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,MortgageProductbyOrigination.
11. Data provided to the FCIC by National Association of Realtors: national home price data from
salesofexistinghomes,comparingsecond-quarter1998($133,800)andsecond-quarter2006($227,100),
thenationalpeakinprices.
12.Core-basedstatisticalareahousepricesforSacramentoArdenArcadeRosevilleCAMetropoli-
tanStatisticalArea,CoreLogicdata.
13. Data provided by CoreLogic, Home Price Index for Urban Areas. FCIC staff calculated house
pricegrowthfromJanuary2001topeakofeachmarket.Pricesincreasedatleast30in401cities,atleast
73in217cities,atleast100in112cities,atleast123in63cities,andmorethan130in16cities.
14.UpdateddataprovidedbyJamesKennedyandAlanGreenspan,whosedataoriginallyappearedin
SourcesandUsesofEquityExtractedfromHomes,FinanceandEconomicsDiscussionSeries,Federal
ReserveBoard,2007-20(March2007).
13.MortgageOriginationsRiseinFirstHalfof2003;DemandforInterestOnly,OptionARMand
Alt-AProductsIncreases,MortgageBankersAssociationpressrelease,October23,2003.
16. In 2007, the weekly wage of New York investment banker was $16,849; of the average privately
employedworker,$841.
17.FederalReserveSurveyofConsumerFinances,tabulatedbyFCIC.
18.AngeloMozilo,interviewbyFCIC,September24,2010.
19. Michael Mayo, testimony before the First Public Hearing of the FCIC, day 1, panel 2: Financial
MarketParticipants,January13,2010,transcript,p.114.
20.MortgageOriginationsRiseinFirstHalfof2003,MBApressrelease,October27,2003.
21.YuliyaDemyanykandYadavK.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),testimonybeforetheFCIC,HearingontheImpactoftheFinancialCrisis
Miami,September21,2010.
23.JuliaGordonandMichaelCalhoun,CenterforResponsibleLending,interviewbyFCIC,Septem-
ber16,2010.
24.FaithSchwartz,atConsumerAdvisoryCouncilmeeting,Thursday,March30,2006.
23.FederalReserveBoard,MeanValueofMortgagesorHome-EquityLoansforFamilieswithHold-
ings,inSCF Chartbook, June13,2009,tablesupdatedtoFebruary18,2010.
26.ChristopherCruise,interviewbyFCIC,August24,2010.
27.Ibid.
28.RobertKuttner,interviewbyFCIC,August3,2010.
29. Timothy Geithner, testimony before the FCIC, Hearing on the Shadow Banking System, day 2,
session2:PerspectiveontheShadowBankingSystem,May6,2010,transcript,p.146.
30.JamesRyan,chiefmarketingofficeratCitiFinancialandJohnSchachtel,executivevicepresident
ofCitiFinancial,interviewbyFCIC,February3,2010.
31.ThesepointsweremadetotheFCICbyconsumeradvocates:e.g.,KevinStein,associatedirector,
CaliforniaReinvestmentCoalition,attheHearingontheImpactoftheFinancialCrisisSacramento,ses-
sion2:MortgageOrigination,MortgageFraudandPredatoryLendingintheSacramentoRegion,Septem-
ber23,2010;GailBurks,presidentandCEO,NevadaFairHousingCenter,attheHearingontheImpactof
theFinancialCrisisStateofNevada,session3:TheImpactoftheFinancialCrisisonNevadaRealEstate,
September 8, 2010. See also Federal Reserve Consumer Advisory Council transcripts, March 23, 2004;
June24,2004;October28,2004;March17,2003;October27,2003;June22,2006;October26,2006.
555 Notes to Chapter 1
32.BobGnaizda,interviewbyFCIC,March23,2010.
33.JamesRokakis,interviewbyFCIC,November8,2010.
34.Ibid.
33. Fed Governor Edward M. Gramlich, Tackling Predatory Lending: Regulation and Education,
remarksatClevelandStateUniversity,Cleveland,Ohio,March23,2001.
36.Rokakis,interview.
37.JohnTaylor,chairmanandchiefexecutiveofficer,NationalCommunityReinvestmentCoalition,
lettertoOfficeofThriftSupervision,July3,2000,providedtotheFCIC.
38.Stein,testimonybeforetheFCIC,transcript,pp.7374,71.
39.U.S.DepartmentoftheTreasuryandU.SDepartmentofHousingandUrbanDevelopment,Joint
ReportonRecommendationstoCurbPredatoryHomeMortgageLending(June1,2000).
40.FederalReserveBoardpressrelease,December12,2001.
41. Sheila C. Bair, written testimony for the FCIF, First Public Hearing of the FCIC, day 2, panel 1:
CurrentInvestigationsintotheFinancialCrisisFederalOfficials,January14,2010,p.11.
42. Fed Governor Edward M. Gramlich, Predatory Lending, remarks at the Housing Bureau for
SeniorsConference,,January18,2002.
43.SheilaC.Bair,testimonybeforetheFCIC,FirstPublicHearingoftheFCIC,day2,panel1:Cur-
rentInvestigationsintotheFinancialCrisisFederalOfficials,January14,2010,transcript,p.97.
44.SheilaC.Bair,interviewbyFCIC,March29,2010.
43. 2009 Mortgage Market Statistical Annual, 1:220, Top B&C Lenders in 2000; 1.223, Top B&C
Lendersin2003.
46.Ibid.,1:237,SubprimeOriginationbyStatein2001;and1:233,SubprimeOriginationsbyState
in2003.
47.Stein,testimonybeforetheFCIC,September23,2010,transcript,p.72.
48.GailBurks,interviewbyFCIC,August30,2010.
49.LisaMadigan,writtentestimonyfortheFCIC,FirstPublicHearingoftheFCIC,day1,panel2:
Current Investigations into the Financial CrisisState and Local Officials, January 14, 2010, p. 43;
HomeMortgageLendersettledPredatoryLendingCharges,FederalTradeCommissionpressrelease,
March21,2002.
30.2009 Mortgage Market Statistical Annual, 1:220,Top23B&CLendersin2003.
31.Madigan,writtentestimonyfortheFCIC,January14,2010,pp.43.
32.EdParker,interviewbyFCIC,May26,2010.
33.PrentissCox,interviewbyFCIC,October13,2010.
34.Ibid.
33.2009 Mortgage Market Statistical Annual, 1:43,47,49,31.
36.AlphonsoJackson,interviewbyFCIC,October6,2010.
37.Cox,interview;Madigan,writtentestimonyfortheFCIC,January14,2010,p.11.
38.Cox,interview.Madigan,testimonybeforetheFCIC,January14,2010,transcript,pp.121122.
39. John D. Hawke Jr. and John C. Dugan, written statements for the FCIC, Hearing on Subprime
Lending and Securitization and Government-Sponsored Enterprises (GSEs), day 2, session 2: Office of
theComptrolleroftheCurrency,April8,2010,pp.43andpp.48,respectively.
60.Madigan,writtentestimonyfortheFCIC,January14,2010,pp.9,10.
61.Cox,interview.
62. 2009 Mortgage Market Statistical Annual, 1:4, Mortgage Originations by Product. Nonprime =
Alt-Aandsubprimecombined.
63.MarcS.Savitt,interviewbyFCIC,November17,2010.
64. Rob Barry, Matthew Haggman, and Jack Dolan, Ex-convicts active in mortgage fraud, Miami
Herald,January29,2009.
63.J.ThomasCardwell,writtentestimonyfortheFCIC,HearingontheImpactoftheFinancialCri-
sisMiami, session 3: The Regulation, Oversight, and Prosecution of Mortgage Fraud in Miami, Sep-
tember21,2010,p.8.
66.Savitt,interview.
67.GaryCrabtree,writtentestimonyfortheFCIC,HearingontheImpactoftheFinancialCrisis
GreaterBakersfield,session4:LocalHousingMarket,September7,2010,p.6.
68.Ibid.
556 Notes to Chapter 1
69. Gary Crabtree, interview by FCIC, August 18, 2010. Crabtree, written testimony for the FCIC,
September7,2010,pp.67.
70.FBIWarnsofMortgageFraudEpidemicfromTerryFrieden,CNNnewsreport,September17,
2004.
71. Kirstin Downey, FBI Vows to Crack Down on Mortgage Fraud; Hot Real Estate Market Drives
ReportsofSuspiciousActivity,AgencySays,Vashington Post, February13,2003.
72. Financial Crimes Enforcement Network, Regulatory Policy and Programs Division, Mortgage
LoanFraud:AnIndustryAssessmentBaseduponSuspiciousActivityReportAnalysis,November2006.
SeealsoFinancialCrimesEnforcementNetwork,AnnualReport:FiscalYear2008.
73.FinCENresponsetoFCICinterrogatories,October1413,2010.
74.WilliamK.Black,writtentestimonyfortheFCIC,HearingontheImpactoftheFinancialCrisis
Miami,session1:OverviewofMortgageFraud,September21,2010,p.8.
73.AlbertoGonzales,interviewbyFCIC,November1,2010;MichaelMukasey,interviewbyFCIC,
October20,2010.
76.FederalReserveConsumerAdvisoryCouncilMeeting,October28,2004,transcript,p.44.
77.Ibid.,p.43.
78.RuhiMaker,interviewbyFCIC,October23,2010.
79.KirstinDowney,ManyBuyersOptforRiskyMortgages,Vashington Post, May28,2003.
80.AftertheFall:Soaringhousepriceshavegivenahugeboosttotheworldeconomy.Whathappens
whentheydrop:The Economist, June16,2003.
81. Fed Chairman Alan Greenspan, The Economic Outlook, prepared testimony before the Joint
EconomicCommittee,109thCong.,1stsess.,June9,2003.
82.Ibid.
83. Fed Chairman Ben S. Bernanke, The Economic Outlook, prepared testimony before the Joint
EconomicCommittee,U.S.Congress,110thCong.,1stsess.,March28,2007.
84.SheilaCanavan,commentsduringoftheFederalReserveConsumerAdvisoryCouncilMeeting,
October27,2003,transcript,p.32.
83.DavidLeonhardt,BeWarned:Mr.BubblesWorriedAgain,^ew York Times, August21,2003.
86.RaghuramRajan,interviewbyFCIC,November22,2010.
87.Ibid.
88.Ibid.
89.RaghuramG.Rajan,Fault Lines. How Hidden Fractures Still Threaten The Vorld Economy (Prince-
ton:PrincetonUniversityPress,2010),p.3.
90.SusanM.Wachter,interviewbyFCIC,October6,2010.
91.MarkKlipsch,quotedinBlizzardCantStopASF2003Conference,Asset Securitization Report,
January31,2003.
92.DennisJ.Black,writtentestimonyfortheFCIC,HearingontheImpactoftheFinancialCrisis
Miami,session2:UncoveringMortgageFraudinMiami,September21,2010,p.1;fortheappraiserspe-
tition,seehttp://appraiserspetition.com/.
93. Karen Mann, written testimony for the FCIC, Hearing on the Impact of the Financial Crisis
Sacramento,session2:MortgageOrigination,MortgageFraudandPredatoryLendingintheSacramento
Region,September23,2010.
94.2009 Mortgage Market Statistical Annual, vol.2,The Secondary Market,p.13,Non-AgencyMBS
IssuancebyType,andFCICstaffestimatesbasedonanalysisofMoodysSFDRSdata.
93.JamieDimon,testimonybeforetheFCIC,FirstPublicHearingoftheFCIC,day1,panel1:Finan-
cialInstitutionRepresentatives,January13,2010,transcript,p.78.
96.MadelynAntoncic,interviewbyFCIC,July14,2010.
97. Anton R. Valukas, Report of Examiner, In re Lehman Brothers Holdings Inc., et al., Chapter 11
CaseNo.08-13333(JMP),(Bankr.S.D.N.Y.),March11,2010,1:114,withn.418.
98.RichardBowen,interviewbyFCIC,February27,2010.
99. Richard Bowen, email to Robert Rubin, David Bushnell, Gary Crittenden, and Bonnie Howard,
November3,2007.
557 Notes to Chapter 1
100.RobertRubin,testimonybeforetheFCIC,HearingonSubprimeLendingandSecuritizationand
Government-SponsoredEntities(GSEs),day2,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.J.KyleBass,testimonybeforetheFCIC,FirstPublicHearingoftheFCIC,day1,panel2:Finan-
cialMarketParticipants,January13,2010,transcript,pp.14344.
104.HerbertM.Sandler,CommentonJointANPRforProposedRevisiontotheExistingRisk-based
CapitalRule,lettertoFederalReserveBoard,OfficeoftheComptrolleroftheCurrency,FederalDeposit
InsuranceCorporation,andOfficeofThriftSupervision,January18,2006.
103.LewisRanieri,interviewbyFDIC,July30,2010.
106.AngeloMozilo,emailtoEricSieracki,April13,2006,re:1Q2006Earnings.
107.AngeloMozilo,emailtoDavidSambol,April17,2006,subject:sub-primeseconds.
108. David Sambol, email to Angelo Mozilo, April 17, 2006, re: Sub-prime seconds (cc Kurland,
McMurray,andBartlett).
109.AngeloMozilo,emailtoDavidSambol,April17,2006,subject:re:Sub-primeseconds(ccKur-
land,McMurray,andBartlett).
110.SabethSiddique,interviewbyFCIC,September9,2010.
111.SurveyofNontraditionalMortgages(actualtitleredacted),confidentialFederalReservedocu-
mentobtainedbyFCIC,producedNovember1,2003,pp.2,3.
112.SusanBies,interviewbyFDIC,October11,2010.
113.JohnDugan,testimonybeforetheFCIC,HearingonSubprimeLendingandSecuritizationand
Government-SponsoredEnterprises(GSEs),day2,session2:OfficeoftheComptrolleroftheCurrency,
April8,2010,transcript,
114.SabethSiddique,interviewsbyFCIC,September9,2010,andOctober23,2010.
113.Bies,interview.
116.MortgageInsuranceCompaniesofAmerica,quotedinKirstinDowney,InsurersWantAction
onRiskyMortgages;FirmsWantMoreLoanRestrictions,Vashington Post,August19,2006.
117.WilliamA.Sampson,MortgageInsuranceCompaniesofAmerica,MICATestimonyonNon-
Traditional Mortgages, before the Senate Subcommittee on Housing and Transportation and the Sub-
committeeonEconomicPolicy,109thCong.,2ndsess.,September20,2006.
118.Siddique,interviews,October23,2010,andSeptember9,2010.
119.ConsumerAdvisoryCouncilMeeting,March30,2006,transcript.
120.ConsumerAdvisoryCouncilMeeting,June22,2006,transcript.
121.Siddique,interview,October23,2010;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 by Moodys along with unrated agency RMBS,
alongwithanestimateforstructuredfinanceassetsnotratedbyMoodys,usingassourcesFannieMae
and Freddie Mac, Bloomberg, American CoreLogic Loan Performance, Fitch Ratings, Moodys, S&P,
ThomsonReuters,andSIFMA.
123.AlanGreenspan,testimonybeforetheFCIC,HearingonSubprimeLendingandSecuritization
and Government-Sponsored Enterprises (GSEs), day 1, session 1: The Federal Reserve, April 7, 2010,
transcript,p.29.
124.MortgageBankersAssociation,NationalDelinquencySurvey.
123. CoreLogic, Inc., August 26, 2010, news release, second quarter, 2010. Second-quarter figures
wereanimprovementfrom11.2millionresidentialproperties(24)innegativeequityinthefirstquar-
terof2010.
126. Mark Zandi, written testimony for the FCIC, First Public Hearing of the FCIC, day 1, panel 3:
FinancialCrisisImpactsontheEconomy,January13,2010,pp.14,13.
127.DeanBaker,interviewbyFCIC,August18,2010.
128. Warren Peterson, testimony before the FCIC, Hearing on the Impact of the Financial Crisis
Greater Bakersfield, session 3: Residential and Community Real Estate, September 7, 2010, transcript,
pp.1067,11920,1078;WarrenPeterson,interviewbyFCIC,August24,2010.
558 Notes to Chapter 2
Chapter 2
1. Ben Bernanke, written testimony before the FCIC, Hearing on Too Big to Fail: Expectations and
ImpactofExtraordinaryGovernmentInterventionandtheRoleofSystemicRiskintheFinancialCrisis,
day1,session1,September2,2010,p.2.
2.AlanGreenspan,TheEvolutionofBankinginaMarketEconomy,remarksattheAnnualConfer-
enceoftheAssociationofPrivateEnterpriseEducation,Arlington,Virginia,April12,1997.
3. Charles Calomiris and Gary Gorton, The Origins of Banking Panics: Models, Facts, and Bank
Regulation,inCalomiris,U.S. Bank Deregulation in Historical Perspective (Cambridge:CambridgeUni-
versityPress,2000),pp.98100.PriortotheendoftheCivilWar,banksissuednotesinsteadofholding
deposits.Runsonthatsystemoccurredin1814,1819,1837,1839,1837,and1861(ibid.,pp.9899).
4.R.AltonGilbert,RequiemforRegulationQ:WhatItDidandWhyItPassedAway,Federal Re-
serve Bank of St. Louis Review 68,no.2(February1986):23.
3.FCIC,PreliminaryStaffReport:ShadowBankingandtheFinancialCrisis,May4,2010,pp.18
23.
6. Arthur E. Wilmarth Jr., The Transformation of the U.S. Financial Services Industry, 19732000:
Competition,Consolidation,andIncreasedRisks,University of Illinois Law Review (2002):23940.
7.FredericS.Mishkin,AsymmetricInformationandFinancialCrises:AHistoricalPerspective,in
Financial Markets and Financial Crises, ed. R. Glenn Hubbard (Chicago: University of Chicago Press,
1991),p.99;Wilmarth,TheTransformationoftheU.S.FinancialServicesIndustry,19732000,p.236.
8.FederalReserveBoardFlowofFundsRelease,tableL.208.AccessedDecember29,2010.
9.KennethGarbade,TheEvolutionofRepoContractingConventionsinthe1980s,Federal Reserve
Bank of ^ew York Economic Policy Review 12, no. 1 (May 2006): 3233, 3839 (available at
http://papers.ssrn.com/sol3/papers.cfm:abstract_id=918498). To implement monetary policy, the Fed-
eralReserveBankofNewYorkusestherepomarket:itsetsinterestratesbyborrowingTreasuriesfrom
andlendingthemtosecuritiesfirms,manyofwhichareunitsofcommercialbanks.
10.AlanBlinder,interviewbyFCIC,September17,2010.
11.PaulVolcker,interviewbyFCIC,October11,2010.
12.FedChairmanAlanGreenspan,InternationalFinancialRiskManagement,remarksbeforethe
CouncilonForeignRelations,November19,2002.
13.RichardC.Breeden,interviewbyFCIC,October14,2010.
14. Wilmarth, The Transformation of the U.S. Financial Services Industry, 19732000, p. 241 and
n.102.
13.Thereafter,bankswereonlyrequiredtolendoncollateralandsettermsbaseduponwhatthemar-
ketwasoffering.Theyalsocouldnotlendmorethan10oftheircapitaltoonesubsidiaryormorethan
20toallsubsidiaries.OrderApprovingApplicationstoEngageinLimitedUnderwritingandDealingin
CertainSecurities,Federal Reserve Bulletin 73,no.6(Jul.1987):473308;RevenueLimitonBank-Inel-
igibleActivitiesofSubsidiariesofBankHoldingCompaniesEngagedinUnderwritingandDealinginSe-
curities,Federal Register 61,no.231(Dec.30,1996),6873036.
16.JulieL.WilliamsandMarkP.Jacobsen,TheBusinessofBanking:LookingtotheFuture,Busi-
ness Lawyer 30(May1993):798.
17.FedChairmanAlanGreenspan,preparedtestimonybeforetheHouseCommitteeonBankingand
FinancialServices,H.R. 10, the Financial Services Competitiveness Act of 1997, 103thCong.,1stsess.,May
22,1997.
18.FCICstaffcalculations.
19.FCICstaffcalculations.
20.FCICstaffcalculationsusingFirstAmerican/CoreLogic,NationalHPISingle-FamilyCombined
(SFC).
21.Thisdataseriesisrelativelynew.Thoseseriesavailablebefore2009showednoyear-over-yearna-
tionalhousepricedecline.FirstAmerican/CoreLogic,NationalHPISingle-FamilyCombined(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. Specifically, between 1980 and 1994, 1,617 federally insured banks with $302.6 billion in assets
and 1,293 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.4,3.
24.WilliamK.Black,AssociateProfessorofEconomicsandLaw,UniversityofMissouriKansasCity,
written testimony for the FCIC, Hearing on the Impact of the Financial Crisis, session 1: Overview of
MortgageFraud,September21,2010,p.4.AndseeKittyCalavita,HenryN.Pontell,andRobertH.Till-
man,Big Money Crime. Fraud and Politics in the Savings and Loan Crisis (Berkeley:UniversityofCalifor-
niaPress,1997),p.28.
23.FDIC,History of the Eighties. Lessons for the Future, 1:39.
26.U.S.TreasuryDepartment,ModernizingtheFinancialSystem:RecommendationsforSafer,More
CompetitiveBanks(February1991),p.33.
27.TestimonyofJohnLaWare,Governor,FederalReserveBoard,atHearingsbeforeSubcommittee
onEconomicStabilizationoftheCommitteeonBanking,Finance,andUrbanAffairsontheEconomic
Implications of the Too Big to Fail Policy, May 9, 1991, p. 11, http://fraser.stlouisfed.org/
publications/tbtf/issue/3934/download/61094/housetbtf1991.pdf.
FDIC,History of the Eighties. Lessons for the Future,1:231.
28.GeorgeG.Kaufman,TooBigtoFailinU.S.Banking:QuoVadis:inToo Big to Fail. Policies and
Practices in Government Bailouts, ed.BentonE.Gup(Westport,CT:Praeger,2004),p.163.
29.FCIC,PreliminaryStaffReport:Too-Big-to-FailFinancialInstitutions,August31,2010,pp.6
9.(Rep.McKinneyisquotedfromthetranscriptofthehearingbeforetheHouseCommitteeonBanking,
Housing,andUrbanAffairs).
30.Ibid.,pp.10,19.
Chapter 3
1. Federal National Mortgage Association, Federal ^ational Mortgage Association, Background and
History (1973).
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 journal, June 19, 1992, and Stephen Labaton, Power of the Mortgage
Twins:FannieandFreddieGuardAutonomy,^ew York Times,November12,1991.
4.ArmandoFalconJr.,writtentestimonyfortheFCIC,HearingonSubprimeLendingandSecuritiza-
tionandGovernment-SponsoredEnterprises(GSEs),day3,session2:OfficeofFederalHousingEnter-
priseOversight,April9,2010,p.2.
3.WaynePassmore,TheGSEImplicitSubsidyandtheValueofGovernmentAmbiguity,FederalRe-
serveBoardStaffWorkingPaper200303.SeealsoCongressionalBudgetOffice,UpdatedEstimatesof
theSubsidiestotheHousingGSEs,April8,2004.
6.FederalHousingFinanceAgency,Report to Congress, 2009 (2010),pp.141,138.
7.FannieMaeCharterActof1968,309(h),codifiedat12U.S.C.1723a(h).The1992FederalHous-
ing Enterprises Financial Safety and Soundness Act repealed this provision and replaced it with more
elaborateprovisions.Currently,theGSEstypicallydefinelow-andmoderate-incomeborrowersasthose
withincomeatorbelowmedianincomeforagivenarea.
8.DepartmentofHousingandUrbanDevelopment,RegulationsImplementingtheAuthorityofthe
Secretary of the Department of Housing and Urban Development over the conduct of the Secondary
marketOperationsoftheFederalNationalMortgageAssociation(FNMA),Federal Register 43,no.138
(August13,1978):36199226.
9.PresidentWilliamJ.Clinton,RemarksontheNationalHomeownershipStrategy,June3,1993.
10.PresidentGeorgeW.Bush,PresidentsRemarkstotheNationalAssociationofHomeBuilders,
GreaterColumbusConventionCenter,Columbus,Ohio,October2,2004.
11.AndrewCuomo,interviewbyFCIC,December17,2010.
12.DanielMudd,testimonybeforetheFCIC,HearingonSubprimeLendingandSecuritizationand
Government-SponsoredEnterprises(GSEs),day3,session1:FannieMae,April9,2010,transcript,pp.
1819.
560 Notes to Chapter 3
13.RichardSyron,interviewbyFCIC,August31,2010.
14. Senate Lobbying Disclosure Act Database (www.senate.gov/legislative/Public_Disclosure/
LDA_reports.htm);figuresonemployeesandPACscompiledbytheCenterforResponsivePoliticsfrom
FederalElectionsCommissiondata.
13.Falcon,writtentestimonyfortheFCIC,April9,2010,p.3.
16. James Lockhart, written testimony for the FCIC, Hearing on Subprime Lending and Securitiza-
tionandGovernment-SponsoredEnterprises(GSEs),day3,session2:OfficeofFederalHousingEnter-
priseOversight,pp.48,17(quotation).
17.SenatorMelMartinez,interviewbyFCIC,September28,2010.
18. June E. ONeill, remarks before the Conference on Appraising Fannie Mae and Freddie Mac,
Washington,D.C.,May14,1998,p.8.
19.FederalHousingFinanceAgency,Report to Congress, 2008 (2009),tables3,4,12,and13.
20.LawrenceLindsey,interviewbyFCIC,September20,2010.
21.JimCallahan,interviewbyFCIC,October18,2010.
22.SecuritiesIndustryandFinancialMarketsAssociation(SIFMA),USABSOutstanding.
23.ScottPatterson,interviewbyFCIC,August12,2010.
24.GillianTett,Fools Gold. How the Bold Dream of a Small Tribe at j. P. Morgan Vas Corrupted by
Vall Street Greed and Unleashed a Catastrophe (NewYork:FreePress,2009),pp.3233,49,70,113.
23.EmmanuelDerman,interviewbyFCIC,May12,2010.
26.Volcker,interview.
27.VincentReinhart,interviewbyFCIC,September10,2010.
28.Lindsey,interview.
29.Afuturescontractisabilateralcontractinwhichoneparty,thelongposition,iscompensatedif
thepriceorindexorrateunderlyingthecontractriseswhiletheotherparty,theshortposition,iscom-
pensatedifitgoesdown.Anoptionscontractgrantstherightbutnottheobligationtopurchaseorsella
commodityorfinancialinstrumentataparticularpriceinthefuture;theoptionholderderivesabenefit
ifthepricemovesinhisorherfavor.Inaswapscontract,thetwopartiesexchangestreamsofpayments
basedondifferentbenchmarks.
30.SecuritiesoptionsareregulatedbytheSEC.
31.CommodityFuturesTradingCommission,ExemptionforCertainSwapAgreements,FinalRule,
Federal Registrar 38(January22,1993):3387.
32.BrooksleyBorn,chairperson,CommodityFuturesTradingCommission,ConcerningtheOver-
the-CounterDerivativesMarket,preparedtestimonybeforetheHouseCommitteeonBankingandFi-
nancialServices,103thCong.,2ndsess.,July24,1998.
33.GAO,FinancialDerivatives:ActionsNeededtoProtecttheFinancialSystem,GGD-94-133(Re-
porttoCongressionalRequesters),May18,1994.
34. Commodity Futures Trading Commission, Division of Enforcement (www.cftc.gov/anr/an-
renf98.htm).
33. Joint Statement by Treasury Secretary Robert E. Rubin, Federal Reserve Board Chairman Alan
Greenspan, and Securities and Exchange Commission Chairman Arthur Levitt, Treasury Department
pressrelease,May7,1998.
36.FedChairmanAlanGreenspan,TheRegulationofOTCDerivatives,preparedtestimonybefore
theHouseCommitteeonBankingandFinancialServices,103thCong.,2ndsess.,July24,1998.
37.GAO,Long-TermCapitalManagement:RegulatorsNeedtoFocusGreaterAttentiononSystemic
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 underlying instrument, commodity,
index,orratethattheswapisbasedon.Itthereforemaybeoflimiteduseinmeasuringthepotentialex-
posureofthepartiestothecontracts.Forexample,aninterestrateswapbasedonchangesininterestrate
ona$100millionloanwouldlikelyinvolveonlyasmallpercentageofthe$100millionnotionalamount.
Ontheotherhand,pricechangesonanoilswapbasedon$100millionworthofoilcouldbeevenmore
thanthenotionalamount,dependingonthevolatilityinoilprices.Forcreditdefaultswaps,whichare
discussedinmoredetaillaterinthisvolume,thenotionalamountisusuallyaclosemeasureofthepoten-
tialfinancialexposureoftheissuerorselleroftheswap.
561 Notes to Chapter 4
38.FedChairmanAlanGreenspan,Private-sectorRefinancingoftheLargeHedgeFund,Long-Term
CapitalManagement,preparedtestimonybeforetheHouseCommitteeonBankingandFinancialServ-
ices,103thCong.,2ndsess.,October1,1998.
39.FedChairmanAlanGreenspan,FinancialDerivatives,remarksbeforetheFuturesIndustryAs-
sociation,BocaRaton,Florida,March19,1999.
40.Over-the-CounterDerivativesMarketsandtheCommodityExchangeAct,reportofthePresi-
dentsWorkingGrouponFinancialMarkets,November1999.
41.Grossmarketvalueisthecurrentpriceatwhichtheoutstandingswapscontractcanbesoldorre-
placedonthemarket.Assuch,thatamountreflectsthecurrentamountowingonacontractbutdoesnot
reflectthepossiblefutureexposureonthesegenerallylong-terminstruments.
42.BankforInternationalSettlements,dataonsemiannualOTCderivativesstatistics.
43. Alan Greenspan, testimony before the FCIC, Hearing on Subprime Lending and Securitization
andGovernment-SponsoredEntities(GSEs),day1,session1:TheFederalReserve,April1,2010,tran-
script,pp.8889.
44.RobertRubin,testimonybeforetheFCIC,FCICHearingonSubprimeLendingandSecuritization
and Government-Sponsored Entities (GSEs), day 2, session 1: Citigroup Senior Management, April 8,
2010,transcript,pp.10810,12324.
43.LawrenceSummers,interviewbyFCIC,May28,2010.
46.DanielK.Tarullo,Banking on Basel. The Future of International Financial Regulation (Washington,
DC:PetersonInstituteforInternationalEconomics,2008),p.38.
47.FinalRuleAmendmenttoRegulationsHandY,Federal Reserve Bulletin 73,no.3(March1989),
16466.
48.Tarullo,Banking on Basel,pp.6164.
49.Formoreonderivatives,seeFCIC,PreliminaryStaffReport:OverviewonDerivatives,June29,
2010.
30.WarrenBuffett,testimonybeforetheFCIC,HearingontheCredibilityofCreditRatings,theIn-
vestmentDecisionsMadeBasedonThoseRatings,andtheFinancialCrisis,session2:CreditRatingsand
theFinancialCrisis,June2,2010,transcript,pp.312,326,323.
31.EricR.Dinallo,formersuperintendant,NewYorkStateInsuranceDepartment,writtentestimony
fortheFCIC,HearingontheRoleofDerivativesintheFinancialCrisis,session2,Derivatives:Supervi-
sorsandRegulators,July1,2010,p.7;RochelleKatz,StateofNewYorkInsuranceDepartment,letterto
BertilLundqvist,Skadden,Arps,Slate,Meagher&Flom,LLP,June16,2000.
32.DataprovidedbyAIGtotheFCIC,CDSnotionalbalancesatyear-end.
33.BankforInternationalSettlements,semiannualOTCderivativesstatistics.
34.DinallotestifiedthatthemarketinCDSinSeptember2008wasestimatedtobe$62trillionata
time when there was about $16 trillion of private-sector debt (written testimony for the FDIC, July 1,
2010,p.9).
33.AIGFPalsoparticipatesasadealerinawidevarietyoffinancialderivativestransactions(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 currency
swaps,and$0.2trillionofotherderivatives(p.163).
36.FCICstaffcalculationsusingdatafromOfficeoftheComptrolleroftheCurrency;callreports.
37.DataprovidedtotheFCICbyGoldmanSachs.
Chapter 4
1.103PublicLaw103-328,September29,1994.Beforethe1994legislation,somestateshadvoluntar-
ilyopenedthemselvesuptoout-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,PreliminaryStaffReport:Too-Big-to-FailFi-
nancialInstitutions,August31,2010,p.14.
3.DatafromSNLFinancial(www.snl.com/).
4.PublicLaw104-208,sec.2222,codifiedas12U.S.C.3311;lawineffectasofJanuary3,2007.
3.ArthurLevitt,interviewbyFCIC,October1,2010.
562 Notes to Chapter 4
6. John D. Hawke and John Dugan, testimony before the FCIC, Hearing on Subprime Lending and
SecuritizationandGovernment-SponsoredEnterprises(GSEs),day2,session2:OfficeoftheComptrol-
leroftheCurrency,April8,2010,transcript,pp.169,173.
7.FedViceChairmanRogerW.FergusonJr.,TheFutureofFinancialServicesRevisited,remarks
attheFutureofFinancialServicesConference,UniversityofMassachusetts,Boston,October8,2003.
8.FedChairmanAlanGreenspan,GovernmentRegulationandDerivativeContracts,speechatthe
Financial Markets Conference of the Federal Reserve Bank of Atlanta, Coral Gables, Florida, February
21,1997.
9.RichardSpillenkothen,Notesontheperformanceofprudentialsupervisionintheyearspreceding
the financial crisis by a former director of banking supervision and regulation at the Federal Reserve
Board(1991to2006),May31,2010,p.28.
10.SeeU.S.DepartmentoftheTreasury,Modernizing the Financial System(February1991),pp.XIX-
3,XIX-6,6769:theexistenceoffeweragencieswouldconcentrateregulatorypowerintheremaining
ones,raisingthedangerofarbitraryorinflexiblebehavior. . . .Agencypluralism,ontheotherhand,may
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, May
1,1994,p.382.
12.SecuritiesIndustryAssociationv.BoardofGovernorsoftheFederalReserveSystem,627F.Supp.
693(D.D.C.1986);KathleenDay,ReinventingtheBank;WithDepression-EraLawabouttoBeRewrit-
ten,theFutureRemainsUnclear,Vashington Post, October31,1999.
13.EdwardYingling,quotedinTheMakingofaLaw,ABA Banking journal,December1999.
14.Thetwo-yearexemptioniscontainedinsection4(a)(2)oftheBankHoldingCompanyAct.The
Fedcouldhavegranteduptothreeone-yearextensionsofthatexemption.
13.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.DepartmentoftheTreasury,Modernizing the Financial System (February1991);FedChair-
man Alan Greenspan, H.R. 10, the Financial Services Competitiveness Act of 1997, testimony before
theHouseCommitteeonBankingandFinancialServices,103thCong.,1stsess.,May22,1997.
17.KatrinaBrooker,CitisCreator,AlonewithHisRegrets,^ew York Times, January2,2010.
18.JohnReed,interviewbyFCIC,March24,2010.
19.FDICInstitutionDirectory;SNLFinancial.
20.FedGovernorLaurenceH.Meyer,TheImplicationsofFinancialModernizationLegislationfor
Bank Supervision, remarks at the Symposium on Financial Modernization Legislation, sponsored by
WomeninHousingandFinance,Washington,D.C.,December13,1999.
21.BenS.Bernanke,writtentestimonybeforetheFCIC,HearingonTooBigtoFail:Expectationsand
ImpactofExtraordinaryGovernmentInterventionandtheRoleofSystemicRiskintheFinancialCrisis,
day1,session1:TheFederalReserve,September2,2010,p.14.
22.PatriciaA.McCoyetal.,SystemicRiskthroughSecuritization:TheResultofDeregulationand
RegulatoryFailure,Connecticut Law Review 41(2009):134347,133333.
23.FedChairmanAlanGreenspan,LessonsfromtheGlobalCrises,remarksbeforetheWorldBank
Group and the International Monetary Fund, Program of Seminars, Washington, DC, September 27,
1999.
24.DavidA.Marshall,TheCrisisof1998andtheRoleoftheCentralBank,FederalReserveBankof
Chicago, Economic Perspectives (1Q2001):2.
23.Commercialandindustrialloansatallcommercialbanks,monthly,seasonallyadjusted,fromthe
FederalReserveBoardofGovernorsH.8release;FCICstaffcalculationofaveragechangeinloansout-
standingoveranytwoconsecutivemonthsin1997and1998.
26.FranklinR.Edwards,HedgeFundsandtheCollapseofLong-TermCapitalManagement,jour-
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.197203;RogerLowenstein,Vhen Genius Failed. The Rise and Fall of Long-Term Capital
Management (NewYork:RandomHouse,2000),pp.3634,7784,94103,12330.
30.HedgeFunds,Leverage,andtheLessonsofLong-TermCapitalManagement,pp.1112.
31.WilliamJ.McDonough,presidentoftheFederalReserveBankofNewYork,statementbeforethe
HouseCommitteeonBankingandFinancialServices,103thCong.,2ndsess.,October1,1998.
32.GAO,Long-TermCapitalManagement:RegulatorsNeedtoFocusGreaterAttentiononSystemic
Risk,GAO/GGD-00-3(ReporttoCongressionalRequesters),October1999,p.39.
33.HedgeFunds,Leverage,andtheLessonsofLong-TermCapitalManagement, pp.1314.
34.Lowenstein,Vhen Genius Failed, pp.20318.
33.McDonough,statementbeforetheHouseCommitteeonBankingandFinancialServices,October
1,1998.
36.AndrewF.Brimmer,DistinguishedLectureonEconomicsinGovernment:CentralBankingand
SystemicRisksinCapitalMarkets,journal of Economic Perspectives,no.2(Spring1989)(lecturebyafor-
merFedgovernor,analyzingtheFedsmarketinterventionsin1970,1980and1987,andconcludingthat
theFedhadconsciouslyassumedastrategicroleastheultimatesourceofliquidityintheeconomyat
large);KeithGarbade,TheEvolutionofRepoContractingConventionsinthe1980s,FederalReserve
BankofNewYorkEconomic Policy Review (May2006):33.
37.HarveyMiller,interviewbyFCIC,August3,2010.
38.StanleyONeal,interviewbyFCIC,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. June23,2006).
44.Time, February13,1999;BobWoodward,Maestro. Greenspans Fed and the American Boom (New
York:Simon&Schuster,2000).
43.SIFMA(SecuritiesIndustryandFinancialMarketsAssociation),Fact Book 2008, pp.910.
46.BoardofGovernorsoftheFederalReserveSystem,Federal Reserve Statistical Release Z.1. Flow of
Funds Accounts of the United States, 4thQtr.1996,p.88(TableL.213,line18);4thQtr.2001,p.90(Table
L.213,line20).
47.SECChairmanWilliamH.Donaldson,TestimonyConcerningGlobalResearchAnalystSettle-
ment,beforetheSenateCommitteeonBanking,HousingandUrbanAffairs,108thCong.,1stsess.,May
7,2003.
48.SEC,SECFactSheetonGlobalAnalystResearchSettlements,April30,2003;FinancialIndustry
Regulatory Authority news release, NASD Fines Piper Jaffray $2.4 Million for IPO Spinning, July 12,
2004.
49. Arthur E. Wilmarth Jr., Conflicts of Interest and Corporate Governance Failures at Universal
BanksDuringtheStockMarketBoomofthe1990s:TheCasesofEnronandWorldCom,GeorgeWash-
ingtonUniversityPublicLawandLegalTheoryWorkingPaper234(2007).
30.FedChairmanAlanGreenspan,InternationalFinancialRiskManagement,remarksbeforethe
CouncilonForeignRelations,Washington,DC, November19,2002.
31.Ferguson,TheFutureofFinancialServicesRevisited.
32.Spillenkothen,Notesontheperformanceofprudentialsupervisionintheyearsprecedingthefi-
nancialcrisis,p.28.
33.FirstthePut;ThentheCut:Economist, December16,2000,p.81.
564 Notes to Chapter 4
34.FedChairmanAlanGreenspan,RiskandUncertaintyinMonetaryPolicy,remarksattheMeet-
ingsoftheAmericanEconomicAssociation,SanDiego,California,January3,2004.SeealsoFedGover-
norBenS.Bernanke,Asset-PriceBubblesandMonetaryPolicy,remarksbeforetheN.Y.Chapterofthe
NationalAssociationofBusinessEconomics,NewYork,October13,2002.
33.FedChairmanAlanGreenspan,ReflectionsonCentralBanking,remarksatasymposiumspon-
soredbytheFederalReserveBoardofKansasCity,JacksonHole,Wyoming,August26,2003.
36.LawrenceLindsey,interviewbyFCIC,September20,2010.
37. The NYSE decided in 1970 to allow members to be publicly traded. See Andrew von Norden -
flycht, The Demise of the Professional Partnership: The Emergence and Diffusion of Publicly-Traded
ProfessionalServiceFirms(draftpaper,FacultyofBusiness,SimonFraserUniversity,September2006),
pp.2021.
38.PeterSolomon,writtentestimonyfortheFCIC,FirstPublicHearingofFCIC,day1,panel2:Fi-
nancialMarketParticipants,January13,2010,p.2.
39.BrianR.Leach,interviewbyFCIC,March4,2010,p.22.
60.JianCai,KentCherny,andToddMilbourn,CompensationandRiskIncentivesinBankingand
Finance,FederalReserveBankofClevelandEconomic Commentary (September14,2010).
61.CarolaFrydmanandRavenE.Saks,HistoricalTrendsinExecutiveCompensation,19362003
(2007),p.3.
62.Cai,Cherny,andMilbourn,CompensationandRiskIncentivesinBankingandFinance.
63.GoldmanSachs,2006and200910-K;MorganStanley,200810-K;MerrillLynch,2003and2008
10-K.
64.GutfreundsPayIsCut,^ew York Times, December23,1987.
63.MerrillLynch,2007ProxyStatement,p.38.
66.GoldmanSachs,ProxyStatementfor2008AnnualMeetingofShareholders,March7,2008,p.
16:Blankfeinreceived$600,000basesalaryanda2007year-endbonusof$67.9million.
67. Lehman Brothers, Proxy Statement for Year-end 2007, p. 28; JP Morgan Chase, 2007 Proxy
Statement,p.16.
68.NewYorkStateOfficeoftheStateComptroller,NewYorkCitySecuritiesIndustryBonusPool,
February23,2010.Thebonuspoolisforsecuritiesindustry(NAICS323)employeeswhoworkinNew
YorkCity.
69.BanksSetforRecordPay,TopFirmsonPacetoAward$143Billionfor2009,Up18,WSJStudy
Finds,WSJ.com,January14,2010.
70.SandyWeill,interviewbyFCIC,October4,2010.
71.LordAdairTurner,interviewbyFCIC,November30,2010.
72.BenS.Bernanke,testimonybeforetheFCIC,HearingonTooBigtoFail:ExpectationsandImpact
ofExtraordinaryGovernmentInterventionandtheRoleofSystemicRiskintheFinancialCrisis,day2,
session1:TheFederalReserve,September2,2010,transcript,p.111.
73. Testimony of Armando Falcon Jr., former director Office of Federal Housing Enterprise Over-
sight, written testimony for the FCIC, Hearing on Subprime Lending and Securitization and Govern-
ment-Sponsored Enterprises (GSEs), day 3, session 2: Office of Federal Housing Enterprise Oversight,
April9,2010,pp.810.
74.SheilaC.Bair,writtentestimonyfortheFCIC,FirstPublicHearingoftheFCIC,day2,panel1:
CurrentInvestigationsintotheFinancialCrisisFederalOfficials,January14,2010,p.22.
73.MaryL.Schapiro,writtentestimonyfortheFCIC,FirstPublicHearingoftheFCIC,day2,panel
1:CurrentInvestigationsintotheFinancialCrisisFederalOfficials,January14,2010,p.18.
76.BloombergLLC,FinancialAnalysisFunction,PublicFilingsforJPM,Citigroup,BankofAmerica,
GoldmanSachs,andLehmanBrothers.
77.FannieMae,SECfilings10-Kand10-Q;seethe200910-K,p.70,TotalAssetsandFannieMaeMBS
heldbyThirdParties;FederalHousingFinanceAgency,Report to Congress, 2008 (2009),pp.111,128.
78.FCICstaffcalculations.
79.SNLFinancialDatabaseandSECpublicfilings.
80.Calculatedfromproxystatements.
81.JohnSnow,interviewbyFCIC,October7,2010.
82.Ibid.
565 Notes to Chapter 5
Chapter 3
1.GailBurks,writtentestimonyfortheFCIC,HearingontheImpactoftheFinancialCrisisStateof
Nevada,session3:TheImpactoftheFinancialCrisisonNevadaRealEstate,September8,2010,p.3.
2.TomC.Putnam,president,PutnamHousingFinanceConsulting,writtentestimonyfortheFCIC,
HearingontheImpactoftheFinancialCrisisSacramento,session2:MortgageOrigination,Mortgage
FraudandPredatoryLendingintheSacramentoRegion,September23,2010,pp.34.
3.BoardofGovernorsoftheFederalReserveSystem, 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.JimCallahan,interviewbyFCIC,October18,2010.
3.LewisRanieri,formervicechairmanofSalomonBrothers,interviewbyFCIC,July30,2010.
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
analysis of loan-level data from Blackbox Inc. and Standard & Poors; Moodys PDS database; Moodys
CDOEMSdatabase;andCitigroup,FannieMaeTermSheet,CMLTI2006-NC2,September7,2006,pp.
1,3.SeealsoBradS.Karp,counselforCitigroup,lettertoFCIC,November4,2010,p.1,pp.23.Allrat-
ingsofitstranchesareasgivenbyStandard&Poors.
10.Technically,thisdealhadtwounratedtranchesbelowtheequitytranche,alsoheldbyCitigroup
andthehedgefund.
11. Fed Chairman Ben S. Bernanke, The Community Reinvestment Act: Its Evolution and New
Challenges,speechattheCommunityAffairsResearchConference,Washington,D.C.,March30,2007.
12.Ibid.
13.SeeGlennCannerandWaynePassmore,TheCommunityReinvestmentActandtheProfitability
ofMortgage-OrientedBanks,WorkingPaper,FederalReserveBoard,March3,1997.UndertheCom-
munityReinvestmentAct,low-andmoderate-incomeborrowershaveincomethatisatmost80ofarea
medianincome.
14. Fed Chairman Alan Greenspan, Economic Development in Low- and Moderate-Income Com-
munities,speechatCommunityForumonCommunityReinvestmentandAccesstoCredit:Californias
Challenge,inLosAngeles,January12,1998.
13.JohnDugan,interviewbyFCIC,March12,2010.
16.LawrenceB.Lindsey,interviewbyFCIC,September20,2010.
17. Souphala Chomsisengphet and Anthony Pennington-Cross, The Evolution of the Subprime
MortgageMarket,Federal Reserve Bank of St. Louis Review 88,no.1(January/February2006):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,Top23B&CLendersin1996;
Thomas E. Foley, Alternative Financial Ratios for the Effects of Securitization: Tools for Analysis,
MoodysInvestorServices,September19,1997,p.3;andMoodysInvestorService,SubprimeHomeEq-
uityIndustryOutlookThePartysOver,MoodysGlobalCreditResearch,October1998.
20. FDIC Announces Receivership of First National Bank of Keystone, Keystone, West Virginia,
FederalDepositInsuranceCorporationandOfficeoftheComptrolleroftheCurrencyjointpressrelease,
September1,1999.
21.FCICstaffcalculationsusingdatafromInside MBS o ABS.
22.SeeMarcSavitt,interviewbyFCIC,November17,2010.
23.HenryCisneros,interviewbyFCIC,October13,2010.
24.GlennLoney,interviewbyFCIC,April1,2010.
23.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
27.13U.S.C.1639(h)2006.
28.LoansweresubjecttoHOEPAonlyiftheyhittheinterestratetriggerorfeetrigger:i.e.,ifthean-
nualpercentageratefortheloanwasmorethan10percentagepointsabovetheyieldonTreasurysecuri-
ties having a comparable maturity or if the total charges paid by 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.34.
29.Ibid.,p.24.
30.BoardofGovernorsoftheFederalReserveSystemandDepartmentofHousingandUrbanDevel-
opment,JointReportConcerningReformtotheTruthinLendingActandtheRealEstateSettlement
ProceduresAct(July1998),p.36.
31. Griffith L. Garwood, director, Division of Consumer and Community Affairs, Board of Gover-
norsoftheFederalReserveSystem,TotheOfficersandManagersinChargeofConsumerAffairsEx-
aminationandConsumerComplaintPrograms,ConsumerAffairsLetterCA981,January20,1998
32.GAO,LargeBankMergers:FairLendingReviewCouldBeEnhancedwithBetterCoordination,
GAO/GGD-0016(ReporttotheHonorableMaxineWatersandtheHonorableBernardSanders,House
ofRepresentatives),November1999,p.20.
33.FedandHUD,JointReport,pp.IXXVII.
34. Griffith L. Garwood, director, Division of Consumer and Community Affairs, Board of Gover-
norsoftheFederalReserveSystem,memorandumtotheCommitteeonConsumerandCommunityAf-
fairs,MemorandumconcerningtheBoardsReporttotheCongressontheTruthinLendingandReal
EstateSettlementProceduresActs,April8,1998,p.42.
33.BoardofGovernorsoftheFederalReserveSystem,FederalDepositInsuranceCorporation,Office
of the Comptroller of the Currency, and Office of Thrift Supervision, Interagency Guidance on Sub-
primeLending(March1,1999),p.1
36.Ibid.,pp.17;quotation,p.3.
37. U.S. Department of the Treasury and U.S. Department of Housing and Urban Development,
CurbingPredatoryHomeLending(June1,2000),pp.1314,12,81(quotations,2,12).
38.GailBurks,presidentandchiefexecutiveofficer,NevadaFairHousingCenter,Inc.,testimonybe-
foretheFCIC,HearingontheImpactoftheFinancialCrisisStateofNevada,session3:TheImpactof
theFinancialCrisisonNevadaRealEstate,September8,2010,transcript,p.24243.SeealsoKevinStein,
associate director, California Reinvestment Coalition, written testimony for the FCIC, Hearing on the
Impact of the Financial CrisisSacramento, session 2: Mortgage Origination, Mortgage Fraud and
PredatoryLendingintheSacramentoRegion,September23,2010,pp.89.Seealsohistestimonyatthe
samehearing,transcript,pp.7374.SeeDianeE.Thompson,ofcounsel,NationalConsumerLawCen-
ter, Inc., and Margot F. Saunders, of counsel, National Consumer Law Center, Inc., interview by FCIC,
September10,2010.
39.DianeE.ThompsonandMargotF.Saunders,bothofcounsel,NationalConsumerLawCenter,in-
terviewbyFCIC,September10,2010.
40.GaryGensler,interviewbyFCIC,May14,2010.
41.SheilaBair,testimonybeforetheFCIC,FirstPublicHearingoftheFCIC,day2,panel1:Current
InvestigationsintotheFinancialCrisisFederalOfficials,January14,2010,transcript,p.97.
42.SheilaBair,interviewbyFCIC,March29,2010.
43.SandraF.Braunstein,interviewbyFCIC,April1,2010,pp.3134.
44.Bair,interview.
43.TreasuryandHUD,CurbingPredatoryHomeLending,p.31.
Chapter 6
1.FiguresrepresentedthecompoundaveragegrowthrateandFCICstaffcalculationsfromCoreLogic
NationalHomePriceIndex,Single-FamilyCombined(SCF);CoreLogicLoanPerformanceHPIAugust
2010.
2.InsideMortgageFinance,The 2009 Mortgage Market Statistical Annual, vol.1,The Primary Market
(Bethesda,Md.:InsideMortgageFinance,2009),p.4,MortgageOriginationsbyProduct.
3.FederalReserveBoardpressrelease,May27,2004.
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., February 20, 2004. See also Olivier Blanchard and John Si-
mon,TheLongandLargeDeclineinU.S.OutputVolatility,Brookings Papers on Economic Activity, no.
1(2001):13364.
3.FedGovernorBenS.Bernanke,Deflation:MakingSureItDoesntHappenHere,remarksbefore
theNationalEconomistsClub,Washington,D.C.,November21,2002.
6.FCICstaffcalculationsfromBoardofGovernorsoftheFederalReserveSystem,H.13SelectedIn-
terestRaterelease,3-monthAANonfinancialCommercialPaperRate,WCPN3M(weekly,endingFri-
day);U.S.DepartmentofTreasury,DailyTreasuryYieldCurveRates,1990toPresent.
7.Thisexampleassumesthatthehomeownerisabletocomeupwithalargerdownpaymenttocover
20ofthehigher-pricedhome.Here,thedifferencewouldbeabout$13,000.
8. Federal Housing Finance Agency, Data on the Risk Characteristics and Performance of Single-
FamilyMortgagesOriginatedfrom2001through2008andFinancedintheSecondaryMarket(Septem-
ber 13, 2010), Table 2a: Share of Single-Family Mortgages Originated from 2001 through 2008 and
AcquiredbytheEnterprisesorFinanceswithPrivate-LabelMBSbyLoan-to-ValueRatioandBorrower
FICO Score at Origination, Adjustable-Rate Mortgages, p. 22. Prime borrowers are defined as those
whosemortgagesarefinancedbythegovernment-sponsoredenterprises.
9.YuliyaDemyanykandOttoVanHemert,UnderstandingtheSubprimeMortgageCrisis(Decem-
ber3,2008),table1:LoanCharacteristicsatOriginationforDifferentVintages,p.7.
10. FCIC staff calculations from CoreLogic/First American, Home Price Index for Single-Family
CombinedStateHPIdata,lastupdatedAugust2010,andCoreLogicStateHomePriceIndex,providedto
theFCICbyCoreLogic.Staffcalculationsofallannualgrowthratesarecompoundannualgrowthrates
fromJanuarytoJanuary.
11.U.S.CensusBureau,HousingVacanciesandHomeownership,CPS/HVS,Table14:Homeowner-
shipRatesfortheUS1963toPresent.
12. Brian K. Bucks, Arthur B. Kennickell, and Kevin B. Moore, Recent Changes in US Family Fi-
nances:Evidencefromthe2001and2004SurveyofConsumerFinances,Federal Reserve Bulletin (2006):
Tables8Aand8B,pp.A20A23,A8.
13.CongressionalBudgetOffice,HousingWealthandConsumerSpending,BackgroundPaper,Jan-
uary2007,p.13.
14.Mortgagesmayhavebeenrefinancedmorethanonceinthatyear.
13. FCIC staff calculations with updated data provided by Alan Greenspan and James Kennedy,
whosedataoriginallyappearedinSourcesandUsesofEquityExtractedfromHomes,FinanceandEco-
nomicsDiscussionSeries,FederalReserveBoard,2007-20(March2007).
16.CBO,HousingWealthandConsumerSpending,p.2.
17. Fed Chairman Alan Greenspan, The Economic Outlook, prepared testimony before the Joint
EconomicCommittee,107thCong.,2ndsess.,November13,2002.
18.FedChairmanAlanGreenspan,FederalReserveBoardsSemiannualMonetaryPolicyReportto
theCongress,preparedtestimonybeforetheHouseCommitteeonFinancialServices,108thCong.,2nd
sess.,February12,2004.
19. FCIC staff calculations from 2009 Mortgage Market Statistical Annual, 1:4, Mortgage Origina-
tionsbyProduct(totalsubprimevolume);2:13,Non-AgencyMBSIssuancebyType(subprimePLS).
20.Ibid.,1:3,MortgageOriginationIndicators;220,227,MortgageOriginationsbyProduct.
21.BartMcDade,interviewbyFCIC,April16,2010.
22.PresentationtotheLehmanBoardofDirectors,March20,2007.Lehmanhadalsoacquiredthree
internationallendersduringthistimeperiod.
23.NewCentury,199910-K,March30,2000,p.2.
24.FinalReportofMichaelJ.Missal,BankruptcyCourtExaminer,inRE:NewCenturyTRSHold-
ings,Chapter11,CaseNo.07-10416(KJC),(Bankr.D.Del.),February29,2008,p42.
23. New Century, 2000 10-K, April 2, 2001, p. 13; New Century, 2003 10-K, March 13, 2004, p. 13.
Rankingsfrom2009 Mortgage Market Statistical Annual, 1:220,223.
26.AseemMitalandAngeloMozilo,quotedinErickBergquist,UnderScrutiny,AmeriquestDetails
Procedures,American Banker 170,no.123(June30,2003):1.Volumeandrankingsfrom2009 Mortgage
Market Statistical Annual, 1:220,223.
568 Notes to Chapter 6
27.LewisRanieri,interviewbyFCIC,July30,2010.
28.JamesM.LackoandJanisK.Pappalardo,TheEffectofMortgageBrokerCompensationDisclo-
suresonConsumersandCompetition:AControlledExperiment,FederalTradeCommissionBureauof
EconomicsStaffReport(February2004),p.1.
29. Jay Jeffries, testimony 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: journal of Urban
Economics 64(2008):223.
31.MichaelCalhounandJuliaGordon,interviewbyFCIC,September16,2010.
32.AnnamariaLusardi,AmericansFinancialCapability,reportpreparedfortheFCIC,February26,
2010,p.3.
33. FCIC staff estimates based on analysis of Blackbox, S&P, and IP Recovery, provided by Antje
Berndt,BurtonHollifield,andPatrikSandas,intheirpaper,TheRoleofMortgageBrokersintheSub-
primeCrisis,April2010.
34. William C. Apgar and Allen J. Fishbein, The Changing Industrial Organization of Housing Fi-
nance and the Changing Role of Community-Based Organizations, working paper (Joint Center for
HousingStudies,HarvardUniversity,May2004),p.9.
33.HerbSandler,interviewbyFCIC,September22,2010.
36.WholesaleAccess,MortgageBrokers2006(August2007),pp.33,37.
37.JamieDimon,testimonybeforetheFCIC,FirstPublicHearingoftheFCIC,panel1:FinancialIn-
stitutionRepresentatives,January13,2010,transcript,p.13.
38.OctoberResearchCorporation,executivesummaryofthe2007 ^ational Appraisal Survey, p.4.
39.DennisJ.Black,writtentestimonyfortheFCIC,HearingontheImpactoftheFinancialCrisis
Miami,session2:UncoveringMortgageFraudinMiami,September21,2010,p.8.
40.KarenJ.Mann,writtentestimonyfortheFCIC,HearingontheImpactoftheFinancialCrisis
Sacramento,session2:MortgageOrigination,MortgageFraudandPredatoryLendingintheSacramento
Region,September23,2010,p.2.
41. Gary Crabtree, testimony 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 Jr. and Patrick McGeehan, Along with a Lender, Is
CitigroupBuyingTrouble:^ew York Times,October22,2000.
44.PamFlaherty,quotedinErickBergquist,JudgingCiti,aYearLater:SubprimeReformonTrack;
CriticsUnsatisfied, American Banker, September10,2001.
43.CitigroupSettlesFTCChargesagainsttheAssociatesRecord-Setting$213MillionforSubprime
LendingVictims,FederalTradeCommissionpressrelease,September19,2002.
46.MarkOlson,interviewbyFCIC,October4,2010.
47.TimothyOBrien,FedAssessCitigroupUnit$70MillioninLoanAbuse,The ^ew York Times,
May28,2004.
48.FederalReserveBoardinternalstaffdocument,TheProblemofPredatoryLending,December
3,2000,pp.1013.
49. Federal Reserve Board, Morning Session of Public Hearing on Home Equity Lending, July 27,
2000,openingremarksbyGovernorGramlich,p.9.
30.ScottAlvarez,interviewbyFCIC,March23,2010.
31.AlanGreenspan,writtentestimonyfortheFCIC,HearingonSubprimeLendingandSecuritiza-
tion and Government-Sponsored Enterprises (GSEs), day one, session 1: The Federal Reserve, April 7,
2010,p.13.
32.AlanGreenspan,quotedinDavidFaber,And Then the Roof Caved In. How Vall Streets Greed and
Stupidity Brought Capitalism to Its Knees (Hoboken,N.J.:Wiley,2009),pp.3334.
33.TruthinLending,Federal Register 66,no.243(December20,2001):63612(quotation),63608.
569 Notes to Chapter 6
34. Robert B. Avery, Glenn B. Canner, and Robert E. Cook, New Information Reported under
HMDA and Its Application in Fair Lending Enforcement, Federal Reserve Bulletin 91 (Summer 2003):
372.
33.AlanGreenspan,interviewbyFCIC,March31,2010
36. Sheila Bair, testimony before the FCIC, Hearing on Too Big to Fail: Expectations and Impact of
ExtraordinaryGovernmentInterventionandtheRoleofSystemicRiskintheFinancialCrisis,day2,ses-
sion2:FederalDepositInsuranceCorporation,September2,2010,transcript,p.191.
37.DoloresSmithandGlennLoney,memorandumtoGovernorEdwardGramlich,ComplianceIn-
spectionsofNonbankSubsidiariesofBankHoldingCompanies,August31,2000.
38. GAO, Consumer Protection: Federal and State Agencies Face Challenges in Combating Preda-
toryLending,GAO04280(ReporttotheChairmanandRankingMinorityMember,SpecialCommit-
teeonAging,U.S.Senate),January2004,pp.3233.
39.SandraBraunstein,interviewbyFCIC,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:GramlichSaysEx-
Colleague Blocked Crackdown On Predatory Lenders Despite Growing Concerns, Vall Street journal,
June9,2007.SeealsoEdmundL.Andrews,FedShruggedasSubprimeCrisisSpread,^ew York Times,
December18,2007.
64. Patricia McCoy and Margot Saunders, quoted in Binyamin Appelbaum, Fed Held Back as Evi-
denceMountedonSubprimeLoanAbuses,Vashington Post, September27,2009.
63.GAO,LargeBankMergers:FairLendingReviewCouldbeEnhancedwithBetterCoordination,
GAO/GDD-00-16(ReporttotheHonorableMaxineWatersandHonorable BernardSanders,Houseof
Representatives),November1999;GAO,ConsumerProtection: FederalandStateAgenciesFaceChal-
lengesinCombatingPredatoryLending.
66.FederalandStateAgenciesAnnouncePilotProjecttoImproveSupervisionofSubprimeMort-
gageLenders,Jointpressrelease(FedReserveBoard,OTC,FTC,ConferenceofStateBankSupervisors,
AmericanAssociationofResidentialMortgageRegulators),July17,2007.
67.TruthinLending,pp.4432223.Higher-pricedmortgageloansaredefinedinthe2008regula-
tionstoincludemortgageloanswhoseannualpercentagerateexceedstheaverageprimeofferratesfora
comparabletransaction(aspublishedbytheFed)byatleast1.3forfirst-lienloansor3.3forsubordi-
nate-lienloans.
68.Alvarez,interview.
69.RaphaelW.Bostic,KathleenC.Engel,PatriciaA.McCoy,AnthonyPennington-Cross,andSusan
M. Wachter, State and Local Anti-Predatory Lending Laws: The Effect of Legal Enforcement Mecha-
nisms,journal of Economics and Business 60(2008):4766.
70.LendingandInvestment,Federal Register 61,no.190(September30,1996):30963.
71. Joseph A. Smith, Mortgage Market Turmoil: Causes and Consequences, testimony before the
SenateCommitteeonBanking,Housing,andUrbanAffairs,110thCong.,1stsess.,March22,2007,p.33
(ExhibitB),usingdatafromtheMortgageAssetResearchInstitute.
72.LisaMadigan,writtentestimonyfortheFCIC,FirstPublicHearingoftheFCIC,day2,panel2:
CurrentInvestigationsintotheFinancialCrisisStateandLocalOfficials,January14,2010,p.12.
73.CommitmentscompiledatNationalCommunityReinvestmentCoalition,CRACommitments
(2007).
74.JoshSilver,NCRC,interviewbyFCIC,June16,2010.
73.DatareferencesbasedonReginaldBrown,counselforBankofAmerica,lettertoFCIC,June16,
2010, p. 2; Jessica Carey, counsel for JPMorgan Chase, letter to FCIC, December 16, 2010; Brad Karp,
counselforCitigroup,lettertoFCIC,March18,2010,inresponsetoFCICrequest;WellsFargopublic
commitments19902010,dataprovidedbyWellsFargototheFCIC.
76.Karp,lettertoFCIC,March18,2010,inresponsetoFCICrequest.
77.Carey,lettertoFCIC,December16,2010,p.9;BradKarp,counselforJPMorgan,lettertoFCIC,
May26,2010,p.10.
570 Notes to Chapter 7
78. FCIC calculation based on Federal Housing Finance Agency, Data on the Risk Characteristics
andPerformanceofSingle-FamilyMortgagesOriginatedin20012008andFinancedintheSecondary
Market(August2010),Table1-C;thisreportcoversallloanspurchasedorsecuritizedbytheGSEsorin
private-labelsecuritizations.DelinquencydataprovidedbyWellsFargocovered81ofloans.
79.OrdersIssuedUndertheBankHoldingCompanyAct,Federal Reserve Bulletin 73,no.4(April
1989):304.
80. Statement of the Federal Financial Supervisory Agencies Regarding the Community Reinvest-
mentAct,Federal Register 34(April3,1989):13742.Thisremainstheinteragencypolicy.Community
Reinvestment Act: Interagency Questions and Answers Regarding Community Reinvestment; Notice,
Federal Register 73(March11,2010):11666.
81.GlennLoney,interviewbyFCIC,April1,2010.
82.CommunityReinvestmentActRegulationsandHomeMortgageDisclosure;FinalRules,Federal
Register 60,no.86(May4,1993):22133223.
83.DivisionofConsumerandCommunityAffairs,memorandumtoBoardofGovernors,August10,
1998.
84.FederalReserveBoardpressrelease,OrderApprovingtheMergerofBankHoldingCompanies,
August17,1998,pp.6364.
83.LloydBrown,interviewbyFCIC,February3,2010.
86.AndrewPlepler,interviewbyFCIC,July14,2010.
87. Assuming 73 AAA tranche ($1.20), 10 AA tranche ($0.20), 8 A tranche ($0.30), 3 BBB
tranche($0.40),and2equitytranche($2.00).SeeGoldmanSachs,EffectiveRegulation:Part1,Avoid-
ingAnotherMeltdown,March2009,p.22.
88.DavidJones,interviewbyFCIC,October19,2010.SeeDavidJones,EmergingProblemswiththe
BaselCapitalAccord:RegulatoryCapitalArbitrageandRelatedIssues,journal of Banking and Finance
24,nos.12(January2000):3338.
89.HenryPaulson,testimonybeforetheFCIC,HearingontheShadowBankingSystem,day2,ses-
sion1:PerspectiveontheShadowBankingSystem,May6,2010),transcript,p.34.
90.Jones,interview.
Chapter 7
1.Forexample,anAlt-Aloanmayhavenoorlimiteddocumentationoftheborrowersincome,may
haveahighloan-to-valueratio(LTV),ormaybeforaninvestor-ownedproperty.
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-Agency MBS Issuance by
Type.FCICstaffcalculationsfrom2004to2006(forgrowthinprivatelabelMBS).
3.CharlesO.Prince,interviewbyFCIC,March17,2010.
4.JohnTaylor,interviewbyFCIC,September23,2010.
3.WilliamA.FleckensteinandFrederickSheeham, Greenspans Bubbles. The Age of Ignorance at the
Federal Reserve (NewYork:McGraw-Hill,2008),p.181.
6.AlanGreenspan,TheFedDidntCausetheHousingBubble,Vall Street journal, March11,2009.
SeealsoBenBernanke,MonetaryPolicyandtheHousingBubble,speechattheAnnualMeetingofthe
AmericanEconomicAssociation,Atlanta,Georgia,January3,2010.
7.AlanGreenspan,testimonybeforetheSenateCommitteeonBanking,Housing,andUrbanAffairs,
109thCong.,1stsess.,February16,2003.
8.FedChairmanBenS.Bernanke,TheGlobalSavingGlutandtheU.S.CurrentAccountDeficit,re-
marks at the Sandridge Lecture, Virginia Association of Economics, Richmond, Virginia, March 10,
2003.
9.FredericMishkin,interviewbyFCIC,October1,2010.
10. Pierre-Olivier Gourinchas, written testimony for the FCIC, Forum to Explore the Causes of the
FinancialCrisis,day1,session2:MacroeconomicFactorsandU.S.MonetaryPolicy,February26,2010,
pp.2326..
11.PaulKrugman,interviewbyFCIC,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
byProduct.
14.ChristopherMayer,KarenPence,andShaneM.Sherlund,TheRiseinMortgageDefaults,jour-
nal of Economic Perspectives 23,no.1(Winter2009):Table2,AttributesforMortgagesinSubprimeand
Alt-APools,p.31.
13.2009 Mortgage Market Statistical Annual, 2:13,Non-AgencyMBSIssuancebyType.
16.2009 Mortgage Market Statistical Annual,1:6,AlternativeMortgageOriginations;previousdata
extrapolatedinFCICestimatesfromGoldenWest,Form10-Kforfiscalyear2003,andFederalReserve,
ResidentialMortgageLendersPeerGroupSurvey:AnalysisandImplicationsforFirstLienGuidance,
November30,2003.
17.InsideMortgageFinance.
18. Countrywide, 2003 Form 10-K, p. 39; 2007 Form 10-K, p. 47 (showing the growth in Country-
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, May 18, 2006; Angelo
Mozilo,interviewbyFCIC.September24,2010.
20.DavidSambol,interviewbyFCIC,September27,2010.
21. See Countrywide, Investor Conference Call, January 27, 2004, transcript, p. 3. See also Jody
Shenn,CountrywideAddingStafftoBoostPurchaseShare,American Banker, January28,2004.
22.PatriciaLindsay,writtentestimonyfortheFCIC,hearingonSubprimeLendingandSecuritization
andGovernment-SponsoredEnterprises(GSEs),day1,sess.2:SubprimeOriginationandSecuritization,
April7,2010,p.3
23.AndrewDavidson,interviewbyFCIC,October29,2020.
24.Ibid.
23.DavidBerenbaum,testimonybeforeSenateCommitteeonBanking,SubcommitteeonHousing,
TransportationandCommunityDevelopment,110thCong.,1stsess.,June26,2007.
26. Email and data attachment from former Golden West employee to FCIC, subject: re: Golden
WestEstimatedVolumeofAdjustableRateMortgageOriginations,December6,2010.
27.HerbertSandler,interviewbyFCIC,September22,2010.
28. Washington Mutual, Option ARM Focus GroupsPhase II, September 17, 2003; Washington
Mutual,OptionARMFocusGroupsPhaseI,August14,2003,Exhibits33and36inSenatePerma-
nentSubcommitteeonInvestigations,exhibits,Vall Street and the Financial Crisis. The Role of High Risk
Home Loans,111thCong.,2ndsess.,April13,2010(hereaftercitedasPSIDocuments),PDFpp.33031,
availableathttp://hsgac.senate.gov/public/_files/Financial_Crisis/041310Exhibits.pdf.
29.PSIDocuments,Exhibits33and36pp.33031.
30.Ibid.,pp.33031,334.
31.Ibid.,p.343.
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. 336; comparing con-
formingandjumbooriginations.
33.Ibid.,p.337.
36.DocumentlistingCountrywideoriginationsbyquarterfrom2003to2007,providedbyBankof
America.
37.CountrywideOctober2003LoanProgramGuide(depictingamaximumCLTVof80andmini-
mumFICOof680)andJuly2004LoanProgramGuide(showing90620FICO).
38.CountrywideLoanProgramGuide,datedMarch7,2003.
39.FederalReserve,ResidentialMortgageLendersPeerGroupSurvey:AnalysisandImplicationsfor
FirstLienGuidance,November30,2003,pp.6,8.
40.AngeloMozilo,emailtoCarlosGarcia(cc:StanKurland),Subject:BankAssets,August1,2003.
572 Notes to Chapter 7
41. Angelo Mozilo, email to Carlos Garcia (cc: Kurland), subject: re: Fw: Bank Assets, August 2,
2003.
42.Countrywide,2003Form10-K,p.37;2007Form10-K,p.F-43.
43.SeeWashingtonMutual,2006Form10-K,p.33.
44.JohnStumpf,interviewbyFCIC,September23,2010.
43.Countrywide,2007Form10-K,p.F-43;2003Form10-K,p.37
46.WashingtonMutual,2007Form10-K,p.37;2003Form10-K,p.33
47. Kevin Stein, testimony before the FCIC, Sacramento Hearing on the Impact of the Financial
CrisisSanFrancisco,day1,session2:MortgageOrigination,MortgageFraudandPredatoryLendingin
theSacramentoRegion,September23,2010,transcript,p.72.
48.MonaTawatao,inibid.,p.228.
49.RealEstateLendingStandards,Federal Register 37(December31,1992):62890.
30.Ibid.
31.OfficeoftheComptrolleroftheCurrency,BoardofGovernorsoftheFederalDepositInsurance
Corporation,OfficeofThriftSupervision,RealEstateLendingStandards:FinalRule,SR931,January
11,1993.
32.OfficeoftheComptrolleroftheCurrency,BoardofGovernorsoftheFederalDepositInsurance
Corporation,OfficeofThriftSupervision,InteragencyGuidanceonHighLTVResidentialRealEstate
Lending,October8,1999.
33.FinalReportofMichaelJ.Missal,BankruptcyCourtExaminer,InRE:NewCenturyTRSHold-
ings,Chapter11,CaseNo.07-10416(KJC),(Bankr.D.Del.),February29,2008,pp.128,149,128.
34.YuliyaDemyanykandOttoVanHemert,UnderstandingtheSubprimeMortgageCrisis,Review
of Financial Studies, May2009.
33.Sandler,interview.
36.CoreLogicloanperformancedataforsubprimeandAlt-Aloans,andCoreLogictotaloutstanding
loansservicerdataprovidedtotheFCIC.
37.ChristopherMayer,KarenPence,andShaneM.Sherlund,TheRiseinMortgageDefaults,jour-
nal of Economic Perspectives 23,no.1(Winter2009):32.
38.WilliamBlack,testimonyfortheFCIC,MiamiHearingontheImpactoftheFinancialCrisis,day
1,session1:OverviewofMortgageFraud,September21,2010,p.27.
39.RichardBowen,interviewbyFCIC,February27,2010.
60.JamieDimon,testimonybeforetheFCIC,January13,2010,p.60.
61.Thisparticulardealwouldbedescribedasanexcess-spreadover-collateralized-basedcrediten-
hancementstructure;seeGaryGorton,ThePanicof2007,paperpresentedattheFederalReserveBank
ofKansasCitysJacksonHoleConference,August2008,p.23.
62.FCICstaffestimatesbasedonanalysisofdatafromBlackBox,S&P,andBloomberg.Theprospec-
tiveloanpoolforthisdealoriginallycontained4,307mortgages.Eightofthesehadbeendroppedfrom
thepoolbythetimethebondswereissued.Therefore,theseestimatesmaydifferslightlyfromthosere-
portedinthedealprospectusbecausetheseestimatesarebasedonapoolof4,499loans.
63.Ibid.
64.Federal Register 69(January7,2004):1904.TheruleswereissuedinproposedformatFederal Reg-
ister 68(August3,2003):46119.
63.SeeOTSOpinionreCaliforniaMinimumPaymentStatute,October1,2002,p.6.
66. Comptroller of the Currency John Hawke, remarks before Women in Housing and Finance,
Washington,D.C.,February12,2002,attachedtoOCCNewsRelease2002-10,p.2.
67.JohnHawke,quotedinJessBravinandPaulBeckett,FriendlyWatchdog:FederalRegulatorOf-
tenHelpsBanksFightingConsumers,Vall Street journal, January28,2002.
68. Oren Bar-Gill and Elizabeth Warren, Making Credit Safer, University of Pennsylvania Law Re-
view 137(2008):182-83,192-94.
69.SeeWattersv.WachoviaBankNA,330U.S.1(2007).
70.JohnDugan,testimonybeforetheFCIC,PublicHearingonSubprimeLendingandSecuritization
andGovernment-SponsoredEnterprises(GSEs),day2,session2:OfficeoftheComptrolleroftheCur-
rency,April8,2010,transcript,p.130.
71.LisaMadigan,testimonybeforetheFCIC,FirstPublicHearingoftheFCIC,day2,panel2:Inves-
tigationsintotheFinancialCrisisStateandLocalOfficials,January14,2010,transcript,p.104.
573 Notes to Chapter 7
72.JohnD.HawkeJr.,writtentestimonyfortheFCIC,PublicHearingonSubprimeLendingandSe-
curitizationandGovernment-SponsoredEnterprises(GSEs),day2,session2:OfficeoftheComptroller
oftheCurrency,April8,2010,p.6.
73.CitigroupWarehouseLinesofCreditwithMortgageOriginators,inGlobalSecuritizedMarkets,
20002010(revised),producedbyCitigroup;staffcalculations.
74.CharlesO.Prince,interviewbyFCIC,March17,2010.
73.MoodysSpecialReport,TheABCPMarketintheThirdQuarterof1998,February2,1999.
76.Moodys2007Reviewand2008Outlook:USAsset-backedCommercialPaper,February27,2008.
77.MoodysABCPReviewsofParkGranadaandParkSienna.
78.MoodysABCPProgramReview:ParkGranada,July16,2007.
79. Letters from the American Securitization Forum (November 17, 2003) and State St. Bank
(November14,2003)totheOfficeofThriftSupervision.
80.DarryllHendricks,interviewbyFCIC,August6,2010.
81.CitiAugust29,2006,LoanSale.
82. Correspondence between Citi and New Century provided to FCIC. FCIC staff estimates from
prospectusandCitigroupproductiondatedNovember4,2010.CitiAugust29,2006,LoanSale.
83.FannieMaeTermSheet.
84.Forthemorethan20institutionalinvestorsaroundtheworld,seeCitigrouplettertotheFCICre
SeniorInvestors,October14,2010.The$382millionfigureisbasedonFCICstaffestimatesthat,inturn,
werebasedonanalysisofMoodysPDSdatabase.
83.SeeBradS.Karp,counselforCitigroup,lettertoFCIC,aboutseniorinvestors,October14,2010,
p.2.SeealsoEricS.Goldstein,counselforJPMorganChase&Co.,lettertoFCIC,November16,2010.
86.CitigrouplettertotheFCIC,November4,2010.
87.See,e.g.,SimonKennedy,BNPSuspendsFundsAmidCredit-MarketTurmoil,August9,2007.
(www.marketwatch.com/story/bnp-suspends-fund-valuations-amid-credit-market-turmoil).
88.SeeBradS.Karp,lettertoFCIC,aboutmezzanineinvestors,November4,2010,p.1.Theequity
trancheswerenotofferedforpublicsalebutwereretainedbyCitigroup.
89.FCICstaffestimatesfromprospectusandCitigroupproductiondatedNovember4,2010.
90.PatriciaLindsay,interviewbyFCIC,March24,2010.
91. PSI Documents, Exhibit 39a: Long Beach Mortgage Production, Incentive Plan 2004, and Ex-
hibit60a(quotingpage2ofWaMuHomeLoansProductStrategyPowerPointpresentation).
92. John M. Quigley, Compensation and Incentives in the Mortgage Business, Economists Voices
(TheBerkeleyElectronicPress,October2008),p.2.
93. Barclays Capital, Bear Stearns, BNP Paribas, Citigroup, Deutsche Bank, Goldman Sachs, HSBC,
JPMorgan,LehmanBrothers,MorganStanley,andUBS.
94.Figuresareaveragetop-tierpayworldwideinmortgagesandMBSsalesandtrading.SeeOptions
Group,2003GlobalFinancialMarketOverview&CompensationReport(October2003),pp.42,32;
Options Group, 2006 Global Financial Market Overview & Compensation Report (November 2006),
pp.39,69;andOptionsGroup,2007GlobalFinancialMarketOverview&CompensationReport(No-
vember2007),pp.73,82.
93.SeeMerrillLynch,2007ProxyStatement,p.46.
96.SeeFCICstaffanalysisofMoodysForm10-Ksforyears2003,2006,and2007.
97.SeeFCICstaffcalculationsbasedonMoodysForm10-Ksforyears200307.
98.MoodysExpandsMoodysMortgageMetricstoIncludeSubprimeResidentialMortgages,Sep-
tember6,2006;FCICstaffestimatebasedonanalysisofMoodysSFDRSandPDSdatabases.
99.Theratingsfromthethreeagenciesmeasureslightlydifferentcreditriskcharacteristics.S&Pand
Fitchbasetheirratingsontheprobabilitythataborrowerwilldefault;Moodysbasesitsratingsonthe
expected loss totheinvestor.Despitesuchdifferences,investorsandregulatorstendtoviewtheratingsas
roughlyequivalent.Ratingsaredividedintotwocategories:investmentgradesecuritiesareratedBBB-to
AAA,whilesecuritiesratedbelowBBB-areconsideredspeculativeandarealsoreferredtoasjunk(for
S&P;similarlevelsforMoodysareBaatotriple-A).
100.RichardCantorandFrankPacker,TheCreditRatingIndustry,FRB^Y Quarterly Review (Sum-
merFall1994):6.
574 Notes to Chapter 7
101.AndrewJ.Donahue,director,DivisionofInvestmentManagement,SEC,SpeechbySECStaff:
Opening Remarks before the Commission Open Meeting, Washington, DC, June 23, 2008. See also
Lawrence J. White, Markets: The Credit Rating Agencies, journal of Economic Perspectives 24, no. 2
(Spring2010):214.
102.LewisRanieri,interviewbyFCIC,July30,2010.
103.EricKolchinsky,testimonybeforetheFCIC,HearingontheCredibilityofCreditRatings,theIn-
vestment Decisions Made Based on Those Ratings, and the Financial Crisis, session 1: The Ratings
Process,June2,2010,transcript,pp.1920.
104.See13U.S.C.78o-7(c)(2).
103.JeromeS.Fons,testimonybeforetheHouseCommitteeonOversightandGovernmentReform,
110thCong.,2ndsess.,October22,2008,p.2.
106. Arnold Cattani, testimony before the FCIC, Hearing on the Impact of the Financial Crisis
GreaterBakersfield,session2:LocalBanking,transcript,p.60.
107.GaryWitt,testimonybeforetheFCIC,HearingontheCredibilityofCreditRatings,theInvest-
mentDecisionsMadeBasedonThoseRatings,andtheFinancialCrisis,session1:TheRatingsProcess,
June2,2010,transcript,p.41.
108. Moodys Investors Service, Introducing Moodys Mortgage Metrics: Subprime Just Became
MoreTransparent,September7,2009.
109.DavidTeicher,MoodysInvestorsService,interviewbyFCIC,May4,2010;MoodysMortgage
Metrics:AModelAnalysisofResidentialMortgagePools,April1,2003.
110.JaySiegel,interviewbyFCIC,May26,2010.
111.Teicher,interview.
112.JaySiegel,testimonybeforetheFCIC,HearingontheCredibilityofCreditRatings,theInvest-
mentDecisionsMadeBasedonThoseRatings,andtheFinancialCrisis,session1:TheRatingsProcess,
June2,2010,transcript,p.29.
113.RogerStein,interviewbyFCIC,May26,2010.
114.MoodysInvestorsService,IntroducingMoodysMortgageMetrics.
113.Stein,interview.
116.JeromeFons,interviewbyFCIC,April22,2010.
117.MoodysRatingCommitteeMemorandum,August29,2006.
118.FCICstaffestimatesbasedonanalysisofMoodysPDSdatabase.
119.InvoicefromMoodysInvestorsServicetoSusanMills,CitigroupGlobalMarketsInc.,October
12,2006.
120. Standard & Poors, Global New Issue Billing Form, Citigroup Mortgage Loan Trust 2006-NC2,
September28,2006.
121.FCICstaffestimatesbasedonanalysisofMoodysSFDRSdataasofApril2010.
122. Chris Cox, SEC chairman, prepared testimony before the Senate Banking Committee, 109th
Cong., 2nd sess., June 13, 2006; Freddie Mac, Four Former Executives Settle SEC Action Relating to
Multi-BillionDollarAccountingFraud,SECpressrelease,September27,2007.
123. James Lockhart, director, FHFA, speech to American Securitization Forum in Las Vegas, New
Mexico,February9,2009(p.2,slide4ofpresentationshowsthechart).
124.OFHEOSpecialExaminationReport,December2003.
123.In2006,OFHEOissueditsfinalReport of the Special Examination of Fannie Mae.OFHEOsaid
thatmanagementengagedinnumerousactsofmisconduct,involvingwelloveradozendifferentforms
ofaccountingmanipulationandviolationsofgenerallyacceptedaccountingprinciples.Asinthecaseof
Freddie,OFHEOsaidFanniesmanagementsoughttohitambitiousearnings-per-sharetargetsthatwere
linkedtotheirowncompensation.
126.DonaldBisenius,interviewbyFCIC,September29,2010.
127.Mortgage Market Statistical Annual 2009.
128.SeeTables3.1/3.2inFHFAConservatorshipreportforthird-quarter2010.
129.OFHEOSpecialExaminationReport,September2004,pp.910.
130.Ibid.,pp.2,10.
131.OFHEO,2003ReporttoCongress,June13,2003,p.13.
575 Notes to Chapter 8
132.AlanGreenspan,testimonybeforetheFCIC,HearingonSubprimeLendingandSecuritization
and Government-Sponsored Enterprises (GSEs), day 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,February2010,p.22;FCICcalculations.
134.FHFA,Report to Congress, 2008 (2009),pp.116,123.
133. BlackRock Solutions, Fannie Maes Strategy and Business Model, Supplementary Exhibits,
December2007.
136.RobertLevin,interviewbyFCIC,March17,2010.
137.MarkWiner,interviewbyFCIC,March23,2010.
138.JohnWeicher,formerFHAcommissioner,interviewbyFCIC,March11,2010.
139.LetterfromRobertLevintoFCIC,June17,2010,p.2.
Chapter 8
1.JoeDonovan,CreditSuisse,quotedinMichaelGregory,TheWhatIf sinABSCDOs,Asset Secu-
ritization Report, February18,2002.
2.FCICstaffcalculations,usingdatafromtheU.S.Census,datainMoodysCDOPDSdatabase,and
data in Moodys CDO Enhanced Monitoring Service database. The FCIC selected CDOs with at least
10oftheircollateralinvestedinmortgage-backedsecuritiesorwithothercharacteristicsthatidentified
themasABSCDOs.
3.ScottEichel,quotedinAllisonPyburn,CDOMachine:Managers,MortgageCompanies,Happy
toKeepFuelComing,Asset Securitization Report, May23,2003.
4.PatrickParkinson,interviewbyFCIC,March30,2010.
3.JianHu,AssessingtheCreditRiskofCDOsBackedbyStructuredFinanceSecurities:RatingAna-
lystsChallengesandSolutions,journal of Structured Finance 13,no.3(2007):46.
6.WingChau,interviewbyFCIC,November11,2010.
7. CDOs that bought relatively senior tranches of mortgage-backed securities were known as high-
grade, thosethatboughttheBBB-ratedandotherjuniortrancheswereknownasmezzanine.
8.JoeDonovan,quotedinGregory,TheWhatIf sinABSCDOs.
9. Laurie Goodman et al., Subprime Mortgage Credit Derivatives (Hoboken, NJ: John Wiley, 2008),
p.313.
10.Hu,AssessingtheCreditRiskofCDOsBackedbyStructuredFinanceSecurities,p.47,Exhibit3.
11.Issuancedroppedin2007to$194billionandvirtuallydisappearedin2008.FCICstaffestimates
basedondataprovidedbyMoodysCDOEnhancedMonitoringSystem(EMS).
12.FCICstaffestimatesbasedonanalysisofMoodysCDOEMSdatabase.
13.NestorDominguez,interviewbyFCIC,September28,2010.
14.MichaelLamont,interviewbyFCIC,September21,2010.
13.ChrisRicciardi,interviewbyFCIC,September13,2010.
16.Lamont,interview.
17.FCICstaffcalculationsusingdatainFCICCDOmanagerandunderwritersurvey.
18.MarkAdelson,interviewbyFCIC,October22,2010.
19. FCIC staff calculations. Our estimate assumes an annual management fee of 0.10 of the total
valueofthedealthatis,thelowestnormallyearnedintheindustryappliedtothemortgage-focused
multisector CDOs in the FCIC database. It does not include other income, such as interest on equity
tranches retained by the managers. CDO managers responding to the FCIC survey reported manage-
mentfeesrangingfromaslowas0.10toashighas0.40.
20.SummaryofKeyFeeProvisionsforCashCDOsasofJanuary20002010,preparedbyMoodys
fortheFCIC.
21.FCICHedgeFundSurvey.SeeFCICwebsitefordetails.
22.FCICstaffestimatesbasedonMoodysCDOEnhancedMonitoringService.
23.BloombergLLC,FinancialAnalystFunction;BearStearnsCompaniesInc.,Form10-K,forthefis-
calyearendedNovember30,2006,filedFebruary13,2007,Exhibit13.
24.TheOptionsGroup,2003GlobalFinancialMarketOverview&CompensationReport,October
2003,p.16.
576 Notes to Chapter 8
23.Moodys,KlerosRealEstateCDOIII,Ltd.,CDOEMSData,lastupdatedMay27,2008.Thefol-
lowingdiscussionofCMLTI2006-NC2reliesonFCICstaffestimatesbasedonanalysisofMoodysCDO
EMSdatabase.
26.Ricciardi,interview.
27.Forexample,KlerosIIItrancheswereinBuckinghamCDO,BuckinghamCDOII,andBucking-
hamCDOIII,alldealsunderwrittenbyBarclays.
28.Adelson,interview.
29.Chau,interview.
30. James Grant, Up the Capital Structure (December 13, 2006), in Mr. Market Miscalculates. The
Bubble Years and Beyond (MountJackson,VA:AxiosPress,2008),186.
31.UBSGlobalCDOGroup,PresentationonProductSeries(POPS),January2007.
32.DanSparks,interviewbyFCIC,June13,2010.
33.Dominguez,interview.
34.Theratioofthebookvalueofassetstoequityrangedfrom2.3to28.3timesforallSIVs;theaver-
agewas13.6times.MoodysInvestorsService,MoodysSpecialReport:MoodysUpdateonStructured
InvestmentVehicles,January16,2008,p.13.
33.MarkKlipsch,quotedinColleenMarieOConnor,DroughtofCDOCollateralTopsConcerns,
Asset Securitization Report, October18,2004.
36. Bear Stearns Asset Management, Collateral Manager Presentation; Ralph Cioffi, interview by
FCIC,October19,2010;BearStearnsHigh-GradeStructuredCreditStrategiesMasterFund,Ltd.,finan-
cial statements for the year ended December 31, 2006 (total assets were $8,373,313,023); Bear Stearns
High-GradeStructuredCreditStrategiesEnhancedLeverageMasterFund,Ltd.,financialstatementsfor
theyearendedDecember31,2006(totalassetswere$9,403,233,402).
37.JamesCayne,writtentestimonyfortheFCIC,HearingontheShadowBankingSystem,day1,ses-
sion2:InvestmentBanksandtheShadowBankingSystem,May3,2010,p.2;WarrenSpector,interview
byFCIC,March30,2010.
38.Cioffi,interview.
39. AIMAs Illustrative Questionnaire for Due Diligence of Bear Stearns High Grade Structured
CreditStrategiesFund;BankofAmericapresentationtoMerrillLynchsBoardofDirectors,BearSteams
AssetManagement:WhatWentWrong.
40.BearStearnsHigh-GradeStructuredCreditStrategiesMasterFund,Ltd.,financialstatementsfor
the year ended December 31, 2006; Financial Statements, Bear Stearns High-Grade Structured Credit
StrategiesEnhancedLeverageMasterFund,Ltd.,financialstatementsfortheyearendedDecember31,
2006;BSAMfundchartpreparedbyJPMorgan.
41.FCICstaffcalculationsusingdatafromFCICsurveyofhedgefunds.Thehedgefundsresponding
tothesurveyhadatotalof$1.2trillionininvestments.
42.IMF,Global Financial Stability Report,April2008,Table1.2,page23,TypicalHaircutorInitial
Margin.
43.AlanSchwartz,interviewbyFCIC,April23,2010.
44.Cioffi,interview.
43.Ibid.
46.Ibid.
47.BearStearnsHigh-GradeStructuredCreditStrategies,investorpresentation,statingthatthefund
issubjecttoconflictsofinterest.BearStearnsHigh-GradeStructuredCreditStrategiesEnhancedLever-
age Fund, L.P., Preliminary 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.
30.BearStearnsAssetManagement,CollateralManagerPresentation.
31.CioffiandTanninCompensationTable,producedbyPaul,Weiss,Rifkind,Wharton&Garrison,
LLP.
577 Notes to Chapter 8
32.MattTannin,BearStearns,emailtoBellaBorg-Brenner,StillwaterCapital,March16,2007;Greg
Quental,BearStearns,emailtoAndrewDonnellan,BearStearns,etal.,June6,2007.
33.CharlesPrince,interviewbyFCIC,March17,2010.
34.RegulatorsinJapanandtheUnitedKingdomalsocamedownonthecompanyin2004and2003.
InSeptember2004,JapansFinancialServicesAgencysuspendedCitibanksabilitytooperatebranchesin
Japanbecauseofthebanksparticipationinallegedillegalactivityinthatcountry,andinthefollowing
year the United Kingdoms Financial Services Authority fined Citigroup $23 million for engaging in a
bondtradingschemelabeledDr.EvilbyCitigroupbondtraders.FinancialServicesAgency,Govern-
mentofJapan,AdministrativeActionsonCitibank,N.A.JapanBranch,September17,2004;Financial
Services Authority, Final Notice to Citigroup Global Markets Limited, June 28, 2003
(www.fsa.gov.uk/pubs/final/cgml_28jun03.pdf); David Reilly, Moving the Market: Citigroup to Take
$23MillionHitinDr.EvilCase,Vall Street journal, June29,2003.
33.Prince,interview.
36.RobertRubin,interviewbyFCIC,March11,2010.
37.Dominguez,interviewbyFCIC,March2,2010.TheCDOdeskearnedrevenuesof$367millionin
2003.Paul,Weiss,Citigroupscounsel,lettertoFCIC,March31,2010,inretheFCICssecondandthird
supplementalrequests,ResponsetoInterrogatoryNo.21.
38. Janice Warne, interview by FCIC, February 2, 2010; Paul, Weiss, Citigroups counsel, letter to
FCIC,March1,2010,ResponsetoInterrogatoryNo.18.
39. Paul, Weiss, Citigroups counsel, letter to FCIC, March 1, 2010, Response to Interrogatory No.
18.
60. Moodys Investors Service, CDOs with Short-Term Tranches: Moodys Approach to Rating
Prime-1CDONotes,February3,2006,p.11.
61.CitigroupInc.,Form10-K,forthefiscalyearendedDecember31,2007,filedFebruary22,2008,
p.91.
62.EverquestFinancialLtd.,FormS-1,May9,2007,p.93.
63.Dominguez,interview,March2,2010.
64.Ibid.;Warne,interview.
63.Dominguez,interview,March2,2010.
66.Warne,interview.
67.GCIBCapitalMarketsApprovalCommittee,CoventreeCapital,LiquidityPutOption,draftasof
December13,2002,p.4.
68.RonFrake,interviewbyFCIC,March11,2010.
69.FormalAgreementbetweentheComptrolleroftheCurrencyandCitibank,July22,2003.
70.MoodysInvestorsService,CDOswithShort-TermTranches.
71. Ibid.; Bank of America Corporation, Form 10-Q for the quarterly period ended September 30,
2007,p.19;FloydNorris,AsBankProfitsGrew,WarningSignsWentUnheeded,^ew York Times, No-
vember16,2007.
72.Dominguez,interview,March2,2010.
73.Paul,Weiss,Citigroupscounsel,lettertoFCIC,June23,2010,ResponsesofNestorDominguez,
p.6.
74.OCC,SubprimeCDOValuationandOversightReviewConclusionMemorandum,Memoran-
dumfromMichaelSullivan,RAD,andRonFrake,NBE,toJohnLyons,Examiner-in-Charge,Citibank,
NA,January17,2008,p.6,
73.Ibid.
76. Tobias Brushammar et al., memorandum to Nestor Dominguez et al., Re: Liquidity Put Valua-
tion,October19,2006,pp.1,34;LiquidityPutDiscussion,pt.1,producedbyCiti.
77.LiquidityPutDiscussion,producedbyCiti.
78.DataprovidedbyMoodystotheFCIC.
79.GaryGorton,interviewbyFCIC,May11,2010.
80.AIG,200810-K,p.133.Assetsareassignedariskweightingorpercentagethatisthenmultiplied
by8capitalrequirementtodeterminetheamountofrisk-basedcapital.
81.AIG,CDSnotionalbalancesatyear-end2000through2010Q1,providedtotheFCIC.
82.Thetotalwouldreach$78billionby2007(ibid.).
578 Notes to Chapter 8
83.GenePark,interviewbyFCIC,May18,2010.
84.CraigBroderick,testimonybeforetheFCIC,HearingontheRoleofDerivativesintheFinancial
Crisis,day1,session3:GoldmanSachsGroup,Inc.andDerivatives,June30,2010,transcript,pp.289
90.
83. Moodys, CDOs with Short-Term Tranches; AIG, Information Pertaining to the Multi-sector
CDSPortfolio,providedtotheFCIC.
86.Park,interview.
87.AIG,CDSnotionalbalancesatyear-end,2000through2010Q1.
88.AlanFrost,interviewbyFCIC,May11,2010.
89.AIGFinancialProductsCorp.DeferredCompensationPlan,March18,2003,p.2.
90.JosephCassano,emailtoAllUsers,re:2007SpecialCompensationPlan,December17,2007.
91.JosephCassanocompensationhistory,providedbyAIGtotheFCIC.
92.AIG,Form8-K,filedMay1,2003.
93.FactSheetonAIGFP,providedbyHankGreenberg,p.4.
94.AIG,CDSnotionalbalancesatyear-end.
93.GenePark,emailtoJosephCassano,re:CDOofABSApproachGoingForwardMessagetothe
DealerCommunity,February28,2006.
96.HenryM.PaulsonJr.,testimonybeforetheFCIC,HearingontheShadowBankingSystem,day2,
session1:PerspectiveontheShadowBankingSystem,May6,2010,transcript,p.22.
97.HenryM.PaulsonJr.,writtentestimonyfortheFCIC,HearingontheShadowBankingSystem,
day2,session1:PerspectiveontheShadowBankingSystem,May6,2010,p.2.
98. Goldman Sachs, 2003 and 2006 10-K (appendix 3a to Goldmans March 8, 2010, letter to the
FCIC).
99.Appendix3ctoGoldmansMarch8,2010,lettertotheFCIC.
100.GoldmansMarch8,2010,lettertotheFCIC,p.28(subprimesecurities).
101. Protection Bought by GS, spreadsheet provided by Goldman Sachs to the FCIC. Specifically,
IKB purchased $30 million of Class A notes, $40 million of Class B notes, and $30 million of Class C
notesonJune9,2004.TCWpurchased$30millionofClassAnotesinJanuary2003,andWachoviapur-
chased$43millionofClassAnotesinMarch2003.Seeibid.,Exhibit1.
102.FCICstaffcalculationsbasedondataprovidedbyGoldmanSachs.
103.ProtectionBoughtbyGS,spreadsheet.
104.FCICcalculationsbasedondataprovidedbyGoldmanSachs.
103.FCICstaffanalysisbasedondataprovidedbyGoldmanSachs.
106.Sparks,interview.
107.Ofcourse,intheorythenet impactonthefinancialsystemisnotgreater,becausethereisawin-
nerforeveryloserinthederivativesmarket.
108.Sparks,interview.
109.FromGoldmanSachsdataprovidedtotheFCICinahandouttitledAmplificationandquoted
attheFCICsHearingontheRoleofDerivativesintheFinancialCrisis,day1,session3:GoldmanSachs
Group,Inc.andDerivatives,June30,2010.
110.FCICstaffanalysisbasedondataprovidedbyGoldmanSachs.
111.LloydBlankfein,chairmanoftheboardandchiefexecutiveofficer,GoldmanSachsGroup,inter-
viewbyFCIC,June16,2010;Sparks,interview.
112.GaryCohn,testimonybeforetheFCIC,HearingontheRoleofDerivativesintheFinancialCri-
sis,day1,session3:GoldmanSachsGroup,Inc.andDerivatives,June30,2010,transcript,p.331.
113.Parkinson,interview.
114.MichaelGreenberger,beforetheFCIC,HearingontheRoleofDerivativesintheFinancialCri-
sis,day1,session1:OverviewofDerivatives,June30,2010;oraltestimony,transcript,p.109;writtentes-
timony,p.16.
113. Moodys Investors Service, Summary of Key Provisions for Cash CDOs as of January 2000
2010.
116.GaryWitt,writtentestimonyfortheFCIC,HearingonCredibilityofCreditRatings,theInvest-
ment Decisions Made Based on Those Ratings, and the Financial Crisis, day 1, session 1: The Ratings
Process,June2,2010,pp.12,13.
579 Notes to Chapter 8
117.Ibid.,12.
118.GaryWitt,testimonybeforetheFCIC,HearingonCredibilityofCreditRatings,theInvestment
DecisionsMadeBasedonthoseRatings,andtheFinancialCrisis,day1,session1:TheRatingsProcess,
June2,2010,transcript,pp.168,436.
119. Moodys Investors Service, Moodys Approach to Rating Multisector CDOs, September 13,
2000,p.3.
120.GaryWitt,interviewbyFCIC,April21,2010.
121.Witt,writtentestimonyfortheFCIC,June2,2010,p.17.
122.GaryWitt,follow-upinterviewbyFCIC,May13,2010.
123.Witt,interview,April21,2010.
124.Forexample,Moodysassumedthatborrowerswithdifferentcreditratingswouldnotdefaultat
thesametime.TheagencysplitthesecuritiesintothreesubcategoriesbasedontheaverageFICOscore
of the underlying mortgages: prime (FICO greater than 700), midprime (FICO between 700 and 623),
and subprime (FICO under 623). Creating three FICO-based subcategories rather than the traditional
two(primeandsubprime)resultedinlowercorrelationassumptions,becausemortgage-backedsecuri-
tiesindifferentsubcategorieswereassumedtobelesscorrelated.MoodysRevisitsItsAssumptionsRe-
gardingStructuredFinanceDefault(andAsset)CorrelationsforCDOs,June27,2003,pp.13,3,7,9,4;
GaryWitt,interviewbyFCIC,May6,2010.
123. Hedi Katz, U.S. Subprime RMBS in CDOs, Fitch Special Report, April 13, 2003, p. 3; Sten
Bergman, CDO Evaluator Applies Correlation and Monte Carlo Simulation to Determine Portfolio
Quality,Standard&PoorsGlobalCreditPortalRatingsDirect,November13,2001,p.8.
126.IngoFenderandJanetMitchell,StructuredFinance:Complexity,RiskandtheUseofRatings,
BIS Quarterly Review (June2003):68(www.bis.org/publ/qtrpdf/r_qt0306.pdf).
127.BasedonanFCICsurveyof40CDOmanagersand11underwritersabouttheprocessofcreat-
ingandmarketingCDOs.
128. Moodys Investors Service, Structured Finance Rating Transitions: 19832006, January 2007,
pp.7,64.Ofstructuredfinancesecuritiesoriginallyratedtriple-Abetween1984and2006,36retained
theiroriginalrating3yearslater,3weredowngraded,and39werewithdrawn.
129.KyleBass,testimonytotheHouseFinancialServicesCommittee,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, Moodys Credit Policy Special Comment,
March2009,p.2.
131. Moodys Investors Service, Announcement: Moodys Updates Its Key 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:OxfordUniversityPress,2010),andaformer
employee of Moodys Investor Service. She and co-principal Sylvain Raines first spoke to the FCIC on
April12,2010.
134.FromMoodysStructuredFinance:SpecialReport, thefollowingpage1headlines:2004U.S.
CDOReview/2003Preview:RecordActivityLevelsDrivenbyResecuritizationCDOsandCLOs,Feb-
ruary1,2003;2003U.S.CDOReview:LookingAheadto2006:RecordYearFollowsRecordYear,Feb-
ruary 6, 2006; 2008 U.S. CDO Outlook and 2007 Review: Issuance Down in 2007 Triggered by
SubprimeMortgagesMeltdown;LowerOverallIssuanceExpectedin2008,March3,2008.
133. Moodys annual gross revenues for ABS CDO ratings was $11,730,234 in 2003, $22,210,693 in
2004, $40,332,909 in 2003, $91,283,903 in 2006, and $94,666,014 in 2007. Information provided by
Moodys,May3,2010.SeealsoMoodysCorporation200610-K,p.66andMoodysCorporation,2007
10-K.
136.Witt,testimonybeforetheFCIC,June2,2010,transcript,p.46.
137.Witt,writtentestimonyfortheFCIC,June2,2010,p.11;Witt,interview,April21,2010.
138.EricKolchinsky,interviewbyFCIC,April27,2010.
139.Witt,interview,April21,2010.
140.FCICstaffestimatesbasedonanalysisofMoodysCDOEMSdatabase.
580 Notes to Chapter 9
141. Yuri Yoshizawa, interview by FCIC, May 17, 2010. The chart was labeled Derivatives (Amer-
ica).
142.BrianClarkson,interviewbyFCIC,May20,2010.
143.HarveyGoldschmid,interviewbyFCIC,March24,2010;AnnetteNazareth,interviewbyFCIC,
April1,2010.
144.OfficeofThriftSupervision,lettertotheSEC,February11,2004.
143.LehmanBrothers,Inc.,lettertotheSEC,March8,2004;J.P.MorganChase&Co.,lettertothe
SEC,February12,2004;DeutscheBankA.G.andDeutscheBankSecs.,lettertotheSEC,February18,
2004.
146.HarveyGoldschmid,interviewbyFCIC, April8,2010.
147.ClosedmeetingoftheSecuritiesandExchangeCommission,April28,2004.
148.In2003,theDivisionofMarketRegulationbecametheDivisionofTradingandMarkets.Forthe
sakeofsimplicity,throughoutthisreportitisreferredtoastheDivisionofMarketRegulation.
149.ErikSirri,interviewbyFCIC,April1,2010.Althoughtherearemorethan1,000SECexaminers,
collectivelytheyregulatemorethan3,000broker-dealers(withmorethan730,000registeredrepresenta-
tives)aswellasothermarketparticipants.
130.MichaelMacchiaroli,interviewbyFCIC,March18,2010.
131.ThemonitorsmetwithseniorbusinessandriskmanagersateachCSEfirmeverymonthabout
generalconcernsandrisksthefirmswereseeing.Writtenreportsofthesemeetingsweregiventothedi-
rectorofmarketregulationeverymonth.Inaddition,theCSEmonitorsmetquarterlywiththetreasury
andfinancialcontrolfunctionsofeachCSEfirmtodiscussliquidityandfundingissues.
132.ErikSirri,writtentestimonyfortheFCIC,HearingontheShadowBankingSystem,day1,ses-
sion3:SECRegulationofInvestmentBanks,May3,2010.
133. Internal SEC memorandum, Re: CSE Examination of Bear Stearns & Co. Inc., November 4,
2003.
134. Securities and Exchange Commission, Office of Inspector General, SECs Oversight of Bear
StearnsandRelatedEntities:TheConsolidatedSupervisedEntityProgram,ReportNo.446-A,Septem-
ber23,2008,pp.1718.
133.MichaelMacchiaroli,interviewbyFCIC,April13,2010.
136.RobertSeabolt,emailtoJamesGiles,StevenSpurry,andMatthewEichner,October1,2007.
137.MattEichner,interviewbyFCIC,April14,2010;SEC,OIG,SECsOversightofBearStearnsand
RelatedEntities:TheConsolidatedSupervisedEntityProgram,p.109.
138.Goldschmid,interview.
139.GAO,FinancialMarketsRegulation:FinancialCrisisHighlightsNeedtoImproveOversightof
Leverage at Financial Institutions, GAO-09-739 (Report to Congressional Committees), July 2009, pp.
3842.
160. Erik Sirri, Securities Markets and Regulatory Reform, remarks at the National Economists
Club,Washington,D.C.,April9,2009.
161.HarveyGoldschmid,interview,April8,2010.
162. Chairman Cox Announces End of Consolidated Supervised Entities Program, SEC press re-
lease,September26,2008.
163.MarySchapiro,testimonybeforetheFCIC,FirstPublicHearingoftheFinancialCrisisInquiry
Commission,day2,panel1:CurrentInvestigationsintotheFinancialCrisisFederalOfficials,January
14,2010,transcript,p.39.
164.TheFedremainedthesupervisorofJPMorganattheholdingcompanylevel.
163.MarkOlson,interviewbyFCIC,October4,2010.
166.FederalReserveSystem,FinancialHoldingCompanyProject, January23,2008,p.3.
Chapter 9
1.WarrenPeterson,writtentestimonyfortheFCIC,HearingontheImpactoftheFinancialCrisis
GreaterBakersfield,session3:ResidentialandCommunityRealEstate,September7,2010,pp.1,3.
2.GaryCrabtree,principalowner,AffiliatedAppraisers,writtentestimonyfortheFCIC,Hearingon
theImpactoftheFinancialCrisisGreaterBakersfield,session4:LocalHousingMarket,September7,
2010,p.2.
581 Notes to Chapter 9
3.LloydPlank,LloydE.PlankRealEstateConsultants,writtentestimonyfortheFCIC,Hearingon
theImpactoftheFinancialCrisisGreaterBakersfield,session4:LocalHousingMarket,September7,
2010,p.2.
4. CoreLogic Single Family Combined (SFC) Home Price Index, data accessed August 2010. FCIC
calculationofchangefromJanuary1997toApril2006,peak.
3.ProfessorRobertShiller,HistoricalHousingdata..
6.FinalReportofMichaelJ.Missal,BankruptcyCourtExaminer,InRE:NewCenturyTRSHoldings,
Chapter11,CaseNo.07-10416(KJC),(Bankr.D.Del),February29,2008,pp.143,138,13940(hereafter
Missal).
7.Ibid.,p.3.
8.NomuraFixedIncomeResearch,NotesfromBocaRaton:CoveragefromSelectedSessionsofABS
East2003,September20,2003,pp.37.
9.AlanGreenspan,TheEconomicOutlook,testimonybeforetheJointEconomicCommittee,109th
Cong.,1stsess.,June9,2003.
10.ChristopherMayer,writtentestimonyfortheFCIC,ForumtoExploretheCausesoftheFinancial
Crisis,day2,session3:MortgageLendingPracticesandSecuritization,February27,2010,pp.36.
11.AntonioFatas,PrakashKannan,PauRabanal,andAlasdairScott,LessonsforMonetaryPolicy
from Asset Price Fluctuations Leaving the Board, International Monetary Fund, Vorld Economic Out-
look (Fall2009),chapter3.
12.JamesMacGee,WhyDidntCanadasHousingMarketGoBust:FederalReserveBankofCleve-
land. Economic Comment (December2,2009).
13.MorrisA.Davis,AndreasLehnert,andRobertF.Martin,TheRent-PriceRatiofortheAggregate
StockofOwner-OccupiedHousing,FederalReserveBoardWorkingPaper,May2003,p.2.
14.PricedatafromCoreLogicCSBAHomePriceIndex,Single-FamilyCombined.RentdataisBu-
reau of Labor Statistics, metro-level Consumer Price Index (CPI-U), Owners Equivalent Rent for Pri-
maryResidence;allindexfiguresareadjustedsothatJan.1997=1.MethodsfollowfromFederalReserve
BankofSanFranciscoEconomicLetter,HousePricesandFundamentalValue,Number200427,Oc-
tober1,2004.
13.NationalAssociationofRealtorsHousingAffordabilityIndex,accessedfromBloombergascom-
positeIndex(HOMECOMP).Theindexbeganin1986.
16.Theindexalsoassumesthatthequalifyingratioof23,sothatthemonthlyprincipal&interest
paymentcouldnotexceed23ofthemedianfamilymonthlyincome.Moreaboutthemethodologycan
befoundatNationalAssociationofRealtors,MethodologyfortheHousingAffordabilityIndex.
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
BostonPublicPolicyDiscussionPaperNo.10-3,August12,2010.
19. Donald L. Kohn, Monetary Policy and Asset Prices, speech delivered at Monetary Policy: A
JourneyfromTheorytoPractice,aEuropeanCentralBankColloquiumheldinhonorofOtmarIssing,
Frankfurt,Germany,March16,2006.
20.RichardA.Brown,RisingRisksinHousingMarkets,memorandumtotheNationalRiskCom-
mitteeoftheFederalDepositInsuranceCorporation,March21,2003,pp.12.
21. Board of Governors, memorandum from Josh Gallin and Andreas Lehnert to Vice Chairman
[Roger]Ferguson,TalkingPointsonHousePrices,May3,2003,p.3.
22.Missal,p.40.
23.WilliamBlack,testimonybeforetheFCIC,HearingontheImpactoftheFinancialCrisisMiami,
Florida, session 1: Overview of Mortgage Fraud, September 21, 2010, transcript, p. 78; and email from
WilliamBlacktoFCIC,December12,2010.
24.ReplyofAttorneyGeneralLisaMadigan(Illinois)totheFCIC,April27,2010,p.7.
23.ChrisSwecker,AssistantDirectorCriminalInvestigativeDivisionFederalBureauofInvestigation,
statementbeforetheHouseFinancialServicesSubcommitteeonHousingandCommunityOpportunity,
108thCong.,2ndsess.,October7,2004.
26.FloridaDepartmentofLawEnforcement,MortgageFraudAssessment,November2003.
582 Notes to Chapter 9
27. Wilfredo Ferrer, testimony 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,supplementalwrittentestimonyfortheFCIC,HearingontheImpactoftheFinan-
cial CrisisMiami, Florida, session 1: Overview of Mortgage Fraud, September 21, 2010, p. 2; Fulmer,
testimony,transcript,pp.8081.
29.EdParker,interviewbyFCIC,May26,2010.
30.DavidGussmann,interviewbyFCIC,March30,2010.
31.WilliamH.Brewster,interviewbyFCIC,October29,2010.
32. Henry Pontell, written testimony for the FCIC, Hearing on the Impact of the Financial Crisis
Miami,Florida,session1:OverviewofMortgageFraud,September21,2010,p.1.
33.DepartmentofJustice,OfficeoftheInspectorGeneral,TheInternalEffectsoftheFBIsReprior-
itization,September2004,p.1.
34.ChrisSwecker,interviewbyFCIC,March8,2010.
33.PatrickCrowley,MortgageDaily.com,November24,2003.
36.Swecker,statementtotheHouseFinancialServicesSubcommitteeonHousingandCommunity
Opportunity,October7,2004.
37.WilliamBlack,writtentestimonyfortheFCIC,September21,2010,p.17.
38.FranciscoSanPedro,interviewbyFCIC,September20,2010.
39.FinCENreporttotheFCIConCountrywideSARactivity,19992009.
40.OCC,lettertoBankofAmerica,June3,2007.
41.DarcyParmer,interviewbyFCIC,June4,2010.
42. FinCEN, Mortgage Loan Fraud: An Industry Assessment Based on SAR Analysis, November
2006,pp.2,6.
43.Swecker,statementbeforetheHouseFinancialServicesSubcommitteeonHousingandCommu-
nityOpportunity,October7,2004.
44.Swecker,interview.
43.FinCEN,MortgageLoanFraudUpdate:SuspiciousActivityReportFilingsfromAprilJune30,
2010,p.21.
46.DOJ,letterfromAssistantAttorneyGeneralRonaldWelchtotheFCIC,April28,2010,pp.1,3,
October21,2010,p.2.
47.RobertMueller,interviewbyFCIC,December14,2010.
48.AlbertoGonzales,interviewbyFCIC,November1,2010.
49.OFHEO,2007PerformanceandAccountabilityReport,pp.13,17.
30.RichardSpillenkothen,interviewbyFCIC,March19,2010.
31.MichaelJ.Mukasey,interviewbyFCIC,October20,2010.
32.DOJresponsetoFCICrequest,April16,2010; seealsoDOJresponsetoFCICrequest,April28,
2010.
33.WilliamBlack,testimonybeforetheFCIC,September21,2010,transcript,p.38.
34.Swecker,interview.
33.EllenWilcox,specialagent,FloridaDepartmentofLawEnforcement,testimonybeforetheFCIC,
HearingontheImpactoftheFinancialCrisisMiami,session2:UncoveringMortgageFraudinMiami,
September21,2010,transcript,p.80;Participantin$13MillionMortgageFraudSchemeConvictedby
PolkCountyJury,OfficeofFloridaAttorneyGeneralBillMcCollumpressrelease,August28,2008.
36. Tenth Judicial Circuit in and for Polk County, Florida, State of Florida vs. Scott Almeida, et al.,
OSWPNo.2003-0236-TPA;July23,2007,seeparagraphs2,17,18,19,28,and32.
37.Wilcox,testimonybeforetheFCIC,September21,2010,transcript,pp.9899.
38. Gary Gorton, The Panic of 2007, paper presented at the Federal Reserve Bank of Kansas City,
JacksonHoleConference,MaintainingStabilityinaChangingFinancialSystem,August2008.
39.AdamB.AshcraftandTilSchuermann,UnderstandingtheSecuritizationofSubprimeMortgage
Credit,FederalReserveBankofNewYorkStaffReportNo.318,March2008,pp.311.
60.RaymondMcDaniel,quotedinthetranscriptofMoodysManagingDirectorsTownHallMeeting,
September11,2007.
583 Notes to Chapter 9
61.KeithJohnson,formerpresidentandchiefoperatingofficerofClaytonHoldings,Inc.,interview
byFCIC,September2,2010.
62.FrankFilipps,interviewbyFCIC,August9,2010.
63. Vicki Beal, testimony 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.133,13336.
64. Beal, testimony before the FCIC, September 23, 2010, transcript, pp. 169, 137; see also Martha
Coakley,MassachusettsAttorneyGeneral,commentlettertotheSecuritiesandExchangeCommission
regardingproposedruleregardingasset-backedsecurities,ReleaseNo.33-9117;34-61838;FileNo.S7-
08-10,August2,2010,p.6.
63.Beal,testimonybeforetheFCIC,September23,2010,transcript,pp.16970.
66. D. Keith Johnson, testimony 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,testimonybeforetheFCIC,September23,2010,transcript,p.172.
69. John J. Goggins, senior vice president and general counsel, Moodys, letter to FCIC regarding
September27,2010ArticlePublishedinThe ^ew York Times MisconstruingCommissionTestimony,
September30,2010.
70.Johnson,testimonybeforetheFCIC,September23,2010,transcript,p.174.
71.Missal,p.67.
72.RogerEhrnman,interviewbyFCIC,September2,2010;Johnson,testimonybeforetheFCIC,Sep-
tember23,2010,transcript,p.178.
73.TonyPeterson,interviewbyFCIC,October14,2010.
74.JosephSchwartz,vicepresidentinchargeofmortgageacquisitionduediligence,DeutscheBank,
interviewbyFCIC,July21,2010;WilliamCollinsBuellVI,headofmortgageacquisition,JPMorgan,in-
terviewbyFCIC,September13,2010.
73.RichardM.Bowen,writtentestimonyfortheFCIC,HearingonSubprimeLendingandSecuriti-
zationandGovernment-SponsoredEnterprises(GSEs),day1,session2:SubprimeOriginationandSe-
curitization,April7,2010,p.2.
76. Richard M. Bowen, interview by FCIC, February 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.136;FCICstaffestimatebasedonanalysisof
MoodysCDOEMSdatabase.
78.See,forexample,JamesC.TreadwayJr.,AnOverviewofRule413andSomeThoughtsAboutthe
Future, remarks to the thirteenth annual meeting of the Securities Industry Association, Hot Springs,
Virginia,October8,1983.
79.ShelleyParrattandPaulaDubberly,interviewbytheFCIC,October1,2010.
80.17C.F.R.Part229.1111(a)(3),PoolAssets,revisedasofApril1,2003.
81. See Part V of complaint filed by Cambridge Place Investment Management Inc., dated July 9,
2010, in Suffolk County (Massachusetts) Superior Court, Cambridge Place Investment Management,
Inc.,v.MorganStanley&Co.,Inc.,CaseNo.10-27841,p.71(hereafterCambridgeComplaint),andPart
VofcomplaintfiledbyFederalHomeLoanBankofChicago,datedOctober13,2010,inCircuitCourtof
Cook County, Illinois (Chancery Division), Federal Home Loan Bank of Chicago v. Banc of America
FundingCorp.etal.,CaseNo.10CH430B3,p.173.
82.CambridgeComplaint,pp.3233,6163,7071,7376.
83.Bowen,interview.
84.D.KeithJohnson,formerpresidentandchiefoperatingofficer,ClaytonHoldings,Inc.,interview
byFCIC,June8,2010.
83. A QIB was defined under Rule 144A to include entities, acting for its own account or the ac-
countsofotherqualifiedinstitutionalbuyers,thatintheaggregateownsandinvestsonadiscretionary
basis at least $100 million in securities of issuers that are not affiliated with the entity. See 17 C.F.R.
230.144A,PrivateResaleofSecuritiestoInstitutions.
584 Notes to Chapter 9
86.DennisVoigtCrawford,testimonybeforetheFCIC,FirstPublicHearingoftheFCIC,day2,ses-
sion 2: Current Investigation into the Financial CrisisState and Local Officials, January 14, 2010,
p.112.
87.RichardBreeden,interviewbyFCIC,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,interviewbyFCIC,September2,2010.
91.FederalReserveBankofNewYork,ReportonSystemicRiskandSupervision,DraftofAugust3,
2009,p.2.
92.RichSpillenkothen,Notesontheperformanceofprudentialsupervisionintheyearspreceding
the financial crisis by a former director of banking supervision and regulation at the Federal Reserve
Board(1991to2006),May31,2010,12.
93.SusanBies,interviewbyFCIC,October11,2010.
94.Bernanke,lettertotheFCIC,December21,2010.
93.JohnSnow,interviewbyFCIC,October7,2010.
96.OfficeoftheComptrolleroftheCurrency,BoardofGovernorsoftheFederalDepositInsurance
Corporation, Office of Thrift Supervision, and National Credit Union Administration, Credit Risk
ManagementGuidanceforHomeEquityLending,May16,2003.
97.2009 Mortgage Market Statistical Annual, 1:3;ResidentialMortgageLendersPeerGroupSurvey:
AnalysisandImplicationsforGuidance,PowerPointpresentation,November30,2003,pp.13,3.
98.SabethSiddique,interviewbytheFCIC,September9,2010.
99. Residential Mortgage Lenders Peer Group Survey: Analysis and Implications for Guidance,
PowerPoint,November30,2003.
100.Bies,interview.
101.OfficeoftheComptrolleroftheCurrency,BoardofGovernorsoftheFederalDepositInsurance
Corporation, Office of Thrift Supervision, and National Credit Union Administration, Interagency
Guidance on Nontraditional Mortgage Products, Federal Register 70 (December 29, 2003): 77,249,
72,232,72,233.
102.PaulSmith,AmericanBankersAssociation,lettertotheFederalDepositInsuranceCorporation,
BoardofGovernorsoftheFederalReserveSystem,OfficeofThriftSupervision,andOfficeoftheComp-
trolleroftheCurrency,March29,2006,p.2.
103. Letter from American Financial Services Association to federal regulators 8, available at
http://www.ots.treas.gov/_files/comments/d1e83ce107ab-4acf-8db38d1747afba0a.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 Indymac Bank
(March29,2006),p.4.
103.TheHousingPolicyCounciloftheFinancialServicesRoundtable,lettertotheOfficeofThrift
Supervision,March29,2006,p.6.
106.Siddique,interview.
107. Binyamin Appelbaum and Ellen Nakashima, Banking Regulator Played Advocate Over En-
forcer:AgencyLetLendersGrowOutofControl,ThenFail,Vashington Post, November23,2008.
108.Bies,interview.
109.See,e.g.CountrywideSeekstoBecomeSavingsBank;TheMortgageLenderSaysItIsPlanning
toApplytoConvertItsCharterSoItWillBeRegulatedbyOneFederalAgencyinsteadofTwo,Los An-
geles Times, November11,2006,basedonBloomberg,Reuters.
110.KimSherer,interviewbyFCIC,August32003.
111. Countrywide, Briefing Paper: Meeting with Office of Thrift Supervision, Thursday July 13,
2006.
585 Notes to Chapter 9
112.AngeloMozilo,emailtoJohnMcMurray(ccDaveSambol,CarlosGarcia),re:PayOptions,Au-
gust12,2006;JohnMcMurray,emailtoAngeloMozilo(ccKevinBartlett,CarlosGarcia,DaveSambol,
re:PayOptions,August13,2006.
113.Thecostofborrowingisreflectedbycreditspreads,theportionofinterestratesthatcompensate
investors for credit risk. Credit spreads are the interest rates that investors require above the so-called
risk-freeinterestrate,usuallymeasuredintermsofTreasuriesorinterestrateswapswithsimilarcharac-
teristics.
114.CongressionalOversightPanel,CommercialRealEstateLossesandtheRisktoFinancialStabil-
ity,February10,2010,pp.3860.
113.LoanSyndicationTradingAssociation,TheUSLoanMarketToday,presentation.
116. Loan Syndication Trading Association, Financial Reform and the Leveraged Loan Market,
presentation.
117.Ibid.,LoanSyndicationTradingAssociation,ChallengesFacingCLOsandtheLoanMarket,
presentation.
118. Ibid., p. 14. SEC, Risk Management Reviews at Consolidated Supervised Entities, memoran-
dum,April26,2007.
119.MichaelFlahertyandDenaAubin,ForPrivateEquityMarket,AllEyesonFirstData,Reuters,
September4,2007.
120. SEC, Risk Management Reviews of Consoldated Supervised Entities, memorandum, July 3,
2007.
121. Charles Prince, quoted in Citigroup chief stays bullish on buyouts, Financial Times, July 9,
2007; testimony before the FCIC, Hearing on Subprime Lending and Securitization and Government-
SponsoredEnterprises(GSEs),day2,session1:CitigroupSeniorManagement,April8,2010,transcript,
pp.4930.
122.RobenFarzad,MatthewGoldstein,DavidHenry,andChristopherPalmeri,NotSoSmart,Busi-
nessVeek, September3,2007.
123.JosephGyourko,UnderstandingCommercialRealEstate:JustHowDifferentfromHousingIs
It:NBERWorkingPaper14708,NationalBureauofEconomicResearch,February2009,pp.23,38.
124.CREFinanceCouncil,Compendium of Statistics, November3,2010,Exhibits3,2.
123.JoeKeohane,HeartbreakHotels,Portfolio, November11,2008.
126.HiltonDebtClogsLendersBalanceSheets,CommercialMortgageAlert,February20,2009.
127.TomMarano,interviewbyFCIC,April19,2010.
128.JeffMayerandTomMarano,FixedIncomeOverview,BearStearns,March29,2007,p.18.
129.Gyourko,UnderstandingCommercialRealEstate:JustHowDifferentfromHousingIsIt:p.1.
130.NewYorkFederalReserveBank,MaidenLaneLLCHoldingsasof9/30/2008.
131.AntonR.Valukas,ReportofExaminer,In re LehmanBrothersHoldingsInc.,etal.,Chapter11
CaseNo.08-13333(JMP),(Bankr.S.D.N.Y.),March11,2010,2:336(hereaftercitedasValukas).
132.Ibid.,2:33638.
133.MadelynAntoncic,LehmanBrothersRiskManagement,August7,2007,p.3;andAntoncic,in-
terviewbyFCIC,July14,2010.
134.Valukas,1:43,4;Antoncic,interview.
133.Valukas,1:4362,7980.
136. Jody Shenn, Lehman Said to Return to Mortgage Market through Aurora Unit (Update 1),
Bloomberg, October21,2009.
137.SEC,RiskManagementReviewsofConsolidatedSupervisedEntities,memoranda,October6,
2006;December6,2007;February2,2007;March30,2007;May31,2007;July3,2007;August3,2007;
September3,2007;October3,2007.
138.ErikSirri,interviewbyFCIC,April1,2010.
139.Valukas,1:7;18nn.63,64;3:742,81322.
140.Valukas,1:8,2021.
141.ThePeopleoftheStateofNewYorkv.Ernst&YoungLLP(N.Y.Sup.Ct.filedDec.21,2010).
142.RonaldMarcus,interviewbyFCIC,July23,2010.
143. See Ronald S. Marcus, OTS, Report of Examination Lehman Brothers Holdings Inc., July 7,
2008,pp.12.
586 Notes to Chapter 9
144.DavidSambol,interviewbyFCIC,September27,2010.
143.SeeCountrywideFinancialCorporation,Form10-K,February29,2007,p.47.SeealsoFannie
Mae, Single-Family Conventional Acquisition Characteristics: Overall (2007); Fannie Mae, Single
FamilyConventionalAcquisitionCharacteristics:CountrywideFinancialCorporation(2007);Country-
wide,ResponsetoJune23Request:11and12:Summary.
146.SingleFamilyGuaranteeBusiness:FacingStrategicCrossroads,June27,2003.
147.Ibid.
148.DanielMudd,interviewbyFCIC,March26,2010.
149.SingleFamilyGuaranteeBusiness:FacingStrategicCrossroads.
130.SingleFamilyGuarantyBusinessStrategicReviewSummary,PowerPointpresentation,July19,
2003.
131.Citigroup,ProjectPhineas:PresentationtotheBoardofDirectors,executivesummary,July18
and19,2003.
132.SingleFamilyConventionalAcquisitionCharacteristicsOverall,producedbyFannieMae.
133.TomLund,interviewbyFCIC,March4,2010.
134.ChristopherDickersontoJamesB.LockhartIII,ProposedAppointmentoftheFederalHousing
FinanceAgencyasConservatorfortheFederalNationalMortgageAssociation,memorandum,Septem-
ber6,2008,p.14
133.FannieMae,3Q2008Form10-Q,p.at113;FannieMae,2007Form10K,pp.12630.
136.ByDecember31,2003,Freddiereportedcapitalof$36.4 billion; $173billioninloanstoborrow-
erswithFICOscoresbelow660;$80billioninhighLTV;and$93billioninloansfornon-owner-occu-
piedhomes. FederalHomeLoanMortgageCorporation,InformationStatementandAnnualReportto
Stockholders:ForthefiscalyearendedDecember31,2007,February28,2008,p.74.
137.RichardSyron,interviewbyFCIC,August31,2010.
138.AnuragSaksena,interviewbyFCIC,June22,2010.
139.DonaldBisenius,interviewbyFCIC,September29,2010.
160.Saksena,interview.
161.OFHEO,SECReachSettlementwithFannieMae;PenaltyImposed,OfficeofFederalHousing
EnterpriseOversightpressrelease,May23,2006.
162. Freddie Mac Voluntarily Adopts Temporary Limited Growth for Retained Portfolio, Federal
HomeLoanMortgageCorporationpressrelease,August1,2006.
163.OFHEO,ReportoftheSpecialExaminationofFannieMae,May2006.
164.OFHEOReport:FannieMaeFaade;FannieMaeCriticizedforEarningsManipulation,Office
ofFederalHousingEnterpriseOversightpressrelease,May23,2006.
163.JamesLockhart,writtentestimonyfortheFCIC,HearingonSubprimeLendingandSecuritiza-
tionandGovernment-SponsoredEnterprises(GSEs),day3,session2:OfficeofFederalHousingEnter-
priseOversight,April9,2010,p.2.
166.Ibid.,p.1.
167.RobertJ.Levin,BoardofDirectorPresentation,PowerPointpresentation,January2006.
168.MinutesoftheFebruary21,2006,meetingoftheBoardofDirectorsofFannieMae(approvedon
April23,2006).
169.StephenB.Ashley,ChairmanFannieMae,remarkspreparedfordeliveryattheSeniorManage-
mentMeeting,Cambridge,Maryland,June27,2006.
170.FannieMae,NotestoSingleFamilyConventionalAcquisitionReport,August3,2007;Seealso
Federal National Mortgage Association, Form 10-K, for the fiscal year ended December 31, 2006, filed
August16,2007.
171.FCICstaffestimatesbasedondataprovidedbyFannieMae.
172.FederalNationalMortgageAssociation,FormDEF14A,November2,2007,p.42;FederalNa-
tionalMortgageAssociation,Form10-K,May2,2007,p.202.
173.OFHEO,ReportoftheSpecialExaminationforFannieMae,May2006,p.8.
174.FederalHomeLoanMortgageCorporation,Form10-K,forthefiscalyearendedDecember31,
2003,filedJune28,2006,pp.3,19.FederalHomeLoanMortgageCorporation,Form10-K,forthefiscal
yearendedDecember31,2006,filedMarch23,2007,pp.3,22.
587 Notes to Chapter 9
173.FederalHomeLoanMortgageCorporation,ProxyStatementandNoticeofAnnualMeetingof
Stockholders(May7,2007),SummaryCompensationTable,p.32(for2006figures).FederalHomeLoan
MortgageCorporation,ProxyStatementandNoticeofAnnualMeetingofStockholders(July12,2006),
SummaryCompensationTable,p.37(for2003figures).
176.Ibid.
177.OFHEO,ReportoftheSpecialExaminationforFannieMae,May2006,pp.3,910,13.
178.Ibid.,p2.
179.Ibid.
180.Ibid.,pp.78.
181.Ibid.
182.MarkWiner,interviewbyFCIC,March23,2010.
183.ToddHempstead,interviewbyFCIC,March23,2010.
184.DanielMudd,interviewbyFCIC,March26,2010.
183.DickersontoLockhart,FannieMaeconservatorshipmemo,September6,2008,p.14.
186.MinutesofaMeetingoftheFannieMaeBoardofDirectors,April21,2007.
187.MinutesofaMeetingoftheFannieMaeBoardofDirectors,May21,2007.
188.FederalNationalMortgageAssociation,Form10-K,forthefiscalyearendedDecember31,2007,
p.24.
189.FCICstaffestimatebasedondataprovidedbyFannieMae.
190.DeepenSegmentsDevelopBreadth,FannieMaeStrategicPlan,20072011.
191. Enrico Dallavecchia, email to Daniel Mudd, Budget 2008 and strategic investments, July 16,
2007.
192.EnricoDallavecchia,emailtoMichaelWilliams,RE:,July16,2007.
193.DanielMudd,emailtoEnricoDallavecchia,RE:Budget2008andstrategicinvestments,July17,
2007.
194.EnricoDallavecchia,interviewbyFCIC,March16,2010.
193. Freddie Mac, Freddie Macs Business Strategy, Board of Directors Meeting, March 23, 2007,
pp.34.
196. Freddie Mac, Freddie Macs Business Strategy, Board of Directors Meeting, March 23, 2007,
pp.34,70,73.
197.OFHEO,2006ReportofExaminationfortheFederalHomeLoanMortgageCorporation,pp.8
9,1011.
198. Federal Housing Finance Agency, Mortgage Market Note 102: The Housing Goals of Fannie
MaeandFreddieMacintheContextoftheMortgage,February1,2010.
199.HUDAnnouncesNewRegulationstoProvide$2.4TrillioninMortgagesforAffordableHous-
ingfor28.1MillionFamilies,DepartmentofHousingandUrbanDevelopment,pressrelease,October
31,2000.
200.Mudd,interview.
201.RobertLevin,interviewbyFCIC,March17,2010.
202.HUDFinalizesRuleonNewHousingGoalsforFannieMaeandFreddieMac,Departmentof
HousingandUrbanDevelopmentpressrelease,November1,2004.
203.Mudd,testimonybeforetheFCIC,HearingonSubprimeLendingandSecuritizationandGov-
ernment-SponsoredEnterprises(GSEs),day3,session:1FannieMae,April9,2010,transcript,pp.63
64.
204.SeeFHFA,AnnualReporttoCongress2009,pp.131,148.Thenumbersareformortgageassets
+outstandingMBSguaranteed.Totalassets+MBSareslightlygreater.
203.OFHEO,2008ReporttoCongress,April13,2008.
206. Robert Levin, interview by FCIC, March 17, 2010; Robert Levin, testimony before the FCIC,
HearingonSubprimeLendingandSecuritizationandGovernment-SponsoredEnterprises(GSEs),day
3,session1:FannieMae,April9,2010,transcript,pp.6872.
207.TomLund,interviewbyFCIC,March4,2010.
208.Dallavecchia,interview.
209.ToddHempstead,interviewbyFCIC,March23,2010.
210.KennethBacon,interviewbyFCIC,March3,2010.
588 Notes to Chapter 10
211.StephenAshley,interviewbyFCIC,March31,2010.
212.Levin,interview.
213.MikeQuinn,interviewbyFCIC,March10,2010.
214.Ashley,interview.
213.ArmandoFalcon,testimonybeforetheFCIC,HearingonSubprimeLendingandSecuritization
andGovernment-SponsoredEnterprises(GSEs),day3,session2:OfficeofFederalHousingEnterprise
Oversight,April9,2010,transcript,pp.13336,192;.writtentestimony,p.10.
216. Lockhart, written testimony for the FCIC, April 9, 2010, p. 6;; Lockhart, testimony before the
FCIC,April9,2010,transcript,pp.13661.
217.JamesLockhart,interviewbyFCIC,March19,2010.
218. Edward DeMarco, interview by FCIC, March 18, 2010; Maria Fernandez (with Alfred Pollard,
ChrisDickerson,JeffreySpohn,andJamieNewell),interviewbyFCIC,March3,2010.
219.MikePrice(withJaniceKuhl,PaulManchester,CharlotteReid,AlfredPollard,andKevinShee-
han),interviewbyFCIC,February19,2010.
220. Department of Housing and Urban Development, HUDs Housing Goals for the Federal Na-
tionalMortgageAssociation(FannieMae)andtheFederalHomeLoanMortgageCorporation(Freddie
Mac)fortheYears20032008andAmendmentstoHUDsRegulationofFannieMaeandFreddieMac,
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,lettertoBrianMontgomeryreaffordablehousinggoals,December21,2007.
223.DeepenSegmentsDevelopBreadth,FannieMaeStrategicPlan.
224.BrianD.Montgomery,FederalHousingCommissioner,toDanielMudd,FannieMae,typedlet-
ter,April24,2008;BrianD.Montgomery,FederalHousingCommissioner,toRichardF.Syron,Fannie
Mae,typedletter,April24,2008.
223.CostofFreddieMacsAffordableHousingMission,PowerPointpresentation,June4,2009,pp.
78,1011.
226.Freddiesnetincomewas$4.8billionin2003,$2.6billionin2004,$2.1billionin2003,$2.3bil-
lion in 2006, net loss of $3.1 billion in 2007, and net loss of $30.1 billion in 2008. Federal Home Loan
MortgageCorporation,Form10-K,forthefiscalyearendedDecember31,2009,filedFebruary24,2010,
Item6,SelectedFinancialData,p.37(for2008figure).FederalHomeLoanMortgageCorporation,In-
formationStatementandAnnualReporttoStockholders:ForthefiscalyearendedDecember31,2007,
February28,2008,SelectedFinancialDataandOtherOperatingMeasures,p.28(for200307figures).
227.CostandBenefitsofMissionActivities:ProjectPhineas,presentation,June14,2003.
228.March13,2007,BusinessReviewBriefing;informationconfirmedbycounseltoFannieMaeon
January4,2011.
229.FannieMaesHousingGoals,AuditTeambriefing,May8,2007.
230.FannieMaeBoardofDirectorsManagementReport,PowerPointpresentation,July17,2007.
231.CostofFreddieMacsAffordableHousingMission,PowerPointpresentation,June4,2009,pp.
78,1011.
Chapter 10
1.GaryGorton,interviewbyFCIC,May11,2010.
2.LewisRanieri,interviewbyFCIC,July30,2010.
3.Complaint,SECv.GoldmanSachs&Co.andFabriceTourre(S.D.N.Y.April16,2010).
4.OfficeoftheComptrolleroftheCurrency,Treasury;OfficeofThriftSupervision,Treasury;Board
ofGovernorsoftheFederalReserveSystem;FederalDepositInsuranceCorporation;andSecuritiesand
ExchangeCommission,InteragencyStatementonSoundPracticesConcerningElevatedRiskComplex
StructuredFinanceActivities(Noticeoffinalinteragencystatement),January3,2007.
3.WingChau,interviewbyFDIC,November11,2010.
6.FCIC,Surveyof40CDOManagers,ScheduleAandB(1stproductionservedon28managers,2nd
productionservedon12managers).
7.VerticalCapital,emailresponsetoFCICsurvey,October29,2010.
589 Notes to Chapter 10
8.Astwomarketobserverswouldlaterwrite,Startingin2004,CDOsandCDOinvestorsbecamethe
dominantclassofagentspricingcreditriskonsub-primemortgageloans. . . .Intheabsenceofrestraints,
lendersstartedoriginatingunreasonablyriskyloansinlate2003andcontinuedtodosointo2007.Mark
AdelsonandDavidJacob,TheSub-primeProblem:CausesandLessons,January8,2008,p.1.
9.ScottSimon,quotedinAllisonPyburn,CDOInvestorsDebateMoralityofSpreadEnvironment,
Asset Securitization Report, May9,2003,p.1.
10.ArmandPastine,quotedinibid.AccordingtotheFCICdatabase,PIMCOdidmanageonemore
newCDO,CostaBellaCDO,whichwasissuedinDecember2006.
11. Source on downgrades: Bloomberg. Source on events on default: Moodys Investors Service,
MoodysdowngradesratingsofNotesissuedbyMaximHighGradeCDOI,Ltd.,April18,2008,and
MoodysdowngradesratingsofNotesissuedbyMaximHighGradeCDOII,Ltd.,April18,2008.
12.ACACapital,200610-K,p.12.
13.ISDAPublishesTemplateforCreditDefaultSwapsonAsset-BackedSecuritieswithPayAsYou
Go Settlement, International Swaps and Derivatives Association press release, June 21, 2003
(www.isda.org/press/press062103.html). Under the terms of the pay-as-you-go swap, if the referenced
mortgage-backed security does not receive the full interest and principal payments, the pay-as-you-go
protectionsellerisrequiredtopaythebuyertheamountoftheshortfall.Forlonginvestorstheprotec-
tion providerundertheswaptheadvantagewastheleverageembeddedinthetrade:theydidnothave
tocomeupwiththecashupfrontfortheprincipalamountofthebond;theysimplyagreedtoreceive
quarterlyswapfeesinreturnforacceptingtheriskoflossifthesecuritiesexperiencedashortfall.
14.LauraSchwartz,interviewbyFCIC,May10,2010.
13.LaurieS.Goodman,ShuminLi,DouglasJ.Lucas,ThomasA.Zimmerman,andFrankJ.Fabozzi,
Subprime Mortgage Credit Derivatives (FrankJ.FabozziSeries)(Hoboken,NJ:JohnWiley,2008), p.176.
16.GregLippmann,interviewbyFCIC,May20,2010.
17.FCICstaffestimatesbasedonanalysisofMoodysCDOEMSdatabase.
18.FCICHedgeFundSurvey.FromJulythroughDecember2006,severalhedgefundswithaverage
assets under management of $4$8 billion accumulated positions totaling more than $1.4 billion in
mortgage-related CDO equity tranches and almost $3 billion of short positions in mortgage-related
CDO mezzanine tranches. FCIC staff used a Moodys proprietary CDO database to estimate the total
mortgage-relatedCDOequitytrancheissuance.PleaseseeFCICwebsiteformoreinformationaboutthe
hedge fund survey. Note: the FCIC did not survey hedge funds that fully liquidated or closed. These
fundsmayhavepurchasedsubstantiallongonlypositionsinmortgage-relatedsecurities.
19.FCICHedgeFundSurvey.SeeFCICwebsitefordetails.
20.Rabobankscounsel,lettertoJudgeFriedoftheSupremeCourtofNY,May11,2010.
21.NormaFlowofFunds,informationprovidedbyMerrillLynch.
22.StevenRoss,emailtoFCIC,December21,2010.
23.SeeletterfromRabobankscounsel,lettertoJudgeFried,May11,2010;theletterwasneverfiled
withthecourtbecausethecasewassettled.
24.DocumentofMagnetarInvestmentsinNorma,AttachmentG-13(showingMagnetarpurchases
ofequitytrancheinNorma);providedbyMerrillLynch.
23.InformationprovidedbyMerrillLynch,December22,2010.
26.Complaint,SECv.GoldmanSachs&Co.andFabriceTourre.
27.IraWagner,interviewbyFCIC,April20,2010.
28.AlanRoseman,interviewbyFCIC,May17,2010.
29.Schwartz,interview.
30.JohnPaulson,interviewbyFCIC,October28,2010.
31.GoldmanSachstoPayRecord$330MilliontoSettleSECChargesRelatedtoSubprimeMortgage
CDO,SECpressrelease,July13,2010.
32.JamieMaiandBenHockett,interviewbyFCIC,April22,2010.
33.SihanShu,interviewbyFCIC,September27,2010.
34.StevenEisman,interviewbyFCIC,April22,2010.
33.JamesGrant,InsidetheMortgageMachine,inMr. Market Miscalculates. The Bubble Years and
Beyond (MountJackson,VA:Axios,2008),pp.18081,18283.
36.Eisman,interview.
590 Notes to Chapter 10
37.MichaelBurry,interviewbyFCIC,May18,2010.
38.Paulson,interview.
39.Burry,interview.
40.FCICHedgeFundSurvey.SeeFCICwebsitefordetails.
41.JohnGeanakoplos,writtentestimonyfortheFCIC,ForumtoExploretheCausesoftheFinancial
Crisis,day1,session3:RiskTakingandLeverage,February26,2010,p.16.
42.OCC,SubprimeCDOValuationandOversightReviewConclusionMemorandum,memoran-
dumfromMichaelSullivan,RAD,andRonFrake,NBE,toJohnLyons,Examiner-in-Charge,Citibank,
NA,January17,2008,p.6;Paul,Weiss,Citigroupscounsel,lettertoFCIC,June23,2010,Responsesof
NestorDominguez.
43.RichardBookstaber,interviewbyFCIC,May11,2010.
44.RMBSandCiti-RMBSasaPercentageofCiti-CDOPortfolioNotionals,producedbyCitiforthe
FCIC.
43.FederalReserveBankofNewYork,FederalReserveBoard,OfficeoftheComptrolleroftheCur-
rency, Securities and Exchange Commission, U.K. Financial Services Authority, and Japan Financial
ServicesAuthority,NotesonSeniorSupervisorsMeetingswithFirms,November19,2007,p.3.
46.FCICstaffestimates,basedonanalysisofMoodysCDOEMSdatabase.
47. Paul, Weiss, Citigroups counsel, letter to FCIC, March 1, 2010, in re the FCICs second supple-
mentalrequest,ResponsetoInterrogatoryno.7;Paul,Weiss,lettertoFCIC,March31,2010,updated
responsetointerrogatoryno.7,p.3.
48.NestorDominguez,interviewbyFCIC,March2,2010;Paul,Weiss,letterofMarch31,2010,pp.
36.
49.BoardAnalystProfileforCitigroupInc.,April16,2007.
30. SEC staff (Sam Forstein, Tim McGarey, Mary Ann Gadziala, Kim Mavis, Bob Sollazo, Suzanne
McGovern,andChrisEaster),interviewbyFCIC,February9,2010.
31. Comptroller of the Currency, memorandum, Examination of Citigroup Risk Management
(CRM),January13,2003,p.3.
32. Ronald Frake, Comptroller of the Currency, letter to Geoffrey Coley, Citibank, N.A., December
22,2003.
33.FederalReserve,NewYorkOperationsReview,May1723,2003,p.4.
34. Federal Reserve Bank of New York Bank Supervision Group, Operations Review Report, De-
cember2009.
33. Federal Reserve Bank of New York, Summary of Supervisory Activity and Findings, Citigroup
Inc.,January1,2003December31,2003,April10,2006;FederalReserveBankofNewYork,Summary
of Supervisory Activity and Findings, Citigroup Inc., January 1, 2004December 31, 2004, April 3,
2003.
36.CitigroupInc.,Form8-K,April3,2006,Exhibit99.1.
37.FederalReserveBoard,memotoGovernorSusanBies,February17,2006.
38.Theboardreverseda13reductionthathadbeenimplementedwhentheissuesbeganandthen
addeda3raise.Citigroup,2006ProxyStatement,p.37.
39. Comptroller of the Currency, letter to Citigroup CEO Vikram Pandit (Supervisory Letter 2008-
03),February14,2008;quotation,p.2.
60.FederalReserveBankofNewYork,lettertoVikramPanditandtheBoardoftheDirectorsofCiti-
group,April13,2008,pp.67.
61. Timothy Geithner, testimony before the FCIC, Hearing on the Shadow Banking System, day 2,
session1:PerspectiveontheShadowBankingSystem,May6,2010,transcript,p.128.
62.GenePark,interviewbyFCIC,May18,2010.
63.AndrewForster,emailtoGaryGorton,AlanFrost,etal.,July21,2003.
64.Park,interview.
63.Gorton,interview.
66.Park,interview.
67.GenePark,emailtoJosephCassano,February28,2006.
68.Park,interview.
591 Notes to Chapter 10
69.DatasuppliedbyAIG.TheCDORFCCDOIIILtd.was93subprimeand7RMBSHome
Equity, according to the AIG credit committee. A review by FCIC staff showed that the remaining 7
designatedasRMBSHomeEquityincludedsubprimecollateral.
70. AIG, Residential Mortgage Presentation (Financial Figures are as of June 30, 2007), August 9,
2007,p.28.
71.Park,interview.
72.JosephCassano,interviewbyFCIC,June23,2010.
73.Park,interview.
74.DowKim,interviewbyFCIC,September9,2010.
73.StanleyONeal,interviewbyFCIC,September16,2010.
76.Kim,interview.
77.FCICstaffestimatesbasedonanalysisofMoodysCDOEMSdatabase.
78. Complaint, Coperatieve Centrale Raiffeisen=Boerenleenbank v. Merrill Lynch, No. 601832/09
(N.Y.S.June12,2009),paragraph147.
79.Kim,interview.
80.FCICanalysisbasedonMoodysCDOEMSdatabase.
81. Presentation to Merrill Lynch and Co. Board of Directors, Leveraged Finance and
Mortgage/CDOReview,October21,2007,p.33.
82.Chau,interview.
83.FCICstaffanalysisofMoodysCDOEMSdatabase.
84.FCICstaffestimatesbasedonMoodysCDOEMSdatabase.DatasuppliedbyMerrillLynch.Rele-
vantinformationnotprovidedforRobecoHighGradeCDOI.
83.FCICstaffanalysisofMoodysCDOEMSdatabase.
86.DatasuppliedbyMerrillLynch.
87. FCIC staff analysis of Moodys CDO EMS database. The total value of Baa tranches issued by
CDOsintheFCICdatabasewas$684millionin2003and$3.9billionin2007;Aatranches,$1.4billion
in2003and$8.3billionin2007;Atranches,$322millionin2003and$4.3billionin2007.
88.FCICstafftelephonediscussionwithSECstaff,September1,2010.
89.FCICstaffanalysisofMoodysCDOEMSdatabase.
90.Chau,interview;fornumberoftheCDOshemanaged,FCICstaffanalysisofMoodysEnhanced
CDOMonitoringDatabase.
91.SuperSeniorCreditTransactionsPrincipalCollateralProvisions,December7,2007,producedby
AIG.
92.PresentationtotheMerrillLynchBoard,LeveragedFinanceandMortgage/CDOReview,p.23;
JeffKronthal,formerheadofMerrillLynchsGlobalCredit,RealEstateandStructuredProducts,inter-
viewbyFCIC,September14,2010.
93.AlYoon,MerrillsOwnSubprimeWarningsUnheeded,Reuters,October30,2007.
94.SEC,RiskManagementReviewsofConsolidatedSupervisedEntities,internalmemotoErikSi-
rriandothers,February2,2007,p.3.
93.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.,Jan-
uary2,2003,S-Prt10782,pp.36,37.
99. Interagency Statement on Sound Practices (Notice of final interagency statement), January 3,
2007(seen.4,above).
100. Office of the Comptroller of the Currency, Treasury; Office of Thrift Supervision, Treasury;
BoardofGovernorsoftheFederalReserveSystem;FederalDepositInsuranceCorporation;andSecuri-
tiesandExchangeCommission,InteragencyStatementonSoundPracticesConcerningComplexStruc-
tured Finance Activities (Notice of interagency statement with request for public comments),May 13,
2004.
101.Ibid.,pp.78.
592 Notes to Chapter 10
102.JohnC.Dugan,ComptrolleroftheCurrency,writtentestimonyfortheFCIC,HearingonSub-
primeLendingandSecuritizationandGovernment-SponsoredEnterprises(GSEs),day2,session2:Of-
ficeoftheComptrolleroftheCurrency,April8,2010,AppendixE:OCCSupervisionofCitibank,N.A.,
p.10.
103.InteragencyStatementonSoundPractices(Noticeoffinalinteragencystatement),January3,
2007,p.6.
104.BaselCommitteeonBankingSupervision:JointForum,CreditRiskTransfer,BankforInterna-
tionalSettlements,March2003,pp.34,67,310.
103.Ibid.,p.4.
106.Ibid.
107.Ibid.,pp.34.
108.SEC,OfficeofComplianceInspectionsandExaminations,ExaminationReporttoMoodysIn-
vestorServices,Inc.,p.4(examinationbegunAugust31,2007).
109.WarrenBuffett,testimonybeforetheFCIC,HearingontheCredibilityofCreditRatings,theIn-
vestmentDecisionsMadeBasedonThoseRatings,andtheFinancialCrisis,session2:CreditRatingsand
theFinancialCrisis,June2,2010,transcript,p.301.
110. Warren Buffett, interview by FCIC, May 26, 2010; Buffett, testimony before the FCIC, June 2,
2010,transcript,p.302.
111. Eric Kolchinsky, written testimony for the FCIC, Hearing on the Credibility of Credit Ratings,
theInvestmentDecisionsMadeBasedonThoseRatings,andtheFinancialCrisis,session1:TheRatings
Process,June2,2010,p.2.
112.BrianClarkson,interviewbyFCIC,May20,2010.
113. Gary Witt, interview by FCIC, April 21, 2010. John Rutherford was the president and CEO of
MoodysCorporationfromthetimeofitsspin-offfromDun&Bradstreetin2000untilheretiredfrom
thefirmin2003.
114.JeromeFons,interviewbyFCIC,April22,2010.
113.RaymondMcDaniel,interviewbyFCIC,May21,2010.
116.Clarkson,interview.
117.Ibid.
118.McDaniel,interview.
119. Raymond McDaniel, testimony before the FCIC, Hearing on the Credibility of Credit Ratings,
theInvestmentDecisionsMadeBasedonThoseRatings,andtheFinancialCrisis,session2:CreditRat-
ingsandtheFinancialCrisis,June2,2010,transcript,pp.2034.
120.ScottMcCleskey,interviewbyFCIC,April16,2010.
121.Clarkson,interview.
122.Witt,interview.
123.MarkFroeba,testimonybeforetheFCIC,HearingontheCredibilityofCreditRatings,theIn-
vestmentDecisionsMadeBasedonThoseRatings,andtheFinancialCrisis,session3:TheCreditRating
AgencyBusinessModel,June2,2010,transcript,p.347.
124.Clarkson,interview;McDaniel,interview.
123.Witt,interview;GaryWitt,testimonybeforetheFCIC,HearingontheCredibilityofCreditRat-
ings, the Investment Decisions Made Based on those Ratings, and the Financial Crisis, Session 3: The
CreditRatingAgencyBusinessModel,June2,2010,transcript,p.394.
126.BrianClarkson,emailtoEdBankole,PramilaGupta,MichaelKanef,AndrewKriegler,SamPil-
cer,AndrewSilver,andLindaStesney,subject:JuneYTDAFGbyanalyst.xls,July3,2001.
127.WilliamMay,emailtoGusHarris,subject:RE:BESandPEs,January12,2006.
128.YuriYoshizawa,emailtodirectreportmanagingdirectors,subject:3QMarketCoverage-CDO,
October3,2007.
129.Clarkson,interview.
130.McDaniel,interview.
131.Witt,testimonybeforetheFCIC,June2,2010,transcript,pp.43637.
132.MoodysInvestorsService:ManagingDirectorsTownHallMeeting,September11,2007,tran-
script,pp.42,3132.
133.Witt,interview.
593 Notes to Chapter 11
134. Andrew Kimball, internal email, October 21, 2007, attaching memorandum, Credit policy is-
suesatMoodyssuggestedbythesubprime/liquiditycrisis.Thesusceptibilityofaratingscommitteeto
externalpressureswasshownintheconstantproportiondebtobligation(CPDO)scandalinEurope.
133.Ibid.,p.3.
136.DavidTeicher,projectmanageratMoodys,interviewbyFCIC,May4,2010;Standard&Poors,
CreditFAQ:TheBasicsofCreditEnhancementinSecuritizations,RatingsDirect,June24,2008.
137.RichardMichalek,testimonybeforetheFCIC,HearingontheCredibilityofCreditRatings,the
InvestmentDecisionsMadeBasedonThoseRatings,andtheFinancialCrisis,session3:TheCreditRat-
ingAgencyBusinessModel,June2,2010,transcript,p.361.
138.Witt,interview.
139.Clarkson,interview.
140.Fons,interview.
141.Kimball,memorandum,CreditpolicyissuesatMoodys,p.1.
142.EricKolchinsky,testimonybeforetheFCIC,HearingontheCredibilityofCreditRatings,theIn-
vestment Decisions Made Based on Those Ratings, and the Financial Crisis, session 1: The Ratings
Process,June2,2010,transcript,pp.6869.
143.EKolchinsky,emailtoYFuandYYoshizawa,May30,2003.
144.Kolchinsky,testimonybeforetheFCIC,June2,2010,transcript,pp.6869.
143.EricKolchinsky,interviewbyFCIC,April14,2010.
146.FCICstaffestimates,basedonanalysisofMoodysSFDRSdatabase.
147.RiachraODriscoll,emailtoYuriYoshizawa,subject:Magnolia20063ClassDs,April27,2006.
148.Kimball,memorandum,CreditpolicyissuesatMoodys,p.2.
149.SEC,OfficeofComplianceInspectionsandExaminations,ExaminationReportforMoodysIn-
vestorsServices,Inc.,p.2.
Chapter 11
1.WilliamDudley,interviewbyFCIC,October13,2010.
2.InsideMortgageFinance,The 2009 Mortgage Market Statistical Annual, vol.2,The Secondary Mar-
ket (Bethesda,Md.:InsideMortgageFinance,2009),p.13,Non-AgencyMBSIssuancebyType.
3.FCICstaffestimatesbasedonMoodysCDOEnhancedMonitoringSystem(EMS)database.
4.2009 Mortgage Market Statistical Annual, 2:373,CommercialMBSIssuance.
3.BenS.Bernanke,chairmanoftheFederalReserve,lettertoPhilAngelides,chairmanoftheFCIC,
December21,2010.
6.MarkZandi,CeliaChen,andBrianCarey,HousingattheTippingPoint,MoodysEconomy.com,
October2006,pp.67.
7. CoreLogic Home Price Index, Single-Family Combined (available at www.corelogic.com/
Products/CoreLogic-HPI.aspx),FCICstaffcalculations,JanuarytoJanuary.
8.CoreLogicCensusBureauStatisticalArea(CBSA)HomePriceIndex,FCICstaffcalculations.
9. Data provided by Mark Fleming, chief economist for CoreLogic, in his written testimony for the
FCIC, Hearing on the Impact of the Financial CrisisSacramento, session 1: Overview of the Sacra-
mentoHousingandMortgageMarketsandtheImpactoftheFinancialCrisisontheRegion,September
9,2010,figures4,3.
10.MarkFleming,testimonybeforetheFCIC,HearingontheImpactoftheFinancialCrisisSacra-
mento,session1:OverviewoftheSacramentoHousingandMortgageMarketsandtheImpactoftheFi-
nancialCrisisontheRegion,September9,2010,transcript,p.14.
11.MortgageBankersAssociation,NationalDelinquencySurvey,dataprovidedtotheFCIC.
12.Ibid.,withFCICstaffcalculations.
13.FCICstaffanalysis,Analysisofhousingdata,July7,2010.TheunderlyingdatacomefromCore-
LogicandLoanProcessingSvcs.TabulationswereprovidedtotheFCICbystaffattheFederalReserve.
14. Subprime and Alt-A mortgages are defined as those included in subprime or Alt-A securitiza-
tions,respectively.GSEmortgagesincludedmortgagespurchasedorguaranteedbyFannieMaeorFred-
dieMac.FHAmortgagesincludedmortgagesinsuredbytheFHAorVA.
13.FCICstaffanalysis.
594 Notes to Chapter 11
16. A recent analysis published by FHFA comes to very similar conclusions. See Data on the Risk
Characteristics and Performance of Single-Family Mortgages Originated from 2001 through 2008 and
FinancedintheSecondaryMarket,September13,2010.
17.FCICstaffanalysis,AnalysisofhousingdataandcomparisonwithEdPintosanalysis,August9,
2010.InthesampledataprovidedbytheFederalReserve,FannieMaeandFreddieMacmortgageswitha
FICOscorebelow660hadanaveragerateofseriousdelinquencyof6.2in2008.Inpublicreports,the
GSEsstatedthattheaverageseriousdelinquencyratesforloanswithFICOscoreslessthan660intheir
guaranteebookswas6.3.FannieMae2008CreditSupplement,p.3;FreddieMacFourthQuarter2008
FinancialResultsSupplement,March11,2009,p.13.
18.InthesampledataprovidedbytheFederalReserve,FannieMaeandFreddieMacmortgageswith
LTVsabove90hadanaveragerateofseriousdelinquencyof3.7in2008.Inpublicreports,theGSEs
statedthattheaverageseriousdelinquencyratesforloanswithLTVsabove90intheirguaranteebooks
was3.8.FannieMae2008CreditSupplement,p.3;
FreddieMacFourthQuarter2008FinancialResultsSupplement,March11,2009,p.13.
19.EdwardPinto,Memorandum:SizingTotalFederalGovernmentandFederalAgencyContribu-
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,respectively.Tothese,headdsanother8.8millionloanswithFICOscores
below660,whichhelabelssubprimebycharacteristic.Healsoadds6.3millionloansattheGSEsthat
areeitherinterest-onlyloans,negativeamortizationloans,orloanswithanLTVincludinganysecond
mortgagegreater than 90, which he collectively refers to as Alt-A by characteristic. The last addi-
tionsincludeanestimated1.4millionloansinsuredbytheFHAandVAwithanLTVgreaterthan90
outofatotalofroughly3.3millionFHAandVAloansand1.3millionloansinbankportfoliosthatare
inferredtohavehisdefinedAlt-Acharacteristics.
20. Fannie Mae 2008 Credit Supplement, p. 3; Freddie Mac Fourth Quarter 2008 Financial Results
Supplement,March11,2009.
21.EdwardPinto,Yes,theCRAIsToxic,City journal, 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,
whichcoverroughly80ofthemortgagemarketintheUnitedStatesseeRobertB.Avery,KennethP.
Brevoort,andGlennB.Canner,OpportunitiesandIssuesinUsingHMDAData,journal of Real Estate
Research 29,no.4(October2007):33179.
23.ElizabethLadermanandCarolinaReid,Lendinginlowandmoderateincomeneighborhoodsin
California: The Performance of CRA Lending During the Subprime Meltdown, November 26, 2008,
workingpapertobepresentedattheFederalReserveSystemConferenceonHousingandMortgageMar-
kets,Washington,DC,December4,2008.
24.FCIC,PreliminaryStaffReport:TheMortgageCrisis,April7,2010.
23.BankofAmericaresponselettertoFCIC,August20,2010.
26.JohnReed,interviewbyFCIC,March4,2010.
27.LewisRanieri,interviewbyFCIC,July30,2010.
28.NicolasWeill,interviewbyFCIC,May11,2010.
29.Ibid.
30.NicolasWeill,emailtoRaymondMcDanielandBrianClarkson,July4,2007.
31.MoodysInvestorsService,EarlyDefaultsRiseinMortgageSecuritizations,StructuredFinance:
SpecialReport,January18,2007,pp.1,3.
32. Moodys Investors Service, Moodys Downgrades Subprime First-lien RMBS-Global Credit Re-
searchAnnouncement,July10,2007.
33.Weill,interview.
34.FCICstaffestimates,basedonanalysisofBlackboxdata.
33.DataonBearStearnsprovidedbyJPMorgantotheFCIC.
595 Notes to Chapter 11
36. Moodys Investors Service, Moodys Downgrades $33.4 billion of 2006 Subprime First-Lien
RMBSandAffirms$280billionAaasandAas,October11,2007;October11RatingActionsRelatedto
2006SubprimeFirst-LienRMBS,StructuredFinance:SpecialReport,October17,2007,pp.12.
37.FCICstaffestimates,basedonanalysisofBlackboxdata.
38.FCICstaffestimates,basedonanalysisofMoodysSFDRSdataasofApril2010.
39.MoodysInvestorsService,TheImpactofSubprimeResidentialMortgage-BackedSecuritieson
Moodys-Rated Structured Finance CDOs: A Preliminary Review, Structured Finance: Special Com-
ment,March23,2007,p.2.
40. Yuri Yoshizawa, email to Noel Kirnon and Raymond McDaniel, cc Eric Kolchinsky, subject:
CSFBPipelineinformation,March28,2007.
41.MoodysInvestorsService,FirstQuarter2007U.S.CDOReview:ClimbingtheWallofSubprime
Worry,StructuredFinance:SpecialReport,May31,2007,p.2.
42. Richard Michalek, testimony before the FCIC, Hearing on the Credibility of Credit Ratings, the
InvestmentDecisionsMadeBasedonThoseRatings,andtheFinancialCrisis,session3:TheCreditRat-
ingAgencyBusinessModel,June2,2010,transcript,pp.44849.
43.2007MCOStrategicPlanOverview,presentationbyRayMcDaniel,July2007.
44.EricKolchinskyretaliationcomplaint,ChronologyPreparedbyEricKolchinsky.
43.FCICstaffestimatesbasedonanalysisofMoodysSFDRS;FCIC,PreliminaryStaffReport:Credit
RatingsandtheFinancialCrisis,June2,2010.
46.EricKolchinsky,interviewbyFCIC,April27,2010.483823036167(checkedBLK);Kolchinsky
retaliationcomplaint.
47.EricKolchinskyretaliationcomplaint.
48.FCIC,PSR:CreditRatingsandtheFinancialCrisis,pp.3033.
49.BinghamMcCutchen,FannieMaecounsel,lettertoFCIC,September21,2010(hereafterBing-
hamLetter);OMelveny&MeyersLLP,FreddieMaccounsel,lettertoFCIC,September21,2010(here-
afterOMelvenyLetter).
30. Federal Housing Finance Agency, Conservators Report on the Enterprises Financial Perform-
ance:ThirdQuarter2010,tables3.1and4.1.
31.RaymondRomano,interviewbyFCIC,September14,2010;BinghamLetter.
32.BinghamLetter.
33.BinghamLetter,Tab3;Tab1,RepurchaseCollectionsbyTopTenSellers/Servicers.
34.OMelvenyletter.
33.BankofAmericaannouncesfourth-quarteractionswithrespecttoitshomeloansandinsurance
business,BankofAmericapressrelease,January3,2011.
36.MortgageInsuranceCompaniesofAmerica,20092010 Fact Book and Member Directory,Exhibit
3:PrimaryInsuranceActivity(InsuranceinForce)p17.
37.DocumentsproducedfortheFCICbyUnitedGuarantyResidentialInsurance,MGIC,Genworth,
RMIC,Triad,PMI,andRadian.
38. FCIC staff calculations based on productions from Fannie and Freddie. Figures are for Alt-A,
optionARMAlt-A,andsubprimeloans.
39.FHFA,ConservatorsReport:ThirdQuarter2010.Accountingchangesforimpairmentshavere-
sultedinoffsettinggainsof$8billion.
60.FHFAIssueSubpoenasforPLSDocuments,FederalHousingFinanceAgencynewsrelease,July
12,2010.
61.Covington&BurlingLLP,FreddieMaccounsel,lettertoFCIC,October19,2010;seeOMelveny
&MeyersLLP,lettertoFCIC,datedOctober19,2010.
62.NERAEconomicConsulting,CreditCrisisLitigationRevisited:LitigatingtheAlphabetofStruc-
turedProducts,PartVIIofaNERAInsightsSeries,June4,2010,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. Attorney General of Massachusetts, Attorney General Martha Coakley and Goldman Sachs
ReachSettlementRegardingSubprimeLendingIssues,May11,2009;MorganStanleytoPay$102Mil-
lionforRoleinMassachusettsSubprimeMortgageMeltdownunderSettlementwithAGCoakleysOf-
fice,June24,2010.
63.Complaint,CambridgePlacev.MorganStanleyetal.,No.10-2741(Mass.Super.Ct.filedJuly9,
2010),p.28.
66.SarahJohnson,HowFarCanFairValueGo: CFO.com, May6,2008.
67.VikasShilpiekandulaandOlgaGorodetsky,WhoOwnsResidentialCreditRisk:LehmanBroth-
ersFixedIncome,U.S.SecuritizedProductsResearch,September7,2007.
68. Moodys Investor Service, Default & Loss Rates of Structured Finance Securities: 19932009,
SpecialComment,September23,2010.
69.BenBernanke,closed-doorsessionwiththeFCIC,November17,2009.
70.VikasShilpiekandulaandOlgaGorodetsky,WhoOwnsResidentialCreditRisk:,September7,
2007,p.1.TheLehmananalystspeggedultimatesubprimeandAlt-Alossesat$200billion.Thosefore-
castswerebased,theanalystssaid,onascenarioinwhichhousepricesfellanaverageof30acrossthe
country.Forthesecuritizationfigures,seeInsideMortgageFinance,The 2009 Mortgage Market Statisti-
cal Annual, vol.2,The Secondary Market.
71.IMF,FinancialStressandDeleveraging:Macro-FinancialImplicationsandPolicy,Global Finan-
cial Stability Report, October 2008, p. 78; IMF, Containing Systemic Risks and Restoring Financial
Soundness,Global Financial Stability Report, April2008.
72.FCICstaffestimates,basedonMoodysInvestorService,Default&LossRatesofStructuredFi-
nanceSecurities:19932009,SpecialComment,September23,2010,andanalysisofMoodysStructured
FinanceDefaultRiskService.
73.BenBernanke,testimonybeforetheFCIC,HearingonTooBigtoFail:ExpectationsandImpactof
ExtraordinaryGovernmentInterventionandtheRoleofSystemicRiskintheFinancialCrisis,day2,ses-
sion1:TheFederalReserve,September2,2010,transcript,p.34.
Chapter 12
1. FCIC staff calculations using data in worksheets Markit ABX.HE. 06-1 prices and ABX.HE. 06-2
prices,producedbyMarkit;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,January4,2007.
4.JimChanos,interviewbyFCIC,October3,2010.
3.SEC,RiskManagementReviewsofConsolidatedSupervisedEntities,memo,January4,2007.
6. Fed Chairman Ben S. Bernanke, The Economic Outlook, testimony before the Joint Economic
Committee,U.S.Congress,110thCong.,1stsess.,March28,2007.
7. Henry Paulson, quoted in Julie Haviv, Bernanke Allays Subprime Fears as Beazer Faces Probe,
Reuters,March28,2007.
8.DavidViniar,writtentestimony,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 testimony, 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,December13,2006,SenatePermanentSubcommitteeonIn-
vestigations,Exhibit3.
13.StacyBash-Polley,emailtoMichaelSwensonandothers,December20,2006,SenatePermanent
SubcommitteeonInvestigations,Exhibit131.
597 Notes to Chapter 12
14.TetsuyaIshikawa,emailtoDarrylHerrick,October11,2006,SenatePermanentSubcommitteeon
Investigations, Exhibit 170c; Geoffrey Williams, email to Ficc-Mtgcorr-desk, October 24, 2006, Senate
PermanentSubcommitteeonInvestigations,Exhibit170d.
13. Fabrice Tourre, email to Jonathan Egol and others, December 28, 2006, Senate Permanent Sub-
committeeonInvestigations,Exhibit61.
16. Daniel Sparks, email to Tom Montag, January 31, 2007, Senate Permanent Subcommittee on
Investigations,Exhibit91.
17. Fabrice Tourre, email to Marine Serres, January 23, 2007, Senate Permanent Subcommittee on
Investigations,Exhibit62.
18.LloydBlankfein,emailtoTomMontag,February11,2007,SenatePermanentSubcommitteeon
Investigations,Exhibit130.
19. FCIC calculations using data from 20042007 GS Synthetic CDOs, produced by Goldman
Sachs.
20.GretchenMorgensonandLouiseStory,BanksBundledBadDebt,BetAgainstItandWon,^ew
York Times,December24,2009.
21.LloydBlankfein,testimonybeforetheFCIC,FirstPublicHearingoftheFCIC,firstday,panel1:
FinancialInstitutionRepresentatives,January13,2010,transcript,pp.2627.
22. Goldman Sachs Clarifies Various Media Reports of Aspect of FCIC Hearing, Goldman Sachs
pressrelease,January14,2010.
23.GaryCohn,testimonybeforetheFCIC,HearingontheRoleofDerivativesintheFinancialCrisis,
day1,session3:GoldmanSachsGroup,Inc.andDerivatives,June30,2010,transcript,p.267.
24.MichaelSwenson,openingstatement,Hearing on Vall Street and the Financial Crisis. The Role of
Investment Banks, SenatePermanentSubcommitteeonInvestigations,pp.23.
23.Complaint,BasisYieldAlphaFundv.GoldmanSachsGroup,Inc.,etal.(S.D.N.Y.June9,2010),
p.29.
26.Blankfein,testimonybeforetheFCIC,January13,2010,transcript,p.140.
27.CraigBroderick,writtentestimonyfortheFCIC,HearingontheRoleofDerivativesintheFinan-
cialCrisis,day1,session3:GoldmanSachsGroup,Inc.andDerivatives,June30,2010,p.1.
28.CraigBroderick,emailtoAlanRapfogelandothers,May11,2007,SenatePermanentSubcommit-
teeonInvestigations,Exhibit84.
29.HighGradeRiskAnalysis,April27,2007,p.4;HighGradeEnhancedLeverageQ&/A,June13,
2007,statingthepercentageofunderlyingcollateralinourinvestmentgradestructurescollateralizedby
sub-primemortgagesisapproximately60.OntheMarch12,2007,investorcall,MatthewTannintold
investorsthatmostoftheCDOsthatwepurchasedarebackedinsomeformbysubprime(Conference
Calltranscript,pp.2122).
30.Emailfrommatt.tannin,gmail.comtomatt.tannin,gmail.com,November23,2006.
31.MatthewTannin,BearStearns,emailtoChavanneKlaus,MEAGNewYork,March7,2007.
32.BSAMConferenceCall,April23,2007,transcript,p.3.
33.MattTannin,BearStearns,emailtoKlausChavanne,MEAGNewYork,March7,2007;Matthew
Tannin, email to Steven Van Solkema, March 30, 2007; Complaint, SEC v. Cioffi, No. 08 Civ. 2437
(E.D.N.Y.June19,2008),p.32.
34.JimCrystal,BearStearns,emailtoRalphCioffi(andothers),March22,2007;RalphCioffi,Bear
Stearns,emailtoKenMak,BearStearns,March23,2007.
33.WarrenSpector,testimonybeforetheFCIC,HearingontheShadowBankingSystem,day1,ses-
sion1:InvestmentBanksandtheShadowBankingSystem,May3,2010,transcript,pp.8384.
36.InformationprovidedtoFCICbylegalcounseltoBankofAmerica,September28,2010.
37.Ibid.
38.AlanSchwartz,interviewbyFCIC,April23,2010.Notably,asoneofonlytwotri-partyrepoclear-
ingbanks,JPMorganhadmoreinformationaboutBSAMslendingobligationsthandidmostothermar-
ket participants or regulators. As discussed in greater detail later in this chapter, this superior market
knowledgelaterputJPMorganinapositiontostepinandpurchaseBearStearnsvirtuallyovernight.
39.EmailfromGoldmantoBear,April2,2007.
40. Steven Van Solkema, Bear Stearns, internal email, Summary of CDO Analysis Using Credit
Model,April19,2007.
598 Notes to Chapter 12
41.MattTannin,BearStearns,emailfromGmailaccounttoRalphCioffi,BearStearns,athisHotmail
account,April22,2007.
42.BSAMConferenceCall,April23,2007,transcript.
43.IrisSemic,emailtoMatthewTanninetal.,May1,2007.
44.RobertErvin,emailtoRalphCioffietal.,May1,2007;emailfromGoldman(ficc-ops-cdopricing)
torervin,bear.com,May1,2007.
43.BSAMPricingCommitteeminutes,June3,2007;RobertErvin,emailtoGregQuentaletal.,May
10,2007,showingthatlossesfortheHighGradefundwouldbe7.02ifBSAMusedthepricesLehmans
repodeskwasusing,ratherthan11.43thelosswithoutLehmansmarks.
46. Email from BSAM Hedge Fund Product Management (Generic), May 16, 2007, produced by
JPMorgan.
47. BSAMFCIC-e0000013. An untitled chart produced by JPMorgan shows losses would have been
over $30 million less; NAV estimate reconciliation chart, produced by JPMorgan, shows losses would
havebeenalmost$23millionless.
48.BSAMPricingCommitteeminutes,June4,2007.
49.RalphCioffi,interviewbyFCIC,October19,2010.
30.RalphCioffi,emailtoJohnGeissinger,June6,2007.
31.Schwartz,interview.
32.Ibid.
33.Ibid.;CSEProgramMemorandumtoErikSirriandothersthroughMatthewEichner,July3,2007.
34.CSEProgramMemorandum,July3,2007.
33. CSE Program Memorandum, July 3, 2007; Merrill Lynch analysis, Bear Stearns Asset Mgmt:
WhatWentWrong;PaulFriedman,interviewbyFCIC,April28,2010.WhilemostoftheBearStearns
executivesinterviewedbyFCICstaffdidnotrecallthepercentagediscountatwhichthecollateralseized
byMerrillLynchwasauctioned,theydidbelievethatitwassignificant(e.g.,RobertUpton,interviewby
FCIC,April13,2010).
36.WhiletheHighGradefundwasnotindefault/hadnotmissedanymargincalls,creditorswere
cutting off its liquidity by increasing haircuts or not rolling repo facilities. Bear Stearns Packet dated
May30,meetingheldonJune20,producedbytheSecuritiesandExchangeCommission,p.3;Upton,
interview.
37.WarrenSpector,emailtoMaryKayScucci,April26,2007.
38.Friedman,interview;WarrenSpector,interviewbyFCIC,March30,2010;SamMolinaro,inter-
viewbyFCIC,April9,2010.
39.ThomasMarano,interviewbyFCIC,April19,2010;Spector,interview(onMaranosbeingsentto
Marin).
60.FedChairmanBenS.Bernanke,lettertoFCICChairmanPhilAngelides,December21,2010.
61.JamesCayne,interviewbyFCIC,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,July3,2007,p.3,bothproducedbySEC.
63.Marano,interview.
64.BillJamison,internalemail,June21,2007,producedbyFederated.
63. JPMorgan, Directors Risk Policy Committee, Worldwide Securities Services Risk Review, Sep-
tember18,2007;MichaelAlix,interviewbyFCIC,April8,2010.
66. For the downgrades, see Moodys Investor Service, Announcement: Moodys Downgrades Sub-
prime First-Lien RMBS, July 10, 2007; Standard & Poors, S&PCorrect: 612 U.S. Subprime RMBS
ClassesPutonWatchNeg;MethodologyRevisionsAnnounced,July11,2007;Standard&Poors,Vari-
ousU.S.First-LienSubprimeRMBSClassesDowngraded,July12,2007,p.2;GlennCostello,U.S.Sub-
primeRatingSurveillanceUpdate,FitchRatings,July2007.
67.FCIC,PreliminaryStaffReport:CreditRatingsandtheFinancialCrisis,June2,2010,p.29.
68.StevenEismanandTomWarrack,Standard&PoorsStructuredFinance,July10,2007,teleconfer-
ence,transcript,p.16.
69.AndrewForster,telephoneconversation,July11,2007,transcript,pp.33.
599 Notes to Chapter 13
70.MartinSullivan,interviewbyFCIC,June17,2010;SteveBensinger,interviewbyFCIC,June16,
2010;RobertLewis,interviewbyFCIC,June13,2010;KevinMcGinn,interviewbyFCIC,June10,2010;
AndrewForster,EliasHabayeb,andSteveBensinger,testimonybeforetheFCIC,HearingontheRoleof
Derivatives in the Financial Crisis, day 2, session 1: American International Group, Inc. and Goldman
SachsGroup,Inc.,July1,2010,transcript,pp.11,6162.
71.ClarenceK.Lee,formermanagingdirectorforComplexandInternationalOrganizations,Office
of Thrift Supervision, testimony before the FCIC, Hearing on the Role of Derivatives in the Financial
Crisis,day2,session2:Derivatives:SupervisorsandRegulators,July1,2010,transcript,pp.23233.
72.AlanFrost,interviewbyFCIC,May11,2010.
73.JosephCassano,interviewbyFCIC,June23,2010.
74. Information Pertaining to the Multi-Sector CDS Portfolio, produced by AIG, with FCIC staff
calculations.
73.AndrewDavilman,emailtoAlanFrost,subject:Sorrytobotheryouon;Frost,emailtoDavil-
man,subject:Re:Sorrytobotheryouon;Davilman,emailtoFrost,subject:Re:Sorrytobotheryou
onallJuly26,2007.
76.GoldmanSachsInternational,CollateralInvoicetoAIGFinancialProductsCorp.,July27,2007,
producedbyGoldmanSachs.
77.AIGhedges,January2006December2008,producedbyGoldmanSachs.
78.AndrewForster,interviewbyFCIC,June23,2010.
79.DanielSparks,interviewbyFCIC,May11,2010.
80. Valuation & Pricing Related to Initial Collateral Calls on Transactions with AIG, produced by
GoldmanSachs.
81.JonLiebergallandAndrewForster,telephoneconversation,July30,2007,transcript,pp.4024.
82.DavidViniar,writtentestimonyfortheFCIC,HearingontheRoleofDerivativesintheFinancial
Crisis,day2,session1:AmericanInternationalGroup,Inc.andGoldmanSachsGroup,Inc.,July1,2010,
p.2.
83.LiebergallandForster,telephoneconversation,July30,2007,transcript,p.407.
84.TomAthan,emailtoAndrewForster,August1,2007.
Chapter 13
1.HenryPaulson,quotedinKevinCarmichaelandPeterCook,PaulsonSaysSubprimeRoutDoesnt
ThreatenEconomy,Bloomberg,July26,2007.
2.MoodysInvestorsService,MoodysABCPProgramIndex:CPOutstandingasof06/30/2007.
3.MoodysInvestorsService,MoodysPerformanceOverview:RhinelandFundingCapitalCorpora-
tion,June30,2007.
4.Asnoted,intheUnitedStates,therewasaminimalcapitalchargeforliquidityputsequalto10of
the base 8, or 0.8. Staff of Bundesanstalt fur Finanzdienstleistungsaufsicht (the Federal Financial
ServicesSupervisoryAuthority,Germanysbankregulators),interviewbyFCIC,September8,2010.See
also OfficeoftheComptrolleroftheCurrency,InteragencyGuidanceontheEligibilityofAsset-Backed
CommercialPaperLiquidityFacilitiesandtheResultingRisk-BasedCapitalTreatment,August4,2003.
Forexample,Citigroupwouldhaveheld$200millionincapitalagainstpotentiallossesonthe$23billion
inliquidityputexposurethatithadaccumulatedonCDOsithadissued.
3.IKB,2006/2007AnnualReport,June28,2007,p.78.
6. Securities Fraud Complaint, Securities and Exchange Commission v. Goldman Sachs & Co. and
FabriceTourre,no.10-CV-3229(S.D.N.Y.April13,2010),p.6.
7. IKB staff, interview by 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,April13,2010,at17,paragraph38.
8. Preliminary results for the first quarter (1April-30 June 2007)
9. IKB staff, interview; IKB, clarification of interview by FCIC, November 13, 2010; IKB, restated
2006/2007AnnualReport,p.3.
10.StevenMeier,testimonybeforetheFCIC,HearingontheShadowBankingSystem,day2,session
3:InstitutionsParticipatingintheShadowBankingSystem,May6,2010,transcript,p.307.
, IKBpressrelease,July20,2007.
600 Notes to Chapter 13
11. Angelo Mozilo, testimony taken by the SEC in the matter of Countrywide Financial Corp., File
No.LA-03370-A,November9,2007,pp.130,3637.
12.AngeloMozilo,emailtoLyleGramley,memberofBoardofCountrywideFinancialCorporation
(ccMichaelPerry,chiefexecutiveofficer,IndyMacBank),August1,2007.
13. Eric Sieracki, quoted in Mark DeCambre, Countrywide Defends Liquidity, TheStreet.com, Au-
gust2,2007.
14. Minutes of a Special Telephonic Meeting of the Board of Directors of Countrywide Financial
Corporation,August6,2007,pp.1,2,1.
13.FedChairmanBenBernanke,lettertoFCICChairmanPhilAngelides,December21,2010.
16.FederalReserveStaff,memotoBoardofGovernorsoftheFederalReserveSystem,Background
onCountrywideFinancialCorporation,August14,2007,pp.12.
17.Ibid.,pp.1213.
18.CountrywideFinancialCorporation,Form8-K,Exhibit99.1,filedAugust6,2007.SeealsoMin-
utesofaSpecialTelephonicMeetingoftheBoardsofDirectorsofCountrywideFinancialCorporation
andCountrywideBank,FSB,August13,2007.
19.AngeloMozilo,interviewbyFCIC,September24,2010.
20.KennethBruce,LiquidityIstheAchillesHeel,MerrillLynchAnalystReport,August13,2007,p.
4; Kenneth Bruce, Attractive Upside, but Not without Risk, Merrill Lynch Analyst Report, August 13,
2007,p.4.
21.Mozilo,interview;thearticle,byE.ScottReckardandAnnetteHaddad,wastitledCreditCrunch
Imperils Lender: Worries Grow about Countrywides Ability to Borrowand Even a Possible Bank-
ruptcy.
22.AngeloMozilo,quotedinOneonOnewithAngeloMozilo,ChairmanandCEOofCountrywide
Financial,^ightly Business Report, PBS, August 23, 2007, transcript; and in CEO Exclusive: Country-
wideCEO,Pt.1,The Call, CNBC,interviewbyMariaBartiromo,August23,2007,transcript,p.1.
23.SebastianBoyd,BNPParibasFreezesFundsasLoanLossesRoilMarkets,Bloomberg, August9,
2007.
24. BNP Paribas Investment Partners Temporally [sic] Suspends the Calculation of the Net Asset
Valueofthefollowingfunds:ParvestDynamicABS,BNPParibasABSEURIBORandBNPParibasABS
EONIA,BNPParibaspressrelease,August9,2007.
23.PaulA.McCulley,testimonybeforetheFCIC,HearingontheShadowBankingSystem,day2,ses-
sion3:InstitutionsParticipatingintheShadowBankingSystem,May6,2010,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 Liquidity to Facilitate the Orderly Functioning of Financial
Markets,FederalReserveBoardpressrelease,August10,2007.
29.FederalReserveBoard,pressrelease,August17,2007.
30. Henry Tabe, Moodys Investors Service, SIVs: An Oasis of Calm in the Sub-prime Maelstrom:
StructuredInvestmentVehicles,InternationalStructuredFinance:SpecialReport,July20,2007,p.1.
31.Ibid.
32.HenryTabe,interviewbyFCIC,October4,2010.
33. Moodys Investors Service, From Illiquidity to Liquidity: The Path Toward Credit Market Nor-
malization,MoodysInternationalPolicyPerspectives,September3,2007,p.1.
34.Tabe,interview.
33.MoodysInvestorsService,MoodysUpdateonStructuredInvestmentVehicles,MoodysSpecial
Report,January16,2008,p.12.
36.InformationprovidedtotheFCICbyDeloitteLLPscounsel,August2,2010.
37. Moodys Rating Action, Sigma Finance, September 30, 2008; Henry 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.TheSECindicateditisawareofatleast44moneymarketfundsthatweresupportedbyaffiliates
becauseofSIVinvestments.SeeSecuritiesandExchangeCommission,MoneyFundReform(Proposed
rule),June20,2009,p.14n.38.
601 Notes to Chapter 14
39. Christopher Condon and Rachel Layne, GE Bond Fund Investors Cash Out After Losses from
Subprime,Bloomberg, November13,2007.
40. The identity of the investor has never been publicly disclosed. See Shannon D. Harrington and
SreeVidyaBhaktavatsalam,BankofAmericatoLiquidate$12BillionCashFund,Bloomberg, Decem-
ber10,2007.SeealsoMichaelM.Grynbaum,MortgageCrisisForcestheClosingofaFund,^ew York
Times, December11,2007.
41.RichRokus,portfoliomanageratMarshallMoneyMarketFunds,interviewbyCraneData,Money
Fund Intelligence, June2009;CraneData,Money Fund Intelligence, January2008.
42.CreditSuisseInstitutionalMoneyMarketFund,Inc.,NotestoFinancialStatements,December31,
2008,Note3,p.30.
43.FloridaLegislature,OfficeofProgramPolicyAnalysisandGovernmentAccountability,TheSBA
[StateBoardofAdministration]IsCorrectingProblemsRelatingtoItsOversightoftheLocalGovern-
mentInvestmentPool,ResearchMemorandum,March31,2009,p.2.
44. SBA report, Update on Sub-Prime Mortgage Meltdown and State Board of Administration In-
vestments,November9,2007,pp.72122.
Chapter 14
1.BloombergProfessional,WritedownsandCreditLossesvs.CapitalRaised(WDCI)function,data
reportedforsecondhalfof2007.Write-downsareforlosses toholdingsinstructuredfinanceandmort-
gages.
2.RoyC.Smith,Paper Fortune$. Modern Vall Street. Vhere Its Been and Vhere Its Going (NewYork:
St.Martins2009),p.341.
3.BloombergHistoricalPricesIndexDecember31,2007;CGS1U3;CBSC1U3;andCLEH1U3.Fig-
uresrefertocreditdefaultswapsonfive-yearseniordebt.
4.PresentationtoMerrillLynch&Co.BoardofDirectors,LeveragedFinanceandMortgage/CDO
Review,October21,2007,p.23.
3.PresentationtoMerrillboard,October21,2007,p.23.
6.DowKim,interviewbyFCIC,September10,2010.
7.PresentationtoMerrillBoardofDirectors,October21,2007,p.23.
8.Ibid.,pp.2324.
9.PresentationtoMerrillLynchRiskOversightCommittee,MarketRiskManagementUpdate,Sep-
tember26,2007,p.7.
10.MerrillLynch,1Q2007EarningsCalltranscript,April19,2007,p.3.
11.MerrillLynch,2Q2007EarningsRelease,July17,2007,p.1.
12.MerrillLynch,2Q2007EarningsCalltranscript,July17,2007,pp.8,20.
13.MerrillLynchFinanceCommitteeSummary,July22,2007,p.7.
14.Ibid.
13.Kim,interview.
16.StanleyONeal,interviewbyFCIC,September16,2010.
17.ABSCDOUpdatebyDaleLattanzio,July2007,p.10.
18.ONeal,interview.
19.MerrillLynch,3Q2007EarningsCalltranscript,October24,2007,pp.7,10.
20.SECnarrativechronology,MerrillLynchspecific,p.1.
21. Nancy Moran and Rodney Yap, ONeal Ranks No. 3 on Payout List, Group Says: Table (Up-
date1),Bloomberg, November2,2007.
22.Kiminterview;MerrillLynch,2007ProxyStatement,April27,2007,p.47.
23.CharlesPrince,interviewbyFCIC,March17,2010;RobertRubin,interviewbyFCIC,March11,
2010.
24.Prince,interview.
23. Moodys Investors Service, Structured Finance Rating Transitions: 19832006, Special Com-
ment,January2007.
26.CharlesPrince,testimonybeforetheFCIC,HearingonSubprimeLendingandSecuritizationand
Government-Sponsored Enterprises (GSEs), day 2, session 1: Citigroup Senior Management, April 8,
2010,transcript,p.11.
602 Notes to Chapter 14
27.Prince,interview.
28.TobiasBrushammar,JamesHua,GrahamJackson,andSubraViswanathan,Citigroupmemoran-
dumtoNestorDominguez,JaniceWarne,MichaelRaynes,andJo-AnneWilliams,subject:LiquidityPut
Valuation,October19,2006.
29.SusanMills,interviewbyFCIC,February3,2010;JamesXanthos,interviewbyFinancialIndustry
RegulatoryAuthority(FINRA),March24,2009.
30. Susan Mills, testimony before the FCIC, hearing on Subprime Lending and Securitization and
Government-SponsoredEnterprises(GSEs),day1,session2:SubprimeOriginationandSecuritization,
April7,2010,transcript,pp.18687.
31.Mills,interview.
32. Murray Barnes, former managing director of Independent Risk, interview by 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 Currency, Securities
andExchangeCommission,U.K.FinancialServicesAuthority,andJapanFSA,November19,2007,p.17.
34. Janice Warne, interview by FCIC, February 2, 2010; Nestor Dominguez, interview by FCIC,
March2,2010.
33.Dominguez,interview.
36.NestorDominguez,testimonybeforetheFCIC,HearingonSubprimeLendingandSecuritization
and Government-Sponsored Enterprises (GSEs), day 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,testimonybeforetheFCIC,April8,2010,transcript,p.118;DavidBushnell,interviewby
FCIC,April1,2010.
42.Bushnell,interview.
43.EllenBebeDuke,CitigroupIndependentRisk,interviewbyFCIC,March18,2010.
44.Barnes,interview.
43.JamesXanthos,interviewbyFinancialIndustryRegulatoryAuthority(FINRA),March24,2009.
46.Barnes,interview.
47.Prince,interview.
48. Robert Rubin, former chairman of the Executive Committee and adviser, interview by FCIC,
March11,2010.
49.ThomasMaheras,formerco-CEOofCitiMarkets&Banking,interviewbyFCIC,March10,2010.
30.Prince,interview.
31. Citigroup, Presentation to the Securities and Exchange Commission Regarding Overall CDO
BusinessandSubprimeExposure,June2007,p.11.
32.Paul,Weiss,Citigroupscounsel,responsetoFCICInterrogatory#18,March1,2010.
33.Citigroup,2Q2007EarningsCallQ&Atranscript,July20,2007.
34. Complaint, Securities and Exchange Commission v. Citigroup Inc., 1:10-cv-01277 (D.D.C), July
29,2010.
33. Federal Reserve Board of New York, letter to Vikram Pandit and the Board of the Directors of
Citigroup,April13,2008,p.11.
36.Dominguez,testimonybeforetheFCIC,April7,2010,transcript,p.281.
37.Maheras,interview,andtestimonybeforetheFCIC,HearingonSubprimeLendingandSecuriti-
zation and Government-Sponsored Enterprises (GSEs), day 1, session 3: Citigroup Subprime-Related
StructuredProductsandRiskManagement,April7,2010,transcript,p.269.
38.Bushnell,interview.
39.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, 3:30 P.M.; Charles Prince, email to
RobertRubin,September9,2007,3:31P.M.
64.RobertRubin,interviewbyFCIC,March11,2010.
63.Prince,interview.
66.Ibid.
67.Citigroup,RiskManagementReview:AnUpdatetotheCorporateAuditandRiskManagement
Committee,October13,2007,p.4.
68.Citigroup,Q32007EarningsCalltranscript,October13,2007.
69.Prince,interview.
70.Paul,Weiss,Citigroupscounsel,lettertoFCICinretheFCICssecondandthirdsupplementalre-
quests,March31,2010;Citigroup,2008ProxyStatementforfiscalyear2007,March13,2008,p.74.
71.FederalReserveBoardofNewYork,lettertoVikramPanditandtheBoardofDirectorsofCiti-
group,April13,2008,p.8.
72.FCICstaffcalculationsfromCitigroupproxystatements(informationfor200006)andinforma-
tionon200709providedbyPaul,Weiss(onbehalfofCitigroup),lettertoFCIC,March31,2010,Re-
sponsetoInterrogatoryNo.7,pp.36.
73.RobertRubin,testimonybeforetheFCIC,HearingonSubprimeLendingandSecuritizationand
Government-Sponsored Enterprises (GSEs), day 2, session 1: Citigroup Senior Management, April 8,
2010,transcript,pp.1316.
74.JohnReed,interviewbyFCIC,March24,2010.
73.AIG,EarningsCallcreditsupplement,August9,2007.
76.JosephSt.Denis,lettertoHouseCommitteeonOversightandGovernmentReform,U.S.Houseof
Representatives,October4,2008,p.4.
77.JosephSt.Denis,interviewbyFCIC,April23,2010.
78.GenePark,interviewbyFCIC,May18,2010.
79.JakeSun,interviewbyFCIC,June21,2010.
80.AlanFrost,interviewbyFCIC,May11,2010.
81.PierreMicottis,interviewbyFCIC,June24,2010.
82.Park,interview.
83.PricewaterhouseCooperauditteam,memore3Q07reviewofAIGssuper-seniorCDSportfolio,
November7,2007,p.2.
84.JosephCassano,interviewbyFCIC,June23,2010.
83.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,telephonecalltoJonLiebergall,July30,2007,transcript.
88.PricewaterhouseCooper,memotoAIGFP20072Qreviewfiles,August8,2007.
89.AndrewForster,emailtoJosephCassanoandPierreMicottis,November9,2007,enclosingmarks
fromMerrillLynch,
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 Quarterly
Holdings Report, January 2010. This probably isnt a complete list of their positions, because not all
CDOtranchesarepartoftheMaidenLaneIIIportfolio.Ofthe333securitieslistedinthatdocument,
FCICstafffounddataon327inMoodysCDOEMSdatabaseandBloomberg.Forthose327securities,
313sufferedadowngradeand206becamemateriallyimpaired(i.e.,weredowngradedtoCa/C).Ofthe
139initiallyratedAaa,134suffereddowngradesand33becamemateriallyimpaired.
92.AlanFrost,emailtoAndrewForster,August16,2007.
93.Cassano,interview.
94.Frost,emailtoForster,August16,2007.
93.TomAthan,emailtoAndrewForster,ccAdamBudnick,September11,2007.
96.JosephCassano,emailtoEliasHabayeb,November11,2007.
604 Notes to Chapter 14
97.MinutesofthemeetingoftheAIGAuditCommittee,November6,2007,p.3.
98.AndrewForster,emailtoJosephCassano,subject:GSPricesvsOthers,November18,2007.
99. Goldman, submission to the FCIC, Valuation & Pricing Related to Initial Collateral Calls on
TransactionswithAIG,pp.23.
100.BasedonstaffanalysisofdataprovidedtotheFCICbytheDepositoryTrust&ClearingCorpo-
rationandMarkit. ABXincludesalltranchesoftheABX.HE06-2. TABXisconstructedbasedonthe
referenceobligationsforthe06-2and07-1BBBandBBB-tranchesoftheABX.
101.Cassano,interview.
102.AndrewForster,emailtoAlanFrost,August16,2007.
103.TimRyan,PricewaterhouseCooper,interviewbyFCIC,June1,2010.
104.SECstaffbriefingofFCICstaff,June4,2010.
103. Joseph Cassano, email to Andrew Forster, Pierre Micottis, James 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,memore3Q07reviewofAIGssuper-seniorCDSportfolio,November7,2007,pp.23031.
107.AIG,3Q2007EarningsCalltranscript,November7,2007,pp.3,17.
108.PwCauditteammemo,p.6.
109. Goldman Sachs International, to AIG Financial Products Corp., Amended Side Letter Agree-
ment,November23,2007.
110. Joe Cassano, email to Bill Dooley, November 27, 2007, attaching memo from Andrew Forster,
CollateralCallStatus.
111.AndrewForster,CollateralCallStatus,memopreparedforJoeCassano.
112.JoeCassano,emailtoBillDooley,subject:CollateralCalls,November27,2007.
113.JoeCassano,emailtoBillDooley,subject:GScallback,November30,2007.
114.GoldmanSachsInternational,CollateralInvoicetoAIGFinancialProductsCorp.,margincall,
November23,2007.
113.PwCauditteam,memo,November7,2007,p.3.
116.PricewaterhouseCooper,notesofameetingtodiscusssuper-seniorvaluationsandcollateraldis-
putes,November29,2007,p.2,producedbyPwC.
117.AndrewForster,interviewbyFCIC,June21,2010.
118.MartinSullivan,interviewbyFDIC,June17,2010.
119.PwC,notesofmeetingofNovember29,2007,p.2.
120.Ibid.,p.3.
121.KevinMcGinn,emailtoPaulNarayanan,November20,2007.
122.Sullivan,interview.
123.AIGInvestorConferenceCall,December3,2007,transcript,pp.46,23.
124.JosephCassano,emailtoMichaelSherwoodandDavidViniar,subject:CDOValuations,January
16,2008.
123.AndrewDavilman,interviewbyFCIC,June18,2010;DavidLehman,interviewbyFCIC,June
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,February24,2008,pp.23,10.
128.PricewaterhouseCooper,notesonaFebruary6,2008,meetingwithAIG,February13,2008,p.2.
129.MartinSullivan,testimonybeforetheFCIC,HearingontheRoleofDerivativesintheFinancial
Crisis,day1,session2:AmericanInternationalGroup,Inc.andDerivatives,June30,2010,transcript,p.
233.
130.PricewaterhouseCooper,notesontheAIGAuditCommitteemeeting,February7,2008,p.2.
131.JosephCassano,testimonybeforetheFCIC,HearingontheRoleofDerivativesintheFinancial
Crisis.day1,session2:AmericanInternationalGroup,Inc.andDerivatives,June30,2010,p.233;Cas-
sano,interview.
132.OfficeofThriftSupervision,lettertoAIGGeneralCounselandBoard,March7,2008.
133.WilliamDudley,interviewbyFCIC,October13,2010.
605 Notes to Chapter 15
134.AdamB.Ashcraft,MortenL.Bech,andW.ScottFrame,TheFederalHomeLoanBankSystem:
TheLenderofNexttoLastResort:FederalReserveBankofNewYorkStaffReports,no.337(November
2008),p.4.
133. Federal Reserve Board, October 2007 Senior Loan Officer Opinion Survey on Bank Lending
Practices,October2007.
136.FredericMishkin,interviewbyFCIC,October1,2010.
137.Dudley,interview.
138.Ibid.
139.Ibid.
140.Standard&Poors,DetailedResultsofSubprimeStressTestofFinancialGuarantors,Ratings-
Direct,February23,2008.
141.AlanRoseman,interviewbyFCIC,May17,2010.
142. SEC, Risk Management Reviews of Consolidated Supervised Entities, internal memo to Erik
Sirriandothers,November6,2007,p.3.
143.Roseman,interview,May17,2010.
144.SEC,RiskManagementofConsolidatedSupervisedEntities,internalmemotoErikSirriand
others,January2,2008,p.2.
143.BillLockyer,State of California 2008 Debt Affordability Report. Making the Municipal Bond Mar-
ket Vork for Taxpayers in Turbulent Times (October1,2008),p.4.
146.JohnJ.McConnellandAlessioSaretto,AuctionFailuresandtheMarketforAuctionRateSecu-
rities(TheKrannertSchoolofManagement,PurdueUniversity,April2009),p.10.
147. Erik R. Sirri, director of Trading and Markets, U.S. Securities and Exchange Commission,
MunicipalBoundTurmoil:ImpactonCities,TownsandStates,testimonybeforetheHouseFinancial
ServicesCommittee,110thCong.,2ndsess.,March12,2008.
148.GeorgetownUniversity,AnnualFinancialReport,20082009,p.3.
149.JacquelineDoherty,TheSadStoryofAuction-RateSecurities,Barrons,May26,2008.
130.SECFinalizesARSSettlementswithBankofAmerica,RBC,andDeutscheBank,SECpressre-
lease,June3,2009.
Chapter 13
1. Prime Asset, 2007 Upper HedgeWorld Prime Brokerage League Table, accessible at Gregory
Zuckerman,HedgeFunds,OnceaWindfall,ContributetoBearsDownfall,Vall Street journal,March
17,2008.
2. Jeff Mayer and Thomas Marano, Fixed Income Overview, March 29, 2007, p. 8, produced by
JPMorgan.
3.InsideMortgageFinance,The 2009 Mortgage Market Statistical Annual, vol.2,The Secondary Mar-
ket (Bethesda,MD:InsideMortgageFinance,2009),pp.1823.
4.FCICstaffestimates,basedonMoodysCDOEMSdatabase.DifferentnumbersareprovidedinJeff
MayerandThomasMarano,FixedIncomeOverview,March29,2007,p.16.
3.SamuelMolinaro,interviewbyFCIC,April9,2010;MichaelAlix,interviewbyFCIC,April8,2010.
6. SEC, Risk Management Reviews of Consolidated Supervised Entities, memorandum to Robert
Colbyandothers,May8,2006.
7.RobertUpton,interviewbyFCIC,April13,2010.
8.SEC,RiskManagementReviewsofConsolidatedSupervisedEntities,memorandumtoErikSirri
andothers,March1,2007.
9.Ibid.
10.BearStearns,FitchPresentation,PowerPointslides,August2007.
11.Upton,interview.
12.BearStearns,Form10-KfortheyearendedNovember30,2007,filedJanuary29,2008,pp.32,22.
13.Upton,interview.
14.Ibid.
13.Standard&Poors,GlobalCreditPortalRatingsDirect,ResearchUpdate:BearStearnsCos.Inc.
OutlookRevisedtoNegative;A+/A-1RatingAffirmed,August3,2007.
16.JimmyCayne,interviewbyFCIC,April21,2010.
606 Notes to Chapter 15
17.MatthewEichner,interviewbyFCIC,April14,2010.
18.WendydeMonchaux,interviewbyFCIC,April27,2010;StevenMeyer,interviewbyFCIC,April
22,2010.
19.MikeAlix,interviewbyFCIC,April8,2010.
20.Eichner,interview.
21.TimelineRegardingBearStearnsCompaniesInc.,April3,2008,producedbySEC.
22.SECOfficeofInspectorGeneral,OfficeofAudits,SECsOversightofBearStearnsandRelated
Entities:TheConsolidatedSupervisedEntityProgram,ReportNo.446-A,September23,2008,pp.ixx.
23.MichaelHalloran,interviewbyFCIC.
24.Cayne,interview.
23. Samuel Molinaro, testimony before the FCIC, Hearing on the Shadow Banking System, day 1,
session 1: Investment Banks and the Shadow Banking System, May 3, 2010, transcript, p. 43; Cayne,
interview.
26. Changes in Approved Commercial Paper List10/01/200712/31/2007 and Changes in Ap-
provedCommercialPaperList1/01/20083/31/2008,producedbyFederatedAdvisedFunds.
27.FederalReserveBankofNewYork,Tri-PartyRepoInfrastructureReform,whitepaper,May17,
2010,p.7.
28.SethCarpenter,interviewbyFCIC,September20,2010.
29.InformationprovidedbyFederatedtotheFCIC.
30.ScottGoebel,KevinGaffney,andNormLind(Fidelityemployees),interviewbyFCIC,February
23,2010.
31.SteveMeier,executivevicepresidentStateStreetGlobalAdvisors,interviewbyFCIC,March13,
2010.
32. Timeline Regarding the Bear Stearns Companies Inc., April 3, 2008, pp. 12, provided to the
FCIC.
33.AlanSchwartz,interviewbyFCIC,April23,2010.
34. Lucian A. Bebchuk et al., The Wages of Failure: Executive Compensation at Bear Stearns and
Lehman20002008,November22,2009,Table2,p.13;SNLFinancial.
33.ThomasMarano,interviewbyFCIC,April19,2010.
36.PaulFriedman,quotedinWilliamCohan,House of Cards. A Tale of Hubris and Vretched Excess
on Vall Street (NewYork:Doubleday,2009),p.71.AlthoughFriedmanacknowledgedtotheFCICmak-
ingthecitedstatements,andmanyothersaswell,heattributesthemtoangerandfrustrationoverBear
Stearnss failure. Currently, Friedman is employed at Guggenheim Securities, Inc., where he works for
AlanSchwartz,theformerpresidentofBearStearns.PaulFriedman,interviewbyFCIC,April28,2010.
37. The Corporate Library, The Bear Stearns Companies Inc.: Governance Profile, June 20, 2008,
p.4.
38.Cayne,interview.
39.Molinaro,interview.
40.Cayne,interview;Schwartz(interviewbyFCIC)statedthatbonusesforindividualexecutiveswere
discussedbytheCompensationCommittee,andthefinalrecommendationforbonusescamefromthe
CEO.
41.Alix,interview.
42. Bear Stearns, 2007 Performance Compensation Plan, p. I-1 (provided to the FCIC); Alix, inter-
view.Thesalarycaphadbeenraisedfrom$200,000to$230,000in2006(Alix,interview;Cayne,inter-
view).
43.Bebchuketal.,TheWagesofFailure,Table1,p.12;Table2,p.13;Table4,p.20.Thebudgetau-
thorityfortheSECin2008was$906million;in2010,itwas$1.026billion.
44.In2006,Alixreceived$3millionintotalcompensation,Caynereceivedmorethan$38.3million
insalaryandbonus,andSchwartzreceivedmorethan$33.7millioninsalaryandbonus.SNLFinancial;
interviewswithSpectorandAlix.
43.Marano,interview.
46.TomMarano,emailtoAlanSchwartzandRichieMetrick,February12,2008.
47.MatthewEichner,emailtoJamesGilesetal.,January30,2008.
48.LouLebedin,interviewbyFCIC,April23,2010.
607 Notes to Chapter 15
49.TimelineRegardingBearStearnsCompaniesInc.,April3,2008,producedbySEC.
30.Upton,interview.
31.MinutesofSpecialMeetingofBearStearnsBoardofDirectors,March13,2008.
32.PatLewis,BearStearns,emailtoMatthewEichner,StevenSpurry,JamesGiles,andKevinSilva,
March10,2008.
33.MatthewEichner,emailtoBrianPeters,March11,2008.
34.DavidFettig,TheHistoryofaPowerfulParagraph,FederalReserveBankofMinneapolis,June
2008.
33.JamesEmbersit,emailtoDeborahBailey,March3,2008.
36.InresponsetotheFCICsinterrogatories,JPMorganproducedalistofallpaymentsBearStearns
madetoorreceivedfromOTCderivativescounterpartiesfromMarch10,2008,throughMarch14,2008.
ThespreadsheetwascreatedinSeptember2008byBearStearnsinresponsetoarequestbytheSECDivi-
sionofTradingandMarkets.ThelargevolumeofnovationsawayfromBearStearnsduringtheweekof
March 10, 2008 and the previous week was confirmed by the New York Federal Reserve and Interna-
tional Swaps and Derivatives Association. (New York Federal Reserve personnel, interview by FCIC;
ISDApersonnel,interviewsbyFCIC,May13and27,2010).
37.BrianPeters,emailtoMatthewEichner,March11,2008.
38.StuartSmith,emailtoBearStearns,March11,2008;MarvinWoolard,emailStuartSmithetal.,
March11,2008;KyleBass,interviewbyFCIC,April30,2010.
39.Bass,interview.
60.DebbyLaMoy,emailtoFainaEpshteyn,March12,2008;FainaEpshteyn,emailtoDebbyLaMoy,
March12,2008.
61.MarvinWoolard,emailtoStuartSmithetal.,March12,2008.
62.CNBCvideo,SchwartzandCNBCsDavidFaber,originalairdateMarch12,2008.
63.YalmanOnaran,BearStearnsInvestorLewisMayIncreaseHisStake,BloombergNews,March
11,2008.
64.MatthewEichner,emailtoErikSirri,RobertColby,andMichaelMacchiaroli,March12,2008.
63.MinutesofSpecialMeetingofBearStearnsBoardofDirectors,March13,2008,pp.12.
66.Upton,interview.
67.MatthewEichner,emailtoErikSirri,RobertColby,andMichaelMacchiaroli,March12,2008.
68. Alan Schwartz, interview by FCIC; Matthew Eichner, email to Erik Sirri, Robert Colby, and
MichaelMacchiaroli,March13,2008.
69.Upton,interview.
70.MinutesofSpecialMeetingofBearStearnsBoardofDirectors,March13,2008([Schwartz]said
therehadbeenseventeenbilliondollarsincashwithatwobillioneighthundredmilliondollarbackstop,
unsecuredline.TheBoardwastoldthattwelvetofifteenbilliondollarshadgoneoutofTBSCIinthelast
twodaysandthatTBSCIhadreceivedabilliondollarsinmargincalls).
71.Upton,interview;Goebel,Gaffney,andLind,interview;StevenMeier,interviewbyFCIC,March
13,2010;MichaelMacchiaroli,interviewbyFCIC,April13,2010.
72.ChristopherCox,writtentestimonyfortheFCIC,HearingontheShadowBankingSystem,day1,
session3:SECRegulationofInvestmentBanks,May3,2010,p.6.
73.TimelineRegardingBearStearnsCompaniesInc.,April3,2008,producedbySEC.
74.JamieDimon,interviewbyFCIC,October20,2010.
73.AlanSchwartz,testimonybeforetheFCIC,HearingontheShadowBankingSystem,day1,session
2:InvestmentBanksandtheShadowBankingSystem,May3,2010,transcript,p.167;Schwartz,inter-
view.
76.Schwartz.,interview.
77.Ibid.;Molinaro,interview;Alix,interview.
78.JohnChrin,interviewbyFCIC,April28,2010.
79.Dimon,interviewbyFCIC,October20,2010;minutesofSpecialMeetingofBearStearnsBoardof
Directors,March16,2008.
80.FederalReserve,ReportPursuanttoSection129oftheEmergencyEconomicStabilizationActof
2008:LoantoFacilitatetheAcquisitionofTheBearStearnsCompanies,Inc.byJPMorgan&Co.,pp.1,
4;Ernst&Young,ProjectLLC:SummaryofFindingsandObservationsReport,June26,2008,p.10.
608 Notes to Chapter 16
81.Contrarytowhatisstatedintheboardminutes(SpecialMeetingofBearStearnsBoardofDirec-
tors,March16,2008,p.3),whenFCICstaffinterviewedSchwartzhesaidthatthe$2asharepricecame
fromJPMorgan,notPaulson.SchwartzalsotoldstaffthatbecauseBeardidnotreceivealotofcompet-
ingoffers,ithadtoacceptJPMorgansofferof$2ashare.
82.Chrin,interview.
83.AlanSchwartz,testimonybeforetheFCIC,HearingontheShadowBankingSystem,day1,session
2:InvestmentBanksandtheShadowBankingSystem,May3,2010,transcript,p.142.
84.Macchiaroli,interview.
83.BenBernanke,closed-doorsessionwithFCIC,November17,2009.
86.Ibid.
87.TimothyGeithner,president,FederalReserveBankofNewYork,ActionsbytheNewYorkFedin
ResponsetoLiquidityPressuresinFinancialMarkets,preparedtestimonybeforetheSenateCommittee
onBanking,Housing,andUrbanAffairs,110thCong.,2ndsess.,April3,2008,p.10.
88.HenryPaulson,testimonybeforetheFCIC,HearingontheShadowBankingSystem,day2,ses-
sion1:PerspectiveontheShadowBankingSystem,May6,2010,transcript,pp.68,39,78.
Chapter 16
1.DavidWong,interviewbyFCIC,October13,2010.
2. JoshFinemanandYalmanOnaran,LehmansFuldSaysWorstIsBehindUsinCrisis(Update3),
Bloomberg,April13,2008.
3. HenryPaulson,testimonybeforetheFCIC,HearingontheShadowBankingSystem,day2,session
1:PerspectiveontheShadowBankingSystem,May6,2010,transcript,p.28.
4. ViralV.AcharyaandT.SabriOnc,TheDodd-FrankWallStreetReformandConsumerProtec-
tion Act and a Little Known Corner of Wall Street: The Repo Market, Regulating Vall Street, July 16,
2010.
3.SandieOConnor,JPMorgan,interviewbyFCIC,March4,2010.
6. JamieDimon,interviewbyFCIC,October20,2010.
7. Adam Copeland, Antoine Martin, Michael Walker, The Tri-Party Repo Market Before the 2010
Reforms,FRBNYStaffReportNo.477,November2010,p.24.
8. StevenMeier,testimonybeforetheFCIC,HearingontheShadowBankingSystem,day2,session3:
InstitutionsParticipatingintheShadowBankingSystem,May6,2010,transcript,p.276.
9. WilliamDudley,interviewbyFCIC,October13,2010.
10. DarryllHendricks,interviewbyFCIC,August6,2010.
11. JamesCayne,testimonybeforetheFCIC,HearingontheShadowBankingSystem,day1,session
2:InvestmentBanksandtheShadowBankingSystem,May3,2010,transcript,p.168.
12. SethCarpenter,interviewbyFCIC,September20,2010.
13. FederalReserve,RegulatoryReform:PrimaryDealerCreditFacility(PCDF),UsageofFederal
Reserve Credit and Liquidity 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.08-13333(JMP),(Bankr.S.D.N.Y.),March11,2010,4:139698;quotation,1396(hereaftercited
asValukas;availableathttp://lehmanreport.jenner.com/).
13. WilliamDudley,emailtoChairman,June17,2008.
16. Dimon,interview.
17. Ibid.
18. Hendricks,interview.
19.LucindaBrickler,emailtoPatrickParkinson,July11,2008;LucindaBrickleretal.,memorandum
toTimothyGeithner,July11,2008.
20.The$200billionfigureisnotedinPatrickParkinson,emailtoBenBernankeetal.,July20,2008.
21.Brickleretal.,memorandum,p.1.
22.PatrickParkinson,emailtoLucindaBrickler,July11,2008.
23.PatrickParkinson,emailtoBenBernankeetal.,July20,2008.
24.Ibid.
609 Notes to Chapter 16
23. BasedonchartinFederalReserveBankofNewYork,Developing Metrics for the Four Largest Secu-
rities Firms, August2008,p.3.
26.Ibid.
27.TobiasAdrian,ChristopherBurke,andJamesMcAndrews,TheFederalReservesPrimaryDealer
Credit Facility, Federal Reserve Bank of New York, Current Issues in Economics and Finance 13, no. 4
(August2009):2.
28.ErikSirri,interviewbyFCIC,April9,2010,p.3.
29. Fed Chair Ben Bernanke, Lessons from the Failure of Lehman Brothers, testimony before the
HouseFinancialServicesCommittee,111thCong.,2ndsess.,April20,2010,p.1.
30.Valukas,1:8n.30:ExaminersInterviewofTimothyF.Geithner,Nov.24,2009,p.4.
31.Valukas,4:1486.
32.Sirri,interview.
33.WilliamBrodowsandTilSchuermann,FederalReserveBankofNewYork,PrimaryDealerMon-
itoring:InitialAssessmentofCSEs,May12,2008,slides910,1316.
34.FederalReserveBankofNewYork,PrimaryDealerMonitoring:LiquidityStressAnalysis,June
23,2008,p.3.
33.Ibid.,p.3.
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.3.
39.PatrickParkinson,emailtoStevenShafran,August8,2008.
40.CounterpartyRiskManagementPolicyGroup,TowardGreaterFinancialStability:APrivateSec-
torPerspective,TheReportoftheCRMPGII,July27,2003.
41. Federal Reserve Bank of New York, Statement Regarding Meeting on Credit Derivatives, Sep-
tember13,2003;FederalReserveBankofNewYork,NewYorkFedWelcomesNewIndustryCommit-
ments on Credit Derivatives, March 13, 2006; Federal Reserve Bank of New York, Third Industry
MeetingHostedbytheFederalReserveBankofNewYork,September27,2006.
42.SeeComptrolleroftheCurrency,OCCsQuarterlyReportonBankTradingandDerivativesAc-
tivities,FirstQuarter2009,Table1;thefiguresinthetextarereachedbysubtractingexchangetradedfu-
turesandoptionsfromtotalderivatives.
43.ChrisMewbourne,interviewbyFCIC,July28,2010.
44.Thisfigurecompareswithalowin2003,attheheightofthemortgageboom,of$7billioninprob-
lem assets. Problem institutions are those with financial, operational, or managerial weaknesses that
threatentheircontinuedfinancialviability;theyareratedeithera4or3undertheUniformFinancialIn-
stitutionsRatingSystem.FDICreportingforinsuredinstitutionsi.e.,theregulatedbankingandthrift
industryoverall.SeeQuarterly Banking Profile. Fourth Quarter 2007= FDIC Quarterly 2,no.1(Decem-
ber31,2007):1,4;Quarterly Banking Profile. First Quarter 2008 =FDIC Quarterly 2,no.2(March31,
2008):2,4;Quarterly Banking Profile. Second Quarter 2008 =FDIC Quarterly 2,no.3(June30,2008):1.
43. By2009,theproblemlistwouldswellto702banks,withassetsof$403billion.Quarterly Banking
Profile. Fourth Quarter 2009 = FDIC Quarterly 4,no.1(December31,2009):4.
46. Quarterly Banking Profile. First Quarter 2008, p.4.
47.RogerCole,interviewbyFCIC,August2,2010.
48.FCICinterviewwithMichaelSolomonandFredPhillips-Patrick,September20,2010.
49.FederalReserveBankofNewYork,lettertoCharlesPrince,April9,2007.
30.FederalReserveBankofNewYork,FederalReserveBoard,OfficeoftheComptrolleroftheCur-
rency, Securities and Exchange Commission, U.K. Financial Services Authority, and Japan Financial
ServicesAuthority,NotesonSeniorSupervisorsMeetingswithFirms,November19,2007,p.3.
31.FederalReserveBoard,FRBNewYork2009OperationsReview:CloseOutReport,p.3.
32. Timothy Geithner, testimony before the FCIC, Hearing on the Shadow Banking System, day 2,
session1:PerspectiveontheShadowBankingSystem,May6,2010,transcript,p.210.
33.SteveManzariandDianneDobbeck,interviewbyFCIC,April26,2010.
34.FederalReserveBoard,WachoviaCaseStudy,November12and13,p.20;
33.AngusMcBryde,interviewbyFCIC,July30,2007.
610 Notes to Chapter 17
36.Thompsonreceivedaseverancepackageworthabout$8.7millionincompensationandacceler-
atedvestingofstock.Inaddition,henegotiatedhimselfthreeyearsofofficespaceandapersonalassis-
tantatWachoviasexpense.Thompsonhadpreviouslyreceivedmorethan$21millioninsalaryandstock
compensation in 2007 and more than $23 million in 2006; his total compensation from 2002 through
2008exceeded$112million.
37.FederalReserveBankofRichmond,lettertoWachovia,July22,2008,pp.33.
38.ComptrolleroftheCurrency,lettertoWachovia,August4,2008,withReportofExamination;let-
ter,pp.8,3.
39.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,July22,2008.
63.OfficesofInspectorGeneral,DepartmentoftheTreasuryandFederalDepositInsuranceCorpo-
ration,EvaluationofFederalRegulatoryOversightofWashingtonMutualBank,ReportNo.EVAL10-
002,April2010,pp.31,12.
66.FDIC,ConfidentialProblemBankMemorandum,September8,2008,p.4.
67.TreasuryandFDICIGs,EvaluationofFederalRegulatoryOversightofWaMu,p.39.
68. Confidential OTS Memorandum to FDIC Regional Director, September 11, 2008; Treasury and
FDICIGs,EvaluationofFederalRegulatoryOversightofWaMu,pp.4347.
69. QuotedinDamianPaletta,FDICPressesBankRegulatorstoUseWarierEye,Vall Street journal,
August19,2008.
70.SheilaBair,interviewbyFCIC,August18,2010.
71.TreasuryandFDICIGs,EvaluationofFederalRegulatoryOversightofWaMu,p.3.
72.ComptrolleroftheCurrency,Large Bank Supervision. Comptrollers Handbook, January2010,p.3.
73.Cole,interview.
74. Rich Spillenkothen, Observations and Perspectives of the Director of Banking Supervision and
RegulationattheFederalReserveBoardfrom1991to2006onthePerformanceofPrudentialSupervi-
sionintheYearsPrecedingtheFinancialCrisis,paperpreparedfortheFCIC,May21,2010,p.24.
73.DougRoeder,interviewbyFCIC,August4,2010.
76. Treasury Releases Blueprint for Stronger Regulatory Structure, Treasury Department press re-
lease,March31,2008.
Chapter 17
1.HenryPaulson,interviewbyFCIC,April2,2010;HenryPaulson,On The Brink. Inside the Race to
Stop the Collapse of the Global Financial System(NewYork:BusinessPlus,2010),p.37.
2.Paulson,interview.
3.JamesLockhart,testimonybeforetheFCIC,HearingonSubprimeLendingandSecuritizationand
Government-SponsoredEnterprises(GSEs),day3,session2:OfficeofFederalHousingEnterpriseOver-
sight,April9,2010,transcript,p.163.
4.DanielMudd,lettertoJamesLockhart,August1,2007,p.1.
3.Ibid.,pp.1,3.
6.DanielMudd,lettertoshareholders,inFannieMae,2007AnnualReport,p.3.
7.ThomasLund,interviewbyFCIC,March4,2010.
8.RobertLevin,interviewbyFCIC,March17,2010.
9.JamesLockhart,lettertoDanielMudd,August10,2007,p.1.
10.JamesLockhart,lettertoSenatorCharlesSchumer,August10,2007.
11. James Lockhart, written testimony for the FCIC, Hearing on Subprime Lending and Securitiza-
tionandGovernment-SponsoredEnterprises(GSEs),day3,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,TonyRyan,andJeremiahNorton,Treasuryofficials,interviewbyFCIC,March12,
2010.
13. James Lockhart, quoted in Steven Sloan, Setting an OFHEO Plan, But Wishing Otherwise,
American Banker, December21,2007.
16.FannieMae,Single-FamilyBookCharacteristicsReport,September2008.
17.OFHEOProvidesFlexibilityonFannieMae,FreddieMacMortgagePortfolios,OFHEOnewsre-
lease,September19,2007,p.1.
18.Lockhart,writtentestimonyfortheFCIC,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,lettertoOFHEODirectorJamesB.LockhartIII,February23,2008;
Schumercontinued,Ifyouhavedecidedthatyouwillbekeepingthecapitalsurchargeinplace . . .,I
would like an explanation as to why you 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,February17,2008.
22.DanielMudd,interviewbyFCIC,March26,2010.
23.RobertSteel,emailtoJeremiahNorton,February28,2008.
24.MichaelFarrell,emailtoRobertSteel,March6,2008.
23.EmailsbetweenRobertK.SteelandDanielMudd,March7,2008.
26.DanielMudd,emailtoRobertLevin,March7,2008.
27.FannieMaeInsolvencyandItsConsequences,p.1;attachmenttoemailfromJasonThomasto
RobertSteel,March8,2008.
28.RobertSteel,emailtoDavidNason,TonyRyan,JeremiahNorton,andNeelKashkari,subject:re:
GSEs,March16,2008.
29.JamesLockhart,interviewbyFCIC,March19,2010.
30.Paulson,interview.
31.JamesLockhart,emailtoDanielH.Mudd,RobertSteel,andDickSyron,subject:Re:announce-
mentdraft,March17,2008.
32.Ibid.
33.OFHEO,FannieMaeandFreddieMacAnnounceInitiativetoIncreaseMortgageMarketLiquid-
ity,OFHEOnewsrelease,March19,2008.
34.Paulson,interview.
33.JoshuaRosner,OFHEOGotRolled,GrahamFisherWeeklySpew,March19,2008.
36.DonaldBisenius,interviewbyFCIC,September29,2010.
37. Freddie Mac CEO Richard Syron Talks about the Stock Slide, PBS ^ightly Business Report,
Wednesday,August6,2008,transcript.
38.Lockhart,interview.
39.DanielMudd,letterstoJamesLockhart,August1,2008,andAugust13,2008.
40. Timothy P. Clark (senior adviser, Division of Banking and Supervision, Federal Reserve Board)
andScottAlvarez(generalcounsel,FederalReserveBoard),interviewbyFCIC,February23,2010.
41.BoardGrantsFederalReserveBankofNewYorktheAuthoritytoLendtoFannieMaeandFred-
dieMacShouldSuchLendingProveNecessary,FederalReserveBoardpressrelease,July13,2008.
42.Alvarez,interview.
43.TreasurySecretaryHenryPaulson,testimonyonGSEinitiatives,Recent Developments in U.S. Fi-
nancial Markets and the Regulatory Responses to Them, SenateCommitteeonBanking,Housing,andUr-
banAffairs,110thCong.,2ndsess.,July13,2008.
44.StatementbyDanielH.Mudd,PresidentandCEO,FannieMaepressrelease,July13,2008.
43.Clark,interview
46.Mudd,interview.
47.Clark,interview.
48.SusanEckert,KevinBailey,andotherOCCstaff,interviewbyFCIC,February19,2010.
612 Notes to Chapter 17
49.Ibid.
30.OfficeoftheComptrolleroftheCurrency,ObservationsAllowanceProcessandMethodology,
August2008(lastrevisedSeptember8,2008),p.3.
31.Paulson,interview.
32.ChristopherH.Dickerson(FHFAActingDeputyDirector,DivisionofEnterpriseRegulation),let-
tertoDanielH.Mudd(PresidentandCEOofFannieMae),Re:NoticeofProposedCapitalClassifica-
tion at June 30, 2008, August 22, 2008, pp. 1, 2; Christopher H. Dickerson (FHFA Acting Deputy
Director, Division of Enterprise Regulation), letter to Richard F. Syron (President and CEO of Freddie
Mac),Re:NoticeofProposedCapitalClassificationatJune30,2008,August22,2008.
33.DraftMid-yearLetter,pp.1113(quotation,p.13),attachedtoChristopherH.Dickerson,let-
tertoDanielH.Mudd,September4,2008.
34.DickersontoMudd,September4,2008;ChristopherH.Dickerson,lettertoRichardSyron,Sep-
tember4,2008,withDraftMidYearLetterattached.
33.DraftMid-yearLetter(Fannie),pp.37.
36.Ibid.,p.3.
37.Ibid.,p.6.
38.Ibid.,pp.910.
39.DraftMidYearLetter(Freddie),pp.1,12,7.
60.Ibid.,p.8.
61.Mudd,interview.
62.ChristopherH.DickersontoJamesB.LockhartIII,memorandum,ProposedAppointmentofthe
Federal Housing Finance Agency as Conservator for the Federal Home Loan Mortgage Corporation,
September 6, 2008 (hereafter Freddie conservatorship memorandum); Christopher H. Dickerson to
JamesB.LockhartIII,memorandum,ProposedAppointmentoftheFederalHousingFinanceAgencyas
ConservatorfortheFederalNationalMortgageAssociation,September6,2008(hereafterFanniecon-
servatorshipmemorandum).
63.Paulson,interview;Lockhart,interview;Paulson,On the Brink, p.8.
64.Lockhart,testimonybeforetheFCIC,April9,2010,transcript,p.191.
63.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.Syron,interview.
73.DanielMudd,testimonybeforetheFCIC,HearingonSubprimeLendingandSecuritizationand
Government-Sponsored Enterprises (GSEs), day 3, session 1: Fannie Mae, April 9, 2010, transcript,
p.38.
74.PaulNash,FDIC,lettertoFCIC,providingresponsestofollow-upquestionstoSheilaBairstesti-
monyduringtheSeptember2,2010,hearing,p.3.
73.Paulson,interview.
76.NeelKashkari,interviewbyFCIC,November2,2010.
77. Tom Baxter, interview by FCIC, April 30, 2010; Kevin Warsh, interview by FCIC, October 28,
2010.
78.Warsh,interview.
79.Lockhart,testimonybeforetheFCIC,April9,2010,transcript,p.232.
80.StaffoftheFederalReserveSystem,DivisionofBankingSupervisionandRegulation,memoran-
dumtotheBoardofGovernors,StressScenariosonBankExposurestoGovernmentSponsoredEnter-
prise(GSE)Debt,January24,2003,p.3.
81.DanielMudd,writtentestimonyfortheFCIC,HearingonSubprimeLendingandSecuritization
andGovernment-SponsoredEnterprises(GSEs),day3,session1:FannieMae,April9,2010,p.3.
82. John Kerr, Scott Smith, Steve Corona (FHFA examination manager), and Alfred Pollard (FHFA
generalcounsel),groupinterviewbyFCIC,March12,2010.
613 Notes to Chapter 18
83.Lockhart,interview.
84.EdwardDeMarco,interviewbyFCIC,March18,2010.
83.Mudd,interview.
86.HenryCisneros,interviewbyFCIC,October13,2010.
87.Mudd,testimonybeforetheFCIC,April9,2010,transcript,p.104.
88.RobertLevin,testimonybeforetheFCIC,HearingonSubprimeLendingandSecuritizationand
Government-Sponsored Enterprises (GSEs), day 3, session 1: Fannie Mae, April 9, 2010, transcript,
p.104.
Chapter 18
1.JosephSommer,counsel,FederalReserveBankofNewYork,emailtoPatrickM.Parkinson,deputy
research director, Board of Governors of the Federal Reserve System, et al., Re: another option we
shouldpresentretriparty:July13,2008.
2.JamesDimon,interviewbyFCIC,October20,2010.
3.BarryZubrow,testimonybeforetheFCIC,HearingonTooBigtoFail:ExpectationsandImpactof
ExtraordinaryGovernmentInterventionandtheRoleofSystemicRiskintheFinancialCrisis,day1,ses-
sion2:LehmanBrothers,September1,2010,p.212.
4.RichardS.FuldJr.,testimonybeforetheFCIC,HearingonTooBigtoFail:ExpectationsandImpact
ofExtraordinaryGovernmentInterventionandtheRoleofSystemicRiskintheFinancialCrisis,day1,
session2:LehmanBrothers,September1,2010,p.148.SeealsoFuldswrittentestimonyatsamehearing,
p.6.
3.BenBernanke,testimonybeforetheFCIC,HearingonTooBigtoFail:ExpectationsandImpactof
ExtraordinaryGovernmentInterventionandtheRoleofSystemicRiskintheFinancialCrisis,day2,ses-
sion1:TheFederalReserve,September2,2010,transcript,pp.26,89.
6.KennethD.Lewis,interviewbyFCIC,October22,2010.
7.Bernanke,testimonybeforetheFCIC,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.08-13333
(JMP),(Bankr.S.D.N.Y.),March11,2010,2:631(hereaftercitedasValukas);seealso1:3andn.16,2:609
andnn.213334,4:1417andn.3441,4:1482andn.3728,4:1494,and3:1663andn.6269.Paulson,2:632.
GeithnertoldtheexaminerthatfollowingBearStearnssnearcollapse,heconsideredLehmantobethe
most exposed investment bank, 2:631; see also 1:3 and n. 16, 2:609, 4:1417 and n. 3441, 4:1482 and
n. 3728, 4:1491 and n. 3769, and 3:1663 and n. 6269. Cox reported that after Bear Stearns collapsed,
LehmanwastheSECsnumberonefocus;1:3andn.16,andp.1491andn.3769;seealso2:609,631.
9.TimothyGeithner,quotedinValukas,1:8andn.30,4:1496.
10. Donald L. Kohn, email to Bernanke, Re: Lehman, June 13, 2008. Valukas, 2:613; 2:609 and n.
2134.
11.HarveyR.Miller,bankruptcycounselforLehmanBrothers,interviewbyFCIC,August3,2010;
Lehmanboardminutes,September14,2008,p.34.
12.ErikR.Sirri,interviewbyFCIC,April1,2010.
13.PaoloR.Tonucci,interviewbyFCIC,August6,2010.
14.Specifically,Lehmandrew$1.6billiononMarch18;$2.3billiononMarch19and20;$2.7billion
onMarch24;$2.1billiononMarch23and26;and$2billiononApril16.LehmanBrothers,Presenta-
tion to the Federal Reserve: Update on Capital, Leverage & Liquidity, May 28, 2008, p. 13. See also
RobertAzerad,vicepresident,LehmanBrothers,2008Q2LiquidityPosition(June6,2008),p.3.Af-
teritsbankruptcy,Lehmandrew$28billion,$19.7billion,and$20.4billion,onSeptember13,16,and
17, until Barclays replaced the Fed in providing financing. Valukas, 4:1399. See also David Weisbrod,
seniorvicepresident,TreasuryandSecuritiesServicesRiskManagement,JPMorganChase&Co.,email
toJamesDimonetal.,Re:TriPartyClose,September13,2008.
13. Thomas A. Russo, former vice chairman and chief legal officer, Lehman Brothers, email to
RichardS.FuldJr.,forwardingarticlebyJohnBrinsley(originallysenttoRussobyRobertSteel),Paul-
son Says Investment Banks Making Progress in Raising Funds, Bloomberg, June 13, 2008 (quoting
RobertSteel),June13,2008.
614 Notes to Chapter 18
16.RichardS.FuldJr.,interviewbyFCIC,April28,2010.
17.Valukas,2:713andnn.276463,2:713andn.2774.SeealsoRusso,emailtoFuld,Fw:Rumorsof
hedgefundputtingtogetheragrouptohaveanotherrunatLehman,March20,2008(forwardingdis-
cussionswithSECregardingshortsellers).
18. Dan Chaudoin, Bruce Karpati, and Stephanie Shuler, Division of Enforcement, SEC, interview by
FCIC,April6,2010;MaryL.Schapiro,chairman,SEC,writtenresponsestowrittenquestionsspecifically,
responsetoquestion13fromFCIC,askedafterthehearingonJanuary14,2010.
19. Jesse Eisinger, The Debt Shuffle: Wall Street Cheered Lehmans Earnings, but There Are Ques-
tionsaboutItsBalanceSheet,Portfolio.com,March20,2008.
20.DavidEinhorn,GreenlightCapital,PrivateProfitsandSocializedRisk,speechatGrantsSpring
InvestmentConference,April8,2008,p.9.SeealsoDavidEinhorn,AccountingIngenuity,speechatIra
W.SohnInvestmentResearchConference,May21,2008,pp.34.
21.NellMinow,interviewbyFCIC,September13,2010.
22. Nell Minow, testimony before the House Committee on Oversight and Government Reform,
HearingonLehmanBrothers,110thCong.,2ndsess.,October6,2008.
23. Kirsten J. Harlow, email to Timothy Geithner et al., On-Site Primary Dealer Update: June 16,
June16,2008.
24.WilliamDudley,emailtoTimothyGeithner,DonaldKohn,andothers,June17,2008.
23. Kirsten J. Harlow, email to Kevin D. Coffey, examining officer, FRBNY, et al., On-Site Primary
DealerUpdate:June19,June19,2008.
26.ThomasFontana,Citigroup,emailtoChristopherM.Foskett,Citigroup,etal., June12,2008.
27.TimClark,FederalReserve,emailtoKevinCoffey,FederalReserve,etal.,June20,2008.
28.FederalReserveBankofNewYork,PrimaryDealerMonitoring:LiquidityStressAnalysis,June
23,2008.
29.BasedonchartinFederalReserveBankofNewYork,DevelopingMetricsfortheFourLargest
SecuritiesFirms,August2008,p.9.
30.FederalReserveBankofNewYork,PrimaryDealerMonitoring:LiquidityStressAnalysis,June
23,2008.
31.KarlMocharko,assistantvicepresidentandseniortrader,FederatedInvestors,Inc.,emailtoGail
Shanley, Federated Investors, Inc., et al., Re: Federated SubCustodial AgreementJPMCs comments,
July10,2008;CharlesWitek,FederatedInvestors,Inc.,emailtoGeorgeV.VanSchaick,LehmanBroth-
ers, et al., FW: Federated SubCustodial AgreementJPMCs comments, April 23, 2008. Despite the
FRBNYsobservation,FederateddidnotfullyterminateitsreporelationshipswithLehman.Infact,asof
September 12, Federateds repo exposure to Lehman was $2 billion, as reported in the Commissions
MarketRiskSurveyofmoneymarketmutualfunds.
32. Patrick M. Parkinson, email to David Marshall, et al., July 11, 2008; David Marshall, email to
PatrickM.Parkinson,July11,2008.
33.Valukas,4:149798(quotingTimothyGeithner);seealsoBartMcDade,presidentandchiefoper-
atingofficer,LehmanBrothers,interviewbyFCIC,April16,2010.
34.WilliamDudley,emailtoGeithneretal.,Re:LehmanGoodBank/BadBankideadiscussedlast
night,July13,2008.
33.PatrickM.Parkinson,emailtoStevenShafran,DepartmentoftheTreasury,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,August13,2010.
38.WilliamBrodows,emailtoPatrickParkinson,August13,2008.
39.Ibid.
40.Ibid.
41.Parkinson,emailtoStevenShafran,August19,2008.
42.Ibid.
43.StevenShafran,emailtoPatrickM.Parkinson,August28,2008.
44.PatrickM.Parkinson,emailtoTheodoreLubke,September3,2008.
615 Notes to Chapter 18
43.EmilCornejo,seniorvicepresident,DepartmentoftheTreasury,LehmanBrothers,emailtoJanet
Birney,seniorvicepresident,DepartmentoftheTreasury,LehmanBrothers,etal.,JPMorganAgenda
forwarded for our review. FYI, September 3, 2008. See Lehman Briefing Memorandum, September 4,
2008;JPMorganAgenda,September4,2008.
46.MegMcConnell,FRBNY,emailtoArthurAnguloetal.,Meetingtomorrowat9:00,September8,
2008.
47.Ibid.
48.PatrickM.Parkinson,emailtoStevenShafran,Re:nowIamonaconfcall,September9,2008.
49.HenryM.PaulsonJr.,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
at3P.M. insteadof6P.M.,September9,2008.
30.JimWilkinson,emailtoMicheleDavis,September9,2008.
31.BarryZubrow,interviewbyFCIC,August19,2010.
32.Paul,Weiss,counseltoStevenBlack,lettertoFCIC,August27,2007,writtenresponsestoFCIC
questionsinemailofAugust26,2007,p.6.
33. John J. Hogan, JPMorgan Chase & Co., email to Steven D. Black, September 9, 2008, 7:07 P.M.;
Steven Black, email to John Hogan, September 9, 2008, 8:24 P.M. See also Valukas, 4:1139, 1140 and
n.4204,and1141.
34. Complaint, In re Lehman Brothers Holdings, Inc., et al., against JPMorgan Chase Bank, N.A.,
Chapter 11 Case No. 08-13333 (JMP) (Bankr. S.D.N.Y. May 26, 2010), pp. 1413 (hereafter cited as
LehmanComplaint).
33.Ibid.
36.Blackresponses,August27,2010,p.6.
37.MatthewRutherford,emailtoTonyRyan,DepartmentoftheTreasury,etal.,September10,2008.
38.MarkVanDerWeide,assistantgeneralcounsel,BoardofGovernorsoftheFederalReserveSystem,
emailtoScottG.Alvarez,generalcounsel,BoardofGovernorsoftheFederalReserveSystem,lehman,
September10,2008.
39.PatriciaMosser,emailtoWilliamDudleyetal.,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,interviewbyFCIC,August11,2010.
63.KenLewis,interviewbyFCIC,October22,2010.
64.SusanMcCabe,GoldmanSachsGroup,Inc.,emailtoWilliamDudleyetal.,Hopeyouhavethe
Radarscreensonearlythismorning,September11,2008.
63.RitaC.Proctor,emailtoBernanke,Fw:FinancialMarketsConferenceCall9/11/08,September
11,2008(forwardingtoChairmanBernankematerialsfortheconferencecall).
66.HayleyBoesky,vicepresident,MarketsGroup,FRBNY,emailtoMegMcConnelletal.,forwarding
LouisBacon,emailtoHayleyBoesky,FW:Optionsforshort-circuitingthemarket,September11,2008,
10:46A.M.
67. Email chain between Jamie McAndrews, Tobias Adrian, Patrick Parkinson and Jeff Stehm, sub-
ject :Fw :DefaultManagementGroup9Sep2008.doc,September11,2008.
68.HayleyBoesky,emailtoDebbyPerelmuter,seniorvicepresident,FRBNY,etal.,Panic,Septem-
ber11,2008.
69. Jane Buyers-Russo, managing director, JP Morgan, email to Paolo R. Tonucci, Fw: Letter to
Lehman, Sept. 11, 2008, (attaching JPMorgan Chase & Co.s September 11, 2008, Notice to Lehman
BrothersHoldingsInc.).
70. Jane Buyers-Russo, email to Bryn Thomas, executive director, Broker Dealer Group, JPMorgan
Chase&Co.,etal.,Re:LehmanBrothersTriPartyCollateral,September12,2008.
71.PaoloR.Tonucci,interviewbyFCIC,August6,2010.
72.SeeValukas,4:113863,1162andn.4304.
616 Notes to Chapter 18
73.LehmanComplaint,pp.2223,paragraphs68,71.
74.BarryZubrow,writtentestimonyfortheFCIC,HearingonTooBigtoFail:ExpectationsandIm-
pact of Extraordinary Government Intervention and the Role of Systemic Risk in the Financial Crisis,
day1,session2:LehmanBrothers,September1,2010,p.7.
73.RichardS.Fuld,interviewbyFCIC,August24,2010.
76.LehmanComplaint,p.23,paragraph70.
77.JimWilkinson,emailtoAbbyAderman,RussellReynoldsAssociates,Re:PaulsonStatementon
TreasuryandFHFAActiontoProtectFinancialMarketsandTaxpayers,September12,2008.
78.KevinM.Warsh,e-mailtoJ.NellieLiang,seniorassociatedirector,DivisionofResearchandSta-
tistics,BoardofGovernorsoftheFederalReserveSystem,September12,2008.
79.Valukas,2:618.
80.HarveyR.Miller,interviewbyFCIC,August3,2010.
81.TomBaxter,Speakingnotes:FinancialCommunityMeeting,attachedtoemailfromHelenAy-
ala,NYFRB,toStevenShafron,Treasure,September12,2008.
82.ThomasC.Baxter,interviewbyFCIC,August11,2010.
83.H.RodginCohen,interviewbyFCIC,August3,2010.
84.Parkinson,emailtoKohnetal.,September11,2008.
83.FinancialServicesAuthorityoftheUnitedKingdom,StatementoftheFinancialServicesAuthor-
itybeforetheLehmanbankruptcyexaminer,pp.43,paragraph23.
86.Paulson,On the Brink, p.193.
87.PatrickM.Parkinson,emailtoLucindaBrickler,seniorvicepresident,paymentspolicy,FRBNY,
Re:tripartyrepothoughtsforthisweekend,September12,2008.
88.PatrickM.Parkinson,interviewbyFCIC,August24,2010;seealsoPatrickM.Parkinson,emailto
LucindaBrickleretal.,Re:anotheroptionweshouldpresentretriparty:July13,2008.
89.JohnThain,interviewbyFCIC,September17,2010.
90.ChristopherTsuboi,examiner,banksupervision/operationalrisk,FRBNY,emailtoAlejandroLa-
Torre, assistant vice president, Credit, Investment and Payment Risk Group, FRBNY, memo re:
Lehmansinter-companydefaultscenario,September13,2008.
91. Scott Alvarez, email to Ben Bernanke et al., Re: Fw: today at 7:00 p.m. w/Chairman Bernanke,
ViceChairmanKohnandOthers,September13,2008.
92.ScottAlvarez,emailtoMarkVanDerWeide,Re:tri-party,September13,2008.
93.BartMcDade,interviewbyFCIC,August9,2010.
94.Baxter,interview.
93.Paulson,On the Brink, p.207.
96.Baxter,interview;RobertDiamond,interviewbyFCIC,November13,2010.
97.Paulson,On the Brink, pp.21213.
98.FinancialServicesAuthorityoftheUnitedKingdom,StatementoftheFinancialServicesAuthor-
itybeforetheLehmanbankruptcyexaminer,p.9,paragraph48.
99.Paulson,On the Brink, pp.20910.SeealsoBaxter,interview.
100.Baxter,interview.
101.JimWilkinson,emailtoJesStaley,September14,2008,7:46A.M.
102.JimWilkinson,emailtoJesStaley,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.
103.H.RodginCohen,interviewbyFCIC,August3,2010.
106.BartMcDade,interviewbyFCIC,August9,2010.
107.AlexKirk,interviewbyFCIC,August16,2010;McDade,interview,August9,2010.
108.Baxter,interview.
109.ThomasC.Baxter,lettertoFCIC,October13,2010,attachingExhibit6,JamesP.Bergin,emailto
WilliamDudleyetal.,Bankruptcy,September14,2008.SeealsoKirk,interview.
110. Ibid., attaching Exhibit 3, Lehman Brothers Holdings Inc., Minutes of the Board of Directors,
September14,2008,p.2.
111.Ibid.,attachingExhibits2and8.
617 Notes to Chapter 19
112.OnSeptember13,2008,LBIborrowed$28billionfromPDCFagainst$31.7billionofcollateral;
onSeptember16,2008,LBIborrowed$19.7billionagainst$23billionofcollateral;andonSeptember17,
2008,LBIborrowed$20.4billionagainst$23.3billionofcollateral.SeeValukas,4:1399andnn.337473.
113.Kirk,interview.
114.Miller,interview.
113.Kirk,interview.
116.Miller,interview.Inhisinterview,KirktoldFCICstaffthathethoughtthereweremorethan1
millionderivativescontracts.
117.McDade,interview,August9,2010.
118.Baxter,interview.
119.HarveyR.Miller,writtentestimonyfortheFCIC,HearingonTooBigtoFail:Expectationsand
ImpactofExtraordinaryGovernmentInterventionandtheRoleofSystemicRiskintheFinancialCrisis,
day1,session2:LehmanBrothers,September1,2010,p.8.
120.Miller,interview.
121.Ibid.
122.Ibid.
123.BenS.Bernanke,closed-doorsessionwithFCIC,November17,2009.
124.Ibid.
123.HenryM.PaulsonJr.,writtentestimonyfortheFCIC,HearingontheShadowBankingSystem,
day2,session1:PerspectiveontheShadowBankingSystem,May6,2010,p.33.
126.Miller,writtentestimonyfortheFCIC,September1,2010,p.14.
127.Ibid.,p.18.
128.Ibid.,pp.6,1213,13,11,13.
129.Bernanke,testimonybeforetheFCIC,September2,2010,transcript,p.23.
130.BenBernanke,emailtoKevinWarsh,member,BoardofGovernorsoftheFederalReserveSys-
tem,September14,2008.
131.Bernanke,testimonybeforetheFCIC,September2,2010,p.22.
132.Ibid.,p.24.
133. Ben Bernanke, U.S. Financial Markets, testimony before the Senate Committee on Banking,
Housing,andUrbanAffairs,110thCong.,2ndsess.,September23,2008.
134.12U.S.C.343(A),asaddedbyactofJuly21,1932(47Stat.713);andamendedbyactsofAugust
23,1933(49Stat.714),December19,1991(103Stat.2386),andJuly21,2010(124Stat.2113).
133.ScottG.Alvarez etal.,memorandum,AuthorityoftheFederalReservetoprovideextensionsof
creditinconnectionwithacommercialpaperfundingfacility(CPFF),March9,2009,p.7.
136.Fuld,writtentestimonyfortheFCIC,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,testimonybeforetheFCIC,HearingonTooBigtoFail:ExpectationsandIm-
pact of Extraordinary Government Intervention and the Role of Systemic Risk in the Financial Crisis,
day 1, session 1: Wachovia Corporation, September 1, 2010, transcript, p. 93. See also Baxter, letter to
FCIC,October13,2010,p.6.
Chapter 19
1.FederalReserveBankofNewYork,notesaboutAIGmeeting,September12,2008.
2.Ibid.
3.Ibid.
4.AIGCommercialPaperOutstanding&MaturitiesweekofSept13th,September16,2008,pro-
ducedbyJPMorgan.
3.AmericanInternationalGroup,Inc.,Form10-QforthequarterlyperiodendedJune30,2008.
618 Notes to Chapter 19
6.FRBNY,notesaboutAIGmeeting.
7. Goldman Sachs International, Collateral Invoice (margin call) to AIG Financial Products Corp.,
July 27, 2007; data on collateral exposures and multisector CDOs supplied by AIG (see Timeline of
Goldman Sachs/AIG collateral calls, pp. 30, 392, 404, available at the FCIC website at http://fcic.gov/
hearings/pdfs/20100701-AIG-Goldman-supporting-docs.pdf);FRBNY,notesaboutAIGmeeting.
8.AlejandroLaTorre,emailtoChristineCumming,TimothyGeithner,WilliamDudley,etal.,Up-
dateonAIG,September12,2008.
9.FRBNY,notesaboutAIGmeeting.
10.MarkHutchings,interviewbyFCIC,June22,2010.
11.EricDinallo,testimonybeforetheFCIC,HearingontheRoleofDerivativesintheFinancialCri-
sis,day2,session2:Derivatives:SupervisorsandRegulators,July1,2010,transcript,pp.3,16.
12. Michael Moriarty, testimony before the Congressional Oversight Panel, Hearing on American
InternationalGroup,111thCong.,2ndsess.,May26,2010,p.4.
13.Dinallo,testimonybeforetheFCIC,July2,2010,pp.1617.
14.FRBNY,notesaboutAIGmeeting.
13.Ibid.
16.SystemicImpactofAIGBankruptcy,attachmenttoFRBNYinternalemailfromAlejandroLa-
TorretoTimothyGeithner,September16,2008.
17.FRBNY,internalmemoaboutAugust11,2008,meetingwiththeAIGteamoftheOfficeofThrift
Supervision.
18.Ibid.
19.FRBNY,internaldocumentaboutAIG,August14,2008.
20.Ibid.
21.GoldmanSachs,companyupdateonAIG,August18,2008.
22.IraSelig,emailtoKevinCoffey,GoldmanReportonAIG,August18,2008.
23.FRBNY,internaldocumentaboutAIG,September2,2008.
24.Ibid.
23.Ibid.;GoldmanSachs,companyupdateonAIG,August18,2008.
26.FRBNY,notesaboutAIGmeeting,September12,2008.
27.Ibid.
28.AIGCommercialPaperOutstanding&MaturitiesweekofSept13th,September16,2008.
29.FRBNY,notesaboutAIGmeeting,September12,2008.
30.HayleyBoesky,emailtoBillDudleyetal.,AIGpanic,September12,2008.
31.FRBNY,emailsofSeptember12and13,2008.
32.ThomasBaxter,interviewbyFCIC,April30,2010.
33.RobertWillumstad,interviewbyFCIC,November13,2010.
34. Patricia Mosser, email to Alejandro LaTorre et al., re: AIG/Board call, September 13, 2008,
12:34P.M.
33.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.J.C.Flowers,interviewbyFCIC,October7,2010.
41.RobertWillumstad,interviewbyFCIC,November13,2010.
42.Ibid.
43.GoldmanSachsInternational,CollateralInvoicetoAIGFinancialProductsGroup,September13,
2008.
44.DatasuppliedbyAIG(Tab31oftheAIG/GoldmanSachscollateralcalltimeline).
43.Baxter,interview.
46.SeeSarahDahlgren,FRBNY,interviewbyFCIC,April30,2010.
47.Ibid.
48.AlexanderJ.Psomas,emailtoNYBankSupAIGMonitoringandAnalysis,September13,2003.
619 Notes to Chapter 20
49.FedChairmanBenBernanke,lettertoFCICChairmanPhilAngelides,December21,2010.
30.FederalReserveBoardofGovernors,pressrelease,September16,2008.
31.CongressionalOversightPanel,TheAIGRescue,ItsImpactonMarkets,andtheGovernments
ExitStrategy,June10,2010,p.98.
32.Ibid.,executivesummary,pp.1,8.
33.TreasuryspokesmanAndrewWilliams,quotedinHughSon,AIGsRescueHadPoisonousEf-
fect,U.S.PanelSays(Update1),Bloomberg, June10,2010.
34.ScottM.Polakoff,AmericanInternationalGroupsImpactontheGlobalEconomy:Before,dur-
ing,andafterFederalIntervention,testimonybeforethe.HouseCommitteeonFinancialServices,Sub-
committee on Capital Markets, Insurance, and Government Sponsored Enterprises, 111th Cong., 1st
sess.,March18,2009.
33.JohnReich,interviewbyFCIC,May4,2010.
36.MichaelE.Finn,preparedtestimonybeforetheCongressionalOversightPanel,May26,2010.
37.C.K.Lee,interviewbyFCIC,April28,2010.SeealsoMemorandumofUnderstandingbetween
Scott M. Albinson, managing director, OTS, and Danile Nouy, secrtaire gnral de la Commission
Bancaire,April11,2003.
38.OTS,MemotoCommission Bancaireregardingitssupervisoryrole,January2003.
39.Reich,interview.
60.JosephGonzalez,interviewbyFCIC,May7,2010.
61.Ibid.
62.OTS,TargetedReviewofAIGFinancialProductsCorp.,July13,2007.
63.AIG/GoldmanSachscollateralcalltimeline,p.30.
64.BradWaring,interviewbyFCIC,May7,2010.
63.Reich,interview.
66.Ibid.
Chapter 20
1.JohnJ.Mack,writtentestimonyfortheFCIC,FirstPublicHearingoftheFCIC,day1,panel1:Fi-
nancialInstitutionRepresentatives,January13,2010,p.6.
2.JamieDimon,interviewbyFCIC,October20,2010.
3.TimothyGeithner,interviewbyFCIC,November17,2009.
4.TimothyGeithner,quotedbyRobertSchmidt,GeithnerSlamsBonuses,SaysBanksWouldHave
Failed(Update2),Bloomberg, December4,2009.
3.BenBernanke,closed-doorsessionwithFCIC,November17,2009.
6.Specifically,theFedbroadenedthePDCFtomatchthetypesofcollateralthatthetwomajorclear-
ingbanksacceptedinthetri-partyreposystem,includingnon-investment-gradesecuritiesandequities;
previously, PDCF collateral had been limited to investment-grade debt securities. The Fed similarly
broadenedtheTSLFtoincludeallinvestment-gradedebtsecurities;previously,TSLFcollateralhadbeen
limitedtoTreasurysecurities,agencysecurities,andAAA-ratedmortgage-backedandasset-backedse-
curities. The Fed also increased both the frequency of TSLF auctions, to weekly instead of every two
weeks,andtheirsize.FederalReserveBoardpressrelease,September14,2008.
7.OnSeptember30,GoldmanSachshada$13billionbalanceinTSLF,anda$16.3billionbalancein
PDCF.FederalReserveBoard,RegulatoryReform:UsageofFederalReserveCreditandLiquidityFacil-
ities,PDCF.
8. Lehman initially asserted that there were around 930,000 derivative transactions at the time of
bankruptcy.SeeDebtorsMotionforanOrderpursuanttoSections103and363oftheBankruptcyCode
to Establish Procedures for the Settlement or Assumption and Assignment of Prepetition Derivatives
Contracts,LehmanBrothersHoldingsInc.,etal,No.08-13333(Bankr.S.D.N.Y.Nov.13,2008),p.4.See
alsoAntonR.Valukas,ReportofExaminer,In re LehmanBrothersHoldingsInc.,etal.,Chapter11Case
No.08-13333(JMP),(Bankr.S.D.N.Y.),March11,2010,2:373.ByNovember13,2008,aspecialfacilityto
unwindderivativestradeswithLehmanhadsuccessfullyterminatedmostofthe930,000derivativecon-
tracts. Nevertheless, in January 2009, Lehmans counsel reported that 18,000 derivatives contracts had
notbeenterminated.Moreover,therearemassiveunresolvedclaimsrelatingtoover-the-counterderiva-
tivesinthebankruptcyproceeding:asofMay2010,bankshadfiledmorethan$30billioninclaimsfor
losses related to derivatives contracts with Lehman. See Debtors Motion for an Order pursuant to
620 Notes to Chapter 20
Sections103and363oftheBankruptcyCodetoEstablishProceduresfortheSettlementorAssumption
and Assignment of Prepetition Derivatives Contracts, Lehman Brothers Holdings Inc., et al., No. 08-
13333(Bankr.S.D.N.Y.Nov.13,2008)[DocketNo.1498],p.4;DebtorsMotionforanOrderApproving
ConsensualAssumptionandAssignmentofPrepetitionDerivativesContracts,LehmanBrothersHold-
ingsInc.,etal.,No.08-13333(Bankr.S.D.N.Y.Jan.16,2009)[DocketNo.2361],p.3.
9.Moneymarketfundholdingsofalltypesoftaxablecommercialpaperdecreasedfrom$671billion
at the end of August 2008 to $303 billion at the end of September (data provided by ICI/Crane to the
FCIC).BNYMellon,initsroleastri-partyclearingbank,reportedthatTreasury-backedreposrosefrom
$193 billion (13) to $466 billion (27) of its tri-party business between March 31 and December 31,
2008(dataprovidedbyBNYMellontotheFCIC).
10.HarveyMiller,interviewbyFCIC,August3,2010.
11.TheReserveFund,Semi-annualreporttoshareholders,March2006.
12.Complaint,SECv.ReserveManagementCompanyInc.,ResrvPartnersInc.,BruceBentSr.,Bruce
Bent II, and The Reserve Primary Fund (S.D.N.Y. May 3, 2009), p. 12 (para. 33); Fidelity, BlackRock,
Dreyfus,ReserveMakeBigGainsPast12Months,CraneDataNewsArchives,September12,2008.
13.TheReservePrimaryFundmanagement,interviewbyFCIC,March23,2010.
14.SECComplaintagainstReserveManagementCompanyInc.,pp.2,18(paras.3,39),p.30(para.
101); The Reserve, The Primary Fund: Plan of Liquidation and Distribution of Assets, December 3,
2008,p.2.
13. SEC Complaint, pp. 2633 (paras. 88113); The Reserve, The Primary Fund: Plan of Liquida-
tion,p.2.
16. SEC Complaint, p. 33 (para. 121). The SEC notes that the Primary Fund likely 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. Moodys Investors Service articles, Sponsor Support Key to Money Market Funds, August 9,
2010,p.4;MoodysProposesNewMoneyMarketFundRatingMethodologyandSymbols,September
7,2010.
18.PatrickMcCabeandMichaelPalumbo,interviewbyFCIC,September28,2010.
19.Ibid.
20. Investment Company Institute, Historical Weekly Money Market Data. While nongovernment
funds lost $434 billion during the period between September 10 and October 1, 2008, government
fundsinvestinginTreasuriesandGSEdebtincreasedby$337billionduringthesameperiod.
21.McCabeandPalumbo,interview.
22.FCICsurveyofmoneymarketmutualfunds.Holdingsforthefivefirmsdecreasedfrom$38bil-
lionto$29billionfromSeptember12,2008,toSeptember19,2008.SeeFCICwebsitefordetails.
23. Timothy Geithner, testimony before the FCIC, Hearing on the Shadow Banking System, day 2,
session2:PerspectiveontheShadowBankingSystem,May6,2010,transcript,p.133.
24.McCabeandPalumbo,interview.
23.TreasuryAnnouncesGuarantyProgramforMoneyMarketFunds,TreasuryDepartmentpress
release,September19,2008.PresidentGeorgeW.BushapprovedtheuseofexistingauthoritiesbySecre-
tary Henry M. Paulson Jr. to make available as necessary the assets of the Exchange Stabilization Fund
(ESF)forupto$30billiontoguaranteepaymentstosupportmoneymarketmutualfunds.Theoriginal
objectiveoftheESF,establishedbytheGoldReserveActof1934,wastostabilizethevalueofthedollar
inthedepthsoftheDepression.Itauthorizedthetreasurysecretary,withtheapprovalofthepresident,to
dealingold,foreignexchange,andotherinstrumentsofcreditandsecuritiestopromoteinternational
financialstability.
26. The program was called the Asset-Backed Commercial Paper Money Market Mutual Fund Liq-
uidityFacility(AMLF).
27.NeelKashkari,interviewbyFCIC,November2,2010.
28.JohnMack,interviewbyFCIC,November2,2010.
29.NewYorkFederalReserve,internalemail,October22,2008,p.2.
30.DavidWong,emailtoFedandSECofficials,September13,2008.
621 Notes to Chapter 20
31.JonathanStewart,FRBNY,internalemail,September17,2008.
32. One year later, the Senior Supervisors Groupa cross-agency task force looking back on the
causes of the financial crisiswould write, Before the crisis [at the investment banks post-Lehman],
manybroker-dealersconsideredtheprimebrokeragebusinesstobeeitherasourceofliquidityoraliq-
uidity-neutralbusiness.Asaresult,themagnitudeandunprecedentedseverityofeventsinSeptember
October 2008 were largely unanticipated. Senior Supervisors Group, Risk Management Lessons from
theGlobalBankingCrisisof2008,October21,2009,p.9.
33.JonathanWood,WhiteboxAdvisors,interviewbyFCIC,August11,2010.
34. The FCIC surveyed hedge funds that survived the crisis. Those in the three largest quartiles
rankedbysizereceivedinvestorredemptionrequestsaveraging20oftheirassetsinthefourthquarter
of2008(thefirstavailableredemptiondateaftertheLehmanbankruptcy).
33.IFSLResearch,HedgeFunds2009,April2009.
36.DavidWong,treasurerofMorganStanley,interviewbyFCIC,October13,2010.
37.Mack,interview.
38.Wong,interview.
39.PatriceMaher(MorganStanley),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.AmyG.White,internalNYFBRemail,September19,2008.
44.MorganStanley,LiquidityandFinancingActivity:08/28/08,LiquidityandFinancingActivity:
09/18/08,LiquidityandFinancingActivity:10/03/08,reportstotheNewYorkFederalReserve.
43.MorganStanleyCorporateTreasury,MeetingwithFederalReserve:September20,2008,attach-
menttoMorganStanleyemailtoNYFRB,September20,2008,includingForwardForecast.
46.MorganStanleyCorporateTreasury,LiquidityLandscape:09/1209/18/2008,inattachmentto
MorganStanleyemailtoNYFRB,September20,2008;AmyWhite,internalNYFRBemails,September
16and19,2008.
47.LloydBlankfein,testimonybeforetheFCIC,FirstPublicHearingoftheFCIC,day1,panel1:Fi-
nancialInstitutionRepresentatives,January13,2010,transcript,pp.3433.
48.Bernanke,closed-doorsession.
49.ThomasBaxter,interviewbyFCIC,April30,2010.
30.Theswitchtobankholdingcompanystatusrequiredasimplecharterchange.BothMorganand
Goldmanalreadyownedbanksthattheyhadcharteredasindustrialloancompanies,atypeofbankthat
isallowedtoacceptFDIC-insureddepositswithouthavinganyFedsupervisionoverthebanksparentor
otheraffiliatedcompanies.
31.FederalReserve,DiscountWindowPaymentSystemRisk:GettingStarted,lastupdatedNovem-
ber17,2009.
32.Mack,interview.
33.Mack,interview.
34.Wong,interview.
33.AmyG.White,internalFRBNYemail,September19,2008.
36. It should be borne in mind that lack of regulation of this market rendered it extremely opaque.
Shortcomingsintransparency,lackofreportingrequirements,andlimiteddatacollectionbythirdpar-
tiesmakeitdifficulttodocumentanddescribethevariousmarkettradingproblemsthatemergedduring
thecrisis.
37.MichaelMasters,testimonybeforetheFCIC,HearingontheRoleofDerivativesintheFinancial
Crisis,day1,session1:OverviewofDerivatives,June30,2010,transcript,p.26.
38.DepositoryTrustandClearingCorporationdataprovidedtotheFCIC.
39.TheGlobalOTCDerivativesMarketatEnd-June1998,BankofInternationalSettlementspress
release,December13,1998;OTCderivativesmarketactivityinthesecondhalfof2008,BankofInter-
nationalSettlementspressrelease,May9,2009,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.Moodys,MoodysdowngradesWaMuRatings;outlooknegative,September11,2008.
62.OTSFactSheetonWashingtonMutualBank,OTS08046A,September23,2008,p.3.
63.JamieDimon,interviewbyFCIC,October20,2010.
64. Sheila Bair, testimony before the FCIC, Hearing on Too Big to Fail: Expectations and Impact of
ExtraordinaryGovernmentInterventionandtheRoleofSystemicRiskintheFinancialCrisis,day2:ses-
sion2:FederalDepositInsuranceCorporation,September2,2010,exchangebetweenBairandCommis-
sionerDouglasHoltz-Eakin,pp.134,149.
63.ScottAlvarez,testimonybeforetheFCIC,HearingonTooBigtoFail:ExpectationsandImpactof
ExtraordinaryGovernmentInterventionandtheRoleofSystemicRiskintheFinancialCrisis,day1,Ses-
sion1:WachoviaCorporation,September1,2010,transcript,p.84.
66.Kashkari,interview.
67.GregFeldberg,WachoviaCaseStudy,presentationatLBOSupervisionConference,November
1213,2008,Atlanta,Georgia,p.13.Theserules,embodiedinsection23AoftheFederalReserveAct,
limit the support that a depository institution can provide to related companies in the same corporate
structure;theyareaimedatprotectingFDIC-insureddepositorsfromactivitiesthatoccuroutsideofthe
bankitself.Exemptionshavetheeffectoffundingaffiliate,nonbankassetswithinthefederalsafetynetof
insureddeposits;theycreateliquidityfortheparentcompanyand/orkeyaffiliates(andreducebankliq-
uidity)duringtimesofmarketstress.
68.RobertSteel,interviewbyFCIC,August18,2010.
69.ScottAlvarez,writtentestimonyfortheFDIC,September1,2010,p.4.
70.RobertSteel,writtentestimonybeforetheFCIC,HearingonTooBigtoFail:ExpectationsandIm-
pact of Extraordinary Government Intervention and the Role of Systemic Risk in the Financial Crisis,
day1,session1:WachoviaCorporation,September1,2010,p.2.
71.DavidWilson,interviewbyFCIC,August4,2010.
72.SheilaBair,interviewbyFCIC,August18,2010.
73.RichardWesterkamp,FederalReserveBankofRichmond,interviewbyFCIC,August13,2010.
74. Wachovia was unable to roll $1.1 billion of asset-backed commercial paper that Friday; James
WigandandHerbertHeld,memototheFDICBoardofDirectors,September29,2008,p.2.Onbrokered
certificatesofdeposit,seeWesterkamp,interview.
73. John Corston, acting deputy director, Division of Supervision and Consumer Protection, FDIC,
written testimony before the FCIC, Hearing on Too Big to Fail: Expectations and Impact of Extraordi-
nary Government Intervention and the Role of Systemic Risk in the Financial Crisis, day 1, Session 1:
WachoviaCorporation,September1,2010,p.4.
76.Wilson,interview.
77.RichWesterkamp,emailtoFCIC,November2,2010.Westerkampsaidthattheestimateofearly
redemption requests was based on a phone conversation with officials in Wachovias treasury depart-
ment,describingtheirconversationswithinvestors;thefigureswereneververified.
78.Bair,interview.
79.RobertSteel,interviewbyFCIC,August18,2010.
80.Bair,interview;Steel,interview;FDICstaff,interviewbyFCICreWachovia,July16,2010.
81.Alvarez,writtentestimonyfortheFCIC,September1,2010,p.3.
82.Steel,interview.
83.Ibid.
84.WigandandHeld,memototheFDICboard,September29,2008,pp.2,43.
83. Federal Reserve staff, memo to the Board of Governors, subject: Considerations Regarding In-
vokingtheSystemicRiskExceptionforWachoviaBank,NA,September28,2008,p.7.
86.JohnA.Beebe,MarketRiskTeamLeader,FederalReserveBankofRichmond,memotoJennifer
Burns,VP-LCBO,WachoviaLargeFundsProviders,September27,2008,pp.12.
87. Federal Reserve staff, memo to the Board of Governors, subject: Considerations Regarding In-
vokingtheSystemicRiskExceptionforWachoviaBank,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,writtentestimonyfortheFDIC,Sep-
tember1,2010,p.10.
91.Specifically,underWachoviasproposal,theFDICwouldprovidecreditprotectionon$200billion
ofloans,whileWachoviawouldabsorbthefirst$23billioninlossesandtheFDICwouldpotentiallyin-
curlossesonthebalanceofthe$200billion.Tooffsetthatrisk,WachoviaproposedthattheFDICreceive
$10billioninpreferredstockandwarrantsoncommonshares(FDICmemototheFDICBoardofDirec-
tors,p.8).
92.TheFDICboardhasfivemembers:thecomptrollerofthecurrency,thedirectorofOTS,andthree
other members appointed by 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)duringwhichGeithnerurgedBairtohelpCitigroupacquireWachoviabyguaranteeingsomeof
itspotentiallosses.GeithnerarguedthatallowingtheFDICtotakeoverWachoviawouldhavetheeffect
ofwipingoutshareholdersandbondholders,which,hewasconvinced,wouldonlyspookthemarkets.
He was still furious with Bair for the way she had abruptly 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.
93.Ibid.;the$34.6billionfigureisasofSeptember30,2008(FDICstaff,memototheBoardofDirec-
tors,subject:ThirdQuarter2008CFOReporttotheBoard,November21,2008,p.1).
96.MinutesoftelephonicmeetingoftheFDICboard,September29,2008,p.8.
97.Bair,interview.
98.Steel,writtentestimonyfortheFCIC,September1,2010,p.4.Ontheboardsvoteandtheagree-
mentinprinciple,seeSteel,interview;seealsoAffidavitofRobertK.Steel,datedOctober3,2008,filedin
WachoviaCorp.v.Citigroup,Inc.,CaseNo.08-cv-083093-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,interviewbyFCIC,August24,2010.
102.Bair,interview.
103.Steel,interview.
104.Bair,interview.Inhisinterview,TreasurysKashkaritoldtheFCICthathedisagreed.Hefeltthat
thehighestprioritywastotransfertheriskofbankstroubledassetsfromthefinancialsystemtothegov-
ernment. Citigroups FDIC-assisted acquisition would have removed potential losses on $270 billion of
assetsfromthefinancialsystembytransferringthosepotentiallossestotheFDIC.
103. Wells Fargo, Wachovia Agree to Merge: Creating Premier Coast-To-Coast Financial Services
FranchisewithoutGovernmentAssistance, WellsFargopressrelease,October3,2008.
106.RichDelmar,TreasuryOfficeoftheInspectorGeneral,interviewbyFCIC,August23,2010;Rich
Delmar,memorandumforInspectorGeneralEricM.Thorson,InquiryRegardingIRSNotice2008-83,
September3,2009,pp.3,3,1112.
107.RichardLevy,interviewbyFCIC,August19,2010.
108.StatementbySecretaryHenryM.Paulson,Jr.onComprehensiveApproachtoMarketDevelop-
ments,TreasuryDepartmentpressrelease,September19,2008.
109.SenatorsChristopherJ.DoddandRichardC.Shelby,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.SecretaryHenryPaulson,testimonybeforetheSenateBankingCommittee,Turmoil in the U.S.
Credit Markets, transcript,p.37.
111.FedChairmanBenBernanke,EconomicOutlook,testimonybeforetheJointEconomicCom-
mittee,110thCong.,2ndsess.,September24,2008,transcript.
624 Notes to Chapter 20
112. Fed Chairman Ben Bernanke, testimony 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,interviewbyFCIC,September28,2010.
114. The TARP legislation, drafted as the Emergency Economic Stabilization Act of 2008, was cou-
pled in Public Law 110-343 with several other vote-attracting acts, including the Energy Improvement
andExtensionActof2008,theTaxExtendersandAlternativeMinimumTaxReliefActof2008,thePaul
WellstoneandPeteDomeniciMentalHealthParityandAddictionEquityActof2008,andtheHeartland
and Hurricane Ike Disaster Relief Act of 2008. Congress originally 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.
113.ThequotationispartoftheformaltitleofPublicLaw110-343,ofwhichtheTARPlegislation
officiallynamedtheEmergencyEconomicStabilizationActof2008isapart.
116.BoardAnnouncesCreationoftheCommercialPaperFundingFacility(CPFF)toHelpProvide
Liquidity to Term Funding Markets, Federal Reserve Board press release, October 7, 2008. The CPFF
complementedtheFedsothercommercialpaperprogram,theAMLF,whichwascreatedshortlyafterthe
ReservePrimaryFundbrokethebuck.WhiletheAMLFtargetedmoneymarketmutualfunds,theCPFF
aimedtocreateliquidityforqualifiedcommercialpaperissuers.
117.FederalReserveBoard,CommercialPaperFundingFacility(CPFF).
118. Ken Lewis from Bank of America, Robert Kelly from BNY Mellon, Vikram Pandit from Citi-
group, Lloyd Blankfein from Goldman, Jamie Dimon from JP Morgan, John Thain from Merrill, John
MackfromMorganStanley,RonaldLoguefromStateStreet,andRichardKovacevichfromWells.
119.Paulson,testimonybeforetheFCIC,May6,2010,transcript,p.70.Formerassistanttreasurysec-
retaryPhillipSwagelargued,ThereisnoauthorityintheUnitedStatestoforceaprivateinstitutionto
acceptgovernmentcapital(TheFinancialCrisis:AnInsideView,BrookingsPapersonEconomicAc-
tivity,conferencedraft,Spring2009,pp.3334).
120.HenryPaulson,On The Brink. Inside the Race to Stop the Collapse of the Global Financial System
(NewYork:BusinessPlus,2010),p.363.
121.Dimon,interview.
122. The Temporary Liquidity Guarantee Program consisted of two programs, the Temporary Debt
GuaranteeProgram(TDGP)andtheTransactionAccountGuaranteeProgram(TAGP).TheTDGPatits
highest point in May 2009 guaranteed $346 billion in outstanding senior debt; see FDIC Announces
PlantoFreeUpBankLiquidity,FDICpressrelease,October14,2008.TheTAGPguaranteed$834bil-
lionindepositsattheendof2009.
123.FactsheetonCapitalPurchaseProgram,FinancialStability.gov,updatedOctober3,2010.
124. Remarks by Secretary Henry M. Paulson, Jr. on Financial Rescue Package and Economic Up-
date,TreasuryDepartmentpressrelease,November12,2008.
123.Paulson,testimonybeforetheFCIC,May6,2010,transcript,p.70.
126.U.S.TreasuryDepartmentOfficeofFinancialStability,TroubledAssetReliefProgram;Trans-
actionsReportforPeriodEndingDecember31,2008:CapitalPurchaseProgram;FactsheetonCapital
PurchaseProgram.
127.U.S.TreasuryDepartmentOfficeofFinancialStability,TroubledAssetReliefProgram:Transac-
tionsReportforPeriodEndingOctober13,2010:CapitalPurchaseProgram.
128.OfficeoftheSpecialInspectorGeneralfortheTroubledAssetReliefProgram,InitialReportto
theCongress,February6,2009,p.6.
129.CongressionalOversightPanel,SeptemberOversightReport:AssessingtheTARPontheEveof
ItsExpiration,September16,2010,p.27.
130.OfficeofFinancialStability,TroubledAssetReliefProgram:TwoYearRetrospective,October
2010,pp.13,31;AIG,WhatAIGOwestheU.S.Government,updatedSeptember30,2010.
131.CongressionalOversightPanel,SeptemberOversightReport,p.27;OfficeofFinancialStabil-
ity,TroubledAssetReliefProgram:TwoYearRetrospective,p.18;TaxpayersReceive$10.3Billionin
Proceeds Today from Final Sale of Treasury Department Citigroup Common Stock, Treasury Depart-
mentpressrelease,December10,2010.
625 Notes to Chapter 20
132.OfficeoftheSpecialInspectorGeneralfortheTroubledAssetReliefProgram,QuarterlyReport
toCongress,October26,2010,table2.1,p.46(obligationfiguresasofOctober3,2010,andexpenditure
figuresasofSeptember30,2010).
133.ThemoneymarketfundingisthroughtheAsset-backedCommercialPaperMoneyMarketMu-
tualFundLiquidityFacility(AMLF);FCICstaffcalculations.
134. Board of Governors of the Federal Reserve System, Regulatory Reform: Agency Mortgage-
backedSecurities(MBS)PurchaseProgram.
133.TheFedhadcreatedthefirstMaidenLanevehicleinMarchtotake$29billioninassetsoffthe
balancesheetofBearStearns,asdescribedinchapter13.SeeAIGRMBSLLCFacility:TermsandCon-
ditions,December16,2008;AIGDisclosesCounterpartiestoCDS,GIAandSecuritiesLendingTrans-
actions, AIG press release, March 13, 2009, Attachment D: Payments to AIG Securities Lending
Counterparties.
136.FederalReserveBankofNewYork,MaidenLaneIII:TransactionOverview;FederalReserve
andTreasuryDepartmentpressrelease,November10,2008;AIGCDOLLCFacility:TermsandCondi-
tions,FederalReserveBankofNewYorkpressrelease,December3,2008;FRBNY,MaidenLaneTrans-
actions.$27.1billionwaspaidto16counterpartiesand$2.3billionwaspaidtoAIGFPasanadjustment
toreflectovercollateralization.
137.OfficeoftheSpecialInspectorGeneralfortheTroubledAssetReliefProgram,FactorsAffecting
EffortstoLimitPaymentstoAIGCounterparties,SIGTARP-10-003,November17,2009,pp.1920.
138.Blankfein,testimonybeforetheFCIC,January13,2010,transcript,pp.9093.
139.DataprovidedtoGoldmanSachstotheFCIC.
140. David Viniar, testimony before the FCIC, Hearing on the Role of Derivatives in the Financial
Crisis,day2,session1:AmericanInternationalGroup,Inc.andGoldmanSachsGroup,Inc.,July1,2010,
transcript,p.148.
141.GoldmanSachs,emailtoFCIC,July13,2010.
142.Ibid.;anddataprovidedbyGoldmanSachstotheFCIC.
143.SIGTARP,FactorsAffectingEffortstoLimitPaymentstoAIGCounterparties,pp.1316,18.
Thereportsaidcounterpartiesinsistedon100coveragebecause(1)concessionswouldmeangiving
awayvalueandvoluntarilytakingaloss,incontraventionoftheirfiduciarydutytotheirshareholders;
(2)theyhadareasonableexpectationthatAIGwouldnotdefaultonfurtherobligations,giventhegov-
ernmentassistance;(3)costsalreadyincurredtoprotectagainstapossibleAIGdefaultwouldbeexacer-
batediftheywerepaidlessthanparvalue;and(4)theywerecontractuallyentitledtoreceivethepar
valueofthecreditdefaultswapcontracts.
144.Inotherwords,thedecisiontoacquireacontrollinginterestinoneoftheworldsmostcomplex
andmosttroubledcorporationswasdonewithalmostnoindependentconsiderationofthetermsofthe
transactionortheimpactthatthosetermsmighthaveonthefutureofAIG(ibid.,p.28).
143.Ibid.,summary,p.1.
146.CongressionalOversightPanel,JuneOversightReport:TheAIGRescue,ItsImpactonMarkets,
andtheGovernmentsExitStrategy,June10,2010,pp.10,8.
147.SuzanneKapner,USCongressionalPanelAttacksAIGRescue,Financial Times, June10,2010.
148.Baxter,interview.
149.SarahDahlgren,interviewbyFCIC,April30,2008.
130.SIGTARP,FactorsAffectingEffortstoLimitPaymentstoAIGCounterparties,p.29.
131. Timothy Geithner, quoted in Jody Shenn, Bob Ivry, and Alan Katz, AIG 100-Cents Fed Deal
DrivenbyFranceBeliedbyFrenchBanks,Bloomberg Businessweek, January20,2010.
132. E.g., Baxter, interview; Jim Mahoney, Federal Reserve Bank of New York, interview by FCIC,
April30,2010;MichaelAlix,FederalReserveBankofNewYork,interviewbyFCIC,April30,2010.
133.Dahlgren,interview.
134.Baxter,interview.
133. GAO, Federal Financial Assistance: Preliminary Observations on Assistance Provided AIG,
GAO-094907 (Testimony: Before the Subcommittee on Capital Markets, Insurance, and Government
SponsoredEnterprises,HouseCommitteeonFinancialServices),March18,2009,p.2;FederalReserve
pressrelease,September16,2008.
136.AIG,WhatAIGOwestheUSGovernment,updatedSeptember30,2010.
626 Notes to Chapter 20
137.EdwardJ.KellyIII,interviewbyFCIC,March3,2010.
138.RogerCole,interviewbyFCIC,August2,2010.
139.Kelly,interview.
160.JamesR.WigandandHerbertJ.Held,memorandumtotheFDICBoardofDirectors,regarding
recommendationforsystemicriskdeterminationforCitigroup,November23,2008,p.3.
161.Kelly,interview.
162.MarkD.Richardson,emailtoJohnH.Corston,JasonC.Cave,etal.,subject:RE:CONFIDEN-
TIALCitigroupDeterioration of Stock Price and CDS Spreads, November 20, 2008; Mark
D. Richardson, email, to John H. Corston, Jason C. Cave, et al., subject: 11-21-08 Citi Liquidity call
notes,November21,2008.
163.WigandandHeld,NovembermemototheFDICboardregardingCitigroup,p.3.
164.Bernanke,closed-doorsession.
163. Arthur J. Murton, email to John V. Thomas, Michael H. Krimminger, et al., subject: RE: Pro-
posed Conduit, November 22, 2008; Michael H. Krimminger, email to Arthur J. Murton, John
V.Thomas,etal.,subject:RE:ProposedConduit,November22,2008.
166.VikramPandit,testimonybeforetheCongressionalOversightPanel,Citigroup and the Troubled
Asset Relief Program, 111thCong.,2ndsess.,March4,2010,transcript,p.79.
167.Kelly,interview.
168.GAO,FederalDepositInsuranceAct:RegulatorsUseofSystemicRiskExceptionRaisesMoral
HazardConcernsandOpportunitiesExisttoClarifytheProvision,GAO-10100(ReporttoCongres-
sionalCommittees),April2010,p.2.
169.WigandandHeld,memototheFDICboardregardingCitigroup,pp.9,10.
170. Department of the Treasury response to Congressional Oversight Panel, Questions for the
Record,p.3,Citigroup and the Troubled Asset Relief Program, March4,2010,p.44.
Joint Statement by Treasury, Federal Reserve, and the FDIC on Citigroup, joint press release,
November23,2008.
171.JointStatementonCitigroup.
172.Intotal,Citigroupreceivedalmost$40billionincapitalbenefitsfromtheNovember2008gov-
ernmentassistance.HalfofthecapitalbenefitswerefromTreasurys$20billionTARPinvestmentinCiti-
grouppreferredstock;$16billionofthecapitalbenefitswerederivedfromachangeintheriskweighting
of the ring-fenced assets. In addition, Citigroup issued Treasury and the FDIC $7 billion in preferred
stockaspaymentfortheguaranteeontheringfence;theresult,afteraccountingfortheinsurancefeature
ofthearrangement,wasa$3.3billionincreaseincapitalforCitigroup.
173.Kelly,interview.
174.Thewarrantsgavethegovernmenttherighttobuy234millionsharesat$10.61ashare;atthe
time, the stock was trading at $3.76 (Congressional Oversight Panel, November Oversight Report:
GuaranteesandContingentPaymentsinTARPandRelatedPrograms,November6,2009,pp.1819).
173.FDICBoardofDirectorsmeeting,closedsession,November23,2008,transcript,p.14.
176.Ibid.,pp.2728.
177.OfficeofFinancialStability,TroubledAssetReliefProgram:TwoYearRetrospective,October
2010, p. 30; Taxpayers receive $10.3 billion in proceeds today from final sale of Treasury Department
Citigroupcommonstock,TreasuryDepartmentpressrelease,December10,2010.
178. Merrill Lynch Reports Third Quarter 2008 Net Loss from Continuing Operations of $3.1 Bil-
lion,MerrillLynchpressrelease,October16,2008,p.4;MerrillLynch,3Q2008EarningsCalltranscript,
October16,2008,p.2.
179.FederalReserveSystem,OrderApprovingBankofAmericaCorporationAcquisitionofaSav-
ingsAssociationandanIndustrialLoanCompany,November26,2008,pp.7,9.Toapprovesuchapro-
posal,theBankHoldingCompanyActrequirestheFedtodeterminethatatransactioncanreasonably
be expected to produce benefits to the public, such as greater convenience, increased competition, or
gainsinefficiency,thatoutweighpossibleadverseeffects,suchasundueconcentrationofresources,de-
creasedorunfaircompetition.12U.S.C.1843(j)(2)(A).
180.TimothyJ.Mayopoulous,formergeneralcounselofBankofAmerica,writtentestimonybefore
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,February26,2009,p.9,availablefromHouseCommitteeonOversightandGovernmentReform
andtheSubcommitteeonDomesticPolicy,Bank of America and Merrill Lynch. How Did A Private Deal
Turn into a Federal Bailout? 111thCong.,1stsess.,June11,2009.
182.BankofAmerica,4Q2008EarningsCalltranscript,January16,2009,p.16.
183.Ibid.,pp.3,10,16.
184.JohnThain,interviewbyFCIC,September17,2009.
183.Complaint,SECv.BankofAmerica(S.D.N.Y.Jan.12,2010);FinalConsentJudgmentAstoDe-
fendantBankofAmerica(S.D.N.Y.Feb.4,2010).
186.KenLewis,interviewbyFCIC,October22,2010.
187.Lewis,depositionIn Re. Executive Compensation Investigation. Bank of AmericaMerrill Lynch,
pp. 34, 38; Henry Paulson, written testimony before the House Committee on Oversight and Govern-
mentReformandtheSubcommitteeonDomesticPolicy,Bank of America and Merrill Lynch. How Did a
Private Deal Turn into a Federal Bailout? Part III, 111thCong.,1stsess.,July16,2009,p.22.
188.Paulson,writtentestimonybeforetheHouseOversightCommittee,July16,2009,p.23(quota-
tion);BenBernanke,writtentestimonybeforetheHouseCommitteeonOversightandGovernmentRe-
formandtheSubcommitteeonDomesticPolicy,Bank of America and Merrill Lynch. How Did a Private
Deal Turn into a Federal Bailout? Part II, 111thCong.,1stsess.,June23,2009,p.18.
189.Lewis,interview.
190.Thain,interview
191.Paulson,writtentestimonybeforetheHouseOversightCommittee,July16,2009,pp.19,23.
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, June23,2009,p.73;RepresentativeEdolphusTowns,inibid.,
p.2.
193.Lewis,interview.
194.MinutesofaSpecialMeetingofBoardofDirectorsofBankofAmericaCorporation,December
22,2008,availableinHouseCommitteeonOversightandGovernmentReform,June11,2009,p.183.
193. Minutes of a Special Meeting of the Bank of America board, December 30, 2008, available in
ibid.,p.188.
196.Lewis,interview.
197.SeeDepartmentoftheTreasury,OfficeofFinancialStability,TroubledAssetsReliefProgram:
TransactionsReport,forPeriodEndingNovember16,2010,November18,2010.Inadditiontodrawing
onthesefunds,itwasalsoasubstantialuseroftheFedsvariousliquidityprograms.Theholdingcom-
panyanditssubsidiarieshadalreadyborrowed$33billionthroughtheTermAuctionFacility.Ithadalso
borrowed $13 billion under the Feds Commercial Paper Funding Facility and $20 billion under the
FDICs debt guarantee program. And newly acquired Merrill Lynch had borrowed another $21 billion
fromtheFedstwoBearStearnserarepo-supportprograms.YetdespiteBankofAmericasrecourseto
theseprograms,theregulatorsworriedthatitwouldexperienceliquidityproblemsifthefourth-quarter
earningswereweak.
198. The amount of FDIC-guaranteed debt that can be issued by each eligible entity, or its cap, is
basedontheamountofseniorunsecureddebtoutstandingasofSeptember30,2008.
199.FRBandOCCstaff,memorandumtoRickCox,FDIC,subject:BankofAmericaCorporation
(BAC) Funding Vulnerabilities and Implications for Other Financial Market Participants, January 10,
2009,p.2.
200. Sheila C. Bair, FDIC Chairman, written testimony before the House Committee on Oversight
andGovernmentReformandtheSubcommitteeonDomesticPolicy,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,andJohnThomas,memoran-
dumtotheFDICBoardofDirectors,subject:BankofAmerica,etc.,January13,2009,pp.8,9.
202.Bair,writtentestimonybeforetheHouseOversightCommittee,December11,2009,p.3.
628 Notes to Chapter 21
203.Glassmanetal.,memototheFDICboard,January13,2009,p.3.Theyagreedtothis23/73split
because 23 of the assets for the ring fence were from depository institutions and 73 were not. See
closedmeetingoftheFDICBoardofDirectors,January13,2009,transcript,p.18.
204. Closed meeting of the FDIC board, January 13, 2009, transcript, p. 24. According to the FDIC
staff, Liquidity pressure may increase to critical levels following the announcement of fourth quarter
2008 operating results that are significantly worse than market expectations. Market reaction to BACs
operating results may have systemic consequences given the size of the institution and the volume of
counterpartytransactionsinvolved.Withoutasystemicriskdetermination . . .significantmarketdisrup-
tionmayensueascounterpartiesloseconfidenceinBACsabilitytofundongoingoperations. . . .[Eco-
nomicdevelopments]pointtoaclearrelationshipbetweenthefinancialmarketturmoilofrecentmonths
and impaired economic performance that could be expected to worsen further if BAC and its insured
subsidiarieswereallowedtofailed.Suchaneventwouldsignificantlyunderminebusinessandconsumer
confidence.Glassmanetal.,memototheFDICboard,January13,2009,pp.1314.
Chapter 21
1.BrianMoynihan,writtentestimonyfortheFCIC,FirstPublicHearingoftheFinancialCrisisIn-
quiryCommission,day1,session1:FinancialInstitutionRepresentatives,January13,2010,p.1.
2.ClarenceWilliams,writtentestimonyfortheFCIC,HearingontheImpactoftheFinancialCrisis
Sacramento,session4:ImpactoftheFinancialCrisisonSacramentoNeighborhoodsandFamilies,Sep-
tember23,2010,p.8;andtestimonybeforetheFCIC,transcript,pp.23960.
3.EdLazear,interviewbyFCIC,November10,2010.
4.JeannieMcDermott,testimonybeforetheFCIC,HearingontheImpactoftheFinancialCrisis
GreaterBakersfield,session6:ForumforPublicComment,September7,2010,transcript,pp.21113.
3.MarieVasile,testimonybeforetheFCIC,inibid.,transcript,pp.24431.
6.NationalDelinquencySurvey,MortgageBankersAssociation,FourthQuarter2007,March2008,
p.4;ThirdQuarter2010,November2010,p.4.
7.CoreLogic,U.S.HousingandMortgageTrends:August2010,November2010,p.3.
8.JeremyAguero,principalanalyst,AppliedAnalysis,writtentestimonyfortheFCIC,Hearingonthe
Impact of the Financial CrisisState of Nevada, session 1: Economic Analysis 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,AuditorsSayColoradoPensionPlanRecovering,AssociatedPress,August16,
2010.
11.CharlesS.Johnson,MontanaPensionFundsGrowingbutHaventMadeUpLosses,The Billings
Gazette, May18,2009.
12.TheConferenceBoardnewsrelease,May27,2008.
13.TheConferenceBoardnewsrelease,December28,2010.
14.GregoryD.Bynum,testimonybeforetheFCIC,HearingontheImpactoftheFinancialCrisis
Greater Bakersfield, session 3: Residential and Community Real Estate, September 7, 2010, transcript,
p.102.
13. Board of Governors of the Federal Reserve System, October 2010 Senior Loan Officer Opinion
Survey on Bank Lending Practices, Net Percentage of Domestic Respondents Tightening Standards on
ConsumerLoans,CreditCards,November8,2010.
16.AmericanBankruptcyInstitute,AnnualBusinessandNon-businessFilingsbyYear(19802009).
17.JeffAgosta,conferencecallwithFCIC,February23,2010.
18. American Bankruptcy Institute, Annual Business and Non-Business Filings by Year (1980
2009).
19.BoardofGovernorsoftheFederalReserveSystem,July2007SeniorLoanOfficerOpinionSurvey
onBankLendingPractices,August13,2007,p.13.
20.LizMoyer,RevolverattheHeads,Forbes, October7,2008.GannettCorporationwithdrew$1.2
billion,FairPointCommunicationswithdrew$200million,andDukeEnergywithdrew$1billion.
21.MurilloCampello,JohnR.Graham,andCampbellR.Harvey,TheRealEffectsofFinancialCon-
straints:EvidencefromaFinancialCrisis,journal of Financial Economics 97(2010):476.
629 Notes to Chapter 21
22. Board of Governors of the Federal Reserve System, January 2009 Senior Loan Officer Opinion
Survey,fourth-quarter2008,p.8.
23.ElizabethDuke,governor,FederalReserveBoard,SmallBusinessLending,testimonybeforethe
HouseCommitteeonFinancialServicesandCommitteeonSmallBusiness,February26,2010,p.1.
24. National Federation of Independent Businesses, NFIB Small Business Economic Trends, De-
cember2010,p.12.
23.BenBernanke,RestoringtheFlowofCredittoSmallBusiness,speakingattheFederalReserve
MeetingSeries:AddressingtheFinancingNeedsofSmallBusinesses,Washington,DC,July12,2010.
26.C.R.RustyCloutier,pastchairman,IndependentCommunityBankersofAmerica,testimony
beforetheFCIC,FirstPublicHearingoftheFCIC,day1,panel3:FinancialCrisisImpactsontheEcon-
omy,January13,2010,transcript,p.194.
27. Federal Reserve Statistical Release, E.2 Survey of Terms of Business Lending, E.2 Chart Data:
CommercialandIndustrialLoanRatesSpreadsoverIntendedFederalFundsRate,byLoanSize,spread
forallsizes.
28.WilliamJ.DennisJr.,SmallBusinessCreditinaDeepRecession,NationalFederationofInde-
pendentBusinesses,February2010,p.18.
29.JerryJost,interviewbyFCIC,August20,2010.
30.BoardofGovernorsoftheFederalReserveSystem,SeniorLoanOfficerOpinionSurveyonBank
LendingPractices,April2010.
31.BoardofGovernorsoftheFederalReserveSystem,SeniorLoanOfficerOpinionSurveyonBank
LendingPractices,July2010.
32. Emily Maltby, Small Biz Loan Failure Rate Hits 12, CNN Money, February 23, 2009; SBA
LossesClimb134in2008,ColemanReport(www.colemanpublishing.com/public/343.cfm).
33. Michael A. Neal, chairman and CEO, GE Capital, testimony before the FCIC, Hearing on the
ShadowBankingSystem,day2,session3:InstitutionsParticipatingintheShadowBankingSystem,May
6,2010,transcript,p.242.
34.GE,2008AnnualReport,p.38.
33.MarkS.Barber,testimonybeforetheFCIC,HearingontheShadowBankingSystem,day2,ses-
sion3:InstitutionsParticipatingintheShadowBankingSystem,May6,2010,transcript,p.263.
36.InternationalMonetaryFund,InternationalFinancialStatisticsdatabase,WorldExports.
37.InternationalMonetaryFund,InternationalFinancialStatistics,WorldTables:Exports,WorldEx-
ports.
38.JaneLevere,OfficeDeals,19MonthsApart,ShowMarketsMove,^ew York Times, August10,
2010.
39. National Association of Realtors, Commercial Real Estate Quarterly Market Survey, December
2010,pp.4,3.
40.BrianGordon,principal,AppliedAnalysis,testimonybeforetheFCIC,HearingontheImpactof
theFinancialCrisisStateofNevada,session3:TheImpactoftheFinancialCrisisonNevadaRealEs-
tate,September8,2010,transcript,p.133.
41.AntonTroianovski,HighHopesasBuildersBetonSkyscrapers,Vall Street journal, September
29,2010.
42. Ibid.; Gregory Bynum, president, Gregory D. Bynum & Associates, Inc., testimony before the
FCIC, Hearing on the Impact of the Financial CrisisGreater Bakersfield, session 3: Residential and
CommunityRealEstate,September7,2010,transcript,pp.7780,7778.
43.FederalDepositInsuranceCommission,FailedBankList,January2,2010.
44.FebruaryOversightReport,CommercialRealEstateLossesandtheRisktoFinancialStability,
CongressionalOversightPanel,February10,2010,pp.2,41,43.
43.TreppWire,CMBSDelinquencyRateNears9,Up21BPsinAugustafterLevelinginJuly,Rate
Now8.92MonthlyDelinquencyReport,September2010,p.1.
46.AllenKenney,CREMortgageDefaultRatetoDoubleby2010,REIT.com,June18,2009.Seealso
DefaultRatesReach16-YearHigh,GlobeSt.,February24,2010.
47.Ibid.GreenStreetAdvisors,CommercialPropertyValuesGainMoreThan30from09Lows,
December2,2010,pp.3,1.
630 Notes to Chapter 21
48.Moodys/REALCommercialPropertyPriceIndices,December2010,MoodysInvestorsService
SpecialReport,December21,2010;MoodysInvestorsService,USCommercialRealEstatePricesRise
1.3inOctober,December20,2010.
49. Congressional Oversight Panel, Commercial Real Estate Losses, February Oversight Report,
February10,2010,pp.23.
30.Dr.KennethT.Rosen,chairman,FisherCenterforRealEstateandEconomics,UniversityofCali-
forniaatBerkeley,slidesintestimonybeforetheFCIC,FirstPublicHearingoftheFCIC,day1,panel3:
FinancialCrisisImpactsontheEconomy,January13,2010.
31. Elizabeth McNichol, Phil Oliff, and Nicholas Johnson, States Continue to Feel Recessions Im-
pact,CenteronBudgetandPolicyPriorities,December16,2010.
32.BruceWagstaff,SacramentoCountywideServicesAgency,testimonybeforetheFCIC,Hearingon
theImpactoftheFinancialCrisisSacramento,session4:TheImpactoftheFinancialCrisisonSacra-
mentoNeighborhoodsandFamilies,September23,2010,transcript,p.234.
33.SujitCanagaRetna,interviewbyFCIC,November18,2010.
34.McNichol,Oliff,andJohnson,StatesContinuetoFeelRecessionsImpact.
33.NCSLFiscalBrief:ProjectedStateRevenueGrowthinFY2011andBeyond,NationalConfer-
enceofStateLegislatures,September29,2010,p.1.
36.Ibid.
37.StateofCalifornia,LegislativeAnalystsOffice,The201112Budget:CaliforniasFiscalOutlook.
38.KaiserCommissiononMedicaidandtheUninsured,MedicaidEnrollment:December2009Data
Snapshot,September2010,pp.1,3.
39.KaiserCommissiononMedicaidandtheUninsured,HopingforEconomicRecovery,Preparing
for Health Reform: A Look at Medicaid Spending, Coverage and Policy Trends, September 30, 2010,
pp.16,23.
60.NationalLeagueofCities,RecessionsEffectsIntensifyinCities,October6,2010.
61.ChristopherW.HoeneandMichaelA.Pagano,CityFiscalConditionsin2010,NationalLeague
ofCities,October2010,p.3.
62.Ibid.,pp.7,2.
63.AlanS.BlinderandMarkZandi,HowtheGreatRecessionWasBroughttoanEnd,MoodysAn-
alytics,July27,2010,p.1.
64.DonaldL.Kohn,vicechairman,FederalReserveBoardofGovernors,TheFederalReservesPol-
icy Actions during the Financial Crisis and Lessons for the Future, speech at Carleton University, Ot-
tawa,Canada,May13,2010.
63. U.S. Department of the Treasury, Office of Financial Stability, 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,
Table1.1SummaryofReceipts,Outlays,andSurplusesorDeficits():17892013,TotalBudgetDeficit.
68.FDIC,FailedBankList.
69.QuarterlyBankingProfile:ThirdQuarter2010,FDIC Quarterly 4,no.4(2010):4.
70. FDIC, Quarterly Banking Profile: First Quarter 2009, FDIC Quarterly 3, no. 2 (2009): 1, and
QuarterlyBankingProfile:FirstQuarter2010,FDIC Quarterly 4,no.2(2010);BoardofGovernorsof
theFederalReserveSystem,ProfitandBalanceSheetDevelopmentsatU.S.CommercialBanksin2009.
71.FDIC,StatisticsonDepositoryInstitutions,IncomeandExpense,AllCommercialBanksAssets
more than $1BNational, Standard Report #1 (reports issued on 3/31/2010 and 3/31/2009). Profit is
loggedasNetincomeattributabletobank.
72.FDIC,StatisticsonDepositoryInstitutions,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 Sharply in 2009, New York State Comptroller Thomas P. DiNapoli
pressrelease,February23,2010.
74.N.Y.StateComptrollerThomasP.DiNapoli,EconomicTrendsinNewYorkState,October2010.
631 Notes to Chapter 22
Chapter 22
1.FCICcalculationsbasedonestimatesfromHopeNowandMoodys.com.
2.MortgageBankersAssociationNationalDelinquencySurvey(thesourcefortherestofthedelin-
quencyandforeclosureratesinthischapter).
3.JuliaGordon,CenterforResponsibleLending,HAMP,ServicerAbuses,andForeclosurePreven-
tion Strategies, testimony before the Congressional Oversight Panel for the Troubled Asset Relief Pro-
gram(TARP),COPHearingonTARPForeclosureMitigationPrograms,111thCong.,2ndsess.,October
27,2010,pp.3,30;CRLtestimonybasedonRodDubitsky,LarryYang,StevanStevanovic,andThomas
Suehr, Foreclosure Update: Over 8 Million Foreclosures Expected, Credit Suisse (December 4, 2008),
andJanHatziusandMichaelA.Marschoun,HomePricesandCreditLosses:ProjectionsandPolicyOp-
tions,GoldmanSachsGlobalEconomicsPaper(January13,2009),p.16.
4.RealtyTracYear-EndReportShowsRecord2.8MillionU.S.PropertieswithForeclosureFilingsin
2009AnIncreaseof21Percentfrom2008and120Percentfrom2007,RealtyTrac,January14,2010.
3.DelinquenciesandLoansinForeclosureDecrease,butForeclosureStartsRiseinLatestMBANa-
tionalDelinquencySurvey,MBApressrelease,November18,2010.
6.MarkFleming,chiefeconomist,CoreLogic,testimonybeforetheFCIC,HearingontheImpactof
theFinancialCrisisSacramento,session1:OverviewoftheSacramentoHousingandMortgageMar-
ketsandtheImpactoftheFinancialCrisisontheRegion,September23,2010,transcript,p.14.
7.FCICstaffestimatesbasedonanalysisofBlackBoxdata.
8.LaurieS.Goodman,seniormanagingdirector,AmherstSecuritiesGroupLP,writtentestimonybe-
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.NewCoreLogicDataShowsThirdConsecutiveQuarterlyDeclineinNegativeEquity,CoreLogic
Inc.,December13,2010,p.1;nationally,third-quarterfigureswereanimprovementfrom11.0million
residentialproperties23innegativeequityinthesecondquarterof2010.
11.JimRokakis,treasurerofCuyahogaCounty,Ohio,interviewbyFCIC,November8,2010.
12.CuyahogaCountyexperienced13,943foreclosurefilingsin2006,14,946in2007,13,838in2008,
and14,171in2009.OhioCountyForeclosureFilings(19932009):CuyahogaCounty,PolicyMatters
Ohio.
13.Rokakis,interview.
14.TheUnitedStatesConferenceofMayors,ImpactoftheMortgageForeclosureCrisisonVacant
andAbandonedPropertiesinCities:A77-CitySurvey,June2010,pp.34.
13.GuyCecala,preparedtestimonyfortheCongressionalOversightPanelfortheTroubledAssetRe-
liefProgram(TARP),COPHearingonTARPForeclosureMitigationPrograms,111thCong.,2ndsess.,
October27,2010,p.2.
16.JohnTaylor,interviewbyFCIC,October27,2010.
17.CongressionalOversightPanel,DecemberOversightReport:AReviewofTreasurysForeclosure
PreventionPrograms,December14,2010,pp.4,7,18.
18.HOPENOW,IndustryExtrapolationsandMetrics(October2010),December6,2010,p.3.
19. New Jersey HomeKeeper Program, New Jersey Housing and Mortgage Financing Agency, ap-
provedSeptember23,2010.
20. Kirsten Keefe, presentation to the meeting of the Federal Reserve Systems Consumer Advisory
Council,Washington,D.C.,March23,2010,transcript,p.34.
21. Diane E. Thompson, testimony 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,WhyServicersForecloseWhenTheyShould
ModifyandOtherPuzzlesofServicerBehavior,October2009.
632 Notes to Chapter 22
23.JosephH.Evers,OfficeoftheComptrolleroftheCurrency,deputycomptrollerforlargebanksu-
pervision,writtentestimonybeforetheCongressionalOversightPanelfortheTroubledAssetReliefPro-
gram(TARP),COPHearingonTARPForeclosureMitigationPrograms,111thCong.,2ndsess.,October
27,2010,pp.710.TheOCCreportedthatmortgageservicershavemodified1,239,896loanssinceearly
2008.Bytheendofthesecondquarterof2010,morethan26ofthemodificationswereseriouslydelin-
quent; 9 were in the process of foreclosure; and 4 had completed foreclosure. The OCC examined
modified loans that were 60 or more days delinquent that were modified during the second quarter of
2009,todeterminewhenafterloanmodificationthatseriousdelinquencyrecurred.At12monthsafter
modification,43ofloansweredelinquentbytwoormoremonths;atninemonthsaftermodification,
41wereinarrears;atsixmonths,34;andatthreemonthsafteraloanchange,nearly19weredelin-
quent.TheOCCnotedthatmorerecentmodificationshaveperformedbetterthanearliermodifications.
24.JuliaGordon,seniorpolicycounsel,CenterforResponsibleLending,writtentestimonybeforethe
CongressionalOversightPanelfortheTroubledAssetReliefProgram(TARP),COPHearingonTARP
ForeclosureMitigationPrograms,111thCong.,2ndsess.,October27,2010,p.11.
23.DavidJ.Grais,partnerwithGrais&EllsworthLLP,interviewbyFCIC,November2,2010.
26.CalculationbyLaurieGoodman,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.GoodmantestimonybeforetheHouseFinancialServicesCommittee,December8,2009.
29. See Deposition of Jeffrey Stephan, GMAC Mortgage LLC v. Ann M. Neu a/k/a Ann Michelle
Perez,No.302008CA040803XXXXMB(Fla.Cir.Ct.Dec.10,2009),pp.7,10.
30. See, for example, Dwayne Ransom Davis and Melisa Davis v. Countrywide Home Loans, Inc.;
Bank of America, N.A.; BAC GP LLC; and BAC Home Loans Servicing, LP, 1:10-cv-01303-JMS-DML
(S.D.Ind.October19,2010).
31. Congressional Oversight Panel, November Oversight Report: Examining the Consequences of
MortgageIrregularitiesforFinancialStabilityandForeclosureMitigation,November16,2010,p.20.
32.See,e.g.,Mortg.Elec.RegistrySys.v.Johnston,No.420-6-09Rdcv(RutlandCo.Vt.Super.Ct.Oct.
28,2009),holdingthatMERSdidnothavestandingtoinitiateforeclosurebecausethenoteandmortgage
hadbeenseparated.
33.TheHonorableF.DanaWinslow,writtentestimonybeforetheHouseCommitteeontheJudiciary,
Foreclosed justice. 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.May20,2010),p.3.Theor-
der cites In re Foreclosure Cases, 321 F. Supp. 2d 630 (S.D. Oh. 2007); In re Vargas, 396 B.R. 311, 320
(Bankr.C.D.Cal.2008);LandmarkNatlBankv.Kesler,216P.3d138(Kan.2009);LaSalleBankv.Lamy,
824N.Y.S.2d769(N.Y.Sup.Ct.2006).
33.Winslow,writtentestimonybeforetheHouseCommitteeontheJudiciary,pp.23.
36.SeeJohnT.Kempv.CountrywideHomeLoans,Inc.,CaseNo.08-18700-JHW(D.N.J.),pp.78.
37.Grais,interview.
38.AdamJ.Levitin,associateprofessoroflaw,GeorgetownUniversityLawCenter,testimonytoSen-
ateCommitteeonBanking,Housing,andUrbanAffairs,Problems in Mortgage Servicing from Modifica-
tion to Foreclosure, 111thCong.,2ndsess.,November16,2010,p.20.
39.CongressionalOversightPanel,NovemberOversightReport,pp.3,7.
40.KatherinePorter,professoroflaw,UniversityofIowaCollegeofLaw,writtentestimonybeforethe
CongressionalOversightPanelfortheTroubledAssetReliefProgram(TARP),COPHearingonTARP
ForeclosureMitigationPrograms,October27,2010,p.8.
41.Levitin,writtentestimonybeforetheSenateCommitteeonBanking,Housing,andUrbanAffairs,
p.20.
42.ErikaPoethig,writtentestimonyfortheHouseSubcommitteeonHousingandCommunityOp-
portunity, Impact of the Foreclosure Crisis on Public and Affordable Housing in the Twin Cities, 111th
Cong.,2ndsess.,January23,2010,p.3.
633 Notes to Chapter 22
43.NationalAssociationfortheEducationofHomelessChildrenandYouth(NAEHCY)andFirstFo-
cus,ACriticalMoment:ChildandYouthHomelessnessinOurNationsSchools,July2010,p.2.Inearly
2010,NAEHCYandFirstFocusconductedasurveyof2,200schooldistricts.Whentheywereaskedthe
reasons for the increased enrollment of students experiencing homelessness, 62 cited the economic
downturn,40attributedittogreaterschoolandcommunityawarenessofhomelessness,and38cited
problemsstemmingfromtheforeclosurecrisis.
44.Dr.HeathMorrison,testimonybeforetheFCIC,HearingontheImpactoftheFinancialCrisis
StateofNevada,session4:TheImpactoftheFinancialCrisisonNevadaPublicandCommunityServices,
September8,2010,transcript,pp.26164.
43. Gail Burks, testimony 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 testimony for the FCIC, Hearing on the Impact of the Financial CrisisSacramento,
session2:MortgageOrigination,MortgageFraudandPredatoryLendingintheSacramentoRegion,Sep-
tember23,2010,p.12;oraltestimony,p.66.
47.DawnHunt,homeownerinCapeCoral,FL,interviewbyFCIC,December20,2010.
48.Zipcode33991,default,foreclosuresandREO,S&PGlobalDataSolutionsRMBSdatabase,July
2010.
49.Hunt,interview.
INDEX
Theindexisavailableonlineatwww.publicaffairsbooks.com/fcicindex.pdf